Dispense International Financial and Foreign Exchange Markets (IBM) - parte prof.Schlitzer, Dispense di Finanza

Scarica Dispense International Financial and Foreign Exchange Markets (IBM) - parte prof.Schlitzer e più Dispense in PDF di Finanza solo su Docsity! INTERNATIONAL FINANCIAL AND FOREIGN EXCHANGE MARKETS LECTURE 1 – INTERNATIONAL FINANCIAL AND FOREX PART 1 – WHAT IS INTERNATIONAL FINANCE AND ITS IMPORTANCE WHAT IS INTERNATIONAL FINANCE Two courses in international economics: 1) INTERNATIONAL TRADE: theory of trade, why countries specialize in some product and others in other product 2) INTERNATIONAL MONETARY ECONOMICS à this course fix here, it’s mostly related to the monetary part (exchange rate, international organization and so on and so furth) International finance is the branch of economics that studies the dynamics of exchange rates, foreign investment, the global financial system, and how these affect international trade. It also studies international projects, international investments and capital flows, and trade deficits. It includes the study of futures, options and currency swaps. International finance is a branch of international economics. Important theories in international finance include the Mundell-Fleming model, the optimum currency area (OCA) theory, as well as the purchasing power parity (PPP) theory. Whereas international trade theory makes use of mostly microeconomic methods and theories, international finance theory makes use of predominantly macroeconomic methods and concepts. It has to do with: • Cross border financial/capital flows (as opposed to ‘domestic’ financial flows) • Assets from one country being acquired by someone from another country, these transactions are made by actors like individuals, organization or institutions. • Exchanges of currencies, hence the role played by ‘reserve’ currencies and exchange rates SOME EXAMPLES - Us tourist paying a lunch in Paris through his credit card placed on a New York bank account - Money transfers - Italian citizen investing his saving in German T-Bills - ECB (European Central Banks) that intervene on foreign exchange market to influence the stance of monetary policy or exchange rate - EU bank transferring money to its branch in Latin America - US company making a greenfield investment in Asia (FDI) Note that each of these cases normally involves an exchange rate transaction as well as a BoP accounting RELEVANCE OF IF For students in economics or business administration understanding IF is of fundamental importance. • Among the events that affect the firms and that must be managed are changes in exchange rates, inflation rates, and asset values (and these events are often themselves related). • Even companies with a domestic focus are affected by the global financial environment as they compete with firms that are internationally active. • Because of the integration of financial markets, events in distant lands have effects that reverberate in other regions of the world (domino effects, contagion, systemic risk). • Inflation, jobs, economic growth rates, bonds and stock prices, oil and food prices, government revenues and other important financial variables are all tied to exchange rates and other developments in the increasingly integrated financial market. JOB OPPORTUNITIES International finance presents a wide range of job opportunities in both the public and private sectors. The wealth management industry is of particular interest in this regard. • Private banking and wealth management are ever growing segments of the financial industry • As economies grow, savings grow, and so the need to invest in real and financial assets • The number of affluent people is steadily growing worldwide, especially in Asia and North America there is the most concentration of wealth rather than Europe SOURCES OF INFORMATION ON IF 1) IMF based in Washington with its global financial stability report à The International Monetary Fund (IMF) was established in 1945 and is based in Washington D.C., USA. It is a forum for policy cooperation – its most well known publication is the World Economic Outlook – and provides financial support to member countries. It promotes policies aimed at both economic growth and financial stability (Levi, pp. 235-8). 2) BIS based in Basel, Switzerland, with its annual report à The Bank for International Settlements (BIS) is the oldest international financial institution. Established in 1930 and based in Basel (Switzerland), it is a bank for central banks and a forum for monetary cooperation. It also hosts the Basel Committee on Banking Supervision, which sets the minimum capital requirements for banks (Levi, p. 250). Other sources of information: • Institute of International Finance (IIF), also based in Washington D.C., is the global association of the financial industry. It is expression of the private financial sector, and the institution that negotiated with Greece the restructuring of the country’s debt in 2011. It offers several reports and publications on the international financial markets (www.iif.com). • The World Bank • OECD THE GLOBAL FINANCIAL STABILITY REPORT 2021 AT A GLANCE IMF deals with financial crises, and for this reason public financial stability report. • Approval and rollout of vaccines have boosted expectations of a global recovery and lifted risk asset prices, despite rising COVID-19 cases and persistent uncertainties surrounding the economic outlook. • Until vaccines are widely available, the market rally and the economic recovery remain predicated on continued monetary and fiscal policy support. Inequitable distribution of vaccines risks exacerbating financial vulnerabilities, especially for frontier market economies. • An ongoing rebound of portfolio flows provides better financing options for emerging market economies facing large rollover needs in 2021. • Policy accommodation has mitigated liquidity strains so far, but solvency pressures may resurface in the near future, especially in riskier segments of credit markets and sectors hit hard by the pandemic. • Profitability challenges in the low-interest-rate environment may weigh on banks’ ability and willingness to lend in the future. • Policymakers should continue to provide support until a sustainable recovery takes hold as underdelivery may jeopardize the healing of the global economy. However, with investors betting on a persistent policy backstop and a sense of complacency permeating markets as asset valuations rise further, policymakers should also be prepared for the risks of a market correction. BIS ANNUAL REPORT: THE DISTRIBUTIONAL FOOTPRINT OF MONETARY POLICY • The long-term rise in economic inequality since the 1980s is largely due to structural factors, well outside the reach of monetary policy, and is best addressed by fiscal and structural policies. • Monetary policy can most effectively contribute to a more equitable society by fulfilling its mandate, which addresses two key factors causing inequality at shorter horizons. This requires keeping inflation low and limiting the incidence and duration of macroeconomic and financial instability, which disproportionately hurt the poor. • Central banks can also help mitigate economic inequality wearing their "non-monetary hats", notably as prudential authorities, promoters of financial development and inclusion, and guardians of payment systems. 3) THE EURODOLLAR MARKET (Chapter 22 of Levi.) • Bank accounts in different currencies exist side-by-side in just about every financial center. In London you can open a bank deposit in € (a foreign currency in the UK) and obtain a loan in US $. • Having a financial transaction in a country using a currency of another one • A Eurodollar deposit is a US dollar-denominated bank deposit outside the US (therefore not under the jurisdiction of the Federal Reserve). • ‘Offshore currencies’ is a generalization to all currencies that are treated in markets outside the country of origin of the currency. • There are no reliable estimates of how big the offshore currency market is but it is certainly very big! As for domestic banking, offshore deposits may give rise to multiplier effect that raise the supply of global liquidity. • Around 90% of all international loans is made through the Eurodollar market. FACTORS BEHING THE GROWTH OF EURODOLLAR MARKET • During the 50s - Soviet Union $ deposits in British and French Banks, which were preferred to US banks by the soviets. • During the 60s and 70s - Regulation Q put limitations on interest rates that US banks could pay on deposits. It became more convenient to deposit $ in banks outside the US, especially in Europe. Most US banks decided to open branches in the old continent. • Regulation M imposed the keeping of reserves against deposits, which created another incentive for offshore operations. • Interest equalization tax (1963-1974): a tax on US loans to foreigners, which made convenient to get loans on the eurodollar market to avoid the tax. • Despite the removal of these restrictions, the eurodollar market continued to grow. • Same factors (mostly avoiding regulatory restrictions) contributed to the growth of the offshore market for other currencies 4) GROWTH OF CROSS-BORDER FINANCIAL FLOWS AND INSTRUMENTS • Parallel to trade, in the world war period and especially after the 70s there has been an enormous growth in cross border financial flows of all kinds: foreign investment in the money market (e.g. interbank market), the bond market, the stock market and the real estate market. • The importance of foreign investment may overshadow that of domestic investments and investors (for instance the role of foreign investors is of crucial importance for the successful sales of US Treasury bills as well as Italian BOTs) • There has been an explosion of internationally oriented financial products such as mutual funds, which can be globally or regionally diversified or focused on a single foreign country market. • Since the mid-70s Americans have increased their investments abroad by more than 10 times while non-US investors have increased their interest in US assets by 20 times (Levi, Fig. 1.1, p. 14). • The US moved from being the largest net creditor to the largest net debtor in only a quarter of a century. • Both advanced, emerging and developing economies are nowadays strictly dependent on foreign financing. Y (nominal income) to S (saving) à Y – T taxes = real income – C consumption = S What is the distinction between savings and wealth? - S is saving flow in one year because is the result obtained from Y which is income in a year, not all saving we have à FLOW VARIABLE - W is wealth is the accumulation of savings over the years à STOCK VARIABLE Wealth is invested in - real estate, - financial assets like stock or bond or mutual funds - gold - liquidity that is what typically there