Class Note for FINOPMGT 413 at UMass(3)
Class Note for FINOPMGT 413 at UMass(3)
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Date Created: 02/06/15
Week 2 Currency Systems and Crises Definition 0 An exchange rate is the amount of currency that one needs in order to buy one unit of another currency or the amount of currency that one receive when selling one unit of another currency Exchange Rates Today 1 Exchange rates are volatile If the exchange rate oats the value of the rate fluctuates daily When the exchange rate is xed or pegged it does not fluctuate daily but can change dramatically if the peg is broken 2 Booms and Busts Exchange rate systems are subject to currency crises The Asian currency crisis of October 1997 Argentina 2002 Exchange Rates Today 0 3 Despite much effort exchange rates have proven to be very difficult to predict or control Historically almost all nations have sought to exert control over their exchange rates but often with limited success 4 Exchange rate fluctuations can have substantial impact on the real economy The Asian crisis had a substantial impact on the domestic economies of the countries that were affected In the case of Indonesia it also had an impact on the political environment resulting in the resignation of Indonesia s President Suharto Questions Every nation has a choice to choose a specific type of exchange rate system What has been our historical experience with exchange rate systems Why is the choice of an exchange rate system important What are the advantages and disadvantages of each system Exchange Rate Systems Over The Times 1 Gold Standard Value of currency is fixed in terms of gold The gold standard was popular before the WW1 Now only of historical interest 2 Fixed Pegged against a single currency or a basket of currencies Thai baht before 1097 currency crisis Chinese renminbi 3 Free Floating US Japanese Yen Euro BP 4 Hybrid Systems egManaged Floating floating with interventions for example with target zones or crawling adjustments Brazil before January 1999 5 Currency BoardFixed exchange rate with foreign reserves sufficient to support 100 of currency Argentina until 12002 HK Estonia and Lithuania Our focus will be mainly on the Fixed Floating and Currency Boards A Quick Look at History 0 1 US and Europe exchange rate and monetary systems 1879 to today 0 2 Recent Currency Crises The Gold Standard 18791913 111 0 1 The official gold price was fixed mint parityquot with free convertibility between domestic money and gold US adopted standard in 1879 and defined the US as 2322 fine grains of gold or US 2067ounce of gold 2 All national currency is backed by gold and growth in money supply is linked to gold reserves 0 3 As each separate currency was convertible into gold at a fixed price the exchange rate between the two currencies was automatically fixed 4 There is no fluctuation in the exchange rate unless either country changes the local price of gold Between WW1 and WW2 and the Great Depression 211 0 Countries experimented with floating rates in the 1920 s and 30 and this was widely thought to be a failure Here s a view from Ragnar Nurske 1944 of the League of Nations If there is anything that the interwar experience has clearly demonstrated it is that currency exchanges cannot be left free to fluctuate from day t00 ay under the influence of demand and supply I39f currencies are left to fluctuate 39specuatI39on Is ley to play havoc With the exchange rate Bretton Woods Agreement 1945 312 1 Fix an official par value of the currency in terms of gold 0ra currency tied to gold 2 In the short run the exchange rate should be pegged within 1 of par value but in the long run leave open the option to adjust the par value unilaterally 3 Permit free convertibility for current account transactions but use capTa controls to limit currency speculation FixedRate Dollar Standard 195070 411 0 1 US maintained a gold standard at US 35ounce 2 All other countries fixed an official par value in terms of the US and tried to keep their currency within 1 of par value Breakdown of Bretton Woods 511 By the late 1960 s US liabilities abroad exceeded their gold reserves US had run an expansionary monetary policy during the height of the Vietnam wars and its current account and trade balance had deteriorated It wasn t possible for the US to back its commitment to its currency with gold On August 15 1971 Nixon officially took the US off the gold