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					     Introduction to International Finance
Econ 192 (International Macro or International Finance)
    covers many topical issues
a) What has happened to the $ relative to the currencies
    of our main trading partners?
b) Is the current account (CA) deficit too large?
c) Should China devalue its yuan (reminbi)? Should it first
    liberalize financial flows?
d) Should Sweden give up its currency in favor of the
    Euro? Note: it is not in the EU
e) Should emerging economies liberalize their financial
    markets? Is this good for world economic growth, or a
    source of instability?
f)    How, if at all, should we reform the IMF? What about
      globalization?
All these are interesting questions. To get some answers, we need
      study International Finance. What is this field all about?
            International Finance
1.   Existence due to the fact that economic activity is affected by the
     existence of nations. Without national economies, there is no
     international finance! If there is no international trade (recall Econ
     190), there would be no international finance or international
     macro.
2.   Because countries trade (not using their currencies), there is a
     problem of payments and what factors determines the prices that
     currencies trade at (exchange rates).
3.   More importantly, countries borrow and lend from each other, that
     is, they trade intertemporally --- consumption today for
     consumption tomorrow or vice versa. International borrowing and
     lending options enable households to have better opportunities to
     smooth their incomes and thus consumption
4.   The international financial system makes international financial
     crises possible -- importantly– why do financial crises arise?
     Some General Facts about the
        International Economy
1.   FX is the biggest market in the world; $1.5 trillion per day, US
     GDP is about $12.3 trillion (2005:2), exports and imports are
     much smaller, about $1.3 and $1.98 trillion annually. Net exports
     are -$680 billion. Federal expenditures are $867 billion, of which
     $581 billion is defense spending; gross private investment is
     $2.04 trillion, gross private savings is $1.65 trillion (gross
     government savings is - $156 billion), thus gross savings as a %
     of GDP is about 13.4% -- most of this is replacement of capital,
     so net savings ($205 billion) as % of GDP is about 1.66% --- very
     low indeed!
2.   Recent years, the US has become the largest international debtor.
     Does this have consequences? US absorbs about 70% of global
     current surpluses (other country‟s savings). US current account
     deficit is about 6% of GDP – large by historic standards. In the
     60s and 70s, the current account was positive (-- we were
     acquiring net foreign assets). Since then foreigners have been
     buying our IOUs
3.   How to eliminate the deficit? Some suggest the $ has to adjust. By how
     much? How is the Current Account determined ---we need a theory
     (theories) of the current account.
        Globalization & International
           Economic Integration
•    Globalization – increasing market integration, the expansion of
     world governance, and increased mobility of people and
     information. 3 areas: trade, financial products & immigration
•    International economic integration refers to the extent and
     strength of real-sector and financial-sector linkages among
     national economies.
A.   Real Sector: The sector of the economy engaged in the
     production and sale of goods and services.
B.   Financial Sector: The sector of the economy where individuals
     trade in financial assets (bonds, equities, deposits etc).
•    Though economists tend to measure activity in these two
     sectors separately, an important point of this course is to show
     that they are linked.