is in the checking account PUBLIC DEBT T-G<0 à taxes which are revenues minus expenses, meaning government spend more than it earns à it is normally negative so create DEFICIT which is a FLOW VARIABLE obtained in a year. On the other and the deficit accumulated over years create DEBT that is a STOCK VARIABLE. How to finance deficit? - Ask the central bank - Debt MAJOR FOREIGN HOLDERS OF US T-BILL Japan is the major foreign holders of US T-Bill CASE OF ITALY Italy’s debt to GDP ratio is now around 150%, one of the highest in the world. Most of the debt is in the form of short and medium-long term securities (Treasury’s BOT or BTPs). Government debt in Italy can be: - T-Bill 6 months, 1 year - 5-10 years - 30 years The public authority that typically manage this debt is Treasury. Every week and year Treasury is engaged in the activity of renew significant amount of bills and bond because they came to the expiry date and need to be renewed. Around 35% of the Italian T-Bills is owned by foreigners. Domestic investors can always be imposed to subscribe debts, with foreigners there is no leverage. BENEFITS FROM INTERNATIONAL INVESTMENT • Micro perspectiveà DIVERSIFICATION: an investor can search for higher returns abroad (for instance investing in emerging market stocks and bonds) and better diversify risk than he could do by investing his savings only domestically. • Macro perspective 1: finance can flow from high saving countries (typically the advanced economies), where returns are low, to the low saving ones where returns are normally higher (fig. 1B.1) 2: borrowing from abroad allows a country to smooth consumption over time (when national income is low and hence consumption is low, one can use foreign capital to keep consumption constant) (fig. 1B.2) Investing internationally is better than investing only at home. THE GAIN FROM A BETTER ALLOCATION OF CAPITAL First graphà advance economy Second graph à developing economy Typically saving increase as long as income increase. The position of saving line is different in the two graphs. Typically, savings is higher in advanced economies. At the same level of interest rate, saving is higher in advanced economies. Developing economies tend to growth faster than advance economies, this create a flow of fund from advanced economies in which saving are higher but return is low to developing economies in which savings are scarce, but returns are higher. That’s an example that explain why international finance is a good thing. HOME BIAS A preference of the financial investors toward domestic assets. • We have seen that cross-border financial flows are very consistent, and that international investment is indeed convenient from a micro and macro perspective… • ..and yet investors from all over the world prefer domestic assets to foreign assets as empirical evidence shows, especially for the case of equities. • This phenomenon is called ‘home bias’ and can (partly) be explained by: • (i) legal restrictions to foreign investment, • (ii) double taxation, • (iii) informational asymmetries (investors normally have more information on domestic firms). • None of these explanation is fully convincing, hence economists speak of a “home bias puzzle”. Given the existence of a home bias, there is still much room for financial globalization!!! Exam qst: preferenza che c’è in tutti I paesi per gli asset domestici, ma perche c’è questa preferenza? (parte schlitzer) CONS FINANCIAL INSTABILITY Financial instability is the ‘dark side’ of international finance. It may consist of: • excess volatility of exchange rates (especially amongst major currencies) which can be disruptive for trade and financial flows; • excess volatility in stock and bond markets, which makes difficult to evaluate investments; • excess instability of financial flows, which can move from one country to another massively and with extreme rapidity giving rise to bubbles, or financial crises having real economic consequences. FINANCIAL CRISES In recent years heavily disruptive financial crises have dominated the scene of global finance and put into question the benefits from financial globalization. • 1982 Latin American Debt Crisis • 1992 ERM crisis • 1994 Mexican crisis • 1997 Asian Crisis • 1998 Russian Crisis • 2000/01 New Economy Bubble Burst • 2001 Argentina’s financial crisis • The Great Crisis 2007-2010 • Greece and the Euro Crisis 2011-2015 • Most of gold is held by central banks and the IMF but private institutions like investment funds also have gold in their asset portfolios. • The US and most European countries hold more than 70% of their foreign reserves in gold bars. Why is gold so important? • Gold still represents an important store of value. Albeit its price changes daily on a market basis, its value does not depend on ‘trust’ like in the case of currencies. Gold was abandoned as a base for currencies, but CB continued to keep gold reserves. CRYPTO CURRENCIES IF finance is in continuing evolution. Since the release of the BITCOIN in 2009, many other digital currencies have been created. An aim of crypto currencies is to create value and move it easier from a country to another. But what is a digital currency? Wikipedia: A cryptocurrency, crypto-currency, or crypto is a digital currency designed to work as a medium of exchange through a computer network that is not reliant on any central authority, such as a government or bank, to uphold or maintain it. The main questions around cryptos are: - What is a cryptocurrency for? Does it serve as a medium of exchange or a store of value? - How does it affect the money supply and central bank management? - What is its link to the real economy? - Are they money? How do CB can control them? EXCHANGE RATES Exchange rates determine the rate of change in the market of a currency with another (or with gold). The US $/euro exchange rate is the number of $ units that are needed to get 1 euro. When left to market forces exchange rates may vary considerably and even abruptly. When the euro was introduced on Jan. 1, 1999, its value was initially set at 1.17$ but at the beginning of 2002 it went to 0.85$. Its quotation is now around 1.12$*. Most countries define their exchange rate in ‘direct terms’, that is ‘units of national currency against 1unit of a foreign currency’ (UK is an exception). This is sometimes called ‘uncertain for certain’. One has always to make sure of what is the currency at the numerator and which one at the denominator. FIXED VS FLEXIBLE EXCHANGE RATES The determination of an exchange rate may be left to market forces, FLEXIBLE (demand and supply of currencies) or may be FIXED in terms of another currency or benchmark (e.g. gold). What ‘regime’ to choose is a political decision. FIXED EXCHANGE RATE à it is decided by the country, setting the parity of the currency with another currency, by low. Before WWI, exchange rates were internationally set in terms of gold and were thus fixed (gold standard), not left to market forces. After WWI till 1971-73 exchange rates were fixed in terms of the US $ which was the dominant reserve currency. In the present ‘system’ we observe a large variety of exchange rates regimes (a non-system?). Flexible regimes are as much frequent as fixed regimes. There is no theoretical or empirical evidence that a given regime is better than another (in terms of growth and employment creation or in terms of financial stability) The exchange rates of the major reserve currencies are left to market forces RELEVANCE OF EXCHANGE RATES • Exchange rates lie at the heart of IF. • The ‘interbank foreign exchange market’ (i.e. the market where international banks exchange deposits in different currencies) is the largest financial market in the world, with an average turnover of $4 trillion per day. • The changes or levels of an exchange rate have important effects on sales prices and costs of imported goods and raw materials and hence influence the profits of importers and exporters (see Exhibit 1.1 Currency matters: corporate experiences ) • They influence a country’s BoP and inflation rate through the valuation of exports and cost of imports especially of oil and raw materials. • They may be related to the persistence of external imbalances at the global level !! SOME TAXONOMY ON EXCHANGE RATES • Exchange rate ‘regime’: is the type of criterion that a country chose to set the value of its exchange rate, whether flexible (i.e. determined by market forces) or fixed or any other form between these two extremes. • Exchange Rate ‘System’: refers to an agreement by which some countries, in a region or at the global level, set their (reciprocal) exchange rates according to a given mechanism (e.g. the Bretton Woods System of exchange rates 1944-1973). • Devaluation/Revaluation: a FIXED EXCHANGE RATE that is devalued/revalued by the country’s authorities (the exchange rate parity is revised). • Depreciation/Appreciation: a FLEXIBLE EXCHANGE RATE that registers a depreciation/appreciation on the foreign exchange market. INTEREST RATES • Interest rates are another fundamental factor of IF. They influence in a significant way cross border financial flows searching for the best risk/return combinations. • Interest rates indicate the returns on financial assets and vary according to the degree of liquidity and the risk embedded in each asset (bank deposits, corporate bonds, treasury bonds, investment funds, etc).ersz • Market interest rates vary on a daily basis but are influenced by the ‘policy’ rates set by the monetary authorities. These are the rates at which central banks lend money to the commercial banks (e.g. the FED overnight rate). • Economic theory has paid a lot of attention to the equilibrium level of interest rates in an international economy (interest parity conditions, Chapter 6). MARKET RATES: rates determined by the market, interest rate that a commercial bank applies on its loans to firms. Or yields on private bonds POLICY RATES: are different from countries to countries. It is the interest rate that the monetary authority adopts, called stance of monetary policy. The most famous policy rate is the Federal Funds Rate. FEDERAL FUNDS RATE FED drives the market to the interest rate that they decided. Banks hold the reserve requirement either at their local Federal Reserve branch office or in their vaults. If a bank is short of cash at the end of the day, it borrows from a bank with extra money. The Fed funds rate is the rate that banks charge each other for overnight loans to meet these reserve balances. The amount lent and borrowed is known as the Fed funds. The Federal Reserve, through its Federal Open Market Committee (FOMC), targets a particular level for the Fed funds rate. It uses open market operations to push the Fed funds rate to its target. If it wants the rate lower, the Fed purchases securities from its member