Intervention in Foreign Exchange Market Under Fixed Exchange Rate Regime

--These two diagram use the asset market (domestic assets) to explain what a central bank needs to do with (

---a) Maintaining an overvalued FX-rate: buy domestic currency; thus reduce the monetary base to raise domestic interest rates and thus shift (INcrease) demand for domestic assets) and make market correspond to fixed (par) exchange rate; or with (but central bank draws down its international reserves in process) 

---(b)Maintaining an Undervalued FX-rate:  sell domestic currency and buy foreign assets; an opposite action (compared to (a) above) by the central bank;  to reduce demand for domestic assets and bring market equilibrium towards the fixed (par) rate of exchange. Central bank accumulates foreign reserves in this case.  {Rock:  Think China from 1998-today}

 

*{Problems of Maintaining a Fixed Exchange Rate (‘anchored’ or ‘tied’ to other currencies;  usually, for many countries, to larger/richer country currencies)

--Over-Valued domestic currency:  Central bank may exhaust its international reserves in supporting the overvaluation and ultimately come under attack from investors who fear for a sudden and large devaluation, that can become a self-fulfilling prophecy.

--Under-Valued domestic currency:  Need to accumulate large foreign asset (international reserves) in order to keep holding the domestic currency down (e.g. by buying foreign assets and currency/deposits).  This is the less difficult task compared to trying to maintain an overvalued currency.

Ch.18 PART 2

 

Chapter 18 The International Financial System, pp.470-487 PART 2

 

======================================

pp.470-475

Case Studies of Exchange Rate Regimes and other Issues:

 

-(1st case) The first examines how China has accumulated close to $1 trillion of international reserves (by 2010: over $2 trillion), a concern to many (not only USA with huge deficit in trade with China) but all worried about ‘global imbalances’ that can lead to financial recycling and financial instability as well as sometimes to ‘trade wars’ (rising protectionist policies to prevent never-ending trade deficits).  

---China’s undervaluation strategy (similar to that followed by Japan (1960s-1980s); South Korea, Taiwan,  (1970s-1990s)

---to promote an ‘export-led growth model’ of domestic industry

---Difficulties:

-------- China owns huge amount of US assets (bonds mainly)

-------- Keeping Chinese products so cheap has threatened trade retaliation by other countries that cannot compete

-------- Purchase of US dollars effectively means large increase in Chinese monetary base with risk of inflation (although central control of banking flows (restricted capital mobility domestically) helps stop this from happening so far)

--------

 

p.470-71

 

How Bretton Woods Worked

--Exchange rates adjusted only when experiencing a ‘fundamental disequilibrium’ (large persistent deficits in balance of payments)

--Loans from IMF to cover loss in international reserves

--IMF encouraged contractionary monetary policies (for persistent deficits)

--Devaluation only if IMF loans were not sufficient

--No tools for surplus countries {One side of Imbalance is thus, Unaddressed!}

--U.S. could not devalue currency {only in concert with other major currency countries, but even then the market might prevent success}

 

p.471

Managed Float

--Hybrid of fixed and flexible

--------Small daily changes in response to market

--------Interventions to prevent large fluctuations

--Appreciation hurts exporters and employment

--Depreciation hurts imports and stimulates inflation

--Special drawing rights as substitute for gold

 

p.472

European Monetary System

--8 members of EEC fixed exchange rates with one another and floated against the U.S. dollar

--ECU value was tied to a basket of specified amounts of European currencies

--Fluctuated within limits (a ‘band’; upper and lower bounds for rate to move within)

--Led to foreign exchange crises involving speculative attack (famously in 1992 vs. UK-Pound)

---------see Fig.8 Foreign Exchange Market for UK Pounds, 1992 graph

 

p.472

Application:  The September 1992 foreign exchange crisis of the ERM.

--Following unification of East and West Germany in 1990, the German central bank (to stem rising inflation) raised interest rates in Germany to very high levels attracting investors and putting stress on the other currencies fixed to the Deutsche Mark

--U.K.

------This led to a drop in the demand for British assets and hence a fall in the Mark/Pound exchange rate.

------The British attempted to keep the Pound at a higher rate (Marks/Pounds) and thus to do so was buying UK domestic currency (pounds) with its international reserves

------Eventually it could no longer do so and this led to the devaluation of the UK pound and fortunes made by speculators who had bet against (sold short) the pound

--Similar defenses were attempted by the central banks of Sweden, France, Italy, Spain but they were not very successful either.

--Since these defenses lead central banks to buy their own currencies

Fig. 3,   p.473 represents the British pound-asset market and what the central bank was trying (unsuccessfully, ultimately) to do.

