Fletcher School of Law and Diplomacy, Tufts University The Economics of International Financial Crises 3. An Introduction to International Macroeconomics and Finance Prof. George Alogoskoufis
Scope of International Finance International macroeconomics and finance, deals with the determination of key macroeconomic and financial variables in open economies. Open economies are interconnected through trade in goods and services, through migration flows and through international capital markets. An open economy can borrow or lend resources to the rest of the world. Domestic investment may thus differ from national savings. The difference determines the balance of payments. Transactions in the global economy are in many currencies. The relative prices of those currencies, exchange rates, are constantly changing in the current system of floating exchange rates. The majority of international transactions takes place through international financial and capital markets. These allow households and businesses to exchange cash and securities (promises of future payment) originating in different countries and denominated in different currencies. 2
The Concept of External Balance The concept of external balance is a key concept in international macroeconomics and finance. It requires a course for the balance of payments and external debt which does not threaten the ability of a country to service its international obligations. What constitutes external balance varies depending on the rules of the international monetary system and the characteristics of international financial markets. In different historical periods the concept of external balance has taken different meanings. 3
National Income Accounting in an Open Economy There are three main points that need to be clearly understood: First, the relationship between domestic income, domestic spending and the trade balance in an open economy Second, the relationship between the trade balance, the fiscal balance and the balance of private savings and investment. Thirdly, the distinction between gross domestic product (GDP) and gross national income (GNI or GNP). 4
The Relationship between Domestic Income and Expenditure in an Open Economy, and the Determination of the Trade Balance Gross Domestic Product (Y) in an open economy is equal to the sum of private consumption (C), private investment (I), government expenditure (G) and exports (X), minus imports (M). This identity takes the form, Y = C + I + G + ( X M ) Aggregate Gross Domestic Expenditure, sometimes called absorption, is equal to It follows that, E = C + I + G Υ = Ε + ( Χ Μ ) The trade balance, exports minus exports is thus equal to the difference between Gross Domestic Product and Gross Domestic expenditure and is given by, X M = Y E 5
The Trade Balance is a Macroeconomic Phenomenon The trade balance is merely the difference of gross domestic product and expenditure. This is a very important observation because it directs our attention to the macroeconomic nature of external imbalances. The correction of external imbalances requires measures to restore the relationship between domestic income and domestic expenditure. One can analyze this connection to an even greater depth by subtracting from both sides of the income and expenditure identity total taxes T, and adding on both sides net income from the rest of the world R. 6
The Current Account of the Balance of Payments Y + R T = C + I + ( G T ) + ( X + R M ) The left hand side measures Gross Disposable National Income, while the right hand side measures the sum of private expenditure C+I, the fiscal deficit G T, and the current account of the balance of payments X +R M. This can be written as, CA = X + R M = S I + ( T G ) The current account CA is by definition equal to the sum of the difference between private savings and investment (Y+R-T-C)-I=S-I and the fiscal balance T-G. This highlights that external imbalances are due to two factors: 1. The difference between domestic private savings and investment, and 2. The fiscal balance. In order to correct external imbalances, a country must either adjust the difference between domestic private savings and investment, or the fiscal balance, or both. 7
The Current Account and the Capital Account In absolute terms, the current account is equal to the capital account. When the current account is in surplus the capital account is in deficit, i.e, there is accumulation of assets (capital) vis-a-vis the rest of the world. If the current account is in deficit, the capital account is in surplus, i.e. there is a de-cumulation of assets vis-avis the rest of the world, or a buildup of external debt. 8
