Chapter 15 Exchange-Rate Systems and currency crises

Exchange-Rate Systems and Currency Crises

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Eastern Illinois University

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Exchange-Rate Practices

• Floating exchange-rate system

• Determined by market forces

• Float independently

• Float in unison with a group of other currencies

• Crawl according to a predetermined formula


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• Pegged exchange-rate system

• Fixed against some standard of value

• Anchor to a single currency

• Anchor to a basket of currencies

• Anchor to gold – not used since 1971


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• Members of the IMF

• Exchange rates should not be manipulated

• To prevent effective balance-of-payments adjustments

• To gain unfair competitive advantage over other members

• Members should act to counter short-term disorderly conditions in exchange markets

• When members intervene in exchange markets

• Take into account the interests of other members


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TABLE 15.1

Exchange-rate arrangements of IMF members, 2008


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TABLE 15.2

Choosing an exchange-rate system


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Choosing an Exchange Rate System:

Constraints Imposed by Free Capital Flows

• Allowing free capital flows

• Constrains a country’s

• Choice of an exchange-rate system

• Ability to operate an independent monetary policy

• Impossible trinity

• A country can maintain only two of the following three policies:

• Free capital flows

• A fixed exchange rate

• An independent monetary policy


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FIGURE 15.1

Countries can adopt only two of the following three policies: free capital flows, a fixed exchange rate, and an independent monetary policy.


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Fixed Exchange-Rate System

• Fixed exchange rates

• Used primarily by small, developing nations

• Currencies are anchored to a key currency

• Key currency

• Widely traded on world money markets

• Demonstrated relatively stable values over time

• Widely accepted as a means of international settlement


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TABLE 15.3

Key currencies: currency composition of official foreign exchange reserves of the member countries of the international monetary fund, 2008


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• Anchoring to a single currency

• Developing nations whose trade and financial relations are mainly with a single industrialcountry partner

• Anchoring to the special drawing right (SDR)

• A basket of four currencies established by the

IMF


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• Anchoring to a basket of currencies

• Developing nations with more than one major trading partner

• Currency basket

• Prescribed quantities of foreign currencies

• In proportion to the amount of trade done


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• Par value

• In terms of gold or other key currencies

• Official exchange rate

• Can be determined by comparing the par values of two currencies

• Exchange-stabilization fund

• To defend the official rate

• Through purchases and sales of foreign currencies


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FIGURE 15.2

Exchange-rate stabilization under a fixed exchange-rate system

To defend the official exchange rate of $2.80 per pound, the central bank must supply all of the nation’s currency that is demanded at the official rate and demand all of the nation’s currency that is supplied to it at the official rate. To prevent a dollar depreciation, the central bank must purchase the excess supply of dollars with an equivalent amount of pounds. To prevent a dollar appreciation, the central bank must purchase the excess supply of pounds with an equivalent amount of dollars.


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• Fundamental disequilibrium

• Long term, the official exchange rate and the market exchange rate may move apart

• Reflecting changes in fundamental economic conditions

• Income levels, tastes and preferences

• Technological factors

• Cost of defending the existing official rate may become prohibitive


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• Balance-of-payments equilibrium

• By devaluing or revaluing its currency

• Currency devaluation

• To cause the home currency’s exchange value to depreciate

• Counteracting a payments deficit

• Currency revaluation

• To cause the home currency’s exchange value to appreciate

• Counteracting a payments surplus


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• Devaluation and revaluation

• Legal redefinition of a currency’s par value under a system of fixed exchange rates

• Depreciation and appreciation

• Actual impact on the market exchange rate caused by

• A redefinition of a par value

• Changes in an exchange rate

• Changes in the supply of or demand for foreign exchange


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TABLE 15.4

Advantages and disadvantages of fixed exchange rates and floating exchange rates

Fixed exchange rates

Advantages

Simplicity and clarity of exchangerate target

Automatic rule for the conduct of monetary policy

Keeps inflation under control

Disadvantages

Loss of independent monetary policy

Vulnerable to speculative attacks

Floating exchange rates

Continuous adjustment in the balance of payments

Operate under simplified institutional arrangements

Allow governments to set independent monetary and fiscal policies

Conducive to price inflation

Disorderly exchange markets can disrupt trade and investment patterns

Encourage reckless financial policies on the part of government


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• Bretton Woods system, 1946-1973