standard Floating Exchange Rates 611 By March 1973 all major currencies were allowed to float against each other Rules of the Game 1 Nations tried to smoothen short term variability without committing to an official par value 2 Permit free convertibility for current account transactions while trying to eliminate restrictions on flow of capital Floating Rates in the 70 s and 80 s 711 Within a few years the major nations had eliminated restrictions on flow of capital and over time the flow of capital became more important as a major determinant of shortterm currency movements than trade imbalances Although in principle the exchange rate was to be determined by the market policymakers soon came to the conclusion that the price reflected by the exchange rate was either not warranted or should be manipulated to better suit domestic economic policies Aside This notion is quite contrary to our usual thinking of other prices as for example stock prices Interventions in the Currency Market 811 For the first decade the US was passive towards the US exchange rate But between 198085 the US had appreciated by almost 50 in real terms Plaza Accord of 1985 To counter the US appreciation the G5 countries met at the Plaza hotel in NY and agree to intervene in a coordinated fashion to depreciate the US This agreement came to be known as the Plaza Accord The accord worked and the US depreciated sharply through 1986 and 1987 This was the first major coordinated intervention Interventions in the Currency Market 911 By 1987 it was clear that the Plaza accord had worked well and the currencies now needed to be stabilized around their current levels Louvre Accord Feb 22 1987 At a meeting in Louvre the G5 countries decided to set target zonesquot or exchange rate ranges and the central banks agreed to defend their currency by active intervention in the currency markets European Monetary Union 1011 0 European Monetary System ECU ERM and the Euro In December 1978 the European countries voted to establish a European Monetary System with the ECU and ERM as some of its building blocks 1 ECU The European Currency Unit ECU was defined as a fixed amount of the national currencies of the member countries European Monetary Union 1111 2 ERM The Exchange Rate Mechanism was the plan to limit exchange rate fluctuations Each country that participated within the ERM agreed to limit the fluctuations to within 225 or 6 for UK Italy Spain and Portugal of the rate defined in terms of the ECU This narrow range proved hard to defend and it was widened to 15 after the ERM currency crisis of 199293 3 Euro Common currency for the countries of the European Union introduced 1 1 1999 The ECU became the Euro Something to think about Will UK join the Euro someday in the future Will Switzerland Currency Crises Example 1 Asian Currency Crisis Thailand Indonesia Malaysia Korea and others Example 2 Brazil in 199899 Example 3 Argentina 20012002 Example 1 Asian Currency Crisis October 1997 c To date the biggest postwar crisis in terms of its geographic reach and magnitude All countries in the region experienced severe economic downturns Pegged before 1097 and float afterwards 60 55 50 45 40 35 30 25 20 Thai Baht vs US THAI BAHT TO US EXCHANGE RATE FROM 1 1 96 TO 9 10 99 WEEKLY 1996 1997 1998 1999 HIGH 5610 1 12 98 LOW 2413 6 16 gun e39b g1 REAM Indonesian Rupiah vs US Pegged before 1097 float afterwards 00039s INDONESIAN RUPIAH TO US EXCHANGE RATE 16 FROM 1 1 96 TO 9 10 99 WEEKLY 14 12 1o 1996 1997 1998 1999 HIGH 1527500 7 13 98 LOW 22800033Egg 9gje gg 79gggp Example 2 Brazil s Currency Crisis in 199899 Brazil August 1998January 1999 In defending its currency Brazil lost more than 45 billion and had to raise interest rates to over 40 However it could not stop the fall of the real and ultimately decided to float the currency Brazil Real vs US Managed Float before 1999 crisis BRAZILIAN REAL TO US EXCHANGE RATE 125 FROM 1 1 96 TO 1 1 99 WEEKLY 120 115 110 105 100 095 1996 1997 1998 1999 HIGH 120800 12 28 98 LOW 0970008Jg gqjstqngggqg Brazil Real vs US Free Float after the 1999 monetary crisis BRAZILIAN REAL TO US EXCHANGE RATE 220 FROM 1 1 99 TO 9 10 99 DAILY 200 190 180 170 160 150 140 130 120 JAN FEB MAR APR MAY JUN JUL AUG SEP HIGH 216000 3 2 99 LOW 120180 gab ggt 1se gm Example 3 Argentina 2002 0 See attached WSJ articles about events on the crises Argentine Peso vs US Currency Board before 2002 ARGENTINE PESO TO US EXCHANGE RATE 