0.00 1960.01 1961.02 1962.03 1963.04 1965.01 1966.02 1967.03 1968.04 1970.01 1971.02 1972.03 1973.04 1975.01 1976.02 1977.03 1978.04 1980.01 1981.02 1982.03 1983.04 1985.01 1986.02 1987.03 1988.04 1990.01 1991.02 1992.03 1993.04 1995.01 1996.02 1997.03 1998.04 2000.01 2001.02 2002.03 2003.04 2005.01 2006.02 2007.03 2008.04 2010.01 2011.02 2012.03 2013.04 2015.01 2016.02 The Current Account of the USA 1960-2016 2.00 1.00-1.00-2.00-3.00-4.00-5.00-6.00-7.00 Current Account of the USA (% of GDP) 9
The Current Account of the Eurozone 1999-2016 5.00 4.00 3.00 2.00 1.00 0.00-1.00-2.00-3.00-4.00 Current Account of the Eurozone (% of GDP) 10
The Current Account of Japan 1999-2016 6.00 5.00 4.00 3.00 2.00 1.00 0.00-1.00 1996.01 1996.03 1997.01 1997.03 1998.01 1998.03 1999.01 1999.03 2000.01 2000.03 2001.01 2001.03 2002.01 2002.03 2003.01 2003.03 2004.01 2004.03 2005.01 2005.03 2006.01 2006.03 2007.01 2007.03 2008.01 2008.03 2009.01 2009.03 2010.01 2010.03 2011.01 2011.03 2012.01 2012.03 2013.01 2013.03 2014.01 2014.03 2015.01 2015.03 2016.01-2.00 Current Account of Japan (% of GDP) 11
Relationship between Gross Domestic Product (GDP) and Gross National Product (GNP) To the extent that a country has net income from the rest of the world, we distinguish between Gross Domestic Product (GDP) and Gross National Product (GNP) or, equivalently, Gross National Income (GNI). GDP is the value of domestic production and income, and GNP (GNI) the total income of the country's inhabitants. Net income from the rest of the world can be either net income from capital (interest and dividends), or net income from labor (labor supply of domestic residents to the rest of the world). When we come to issues of asset or debt accumulation from the rest of the world, this distinction becomes central. 12
Nominal and Real Exchange Rates The bilateral nominal exchange rate (S) is defined as the value of a country's currency in terms of another currency. S = 1.1 $ / means that it takes 1.1 US dollars ($) for the purchase of one euro ( ). If the rate changed to 1.2 then we say that the euro has appreciated against the dollar (or that the dollar has depreciated against the euro). The bilateral real exchange rate (Q) is defined as the ratio of the two countries' price levels expressed in a common currency. If P is the price level in Europe (in euros) and P * the price level in the US (in dollars), the real exchange rate between the $ and the is defined as Q=S (P/P*). 13
Nominal and Real $/ Exchange Rate 1.7 1.6 1.5 1.4 1.3 $ per 1.2 1.1 1 0.9 0.8 1999.01 1999.05 1999.09 2000.01 2000.05 2000.09 2001.01 2001.05 2001.09 2002.01 2002.05 2002.09 2003.01 2003.05 2003.09 2004.01 2004.05 2004.09 2005.01 2005.05 2005.09 2006.01 2006.05 2006.09 2007.01 2007.05 2007.09 2008.01 2008.05 2008.09 2009.01 2009.05 2009.09 2010.01 2010.05 2010.09 2011.01 2011.05 2011.09 2012.01 2012.05 2012.09 2013.01 2013.05 2013.09 2014.01 2014.05 2014.09 2015.01 2015.05 2015.09 2016.01 2016.05 2016.09 Real $/ Exchange Rate Nominal $/ Exchange Rate 14
Effective Nominal and Real Exchange Rates The nominal effective exchange rate SE, is the weighted average of the bilateral nominal exchange rates of a country, against the currencies of all countries with which it has international transactions. The weights depend on the share of international transactions of the country with each of its trading partners. Thus, the nominal effective exchange rate is defined as, S E = π 1 S 1 + π 2 S 2 +...+ π N S N = N π i=1 i S i The real effective exchange rate Q E, is the weighted average of the bilateral real exchange rates of a country, against the currencies of all countries with which it has international transactions. The weights depend on the share of international transactions of the country with each of its trading partners. Thus, the nominal effective exchange rate is defined as, Q E = π 1 Q 1 + π 2 Q 2 +...+ π N Q N = N π i=1 i Q i 15
Nominal and Real Effective $ Exchange Rate 150.00 140.00 130.00 120.00 110.00 100.00 90.00 80.00 70.00 60.00 50.00 1973.01 1973.12 1974.11 1975.10 1976.09 1977.08 1978.07 1979.06 1980.05 1981.04 1982.03 1983.02 1984.01 1984.12 1985.11 1986.10 1987.09 1988.08 1989.07 1990.06 1991.05 1992.04 1993.03 1994.02 1995.01 1995.12 1996.11 1997.10 1998.09 1999.08 2000.07 2001.06 2002.05 2003.04 2004.03 2005.02 2006.01 2006.12 2007.11 2008.10 2009.09 2010.08 2011.07 2012.06 2013.05 2014.04 2015.03 2016.02 Nominal (Major Currencies) Real (Major Currencies) 16