• Semi-fixed exchange-rate system

• Adjustable pegged exchange rates

• Currencies were tied to each other

• Provide stable exchange rates for commercial and financial transactions

• A nation could repeg its exchange rate via devaluation or revaluation policies

• Use fiscal and monetary policies first to correct payments imbalances


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• Bretton Woods system, 1946-1973

• Agree to defend existing par values

• Correct fundamental disequilibrium by repegging their currencies

• Up to 10% without permission from the IMF

• By greater than 10% with the fund’s permission

• Par value set in terms of gold

• Or gold content of the U.S. dollar in 1944

• Market exchange rates were almost but not completely fixed


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• Operational problems of the Bretton Woods system

• Adjustments in prices and incomes often conflicted with domestic-stabilization objectives

• Currency devaluation was considered undesirable

• Failure of domestic policies

• Loss of international prestige


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• Operational problems of the Bretton Woods system

• Currency revaluations were unacceptable to exporters

• Repegging exchange rates only as a last resort

• Sizable adjustments

• Difficult because of adjustable pegged rates

• Speculators


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TRADE

CONFLICTS

Is China a currency manipulator?

• China - manipulates the Yuan

• Yuan - significantly undervalued relative to the dollar

• U.S. exports to China more expensive

• Harms U.S. production and employment

• Chinese goods cheaper for American consumers – more imports

• Huge trade surplus with the United States

• Large accumulation of dollar reserves


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TRADE

CONFLICTS


• Little or no connection between the Yuan and the health of U.S. manufacturing

• Transition away from manufacturing in the U.S. is a long-term trend

• Goes far beyond competition from Chinese exports

• Jobs have been slashed: technological improvements

• Each worker more productive

• U.S. – more competitive workers

• Reform its educational system


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TRADE

CONFLICTS


• Good economic rationale for China’s peg policy

• Effective monetary anchor for China’s internal price level

• Positive results for the U.S. economy

• Large investments in U.S. debt - keep U.S. interest rates low

• Increase the size of the economy

• Promotes a lower inflation rate in the United

States

• Foster economic stability


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Floating Exchange Rates

• Floating (flexible) exchange rates

• Currency prices established daily in the foreignexchange market

• Without restrictions imposed by government policy

• Equilibrium exchange rate

• Demand for and supply of the home currency

• Changes in the exchange rate

• Correct a payments imbalance

• Shifts in imports and exports of goods, services, and short-term capital movements


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FIGURE 15.3

Market adjustment under floating exchange rates

Under a floating exchange-rate system, continuous changes in currency values restore payments equilibrium at which the quantity supplied and quantity demanded of a currency are equal. Starting at equilibrium point

A, an increase in the demand for francs leads to a depreciation of the dollar against the franc; conversely, a decrease in the demand for francs leads to an appreciation of the dollar against the franc.


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• Economic downturns

• Labor unions lobby for import restrictions

• To save jobs for domestic workers

• Implementation of import restrictions

• Help one industry

• Shift jobs from other industries in the economy to the protected industry

• No significant impact on aggregate employment

• Short-term employment gains in the protected industry

• Offset by long-term employment losses in other industries


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• Arguments for floating exchange rates

• Simplicity

• Respond quickly to changing supply and demand conditions

• Clear the market of shortages or surpluses of a given currency

• Simplified institutional arrangements that are relatively easy to enact


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• Arguments for floating exchange rates

• Continuous adjustment in the balance of payments

• Partially insulate the home economy from external forces

• Nations have greater freedom to pursue policies that promote domestic balance


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• Arguments against floating exchange rates

