Global Financial Systems Chapter 11 Currency Markets Jon Danielsson London School of Economics 2018 To accompany Global Financial Systems: Stability and Risk http://www.globalfinancialsystems.org/ Published by Pearson 2013 Version 5.0, August 2018 Global Financial Systems 2018 Jon Danielsson, page 1 of 104
Book and slides The tables and graphs are the same as in the book See the book for references to original data sources Updated versions of the slides can be downloaded from the book web page www.globalfinancialsystems.org Global Financial Systems 2018 Jon Danielsson, page 2 of 104
Introduction Global Financial Systems 2018 Jon Danielsson, page 3 of 104
Introduction There are around 180 currencies in the world Using a wide variety of arrangements for determining the exchange rate (see next slide) Countries frequently change their regime And usually are unhappy with what they have chosen Global Financial Systems 2018 Jon Danielsson, page 4 of 104
Currency regimes Currency union or more independent countries have same currency (Eurozone, Panama) Unilateral adoption/ currency substitution adopt foreign currency unilaterally (Ecuador) Single/basket currency peg/fixed exchange rate unilaterally fix a currency to that of another country (Hong Kong) Crawling peg a peg where a currency slowly and steadily depreciated over time (Turkey) Currency board a country pegs and keeps full reserves of the other country s money (Argentina) Target zones currency floats inside a upper and lower limit Managed float currency floats but is subject to intervention Free float the government does not try to control currency Global Financial Systems 2018 Jon Danielsson, page 5 of 104
Daily volume by instrument in USD trillions BIS tri-annual survey USD trillion $5 $4 $3 $2 Total Spot Forward Swap Options+other $1 $0 2001 2004 2007 2010 2013 2016 Global Financial Systems 2018 Jon Danielsson, page 6 of 104
40% Relative trade volume by currency USD EUR BIS tri-annual survey JPY GBP AUD CAD CHF CNY 30% 20% 10% 0% 2001 2004 2007 2010 2013 2016 Global Financial Systems 2018 Jon Danielsson, page 7 of 104
40% Where trade takes place United Kingdom United States Singapore Hong Kong SAR Japan France Switzerland 30% 20% 10% 0% 2001 2004 2007 2010 2013 2016 Global Financial Systems 2018 Jon Danielsson, page 8 of 104
Purchasing-power parity (PPP) Long run FX should move towards a rate that makes the prices of an identical basket of goods and services the same Most likely with globally traded goods, like oil Least likely with services, like hair cuts Big Mac index Since it is an identical product with heavy service component Global Financial Systems 2018 Jon Danielsson, page 9 of 104
Switzerland Norway United States Germany Britain Singapore Venezuela Chile Japan China India Mexico Russia Taiwan South Africa Malaysia Egypt Ukraine Big Mac index relative to USD, amount and rank 1 2 3 4 56 21 1314 12 30 33 34 35 40 53 55 56 70% 50% 30% 10% 10% 30% Global Financial Systems 2018 Jon Danielsson, page 10 of 104
FX Regimes Global Financial Systems 2018 Jon Danielsson, page 11 of 104
Gold standard The world s most successful FX regime In effect from 1870s to 1914 (and before and after) Benefited capital exporters and the wealthy classes Agricultural exporters and the poor lost Reason is deflation Speculation is stabilizing (next slides) Ultimately undermined by universal suffrage Global Financial Systems 2018 Jon Danielsson, page 12 of 104
Speculation is stabilizing under the gold standard Trade deficit Net gold outflows (M ) P imports imports P domestic exports Trade imbalance eliminated Global Financial Systems 2018 Jon Danielsson, page 13 of 104
Bretton Woods 1944 1972 A system of pegged but adjustable exchange rates dollar fixed at $35 per ounce of gold other currencies fixed to the dollar With capital controls as a substitute for an adjustment mechanism IMF surveillance, extend financing to countries at risk Par values could be changed to correct a fundamental disequilibrium after approval from IMF Global Financial Systems 2018 Jon Danielsson, page 14 of 104
Domestic priorities Governments were fully committed to domestic policies growth and full employment Philips curve Britain adopted a Stop Go policy France had to combine devaluation with fiscal discipline to overturn its deficit US had Vietnam, Great Society Germany and Japan vs. the weak countries Global Financial Systems 2018 Jon Danielsson, page 15 of 104