Nominal and Real Effective Exchange Rate 115 110 105 100 95 90 85 80 1993.01 1993.06 1993.11 1994.04 1994.09 1995.02 1995.07 1995.12 1996.05 1996.10 1997.03 1997.08 1998.01 1998.06 1998.11 1999.04 1999.09 2000.02 2000.07 2000.12 2001.05 2001.10 2002.03 2002.08 2003.01 2003.06 2003.11 2004.04 2004.09 2005.02 2005.07 2005.12 2006.05 2006.10 2007.03 2007.08 2008.01 2008.06 2008.11 2009.04 2009.09 2010.02 2010.07 2010.12 2011.05 2011.10 2012.03 2012.08 2013.01 2013.06 2013.11 2014.04 2014.09 2015.02 2015.07 2015.12 Nominal Effec9ve Exchange Rate Real Effec9ve Exchange Rate 17
The International Monetary System International monetary systems are characterized by internationally agreed rules, conventions and supporting institutions, that facilitate international trade, cross border investment and generally the reallocation of capital between nation states. They provide means of payments acceptable between buyers and sellers of different nationality, including means of deferred payments (debt instruments). To operate successfully, they need to inspire confidence, to provide sufficient liquidity for fluctuating levels of trade and to provide means by which global imbalances can be corrected. The systems can grow organically as the collective result of numerous individual agreements between international economic factors spread over several decades, or they can arise from a single architectural vision as happened at Bretton Woods in 1944. 18
Characteristics of International Monetary Systems The degree to which international trade in goods, services and capital is free. The means through which international transactions are settled and the internationally accepted means of payments. Whether exchange rates are fixed or flexible. The degree of symmetry or asymmetry in the benefits and obligations of different countries. Whether it is based in precious metals or not. These are some of the most critical characteristics concerning the international monetary system and the correction of external imbalances. 19
Monetary Policy, Exchange Rates and Capital Mobility in Open Economies The ability of the central bank of a country to pursue an independent monetary policy differs depending on the exchange rate regime and the regime of capital mobility. When there is free mobility of capital, the central bank has two basic options. It can either let the exchange rate fluctuate freely (floating exchange rates) without interventions in the foreign exchange market, or it can make interventions in the foreign exchange market (fixed or managed exchange rates). In the latter case, it transpires that it cannot pursue an independent monetary policy. To enable a central bank to pursue an independent monetary policy under a fixed or managed exchange rate regime, a country must impose restrictions on capital movements (capital controls). 20
The Trilemma of Open Economies 1. Fixed (or Managed) Exchange Rate 2. Independent National Monetary Policy 3. Free Mobility of Capital Only two of the three options are available in a country. All three options are simultaneously incompatible. Between the end of World War II and 1973 the industrial countries operated a system of fixed exchange rates, the Bretton Woods system. In fixed rate systems, the required level of cooperation between central banks and governments of the major economies is high, as it requires coordination of monetary, and budgetary policies in order to maintain and operate the system. From 1973 until today, the US, the Euro Area, Japan, the United Kingdom and Switzerland have chosen free capital mobility, and domestic monetary autonomy, resulting in a system of floating exchange rates. China has chosen capital controls in order to combine managed exchange rates with domestic monetary autonomy. 21
