Currencies and capital flows

Monetary issues more important

Internal and external balance

The international monetary system

Ari Kokko

Monetary issues more important Increasing capital mobility

– long run: possible to finance more investment

– short run: volatility? Daily turnover in int’l forex markets at least USD 1,500 billion

Increasingly volatile exchange rates– larger fluctuations than in underlying real

variables (trade, production) Institutional consequences

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Conceptual framework

Accounting identities

Y = C + I + X - M

Y - C - I = X - M

S - I = X - M

Internal balance = External balance

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Conceptual framework

More complicated, with government

(Sp + T) - (Ip + G) = X - M

T = government ”savings” (taxes)

G = government ”investment” (expenditure)

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Conceptual framework

International macroeconomics:

S - I = X - M

Employment Current account

Growth Exchange rates

Interest rates Capital inflows

Gov’t budget

Inflation

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The international monetary system Historical development of solutions to

reconcile internal and external balance Not only choice of currency

arrangement (fixed or flexible exchange rates) but also regulation of trade and capital flows (current account and capital account regulations)

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Schedule

Gold standard ( - 1914) Interwar period (1920 - 1939) Bretton Woods (1945 - 1973) Post-Bretton Woods (1973 - ) European solutions Developing countries New financial architecture

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Gold standard

Established in Western Europe during 1870s (in Great Britain in 1717)

Extended to rest of the world by 1900 Stable exchange rates contributed to

first round of internationalization... … but free trade and capital flows also

contributed to success of gold standard

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How did the gold standard work?

Price-specie flow model (Hume 1752):

trade deficit => outflow of gold =>

lower money supply and lower prices =>

improvement in competitiveness =>

new equilibrium increase in discount rate speeds up

price adjustment without gold transfers

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Why did the gold standard work? Political commitment to converitibility

– no doubts about priorities– weak labor interests– flexible prices and wages

Free trade and free capital mobility– leading country - Great Britain - recycled

surpluses by lending to infrastructure development.

International cooperation - but still unstable at the periphery

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Interwar period War expenditures so large that gold

convertibility was abandoned - soldiers and suppliers paid with fiat money. Only USD remained convertible into gold.

Widely diverging exchange rates because of differing rates of inflation

Floating rates until mid-1920s Differences in new gold parities

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Interwar period

Weak-currency countries: attempts to get close to old gold parities (Britain)

Strong-currency countries: new parities close to floating rates (France)

Weak countries in chronic BoP deficits, strong countries with persistent surpluses

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Interwar period Changing political environment reduced

absolute commitment to convertibility– democratization and stronger labor intersts – burden of reconstruction

Great Depression end of gold standard– primary product exporters hurt by lower

prices and reduced capital flows– bank failures in Europe drained gold

reserves: capital controls, end of convertibility, protectionism

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Lessons from interwar period

Unquestionable commitment to convertibility central issue– if yes: international capital flows will

facilitate equilibrium– if no: speculation will aggravate

imbalances

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The Bretton Woods system

Comprehensive solution negotiated after 2nd World War

Strong institutional basis– ITO– IBRD– IMF

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Bretton Woods

Fixed but adjustable exchange rates Capital controls IMF for monitoring and BoP financing

Current account controls until 1959 to facilitate post-war expansion

Intervention: interest rate controls, no capital account convertibility

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Main objective: free trade

To create conditions for rapid increase in international trade

Controls necessary because full employment had become new policy goal: little room for deflationary policy

Last line of defence: adjustment of peg

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Problems with Bretton Woods Asymmetry

– US leading power. Deficits could always be financed with USD. Could be too expan-sionary (inflation) or restrictive (deflation)

Liquidity needs– expansionary policies & low interest rates +

fixed exchange rates => need for financing Unwillingness to change peg

– Fund approval required, only ex post adj.– destabilizing, admission of past mistakes?

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Bretton Woods collapse Attempts to save system

– central bank collaboration, Gold Pool– US policies to tighten capital controls

Still, too much USD in circulation– Vietnam war

Suspension of USD gold convertibility 13 August 1971, Smithsonian ”broad-band” agreement – USD devaluation, wider bands, finally

collapse of fixed rates in 1973

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Why did Bretton Woods collapse? No credible political commitment to

fixed rates (or gold convertibility)– lower price and wage flexibility

Pressure from increasing international capital flows– current account convertibility reduces

impact of capital controls– increase in FDI

Warming of cold war– less international collaboration

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Post-Bretton Woods

Two solutions Large countries: floating rates

– external trade small share of GDP Small countries: pegged rates

– much external trade, need to avoid excessive volatility

– capital controls, particularly in developing countries

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Floating rates: 1970s Some volatility, but surprising stability in

spite of oil crises and commodity shocks– concerted intervention by central banks– remaining capital controls used extensively

Willingness to adapt domestic policies to maintain external balance (justified by external crises?)

