POL 4410: Week 7

1. POL 4410: Week 7 • International Finance

2. Structure • TUESDAY:1) Test2) Capital Flows and Exchange Rates • THURSDAY1) Currency Crises2) Currency Unions3) Multinational Corporations

3. International Capital • Capital flows are like any other factor • ‘Returns’ to capital should equalize: • Bonds • Equities and Equity • Real Estate • Currency

4. Bonds • Investment in foreign governments • Issued by a central bank • Price of bonds can vary after their issuing • Price is inversely related to ‘yield’ or interest rates • Arbitrage in bonds implies equalization of interest rates

5. Private Equity • Invest directly in a foreign private company or investment scheme • Invest in foreign equities = public companies abroad • Portfolio finance • MNC internal investment?

6. Real Estate • Owning foreign real estate means purchasing assets excluded from GDP • Might do this for a holiday home • Or as a rental property (income stream) • Or... for speculative reasons

7. Currency: FOREX • Unlike other assets, currencies do not promise stream of returns. • Like equities and real estate there may be a speculative reason to purchase them. • Common practice to ‘long’ or ‘short’ currencies - which can undermine or overvalue them.

8. Who does this? • International Banks • International Governments • Hedge Funds • Equity Funds • Private Investors

9. Balance of Payments • Current Account is the gap between exports and imports. • Capital Account is the gap between purchases of foreign assets and foreign purchases of domestic assets. • US 1980s led to Japanese inward investment

10. The Exchange Rate • If interest rates differ substantially from comparator states - lose capital inflows, lose value in your currency. • Balance of payments problems because of over-valued currency lead to currency attacks by speculators. • You lose currency strength because of weak capital inflows, or a run on the currency, or both.

11. History of International Finance • International finances were originally just denominated in gold. Think of origins of balance of payments - gold specie model. • Now most currencies are floating and capital can move into a broad array of asset classes. Different types of BOP problems.

12. International Monetary System • Footloose capital means exchange rate stability is tough to maintain - hence desire for currency unions. • International Monetary Fund supposed to act as a banker of last resort. • But hedge funds and currency speculators can trade rapidly in enormous volume.

13. Mundell-Fleming Conditions • Only two of the following three:1) Fixed exchange rate2) Open capital markets3) Autonomous monetary policy • Why? Think through each

14. Graph of M-F Dollars per Euro Undervalued $ Equilibrium Ex Rate Overvalued $ US $ return from holding Euros US Interest Rate Rate of Return

15. Graph of MF (2) Dollars per Euro Old Ex Rate New Ex Rate US $ return from holding Euros Old US IR New US IR Rate of Return

16. Graph of MF (3) Dollars per Euro New Ex Rate Old Ex Rate New US $ return from holding Euros Old US $ return from holding Euros US IR Rate of Return

17. Currency Crises • If investors believe your currency is massively overvalued they start to move money abroad. • Eichengreen estimates loss of 0.7% of GDP per annum. • Problems: debt denominated in foreign currency. Move from spending more money than you earn to less.

18. Banking Crises • Foreign investors panic that banking system is unsustainable (or that currency will collapse and take down banks). • Run on the banks leads to banks calling in loans. • Businesses cannot pay back loans - bankruptcies. • Lose 0.3% GDP per anunum

19. Eichengreen: Causes • Unsustainable Macroeconomic Policies. Currency = too expansionary to maintain peg. Banking = bank takes bad public debt • Fragile Financial Systems: dependence on short term debt • Corporate and public sector governance • Flaws in international markets

20. Benefits of Open Capital (Wolf) • Individual freedom to send money abroad • Import outside capital and expertise • Crises are not inevitable and rare in OECD • People circumvent controls • Forces transparent governance of finance

21. Asian Financial Crisis • 1997 speculators short the Thai baht • Collapse of baht leads to ‘currency contagion’ • Banking sectors collapsed in Thailand, Malaysia, Korea, Philippines, Indonesia • IMF recommended raising interest rates to prevent currency collapse - hurt economies

22. Causes of AFC • Attempt to peg currencies was not credible • IMF failed to bailout states properly plus poor advice • Banking sectors were cronyistic - lots of bad debts • Reliance on short-term debt led banks to make risky loans • Fear of FDI and long-run investment made systems volatile

23. Solutions to Crises • Eichengreen:(1) Re-regulate financial markets(2) Re-impose capital controls(3) Create world currency(4) Create Emerging Markets index • Scrap IMF / Rebuild IMF • Tobin Tax • Democracy, transparency, growth

24. Multinational Corporations • Big users of foreign currency. If they need to pay for 5,000,000 Euros they must swap dollars through bank or have own currency traders (Kodak). • Within own firm may trade in dollars but will need to pay local suppliers • Foreign Direct Investment: politically advantageous or not?

