Forum Nexus Finance Class - Brians presentations - Final

Forum-NexusInternational Finance Class – Lecture #1

Brian David ButlerBrian 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.

Brian earned an MBA with distinction from the Thunderbird School of Global Management and he has taught Finance, Economics and Global Trade at Thunderbird’s Global MBA program in Miami. Brian is currently a teacher and country director for Forum-Nexus study abroad program in Brazil.

He previously worked as financial analyst for the Columbia University Business School and for NextLogics, a boutique investment and consulting firm focused on early stage endeavors with social impact.

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

[email protected]@gmail.comLinkedIn/briandbutlerSkype: briandbutler

Introduction to International Finance• Topics we will cover: What is “international

finance”?▫ International Financial Markets▫ The Foreign Exchange Market▫ Determination and Forecasting of Exchange Rates

(fundamentals: purchasing power parity and international Fisher effect)

▫ Protection against Exchange Rate Risk▫ The International Monetary System▫ The European Monetary Union (and the euro)▫ Fixed vs. Flexible Exchange Rate regimes

Introduction to International Finance•Topics we will cover:

▫The Balance of Payments▫National Income and the BOP▫Monetary and Fiscal Policies and the BOP▫Global Financial Markets (euromarkets)

▫GLOBAL ECONOMIC CRISIS

Key issues:• Why is the exchange rate xxx Euros per $US?

▫(PPP, IFE, other factors)▫(currency crises)

• What are key financial flows and why do they occur?▫(forex transactions; international lending; ‘hot

money’ flows)

Key issues:

• What is the Sub-prime Mortgage Crisis? And what can you do about it?

• How can you deal with exchange risk?▫ (derivatives; operational hedging; diversifying)

• Who cares about the balance of payments?▫ (impact on XR, government policies)▫ (foreign debt problem; tequila crisis; Asia crisis)

• How do national economic policies affect the BOP and international firms?▫ ( Ms, G)

Challenge to students…

While we are in Europe together…

•Think critically •Challenge accepted assumptions•Look for trends (not facts & figures)•Educational journey…

Questions:Finance:1. How many econ / finance majors? 2. Taken “international finance” before?3. Studied Currencies?

Global Crisis:1. How many “understand” more or less what

happened so far? (ask volunteer)2. In US? (ask volunteer)3. In Europe?4. Predictions of what will happen in 6

months?

Failure of “economic forecasting” profession

•Why didn’t predict worst crisis since Great Depression?

•Some exceptions (Nouriel Roubini, others..)

•But, in general, a few lone voices does not equal a profession (dismissed as quack, “Dr. Doom”, etc…)

Mis-diagnosis of the problem• Globally, during much of 2008, economic growth

appeared to be holding up in general, and inflation, particularly in commodity prices, was still rising.

• IMF Projection▫ In April 2008, eight months into the global crisis if we date

its start as August 2007, the IMF (2008) was forecasting only a mild slowdown in global growth in 2008 and 2009 to 3.7 and 3.8 percent, respectively, from the 4.9 percent that then was estimated for 2007.

▫ Median consumer price inflation in the advanced countries was projected to rise to 2.9 percent in 2008 from 2.1 percent in 2007. In fact, median inflation rose to 3.2 percent.

• ECB▫ Recall that the European Central Bank (ECB) raised the

target for its key refinancing rate on July 3, 2008, and the ECB was not alone in its inflation concerns at that time.

As late as 2008, the IMF forecasted growth in 2009

Failure of “economic forecasting” profession

Conclusion: highest trained, most respected, most influential did not predict collapse

Repeat challenge to students:

•Think critically, don’t accept “expert” forecasts, challenge accepted assumptions.

•With critical analysis, any one can learn to spot macro trends

•GET AHEAD OF THE TRENDS!!!▫Tools for investors▫Business leaders – position for threats /

opportunities

First critical thinking challenge:

•Question:▫“Why is it “expensive” to come to Europe

and travel (shop, stay, enjoy)?▫Compared to US, Mexico, Brazil, etc…▫Why does it “seem” expensive here?

Global travel…

How about if you went to Argentina?• at about 4-1 USD…. Everything

SEEMS cheap….hotels, restaurants, clothes shopping.

Watch from China = $10• is that “cheap”?• how about if you lived in China? Is it

still cheap?

Question:Why is the Euro more valuable than the US

dollar?

Example: back in 2000 – dollar was more valuable, and it was CHEAP to come to Europe.

Why no more? What happened? What is happening?

Note: in Sept-December 2008 (height of crisis), the Dollar appreciated v Euro…. Why?

Impossible to Predict

•Currencies when flexible are impossible to predict▫Don’t believe anyone that tells you other

wise▫Note: in this class, we will review PPP, IFE

Effects…▫Effect on companies:

Liabilities in Foreign currency – (account receivable 1 mm euros in 6 months…what will it be worth?

▫Effect on countries: Currency appreciates, can factories still

produce? Effect on Exporters (example Brazil 4-1 to 2-

1, and exports stop) “de-industrialization” / “Dutch-disease”

Core of our class:

•Tools to protect•Hedging techniques:

▫Forward, Futures, options, etc…

▫We will teach tools to PROTECT (and potentially speculate)

•But first… today- some Finance Basics…

20

1.

2.

3.

Foreign Exchange Market

Domestic FinancialMarkets in OtherCountries—Short-Term

Domestic FinancialMarkets in OtherCountries—Long-Term

Deposits, Cash, Forwards, Futures

T-Bills, Deposits,Commercial Paper,Money Market Funds

Bonds, Stocks,ADRs, Deposits, CMOs

Banks, Companies, Brokers

Banks, Companies,Brokers

Banks, Companies,Brokers

International Financial Markets

MARKET INSTRUMENTS PARTICIPANTS

21

4.

5.

6.

7.

Euro-Currency Market

Euro-Bond Market

International MonetarySystem (IMF)

The Real Sector

Deposits, Euro CPEuroloans

Eurobonds, FloatingRate Notes,Euro-Equities

SDRs, $US, [Gold],Position in the Fund

Banks, Clients

Investment Banks Companies, Brokers

Central Banks,The Fund

International Financial Markets (cont.)

MARKET INSTRUMENTS PARTICIPANTS

Goods & Services Consumers & Firms

Benefits of Global Finance

•Question for class: what are the Benefits of Finance? Of “GLOBALIZED” finance?

Benefits of Global Finance1. Serve international companies

▫Citi bank in Sao Paulo▫HSBC everwhere

2. Some countries don’t have DEEP enough capital markets

▫Needs of companies Bigger than Depth of capital markets

3. Efficiency, 4. Best practices (international competition

forces local monopolies to offer better rates)

Benefits of Global Finance

•“remember the remarkable prosperity of the past 25 years. Finance deserves some of the credit for that.”

source: http://www.economist.com/printedition/displayStory.cfm?Story_ID=12957709

Pyramid of Promises

•“Central feature of the financial system: it is a Pyramid of promises- often promises of long or even indefinite duration. This makes it remarkable that sophisticated finance systems exist”

•Promises may not be kept•Interest of those who make promises NOT

to keep them

Martin Wolf, “Fixing Global Finance”… based on McKinsey “Mapping Global Capital Markets”, 2005

What “promises”?• Financial assets represents “promises of

future, often contingent, receipts in return for current payments”

• Bonds▫Represent PROMISES of fixed payment (in

time), plus PROMISE of regular payments in between

• Equity (stocks)▫Represent PROMISES a share in future

corporate profits• Pensions

▫Represent PROMISES for a stream of income in retirement


What “promises”?• Life Insurance Policy

▫Represent PROMISES of payment after some fixed date or death

• Accident / Health Insurance Policy▫Represent PROMISES of payment if something

happens• Mutual Fund

▫Promises to return to investors the proceeds from mutual funds purchase of promises from corporations

• Options▫Is a promise to hand over a claim to a certain

promise under specific conditionsMartin Wolf, “Fixing Global Finance”… based on

McKinsey “Mapping Global Capital Markets”, 2005

Pyramid of “promises”?

•“As the financial system grows more complex… it piles PROMISES on PROMISES”.


Just how big is the MOUNTAIN of promises…?

•Amazing….


Size of Finance…• Size of the Financial sector: * data from McKinsey report 2005, "

Mapping the global capital market" and http://www.federalreserve.gov/releases/

• What is amazing is that the financial sector ballooned to the size that it has...with a worldwide total of $140 trillion in promises outstanding in 2005 (surely more in 2008/9).

• Of that total, the US was the prime holder of promises (assets). The US household sector held about $39 trillion (28% of world total), and with the US as a whole holding nearly $52 trillion (37% of all world financial assets, or promises).


Size of Finance…


Size of Finance…


Size of Finance…


Size of Finance…


“PYRAMID of Promises”


•Modern economies depend on pyramids of promises far more impressive and complex than those of stone constructed almost 5 thousand years ago”

•But, the system is extremely FRAGILE•Confidence that sustains them could be

misplaced•People would end up with promises NOT

WORTH the paper (they used to be) printed upon

Underneath that “PYRAMID”


•The “Foundation” of all of these PROMISES is = title to real assets▫Housing, land, property, factories,

machines, etc

▫Need to BELIEVE the original owner really ownes what they say they own.

▫So, key = property rights, law, institutions – for trust, and development of financial system

Forum-NexusInternational Finance Class – Lecture #2

Themes to cover today• Review

▫ Key theme – borrowing in foreign currency = risky• Foreign exchange risk management example

▫ Germany importing Brazilian furniture• Fragility of Banking• Bank Business Model

▫ Borrow short, Lend long• Liquidity v Solvency

▫ Stages of crisis▫ Money markets▫ Transmission to Europe▫ Paulson Plan / Geitner Plan

• Moral Hazard▫ Reserve requirements + regulation & lender of last

resort▫ Cause crisis? Make crises more likely?

Risk - in foreign currency

•Example: ▫Lets assume… you are a German company…

buying a container of furniture from Brazil (to resell at a fixed price in Germany)

▫You agree to pay 100,000 Reais (Brazilian currency) in 6 months to the Brazilian company for delivery

▫Assume the currency exchange rate is currently 2:1

▫What is your risk?

