Financial Liberalization

1. Current Account represents the net sum of trade in goods and services, primary income and secondary income: NX +NFI. a. Net Exports 1. Trade balance refers to net export (export less import) of goods 2. Net Services, defined as the net export (export less import) of services. b. + c. Net Factor Income b. Primary Income comprises compensation of employees (wages, salary) and investment income c. Secondary Income refers to donation or grant paid to or received from nonresidents Meta Data

Balance of Payments Table

Savings &Current Account Gross National Savings: GNI – Consumption (Publ. + Private) GDP = Consumption + Gross Capital Formation + Net Exports (Exports – Imports) GNI = GDP + NFI GNS – GCF = NX + NFI = Current Account

Capital & Financial Account Net {Non Reserve} Capital Inflows Two Parts Capital Account: Transfers of copyright, patents, mineral rights, debt forgiveness by govt Financial Account: Vast bulk of international capital movements [Inflows less outflows] – Inflows: Foreign purchases of domestic securities, FDI, loans from foreign banks. – Outflows: Domestic purchases of foreign securities, FDI, loans from domestic banks

Types of Capital Flows Direct Investment reflects the lasting interests of nonresidents of an economy in a resident entity. A direct investor may invest in equity capital, lending to affiliates, or reinvested earnings. Portfolio Investment refers to transaction that involves buying and selling of equity securities, debt securities in form of bonds, notes, money market instruments Other Investment includes loans, trade credits, deposits as well as other account receivables and payables

Balance of Payments Foreign Currency Received (Credit) Foreign Currency Paid (Debit) Exports (+) Income Receipts (+) {Non reserve} Capital Inflows (+) Imports (-) Income Payments (-) {Non reserve} Capital Inflows (-) Overall Balance = Current Account + Capital & Financial Account Credits – Debits = Increase in Reserves Link

Accounting Current Account + Capital & Financial Account should equal increase in Reserve Assets. Not all financial transactions measured. CA + C&FA + NEO =Overall Balances NEO = Uncounted Inflows

Balance of Payments Equation Current Account Net Capital Inflows += Current Account Overall Balance (increase in reserves)

What if current account or capital inflows is too low to balance (i.e too much imports/not enough exports) Net Capital Inflows + ≠ Current Account Overall Balance (increase in reserves) What if economy runs a current account deficit? Not enough buyers for domestic currency goods Too many buyers for foreign currency assets

Current Account What if economy runs a current account deficit? Net Capital Outflows Too many buyers for foreign currency assets Not enough buyers for domestic currency goods

Two Possibilities Floating Exchange Rates – Changes in the exchange rate equalize forex market. Pegged Exchange Rate – Changes in reserve assets equalize forex market.

Net Capital Inflows Domestic goods and assets become more competitive and create more capital inflow and greater current account Net Capital Inflows + Current Account Overall Balance (increase in reserves) = 0 Flexible Exchange Rate: Not enough demand for domestic currency causes exchange rate to depreciate. Central Bank does not participate in the market Current Account =

Overall Balance (increase in reserves) Net Capital Inflows + Current Account Overall Balance (increase in reserves) Fixed Exchange Rate: Central bank must use forex reserves to buy domestic currency to absorb pressure on its value = Central bank spends its stock of foreign currency.

Current Account Not enough demand for domestic currency causes exchange rate to depreciate. Net Capital Outflows Falling price of currency makes domestic goods & financial assets more competitive Current Account Net Capital Outflows

Net Capital Outflows Central bank must use forex reserves to buy domestic currency to absorb pressure on its value. Current Account Net Capital Outflows

Current Account What if economy receives a surge in inflows? Net Capital Outflows Hot Money

What if economy receives a surge in inflows? Current Account Net Capital Inflows + Current Account Overall Balance (increase in reserves) Money coming into the economy drive foreign exchange payments out of balance. =

Hot Money: Fixed Exchange Rate Central bank buys incoming foreign currency ? Current Account Net Capital Inflows + Current Account Overall Balance (increase in reserves) Purchase of foreign currency boosts reserves. Overall Balance (increase in reserves) =

Hot Money: Flexible Exchange Rate Increase demand for domestic currency causes appreciation. Net Capital Inflows += Current Account Overall Balance (increase in reserves) = 0 More expensive currency reduces export competitiveness drives the trade balance into deficit. Current Account

