1

2011 Examination Question (5)

(a) “The currency swap contract behaves like a long-dated forward exchange contract, in which the forward rate is the current spot rate” Explain.

(3 marks)(b) Illustrate with a hypothetical example how a

currency swap arrangement can work for the benefit of both parties.

(8 marks)

2

2011 Exam Q&A (5a)• A currency swap is a simultaneous borrowing and lending operation

whereby two parties exchange specific amounts of two currencies at the outset at the spot rate.

• They also exchange interest rate payments in the 2 currencies.• They undertake to reverse the exchange after a fixed term at a fixed

exchange rate (current spot rate = forward rate).• It involves an exchange of principal amounts at maturity at pre-

determined exchange rate.• It works like forward exchange contract in a round-about way, to avoid

exchange risks. The interest differential represents the forward spread.• Why do this if forward exchange market can offer simpler solutions?

This is because forward exchange rates do not exist for long –dated contracts and big amounts.

3

2011 Exam Q&A (5b)• US chemical Co. operating in France needs to borrow EUR 100m

while a French tyre manfacturer operating in US needs to borrow an equivalent amount in USD (i.e. USD 140m at exch. rate EUR 1=USD 1.40).

• Loan tenor = 5 years; int. rate = 5% in France and 7% in US.• If these Cos were to take the loans without hedging, they will

face XR risks on both the principal and the annual interest rate payments.

• If EUR appreciates, the effective cost of the US Co will rise; if USD appreciates, the effective cost to the French Co will rise.

• There will be currency mismatch if the revenues are in home currency and costs are in foreign currency.

4

2011 Exam Q&A (5b) cont’d• To avoid these problems, both Cos could take foreign currency loans

and then enter into a currency swap arrangement.• To lock-in the prevailing exchange rate (EUR 1 = USD 1.40) and avoid

currency risk on both principal and interest payments over the next 10 years, a currency swap can help.

• The US Co takes the loan principal of EUR 100m in France and forwards it to the French Co, which in turn gives the US Co USD 140m it borrowed in the US.

• The principal amounts are reversed at the end of the 10th year. In addition, at the end of each year, the US Co pays USD 9.8m being 7% int. on USD 140m to the French Co which in turn gives EUR 5m being interest on EUR 100m.

5

2011 Exam Q&A (5b) cont’d• Thus, each Co passes on the payments to their respective

banks as fulfillment of their obligations.• At the end of the 10th year, the US Co would have paid USD

238m (140+98), while the French Co would have paid EUR (100+50).

• Note that the US Co pays 7% and receives 200 basis points less. The differential reflects the spread between the spot and forward exchange rate. The currency with lower int. rate has a higher forward exchange value (int. rate parity theory). Thus, the future exchange of currencies at the present spot exchange rate would offset the difference in interest rates.

6

INTERNATIONAL MONETARY SYSTEM

PAST, PRESENT, FUTURE

LECTURE 12

7

The Outline

• Evolution• Types of Exchange Rate Systems• Gold Standards• Bretton Woods• Current Hybrid System (Post Bretton Woods) • Free Floats• Managed Floats• Pegged Exchange rates• “Target Zone”/Regional Currency Arrangements• The Mighty Dollar and Beyond

8

The International Monetary System – History

In terms of evolution, there have been 4 phases.

• Classical Gold Standard (1821 – 1914) • The Gold Exchange Standard (1925 – 1931) • The Bretton Woods System (1946 – 1971) • Post Bretton Woods (1971 to present)

9

Classical Gold Standard (1821 – 1914)

• The classical Gold Std. was when England returned to the Gold Standard, following the Napoleonic wars and its associated inflation.

• By 1880, the majority of the world’s nations were on some form of gold std.

• The period from 1880 –1914 when the Gold Std. was in its most pristine form. • The period was characterized by rapid expansion of world trade, economic

growth and price stability. • Advocates of the Gold Std. (including Edward Balladur French Finance

Minister) draw inspiration from this period. • Opponents of the Gold Std. also point to this period, severe recession in

1890s, and early 1900s.

10

The Gold Exchange Standard

• The classical Gold Std. broke down during WW I, and was reinstated in 1925 as the Gold Exchange Standard (GES).

• Under the GES, only the US and England could hold gold reserves but other nations could hold both gold and $ or £ as reserves.

