Introductory Finance Issues: Current Patterns, Past

History, and International Institutions

 International economics is growing in importance as a field of study because of the rapid integration of
international economic markets.
 The overall annual exports measured in billions of U.S. dollars from 1948 to 2008 reveals an exponential
growth in outflows and inflows.
 World exports as a percentage of the world gross domestic product (GDP) for the years 1970 to 2008
exhibits a steady increase in trade as a share of the size of the world economy.
 The sum total value of FDI around the world taken as a percentage of the world GDP between 1980 and
2007, gives an indication of the importance of foreign ownership and influence around the world.
 The General Agreement on Tariffs and Trade, or GATT, prompted regular negotiations among a growing
body of members to reciprocally reduce tariffs (import taxes) on imported goods.
 Eight rounds of negotiations were completed between 1948 and 1994.
 Uruguay Round, the most recently completed round, was finalized in 1994. Countries agreed to lower
tariff, eliminate quota systems, and adhere to certain minimum standards to protect intellectual property
rights.
 The World Trade Organization (WTO) was created to manage the system of new agreements, to provide a
forum for regular discussion of trade matters, and to implement a well-defined process for settling trade
disputes that might arise among countries.
 Regional free trade agreements have also prompted trade liberalization.
 Globalization refers to the economic, social, cultural, or environmental changes that tend to interconnect
peoples around the world.
 What Is International Economics?
 It is a field of study that assesses the implications of international trade, international investment, and
international borrowing and lending.
 International trade is a field in economics that applies microeconomic models to help understand the
international economy.
 International trade explains the effects of international trade on individuals and businesses and the effects
of changes in trade policies and other economic conditions.
 International finance applies macroeconomic models to help understand the international economy.

2. GDPs, Unemployment, Inflation, and Government Budget Balances

 One way to make judgments about a country’s economic performance is to compare its economic
indicators with other countries.
 The U.S., the EU, and Japan represent the largest economies in the world today.
 Brazil, Russia, India, and China are watched so closely today that they have acquired their own acronym:
the BRIC countries

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 Indonesia, Kenya, Ghana, and Burundi are among the poorest nations of the world.
 Gross Domestic Product around the World
 GDP measures the total value of all goods and services produced by a country during a year.
 GDP per capita (i.e., per person) is used to indicate the average well-being of individuals in a country.
 The U.S. and the EU, each make up about one-fifth of the world economy.
 The U.S., the EU, and Japan produce almost one-half of the total world production, while accounting for
less than one-sixth of the world’s population.
 It takes another five billion people to produce the remaining half of the GDP.
 There is a wide dispersion of GDPs per capita across countries.
 The U.S. ranks sixth in the world in terms of per capita income at $47,000.
 Average GDP per capita in the world is just over $10,000
 Burundi has a GDP of only $370 per person.
 Unemployment and Inflation around the World
 Two other key macroeconomic variables are the unemployment rate and the inflation rate.
 The unemployment rate measures the percentage of the working population in a country who would like
to be working but are currently unemployed.
 The lower the rate, the healthier the economy and vice versa.
 The inflation rate measures the annual rate of increase of the consumer price index (CPI).
 In general, a relatively moderate inflation rate (about 0–4 percent) is deemed acceptable.
 When most economies of the world were booming several years earlier, a normal unemployment rate
would have been 3 to 5 percent, while a normal inflation rate would stand at about 3 to 6 percent.
 Government Budget Balances around the World
 The state of the country’s government budget is also considered while analyzing the health of an
economy.
 If the budget is in surplus then there is little cause for concern.
 If the budget is in deficit, there are two ways to finance it: borrow money by issuing bonds and Treasury
bills or by printing money.
 The total outstanding balance of IOUs (i.e., I owe you) that the government must pay back in the future to
repay its creditors is called the national debt.
 This debt is owed to whoever has purchased the Treasury bonds.
 Excessive borrowing by a government can cause economic difficulties.
 Monetizing the debt by printing money can also be problematic as it leads to inflationary pressures and
may cause damage to the economy.
 Although there is no absolute number above which a budget deficit or a national debt is unsustainable, the
following tends to raise concerns among investors:
 Budget deficits greater than 5 percent per year.
 Budget deficits that are persistent over a long period.
 A national debt greater than 50 percent of GDP.
 Budget deficits are very large, exceeding 10 percent, in the U.S. and Spain.
 In most cases, as budget deficit rises, so does national debt.

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 In the U.S. national debt is still at a modest 37.5 percent, but recent projections suggest that it may
increases substantially in a few years.
 These figures subtract any debt issued by the government and purchased by another branch of the
government.
 China and Russia’s debts are fairly modest at only 15.6 percent and 6.5 percent of GDP respectively.
 Japan’s national debt is an astounding 172 percent of GDP.