Current Account Excess demand for domestic currency causes exchange rate to appreciate? Net Capital Outflows Floating exchange rates Current Account Net Capital Outflows

Net Capital Outflows Central bank purchases inflows and increases reserves Current Account Net Capital Outflows

FINANCIAL CRISIS

International Financial Crises Currency Crises – Loss of credibility of fixed exchange rate system. Banking Crisis – Sudden collapse of the domestic banking system. Systemic Financial Crisis/Sudden Stops – Breakdown of system of international capital flows. Sovereign Debt Crisis – Gov’t unable to pay-off debts IMF World Economic Outlook, 1998

Devaluation/Revaluation Devaluation of the currency occurs when central bank operating an exchange rate peg increases the number of domestic dollars needed to purchase one foreign dollar. Revaluation is a decrease in domestic currency price of foreign dollars.

Currency Crises Market believes that exchange rate will be devalued in the near future. Lenders demand higher interest rates to lend in domestic dollars to compensate for loss of value after devaluation. Central bank must use its foreign reserves to buy domestic currency and prop up exchange rate. If pain of interest rates is too painful or loss of reserves too severe, central bank may be forced to devalue.

ERM Crisis In 1980’s, European economies constructed a system of linked currencies called the Exchange Rate Mechanism. Inflationary German fiscal policy following re- unification led to high DM interest rates. To maintain link, other Euro currencies needed to have interest rates too high for their own situation. In Sept. 1992, markets expected a delinking/devaluation of currencies. Go for the Jugular

Currency Crisis Speculation against the pound forced Bank of England to raise interest rates and buy pounds in forex markets. Pain of interest rates was viewed as too severe and B of E was forced to abandon the peg. Principal Global Indicators Database

Banking Crises Bank Runs – Sudden withdrawal of deposit base forcing bank closures or gov’t assistance. – Solvency Crisis: Banks have substantial amounts of loans gone bad and thus have insufficient funds to repay depositors. Swedish Banking Crisis, 1991 LinkLink – Liquidity Crisis: Sudden deposit withdrawal requires liquidation of otherwise sound assets. Bank of East Asia, 2008 Link Link

Roles of Banking System Why Not Finance Corporate Sector w/ Stocks and Bonds? Banks accept deposits from retail customers and make larger, longer-term loans. Information: Banking institutions study credit- worthiness of borrowers. Monitoring: Banks can enforce covenants and conditions on lending. Liquidity : Deposits easily used for necessary transactions Link

Systemic Crisis Bank failure can be contagious 1.Interbank Lending 2.Panic conditions Link

Lender of Last Resort Banking system sufficiently important that gov’ts will usually protect depositors and prevent mass bankruptcies. – Liquidity Crisis: Lend at penalty rates against good collateral. Walter Bagehot, 1840’s. – Solvency Crisis: Recapitalize banks through gov’t purchase of equity, diluting or destroying shareholder value. Moral Hazard: Banks creditors and (sometimes owners) are protected from consequences of risky behavior. Link

Banking Crisis Currency Crisis Fragile banking system makes high interest rates untenable and can lead to fears of devaluation (especially if central bank funds used to bailout banking system) Exchange rate devaluation can damage balance sheets if balance sheets (deposits or borrowings) are dollarized.

Financial Crises Sudden Stops: Foreign investors herding behavior and short-termism lead them to move in and out of countries rapidly. – “The greatest concern I have is that capital account convertibility would leave economic policy in a typical ‘emerging market’ hostage to the whims and fancies of two dozens or so thirty-something country analysts in London, Frankfurt, and New York. ” Dani Rodrik, 1998

Sudden Stops International hot money (short-term lending) is subject to herding behavior from international financial market. – Rapid inflows and rapid outflows. When capital inflows stop, either those can be replaced with forex reserves, or domestic borrowers will face bankruptcy. – Domestic firms can no longer finance investment – Demand, GDP, and employment fall. – Devaluation of currency. Link

Balance of Payments Equation Current Account Net Capital Inflows += Current Account Overall Balance (increase in reserves)

Sudden Stop What if capital flows out? Current Account Net Capital Inflows + Current Account Overall Balance (increase in reserves) Money going out of the economy drive foreign exchange payments out of balance. =

Current Account Sudden Stop Increase demand for domestic currency causes depreciation. Net Capital Inflows + = Current Account Overall Balance (increase in reserves) = 0 Depreciation leads to currency account reversal.