Main problem: inflation– money creation by central banks to finance

expansionary policies

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Floating rates: 1980s - volatility US policy driven by domestic agenda

– Reagan: tax cuts, military spending, budget deficits, high demand

– Fed chairman Volcker: interest rate increases to keep inflation in bounds

– capital inflows and USD appreciation Severe consequences

– Latin American debt crisis– widening US current account deficit and

protectionist pressures

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Floating rates: 1980s - solutions Plaza agreement September 1985

– G-5 statement regarding “orderly appreciatíon of non-dollar currencies”

– rapid dollar depreciation Louvre meeting February 1987

– problem: excessive depreciation of USD– ambition to stabilize exchange rates and

instead adjust domestic policies: expansion in Japan and Europe, contraction in US

– little internal adjustment in the US: cont’d overvaluation in Europe (and Japan)

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Meanwhile in Europe: pegged rates 1970 Werner plan (EMU) failed

– Bretton Woods collapse and EC expansion 1971 agreement about bilaterally

pegged EC rates: Snake in the tunnel 1973 collapse of Smithsonian tunnel:

Snake in the lake But Snake very troubled

– oil shocks but no harmonization of economic policies

– asymmetry: Bundesbank dominant

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1979 European Monetary System Attempt to create symmetric system with

harmonization– Exchange Rate Mechanism (ERM) to fix

rates within set bands– European Monetary Fund (EMF) for BoP

financing and monitoring of policies Tough start

– remaining policy divergence - expansion in France, contraction in Germany - big threat

– French thoughts of leaving EC in 1983

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The European Monetary System More stable development after 1983 as

oil shocks ebb out Fundamental inconsistencies emerging

– EMS reduced scope for macro policy– instead, micro policies to affect social

objectives: wages, job security, benefits– problem: reduced labor market flexibility

and “Eurosclerosis” Proposed solution: EU Single Market

and EMU

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Problems with EMS Single Market program included free

capital mobility– but free capital mobility led to larger

imbalances and made it hard to maintain fixed exchange rates before EMU

– several shocks in early 1990s: German reunification, Gulf war, global recession

EMS crisis in 1992– Danish no to Maastricht led to doubts

about commitment and currency crises

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Economic and Monetary Union Need to establish ultimate peg: a common

currency Convergence criteria to achieve enough

domestic adjustment– inflation– interest rates– budget deficit and public sector debt

Apparent political commitment: likely to succeed– but what about USD/Euro rates?

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Developing countries Large financing needs

– investment essential for growth, but limited domestic savings capacity

– fluctuations in export incomes Fixed rates popular in 1970-80s

– nominal anchor to limit inflation Reasonably stable system up to late

1980s– extensive capital controls helped insulate

domestic markets

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Developing countries Changing environment from mid-1980s

– Washington consensus: liberalization of international capital flows

– private capital more important Temptation to borrow a lot

– but capital inflows are hard to combine with fixed exchange rates

– and are OK only if the strengthen economy– warning for crises:Latin America(1980s),

Mexico (early 1990s), Asia (late 1990s)

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Anatomy of a crisis Increases in supply and demand of capital

– export boom, investment demand– deregulation, improved availability of credits

=> rising asset prices and inflation Appreciating real exchange rates

– weaker int’l competitiveness, current account deficits, foreign borrowing

Collapse when foreign confidence disappears– no money, not funny

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Developing country crises worse than our own crises because… Weak banking supervision Lack of transparency Corruption and cronyism Weak human capital

Industrial policy and development strategy: Korean example

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Differences between developing countries

Middle-income countries have access to private capital flows– problem: capital account and volatility of

private flows– extreme solutions: currency boards

Low-income countries have little FDI and private capital– problem: current account and volatility of world

market prices of primary products

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Differences between developing countries Middle-income countries subject to IMF

financing– Argentina, Mexico, Indonesia, Russia,

Korea Low-income countries more dependent

on foreign aid– but aid flows have fallen since mid-1980s

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Solutions for low-income countries: HIPC WB/IMF program to support “Highly

Indebted Poor Countries”– main item: debt reduction– countries that are identified as HIPC are

required to undertake structural reforms (exports, public revenue)

– in return, external debt will be reduced to “sustainable levels” (150% of annual export revenue)

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New Financial Architecture

Mainly relevant for middle-income countries

Key words– transparency and crisis prevention– regulation and policies– financing

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New Financial Architecture Information and transparency

– international reserves, foreign debt, NPLs– fiscal transparency

Regulation– sound macro policies– controls on capital inflows?– prudent regulation of financial sector

Financing– IMF Contingency Credit Line (April 1999)– remaining question: lender of last resort?

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Summary Complex evolution of international

financial system– remaining problems mainly for LDCs

Trend: free capital mobility and problems to maintain adjustable pegs

Consequences: – tough adjustment and protests– industry localization new choice variable– new instruments for improving domestic

competitiveness: industrial policy