Interna2onal Capital and Financial Markets, and the Determina2on of Exchange Rates Prof. George Alogoskoufis Fletcher School, TuEs University
Methods of Financing Deficits in the Current Account 1. Foreign Exchange Reserves (short term) 2. Interna2onal Bond Issues 3. Interna2onal Bank Loans 4. Official Borrowing (IMF, World Bank, other governments) 5. Foreign Direct Investment 6. Interna2onal PorWolio Investment 2
2. Interna2onal Bond Issues Bond issues are the main method of financing for advanced economies. It used to be the main method of financing for less developed economies un2l 1914, and in the inter-war period. Bond issues by less developed economies have staged a comeback aeer 1990, with the liberaliza2on of the financial systems of developing economies. 3
3. Interna2onal Bank Lending Since the end of the 1970s, and un2l the end of the 1980s this was the main method of financing for less developed economies. In the beginning of the 1980s bank lending corresponded to the whole of the current account deficits of less developed economies. Since then, the importance of interna2onal bank lending has diminished, although it remains one of the most important methods of finance. 4
4. Official Lending These loans may be concessionary, or at market interest rates. Before the 2008-09 crisis, official lending had been very low, used for very poor economies, such as those of sub-saharan Africa. Official lending has made a comeback aeer the recent crisis, and is mainly used by countries which have agreed an adjustment program with the IMF. 5
5. Foreign Direct Investment Financing the crea2on or development of subsidiaries of mul2na2onal enterprises. For example, a loan or a capital injec2ons from MicrosoE or Unilever in its greek subsidiary cons2tutes foreign direct investment in Greece, and helps finance the current account deficit of Greece. 6
6. Interna2onal PorWolio Investment If a US insurance fund were to buy shares of a Greek company, or Greek sovereign or corporate bonds, this is an interna2onal porwolio investment, and helps finance the deficit of the current account in Greece. This trend is oeen reinforced by priva2za2on ini2a2ves in various countries. 7
Finance through Debt and Other Securi2es Interna2onal bonds, interna2onal bank loans and official lending cons2tute debt, whereas foreign direct investment and interna2onal porwolio investment in shares does not cons2tute debt. The difference between the two methods of financing is that in debt contracts, the borrower agrees to repay in specific installments (interest and amor2za2on) to the lender, irrespec2ve of condi2ons, while in the case of equity investment, the investor shares in the profits of firms only if the firm makes profits. 8
Differences between Advanced and Less Developed Economies The problem with less developed economies is that a large part of the financing of their current account deficits is through external debt, and in par2cular debt denominated in foreign currencies. Interna2onal investors refrain from assuming the currency risk associated with a peripheral currency, even if they assume the country risk. On the other hand, the major advanced economies, whose currencies are widely traded interna2onally, almost always borrow in their own currency. Thus, the US borrows in US dollars, the Euro Area economies in euro s, Japan in Japanese yen, Britain in sterling. Even Switzerland, due to the interna2onal acceptance of the Swiss franc, borrows in its own currency. A country that can borrow in its own currency has significant advantages over countries which cannot do this. It can con2nue servicing its loans, even if it has to resort to issuing money in order to pay its creditors. So it does not run the risk of default. This op2on is not available to developing economies which borrow in foreign currency. 9
