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Week 2 Exchange Rate Systems

1. Exchange Rate Systems2. The Role of Central Banks3. History of Exchange Rate Systems

FINS3616International Business Finance

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1. Given great demand of cross-border trade and investment, how do we exchange currencies?

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The International Monetary Fund

IMF member state

IMF member states not accepting some obligationsChristine Lagarde, managing director (July 2011-now)

The IMF is an international organization of 187 member countries, basedin Washington, DC, which was created at a UN conference in BrettonWood, the U.S., 1944.

The main goal of IMF is to ensure the stability of the internationalmonetary and financial system, to help resolve crises, and to promotegrowth and reduce poverty.

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Two major exchange rate systems

Pegged exchange rate systems• Governments maintain currency values at official exchange

rates

• Fixed to the U.S. dollar, the Euro, and a composite currency(SDR)

• Devaluation (revaluation) is used when the currency falls(rises)

In July 2015, 1USD=7.75HKD

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Special drawing rights (SDR)

• Supplementary foreign exchange reserve assets definedand maintained by the International Monetary Fund (IMF).

• Their value is based on a basket of key internationalcurrencies reviewed by IMF every five years

2016-2020The internationalization of RMB

• In Nov. 2014, RBA and PBC signed anagreement to established official RMBclearing arrangements in Australia

• China seeks confirmation of RMB’sarrival on world stage

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Two major exchange rate systems Floating exchange rate systems

• Currency values fluctuate according to market supply anddemand.

• Depreciation (appreciation) is used when the currency falls(rises).

In July 2015, 1USD=1.37AUD

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Exchange rate systems around the World

Pegged exchange rate systems• Conventional fixed rate like Saudi Arabia and UAE• Target zones and crawling pegs like Denmark and China• Currency board like Hong Kong

Floating exchange rate systems• Independently floating like Canada, Japan, and Australia• Managed floating like Argentina and Brazil

No separate legal tender• Adopt the currency of another country. For example,

Ecuador and Panama use the US dollar, Kiribati uses theAustralian dollar, and Kosovo uses the Euro

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Conventional fixed rateIn July 2015, 1USD=3.75 SAR (Saudi Riyal)

In July 2015, 1USD=3.67 AED (UAE Dirham)

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Target zones and crawling pegsIn July 2015, 1EUR=7.46 DKK (Danish Kroner)

In July 2015, 1USD=6.20 CNY (Chinese Yuan)

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Currency board

HSBC (Hong Kong)

SCB (Hong Kong)

BOC (Hong Kong)

HKMA1 USD 7.75 HKD

The Market

Certificates of indebtedness

In July 2015, 1USD=7.75HKD

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Independent floatingIn July 2015, 1USD=1.30CAD (Canadian dollar)

In July 2015, 1USD=124.3JPY (Japanese yen)

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Managed floatingIn July 2015, 1USD=8.80ARS (Argentine Peso)

In July 2015, 1USD=3.37BRL (Brazilian Real)

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No separate legal tenderPopulation: 15.74 millionLanguage: SpanishCurrency: the U.S. dollarMajor industries: mining andpetroleum refining

Population: 3.84 millionLanguage: SpanishCurrency: the U.S. dollarMajor industries: tourism andCanal

Population: 102,351Language: EnglishCurrency: the Australian dollarMajor industries: fishing

Population: 1.82 millionLanguage: AlbanianCurrency: the EuroMajor industries: mining

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Trend and distribution in exchange rate systemsTrend:

Distribution in 2010:

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Exchange rate variations are determined by marketdemand and supply of a currency.• Large demand=>• Large supply =>

Determinants• Differences in money supply growth• Differences in real interest rate• Political and financial risks

Measure of currency risk• Volatility• Historical data that indicates past currency volatility• Are pegged currencies risk free?

What drives exchange rate in a floating system?

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2. Exchange rate variations in a floating system--the role of central banks

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• RBA’s duty is to contribute to the stability of the currency,full employment, and the economic prosperity and welfare ofthe Australian people.

• It does this by setting the cash rate to meet an agreedmedium-term inflation target, working to maintain a strongfinancial system and efficient payments system, and issuingthe nation's banknotes.

Reserve Bank of Australia

Glenn StevensGovernor of the Reserve Bank of Australia

from 2006 to now

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“Our mission, as set forth by theCongress, is a critical one: topreserve price stability, to fostermaximum sustainable growth inoutput and employment, and topromote a stable and efficientfinancial system that serves allAmericans well and fairly”Ben Bernanke

Chairman of the Federal Reserve of the U.S.from 2006 to 2014

Zhou, XiaochuanGovernor of the People's Bank of China

from 2002 to now

“Functions of the PBC areformulating and implementingmonetary policy; issuing RMB andadministering its circulation;regulating inter-bank lending marketand inter-bank bond market;administering foreign exchange andregulating inter-bank foreignexchange market; regulating goldmarket…”

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Households Corporations

Deposits(deposit rate, 2.0%)

Loans(lending rate, 5.4%)

Loans (cash rate, 2.0%)

Government bonds

Westpac

RBA

Inside the RBA: The secondary

market

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The balance sheet of the RBAAssets

Official international reserves

Domestic credit

Government bonds

Loans to domestic financial institutions

Other

Liabilities

Deposits of domestic financial institutions

Currency in circulation

Other

• Official international reserves: foreign currency reserves (86%); goldreserves (14%)

• Domestic credit: the purchase or sales of government bonds by the centralbanks are used to influence the money supply; loans to domestic financialinstitutions are especially important in times of panic and financial crisis

• Deposits of domestic financial institution: countries require theircommercial banks to hold a certain percentage of the deposits the banksaccept from the public

• Currency in circulation: the coins and bills are used by the public

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The current exchange rate is A$1.0/US$.(1) Reserve Bank of Australia buys A$5 billion Australiangovernment bonds from the Australian government. Whatis the outcome on the Australian dollar? What about theimpact on inflation in Australia?

