Chapter 8
The International Financial
System
1
(Unsterilized) Foreign Exchange
Intervention and Money Supply
Central Bank
Assets
International
Reserves ($)
Liabilities
+TL1B Reserves
+TL1B
(or Currency in
Circulation)
 To control the ExchRate, CBs might want to intervene in
the forex mkt:
 When Central Bank of TR purchases dollar (foreign
currency) and sells TL (domestic currency), its dollar
(international) reserves increase, the monetary base and
the money supply (TL) increases.
 When CBT sells dollars and purchases TL (dom.
currency), its dollar (international) reserves decrease,
the monetary base and money supply decreases.
2
Unsterilized Intervention
 When CB purchases or sells foreign currency from
and to the banking system, we call these
operations “unsterilized interventions”. Why does
the CB intervene?
 An unsterilized purchase (sale) of foreign
currency ($) leads to
 a gain (loss) in international ($) reserves,
 an increase (decrease) in the money supply,
and
 a depreciation (appreciation) of TL (domestic
currency) against dollar (foreign curr.)
3
Effect of an Unsterilized Purchase
of Foreign Currency
S
$/TL
exch. 0.83
Rate
0.76
D
0.62
D’
D’’
Qty of TL
assets
4
Sterilized
Foreign Exchange Intervention
Central Bank
Assets
International Reserves
Liabilities
+TL1m Monetary Base
no
change
(reserves+currency i.c.)
Government Bonds
-TL1m
 Since unsterilized interventions raise Mspply and might
cause inflation, CBs usually sterilize forex interventions.
Sterilization: By doing an offsetting open market
operation, CB neutralizes the effect of the forex
intervention on the money supply.
 Example: If CB buys dollars and increases the TL
reserves, immediately CB also sells govt. bonds at the
same amount. This leaves the monetary base and the
money supply unchanged.
5
Sterilized
Foreign Exchange Intervention
A sterilized purchase (sale) of foreign
currency leads to
 a gain (loss) in international reserves,
 No change in the money supply,
6
Balance of Payments (BOP)
Balance of Payments = Current Account +
Capital Account
(Net Capital Inflows)
 Balance of payments shows the net
change in the foreign exchange
(dollar) reserves of an economy during
a certain time period.
7
Balance of Payments
1. Current Account :Inflows (+) Outflows (-)
1. Trade Balance = +Exports – İmports
2. Services Balance
1.
2.
3.
4.
+Net Foreign Tourism Revenues
+Banking & Insurance Net Revenue
+Construction & Transportation Net Revenue
+Workers’ Remittances + Paid Military Service
3. Net Income from Foreign Capital
(interest+profit transfers)
4. Unilateral transfers (Aid to or from other
countries)
8
Balance of Payments
“Current Account (CA) Deficit” means that
CA balance is a negative number. This is
usually because the largest item “Trade
Balance” is negative. For example,
Turkey’s 2008 (2007) January-March
exports are $33 ($24.4) bn, imports are
$49 ($33) bn, trade balance is -$16 ($8.6) bn.
9
Balance of Payments
2. Capital Account = Net Capital İnflows
=capital inflows – capital outflows
1. +Purchases of Domestic (Turkish) assets by
Foreigners (ind., firms, govts)
2. – Purchases of Foreign Assets by Domestic
(Turkish) Residents
3. Credits: + Net Borrowing of Turkish Residents
from Foreign residents (+borrowing, -lending)
10
Balance of Payments
 Capital Inflows: Two types:
1.Foreign Direct Investments (FDI): Takes
control of the firm, bank, etc. Ex: Migros sale
to British, Finansbank sale to NBG, ToyotaSA,
are FDI inflows. Ülker purchase of Godiva is
FDI outflow.
2.Foreign Portfolio Investment (FPI) (stocks,
bonds, credits). Foreign investors buying
stocks at BIST, Turkish banks & firms
borrowing from foreign banks are FPI inflows.
Turkish banks lending to Azeri firms is FPI
outflow.
11
Balance of Payments
Difference btw FDI and FPI: In FDI, the
investor has a share in the investment
enough to control the decisions of the
company (maybe10%). In FPI, investor is
only creditor, takes less risk (only default
and int rate risk). Has small shares in
various companies.
12
Balance of Payments
Except for year 2001, TR’s current account
has been negative. However, TR’s capital
account surplus is positive and usually
greater than its current account deficit.