banks. It deposits credit onto the banks' balance sheets, giving them more reserves than they need. That means the banks need to lower the Fed funds rate to lend out the extra funds to each other. When the Fed wants rates higher, it does the opposite. It sells its securities to banks, removing funds from their balance sheet, giving them fewer reserves. That allows them to raise rates. The Fed uses the Fed funds rate as a tool to control U.S. economic growth. That makes it the most important interest rate in the world. Banks use the Fed funds rate to base all other short-term interest rates that they apply to their customers on deposits and loans. Central Banks all over the world have their policy rates to regulate liquidity in their ‘domestic’ systems. Longer-term interest rates are indirectly influenced. Usually, investors want a higher rate for a longer- term Treasury note. The yields on Treasury notes drive long-term conventional mortgage interest rates. Since March 2020, the Fed funds rate is targeted to be between 0.00% and 0.25%, its lowest level ever. Each CB of each country has its own policy rates. Investment depends on interest rates, so if CB lower Interest rates the investment goes upà that’s why are really important as a monetary impulse for the economy. How the Fed Uses It to Control the Economy The FOMC changes the Fed funds rate to control inflation while maintaining healthy economic growth. The FOMC members watch economic indicators to determine if the economy is speeding up (inflation) or slowing down (recession). The key indicator for inflation is the core inflation rate. The most important indicator in predicting a slowdown is the durable goods report. ACTUAL CRISIS Currently, due to the Ukrainian crisis, interest rates, both market rates and policy rates, are really low. Why are we seeing a reversal of these policies? Due to the high inflation rates. CB and institutions are revising downward their forecast, but the attitude to change policies is complexà now, mainly because the inflation is a cost inflation, due to raw material appreciation in prices. When inflation is driven by demand, typically monetary authority tries to chill a bit demand for consumption and investment goods. Typically, CB restricts Monetary policy when the demand growing too fast, but now it is not the case, after pandemic it was but not with the war. Sometimes it happens that if CB let the inflation to rise, people have the expectation that will continue and built up an inflationary expectation. INTEREST RATES AND FINANCIAL CRISIS • An inappropriate ‘level’ of some (reference) interest rates may be at the root of a financial crisis (interest rates reflect the ‘stance’ of monetary policy). • When interest rates are too high on a reserve currency, this may cause financial problems in the periphery: - the Latin American crisis in 1982 was (also) due to the change in monetary policy operated by Paul Volcker - the ERM crisis in the early 90s was (also) a consequence of the Bundesbank policy of high interest rates (after German Unification) • When interest rates are too low for a sustained period they are also a cause for concern as they may reflect too much liquidity in the system that in turn leads to inflation and/or a lax credit policy. • Greenspan legacy: In autumn 2001, as a decisive reaction to the September 11 attack and various corporate scandals which undermined the economy, the Greenspan-led Federal Reserve initiated a series of interest cuts that brought down the Federal Funds rate to 1% in 2004. Most critics attribute the rapid rise in commodity prices and asset inflation as well as a weak dollar to Greenspan's loose monetary policy. RISK Interest rates vary according to the degree of risk embedded in financial assets. The higher the risk for the lender or the investor to get his money back, the higher the interest rate that he demands. International investors face all kinds of risk that are typical in the activity of lending/borrowing money: i.e. credit risk, operational risk, etc. What kinds of (additional) risks an international investor face? EXCHANGE RATE RISK: when investing in an asset denominated in a foreign currency, the exchange rate prevailing at the end of the investment period is going to affect significantly the final return. • SWF are a special kind of investment funds in that they are not private but state-owned funds. • They hold and manage the wealth accumulated by a country through its central banks’ activity, its balance of payments (mostly oil revenues) or its state-owned entreprises. • The first SWF was the Kuwait Investment Authority, that was created in 1953 from oil revenues. It is now worth approximately $300 billion. • Sovereign wealth funds have been around for decades but since 2000 their number and importance has increased dramatically. • There are several reasons why the growth of sovereign wealth funds is attracting close attention: (1) their potential impact on financial markets given their sheer size; (2) the concern that SWF can get control of strategically important industries for political and not economic reasons; (3) their lack of transparency. • It’s estimated that taken together, governments of SWFs, largely those in emerging economies, have access to a pool of funds totalling $20 trillion. • The Santiago Principles (2008) set out the best practices that SWFs should follow, on a voluntary basis, in their operations. CENTRAL BANKS • Central banks are major actors in financial markets as they create money (fiat money) and regulate the amount of liquidity in the system. • They play a fundamental role in financial crises by discharging the ‘lender of last resort function’. • In systemic crises they can help avoid a liquidity crunch (see the role the ECB is playing in the current euro crisis) by providing cheap money to banks or (exceptionally) through the subscription/acquisition of government debt or other assets (e.g., bad loans from banks). • Approaches differ from central bank to central bank. For instance, there is a major difference between the FED, whose mandate includes the objective of supporting economic growth, and the ECB, that targets inflation (less than 2%). • In some cases, CBs are also charged with banking supervision, in others they are not (e.g. Prudential Regulation Authority-PRA in the UK). THE BASEL CAPITAL ACCORD • The Basel Accord is the way prudential supervision is implemented at the international level, with the purpose of avoiding ‘competitive deregulation’. • The Accord is an outcome of the work of the Basel Committee on Banking Supervision, a forum for regular cooperation on banking supervisory matters that was established in 1974 after the default of the Herstatt bank. • The Committee is headquartered at the BIS (Bank for International Settlements) (see Levi p. 515). Its objective is to enhance the understanding of key supervisory issues and improve the quality of banking supervision worldwide. • The Basel Accord sets the minimum capital requirements that banks around the world should hold on a prudential basis. • The level at which capital requirements are set is a major determinant of the banks’ capacity to provide credits and of the likelihood that financial crises occur. Basel I – 1988 Focused on credit risk. Assets of banks were classified and grouped in five categories according to credit risk, carrying risk weights of zero (for example home country sovereign debt), 10, 20, 50, and up to 100 percent (this category include, among others, most corporate debt). Banks with international presence were required to hold capital equal to 8 % of the ‘risk-weighted assets’ Basel II – 2004 Uses a "three pillars" concept – (1) minimum capital requirements (addressing risk), (2) supervisory review and (3) market discipline. Extends the focus to ‘operational risk’ and ‘market risk’. Relies heavily on ratings either set by rating agencies or directly by banks Basel III – 2010-11 A much wider and complex approach to banking supervision developed in response to the deficiencies in financial regulation revealed by the late-2000s financial crisis. In addition to raising basic capital requirement levels, it introduces additional capital buffers in order to reduce: (i) leverage, (ii) the maturity mismatch, and (iii) countercyclical effects. Basel IV – 2023 More stringent requirements for systemically important entities (among other things). RATINGS • Ratings help assess the creditworthiness of firms, banks and countries (government bonds) when they operate internationally. They are a measure of the ‘quality’ of credits. • Standard&Poors, Moody’s and Fitch are the best known (international) rating agencies but there are a lot more. • Ratings go from AAA of Std&Poors (Aaa for Moody’s and Fitch) to Bbb or ‘C’ (junk bonds.) Assets with a rating above BBB are said ‘investment grade’. • Bank regulation relies significantly on ratings (Basel Accord) • Institutional Investors also rely on ratings in their investment decisions. Fund managers may set a threshold rating above which investments are allowed (this implies that if an asset that is present in the fund portfolio falls below the threshold rating it is to be dismissed). HOW RELIABLE ARE RATING AGENCIES? There is a serious debate on the validity of ratings, on rating agencies and their methods. Rating agencies are accused of: setting often the wrong ratings (e.g. subprime loans) - failing in predicting financial/corporate crises thus issuing downgrades when it is too late (see Lehman Brothers), thus aggravating financial or corporate crises due to the wrong timing of downgradings (see the recent downgrading of several European countries during the euro crisis) - being in a conflict of interest as they are paid by the firms that ask to be rated. Yet, it is difficult to imagine a world without ratings! INTERNATIONAL ACCOUNTING STANDARDS • Accounting Standards are an important variable in the context of financial crises, as they may contribute to the spread of financial instability depending on the way assets are valued in financial statements. • Recording assets at their ‘historical’ values may not reflect over time their true value. • Using the ‘mark-to-market’ principle (i.e. the market price or quotation), however, introduces ‘instability’ in financial statements. • During financial/liquidity crises, application of the mark-to-market principle may trigger a downward spiral: assets prices go down, financial statements worsen and this may lead to more asset sales. • This spiral was certainly at work during the recent crisis, and has hit especially banks. • Economists and accountants are debating on how to mitigate the undesired effects of the mark-to market principle. INTERNATIONAL FINANCIAL ORGANIZATION • International financial organizations, like the World Bank and the IMF, provide liquidity