the international financial system part i: the foreign exchange market
TRANSCRIPT
THE INTERNATIONAL FINANCIAL SYSTEM
PART I:
THE FOREIGN EXCHANGE MARKET
Foreign Exchange (Forex)
• A commodity that consists of currencies issued by countries other than one’s own.
Foreign Exchange Market
• The Foreign Exchange Market: a market for converting the currency of one country into the currency of another country.
• An Exchange Rate: is the rate at which one currency is converted into another.– Example:
1.7600 S$/US$ (direct quote)0.5682 US$/S$ (indirect quote)
Bid 1.7645Offered 1.7655 Spread .0010 = 10 points
Daily Currency Trading (US$bil)
1989 1992 1995 1998 2001
UK 184 291 464 637 504
US 115 167 244 351 254
Japan 111 120 161 136 147
Singapore 55 74 105
76
87
90
139 101
Germany 55 94 88
Swiss 56 66 82
79
71
HK 49 60 67
TOTALS 718 1076 1572 1958 1618
Source: bis.org
A Hierarchy of International Financial Centres
Note: Size of dots (squares) indicates cities’ relative importance
São PauloRio de Janiero
MexicoCity
SanFrancisco New
York
Toronto
Bombay
Melbourne
Sydney
Tokyo
Hong Kong
Singapore
London
Paris ZurichFrankfurt
Amsterdam
ViennaMadrid
HamburgDusseldorf
RomeBasel
Brussels
Chicago
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Forex market contracts to reduce Risk
• Spot Exchange: when two parties agree to exchange currency and execute the deal immediately.
• Forward Exchange: when two parties agree to exchange currency and execute the deal at some specific future date.
• Swap: the simultaneous purchase and sale of foreign exchange for two different value dates.
Foreign Exchange Transactions April 2001
(%)
32
11
54
3
Spot Forward Swaps error
Economic theories to explain the Determinants of Forex rates
• At lowest level = supply/demand.
• Inflation (Law of One Price
and Purchasing Power Parity).
• Interest rates (International Fisher Effect --IFE).
(So – Sn) / So x 100 = iS$ – iUS$
• Governments
• Investor psychology.
Notation:
So = spot rate
Sn = forward rate
iS$ = S’pore interest
iUS$ = US interest
Notation:
So = spot rate
Sn = forward rate
iS$ = S’pore interest
iUS$ = US interest
Law of One Price
• In competitive markets free of transportation costs and barriers to trade, identical products sold in different countries must sell for the same price when their price is expressed in terms of the same currency.
• Example: US/French exchange rate: $1 = FFr 5. A jacket selling for $50 in New York should retail for FFr 250 in Paris (50x5)
Purchasing Power Parity
• By comparing the prices of identical products in different currencies, it should be possible to determine the PPP exchange rate -- if markets were efficient.
• In relatively efficient markets (few impediments to trade and investment) then a ‘basket of goods’ should be roughly equivalent in each country.
The Big Mac IndexPurchasing Power Parity: April 25th 2000
United States $ 2.51 (average) - - - - - - - - - - - -Switzerland SwFr 5.90 2.35 1.70 +39Japan ¥ 294 117.00 106.00 +11Argentina Peso 2.50 1.00 1.00 0Canada C $ 2.85 1.14 1.47 -23Singapore S$ 3.20 1.27 1.70 -25Russia Ruble 39.50 15.70 28.50 -45Hong Kong HK $ 10.20 4.06 7.79 -48Malaysia M$ 4.52 1.80 3.80 -53
Price inLocal
Currency
ImpliedPPP of the
Dollar
ActualExchange
Rate
Local Currency% Over(+)or Under(-)Valuation
Against Dollar
Source of data: The Economist Big Mac Index, April 27th 2000
Determinants of Forex rates I: PPP
• Inflation – Purchasing Power Parity and “law of one price”– example
Forex rate @ ‘time t0’: 1.76 S$/$inflation in USA: 3%inflation in Singapore: 1%
Future Forex rate: 1.76 x (1.01/1.03) = 1.726
Determinants of Forex rates II: IFE
• Forward/future exchange premium or discount
= Interest rate differential
(So – Sn) / So x 100 = iS$ – iUS$
Determinants of Forex rates: PPP and IFE are related by FE
(Fisher Effect (FE): i = r + I)
i Forexrate
I
FE
IFE
PPP
Determinants of Forex rates III: misc
• Direct government controls– Central bank interventions– Non-convertibility– Multiple exchange rates– or other restrictions
• Natural supply / demand factors – Due to balance of payments, money supply, etc
• Speculation• Technical, psychological factors• etc
Exchange Rate Forecasting
• Efficient market: where prices reflect all available public information.– Forward exchange rate is an unbiased predictor of
future spot rates. (F= Sn)
• Inefficient market: where prices do not reflect all available information. Forward exchange rates are not the best predicators of future spot exchange rates.– Use fundamental or technical analysis to predict the
exchange rates.