International cooperation Lack of effective adjustment mechanism Capital controls difficult to enforce corruption Easy to under or over invoice trade Parity changes were rare (but disastrous) Intentions might be leaked to the market, inducing capital outflows Frequent small adjustments might be destabilizing System survived because of international cooperation Gold pool Lines of credit Global Financial Systems 2018 Jon Danielsson, page 16 of 104
The collapse Balassa Samuelson Effect Lack of monetary discipline in the US Vietnam war Spending on welfare Not sufficient for the US to simply match the inflation rates of other countries Fast growing countries (e.g. Germany and Japan) can afford to run higher inflation Limits to the extent of support from foreign governments Global Financial Systems 2018 Jon Danielsson, page 17 of 104
Liquidity The dollar becomes the anchor, countries accumulate dollars enabling the US to run payments deficits Triffin dilemma: Bretton Woods system dynamically unstable if foreign dollar balances exceed US gold reserves and all countries try to convert dollars into gold, similar effect as a bank run Creation of special drawing rights (SDR) which act as another reserve asset The SDR has popped up in public discussions recently. Why? Global Financial Systems 2018 Jon Danielsson, page 18 of 104
Impossible trinity Trilemma it is impossible for a country to simultaneously have all the following policies in place Fixed exchange rate Free capital movements Independent monetary policy Global Financial Systems 2018 Jon Danielsson, page 19 of 104
Example Start with a country in equilibrium and fixed FX If the country then embarks on an expansionary monetary policy, or simply loses control of inflation, the money supply is increasing In this case, speculators can borrow the country s currency and exchange for foreign money carry trade Such a trade is likely to attract a large number of market participants In order for the government to maintain the exchange rate, it has two choices 1. continue selling its foreign currency reserves until it runs out, at which time the regime will collapse 2. impose capital controls Global Financial Systems 2018 Jon Danielsson, page 20 of 104
Impossible trinity Fixed Exchange Rates International capital mobility Independent monetary policy Gold Standard Bretton Woods EU/US China Global Financial Systems 2018 Jon Danielsson, page 21 of 104
ERM System Part of the European Monetary System, precursor of the euro A target zone exchange rate regime The European Currency Unit (ECU), an artificial unit of account, was created Exchange rates for each currency against the ECU were established The system allowed a fluctuation band of ±2.25% around this central rate Member countries had to intervene to ensure their currencies stayed within the band Global Financial Systems 2018 Jon Danielsson, page 22 of 104
Dominant role of Germany Effectively, the bands were maintained against the most stable currency, the Deutschmark (DM), which became the unofficial reserve currency The Bundesbank was supposed to lend DM to countries whose currencies came under depreciatory pressure Therefore, Germany was the only country with discretion over its own monetary policy Global Financial Systems 2018 Jon Danielsson, page 23 of 104
Reunification of Germany Amalgamation of a large rich economy with a smaller poorer economy Germany embarked on a massive fiscal expansion to transfer resources to the east East German marks were converted to DM at a rate of 1.8:1 The government deficit rose from 5% to 13.2% Bundesbank concerned about high inflation pursued a contractionary monetary policy, by raising interest rates Global Financial Systems 2018 Jon Danielsson, page 24 of 104
Adverse impacts High interest rates and appreciation of DM hurt other countries UK was in a recession, with unemployment levels over 10% Same was true of Italy, Spain, Sweden Those countries couldn t use expansionary monetary policy or a weaker currency to stimulate their economy Speculators figured the system was not sustainable Global Financial Systems 2018 Jon Danielsson, page 25 of 104
Speculative attacks September 16, 1992 is nicknamed Black Wednesday In the morning, BoE raised rates from 10% to 12%, a few hours later, to 15% but could not stop the massive selling of pounds Eventual loss for the UK of 3.3 billion Sterling left the ERM that evening, followed by the Italian lira Eventually, on August 3, 1993, the size of the bands were widened from ±2.25% to ±15% Basically a free float Global Financial Systems 2018 Jon Danielsson, page 26 of 104