25. The Product Cycle • Raymond Vernon • New labor-saving technology started in the USA because early innovation must be close to market. • Standardization of technology permits labor cost reduction by sending to cheaper OECD states. Also adapt for market. • Eventually LDCs take over

27. Exchange Policies • Three main types of x-rate1) Fixed exchange rate2) Managed peg3) Full flexibility

28. Fixed X-rate • Gold standard • Explicit fixed x-rate to dollar • Dollarization

29. Flexible Peg • Bretton Woods system • European Monetary System • East Asian Tigers • China?

30. Total Flexibility • Canada to United States • Dollar to Euro to Yen • How much flexibility can governments stand?

31. Frieden on Mundell-Fleming • Capital mobility means that monetary and fiscal policy are synonymous with exchange rate policy. • Monetary expansion = currency devaluation • Fiscal expansion = currency appreciation • Think about US in 1980s

32. Frieden (2) • Specific vs. mobile capital • Open capital markets favor mobile capital and harm specific capital in developed world. Thus sectors matter. • Open capital markets favor specific capital and harm mobile capital in developing world.

33. Individual Preferences on Finance

34. Frieden and USA • Frieden predicts that mobile capital in USA will be chief beneficiary and specific capital loses out in ACM world. • Decline of old ‘specific’ sectors like autos. Rise of finance. Finance now larger than manufacturing (27% vs. 25%) • Meanwhile, dollar is overvalued. Who benefits? Finance and real estate? Who loses? Exporters and manufacturers / farmers -> outsourcing. • Monetary policy is flexible. Beneficiaries: real estate and manufacturers / farmers. But how can it be so flexible and dollar remain overvalued?

35. More on the USA • Current dollar is weaker than two years ago but still overvalued in terms of BOP. • How is this sustained? Huge capital account inflows. but why is capital flowing to a capital-rich state like USA? • Asian banks hold 1/2 US T-bills. Massive capital inflows keep interest rates down: boom in housing / rise in DJIA.

36. Debt and the USA • Debt

37. Broz • How do countries signal low inflation to international investotr? • Developed states increasingly use independent central banks. • But who would believe that such a bank is independent in an autocracy? • Autocracies must peg currency instead.

38. Broz (2) • Pegging and central banks are substitute methods of ensuring transparency to international investors. • But central banks only work in transparent political system. • This means democracies should have more macroeconomic flexibility in an ACM world than autocracies.

39. Broz (3)

40. Broz (4)

41. Broz (5)

42. Broz (6)

43. Eichengreen and EMU • EMU emerged from Werner report 1970, which had advocated fully fixed x-rates and coordinated fiscal policies. Led to Snake then ERM. • 1986 Single European Act: Delors report. Remove capital controls, single central bank, no fiscal harmonization. • 1990 Maastricht treaty signed. Capital mobility then coordinated monetary policy, then fixed x-rates, then single currency.

44. EMU • 1998 currencies fixed to one another. • Euro existed non-physically from Jan 1 1999. • Currencies changed over to Euro Jan 1. 2002 • European Central Bank, based in Frankfurt, is sole setter of monetary policy. 6 seats. • Stability and Growth Pact • Real exchange rates still exist. how?

45. Who is a member?

46. Concerns with EMU • Rationale was transactions costs (0.4% of GDP) and exchange rate risk (but already high stability). Maybe SEA undermined ERM. This leads to political economy explanation. • Why can all countries not just fix x-rates? Escape clause problem. • Concern about asymmetric shocks. Is US economy better integrated than Europe? Interest rate adjustment vs. mobility adjustment. • Fiscal autonomy and specificity. Fiscal coinsurance. Fiscal coordination: spillover effects?

47. EMU Expansion • Eichengreen and Ghironi examine impact of Central and East European entrants on EMU • Concern is about convergence of growth rates. Likely a function of institutional reform. • Concern about banking crises in CEEs • Should loosen Stability and Growth Pact • Migration could help adjustment but will be low • Voting rights in ECB.

48. Next Week • Development. • Begin at the international level - World Bank and IMF • International Inequality • Week after: development strategies at the domestic level