International FinanceFINA 5331

Lecture 7:

Exchange rate regimesAaron Smallwood Ph.D.

Integration in Europe

• Integration in Europe begins with the ECSC in 1951. With the Treaty of Rome, the ECSC, EUROTOM, and the EEC are formed, which eventually are absorbed into the EU in 1994.– ESCS leads to EEC, which leads to EC, which leads to the EU.

• Monetary integration is formalized with the establishment of the EMS where exchange rates are fixed. The mechanism by which exchange rates are fixes is known as the exchange rate mechanism. The EMS leads to European Monetary Union. The 17 countries that use the euro are part of a currency union known as the EMU. Monetary policy for the entire EMU is overseen by the European Central Bank in Frankfurt.

The EU and the EMU.

• Today, there are 27 EU countries. The European Union is a political and economic union based on free trade. NOT ALL countries use the euro.

• There are several distinct groups

– EU Countries• EU countries who are not in the ERMII and have no

intention of adopting the euro

• EU Countries that will adopt

• ERM II countr(y)ies that have no stated intentions of adopting the euro

• ERM II countries that will adopt

• EMU Countries

EU countries that are not part of the ERMII

• EU countries that will eventually adopt (or plan to):

– Bulgaria– Croatia– Czech Republic– Hungary – Poland– Romania

• EU countries (not part of ERMII) with no stated intention of adopting the euro

– Sweden– UK

ERM II Countries

• That will adopt:• Latvia• Lithuania

• The have no stated intentions of adopting• Denmark

EMU Countries

– Austria (in 1999) - Netherlands (in 1999)

- Portugal (in 1999)– Belgium (in 1999) - Slovenia (in 2007)– Cyprus (in 2008) - Slovakia (in 2009)– Estonia (in 2011) - Spain (in 1999)– Finland (in 1999)– France (in 1999)– Germany (in 1999)– Greece (in 2000)– Ireland (in 1999)– Italy (in 1999)– Luxembourg (in 1999)– Malta (in 2008)

Is the EMU an OCA?

• OCA optimum currency area: The best geographic region where one currency is used within the region, and where outside the region, different currency(ies) are used.

• It is generally accepted that within an OCA:– Countries should be relatively buffered from

asymmetric shocks (economic/financial events that affects different regions differently).

– Factors of production should be mobile

Benefits of joining currency unions

• Reduction in transactions costs such as the bid-ask spread.

• Increased transparency (traders throughout the eurozone immediately know the costs of goods and services with no need for currency conversion)

• Deeper financial markets

• Potential for increased political harmony

Costs of being in a currency union

• Loss of monetary policy independence– Lacking fiscal federalism, policy responses to

asymmetric shocks can be limited

• Loss of exchange rate as an automatic adjustment mechanism.– Greece’s currency today is likely stronger

than it would if Greece was not part of the EMU.

Major currency crises

• EMS crises of 1992-93.– Following German re-unification contractionary monetary policy caused

the currencies of German trading partners to become overvalued.

• Mexican peso crisis 1994-95.– An overvalued exchange rate, policy mistakes, and political turmoil led

to collapse of the peso, a severe recession and inflation before an IMF and US led bailout.

• Asian currency crisis (1997-98)– Contagion

• Argentina (2001-02)– Failure to use fiscal restraint and inflexibility in labor markets led to the

collapse in this board system.

Overvalued/Undervalued?

• How would we know if a currency was overvalued or undervalued?

• Most economists use “real exchange rates”.• According to the law of the one price:

1$$)/(

$$)/()(

FCt

tFC

t

tFC

tFC

t

P

PS

PSP

Real Exchange Rate

• The real exchange rate is defined as:

• Take Mexico as an example: Suppose St is relatively stable but, Pt

Mex increases much more rapidly than Pt

US. The result, Rt increases. The Mexican peso appreciates in real terms.

