Chapter 6: The International Monetary System and Balance of Payments

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Chapter 6 The International Monetary System
and Balance of Payments
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Lesson Outline

• The International Financial System
• 1929-1933 trade decline, Bretton Woods
• Comparing fixed and flexible exchange rates
• International Monetary Fund (IMF)
• Purpose, structure, performance
• International Debt
• Whos involved, history, Bolivias debt

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Lesson Outline

• Balance of Payments (BOP)
• purpose, uses, defining accounts, debits vs
  credits
• Applying Todays Material to Understanding the
  Prospects of Nations
• Interpreting international debt figures using GDP
  and export deflators
• Comparing international and domestic debt
• Interpreting BOP figures

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International Financial System (IFS)

• The IFS encompasses all those institutions
  involved in carrying out and/or monitoring
  international financial transactions.
• Two parts of the history of the IFS stand out
• The downward spiral in trade between 1929 and
  1933 and its harmful effects on worldwide
  economic growth
• The rise and fall of the Bretton Woods System

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The downward spiral of trade between 1929 and 1933

• See Figure 6.1, p. 158 in your textbook
• note the "vicious cycle" set in motion by
  competitive devaluation in national currencies
  and escalating import tariff levels
  ("beggar-thy-neighbour" policies described on pp.
  157-8 in your textbook)

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Bretton Woods

• Bretton Woods provided stability in exchange
  rates that helped international trade and
  investment flourish after WWII.
• Reasons for decline fall of Bretton Woods
• Increasing dollar holdings by foreigners
  undermined confidence that the US could honor its
  promise to exchange gold for US dollars
• "Tiffin paradox" arose, leading to 1971 collapse

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Comparing fixed and flexible exchange rate regimes

• Under flexible exchange rates currency prices
  adjust to clear the foreign exchange market.
  Under fixed exchange rates central banks
  intervene in foreign exchange markets to ensure
  that foreign exchange markets clear.
• Fixed exchange rates provide a lower level of
  foreign exchange risk (obviously) as long as a
  nation's central bank can prevent depreciation.
• Flexible exchange rates are an "unbreakable"
  system, as central banks do not need to use their
  foreign exchange reserves.

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International Monetary Fund (IMF)

• Purpose
• The IMF's primary responsibility is to oversee
  the international monetary system.
• Structure
• To join the IMF, countries must pay a deposit,
  called a quota. Quotas are important because
  they determine a countrys voting power within
  the organization, serve as part of a nations
  official reserves, and determine a countrys
  borrowing power from the IMF.

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International Monetary Fund (IMF)

• Rich nations have the largest quotas and
  therefore have power within the IMF. Developing
  nations are not happy about this.
• A country is allowed to borrow up to 25 of its
  quota from the IMF. Additional borrowings
  requires that countries agree to IMF
  conditionality.

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International Monetary Fund (IMF)

• Performance
• IMF conditionality means, practically speaking,
  that a nation seeking IMF assistance above and
  beyond its usually maximum allowed amount must
  agree to undertake a series of internal reforms
  before being granted more credit.

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International Monetary Fund (IMF)

• Performance
• Examples of changes the IMF often requires
  include limiting fiscal deficits, reducing
  inflation, closing bankrupt enterprises, opening
  up to foreign investment, reducing or eliminating
  price subsidies, privatization of public
  functions and assets, and limiting corruption,
  amongst others. The IMF has a very strong
  orientation towards pro-market, laissez faire
  policies in the conditions it sets for borrowing,
  according to many.

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International Monetary Fund (IMF)

• Performance
• IMF credit is very important to nations which are
  struggling with external (ie international)
  debt. Such nations often charge that IMF
  conditionality depresses their economies and
  effectively opens up opportunities for foreigners
  to capitalize on their temporary internal
  weaknesses.

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International Monetary Fund (IMF)

• Performance
• IMF conditionality often has, in fact, adversely
  impacted economic growth, which is why sometimes
  nations prefer not to seek IMF assistance when
  they can no longer meet their external
  obligations. However, the decision not to work
  with the IMF also has adverse effects, as if a
  nation cannot reach agreement with the IMF to
  work through problems it is facing, then
  international investors will tend to shun that
  country and international credit becomes very
  difficult and very expensive to arrange.

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International Monetary Fund (IMF)

• Performance
• On the other hand, the IMF has an extremely
  difficult task in assessing how to deal with
  nations which stubbornly refuse to engage in
  internal reforms that facilitate their own long
  term economic growth and which help them become
  reliable, paying members of the international
  community.