In-class questions

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The current exchange rate is A$1.0/US$.(2) Reserve Bank of Australia buys US$5 billion USgovernment bonds from the U.S. government (RBA doesnot use their foreign currency reserves). What is theoutcome on the Australian dollar? What about the impacton inflation in Australia?

In-class questions

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The current exchange rate is A$1.0/US$.(3) Reserve Bank of Australia buys US$5 billion USgovernment bonds from the U.S. government (RBA doesnot use their foreign currency reserves) and sells A$5billion Australian government bonds to the ANZ bank. Whatis the outcome on the Australian dollar? What about theimpact on inflation in Australia?

In-class questions

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Central banks affect exchange rates directly• By supplying domestic currency, central banks weaken

the value of domestic currency.• By demanding domestic currency, central banks

strengthen the value of domestic currency.

Two methods of foreign exchange rate intervention• Non-sterilized interventions (currency value and inflation)• Sterilized interventions (currency value)

Foreign exchange rate intervention

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3. The history of exchange rate systems

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• A double standard: both gold and silver were used as money,accepted as means of payment.

1875• The gold standard: European countries and the U.S. pegged their

currency to gold. For example, $20.7 per ounce and £4.2 per ounce

1914

1944

• WWI : 1914-1918, John M. Keynes called it “the barberian relique”.• The Great Depression: 1929-1935, the longest, deepest, and most

widespread depression of the 20th century• WWII: 1939-1945, the deadliest conflict in human history

1976

• Bretton Woods system: $35 per ounce and other currencies arepegged to the U.S. dollar

• Vietnam War: 1955-1975, Americans paid a lot• 1971: U.S. president Nixon surrendered to market forces and took

the U.S. off the gold standard

• Jamaica agreement: floating exchange rates were declaredacceptable.

1999

• Euro zone: the Euro was introduced into Europe.

A brief history

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• Mexican peso crisis in 1995

• Asian financial crisis in 1997

• Russian ruble crisis in 1998

• Brazilian real crisis in 1998

• Turkish lira crisis in 2001

• Argentinian peso crisis in 2002

Currency crises

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Asian currency values: $1.0/unit in Jan. 1996

Korean won

Thai baht

Indonesian rupiah

Asian financial crisis in 1997

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George Soros’s Quantum Fund:

Fundamental reasons:• A pegged exchange rate system that overvalued the local

currency• A large amount of foreign currency debt

Consequences:• Currency crises have a negative short-term impact on the

local economy• A shift to floating systems has a positive long-term impact on

the local economy

1. Borrowed a lot of Thai baht from Thai banks2. Sold the Thai baht to the Thai government for the

U.S. dollar and spread negative sentiment3. After the Thai government devaluated the Thai

baht, he bought the baht at a lower value andrepaid his loans.

Asian financial crisis in 1997

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Proponents:• IMF loans helped countries overcome financial crises

Critics:• Borrowing conditions such as fiscal constraints and

capital market liberalizations increased economic andfinancial risks

• IMF loans usually lasted for decades• IMF loans were spent to support an overvalued exchange

rate• IMF loans benefited developed countries but not crisis

countries

Should IMF lend money to those crisis countries?

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The desire for currency stability in Europe is verystrong• Western European countries’ trading partners are

their neighboring countries• Need for a common market for agricultural products• Political reason to achieve the integrated union

among European countries

The approach to achieve currency stability in Europe• 1944-1973: the Bretton Wood system• 1979-1999: the European Monetary System• 1999 to now: the Euro

The road to monetary integration in Europe

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Conditions:• A grid of bilateral exchange rates is 2.25% on each side• Central banks should intervene when the grid is reached• If the grid can not be sustained, a new grid will be

established

Outcomes:• Daily variations were reduced but large devaluations

still occurred• The EMS was designed to be a symmetric system but

Germany played a central role and other countriespegged their currencies to the German mark.

• Inflation and interested differential were controlled but ithurt a weak country’s economy in the long run.

The European Monetary System (1979-1999)

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The Maastricht Treaty:In 1991, the European heads of state met in Maastricht in theNetherlands to map out the road to economic and monetaryunion with a single currency to be reached by 1999.

Criteria:• Inflation within 1.5% of 3 best performing countries• Interest rate on government bonds within 2% of 3 best-

performing countries• Budget deficit to GDP <3%• Government debt to GDP< 60%• No devaluation over the past 2 years

Phases:• Restrictions of movement on capital removed, and European

Monetary Institute was created in Jan. 1994• European Central Bank replaced European Monetary Institute

in Jan. 1999

The Euro (1999 to now)

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Euro Zone (2013)

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Should the European Union adopt the Euro?

Pros: enhanced price transparency, lower transaction costs,and no exchange rate uncertainty that promote trade andeconomic growth.

Cons: loss of independent monetary policy. It is bad if country isin a bad stage. For example, Greece in a great recession from2010.