 

pp.474-475

Application: 

Foreign Exchange crises IN EMERGING MARKET COUNTRIES (1994 to 2002)

=The currency and financial crises in Mexico (1994) , East Asia (1997), Brazil (1999), and Argentina (2002) in recent years have caused policymakers throughout the world to focus on how the architecture (institutional arrangements and ‘rules of the game’) of the international financial system might be reformed in order to limit the threat of financial crises, and specifically about the role of the International Monetary Fund and capital controls.

-CASES:

--Mexico (1994):

-------Political instability (assassination of presidential candidate; previous 1982 debt crisis and devaluation) led to expectations of imminent devaluation; stories of bad banking practices and troubles;

-------Using Fig. 3 (from German/UK story in 1992), one can also tell the story of Mexico with an overvalued currency, and investors shifting (decreasing) the demand curves for Mexican peso-denominated assets

--Thailand (1997): 

-------A large current account deficit, weak financial system, etc. led to expectations of a devaluation; one can tell the same story with Fig. 3

--Brazil (1998-1999) & Argentina (2001-2002)

 -------Worried investors; fiscal system stress; fear of monetary expansion to finance budget deficit; inflation result fears; also likely devaluation; runs on banks

-------Fig. 3 also:  Shifts in demand for domestic assets as expected return on domestic currencies falls;  market exchange rate expected below fixed rate

-------Eventual devaluations

--Other countries part of contagion and forced to devalue also:  Indonesia, Malaysia, South Korea, Philippines; Russia

--Some countries had solid enough financial sectors that survived speculative attacks on currencies without large devaluations:  Hong Kong, Singapore, Taiwan

--REAL Economy results:  Severe recessions/depressions and failure of many non-financial businesses and financial institutions

 

--In both the European 1992 and these emerging market (1994-2002) cases, some economic agents made huge profits during these crises and government intervention in the markets was massive.

--These cases and their foreign exchange aspects also are related to the challenges of applying themodel of assets-demand of the foreign exchange market developed in Chapter 17.

--Many of these cases also show that what happens outside any domestic economy (including the United States) is still capable of important direct and indirect (or secondary in time) effects on those other economies. 

================================================== 

 

pp.475-76

PROTECTING DOMESTIC ECONOMIES FROM WORST NEGATIVE POTENTIAL EFFECTS OF INTERNATIONAL FINANCE

 

*CAPITAL CONTROLS   (Out/In and Problems)

--Outflows

-------Promote financial instability by forcing a devaluation (some argue)

-------Controls are seldom fully effective and may increase capital flight

-------Lead to corruption (as people try and get around the controls)

-------Lose opportunity to improve the economy

--Inflows

-------Lead to a lending boom and excessive risk taking by financial intermediaries

-------Controls may block funds for productions uses

-------Produce substantial distortion and misallocation

-------Lead to corruption

--Strong case for improving bank regulation and supervision

 

{NOTE: Book author bias evident:  Mishkin is clearly on the side of no outflow controls since every argument against, but nothing in favor. He has apparently not surveyed the literature and case studies on innovative capital restrictions, or other arguments for controls which have been in the news a lot lately after 2008 and after 1997-1999 capital flight problems in Asia, etc.   E.G. Chile investment law: minimum of 1 year in order to repatriate profits otherwise penalty for short-termism has been praised, etc. etc.  He is more balanced on inflows and bank regulations to more easily reach the same goals. }

======================== 

pp.476-478

WHAT SHOULD THE IMF do and should it be reformed?

 

*The IMF: Lender of Last Resort?

--Emerging market countries with poor central bank credibility and short-run debt contracts denominated in foreign currencies have limited ability to engage in this function

--May be able to prevent contagion (spread of fears from one country crisis to another)

--The safety net may lead to excessive risk taking (moral hazard problem) and the perception that countries are even more risky (even more inflation is likely) due to the IMF back up.

--Since 1994 Mexican crisis, IMF has been more active in this role;  now (2011) with the Eurodebt crisis and IMF participation in the new institutional arrangements to help Eurozone countries with debt/liquidity problems the IMF role may continue to expand.

*How Should the IMF Operate?

--May not be tough enough {or creative enough} to set up rule-based system to describe necessary behavior by countries in order to receive assistance (lending); then need to adhere to it for future credibility;

--Austerity programs focus on tight macroeconomic policies rather than financial reform {and often hurt the poorest the most--those least responsible for problems}

--It is often too slow, which worsens crisis and increases costs; need quick response since that can stop crisis more effectively and reduce total costs as well.

