International Financial Environment Final Study Guide
International Financial Environment Final Study Guide BADM 2201
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This 29 page Study Guide was uploaded by Annalea Soudry-Maurer on Saturday May 9, 2015. The Study Guide belongs to BADM 2201 at George Washington University taught by Yoon Park in Fall 2014. Since its upload, it has received 39 views. For similar materials see International Financial Environment in Business Administration at George Washington University.
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Date Created: 05/09/15
Term Definition Symptoms of Impending Financial Crises 39 budget deficits 39 chronic and rising current account deficits imports gt exports rising foreign debt especially shortterm debt 39 excessive government debts at least 40 of GDP for LDCs 39 weak financial supervisory framework lack of robust capital markets Washington Consensus Asian Financial Crisis of 1997 most affected Asian countries did not have chronic budget deficits and high inflation Began in Thailand with the collapse of the Thai Baht they were forced to float the currency due to lack of foreign currency to support their fixed exchange rate 39 Thai devaluation made exports from neighboring countries less competitive and forced them to engage in devaluations growth rates suffered in 1998 Indonesia 132 Thailand 102 and Korea 67 39 Large trade deficits gt large financial account surpluses companies went bankrupt and unemployment rose 39 Capital flight money flying out of Asia so governments were short on dollars and would have to default on international loans 39 to avoid the default Asian countries begged the IMF for emergency loans IMF required an increase in interest rates which would promote domestic investment however during capital flight people will be panicking no matter what and will not keep their money in place just because of a higher interest rate quotIMF crisisquot IMF worsened the crisis by creating bad conditions Lessons of the Asian Financial Crisis harmful impact of overvalued currencies freer international capital movements and financial market opening to foreign capital may also lead to speculative overinvestments 39 tight fiscal and monetary policies in the midst of crisis may be counterproductive for capital flight and exchange rate stabilization Term Definition Argentine Financial Crisis of 2001 19903 currency board system was adopted required to maintain a fixed exchange rate with a foreign currency 39 brought low inflation and interest rates and an economic boom through new investments country was prevented from printing more money due to system but government engaged in foreign borrowing to engage in reckless public spending 12001 Government declared sovereign default on 100 billion of foreign debt In late 2001 bank holidays were declared 39 On 102 currency board system was abandoned 2004 government announced largest bond restructuring to swap 103 billion defaulted bonds for 3 types of new bonds foreign bondholders were getting about 30 cents to their dollar Phase 1 of the Global Financial Crisis August 2007 September 7 2008 39 1st half of 2007 the market for subprime mortgage related securities started to crack due to the burst of US housing market bubble 39 807 subprime mortgage crisis produced its first financial casualties when 2 German banks IKB Sachsen LB that invested a lot in subprime mortgagerelated securities and suffered huge losses had to be bailed out by the German authorities 39 907 Northern Rock UK Mortgage lender experienced liquidity crisis triggering the 1st British bank run in 150 years 39 308 Bear Stearns merged with JP Morgan Chase and since then other financial institutions had to announce huge writedowns of subprime mortgage related investments 39 at this first stage mostly longterm bonds were affected including MBS CMOs CDOs and 330 billion auctionrate notes 39 subprime mortgage crisis appeared to reach its climax with the US government rescue of Fannie Mae and Freddie Mac on 9708 Term Definition Phase 2 of the Global Financial Crisis September 15 2008 2009 39 91508 new financial crisis started with the bankruptcy of Lehman Brothers which had 740 billion in derivatives contracts with over 5000 counter parties 39 Merrill Lynch was merged into BOA through stock swap worth 50 billion 39 91608 AIG insurance was bailed out by government with 2 year 85 billion loan from the FRB at punitive interest rate of 3month LIBOR benchmark rate that leading banks charge each other for short term loans plus 85 Eurodollar interbank market was frozen 3 month LIBOR doubled to over 5 in 1 week 35 trillion MMFS 13 trillion CP market and 58 trillion CDS market