Risk - in foreign currency

• Example – Brazilian furniture ▫You fear that:▫What happens if the exchange rate goes from

2:1 to 1:1?▫Instead of needing 50,000 Euros to pay that

R$100,000 bill…▫You now need 100,000 Euros… ouch

▫Question: how could you have avoided that risk?

Avoiding Risk

1. Don’t buy foreign goods (avoid risk)2. Negotiate contract so currency is based

in YOUR currency (transfer risk)3. How else?

Guess…

Avoiding Risk1. Don’t buy foreign goods (avoid risk)2. Negotiate contract so currency is based in

YOUR currency (transfer risk)3. How else?

You could…1. Convert your money to R$ today…and deposit

that money in a Brazilian bank account (deposit hedge)

2. Contract with your bank to buy $R in 6 months at a fixed rate (2:1) for a fee (forward contract)

3. Buy a Future contract (similar) on exchange (if you can find one).

4. More… (next class)

Themes to cover today• Review

▫Key theme – borrowing in foreign currency = risky

• Fragility of Banking• Bank Business Model

▫Borrow short, Lend long• Liquidity v Solvency

▫Stages of crisis▫Money markets▫Transmission to Europe▫Paulson Plan / Geitner Plan

• Moral Hazard▫Reserve requirements + regulation & lender of

last resort▫Cause crisis? Make crises more likely?

Commercial Banking (business model)•Simplified:

▫Borrow short, lend long▫?

•Who can explain what that means?

Borrow Short

•Deposits are LIABILITIES for banks•They are BORROWING money from

clients•But, deposits can be withdrawn at any

time

•So… their Liabilities are short term (might owe money tomorrow)

Lend Long•Banks invest in Long term Assets•Mortgages, for example… 30 years duration

•So, money is borrowed short (term), but lent out long (term)

•What is the risk?• Is this “solvency” or “liquidity” risk?

(answer: Liquidity) why? (answer soon…)

Overcoming Banking Weakness (trying)

Federal Insurance• As a result of this inherent weakness, banks are offered

federal insurance for the deposits. The government is forced to federally protect (guarantee) depositors that their money will be there if they want it. Or else, people would not trust the banks, and would not deposit their money.

Regulation• In exchange for this federal guarantee (that they

receive), the banks (give up) are subject to stiff regulation. One of the main requirements for deposit-taking banks is that they have to maintain a certain level of money on reserve at the (Federal Reserve). In the US, this reserve requirement is 10%.

http://globotrends.pbworks.com/Commercial-Banking

Getting around Regulations….Innovation•Wherever you see regulation, you will see

innovation (to get around the regulation). Banks are some of the most creative organizations when it comes to developing products to get around regulation. For example, there has been massive Innovation in the financial sector when it comes to the securitization of mortgages (which partly is to blame for the subprime lending crisis).

http://globotrends.pbworks.com/Commercial-Banking

Discussion

•Law of unintended consequences•Moral Hazard

▫Ex: fire insurance… less likely to smoke? Health insurance…. Less likely to be safe?

Solvency v Liquidity – QUIZ (extra credit)•Extra credit – 1 point in final grade

•In 20 words or less – what is a “Solvency” problem (for banks)

•In 20 words or less – what is a “Liquidity” problem (for banks)

•* think of the business model•* remember the video

In addition....for those of you who have time & interest..... I am also sending you links to highly recommended videos from the "Khan Academy" http://www.khanacademy.org/ They are free to watch, and are an excellent way to understand the financial crisis. These additional videos are not a requirement for this course, but if you do watch them... you will really understand the economic crisis from a very advanced level....

Paulson Bailout• Bailout 1: Liquidity vs. Solvency• Bailout 2: Book Value• etc... 13 videos in series....Geithner Plan• Geithner Plan I• Geithner Plan II• etc... 5 videos in series…

In addition....for those of you who have time & interest..... I am also sending you links to highly recommended videos from the "Khan Academy" http://www.khanacademy.org/ They are free to watch, and are an excellent way to understand the financial crisis. These additional videos are not a requirement for this course, but if you do watch them... you will really understand the economic crisis from a very advanced level....

Credit Crisis• The housing price conundrum• Mortgage-Backed Securities I• Collateralized Debt Obligation (CDO)• Credit Default Swaps• Wealth Destruction 1• etc.... 15 videos in series....Banking and Money• Banking 1• Banking 2: A bank's income statement• Banking 3: Fractional Reserve Banking• Banking 4: Multiplier effect and the money supply• etc... more than 15 videos in series...

Solvent: not Solvent•Ok NOT OK

ASSETS-Include home mortgages-subprime

Liabilities (Borrowing, debt)

Equity



Equity

Solvency v Liquidity• Insolvent: liabilities > assets (equity = 0)

▫Person: I owe more than Im worth▫Bank: assets loose value (subprime mortgages)▫Country: cant pay debts…default

• Illiquidity: long term asset, short term liability▫ I owe money NOW, but have money tied up in my

house, car, etc…▫Bank: lend long term, borrow short term▫Country: cant access credit markets to pay

imports

Solvency v Liquidity

•How does this relate to the Global Financial Crisis?▫discuss Solvency first:▫Then Liquidity…

•Examples?

Solvency v Liquidity Timeline

•2007 – September 2008▫Mortgages (assets on

Banks balance sheet) worth less than anticipated… write down

▫Hedge funds Funds go under (Bear Stearns)

▫Bankruptcy threat



Equity

Policy Response

•Question: ▫If Banks have

SOLVENCY troubles.. What should the government do?

▫Bail out?▫Why? Why not? ▫discuss



Equity

Policy Response

•Key issues:▫Moral Hazard – does one

bailout lead to future risky behaviour

▫Fairness – is it fair to privatize gains, but socialize losses

▫Risks Systematic risks Counter party risks



Equity

Credit Crisis timeline – key dates in SeptemberSeptember 7, 2008: Federal takeover of Fannie Mae and Freddie Mac[25]

[26] September 14, 2008: Merrill Lynch sold to Bank of America amidst

fears of a liquidity crisis and Lehman Brothers collapse[27] September 15, 2008: Lehman Brothers files for bankruptcy

protection[28] September 16, 2008: Moody's and Standard and Poor's downgrade

ratings on AIG's credit on concerns over continuing losses to mortgage-backed securities, sending the company into fears of insolvency.[29][30]

September 17, 2008: The US Federal Reserve loans $85 billion to American International Group (AIG) to avoid bankruptcy.

September 19, 2008: Paulson financial rescue plan unveiled after a volatile week in stock and debt markets.

September 25, 2008: Washington Mutual was seized by the Federal Deposit Insurance Corporation, and it's banking assets were sold to JP MorganChase for $1.9bn.


•September 2008 - now▫Crisis CHANGED▫No longer just a SOLVENCY CRISIS▫Became a MIXED crisis of BOTH solvency

and liquidity▫How? Why? What does that mean?

▫Someone tell me again…what is “liquidity”?

NY times article 1999…

• Fannie Mae Eases Credit To Aid Mortgage LendingBy STEVEN A. HOLMESPublished: Thursday, September 30, 1999

• “In a move that could help increase home ownership rates among minorities and low-income consumers, the Fannie Mae Corporation is easing the credit requirements on loans that it will purchase from banks and other lenders.”

NY Times, “Fannie Mae Eases Credit To Aid Mortgage Lending”, By STEVEN A. HOLMES, September 30, 1999


•“The action…will encourage those banks to extend home mortgages to individuals whose credit is generally not good enough to qualify for conventional loans.”



•“Fannie Mae…has been under increasing pressure from the Clinton Administration to expand mortgage loans among low and moderate income people

•… and felt pressure from stock holders to maintain its phenomenal growth in profits.”


NY times article 1999…• In addition, banks, thrift institutions and

mortgage companies have been pressing Fannie Mae to help them make more loans to so-called subprime borrowers.

• These borrowers whose incomes, credit ratings and savings are not good enough to qualify for conventional loans, can only get loans from finance companies that charge much higher interest rates -- anywhere from three to four percentage points higher than conventional loans.


NY times article 1999…• In moving into this new area of lending, Fannie

Mae is taking on significantly more risk, which may not pose any difficulties during flush economic times. But the government-subsidized corporation may run into trouble in an economic downturn, prompting a government rescue similar to that of the savings and loan industry in the 1980's.

• ''If they fail, the government will have to step up and bail them out the way it stepped up and bailed out the thrift industry.''


NY times article 1999…• Fannie Mae, the nation's biggest underwriter

of home mortgages, does not lend money directly to consumers. Instead, it purchases loans that banks make on what is called the secondary market. By expanding the type of loans that it will buy, Fannie Mae is hoping to spur banks to make more loans to people with less-than-stellar credit ratings.

• Fannie Mae officials …add that the move is intended in part to increase the number of minority and low income home owners who tend to have worse credit ratings ...


Homework:

•Find 1 example of Spain & the economic crisis

•Observation ok•News story ok

•Due – BEGINNING of next class (Tuesday)•Have a great weekend!!

Forum-NexusInternational Finance Class – Lecture #3 – WednesdaySPAIN

Themes to cover Today

1.Spain & the crisis – ▫ Review student comments▫ discuss▫ quick summary (what you absolutely need

to know)2.Hedging Example

▫ Interest rates & Exchange rates▫ Group assignment – in class▫ Presentation

Spain

http://www.economist.com/countries/Spain

Spain & the crisis – - Review student comments- discuss- quick summary (what you absolutely need to know)

•Homework was:•“Find 1 example of Spain & the economic

crisis: Observation, News story, class…

Spain & the Crisis:

•Comment ▫Each student, what is your observation?

How has Spain been effected by the crisis? What have you seen? Read? What Questions do you have? What risks do you see going forward?

Key points to highlight…1. Dual structure – labor market

▫ Who can explain?▫ Why important for crisis?

2. Dual structure – banking market▫ Banks / cajas (caixas)▫ Who can explain?▫ Why important for crisis?

▫ EXAM material!!

Dual Labor Market•Temp:

▫High unemployment▫Young, ▫Immigrants▫University grads

•The rest enjoy a high level of job protection which politicians dare not dismantle.

•Risk = political backlash if crisis is LONG (if recovery takes YEARS not months)

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

Temp workers –during the boom

• The spread of fixed-term employment contracts in Spain (from the mid-1980s) helped make hiring and firing more responsive to the business cycle.

