History of Foreign Exchange Rates Price Transparency

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					                 Today’s Agenda
 Note on TF office hours: W, 1:30-2:30pm, KMEC 7-
    181,TF: Ms. Desi Peteva, MBA2
   Why study int’l monetary systems?
   Terminology of exchange rates & currency regimes.
   Differences b/n devaluation & depreciation?
   Ideal currency?
   Explain currency regime choices.
   Describe Euro creation.
   Case-in-point: the stubborn forex regime in China.
Why study int’l monetary system?
 Fact: the volatility of exchange rates has increased.

 Volatile exchange rates increase risk, create profit

 The international monetary system is the structure
  within which foreign exchange rates are determined.

        Currency Terminology
• Foreign currency exchange rate: price of one
  country’s currency in units of another currency or
   – The system, or regime, classified as:
      – fixed,
      – floating, or
      – managed exchange rate regime.
• Par value: the rate @ which currency is fixed, pegged.
• Floating or flexible currency: government does not
  interfere in valuation of currency

           Currency Terminology
 Spot exchange rate: quoted price for foreign
  exchange to deliver @ once, or @ T+2 for interbank
   • ¥114/$ (114 yen to buy one US $), immediate delivery
 Devaluation: drop in foreign exchange value pegged
  to gold or another currency. Opposite to revaluation.

 Weakening, depreciation: refers to drop in foreign
  exchange of a floating currency. Opposite to

            Currency Terminology
 Soft or weak currency: currency expected to devalue/
    depreciate relative to major currencies;
   Hard or strong: the opposite.
   Eurocurrencies: type of money although in reality
    they are domestic currencies of a country deposited in
    another country.
    • E.g.: Eurodollar - US$ denominated deposit in bank
      outside of US

Evolution of the International Monetary
  Bimetallism: Before 1875
  Classical Gold Standard: 1875-1914
  Interwar Period: 1915-1944
  Bretton Woods System: 1945-1972
  The Flexible Exchange Rate Regime: 1973-Present

        Bimetallism: Before 1875

 A “double standard”: both gold and silver were
    used as money, accepted as means of payment.
   Some countries were on the gold standard, some
    on the silver standard, some on both.
   Exchange rates among currencies were determined
    by either their gold or silver contents.

    The Gold Standard, 1876-1913
•   Countries set par value for currency in terms of gold
•   Acceptance in Europe in 1870s
•   US adopted it 1879
•   “Rules of the game”:
     – Rule 1: Set a rate @ which can buy/sell gold for
     – Rule 2: Credibly maintain adequate reserves of gold.
     – E.g. US$ gold rate $20.67/oz, Brits pegged at
     – US$/£ rate calculation
                 $20.67/£4.2472 = $4.8665/£

     The Gold Standard, 1876-1913
 Since the rate of exchange for gold was fixed, the
    exchange rates b/n currencies was fixed too.
   Gold standard worked until WW1
   WW1 interrupted trade flows & free movement of
    gold forcing nations suspend gold standard.
   J.M. Keynes called it “the barberian relique”.

Inter-War years & WWII, 1914-1944
 • During WWI: currencies fluctuate over wide ranges to gold
    – Due to S & D for imports/exports
    – Due to speculative pressure,
        – SHORT SELLING week currencies.
        – BUYING strong currencies.
            SHORT SELLING: investor expects price to fall soon, borrows
              currency & sells it.
 • 1934: US devalued currency to $35/oz from $20.67/oz.

 • 1924 - end WWII: exchange rates determined by currency
   value in gold.
 • During WWII & after, main currencies lost convertibility.
   US$ remained only convertible currency.
        Bretton Woods & IMF
• Bretton Woods, NH: US coalition created post-war
  international monetary system.
   – establishes US$ based monetary system
   – IMF (International Monetary Fund) & World Bank
      – IMF renders temp assistance to member-countries to defend
        currency & overcome econ problems
• All member-countries fix currencies in gold, not
  required to exchange it.
• Only US$ convertible to gold (@ $35/oz, Central
  banks only)
   – The advent of central banking worldwide.
             Bretton Woods
• Countries establish exchange rate vis-à-vis US$
• Agree to maintain currency values +/- 1% par by
  trading US$ & gold.
• No use of devaluation as a competitive trade policy
• Up to 10% devaluation w/o formal approval by IMF.

             Bretton Woods
• Special Drawing Right (SDR): international reserve
   – A unit of account for IMF & base some countries peg
     exchange rates.
   – Is weighted average 5 IMF members currencies, w/
     largest exports/ imports
• Members deposits US$ & Gold in IMF, get SDR.