• In 1931, England left GES in the face of massive gold outflows owing to an unrealistic (overvalued) exchange rate phenomenon.

• Following the inevitable devaluation of the £, 25 other countries devalued their currencies to maintain competitiveness beggar-thy-neighbor policies became the mainstay.

• Trade wars (competitive devaluation) and protectionism came to rule and resulted in depression the massive inflation in Germany indirectly led to WW II.

• Even before the World War II ended, the allied nations set forth to establish new foreign exchange ground rules this led to the Bretton Woods System.

11

How the Gold Standard Worked

Under the GS’ “mint par of exchange”: A’s monetary unit with 5 times as much gold would exchange for 0.20 for B’s. The market rate of exchange, determined by BOP strength, may not correspond to the mint par, but could never deviate much from the mint par of exchange, as gold will physically move if market rates deviate, subject to cost of transporting gold.

Gold movements were determined by “gold-export point” and “gold-import point”. Thus, if USD/GBP rose above the par by an amount more than the cost of shipping gold, an American importer would ship gold to British exporter. Conversely, if USD/GBP fell below the par by an amount greater than the cost of shipping gold, an American exporter would ask British importer to send gold instead of paying with paper currency.

Gold flowed from BOP deficit countries to BOP surplus ones, causing changes in money supply and price levels, impacting on competitiveness and hence BOP.

But, the system - while enforcing discipline and therefore stability - had severe problems.

12

The Magic of the Gold Standard• Gold has long been used as a medium of exchange, thanks to its

special attributes: it is durable, storable, portable, divisible and easily standardized.

• It is difficult to manipulate, as short-run changes in stock are limited by high production cost.

• As commodity money, it ensured long-run tendency towards price stability.

• It ensured monetary discipline as the value of gold relative to other goods and services would not change much over time.

• However, when inflation was no longer an issue under the gold standard, the value of gold as an inflation hedge declined.

• Even CBs had replaced gold reserves with UST bonds, which unlike gold pay interest, causing gold price to decline.

13

1) It worsened economic cycles, increased economic volatility.

2) Countries had to “surrender” their monetary policy for the sake of exchange rate stability (fixed XR).

*The system therefore did not provide the flexibility needed for ‘smart’ economic policies.

3) Maintaining fixed exchange rates also meant that one country’s policy will have to be absorbed or accommodated by another country.

4) Finally: Politics (Cold War) Soviet Union and South Africa were largest gold producers. While other countries did not like being at their “mercy”, gold producers were also unhappy with fixed gold prices.

Why the Gold Standard Collapsed

14

Why Gold Continues to Glitter• Gold has returned with a vengeance, in the aftermath of

financial crises which eroded peoples’ trust in fiat money.• The resurfacing of inflation has renewed the demand for gold

as safe haven.• With the declining role of the USD as reserve currency and

absence of viable substitutes for USD (EUR is no longer promising), CBs are increasingly turning to gold as reserves with upward pressure on gold prices.

• Other factors behind the renewed importance of gold include: the oil price hike (oil producers amassing gold) and the loss of trust in paper money due to exchange rate uncertainty.

15

The Bretton Woods System

• This system was implemented in 1945; each govt. pledged to maintain a fixed or pegged exchange rate for its currency vis-à-vis the dollar or gold.

• Agreed upon at Bretton Woods, New Hampshire (Keynes for Britain and White for the US).• Since each ounce of gold was set equal to $35, thus fixing a currency’s

gold price was equivalent to fixing its exchange rate against the dollar.• Govts. were expected to intervene to maintain (defend) these fixed

exchange rates.• Bretton Woods also set up: (1) IMF [lender of last resort], (2) IBRD or

World Bank [lending to developing countries], and (3) BIS [central bank for industrial countries’ central banks].

• IMF was set up to administer SDR and help countries overcome temporary BOP problems .

• IMF was also to help countries defend their currencies where necessary.

16

Fixed/Pegged Exchange Rate System

• Any $ accumulated by monetary authorities as a result of such intervention was technically fully redeemable in gold at $35 per ounce. The US Treasury had to stand ready to redeem.

• Fixed or Pegged? To have some amount of flexibility, a 1% band was introduced.• All of this was meant in principle to provide a stable framework for international

trade and to introduce / force discipline on countries. • E.g. Suppose a country has too expansionary a monetary policy, there would be

an excess SS of its currency thereby causing its currency to fall in value against other currencies. Should it fall more than the stipulated band, the govt. would have to intervene to maintain the exchange rate.

