macroeconomics, foreign trade and the european union. basics and examples

Lecture 5. December 3rd

Macroeconomics, foreign trade and the European Union. Basics

and Examples.

http://www.uni-goettingen.de/de/1.html

http://www.uni-goettingen.de/de/die-universitaet/50217.html

Macroeconomics, foreign trade and European Union. Basics.

• what are exchange rate regimes?• the classical gold standard and Bretton Woods system• Today’s situation• unilateral binding of currencies• the case of China – a currency war?

Lecture 5Dipl.- Kfm. Thomas Stiegler, University of Göttingen.2

Today‘s topics



• today it is often argued that countries – especially China – are using their currency as a “weapon”; we can read about future currency wars.• How can this work? Which mechanisms can lead to such a situation?• Let’s have a short look at exchange rate regimes and the situation appearing through international trade


Money as a weapon?



In general there are two types of exchange rate regime. All thinkable systems are a mixture of them:

1. fixed exchange rate regimes2. flexible (free floating) exchange rates

Let’s have a short look on them


Regimes of exchange rates



In a strict regime of fixed exchange rates there is no change in the value of a currency given in another currency.• this system can only work, when there is no chance for a market to have any gains by using arbitrage in between different currencies• The typical example for this situation is the classical gold standard


Fixed exchange rates



• Each country issued gold coins. If it issued banknotes, they were backed by gold, so everybody could get gold coins from central bank for his banknotes. • ALL states were using gold as a medium, so through the gold weight of the coins, the exchange rates were distinguished.• example: a tsarist 10 ruble coin contained of 7,74gr. of gold; a German 10 Mark coin of 3,58gr. So the exchange rate given by the gold weight was 2,16 marks for one ruble


The classical gold standard (≈1880-1914/15)



• There were no limitations in worldwide transportation of gold, so de facto freedom of world wide capital movements• As the exchange rates were fixed, the traders had security on financial planning• The time of the classical gold standard is often called the first wave of globalization, as international trade rose largely• By the capital needs for the war and “printing money” the gold standard ceased to exist de facto in 1915


The classical gold standard



• in 1944, when a victory in WWII was already expectable, a new system of fixed and solid exchange rates was thought of. The USSR was invited to the talks, but didn’t want to join.• It was agreed, that there will be a system of fixed exchange rates towards the US$. For the US$ there was the obligation to be backed in Gold. So everybody could change his US$ into gold. However this obligation wasn’t existent for the other currencies. Usually as the fixed rate the rates of gold standard were taken


The Bretton Woods System – the last big attempt



• the system was working well in the first years after WWII. Because the fault in creating this system wasn’t visible: destroyed Europe imported a lot of US products, the USA were in surplus with their trade balance, so money from abroad did flow to the USA to pay for the goods.• Gaining strength in the 1960 Europe and Japan started to export more to the USA than they imported from the US. The US got into deficit in trade balance


The Bretton Woods System – its fading



• Through this development the US$ reserves of the central banks abroad got bigger and bigger. Reaching an amount being higher than the gold reserves of the US. In 1971 the $ reserves of the Deutsche Bundesbank were higher than US gold reserves. So Germany as a single state could have sent the US Federal Reserve Bank to bankrupt. The US so decided to cancel the gold exchange clause for the $ Aug71• As not having any real anchor anymore the fixed rate was abandoned after 2 years. (1971-1973 it worked unbacked)


The Bretton Woods System – the break down



• It was thought that after 2 or 3 years, when markets would have found a new and more realistic exchange rate between currencies they should be fixed with a new system again.• However the movements were so strong as well as volatile that the aim was never reached again.• To illustrate: The rate DM-$ in the Bretton Woods System was 4,20 : 1; in July 1973 the rate reached 2,33 : 1; meaning a change by 45%!!!


after Bretton Woods System



• if there is a fixed exchange rate, not backed by real goods, nor by the foreign trade development, there will be a pressure inside the system. • If the aim is to sustain in the system, at least one side has to act to take some pressure away from the exchange rate.• However this will lead to growing reserves in foreign currency (or gold)


What we can learn.


