INTERNATIONAL MONETARY SYSTEM &

IMPACT OF CAPITAL FLOWS

(DEBT/EQUITY) LIQUIDITY & SHOCKS

Presented by:
Punit Bhanji Akhilesh garde Laxmikant Maheshwari Nilesh Nawal Kunal Patil Pratik Soni Abhiheet Thakur 6 16 29 42 47 57 58

PPT OUTLINE:

Evolution of the International Monetary System Current Exchange Rate Arrangements European Monetary System The Mexican Peso Crisis The Asian Currency Crisis The Argentine Peso Crisis Fixed versus Flexible Exchange Rate Regimes The East Asian Crisis

EVOLUTION OF THE INTERNATIONAL MONETARY SYSTEM

Bimetallism: Before 1875 Classical Gold Standard: 1875-1914 Interwar Period: 1915-1944 Bretton Woods System: 1945-1972 The Flexible Exchange Rate Regime: 1973-Present

BIMETALLISM: BEFORE 1875

A double standard in the sense that both gold and silver were used as money. Both gold and silver were used as international means of payment and the exchange rates among currencies were determined by either their gold or silver contents. Since exchange rate between two currency was fixed officially, only the abundant metal was used as money, driving more scarce metal out of circulation.

Greshams Law: Bad (abundant) money drives out Good (scarce) money

CLASSICAL GOLD STANDARD: 1875-1914

During this period in most major countries:

Gold alone was assured of unrestricted coinage There was two-way convertibility between gold and national currencies at a stable ratio. Gold could be freely exported or imported.

The exchange rate between two countrys currencies would be determined by their relative gold contents.
For example, if the dollar is pegged to gold at U.S.$30 = 1 ounce of gold, and the British pound is pegged to gold at 6 = 1 ounce of gold.

$30 = 6 $5 = 1

CLASSICAL GOLD STANDARD: 1875-1914

Highly stable exchange rates under the classical gold standard provided an environment that was favorable to international trade and investment. Misalignment of exchange rates and international imbalances of payment were automatically corrected by the price-specie-flow mechanism.

PRICE-SPECIE-FLOW MECHANISM
Suppose

Great Britain exported more to France than France imported from Great Britain.
Net export of goods from Great Britain to France will be accompanied by a net flow of gold from France to Great Britain. This flow of gold will lead to a lower price level in France and, at the same time, a higher price level in Britain.

The

resultant change in relative price levels will slow exports from Great Britain and encourage exports from France.

CLASSICAL GOLD STANDARD: 1875-1914

There are shortcomings:

The supply of newly minted gold is so restricted that the growth of world trade and investment can be hampered for the lack of sufficient monetary reserves. Even if the world returned to a gold standard, any national government could abandon the standard.

INTERWAR PERIOD: 1915-1944

Exchange rates fluctuated as countries widely used predatory depreciations of their currencies as a means of gaining advantage in the world export market. Attempts were made to restore the gold standard, but participants lacked the political will to follow the rules of the game. The result for international trade and investment was profoundly detrimental.

BRETTON WOODS SYSTEM: 1945-1972

Named for a 1944 meeting of 44 nations at Bretton Woods, New Hampshire. The purpose was to design a postwar international monetary system. The goal was exchange rate stability without the gold standard. The result was the creation of the IMF and the World Bank.

BRETTON WOODS SYSTEM: 1945-1972

Under the Bretton Woods system, the U.S. dollar was pegged to gold at $35 per ounce and other currencies were pegged to the U.S. dollar. Each country was responsible for maintaining its exchange rate within 1% of the adopted par value by buying or selling foreign reserves as necessary. The Bretton Woods system was a dollar-based gold exchange standard.

BRETTON WOODS SYSTEM: 1945-1972

German mark

British pound

French franc

Par Value
U.S. dollar

Gold

Pegged at $35/oz.

THE FLEXIBLE EXCHANGE RATE REGIME: 1973PRESENT.

Flexible exchange rates were declared acceptable to the IMF members.

Central banks were allowed to intervene in the exchange rate markets to iron out unwarranted volatilities.

Gold was abandoned as an international reserve asset. Non-oil-exporting countries and less-developed countries were given greater access to IMF funds.

CURRENT EXCHANGE RATE ARRANGEMENTS

Free

Float

The largest number of countries, about 48, allow market forces to determine their currencys value.

Managed

Float

About 25 countries combine government intervention with market forces to set exchange rates.

Pegged

to another currency

Such as the U.S. dollar or euro.

No

national currency

Some countries do not bother printing their own, they just use the U.S. dollar. For example, Ecuador, Panama, and El Salvador have dollarized.

EUROPEAN MONETARY SYSTEM

Eleven European countries maintain exchange rates among their currencies within narrow bands, and jointly float against outside currencies. Objectives:

To establish a zone of monetary stability in Europe. To coordinate exchange rate policies vis--vis non-European currencies. To pave the way for the European Monetary Union.