So Market sentiment gradually turned and was casting doubt whether governments would stay firmly committed to the ERM Governments were weighting the costs involved in staying in the ERM (loss of monetary independence) against the benefits (monetary union) Investors started to believe that the costs for some governments in the ERM had become too high and they were no longer committed to the peg Countries with the weakest fundamentals were the first to be attacked and the first to abandon the ERM Global Financial Systems 2018 Jon Danielsson, page 27 of 104
Parallels with today 1. Devalue The countries that devalued/left were in a short term recession Devaluation helped them to recover long term benefits Is that needed today? 2. Be stable Currency crises and devaluations and inflation costly Stability valuable Hence common currency Should Italy leave the Euro? We discuss later Global Financial Systems 2018 Jon Danielsson, page 28 of 104
Fixed or Floating Global Financial Systems 2018 Jon Danielsson, page 29 of 104
In favor of fixed Wrong rate argument The market is inefficient It does not make use of available information Prone to destabilizing speculation Attaches too high a probability on a devaluation or appreciation, not usually justified by economic fundamentals Speculators may deliberately manipulate the rate to profit from the resulting volatility Global Financial Systems 2018 Jon Danielsson, page 30 of 104
After all High frequency FX volatility is very high Whilst economic fundamentals move slowly So intervention is useful to get the correct rate Benefits society though low transaction costs and risk Encouraging trade and investment Global Financial Systems 2018 Jon Danielsson, page 31 of 104
In favor of floating Authorities incapable of identifying the correct FX May want a wrong rate for political reasons overvalued currency to make voters feel artificially wealthy undervalued to help industry Costs of incorrect rate are high Interventions are distortionary Speculators may undermine the interventions Global Financial Systems 2018 Jon Danielsson, page 32 of 104
So... Floating may not be less stable Are we trading volatility for jumps? See DM/USD plot below, or Venezuelan bolivar FX Allows for an independent monetary policy So the speculators attacking a fixed regime are doing the country a favor Global Financial Systems 2018 Jon Danielsson, page 33 of 104
Dollar crisis DM/USD 2.0 2.5 3.0 3.5 4.0 1973 Return 10% 5% 0% 5% 10% 1973 1959 1964 1969 1974 1979 1959 1964 1969 1974 1979 Global Financial Systems 2018 Jon Danielsson, page 34 of 104
Venezuelan bolivar to the dollar 4.0 Log exchange rate 2.0 1.0 0.5 0.2 0.1 1995 2000 2005 2010 Global Financial Systems 2018 Jon Danielsson, page 35 of 104
Conclusion Both compelling elements Countries alternate, never happy No exchange rate regime is perfect All governments think some interventions are necessary Academic economists are often vocal in their opposition to FX interventions, those actually in charge disagree Global Financial Systems 2018 Jon Danielsson, page 36 of 104
Intervention Global Financial Systems 2018 Jon Danielsson, page 37 of 104
Official intervention Introduction The government chooses the exchange rate regime In no other asset market do governments interfere as strongly Fixing an exchange rate means that the government must always be willing and able to trade its currency with investors at this rate unless capital controls Fixing an exchange rate means that the government gives up independence of its monetary policy Governments have actually intervened more heavily with (officially) flexible exchange rates Global Financial Systems 2018 Jon Danielsson, page 38 of 104
Sterilization central bank balance sheet Assets Liabilities Net foreign currency bonds Monetary base Net domestic currency bonds Net worth Foreign currency reserves Gold Official intervention is sterilized when the central bank carries out transactions that insulate the effects of a change in net foreign asset holdings on the domestic money supply Global Financial Systems 2018 Jon Danielsson, page 39 of 104
Foreign exchange interventions involve a purchase or a sale of foreign assets If the CB wants to keep its currency from appreciating, it will sell it for foreign currency and purchase foreign assets The purchase leads to an increase in assets and therefore the monetary base To sterilize, the CB sells domestic bonds drawing currency out of circulation to keep the monetary base constant Global Financial Systems 2018 Jon Danielsson, page 40 of 104
