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ECON113: ECONOMICS OF GLOBALISATION

Week 13: Global Financial Markets

Yuan MEI

2022 – 2023 Term 1

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Recap from Last Week

• Balance of payments
▪ Current account
▪ Capital account
▪ US trade deficit

• Exchange rate
▪ Exchange rate regime
• Fixed versus floating
▪ Determinants of exchange rate
▪ Currency manipulation

• MAS

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Contents

• Currency and gold standard

• Bretton Woods
▪ Gold exchange standards
▪ IMF
▪ World Bank

• Bonds
▪ Credit rating and sovereign default
▪ Argentina

• SWIFT
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Currency History in China

• One of the countries with longest currency history

▪ First use metal coins to replace shells in the Shang Dynasty
(1600 -1000 BC)

▪ Uniform copper coins introduced by Qin Shi Huang (260 –

210 BC)

▪ Paper money widely used in Song Dynasty (960 – 1279)

▪ Ming Dynasty (1368 – 1644)

• Paper notes abandoned due to inflation
• Silver started to be used as a currency

▪ Qing Dynasty: copper and silver currency system 4

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Currency History in China

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Gold and Gold Standard

• After the discovery of America, silver supply surged

• Gold gradually replaced silver as the key monetary asset

▪ Overall acceptability: international means of payment

▪ A unit of account of commodity prices

▪ A viable store of value despite inflation, wars and revolutions

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Gold and Gold Standard

• Gold standard can have three different forms

▪ Gold coins and other forms of currency both in circulation

▪ Gold coins do not circulate, but authorities agree to sell gold

at a fixed price in exchange for the circulating currency

▪ Gold exchange standard (Bretton Woods): authorities

guarantee a fixed exchange rate to another currency that uses
gold standard

• Advantage: no hyperinflation

• Disadvantage: money supply constrained by gold reserve

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Reserve Currency
• Held in significant quantities by governments and institutions as
part of their foreign exchange reserves

• Starting from the 1800s, the British pound (GBP) became the first
reserve currency
▪ UK was the primary exporter and 60% of world trade was
invoiced in pound
▪ London recognized as an international market for insurance
and commodities
▪ Gold standard: the pound was freely convertible into gold

• Replaced by US dollar (USD) as Britain’s commercial and

financial status deteriorated
▪ UK abandoned gold standard in 1931
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Bretton Woods

• 1944: United Nations Monetary and Financial Conference at

Bretton Woods, United States

• Led by the United States

▪ Soviet Union representatives attended the conference but
refused to ratify the final agreement

• Two major outcomes of the conference

▪ An international monetary system characterized by gold
exchange standard

▪ Establishment of the World Bank and International

Monetary Fund
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Bretton Woods

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Bretton Woods System

• United States assumed responsibility for buying and selling gold

at a fixed price ($35 per ounce)
▪ The government should only print as much money as the
United States had gold

• USD was the only currency that was made convertible to gold

• Other currencies were pegged to USD

• USD became a reserve currency

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Bretton Woods and Banking Crisis

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Source: This time is different: Eight centuries of financial folly
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Demise of Bretton Woods

• Beginning of Bretton Woods: the US produced half of the world’s

manufactured good and held half of world’s reserves

• 1970: US only held 16% of international reserves

▪ Europe and Japan grew rapidly, but international liquidity was still
solely determined by the US

• US dollar became increasingly overvalued

▪ Growing public debt by Vietnam War and social welfare programs
▪ Inflation

• Gold outflow despite effort from US government

▪ By 1970, US gold coverage dropped from 55% to 22%
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Nixon Shock in 1971

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Source: Wikipedia
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Historical Gold Price

Source: macrotrends.net 15
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USD Today

• Fiat money
▪ With no intrinsic value
▪ Cannot be converted to precious metal

• Still a primary reserve currency

• Circulated as official currency in the US and

▪ East Timor
▪ El Salvador
▪ Panama
▪ Zimbabwe

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IMF

• International Monetary Fund

▪ Formally created in 1945 with 189 member countries today
▪ Headquarter: Washington D.C. USA
▪ Managing director: always a European
▪ USA (16.52% total votes) has veto power

• Objectives:
▪ Foster global monetary cooperation
▪ Secure financial stability
▪ facilitate international trade
▪ Promote high employment and sustainable economic growth
▪ Reduce poverty around the world

