LECTURE 1LECTURE 1INTERNATIONAL TRADE & FINANCEINTERNATIONAL TRADE & FINANCE

Sabur Mollah, PhDAssociate Professor of Finance

Stockholm Business School

Part I: History of Part I: History of International Trade and International Trade and

FinanceFinance

A Brief History of the A Brief History of the International Trade and International Trade and FinanceFinanceBimetalism and Gresham’s Law◦Coinage Act of 1792

1 ounce of gold=15 ounces of silver◦1834: U.S. sets price of gold at $20.67/ounce “De facto” gold standard

◦1873: U.S. demonetizes silver1880: Beginning of the modern international gold standard

1900: U.S. formally joins international gold standard

A brief history of the A brief history of the international financial international financial system & the role of the system & the role of the U.S.U.S.World War I causes countries to leave the gold standard◦ U.S. returns in 1919◦ U.K. returns in 1925, but wartime inflation made a return to the pre-war gold price problematic.

◦ U.K. leaves gold standard again in 1931◦ U.S. raises gold price to $35/ounce in 1933 to stem the outflow

German hyperinflation in 1923 added to the post-war instability

A brief history of the A brief history of the international financial international financial system & the role of the system & the role of the U.S.U.S.1944: Bretton Woods Conference leads to creation of the International Monetary Fund and World Bank.

Bretton Woods creates an international system of fixed exchange rates.◦All currencies are fixed to the U.S. dollar

◦Dollar is defined to be equal to 1/35 ounce of gold. (That is, 1 ounce of gold=$35…same as 1933.)

A brief history of the A brief history of the international financial international financial system & the role of the system & the role of the U.S.U.S.Bretton Woods works well until the late 1960s.◦U.S. begins running balance of payments deficits while Japan and Europe run surpluses.

◦Foreign governments begin piling up dollar assets and want to exchange them for gold.

◦By 1971, foreign claims exceeded the U.S. stock of gold. Nixon suspends convertibility—”closing the gold window”.

A brief history of the A brief history of the international financial international financial system & the role of the system & the role of the U.S.U.S.Thereafter the U.S. devalues the dollar, first to $38/ounce, then to $42.22/ounce, where it remained until the system was finally and permanently abandoned.

A brief history of the A brief history of the international financial international financial system & the role of the system & the role of the U.S.U.S.Post-Bretton Woods there are a variety of exchange rate arrangements. In addition to the completely fixed and flexible regimes, there are:◦Crawling peg◦Currency boards◦Managed float◦And others…

A brief history of the A brief history of the international financial international financial system & the role of the system & the role of the U.S.U.S.European Union◦Treaty of Rome (1957)

Created a customs union among France, Germany, Italy, Belgium, the Netherlands, and Luxembourg.

◦Closer monetary union begins to take shape in the 1970s European Monetary System Maastricht Treaty (1992)

A brief history of the A brief history of the international financial international financial system & the role of the system & the role of the U.S.U.S.Maastricht Treaty established “convergence criteria” for joining the monetary union.

Common currency goes into effect January 1, 1999.

Euro banknotes and coins go into circulation January 1, 2002.

Trade AgreementsTrade AgreementsMany agreements have been made to

reduce trade restrictions:◦1988 U.S. and Canada free trade pact ◦North American Free Trade Agreement

(NAFTA)◦General Agreement on Tariffs and Trade

(GATT)◦Single European Act and the European Union

Trade DisagreementsTrade DisagreementsHowever, even without tariffs and

quotas, governments seem always able to find strategies that can give their local firms an edge in exporting:◦different environmental, labor laws◦bribes, government subsidies (dumping)◦tax breaks for specific industries◦exchange rate manipulations

Trade DisagreementsTrade DisagreementsOther trade-related issues include:◦the outsourcing of services◦the use of trade policies for political reasons◦disagreements within the European Union

Part II: International Part II: International Trade & Finance- Current Trade & Finance- Current

State State

International Trade and International Trade and Finance: Some Key IssuesFinance: Some Key Issues

Many developing countries rely heavily on exports of primary products with attendant risks and uncertainty

Many developing countries also rely heavily on imports (typically of machinery, capital goods, intermediate producer goods, and consumer products)

Many developing countries suffer from chronic deficits on current and capital accounts which depletes their reserves, causes currency instability, and a slowdown in economic growth

Balance of PaymentsBalance of PaymentsThe balance of payments is a summary of

transactions between domestic and foreign residents for a specific country over a specified period of time.

Current AccountCurrent AccountThe current account summarizes the flow

of funds between one specified country and all other countries due to purchases of goods or services, or the provision of income on financial assets.

Key components of the current account include the balance of trade, factor income, and transfer payments.

The U.S. Current Account in 2003The U.S. Current Account in 2003

(1) U.S. exports of goods + $712+ (2) U.S. exports of services + 292+ (3) U.S. income receipts + 275

= (4) Total U.S. exports & income receipts = $1,279

(in billions of $)

(5) U.S. imports of goods – $1,263+ (6) U.S. imports of services – 246+ (7) U.S. income payments – 259

= (8) Total U.S. imports & income payments = $1,768

(9) Net transfers by the U.S. – $68

(10) Current account balance = (4) – (8) – (9) – $557

International Trade FlowsInternational Trade FlowsSome countries are more dependent on

trade than others.◦The trade volume of a European country is

typically between 30 – 40% of its GDP, while the trade volume of U.S. (and Japan) is typically between 10 – 20% of its GDP.