101 FROM 1 1 96 TO 9 1 0 99 WEEKLY 100 1 996 1 997 1 998 1 999 HIGH 1000 1 8 96 LOW 0999 1 1 9 OICCT B gS l REAM 0 N 00 P omAmwamAm 122002 222002 4 322002 4 422002 4 522002 4 622002 4 722002 4 822002 4 922002 4 ARSUSD ARSUSD Argentine Peso vs US 2002 Choice of Exchange Rate Systems 0 Every country has to make a choice of an exchange rate system The possible choices are fixed or pegged float currency board or some mixture like managed float Why is the choice of exchange rate system important 0 1 Because the exchange rate affects the price of traded goods and therefore domestic inflation and production growth rates The high industrial growth in China can be directly linked to their choice of a fixed and grossly undervalued exchange rate Why is the choice of exchange rate system important 0 2 Because the exchange rate is tied in with the monetary system it directly impacts flexibility of domestic policy decisions Currency board The Central Bank has no discretionary power to change money supply and thus for example stimulate or slow down the economy Fixed The Central Bank has some flexibility with monetary policy but this flexibility is secondary to the task of maintaining the peg Floating The Central Bank can focus completely on domestic policy ignoring the exchange rate fluctuations Evaluating the Fixed Exchange Rate 0 1 Can create stability in the short run 0 2 Reduces flexibility of both domestic fiscal and monetary policy as domestic policy has to be geared towards keeping the peg A country with a history of economic mismanagement can create a short window of credibility to set into place new policies 0 3 Our historical experience has been that without restrictions on capital flow a fixed exchange rate system is difficult to sustain Both Malaysia and China have restrictions on capital flow Evaluating the Floating Exchange Rate System 0 1 Domestic policy can be conducted independently of the exchange rate This may be good or bad depending on quality of domestic institutions In US GreenspanBernanke worry a lot of inflation and growth but rarely about the exchange rate Loss of confidence can create a selffulfilling crisis with a severely depreciating currency leading to hyperinflation and panic Exchange rate volatility has to be managed by corporations and investors Requires a sophisticated derivatives market for hedging risk Evaluating the Currency Board 0 1 Limited discretionary domestic policy Central Bank cannot change money supply or change exchange rate 0 2 It links the domestic economy to the country that the currency is tied to This is good in the short run but may have adverse consequences in the long run as domestic producers have to compete on an equal footing with the foreign country s firms Why did Argentina break its currency board in 2002 Some Questions to Think About 0 1 The consensus before WWII was that floating exchange rates were dangerous But today we are more comfortable with floating rates than fixed Why do you think the shift has occurred 0 2 China is the most important country that pegs its currency now its more of a managed float rather than a peg Do you think it can successfully manage the strengthening of its currency the RMB renminbi or yuan Why Currency Crises First three common reasons you will hear discussed in the press 1 Speculators The Malaysia PM Mahathir blamed George Soros for the Asian crisis 2 Investor panic I panic and therefore you panic and eventually we all panic 3 Contagion Because markets are inter linked a crisis in one market leads to a crisis in another Why Currency Crises The above reasons apply to all markets including equity In addition there are reasons that are specific to the currency markets 0 4 Domestic policy is not in sync with exchange rate policy Example Suppose a country has a fixed rate but its domestic inflation consistently exceeds the foreign country s inflation This will lead the currency to be overvalued in real termsquot eventually leading to lower growth rates unemployment loss of confidence and eventual panic Why Currency Crises 5 Politics matter Governments decide to abandon a regime after doing a costbenefit analysis so their politics or who governs matters Devaluing or keeping a currency weak helps growth rate lower unemployment rate Keeping a currency strong can help control inflation bring credibility to the government and be a source ofnannalpnde
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