East Asian Crisis Link

Foreign Reserves Measures of Adequate Reserves Import Coverage: Reserves > Imports for 2-3 Months Greenspan-Guidotti Rule: Reserves exceed 100% of debt due within one year. Link

Buildup Foreign Reserve Assets IMF Financial Statistics

Korea

Dealing with Sudden Stops Modern Approach Swap lines LinkLink

The debate over financial globalization Broad agreement (among economists at least) that trade liberalization is beneficial and leads to faster growth → Free trade in good and services makes countries better off In contrast, much controversy over whether the liberalization of international financial flows is desirable → Free trade in financial assets may not make countries better off

Capital Controls Stock Market: Limits on foreigners holdings of shares, possibly in certain sectors. Financial Institutions: Limits on businesses of foreign banks, insurance co’s. Restrictions on Direct Investors – Requirements of Domestic Partners Currency Controls: Limits on domestic and foreign residents to exchange currency

Liberalization and Economic Growth i.Capital Deepening: Absent capital mobility, national investment must be financed with national savings. In low savings countries, investment may be slow. ii.Allocative Efficiency: Capital mobility allows seeking out the highest rate of return. Investment can go to locations where it has the highest productivity. iii.Technology Transfer: Foreign investors may bring along techniques of production.

Empirical Evidence: Economic Growth Kose, Prasad, Rogoff, and Wei: 2006: “it remains difficult to find robust evidence that financial integration systematically increases growth.” summary of 40 studies.. Link

Reaping the Benefits of Financial Globalization But there are several factors which have been shown to allow countries with open capital accounts to: A.Increase risk-sharing ; B.Increase economic growth; C.Reduce the likelihood of crises. Empirical evidence shows that the benefits of opening capital account are mixed.

Keys to Benefiting from Globalization 1.Financial sector development. Well- regulated domestic financial markets 2.Institutional Quality. Low corruption, high transparency, good corporate governance. 3.Sound Macroeconomic Policies. Low deficits and price stability. 4.Trade Integration. High degree of trade openness. ft/fandd/2007/03/kose.htm

Nominal Anchors Nominal Anchors act as the measure of currency value maintenance which orient the activities of the central bank. Exchange Rate Targets: Maintain value relative to another currency or basket of currencies. Inflation Targets: Maintain value relative to a basket of goods.

How to Liberalize During the early 1990’s, some authors argued in favor of a “big bang” approach to capital account liberalization. Since mid-1990’s, taking empirical evidence in mind, IMF has adopted a more moderate approach referred to as sequencing or ‘integrated approach’

Integrated Approach (1) capital account liberalization is best undertaken against a background of sound and sustainable macroeconomic policies; (2)domestic financial reform should be complemented by prudential regulation and supervision, and financial restructuring policies; (3) liberalization of capital flows by instruments and/or sectors should be sequenced to take into account concomitant risks—in general, long-term and non-debt creating flows (especially FDI) should be liberalized before short-term and debt- creating flows; Link

Final Exam ECON2000 L1 19-Dec-13 16:30-19:30, G017 Cumulative Bring: Writing materials, calculator, 1 A4 size piece of paper with handwritten notes on both sides Office Hours: WF 9-11:30 Dec. 4-18

Troubles with Inflation 1.Unpredictable inflation generates risk for: - borrowers and lenders - workers and employers 2.High inflation generates losses of purchasing power for people who hold money. Money is a tool of liquidity, becomes less useful when subject to a high inflation tax.

Importance of Nominal Anchors Commitment to nominal anchor can stabilize the value of money and implement low and stable inflation. Visible, credible commitment to nominal anchor implements low inflation expectations in financial markets and private sector.

Great Inflation of the 70’s & 80’s

Inflation Targeting

List of Inflation Targeting Countries Rose A Stable International Monetary System Emerges: Inflation Targeting is Bretton Woods, Reversed Rose

De Facto Classification of Exchange Rate Regimes and Monetary Policy Frameworks

Why Exchange Rate Stability? Why Exchange Rate Anchor? Easily measurable & visible benchmark for maintaining value of the currency. Stabilizes international trade and finance. Why Exchange Rate Instrument? Forex markets most liquid market in frontier markets. Link