--Countries were restricting borrowing from the IMF until the recent subprime financial crisis to avoid some IMF restrictiveness if possible and due to access to alternatives in many cases

*The Reform of the Role of the IMF is a current debate and may lead to real changes (2011)

--In the Euro crisis, there have already been changes seen through ad hoc ‘experimentation’ of IMF/ECB joint actions (with other Central Banks as possible collaborators also).

=============== 

 

pp.479-480

**INTERNATIONAL CONSIDERATIONS and MONETARY POLICY:

The next section on explains how international financial transactions and movements in the exchange rate can affect monetary policy.   This material is closely related to the discussions in Chapter 16 about the conduct of monetary policy.

 

*(I) DIRECT EFFECTS of the Foreign Exchange Market on the MONEY SUPPLY

--Intervention in the foreign exchange market affects the monetary base

--USA almost unique in world at present:  U.S. dollar has been a reserve currency: monetary base and money supply is less affected by foreign exchange market (i.e. the US compared to most other countries).

--Example of Germany early 1970s Bundesbank (central bank) trying to prevent excessive appreciation of D-mark led it to buy significant international reserves (dollars) to try and reduce D-mark appreciation; but this also meant money supply growth (and potential inflation). 

 

*(II) BALANCE-OF-PAYMENTS Considerations 

--Under fixed exchange rate regime like early Bretton Woods, the Balance of Payments components could be severely affected by international changes in exchange rates; in flexible exchange rate system they are less important

--Current account deficits in the U.S. suggest that American businesses may be losing ability to compete because the dollar is too strong (cannot devalue as easily as other countries with less key role in world financial system). 

--U.S. deficits mean surpluses in other countriesÞ large increases in their international reserve holdingsÞworld inflation

 

*(III) EXCHANGE RATE Considerations

--In flexible exchange rate system the effects from exchange rate shifts can be very important (more than in the past fixed rate system);

--A contractionary monetary policy will raise the domestic interest rate and strengthen the currency (increasing imports and trade deficit and worsen even more some other macroeconomic problems)

--An expansionary monetary policy will lower interest rates and weaken currency…which may have more micro/distributional effect rather than macro (but some in US on fixed or low incomes could be disproportionately hurt by certain types of inflation, e.g. fuels for transport to work) {but could also bring promote exports, although raise domestic costs of macro-important imports like energy/fuels}

--Pressures to influence exchange rates seem more politically sensitive in other countries rather than the US (although with the China surplus/US deficit and loss of jobs in some sectors there are more calls today for some implicit devaluation of the US currency to help US competitiveness (especially from some on the left as the bottom half of income earners have made little gains in past 35 ears). 

--The famous ‘Plaza Agreement’ in autumn of 1985 is symbol of even US needing to pay attention to US$ FX-rate when several countries finance ministers agreed to work together (collective interventions in the exchange rate markets) to bring down the relative value of the US currency;

=================================

 

pp.481-485

--The final section on exchange rate targeting considers the pros and cons of FIXED versusFLEXIBLE exchange rate regimes.  These positive and negative aspects of different exchange rate system are linked to international financial institutions and the architecture of the global system.

--In this discussion there is some treatment of the desirability of exchange rate targeting versusother monetary policy strategies such as monetary targeting versus inflation targeting.

 

To Peg or Not to Peg: 

*EXCHANGE RATE TARGETING as ALTERNATIVE MONETARY POLICY Strategy

(“Exchange Rate Targeting” is also called “an Exchange Rate Peg”}

(In past done by tying currency to Gold; more recently to “anchor currency”)

=*ADVANTAGES of Exchange-Rate Targeting

---Contributes to keeping inflation under control (if tied to non-inflationary anchor  currency)

---Automatic rule for conduct of monetary policy (less inconsistent policy choices)

---Simplicity and clarity (easy to understand by public)

=*DISADVANTAGES of Exchange-Rate Targeting

---Cannot respond to domestic shocks (independent monetary policy compromised especially with today’s capital mobility) and shocks to anchor country are transmitted into pegging country (e.g. from Germany into other member of European Rate Mechanism in 1990-1992)

---Open to speculative attacks on currency (e.g. the non-German members of European Rate Mechanism in 1990-1992)

---Weakens the accountability of policymakers as the exchange rate loses value as signal

 

*Exchange-Rate Targeting FOR INDUSTRIALIZED COUNTRIES

---Exchange-rate targeting for industrialized countries is desirable if

-------Domestic monetary and political institutions are not conducive to good policy making (Independent Monetary policy making is lost by targeting FX-rate)

-------Other important benefits such as enhanced economic integration (e.g. EU countries prior to Euro creation) arise from this strategy since FX-rates are more stable and promote trade (less uncertainty about relative prices)

 

*Exchange-Rate Targeting FOR EMERGING MARKET COUNTRIES

---Exchange-rate targeting for emerging market countries is desirable if

-------Political and monetary institutions are weak (strategy becomes the stabilization/anti-inflationary policy of last resort).  