THE MEXICAN PESO CRISIS

DECEMBER 20, 1994

On 20 December, 1994, the Mexican government announced a plan to devalue the peso against the dollar by 14 percent. This decision changed currency traders expectations about the future value of the peso. They stampeded for the exits. In their rush to get out the peso fell by as much as 40 percent.

THE MEXICAN PESO CRISIS

DECEMBER 20, 1994

The Mexican Peso crisis is unique in that it represents the first serious international financial crisis touched off by cross-border flight of portfolio capital. Two lessons emerge:

It is essential to have a multinational safety net in place to safeguard the world financial system from such crises. An arrival of foreign capital can lead to an overvaluation in the first place.

THE ASIAN CURRENCY CRISIS

JULY 2, 1997

The Asian currency crisis turned out to be far more serious than the Mexican peso crisis in terms of the extent of the contagion and the severity of the resultant economic and social costs. Many firms with foreign currency bonds were forced into bankruptcy. The region experienced a deep, widespread recession.

THE ARGENTINEAN PESO CRISIS

2002

In 1991 the Argentine government passed a convertibility law that linked the peso to the U.S. dollar at parity. The initial economic effects were positive:

Argentinas chronic inflation was reduced Foreign investment poured in

As the U.S. dollar appreciated on the world market the Argentine peso became stronger as well.

THE ARGENTINEAN PESO CRISIS

The strong peso hurt exports from Argentina and caused a protracted economic downturn that led to the abandonment of pesodollar parity in January 2002.
The unemployment rate rose above 20 percent The inflation rate reached a monthly rate of 20 percent

THE ARGENTINEAN PESO CRISIS

There are at least three factors that are related to the collapse of the currency board arrangement and the ensuing economic crisis:
Lack of fiscal discipline Labor market inflexibility Contagion from the financial crises in Brazil and Russia

CURRENCY CRISIS EXPLANATIONS

In theory, a currencys value mirrors the fundamental strength of its underlying economy, relative to other economies. In the long run. In the short run, currency traders expectations play a much more important role. In todays environment, traders and lenders, using the most modern communications, act by fight-or-flight instincts. For example, if they expect others are about to sell Brazilian reals for U.S. dollars, they want to get to the exits first. Thus, fears of depreciation become self-fulfilling prophecies.

FIXED VERSUS FLEXIBLE EXCHANGE RATE REGIMES

Arguments in favor of flexible exchange rates:

Easier external adjustments. National policy autonomy.

Arguments against flexible exchange rates:

Exchange rate uncertainty may hamper international trade. No safeguards to prevent crises.

FIXED VERSUS FLEXIBLE EXCHANGE RATE REGIMES

Suppose the exchange rate is $1.40/ today. In the next slide, we see that demand for British pounds far exceed supply at this exchange rate. The U.S. experiences trade deficits.

FIXED VERSUS FLEXIBLE EXCHANGE RATE REGIMES

Dollar price per (exchange rate) Supply (S)

$1.40

Demand (D) Trade deficit S D Q of

FLEXIBLE EXCHANGE RATE REGIMES

Under a flexible exchange rate regime, the dollar will simply depreciate to $1.60/, the price at which supply equals demand and the trade deficit disappears.

FIXED VERSUS FLEXIBLE EXCHANGE RATE REGIMES

Dollar price per (exchange rate)

Supply (S)

$1.60
$1.40 Dollar depreciates (flexible regime)

Demand (D) Demand (D*) Q of

D=S

FIXED VERSUS FLEXIBLE EXCHANGE RATE REGIMES

Instead, suppose the exchange rate is fixed at $1.40/, and thus the imbalance between supply and demand cannot be eliminated by a price change. The government would have to shift the demand curve from D to D*

In this example this corresponds to contractionary monetary and fiscal policies.

FIXED VERSUS FLEXIBLE EXCHANGE RATE REGIMES

Dollar price per (exchange rate)
Contractionary policies

Supply (S)

(fixed regime)

$1.40

Demand (D) Demand (D*) Q of

D* = S

IMPACT OF CAPITAL FLOWS, LIQUIDITY & SHOCKS

ADVANTAGES OF CAPITAL FLOW

Allow countries with limited savings to attract financing for productive investment
if countries can manage to run stable current account deficits; and, in any case, most financing does not lead to investment.

Foster the diversification of investment risk

Certainly for source countries; for recipient countries, there are increased risks

Contributes to the development of financial markets

This is partly correct, so long as funds are stable

Access to global capital markets is good, but capital account liberalization has unclear benefits.