Sterilization may lead to an increase in domestic interest rates As a result, money flows in to profit from the higher rates, leading to an appreciation of the currency For sterilization to be effective, capital controls often need to be implemented (as in emerging markets) Sterilization is a useful tool in the short term for countries that accumulate reserves to ease inflationary pressures But creates problems in the longer run by introducing economic distortions and impeding corrections of global imbalances Global Financial Systems 2018 Jon Danielsson, page 41 of 104
Choices Hard in developed countries because assets are substitutable Sterilization increases interest rates, attracting investors to domestic assets strengthening FX Easier in developing countries China largest user, sterilizing 80% of its intervention Global Financial Systems 2018 Jon Danielsson, page 42 of 104
Capital Controls Global Financial Systems 2018 Jon Danielsson, page 43 of 104
Capital controls Control the flow of foreign currency taxes on transactions outright prohibitions on buying/selling a foreign currency Strict capital controls were common in many countries Capital controls (2.0) of a different form now popular Global Financial Systems 2018 Jon Danielsson, page 44 of 104
Traditional capital controls The nations during gold standard allowed free capital mobility Capital controls introduced at the start of WWI and common until the end of Bretton Woods or later Increasingly seen as damaging Always quite leaky Encouraged corruption Most major countries had abolished capital controls by the mid 1970s Global Financial Systems 2018 Jon Danielsson, page 45 of 104
OECD study on capital controls Country Year Country Year Country Year Australia 1978 Greece 1980 Portugal 1992 Austria 1980 Iceland 1993 Spain 1985 Belgium Italy 1984 Sweden 1986 Canada Japan 1979 Switzerland 1979 Denmark 1983 Luxembourg Turkey 1985 Finland 1991 Netherlands United Kingdom 1971 France 1986 New Zealand United States 1974 Germany 1980 Norway 1989 Global Financial Systems 2018 Jon Danielsson, page 46 of 104
Hot money Large inflows of short term foreign currency which then can leave very quickly When the money comes in it makes the currency appreciate Creating the conditions for economic difficulties Which then make the hot money leave Collapsing the currency in the process Often related to carry trades Global Financial Systems 2018 Jon Danielsson, page 47 of 104
Capital controls 2.0 Share the name capital controls but are fundamentally different from the traditional type. Can call them Capital controls 2.0 I am open to suggestions for a better name Impose restrictions on hot money inflows e.g. Brazil, Chile, Colombia, Iceland, Korea Objective to prevent the adverse impacts of hot money flows and avoiding distortions caused by capital controls Targeted at a specific problem Surprisingly, IMF recently in favor In the 1950s the IMF was intimately connected to the use of capital controls But after that changed its view and advocated free capital flows Global Financial Systems 2018 Jon Danielsson, page 48 of 104
Where to invest and borrow Often best if savers invest in own country and currency Eliminates currency risk (e.g. hot money and sudden stop) But at least 3 reasons not to 1. Diversification for savers why many EMEs simultaneously export and import capital 2. Cost of borrowing 3. Amount of credit Global Financial Systems 2018 Jon Danielsson, page 49 of 104
Who borrows Matters whether borrower is an exporter, earning in foreign currency Not advisable for domestically oriented firms or households to borrow abroad whether directly in foreign currency from banks or in domestic currency from domestic banks who borrow abroad Think of Asia 1998, and several European countries (e.g. Poland) before 2008 households and very small SMEs would borrow in foreign currency caused significant pain for them and their banks in the crisis Global Financial Systems 2018 Jon Danielsson, page 50 of 104
Policy options Strong pressures for foreign borrowing Expansionary and makes everybody feel wealthier So what is the CB to do? raise interest rates (see next plot) inflow capital controls restrict who can borrow in foreign currency Global Financial Systems 2018 Jon Danielsson, page 51 of 104
The risk-taking channel of the currency appreciation Central bank rates Inflow from carry traders Demand for foreign currency loans Currency strengthens Banks intermediate FX loans Positive wealth effect Economy strengthens Global Financial Systems 2018 Jon Danielsson, page 52 of 104