also frozen 39 921 Goldman Sachs and Morgan Stanley were turned into BHCs thus ending the 75 year history of monoline investment banks 103 Congress passed 700 billion bank bailout package but US stock market experienced the worst weekly decline of 18 the following week Conventional Explanation for the causes of the recent financial crisis 39 Global current account imbalance between the US and the rest of the world especially in East Asian countries Massive foreign exchange reserves accumulated in East Asia were recycled back to the US excessive liquidity lower interest rates Americans ran down savings and kept excessively spending US FRB s prolonged low interest rate policy encouraged banks and investors to search for high yields at greater risks 39 Strong US political pressure for home ownership even in low income areas gt Widespread subprime mortgage lending Term Definition Alternative explanation for causes of recent financial crisis The world has lived with global imbalances before without resulting in such a crisis 39 phenomenal growth of finance recently shares of profits of financial services sector rose from 10 of corporate profits in 19803 to 40 in 2007 conversion of Wall Street firms from partnership into incorporation led to explosive growth of balance sheetfunded by overnight repos GS increased 11 times over 12 years 39 such rapid growth from new products and technology increasing abuse of financial innovations misuse of market can result in catastrophic losses for impacted financial institutions and investors CDOS Collateralized debt obligations o quotstructured finance productsquot and packaged as paythrough securities 39 CDOs first emerged in 19903 banks desire to offload high risk loans such as leveraged loans used in MampAs Wall street firms acting as CDO underwriters earned fees of 25 o35 o 39 Merrill Lynch launched 150 billion CD05 in 20042007 fee income of 5 billion Wall Street banks eager to make more CMOs but constrained by the availability of mortgage loans 39 CDOs do not need mortgage loans CMOS collateralized mortgage obligations 39 fixed income security that uses mortgage backed securities as collateral 39 subdivided into graduated risk losses called tranches that vary based on maturity structure of mortgages 39 Class A CMO highest risk tranche offering the highest rate of return Triple to single A rated risk preferences result in opportunities to profit at different levels depending on willingness to take the risk provide a way for lending institutions to reduce interest and default risk and increase lending power Term Definition Evolution of EU Monetary System 1971 Smithsonian Agreement wider band from 1 to 225 1972 Snake in the Tunnel arrangement 1973 Snake in the Sea arrangement 1979 European Monetary System MS ECU European Currency Unit and ERM Exchange rate mechanism 1992 EMS crisis Pound and lira dropped out of ERM 1992 Maastricht Treaty in the Netherlands 1993 ERM band widened from 225 to 15 around ECU 1999 Replacement of ECU by Euro Smithsonian Agreement December 1971 adjusted the fixed exchange rates established at the Bretton Woods Conference of 1944 abolition of dollar39s convertibility into gold President Nixon suspended convertibility thus defaulting on US debt pledge to peg the at 38ounce with 225 trading bands other countries pledged to appreciate currencies vs failed to encourage discipline by the Fed or the government 10 devaluation accounted in 021973 and Japan and European Economic Community let their currencies float Snake in the Tunnel Agreement 1972 attempt at creating a single currency band for EEC pegging all EEC currencies to one another attempt at creating a single currency band for EEC first attempt at European monetary cooperation 9 band EU currencies will fluctuate at 45 225 bands attempt at creating a single currency band for EEC pegging all EEC currencies to one another all currencies tended to move together against the dollar established because Smithsonian bands were seen as excessive and applied a 225 bilateral margin implying a maximum change between any 2 currencies of 45 Snake in the Sea Agreement 1973 Snake in the Tunnel agreement was deemed too constraining at 225 band made more flexible at 24 Term Definition EMS European Monetary System 1979 established in 1979 where most nations of the European Economic Community EEC linked their currencies to prevent large fluctuations relevant to one another replaced the quotcurrency snakequot agreement system ECU European Currency Unit member countries agreed to keep foreign exchange rates within agreed bands of 225 and 6 ERM Exchange rate mechanism reduced exchange rate variability and gained an evaluation mechanism Maastricht Treaty 1992 