International Finance - Part 1.2.

1
International Finance - Part 1.2.

• The Economics of Monetary Union
• Exchange Rate Management

2
1. Exchange Rate Management

• Introduction
• Goals of the chapter
• Ask whether a flexible exchange rate system is
  desirable,
• Discuss the argument for greater exchange rate
  fixity
• Flexible exchange rate system
• Implies a minimum of insitutional design
• Carry weaknesses linked to this minimal framework
  
• Uncertainty
• Lack of discipline
• Problems of volatility and misalignments
• Case for more managed exchange rates
• Then leads to problems of speculative attacks if
  monetary policy is inconsistent with fixed
  exchange rate target.

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1. Exchange Rate Management

• The case for flexible exchange rates - Arguments
• Defined as
•  Rates of foreign exchange that are determined
  daily in the markets for foreign exchange by
  forces of demand and supply 
• Avoid the intervention of the government and the
  possible run out of reserves
• Automatically adjusts the BOP disequilibria
• Speculators facilitate and smooth the adjustment
  of the exchange rate, having a stabilising effect
• Confer monetary autonomy to a country
• Provide insulation from external shocks via
  exchange rates adjustements, upward or downward.

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1. Exchange Rate Management

• The case for flexible exchange rates - Challenges
• However, the argument for flexible exchange rates
  have been seriously challenged to several
  extents.
• Floating rates since 1973 have exhibited high
  volatility and spent long periods away from their
  long-run fundamental equilibrium level
  (misalignement)

Domestic price of foreign exchange
Supply of foreign exchange (brought by X) D of
domestic curr.
Seq
Deficit M gt X
Demand for foreign exchange(brought by M) S of
domestic curr.
X
M
Q of foreign exchange
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1. Exchange Rate Management

• The case for flexible exchange rates - Challenges
• Exchange rate determination models do not seem to
  prove empirically that fundamentals drive the
  exchange rate.
• Studies showed that same current account
  imbalances persisted after the adoption of
  floating exchange rates in 1970 s and 1980 s.
• Changes in prices caused by depreciation may not
  alter demand for the product (ex. Switzerland,
  Germany, Japan), in particular for high quality
  goods with few substitutes.
• Monetary autonomy ? UK example in 1979-1981 where
  monetary tightness rise interest rates, causing a
  huge capital inflow, leading to exchange rate
  appreciation, affecting badly the tradeable
  sectors.-gt few autonomy.

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1. Exchange Rate Management

• The case for flexible exchange rates - Challenges
• Insulation from external shocks?
• Full insulation idea abandoned.
• Still a question on whether flexible rates better
  insulate the domestic economy. Via, p.ex.,
  appreciation of the rate in case of rise of
  foreign demand for domestic exports, and vice
  versa.
• Empirical results are mixed.
• Overall several exaggerated benefits for
  flexible exchange rates.

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1. Exchange Rate Management

• The benefits of greater exchange rate fixity
• Four arguments in favour of some degree of
  exchange rate intervention
• The discipline argument helps to promote lower
  inflation.
• The need to reduce exchange rate volatility
  more uncertainty can reduce the volume of trade.
• The desire to eliminate misalignments long
  period of over- and under valuation - like
  displayed in the floating rates period - results
  in various cost for the real sector.
• The benefits of a single currency

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1. Exchange Rate Management

• Exchange rate fixity The Discipline argument
• (1) Flexible rates tend to promote inflation
  (evidence is mixed and theoretically unlikely)
• (2) Fixed exchange rate force countries to
  contain inflation one of the core arguments in
  favour of EMS.
• Consider 2 countries
• UK high inflation, and current account deficit
• Germany low inflation, and current account
  surplus
• In theory leads to a tendency of appreciation
  of the DM Bundesbank should sell DM against
  foreign currencies, expanding the monetary base,
  and reducing pressure on S.
• UK should disinflate, buy Pounds against
  foreign currencies to reduce pressure of
  depreciation.

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1. Exchange Rate Management

• The Discipline Argument
• Asymmetry Germany could sterilise (and avoid a
  price rise) by selling bonds against DM, reducing
  back the monetary base.
• UK cannot sterilise much, soon running out of
  reserves. -gt this asymmetry leads to a
  disinflation bias.
• And, the credibility bonus brought by the
  exchange rate target reduces the costs of
  disinflation in terms of unemployment agents
  easily observe the exchange rate target and
  believe that inflation will fall
• -gt they adapt their wage bargaining behaviour.
• Exchange rate targets are more efficient
  (credible) disinflation tools than monetary
  growth targets.