3. Exchange Rate Regimes, Trade Balances, and Investment Positions

 The most important international macroeconomic variables are:

 The trade balance (the difference between the total value of exports and the total value of imports)
 The exchange rate (the number of units of one currency that exchanges for one unit of another currency)
 Exchange Rate Regimes
 One of the decisions a country must make is whether to fix its exchange or whether to allow its value to
float according to market conditions.
 Throughout history fixed exchange rates have been the norm.
 Since 1973, countries have pursued a variety of different exchange rate mechanisms.
 The U.S. dollar, the Japanese yen are among the floating currencies.
 The EU nations have a common currency which is flexible against non-EU nations.
 Trade Balances and International Investment Positions
 One of the most widely monitored international statistics is a country’s trade balance.
 When the value of exports exceeds (falls short of) the value of imports, the country has a trade surplus
(deficit).
 In case of a trade deficit, the extra purchases are financed by the sale of domestic assets to foreigners
(investments) or through the sale of IOUs (borrowing).
 In the latter case, foreign loans entitle foreigners to a future repayment, thus linking trade and
international investment.
 A country with a deficit (surplus) thus becomes a debtor (creditor) country.
 International investment position (IIP) measures the total value of foreign assets held by domestic
residents minus the total value of domestic assets held by foreigners.
 If the value of a country’s trade deficits over time exceeds the value of its trade surpluses, then its IIP will
reflect a larger value of foreign ownership of domestic assets than domestic ownership of foreign assets..
 Any large international debt is likely to cause substantial declines in living standards for a country when it
is paid back.
 On the other hand, international creditor countries may be in jeopardy if their credits exceed 30, 40, or 50
percent of GDP.
 The U.S. is referred to as the largest debtor nation in the world; it has amassed an international debt
totaling about $3.4 trillion or almost 25 percent of its GDP.
 Japan is the largest creditor country in the world.

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4. Business Cycles: Economic Ups and Downs

 The recent economic recession was caused by the bursting of the real estate bubble in the U.S.
 A bubble is described as a steady and persistent increase in prices in a market, in this case, in the real
estate markets in the U.S. and abroad.
 When the bubble bursts, the demand driving the price increases cease and a large number of participants
begin to sell off their product to realize their profit and prices plummet.
 The financial market instabilities caused by the bursting of the real estate bubble finally spilled over into
the real sector contributing to a world recession.
 An economic recession refers to a decline in a country’s measured real growth domestic product (GDP)
over a period usually coupled with an increasing aggregate unemployment rate.
 In the United States, it is typical to define a recession as two successive quarters of negative real GDP
growth.
 The opposite of a recession is an economic expansion or economic boom.
 The NBER (National Bureau of Economic Research) measures the contractions and expansions in the
U.S. economy to identify the business cycles.
 The Recession of 2008–2009
 Growth rates refer to the percentage change in real GDP, which means that the effects of inflation have
been eliminated.
 Refer to Table 1.6 for the quarterly U.S. real GDP growth rates and unemployment rates for 2007-09.
 The Recession of 1980–1982
 The NBER declared two recessions during this period; the first lasting from January to July 1980 and the
second lasting from July 1981 to November 1982.
 It appears that the recession of the early 80s was worse than the latest recession experienced so far.
 It must be noted that unemployment rate usually responds slowly to the changes in an economy.
 The unemployment rate is often called a lagging indicator of a recession; it responds only after the
recession has already abated.
 The Great Depression
 There is no quarterly data available for the 1930s.
 The numbers presented by the U.S. Bureau of Economic and Analysis (BEA) were constructed by piecing
together available data.
 Annual GDP growth rates tend to have much less variance than quarterly data.
 Refer to Figure 1.8 for annual U.S. real GDP growth rates and unemployment rates for 1930-40.
 The NBER dated the first part of the Depression as having started in August 1929 and ending in March
1933.
 This was followed by another recession beginning in May 1937 and ending in June 1938.
 The movement out of the Great Depression was associated with a national emergency (World War II)
rather than a more secure and rising standard of living.
 The current recession comes nowhere close to the severity of the Great Depression.

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 However, we should always be mindful of a second downturn as was seen in the late 1930s. Even after
things begin to improve, economies can suffer secondary collapses.

