Transcript speculative

POL 4410: Week 7
International Finance
Structure
• TUESDAY:
1) Test
2) Capital Flows and Exchange Rates
• THURSDAY
1) Currency Crises
2) Currency Unions
3) Multinational Corporations
International Capital
• Capital flows are like any other factor
• ‘Returns’ to capital should equalize:
• Bonds
• Equities and Equity
• Real Estate
• Currency
Bonds
• Investment in foreign
governments
• Issued by a central bank
• Price of bonds can vary after
their issuing
• Price is inversely related to
‘yield’ or interest rates
• Arbitrage in bonds implies
equalization of interest rates
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Private Equity
Invest directly in a foreign private company or
investment scheme
Invest in foreign equities = public companies
abroad
Portfolio finance
MNC internal investment?
Real Estate
• Owning foreign real
estate means
purchasing assets
excluded from GDP
• Might do this for a
holiday home
• Or as a rental
property (income
stream)
• Or... for speculative
Currency: FOREX
• Unlike other assets, currencies
do not promise stream of
returns.
• Like equities and real estate
there may be a speculative
reason to purchase them.
• Common practice to ‘long’ or
‘short’ currencies - which can
undermine or overvalue them.
Who does this?
• International Banks
• International Governments
• Hedge Funds
• Equity Funds
• Private Investors
Balance of Payments
• Current Account is the gap between
exports and imports.
• Capital Account is the gap between
purchases of foreign assets and foreign
purchases of domestic assets.
• US 1980s led to Japanese inward
investment
The Exchange Rate
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If interest rates differ substantially from
comparator states - lose capital inflows, lose
value in your currency.
Balance of payments problems because of
over-valued currency lead to currency
attacks by speculators.
You lose currency strength because of weak
capital inflows, or a run on the currency, or
both.
History of International
Finance
• International finances were originally
just denominated in gold. Think of
origins of balance of payments - gold
specie model.
• Now most currencies are floating and
capital can move into a broad array of
asset classes. Different types of BOP
problems.
International Monetary
System
• Footloose capital means exchange rate
stability is tough to maintain - hence
desire for currency unions.
• International Monetary Fund supposed
to act as a banker of last resort.
• But hedge funds and currency
speculators can trade rapidly in
enormous volume.
Mundell-Fleming
Conditions
• Only two of the following
three:
1) Fixed exchange rate
2) Open capital markets
3) Autonomous monetary
policy
• Why? Think through each
Graph of M-F
Dollars
per Euro
Undervalued $
Equilibrium Ex
Rate
Overvalued $
US $ return from
holding Euros
US Interest Rate
Rate of Return
Graph of MF (2)
Dollars
per Euro
Old Ex Rate
New Ex Rate
US $ return from
holding Euros
Old US IR New US IR
Rate of Return
Graph of MF (3)
Dollars
per Euro
New Ex Rate
Old Ex Rate
New US $ return
from holding
Euros
Old US $ return
from holding
Euros
US IR
Rate of Return
Currency Crises
• If investors believe your
currency is massively
overvalued they start to move
money abroad.
• Eichengreen estimates loss of
0.7% of GDP per annum.
• Problems: debt denominated in
foreign currency. Move from
spending more money than
you earn to less.
Banking Crises
• Foreign investors panic that
banking system is
unsustainable (or that
currency will collapse and
take down banks).
• Run on the banks leads to
banks calling in loans.
• Businesses cannot pay back
loans - bankruptcies.
• Lose 0.3% GDP per anunum
Eichengreen: Causes
1. Unsustainable Macroeconomic
Policies. Currency = too
expansionary to maintain peg.
Banking = bank takes bad public
debt
2. Fragile Financial Systems:
dependence on short term debt
3. Corporate and public sector
governance
4. Flaws in international markets
Benefits of Open Capital
(Wolf)
1. Individual freedom to send money
abroad
2. Import outside capital and expertise
3. Crises are not inevitable and rare in
OECD
4. People circumvent controls
5. Forces transparent governance of
finance
Asian Financial Crisis
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1997 speculators short the Thai
baht
Collapse of baht leads to
‘currency contagion’
Banking sectors collapsed in
Thailand, Malaysia, Korea,
Philippines, Indonesia
IMF recommended raising
interest rates to prevent currency
collapse - hurt economies
Causes of AFC
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Attempt to peg currencies was not credible
IMF failed to bailout states properly plus poor
advice
Banking sectors were cronyistic - lots of bad
debts
Reliance on short-term debt led banks to make
risky loans
Fear of FDI and long-run investment made
systems volatile
Solutions to Crises
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Eichengreen:
(1) Re-regulate financial markets
(2) Re-impose capital controls
(3) Create world currency
(4) Create Emerging Markets index
Scrap IMF / Rebuild IMF
Tobin Tax
Democracy, transparency, growth
Multinational
Corporations
• Big users of foreign currency. If they
need to pay for 5,000,000 Euros they
must swap dollars through bank or have
own currency traders (Kodak).