This means that there was a net dollar
inflow into TR. This is why dollar has
depreciated against TL during 2002-2007
Current Account/GNP(%)
2000
2001
2002
2003
2004
2005
2006
2007
-4.90
2.37
-0.99
-2.86
-5.17
-6.39
-6.62
-5.7
13
Exchange Rate Regimes
Fixed exchange rate regime
 Value of a currency is fixed (pegged) to the
value of one other currency (usually dollar or
euro). CB intervenes daily by buying and
selling dollars to keep ER fixed.
 Turkey followed fixed ER regime before
2001. ER was kept within a band. Will
explain below...
14
Exchange Rate Regimes
Floating exchange rate regime
 Value of a currency is allowed to freely
fluctuate against all other currencies: no
interventions in the forex market.
Managed float regime (dirty float)
 Officially free floating, but from time to time,
CB intervenes by buying and selling
currencies. Because sometimes the E.Rates
becomes very volatile, during turbulances.
Turkey has followed managed float after 2001.
A turbulance in 2006, others. Turkey currently
follows “inflation targeting”, but still want to
control ERs: “impossible trinity”
15
How a Fixed Exchange Rate
Regime Works
 Suppose that the official fixed parity is 1,31
TL/USD. Suppose that for some reason demand
for TL assets increases. This increases value of TL
in the free forex market above the official parity:
1,20 TL/USD.
 In this case, CB buys dollars and sells TL and
increases the money (TL) supply. This decreases
the interest paid by TL assets, which reduces
demand for TL assets. CB can buy dollars until
the free market ER is equal to the fixed 1,31
TL/USD. CB’s international (forex) reserves
increase.
16
How a Fixed Exchange Rate
Regime Works
1/E
($/TL)
S
1/1,20
1/1,31
1/1,60
D
D’
Qty of TL
assets
17
How a Fixed Exchange Rate
Regime Works
 Now let us suppose that for some reason demand
for TL assets decrease (maybe because FED
increases policy rates). TL loses value in the free
forex market below the fixed parity.
 In this case CB buys TL and sells dollars. This
reduces money(TL) supply and increases the
interest rate on TL assets, which increases
demand for TL assets, which increases the value
of TL back to 1,31 TL/$.
 But notice that CB’s dollar reserves decline in this
process. If CB does not have enough reserves to
defend the peg, then it must either float or
devalue TL to a lower level like 1,6 TL/$.
18
How a Fixed Exchange Rate
Regime Works
1/E
($/TL)
S
1/1,20
1/1,31
1/1,60
D’
D
Qty of TL
assets
19
Gold Standard
Gold standard: 19th century and until
World War I
 Fixed exchange rates system: all currencies are
pegged to (backed by) a certain amount of gold.
 No control over monetary policy
 Money supply influenced heavily by production of
gold, gold discoveries and imports. When gold
production rate (or imports) is smaller than
(higher than) GDP growth rate, money supply
increases slowly (fast), deflation (inflation)
happens. (qty theory, MV=PY)
20
Bretton Woods System
 Bretton Woods System: 1944-1971
 Fixed exchange rates system using U.S. dollar as
the reserve currency: $ 35 convertible per 1 ounce of
gold (only for governments and CBs, not public).
 Institutions that support the system:
 International Monetary Fund (IMF)
 World Bank
 General Agreement on Tariffs and Trade (GATT)
 Became World Trade Organization
21
How Bretton Woods (1944-71)
Worked
 Exchange rates adjusted (devaluation or revaluation)
only when countries experience a ‘fundamental
disequilibrium’ (large and persistent deficits (or
surpluses) in their balance of payments)
 Loans from IMF to the deficit countries to cover loss in
their international reserves
 IMF encourages contractionary monetary and fiscal
policies
 Devaluation happens only if IMF loans are not sufficient
 IMF cannot force surplus countries (Ger) to
revalue.
 U.S. could not devalue the dollar during 1960s (Vietnam
war). The surplus countries did not want to revalue.
22
System collapsed in 1971 (Nixon).
Managed Float (1971-now)
 Bretton-Woods collapsed: US and many others
(developed) allowed exchange rates to float.
 Hybrid of fixed and flexible
 Allow Small daily changes in response to market
 Interventions to prevent large fluctuations
 Appreciation of domestic currency reduces
exports, growth and employment. Increases
current account deficit and risk of a BOP crisis.
 Depreciation of domestic currency reduces
imports and stimulates inflation. Inflation
increases uncertainty and reduces long-run
growth rate.