Nevertheless, the volume of trade has grown over time for most countries.

Distribution of U.S. Exports across CountriesDistribution of U.S. Exports across Countries(in billions of $)

Distribution of Distribution of U.S. Exports and U.S. Exports and ImportsImports

U.S. U.S. Balance Balance of Trade of Trade Over TimeOver Time

The Pace QuickensThe Pace Quickens

Changing U.S. Economy1970…International trade is 7%2000…International trade is 27% 2050…International trade up to 50%

Changing U.S. Life StylesLocal Economy of 19th Century—93% of Work Force

Employed in AgricultureGlobal Economy of 21st Century—3% of Work Force

Employed in Agriculture

The Global Marketplace of the 21The Global Marketplace of the 21stst Century – Looking AheadCentury – Looking Ahead(% of World GDP)(% of World GDP)

2004 2050

Factors AffectingFactors AffectingInternational Trade International Trade FlowsFlowsImpact of Inflation◦A relative increase in a country’s inflation rate

will decrease its current account, as imports increase and exports decrease.

Impact of National Income◦A relative increase in a country’s income level

will decrease its current account, as imports increase.

Factors AffectingFactors AffectingInternational Trade International Trade FlowsFlowsImpact of Government Restrictions◦A government may reduce its country’s

imports by imposing a tariff on imported goods, or by enforcing a quota.

◦Some trade restrictions may be imposed on certain products for health and safety reasons.

Factors AffectingFactors AffectingInternational Trade International Trade FlowsFlowsImpact of Exchange Rates◦If a country’s currency begins to rise in value,

its current account balance will decrease as imports increase and exports decrease.

The factors interact, such that their simultaneous influence on the balance of trade is complex.

Correcting Correcting A Balance of Trade A Balance of Trade DeficitDeficitBy reconsidering the factors that affect

the balance of trade, some common correction methods can be developed.

A floating exchange rate system may correct a trade imbalance automatically since the trade imbalance will affect the demand and supply of the currencies involved.

Why a Weak Home Currency Why a Weak Home Currency Is Not a Perfect SolutionIs Not a Perfect Solution• Counterpricing by competitors• Impact of other weak currencies• Stability of intracompany trade–Many firms purchase products that are produced by their subsidiaries.

• Prearranged international transactions–The lag time between a weaker U.S.$ and increased foreign demand has been estimated to be 18 months or longer.

Part III: Credit & Eurozone CrisesPart III: Credit & Eurozone Crises

Menzie Chinn & Hiro Ito, "A New Measure of Financial Openness" (Journal of Comparative Policy Analysis, 2008), updated July 2010

http://web.pdx.edu/~ito/Chinn-Ito_website.htm.

I. Direct Measure of Financial Barriers: Chinn-Ito tally of capital controls, from IMF data

Rapid financial

liberalization in 1990s

ITF220 Prof.J.Frankel

Securitization, internationally

1982 – International debt crisis: Banks lose enthusiasm for lending to developing countries.

1987 – Basel I Agreement sets standards for international banks (e.g., minimum capital requirements).1989 – Brady bonds securitize bad bank loans to developing countries.

1994 – Mexican peso crisis hits when foreign investors lose willingness to hold CETES & tesobonos.

1997 – Thai baht crisis also features a larger role for securities.

2007-08 – International securitization of US mortgages (“MBS”)ends in tears, with the sub-prime mortgage market crisis.

2011 – Basel III: AAA ratings for MBSs, ABSs or CDOs => 0 risk./

““Till debt do us Till debt do us part?part?””- PIIGS- PIIGS

Source: New York TimesEurope’s Web of Debt

The Great Depression and The Great Depression and the recent crisis in the recent crisis in

EuropeEuropeGreat Depression (1930s) Present crisis

Quarters of negative growth: 13-15.

Industrial output: -25 to -30%.

First year: - 8 %.GDP: -5% to -10%.GDP first year: -5%.World trade : -25%World trade first year: -7%.

Unemployment: 15-25%.

Quarters of negative growth: 3- 5.

Industrial output: -10 to -15 %.

First year:-10 to -15%.

GDP: -5%GDP first year: -5%.World trade: -38%.World trade first year:- 38%.

Unemployment: 8-12%

Policy responses in Policy responses in EuropeEurope

Great Depression (1930s) Present Crisis Banking crises not contained.

Money supply response limited by gold standard discipline until 1931 or later for gold bloc nations.

Initial budget deficits were met by attempts to restore budget balance through spending cuts or tax increases.

Discretionay spending and automatic stablizers: weak.

Increase in public debt: small

Banking crises contained by vigorous lender of last resort lending and nationalization of insolvent banks.

Strong automatic stablizers as well as increase in discretionary spending .

Budget deficits as a share of GDP: 5-12 % of which half discretionary.

Public debt/GDP increases by 10-30 percentage points.

References:

Madura, Jeff (2013). International Financial Management. CENGAGE Learning, 12e (Chapters 1, 3, and 19).