• Benefits:▫ Immediate pay-off: it created jobs. ▫Firms were content to take on temporary

workers, often immigrants, because they knew they could easily lay them off again.

• Growth▫Before the crisis hit, temporary jobs accounted

for more than a third of Spain’s total, the largest share in the EU.


Temp workers - crisis•Unfair:

▫“The downturn has highlighted the gross unfairness of the dual labour market.

▫It puts the burden of adjustment on groups with no tenure (women, immigrants and the young).

•Future ▫Firms have little incentive to train tomorrow’s

workforce. Instead they are stuck with older, tenured workers heading for retirement.

• less than 5% are converted into permanent jobs.


Spain – Banking• “Spain’s financial sector has weathered the crisis

well so far, thanks to strong and forward-looking prudential regulation. Dynamic loan-loss provisioning saw banks build up significant cushions during the expansion, and rigorous consolidation rules discouraged the development of off-balance sheet vehicles. And because they mainly cater to retail customers, Spain’s banks were not directly affected by U.S. subprime losses.”

Source: IMF “Hard Landing for Spain” IMF Survey online, April 24, 2009

1. After visiting Sabadell yesterday…2. Everything seemed alright…right?3. But, whats wrong? …

Cajas

•Prediction: •the banking crisis will hit Spain...

but not with the Big 2 banks of BBVA & Santander, but rather with the many small "cajas", or regional banks that lent heavily to the construction sector

The Economist, “Spanish banks, The mess in La Mancha” , Apr 2nd 2009

Banking troubles looming…

•“Trouble on the SMALL side: The bail-out on March 29th of a small savings bank, Caja Castilla La Mancha, could change that perception. The government’s liquidity package of up to €9 billion ($12 billion), which will probably be bolstered with equity, is a reminder that many of Spain’s bad debts fester outside the listed banks.


Cajas

•Spain’s cajas are mutually owned and controlled by a mix of depositors, employees and local politicians, and they distribute a big chunk of their profits to local causes.

•Since the 1960s they have increased their market share of loans from about 10% to 50% by opening branches in smaller cities and by extending credit to people and businesses ignored by the market leaders.


Cajas & the crisis (housing)• When the big two banks put the brakes on in

2006-07, the cajas continued lending more keenly, tapping wholesale debt markets to fund themselves.

• That alone makes them higher risk. • But the savings banks also supplied about half

of the €318 billion borrowed by Spain’s property developers. These loans now represent about a fifth of the cajas’ assets, according to Santiago López Díaz, an analyst at Credit Suisse.

• They are deteriorating fast.The Economist, “Spanish banks, The mess in La Mancha” , Apr 2nd 2009

Cajas & the crisis (housing)

•Mr López Díaz (analyst at Credit Suisse) reckons that 9% of the cajas’ total loans could become non-performing, and within that a fifth of the loans made to property developers.


Cajas•The pace of

deterioration (see chart) threatens to overwhelm the scope of reserves, capital and ongoing profits to absorb losses.


Cajas •“The cajas could need €60 billion of new equity, on top of the €64 billion they already have.

•“the government would

probably be on the hook for most of it.



1.Spain & the crisis – ▫ Review student comments▫ discuss▫ quick summary (what you absolutely need

to know)2.Hedging Example3.Interest rates & Exchange rates

▫ Group assignment – in class▫ Presentation

Question:

If you were a US based bank, with dollars to invest for 12 months…..where would you choose to deposit your money (to make the most return)?

Note: You can assume you have an account with a bank in London (HSBC, etc)… and its easy to switch from one account to the other (click of a button)

International Money Market Rates (Bid Side)

United Statesdollar

Englandsterling

Europeeuro

Switzerlandfranc

Japanyen

Eurocurrency Rate

LIBOR 12 months 3.2% 6.0% 5.3% 3.2% 1.1%

International Money Market Rates (Bid Side)

United Statesdollar

Englandsterling

Europeeuro

Switzerlandfranc

Japanyen

Eurocurrency Rate

LIBOR 12 months 3% 6.0% 5% 3.5% 1.1%

Expected appreciation / depreciation vs. US Dollar to

EQUATE choices…

x -3% -2% -0.5% +1.9%

Answer: it DEPENDS not just on the interest rate, but also on the expected change in foreign exchange rate as well.

You might be temped to choose the England (sterling) option of 5.99% because it’s the highest…but that currency might be expected to lose value (depreciate) over the next year…wiping out the expected gains.

Interest Rate Parity

•FX market in equilibrium ONLY when interest rate parity exists

•When deposits of all currencies offer the same EXPECTED rate of return

•Rate + expected (appreciation / depreciation) = rate

•Example: •US / Euro. If US interest = 5%, EU = 10%, but US dollar is expected to appreciate +5% = balance

Prof. Grosse, Financial Markets (p323-5)

Foreign Currency Exchange Rates (Bid)

Canadadollar

UK*sterling

Europe*euro

Switzerlandfranc

Japanyen

Spot Rate— (Closing Foreign currency units per US dollar)

1.0625 1.7863 1.4522 1.1090 108.84

Forward Rate—Closing Rates

1 month outright

1.0630 1.7822 1.4498 1.1086 108.652

3 months outright

1.0636 1.7749 1.4454 1.1080 108.281

6 months outright

1.0639 1.7638 1.4391 1.1066 107.716

12 months outright

1.0642 1.7493 1.4283 1.1043 106.453

*(U.S. dollars per foreign currency unit)

Market Exch Rates as of: Sept 2, 2008

CDN depreciate

UK sterling depreciate

Euro depreciate

Swiss F appreciate

JPN yen appreciate

New example…

•Team calculation…•Form groups of 2, •Be prepared to answer the following….

Borrowing in Foreign Currencies….Where would you prefer to borrow?You have a factory in Brazil, and want to borrow

money to expand. You could…1.Borrow money locally at 10%2.Borrow money abroad (in US) at 5%

• Which would you choose?• What is the risk of borrowing abroad (in the US)?

– general comment 20 words or less

Note: fictional data based on current loan rates Brazil…• LIBOR + 1.5% for US = 2.5+1.5 = 4%• CDI + 2% for Brazil = 9.75 +2 = 11.75%

Questions:

1. Assume you borrow R$2mm for 1 year, and assume exchange rate is 2:1 today…. But moves to 4:1

2. How much will you owe in 1 year (in local currency)

▫ Local borrow (Brazil)? ▫ Foreign borrow (US)? ▫ Compute (teams)

3. Which is better? By how much?

Where would you prefer to borrow?• Local Brazil = $1.1 mm = R$2.2 mm• Foreign USA = $1.05 mm = R$2.1 mm• Difference = $50,000 USD (100,000R$)• (tempting to borrow abroad

▫ But,▫ What if FX rate goes from 2:1 to 4:1…▫ How much will you owe (in local

currency)?

Where would you prefer to borrow?• Local Brazil = $1.1 mm = R$2.2 mm• Foreign USA = $1.05 mm = R$2.1 mm• Difference = $50,000 USD (100,000R$)• (tempting to borrow abroad

▫ But,▫ What if FX rate goes from 2:1 to 4:1…▫ How much will you owe (in local currency)?

▫ Answer:▫ Locally – still just owe R2.2mm▫ But Foreign – would owe R4.2mm …. Double

▫ Conclusion: Borrowing Abroad = MUCH more RISK

Avoiding Risk

1. Assignment

2. Group 1 way of avoiding / reducing risk….

Avoiding Risk

1. Don’t borrow in foreign currency (avoid risk)

2. How else? You could…1. Contract with your bank to buy $US in 12

months at a fixed rate (2:1) for a fee (forward contract)

2. Buy a Future contract (similar) on exchange (if you can find one).

3. More… (next class)

Forum-NexusInternational Finance Class – Lecture #5France - (American Business School)– guest lecture – careers in Finance

Financial careers

•Commercial Banking•Investment Banking•Private Banking•Top US Private Banks – list & discuss•Top Global Private Banks – list & discuss

Forum-Nexus

International Finance Class – France –Monday July 13th, 2009


1.France – ▫ Discuss & review meeting notes and

observation from the meeting @ Credit Agricole on Saturday

▫ Observations▫ Student comments & Discussion

2.Exam preview▫ Preview…▫ Extra credit essays

3.OECD meeting in the afternoon▫ Causes / implications / current issues of the

Global Economic Crisis

Exam Overview 1 ½ hours• 1 hedging problem• 1 interest rate problem• 5 – 10 multiple choice• 2-3 short answer (20 words or less)• (extra credit) essays *

• Note: ▫all material on exam comes from Lectures (Prof.

Brian Butler), guest lectures, and from professional visits (Sabadell, Credit Agricole, Stock exchange, OECD)

To answer the essays….

•While at the OECD, ask questions to help you with the (extra credit) essay questions on the midterm exam:

•Martin Wolf book: “Fixing Global Finance”

•Internet search▫OECD website▫OECD youtube videos (search for OECD on

youtube)

Extra Credit Essays – 5 points each

1. East Europe & the Global Economic Crisis: many economists now talk about a potential debt and currency crisis in Eastern Europe. In 1 page or less, explain what are the key issues, and which countries are involved. How does this topic relate to our class discussion of the “risks of borrowing abroad”?

Extra Credit Essays

2. China – USA (global imbalances): In one page or less, explain how/ why the relationship between China & USA is important to global finance, and how the “global imbalances” (Breton Woods II) is often discussed among economists as contributing to the global economic crisis.

* Hint: focus on “cheap credit” from China* note: this issue is hotly debated and

controversial. For a great summary, see the Martin Wolf “Fixing Global Finance” book

Extra Credit Essays

3. Anglo-Saxon style finance: many economists in main-land Europe (France, Germany, etc) discuss the “failure of Anglo-Saxon finance” during the global economic crisis. In 1 page or less, tell me “What do they mean”? What differences are they referring to? What changes would they recommend for the future? How do the US / UK respond to these suggestions?

Forum-Nexus

International Finance Class – France – last day before trip to Italy…Wednesday July 15th, 2009


1.Exam review▫ Hedging example

2.Fixed vs Flexible exchange rates▫ Mundell Trilemma▫ Brief history▫ Financial liberalization▫ Series of crises

3.Pessimistic Forecasts▫ Tracking the great depression▫ Why doesn’t it “feel” feel like a depression (at

the stock exchange / banks?)