The Original Sin of Less Developed Economies The inability of less developed economies to borrow in their own currency, is oeen called the original sin. On the other hand, the ability of the US to borrow in dollars, and in this way to reduce the real value of its interna2onal obliga2ons, is oeen referred to as the exorbitant privilege of the US. It is also worth no2ng that, as shown by the recent crisis in the peripheral economies of the Euro Area, par2cipa2on in a single currency area like the euro area does not ul2mately absolve a less developed economy from the original sin. The governments of a small open economies par2cipa2ng in the Euro Area cannot rely on the European Central Bank (ECB) to lend them euros to service their euro denominated debts, or the debts of their banks. This is because of the ECB's poli2cal independence and the prohibi2on of monetary financing of budget deficits in the Euro Area. In essence, the statutes of the ECB do not allow it to func2on effec2vely as a lender of last resort to Euro Area governments, in contrast to the central banks in the US, Britain or Japan who do in fact act as lenders of last resort. 10
The Interna2onal Foreign Exchange Market An Interna2onal Network of Traders in Currencies Vehicle currency, the US dollar Exchange rates Spot Transac2ons Swap transac2ons Forward Transac2ons Eurodeposits and Eurocurrencies 11
Structure of the Foreign Exchange Market The different currencies are bought and sold through dealers located in major interna2onal banks and financial ins2tu2ons. Dealers hold currency reserves, and their goal is to make profits by buying cheaply and selling expensively. The foreign exchange market is characterized by high liquidity and the trading volume is huge. The volume of foreign exchange transac2ons is much greater than the volume of transac2ons necessary for financing interna2onal trade. 12
Major Financial Centers New York London Frankfurt Hong Kong Tokyo George Alogoskoufis, Interna'onal Finance, 2016 13
Exchange Rates The price of the dollar in foreign currency (ie 0.91 euros per dollar) is called the exchange rate (in European terms). The reverse, ie a currency value in dollars (eg $ 1.1 per euro) is the exchange rate in US terms. An increase in the exchange rate in European terms means that the currency has depreciated against the dollar, while a rise in the exchange rate in US terms means that the currency has appreciated against the dollar (i.e the dollar has depreciated). 14
Alterna2ve Defini2ons of Exchange Rates We shall define the exchange rate in European terms as S. This means that an increase in the exchange rate S cons2tutes a deprecia2on of the Euro and an apprecia2on of the dollar, since more euros are required in order to buy one dollar. We shall define the exchange rate in US terms as E. This means that an increase in the exchange rate E cons2tutes an apprecia2on of the euro and a deprecia2on of the dollar, since it takes more dollars to buy one euro. 15
The Euro Dollar Exchange Rate /$ 16
The Euro Dollar Exchange Rate $/ 17
The US Dollar and Triangular Transac2ons The US dollar is considered as a vehicle currency for transac2ons in the foreign exchange market. For example, to convert sterling into yen usually requires two transac2ons. One to convert sterling to dollars, and one to convert dollars to yen. Because of the depth (high trading volume) in the dollar market, the cost of this triangular transac2on is usually less than the direct exchange of sterling for yen. 18
Arbitrage and Exchange Rates In the foreign exchange market, because of arbitrage, there are no poten2al profits from triangular transac2ons in different currencies. For example, if E 1 is the sterling dollar exchange rate, E 2 the euro dollar exchange rate, and E 3 the sterling euro exchange rate, and transac2ons have no cost, in equilibrium it can only be the case that, E 1 =E 3 x E 2 19
Transac2on Categories in the Foreign Exchange Market Spot transac2ons, where the transac2on closes immediately (in fact within two days). These determine spot exchange rates. Swap transac2ons, in which the currency is bought (sold) today and resold (re-bought) at a future date. The value of both the spot and the forward exchange rate is determined today. Forward transac2ons. These are current agreements for future purchase or sale of a currency. The price, quan2ty and the date of the transac2on are determined today. 20
