Contents of the course

1
International Finance
Lecture n1 Balance of Paiements
Reminder - Addendum
2
The international financial system

• Introduction
• Different forms of exchange rates organisation
• fixed
• floating
• managed
• monetary unions
• Questions of
• adjustment of balance of paiements
• liquidity provision in the system
• international money deficition and usage

3
The international financial system

• Impossible Trinity 
• Exchange rate stability
• Full financial integration (free capital flows)
• Monetary independence
• Is there a best system?
• What design of institutions?

4
The international financial system

• International money
• Caracteristics International money should be
• defined
• convertible
• inspire confidence
• store of value
• Summary issues concerns of financial markets
• Adjustments of BOP
• Provision of liquidity
• -gt 4 different systems address these 2 issues.

5
Adjustment issue the BOP

• Balance of payments (BOP) - reminder
• 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 and
  services
• Capital account capital inflows - capital
  outflows capital transferts related to purchase
  and sale of fixed assets
• Financial account financial inflows - financial
  outflows net foreign direct investments net
  portfolio investments
• Sum of 3 first terms Basic balance
• FXB changes in official monetarry reserves
  (gold, foreign currencies, IMF position)

6
Adjustment issue the BOP

• Balance of payments (BOP) - reminder
• In equilibrium BOP 0
• Deficit country BOP lt 0
• Surplus country BOP gt 0
• Deficit country (current account deficit)
• X - M lt 0 too many imports compared to exports
• Money supply gt money demand (in domestic
  currency)
• Too large amount of domestic currency
  deflationary pressures

7
Adjustment issue the BOP

• 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)

8
Adjustment issue the BOP

• Surplus country (current account surplus)
• X - M gt 0 too many exports compared to imports
• Money demand gt money supply (in domestic
  currency)
• Lack of domestic currency inflationary
  pressures
• 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

9
Adjustment issue the BOP

• Possible policies for a surplus country
• increase the supply of money and sterilise to
  avoid a price rise exchange M1 and M3 sell
  government bonds against domestic currencies. The
  process is here
• increase the domestic money supply by buy foreign
  currencies using domestic currencies to ease the
  appreciation pressure
• reduce back the supply of domestic money by
  selling government bonds
• lower interest rates to discourage capital
  inflows (increase outflows) and to reduce
  financial surplus

10
Adjustment issue the BOP

• Adjustment issue - reminder
• 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
• surplus and deficit countries experience
  asymetric pressures for adjustments
• Problem of adjustments central concern of
  government
• -gt need for design of institutions

11
International Finance
Lecture n3 FX rate determination
Overshooting - Addendum
12
Monetary approach

• Overshooting model - Specification
• Equations (1) and (2) lead to
• s s- (1/??) (m - p - ?y ?i) in logarithm
• meaning that the exchange rate and price level
  are function of three exogenous variables
• the real money supply (m-p)
• the domestic real income (y)
• the foreign interest rate (i)
• s- is the long-run exchange rate, determined by
  monetary (inflation differential) and real
  factors (economic fundamentals). If s above s-,
  then s is expected to appreciate.

13
Monetary approach

• Overshooting model - Graphical Equilibrium

P
45
Q
? p 0
Peq
Q
s
Seq
14
Monetary approach

• Overshooting model - Graphical Equilibrium
• QQ asset market equilibrium
• Negative slope, a relatively high level of s is
  required iof p is low. The dynamic is as follows
  
• If p falls, the real supply money rises (m-p
  rises when p falls).
• Then, i falls to maintain MM equilibrium (1).
• Then ?se has to fall to maintain the interest
  parity condition
• (ii ?se ) the exchange expected to
  appreciate.
• ?p0 goods market equilibrium
• The curve expresses the combinations of p and s
  that ensure that excess demand is equal to zero,
  that is, that the goods market are in
  equilibrium. Positively sloped, but flatter than
  45.