5. International Macroeconomic Institutions: The IMF and the World Bank

 The gold standard, prevalent before World War II, was a system of fixed exchange rates.
 During the Depression years, most countries dropped off the gold standard because the loss of confidence
threatened a complete conversion of currency to gold.
 The Bretton Woods Conference was held in July 1944 to establish a set of institutions that would support
international trade and investment and prevent some of the monetary instabilities that had plagued the world
after World War I.
 The conference proposed three institutions, only two of which finally came into being.
 The two successfully chartered institutions from the Bretton Woods Conference were the International
Bank for Reconstruction and Development (IBRD) and the International Monetary Fund (IMF).
 The IBRD is one component of a larger organization called the World Bank.
 The U.S. dollar was singled out as the international reserve currency: 44 of the 45 ratifying countries
agreed to have their currency fixed to the dollar.
 The dollar in turn was fixed to gold at $35 per ounce.
 To facilitate the expansion of international trade the countries agreed not to put any restrictions or
controls on the exchange of currencies when that exchange was intended for transactions on the current
account.
 Currency controls or restrictions were allowed for transactions recorded on the financial accounts (capital
controls).
 The IMF was created to help stabilize exchange rates in the fixed exchange rate system.
 In particular, member countries contribute reserves to the IMF, which is then enabled to lend money to
countries suffering balance of payments problems.
 To ensure repayment, the IMF generally establishes conditions such as changes in monetary and fiscal
policies intended to eliminate the original problems with the balance of payments.
 The role of the IMF has changed more recently; it is a kind of lender of last resort to national
governments.
 In the past thirty years or so, almost every time a country has run into difficulty repaying its external debt,
the IMF has stepped in to assure continued repayment.
 This has led to the moral hazard problem
 Lending institutions in the developed countries may view the IMF like an insurance policy and thus make
much riskier loans than they would have otherwise.

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Exchange Rate Regimes

ANNUAL REPORT ON EXCHANGE ARRANGEMENTS AND EXCHANGE RESTRICTIONS 2021 IMF (AREAER)

The classification system is based on the members’ actual, de facto arrangements as identified by IMF staff,
which may differ from their officially announced, de jure arrangements. The system classifies exchange rate
arrangements primarily based on the degree to which the exchange rate is determined by the market rather
than by official action, with market-determined rates being on the whole more flexible.

The system distinguishes among four major categories: hard pegs (such as exchange arrangements with no
separate legal tender and currency board arrangements) soft pegs (including conventional pegged
arrangements, pegged exchange rates within horizontal bands, crawling pegs, stabilized arrangements, and
crawl-like arrangements) floating regimes (such as floating and free floating) and a residual category, other
managed.

Dollarisation, also currency substitution, means a country unilaterally adopts the currency of another
country. Most of the adopting countries are too small to afford the cost of running its own central bank or
issuing its own currency. Most of these economies use the U.S dollar, but other popular choices include the
Euro.

A currency board arrangement is a monetary arrangement based on an explicit legislative commitment to

exchange domestic currency for a specified foreign currency at a fixed exchange rate, combined with
restrictions on the issuing authority to ensure the fulfillment of its legal obligation. This implies that
domestic currency will be issued only against foreign exchange and that it remains fully backed by foreign
assets, eliminating traditional central bank functions such as monetary control and lender-of-last-resort, and
leaving little scope for discretionary monetary policy

In Conventional Pegged the country formally (de jure) pegs its currency at a fixed rate to another currency or
a basket of currencies, where the basket is formed, for example, from the currencies of major trading or
financial partners, and weights reflect the geographic distribution of trade, services, or capital flows. The
country authorities stand ready to maintain the fixed parity through direct intervention (i.e., via sale or
purchase of foreign exchange in the market) or indirect intervention (e.g., via exchange rate related use of

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interest rate policy, imposition of foreign exchange regulations, exercise of moral suasion that constrains
foreign exchange activity, or intervention by other public institutions).

Pegged exchange rate within horizontal bands involves the confirmation of the country authorities’ de jure
exchange rate arrangement. The value of the currency is maintained within certain margins of fluctuation of
at least ±1% around a fixed central rate, or the margin between the maximum and minimum value of the
exchange rate exceeds 2%. It includes arrangements of countries in the Exchange Rate Mechanism (ERM) of
the European Monetary System (EMS), which was replaced with the ERM II on January 1, 1999, for those
countries with margins of fluctuation wider than ±1%.

Stabilized arrangement is a spot market exchange rate that remains within a margin of 2% for six months or
more (with the exception of a specified number of outliers or step adjustments), and is not floating. The
required margin of stability can be met either with respect to a single currency or a basket of currencies,
where the anchor currency or the basket is ascertained or confirmed using statistical techniques.

A crawling peg involves the confirmation of the country authorities’ de jure exchange rate arrangement. The
currency is adjusted in small amounts at a fixed rate or in response to changes in selected quantitative
indicators, such as past inflation differentials vis-à-vis major trading partners or differentials between the
inflation target and expected inflation in major trading partners. The rate of crawl can be set to generate
inflation-adjusted changes in the exchange rate (backward looking) or set at a predetermined fixed rate
and/or below the projected inflation differentials (forward looking).