Swap and Forward Transac2ons The swap rate is the difference between the repurchase rate (repo) and the spot exchange rate. The spot exchange rate and the swap rate determine the forward exchange rate. Swap and forward transac2ons take place for 1 and 2 weeks, and for 1, 3, 6 and 12 months. We say that a currency trades at a premium when the forward exchange rate is higher than the spot rate (on the US defini2on). Otherwise it trades at a discount. 21
The Structure of Transac2ons in the Foreign Exchange Market The vast volume of transac2ons in the foreign exchange market are spot transac2ons between dealers. Swap transac2ons cons2tute about 1/3 of the total volume. Forward transac2ons cons2tute a very small percentage of the total volume. 22
Eurodeposits and Eurocurrencies A Eurocurrency deposit, or a Eurodeposit, is a deposit in foreign currency outside the country issuing the currency. A deposit in US dollars in a London bank is a Eurodollar deposit, while a deposit in yen at a bank in New York is a Euroyen deposit. Most eurodeposits are fixed rate deposits with terms reflec2ng those available for swap and forward currency transac2ons. 23
LIBOR and EURIBOR LIBOR (London Interbank Offered Rate) is the rate at which banks are willing to lend dollars or pounds to the most reliable banks and nonbank enterprises that par2cipate in the London interbank market. Loans to less reliable banks and enterprises have a higher rate than LIBOR (premium). The EURIBOR (Euro Interbank Offer Rate) is the rate at which banks are willing to lend euros to the most reliable banks and non-bank enterprises, par2cipa2ng in the euro area interbank market. Loans to less reliable banks and enterprises have a higher interest rate than EURIBOR (premium). The LIBOR and the EURIBOR vary depending on the loan term (from one week to 12 months). 24
Dollar and Euro 3-month LIBOR 8.00000 7.00000 6.00000 5.00000 4.00000 3.00000 2.00000 1.00000 0.00000-1.00000 1999-01-04 2000-01-04 2001-01-04 2002-01-04 2003-01-04 2004-01-04 2005-01-04 2006-01-04 2007-01-04 2008-01-04 2009-01-04 2010-01-04 2011-01-04 2012-01-04 2013-01-04 2014-01-04 2015-01-04 2016-01-04 $ LIBOR LIBOR 25
The EURIBOR (1 month, 2 months, 3 months) 26
The Expected Rate of Return of a Euro deposit in dollar terms using only the Spot Market Suppose you have 1 million $ to invest for a year. If you invest in a dollar deposit, at the end of the year you will get 1+i $ If you invest in a euro deposit, you must convert your million into euros. Thus you will invest S 2mes one million, where S is the spot euro/dollar exchange rate. At the end of the year, you will earn (1+i )S in euros. To convert them into dollars, you will need to use the euro/dollar exchange rate in a years 2me which you do not know, but can form expecta2ons about. Thus, the expected rate of return in dollars of your euro deposit is uncertain, and equal to (1+i )(S/S e ), where S e is the expected spot euro/dollar exchange rate in a year s 2me. 27
The Rate of Return of a Euro deposit in dollar terms using the Forward or Swap Market Suppose you have 1 million $ to invest for a year. If you invest in a dollar deposit, at the end of the year you will get 1+i $ If you invest in a euro deposit, you must convert your million into euros. Thus you will invest S 2mes one million, where S is the spot euro/dollar exchange rate. At the end of the year, you will earn (1+i )S in euros. At the same 2me as you make the spot transac2on buying 1m euros, you can make a forward transac2on, selling (1+i )S euros in the forward market, at the forward exchange rate F. Thus, at the end of the year you will use your (1+i )S euros to fulfil your forward contract, and you will be lee with (1+i )(S/F) dollars. Thus, the rate of return in dollars of your euro deposit is certain and equal to (1+i )(S/F). 28
Covered Interest Parity If your use both the spot market and the forward or swap market, then the rate of return of a dollar deposit must be equal to the rate of return in dollars of a euro deposit. It must hold that, 1+i $ =(1+i )(S/F) Spot exchange rates (S), forward exchange rates (F) and eurodeposit interest rates (i $ for the $ and i for the ) are related through the so called, covered interest parity. We can rearrange this condi2on as, 1+i =(1+i $ )(F/S) 29
