Chapter

10

The International Monetary system

10-2

Turkeys 18th IMF program

Large and inefficient state sector heavy subsidies Government debt risen to 60% of gross domestic product Rampant inflation IMF focus

Reduce inflation Stabilize value o f currency Privatization Reduction of subsidies Government reforms

Reasons for failure

10-3

International monetary system (IMF)

The institutional arrangements that countries adopt to govern exchange rates Dollar, Euro, Yen and Pound float against each other Floating exchange rate: Foreign exchange market determines the relative value of a currency

10-4

International monetary system (IMF)

Some countries use other institutional arrangements to fix their currencys value Pegged exchange rate

Value fixed relative to a reference currency Hold value within range of a reference currency Set of currencies are fixed against each other at some mutually agreed upon exchange rate

Dirty float

Fixed exchange rate

10-5

The gold standard

Roots in old mercantile trade. Inconvenient to ship gold, changed to paperredeemable for gold. Want to achieve balance-of-trade equilibrium

Japan

USA

10-6

Balance of trade equilibrium

Decreased money supply = price decline.
Trade Surplus

As prices decline, exports increase and trade goes into equilibrium.

Gold

Increased money supply = price inflation.

10-7

Between the wars

Post WWI, war heavy expenditures affected the value of dollars against gold
US raised dollars to gold from $20.67 to $35 per ounce

Dollar worth less?

Other countries followed suit and devalued their currencies

10-8

Bretton Woods

In 1944, 44 countries met in New Hampshire Countries agreed to peg their currencies to US$ which was convertible to gold at $35/oz. Agreed not to engage in competitive devaluations for trade purposes and defend their currencies Weak currencies could be devalued up to 10% w/o approval IMF and World Bank created

10-9

Role of the IMF

Created to police monetary system by ensuring maintenance of the fixed-exchange rate Promote intl monetary cooperation and facilitate growth of intl trade Wanted to avoid problems following WW1, through A) Discipline Maintaining a fixed exchange rate imposes monetary discipline, curtails inflation , Brake on competitive devaluations and stability to the world trade environment

10-10

Role of the IMF

B) Flexibility Lending facility:

foreign currencies to countries having balance-of-payments problems Adjustable parities: Allow countries to devalue currencies more than 10% if balance of payments was in fundamental disequilibrium

Lend

Persistent borrowings leads to IMF control of a countrys economic policy

10-11

Principal duties

Surveillance of exchange rate policies (No longer fixed rate exchange) Financial assistance (including credits and loans) Technical assistance (expertise in fiscal/monetary policy)

10-12

Sources of funds

182 nations pay into fund according to the size of their economy Funds remain their property Borrower repays loan in 1 to 5 years, with interest No nation has ever defaulted; some are given extensions

10-13

Membership in the IMF

Open to any country willing to agree to its rules and regulations Must pay a deposit (quota) Quota size reflects global importance of a nations economy Quota determines voting powers

10-14

Largest contributors
Fig 10.0

18.3 20 15 10 5 0 US Germany Japan Britain France 5.7 Percent

5.7

5.1

5.1

10-15

Role of the World Bank

International Bank for Reconstruction and Development (IBRD) Purpose: To fund Europes reconstruction and help 3d world countries. Overshadowed by Marshall Plan, Turns to development Lending money raised by WB bond sales
Agriculture Education Population

control Urban development

10-16

Collapse of the fixed exchange system

Pressure to devalue dollar led to collapse President Johnson financed both the Great Society and Vietnam by printing money

High inflation and high spending on imports

August 8, 1971, Nixon announces dollar no longer convertible into gold.

