Transcript Contents of the course - Solvay Brussels School

International Finance
2003-2004
Pr. Ariane Chapelle
[email protected]
site : http//solvay.ulb.ac.be/cours/chapelle
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Contents of the Course
 Introduction : The International Financial Environment
 Part 1 : Fundamentals of International Finance
Exchange rate determination
Purchasing power parity and interest parity relations
Exchange rate determination : overshooting & portfolio
models
Exchange rate management and targets
The case for flexible exchange rates
Exchange rate management : operation and problems
Monetary integration in the European Union
The IMF and the provision of finance
A critique of the IMF approach
International debt crisis
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 Case study : following and commenting the exchange rate evolution
Contents of the Course
 Part 2 : International Corporate Finance
Foreign Exchange Exposure (2 hrs):
Transaction exposure
Operating exposure + decision case
Financing the Global Firm (2 hrs):
Sourcing equity globally
Financial structure and international debt
Foreign Investment Decision (4 hrs) :
FDI theory and strategy
Multinational capital budgeting
Adjusting for risk + decision case
Managing Multinational Operations (4 hrs)
International tax management
Repositioning funds
Working capital management + decision case
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Contents of the Course
Reference textbooks
Copeland, L., Exchange rates and International Finance
3rd edition, Prentice Hall ed., 2000.
Moffet, M., Stonehill, A. and Eiteman, D., Fundamentals
of Multinational Finance, Addison Wesley ed., 2003.
 Other references
Gibson, H. International Finance, Longman ed., 1996.
De Grauwe, P., The Economics of Monetary Union,
Oxford University Press ed., 2003.
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The international financial system
Introduction
Different forms of exchange rates organisation :
fixed
floating
managed
monetary unions
Questions of
adjustment of the balance of paiements
liquidity provision in the system
international money definition and usage
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The international financial system
 Impossible Trinity :
Exchange rate stability
Full financial integration (free capital flows)
Monetary independence
Full Capital Controls
Monetary
Independence
Pure float
Exchange rate
stability
Impossible
Trinity
Full Financial
Integration
Is there a best system?
What design of institutions?
Monetary Union
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The international financial system
International money
Characteristics : International money should be :
defined
convertible
inspire confidence
store of value
Summary issues & concerns of financial markets
Adjustments of the BOP
Provision of liquidity
-> 4 different systems address these 2 issues.
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The adjustment issue
 General idea : FX rates are adjusted so that the BOP is in
equilibrium
 Balance of Payments (BOP) - Definition :
Balance of paiements : sum of all the transactions between the
residents of a country and the rest of the world
BOP = current account balance + capital account + financial
account + changes in reserves
BOP = (X - M) + (CI - CO) + (FI - FO) + FXB
Current account = exports - imports of goods & services
Capital account = capital inflows - capital outflows = capital
transfers related to purchase and sale of fixed assets.
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The adjustment issue
 Balance of Payments (BOP) - Definition :
Financial account = financial inflows - financial outflows =
net foreign direct investments + net portfolio investments
Current + Capital + Financial accounts = Basic balance
FXB : changes in official monetary reserves (gold, foreign
currencies, IMF position)
 Current account balance (X-M)
In equilibrium : X-M = 0
Deficit country : X-M < 0
Surplus country : X-M > 0
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The adjustment issue
Domestic price of
foreign exchange
Supply of foreign exchange (brought by X)
= D of domestic curr.
Seq
Deficit M > X
X
M
Demand for foreign exchange(brought by M)
= S of domestic curr.
Q of foreign exchange
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The adjustment issue
 Deficit country (current account deficit)
X - M < 0 : too many imports compared to exports
Money supply > money demand (in domestic currency)
Too large amount of domestic currency : deflationary
pressures
 Surplus country (current account surplus)
X - M > 0 : too many exports compared to imports
Money demand > money supply (in domestic currency)
Lack of domestic currency : inflationary pressures
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The adjustment issue
 Possible policies for a deficit country :
let the FX rate depreciate and restore competitiveness,
leading to a rise in X and a reduction in M (if FX rates are
floating)
reduce the stock of money by direct intervention : buy
domestic currencies against foreign currencies held in
monetary reserves (if FX rates are fixed)
increase interest rates to attract capital inflows (financing the
deficit) and to reduce demand for imports (monetary view)
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The adjustment issue
 Possible policies for a surplus country :
let the FX rate appreciate and decrease competitiveness, leading
to a reduction in X, and an increase of M
increase the supply of money by direct intervention : sell
domestic currencies and buy foreign currencies, growing the
monetary reserves, to avoid FX appreciation
increase the supply of money and sterilise to avoid a price
rise : exchange M1 and M3 : sell government bonds against
domestic currencies.