to countries with temporary or structural problems and hence may influence financial markets. • The WB issues AAA-rated bonds in order to finance projects in developing countries (long term financing). • The IMF supports countries with liquidity problems due to a worsening of the BoP and helps prevent or resolve financial crises (short terms or emergency financing). • The IMF supervises economic and financial policies around the world and is the true guardian of financial and exchange rate stability. • It has intervened in almost every recent financial crisis episode, but it failed to predict the Great Crisis. BACK TO FINANCIAL CRISES • Financial Crises touch most of the variables and players we have discussed. • They normally affect (i) the exchange rate; (ii) the banking system; (iii) the BoP and the external debt of a country… • .. and can trigger domino effects. • Causes of financial crises vary from case to case and can be found in both ‘internal’ and ‘external’ factors. • Internal factors are normally to be found in unsound domestic policies (typically fiscal policy) and inefficiencies in the economy. • External factors may be found in the instability of international financial flows and/or too high (international) interest rates. • In every financial crisis economists and policy makers debate on how relevant are the internal factors vis-à-vis the external ones. THE PHASES OF A BUSIENSS CYCLE - Expansion phase - Recession phase - Recovery phase GROWTH RATES AND RECESSIONS There are several techniques to separate the trend from the cycle. The simplest one is using growth rates, i.e., the percentage changes in GDP: Growth rates are perhaps the most significant indicator of the health of an economy. They are published by statistical bureaus around the world on a quarterly or annual basis. - When you register two consecutive quarters of negative growth, the economy is officially in a recession (the NBER criterion) HOW LONG ARE RECESSIONS? Historically, phases of the business cycles differ from one another, and the length of recession and recoveries is always uncertain. Recessions can be deep and short, or long and soft, or they can be both deep and long in duration, in which case they are often called depressions (like the Great Depression of the 30s). Soft-landing is a term often used to describe the case of a recessions that cannot be avoided but policies are calibrated so as to minimize the damage. Recoveries can display different shapes. A swift recovery is normally called v-shaped whereas a slower one is u-shaped. In general, in free market economies recessions are sharper and recoveries fasted due to the high flexibility embedded in the system (like in the Us). The opposite happens in economies with a larger welfare state to protect the weakest, but suffer for more rigidities (the case of Europe): An economy may experience a false recovery, and quickly get back into recession. In this case is normally called double-deep and happens when the causes of the recession were not definitely removed. LONG AND SHORT-TERM MODELS Economists have developed different models to interpret the trend and the cycle. § LONG-TERM MODELS are normally named growth models. Their first and most known examples are o the Keynesian Harrod-Domar model of the late 40s o the Neoclassical model developed by the Nobel Prize Robert Solow in 1956 o The Endogenous Growth Models where the human capital and technological progress are endogenous and not given as in the previous models. § SHORT-TERM MODELS: economists have devoted a lot of attention to the analysis of the business cycle too. Beyond the standard IS-LM model, which describes how an economy works in the short term, a lot of empirical research has been devoted to the prediction of recessions and recoveries Forecasting is an important branch of the empirical economics and a number of techniques have been developed, which are commonly used in business and finance. Regardless of whether you will be working in business or finance, in a small or large company, assessing the state of the business cycle and trying to foresee changes in its direction will be an important part of your job. THE IMPORTANCE OF PREDICTION FOR INVESTMENT DECISIONS Knowing at what stage of the business cycle you operate is of crucial importance when taking an investment decision, whether real or financial. - Buying shares when you are at the peak of a cycle can prove a serious mistake as you will suffer capital losses. Similarly, it would be a mistake to plan the acquisition of new physical capital to increase the productive capacity of your factory when demand will decline because of an incoming recession. Governments and public administrations in general also have an interest to predict the business cycle. Only think to the need of preparing their annual budgets. Predicting peaks and troughs of the business cycle is not an easy task. But a number of techniques have been developed to this end that make use of both economic indicators and econometric models. MAIN BUSINESS CYCLE INDICATORS The rate of change in GDP, consumer prices and employment/unemployment are normally used as the main barometers of economic conditions. However, they are published with some delay. Thus, there is a variety of other indicators that are normally monitored by business and financial analysts, such as: - The industrial/manufactory production index - The households (consumers’ confidence index - The purchasing managers index (PMI) - Sales and new orders - Wages and salaries (payrolls) - Some financial indicators (banks’ loan to firms, yield curve, etc.) LEADING AND LAGGING INDICATORS Business cycle indicators (BCI) provide early signals about the state of economic activity. They are normally published monthly by statistical bureaus, much before the release of quarterly GDP growth. BCI are published with a short delay (normally 1 or 2 months) due to the time that is required to collect data. However, as they are normally based on representative samples of consumers and firms, thet are released much faster than any other indicator of economic activity. A further distinction is between leading, lagging and coincident indicators. - LEADING INDICATORS: are those that anticipate future production and are thus the most relevant from the point of view of predicting turning points - LAGGING - COINCIDENT While sales and industrial production indicators coincide with the cycle, manufacturing orders or business and consumer confidence may signal in advance that a regime change is coming. - Employment/unemployment figures typically lag the cycle. Why? - What can be inferred from changes in salaries and wages (payrolls)? Orders received per month: leading indicator (because I want to predict production, and by definition orders come before production) GDP indicator: coincident indicator (it is production, which is want I want to predict) Confidence indicator: leading indicator (it helps me forecast production) Employment / unemployment: lagging indicator (there is a lag in adjusting the workforce; it is not the first thing I cut, since I have invested in it). FINANCIAL INDICATORS A number of indicators from the credit and financial markets can also be tracked to assess the business cycle. Some common leading indicators of these kind are: • The change in banks’ lending to the corporate sector • The shape of the yield curve, that describes the time profile of interest rates STOCK MARKET INDEXES tend to follow the business cycle and contribute to understanding the health of an economy. However, they are highly volatile and can rarely be used to predict turning points. However, a stock market crash following a long “boom” or a market bubble may indeed produce serious real consequences, thus anticipating or even causing a recession (e.g., the dot.com bubble of 2000-2002) MAIN INDICATOR FOR THE US STOCK MARKET BUSINESS CYCLE AND PORTFOLIO MANAGEMENT Financial assets often display dissimilar performances during business cycles, depending on the asset class or the economic sector to which they belong. Some assets may display pro-cyclical behavior, while others will be a-cyclical, which means that they display a sort of neutrality vis-à-vis the cycle, or simply that they fluctuate less. It might be useful to balance your portfolio with an appopriate share of a-cyclical assets in order to reduce the risk of sharp losses during a downturn. Cyclical stocks represent companies that produce or sell goods and services that are in demand when the economy is doing well. Examples are restaurants, hotel chains, airlines, furniture, high-end clothing retailers, and automobile manufacturers. These are also the items that people cut first when times are tough! Stocks of utility companies are typically a-cyclical. People need power and heat for themselves and their families. By providing a service that is consistently used, utility companies grow conservatively and do not fluctuate dramatically. COMPOSITE INDICATORS The is no single indicator being able to predict turning points at every juncture. As cycles differ from one another, an indicator that was able to anticipate a recession might fail to do so on another occasion. For this reason, analysts and economic think tanks prefer to rely on composite indicators. These are synthetic indexes based on a selection of short term indicators. The oecd, the organization for economic cooperation based in paris, has developed a system of leading indicators for its member countries since the 70s. https://www.oecd.org/sdd/leading-indicators/ The empirical evidence shows that the oecd’s composite leading indicators (clis) tend to anticipate business cycle turning points by 6-9 months. ECONOMETRIC MODELS Macro-econometric models are complex statistical models normally based on regression techniques and long time series data (quarterly or annual). They typically consist of a number of equations that put in relation the main macroeconomic variables, normally according to economic theory. Remember: we define Ɛ as the amount of domestic currency needed to buy one unit of the rest of the world’s currency, hence a devaluation/depreciation implies that Ɛ goes up (viceversa for a revaluation/appreciation) The changes in flows when these variables change - Increase in income (Y) à imports increase à current account improves, currency depreciate - Why CA improves when my currency valuation on the exchange rate market worsens? Because my country export more because from foreign point of view my goods became cheaper - Increase in r (rate of interest in this case domestic) à inflow of capital, because investor that want to buy our financial assets will have better return, also in this case because our asset became cheaper for foreign investor When BOP is equal to 0 it means is in equilibrium. THE BB LINE As the BB line