• Within own firm may trade in dollars but
will need to pay local suppliers
• Foreign Direct Investment: politically
advantageous or not?
The Product Cycle
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Raymond Vernon
New labor-saving technology started in
the USA because early innovation must
be close to market.
Standardization of technology permits
labor cost reduction by sending to
cheaper OECD states. Also adapt for
market.
Eventually LDCs take over
Exchange Policies
• Three main types of x-rate
1) Fixed exchange rate
2) Managed peg
3) Full flexibility
Fixed X-rate
• Gold standard
• Explicit fixed x-rate to dollar
• Dollarization
Flexible Peg
• Bretton Woods system
• European Monetary System
• East Asian Tigers
• China?
Total Flexibility
• Canada to United States
• Dollar to Euro to Yen
• How much flexibility can governments
stand?
Frieden on MundellFleming
• Capital mobility means that monetary
and fiscal policy are synonymous with
exchange rate policy.
• Monetary expansion = currency
devaluation
• Fiscal expansion = currency
appreciation
• Think about US in 1980s
Frieden (2)
• Specific vs. mobile capital
• Open capital markets favor mobile
capital and harm specific capital in
developed world. Thus sectors matter.
• Open capital markets favor specific
capital and harm mobile capital in
developing world.
Individual Preferences on
Finance
Frieden and USA
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Frieden predicts that mobile capital in USA will be
chief beneficiary and specific capital loses out in ACM
world.
Decline of old ‘specific’ sectors like autos. Rise of
finance. Finance now larger than manufacturing (27%
vs. 25%)
Meanwhile, dollar is overvalued. Who benefits?
Finance and real estate? Who loses? Exporters and
manufacturers / farmers -> outsourcing.
Monetary policy is flexible. Beneficiaries: real estate
and manufacturers / farmers. But how can it be so
flexible and dollar remain overvalued?
More on the USA
• Current dollar is weaker than two years
ago but still overvalued in terms of BOP.
• How is this sustained? Huge capital
account inflows. but why is capital
flowing to a capital-rich state like USA?
• Asian banks hold 1/2 US T-bills.
Massive capital inflows keep interest
rates down: boom in housing / rise in
DJIA.
Debt and the USA
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Debt
Broz
• How do countries signal low inflation to
international investotr?
• Developed states increasingly use
independent central banks.
• But who would believe that such a bank
is independent in an autocracy?
• Autocracies must peg currency instead.
Broz (2)
• Pegging and central banks are
substitute methods of ensuring
transparency to international investors.
• But central banks only work in
transparent political system.
• This means democracies should have
more macroeconomic flexibility in an
ACM world than autocracies.
Broz (3)
Broz (4)
Broz (5)
Broz (6)
Eichengreen and
• EMU emerged EMU
from Werner report 1970,
which had advocated fully fixed x-rates and
coordinated fiscal policies. Led to Snake then
ERM.
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1986 Single European Act: Delors report.
Remove capital controls, single central bank,
no fiscal harmonization.
1990 Maastricht treaty signed. Capital
mobility then coordinated monetary policy,
then fixed x-rates, then single currency.
EMU
• 1998 currencies fixed to one another.
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Euro existed non-physically from Jan 1
1999.
Currencies changed over to Euro Jan 1.
2002
European Central Bank, based in
Frankfurt, is sole setter of monetary
policy. 6 seats.
Stability and Growth Pact
Real exchange rates still exist. how?
Who is a member?
Concerns with EMU
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Rationale was transactions costs (0.4% of GDP) and
exchange rate risk (but already high stability). Maybe SEA
undermined ERM. This leads to political economy
explanation.
Why can all countries not just fix x-rates? Escape clause
problem.
Concern about asymmetric shocks. Is US economy better
integrated than Europe? Interest rate adjustment vs.
mobility adjustment.
Fiscal autonomy and specificity. Fiscal coinsurance.
Fiscal coordination: spillover effects?
EMU Expansion
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Eichengreen and Ghironi examine impact of
Central and East European entrants on EMU
Concern is about convergence of growth rates.
Likely a function of institutional reform.
Concern about banking crises in CEEs
Should loosen Stability and Growth Pact
Migration could help adjustment but will be low
Voting rights in ECB.
Next Week
• Development.
• Begin at the international level - World
Bank and IMF
• International Inequality
• Week after: development strategies at
the domestic level