Chapter 2 International Financial Mgmt Eun, et.al.
3460.03
notes: A.P. Palasvirta, PhD
 When


CBs execute a monetary policy
discipline of the gold standard is gone
after WWII governments ran inflationary policies



interest rate policies
employment policies
inflation sometimes running at 200% or more
 Exchange

rates fluctuate
creating uncertainty for trade
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

Dollarization
Currency boards


Managed exchange rate





http://users.erols.com/kurrency/
Pegged
Banded peg
Crawling peg
Floating exchange rate
Currency unification
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 Markets
and/or individuals in a country use a
foreign currency without formal government
approval

Individuals wealth denominated in foreign currency



Markets accept or prefer the use of a foreign currency


Notes, bonds, bank deposits in domestic or foreign banks
Protect against domestic inflation
Grey and black markets
Foreigners hold from 55 to 70% of the U.S. Dollars
currently in circulation
 U.S.
Dollar, Euro, and Yen are the primary
currencies held
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
Government adopts a foreign currency as a predominant
or exclusive legal tender


Panama, Ecuador
No currency board, no central bank

Benefits




Loss of sovereignty



Dollar inflation
Low interest rates
No exchange rate risk (transaction, translation, & operating
exposure)
No independent monetary policy
Loses the power of seignorage
http://users.erols.com/kurrency/basicsup.htm
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 Currency
board issues notes & coin convertible into
foreign currency at a fixed exchange rate on
demand

100% to 110% in foreign reserves


General t-bills denominated in the foreign currency
Has no discretionary power
 Inflation and interest rates are approximately in line with the
foreign currency
 Cannot be a lender of last resort
 http://users.erols.com/kurrency/intro.htm
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Liabilities
Assets
 Gold,
silver
 Domestic
coinage
and cash
 Foreign
exchange
 U.S.
dollar assets
(T-bills)
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 Commercial
deposits
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Bank
 Create
money
 Mandate reserve ratios
 Mandate capital ratios
 Control bank rate
 Operate in t-bill market
 Operate in exchange markets
 Bank
of Canada Report
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 Advantages


No exchange rate risk (transaction, operating and
translation exposure is zero)
Maintain artificially low prices for one’s products
 Disadvantages


Lack of monetary policy independence
Imbalances in international financial markets
continue and grow

Eventually sudden large adjustments in exchange rates
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 Pegged

A fixed peg maintained by the central bank
 Banded

peg
Central bank intervenes if the exchange rate
increases or decreases by more than a given
percentage
 Crawling

peg
Central bank fixes to an exchange rate, but
changes the fixed value it defends periodically

China
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 China

CB of China will supply enough Yuan to satisfy
the demand for the Yuan due to Balance of
Payments surplus


(Yuan)
Causes money supply to increase (inflationary
pressure)
CB of China is moving to a managed float

Will allow the Yuan to appreciate but is not
announcing how or when it is allowing the Yuan to
appreciate
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 Brazilian
Stock market take a hit
 Government borrowing in dollars


have to pay back in higher valued currency
often leading to re-negotiation of terms
 operating



exposure
(change in real exchange rate)
on exporters
on importers
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
Inflation targets

Bank tries to increase supply of money just enough
to accommodate demand



Assume demand increases by 5% per year
If bank is targeting 2 – 3 % inflation rate, supply will be
increased by about 8%
Interest rate targets
Low interest rates tend to increase capital
investment
 Keep growth in the economy positive


Exchange rate targets

Fixing exchange rates reduces transaction risk and
keeps international prices in one’s favor
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 Floating

Does not try to affect trend



exchange rate regime
To affect trend it would have to either buy or sell
foreign exchange in large quantities
Bank’s policy is directed at an inflation target
 2 – 3% inflation per year
Will jump into the market to affect volatility

Over the year this means that the net sales and
purchase of foreign exchange is approximately zero
 http://www.bankofcanada.ca/en/annual/20
07/ar2007.html
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 Control


Open market operations
Bank rate
 Manage

banking system
Reduce liquidity risk



money
Reserve ratios
Deposit insurance
Reduce default risk


Capital ratios
Lender of last resort
 Bank
of Canada balance sheet
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 Central
banks order coin and currency which
is stored in the vault
 Money is created when the central bank buys
something with that coin and currency


Gold and silver
Foreign exchange




Foreign denominated cash and currency
Foreign denominated t-bills
Domestically denominated t-bills
Keeps purchases sufficiently high to meet
inflation targets
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 Central
bank has large influence in two
markets