represents points of EQUILIBRIUM of the BOP – no surplus or deficit – along the line there are no changes in either ‘r’ or ‘ɛ’. CA (Y; Ɛ°) + KA (R; Ɛ°) = 0 Where ɛ° stands for a given level of the exchange rate (either set by the market or, in case of a fixed exchange rate regime, by the authorities) Points above of below the line are points of disequilibrium. Hence an adjustment takes place either through a change in the exchange rate or the level or reserves (or both). Important: the bb line moves downright in the case of a devaluation/depreciation of the exchange rate (when ɛ goes up; viceversa in the case of a revaluation/appreciation) PROPERTIES OF THE BB LINE • The bb line works for both cases of fixed and flexible exchange rate regime • It is POSITIVELY SLOPED. Since CA (Y; Ɛ°) + KA (r; Ɛ°) = 0 an increase in Y worsens CA (pushes imports up) hence it must be compensated by an increase in r which STIMULATES CAPITAL ACCOUNT inflows KA à if one account improve, the other has to worsen in order to maintain the equilibrium. • Points above or below the bb line represent - by definition - points where the bop in not in equilibrium (have changes in r and/or Ɛ). In particular: • above the bb line, the bop will be in surplus, hence either r increase or the exchange rate appreciates • below the bb line, the bop will be in deficit, hence either r decrease or the exchange rate depreciates • it shifts with the level of the exchange rate (downward if Ɛ↑, upward if Ɛ↓) THE BB LINE AGAIN Above or below the line there is DISEQUILIBRIUM - Above the line à surplus à improving reserves, exchange rate appreciates - Below the line à deficit à loosing reserves, exchange rate depreciates, in case of fixed exchange rate you are forced to devalue SHORTCOMINGS OF THE IS-LM-BB MODEL Before moving foward, we must be aware of the following caveat • The IS-LM-BB is an ‘open economy’ model, hence it takes the point of view of the domestic economy • In particular, it does not consider the reactions of rest of the world to the domestic policy changes à if CB change the monetary policy, it seems that the rest of the world maintain the same ones, but this does not happen in reality • For instance, in the case of a monetary expansion that reduces the interest rate to stimulate (domestic) investment, or of a devaluation to stimulate (domestic) exports, the rest of the world may do the same • Reactions by the rest of world in the same direction may reduce and even fully undo the benefits of the policy move • This is an important shortcoming of the model to keep in mind, in addition to those mentioned before for the basic IS-LM model ASSESSING THE EFFECTIVENESS OF POLICY CHANGES In an open economy setting, where capital flows are free to move, everything changes with respect to the standard closed economy model • Policy makers must keep this in mind when deciding changes in the stance of economic policies to ‘fine tune’ the (domestic) cycle • Levi’s chapter xii illustrates in details what happens when expanding monetary or fiscal policies in an open economy setting, as well as the case of an exchange rate devaluation (in the case of a fixed ex. Rate regime) • Taking into account the exchange rate regime is crucial to assess the effectiveness of a policy change. In fact, results radically change depending on whether we are under a fixed of flexible ex. Rate regime THE CASE OF MONETARY POLICY The case of an expansionary monetary policy is particularly illuminating The outcome depends strongly on • the exchange rate regime being adopted and • the fact that capital flows react to the policy change As we will see, monetary policy • is ‘ineffective’ (to stimulate growth) under a fixed exchange rate regime, • whereas it proves especially effective under a flexible exchange rate regime. CASE 1 – FIXED EXCHANGE RATE Monetary policy is NOT effective The case of fixed exchange rate shows that monetary authorities cannot pursue two (conflicting) objectives at the same time, that is raising domestic income and preserving the exchange rate parity. In economic theory this result can be explained by way of two principles. • Principle 1 (economic policy): you need at least as many instruments as policy objectives • Principle 2 (impossible trilemma): cannot have at the same time an autonomous monetary policy, free capital mobility and a fixed exchange rate, must give up at least one the three objectives IMPOSSIBLE TRILEMMA/TRINITY CANNOT HAVE THESE THREE THINGS AT THE SAME TIME, MUST GIVE UP AT LEAST ONE (TYPICALLY USE CAPITAL CONTROLS TO LIMIT CAPITAL MOBILITY) You want to move monetary policy at your discretion but if you have decided to adopt a fixed exchange rate, you have to change the stock of money to adapt the exchange rate. CASE 2 – FLEXIBLE EXCHANGE RATE Monetary policy is effective The situation is well illustrated through our IS-LM-BB diagram in the following slide As before, the CB expands money supply, hence the LM moves to the right. There are two effects on the real economy following the fact that r↓. 1. An increase in investments (a movement along the IS) 2. A depreciation of the exchange rate, as a lower return on domestic assets will determine a reduction in net capital inflows 3. 3. As a consequence of 2, net exports will increase (the IS moves to the right); the BB also moves to the right. à due to depreciation of interest rate The new equilibrium is reached at a new intersection of the 3 lines at a higher level of Y (and GDP). A WARNING ABOUT CASE 2 When considering case 2, where monetary policy acts under a flexible exchange rate, everything seems to work nicely. You can expand monetary policy at pleasure and improve well being for all. As said the model is too simple and reality is different. You should always keep in mind that: • Money creation can be useful in the short run or in emergency situations (for instance a financial crisis) but does not provide sustainable growth. • Competitive (ex. rate) devaluations are beggar-thy-neighbor policies and normally cause reactions by other countries. OTHER CASES OF POLICY CHANGES • Go through levi’s chapter xii to study other cases of policy changes 1. Monetary financing. This solution relies on the new liquidity provided by the cb (extra purchasing power). While being the easiest, it brings about higher inflationary risks. Hence, you might repress investment and consumer spending. 2. Debt financing. Means relying on the ‘saving pool’ existing in the system. The government issues t- bill and t-bonds, thus borrows from the private sector (domestic and foreign). Therefore, less saving will be available to finance private spending. In both cases there is a risk of ‘crowding out’ private demand (through higher inflation in 1, and higher interest rates in 2) PUBLIC DEBT AND ITS SUSTAINABILITY The public debt is the stock of debt that an economy has accumulated over time to finance its deficits. It is a key variable to monitor for financial investors. The level of public debt is normally measured in terms of GDP (debt/GDP), a number that varies a lot across countries. Italy and japan have some of the highest debt/GDP ratios in the world (around 150% and 230%, respectively). Ministries of finance/treasury departments across the world struggle daily to assure the financing of the debt (new debt and renewal of old debt). The higher is the share of debt owned by foreigners, the more you are subject to the laws of the market. The annual interest rates paid on the debt contribute to produce deficits every year, hence to the further accumulation of debt. Their level depends on a number of factors, that are in some way reflected in the rating assigned to the debt. The so called ‘primary deficit’ is the government deficit without considering interests on the debt. Public debts have been on the rise worldwide as governments tried to cope with the economic crisis due to the pandemic. As GDP growth rates are falling, debt/GDP ratios have increased significantly. WHICH POLICY IS MORE EFFECTIVE? Monetary and fiscal policies respond to different purposes and should be used in combination rather than in isolation. MONETARY POLICY can be enacted swiftly and is the best instrument to fine-tune the cycle or cope with situations of financial distress (lender of last resort). However, its management is a lot more complex than normally thought and central banks have refined their approaches and methods over time. If ill-managed, monetary policy can produce significant damages to the real economy and the financial sector. FISCAL POLICY serves a variety of purposes: 1) supporting aggregate demand, redistributing income, 3) enhancing the productive potential of the economy in the long-run (through infrastructure building and public investments). During recessions, fiscal policy uses a variety of measures: unemployment benefits, various forms of subsidies and compensations (as in the current covid crisis), and ‘automatic stabilizers’ (such as progressive taxation). MAIN LESSONS FROM PART III 1. Monetary and fiscal policies are a lot more complex than in the is-lm-bb model 2. They produce effects over the entire structure of interest rates, real and nominal, short and long 3. They affect income, employment and prices in different guises 4. They act at different speeds and serve different purposes 5. They should be used in combination rather in isolation to cure the ills of an economy 6. As any medicin may have side-effects, so both monetary and fiscal policies must be managed wisely in order to balance costs and benefits LECTURE 4 – INTERNATIONAL FINANCIAL AND FOREX THE INTERNATIONAL MONETARY AND FINANCIAL SYSTEM IN HISTORICAL PERSPECTIVE From the Gold Standard to the Euro PART 1 – GLOBALIZATION AND THE ROLE OF EXCHANGE RATES Globalization is the word used to describe the growing interdependence of the world's economies, cultures, and populations, brought about by cross-border trade in goods and services, technology, and flows of investment, people, and information. Deglobalisation is the process of diminishing interdependence and integration between certain units around the world, typically nation-states. It is widely used to describe the periods of history when economic trade and investment between countries decline. It stands in contrast to globalization. PHASES OF GLOBALIZATION/DEGLOBALIZATION 1) 1820-1913 – 1° Phase of Globalization (Gold Standard) 2) 1914-1944 - 1° Phase of Deglobalization 3) 1944-1973 – 2° Phase of Globalization 4) 1973-2007/8 – 3° Phase of Globalization 5) 2008/9 – 2° Phase of Deglobalization? Globalization is neither ‘new’ nor ‘irreversible’!! FIRST PHASE OF GLOBALIZATION – GOLD STANDARD 1820-1913 • Starts with the industrial revolution in the UK, that spreads all over the world • London was the financial center of the world, not just the UK • Innovations like steam power, sea and rail