• The intervention would be to “buy” its currency in exchange for the $, this will the amount of its currency outstanding, thereby forcing the economy to go slow or reverse the expansionary policy.

• Changes in fixed exchange rates were only allowed in the case of “fundamental disequilibrium”.

• “ Fundamental disequilibrium” however was never properly defined and govts. often took advantage to delay the inevitable re/devaluation – which had high political costs.

17

How the Fixed/Pegged XR System Worked

• Exchange rates were established and maintained within 1% of parity.• Exchange rates might be adjusted to correct “fundamental

disequilibrium” with IMF permission (to avoid competitive devaluation).• BOP deficit was financed by using reserves, private foreign capital

inflows or IMF loans.• The currency of the deficit country would depreciate, warranting CB

intervention to keep the XR within the 1% narrow band with IMF help if necessary.

• The deficit country would adopt deflationary fiscal and monetary policy, while the surplus country would adopt reflationary policies (economy taking a toll).

• If BOP deficit persisted (a sign of fundamental disequilibrium) IMF might allow devaluation.

18

Problems with Fixed/Pegged System

• The system allowed BOP to dictate domestic economic policy (expansion in surplus country and contraction in deficit country: in conflict with full employment and price stability goals).

• CB role was to maintain currency convertibility by protecting reserves: monetary policy was to lower interest rates when reserves rose and to raise them when reserves fell.

• Changes in pegged rates were allowed only as a last resort and at rare intervals: in the interim no variable to correct imbalance.

• Devaluation/revaluation tended to get postponed as long as possible until crisis break-out.

19

Fixed/Pegged XR (cont’d)• Real danger of excessive devaluation for 2 reasons: (a) to ensure

devaluation impact is strong enough to eliminate deficit and (b) frequent devaluation is disallowed.

• The system requires large reserves to finance BOP deficit for a prolonged period.

• The system was breeding unhealthy speculation, as it was easy to identify a weak currency (prolonged deficit acted as an obvious indictor), which worked in speculators’ favour: weak currency will not appreciate even if it doesn’t depreciate (one-way option!)

• Friedman: the system represents the worst of both worlds, as it neither provides permanently stable XR of the GS nor the continuous adjustments of the flexible XR system.

20

Demise of the Bretton Woods System

• Also, many govts. were unwilling to take coordinated efforts to maintain exchange rates thus adjustments were rare and large in magnitude.

• Many dramatic battles between central banks and speculators took place.• Finally, the US lacked discipline to maintain parity, excess govt. spending and

inflation over the 60’s, the Vietnam War financing etc. meant that SS of $ far exceeded gold reserves in the US treasury.

• For parity to hold, other countries had to agree to have the same level of inflation as the US, but the other major OECD countries found this unacceptable.

• Countries like Germany and Japan had to intervene heavily to support the $.• Finally, the British who had accumulated lots of $ from such intervention, hinted

that they would like to redeem the $ for gold at $35 per ounce.

• This was the last straw, US President Nixon knew the US could in no way redeem $ at the $35 per ounce.

• Thus, the decision was made that the US abandon the Bretton Woods system.

• Following US departure, the other major countries followed suit and the system folded up.

21

The Current Hybrid System

• Following US departure from gold redemption in 1971, the world moved to various forms of floating exchange rate regimes.

• These are in 4 broad categories.• Free Float• Managed Float• Target Zone Arrangement (EMS).• Pegged Exchange Rate

22

The Case for Floating Exchange Rates

• Market forces will ensure that a currency does not remain overvalued or undervalued for long.

• Floating exchange rates ensure BOP equilibrium (through changes in prices of exports and imports).

• Can insulate economies: Eg. if foreign country has inflation, PPP adjustment will cause HC to appreciate thereby eliminating / preventing imported inflation.

• Floating system promotes economic stability. • Does not worsen economic cycles.• Exchange rates act as shock absorbers against externally

induced shocks.

23

More Merits of Free Float• It is simple to operate, as it responds readily to market forces, restoring

equilibrium without monetary or fiscal intervention (automatic mechanism).• Adjustment is continuous, avoiding prolonged disequilibrium.• It permits greater independence in domestic policies (which is good for free

trade and convertible currencies).• It tends to reinforce the effectiveness of monetary policy (lower interest rate

to stimulate output and employment will cause capital outflow which in turn would cause spot rate to fall, exports to rise).