Exam Overview 1 ½ hours•1-2 hedging / interest rate problems•5 – 10 multiple choice•2-3 short answer (20 words or less)•(extra credit) essays *

•Note: ▫all material on exam comes from Lectures

(Prof. Brian Butler), guest lectures, and from professional visits (Sabadell, Credit Agricole, Stock exchange, OECD)

Extra Credit Essays – 5 points each

1. East Europe & the Global Economic Crisis: many economists now talk about a potential debt and currency crisis in Eastern Europe. In 1 page or less, explain what are the key issues, and which countries are involved. How does this topic relate to our class discussion of the “risks of borrowing abroad”?

Extra Credit Essays

2. China – USA (global imbalances): In one page or less, explain how/ why the relationship between China & USA is important to global finance, and how the “global imbalances” (Breton Woods II) is often discussed among economists as contributing to the global economic crisis.

* Hint: focus on “cheap credit” from SE Asia, China, etc…

* note: this issue is hotly debated and controversial. For a great summary, see the Martin Wolf “Fixing Global Finance” book

Extra Credit Essays

3. Anglo-Saxon style finance: many economists in main-land Europe (France, Germany, etc) discuss the “failure of Anglo-Saxon finance” during the global economic crisis. In 1 page or less, tell me “What do they mean”? What differences are they referring to? What changes would they recommend for the future? How do the US / UK respond to these suggestions?






Hedging foreign currency risk

•Example:

▫Answer:1. Purchase from local US suppliers only (risk

avoidance)2. Change money to Euros today, deposit in

Euro bank account, pay liability in 6 mo. (deposit hedge)

3. Contract with your bank to exchange Dollars for Euros in 6 months at specified rate (1.5:1) + fees (forward contract)

4. Similar choices: futures, options, etc…


• Example: ▫Lets assume… you are a US based company…

buying machinery from a company in Germany▫You agree to pay 1mm Euros in 6 months▫Assume the currency exchange rate is currently

1.5 USD for each 1 Euro

▫Team assignment: Assume the same exchange rate, how many US

dollars do you expect to pay in 6 months? In 10 words or less, describe “What is your

currency risk”? (you could be harmed if WHAT happens?...)


• Example:

▫Answer: You expect to pay $US 1.5mm Risk = US dollar will depreciate (Euro will

appreciate)… and you would owe more USD (for same bill in Euros)

• Next question: ▫assume the exchange rate changes from 1.5

USD$ / Euro… and becomes 2 USD$ / Euro… how many US dollars will you owe in 6 months?


•Example:

▫Answer: Instead of owing $US 1.5mm You would owe $US 2 mm

•Next question: ▫What could you do to avoid that risk?






Fixed vs. Flexible exchange rates

•Important to INTERNATIONAL finance▫why?

•Fixed exchange rates▫Any examples?

•Floating exchange rates▫Any examples?

•What system is active today? (globally)

The “dollar bloc”• “currencies either pegged to the dollar or more or less

actively managed against it (a group that includes Japan)” Oil Exporters

Bahrain Oman Qatar Saudi Arabia UAE (Dubai included)

China Japan Russia Singapore Taiwan Malaysia Hong Kong Thailand India Others: Ecuador, Panama, more…. Used to be Argentina!

Sources: figure 6.6 from Wolf “Fixing Global Finance”And, Economist.com, May 23 2009, “Monetary Union in theGulf”

Dollar bloc:

•What is the impact on the Euro-zone?

Difficult Choices… the “Mundell Trilemma”

•Countries face a trade-off when deciding whether to fix or be flexible

•Can only have 2 of the following 3 …▫Monetary policy independence (interest rates)▫Fixed exchange rates (predictable, stable)▫Free flow of money (access to global capital)

Mundell Trilemma• Country wants (example of USA)

1.Monetary Policy control (US wants to have control of interest rates to heat-up / slow-down economy)

2.Open access to international finance (US wants access to external funding, example from China)

3.Fixed, predictable exchange rates (US would like this, but according to the Mundell Trilemma, they need to give up one, and this is the one that the US lives without)

Fixed vs. Flexible exchange rates

•What system is Better? Why?

▫Groups of 2-3 students, answer

Brief History – Key points

•Key point: there is NO “best” system•It all depends on what you want to

achieve…•History: Cycle from Fixed to Flexible to

Fixed to Flexible……(future?)

Fixed Fixed

Flexible Flexible

The gold standard (~1850–1914)Fixed exchange rates during the 1920s

Great Depression era

Post WWIIBretton Woods / IMF system (1944–1971)

1970’s –today: since U.S. left the gold/dollar standard

?????

Brief History – Key points

•QUESTION:▫Why change from flexible to fixed? (give 1

reason)▫Why change from fixed to flexible?

Fixed Fixed

Flexible Flexible


Inter-war periodGreat Depression era



Brief History – Key points• ANSWER:

▫Why change from flexible to fixed? CONTROL, STABILITY, LOWER INFLATION,

END CHAOS Note: Too chaotic in depression… so fixed for

stability Note: Argentina = fixed to dollar was “brilliant”

at the time…but should have dropped sooner (not just in 2002)

▫Why change from fixed to flexible? EASE ADJUSTMENT PROCESS, IMPROVE

LOCAL MONETARY CONTROL, INCREASE GLOBAL FLOW OF FUNDS

FIXED system…

Painful ADJUSTMENT mechanism:

Example: Under the GOLD Standard:

If exports > imports… build up gold reservesIf imports > exports… run out of gold reserves

KEY QUESTION:

▫ Under a fixed system, how do you increase exports? (to stop burning through gold reserves)?

▫….Group answer

FIXED system…

Answer▫ need to decrease prices, wages ▫ So exports more competitive▫Can’t adjust FX rates, so adjustment has to be painfully with wages, prices

• KEY POINT:▫ adjustment in fixed system is = painful process, slow, very unpopular!▫

Automatic Adjustment Process

In General… with Gold standard (fixed exchange rates)

1. how does adjustment occur?2. Imagine an importer, importing

products from the US… if you pay your currency to the US, then the US will go to your country and return currency and ask for gold….

3. due to international rules… your country pays out gold,

4. With less gold, you “should” decrease $ supply

5. Home prices should fall (with M3 down)

6. Imports should fall, exports should rise, trade balance should re establish

Note: For THIS class… you do NOT need to memorize this!

Flexible Exchange Rates

Key point:Adjustment in currency FX rate; and doesn’t

require a fall in WAGES….

1. Excess supply of home currency in the foreign market2. S>D cause price of home currency to decline, i.e.,

currency devalues3. Imports decline and exports rise4. Trade balance re-establishes

Future…. ….Fixed vs. Flexible ?• Future… if crisis brought terrible volatility…

• Will we move toward era of FIXED FX?▫ emerging markets DOLLARIZE?▫ More countries to join the EURO?▫ US / euro move to fixed?▫ New Breton Woods?

• Or, move toward more flexibility?▫ “Dollar Bloc” move toward flexibility?▫ Europe abandon the Euro?

▫ Answer: no body knows what will happen, but HISTORY tells us the CHANGE = the only CONSTANT!!

Take away: Key points

•History: systems change•Business leaders NEED to watch carefully

for SHIFTS in political attitude, and be READY for potential shifts in the system

•Protect yourself!!

Fixed Fixed

Flexible Flexible


Great Depression era



?????

Pessimistic Forecast“Tale of 2 Depressions”

Source: “A Tale of Two Depressions” , June 4, 2009, Barry Eichengreen and Kevin O’Rourke, © voxEU.org

If you look just at the USA…

If you look just at the US, you might be tempted to believe that this “Great Recession” of 2009 is not as bad as the “Great Depression of 1929-32

A tale of 2 depressions:


•This, however, is a misleading picture. The Great Depression was a global phenomenon. Even if it originated, in some sense, in the US, it was transmitted internationally by trade flows, capital flows and commodity prices. That said, different countries were affected differently. The US is not representative of their experiences.

•Our Great Recession is every bit as global

A tale of 2 “GLOBAL” depressions:



A tale of 2 “GLOBAL” depressions:

The Volume of World Trade, Now vs Then (updated)


Industrial output, four big Europeans, then and now


Industrial output, four big Europeans, then and now


Industrial output, four Non-Europeans, then and now


Industrial output, four Non-Europeans, then and now


Industrial output, four small Europeans, then and now.


Industrial output, four small Europeans, then and now.



•The “Great Recession” label may turn out to be too optimistic. This is a Depression-sized event.

•That said, we are only one year into the current crisis, whereas after 1929 the world economy continued to shrink for three successive years.

•What matters now is that policy makers arrest the decline. We therefore turn to the policy response.


Central Bank Discount Rates, Now vs Then (7 country average)

In the present crisis, rates have been cut more rapidly and from a lower level.

The central bank response has differed globally.


Money Supplies, 19 Countries, Now vs Then

• Clearly, monetary expansion was more rapid in the run-up to the 2008 crisis than during 1925-29, which is a reminder that the stage-setting events were not the same in the two cases.

• Moreover, the global money supply continued to grow rapidly in 2008, unlike in 1929 when it levelled off and then underwent a catastrophic decline.


Government Budget Surpluses, Now vs Then

•fiscal deficits expanded after 1929 but only modestly.

•willingness to run deficits today is considerably greater.




•Conclusion•To summarize: the world is currently

undergoing an economic shock every bit as big as the Great Depression shock of 1929-30.

•Looking just at the US leads one to overlook how alarming the current situation is even in comparison with 1929-30.

•The good news, of course, is that the policy response is very different. The question now is whether that policy response will work.

Repeat challenge to students:

•Think critically, don’t accept “expert” forecasts, challenge accepted assumptions.

•With critical analysis, any one can learn to spot macro trends

•GET AHEAD OF THE TRENDS!!!▫Tools for investors▫Business leaders – position for threats /

opportunities

As late as 2008, the IMF forecasted growth in 2009

Good NEWS!!

•Todays lecture will NOT be on the midterm on Friday!

•(bad news): it will be on the FINAL!!