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1. Exchange Rate Management

• Exchange rate fixity The Volatility argument
• Need to reduce exchange rate volatility more
  uncertainty can reduce the volume of trade.
• Foreign direct and long-run foreign investment
  might also decline in greater exchange rate
  uncertainty.
• Sudden changes in the value of reserve currencies
  can be problematic.
• However, possible recourse to the forward market,
  but
• only existing for large currencies,
• can be expensive.

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1. Exchange rate management

• Exchange rate fixity The Misalignment Argument
• Floating rates have a tendency for persistent
  departures from long-run equilibrium
• Long period of overvaluation and undervaluation
  cause changes in the price of tradeables goods
  relative to non tradeables.
• Example persistent overvaluation, causing
  industries to become uncompetitive, but capital
  and labour are not easily convertible into other,
  non tradeable sectors
• -gt overvaluation usually leads to unemployment
  and underutilisation of resources, and
  ultimately, to desindustrialisation.
• Also effect of misalignment on long-term debt
  accumulated in foreign currencies can
  significantly change the return of project
  financed by borrowed currencies.

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1. Exchange Rate Management

• Exchange rate fixity The Single Currency
• Benefits of a single currency within any country
  are
• simplification of the profit-maximising
  computations of producers and traders
• facilitated competition among competitors of the
  country
• promotion of the integration of the economy into
  a connected series of markets for the factors of
  production
• If single currency among different countries
  accrued benefits due to the suppression of the
  transaction costs of exchanging currencies.
• If exchange rate management part of these
  listed benefits could be achieved, compared to a
  fixed rate regime.

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2. Single Currency

• Costs of a single currency
• Costs of a single currency across different
  countries
• loss of the exchange rate
• loss of the monetary policy
• Loss of exchange rate
• Eliminate the possibility of using the exchange
  rate as a policy instrument to rectify external
  equilibria.
• Example External shock of price fall in steel
  leads Belgium (large exporter) to a deficit on
  its current account.
• Belgium should either deflate (allowing prices to
  fall) or let the currency depreciate (or devalue
  if fixed exchange rate) in order to restore
  equilibrium.
• If prices are sticky and cannot fall to restore
  competitiveness, deflation (i rises, M falls)
  will create unemployement.

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2. Single Currency

• Costs of a single currency - loss of exchange
  rate
• Example
• If Belgium is in a monetary union no
  depreciation is allowed, the economy will go into
  recession.
• Belgium has no longer a BOP problem, but has a
  regional problem within EMU.
• Three factors mitigating the costs
• Factor mobility
• Openness of the economy
• Product diversification

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2. Single Currency

• Costs of a single currency - Mitigation factors
• Factor mobility
• The greater the mobility of capital and labour,
  the lower the cost of joining a monetary union.
• Example asymmetric demand shock rise of D in
  region A, drop in region B. If prices are sticky
  downwards, region B will have unemployement, and
  inflationnary pressures in region A.
• Solution move unemployed workers from region B
  to region A.

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2. Single Currency

• Costs of a single currency - Mitigation factors
• Openness of the economy
• The loss of exchange is less costly if the
  economy is more open.
• Reason exchange rate changes are less effective
  at improving competitiveness because money
  illusion is reduced.
• In fixed exchange rates, devaluation increase
  competitiveness via the drop real wages following
  the increase in prices of imported goods.
• In open economies, workers anticipate this change
  and will adjust their demand of wage increase to
  offset the effect.
• Product diversity
• A demand disturbance in one product is less
  likely to affect significantly the exchange rate,
  if the diversfication is large.

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2. Single Currency

• Costs of a single currency - Loss of monetary
  policy
• Costs of a single currency across different
  countries
• loss of the exchange rate
• loss of the monetary policy
• Loss of monetary policy
• Eliminate the ability to conduct an individual
  monetary policy, since monetary policy is
  directed from the centre rather than from
  individual countries.
• Many believe that the more similar inflation
  rates countries have, the more appropriate
  candidates they are for a monetary union.
• More generally the closer degree of policy
  integration at macro level, the more easy it is
  to form a monatery union.

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2. Single Currency

• Criteria for countries to benefit from a single
  currency
• Similar policy goals
• Similar macroeconomic performance
• Close inflation rates
• Conduction a lot a of trade transactions between
  one another.

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International Finance - Part 2

• The Economics of Monetary Union
• Construction of the EMU

20
Contents

• The Economics of Monetary Union
• 1. European Monetary Union Construction
• 2. European Monetary Union Steps
• 3. The Stability and Growth Pact
• 4. The European central Bank
• 5. Is Enlargement favorable?
• 6. Has Euro become an international currency?