created the European Union led to the creation of the euro members were to keep sound fiscal policies with debt limited to 60 of GDP and annual deficits no more than 3 of GDP established 3 pillars of the EU European Community Common Foreign and Security Policy Justice and Home Affairs strived to keep price stability even with inclusion of new members Economic and Monetary Union EMU umbrella term for group of policies aimed at converging economies of EU member states at 3 stages Stage 1 through 1993 closer economicmonetary cooperation Stage 2 19941998 move toward convergence to Stage 3 requirements at Stage 2 Inflation cannot exceed 15 budget deficit is at most 3 of GDP IR has to be less than 2 no devaluation of exchange rate for 2 years Stage 3 1999 creation of the Euro which aimed to replace EMU domestic currencies from 2002 onwards EU Financial System 28 countries EMU 18 countries creating Eurozone or Euro Area ECB European Central Bank created in 1998 ESCB European System of Central Banks ECB 28 member country central banks Eurosystem composed of ECB 18 EMU Term Definition member country central banks Problems and Prospects in the Euro Area Benefits and costs of a common currency positive effects on trade employment loss of independent monetaryfiscal policy loss of economic policy flexibility to deal with inflation or recession Preconditions for a successful currency area full labor mobility fiscal integration taxing and government spending policies Right after euro creation convergence of borrowing costs in eurozone Greece over borrowed benefitting from low interest costs Prospects of eurozone crisis debt restructuring default andor abandoning the euro Eurozone Bonds debt investments where an investor loans money to the eurozone bloc all together which then funds money to governments supported by rating of noncrisis states leads to better overall conditions Germany Finland and the Netherlands vs France Italy Spain and Greece Eurobonds result in interest rate subsidies for the latter group at the expense of the former Germany etc are not likely to support euro bonds unless there is commitment to fiscal policy harmonization Economic costs of Eurozone crisis fragile condition of banks due to heavy credit exposure to affected countries Spain Greece Ponugal many EU banks cannot borrow money from other banks in the interbank market so they rely on E08 for funding ECB has relied on the Fed for dollar funds through the central bank currency swap system high unemployment rate especially youth slower European and global economic growth Conclusion this crisis has a depressing impact on the world economy and global financial Term Definition markets Central Bank Currency Swaps 39 shortterm lending and borrowing of currencies between 2 countries normally the ECB will call the Fed to ask for funds but the Fed cannot loan emergency funds without US congress approval 39 to avoid going through US congress the Fed will sell funds to E08 and buy the equivalent funds in returnexchange They enter an agreement that the ECB has to buy back that exact amount of its own currency by a certain date at the same exchange rate plus a certain set interest rate Term Definition Root Causes of the Eurozone Crisis design flaws currency union is not accompanied by fiscal union each EMU country is free to pursue its own fiscal policy including budget deficit and government spending Spain or Greece cannot print its own money Euro is protected by all EMU countries but some have over borrowed and overspent Greece Ireland without the banking union Spanish banks have to be protected by the Spanish government alone without the power to print euros eurozone structure encourages capital flight from banks of periphery countries to stronger countries such as Germany if Greece or Spain leaves the eurozone and adopts its own currency depositors at Greek banks would be paid back in much cheaper Greek currency to prevent such deposit flights EmuWide deposit insurance system is needed but the cost is very high and will be borne by the strong countries Germany and other noncrisis members are reluctant to shoulder such a burden unless the eurozonewide fiscal policy system is adopted Why such design falws Initial impetus toward euro was not economic but political 1956 During Suez Canal crisis US forced Britain and France to withdraw their forces from Egypt even though Egypt nationalized their Suez Canal without compensation Europe realized that without a union the individual countries were no match for the US and the Soviet Union 1957 Europe launched the Common Market precursor to the EU 1992 Maastricht Treaty EMU EUFO Germany was persuaded by France and Britain to abandon German Mark Efforts to