• In such a system, currencies float freely against each other.• This does not mean, that there’s no influence on the exchange rate by central banks. In opposite, there is evidence, that western central banks were much more active on international markets AFTER Bretton Woods break down• In such a system especially smaller states are in danger of speculative attacks. Politics is exposed highly to the world markets


System of free exchange rates


• Major currencies as the US$, EURO, £, Japanese ¥, Swiss Franc are free floating against each other.• Most of the other states bound their currency at least to some extend to one of these currencies• Markets are highly speculative, even against big players like EU


Where are we today?


• many of the states binding their currency to $ or € are doing so especially for two reasons: 1. to gain trust in the currency and with it into the domestic economy 2. to stabilize economic development and stop capital flowing to abroad• Many countries bind their currency to a basket in order to stabilize it and allow some movement in the exchange rate according to world market development


Why to bind your currency to another one?


• binding a currency to a single currency brings dangers: once a currency is bound to another one, you have to accept the monetary policy of that country. As you need to keep the rate fixed, you can’t for example leave the interest rate higher, than in the country you are bound to: capital would flow into your country, a pressure of appreciation of your currency would appear, to erase it you would have to issue domestic money, increasing the circulating money which

then finally leads to lower interest rates again…


Why a basket is a good idea (1)


• having a basket avoids such situations to some extend.• having a basket makes your currency more stable in respect to the world markets, although it now floats against the major currencies to some extend• Using a basket can reflect your economical situation• Good example: Russia. RUR is bound by 55% to $ and 45% to €, reflecting the dependence of oil and gas, which are traded in $ and the strong economic connections with EU


Why a basket is a good idea (2)


• As we saw, if there are situations when rates are fixed, but the economical reality, especially in foreign trade, isn’t reflected, there is a pressure on the currencies to fix the rate.• Many countries just fix their rates towards another currency without any treaties with the state. So only them then take care for the fixation


What can be dangerous in this system?


• if then a situation appears like in China, where a lot of exports are done a pressure on appreciation appears.• If there is a pressure of appreciation two ways of eliminating it can be thought of: 1. expanding the offer of the Yuan or decreasing the offer of Dollar.• Usually only one way works if there’s no bilateral

agreement: expanding the Yuan and buying Dollars with it.


The Chinese case.


• in the Chinese case to some extend even only the second is possible: state firms just give their Dollar income to the state bank without getting anything back for it (small extent)• This situation leads to large reserves of Dollar in China, as this situation is to observe for a long time now.• The reserves of China – if it would exchange it at world markets – could let the Dollar rate break down within few minutes.


The Chinese case (2).


• as China is exporting so much it is disclaiming domestic wealth growth. Chinese are producing goods, but hardly have the possibility of consuming them their selves, as wages are to low.• China is supplying world markets, however under situations destroying its basis of surviving (nature, poverty)• Being dependent on US monetary policy is avoided by

having restrictions on currency exchange. (no arbitrage possible)


Consequences of this situation


• keeping the Yuan down is a direct subsidy for exports. • Getting more and more $ strengthens the geo-strategical situation of China. (however China is slowly moving towards a basket)• Chinese are running a two columns strategy: 1.dominating markets abroad with cheap (imitation) products 2. Developing technologies to produce high tech later. With this high tech the then want to enter the markets they won with cheap exports now


Why are they acting that way?


• China’s policy is to China’s and only China’s profit. So other states will more and more refuse to accept that non realistic exchange rate.• However: today China is already in a very strong position. A lot of supply for high tech production is produced in China, so by imposing a tariff for example, many products will be much more expensive in all other states.


So will there be currency wars?


• companies from many states invested a lot of money in China. China is a dictatorship, so they could just take all these investments in state ownership and huge amounts of money would be lost.• China is today dominating on a lot of raw material markets of the world. So it can damage the supply of industry states.• one in free floating, Yuan quickly will move to a major currency in the world. Giving more power to the communist central bank over world financial markets.


So will there be currency wars?


It is already too late!China’s economical – and with it geo strategical – power is there to stay for at least the next decades. You can not force China to do something without hurting yourself even more, as the economical connections got too close. Industrial states should have thought of China’s potential before entering a huge but totalitarian economy. China will break the monopoly of values of the Western world. Most likely leading to a new cold – this time economic – war. But not hot one.


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macroeconomics, foreign trade and the european union. basics and examples

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