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IMF Voting Shares

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THE BEST JOB

• Eligibility: Economics PhD under the age of 34

• Competitive salary with no income tax

• 26 days annual leave with complimentary business class air tickets

• Best available health insurance and education subsidies

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Special Drawing Rights

• A supplementary international reserve asset
▪ Provide liquidity and supplementing IMF member countries’
foreign reserve
▪ Total amount 204 B in 2014, around 4% of global foreign reserve
▪ Pegged to a basket of five currencies: USD, EUR, CNY, JPY, GBP

• Cost-free alternative to building foreign exchange reserves when the

USD is weak or otherwise unsuitable to be a foreign reserve

• Concerns
▪ Mostly allocated to large countries
▪ Not available to private parties: have to be converted to other
currencies first

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IMF and India in 1991

• In June 1991, India’s foreign reserve was only enough for two
weeks’ of imports

• Indian government seek $5-7 billion from the IMF

• Conditionality of the loan: IMF requested India to

▪ Reduce budget deficit
▪ Open its market to foreign competition
▪ Diminish licensing requirement
▪ Cut subsidies

• Criticism: IMF is imposing its economic sovereignty over India

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Asian Financial Crisis

• A financial crisis in the late 1990s

▪ Most affected countries: Indonesia, South Korea, and Thailand
▪ Less affected countries: Hong Kong, Laos, Malaysia, and the
Philippines

• Started when Thailand was forced to float the Baht due to lack of
foreign reserve, and soon spread to stock markets and other assets

• Causes:
▪ Malaysian Prime Minister Mahathir: speculators like Soros
▪ Soros: “the responsibility doesn't belong to speculators but to
the authorities”

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Asian Financial Crisis

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Source: Wikipedia
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Asian Financial Crisis

• In the mid-1990s, Thailand, Indonesia and South Korea

▪ Experienced large current account deficits
▪ Large external debt
▪ Maintained a fixed exchange-rate regime

• Speculators believed that those currencies were overvalued

• Strategy
▪ Borrow Thai Baht at fixed rate (1USD = 25 Baht)
▪ Sell Baht at foreign exchange market
▪ Baht depreciates when Thai government does not have
enough reserve to buy Baht to maintain a fixed rate
▪ 25 Baht < 1USD, hence profit for speculators
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Thai Baht

Source: World Bank 25

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Indonesia Rupiah

Source: World Bank 26

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Hong Kong Dollar

Source: World Bank 27

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IMF and Asian Financial Crisis

• July 1997: Thai Baht depreciated by 20%

▪ August: Thailand adopted measures proposed by IMF in
exchange for $17 billion worth of loans.
▪ October: IMF agrees to a load package for Indonesia that
eventually swells to $40 billion
▪ December: IMF approves a $57 billion package to South
Korea, the largest in history

• Conditionality: all packages come with a list of conditions

▪ Layoffs with businesses and government leaders
▪ Closing insolvent banks
▪ Austerity in government expenditure and external debt

• Delayed assistance when requests are not met 28

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Let’s watch a video.

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What do you think of IMF’s rescue plans

amidst economic crisis? Should IMF
require countries in crisis to satisfy the list
of conditions in exchange for the financial
assistance?

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World Bank

• Established in 1944 after the Bretton Woods Conference

▪ Headquarter: Washington DC, USA
▪ More than 10,000 employees and 120 offices world wide

• Two goals for the world to achieve by 2030

▪ End extreme poverty by decreasing the percentage of people
living on less than $1.90 a day to no more than 3%
▪ Promote shared prosperity by fostering the income growth of
the bottom 40% for every country

• Main instrument: low-interest loans, zero to low-interest credits,

and grants

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Criticisms

• World Bank represents 188 countries, but it is run by a small

group of developed countries
▪ All 12 presidents from 1946 to now are US citizens
▪ United States have the veto power

• Emphasizing growth of GDP instead of equality and better

living standards

• Sovereign immunity

• Inefficiency

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Washington Consensus

• A set of ten economic policy prescriptions advocated by

institutions based in Washington DC, such as the World Bank,
IMF and US Treasury Department

• First used in 1989 by British economist John Williamson

• Main contents
▪ Disciplined government budget
▪ Market-determined interest rate and exchange rate
▪ Liberalization of trade and foreign direct investment
▪ Privatization and deregulation
▪ Legal security of property rights
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Criticisms

• Disciplined budget versus public spending on infrastructure

• China and India succeeded but those following the Washington

Consensus failed

• US itself has substantial government budget deficit

• Government intervention in developed countries after the

financial crisis in 2008
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Government Bond

• A bond issued by a national government, generally with a

promise to pay periodic interest payments and to repay the
face value on the maturity date.