15
Monetary approach

• ?p0 goods market equilibrium
• The mechanism is as follows
• A decrease in p has two effects
• (1) it increase the real value of money supply
  (m-p), leading to a decrease of i, that in turn
  lead investment and aggregate demand to grow
  (Keynes effect)
• (2) it increases competitiveness, leading to an
  increase of the net demand for export (X-M)
• These 2 effects lead to an excess demand on the
  goods market. Therefore, s has to fall (i.e.
  appreciate) more that proportionally in order to
  restore the equilibrium. The fall in s has to
  compensate both the Keynes effect and the
  competitiveness effect.

16
Monetary approach

• Overshooting model - Hypothesis
• Goods market adjust only slowly toward
  equilibrium, whereas asset market are assumed to
  clear continuously (always on QQ)
• Money is neutral in the long-run changes in the
  supply of money have no long-run effect on the
  real economy an increase (decrease) in money
  supply will lead to the same increase
  (decrease) in p and s. There is no money illusion
  or price stickiness in the long run.
• Short-run adjustments the fall in interest
  rates disturbs the interest parity. There is a
  capital outflows causing s to rise (depreciate),
  but it has to rise beyond its equilibrium level
  to generate expectations of appreciation
  overshooting.
• Overshooting reaction of money markets are
  necessary for the asset markets equilibrium to
  hold continuously.

17
Monetary approach

• Overshooting model - Input
• Dornbushs model can provide an explanation for
  the large fluctuations in exchange rates.
• The model has served as a basis for other models
  of the overshooting type no full employment,
  imperfect currencies and assets substitutability,
  imperfect capital mobility, rational
  expectations, dynamic (not analysed here).
• Overshooting model - Empirical evidence
• Methods multivariate lagged regressions
• Mixed evidence some support of PPP in the
  long-run, some evidence of overshooting in the
  short-run.
• Some support from recent tests.

18
International Finance
Lecture n6 - FMI and the provision of
finance Financial Crises - Addendum
19
Financial crises

• Recent financial crises
• The Asian crisis of July 1997
• The Russian roubles collapse in August 1998
• The fall of the Brazilian real in January 1999
• These crises provide a spectrum of emerging
  markets economic failures, each with its own
  complex causes and unknown outlooks.
• They also illustrate the growing problem of
  capital flights and short-run international
  speculation in currency and securities markets.

20
Financial crises

• The Asian crisis
• Roots fundamental change in the economies of
  the region of many Asian countries, expanding
  their economies from net exporters to net
  importers
• Starting in 1990 in Thailand, this rapid
  expansion required major net capital inflows to
  support their currencies
• As long as capital kept flowing in, the
  currencies were stable, but if this inflow
  stopped then the governments would not be able to
  support their fixed currencies
• Most visible part the excesses of capital
  inflows into Thailand in 1996 and 1997.
• Easy access to capital for firms and Thai banks
  to US dollar denominated debt at cheap rates.
• Banks continued to extend credits and as long as
  the capital inflows were still coming.

21
Financial crises

• The Asian crisis

• After some time, the Thai Baht came under attack
  due to the countrys rising debt.
• The Thai government tries to support the exchange
  rate by direct intervention on the markets by
  selling foreign reserves and indirectly by
  raising interest rates.
• This caused the Thai markets to come to a halt
  along with massive currency losses and bank
  failures
• On July 2, 1997 the Thai central bank allowed the
  Baht to float and it fell over 17 against the
  dollar and 12 against the Japanese Yen
• By November 1997, the baht fell 38 against the
  US dollar, form Baht 25/US to Baht 40/.

22
Financial crises

• The Asian crisis
• Within days, other Asian countries suffered from
  the contagion effect from Thailands devaluation.
• Speculators and capital markets turned towards
  countries with similar economic traits as
  Thailand and their currencies fell under attack
  Indonesia, Korea, Malaysia, Philippines,
  Taiwan...
• The only currencies that were not severely
  affected were the Hong Kong dollar and the
  Chinese renminbi.
• The causal factors of the crisis were complex
• Corporate socialism
• Corporate governance
• Banking and liquidity management

23
Financial crises

• The Asian crisis
• Corporate socialism
• Great stability in Asia in the post-war period,
  with active government intervention in the
  economy, and life-long employment in firms. Until
  the crises, the government was reluctant to allow
  firms and banks to close, workers to lose their
  jobs.
• Corporate governance
• Most firms were controlled by families or groups
  related to the governing parties. Theses
  practices could favor exploitation of private
  benefits of power and conflicts of interest of
  the management or controlling shareholders not
  acting in the firms best interests.