Stop eurozone breakup EFSF European Financial Stability Facility ESM European Stability Mechanism Troika ECB IMF and European Commission Term Definition EFSF European Financial Stability Facility 39 temporary rescue mechanism 39 created by euro area member states 39 safeguards financial stability by providing financial assistance to euro states 39 borrows money by issuing bonds in global financial markets with the guarantee of Eurozone members especially Germany it then lends the revenue to countries such as Greece to bail out its banks etc 39 can intervene in primary and secondary bond markets and finance recapitalizations of financial institutions through loans to governments As of July 1 2013 the EFSF cannot enter into new loan agreements replaced by ESM ESM European Stability Mechanism replaced EFSF 39 could eventually become the European IMF provides financial assistance to euro member states experiencing or threatened by financial difficulties new and sole mechanism for responding to financial assistance requests raise funds by issuing money market instruments and medium and long term debt with up to 30 year maturities issuance is backed by a paidin capital of 80 billion euros 39 cooperates closely with the IMF 39 acts as a financial backstop and applies lending instruments that will stabilize the financing needs of a country Troika 39 tripartite committee formed by the European Commission the European Central Bank and the IMF 39 sets strict conditions on a loan recipient country such as Greece or Spain in terms of budget deficit and spending goals 39 charged with monitoring the Euro debt crisis 39 make recommendation on policy to help solve the crisis Term Definition Internationalization of RMB 39 Chinese Renminbi RMB is not yet a world reserve currency 39 a reserve currency is a currency held by governments as part of foreign exchange reserves and is used in international transitions 39 requirements for a reserve currency free convertibility for trade settlements and financial transitions 39 China has embarked on partial internationalization of RMB 1 Banks in selected offshore centers Hong Kong London are allowed to open RMB accounts 2 Exporters in China can keep their RMB in these accounts which can be used for paying for imports from China or other purposes in China as allowed by China 3 When such offshore RMB is more expensive than domestic RMB Chinese importers settle with offshore RMB 39 4 Offshore RMB has a slight premium of 01 over domestic RMB 39 Offshore RMB can be used for investments in China Banks in offshore locations accept deposits make loans in RMB 39 China has fostered RMB growth quotdenominated banksquot in Hong Kong 0 China s central bank has increased bilateral currency swaps with foreign central banks to increase RMB liquidity in a move to promote wide RMB use by foreign banks and businesses Term Definition Latin American Debt Crisis 39 began with skyrocketing oil prices in the 19703 and 19803 and the world recession liquidity crisis high oil prices caused countries to seek out more loans interest rates increased in the US and Europe gt debt payments increased making it harder for borrowing countries to pay back debts deterioration of exchange rate with US meant that Latin American governments owed high amounts of their own currencies and lost purchasing power began when international capital markets became aware that Latin American countries would not be able to pay back their loans and since they were short term refinancing was refused Mexico defaulted on its loans banks had to restructure debts with new loans with strict restrictions 19821985 IMF mandated austerity measures based on free market capitalism reduce budget deficits increase taxes lower subsidies raise interest rates reduce current account deficits currency devaluation attempted to lower total spending to recover from debt crisis brought the economy to become a capitalist free trade economy which is generally preferred by wealthy countries led to a falling growth rate as they could not spend more to grow their economies living standards fell generated hatred towards the IMF and their policies leaders and officials were ridiculeddischarged for involvement with the IMF Term Definition Latin American Debt Crisis amp the Baker Plan 39 1985 1988 long term structural crisis 39 Baker Plan of 1985 offered reward for fundamental economic reforms launched at the IMFWorld Bank meeting in Seoul by James Baker who was the Secretary of the Treasury at that time 39 plan was designed to help highly indebted middleincome countries that owed money 1015 were in latin America 39 suggested that the World Bank and Private banks provide funding while countries undergo