• Features
▪ Maturity
▪ Face value/principal
▪ Interest rate
▪ Credit rating

• Example: if the face value of a one-year bond is $100 and

the interest rate 1%, then the price of the bond is about $99

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US 10-Year Bond Rate

Source: macrotrends.net 36
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Credit Rating

• Debtors do not always have the ability to pay back at maturity

• Credit rating agencies evaluate the credit risk of debtors and

predict their ability to pay back the debt
▪ Higher ratings indicate a smaller likelihood to default
▪ Riskier bonds also have higher returns (interest payment)

• Three largest credit rating agencies:

▪ Moody’s
▪ Standard & Poor’s
▪ Fitch

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Sovereign Default

• Sovereign default: failure or refusal of the government of a

sovereign state to pay back its debt in full

• Causes:
▪ Insolvency
▪ Illiquidity
▪ Change of government

• Consequences
▪ Immediate relief of debt burden
▪ Significant damage to the country’s credit rating

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Sovereign rating list

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Argentina

• One of the ten wealthiest countries in the world 100 years ago
▪ Major exporter of agricultural products
▪ Substantial foreign investment from Europe
▪ Massive immigration
▪ First subway in Latin America (Buenos Aires in 1913)

• In 2021
▪ Considered as an emerging market
▪ GDP per capita: USD$10,729 (60th)
▪ Inflation: 48.4%
▪ Agricultural products still account for more than half of
exports
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Argentina GDP Per Capita

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Source: World Bank
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Inflation in Argentina

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Source: World Bank
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Argentina Economy

• Before 1976
▪ Import substitution
▪ Economic centralization
▪ Unstable growth accompanied by high inflation

• 1976 – 1990
▪ Substantial political uncertainty accompanied hyper inflation
▪ Sovereign default in 1982
• IMF rescue program failed in 1983
• $300 M loan from other Latin American countries
• IMF rescue program in 1984
• Default again in 1986
• IMF rescue in 1987 but failed in 1988
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Argentina Economy

• In 1991, currency board adopted to tackle hyperinflation

▪ Freely exchangeable to USD
▪ Robust recovery during the 1990s
▪ Problem: overvalued currency reduced exports

• Inflation was controlled, but debt still accumulated

• In Dec 2001
▪ IMF refused to release a $1.3 B worth of loan
▪ Bank accounts frozen due to large scale withdrawal
▪ Default on public debt worth $132 B

• Currency board abandoned in 2002 44

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The Most Recent Financial Crisis

• The pro-business President Macri lost the election in Oct 2019

• Investors are horrified by the opposition’s interventionist policies

and inflation rose to 55% from 25%

• Earlier in 2022, Argentina avoided defaulting on a $44bn

International Monetary Fund
▪ Targets inflation of 38%-48% this year

• Argentina's central bank raised its main rate of interest to 69.5%

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SWIFT

• Society for Worldwide Interbank Financial Telecommunication

(SWIFT) is a member-owned cooperative and the world’s leading
provider of secure financial messaging service

• Founded in 1973 in Belgium to replace Telex, a public system

involving manual typing and reading of messages

• Principal function: serve as the main messaging network through

which international payments are initiated

• Users: banks, trading institutions, dealers and brokers, exchanges,

clearing institutions…

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Telex

https://en.wikipedia.org/wiki/Telex
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SWIFT Sanctions
• Swift links 11,000 institutions in more than 200 countries

• Under Belgian law and owned by its member financial institutions

▪ in partnership with major central banks around the world -
including the US Federal Reserve and the Bank of England

• Messages sent: more than 40 million per day

▪ More than 1% of those messages were thought to involve
Russian payments (according to BBC)

• March 2022: seven Russian banks were removed from Swift

• June 2022: three more banks including the largest Sberbank

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SWIFT Sanctions

https://www.thephuketnews.com/phuket-officials-deny-
russian-credit-cards-refused-83388.php
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Russia’s Alternatives

• Russian banks now have to deal directly with one another, adding
delays and extra costs

• Russia’s alternatives:
▪ Develop its own transfer system: System for Transfer of
Financial Messages (more than 440 institutions by Sep 2022)

▪ Connect to China's Cross-Border Interbank Payment System

(CIPS) - another alternative to Swift which processes payments
in Chinese yuan.

▪ Digital currency and block chain?

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Quiz Time

https://www.wooclap.com/ECON113L13