24
Financial crises

• The Asian crisis
• Banking and liquidity management
• The government used up its reserves in tentative
  of direct intervention and could not support
  banks when large speculative attacks and huge
  capital outflows cause the failure of many of
  them.
• The liquidity disruption of the banking and
  financial system profoundly affected the real
  economy, causing a chain effect of failures among
  Asian companies, leading to a region-wide
  recession.
• There are interpretation disputes over the role
  of the IMF in the provision of finance in
  distressed Asian countries during the crisis.

25
Financial crises

• The Russian crisis of 1998
• The Russian crises was the culmination of a
  continuing deterioration in general economic
  conditions in Russia.
• From 1995 to 1998 Russia extensively borrowed on
  international capital markets and the servicing
  of the debt became soon a preoccupying problem.
  Although the country run a surplus of 15-20
  billion per year, capital flight was accelerating
  as hard-currency earnings were leaving the
  country.
• The Ruble operated within a managed float from
  Rub 5.75/ to Rub 6.35/. The government
  maintained this band by announcing what rate it
  was willing to buy/sell rubles to the markets.
• Even after a 4.3 billion IMF facility, the ruble
  fell under attack in August of 1998.

26
Financial crises

• The Russian crisis of 1998
• On August 7, 1998 the central bank announced that
  its hard currency reserves had fallen by 800
  million to a level of 18.4 billion as of July
  31st
• Russia announced that it would issue an
  additional 3 billion in foreign bonds but the
  ruble continued to fall
• On Monday August 10th, the Russian stocks fell by
  more than 5 as investors feared a Chinese
  renminbi devaluation that would aid Chinese
  exports but would deteriorate Russias ability to
  generate foreign exchange reserves. Russias
  ability to collect taxes was also waited to be
  proved.
• On August 17th, the central bank announced that
  the Ruble would be allowed to fall by 34 to
  Ru9.50/. They postponed 43 billion in
  short-term debt as well as a 90-day moratorium on
  all repayment of foreign debt in order to avoid a
  banking collapse.

27
Financial crises

• The Russian crisis of 1998
• On August 28th, trading of the Ruble was halted
  after ten minutes as the Ruble traded around
  Ru19.0/. By January, the Ruble had settled at
  Ru25.0/
• Russia had defaulted on its foreign denominated
  debt, mostly dollar debt marking the first time a
  sovereign issuer defaulted on Eurobonds.
• The crisis of the Ruble and the loss of Russias
  access to international capital markets has
  brought into question the benefits of a free
  market economy among the Russian society.

28
Financial crises

• The Brazilian crisis of 1999
• In 1997 and 1998, most analysts did not question
  the perspective of a devaluation of the Real, but
  wondered when and how much.
• Since 1994, its value had been artificially
  maintained by the government in the hopes of
  stabilization of economic condition and financial
  growth.
• But the governments inability to resolve the
  persistent current account deficit and the
  inflationary pressures drove expectations of a
  devaluation.
• Increased volatility on the markets in the second
  half of 1998, in the context of the Russian
  crises, pave the way for speculative attacks on
  the Real.
• From January 11th, till 15th, 3.44 billion USD
  flew out of the country and the Real lost 16 of
  its value, devalued twice at R1.43/

29
Financial crises

• The Brazilian crisis of 1999
• During the following week, the floating rate was
  temporarily adopted and the Real continued to
  fall.
• The finance minister rose interest rates from 36
  to 41 to limit inflationary pressures from the
  devaluation.
• By April of 1999, the real had appreciated
  against the dollar and was now hovering around
  R1.70/
• After a sharp drop, equity markets steadily
  recovered in the following weeks and month, based
  on positive expectations due to the improved
  competitive position of Brazil compared to its
  major competitors, and following the renewed
  confidence brought by the return of foreign
  investors to the Brazilian markets, signaling the
  end of the crisis.