transports contributed to economic & financial integration and to economic growth Monetary Regimes at the time were based on preciuos metals, mostly gold and silver The value of money was given by the content of precious metal. Gold Standard 1870-1913 Historians place the start of the "gold standard” in 1870-71, when Germany and most of the major economies in the world adopt gold as the reference metal. US$=grains of 23.22 gold à Exchange rate 113/23.22= 4.87* ß UK£=113 grains of gold Before 1870 there was no clear-cut rule. Some countries were on the gold std (UK, Portugal), others on the silver std (Germany, Austria, Netherlands, Russia, Sweden); other adopted bimetallism, (e.g. USA, France, Italy, Belgium). !!Banknotes!! countries were committed to assure "full convertibility" of fiat money at any moment Under the gold std (basically, a system of fixed exchange rates) there was a period of exceptional growth & financial stability (historians are re-visiting this) à The 1913 peak in world export equaled only in 1970 FIRST PHASE OF DEGLOBALIZATION • WWI puts an end to the gold standard era • Countries start to rely on ‘beggar-thy-neighbor’ policies to gain a competitive advantage • Competitive devaluations become the norm • Bilateral agreements prevail on multilateral/regional agreements • Some countries impose banknotes circulation by law without committing to full convertibility • Widespread use of restrictions on commercial & financial cross-border flows • Hyperinflation in some countries 1944 - Bretton Woods Conference In May 1944 the US invite 44 other countries to a conference with the aim to establish a "new economic order" (Germany, Italy & Japan not invited). The IMF, WB and (later on) the WTO are established. Currencies are placed on a "dollar std" so called "Bretton Woods System" of "fixed but adjustable" exchange rates. SECOND PHASE OF GLOBALIZATION 1944-1973 The reconstruction after the war and the BW economic order fosters a new era of growth and financial stability. • Inflation is low and is not yet an objective of monetary policies (at least not for all CBs) • Globalization is back in terms of both trade and financial flows • The US replace the UK as world main power and the US$ becomes the world reference currency THIRD PHASE OF GLOBALIZATION 1973-2007/8 It is an extended period of time that can in principle be subdivided in more subperiods. For instance, there is evidence that after 1989 (break of Berlin wall) world integration accelerated. • This period ends in 2007/8 with the start of the Great Crisis. • World integration rose only slightly after the Great Crisis and in 2015 it decreased for the first time since 1975. • The trade war between the US and China, the spread of the coronavirus and, most recently, the Russia-Ukraine conflict explain the start of a negative trend. GROWTH AND MONETARY AND FINANCIAL STABILITY • When we classify historical periods as ‘good’ or ‘bad’ from an economic standpoint, we normally use the notions of ‘growth’ and ‘stability’. Growth is the process of increase in national products, incomes and employment (when including ‘social’ progress we rather speak of ‘development’). • The Gold Standard, for instance, was considered a period having high economic growth coupled with monetary and financial stability. By contrast, the 3rd phase of globalization has been marked by dynamic growth together with pronounced financial and exchange rate instability. But what do we mean by "stability/instability"? There are basically 3 definitions of "stability": 1. Stability in (domestic) prices, hence inflation: You want prices to be as stable as possible since this helps domestic transactions 2. Stability in exchange rates: You want ex-rates to be as stable as possible in order to facilitate international transactions. Stable ex-rates mean less uncertainty in pricing/revenues. But exchange rates depend on domestic conditions (especially the BOP) and cross border capital flows….. 3. Financial stability: This notion refers to stability in financial markets, mostly in the banking system. A "stable" banking system is one that is not prone to crises, which may lead to deposit runs and ultimately defaults. The three notions of stability interact with each other. 1ßà3 Inflation is relevant for financial transaction. For instance it is important to value a debt in "real" terms. In fact inflation reduces the real value of a debt, hence helping debtors. It is also relevant to determine nominal/real interest rates. 1ßà2 Domestic prices & the exchange rate interact in several guises. Devaluations may be inflationary, but also inflation spirals may cause devaluations. A parallel with the United Nations The genesys of the BW agreements has parallels with the process of foundation of the United Nations, that also started in 1944 (the UN Charter was signed in San Francisco in June 1945 and came into force in October of the same year). However, it was de facto largely autonomous from it. Albeit the IMF and WB are formaly ‘specialized agencies’ of the UN System, the BW organizations always opposed resistence in order to preserve their independence. Practical solutions adopted by the two systems differed in several respects, as for instance in the case of the languages to adopt: English in the case of the BW institutions, whereas the UN General Assembly adopted 5 ‘official’ languages (English, French, Chinese, Russian and Spanish) with the first two being also the ‘working’ languages. Is the BW System still relevant/adequate? • Over time there have been frequent calls for the foundation of a New Economic Order to replace the ‘old’ BW system. For instance, during the 70s Third World Countries called for a revision of the international economic system, which in their view was favoring the leading states that had created it, especially the US. Even today there are discussions on whether the BW Organizations are adequate to deal with the economic challenges the world is currently facing. • On their side, the BW Organizations have been continuously updating and revising their modus operandi. For instance, after the break of the BW system of exchange rates, the IMF has even increased its presence and expanded its resourses. And in 1995 the WTO was established replacing the GATT. A PROLIFERATION OF INTERNATIONAL BODIES • Over time, a lot of other international or regional economic organizations were created. Think of the OECD, the ILO (International Labor Organizations),the Bank for International Settlements (BIS), as well as to the European Bank for Reconstruction and Development (EBRD), the European Investment Bank (EIB), or the regional development banks (African, Latin American, and Asian Develpment Banks), only to mention a few. • This trend contributed to delute the power of the BW institutions and allowed a greater voice to developing economies. However, none of these organizations is universal in membership, only a few of them provide financing, none can resolve trade disputes. Hence the BW triade remains central…and the debate on their adequacy goes on! SOME DIFFERENCES BETWEEN IMF AND WB A notable difference between IMF and World Bank is that IMF resources come from the members quota (the ‘Fund’), whereas the World Bank taps financial markets through the emissions of AAA rated bonds. In principle, the IMF can also issues bonds, but this option has never been used. Similarly, the WB has also quotas that determine the members’ voting power, and yet its major financing channel is through the market. The difference in the resource mechanism between IMF and WB was used to justify the fact that the President of the WB had to be an American while the head of the IMF an European. Since the WB had to tap the financial markets, it was said that an American banker would be reassuring. Indeed the story is much more complex. This rule has so far never been breached. The current Managing Director of the IMF is Kristalina Georgieva, a national of Bulgaria (who succeded to the French Christine Lagarde), whereas the President of the WB is David R. Malpas, a US national. THE IMF AND ITS FUNCTIONS A universal organization of 189 members whose main functions are: While the IMF is known especially for its lending role, its primary function is actually surveillance and coordination of economic policies. Lending and technical assistance can be seen as subordinated functions. Technical assistance is perhaps the least known but has been absorbing a growing share of the IMF budget. Through it the IMF helps its member countries – mostly low income countries in Africa and Asia - to improve their standards in a variety of fields, such as statistics, central banking, balance of payments, banking supervision, etc. These activity is made possible almost at zero costs thanks to the contributions of donors. SURVAILLANCE Surveillance/coordination of economic policies, the primary function of the IMF, takes different forms in practice. - MULTILATERAL SURVEILLANCE - REGIONAL SURVEILLANCE - SURVEILLANCE ON MEMBERS ECONOMIC POLICIES In ‘multilateral surveillance’ the IMF looks at developments at the level of the global economy. Its analysis, conclusions and recommendations are contained in its main publications, the World Economic Outlook (WEO) and Global Financial Stability Report being the most prominent. ‘Regional surveillance’ refers instead to the monitoring of developments in the main regions of the world, on which the IMF also publishes specific (regional) reports. Finally, a great deal of the IMF activity is devoted to surveillance on its members’ economic policies, and is done partly with annual on site missions of the IMF staff. These take the name of Art. IV Consultations from the article in the IMF statute that deals with them. FINANCING/LEADING • IMF financing is aimed at correcting policies that have led to a disequilibrium in the BoP or level of reserve/exchange rate. • Lending is provided under "conditionality“, that is under the condition that the adjustment program agreed with the authorities is implemented. • Financing is normally devolved in tranches, so that the IMF can verify each time whether there has been progress in the economic program. If not, financing can be post-poned or even interrupted. • Conditionality is quantified through "performance criteria" that may concern macroeconomic policies as well as ‘structural’ policies (i.e. market or institutional reforms). CONDICIONALITY Conditionality covers the design of IMF-supported programs—that is, macroeconomic and structural policies—and the specific tools used to monitor progress toward goals outlined by the country in cooperation with the IMF. Conditionality helps countries solve balance-of-payments problems without resorting to measures that are harmful to national or international prosperity. At the same time, the measures are meant to safeguard IMF resources by ensuring that the country’s balance of payments will be strong enough to permit it to repay the loan. Quantitative performance criteria (QPCs) are specific, measurable conditions for IMF lending that always relate to macroeconomic variables under the control of the authorities. Such variables include monetary and credit aggregates, international reserves, fiscal balances, and external borrowing (e.g. a ceiling on government borrowing, a minimum level of international reserves, etc.) FINANCING CAPABILITY The resources of the Fund are limited (total quotas amount at around $680 billions) thus, although the Fund can rely on extra resources, they must be used on a "rotative basis" as in a cooperative system. Today, the IMF’s total lending capacity – which adds to the IMF own resources the ones that the Fund can obtain from other sources, including its member countries on a bilateral basis - is at around $1 trillion. IMF financing normally covers only 9-15% of a country's financing need. Its role is more in terms of a "catalyst" for additional public and private financing. 