Forum-Nexus

International Finance ClassItaly– (1st class after Midterm EXAM)Saturday July 18th, 2009


1.Exam review2.Appreciation vs Depreciation3.Monetary policy4.Inflation vs. Deflation5.Fiscal Policy6.Review: Fixed vs Flexible exchange rates

▫ Mundell Trilemma▫ Brief history▫ Financial liberalization▫ Series of crises

Exam review

•Key lesson of international finance:

•Currencies change, so… ▫Borrowing money in foreign currency =

risky…. Why? Discuss

▫Lending money (being owed money) in foreign currency = risky…. Why? Discuss…

Understanding Risks:

•Risks▫Account Payable

Borrowing abroad IN FOREIGN currency = risky FEAR…. That you might end up owing MORE in

your OWN currency (than you expected)

▫Account receivable Someone abroad OWES you money in THEIR

currency = Risky! FEAR…That you might end up receiving LESS

in your OWN currency (than you expected)

Understanding Risks:

•Risks

•Need to UNDERSTAND this, in order to understand…▫Global Economic crisis & Eastern Europe▫SE Asian Crisis ‘97▫Argentina Crisis ‘02▫Any and all currency crises… (this lesson =

key)

Terms you need to know….• Appreciation:

▫ Currency gets STRONGER vs other▫ Example:

US Dollar Appreciates Goes from 2.0 USD per Euro to 1.0 USD per Euro

So, it takes LESS US dollars to buy one Euro Goes from 1 usd buys 0.5 Euro…. Now; 1 usd buys 1

Euro So, it 1 USD buys MORE Euros

• Depreciation:▫ Currency gets WEAKER vs other▫ Example:

US dollar Depreciates Goes from 1.0 USD per Euro to 2.0 USD per Euro

So, it takes MORE US dollars to buy one Euro

Exam review – Hedging problem (Account Payable): fear = you will owe MORE than expected…

•Assume that you are a Mexican shoe manufacturer, and that you borrowed money abroad in order to finance expansion of your shoe factory. In 1 year, you will owe $1 million USD to repay that loan. ▫In 15 words or less, describe the foreign

exchange risk (what are you afraid of?) Answer: Mexican Peso Depreciates / US

dollar appreciates (5 points)

•Assume that you are a Mexican shoe manufacturer, and that you borrowed money abroad in order to finance expansion of your shoe factory. In 1 year, you will owe $1 million USD to repay that loan. ▫Assume that the exchange rate today is 10

Mexican Pesos to $1 US dollar, how many Mexican Pesos would you owe if the exchange rate were to remain the same in 1 year? 10 MM Pesos (2 points)

▫If the exchange rate were to change and become a new rate of 13 Mexican Pesos per $1 US dollar, how many Mexican Pesos would it take for you to pay off your loan in 1 year? 13 MM Pesos (3 points)

•Assume that you are a Mexican shoe manufacturer, and that you borrowed money abroad in order to finance expansion of your shoe factory. In 1 year, you will owe $1 million USD to repay that loan. ▫Assume that you want to borrow abroad:

in 20 words or less, describe one way you could limit this foreign currency risk? Forward contract (5 points)

Buy dollars, sell pesos (5 points) Other answers ok (partial credit): deposit

hedge (but doesn’t make business sense)

Exam review – Hedging problem (Account Receivable): fear = you will receive LESS than expected…

• Assume that you are a French Wine producer, and that you sold a full container of wine to an importer in the USA for $1.5 million dollars, to be paid in 6 months. Assume that today’s exchange rate is $1.5 US dollars to 1 Euro. (assume that the buyer always pays on time)▫If the exchange rate were to remain the

same, how many Euros would you expect to receive? 1 mm Euros (2 points)

▫In 15 words or less, describe the foreign exchange risk (what are you afraid of?) USD depreciate / Euro appreciate (5 points)

•Assume that you are a French Wine producer, and that you sold a full container of wine to an importer in the USA for $1.5 million dollars, to be paid in 6 months. Assume that today’s exchange rate is $1.5 US dollars to 1 Euro. (assume that the buyer always pays on time)▫If the exchange rate were to change

from $1.5 US dollars per 1 Euro, and become $2 US dollars per 1 Euro; How many US dollars would you expect to

receive in 6 months? 1.5 MM USD (1 point)

How many Euros? 0.75 MM Euros (2 points)

•Assume that you are a French Wine producer, and that you sold a full container of wine to an importer in the USA for $1.5 million dollars, to be paid in 6 months. Assume that today’s exchange rate is $1.5 US dollars to 1 Euro. (assume that the buyer always pays on time)▫Assuming that you DO want to sell wine

abroad (From France to the USA): In 20 words or less, describe one way you could limit this foreign currency risk? Forward contract (or futures, options) (5

points) Sell dollars, buy euros (5 points)

Multiple Choice• If you are a manager at a company (GE, for

example), and you expect the future exchange rate to change from $1.5 US dollars per Euro now, to $2.0 US dollars per Euro in 1 year. (you expect the US dollar to “depreciate”) What should you do? ▫Convert your cash to Euros today▫Convert your cash to Dollars today▫Neither, because both are speculation▫Neither, because both are forms of hedging

▫Remember…. No body can predict the future exchange rate with any accuracy. Do not bet your company on future exchange rate predictions. Hedge. Protect. If someone tells you that they know what the exchange rate will be in the future, don’t believe it!!

Multiple choice

•The “business model” for commercial banks was described in class as:▫Borrow long, lend long▫Borrow short, lend short▫Borrow short, lend long▫Borrow long, lend short

Borrow Short▫Deposits are LIABILITIES for banks▫They are BORROWING money from clients▫But, deposits can be withdrawn at any time▫So… their Liabilities are short term (might

owe money tomorrow)

Lend Long• Banks invest in Long term Assets• Mortgages, for example… 30 years

duration• So, money is borrowed short (term), but

lent out long (term)

Banks Business model = fragileBorrow short, lend long

Note: this is the HEART of the issue for why banks are “fragile” business models (answer to other question). This is why government issues guarantees (FDIC), which results in “moral hazard”, and why we need regulation

*** For FINAL exam, you will need to remember this order:1. Fragile business model (borrow short, lend

long)2. Government guarantees (FDIC)3. Moral Hazard (guarantees lead to risky

behavior?)4. Regulation (in exchange for guarantees)

• must understand this…. In order to understand crisis, and to understand international finance.

Multiple Choice• Prior to September 2008, the global financial

crisis was primarily described in class to be:▫Liquidity crisis▫Solvency crisis▫Neither▫Both

• After September 2008, the global economic crisis was primarily described in class to be:▫Liquidity crisis▫Solvency crisis▫Neither▫Both

Solvent: not Solvent•Ok NOT OK



Equity



Equity

Solvency v Liquidity

•Insolvent: liabilities > assets (equity = 0)▫“I owe more than Im worth”

•Illiquidity: long term asset, short term liability▫“I owe money NOW, but have money tied

up in my house, car, etc…”


•2007 – September 2008▫Mortgages (assets on

Banks balance sheet) worth less than anticipated… write down

▫SolvencyASSETS-Include home mortgages-subprime


Equity

Credit Crisis timeline – key dates in SeptemberSeptember 7, 2008: Federal takeover of Fannie Mae and Freddie Mac[25]

[26] September 14, 2008: Merrill Lynch sold to Bank of America amidst

fears of a liquidity crisis and Lehman Brothers collapse[27] September 15, 2008: Lehman Brothers files for bankruptcy

protection[28] September 16, 2008: Moody's and Standard and Poor's downgrade

ratings on AIG's credit on concerns over continuing losses to mortgage-backed securities, sending the company into fears of insolvency.[29][30]

September 17, 2008: The US Federal Reserve loans $85 billion to American International Group (AIG) to avoid bankruptcy.

September 19, 2008: Paulson financial rescue plan unveiled after a volatile week in stock and debt markets.

September 25, 2008: Washington Mutual was seized by the Federal Deposit Insurance Corporation, and it's banking assets were sold to JP MorganChase for $1.9bn.


•September 2008 - now▫Crisis CHANGED▫No longer just a SOLVENCY CRISIS▫Became a MIXED crisis of BOTH solvency

and liquidity

Essay projects• East Europe & the Global Economic Crisis: many economists

now talk about a potential debt and currency crisis in Eastern Europe. In 1 page or less, explain what are the key issues, and which countries are involved. How does this topic relate to our class discussion of the “risks of borrowing abroad”?

• China – USA (global imbalances): In one page or less, explain how/ why the relationship between China & USA is important to global finance, and how the “global imbalances” (Breton Woods II) is often discussed among economists as contributing to the global economic crisis.

• Anglo-Saxon style finance: many economists in main-land Europe (France, Germany, etc) discuss the “failure of Anglo-Saxon finance” during the global economic crisis. In 1 page or less, tell me “What do they mean”? What differences are they referring to? What changes would they recommend for the future? How would the US / UK respond to these suggestions?

• Undergrad: 3 groups of 4 students• Grad: 1 group of 3 students• Assignment will be given in next class, groups will be assigned

in next class


1.Exam review2.Appreciation vs Depreciation3.Monetary policy4.Inflation vs. Deflation5.Fiscal Policy6.Review: Fixed vs Flexible exchange rates

▫ Mundell Trilemma▫ Brief history▫ Financial liberalization▫ Series of crises

Review: Difficult Choices… the “Mundell Trilemma”• Countries face a trade-off when deciding

whether to fix or be flexible

• Can only have 2 of the following 3 …▫Monetary policy independence (interest rates)▫Fixed exchange rates (predictable, stable)▫Free flow of money (access to global capital)

Group assignment: in teams of 2-3, using the USA as an example, please explain which 2 the US selected, and which 1 the US gave up. Why were these selected?

Mundell Trilemma• Country wants (example of USA)

1.Monetary Policy control (US wants to have control of interest rates to heat-up / slow-down economy)

2.Open access to international finance (US wants access to external funding, example from China)

3.Fixed, predictable exchange rates (US would like this, but according to the Mundell Trilemma, they need to give up one, and this is the one that the US lives without)

Italy & the “Mundell Trilemma”

•Using Italy (after joining the Euro-zone)•Group assignment: in teams of 2-3, using

the Italy as an example, please explain which 2 the Italy selected, and which 1 Italy gave up. ▫Why were these selected?▫What was given up? Why is this good /

bad?