THE INTERNATIONAL FINANCIAL SYSTEM
PART II:
THE GLOBAL MONETARY SYSTEM
History of the global monetary system
Gold Standard ~ 18801914
Bretton Woods System ~ 19441973
Managed Float ?
• Unresolved issue: Which is best, fixed or floating exchange rates?
Bretton Woods
NEW HAMPSHIRE
(International Bank for Reconstruction and Development)
• Created at Bretton Woods
• Created to fund Europe’s reconstruction and help less-developed countries.
• Overshadowed in Europe by Marshall Plan, so the bank turned to development.
International Monetary Fund (IMF)
• Created to police Bretton Woods monetary system by ensuring maintenance of fixed-exchange rates.
• To allow adjustment for Balance of Payments disequilibrium, the IMF created: – Lending facilities to help countries with payment deficits (short
term imbalances).• Persistent borrowings leads to IMF control of a country’s economic policy.
– Adjustable parities (for fundamental imbalance).
• Today: Surveillance of international payments and exchange rate policies. (No longer fixed rate exchange.)– IMF has become a global crisis manager.
US Dollar Movements since the end of Bretton Woods regime
90
100
110
120
130
140
150
160
1974 1976 1978 1980 1982 1984 1986 1988 1990 1992 1994
Desert Storm
Recession Ends
Oil Crisis
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How IMF members* determine exchange values (@ June 1990)
0
5
10
15
20
25
30
35
limitedflexibility
moreflexibility
US$ other peg
basket
na
managedfloat
freefloat
Pegged exchange rates
* 138 members* 138 members
How IMF members* determine exchange values (@ June 2000)
0
10
20
30
40
50
60
70
80
90
limitedflexibility
moreflexibility
CurrencyBoard
other peg
na
managedfloat
freefloat
Pegged exchange rates
(“Other peg” includes to US$ and basket. It also includes the Euro zone. And miscellaneous others.)
* 185 members* 185 members
TOWARDS A NEW FINANCIAL SYSTEM
•Today’s non-system emerged from the wreckage of Bretton Woods.
•Reforms will have to heed:–Global financial community–Country stakeholders
VIEWS FROM THE ECONOMIST:1. “Capital controversies”
2. “Currency dilemmas”
Largest Contributors* to the International Monetary Fund
17.5
6.1 6.35.1 5.1
0
2
4
6
8
10
12
14
16
18
US Germany Japan Britain France
US
Germany
Japan
Britain
France
* 5 March 2002
What logic shapes current IMF advice?
• “Currency dilemmas,” The Economist 18-11-2000)
– Free float: allows monetary policy autonomy• But for most, there is a “fear of floating”.
– Currency board: creates the strongest fixed rate• But sacrificing monetary independence involves
real economic costs.
– other regimes –fixed rates but not quite– attempt to achieve the “impossible trinity”.
“Capital controversies” The Economist, May 5th 1998
• “... a revisionist chorus is gaining voice.”– Is the theoretical case for free capital markets
robust?– Does experience show benefits of free capital
markets exceed costs?
• “…capital liberalisation should proceed cautiously, not that it should be stalled.”
IMF Policy Criticisms
• “One size fits all” prescription for countries.
• Rescue efforts exacerbate the ‘moral hazard’ problem.
• Too powerful without accountability.
The radical critique The Asian Financial Crisis may be seen as a failure of “Asian capitalism” or
alternatively, a failure of the “international financial system”.
• Mahathir Mohamed: “The fight for independence will have to begin all over again for the present market rules will surely result in a new imperialism more noxious and debilitating than the old.”
• George Soros: “I’m afraid that the prevailing view, which is one of extending the market mechanism to all domains, has the potential of destroying society.”
• Cronyism.• Too much money,
dependence on speculative capital inflows.
• Lack of transparency in the financial sector.
• Currencies tied to strengthening dollar.
• Increasing current account deficits.
