International FinanceFINA 5331

Lecture 8:

Exchange rate regimes

Read: Chapters 2Aaron 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

Euro Area

• Austria Denmark• Belgium Latvia• Cyprus Lithuania• Estonia• Finland• France• Germany• Greece Bulgaria• Ireland Czech Republic• Italy Hungary• Luxembourg Poland• Malta Romania• Netherlands• Portugal Sweden• Slovenia UK• Spain• Slovakia

EU

EU countries that are not part of the ERMII

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

– Bulgaria– 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

Debt crisis

• On April 27 ,2010, Greece sovereign debt is downgraded to “junk” status by Standard & Poors. Facing a strong probability of default, the EMU and IMF approve a €110 billion rescue package for Greece on May 2, 2010.

• In May 2010, the European Financial Stability Facilty is formed. In conjunction with the IMF, up to €750 billion is available for countries potentially facing a crisis.

• In Ireland, the Anglo-Irish Bank is effectively nationalized in December 2008. On November 21, 2010, Ireland reaches an agreement for a bailout. On March 30, 2011, Ireland announces that it will need an additional €24 billion from the IMF and EFSF to aid ailing banks. The total bailout for Ireland has reached €70 billion.

• The Portuguese government released figures on March 30, 2011, indicating that the deficit had reached 8.6% of GDP.

• On April 6, 2011, the Portuguese government asks the EMU for a bailout.

Debt crisis continued (2011)

• July 2: A compromise is reached so that an installment of the €110 billion can be made. European leaders call on private bondholders to contribute to the bailout.

• July 21: A new bailout is approved for Greece. Originally valued at €109 billion, the totally has recently increased to €130 billion.

• August 7: The ECB begins to actively intervene to aid bond markets in PIIGS countries.

• October 26: In a summit of EU leaders, a grand plan is put together, where bondholders indeed agree to take up to 50% losses on holdings of Greek debt.

• As a result of severe political pressure, prime ministers George Papandreou (Greece) and Silvio Berlusconi (Italy) resign in November.

Debt crisis continued

• December 9: In a summit in Brussels, an intergovernmental treaty is agreed to, which among other things, cements more rigid rules for broaching thresholds on deficit and debt to GDP levels.

• December 21: The ECB announces that it will provide€489 billion in three-year loans to more than 500 banks in the EMU.

• As of January 4, 2012, with Italian sovereign debt hovering around 7%, the dollar price of the euro is $1.2923.

Debt crisis

• In late January, the “fiscal pact” agreed to in December is signed by all EU members except the UK and the Czech Republic.

• On February 12, Greece’s parliament passes an austerity bill in anticipation of receiving additional bailout funds.

• On March 13, the eurozone agrees to an additional bailout of Greece totaling €130 billion.

• According to the WSJ, earlier this week, French voters elected Socialist Party candidate François Hollande, an opponent of austerity, as their new president. In Greece, voters rejected austerity policies backed by the two incumbent parties. The dollar price of the euro closed at $1.3089 on Monday.

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

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%