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1. European Monetary Union - Construction

• Introduction
• European Union case study for exchange rate
  co-operation leading to a monetary union.
  Catalogue of lessons about benefits and costs of
  a single currency, and of advantages and
  disadvantages of different institutional
  structures.
• History
• European Monetary System (EMS) started in 1979
  with relatively flexible target zones, becoming
  progressively more rigid.
• 1987 - 1993 rigid exchange rate fluctuation
  bands
• 1993 large speculative attacks, causing a large
  threat on the system. Introduction of Euro
  postponed of 2 years.
• 1999 Euro as scriptural common currency
• 2002 Euro as fiduciary common currency

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1. European Monetary Union - Construction

• The European Monetary System (EMS)
• Main objective of EMS promotion of monetary
  stability within Europe.
• Three immediate aims as established in 1979
• Reduction of inflation in EU countries
• Promotion of exchange rate stability to favor
  trade flows and investments
• Gradual convergence of economic policy, allowing
  for more fixed exchange rates.

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1. European Monetary Union - Construction

• Three main features of the EMS
• the European Currency Unit (ECU) weighted
  average of all EU currencies, weights depending
  on the size of each country and its importance in
  intra-EU trade (DM, FRF, Sterling).
• the Exchange Rate Mechanism (ERM) exchange
  rates allowed to fluctuate up to 2.25 or 6 on
  either side of the central rate.
• the European Monetary Cooperation Fund (EMCF)
  provides credit for members to help in adjusting
  balance of payments problems, at short-term (9
  months) or medium-term (2-5 years).

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1. European Monetary Union - Construction

• The achievements of the ERM
• Stability of the exchange rates
• The cost of higher interest rates volatility (to
  reduce pressure on FX rates) has been avoided
  thanks to the capital controls in the ERM in the
  1980s.
• Question of the benefits of exchange rates
  stability on the intra-EU trade. Sekkat Sapir
  (1990) find little evidence of the effect of FX
  rate volatility on prices -gt little impact on
  commercial trade activities
• Reduction of inflation
• Argument due to asymmetry effect in fixed FX
  rates regime, deficit countries have to
  disinflate, whereas surplus countries could avoid
  inflationary policies by sterilisation.

25
1. European Monetary Union - Construction

• Reduction of inflation in EU - empirical evidence
• Number of pieces of evidence which suggests that
  ERM has worked asymmetrically.
• Intervention within the system support the view
  that Germany was the leader.
• Inflation in initially higher inflation countries
  did converge on German levels.
• Idea of a reduced cost of disinflation (in terms
  of unemployment), thanks to the credibility bonus
  brought by the pegging of currencies to low
  inflation countries (Germany).
• However, empirical evidence is mixed on this
  view. But high costs in ERM countries might be
  due to the nature of the labour markets (half way
  between high centralisation and high
  decentralisation).

26
1. European Monetary Union - Construction

• Five success factors for the stability of the ERM
  
• (1) Co-operation among ERM countries and the
  existence of the various financing facilities.
• ERM is part of a wider, institutionalized,
  co-operation framework among European countries.
• (2) Clever operational features in the design of
  the exchange bands
• Co-existence of narrow bands (2.25) and wider
  bands (6), providing some flexibility for high
  inflation countries, allowing them to gradually
  adapt their economic policies.

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1. European Monetary Union - Construction

• Five success factors for the stability of the ERM
  
• (3) Luck.
• Co-operation of policy goals among several ERM
  governments, focusing on disinflation and willing
  to accept the discipline implied by the system
  (in the 1980s).
• UK was not a member DM was the only large
  currency in the system.
• Strength of the dollar in the 1980s reduced the
  pressure for appreciation on the DM.

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1. European Monetary Union - Construction

• Five success factors for the stability of the ERM
  
• (4) Existence of capital controls
• Allow some monetary independence to the
  countries, by preventing large capital flows if
  interest rates differentials.
• (5) Growing credibility of the exchange rate
  parities.