Forward Exchange Rate and Expected Future Spot Rate The profit from a forward transaction in the foreign exchange market is the difference of the forward rate from the spot rate, at the end of the term of the transaction. Consequently, at the time of agreement to the forward transaction, with the assumption of risk neutrality, it should apply, F=S e where S e is the expected spot rate at the end of the term of the forward transac2on. 30
Uncovered Interest Parity Thus, even if you only use the spot market, if you are risk neutral, you would seek equality between the return of a dollar deposit, and the expected return of a euro deposit in dollar terms. Thus, it should hold that, 1+i $ =(1+i )(S/S e ) Spot exchange rates (S), expected future spot exchange rates (S e ) and eurodeposit rates (i* for the $ and i for the ) are thus related through the so called uncovered interest parity. This condi2on can be rearranged as, 1+i =(1+i $ )(S e /S) 31
Alterna2ve Form of Uncovered Interest Parity i =i $ +(S e -S)/S The interest rate differen2al between a euro and a dollar eurodeposit reflects the expected deprecia2on of the euro. If this condi2on is violated, expected profits can be made by borrowing in one currency and lending in the other. These expected profits will lead to equilibra2ng trades (arbitrage) un2l this condi2on is sa2sfied. 32
The Determina2on of Exchange Rates Covered Interest Parity 1+i =(1+i $ )(F/S) Uncovered Interest Parity 1+i =(1+i $ )(S e /S) Exchange Rate Determina2on S=S e ((1+i $ )/(1+i )) 33
Determining Factors of Spot Exchange Rates S=S e ((1+i $ )/(1+i )) Three factors determine the spot euro/dollar exchange rate First, the euro nominal interest rate. A rise in the euro nominal interest rate causes the euro to appreciate. Second,the dollar nominal interest rate. A rise in the dollar nominal interest rate causes the euro to depreciate. Third, the expected future spot rate. An expected future deprecia2on of the euro causes the euro to depreciate immediately. 34
A Diagramma2c Exposi2on of Exchange Rate Determina2on Uncovered interest parity requires that the return of a deposit in dollars is equal to the expected return in dollars of a deposit in euros. This can be wripen as, 1+i $ =(1+i )(S/S e ) We can depict this equilibrium condi2on in a diagram. The lee hand side is independent of S, whereas the right hand side is a linear func2on of S. 35
A Diagramma2c Exposi2on of Exchange Rate Determina2on 36
A Rise in US Nominal Interest Rates 37
A Rise in EA Nominal Interest Rates 38
An Expected Future Deprecia2on of the Euro 39
Interna2onal Financial Markets and Exchange Rate Determina2on Exchange rates are determined in interna2onal financial markets. The main agents par2cipa2ng in these markets are banks, mul2na2onal corpora2ons, non-bank financial ins2tu2ons, governments and central banks. Banks have a key role by facilita2ng the exchange of bank deposits in different currencies, which cons2tutes the bulk of transac2ons in the foreign exchange market. The interna2onal foreign exchange market is essen2ally a unified world market that operates almost 24 hours each day. 40
The Foreign Exchange Market The bulk of transac2ons in foreign exchange markets are spot transac2ons, but large part consists of swaps and forward transac2ons. In swaps and forward transac2ons there is an agreement between the par2es on the future exchange of currencies at a predetermined price. Spot transac2ons are sepled immediately. 41
Eurodeposits and Interest Parity Equilibrium in the foreign exchange market requires equaliza2on of returns of securi2es that are denominated in different currencies, when the returns are measured in a common currency. This is the basis of of interest rate parity. For given interest rates on deposits denominated in different currencies, and for given expecta2ons for the future development of the exchange rate, uncovered interest rate parity determines the current exchange rate. 42
Exchange Rate Determina2on Ceteris paribus, an increase in dollar interest rates causes the dollar apprecia2on. Ceteris paribus, an increase in euro interest rates causes the euro apprecia2on. Finally, ceteris paribus, an expected future apprecia2on (deprecia2on) of the euro, leads immediately to a spot apprecia2on (deprecia2on) of the euro. 43