-------Not so much is lost from the effect of non-independence of monetary policy, as it (M-policy) may not be very effective dealing with shocks anyway in some countries;

---BUT, they can be susceptible by speculative attacks on currency as troubles mount

---Also can hurt accountability of policy makers since it removes one signal of how policies are doing in keeping system stable (not so many visible movements in exchange rates until, perhaps, it is too late, and speculators are already on the attack);  also if bond markets are quite thin, then these markets may not signal (in place of exchange rate signals) so that giving up freely moving exchange rate may be costly (loss of information to monetary policy makers

 

========================= 

pp.485-486

*=* TWO STRATEGIES TO CONSTRAIN POLICY MAKERS TO PEGGED-CURRENCY

 

*(#1) CURRENCY BOARDS (pros and cons) {Give a commission the near total independence to ensure that the currency if fixed inflexibly to anchor currency or weighted basket of currencies and this foreign currency is held as backing for the domestic currency in use in a fixed ratio}

---Solution to lack of transparency and commitment to target

---Domestic currency is backed 100% by a foreign currency

---Note issuing authority establishes a fixed exchange rate and stands ready to exchange currency at this rate

---Money supply can expand only when foreign currency is exchanged for domestic currency (speculative attacks on domestic currency may lead to massive shrinking of the money supply as everyone tries to turn domestic into anchor currency)

---Stronger commitment by central bank

---Similar problems to fixed rate regime:  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

 

*(#2) DOLLARIZATION (pros and cons) {Abandon own currency; Adopt strong currency as the legal means of payments in the country} (e.g. Ecuador

---Another solution to lack of transparency and commitment

---Adoption of another country’s money

---Even stronger commitment mechanism

---Completely avoids possibility of speculative attack on domestic currency

---Lost of independent monetary policy and increased exposure to shocks from anchor country

---Inability to create money and act as lender of last resort

---Loss of seignorage (ability for taxing or gaining public financial resources through various control aspects of the currency and monetary system)

 

 

 

p.486

*Global:  Argentina’s Currency Board

--1991:  Currency Board established after many years of inflation and often hyperinflation;

--Was 1 peso = 1 US$ fixed exchange rate;  money controlled by Board (not by Central Bank no longer lender of last resort)

--Following Mexican peso crisis of 1994, Argentines turned their Argentine pesos for US dollars;  led to sharp contraction in money supply

--IMF lent large amounts to country to help it out in 1995

--1998 following up E.Asia currency FX-rate etc. crises, Argentina in more difficulties with deep recession (20% unemployment) and large government debt

--Banking crisis (big borrowing foreign finance to finance projects in country)

--Economic emergency 2000-2001:  Default on government debt (still in dispute today 2011 with some creditors); socialization of some dollar accounts; severe depression, etc.

RECOVERY SUCCESS STORY SINCE EARLY 2000s:

-Since 2003-2011, Argentine growth rate very high; rise in AG-commodity prices very helpful as country moved from meat exports to mainly Soya beans/oil for animal feed and food and large export earnings from this;

-also some benefits from Brazils growth success next door

-A lesson for others?  Just default and walk away?

 

============================================== 

USA CRISIS OF 2008->

--(In this 9th edition there is only a small change in the text, an additional half page titled “Global The Subprime Financial Crisis and the IMF” and found in another reading named “Mish9ed_c18_TXTnewIMFsubpriNSGSum.pdf”

 

*The U.S. Subprime Financial Crisis and the IMF (p.484, 9th ed., 2010)

-In the chaotic crisis period in the USA, when mortgage-backed-securities collapsed in market values and into strong illiquidity in late 2008 (October), foreigners and domestic investors began pulling out large funds out of many other economies (Iceland, many East European and other ‘emerging economies’ around the world).

----This put pressures on many of their banks (balance sheet liquidity problems).

-The IMF played the role of “lender of last resort” for many of these countries (e.g. Hungary, Ukraine, Iceland, etc.) using its normal lending mechanisms.

-But due to the severity of the crisis, the IMF invented a new mechanism at end of 2008, called the ‘Short-Term Liquidity Facility’ with $100 B of funds, providing 3-month loans to ‘sound’ (good quality) economies under ‘stress’.  These loans could be made quickly and had not requirements (as often IMF loans do) for ‘austerity’ programs. There is no need to pre-apply before actually asking to take out a loan.

---In 1999 the IMF had done something similar, but it did not succeed since those loans did require an IMF-preapproval and countries did not want to get labeled in advance as ‘probably in trouble’ that could frighten private financing.