1) Stand-by Arrangement (SBA) The traditional IMF financing tool for temporary problems that last normally 1-2 years (repayments within 5 years). à short 2) Extended Fund Facility (EFF) Aimed at supporting programs to solve longer term, structural problems (repayments within 10 years). 3) Flexible Credit Line & Precautionary Credit Line Used in situations of financial tensions/instability, on a precautionary basis, to avoid "domino" effects. 4) Concessional financing to low income countries (zero interest rate) Stand-by Credit Facility and Extended Credit Facility 5) Emergency Facilities (low conditionality) Rapid Financing Instrument (RFI) and Rapid Credit Facility (RCF) - Provide easy access to IMF financing under emergency situations without the need of a full-fledged program. Their access limits has been augmented to face Covid-related financing needs. HOW COSTLY IS IMF LENDING? Most of the IMF lending is provided under non-concessional terms. Borrowing members pay an interest rate that is an average of market rates. Consider, however, that this is lower than the rate that the country would pay on the market given its situation of difficulty. The Fund also provides concessional financing (zero interest rate) in favor of the poorest and/or highly indebted developing countries. This can be disbursed under the Stand-By Credit Facility, the Extended Credit Facility, or an Emergency Financing Facility depending on the type of liquidity need. Beyond the cost of capital, IMF conditionality is also seen as a ‘cost’ that borrowing countries have to bear if they want access to the Fund resources. But there can be important benefits….. DOES IMF FINANCING HELP In the absence of IMF financing, the adjustment process for the country could be more abrupt and difficult. For example, if investors are unwilling to provide new financing, the country would have no choice but to adjust—often through a painful compression of government spending, imports and economic activity. IMF financing facilitates a more gradual and carefully considered adjustment. As IMF lending is usually accompanied by a set of corrective policy actions, it also provides a seal of approval that appropriate policies are taking place. In most cases, this is seen by the market as a precondition for providing additional financial support (the so called IMF’s ‘catalytic’ role). As we have seen, the IMF’s various lending instruments are tailored to different types of balance of payments need as well as the specific circumstances of its diverse membership. SPECIAL DRAWING RIGHTS (SDRs) The SDR was created as a supplementary international reserve asset in the context of the Bretton Woods fixed exchange rate system. Its creation was inspired by J. M. Keynes’ idea of an international currency. However, it never became relevant in international transactions, partly because it can only be used in official transactions (between monetary authorities). Nonetheless, SDR allocations can play a role in providing liquidity and supplementing member countries’ official reserves. Each SDR allocation increases global liquidity! The SDR serves as the unit of account of the IMF and some other international organizations. Its value is determined on a basket of currencies. The US dollar, the Euro, the Japanese Yen, the Pound Sterling , and the Chinese Yuan (since 2015). Its (exchange rate) value is market determined and changes daily. THE MAASTRICHT TREATY In 1992 the 12 countries making up the European Community decided to speed up economic integration and thus signed the Maastricht Treaty which created the EU. The Treaty promoted great cooperation and coordination in a number of areas, and aimed at the creation of an economic and monetary union, with a common currency and a common central bank in the context of free capital movements within the Union! The euro "convergence" criteria (also known as the Maastricht criteria) are the targets which EU members are required to meet to enter the Economic and Monetary Union (EMU) and adopt the euro as their currency. Convergence concerns "fundamental" economic variables such as inflation, debt/deficit and interest rates. The idea is that the more "homogeneous" are the members of EMU, the greater will be the sustainability of the euro. The Maastricht Criteria 1. HICP inflation (12-months average of yearly rates): Shall not exceed the HICP reference value which is calculated by the end of the last month with available data as the unweighted arithmetic average of the similar HICP inflation rates in the 3 EU member states with the lowest HICP inflation plus 1.5 percentage points 2. Government budget deficit: < 3% 3. Government debt-to-GDP ratio must not exceed 60% at the end of the preceding fiscal year or if the debt-to-GDP ratio exceeds the 60% limit, the ratio shall at least be found to have "sufficiently diminished and must be approaching the reference value at a satisfactory pace 4. Exchange rate stability: Applicant countries should not have devalued the central rate of their euro pegged currency during the previous two years, and for the same period the currency stability shall be deemed to have been stable without "severe tensions" 5. Long-term interest rates Shall be no more than 2.0 percentage points higher, than the unweighted arithmetic average of the similar 10-year government bond yields in the 3 EU member states with the lowest HICP inflation THE ROAD TO THE EUROPEAN MONETARY UNION – EMU Stage One: July 1, 1990 The complete elimination of capital controls among the Member States and increased cooperation between their central banks. Stage Two: January 1, 1994 The real beginning of the transition to EMU with the establishment of the European Monetary Institute (EMI). EMI = precursor of the European Central Bank, charged with coordinating monetary policy and preparation for the single currency. Stage Three: January 1, 1999-2002 Eleven countries fixed their exchange rates to the EURO, which replaced the ECU. The ECB took over responsibility for monetary policy in the euro area. On January 1st, 2002, the EURO entered into circulation thus replacing the national currencies. THE EURO – A SINGLE CURRENCY FOR EUROPEANS • No fluctuation risk and foreign exchange cost • More choice and stable prices for consumers • Closer economic cooperation between EU countries The eurozone Today 19 countries are part of EMU and an even larger number of nations adopted the euro as their official currency. • The four micro states have formal monetary agreements with the EU, whereas Montenegro and Kosovo use the euro unilaterally. Liechtenstein uses the Swiss franc. WAS EMU A BAD IDEA FROM THE START? THE THEORY OF OPTIMAL CURRENCY AREAS WHAT IS AN OPA? It is a region where it is best (optimal) to have a single currency. Optimality depends on degree of economic integration: • Trade in goods and services • Factor mobility A fixed exchange rate area will best serve the economic interests of each of its members if the degree of output and factor trade among them is high. We can use comparative analysis to see if Europe performs as well as or better than the United States (viewed as a common currency zone) on each of the OCA criteria, which would lend indirect support to the economic logic of the euro: • Trade integration • Labor mobility • Fiscal transfers EUROPE VS US TRADE FLOWS Most economists believe that the United States is much more likely to satisfy the OCA criteria than the EU. Why? Data in panel (a) show that interregional trade in the United States rises to levels much higher than those seen among EU countries. LABOR MOBILITY Labor in Europe is much less mobile between states than it is in the United States. The flow of people between regions is also larger in the United States than in the EU. Labor markets in Europe are generally less flexible, and differences in unemployment across EU regions tend to be larger and more persistent than they are across the individual states of the United States. In short, the labor market adjustment mechanism is weaker in Europe. On this test, Europe is far behind the United States. FISCAL TRANSFERS Fiscal Transfers Stabilizing transfers, whereby substantial taxing and spending authority are given to the central authority, exist in the United but not in the EU. Data in panel (c) show that interstate fiscal stabilizers are large in the United States, but essentially nonexistent in the EZ. FEDERAL BUDGET The annual EU budget is €157 bn (2017 figures) – a large sum in absolute terms, but only about 1% of the EU GDP. In 2017 Us federal spending averaged 21% GDP Summary • On the simple OCA criteria, the EU falls short of the United States as a successful optimal currency area. • Goods market integration is weaker, fiscal transfers are negligible, and labor mobility is very low. At best, economic shocks in the EU are fairly symmetric, but this fact alone gives only limited support for a currency union given the shortcomings in other areas. • Most economists think there are still costs involved when a country sacrifices monetary autonomy. • On balance, economists tend to believe that the EU, and the current Eurozone within it, were not an optimal currency area in the 1990s and that nothing much has happened yet to alter that judgment. THE FUTURE OF THE EURO Despite the criticisms, and the evidence that the Eurozone falls short of being an optimal currency area, the Euro is still alive and has overcome the dramatic debt crisis of 2009-2011 that has hit a number of EU countries (Greece, Spain, Ireland, Cyprus and Italy). The role of monetary policy and Quantitative Easing was crucial in resolving the crisis (more on this in my final lecture). Confidence in the euro has been steadily rising (see graph). The debate