29
1. European Monetary Union - Construction

• Benefits claimed from the EMU
• The European Commission estimated to gains to 10
  of the EU GNP. Benefits should come from
• 1. Direct gains from the elimination of
  transaction costs (0.5 - 1.0 of EU GDP)
• 2. Indirect gains from the elimination of
  transaction costs price transparency
• 3. Welfare gains from less uncertainty (in
  optimisation function of firms)
• 4. Positive impact on trade and growth
• 5. Benefits of having an international currency
• additional revenues for the central bank
• increased foreigners investments in domestic
  markets

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1. European Monetary Union - Construction

• Costs claimed from the EMU
• Depends on several factors
• The extent to which the area in question suffers
  from asymmetrical shocks (see Reichlin) newer
  and poorer countries of the union could have more
  problems than the others.
• However, opinions are mixed regarding the
  likelihood of occurrence of asymmetrical shocks
  in single currency zones.
• Business cycles might also have adverse effects.
  Cycles are the outcome of 3 factors shocks -
  propagation mechanisms - and policy response.
• Shocks and cycles could both be costly for the
  EMU.

31
2. European Monetary Union - Steps

• Economic and Monetary Union - plan
• Delors report (1989), basis of the Maastricht
  Treaty
• Monetary union to be achieved by a gradualist and
  parallel approach
• Parallel economic convergence to achieve at the
  same time as monetary union (the one needing the
  other)
• Gradualist economic integration is a slow
  process
• Stage 1 all countries join ERM with 2.25
  fluctuation bands, capital controls removed,
  single financial area.
• Stage 1 began on July 1, 1990.
• Maastricht Treaty signed in December 1991,
  setting a timetable for the whole process.
• Stage 1 was supposed to be completed by end of
  1993, but the exchange rate crises set back the
  process.

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2. European Monetary Union - Steps

• Stage 2 exchange rate commitment more
  stringent. Realignments expected to be more
  infrequent. Creation of a central European body
  in charge of the monetary policy.
• Started in January 1994.
• The European Monetary Institute (EMI) was created
  to co-ordinate monetary policy.
• Stage 3 irrevocable fixing of the exchanges
  rates, replacement of the national currencies.
  Monetary policy fully transferred to the European
  Central Bank.
• From January 1997.
• Adoption of the Euro of 11 members in January
  1999, Greece joined in 2001.

33
2. European Monetary Union - Steps

• Crises of the ERM - Facts
• September 1992 speculative attacks leading to
  the departure of Italy and the UK from the
  system. Peseta devalued by 5. Ireland, Portugal
  and Spain tightened their capital controls.
• July 1993 Several realignments of Ireland,
  Portugal and Spain. Pressure on the FRF and bands
  extended to 15.
• Crises of the ERM - Triggering Factors
• Breakdown in the economic policy agreement.
  France wanted to focus on growth and
  unemployment, Germany trying to absorb the shock
  of the reunification. Recession on major
  industrialised countries.
• Release of capital controls, according to the
  Delors plan to monetary union, implying lesser
  flexibility on exchange bands (2.25 for all) and
  no capital controls.

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2. European Monetary Union - Steps

• Stage 3 Convergence criteria Stability and
  Growth Pact
• Inflation max 1.5 above the average of the 3
  lowest inflation countries.
• Interest rates on LT government bonds max 2
  above the average of interest rates in the 3
  lowest inflation countries.
• Government deficit does not exceed 3 of the GDP.
• Government debt to GDP ratio does not exceed 60.
• The exchange rate must have been fixed within its
  ERM without a realignment for at least 2 years.
• The statutes of the central banks should be
  compatible with those of the ECB.

35
2. European Monetary Union - Steps

• Fiscal policy and EMU
• Fiscal autonomy is useful to individual countries
  if they are affected by asymmetric shocks (since
  monetary policy is no longer available).
• However, the constraints on the public debt to
  GDP ratio limit the fiscal autonomy of the EC
  members.
• In a limited fiscal autonomy framework, the EU
  central budget should play a greater role, to
• equalise the effect on different regions
  (transfer fiscal resources to badly affected
  regions)
• provide an automatic stabilisation for regions
  suffering from a temporary loss of income
• spread the costs of an adverse shock over the
  entire area.

36
2. European Monetary Union - Steps

• The transition to Euro
• Eleven member states of the EU initiated the EMU,
  adopting the Euro on Jan 4th 1999, replacing
  their national currencies on the financial
  markets.
• Countries are Austria, Belgium, Finland,
  France, Germany, Ireland, Italy, Luxembourg, the
  Netherlands, Portugal, Spain, and Greece 2 years
  later. UK, Sweden, and Denmark choose to keep
  their national currencies.
• The final fixed rates have been determined on
  Dec. 31, 1998.
• The value of Euro against the slid steadily
  following its introduction, from 1.19 in Jan
  1999, to 0.87 in Feb 2002. Its lowest was 0.825
  in Nov. 2000.
• The fiduciary introduction of the Euro started
  Jan 1st, 2002. Since the spring 2002, the Euro
  gained in value against the .

