Title: Currencies and capital flows
1Currencies and capital flows
- Monetary issues more important
- Internal and external balance
- The international monetary system
2Monetary issues more important
- Increasing capital mobility
- long run possible to finance more investment
- short run volatility? Daily turnover in intl
forex markets at least USD 1,500 billion - Increasingly volatile exchange rates
- larger fluctuations than in underlying real
variables (trade, production) - Institutional consequences
3Conceptual framework
- Accounting identities
- Y C I X - M
- Y - C - I X - M
- S - I X - M
- Internal balance External balance
4Conceptual framework
- More complicated, with government
- (Sp T) - (Ip G) X - M
- T government savings (taxes)
- G government investment (expenditure)
5Conceptual framework
- International macroeconomics
- S - I X - M
- Employment Current account
- Growth Exchange rates
- Interest rates Capital inflows
- Govt budget
- Inflation
6The international monetary system
- Historical development of solutions to reconcile
internal and external balance - Not only choice of currency arrangement (fixed or
flexible exchange rates) but also regulation of
trade and capital flows (current account and
capital account regulations)
7Schedule
- Gold standard ( - 1914)
- Interwar period (1920 - 1939)
- Bretton Woods (1945 - 1973)
- Post-Bretton Woods (1973 - )
- European solutions
- Developing countries
- New financial architecture
8Gold standard
- Established in Western Europe during 1870s (in
Great Britain in 1717) - Extended to rest of the world by 1900
- Stable exchange rates contributed to first round
of internationalization... - but free trade and capital flows also
contributed to success of gold standard
9How did the gold standard work?
- Price-specie flow model (Hume 1752)
- trade deficit gt outflow of gold gt
- lower money supply and lower prices gt
- improvement in competitiveness gt
- new equilibrium
- increase in discount rate speeds up price
adjustment without gold transfers
10Why did the gold standard work?
- Political commitment to converitibility
- no doubts about priorities
- weak labor interests
- flexible prices and wages
- Free trade and free capital mobility
- leading country - Great Britain - recycled
surpluses by lending to infrastructure
development. - International cooperation - but still unstable at
the periphery
11Interwar period
- War expenditures so large that gold
convertibility was abandoned - soldiers and
suppliers paid with fiat money. Only USD remained
convertible into gold. - Widely diverging exchange rates because of
differing rates of inflation - Floating rates until mid-1920s
- Differences in new gold parities
12Interwar period
- Weak-currency countries attempts to get close to
old gold parities (Britain) - Strong-currency countries new parities close to
floating rates (France) - Weak countries in chronic BoP deficits, strong
countries with persistent surpluses
13Interwar period
- Changing political environment reduced absolute
commitment to convertibility - democratization and stronger labor intersts
- burden of reconstruction
- Great Depression end of gold standard
- primary product exporters hurt by lower prices
and reduced capital flows - bank failures in Europe drained gold reserves
capital controls, end of convertibility,
protectionism
14Lessons from interwar period
- Unquestionable commitment to convertibility
central issue - if yes international capital flows will
facilitate equilibrium - if no speculation will aggravate imbalances
15The Bretton Woods system
- Comprehensive solution negotiated after 2nd World
War - Strong institutional basis
- ITO
- IBRD
- IMF
16Bretton Woods
- Fixed but adjustable exchange rates
- Capital controls
- IMF for monitoring and BoP financing
- Current account controls until 1959 to facilitate
post-war expansion - Intervention interest rate controls, no capital
account convertibility
17Main objective free trade
- To create conditions for rapid increase in
international trade - Controls necessary because full employment had
become new policy goal little room for
deflationary policy - Last line of defence adjustment of peg
18Problems with Bretton Woods
- Asymmetry
- US leading power. Deficits could always be
financed with USD. Could be too expan-sionary
(inflation) or restrictive (deflation) - Liquidity needs
- expansionary policies low interest rates
fixed exchange rates gt need for financing - Unwillingness to change peg
- Fund approval required, only ex post adj.
- destabilizing, admission of past mistakes?
19Bretton Woods collapse
- Attempts to save system
- central bank collaboration, Gold Pool
- US policies to tighten capital controls
- Still, too much USD in circulation
- Vietnam war
- Suspension of USD gold convertibility 13 August
1971, Smithsonian broad-band agreement - USD devaluation, wider bands, finally collapse of
fixed rates in 1973
20Why did Bretton Woods collapse?
