Currencies and capital flows

1
Currencies and capital flows

• Monetary issues more important
• Internal and external balance
• The international monetary system

2
Monetary 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

3
Conceptual framework

• Accounting identities
• Y C I X - M
• Y - C - I X - M
• S - I X - M
• Internal balance External balance

4
Conceptual framework

• More complicated, with government
• (Sp T) - (Ip G) X - M
• T government savings (taxes)
• G government investment (expenditure)

5
Conceptual framework

• International macroeconomics
• S - I X - M
• Employment Current account
• Growth Exchange rates
• Interest rates Capital inflows
• Govt budget
• Inflation

6
The 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)

7
Schedule

• Gold standard ( - 1914)
• Interwar period (1920 - 1939)
• Bretton Woods (1945 - 1973)
• Post-Bretton Woods (1973 - )
• European solutions
• Developing countries
• New financial architecture

8
Gold 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

9
How 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

10
Why 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

11
Interwar 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

12
Interwar 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

13
Interwar 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

14
Lessons from interwar period

• Unquestionable commitment to convertibility
  central issue
• if yes international capital flows will
  facilitate equilibrium
• if no speculation will aggravate imbalances

15
The Bretton Woods system

• Comprehensive solution negotiated after 2nd World
  War
• Strong institutional basis
• ITO
• IBRD
• IMF

16
Bretton 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

17
Main 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

18
Problems 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?

19
Bretton 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

20
Why 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

21
Post-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

22
Floating 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

23
Floating 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

24
Floating 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)

25
Meanwhile 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

26
1979 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

27
The 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

28
Problems 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

29
Economic 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?

30
Developing 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

31
Developing 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)

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Anatomy 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

33
Developing 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

34
Differences 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

35
Differences 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

36
Solutions 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)

37
New Financial Architecture

• Mainly relevant for middle-income countries
• Key words
• transparency and crisis prevention
• regulation and policies
• financing

38
New 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?

39
Summary

• 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