Part 12 rhodes finance class summer 2010 forum nexus

Class 12

Rhodes, Greece

LAST LECTURE!!!

Brian David ButlerProfessor of international finance and global entrepreneurship with Forum-Nexus Study Abroad. Guest lecturer with the IQS Business School of the Ramon Llull University in Barcelona, and the Catholic University of Milan. Previously, Brian taught finance, economics and global trade courses at Thunderbird’s Global MBA program in Miami, and worked as a research analyst with the Columbia Business School in New York City. Brian currently lives in Recife, Brazil where he is teaching classes at the university Faculdade Boa Viagem.

A global citizen, Brian was born in Canada, raised in Switzerland (where he attended international British school), educated through university in the U.S., started his career with a Japanese company, moved to New York to work as an analyst, married a Brazilian, and has traveled extensively in Latin America, Asia, Europe and North America.

[email protected]

LinkedIn/briandbutler

Skype: briandbutler

Brian Butler is a specialist in international economic analysis, and is founder of the prestigious “GloboTrends“ (www.globotrends.com) online economics site, which has been featured as syndicated content on Nouriel Roubini’s RGE Monitor, Emerginvest.com, Business Week Exchange, Wikinvest.com, and other leading news outlets.

http://globotrends.pbworks.com/ , http://blog.globotrends.com/

Find my slides:

www.slideshare.net/briandbutler

Lecture Schedule*

* Does not include professional visits, *Subject to change, modification without warning

Team Project

•Due date:

▫Wed July 28th - Today by midnight

•Team project 25% of final grade•Peer review

Grading

•Components of Final Grade▫Midterm exam 20%

▫Final exam 30% ▫Team project 25% ▫Assignments 15% ▫Class participation 10%

Exam material

•Cumulative •Review midterm exam•Review my slides

Extra credit on the exam (3 points)

•Why were there no emerging market financial crises between 2001-2007?

•What role did the US play in stability?

Greece – benefit to being in the Eurozone

•Why was Greece able to borrow at NEARLY German rates?

•Why did that come to an end? What was the impact?

Exam question (and in paper!)

•How can Greece (or Spain) regain competitive edge? Why doesn’t Greece (or Spain) drop out of the Euro? What is the risk of leaving?

•Make sure to READ handout, include this on paper, and be ready for EXAM #2!!!

My comments

1.Anyone (person, bank, or company) who borrowed in Euros (thinking the peg would last) would be punished by a devaluation of the local Greek (or Spanish) currency (if they broke from the Euro)

2.In the future; investors would demand extremely high interest rates from these countries (if they did leave the euro) to compensate for the risk of further devaluation, inflation

3.Just the hint that the country MIGHT devalue would cause investors to pull money out of the country

From the reading…• “The costs of backing out of the euro are hard to

calculate but would certainly be heavy. The mere whiff of devaluation would cause a bank run: people would scramble to deposit their euros with foreign banks to avoid forced conversion to the new, weaker currency. Bondholders would shun the debt of the departing country, and funding of budget deficits and maturing debt would be suspended.

• Changing all contracts in euros—bonds, mortgages, bank deposits, wage deals and so on—to the new currency would be a logistical nightmare. The changeover to the euro was planned in detail and the exchange rate was fixed in advance, in co-operation with all the euro members. The reverse operation would be nothing like as orderly, not least because the exchange rate would be a moving target.

Economist.com, A special report on the euro area, Jun 11th 2009

Heavy cost to exit…

•“A country that forced bondholders to take a loss would be punished. Continued access to bond markets would come at a high price. Investors would ask for a huge premium to cover the risk of further default. On that count alone, borrowing costs would be far higher than they were within the safer confines of the euro area.


Heavy cost to exit…•A former euro member would have to

reinvent its own monetary policy and would struggle to convince investors that it could keep a lid on inflation. One of the euro’s big attractions was that it offered many countries a shortcut to a credible monetary set-up. Devaluation could itself trigger a wage-price spiral. For high-debt countries, such as Greece and Italy, the interest rates demanded by markets to insure themselves against such risks would be ruinous.


Better solutions…

•The wrong cure•An exit from the euro would not tackle

weak productivity growth and inflexible wages, which are the root causes of low competitiveness


• A more plausible, though still unlikely, scenario would involve a breakaway by a group of low-debt and cost-competitive countries, centred around Germany. Members of a new, “hard” European currency would leave behind a stock of depreciating euro debt and might be rewarded by lower borrowing costs on debt issues in the new currency. Yet a large part of the appeal to Germany of the single currency has been that it rules out revaluations and rewards its firms for being competitive. Germany, France and the rest have too much invested in the success of the EU and the euro to put it at risk. As Daniel Gros of the Centre for European Policy Studies, a Brussels think-tank, puts it: “The weak can’t leave and the strong won’t leave.”