Countries agreed to revalue their currencies against the dollar March 19, 1972, Japan and most of Europe floated their currencies In 1973. Bretton Woods fails when key currency (dollar) is under speculative attack

Now have a managed-float system

10-17

Long term exchange rate trends 19702001

Fig 10.1

10-18

The floating exchange rate

Jamaica Agreement - 1976

Floating rates acceptable Gold abandoned as reserve asset IMF quotas increased

IMF continues role of helping countries cope with macroeconomic and exchange rate problems

10-19

Exchange rates since 1973

More volatile: Oil crisis -1971 Loss of confidence in the dollar - 1977-78 Oil crisis 1979, OPEC increases price of oil

Unexpected rise in the dollar - 1980-85 Rapid fall of the dollar - 1985-87 and 1993-95 Partial collapse of European Monetary System 1992 Asian currency crisis - 1997

10-20

Floating exchange rates

Trade balance adjustments Monetary policy autonomy

10-21

Fixed exchange rates

Monetary discipline Speculation Uncertainty Trade balance adjustments

10-22

Fixed versus floating exchange rates

Floating:

Monetary policy autonomy Restores control to government Trade balance adjustments Adjust currency to correct trade imbalances

Fixed: Monetary discipline .Speculation Limits speculators Uncertainty Predictable rate movements Trade balance adjustments Argue no link between exchange rates and trade Link between savings and investment

10-23

IMF members exchange rate policy,2002

Fig 10.2

10-24

Exchange rate regimes

Pegged Exchange Rates.

Peg own currency to a major currency ($). Popular among smaller nations Evidence of moderation of inflation
Country commits to converting domestic currency on demand into another currency at a fixed exchange rate Country holds foreign currency reserves equal to 100% of domestic currency issued

Currency Boards.

10-25

Crisis management by the IMF

Role has expanded to meet crisis

Currency crisis

when a speculative attack on a currencys exchange value results in a sharp depreciation of the currencys value or forces authorities to defend the currency Loss of confidence in the banking system leading to a run on the banks When a country cannot service its foreign debt obligations

Banking crisis

Foreign debt crisis

10-26

Incidence of currency and banking crisis

Fig 10.3

10-27

Crises have common underlying causes

Common causes:

High inflation Widening current account deficit Excessive expansion of domestic borrowing Asset price inflation

10-28

Mexican currency crisis of 1995

Peso pegged to U.S. dollar Mexican producer prices rise by 45% without corresponding exchange rate adjustment Investments continued ($64B between 1990 -1994 Speculators began selling pesos and government lacked foreign currency reserves to defend it IMF stepped in

10-29

Russian Ruble crisis

Financial markets loss of confidence in Russias ability to meet national and international payments

Led to loss of international reserves and roll over of treasury bills reaching maturity

Financial markets unable to determine whos in charge

10-30

Russian Ruble crisis

Persistent decline in value of ruble:

High inflation
Artificial low prices in Communist era Shortage of goods Liberalized price controls Too many rubles chasing too few goods

Growing public-sector debt

Refusal to raise taxes to pay for government

10-31

Government actions: Exacerbating the Situation

Defacto devaluation of the ruble Unilateral restructuring of ruble-denominated public debt 90-day moratorium on foreign credits repayment Hike in interest rates to defend ruble Duma rejects measures designed to alleviate problems.

10-32

Decline of the Ruble

0 -1000 -2000 -3000 -4000 -5000 -6000 1992 1993 1994 1995

10-33

The Asian crisis

Factors leading to the Asian financial crisis of 1997 The investment boom Excess capacity The debt bomb Expanding imports

10-34

The Asian crisis

Mid 1997 several key Thai financial institutions were on the verge of default

Result of speculative overbuilding Excess investment (dollar denominated debt) Deteriorating balance-of payments position 17.2 billion in loans, given with restrictive conditions

Thailand asks IMF for help

Following devaluation of Thai baht speculation hit other Asian currencies

Malaysia Singapore Indonesia Korea

10-35

Problems in Asian Market Economies

Cronyism. Too much money, dependence on speculative capital inflows. Lack of transparency in the financial sector. Currencies tied to strengthening dollar. Increasing current account deficits. Weakness in the Japanese economy

10-36

Evaluating the IMF policy prescriptions

Inappropriate policies:

One size fits all Moral hazard:

People behave recklessly when they know they will be saved if things go wrong Foreign lending banks could fail Foreign lending banks have paid price for rash lending IMF has grown too powerful

Lack of Accountability

10-37

Impact on the countries

Currency devaluation Declining investment Rising prices Rising unemployment Rising poverty Rising resentment?

10-38

Implications for business

Currency management Business strategy

Forward exchange market (months not years ahead) Strategic flexibility

Corporate-government relations