23
European Monetary System
 European Monetary System: 1979-1990
 Exchange rate mechanism (ERM) is a fixed ER
regime within Europe. Before the euro in 1999,
as a preparation for euro.
 Euro’s challenge to the dollar as the reserve
currency in international financial transactions:
 Not likely because Europe is not a united
political entity. Especially considering the
“sovereign debt crisis” in Greece, Spain, Italy,
Portugal and France (?) casts shadow on the
future of euro. There is no “exit clause” for
euro: http://euobserver.com/political/118925
http://www.reuters.com/article/2012/07/23/us-eurozone-exitidUSBRE86M04J20120723
24
European Monetary System
 1979: 8 members of European Economic
Community fixed exchange rates with one
another and floated against the U.S. dollar
 ECU value was tied to a basket of specific
amounts of European currencies: “Exchange
Rate Mechanism (ERM)”. ECU value fluctuated
within limits. If it goes beyond limits, Central
Banks intervene in the market by buying the
weak currency and selling the strong currency.
25
Currency or BOP Crises
 Fixed ER policies may lead to currency crises
involving speculative attacks: massive sales of
the weak domestic currency and purchases of the
strong currency (dollar or euro), “capital flight”.
 Profitable for speculators if they can cause a
sharp devaluation of the weak currency.
 Turkey: 1994, 2001. Europe: 1992, Brazil 1998,
East Asia 1997-98, Mexico 1994, Russia 98.
26
What Happens Before a Currency
Crisis? MICRO risks
 Before the crisis: Banks and financial
institutions take excessive risks of three types:
 Exchange Rate risk: Dollar (forex) liabilities (debt) are
much larger than dollar (forex) assets.
 Maturity Mismatch (Liquidity) Risk: Avg. Maturity of
Liabilities are much shorter than avg. maturity of assets.
Banks always transform liquid liabilities into illiquid
assets, but there is a healthy limit to this.
 Excessive Leverage: banks finance assets by either
equity (own funds) or debt. If Leverage=Assets/ Equity
is very high, too much debt=too little equity causes risk
of bankruptcy. “capital adequacy ratio”
 Moral Hazard: if the Central Bank follows Fixed ER policy,
transfers the ER risk to the govt. Encourages banks take
more ER risk by borrowing in dollar, lending in TL.
27
What Happens Before a Currency
(or BOP) Crisis? MACRO risks
 Fiscal Deficits: Government has high Budget
Deficits and relatively short-term Foreign Debt:
Mexico 1994, Brazil 1999, Argentina 2002,
Turkey 2001. Not in Asian 1997 crisis.
 High current account deficits (CAD)/GDP. If
CAD cannot be financed by capital inflows, then
BOP is negative.
 If Both deficits are present, called “twin deficits”
very risky situation.
28
What Happens During a Currency (or
BOP) Crisis?
 During the Crisis: Speculators force the CB to
“float” or “devalue” by quickly selling TL assets
and buying dollar assets: speculative attack.
Their objective is to make profit from a potential
devaluation.
 CB sells dollars and buys domestic currency to
defend the domestic currency (raise int rates).
But when the CB runs out of dollars, then the CB
cannot defend the value of TL anymore. So it is
forced to float the TL(domestic currency) and
allow it to depreciate: Devaluation.
29
What Happens During a Currency (or
BOP) Crisis?
 Self-fulfilling Prophecies: When creditors panic
and start to believe that the domestic country is
unable to repay its debts and the domestic
currency will be devalued, they stop lending to
the country: “sudden stop”. Independent from
initial fundamentals, this belief makes itself real.
 Contagion: Currency or financial crisis in one
country spreads to other countries that are
similar:
 in 1997 from Thailand to Malaysia, Indonesia, South
Korea, Philippines.
 İn 1998 Russia to Brazil and 1999 and 2001 in Turkey,
then 2002 in Argentina
30
European ER Crisis of September
1992
 German unification (1990) and inflationary
pressures led Bundesbank to increase interest
rates.
 This led Demand for British pound to fall and
pound depreciated below the official ERM parity
2.778 DM/pound. To correct this, either British
had to increase rates or Germans had to
decrease rates. Neither wanted to do the
necessary action b/c Britain was in recession.
 Speculators knew pound devaluation is coming
and sold massive amounts of pound assets and
bought DM assets: speculative attack on
pound. Demand for pound fell even further.