• No a priori reason for floating rates to be unstable, barring unstable economic conditions.

• Exchange rate risk is a non-systematic risk that can be diversified away (minimized if not eliminated by hedging).

• It does not require CBs to hold large forex reserves.

24

The Free Float or Clean Float

• Under a freely floating exchange rate system, exchange rates between 2 currencies are determined by market forces.

i.e. DD and SS for the currency.

• Thus, over time the exchange rate of any 2 currencies will fluctuate “randomly” as new information arrives and participants reassess their expectations given these new information.

• Stabilizing speculation: if speculators believe that a fall in the price of a currency is temporary, or that the currency has depreciated more than necessary, they will buy that currency. (Speculation can be destabilizing if speculators dump a weak currency in panic).

25

$ Price per DM S

S1D2

D

DD1

Quantity of DM

Free Floats- Exchange Rate Equilibrium

et

et+z

Thus, as shown above, the exchange rate (e) between $ and DM will change, as DD or SS of DM change. Likewise, the same logic if $ SS or DD change’s.

26

Free Float (cont’d)

* In a freely floating system, by definition, there is no govt. intervention.

* A free / clean float however can mean volatile exchange rates, and hence the trade disruption that comes with it.

* Exchange rate volatility will depend on whether speculation is stabilizing or destabilizing.

* Meade argued in favour of govt. intervention to iron out short-term fluctuations without interfering with long-term trends.

* Friedman thought otherwise: govt. officials are no better judges than speculators.

27

Case Against Free Float?

The Argument Against• Elasticity pessimism: BOP imbalance

may not be eliminated, making weak currency weaker and rendering exchange rates unstable.

• Exchange rate uncertainty can inhibit trade and investment.

• Speculation can be destabilizing, with excessive depreciation.

• Threat of cumulative inflation: depreciation leads to more expensive imports, feeding inflation and festering more depreciation

The Counter-argument• Demand tend to be price-elastic in the

long run.• Peg does not guarantee exchange

certainty either (more disruptive, more drastic). Besides, uncertainty can be diversified away.

• Whether speculation is stabilizing or not depends not on the XR system but underlying economic conditions.

• Depends on the share of imports in the consumer price index; lag between depreciation and impact on domestic prices will permit payments adjustment.

28

Managed Floats

• Most countries try to “manage” their currency by actively intervening to “smooth” out movements and prevent “excessive speculation”.

• Exchange rate uncertainty also reduces economic efficiency (adds to costs) by acting as a tax on trade and foreign investment.

• Managed Floats come in several forms: Leaning Against the Wind: going against the market to prevent short-medium term

aberrations (due to events, even random) that are expected to be only temporary.

Snake in the Channel: containing market rates between ceiling and floor levels (wide-enough band) that allows some flexibility – so that there can be greater freedom for domestic policy pursuits.

Dirty Float: only upper bound, no lower bound (biased to boost export competitiveness).

(A variant of exchange controls are the multiple exchange rate regimes of some countries like India, Pakistan & some Latin America Countries before, Myanmar now)

29

Pegged Exchange Rate Systems* 1) Hard Peg (Formal/Fixed XR) Typically with a Currency Board (e.g. HK, Argentina,

Liberia, Estonia) / administrative fiat (e.g. Malaysia Sept 1998 – July 2005, Saudi Arabia, UAE now).

* 2) Soft Peg Malaysia, Thailand, Indonesia prior to the Asian

financial crisis (Pre-July1997)* 3) Crawling Peg Brazil, Mexico at one time. A crawling peg involved

steady pre-determined rates of depreciation.

30

Target–Zone Arrangement• Under a “target-zone” arrangement, countries adjust their

national econ. policies to maintain their exchange rates within a specific margin around agreed-upon fixed central exchange rates.

• EMS is a good example of a “target zone” arrangement; a variant of “Optimum Currency Area” (OCA) – “domain within which exchange rates are fixed” (Mundell).

• EMS (European Monetary System) began operating in March 1979. Its purpose was to foster monetary stability in the EEC.