                                                                        4
            International Finance
1.   Thus, Econ 192 is a consequence of multiple currencies.
2.   It is also a consequence of intertemporal trade – normally a
     subject of trade theory (Econ 190) but we do it here because it
     manifests itself in securities – flows are larger than trade on a
     gross basis.Gross capital flows as 6 – 7 times net flows). It is
     these gross flows that unsettle securities markets. That is, many
     countries borrow in currencies that differ from their domestic ones
     - currency and financial crises.
3.   Globalization is NOT new (see previous slide) --- specific role of
     technology, capital flows, and institutions.
4.   International Financial System is critical for the efficient
     organization of international economies: several periods
a.   Gold Standard --- peak of an integrated global capital market. It
     worked so well then, why can‟t we return to it now? Good
     question!
b.   WWI, Depression breaks the System; Bretton Woods – works
     until it breaks down with Vietnam War and OPEC
                       Continued
d.   Is globalization the culprit? NO, since capital mobility was very
     high in the 19th century. Does globalization cause debt crises or
     does it enhance growth in poorer countries?
e.   Breakdown of Bretton Woods led to floating rates and currency
     areas; major floats (US, Japan), dirty floats or managed floats,
     currency boards (HK, Argentina), pegged (China and many Asian
     economies), eliminated currencies to form a union (EU)
A feel for International Finance: US data   1. Bilateral exchange rates
                                               (price of currency in
                                               terms of another) –see
                                               Figure 5 [price of a $ in
                                               terms of the Yen] since
                                               1970 -- $ has generally
                                               depreciated (Yen
                                               appreciated) but has
                                               also been volatile –
                                               more so when one looks
                                               at the short period (from
                                               1990) in Figure 6.
                                            2. Recently (last 2 years),
                                               the Yen has been
                                               appreciating (getting
                                               stronger) as the $ has
                                               depreciated (getting
                                               weaker)
Japan and US – largest economies‟ exchange rate being so volatile!
Same holds for the European Currency Unit (ECU) [precursor to the
Euro] and $ in Figure 7.
1.   Trade-weighted or effective exchange rates. Reason: bilateral rate is
     misleading since the Current Account is an outcome of trade with many
     countries. Trade-weighted exchange rates give an average for a group
     of countries based on their share of trade with the US. Fed calculates
     an index of a $‟s value based on 10 major currencies [ Figure 7]
Figure 8 plots the trade-weighted value of the $ since 1973 --- note the long
swings! Why? --- role of different national inflation rates
1.   Patterns in the Current Account (CA) = (ex- im)+ Any Net Transfers. It
     is a measure of a country’s relations with ROW.
2.   If CA>0 -> the country is acquiring Assets from ROW (say, Japan) and if
     CA<0  ROW (Japan) acquires more assets in the country or its Debt is
     increasing (USA.) Figure 9 – CA from 1960 to 2005 (absolute terms)
     BUT more useful to examine CA/GDP as in Figure 10
                                                US CA as a share of GDP.
                                                Two facts:
                                                (a) used to be a large
                                                international creditor and earned
                                                 interest income which offset a
                                                 tiny trade deficit,
                                                (b) now a large international
                                                debtor (since 1985) – hence
                                                 paying out interest income to
                                                 holders of our IOUs.




3.   Looking across economies between
      1996 and 2004, we can see changes in
      CAs (see Figure 10): (a) huge increase
      in US CA deficits, and (b) big swing in
      some developing countries: Funny
      thing: In Figure 11, Developing
      countries are now large net lenders to
      the rich world!
Developing Countries as Net
     Lenders
1.Reason for this anomaly: (a)
currency crises in late 90s – LDCs
reacted by building up reserves of US
 IOUs, (b) oil producing countries built
 up reserves. Note: Germany and
Japan --- large surpluses ---
demographic problems. Note: in
Figure 11, numbers don‟t add up 
statistical discrepancy.
2. Is a large CA deficit bad?
Example: Japan has CA surplus
=2.5% of GDP: 2 things: Which is
 better? (a) Japan lends 2.5% of its
GDP to foreigners or (b) that it can
borrow from ROW?
1.The other side of a CA <0 is a Financial Account surplus, KA>0 (see Figure 12
      for the Financial Account since 1960). Compare Figure 9 and 12 – patterns
      are mirror images!
2. There is concern that CA <0 in the US are being financed by capital inflows
      (KA>0). Fear that such inflows could dry up!
3. Why capital inflows into the US? (a) domestic I > domestic S, that is, the US
      spends more than its production, and ROW is financing it, (b) higher
      standard of living (living beyond our means) and the willingness of ROW to
      finance it (since the $ is an international currency) --- which is why we can
      get away with such deficits.
     Recent Events – Asian Currency &
                   Emergence of the Euro
1.   Effect of the currency crisis --- examine the exchange value of
     the baht. Depreciation of the baht in Figure 13 – triggered the
     „Asian flu‟ and spread throughout emerging markets. Similar
     events in Brazil & Turkey.
2.   Issue: What caused the baht to depreciate, the consequences of
     it, and the reasons for contagion.
3.   Such is an example of a sudden stop, and reversal of capital flows
     across countries and this is reflected in the price. Such events are
     reflected at CAs of developing & emerging markets (Figure 14)---
     deficits here imply capital inflows and the 90s were good for these
     economies. In 1998, there was a sudden reversal in the direction
     of these flows.
4.   The reversals of the 80s were smaller than the 90s reversals.
                                                        “Don’t Cry for me
                                                        Argentina!”
                                                        1. A currency crisis
                                                        turned into an
                                                        economic and social
                                                         crisis – governments
                                                        replaced, and by
                                                        Sept.1, 2005, an
                                                        interim agreement with
                                                         IMF expired ----
                                                        possibility of a default.