Domestic t-bill market (largest single entity)
Exchange market (largest single entity in
domestic currency in exchange markets)
 As
a large entity it, unlike other operators in
the market, can affect price
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 Bank

rate
Interest rate charged member banks for
borrowing to increase reserves


Increase the bank rate decreases system reserves
thereby leading to a decrease in the money supply
Decrease the bank rate increases system reserves
thereby leading to an increase in the money supply
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 Commercial
banks required to maintain
liquid reserves to meet demand of deposit
holders demanding redemption
 Inverse of reserve ratio is called the money
multiplier

How much bank money, base money will support
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Reserves
Cash
Currency
Deposits with CB
cd t-bills
Checking Accounts
Loan Portfolio
Lines of Credit
Car loans
Business Loans
Home and Business
Mortgages
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Savings Accounts
GICs
Bank Capital
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 Reserve
Ratio = 10%
 Money multiplier = 10
Reserves = $1 billion
Checking deposits
Savings Deposits
Loan Portfolio = $9 billion
$9.6 billion
GICs
Bank capital = 400 million
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 Reserve
Ratio = 20%,
 Money multiplier = 5
Checking deposits
Reserves = $1 billion
Savings Deposits
$4.8 billion
GICs
Loan Portfolio = $4 billion
Bank capital = 200 million
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 Leverage


Measured by the debt/equity ratio or debt ratio
Measure of risk


Manufacturing firms usually D/E = 1 or D/TA = 0.5
Banks D/E = .96/.04 = 24 or D/TA = 0.96
 The liabilities (deposits) in a bank are guaranteed
(insured) by the government
 Banks can lever quite a bit because of this
 CIBC
balance sheet
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 Advantages

Purchasing power parity allowed to hold


Trend line reflects relative inflation
International prices adjust automatically

Prices more transparent
 Allows
an independent monetary policy
 Disadvantages
Exchange rate volatility increases
 Higher costs due to need to hedge volatility

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Liabilities
Assets
Cash, currency
Gold, foreign
exchange
Commercial bank
reserves held at
BOC
T-bills 70 – 80%
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 Independent
European Central Bank
 convergence criteria

nominal inflation < 1.5% above


long-term interest < 2.0 % above



avg of 3 with lowest in previous year
avg of 3 with lowest in previous year
fiscal deficit no more than 3 % of GDP
debt no more than 60% of GDP
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 Advantages


One monetary policy
No exchange rate risk


Costs of trade much lower
Financial market integration (money & capital)
 Disadvantages


Loss of sovereignty on monetary/fiscal policy
Loss of national currency
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 Belgium
(franc)
 Germany
(deutschemark)
 Spain (peseta)
 France (franc)
 Ireland (punt)
 Luxembourg (franc)
 Italy (lira)
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 Netherlands
(guilder)
 Austrian (shilling)
 Portugal (escudo)
 Finland (markka)
 Vatican City (lira)
 Greece (drachma)
 Slovenia (tolar)
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 Bulgaria
(Lev)
 Czech Republic
(Koruna)
 Denmark (krone)
 Estonia (Kroon)
 Hungary (Forint)
 Latvia (Lats)
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 Lithuania
(Litas)
 Poland (Zloty)
 Romania (Leu)
 Slovakia (Koruna)
 Sweden (krona)
 United Kingdom
(pound)
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 Price


Price of one currency in terms of another
Delivery no later than four business days
 Price

for current delivery
market determined
fluctuates to reflect new information
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 Current
demand for CD by holders of foreign
currency

foreigners want to buy something Canadian
 Current
supply from Canadians holding CD
demanding foreign exchange

Canadians want to buy something foreign
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
e0 , Can terms = CD/USD = 1.0004


CD cost of the USD
e0 , us

terms
= USD/CD = 0.9996
USD cost of the CD
 exchange
rates
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 Croatia
 Macedonia
 Turkey
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 Deposits
held in other than the domestic
currency

A usd account at a Chartered Bank is a
eurocurrency deposit


Off-balance-sheet account
Chartered bank would hold a liability to the depositor
which is matched equally by an asset which is a
deposit to an U.S. bank for the same amount
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 Eurocurrency


interest rates
PIBOR (Paris), MIBOR (Madrid), SIBOR (Singapore)
Off-balance-sheet lending in currencies other
than home currency


Wholesale market
 Between multinationals
 Large banks
 Central banks
Narrow spread
 Low risk
 Large amounts ($500,000) or more
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