DISADVANTAGES OF CAPITAL FLOW

Volatility has increased over time and is higher for

EMEs than for AEs

Flows towards EMEs are highly sensitive to monetary policy in AEs, and to risk perception Different types of flows differ in terms of volatility and persistence (though differences have narrowed down) Recent surge is peculiar because of pace rather than level of investment

THE EAST ASIA CRISIS

PRIOR TO THE CRISIS

The Asian Miracle $94.1 billion dollars flowed into East Asia between 1991 and 1997 Growth was fueled by export promotion, industrial policy, lowered trade barriers, and the rapid accumulation of physical and human capital By 1992, income per capita averaged $11,100

THE COLLAPSE OF THE THAI BAHT

July 1996: Bangkok Bank of Commerce fails and the Bank of Thailand expands the money supply to support the financial systems, putting pressure on the baht. May 14, 1997: The stock market declines 7 percent amid political instability June 19, 1997: Finance Minister Virava resigns sending the stock market tumbling 11 percent July 2, 1997: The fixed exchange rate is abandoned and the Thai is floated freely, devaluing 25 percent

EFFECTS OF THE INFLOWS

Effects of the Inflows:

Speculative attacks Deficits in balance of payments Inefficient financial systems Lack of capital controls Exchange Rate regimes External debt

SPECULATIVE ATTACKS

Korea: Widespread corporate bankruptcy caused by heavy borrowing from foreign banks.

Indonesia: Large scale borrowing from off-shore banks made firms debt understated.
Malaysia: The real estate bubble burst leading to bad loans & foreign investors selling of stocks lead to crash of the stock market. Other countries: Contagion effect the crisis spread because of investors worrying that others countries in the region would face similar problems

BALANCE OF PAYMENT DEFICITS

In Indonesia and Thailand, the current account deficit was above 5% of GDP. ASEAN countries and Korea had a combined deficit of $33 billion from 1995-1996 that jumped to $87 billion in 1998-1999. Mostly driven by overvalued currency and over lending to moral hazard borrowers.

INEFFICIENT FINANCIAL SYSTEMS

Financial institutions were not especially concerned with over lending due to explicit and implicit government guarantees Mismatch of the maturities of financial institutions' assets and liabilities Deterioration in the quality of banks' portfolios Lack of ability to assess credit risk

CAPITAL FLOWS

The majority of the East Asian economies engaged in capital market liberalization. Hot money flowed out of the countries quickly when negative speculation of occurred leaving financial institutions liquidity strapped. Portfolio equity investment went from $12.4 billion in 1996 to an outflow of $4.3 billion in 1997 in Korea, Indonesia, Malaysia, Philippines and Thailand. Capital inflows of $73 billion turned into outflows of $30 billion in 1997.

EXCHANGE RATE REGIMES

Pre-Crisis: Hong Kong, Indonesia, Korea, Malaysia, Philippines, Singapore, Taiwan and Thailand pegged their currencies to the US dollar. Depreciation of the local currencies on the foreignexchange market means an increased burden of external debt. Pegged exchange rates forced Asian banks to keep interest rates comparable to US rates and compete with US trade.

EXCHANGE RATE REGIMES

DEBT

Thailand: Foreign lending expanded from $20 billion to $98 billion between 1990 and 1996.
Nearly 86% went to Thai institutions 70% of loans were short term

Corporations borrowed in dollars and loans became two or three times more expensive.

EAST ASIA CRISIS

1997

- 1998 economies hit by banking and exchange rate crises Greatest economic crisis since Great Depression Most literature focuses on:

Japan, Hong Kong, South Korea, Singapore, Taiwan, Indonesia, Malaysia, & Thailand Korea, Thailand, Philippines, & Malaysia

Most affected Indonesia, South

EAST ASIA CRISIS

1996 investors poured $100 billion into East Asian countries & 20 million workers benefited The crisis affected other parts of the world and caused a global financial crisis

Russia & Brazil affected

Economies experienced reductions in poverty, income inequality, & increase in life expectancy

POLICIES
Policies

implemented by domestic governments varied across economies Taiwan and Singapore basically escaped the crisis South Korea recovered fastest Malaysia and China did not accept IMF policies
Prime Minister Mahathir kept interest rates low Recession shorter than other countries

Who

adopted IMF policies?

Thailand, Korea, Philippines & Indonesia

INTERNATIONAL MONETARY FUND

Provided huge amounts of money Bailout packages amounted to $95 billion Bailout

money used to repay loans of Western bankers IMF imposed:

High interest rates, decrease in government spending, increase in taxes, devaluation of currency Political and economic changes Major restructuring Increased transparency Other minor reforms

GDP & UNEMPLOYMENT RATES

GDP Dropped significantly and led to: High rates of unemployment, under utilization

capital, severe economic hardship

of

In

1998 GDP fell by 13.1% in Indonesia, 6.7% in Korea, and 10.8% in Thailand Unemployment Rates

Malaysias unemployment rose to 405,000 Hong Kongs unemployment rose to 152,000 Thailands unemployment rose to 1.1 million Indonesias unemployment rose to 13.7 million

In

South Korea, urban poverty tripled In Indonesia, poverty doubled

DEVALUATION

Thai authorities decided to float the Baht in July 1997 Crisis spread across the region Thailand, Korea, and Indonesia devalued their currency Exchange rate movements had consequences East Asian financial institutions were bankrupt Foreign lenders were uncertain of repayment Insolvency spread across the economies

DETERIORATING FINANCIAL CONDITIONS

Fuelled further withdrawal of capital Firms who borrowed prudently were having trouble obtaining credit Financial sector problems spilled into economic activity In Thailand lenders reduced exposure

Creditors fled region

THANK YOU !!!