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International Monetary Fund (IMF)

• Performance
• Overall, the IMFs both boosters and detractors
  have good points to raise.
• Essentially, the reforms the IMF routinely
  prescribes have multiple effects and whether on
  balance the conditions it sets helps or hurts a
  country often hinge on external events over which
  neither the IMF nor the country directly involved
  have any control.

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International Debt

• Whos involved
• Creditors and lenders are directly involved, as
  well as monitoring institutions like the IMF and
  national treasuries and central banks.
• Its mostly developing nations which have large
  levels of international debt relative to their
  exports and GDP. Its mostly governments and
  commercial banks in the rich, industrialized
  nations that are creditors to developing nations.
  

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International Debt

• The relation between sovereign borrowers and
  their creditors is like that of partners in a
  three-legged race they can run, limp, or fall
  together, but they cannot part company.
• World Bank, World Debt Tables, 1983-84

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International Debt

• The earlier quote nicely captures the challenge
  of nations and lenders involved with
  international debt. There is no bankruptcy court
  for nations. And, the amounts involved in
  international lending to nations have
  historically been large enough, from the 1970s
  onwards, that large-scale forgiveness of
  outstanding sovereign debt by commercial banks
  has not been possible (nor would banks be likely
  to agree to it).

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International Debt

• A "catch-22"
• For nations with extensive international debts,
  payments drain cash needed to help their economy
  grow, but non-payment threatens the
  creditworthiness of the nation that defaults
• For commercial lenders, doing anything other than
  taking a hard line against forgiving loans would
  probably lead to multiple nations shirking loan
  obligations, shrinking bank equity. But,
  insisting on a perfect payment record can
  undermine a nation's future ability to pay back
  loan principal.

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International Debt

• So, banks have at times restructured loans to
  allow more up-front cash to debtor nations, while
  typically refusing requests to forgive any
  outstanding debt.
• This buys nations time and keeps banks out of
  bankruptcy court.

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Balance of Payments (BOP)

• Purposes
• Balance of payments statements are designed to
  measure and record all economic transactions
  between residents of one country and residents of
  all other countries during a particular time
  period.

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Balance of Payments (BOP)

• Uses of BOP information
• BOP statistics help identify emerging markets for
  goods and services.
• They can warn of possible new policies that may
  alter a countrys business climate, thereby
  affecting the profitability of a firms
  operations in that country.
• They can signal increased riskiness of lending to
  particular countries.

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Balance of Payments (BOP)

• Uses of BOP information
• They can indicate reductions in a countrys
  foreign reserves, which may mean that a countrys
  currency will depreciate in the future.
• They provide an indication of structural changes
  taking place in national economies through the
  changing composition of trade.

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Balance of Payments (BOP)

• There are 4 major accounts
• current, capital, official reserves, errors and
  omissions
• Current Account
• The current account records exports and imports
  of merchandise and services, investment income,
  and gifts.

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Balance of Payments (BOP)

• The current account balance measures the net
  outflow or inflow resulting from merchandise
  trade, service trade, investment income, and
  unilateral transfers.
• Trade surplus exports gt imports
• Trade deficit exports lt imports

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Balance of Payments (BOP)

• Capital Account
• The capital account records purchases and sales
  of assets (and payments).  
• There are 2 types of capital account
  transactions foreign direct investment (FDI)
  and portfolio investment. The former is any
  investment made for the purpose of controlling
  the organization in which the investment is made,
  while the latter is any investment made for
  purposes other than control.

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Balance of Payments (BOP)

• Short-term portfolio investments are financial
  instruments with maturities of one year or less.
  
• Long-term portfolio investments are stocks,
  bonds, and other financial instruments issued by
  private and public organizations that have
  maturities greater than one year and that are
  held for purposes other than control.
• Payments for current account transactions show up
  in the capital account as short term portfolio
  flows.

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Balance of Payments (BOP)

• Official Reserves Account
• The official reserves account records holdings
  of the official reserves held by a national
  government.
• Errors and Omissions
• The errors and omissions account is used to make
  the BOP balance as per the following equation
• Current Account Capital Account Errors and
  Omissions Official Reserves 0

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Balance of Payments (BOP)

• Use the fact that BOP statements resemble
  sources and uses of funds statements. Credit
  entries are for sources of funds. Debit entries
  are for uses of funds.

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Balance of Payments (BOP)

• Table 6.3 on p.173 gives a straightforward
  application of the above principle to the current
  account.
• Using the above principle, exports are sources of
  funds, therefore they appear as credit entries.
  Imports are uses of funds, therefore they appear
  as debit entries.