privatization deregulation liberalization and internationalization failed due to inequitable principals on deciding which countries were to receive aid Latin American Debt Crisis amp Brady Plan 1989 1992 solvency crisis Brady Plan US Treasury Secretary Nicholas Brady 39 offered debtreduction and forgiveness through innovative financial techniques recognized that reversing the exodus of capital from debtor countries was critical and that global capital markets would direct resources to any countries that had the will to implement reforms focused on debt service reduction by commercial bank creditors for debtors who agreed to implement economic reform programs 39 offered banks credit enhancements in exchange for their agreement to reduce claims 39 credit enhancements were created by first converting commercial bank loans into bonds and then collateralizing principal and rolling interest payments on those bonds with US Treasury zeroes purchased with the proceeds of IMF and World Bank loans Brady restructurings have been implemented in 16 countries gt 150 billion market in Brady Bonds Term Definition 1988 JP Morgan Plan 1 Mexico buys 10 billion 20 year US zero coupon Treasury bonds for 18 billion 2 Mexico issues 10 billion 2 year FRNs at LIBOR 1 58 with the principal backed by US zerocoupon treasury bonds 3 Mexico offers to swap FRNs for Mexican government bank debt at discount in cooperation with Mexican government to solve the debt problem 1 Mexico buys 10 billion 20year US zero coupon Treasury Bonds for 18 billion Maturity value 18 1x 20 10 billion so interest rate is x 9 IR 2 Mexico issues 10 billion 20 year FRNs at LIBOR 1 58 with the principal backed by US zerocoupon Treasury bonds 20 years from now US will pay 20 billion to Mexico as bond matures this 20 billion will be used to pay off principal of FRNs 3 Mexico offers to swap FRNs for Mexican government bank debt at discount FRNS Floating Rate Notes 39 bonds that have a variable coupon equal to a money market reference rate like LIBOR or federal funds rate plus a quoted spread quoted margin 39 the spread is a rate that remains constant 39 almost all FRNs have quarterly coupons pay out interest every 3 months 1989 Brady Plan modifications 20 year maturity to 30 year maturity Interest rate also guaranteed by IMFIBRD on 18 month rolling basis 3 Mandatory swap with 3 options 39 1 30 year FRNs at LIBOR 1316 at 35 discount 39 30 year Eurobonds at 625 fixed rate at par 39 15 year FRNs LIBOR 1316 for 25 extra exposure N L Historical Overview of the Asian Economy 39 until about 200 years ago Asia39S economy Was far more advanced than the West 39 Annual revenue of India39S Mogul Emperor 1658 1701 were about 10 times those of Louis XIV of France 39 1820 was the beginning of Asia s economic decline and it hit the bottom in 1952 39 62 of World GDP percent share in 1700 39 17 in 1952 Term Definition Reasons for Asia s economic decline and recent resurgence less emphasis traditionally on business and profits by Asia s elites but more on arts literature and scholarly pursuit lsolationism China as the Middle Kingdom considered to be at the center of the world 39 arrogance and selfcomplacency among countries 39 Changes in Japan from the 1950s Korea and other Asian tigers from the 1960s tiger cubs from 1970s China from 1980s and India from 1990s Initial Barriers to Asian Economic Development in 1950s 1980s 39 very poor rural agrarian economy 39 small domestic markets weak entrepreneurial base lack of capital and technology low managerial capabiltiy Government responses 39 government industrial policy 39 export promotion industries import substitution industries 39 encouragement of FDI inflows to bring in capital technology and management knowhow Historical Perspective on Asian Economic Miracle o Amod Toynbel s theory of quotchallenge and responsequot great civilizations have risen not because of fertile lands and other plentiful natural resources but in response to heroic human efforts to overcome threats 4 Asian Tigers and their Threats 39 South Korea North Korean Military threat Taiwan and Hong Kong China threat 39 Singapore Malaysia and Indonesia Threat Economic development model of 4 Asian Tigers 39 governmentled free market economy 39 exploited US security umbrella and its generous openmarket policy for East Asian products in the US during the Cold War Mercantilist trade policy with an aggressive export drive combined with closed domestic markets tariff and non tariff barriers 39 focus on exportpromoting and import substituting manufacturing sector while neglecting bankingfinance sectors high domestic savings channeled by the government to favored sectors
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