lower interest rates to discourage capital inflows (increase
outflows) and to reduce financial surplus
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The adjustment issue
The deficit is not dependant of the exchange rate (in theory)
In practice, however :
prices and wages are sticky
some regional shocks can create asymmetric disequilibrium
large players like government and financial insitutions
influence equilibrium
Problem of adjustments : central concern of government
-> need for design of institutions
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The international financial system
International Financial systems - 4 types :
Automatic mechanisms
Pure floating rates : between the two World Wars
Pure fixed exchange rates : gold period
(N-1) Systems
N countries linked to gold : a large country, its currency =
international money
N-1 countries linked to N = fixed exchange rate regime :
Bretton Woods
Policy coordination & Multilateral mechanisms : SME
Monetary union : EU
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Automatic Mechanisms
Automatic mechanisms:
2 mechanisms can be defined as fully automatic :
freely floating exchange rate system
fully fixed commodity standard
Freely floating : no BOP problem : any disequilibirum leads
to automatic adjustment of exchange rates.
Automatic market mechanism of the demand / supply
market for foreign exhange.
Demand curve for foreign exchange (D) derives from the
desire of domestic residents to purchase foreign goods,
services and assets.
D is negatively related to exchange rate (S).
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Automatic Mechanisms
Domestic price of
foreign exchange
Depreciation
Supply of foreign
exchange
S0
S1
Demand for
foreign exchange
Q of foreign exchange
S = FX rate = amount of domestic currency per one unit of foreign
currency. Ex. €/$ = S for Europeans.
A depreciation of the domestic currency = a rise in S.
Ex. S0= 1, S1 = 0.9.
S1 : excess of demand= deficit of BOP (too many imports). A
depreciation makes foreign goods more expensive, and D
decreases to equilibirum.
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Automatic Mechanisms
Automatic mechanisms:
Full floating rates :
liquidity in the system is unnecessary provided adjustment
occurs immediatly
international money is not explicitly specified; a few
currencies will be widely used as international means of
payment.
Fully fixed commodity standards
Main characteristics : fiduciary money is backed by a
particular commodity (ex. Gold)
The ratio of fiduciary money to the reserves of the
commodity is fixed, and the monetary authorities garantee
free convertibility.
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Automatic Mechanisms
 Fully fixed commodity standards
All countries set a fixed price between their national currency
and the commodity
All currencies are tied together -> exchange rates are fixed.
The international money is the commodity.
BOP disequilibira are eliminated by transfering the commodity
from the deficit country to the surplus country, leading to :
a contraction of the money supply in deficit country
an expansion of the money supply in the surplus country
leading to symmetrical adjustments
However, if the surplus country « sterilise » (do not expand the
money supply to prevent inflation), the system becomes
asymmetrical.
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Automatic Mechanisms
Automatic mechanisms - in practice:
Fully fixed commodity standards : the Gold Standard : 1870
- 1914 + short period in the 1920 ’s
Pre-World War I : « classical gold standard »
Inter-War period : « managed gold standard »
Not worked as in theory : currencies more considered as
international money; manipulation of interest rates by central
banks, sterilisation policies ; positive correlation of prices and
wages accross countries, whereas the opposite was expected.
The gold standard did not bring the price stability expected.
Gold discoveries played a role in explaining price movements.
Adjustment in bank credit (1/3 of the money) helped smooth
monetary growth.
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Automatic Mechanisms
Automatic mechanisms - in practice:
Full floating rates : the inter-war period
absences of co-operation and agreement on how the
international monetary system should be organised
desastrous consequences for the economies of individual
countries
played a role in the depth and length of the 30 ’s crisis
3 rounds of vane tentatives to bring monetary coordination
number of competitive depreciations between US and UK.
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The international financial system
Second type : (N-1) System
N countries
Nth country is linked to a commodity standard,
convertible at a fixed price.
All other currencies fixed to the Nth country
(N-1) exchange rates, fixed. Arbitrage occurs by buying
and reselling the commodity if the FX rate moves.
How adjustment occurs?
No automatic adjustment, no connection between money
and the commodity.
In principle, unadjusted countries should increase or
decrease their money supply to get back to equilibrium.
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(N-1) System
How adjustment occurs?
A deficit country (too many imports - too low foreign currency) :
should undertake a deflationary policy. Problem : prices and
wages are sticky.
A surplus country (too many exports - too high domestic
currency) : should reflate. Problem : less pressure for
adjustment. Tempted to build up their reserve of foreign
currencies (selling domestic currencies) and sterilise the impact
by selling domestic bonds (reducing back M to control inflation)
System that tends to create asymmetry.
No fixed ratio clearly defined between money supply and the
commodity.
No clear definition of the process deflation or reflation, leaving
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great room for discretion.
(N-1) System
Nth country
Is in a special position, that creates and 2d asymmetry.
Does not intervene in the foreign exchange markets. The (N-1)
countries maintain their chosen FX rate.
The BOP of the N countries should balance, so the Nth country
should accept whatever aggregate BOP the N-1 countries have.
