International Finance

International Finance - Part 1.2. The Economics of Monetary Union Exchange Rate Management

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

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

1. Exchange Rate Management • The case for flexible exchange rates - Challenges • However, the argument for flexible exchange rates have been seriously challenged to several extents. • Floating rates since 1973 have exhibited high volatility and spent long periods away from their long-run fundamental equilibrium level (misalignement) Domestic price of foreign exchange Supply of foreign exchange (brought by X) = D of domestic curr. Seq Deficit M > X Demand for foreign exchange(brought by M) = S of domestic curr. X M Q of foreign exchange

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

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

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

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

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

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

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

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

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

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

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

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

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

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

International Finance - Part 2 The Economics of Monetary Union Construction of the EMU

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

4. The European Central Bank Governing Council • Decentralisation of the system: • high representativity of the national interests and needs • could (does) lead to immobility on case of diverging interests. Decision stage Executive Board ECB (6) Governors of NCB ’s (12) Implementation stage European Central Bank NCB NCB NCB NCB ….

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

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

5. Is enlargment favourable? Source : Korhonen, Fidrmuc, 2001 in De Grauwe, 2003.

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

International Finance - Part 1.2.