is ongoing on how to make the monetary union more resilient. GREXIT While the eurozone now appears quite stable as a common currency area, one should not forget that in the recent past some countries have risked leaving the euro, and that similar episodes may occur in the future. Grexit – the risk that greece could leave the eurozone and return to the drachma – is the most well known of such episodes. The risk of grexit arose in 2012, when greece was managing its very serious debt crisis, following the global great crisis. It arose again in 2015, when the greeks voted on a referendum to decide whether to accept or not the bailout conditions imposed by the so-called ‘troika’ (imf, eu commission and ecb), which ended with a ‘no’ winning! Nonetheless, the then greek government of alexis tsipras ultimately reached an agreement on a bailout program which allowed greece to manage the crisis. Imf conditionality was essential but also very tough! Will provide a more comprehensive review of the greek economic and financial crisis in my may lecture, within the context of global financial crises • M1 = M0 + Demand deposits with the banking system (checking accounts) + other items easily transformable in cash (e.g., travelers checks) à liquid form of aggregates • M2 = M1 + saving and small-time deposits (depositi vincolati) + money market mutual funds, etc. • M3 = M2 + large time deposits with the banking system The precise definition of the monetary aggregates may vary from CB to CB 2. TARGET INFLATION DIRECTLY As monetary aggregates became too unstable to control, CBs started to target inflation more directly. This means to set their objective/target in terms of consumer price growth on price stability. For instance, the ECB is required by statute to contain inflation in the eurozone under 2%. The FED also states regularly its desired inflation target, that is normally expressed as a range, usually 1,5-2%. This approach is know as inflation targeting. in practice: - the CB reacts when there is a divergence between the actual and the desired/statuary inflation target - when this happens, it adjust money supply and policy rates accordingly the more precise/stringent is the inflation target, either in quantitative terms or in terms of the time period required to reach the target, the less autonomy has monetary policy to target other objectives, such as growth and employment. The FED pursues by statute 2 objectives: 1) supporting growth and employment 2) fighting inflation That’s probably why the FED was often accused to be too accommodative and the ECB too restrictive. However, the more you have discretion in setting the inflation target, the more you may be subject to the criticism that your action was inflationary. THE END OF THE INFLATION In the current globalized economy, inflation is much less a problem than in the past. In the European union, after the pick of November 1997, the inflation rate went systematically down, hitting a record low of -0.50% in January of 2015. From 1997 throughout 2002 the inflation rate has averaged 2.41%. In recent years most CBs have been fighting deflation more than inflation! There are several factors that can explain the sharp fall in inflation rates. - One is certainly the globalization process itself, that has provided consumers with goods from countries where labor costs and labor standards are much lower like in China and India. - Another is the improvement in monetary policy management in emerging and transition economies /thanks also to IMF technical assistance) - Price of oil and raw materials which have not only gone down but have also proved to be less inflationary than in the past IS INFLATION BACK? In recent years, starting with the pandemic, inflation is on the rise again. Price tensions, especially in commodity markets and intermediate products, were exacerbated by the current Russia-Ukraine conflict. • One main factor for the surge in inflation is the widespread shortages of raw materials and parts that is magnifying costs. Builders can’t find enough lumber to build new homes. Manufacturers are desperate for more copper and other commodities. Auto makers need more semiconductor chips. • Another factor is that aggregate demand was boosted by the ultra-expansive fiscal policies around the globe. Inflation is going up again to around 8% in US. While in 2009 there were deflation. Everywhere inflation is going up. CURRENT INFLATION IN THE EURO AREA The annual inflation rate (consumer prices) in the Euro Area was revised slightly lower to 7.4% in April of 2022 from a preliminary of 7.5% but remaining at a record high level. It compares with a 7.4% rate in March. The highest increase continues to come from energy followed by service, food, alcohol and tobacco, and non-energy industrial goods. Inflation is now more than three times above the ECB target of 2% and is not expected to get back to the target soon as the energy crisis was exacerbated by the Russian invasion of Ukraine while rising demand and persistent supply and logistics constraints due to the coronavirus pandemic led to a generalized rise in consumer prices. The European Commission sees inflation at 6.1% in 2022, before falling to 2.7% in 2023. UNCONVENTIONAL MONETARY POLICIES (UMP) AND QUANTITATIVE EASING (QE) In the recent decades the absence of monetary anchors, coupled with the generalized fall in inflation rates and a gradual decline in the growth rates of the advanced economies, has puched CBs to expand the monetary stance quite significantly. This new attitude started in Japan since the early 90s as the economy entered a phase of prolonged/secular stagnation. With the start of the Great Crisis in 2007, overly expansionary monetary policies as measure to fight the financial crisis and the risks of deflation have become the norm. As nominal policy rates approached the zero bound, in order to, further expand the money and credit supply in support of aggregate demand, major CBs have started relying on so-called unconventional measures. !! exam qst: what is the definition of unconventional monetary policies? What is the difference between unconventional monetary policy and quantitative easing These are the main unconventional measures that define UMP: 1. Paying negative interest rates on the reserve deposits of the commercial banks (banks have to pay to hold deposits as the Central Bank) à push banks to lend more money to household, consumers and firms 2. Buying Tbills or even corporate bonds from the banks in large amounts (quantitative easing) 3. Public announcements that the monetary stance will stay relaxed for long (so called forward guidance) 4. Targeting explicitly long-term interest rates in order to flatten the yield curve (normally monetary policies manage short term rates only) Note that UMP and QE are not exactly the same thing, but it has become common practice referring to Quantitative Easing or more simply QE. Not only inflation rate has been low for many years, but also interest rate (also on mortgages) were extremely low. DRAWBACK OF QUANTITIVATIVE EASING There are 3 drawbacks of QE: 1. Banks use the abundant and cheap liquidity to lend more and more to risky clients 2. Part of the liquidity goes into trading in the financial markets and may prompt bubbles in the valuation of real estates and financial assets. Therefore, while consumer inflation remains possibly subdued, you have other signs that the economy is becoming hot (value of financial assets and real estate goes up) 3. By pushing interest rates below zero, QE creates incentives for the investors to search for positive returns on risky assets. à IMF stated that they are increasing the level of risk in the global economies The debate is open among economists even if today is over, because CBs are now looking for ways to reduce money supply because inflation is back. Many economists, like Stephen Roach (2017), think that QE has gone too far. They criticize the CBs’ bias towards keeping monetary policies expansionary over a prolonged period of time. Others, like Martin Feldstein (2016), argue that QE has been effective in the United States but much less in Europe in supporting aggregate demand and pushing up the inflation rate. CBs oppose that monetary policies simply react to market conditions. The low interest rates reflect the fact that both inflation and real growth have sharply declined due to a structural change in the economy. MAIN CONCLUSION: expansionary monetary policies have proven essential to resolve financial crises. And yet, they may be themselves at the root of financial instability. PART 2 – SYSTEMIC FINANCIAL CRISES FINANCIAL CRISES IN THE POST BRETTON WOODS ERA Several episodes of financial/exchange rate instability/BoPs imbalances (with domino effects) Systemic financial crises typically originate in a country or region and have much wider consequences due to the strong integration or real and financial markets, hence the word systemic. Latin American debt crisis of 1982 - Large exposure of industrialized countries banks to Developing nations (similarities with recent euro financial crisis and Greece) - Debts were denominated in US dollar - Many of the loans were made to governments and were given little probability of default - The trigger: Paul Volcker’s change in monetary policy leading to a substantial rise in world interest rate Exchange Rate Mechanism Crises (ERM) in 1992 - In September 1992 British pound was pushed to abandon the system. It was followed by the Italian Lira. A year later the ERM was the facto dead. - The trigger: high German interest rates to counteract fiscal expansion after re-unification put. The ERM under stress Mexican crisis in 1994-95 (first systemic and global crisis) - Mexico was under a fixed exchange rate regime with the peso pegged to the US dollar - A lax fiscal policy, insufficient dollar reserves and raising lack of confidence in the banking system led to the abandonment of the peg - A domino effect onto several emerging markets could subside only after an IMF led support financial package was agreed. Asian Financial Crisis of 1997-1999 - A crisis of vast proportions on which thousands of pages have been written in the economic literature - Surprising since it touched the Asian tigers which were a model of economic growth - Causes not in sovereign debt but in private debt and badly regulated domestic banking system Argentina 2001 exchange rate and banking crisis - Currency board since 1991 to fight inflation - By the end of 2001, early 2002 the currency board broke down - Causes are debated: fiscal laxity was one of the reasons but an overvalued currency which contributed to low growth also played a role - The case of Argentina is interesting not for the domino effect (which was very limited) but for demonstrating how difficult it is to defend fixed exchange rates.