• An unregulated market may lead to wide fluctuations in currency values

• Discourage foreign trade and investment

• Inflationary bias

• Monetary authorities may lack financial discipline

• Greater freedom for domestic financial management


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Managed Floating Rates

• Managed floating system

• Informal guidelines established by IMF for coordination of national exchange-rate policies

• Nations might intervene in the exchange markets to avoid exchange-rate alterations that would weaken their competitive position

• Concern that floats over time might lead to disorderly markets with erratic fluctuations in exchange rates

• A nation can alter the degree to which it intervenes in the foreign-exchange market


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• Leaning against the wind

• Intervene to reduce short-term fluctuations in exchange rates

• Without attempting to adhere to any particular rate over the long term

• Target exchange rates

• To reflect long-term economic forces that underlie exchange-rate movements


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• Managed floating rates

• Market intervention - used to stabilize exchange rates in the short term

• Allows market forces to determine exchange rates in the long term


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FIGURE 15.4

Managed floating exchange rates

Under this system, central bank intervention is used to stabilize exchange rates in the short term; in the long term, market forces are permitted to determine exchange rates.


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• Monetary policy

• To stabilize a currency’s exchange value

• Expansionary monetary policy

• Increase the money supply

• To offset currency appreciation

• Contractionary monetary policy

• Decrease the money supply

• To offset currency depreciation


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FIGURE 15.5

Exchange-rate stabilization and monetary policy

In the absence of international policy coordination, stabilizing a currency’s exchange value requires a central bank to initiate (a) an expansionary monetary policy to offset an appreciation of its currency, and (b) a contractionary monetary policy to offset a depreciation of its currency.


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• Official foreign-exchange intervention

• May be useful when the exchange rate is under speculative attack

• May be helpful in coordinating private-sector expectations

• Some support for the short-term effectiveness

• No support for the long-term intervention


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The Crawling Peg

• The crawling-peg system

• Small, frequent changes in the par value of its currency

• To correct balance-of-payments disequilibrium

• The process of exchange-rate adjustment

• Continuous for all practical purposes

• Used by nations with high inflation rates

• Combines the flexibility of floating rates with the stability usually associated with fixed rates


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Currency Crises

• Currency crisis, speculative attack

• A weak currency experiences heavy selling pressure

• Sizable losses in the foreign reserves held by a country’s central bank

• Depreciating exchange rates in the forward market

• Widespread flight out of domestic currency

• Into foreign currency

• Into goods that people think will retain value

• Can decrease GDP growth by 6%


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TABLE 15.5

Examples of currency crises

Mexico, December 1994–1995. Mexico’s central bank maintained the value of the peso within a band that depreciated four percent a year against the U.S. dollar. In order to reduce interest rates on its debt, the Mexican government in April 1994 began issuing debt linked to the dollar. The amount of this debt soon exceeded the central bank’s falling foreign-exchange reserves. Unrest in the province of Chiapas led to a speculative attack on the peso. Although the government devalued the peso by 15 percent by widening the band, the crisis continued. The government then let the peso float; it depreciated from

3.46 per dollar before the crisis to more than 7 per dollar. To end the crisis, Mexico received pledges for $49 billion in loans from the U.S. government and the IMF. Mexico’s economy suffered a depression and banking problem that led to government rescues.

Russia, 1998. The Russian government was paying high interest rates on its short-term debt. Falling prices for oil, a major export, and a weak economy also contributed to speculative attacks against the ruble, which had an official crawling band with the U.S. dollar. Although the IMF approved loans for Russia of about $11 billion and the Russian government widened the band for the ruble by 35 percent, the crisis continued. This crisis led to the floating of the ruble and its depreciation against the dollar by about 20 percent.

Russia then went into recession and experienced a burst of inflation. Many banks became insolvent. The government defaulted on its ruble-denominated debt and imposed a moratorium on private-sector payments of foreign debt.


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TABLE 15.5

Examples of currency crises

Turkey, 2001. The Turkish lira had an IMF-designed official crawling peg against the U.S. dollar. In November 2000, rumors about a criminal investigation into ten government-run banks led to a speculative attack on the lira. Interbank interest rates rose to 2,000 percent.