2. Figure 15 shows why –(a) had a major depression – fall in GDP and its
      components until 2002, and then experienced recovery as the peso
      resulted in depreciation.
3. Major problem --- How to exit the Currency Board. Renegotiated with the
      IMF; large foreign debt ($128 billion or 3 times its GDP); peso cannot
      depreciate because of the Currency Board; most Argentines like the
      Board because it saved the country from worse inflation. Sticking by the
      Board induces capital outflows in anticipation of a possible default. To
      understand this, we need to understand why countries establish Currency
      Boards.
     Euro: Group of Countries share the same
                             currency
1.   Interesting questions in International Finance: When should
     countries share a common currency? Why should countries have
     different currencies? Doesn‟t such a state of affairs make trade
     more difficult? Note: The US is a monetary union – states don‟t
     have their own currencies – „A Benjamin Franklin in SF is as good
     there as it is in NY.” Europe has now formed a monetary union –
     What are the costs and benefits of such a union? Question is
     important for 2 reasons:
A.   10 new countries must adopt the Euro as a condition of joining.
     But is it advantageous for them to join (UK has delayed).
B.   Italy is debating whether to exit (facing similar problems like
     Argentina); Sweden stayed to protect its oil revenues). These
     problems come in the wake of difficulties in having the stability
     pact work. Why is it needed for the Euro?
 International Financial Architecture
1.   Major issue – How to reform the IMF: Fundamental criticisms
a)   some have suggested that as it stands, it tends to introduce risk
     into the system - moral hazard.
b)   IMF remedies in cases of crises are too painful -- witness the
     rejection of the “Washington Consensus” sweeping through Latin
     America: Chile, Argentina, Venezuela, Bolivia, Brazil and may be
     Mexico!
2.   Some look for reform to make the system better. Is it broke? How
     to fix it? The answers require a clear understanding of
     international capital flows.
3.   All related to the issue of globalization: (a) Should the IMF
     encourage financial liberalization in emerging markets? (b) Do
     international financial institutions make the system better or
     worse?
            CA=Current Account
9.   Question: With floating rates after 1973, why has the CA become
     so large?
(a) With flexible rates, it was assumed that exports and imports would
     natural balance. The opposite has occurred. Why? Because CA
     represents just more than trade behavior with ROW – also
     depends on Saving (S) and Investment ( I).
(b) Large CA<0 + low S -- net borrowing from ROW or increasing
     CA deficit.
10. Volatility of exchange rates---- some economists have called for a
     return to fixed exchanges (pre-1971) or to the Gold Standard (19th
     and early 20th centuries) to eliminate volatility (risk)?
              US Current Account (2003)