• Under EMS member countries agreed to establish the ECU (European Currency Unit) which is a composite currency that consists of fixed amounts of 10 European currencies the weights being reflective of the country’s economic strength within the EC.

31

Target Zone (cont’d)• The ECU could function as a unit of account, as a means of

settlement and as a reserve asset for the members of the EMS.• At the heart of EMS was the ERM (Exchange Rate Mechanism),

which allowed each member to determine a mutually agreed upon central exchange rate for its currency; each rate was denominated in currency units per ECU.

• Since each currency was ‘pegged’ to the ECU, cross-rates between currencies were easily determined. These are central cross rates.

• All members except (Spain & Britain) pledged to keep their currencies within a 2.25% margin of the central cross-rates.

32

EMS

• Spain & Britain had6% margins.

• Given that all members had pledged, a problem with a single currency would often require co-ordination and intervention by member countries.

Thus, coordination & commitment of all parties are extremely critical in target-zoning.

• EMS faced several problems. In the first 8 years (by 1987) there had been 12 realignments.

• This has largely been due to French & Italian accommodation of higher inflation.

• Bundesbank, on the other hand, was extremely sensitive of inflation intolerant.• Besides neither France nor Germany were willing to allow exchange rate

considerations to override domestic political priorities.

• France & Italy had often delayed the inevitable saying “NO” to devaluation; because of national ‘prestige’.

• In March 1983 for example the French Govt. spent in excess of US$ 5 billion over 2 weeks to defend the Franc and still lost. The Franc had to be devalued.

33

EMU

• ** The experience of EMS shows that FX intervention without undertaking the necessary monetary policy change is merely cosmetic and cannot work. It only delays the inevitable.

• Then again in Sept. 1993 there was major crisis within EMS.

European Monetary Union (EMU)• Eleven EU nations agreed to establish a single central bank (ECB) with power

to issue a single European currency (the euro): Common Currency Area (CCA).

. The euro was born in 1 January 1999 with 11 founding members surrendering their monetary autonomy to ECB: membership has subsequently expanded to 17.

• Based on The Maastricht Agreement and Convergence Criteria

34

EMU: Maastricht CriteriaMaastricht Convergence Criteria imposed:Tough standards on inflation, currency stability and deficit

spending: (a) government debt not to exceed 60% of GDP (b) budget deficit not to exceed 3% of GDP (c) inflation rate not to exceed 1.5 percentage

points above the average of Europe’s 3 lowest-inflation countries.

(d) long-term interest rate not to exceed 2 percentage points above the average interest rate in 3 lowest inflation nations.

35

EMU: More To It Than Meets The Eye• EMU is not just about currency stability; there is a lot more

to it.• It is also about reining in the expensive European welfare

state and its costly regulations.• It attempts to fix European malaise associated with high

taxes, generous social welfare and unemployment benefits, mandatory worker benefit packages and costly labour market regulations (all of which reduce incentives to work, save, invest, create jobs and stay competitive) – not to mention onerous regulations on business, state subsidies and protection to ailing industries.

• Slow progress in this front, due to lack of discipline and enforcement, but seen as stepping stone towards a United Europe

36

Regional Financial Cooperation in Asia

• Intra-regional financial cooperation has been slow compared to real-sector cooperation everywhere.

• Asian Monetary Fund (AMF) proposal in the aftermath of the Asian financial crisis (97/98) failed to take off.

• Chiang Mai Initiative (CMI): too little, too late.• CMIM looks promising but falls short.

37

Regional Currency: East Asia Perspective (1)

Common Currency Area (CCA) for East Asia? • East Asia is far more diverse than EU. • Euro experience is not encouraging.• Monetary integration can’t work without fiscal

policy coordination.• Sovereignty concerns too formidable.• Geopolitical factors not conducive.• Remote prospects.

38

Regional Currency: East Asia Perspective (2)

Optimum Currency Area (OCA) for East Asia?• Asian Currency Unit (ACU) as unit of account.• Pegging member currencies to ACU.• Govt. interventions necessary to defend the peg.• Lessons from Europe (EMS) points to the importance of monetary

policy coordination. • “Managed float” based on common basket of currencies can also

ensure intra-regional exchange rate stability, but warrants consultations among central banks.

• A regional “lender of last resort” would be reassuring. • OCA looks more realistic than CCA for at least some East Asian

countries.