DCt

DCt

DCFCt

tP

PSR

)/(

Real Exchange rate

• If a country’s real exchange rate rises, some combination of the following three are occurring:– The nominal exchange rate is appreciating– Domestic prices are rising rapidly– Foreign prices are falling.

• ALL THREE LIKELY LEAD TO A DECLINE IN THE DEMAND FOR EXPORTS

Real Exchange rate

• If a country’s real exchange rate rises, some combination of the following three are occurring:– The nominal exchange rate is appreciating– Domestic prices are rising rapidly– Foreign prices are falling.

• ALL THREE LIKELY LEAD TO A DECLINE IN THE DEMAND FOR EXPORTS

The Asian currency crisis

• On July 2, 1997, Thai Baht is devalued.• July 11 Philippines devalues the peso• July 14: Malaysia floats the ringgit• July 17: Singapore devalues• August 14: Thailand moves to a float• October 14: Taiwan devalues• November 14: Korea floats• August 17, 1998: Russia abandons its peg• Hong Kong: At one point, Hong Kong monetary

authority raises rates to 500%.

Asian currency preview: The causes

• Liberalization of capital markets in a weak domestic financial environment.– Crony capitalism– Surge in risky real estate investment– Maturity mismatch

• Secondary cause: Over-valued real exchange rates.

Review: Asian currency crisis

• Crony capitalism: A very close connection between government leaders and private enterprise, “lending decisions were often influenced by political considerations” (page 49, Eun and Resnick).

• Violation of the trillema

• Maturity mismatch:– Given capital inflow, Asian economies become reliant on short

term debt instruments.

• Aftermath: Average economic growth of Indonesia, Korea, Malaysia, Philippines, and Thailand (source: Krugman and Obstfeld, 6th Edition):

• 1996: 7.0% 1997: 4.5% 1998: -8.1%

Recent trend in China’s exchange rate policy

• In May 1995, a conventional pegged exchange rate system was implemented. By September 1998, the yuan price of the dollar was pegged at RMB 8.28, where it remained until July 2005.

• In July 2005, the RMB was revalued by 2.1% against the dollar as part of China’s exchange rate reform.

• At the same time, China altered it’s peg against a single currency to a peg against a basket of currencies, including the dollar, euro, yen, Canadian dollar, pound, and several others

• The actual exchange rate is allowed to vary each day within +/- 0.30 relative to the target for the basket.

China’s policy, continued

• During the financial crisis, in October 2008, a de facto conventional peg against the dollar is established. The RMB price of the dollar was fixed to about RMB 6.83 to RMB 6.84 from Oct. 2008 to June 2010.

• On June 21, 2010, the People’s Bank of China announces “the reform of the CNY exchange rate flexibility.” The RMB sets a parity rate against the dollar each day. The actual value of the exchange rate is maintained within bands less than +/-0.50% relative to the central target.

• On April 14, 2012, the trading bands were increased to +/- 1%.

China’s policy, continued

• Since the conventional peg was abandoned in 2005, the RMB has appreciated significantly against the dollar. On July 5, 2013, the CNY price of the USD was 6.1328.

• The increased flexibility of the CNY, along with the appreciation of the currency, reflects a transition for China as they move away from the export-led growth strategy that spurred strong growth. According to a recent article on thediplomat.com:

“rebalancing implies the complicated and difficult process of lowering investment levels, increasing household consumption, reducing the role of the state sector, and significantly altering the way credit is allocated.”

China’s policy, continued

• Interbank interest rates spiked to 12% in June as the PBOC did not respond to pressure to inject liquidity during a short term credit crunch. Rates have since stabilized.

• New leadership in China appears committed to a new rebalancing policy. Real GDP growth slowed to 7.7% in the first quarter of 2013, from 14.2% in 2007.

• According to president Xi Jinping in an article published by the Financial Times,

“I don’t think China will be able to sustain a super-high or ultra-high speed of growth and that is not what we want. China’s model of development is not sustainable, so it is imperative for us to speed up the transformation of the growth model.”