         Exports           Millions                                  1,314,888
                           Goods                                       713,122
                           Services                                    307,381
                           Income Receipts                             266,799
         Imports                                                    -1,778,117
                     Goods                                          -1,260,674
                     Services                                         -256,337
                     Income Payments                                  -261,106
         Unilateral Transfers                                          -67,439
         Current Account Balance                                      -530,668
       Note: The US normally has DR (-) on Unilateral Transfers because it is as if we
are importing goodwill, e.g. food aid to Pakistan is never paid BUT for double-entry purposes
                                                                                        21
                              it is reflect that as a negative entry.
                                                                    22
Note: For the US, Services & Income Accounts tend to be positive.
             Balance of Payments
                      Capital Account (KA)
The Capital Account
Records international flows of transfer payments relating to capital items
(i.e. inflows & outflows of payments and transfer of ownership of fixed
assets [capital goods, e.g. factories]) OR records acquisition or disposal of
non-financial assets, e.g. land, mines etc.
Capita Account can be broken into monetary flows from
(a) Debt forgiveness – HIPC countries->Bono’s project
(b) Transfer of financial assets by migrants leaving & entering a country,
     e.g. remittances to Mexico enter as DR item
(c) Transfer of funds received in the sale/acquisition of fixed assets, e.g.
     purchase of Moscow land for a US Embassy (DR)
(d) Uninsured damage to a fixed assets, e.g. English family pays for
     storm damage to their uninsured property in Southern California
     (CR)
US Assets used to purchase foreign assets are capital outflows and DR (-)
     entries in the Financial Account AND foreign purchase of US assets
     are a capital inflow and a CR (+) in the Financial Account.
                                                                           23
        Financial Account (FA);1
B. We can then state the general principle: Any acquisition of foreign
     assets by US residents is a Capital Outflow (DR) and any acquisition
     of US assets by foreigners is a Capital Inflow (CR).
C. Relationship between CA and Financial Account Balances: If Capital
     Account =0, the Financial Account must be the same as the CA, but
     with an opposite sign. Example: If CA = -$20 trillion, then to cover
     the deficit, the US must generate capital inflows =+20 trillion
Financial Account (FA) or Official Reserve Account
Records net changes in foreign ownership of domestic and foreign
financial assets. It records 3 types of payment inflows and outflows. It
records trade in assets such as business firms, bonds, stocks and real
 estate.
•     Portfolio Investment: Individual or business purchase of stocks,
      bond, or other financial assets or deposits (an income strategy) with
      less than 10% ownership.
•     Foreign Direct Investment (FDI): Purchase of financial assets that
      results in a 10 percent or greater ownership share (a financial control
      strategy)
•     Other –transactions in currency and bank deposits
                                                                            24
               The Financial, KA;2
A country may desire to receive both portfolio and direct
 investment due to the type of investment each represents.
•    Portfolio investment is a financial investment
•    Further, portfolio investment tends to be short-run
     (popularly designated as “hot money”) in nature, while
     FDI tends to be long-run in nature.
•    (a) If FA > 0: foreign ownership of domestic assets >
     domestic ownership of foreign financial assets OR in US
     terms: Foreign-owned assets in the US> Foreign Assets in the
     US.
•    (b) If FA < 0: domestic ownership of foreign assets > foreign
     ownership of US financial assets
•    (c ) If FA = 0: domestic ownership of foreign assets = foreign
     ownership of US financial assets

                                                                  25
                Capital and Financial Account
Note: Net Capital Account = (Foreign Assets used to purchase US Assets -US Assets used to purchase
                                          Foreign Assets)
                                   = (CR – DR) = <0 → CR <DR


                  1   Capital Account, Net                                 -3,079
                      Financial Account
                  2   US-Owned Assets Abroad                           -283,414        An increase/
                                                                                       outflow (-)
                         US Official Reserve Assets                      -1,523
                         US Government Assets                               537
                         US Private Assets                             -285,474
                  3   Foreign-Owned Assets                              829,173 Increase/inflow
                       Foreign Official Assets                          248,573 (+)
                       Other Foreign Assets                             580,600
              2+3= Net Financial Account Flows                          545,759
 1: In many countries, this account is of lesser importance than the Financial
 Account. It includes transfers of specific types of capital (debt forgiveness, personal
 assets of immigrants, transfer of real estate and other fixed assets, e.g. transfer
                                                                                   26
 of ownership of a military base or an embassy.
                       The Balance of Payments
                      The Statistical Discrepancy
     • The sum of the debit and credit
       entries in all of the BOP should
       total zero.
                                                   Balance on Current Account      -530,668
     • Of course there are errors and
       omissions resulting in a non-               Capital Account, net              -3,079
       zero balance.
     • An offsetting entry to this non-            Net Financial Flows              545,759
       zero balance is made in the
       statistical discrepancy account.            Statistical Discrepancy          -12,012 *
     • In this way, the total of the
       debit and credit entries equals
       zero.