Mundell Trilemma

•Country wants (example of ITALY)

1.Monetary Policy control (Italy had to give this up… to ECB)

2.Open access to international finance (given)

3.Fixed, predictable exchange rates (achieved this within the Euro-zone)

Monetary policy•“interest” = cost of money• Increase interest = increased cost of money

Leads to slow down of economy

•Decrease interest = decreased cost of money Leads to speed up of economy

•Group Question:▫“why would a government EVER want to

increase interest (increase the cost of money) and SLOW down the economy?” answer, turn in, then discuss

Inflation•How to think about it:

▫A general rise in prices (ok, but not useful)▫A decrease in the value of money (better)… less

purchasing power for $1 in future (than now)

▫Example: $1 will buy 1 apple now, but only 1/10th of an apple in the future. This is inflation! Money is worth less (in terms of real goods) in the future

▫Question: if you think your money will be worth less in the future, what would you do today?

SPEND today!!!(don’t save)

Hyper-Inflation• Who has ever lived in a country with Hyper

inflation?• What is it like?• How do consumers behave?• Do companies invest long term? Or short term?• What happens with interest rates? Why?• What happens to wages? Union contracts?• Can you plan for the future?

• Examples:▫ Zimbabwe (now)▫ Brazil (recently), Latin America▫ Others…

Inflation – why bad

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

(a) from a savers perspective? (b) from a banks perspective?

Inflation: effect on life savings• What happens to your life savings during inflation?• Imagine if you had saved $1 mm USD in a

retirement account, and you expected to live comfortably for the next 30 years off of principal + interest… you could be comfortable… unless…

• Inflation!▫Remember: Inflation = decreased value of money in

future▫Your money will buy less (food, travel, clothing, etc)

• Conclusion: inflation = terrible for savers!!

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?

Inflation – why bad• Inflation = 2nd biggest fear of central bank

▫In US, the Fed has “dual mandate” for growth (employment) and inflation

▫In Europe, the ECB only has one: fight inflation

▫Inflation targeting▫Generally want low but stable inflation (2-3% is

ok)

• Group question:▫What do you think is the #1 fear of central

bankers? (more than inflation)?

Deflation –

•If inflation = general increase in prices of goods and services▫What do you think deflation is?▫Why are central banks afraid of

“deflation”? Hints:

Japan’s “lost decade” of the 1990’s, and ongoing discussion during this Global

Economic Crisis (especially early 2009)

Deflation –

•Example: if house prices are falling, do you think a bank would want to lend money to a person to buy a home? Do people want to borrow money to invest in homes?

•This is the root of the problem with deflation: banks don’t want to lend, people don’t want to invest, economy stalls

Monetary Policy + deflation

•With fears of slowing economy, the Central Bank (Fed, ECB, etc) want to cut interest rates (make money cheaper to stimulate growth)… but what happens if the rates get cut to 0% and growth still hasn’t materialized? Can the Fed cut interest rates below 0%? No!

Monetary vs. Fiscal Policy

Group assignment;•Who can describe the difference?

Monetary vs. Fiscal Policy

• Monetary Policy:▫Think “interest rates”,▫Central Bank (FED, ECB, etc)▫Issue: inflation▫Milton Friedman

• Fiscal Policy▫Think “government spending”▫Fiscal Stimulus▫Issue: budget deficits▫John M. Keynes

Forum-Nexus

International Finance ClassItaly– (2st class after Midterm EXAM)Monday July 20th, 2009

Group Project – Under Grad, “The Euro Zone – before, during and after the Global Economic Crisis”

1. During this global economic crisis (2007-09), ▫ What are the benefits to countries for being inside of the Euro-

zone? What are the drawbacks of being inside? ▫ What have been the benefits of being outside? What are the

drawbacks of being outside?

Among other things, you must mention: 1. How does this discussion relate to our class lectures on “fixed vs.

flexible exchange rates”, 2. The risks of borrowing abroad

Countries you must mention:1. UK 2. At least one of the following from our trip: (Spain, France, Italy,

Greece)3. At least one of the “East-central” European states: Czech

Republic, Hungary, Poland, Slovakia, Slovenia4. At least one of the Baltic States: (Estonia, Latvia, Lithuania)

Extra credit (5 points) - (1 page max) Compare and contrast the experience of “Ireland vs Iceland”

during the global economic crisis (with relation to “fixed, flexible exchange rates”, and to “borrowing in foreign currencies”

1. During this global economic crisis (2007-09), ▫ What are the benefits to countries for being inside of the Euro-

zone? What are the drawbacks of being inside? ▫ What have been the benefits of being outside? What are the

drawbacks of being outside?

Among other things, you must mention: 1. How does this discussion relate to our class lectures on “fixed vs.

flexible exchange rates”, 2. The risks of borrowing abroad

Countries you must mention:1. UK 2. At least one of the following from our trip: (Spain, France, Italy,

Greece)3. At least one of the “East-central” European states: Czech

Republic, Hungary, Poland, Slovakia, Slovenia4. At least one of the Baltic States: (Estonia, Latvia, Lithuania)5. At least one of the Balkans: (Albania, Bosnia and Hercegovina,

Bulgaria ,Croatia, Macedonia, Montenegro, Romania, Serbia)Extra credit (5 points) - (1 page max)

Compare and contrast the experience of “Ireland vs Iceland” during the global economic crisis (with relation to “fixed, flexible exchange rates”, and to “borrowing in foreign currencies”

Group Project –Grad, “The Euro Zone – before, during and after the Global Economic Crisis”

Who?12 undergrad students: split into 3 groups of 4

* tell me the groups tomorrow (assign?)3 grad students: one group of 3

What to turn in? ▫ Undergrad: 3-5 pages▫ Grad: 5-6 pages

How?- either (hand written, neatly!) or computer, email:

Resources:1. Read Book: “An Introduction to Global Financial Markets”

(Valdez), chapter 11, “European Economic and Monetary Union” 2007, (suggested focus: p. 287-305)

2. Read handout article: “Holding Together, A special report on the euro area”, from the Economist, June 13th 2009 (p 1-16)

*Grad Students only:▫ Read handout: “Country Forecast, Economies in Transition,

Eastern Europe”, from EIU, May 2009 (p. 5-10)

Group Project, “The Euro Zone – before, during and after the Global Economic Crisis”

Grading:• 30% of final grade for course• comparative (one team compared to others)

• there is no “right answer”, but grading will be based upon:

▫ Cover all required topics▫ Answer the questions asked▫ Additional insights▫ Strength of arguments (pro / con)▫ Depth of analysis▫ Be concise! ▫ Ability to capture “heart” of issue


Themes still to cover – Martin Wolf Book “Fixing Global Finance”

1.Macro factors▫ Brief summary / history

2.Series of crises▫ Financial liberalization = age of crises

3.Response to crises:▫ NO current account deficits▫ “smoke but don’t inhale” of global finance▫ USA as “borrower of last resort”▫ “savings glut”, Flood of “cheap credit”

4.US unique position:▫ Reserve currency▫ Borrow in own currency▫ Can NOT face Solvency crisis▫ US is “in trouble”?

5.Fixing global finance:▫ Must borrow only in own currency▫ Need for local-currency bond markets

http://www.youtube.com/watch?v=Q0zEXdDO5JU

MACRO FACTORS

•While watching the video…

•Look for discussion about “savings from abroad, flooding US with cheap credit”

•This will be the focus of today's lecture.

What caused the crisis: a look at the “Macro Factors”

Macro Factors

•Discuss…

•What did you see in the video?▫Comments?▫Questions?▫Observations

Comments:• During the lecture at OECD, he mentioned:

▫“managed exchange rates in Asia”▫Leading to “low interest rates” in USA▫“search for Yield”▫“risk was underpriced”

= “driving factors” of the crisis

What does this mean? This will be our discussion over the next couple of days together..

Note: when asked to elaborate more…. Too political discussion …

Cheap money: Low interest rates: ▫why so low for so long?

Comments:

•Low interest rates: ▫But, the key question…▫why so low for so long? ▫Why was money supplied in such massive

quantity to the US??

▫Lets take a look at the “MACRO FACTORS” more closely…

Macro Factors… look back to the early 2000’s• Money was “cheap”

▫ Volatility was low▫ Inflation was low

• “the Great conundrum”: Greenspan▫ With high growth, why are long term interest rates so

low? ▫ Typically long term interest rates would be high

• Reason: cheap supply of money…▫ East Asia, Oil exporters, ▫ But why? Why cheap? What happened BEFORE to

lead to this situation?▫ Need to put this crisis in context, and understand what

was happening BEFORE this one started…▫ Next discussion: a “series of crises” . Recommended

reading: Martin Wolf book “Fixing Global Finance”

Martin Wolf book “Fixing global Finance”

•Why are we reading THIS book? ▫Gives a great background to understand

background to this crisis, and to understand what was it that led to this crisis

▫Don’t make the mistake of just looking at this event in isolation

•Need to consider past to understand present…

Series of Crises

Series of Crises• Financial liberalization = series of crises?

• Finance is increasingly fragile. Barry Eichengreen of the University of California at Berkeley and Michael Bordo of Rutgers University identify 139 financial crises between 1973 and 1997 (of which 44 took place in high-income countries), compared with a total of only 38 between 1945 and 1971. Crises are twice as common as they were before 1914, the authors conclude.

Martin Wolf book, “Fixing Global Finance”

Series of Crises – 1990’s• Japanese recession - 1990 to 2003, collapse of a real estate bubble

and more fundamental problems halts Japan's once astronomical growth, “lost decade”

• United Kingdom - 1992 - devaluation of currency, "broke the bank of England“, currency speculating against the European currency unit peg

• Mexico crisis 1994 ”tequila crisis” - currency devaluation, debt crisis

• Asian Crisis 1997: SE Asia Crisis - 1997 & 1998 - currency devaluation, debt crisis

• South Korea - 1998 • Russia - 1998 • USA - Long term capital management - hedge fund meltdown - 1998

- causes were SE Asia Crisis of 1997, and Russia crisis of 1998• Brazil - 1999 - currency Real was pegged to US dollar, then forced

to float – currency crisis

http://globotrends.pbworks.com/history-of-economic-crisis-and-currency-devaluations

Series of Crises – 1990’s• Critical event: SE Asia Crisis 1997-1998

▫ Leading up to event: currencies were “pegged” to dollar▫ Interest rates much lower in the US▫ Investors bet that peg would last▫ Borrow money abroad at low interest rates▫ Invest in SE Asia at higher rates▫ Make bigger returns, use money to pay back loans

abroad▫ Great way to make money!