Global bank retrenchment The inflow mechanism has changed since the crises Before banks were the primary intermediary e.g. NYC banks lending to domestic banks who lent to domestic agents But there has been a major retrenchment of global banks They have been leaving countries and reducing their operations And when not, may be required to establish separately capitalized subsidiaries Global Financial Systems 2018 Jon Danielsson, page 53 of 104
Financing from debt securities issuance Borrowers in EMEs have easier access to international capital markets than before Consequently, the debt issuance of EME corporate in offshore financial centers (like NYC) has increased rapidly 1. Lower interest rates 2. Positive feedback between inflows and FX appreciation 3. Lower administrative, legal and tax costs 4. Offshore markets are also more developed for sub-investment grade bonds 5. Preferential tax system for foreign investors Global Financial Systems 2018 Jon Danielsson, page 54 of 104
Outstanding international securities Developing countries, all borrowers 2000 1000 500 USD billion 200 100 50 20 10 5 China nationality global residence global nationality 1990 1995 2000 2005 2010 2015 Global Financial Systems 2018 Jon Danielsson, page 55 of 104
Turkish lira/euro 1.75e6 7 1.5e6 1.25e6 1e6 0.75e6 0.5e6 6 5 4 3 2 2000 2005 2010 2015 Global Financial Systems 2018 Jon Danielsson, page 56 of 104
Current account balance Net trade in goods and services, net earnings on cross-border investments, and net transfer payments Positive current account balance: a net lender to the rest of the world Negative current account balance: a net borrower from the rest of the world Global Financial Systems 2018 Jon Danielsson, page 57 of 104
Current account balance/gdp 5% 0% 5% 10% 15% TUR DEU EA19 ITA GRC 2000 2005 2010 2015 Global Financial Systems 2018 Jon Danielsson, page 58 of 104
Recent policies Credit is increasingly directed Policy rate is very low as believed that high interest rates are inflationary Government and financial sector USD exposure rapidly increasing Vulnerability to FX Global Financial Systems 2018 Jon Danielsson, page 59 of 104
USD billions Turkey. International debt securities 150 100 50 in USD and EUR. GDP USD 851 bn. Government Banks Non financial 0 2000 2005 2010 2015 Global Financial Systems 2018 Jon Danielsson, page 60 of 104
Overvaluing Global Financial Systems 2018 Jon Danielsson, page 61 of 104
Overvaluing it just happens Often because a country is fighting high inflation or has resorted to printing money to finance itself Fixing the exchange rate may be a way to fight inflation In the short run makes consumers, and hence voters, happy because it makes imported goods artificially cheap In the longer run it hurts exporters who are no longer competitive Global Financial Systems 2018 Jon Danielsson, page 62 of 104
Often ends in speculative attacks Speculators, who usually are well connected local companies, observe this and seek to export the domestic currency In effect, speculating against the currency regime The government may give in or resort to capital controls or multiple exchange rates The latter two are often a recipe for corruption because those giving permission to import or buy currencies at cheaper rates will reap artificial profits All of this suggests that it is virtually impossible for government to maintain an artificially strong exchange rate for long without resorting to very costly measures Global Financial Systems 2018 Jon Danielsson, page 63 of 104
Asian crisis 1998 Chapter 6 of book The then, (now returned) PM of Malaysia blamed foreign speculators for attacking its currency Similar said in Korea, Indonesia, Thailand But data shows it was the well connected local families who attacked first While foreign speculators stuck with currency Global Financial Systems 2018 Jon Danielsson, page 64 of 104
25 Frequency of currency crisis 20 15 10 5 0 1975 1980 1985 1990 1995 2000 2005 Global Financial Systems 2018 Jon Danielsson, page 65 of 104
The aftermath Currency crises 3 years after a currency crisis, the level of GDP is between 2% and 6% lower than if there had been no crisis The losses tend to materialize before the currency collapses Output growth tends to slow down prior to and in the year of the currency crisis After the currency collapse, positive growth rates seem to be the norm The economic costs of a currency collapse do not appear to arise from the collapse of the currency itself but from negative fundamentals But the government is often thrown out of power Global Financial Systems 2018 Jon Danielsson, page 66 of 104