31
32
European ER Crisis of September
1992
 Sept. 16: British floated the pound: 10%
devaluation against the DM. They also quit the
ERM and did not join the euro.
 George Soros made $1 bn, Citibank made $200
mln.
 Similar story in Turkey 1994, 2001, Argentina
2002, East Asia 1997, Mexico 1994, Brazil 1999.
 Causes may be different. But all were following
fixed ER policies.
 Difference: Argentina’s 2002 and Turkey’s 2001
crises were both due to unsustainable
government budget deficits and debt.
33
Capital Controls
 Prevent Capital flight: Controls on Outflows
 Outflows of capital promote financial instability
by forcing a devaluation
 Controls are seldom effective because it is
easy to find ways around them.
 Controls may block funds for productive uses
such as roads, infrastructure
 Chilean experience: capital cannot leave the
country before one year (Tobin Tax on shortterm capital) .
 Controls on outflows reduces the inflows too.
34
Capital Controls (cont’d)
 Controls on İnflows: Capital İnflows lead to a
lending boom and excessive risk taking by
financial intermediaries (1997 Asian Crisis)
 Strong case for improving bank regulation
and supervision. Turkey has been successful in
reforming the banking system after the 2001
crisis.
 Financial integration or not?
35
IMF
 Was established after World War II. Its purpose
was to maintain the fixed exchange rate system
called “Bretton Woods” (1944-71) by lending to
the countries that had balance of payments
deficits.
 However, the Bretton Woods system collapsed in
1971 and IMF became an institution that provides
financial and technical assistance to member
countries.
36
IMF
 IMF has lent to less developed countries in repaying
their foreign debt during:
 1980s’ Third World Debt Crisis, 1994-95 Mexican
Crisis, 1997-98 East Asian Crisis, and 2001 Turkish
Crisis (~20billion).
 Of course, during a credit arrangement, IMF asks the
borrowing country to write a commitment letter in
which the country’s government commits to the
policies prescribed by IMF. Because if these policies
are not followed, the same imbalances in the
economy will cause another crisis in the future. If the
borrowing country believes that IMF will bail them out
even if they do not follow prescribed policies, then the
country will never solve its problems and this is moral
hazard problem.
37
IMF Credits: (billion$, Radelet)
Country
Committed
Realized
Turkey(99-02)
33,8
23,1
Brazil (2001-2)
35,1
30,1
Brazil (98-99)
18,4
17,5
Argentina (2000-1)
22,1
13,7
S. Korea (97)
20,9
19,4
Mexico (95)
18,9
27,6
38
IMF Critics
 IMF critics say: To the governments that cannot
sell its debt and cannot preserve the value of
their currency, IMF lends if the following
conditions are promised by the borrower:
1. Reduce government expenditures or
increase taxes (contractionary fiscal p.)so
that you need to borrow less. Joseph Stiglitz
and other critics: such measures during a
crisis can only deepen the crisis and
recession. They argue that government
should increase expenditures and aggregate
demand so that the economy is brought out
of recession.
39
IMF Critics
2. Increase interest rates. This helps protect
the value of domestic currency from
depreciation. However, according to Stiglitz,
this causes otherwise sound firms to go
bankrupt because they cannot repay their debt
with higher interest rates and “Debt deflation”:
Real value of nominal debt increases.
3. Trade and Financial Liberalization: Critics:
The industrialized countries of today did not
have liberal trade and financial systems when
they were industrializing 200 years ago.
Foreign banks take over the weak banking
systems in less developed countries.
40
IMF Critics
4. Privatization: Critics argue foreign
companies take over sectors
(monopolize) and increase dependency of
domestic economy to foreign firms.
5. Fear of default. Critics argue that one
of the objectives of the IMF is to ensure
that high-risk, high-return loans from
international banks to less-developed
countries are repaid.
41
IMF Critics
6. Instead of financial reform, IMF
prescribes contractionary
macroeconomic policies. This causes
the IMF to be a profitable scapegoat for
domestic politicians as anti-growth,
anti-employment. IMF is seen as a
foreign entity interfering with domestic
policy. Do you agree?
42
IMF as a Lender of Last Resort
IMF can prevent contagion of crises.
“herding behavior” in financial markets
causes contagion.
IMF bailouts may cause excessive risktaking (moral hazard) for domestic
banks and their international creditors.
This will increase risk of crisis in the
future.