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Balance of Payments (BOP)

• The main point of raising this issue is that
  sometimes you may read and hear about statistics
  being presented in different ways. The above
  schema is one way in which you may encounter the
  data being presented.
• That said, in the analytic presentation of BOP
  statements given in the IMF Balance of Payments
  Statistics Yearbook, figures are given as per the
  figures for the 1999 US BOP statistics in the
  textbook (Table 6.6, p.178).

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Applying Todays Material to Understanding the
Prospects of Nations

• Interpreting international debt figures using GDP
  and export figures as deflators
• Nations, like people, need income (GDP) to
  generate surplus resources needed to make
  interest and principal payments on debt.
• When debt becomes too high relative to GDP,
  this means the nation has little room to maneuver
  to spend money if the economy takes a downturn
  and has little cash left over to invest, for
  example, in infrastructure or in education and
  training. These facts work against economic
  development, which in turn suggests that nation
  may find it difficult to meet debt obligations in
  the future.

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Applying Todays Material to Understanding the
Prospects of Nations

• Interpreting international debt figures using GDP
  and export figures as deflators
• Also, nations need exports to service debt
  denominated in other currencies, as exports are
  the most reliable provider of foreign exchange
  reserves needed to meet external obligations.
• When debt becomes very high relative to exports,
  people start to become nervous about the ability
  of that nation to earn foreign currency reserves
  to make debt payments. The nation becomes
  dependent on the willingness of foreigners to
  accept that nations domestic assets as payment
  and/or to roll over loans, something foreigners
  will become increasingly reluctant to do as
  exports keep shrinking relative to international
  debts.

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Applying Todays Material to Understanding the
Prospects of Nations

• Interpreting international debt figures using GDP
  and export figures as deflators
• Also, a high ratio of debts to exports may mean
  there is price instability or competitiveness
  problems affecting that nations export
  industries, which may suggest future depressed
  economic growth and problems in meeting future
  debt obligations.

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Applying Todays Material to Understanding the
Prospects of Nations
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Applying Todays Material to Understanding the
Prospects of Nations

• Observations
• These figures look better for all three nations
  than for the collective of developing, debtor
  nations in the 1980s, when international debt
  ratios were well over 100 of GDP. However,
  these nations still have a lot of external
  debt, especially relative to exports.
• Argentina and Bolivia depend on volatile
  industries for export earnings (tin mining for
  Bolivia, oil and agricultural products for
  Argentina). This makes them doubly vulnerable to
  debt problems because commodity price shocks may
  impair their ability to meet external
  obligations.

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Applying Todays Material to Understanding the
Prospects of Nations

• Comparing international and domestic debt
• International debt does not crowd out other
  domestic investment, keeping domestic interest
  rates lower, at least in the short run. It may
  be available when domestic sources of credit are
  exhausted.
• But, international debt is inherently more risky,
  in general, because of foreign exchange risk and
  because external debts are very difficult and
  painful to extinguish if payment becomes
  problematic.

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Applying Todays Material to Understanding the
Prospects of Nations

• Comparing international and domestic debt
• Domestic debt confers the opposite advantages and
  disadvantages, more or less, with one exception.
  High levels of domestic debt are relatively more
  likely to lead to high inflation by governments
  printing money to pay their domestic bills. This
  in turn can lead to devaluation of the currency,
  which in turn lowers living standards and tends
  to push inflation further upwards.

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Applying Todays Material to Understanding the
Prospects of Nations

• Interpreting BOP Figures
• Similar to the way international debt gets
  analyzed, dividing or deflating the current
  account balance by a nations GDP for the same
  time period is often a useful way to try to
  examine the stability of a nations currency in
  foreign exchange markets.

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Applying Todays Material to Understanding the
Prospects of Nations

• Interpreting BOP Figures
• As a very rough guide, a figure of greater than
  or equal to .05 (in absolute value terms) as a
  ratio of the current account balance over
  national GDP suggests the currency value may
  fluctuate. A fixed exchange rate may become
  unsustainable in the not too distant future if
  the exports-over-GDP ratio implies there is
  strong downward pressure on the currency.

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Applying Todays Material to Understanding the
Prospects of Nations

• Interpreting BOP Figures
• If there is a sustained rise in exports and in
  GDP, that may mean that country is a potential
  emerging market for new goods and services.
  Steadily rising exports implies good things about
  the global competitiveness of that nations
  leading export industries.
• If currency rates are relatively stable and
  imports suddenly jump upwards, something is going
  on. Perhaps the economy is overheating, perhaps
  new investments are taking place. It probably
  warrants further investigation.