The Nth country plays a key role in the provision of international
money and liquidity : its currency is the international means of
exchange.
It should be a large country, with a fairly closed economy.
The Nth currency should be acceptable as international money :
central Banks should be confident in its value.
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(N-1) System - in practice
 Bretton Woods (1944 - 1971)
US as the most powerful nation after the War, keen to ensure
access to foreign markets for its goods.
Europe and Japan physically devastated, seeking access to
international credit.
Huge recycling problem of funds collected in the US, to rebuild
Europe and Japan.
Bretton Woods agreement (July 1944) negociated between US
and Europe (essentially UK).
UK representative : John Maynard Keynes.
US representative : Harry Dexter White.
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(N-1) System - in practice
 Bretton Woods (1944 - 1971)
Agreement on the need for greater fixity of exchange rates.
Disagreements over :
the question of financial flows
the problem of recycling
White proposal :
creation of a fund to help maintain BOP and encourage
international trade.
Aim : eliminate control on trade flows and restrictions on
foreign exchange transactions.
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(N-1) System - in practice
Keynes ’ proposal :
creation of a recycling mechanism to allow deficit countries
to finance their development without the need to resort to
trade restrictions.
concerned about the risk of surplus countries to exert a
deflationary pressure on the world economy.
Proposed to create a international Clearing Union which
would receive funds from surplus countries, and would lend
them to deficit countries.
Recycling would be automatic and deflation avoided.
Final agreement was much closer to White ’s proposal.
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(N-1) System - in practice
 Bretton Woods : (N-1) system where the US is the Nth country.
 Relies on 5 main principles :
1. FX rate could fluctuate by max. 1%, and be reajusted only in
case of « fundamental disequilibrium »
2. Pool of currencies contributed by members countries to help
deficit countries funding their temporary disequilibrium, in a
regime of fixed FX rates.
3. The trading system should be open. Principle of free trade.
Desire to dismantle protectionism and restore convertibility, at
least for trade reasons.
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(N-1) System - in practice
 Bretton Woods : (N-1) system where the US is the Nth country.
4. Disequilibria of BOP was supposed to be the responsability of
both the deficit and the surplus countries, in a system tending
to produce asymmetry.
5. Design and set-up of institutions to support the exchange rate
organisation : IMF, IBRD, GATT.
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Bretton Woods - two periods
 1945 - 1959 : reconstruction
Setup of the Marshall Plan : US gave $4-$5 billions a year to
European countries between 1948 - 1951.
Set-up of the European Paiement Union (EPU) to organise trade
witihin Europe and gradually restore convertibility.
 1959 - 1971 : Bretton-Woods into action
End of the EPU and convertibility restored.
Achievements : stability of exchanges rates, availability of
foreign exchange for current transactions, rapid growth of trade,
marcoeconomic stability.
Problems gradually occurred in the adjustement proces : speed
of adjustment insufficient, and asymmetrical.
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Bretton Woods - two periods
 1959 - 1971 : Bretton-Woods into action
Prices stickiness downward, but flexibility upwards.
In the 1960 ’s : increasing deficit in the US, UK and France.
Surplus in Switzerland and Germany.
Growing loss of confidence in the $, likely to be devalued.
1971 : end of the Bretton-Woods agreements
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The international financial system
 Third type : Policy co-ordination
This category : all the attempts to co-ordinate policy and
manage exchange rates.
 Two sources of BOP disequilibria :
Exogenous shocks : if they are asymmetric
Ex. Rise in oil prices : deficit for importing, surplus for
exporting countries) -> large BOP disequilibria to adjust.
Incompatible policies pursued by individual countries.
Ex.: a number of countries pursuing a deflationary policy
to reduce inflation, will end up running a surplus, and
create deficit of trade balance in countries trying to expand
their economy.
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Policy co-ordination
In theory :
The more flexible the exchange rate, the more easily
countries can adjust to asymmetric shocks and the
greater is the opportunity for countries to pursue their
own policies.
Automatic adjustments through floating rates.
However:
Need for policy co-ordination since adjustements are
imperfect.
Need for international liquidity to help smooth the
process and finance the disequelibria.
See further.
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Policy co-ordination - in practice
 Managed float 1971 - present
Smithsonian agreement : 1971 - 1973 : after Bretton Woods,
attempt to peg European currencies to the dollar.
After 1973 : managed float for major currencies : $, Yen,
Sterling.
Co-operative arrangements under the European Monetary
System.
However, still highly volatile exchange rates over this period,
both nominal and real.
Floating exchange rates did not appear to solve the
adjustment issue, with persistent large surplus of Japan and
Germany, and large deficits of the US.
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The international financial system
 Fourth type : Monetary union
Individual currencies eliminated : common currency adopted.
The union currency is the international money.
BOP disequilibria no longer exist (in their usual form) : BOP
problems become regional problems.
See further.
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