• Unless….

• Group assignment: what is risk, what do you think happened?



• Unless….

▫ Peg was ultimately unsustainable▫ Speculators lined up to bet against ▫ Peg was broken, and local currencies fell, and fell,

and fell more… = “currency crisis”

▫ Group answer: Then, what do you think happened to the debt?



Debt crisis:▫ debts in foreign currency become too “expensive”

to pay back▫ Massive defaults

▫ “Debt crisis + Currency crisis” = TWIN Crisis!

Note: a similar thing happened in Argentina in 2001/2… can anyone tell me what happened? Based on this story of SE Asia, give it a try (repeat story, substitute “Argentina” for “Malaysia, Thailand, Indonesia, etc”



Lessons learned:▫ Dangers in borrowing abroad▫ Danger s in Relying on Foreign capital ▫ Must be free from Current Account deficits! Current

account deficits = dangerous!▫ Since financial liberalization: countries that run current

account deficits = crisis▫ Right, or wrong… this is the main lesson that was learned

(the hard way)▫ Who was watching?

China – right next door, ring-side seats to watch the damage! Decision: never to let that happen to them! For all SE Asia… “never

again!!”


Forum-Nexus

International Finance ClassItaly– (2st class after Midterm EXAM)Tuesday July 21st , 2009

Who?

• 12 undergrad students: ▫split into 3 groups of 4

• 3 grad students: ▫one group of 3


Resources:1. Read Book: “An Introduction to Global Financial Markets”

(Valdez), chapter 11, “European Economic and Monetary Union” 2007, (suggested focus: p. 287-305)

2. Read handout article:, A special report on the euro area”, from the Economist, June 13th 2009 (p 1-16)

Today: each student to present portion of “Holding Together”, Economist report to rest of class…

Group Project

Forum-Nexus

International Finance ClassGreece– (1st class)Friday July 24th , 2009

Themes to cover – Martin Wolf Book “Fixing Global Finance”1. Series of crises

▫ Financial liberalization = age of crises2. Response to crises:

▫ NO current account deficits▫ “smoke but don’t inhale” of global finance▫ USA as “borrower of last resort”▫ “savings glut”, Flood of “cheap credit”

3. US unique position:▫ Reserve currency▫ Borrow in own currency▫ Can NOT face Solvency crisis▫ US is “in trouble”?

4. Fixing global finance:▫ Must borrow only in own currency▫ Need for local-currency bond markets

Essay projects• East Europe & the Global Economic Crisis:

many economists now talk about a potential debt and currency crisis in Eastern Europe. In 1 page or less, explain what are the key issues, and which countries are involved. How does this topic relate to our class discussion of the “risks of borrowing abroad”? ▫Focus on:

companies, countries & individuals in CEE borrow abroad (in euros & Swiss Francs).

Then, when the Global Economic Crisis hit, local currencies depreciate (or, face pressure to depreciate).

Foreign debts (in Euros / Swiss Francs could become VERY difficult to service!)

Essay projects

•China – USA (global imbalances): In one page or less, explain how/ why the relationship between China & USA is important to global finance, and how the “global imbalances” (Breton Woods II) is often discussed among economists as contributing to the global economic crisis.

Most students had a good basic understanding… but, lets look closer…

Who can give me their answer? Discuss….

Review last class

Key event: Asian Crisis ‘97-98

•Group :▫Why was this important?▫Who was watching?▫What changed, what lessons were learned?


Changed international finance

▫Who was watching? China & all emerging markets

▫What key lesson was learned? Relying on foreign capital = dangerous


•How the world changed…

From that point on… …emerging markets try to be independent of

foreign capital…

How?▫If money comes in… send it back▫Export earnings sent back overseas -

response…

•“…we now see the phenomenon of capital markets trying to put money into emerging economies even as the governments of these economies, with even greater determination, recycle the funds in the form of foreign currency reserves”

Martin Wolf, Fixing Global Finance, p56

Key lesson

• •Risk in borrowing abroad… why?

Imagine…

•“The Indonesian rupiah lost 80% of its value almost overnight”

•“devastating effect on an economy”•“it is a horrifying story for a country that

had had no history of serious inflation”

▫Question: what do you think happened to companies that borrowed abroad (say, in US dollars)?

Martin Wolf, Fixing Global Finance

Question

•How does the “Asian Crisis of ‘97” lead to…▫Modern world of international finance▫Strange situation where money flows from

poor to rich? From China to USA

Answer• After the Asian Crisis of ‘97

▫Emerging markets no longer willing to accept international capital

• Ok, but how?• How do you “reject” international capital?

▫Dynamics of “how” will be covered in “Balance of Payments” discussion… (current account / capital account)

Summary ▫No “current account deficits

Fight to run “current account” surplus

▫Avoid devaluation Fight to keep currency “undervalued”

▫Send money back… buy US Treasuries (run “capital account” deficits)…

** don’t worry, this will make sense soon…

Current Account / Capital Account

•Terms to learn…

▫Current Account▫Capital Account▫Reserves▫Balance of Payments….

Assignment

•Everyone must read•“Legacy of the crisis” section of

▫Martin Wolf “Fixing Global Finance”▫p 55-57

•Tomorrow – turn in ½ page report•1 person will be chosen to present to

class…

Lessons…

•“current account deficits have come to mean crisis”!

•“policy makers are (now) frightened of running current account deficits”

Martin Wolf, Fixing Global Finance, p40

Current Account:• Approx:

▫Exports – imports▫in a basic sense, its exports - imports....so, if its

negative, then you are importing more than exporting...and you need to finance that deficit.

• So, if you have more imports than exports▫Deficit▫Must be “financed” by “capital account”

• Globally, must balance▫If some countries run surplus, then others

must run deficits

Current Account•From an economic standpoint…•A current account could also be described

as:

▫the current account surplus is determined by the gap between savings and investment

deficit: more aggregate spending than output. to get rid of a deficit...need to reduce aggregate

spending in relation to output a surplus is = more savings, than investment

Current Account Deficit• How does the country finance this excess

spending? ▫Answer: It borrows.

▫Q: what do we do when we spend more than we earn?

▫A: we use a credit card (borrow money that has to be paid later).

• The current account shows the amount of international lending or borrowing.

From the book…

•“If a collection of people spend more than their income on goods and services, they must be receiving loans or investment from elsewhere, to finance the excess of their imports over their exports”.

Martin Wolf, Fixing Global Finance

Country’s Balance Sheet:

•How does a country “finance” its current account deficit?

•In order to answer this question…

•First need to understand basic national accounts…

National “Balance Sheet”

• Key: must “balance”

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

Flow of goods and services, Roughly= exports - imports

▫Capital account Paying for the current account - Money flows Example: US government sells treasury bills

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

accounts “below the line”


What is a “current account deficit?

▫Group assignment: write down the answer to this:

▫What is a “current account” When is it in “deficit”?

▫What is a “capital account” When is it in “deficit”?


•Current Account ▫Goods, services

(imports / exports, goods, services, gifts)

•Capital Account ▫Money

(financials, treasury bonds, IBM shares, etc).


•Key: must “balance”

If “current account” deficit,

then… by definition…

▫“capital account” = surplus


•GROUP:

▫So…If imports are > exports… what must be happening in the “capital account”?

Answer…

SURPLUS!! Money must be coming in from abroad to

finance the current account deficits!

National “Balance Sheet”• But…

▫What happens if you do NOT have money coming in from abroad

▫Note: just because you have a “current account” deficit… that doesn’t mean foreigners will pay the bill…

▫Group assignment: What happens? What must you do? (hint: 3rd part of national

accounts mentioned before)…

Answer:

▫You must then dip into the Reserves (if you have any) and pay the difference… (gold, foreign currency)

Follow up question:▫What if you don’t have enough reserves? Then

what? What can you do?

(What happens if you are running a current account deficit, and if foreigners SUDDEN STOP supplying capital, but… you do not have enough reserves to pay the bill?)

Answer:

1. You MUST cut the Current Account Deficit:

▫ How?

▫ If Imports are too BIG compared to Exports (deficit),

▫ Then…You must… cut imports vs exports

▫ Note: this sounds easy… but HOW does a country do this quickly? (GROUP)….

Answer:

1. To cut a current account deficit…

▫ Currency devaluation Makes imports more expensive Makes exports more competitive

Exports rise, imports fall… current account goes back to balance

Problems: Devaluation is very painful…. Who can tell me

why?

Devaluation = answer to current account deficits

1. After the Asian Crisis ’972. Country after country was determined

not to ever face devaluation again…3. So, needed to AVOID current account

deficits at ALL costs4. How?

▫ Artificially keep currency low… so that it wouldn’t later devalue…and cause trouble.

But, what if devaluation doesn’t solve the problem

1. Question:

▫ Who can you turn to if your country faces situation outlined above (running a current account deficit, and if foreigners SUDDEN STOP supplying capital, but… you do not have enough reserves to pay the bill?)

▫ Who is there to “help”?

Call for help!

•IMF▫Lender of last resort▫The IMF (international monetary fund)

came into existence after WWII in what was called the Breton Woods agreements that created both the IMF and the World Bank.

IMF – “business model”• IMF as a "Bank" (not a "fund")

▫Its interesting that the IMF (international monetary fund) acts more like a bank, but the World Bank acts more like a fund.

▫Actually, the IMF acts more like a "credit union”...the 185 member countries put money in on deposit, and they receive interest payments back. The interest payments are small, because the IMF is seen as a high quality borrower (and there is a social cause behind the mission). The money borrowed then gets re-loaned out to countries in trouble.

IMF – “business model”

•The IMF receives its major inputs of funding from the member countries (quotas), but then sustains itself by making loans (investments). In a simplified sense, the IMF gets money from its members at very low interest rates, and then turns around and loans that money out to countries in trouble at higher interest rates (short term loans at higher rates).