[CA] - [Net Financial Flows – Capital Net Account + FA] = Statistical Discrepancy Account
                      = [-530,668 ] - [545,759+ (-3,079)] = -12,012 *                   27
     Net Creditor and Net Debtor
                Status
1. A net creditor country is a country whose total claims
   on foreign residents (US Assets Abroad) exceed the
   total claims of foreign residents (Foreign Assets in
   the US) on the residents of the domestic nation (US
   between 1914 and 1985), i.e. FA >0
2. A net debtor is a nation whose total claims on foreign
   residents are less than the total claims of foreign
   residents on the residents of the domestic nation (US
   between 1874 and 1914 and since 1985), i.e. FA <0
3. It is not necessarily good nor bad to be either a net
   debtor or net creditor.

                                                       28
FA<0

       29
 The Relationship Between the Current Account
   (CA) and the Capital Account (KO);1 →2
                  approaches
1.    Expenditures Approach (Sources) to National
      Income
     A. National income (y) is the sum of expenditures in the
        following categories; consumer expenditures ( c), private
        investment expenditures (iPr ), government expenditures (g),
        and net export expenditures (ex –im),
     B. y= c + ipr + g + (ex-im)
     C. Let the current account, CA equal ;CA = (ex – im)
     D. Then
         y=c + ipr + g + CA Or
         CA = y –c – ip – g

                                                                   30
 The Relationship Between the Current Account
           and the Capital Account;2
  CA = y –c – i – g
         p



2. Income Approach
  A.   Income (y) has three possible uses; it can be spent on current
       consumption (c ), it can be saved (private saving) (spr), and we
       pay taxes (t) to the government
      y= c + spr + t
B. Because both approaches equal national income (y) , we
    can set the two identities equal:
      c + spr + t = c +ipr + g + ca
or,
C. (spr – ipr) – (g - t) = CA or (spr – ipr) + (t - g)=CA
                                                                      31
     The Relationship Between the Current Account
               and the Capital Account; 3
1.   Private Saving
   A. Private saving can be used to purchase three types of assets,
        domestic private investment (iPr ), government debt (g – t) (if g>t)
        or to accumulate foreign assets (fa),
         sp = ipr + (g – t) + fa
where fa is the (net) accumulation of foreign assets (domestic residents’
     purchases of foreign assets in excess of foreign residents’ purchases
     of domestic assets).
B. Then, by rearrangement
         sp – ip – (g – t) = fa
Putting the two together: (Recall that: (sp – ip) – (g - t) = CA)
         CA = sp – ip – (g – t) = fa
GIST: In words, private domestic saving (sp) less private domestic
     investment (ip) less the fiscal balance (government saving) ((g – t) )
     equals the current account balance (CA), which also equals the (net)
     accumulation of foreign assets (fa).

                                                                           32
     An Example of the Relationship Between the
     Current Account and the Capital Account; 4

1. Using the equality we derived,
      ca = sp – ip – (g – t) = fa
2) Suppose a nation’s private saving rate is 5.2 percent
   of its total output, its private investment rate is 7.3
   percent, and its fiscal budget deficit (g>t by 3.3%) is
   3.3 percent. Then
        ca = 5.2 – 7.3 – 3.3 = -5.4 = fa
     3) In words, this nation’s residents must borrow from abroad
        (fa = -5.4) to finance their investment expenditures, resulting
        in a current account deficit in the amount of 5.4 percent of
        total output, CA/GDP= fa/GDP =-5.4%
                                                                     33

				
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