37
3. The Stability and Growth Pact

• Stage 3 - Convergence criteria Stability and
  Growth Pact
• Inflation max 1.5 above the average of the 3
  lowest inflation countries.
• Interest rates on LT government bonds max 2
  above the average of interest rates in the 3
  lowest inflation countries.
• Government deficit does not exceed 3 of the GDP.
• Government debt to GDP ratio does not exceed 60.
• The exchange rate must have been fixed within its
  ERM without a realignment for at least 2 years.
• The statutes of the central banks should be
  compatible with those of the ECB.

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3. The Stability and Growth Pact

• Stability and Growth Pact - Some Remarks
• Inflation target at 2
• Studies show that the high growth countries are
  the high inflation countries (Greece, Ireland,
  Luxembourg, Spain)
• Known as the Balassa-Samuelson effect
• Different transmission mechanisms of monetary
  policy per country , if different labour
  flexibility, or market organisation
• 2 nominal -gt potential risk for deflationary
  pressure
• Deficit at 3 of GDP
• countries should run a surplus in good years
• implies that government will fully wipe out debts
  in the long run

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3. The Stability and Growth Pact

• Stability and Growth Pact - Some Remarks
• Deficit at 3 of GDP, underlying reasons
• avoid high budget deficit increasing interest
  rates, putting ECB under pressure to loosen
  monetary policy, rising the risk of inflation
• -gt weak argument because
• in globalised financial markets, few influence of
  national deficits
• on the contrary, leads to the loss of the
  stabilising effect of the fiscal policy
• risk of default? Only valid when huge existing
  public debt -gt not relevant in industrialised
  countries
• more generally, the deficit threshold shoud be
  linked to the debt ratio.

40
4. The European Central Bank

• Possible models offered to the ECB
• The Anglo-French model the objectives of the
  Central Bank are,e.g. price stability,
  stabilisation of business cycle, maintenance of
  high employment, financial stability. Political
  dependence of the central bank.
• The German model the primary of the Central
  Bank is price stability, i.e., inflation control.
  Political independence of the central bank.
• Maastricht Treaty opted for the German model.
• Possible reasons
• The come-back of the monetarist view
• The political dominance of Germany, very focused
  on inflation control.

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4. The European Central Bank

• Accountability of the ECB
• Accountability should grow with independence
• Low accountability of the ECB, for two reasons
• absence of controlling institutions
• vagueness of the objectives defined
• Statutes fixed by the Maastricht treaty -gt need a
  unanimous vote to be modified
• As independent than the Bundesbank, less
  independent than the Fed, and less accountable
  than both.
• Decision body of the ECB the Governing Council,
  made of representative of national central banks
  and the executive board (18 members)

42
4. The European Central Bank
Governing Council
Decision stage
Executive Board ECB (6)
Governors of NCB s (12)
Implementation stage
European Central Bank
NCB
NCB
NCB
NCB
.

• Decentralisation of the system
• high representativity of the national interests
  and needs
• could (does) lead to immobility on case of
  diverging interests.

43
4. The European Central Bank

• Possible ways of reform of the decision-making
  process the ECB, in the perspective of
  enlargement
• The US Fed formula all governors participate to
  the council, but restricted voting rights among
  governors, on a rotating basis.
• The IMF formula small countries are grouped
  together, represented by one governor.
• The centralised formula decision making
  restricted to the executive board of the ECB (6
  members currently).

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5. Is enlargement favourable?

• Main criteria of benefits to join a Single
  Currency Area
• Openness of the economy to international trade
  with members
• Non asymmetric economic shocks to members
• In case of shock labour flexibility
• Characteristics of the new entrants (Check,
  Slovakia, Estonia, Hungary, Poland, Romania,
  Lithuania, Latvia)
• Trade in of GDP at least equal to current
  members
• Asymmetric of shocks for most of them, and UK,
  not for Hungary and Poland (De Grauwe, p. 94)
• Transition phase should be as short as
  possible, due to vulnerability of speculative
  attacks.

45
5. Is enlargment favourable?
Source Korhonen, Fidrmuc, 2001 in De Grauwe,
2003.
46
6. Has Euro become an International Currency?

• Size matters
• Share of output and trade US and EU (non-UK)
  similar in size (25 output 20 trade)
• Outstanding equity and bonds US twice as big as
  EU (2.3 bios equity 7 bios bonds in EU)
• Financial liberalisation matters
• to allow investors to hold liquid, diversified,
  freely tradable portfolios.
• Financial stability matters
• not to confuse with price stability that, if
  excessive, could lead to deflation.