IMF – “business model”

•Profits from Crisis?•In a strange way, the IMF is only

profitable when there is a period of economic uncertainty or turmoil. If there is not a crisis, then there is no one taking the loans, and the IMF can not call on the quotas from its members.

IMF – “conditionalities”

•The first thing is that a country will have to make guarantees to the IMF that they will make hard policy changes to fix the underlying structural problems that caused the crisis (to fix the imbalance in the current account, they may have to raise taxes, raise interest rates, and other drastic measures).

•Why is this controversial?

Unpopular… scapegoat

•Countries that are democracies are often reluctant to make the hard structural reforms that are necessary to fix their own internal balance of payments problems. Raising interest rates and taxes might help the governments books balance, but it would effectively slow down the economy and put people out of work.

“Conditionalities” – why?• You can think of the IMF as the tip of the

iceberg in international lending.

• They are the most visible part, but behind them there are government and commercial loans that makeup a bulk of the debt package to a developing country. IMF conditionalities and structural adjustment programs are necessary to give international confidence to the capital markets that a country is implementing the necessary structural changes that will ensure that future loans to the country will not be made in vain.

“Conditionalities” – why?•For example, without an IMF agreement, the

Paris club in international lending governments will not meet with a debtor nation to reschedule (reduce) the debt payments. Its only after a country has already made a deal with the IMF (and accepted their conditionalities) that the other lenders will agree to meet with the country to reschedule their debt. For this reason, the IMF loans are extremely important in that they send a signal (to the rest of the iceberg of international lenders).

Why is the IMF avoided “at all costs”?• IMF

▫Lender of last resort

Group assignment:▫But why is the IMF lending avoided at all

costs by borrowers? What were the lessons of the debt/ currency crises in SE Asia / Latin America?

▫Why are countries so reluctant to turn to the IMF for help?

Conditionalities - controversial• But it is these very same structural adjustment

programs (conditionalities) that make the IMF loans so controversial. From a mercantilist or structuralist perspective (of the borrowing countries), these conditionalities are seen as a weapon of the developed western nations to force the developing countries to conform to liberal economic policies (such as privatizations, lowering of trade barriers, deregulation of industries, floating exchange rates, increasing FDI, balancing budgets, removing price controls, and fighting corruption). These liberal goals are often called the “Washington Consensus

Conditionalities - controversial

•The mercantilists of the borrowing nations argue that the conditions dictated by the IMF limit their national sovereignty by placing external controls on how they are supposed to run their internal economy.

Conditionalities - controversial• One of the most controversial conditions of the

loans is that borrowing nations must cut back on government spending. These “austerity” measures are often blamed for the cutting of social programs that benefit the poor. For this reason, many blame the IMF for placing the needs of the rich over the needs of the poor. By requiring the borrowing nations must balance their budgets, the IMF is often blamed for the cut backs in social programs in these countries (such as education, public health, and other development projects for the poor).

Conditionalities - controversial• Another criticism of the IMF is that they often

recommend that a country should raise taxes and cut spending in order to balance their budgets. But economists of Keynesian school of thought argue that this is the exact opposite of what a country in recession needs. Keynes would argue that in order to jump start the economy, they actually need to do the opposite – cut taxes and increase government spending.

• The IMF is therefore often criticized for making an economic recession into a depression as increased taxes and decreased spending slows the economy and decreases the chances for a quick recovery.

IMF & Asian Crisis ‘97

•Key lessons…

•What do you think was learned?•Who was watching?•What has changed?

Call for help!

•IMF – lessons from previous crises…▫During the SE Asia crisis ‘97-’98, country

after country turned to the IMF to help▫Money was available…▫But “conditionalities” were very unpopular!▫What conditions did the IMF tie to its

loans?

▫Any guesses?

Call for help!• IMF – lessons from previous crises…

▫During the SE Asia crisis ‘97-’98, country after country turned to the IMF to help

▫Money was available…▫But “conditionalities” were very unpopular!▫What conditions did the IMF tie to its loans?

Raise taxes Cut spending Goal of IMF: recipe to balance budget

why this was unpopular?

•IMF – lessons from previous crises…SE Asia crisis ‘97-’98?

Raise taxes Cut spending Goal of IMF: recipe to balance budget

Unpopular: Higher taxes + lower government spending =

drag on economy, slower growth Result: IMF ends up SCAPEGOAT – easy for

politicians to blame for unemployment Lesson: avoid the IMF at all costs!!!

Forum-Nexus

International Finance ClassAthens, Greece– (2st class)Saturday July 25th , 2009

Group Project:• Due: Tuesday 28th (before class)

▫ How is your progress going? Has everyone READ the required readings? (you should have!)

▫ Note: today is Saturday 25th (and we travel tomorrow Sunday…boat to Rhodes, arrive Monday – boat, pool, resort, etc)

▫ You should: do the project NOW in Athens BEFORE going to Rhodes

▫ In today's lecture… Everyone should have brought the reading handout + book. We will try to make time (1/2 hour+) today for some group

work…

▫ Additional recommended reading: Martin Wolf Book: “fixing global finance”, p 87 (1 page) 2nd paragraph… “in fact, there is only one region…” Excellent material for your papers!!!

Themes to cover – Martin Wolf Book “Fixing Global Finance”1. Series of crises

▫ Financial liberalization = age of crises2. Response to crises:

▫ NO current account deficits▫ “smoke but don’t inhale” of global finance▫ USA as “borrower of last resort”▫ “savings glut”, Flood of “cheap credit”

3. US unique position:▫ US is “in trouble”? No…▫ Reserve currency▫ Borrow in own currency▫ Can NOT face Solvency crisis

4. Fixing global finance:▫ Must borrow only in own currency▫ Need for local-currency bond markets

Question…•Last class, we discussed the strange

situation where…. “International finance generally flows more from the poor developing countries to the rich developed ones…”

•Group assignment:▫Explain why money flows from poor to rich

countries… What caused this?▫How? ▫Should international finance be like this?

Answers…• Why?

▫ Response to previous crises: emerging markets ‘smoke but don’t inhale’ from international finance (“throw it back”)

• How? ▫ Keep currency undervalued… promote EXPORTS▫ Current account surplus = money coming in▫ Accumulation of reserves (purchase of US treasuries)

= money going out

• Should international finance be like this? ▫ No, clearly not! ▫ Note: the purpose of Martin Wolf book “Fixing Global

Finance”: propose changes


• Key: must “balance”

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

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

Capital account▫Paying for the current account - Money flows▫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 not… pay out reserves..

Assignment

•Everyone was supposed to have read:•“Legacy of the crisis” section of

▫Martin Wolf “Fixing Global Finance”▫p 55-57

•Due TODAY– turn in ½ page report•1 person will be chosen to present to

class…

•Discuss… present??Martin Wolf book, “Fixing Global Finance”

Legacy of the Crises1. Danger in capital flows

▫avoid current account deficits▫Result: run current account surplus +

capital account deficits (sending $ abroad) money flows from poor to rich

2. Avoid IMF▫Conditionalities unpopular

3. Focus on self-insurance (build up own stock pile of reserves) today's lesson: reserves


Legacy of the Crises – PART I

•Managed Exchange rates:

▫After Asian Crisis ‘97, emerging markets fight to keep currency value down vs. Dollar…

•Why? Discuss, group…


Legacy of the Crises - 1

•Goal: keep FX undervalued for:▫Avoid risk of devaluation in future (don’t

get caught with debts in foreign currency)▫Exports to increase▫Avoid Current account deficit (keep

imports low, exports high)


Legacy of the Crises – part 1

•But, if “dollar bloc” ALL fight to keep currency LOW vs Dollar

▫See chart next page…


The “dollar bloc”• “currencies either pegged to the dollar or more or less

actively managed against it (a group that includes Japan)” Oil Exporters

Bahrain Oman Qatar Saudi Arabia UAE (Dubai included)

China Japan Russia Singapore Taiwan Malaysia Hong Kong Thailand India Others: Ecuador, Panama, more…. Used to be Argentina!

Sources: figure 6.6 from Wolf “Fixing Global Finance”And, Economist.com, May 23 2009, “Monetary Union in theGulf”


•And, if ALL are determined to run current account surpluses….

•Question:▫Who MUST run current account deficits

(remember, by definition SOMEONE must)!!


Legacy of the Crises – Part I

• Answer:

• The ONLY country on the planet that was willing and ABLE to run deficits (on a large scale) was the USA

• Question: ▫why can the USA run large current account

deficits without running the risk of a currency crisis? …. We will try to answer this question TODAY



•“The overall consequence of these policies has been gigantic accumulations of foreign-currency reserves”

•Group Question:▫What are foreign-currency reserves?▫Why do they accumulate in a massive scale

since ‘97-’98 Asian Crisis?



•3 Important parts (for our class discussion):

Current account▫Flow of goods and services, Roughly=

exports - imports

Capital account▫Paying for the current account - Money flows▫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 (2008-09)

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

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

•“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)?

China – USA

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

The risk 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? How are they related? Why is #2 more important from the US perspective than the Chinese?

2 threats:1. US dollar devalue (depreciate)….or, from a

US perspective, we usually talk about Chinese YUAN (Renminbi) appreciating…this is the SAME as saying USD depreciating!

▫ 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 (in local currency terms)…

1. Tell me again, what is the risk to China? What are they afraid of?

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)


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!


US inflation▫ Note:▫ Inflation is a SLOWER, Indirect threat

Slower impact than currency devalue From an external lenders perspective,

LOCAL inflation is not a (huge) concern … ▫ UNLESS

*** it has an effect on currency value …and unless you import large quantity of

products from that country

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?

• This will be the topic of our next class on this topic ▫ Monday: US position▫ Tuesday: “Fixing Global Finance”

• For the rest of Today’s class… we will take some time to work on the Group Project…

Group Project - presentations• Divide into 4 groups…• Each read 1 section• Group presentation (4 total)

▫Group 1 & 2 “Soft Center”

Intro “rules of the game” “Good old ECB” “the beauty of a euro bond”

▫Group 3 & grads “Warmer Inside”

Intro Deconstructed

Group Project - presentations

•Divide into 4 groups…•Each read 1 section•Group presentation (4 total)

▫Group 1 & 2 “EMU – the benefits” – p 287

▫Group 3 “The counter arguments” – p289

▫Grads: The UK position