Fear of Floating

“The financial crisis has made the euro look more alluring”


International financial system

USA – unique position

What is unique about the USA?

▫Why is the US able to run large current account deficits?

▫If current account deficit = crisis, and if the USA has current account deficit for more than 20+ years why no crisis in USA?

Devalue currency

•If the US were to devalue its currency…

•“an elegant, painless, and entirely legal way for the US to default” (without actually defaulting)

Martin Wolf book, “Fixing Global Finance”

No threat of solvency crisis:

The US does NOT face a “solvency” crisis in the foreseeable future (due to excessive borrowing from abroad)

Who can explain this?

Exorbitant privilege

•What is this? How related to global finance?

Real threat to the USA•Might loose “exorbitant privilege”

•“You Don’t know how luck you are, babe”

▫Able to borrow (seemingly) unlimited ▫In own currency▫At a very low rate

▫(and invest abroad at higher returns, and run NO risk of insolvency!)

Why US needs this privilege (low rates, in own currency)

Currently Funding ▫2 wars.▫Economics stimulus▫Economic recovery▫Massive Current account deficit

Future ▫ Social Security / Health care reforms

International Reserves

IOU’s

From exam…

•In class we discussed the danger of pegging a currency artificially HIGH (as compared to pegging artificially LOW). (a) Explain this statement using examples. (b) Which situation results in accumulation of reserves? __________________________________________________________________________

National “Balance Sheet”

• 3 Important parts (for our class discussion): Current account

▫Flow of goods and services, Roughly= exports - imports

Capital account▫Money flows in / out ▫Think “Paying for the current account deficit”▫Example: US government sells treasury bills

Reserves▫Foreign currency, gold, etc▫Used to finance gap between current & capital

accounts▫“below the line” Martin Wolf book, “Fixing Global Finance”

Must Balance!!

If deficit…

pay out reserves.

If surplus..

Build up reserves.

Foreign reserves = I.O.U’s

•“Gigantic accumulations of foreign – currency reserves, which are also, by definition, huge official capital OUTFLOWS!”

•Who can explain this?


Foreign reserves = I.O.U’s• Important concept to understand…• Foreign currency reserves are NOT = a big

pile of money.• Instead, they are a big pile of I.O.U’s• Example:

▫China buys Treasury bills▫ = promise to pay in future (remember the

“pyramid of promises”?)▫China alone is sitting on a pile of $1 trillion +

I.O.U.’s▫Question: what is the risk (to China)?

Legacy of the Crises

•By March 2007:

Both Taiwan & South Korea held more reserves than the entire Eurozone!

▫When? Almost all between 2000-2007


Foreign reserves = I.O.U’s (2008-09)

https://www.cia.gov/library/publications/the-world-factbook/rankorder/2188rank.html

“rebalancing” world economy

China – USA

▫Question: what is the risk (to China) with respect to their accumulation of foreign-currency reserves?

The two risks to China:

#1. If the US dollar were to Depreciate

#2. Secondary: If the US inflation were to rise

•Who can explain these two threats? (to China and to the USA)

2 threats:


▫ How would this effect Chinese reserves? Remember: Think of China like a “bank”,

and the US like a “borrower” If a bank lends abroad to foreign borrower,

what happens if foreign currency devalues?

Group…

If a bank lends abroad to foreign borrower, what happens if foreign currency devalues?

Bank still gets back SAME amount of foreign currency,

but…

Bank gets back LESS than they anticipated (when converted to local currency)…

2nd threat : Inflation

Question: who remembers my preferred definition of “inflation”?

Inflation

•How to think about it:▫(ok definition, but not useful)

A general rise in prices

▫(better definition) A decrease in the value of money in the

future … less purchasing power for $1 in future (than now)

QUESTION

•Group assignment:▫“why is inflation bad?”

(b) from a banks perspective?

Inflation: bad for banks• What if you were a bank and you loaned out

$10 mm USD to be paid back in 5 years. The borrower gets the money now, and pays back in the future.

▫Why is inflation bad for the bank? Remember: Inflation = decreased value of money

in future So, bank will be paid back in future with dollars

worth less

▫On the other hand…▫ why is this good for the borrower?

2nd threat (TO) China’s foreign-currency reserves : Inflation

Group:tell me…

why is US inflation a threat to China’s accumulation of US debt (Treasuries, etc)

2nd threat (TO) China’s foreign-currency reserves : Inflation

why is US inflation a threat to China’s accumulation of US debt (Treasuries, etc)

Answer:remember: inflation is = decrease in value of money in the future.

remember: US treasury purchases = China giving US $$ today in exchange for promise to pay in future.