The central bank then intervened. Eight banks became insolvent and were taken over by the government. The central bank’s intervention had violated Turkey’s agreement with the

IMF, yet the IMF lent Turkey $10 billion. In February 2001, a public dispute between the president and prime minister caused investors to lose confidence in the stability of Turkey’s coalition government. Interbank interest rates rose to 7,500 percent. Thus, the government let the lira float. The lira depreciated from 668,000 per dollar before the crisis to 1.6 million per dollar by October 2001. The economy of Turkey stagnated and inflation skyrocketed to

60 percent.


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Currency Crises

• End a currency crisis - end the selling pressure

• Devalue - establish a new exchange rate at a sufficiently depreciated level

• Adopt a floating exchange rate

• Impose restrictions on the ability of people to buy and sell foreign currency

• Obtain a loan to bolster the foreign reserves of the monetary authority

• Restore confidence in existing exchange rate


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Currency Crises

• Sources of currency crises

• Currency speculators

• Budget deficits financed by inflation

• Weak financial systems

• Recently deregulated financial systems

• A weak economy

• Political factors

• External factors

• Choice of an exchange-rate system


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Capital Controls

• Capital controls, exchange controls

• Government-imposed barriers

• To foreign savers investing in domestic assets

• To domestic savers investing in foreign assets


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Capital Controls

• Capital controls, exchange controls

• Advantages

• Government can influence its payments position

• Regulating the amount of foreign exchange allocated to imports or capital outflows

• Government - encourage or discourage certain transactions

• Different rates for foreign currency for different purposes

• Can give domestic monetary and fiscal policies greater freedom in their stabilization roles


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Capital Controls

• Controls on capital outflows – problems:

• Capital outflows may further increase after the controls are implemented

• Result in evasion

• Provide government officials the false sense of security that they do not have to reform their financial systems to ameliorate the crisis


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Capital Controls

• Controls on capital inflows

• Support

• If speculative capital cannot enter a country, then it cannot suddenly leave and create a crisis

• Problems

• Can prevent funds that would be used to finance productive investment opportunities from entering

• Are seldom effective because the private sector finds ways to evade them and move funds into the country


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Capital Controls

• Taxing foreign-exchange transactions

• A tax would increase the cost of these transactions

• Discourage massive responses to minor changes

• Dampen volatility in exchange rates

• Drawbacks:

• We do not know how much volatility is excessive or irrational

• A tax could impose a burden on countries that are quite rationally borrowing overseas

• Would be difficult to implement


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Increasing the Credibility of Fixed Exchange

Rates

• Currency board

• Monetary authority that issues notes and coins convertible into a foreign anchor currency at a fixed exchange rate

• Can operate in place of a central bank or as a parallel issuer alongside an existing central bank

• Takes over the role of a central bank in strengthening the currency of a developing country


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Rates

• Currency board

• Has no discretionary powers

• Sole function: to exchange its notes and coins for the anchor at a fixed rate

• The government can finance its spending only by taxing or borrowing

• Not by printing money and thereby creating inflation


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Rates

• Currency board

• Monetary policy on autopilot

• When the anchor currency flows in

• The board issues more domestic currency

• Interest rates fall

• When the anchor currency flows out

• Interest rates rise


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Rates

• Major benefits of the currency-board system:

• Making a nation’s currency and exchange-rate regimes more rule-bound and predictable

• Placing an upper bound on the nation’s base money supply

• Arresting any tendencies in an economy toward inflation

• Forcing the government to restrict its borrowing to what foreign and domestic lenders are willing to lend it at market interest rates


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Rates

• Major benefits of the currency-board system:

• Engendering confidence in the soundness of the nation’s money

• Assuring citizens and foreign investors that the domestic currency can always be exchanged for some other strong currency

• Creating confidence and promoting trade, investment, and economic growth


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Rates

• Objections to the currency-board system:

• Prevents a country from pursuing a discretionary monetary policy

• Reduces its economic independence

• Susceptible to financial panics

• It lacks a lender of last resort

• Creates a colonial relation with the anchor currency


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Rates

• Dollarization

• When residents of a foreign country use the

U.S. dollar alongside or instead of the domestic currency

• Full dollarization

• Elimination of the domestic currency and its complete replacement with the U.S. dollar

• U.S. Virgin Islands, Marshall Islands, Puerto

Rico, Guam, Ecuador, other Latin American countries


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Rates

• Benefits of dollarization

• Credibility and policy discipline

• Avoid the capital outflows that often precede or accompany an embattled currency situation

• Decrease in transaction costs

• Lower rate of inflation

• Tied to inflation rate of the issuing country

• Greater openness

• Balance-of-payments crises are minimized


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Rates

• Effects of dollarization for the foreign country

• Monetary policy of the Federal Reserve

• Federal Reserve

• Not a lender of last resort for the foreign nation

• The country

• No seigniorage from its monetary system

• State expenditures are not affected

• Can establish its own trade policies

• Constraint on fiscal policy:

• Cannot print more domestic currency to finance budget deficits


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Rates

• Effects of dollarization for the U.S.

• For each dollar sent abroad, Americans enjoy a one-time increase in the amount of goods and services they are able to consume

• The U.S. gets an interest-free loan from the foreign country


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Rates

• Effects of dollarization for the U.S.

• Might hinder the formulation and execution of monetary policy by the Federal Reserve

• Could result in more pressure on the Federal

Reserve to conduct policy according to the interests of the foreign country


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TRADE

CONFLICTS

The global economic crisis of

2007–2009

• General factors causing economic crises

• An overshooting of markets

• Excessive leveraging of debt

• Credit booms

• Miscalculations of risk

• Rapid outflows of capital from a country

• Unsustainable macroeconomic policies


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TRADE

CONFLICTS


2007–2009

• Global economic crisis of 2007–2009

• Bursting of the U.S. housing market bubble

• Increase in foreclosures

• Global financial and economic crisis

• The U.S. - major center of the financial world

• Main guarantor - international financial system

• Provider of dollars: currency reserves, international medium of exchange

• Financial capital - moves around the world


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TRADE

CONFLICTS


2007–2009

• Spreading of the financial crisis

• Industrial countries

• Emerging market

• Developing economies

• Economies deteriorated

• Investors pulled capital from countries

• Plunging values of stocks, domestic currencies

• Slumping exports and commodity prices

• Recession or slow economic growth


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TRADE

CONFLICTS


2007–2009

• Global crisis played out at two levels

• Among the industrialized nations of the world

• Losses from subprime mortgage debt, excessive leveraging of investments, and inadequate capital backing financial institutions

• Among emerging market and other economies

• Innocent bystanders to the crisis - weak economies


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TRADE

CONFLICTS


2007–2009

• Cope with the global financial crisis

• Control the contagion

• Minimize losses to society

• Restore confidence in financial institutions and instruments

• Lubricate the wheels of the economy


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TRADE

CONFLICTS


2007–2009

• Measures

• Injecting capital

• Loans or stock purchases

• Prevent bankruptcy of financial institutions

• Increasing deposit insurance limits

• To limit withdrawals from banks

• Purchasing toxic debt of financial institutions on the verge of failure

• So that they would start lending again


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TRADE

CONFLICTS


2007–2009

• Measures

• Coordinating interest-rate reductions by central banks

• To inject liquidity into the economy

• Enacting stimulative fiscal policies

• To bolster sagging aggregate demand


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Chapter 15 Exchange-Rate Systems and currency crises

Exchange-Rate Systems and Currency Crises

Choosing an Exchange Rate System:

Constraints Imposed by Free Capital Flows

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Chapter 15 Exchange-Rate Systems and currency crises

Exchange-Rate Systems and Currency Crises

Choosing an Exchange Rate System:

Constraints Imposed by Free Capital Flows

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