Argentina Global Financial Systems 2018 Jon Danielsson, page 67 of 104
1 10 20 30 40 50 60 GDP per capita ranking 1880 1900 1920 1940 1960 1980 2000 Global Financial Systems 2018 Jon Danielsson, page 68 of 104
Argentina Background Argentina was one of the riches countries until the middle of the last century, now on par with or below poorest countries in EU Experienced currency crises, hyperinflation, sovereign default in the second half of last century High inflation rate persisted until the early 90s In 1991 the government adopted a currency board at parity to the dollar Prices stabilize quickly and inflation is brought down rapidly Global Financial Systems 2018 Jon Danielsson, page 69 of 104
The peso depreciation 10000 1000 100 10 1 1990 1995 2000 2005 Global Financial Systems 2018 Jon Danielsson, page 70 of 104
The 90s With low inflation, Argentina saw strong growth in the 90s Persistent budget deficits and fiscal problems continued but were masked by the strong growth performance In the late 90s, Asia, Russia and Brazil were all hit by a crisis and reacted with a devaluation of their currencies At the same time the dollar appreciated strongly Making the Argentinean peso look overvalued Global Financial Systems 2018 Jon Danielsson, page 71 of 104
The crisis Debt as a ratio of GDP increased even in boom times Growth unsustainable Argentina plunges into recession in 1999 driven by loss of export competitiveness due to the overvalued peso The government facing an election responds by increasing fiscal spending (AKA fiscal stimulus) Fiscal federalism regions borrow, center does now know or can t control Recent echoes in e.g. Spain and China Global Financial Systems 2018 Jon Danielsson, page 72 of 104
As growth stalls, the government resorts to expansionary fiscal policy causing the debt ratio to surge Investors get nervous and start pulling out capital As capital outflows increase, the government finds it difficult to service its debt Devaluation not an option due to the currency board Large part of the debt is denominated in dollars Government continues with expansionary fiscal policy, heading for disaster (sound familiar?) Global Financial Systems 2018 Jon Danielsson, page 73 of 104
Reasons Vulnerable to external shocks because fiscal policy incompatible with a fixed exchange rate regime The dollar peg eliminated monetary policy as an option and put strong restrictions on fiscal policy to keep debt sufficiently low to avoid an overvaluation of the peso Prudent fiscal policy was also important to maintain the credibility of the currency board (stimulus) The government never got its finances under control and when faced with a crisis, responded with an expansionary fiscal policy The fiscal policy of expansion was the result of political institutions pushing to commit more fiscal resources than they had Global Financial Systems 2018 Jon Danielsson, page 74 of 104
Analysis Everybody knew it was unsustainable Government used up all reserves Markets anticipated drop Capital controls ADR (American depository receipts) market classic example of how agents bypass restrictions Global Financial Systems 2018 Jon Danielsson, page 75 of 104
Post-crisis policies Inflation Export tax on beef (to lower domestic prices) Worked in short run, but production soon collapsed Banned measuring inflation Global Financial Systems 2018 Jon Danielsson, page 76 of 104
Governments Undervaluation of Foreign Exchange Global Financial Systems 2018 Jon Danielsson, page 77 of 104
Undervaluing Beggar thy neighbor Attempt to make other countries subsidize your industry Beggar thy neighbor policies Uses domestic money to buy foreign currency a country overvaluing will run out of money a country undervaluing can, at least in theory, intervene indefinitely The effects of undervaluing the currency in the short run are to make imports more expensive and exports cheaper Subsidy given to exporters and foreign consumers paid for by domestic consumers and foreign competitor industry Global Financial Systems 2018 Jon Danielsson, page 78 of 104
Costs of undervaluing Makes other countries very unhappy Can lead to competitive devaluations, where countries in turn devalue their currencies High inflation and huge disruption to domestic industries A country not engaging in such practices may end up being the strongest at the end Can also lead to restrictions on trade This can then spiral out of control The Great Depression is a cautionary tale Global Financial Systems 2018 Jon Danielsson, page 79 of 104