International Money Unlike in national states, in international economic transactions there is no single government that can impose the use of a single currency. Thus, the global economy ends up with a plurality of currencies, although usually only a few of them are fully acceptable internationally. Thus, only a few currencies are used as international units of account, international means of payment and international stores of value. The international monetary system today is basically tripolar, with a dominant role for the US dollar ($). The other two major currencies are the Euro ( ) and the Japanese Yen ( ). In addition, the pound sterling ( ), the Swiss franc and the Chinese renmimbi, or yuan, are international currencies. Competition among currencies does not result in the predominance of a single international currency, a situation that implies the lowest possible transaction costs and a lesser degree of monetary and financial instability. Yet, some currencies tend to become dominant, and are called international reserve currencies. such currencies were sterling in the period of the international gold standard (1880-1914) and the dollar since the end of the First World War. International reserve currencies typically are issued by large or extremely open economies with a large share in international trade and international portfolios of assets. The US dollar remains the dominant international currency for about a century. It is the major unit of pricing international imports and exports, and is widely used in foreign exchange transactions in international financial markets and as a reserve currency for other central banks. 22
Currency Convertibility Convertibility is the quality that allows money or other financial instruments to be converted into other liquid stores of value. Currency convertibility is an important factor in international exchanges, where instruments valued in different currencies must be exchanged. Traditionally, currency convertibility was defined in relation to precious metals, such as silver and gold. After World War I, convertibility of a currency is defined relative to the dominant international reserve currency, i.e. the dollar, and not necessarily in relation to gold. If the international reserve currency is convertible into a precious metal such as gold, the international monetary system is considered to be based on metallic standard. The international monetary system was loosely based on a metallic standard until 1968. In that year the US abolished the convertibility of the dollar into gold at a fixed price of $35 per ounce, resulting in the international monetary system getting completely delinked from gold. 23
Fixed, Managed and Flexible Exchange Rates For about forty years before World War I (1879-1914) the main economies operated under an international monetary system called the international gold standard. This was a system of fixed exchange rates, based on gold, and the dominant international reserve currency of the time, the pound sterling. The interwar period was characterized by a variety of exchange rate regimes ranging from floating exchange rates in the first part of the 1920s, to a brief restoration of the international gold standard (1926-1931), to managed exchange rates and capital controls in the 1930s. This period is characterized as a period of international monetary instability, and is also marked by protectionism in international trade and the onset of the Great Depression. Between the end of World War II and 1973 the industrial countries operated a system of fixed but adjustable exchange rates, the Bretton Woods system, which was also underpinned by capital controls. In fixed exchange rate systems, the required level of cooperation between central banks and governments of the major economies is high, as it requires coordination of monetary, and budgetary policies in order to maintain and operate the system. Capital controls were gradually relaxed during the 1960s, but the system came under severe pressure towards the end of the decade. From 1973 until today, the US, the Euro Area, Japan, the United Kingdom and Switzerland have chosen free capital mobility, and domestic monetary autonomy, resulting in a system of floating exchange rates. Other countries have chosen a variety of exchange rate regimes, ranging from floating to unilaterally fixed exchange rates. In 1978, the countries of the European Economic Community (later the European Union) established the European Monetary System, a system of fixed but adjustable exchange rates among their currencies. This later developed into a single currency, the euro, which materialized in 1999. China has opted capital controls in order to combine managed exchange rates with domestic monetary autonomy. 24