Fixed exchange rates, 1945-1973
• Worked well for post-WW2
• Fiscal & monetary policies & external shocks caused
   – US$ main reserve currency.
   – Heavy overhang of US$ abroad.
   – Lack of confidence.
   – Heavy outflows of US gold.
• Nixon (08/15/71): suspend trading gold. Allow
  exchange rates to float freely.
• Nixon (08/15/71): yet another run on US$.
• Devalue US$ to $42/oz gold.
 Fixed exchange rates, 1945-1973

Triffin paradox
 To maintain the gold-exchange system, the US
  had to run Balance of Payment deficits
 But: large, persistent deficits would diminish
  confidence and lead to a run on the US$.
 This would destroy the system – indeed, it
  happened in the 50s & 60s.

               World Currency Events
OPEC embargo       Jamaica        EMS created      OPEC raises
  1973-74         Agreement         3/1979           prices
                   1/1976                            1979
Latin American      Plaza         Louvre Accord     Maastricht
  Debt Crisis     Agreement          2/1987          Treaty
    8/1982         9/1985                            9/1991
  EMS crisis     Peso Collapse     Asian Crisis   Russian Crisis
   2/1992          12/1994           6/1997          8/1998

Euro Launched    Brazilian real      Turkey       Argentine peso
   1/1999            crisis           2001            crisis
                    1/1999                           1/2002

    Why do Currency Crises Happen?

 Long run: In theory, a currency’s value mirrors
    the fundamental strength of its underlying
    economy, relative to other economies.
   Short run: currency traders’ expectations play a
    much more important role.

    How do Currency Crises Happen?

 Mass exodus causes sharp drop in currency
    valuation  currency crisis.
   Fears of depreciation become self-fulfilling
   Policy for recovery unclear – appears to be
    contextual. Therefore we can examine Mexican &
    Asian crises to gain perspective.

      Mexican Peso Crisis (1994-95)
 The Mexican government announced a plan to
    devalue the peso against the dollar by 14%.
   Investors’ response: dump Mexican currency, stocks
    and bonds  40% drop in peso.
   Led to flotation of peso. Crisis spilled over to Latin
    America/Asia. “Tequila Crisis”.

       Importance of Mexican Crisis
 This was the 1st serious int’l financial crisis sparked
    by cross-border flight of portfolio capital.
    • In prior crises, currency had been abandoned; here also
      the stocks & bonds.
 Underscored degree of interdependency of financial
    systems world-wide.
   Highlighted the inherent riskiness of relying on
    foreign capital to finance domestic investments.
    • Influx of foreign capital can cause overvaluation of

           Asian Crisis (1997-98)
   Thai baht devalued on July 2, 1997. Sparked crisis region-
    wide; overflowed to Russia and Latin America.
   Far more serious than the Mexican peso crisis in terms of
    the extent of the contagion and the severity of the resultant
    economic and social costs.
   Many firms with foreign currency bonds were forced into
   The region experienced a deep, widespread recession,
    which is still ongoing, despite IMF bail-out packages.
    • Moral hazard?

                      Why Asia?
 Weak domestic financial systems.
 Free international capital flows.
 Market sentiment – sparked contagion.
 Inconsistent economic policies and incomplete
    disclosure thereof.
   Hardest hit countries (Indonesia, Korea, Thailand)
    had especially high ratios of
    • (1) short-term foreign debt/FX reserves and
    • (2) broad money (representing banking system
      liabilities)/FX reserves.

 Financial market liberalization must be paired with
    development of strong domestic financial system.
   Note: Mexico and Korea joined the OECD a few
    years prior to crises – OECD membership had
    required significant market liberalization.
   Governments should
    • strengthen financial market regulation & supervision
    • discourage short-term cross-border investments
    • encourage FDI and long-term equity & bond

           IMF on Currency Regimes
IMF Regime Classification
 No separate legal tender (39): Ecuador
 Currency Board (8): commit exchanging domestic currency
  at a fixed rate to foreign currency.
 Conventional Fixed Peg (44): Country pegs its currency
  (formally) at a fixed rate to major currency ± 1% variation
 Pegged Exchange w/in Horizontal Bands (6): maintain
  within margins wider than ± 1% around de facto fixed peg.
 Crawling Peg (4): Currency adjusted periodically in small
  amounts at pre-announced rate

       Contemporary Currency Regimes
 Exchange Rates w/in Crawling Peg (5): Currency
    maintained within certain fluctuation margins around
    a central rate that is adjusted periodically
   Managed Floating w/ No Preannounced Path for
    Exchange Rate (33): Monetary authority active
    intervention in foreign exchange markets
   Independent Floating (47): Exchange rate is market