- No credible political commitment to fixed rates
(or gold convertibility) - lower price and wage flexibility
- Pressure from increasing international capital
flows - current account convertibility reduces impact of
capital controls - increase in FDI
- Warming of cold war
- less international collaboration
21Post-Bretton Woods
- Two solutions
- Large countries floating rates
- external trade small share of GDP
- Small countries pegged rates
- much external trade, need to avoid excessive
volatility - capital controls, particularly in developing
countries
22Floating rates 1970s
- Some volatility, but surprising stability in
spite of oil crises and commodity shocks - concerted intervention by central banks
- remaining capital controls used extensively
- Willingness to adapt domestic policies to
maintain external balance (justified by external
crises?) - Main problem inflation
- money creation by central banks to finance
expansionary policies
23Floating rates 1980s - volatility
- US policy driven by domestic agenda
- Reagan tax cuts, military spending, budget
deficits, high demand - Fed chairman Volcker interest rate increases to
keep inflation in bounds - capital inflows and USD appreciation
- Severe consequences
- Latin American debt crisis
- widening US current account deficit and
protectionist pressures
24Floating rates 1980s - solutions
- Plaza agreement September 1985
- G-5 statement regarding orderly appreciatíon of
non-dollar currencies - rapid dollar depreciation
- Louvre meeting February 1987
- problem excessive depreciation of USD
- ambition to stabilize exchange rates and instead
adjust domestic policies expansion in Japan and
Europe, contraction in US - little internal adjustment in the US contd
overvaluation in Europe (and Japan)
25Meanwhile in Europe pegged rates
- 1970 Werner plan (EMU) failed
- Bretton Woods collapse and EC expansion
- 1971 agreement about bilaterally pegged EC rates
Snake in the tunnel - 1973 collapse of Smithsonian tunnel Snake in the
lake - But Snake very troubled
- oil shocks but no harmonization of economic
policies - asymmetry Bundesbank dominant
261979 European Monetary System
- Attempt to create symmetric system with
harmonization - Exchange Rate Mechanism (ERM) to fix rates within
set bands - European Monetary Fund (EMF) for BoP financing
and monitoring of policies - Tough start
- remaining policy divergence - expansion in
France, contraction in Germany - big threat - French thoughts of leaving EC in 1983
27The European Monetary System
- More stable development after 1983 as oil shocks
ebb out - Fundamental inconsistencies emerging
- EMS reduced scope for macro policy
- instead, micro policies to affect social
objectives wages, job security, benefits - problem reduced labor market flexibility and
Eurosclerosis - Proposed solution EU Single Market and EMU
28Problems with EMS
- Single Market program included free capital
mobility - but free capital mobility led to larger
imbalances and made it hard to maintain fixed
exchange rates before EMU - several shocks in early 1990s German
reunification, Gulf war, global recession - EMS crisis in 1992
- Danish no to Maastricht led to doubts about
commitment and currency crises
29Economic and Monetary Union
- Need to establish ultimate peg a common currency
- Convergence criteria to achieve enough domestic
adjustment - inflation
- interest rates
- budget deficit and public sector debt
- Apparent political commitment likely to succeed
- but what about USD/Euro rates?
30Developing countries
- Large financing needs
- investment essential for growth, but limited
domestic savings capacity - fluctuations in export incomes
- Fixed rates popular in 1970-80s
- nominal anchor to limit inflation
- Reasonably stable system up to late 1980s
- extensive capital controls helped insulate
domestic markets
31Developing countries
- Changing environment from mid-1980s
- Washington consensus liberalization of
international capital flows - private capital more important
- Temptation to borrow a lot
- but capital inflows are hard to combine with
fixed exchange rates - and are OK only if the strengthen economy
- warning for crisesLatin America(1980s), Mexico
(early 1990s), Asia (late 1990s)
32Anatomy of a crisis
- Increases in supply and demand of capital
- export boom, investment demand
- deregulation, improved availability of credits
- gt rising asset prices and inflation
- Appreciating real exchange rates
- weaker intl competitiveness, current account
deficits, foreign borrowing - Collapse when foreign confidence disappears
- no money, not funny
33Developing country crises worse than our own
crises because
- Weak banking supervision
- Lack of transparency
- Corruption and cronyism
- Weak human capital
- Industrial policy and development strategy
Korean example
34Differences between developing countries
- Middle-income countries have access to private
capital flows - problem capital account and volatility of
private flows - extreme solutions currency boards
- Low-income countries have little FDI and private
capital - problem current account and volatility of world
market prices of primary products
35Differences between developing countries
- Middle-income countries subject to IMF financing
- Argentina, Mexico, Indonesia, Russia, Korea
- Low-income countries more dependent on foreign
aid - but aid flows have fallen since mid-1980s
36Solutions for low-income countries HIPC
- WB/IMF program to support Highly Indebted Poor
Countries - main item debt reduction
- countries that are identified as HIPC are
required to undertake structural reforms
(exports, public revenue) - in return, external debt will be reduced to
sustainable levels (150 of annual export
revenue)
37New Financial Architecture
- Mainly relevant for middle-income countries
- Key words
- transparency and crisis prevention
- regulation and policies
- financing
38New Financial Architecture
- Information and transparency
- international reserves, foreign debt, NPLs
- fiscal transparency
- Regulation
- sound macro policies
- controls on capital inflows?
- prudent regulation of financial sector
- Financing
- IMF Contingency Credit Line (April 1999)
- remaining question lender of last resort?
39Summary
- Complex evolution of international financial
system - remaining problems mainly for LDCs
- Trend free capital mobility and problems to
maintain adjustable pegs - Consequences
- tough adjustment and protests
- industry localization new choice variable
- new instruments for improving domestic
competitiveness industrial policy