39

An Assessment of the Post Bretton Woods System

• In 1973 when the world moved to a floating rate regime, there was promise of stability. • In that, floating currencies would adjust accordingly, i.e. nominal exchange rates will adjust, but real

rates will be stable (Purchasing Power Parity). • i.e. floating exchange rate will be a shock absorber, thereby avoiding painful disruptions. • Again, as in previous regimes, the experience has not been as promised.

• Uncertainty has increased. This increase in volatility cannot be attributed entirely to in underlying economic fundamentals, but uncertainty due to govt. policies i.e. expectations of future govt. policies have also played a role.

• Credibility of govt. policies / announcements is extremely important. Govts. often announce things they

have no intention of doing (politics!). Also, bureaucrats often overestimate their importance and think they can talk up or down their currency.

• Additionally, govts. must be willing to adopt, or have as it’s core policy, a commitment to price stability

i.e. taking the necessary steps so as not to let the value of their currency erode. • **Recall, that one of the main functions of money is as a store of value. When govts. play around with

inflation (expansionary policies) they destroy this important function of their currency.

40

Devaluation, Anyone? • Technically, under a freely floating rate system, there is no need for a govt.

to devalue the home currency. • Currency values will constantly adjust itself, appreciating or depreciating. • However, when a country is on any variant of the managed float, or

operating in a target zone arrangement, then a officially announced devaluation might be necessary.

• From an economic standpoint, a devaluation could be helpful in the long-

run, but devaluation is often seen as a “national disgrace”, or politically unpalatable.

• Thus, govts. often try to take measures (all stop–gap) to try to postpone the devaluation that is inevitable.

41

Alternatives to Devaluation

• Foreign Borrowing When a devaluation is necessitated by persistent BOP deficits govts. could try to finance these deficits

by foreign borrowing. Instead of correcting the necessary underlying fundamental problem e.g. having maintained an artificially overvalued currency.

• Austerity Fiscal austerity - if combined with genuinely reduced govt. expenditures and increased taxes - can be an

effective alternative to devaluation.• The aim of austerity should be to bring about disinflation. • More often than not, govts. announce austerity programs but seldom stick to it.

• Wage & Price Controls• May be politically more palatable than austerity. However, it treats the symptoms and not the cause.

• Exchange Controls A way of life in some countries• Most drastic form is where all FX earnings must be surrendered to Central Bank which then apportions

this funds to users according to govt. priorities e.g. India’s multiple exchange rate mechanism in the past.

• In countries with foreign exchange controls, there are huge incentives for black-market trading.

42

The Mighty Dollar• The USD rides high and stays supreme by default, not necessarily by design.• The $ is still the single most important reserve currency for all central banks.

• There is no real alternative to the dollar. Hopes of the euro rising to challenge the dollar have faded after the global 2007-08 financial crisis and the ongoing sovereign debt problem in the euro zone.

• The US is the only country in the world than can borrow in its own currency internationally:

(a) zero exchange risk (b) just print money to pay debts

(c) the rest of the world chooses to remain blind

* The US does not have to defend its dollar: the rest of the world will do that favor for free! They won’t let the dollar sink, as they will have to sink with it.

43

The Dollar Magic• Is the US taking the whole world for a ride? Is the rest of the

world totally stupid? No simple answers!• The universal acceptability of the dollar has no doubt enabled

the US to live beyond its means with huge twin deficits (fiscal and current account).

• The US is a huge consumer importing nearly anything and everything from anywhere and everywhere, never mind the yawning BOP deficit, so long as it is financed by massive capital inflows.

• After all, cheap imports help keep cost down and inflation low.• Is all this good or bad for the rest of the world? Again, no simple

answers!

44

The Dollar Magic (cont’d)• Ironical as it may sound, the rest of the world apparently

loves the dollar inasmuch as it may dislike the US!• The fact remains that the US, as the largest economy in the

world and the biggest consumer is fuelling economic growth of its trade partners. Of all the nations, the US is the least protectionist, despite strong domestic protectionist forces.

• East Asia, in particular, has benefited greatly from the relatively free access to the US market for its exports. The more the US consumes and the faster the US grows , the better for East Asian economies which can export more and grow even faster.

45

The Dollar Magic (cont’d)• It is thus in the interest of East Asia and other exporters that

the US continues to import more and more. • To enable the US to play this role, East Asia is more than

willing to use their BOP surplus to finance the BOP deficit of the US by buying US papers.