   Fixed vs. Flexible Exchange Rates

 Why countries prefer fixed exchange rates?
   • Stability in international prices for the conduct of trade
   • Anti-inflationary, requires country to follow restrictive
       monetary & fiscal policies
   •   Credibility, if central banks maintain large
       international reserves to defend fixed rate
   •   Fixed rates may be maintained @ rates inconsistent
       with economic fundamentals. For example, Asia these

           The curious case of Asia
 Recently Asian countries have shown reluctance to
    allow their currencies to rise against the dollar
   Why?
    • Prefer fixed exchange rates (ergo stability)
 Consequences:
    • Rise of the euro – good or bad? What do you think?
 Solutions:
    • Float of exchange rates of Asian economies.
    • Financial sector liberalization in China.

    Ideal Currency Or Impossible Trinity?

   Exchange rate stability –value of currency would be fixed to
    other currencies

   Full financial integration – complete freedom of monetary
    flows allowed, traders & investors could move funds in
    response to economic opportunities

   Monetary independence – domestic monetary policies by
    each individual country to pursue national economic policies,
    e.g. limiting inflation, foster prosperity & full employment.

      The Impossible Trinity
                  Full Capital Controls

     Monetary                              Exchange Rate
   Independence                               Stability
                       Increased Capital

     Pure Float                             Monetary Union
                      Full Financial
Can have only 2-sides/ system.E.g., if Monetary Independence
                  & Financial Integration,
          cannot attain Exchange Rate Stability.
Emerging Markets & Regime Choices
 Currency Boards: country’s central bank commits to
  back monetary base, with foreign reserves @ all
  • means a unit of domestic currency cannot be
    introduced w/o an additional forex reserves
     – Argentina (1991), fixed Peso to US$
     – Bulgaria (1997), fixed Leva to Euro.

Emerging Markets & Regime Choices
   Dollarization: use of US$ as official currency
         – Panama, 1907 & Ecuador, 2000.
   Why dollarization?
    • Removes possibility of currency volatility;
    • Eliminate possibility of currency crises;
    • Economic integration with US & other dollar based markets
   Why not dollarization?
    • Loss of sovereignty over monetary policy
    • Loss of power of seignorage, the ability to profit from printing
        own money.
    •   Central bank no longer lender of last resort.

              Living on the edge…
                          Emerging Market   High capital mobility

 Free-Floating Regime                            Currency Board or

•Currency free to float                      •No monetary
•Independent monetary                        independence
policy & free                                •No political influence
movement of capital                          on monetary policy
allowed, but @ loss of
stability                                    •Seignorage rights lost

•Increased volatility

                       The Euro
 European Monetary System (EMS):15 Member
   Maastricht Treaty’ 92 – timeline of economic &
    monetary union.
    • Convergence criteria called
       – Nominal inflation < 1.5% above average for EU lowest
         3 inflation rates year before.
       – LT interest rate < 2% above average for EU lowest 3
         interest rates.
       – Fiscal deficit < 3% of GDP.
       – Government debt < 60% of GDP.
    • European Central Bank (ECB) established.

        The Euro & Monetary Unification
 The euro, €, was launched on Jan. 4, 1999 with 11
    member states
   Benefits of the euro?
    • Lower transaction costs in EU.
    • Currency risks reduced.
    • All consumers and businesses, both inside and outside
      of the euro zone enjoy price transparency and
      increased price-based competition

       The Euro & Monetary Unification

 Successful unification ?
   • ECB has to coordinate monetary policy
      – Focus on price stability.
   • Fixing the euro
      – 12/1998, national exchange rates were fixed to the Euro.
      – 1/1999 euro trading on world currency markets.

Euro’s Way-up

       Tradeoffs b/n Exchange Rate Regimes

                        Policy Rules

 Non-cooperation                             Cooperation
Between Countries                          Between Countries

                    Discretionary Policy

                                What Lies Ahead?
   Tradeoff b/n rules & discretion, cooperation & independence.
                      •Gold            Rules             •Bretton
                     Standard                             Woods

No cooperation b/n
                                                        System Cooperation b/n
    Countries                                                       Countries


             •US Dollar,
             1981-1985               Discretion

   Terminology
    •   Foreign currency exchange rate
    •   Spot exchange rate
    •   Devaluation (revaluation)
    •   Depreciation (appreciation)
   The impossible trinity of goals for forex: fixed value,
    convertibility, independent monetary policy.
   Currency board or dollarization?
   Fixed vs. Floating Exchange Rates.
   Euro advent.


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Description: History of Foreign Exchange Rates Price Transparency