• Weakness in the Japanese economy
• Currency devaluation.• Capital flight.• Rising prices.• Rising unemployment.• Rising poverty.• Rising resentment?
Investment impacts
• Loss of investment confidence.• Deflation of asset values.• Huge corporate debt burdens.• Reversal of capital flows
– Declining access to operating cash.
• Declines in domestic demand.– Decline of intra regional trade.
Problems leading to Crisisin Asian market economies
Impact of IMF policies on the Countries
THE INTERNATIONAL FINANCIAL SYSTEM
Further notes:
THE FOREIGN EXCHANGE MARKET
Currency composition of Forex market (%)
(%) 1989 1995 1998 2001
US$ 45 42 44 45
Euro None None None 19
Deutschemark 14 18 15 None
Yen 13 12 10 11
Singapore $ …. 0.15 0.6 1.1
All others 28 28 31 24
US$/Euro
US$/DM
US$/Yen
US$/others
Euro/others
All others
no
22
21
39
no
18
no
20
18
48
no
4
30
no
20
41
8
1
Source: bis.com
Difference between forward/futures contracts: standardization and marketability– Example: SIMEX
• Contract: US$/Yen
• Contract size:12.5 mil Yen
• Delivery: fixed maturity dates
Protecting an anticipated forex receipt/payment (example)
A Singapore importer owes US$ 102,000 in 6 months• Data: Spot rate = 1.76 S$/US$ 6 mo. Forward rate = 1.75 S$/US$ Singapore $ interest rate = 2% US $ interest rate = 4%
Alternatives to obtain the US$:1. Do nothing: Cost is $102,000 x actual future spot rate2. Forward purchase: Cost is $102,000 x 1.75 = S$ 178,5003. Spot purchase: Buy US$ at spot, invest; pay with proceeds
US$ x (1 + .04(6/12)) = 102,000US$ = 100,000
cost = 100000 x 1.76 = S$ 176,000+ Singapore interest for 6 months = S$ 177,760
Decision: choose the lowest cost hedge; or no hedge and take the risk!
Arbitrage swap (same example)• (Same Data)
• Today: Swap!1. Borrow S$ 176,000 for 6 months
cost of loan: 176,000 x 1.01 = S$ 177760
2. Buy US$ spot 176000 / 1.76 = US$ 100,000
3. Invest US$ for 6 months100000 x 1.02 = US$ 102,000
4. Sell US$ forward– Proceeds: 102000 x 1.75 = S$ 178500 – Cost: 176000 x 1.01 = 177760– Profit: S$ 740
Arbitrage (continued)
• Profit should be eliminated due to arbitrage.
• Therefore, interest and exchange markets should be in equilibrium.
forward exchange premium/discount
= interest differential
(So – Sn) / So x 100 = iS$ – iUS$
This is called International Fisher Effect (IFE).
Notation:
So = spot rate
Sn = forward rate
iS$ = S’pore interest
iUS$ = US interest
Notation:
So = spot rate
Sn = forward rate
iS$ = S’pore interest
iUS$ = US interest
Proof of IFE(This is for math buffs only!)
• International investment alternatives with a given amount of money (Principal):
1. Domestic: return = P(1 + iS$ )
2. Foreign: return = P/ So(1 + iUS$)
convert foreign return back to domestic cash:
P/ So(1 + iUS$) Sn
Arbitrage insures domestic return equals foreign return after conversion, so 1 = 2.
Under certain assumptions, it leads to the IFE formula.
Japanese Big Mac Valuation (Yen Over (+) or UNDER (-) Valuation Against the $)
-40
-20
0
20
40
60
80
100
120
1989 90 91 92 93 94 95 96 97 98
Percent
© McGraw Hill Companies, Inc., 2000
East Asian Big Mac Valuation
-70
-60
-50
-40
-30
-20
-10
0
10
20
30
1993 94 95 96 97 98 S. Korea
Thailand
Indonesia
Malaysia
© McGraw Hill Companies, Inc., 2000
THE INTERNATIONAL FINANCIAL SYSTEM
Further notes:
THE GLOBAL MONETARY SYSTEM
The Gold Standard• Has its roots in old mercantile trade.
• Inconvenient to ship gold, changed to paper - redeemable for gold.
• Reflected international desire to achieve ‘balance-of-trade equilibrium’
Between the Wars
• Post WWI, war heavy expenditures affected the value of currencies against gold.
• Countries engaged in competitive devaluations.
• Gradually, gold convertibility was suspended.