• Strong dollar is good for the rest of the world: (a) their reserves are denominated mostly in dollars, and (b) strong dollar is good for the competitiveness of their exports in the US market.

• No wonder, the dollar stays afloat all the time, thanks to the intervention of other countries.

The Dollar Magic (cont’d)• Thus, the US enjoys the luxury of having a currency that is

globally used as a unit of account, a store of value and a means of exchange.

• But, then, there is always a price to pay: the US has no control over its own currency. A strong dollar would hurt the US economy but there is little that the US can do about that. The US might prefer a weaker dollar but others won’t let it weaken. Dollar devaluation will destroy its reserve currency role.

• By internationalizing its currency, the US has unwittingly constrained its own domestic policies with respect to inflation, unemployment, interest rate, etc.

• The US can be held at ransom by countries that hold massive US dollar reserves or is it the other way around? 46

47

Looking Beyond the Dollar• The collapse of the Bretton Woods System has left the world like a ship without

radar.• There is a need for a new international financial architecture.• Attempts at international monetary reforms are going nowhere.• G7, G20 efforts are not promising.• Going back to gold is not a practical proposition.• Gold dinar? (not until gold prices are fixed and inflation contained, otherwise

gold will be hoarded).• Islamic dinar? (needs heroic assumptions relating to political will and economic

discipline amid horrendous policy coordination problems).• Basket peg?• World currency?• A three-legged currency stool (USD + EUR + ACU)?• Can East Asia cut the dollar Gordian Knot?

48

The Future of Gold

• Why Gold Can Fly So High? Worries about fiat currencies, safe haven, hedge against inflation, BOP surplus and CB reserves, volatile exchange rates.

• Hedge funds diversifying into commodities, especially gold, bidding up commodity prices.

• In short, growing DD for and limited SS of gold.

49

The Future of Gold• Will This Uptrend Go On And On?

• Nothing can last forever! A soft landing for gold is not unthinkable• Consider the following scenario: (a) the global economy

rebalances, (b) BOP imbalances narrow, (c) BOP surplus decline and with it CB reserves, (d) prudent monetary policies in place, (e) fiscal discipline is practiced, (f) oil prices decline, thanks to other sources of energy, (g) inflation becomes a non-issue, (h) good governance, best practices prevail.

• In which case, DD for gold will decline sharply. Gold is a scarce metal but unproductive unlike other metals which are used as inputs in production (except in the case of ornaments)

50

Concluding Thoughts• Exchange rates cannot remain “fixed” for long - so long as

governments subordinate exchange rate considerations to domestic political considerations.

• Exchange rates are taken not as a ‘given’ but as a policy tool to achieve domestic policy objectives: no genuine desire for equilibrium exchange rates.

• Calls for a new gold standard reflect a fundamental distrust that monetary authorities are not averse to tampering with the integrity of fiat money.

• Returning to gold is not a viable option: not enough gold to go around; gold as a commodity is subject to unstable prices; gold is likely to be hoarded unless its price is rigidly fixed and inflation is vehemently contained.

51

Concluding Thoughts (cont’d)• Maintaining a disequilibrium or unrealistic exchange rate is

injurious when pursued over lengthy periods.• Collective judgments of currency traders tend to prevail:

policymakers cannot outsmart them for any extended period.• The world is unlikely to return to the fixed exchange rate

system, as all else will have to adjust to exchange rates – which is politically not palatable.

• Rigidly fixed exchange rates can also be problematic, as some flexibility will do good.

• Floating rates need not be unstable, provided underlying economic conditions are stable.

52

Concluding Thoughts (cont’d)• For exchange rates to be stable, inflation rates and interest rates

must also be stable (recall: PPP, Fisher effect & International Fisher effect).

• There are costs associated with unrealistic exchange rates and, in the end, there is no escape from market forces.

• Politicians tend to mess up exchange rates wittingly or unwittingly, directly or indirectly: they want to shift the costs of their economic policies to (a) foreigners who do not vote or (b) future generations who do not vote yet.

• Politicians take credit when things go right and blame the rest of the world when things go wrong.

• Politicians blame currency traders - but not themselves - for currency meltdown: shooting the messenger with a message!

53

END OF LECTURE 12

STAND TALL, BE COUNTED!