But, inflation = threat that the $$ in future is worth less in real terms!

Think about this…

•Yes, China is the “banker”, and the US is the “borrower”, but…

▫“if you owe your bank a hundred pounds, you have a problem, but if you owe a million, it has”

John Maynard Keynes

▫“if you owe your bank a billion pounds, everybody has a problem”

The EconomistMartin Wolf book, “Fixing Global Finance”

But, that assumes… The assumption is that the US might

“default” on its debt...

Is that possible? Lets consider….

Think about this: “One trillion dollars is 7% of US GDP. And

we will be running trillion-dollar deficits for a very long time.”

“Buddy, Can You Spare $5 Trillion?”, John Mauldin, July 10, 2009

“Buddy, Can You Spare $5 Trillion?”, John Mauldin, July 10, 2009

US government debt

•As of July 5, 2010, the "Total Public Debt Outstanding" was approximately 90% of annual GDP, ($13.182 Trillion)

That’s a lot of debt!

•USA has massive fiscal deficits , budget deficits AND current account deficits – much of it held by foreign governments + foreign investors…

The fear is that the US might “default” on its foreign debts...

Is that a risk??

No!

The US does NOT face a “solvency” crisis in the foreseeable future (due to excessive borrowing from abroad)

Who can explain this?

But… this is = Threat to China -

•If the US were to devalue its currency…

•“an elegant, painless, and entirely legal way for the US to default” (without actually defaulting)


Question:

•From the US perspective:

▫Other than currency devaluation,…..what is the other way in which they could legally diminish their debts?

Answer:

•Inflation

Inflation▫“A decrease in the value of money in the

future … less purchasing power for $1 in future (than now)”

▫Bad for a bank (in this case, China): they will be paid back in future with dollars worth less

Inflation

remember:

▫ US treasury purchases = China giving US $$ today in exchange for promise to pay in future. (pyramid of promises!)

But, inflation = threat that the $$ in future is worth less in real terms!

Risks to US

•BUT….In reality, the US does NOT want to follow either of these paths (inflation, currency devaluation)

•Why?

▫Group answer:

Risks to US

▫If foreigners fear the threat of inflation / devaluation… they would:

Demand higher % Compensate for RISK

This would add COST to US borrowing in the future (remember the ticking demographic bomb?)

Lesson: don’t push China

•Yes, reforms are needed, but…

•$2 trillion in “risky” loans to US = politically difficult problem for Chinese government

•Especially with unemployment ticking upward due to the “US-caused” global economic crisis!

Sovereign Wealth funds• Search for “better” returns (than 1-3% on US

Treasuries)

• Reach for yield (alpha, Beta, SML, low volatility)

• Bad investments in US banks (lost lots of $$ at beginning of crisis ‘07-‘09)

• Politically unpopular

• Pressure on China domestically (doesn’t help to also have US pressure on them internationally!)

Challenge for China• Unemployment = key issue

• Some 20 million + unemployed since crisis began

• Can not afford to appreciate currency, and lose value of US investments, and international competitiveness of production

• Result: government stimulus = more capacity, more production…. ▫But, fear ?

Review…

•Group question:

•China position:▫What are the risks to China with respect to

the (approx) $2 trillion US dollar “foreign-currency reserves”?

▫Discuss…

The risk to China:


#2. Secondary: If the US inflation were to rise

•Who can explain these two threats?

US Threat…

•On the other hand, politicians like to talk about the “threat” to the US from having China and others accumulate massive foreign-currency reserves…

•Does anyone think this is a threat to the US?

• Why? / why not?

Populist fears:

1. What could China do with $2 trillion USD? Buy up American companies?

2. Politically: is the US dependent? If yes, how does policy change?

3. Economically: China to get more international clout internationally/ say in global policy decisions/ increased role in IMF? World Bank?

Fixing Global Finance

Key:

Develop local – currency debt markets for emerging markets

Don’t borrow in foreign currencies!

Fixing Global Finance1. Limits to export-oriented growth

▫ What worked for JPN, South Korea, might not work for China / India

2. Develop local financial markets▫ Develop local – currency debt markets for

emerging markets▫ Don’t borrow in foreign currencies!

3. Reform global institutions▫ IMF – pooled insurance vs self insurance▫ Additional resources / bite.

Extra credit on the exam (3 points)

•Why were there no emerging market financial crises between 2000-2007?

•What role did the US play in stability?

Part 12 rhodes finance class summer 2010 forum nexus

Education

Transcript of Part 12 rhodes finance class summer 2010 forum nexus