The Bretton Woods System
• In 1944, 44 countries met in New Hampshire, US.• Countries agreed to peg their currencies to US$
which was convertible to gold at $35/oz.• Agreed not to engage in competitive devaluations
for trade purposes and to defend their currencies.• Created IMF and World Bank.
Collapse of the B.W. regime
• Under BW, US Treasury required to deliver 1oz of gold to any IMF member that redeemed US $35.00.
• 1958 –1971: US ran accumulated deficit of $56 billion. US gold reserves shrank from $34.8 bil to $12.2 bil.
• August 8, 1971, USA left gold standard.• March 19, 1972, Japan and most of Europe
floated their currencies.• Fully collapsed in 1973.
– Vietnam War was blamed.
• Floating currencies considered to be a temporary fix.– Still going on today.
Floating Exchange Regime
• Formalised in 1976 in Jamaica by IMF members.– Accepted floating exchange rates.
– Abandoned gold as a reserve asset.
– Increased IMF funds.
• Increased exchange rate volatility under the floating exchange regime.– Government intervention to reduce the market’s
volatility has led to managed-float system.
Fixed versus Floating Exchange Rates
• The case for fixed exchange rates– ensure monetary discipline
– limit the effects of speculation
– reduce uncertainty
• The case for floating exchange rates– provide governments with monetary policy autonomy
– help adjust trade imbalances
A “Currency Board” is a modern rendition of the Gold Standard
• Gold Standard automatic fixed exchange rates becauseall currencies redeemed in gold at par:
Balance of Payments disequilibrium (eg, deficit)
Reduction in gold supply
Reduction in money supply
Reduction in price levels(or decline in exchange rate)
• Currency Board (eg, HK) automatic fixed exchange rate because
HK$ redeemed in US$ at par:
HK$ redemptions
Reduction in US$ reserves
Reduction in local money supply
Deflation
Restores equilibrium Restores equilibrium
Largest Borrowers from the IMF
4
11 11.6
21
0
5
10
15
20
25
Thailand Russia Indonesia S. Korea
Thailand
Russia
Indonesia
S. Korea
© McGraw Hill Companies, Inc., 2000
$ Billion
(Recently, these loans were exceeded by commitments to Turkey and Brazil.)
(Recently, these loans were exceeded by commitments to Turkey and Brazil.)
The radical argument
• Today’s dominant economic doctrines rule out any interpretation, or resolution, of global financial crises (such as the Asian Crisis) that puts part of the blame on the effects of the ideology of globalized markets.– The Asian Financial Crisis may be seen as a
failure of “Asian capitalism” or alternatively, a failure of the “international financial system”.
Global capitalismThe “New Imperialism” (?)
• Mahathir Mohamed: “…the fight for independence will have to begin all over again for the present market rules will surely result in a new imperialism more noxious and debilitating than the old.”
• George Soros: “I’m afraid that the prevailing view, which is one of extending the market mechanism to all domains, has the potential of destroying society.”
One culprit: the IMF
• The IMF is the institution responsible for the “system”. • Nationalists from the Global South are critical of the
IMF for (at least):– Forcing countries to open up to foreign competition and
takeovers– Forcing liberalization American-style– Bailing out foreign banks, while insisting on bankruptcy for
local banks– Fiscal and monetary restraints that kill local businesses– Dictating policy from Washington DC– Lack of transparency
Another culprit: market speculators
• The case for free capital movement is weaker than the case for free trade.
• George Soros himself believes there must be reform of the “system” and hedge funds like his own should be controlled.
• Radical reforms are occasionally implemented:– Debt write-offs, capital controls, market intervention
• Conventional solutions are relied upon:– Better information, sound financial practices, less
government involvement, improved banking and corporate governance, etc etc
TOWARDS A NEW FINANCIAL SYSTEM
• “today’s non-system of floating rates emerged from the wreckage …”
• …identify the problem– The crisis was a product of Asian capitalism.– The crisis was a failure of the “system”.
• Solutions depend on the problem.
Ideas for reform
• Market-reinforcement– transparency
• reserve transactions• economic statistics• foreign indebtedness
– regulation• capital adequacy• a global regulator
– reduce moral hazard• curb the IMF• bail in private lenders• “orderly workouts”
• System reinforcement– guarantor for loans– capital controls
• tax forex transactions• control ST inflows
– “lender of last resort”
• Regional mechanisms– Currency swaps– Surveillance– Common currency or
basket– Asian Monetary Fund