Dollar Sterling Exchange Rate, 1791-2016 12.00 10.00 8.00 6.00 4.00 2.00 0.00 1791 1796 1801 1806 1811 1816 1821 1826 1831 1836 1841 1846 1851 1856 1861 1866 1871 1876 1881 1886 1891 1896 1901 1906 1911 1916 1921 1926 1931 1936 1941 1946 1951 1956 1961 1966 1971 1976 1981 1986 1991 1996 2001 2006 2011 2016 $/ Exchange Rate 25
The Daily Dollar Euro Exchange Rate 1.6 $ per 1.5 1.4 1.3 1.2 1.1 1 0.9 0.8 1/4/99 1/4/00 1/4/01 1/4/02 1/4/03 1/4/04 1/4/05 1/4/06 1/4/07 1/4/08 1/4/09 1/4/10 1/4/11 1/4/12 1/4/13 1/4/14 1/4/15 1/4/16 1/4/17 26
The Daily Yen Dollar Exchange Rate 140 /$ 130 120 110 100 90 80 70 1/4/99 1/4/00 1/4/01 1/4/02 1/4/03 1/4/04 1/4/05 1/4/06 1/4/07 1/4/08 1/4/09 1/4/10 1/4/11 1/4/12 1/4/13 1/4/14 1/4/15 1/4/16 1/4/17 27
The Daily Sterling Dollar Exchange Rate 0.85 /$ 0.8 0.75 0.7 0.65 0.6 0.55 0.5 0.45 28
The Daily Renbinbi Dollar Exchange Rate 8.5 /$ 8 7.5 7 6.5 6 4/1/05 4/1/06 4/1/07 4/1/08 4/1/09 4/1/10 4/1/11 4/1/12 4/1/13 4/1/14 4/1/15 4/1/16 29
International Financial Markets and the Financing of External Imbalances 1. Foreign Exchange Reserves (short term) 2. International 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 until 1914, and in the inter-war period. Bond issues by less developed economies have staged a comeback after 1990, with the liberalization of the financial systems of developing economies. 3. International Bank Loans: Since the end of the 1970s, and until 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 international bank lending has diminished, although it remains one of the most important methods of finance. 4. Official Borrowing (IMF, World Bank, other governments): 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 after the recent crisis, and is mainly used by countries which have agreed an adjustment program with the IMF. 5. Foreign Direct Investment: Financing the creation or development of subsidiaries of multinational enterprises. If a Japanese firm invests in its subsidiary in the US, then this is foreign direct investment, which also helps finance the US current account deficit. 6. International Portfolio Investment: If a Japanese insurance fund were to buy shares of a US company, or US sovereign or corporate bonds, this is an international portfolio investment, and helps finance the deficit of the current account of the USA. 30
Finance through Debt and non Debt Securities International bonds, international bank loans and official lending constitute debt, whereas foreign direct investment and international portfolio investment in shares does not constitute debt. The difference between the two methods of financing is that in debt contracts, the borrower agrees to repay in specific installments (interest and amortization) to the lender, irrespective of conditions, while in the case of equity investment, the investor shares in the profits of firms only if the firms make profits. 31
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 particular debt denominated in foreign currencies. International investors tend to 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 internationally, almost always borrow in their own currency. Thus, the US borrows in US dollars, the Euro Zone economies in euro s, Japan in Japanese yen, Britain in sterling. Even Switzerland, due to the international 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 continue 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 option is not available to developing economies which borrow in foreign currency. 32
The Original Sin of Less Developed Economies and the Exorbitant Privilege of the USA The inability of less developed economies to borrow in their own currency, is often 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 international obligations, is often referred to as the exorbitant privilege of the US. It is also worth noting that, as shown by the recent crisis in the peripheral economies of the Euro Zone, participation in a single currency area like the euro area does not ultimately absolve a less developed economy from the original sin. The governments of a small open economies participating in the Euro Zone 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 political independence and the prohibition of monetary financing of budget deficits in the Euro Zone. In essence, the statutes of the ECB do not allow it to function effectively as a lender of last resort to Euro Zone governments, in contrast to the central banks in the US, Britain or Japan who do in fact act as lenders of last resort. 33