Direct domestic effects Because industries are developed in a deliberately low cost environment Companies adjust to this in their strategies, which may hamper their long term competitiveness If a country is forced to revalue its currency it then would be very costly It would have been better for industry to develop in an appropriate exchange environment Hard to control credit Finally, such a policy can create hidden inflation that down the road makes a realignment a necessity Global Financial Systems 2018 Jon Danielsson, page 80 of 104
Compatibility of other policies Need to consider the compatibility FX policy with other policy areas, monetary policy fiscal policy financial stability Japan s dilemma highest sovereign debt in the developed world deflation overvalued currency Addressing any of those is likely to adversely affect the others (deflation and FX pull the same way) Global Financial Systems 2018 Jon Danielsson, page 81 of 104
Currency war Deliberate policies of manipulating exchange rates downwards to increase domestic competitiveness have recently been given the name currency wars Relates to reserve currencies Global Financial Systems 2018 Jon Danielsson, page 82 of 104
Plaza Accord 1980 to 1985 dollar had appreciated against yen and mark (next slide) France, West Germany, Japan, United States, United Kingdom Depreciate the dollar to yen and mark Signed in 1985 at the Plaza Hotel in NYC Global Financial Systems 2018 Jon Danielsson, page 83 of 104
280 260 240 Yen and DM to USD yen dm 3.0 220 200 180 160 Plaza 2.5 2.0 1980 1981 1982 1983 1984 1985 1986 Global Financial Systems 2018 Jon Danielsson, page 84 of 104
UK and France in 1920s and 1930s In 1925, UK went back on the gold standard at pre war rates France restored convertibility in 1926 at a devalued rate an undervaluation of 15 20% France export boom in France gold flowed to France UK balance of payments problems recession Considerable friction between France and the UK France became increasingly uncompetitive, adjusted to a weak currency, found it difficult to re adjust when over, causing significant political instability Global Financial Systems 2018 Jon Danielsson, page 85 of 104
The case of Switzerland Until the crisis thee exchange rate was about 1.6 Then, Switzerland was seen as a safe haven and money flowed in Tried to fix the FX in 2011 Gave in in January 2015 www.voxeu.org/article/what-swiss-fx-shock-says-about-risk-models Global Financial Systems 2018 Jon Danielsson, page 86 of 104
1.7 1.6 1.5 CHF/e SRF/EUR 1.4 1.3 1.2 1.1 2000 2005 2010 2015 Global Financial Systems 2018 Jon Danielsson, page 87 of 104
Why If one considers who owns the Swiss National Bank And some factors, perhaps SNB dividend payments Money supply Reserves Government bonds outstanding Loss to the SNB about CHF 50 million SNB has now $750 billion in stocks, bonds and cash $2.7 billion in Apple The SNBs profit last 2016 was SNB 24.5 billion (3,000 per Swiss resident) Global Financial Systems 2018 Jon Danielsson, page 88 of 104
Does it make sense to manipulate? The larger the country the less foreign markets matter Most consumption is domestic and because part of that is local Considerable empirical evidence that FX is not all that important for larger countries Case study Brexit For a small country, the pass-through from FX to domestic prices can be very rapid Undermining benefits of manipulating FX While creating instability Global Financial Systems 2018 Jon Danielsson, page 89 of 104
Reserve Currencies Global Financial Systems 2018 Jon Danielsson, page 90 of 104
Reserve currency One currency, or asset is reserve currency Was gold and sterling. Now US dollar Advantages major products priced in your own currency eliminating currency risk. This does not matter, contrary to popular belief foreigners hold it as reserves exchanging real goods for paper Make others unhappy transfers power to the reserve currency country misbehavior like inflation or QE is tax on other countries reserves Global Financial Systems 2018 Jon Danielsson, page 91 of 104
The power of clearing All USD transactions are cleared via NY (Fed) If Iran sells oil to China in USD, funds travel via NYC Denial of New York clearing a powerful tool Germany s Foreign Minister has called for alternative clearing mechanisms as have many others Global Financial Systems 2018 Jon Danielsson, page 92 of 104