43
IMF Stand-By Arrangements with TR
Figure 1. Stand-By Arrangements Cases in Turkey (1960-2004)
2008 Karagöl, Erdal and Metin Özcan, Kıvılcım, “The Economic Determinants of IMF Standy Aggreements in Turkey”
Actual
1
0.5
0
1955
1960
1965
1970
1975
1980
1985
1990
1995
2000
Actual
44
World Bank
 Mission: Established after WWII to provide funds
to reduce poverty and promote development in
the world. Provides loans for infrastructural
projects in health, education, agriculture, energy.
 Critics: Stiglitz, Caufield: Too quick and
unregulated free market reforms prevent
economic development.
45
Balance-of-Payments Considerations
Current account deficits in Turkey suggest
that Turkish producers are not competitive
maybe because the TL is too strong
(maybe b/c they are not productive).
CADs increases the risk of a BOP crisis. CB
may reduce interest rates for this
purpose: expansionary policy.
Expansionary (contractionary) policy
reduces (increases) interest rates and
decreases (increases) value of TL.
46
Balance-of-Payments Considerations
But expansionary policy increases risk of
inflation for two reasons:
 Prices of imported goods (tradables) increase
(energy)
 Since money supply increases, real value of
money (in terms of goods and services)
decreases.
47
Exchange-Rate Targeting in TR
 ER targeting (Crawling Peg) Policy
applied in Turkey 1999-2001 as a
method to bring inflation under control.
Tradable goods’ prices are quoted in
dollars, so rate of inflation fell.
ER targeting keeps the ER in a prespecified band. Ex: (1,50 TL/$ ± 0,20
TL/$) for a specific period. Allows lira to
move within the band.
We floated after the 2001 crisis.
48
Advantages of
Exchange-Rate Targeting (Fixed ER)
Automatic rule for conduct of monetary
policy. Prevents temptation of short-run
benefits of expansionary policy. (Ex:
election economics). Reduces political
pressure on the CB to expand the money
supply.
49
Exchange-Rate Targeting
for Emerging Market Countries
Political and monetary institutions
are weak. Not much to gain from
independent mon. policy. But much to lose
from irresponsible politicians (high
inflation 1977-2003).
Helps tie the hands of the govt. from
conducting expansionary policies.
BUT!!! Costs of a currency crisis much
higher than these benefits.
50
Disadvantages of
Exchange-Rate Targeting
 Moral Hazard: Banks take on too much
exchange rate risk expecting the govt. to
defend the peg. İncreases financial fragility.
 Then economy becomes vulnerable to
speculative attacks on currency. İnt. creditors
suddenly sell lira assets, capital flight. Force
the CB to devalue.
 Loss of independent control of money supply.
Cannot fix both ER and money supply. Cannot
respond to domestic shocks.
 Shocks to anchor country (US or Germany) are
transmitted to domestic country
51
Currency Boards
 Extreme case of fixed ER policy.
 Domestic currency is backed 100% by a foreign
currency
 CB establishes a fixed exchange rate and
stands ready to exchange currency at this rate.
(Ex: 1 TL/$)
 Money supply can expand only when CB’s
dollar reserves increase. Decreases the
possibility of a speculative attack-currency
crisis.
52
Currency Boards (cont’d)
 Stronger commitment by central bank
 Loss of independent monetary policy
and increased exposure to shock from
anchor country
 Loss of ability to create money and act as lender
of last resort
 Applied in Argentina (1991-2002), Bulgaria
(1997), Bosnia (1998), Hong Kong (1983),
Estonia (1992), Lithuania (1994)
53
Dollarization
 Totally giving up domestic currency and adoption
of another currency (dollar)
 Ecuador dollarized in 2000.
 15 EU countries “euroized” after 2002. 12 EU
member countries are not in “eurozone”. UK,
Denmark and Sweden chose not to join.
 Completely avoids possibility of speculative
attacks on domestic currency
 Loss of independent monetary policy
and increased exposure to shocks from
anchor country (US)
54
Dollarization (cont’d)
 Inability to create money and act as lender
of last resort
 Loss of seignorage revenue earned from
purchasing bonds with printed currency. $30bn
per year for US.
 Ex: “President Carlos Menem of Argentina has
advocated replacing the Argentine peso with
the dollar. Dollarization would benefit Argentina
because it would eliminate the peso-dollar
exchange-rate risk, lower interest rates, and
stimulate economic growth” March 12, 1999 by Steve H. Hanke
and Kurt Schuler, ”A Dollarization Blueprint for Argentina”, CATO Foreign Policy Briefing No. 52
55