In Crawl-like arrangement, the exchange rate must remain within a narrow margin of 2% relative to a
statistically identified trend for six months or more (with the exception of a specified number of outliers),
and the exchange rate arrangement cannot be considered as floating. Normally, a minimum rate of change
greater than allowed under a stabilized (peg-like) arrangement is required. However, an arrangement will be
considered crawl-like with an annualized rate of change of at least 1%, provided that the exchange rate
appreciates or depreciates in a sufficiently monotonic and continuous manner.

A floating exchange rate is largely market determined, without an ascertainable or predictable path for the
rate. In particular, an exchange rate that satisfies the statistical criteria for a peg-like or a crawl-like
arrangement will be classified as such unless it is clear that the stability of the exchange rate is not the result
of official actions. Foreign exchange market intervention may be either direct or indirect, and serves to
moderate the rate of change and prevent undue fluctuations in the exchange rate, but policies targeting a
specific level of the exchange rate are incompatible with floating. Indicators for managing the rate are
broadly judgmental (e.g., balance of payments position, international reserves, parallel market
developments). Floating arrangements may exhibit more or less exchange rate volatility, depending on the
size of the shocks affecting the economy

A floating exchange rate can be classified as free floating if intervention occurs only exceptionally, aims to
address disorderly market conditions, and if the authorities have provided information or data confirming
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that intervention has been limited to at most three instances in the previous six months, each lasting no more
than three business days.

De facto means a state of affairs that is true in fact, but that is not officially sanctioned. In contrast, de jure
means a state of affairs that is in accordance with law (i.e. that is officially sanctioned).

The de jure exchange rate arrangement is floating. Exchange rate is determined by market forces, that is,
demand and supply of FE.

The State Bank of Pakistan (SBP) does not explicitly or implicitly commit to an exchange rate target or path.
The SBP intervenes in the market to curb speculative pressures for ensuring smooth functioning of the
markets.

Banks are free to quote and trade at any exchange rate. Since June 2019, Pakistan has adopted a market
based flexible exchange rate system where interventions are limited to safeguarding financial stability and
preventing disorderly market conditions (DMC).

Under the new market-determined flexible exchange rate mechanism, the PKR moved in tandem with
changes in the country’s trade balance and foreign inflows. After disruption in global markets because of the
COVID-19 pandemic in early 2020, the PKR depreciated in the face of capital outflows.

Afterwards, in line with the reduction in the trade deficit because of the economic slowdown and favorable
terms of trade, the PKR started to appreciate. This was further supported by gradual resumption in private
flows.

However, as the economy rebound strongly from the pandemic, the trade deficit has increased in recent
months, and the PKR reflected these developments. In addition, common seasonal factors such as budget
utilization and foreign repatriation at the end of each financial and calendar years also have a temporary
impact on the PKR exchange rate. The de facto exchange rate arrangement was reclassified to floating from
other managed, effective March 9, 2020. The SBP does not publish data related to market intervention

Table 1.4 shows the selected set of countries followed by a currency regime. Notice that two currencies—the
U.S. dollar and the Japanese yen, are listed as freely floating whereas the Indian Rupee, the Brazilian real,
the South Korean won, the Indonesian rupiah and the South African rand—are just floating.

In general, floating means that the exchange values are determined in the private market on the basis of
supply and demand. Because supply and demand for currencies fluctuate over time, so do the exchange
values, which is why the system is called floating. The distinction between freely floating and floating is
whether a country's central bank periodically intervenes to affect the currency value. Freely floating
currencies are left entirely to market forces. Floating currencies may have an occasional intervention.
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China is listed as maintaining a crawl-like arrangement, which means that the currency is essentially fixed
except that the Chinese central bank is sometimes allowing its currency to appreciate slowly with respect to
the U.S. dollar and at other times allowing it to depreciate. In other words, the fixed rate itself is gradually
but unpredictably adjusted. The Chinese RMB was allowed to slowly rise in value between 2005 and 2008.
After the financial crisis began in 2008, the rise of the RMB value slowed and sometimes ceased for long
periods. In 2013, the Chinese again began to allow the RMB to rise slowly in value. In the past year the
RMB has drifted down slightly in value.

Hong Kong is listed as having a currency board. This is a method of maintaining a fixed exchange rate by
essentially eliminating the central bank in favor of a currency board that requires that adequate foreign
reserves be held for every HK dollar put into circulation. This process automatically keeps its currency fixed
in value.

Russia is listed as having an other managed arrangement. They are currently in transition from a currency
fixed to a basket of currencies, also called a composite currency, to a freely floating system.

Finally, eighteen countries in the European Union are currently members of the euro area. Within this area,
the countries have retired their own national currencies in favor of using a single currency, the euro. When
all countries circulate the same currency, it is the ultimate in fixity, meaning they have fixed exchange rates
among themselves because there is no need to exchange. However, with respect to other external currencies,
like the U.S. dollar or the Japanese yen, the euro is allowed to float freely.