Dollar as reserve currency Is it inevitable to have a single reserve currency, and does it have to be the dollar? Interest rates in the US are close to zero, and government debt at historical levels Economic growth is anaemic and running a trade deficit If the US did not have a reserve currency it would likely experience a sharp depreciation in its currency stimulating exporters and correcting the trade balance Global Financial Systems 2018 Jon Danielsson, page 93 of 104
Because of the reserve status this is not happening Foreign countries directly intervene in the FX markets, to build up reserves and maintain the dollar rate of exchange So, global imbalances build up, other countries accumulate vast reserves and the dollar remains artificially high For the US however there is a way out of this inflation 1. depreciating its currency stimulate exports 2. reducing the real value of its debt make the foreigners pay No wonder countries like China grumble at QE but there is not much they can do Global Financial Systems 2018 Jon Danielsson, page 94 of 104
US federal government debt(end 2016) Foreign holdings: % of total and billions 0% 1% 2% 3% 4% 5% Finland Peru Malaysia Vietnam Iraq Oman Denmark Kazakhstan Indonesia Colombia Kuwait Chile Israel Poland Australia Spain Philippines Sweden Italy Mexico Norway Netherlands Turkey United Arab Emirates France Bermuda Thailand Germany Canada Russia Korea, South Singapore Saudi Arabia India Belgium Taiwan Hong Kong United Kingdom Luxembourg Switzerland Brazil Cayman Islands Ireland China, Mainland Japan $0 $200 $400 $600 $800 $1000 Global Financial Systems 2018 Jon Danielsson, page 95 of 104
1200 1000 800 600 400 200 0 US federal government debt Japan China, Mainland Ireland Cayman Islands Foreign holdings: 2000 2005 2010 2015 Global Financial Systems 2018 Jon Danielsson, page 96 of 104
Power Do the Japanese, Chinese, Brazilian, Russian etc. holdings of US government debt Give them power over the US? No The US gets the power It can deflate the debt when it wants The other countries cannot sell without encouraging very large losses Which would not hurt the US much Global Financial Systems 2018 Jon Danielsson, page 97 of 104
10 Real return on US bonds 5 2 1 profit loss 1900 1920 1940 1960 1980 2000 Global Financial Systems 2018 Jon Danielsson, page 98 of 104
The Chinese renminbi The reserve status of the US dollar creates significant problems for China Have to keep their currency weak viz. the US dollar Reserve status of the dollar facilitates the Chinese undervaluation of the renminbi Creating significant domestic problems in China For this reason it is no surprise that the biggest champion of alternative reserve currencies is China With China just about the second largest economy in the world, shouldn t the RMB become the next reserve currency? If China were to abolish capital controls and currency interventions, and continue to grow, that eventuality cannot be dismissed Global Financial Systems 2018 Jon Danielsson, page 99 of 104
Euro Recently, there was much talk about the euro becoming the next reserve currency It is the currency of the biggest economic unit in the world With the recent difficulties facing the euro, unlikely to happen anytime soon Future of the euro no longer certain The European authorities have shown themselves to be poor stewards of a currency, and therefore unreliable as the owners of the future reserve currency Global Financial Systems 2018 Jon Danielsson, page 100 of 104
Math Global Financial Systems 2018 Jon Danielsson, page 101 of 104
The nominal exchange rate The price of one currency in terms of another, usually expressed as the domestic price of the foreign currency e = 1.36 $ e = 0.735e $ Real exchange rate (RER) The real exchange rate is calculated as the nominal exchange rate adjusted for differences in price levels between countries: RER = e P P Economist s BigMac analysis Global Financial Systems 2018 Jon Danielsson, page 102 of 104
Purchasing power parity (PPP) Absolute PPP the exchange rate of two currencies results in equal purchasing power e t = P t P t Relative PPP the change in the nominal exchange rate should equal the price level differentials of two countries: e t e t 1 e t 1 = P t P t 1 P t 1 P t P t 1 P t 1 1+ P t P t 1 P t 1 Global Financial Systems 2018 Jon Danielsson, page 103 of 104
Interest parity Uncovered interest parity, UIP The expected movement in an exchange rate is equal to the differential between domestic and foreign interest rates e e t e t 1 e t 1 = i t 1 i t 1 1+i t 1 Or approximately: i t = i t +E t 1 e t Global Financial Systems 2018 Jon Danielsson, page 104 of 104