Chapter 2 International Financial Mgmt Eun, et.al notes: A.P. Palasvirta, PhD

 When CBs execute a monetary policy  discipline of the gold standard is gone  after WWII governments ran inflationary policies interest rate policies employment policies inflation sometimes running at 200% or more  Exchange rates fluctuate  creating uncertainty for trade September 4, int'l money notes a.p. palasvirta, ph.d. 2

 Dollarization  Currency boards   Managed exchange rate  Pegged  Banded peg  Crawling peg  Floating exchange rate  Currency unification September 4, int'l money notes a.p. palasvirta, ph.d. 3

September 4, int'l money notes a.p. palasvirta, ph.d. 4  Markets and/or individuals in a country use a foreign currency without formal government approval  Individuals wealth denominated in foreign currency Notes, bonds, bank deposits in domestic or foreign banks Protect against domestic inflation  Markets accept or prefer the use of a foreign currency Grey and black markets  Foreigners hold from 55 to 70% of the U.S. Dollars currently in circulation  U.S. Dollar, Euro, and Yen are the primary currencies held

September 4, int'l money notes a.p. palasvirta, ph.d. 5  Government adopts a foreign currency as a predominant or exclusive legal tender  Panama, Ecuador  No currency board, no central bank  Benefits  Dollar inflation  Low interest rates  No exchange rate risk (transaction, translation, & operating exposure)  Loss of sovereignty  No independent monetary policy  Loses the power of seignorage 

September 4, int'l money notes a.p. palasvirta, ph.d. 6  Currency board issues notes & coin convertible into foreign currency at a fixed exchange rate on demand  100% to 110% in foreign reserves General t-bills denominated in the foreign currency Has no discretionary power Inflation and interest rates are approximately in line with the foreign currency Cannot be a lender of last resort 

 Gold, silver  Foreign exchange  U.S. dollar assets (T-bills)  Domestic coinage and cash  Commercial Bank deposits September 4, int'l money notes a.p. palasvirta, ph.d. 7 Assets Liabilities

 Create money  Mandate reserve ratios  Mandate capital ratios  Control bank rate  Operate in t-bill market  Operate in exchange markets  Bank of Canada Report September 4, int'l money notes a.p. palasvirta, ph.d. 8

 Advantages  No exchange rate risk (transaction, operating and translation exposure is zero)  Maintain artificially low prices for one’s products  Disadvantages  Lack of monetary policy independence  Imbalances in international financial markets continue and grow Eventually sudden large adjustments in exchange rates September 4, int'l money notes a.p. palasvirta, ph.d. 9

 Pegged  A fixed peg maintained by the central bank  Banded peg  Central bank intervenes if the exchange rate increases or decreases by more than a given percentage  Crawling peg  Central bank fixes to an exchange rate, but changes the fixed value it defends periodically China September 4, int'l money notes a.p. palasvirta, ph.d. 10

 China (Yuan)  CB of China will supply enough Yuan to satisfy the demand for the Yuan due to Balance of Payments surplus Causes money supply to increase (inflationary pressure)  CB of China is moving to a managed float Will allow the Yuan to appreciate but is not announcing how or when it is allowing the Yuan to appreciate September 4, int'l money notes a.p. palasvirta, ph.d. 11

 Brazilian Stock market take a hit  Government borrowing in dollars  have to pay back in higher valued currency  often leading to re-negotiation of terms  operating exposure  (change in real exchange rate)  on exporters  on importers September 4, int'l money notes a.p. palasvirta, ph.d. 12

 Inflation targets  Bank tries to increase supply of money just enough to accommodate demand Assume demand increases by 5% per year If bank is targeting 2 – 3 % inflation rate, supply will be increased by about 8%  Interest rate targets  Low interest rates tend to increase capital investment  Keep growth in the economy positive  Exchange rate targets  Fixing exchange rates reduces transaction risk and keeps international prices in one’s favor September 4, int'l money notes a.p. palasvirta, ph.d. 13

 Floating exchange rate regime  Does not try to affect trend To affect trend it would have to either buy or sell foreign exchange in large quantities Bank’s policy is directed at an inflation target 2 – 3% inflation per year  Will jump into the market to affect volatility Over the year this means that the net sales and purchase of foreign exchange is approximately zero  07/ar2007.html 07/ar2007.html September 4, int'l money notes a.p. palasvirta, ph.d. 14

 Control money  Open market operations  Bank rate  Manage banking system  Reduce liquidity risk Reserve ratios Deposit insurance  Reduce default risk Capital ratios Lender of last resort  Bank of Canada balance sheet Bank of Canada balance sheet September 4, int'l money notes a.p. palasvirta, ph.d. 15

 Central banks order coin and currency which is stored in the vault  Money is created when the central bank buys something with that coin and currency  Gold and silver  Foreign exchange Foreign denominated cash and currency Foreign denominated t-bills  Domestically denominated t-bills  Keeps purchases sufficiently high to meet inflation targets September 4, int'l money notes a.p. palasvirta, ph.d. 16

 Central bank has large influence in two markets  Domestic t-bill market (largest single entity)  Exchange market (largest single entity in domestic currency in exchange markets)  As a large entity it, unlike other operators in the market, can affect price September 4, int'l money notes a.p. palasvirta, ph.d. 17

 Bank rate  Interest rate charged member banks for borrowing to increase reserves Increase the bank rate decreases system reserves thereby leading to a decrease in the money supply Decrease the bank rate increases system reserves thereby leading to an increase in the money supply September 4, int'l money notes a.p. palasvirta, ph.d. 18

 Commercial banks required to maintain liquid reserves to meet demand of deposit holders demanding redemption  Inverse of reserve ratio is called the money multiplier  How much bank money, base money will support September 4, int'l money notes a.p. palasvirta, ph.d. 19

September 4, int'l money notes a.p. palasvirta, ph.d. 20 Reserves Cash Currency Deposits with CB cd t-bills Loan Portfolio Lines of Credit Car loans Business Loans Home and Business Mortgages Checking Accounts Savings Accounts GICs Bank Capital

 Reserve Ratio = 10%  Money multiplier = 10 September 4, int'l money notes a.p. palasvirta, ph.d. 21 Reserves = $1 billion Loan Portfolio = $9 billion Checking deposits Savings Deposits $9.6 billion GICs Bank capital = 400 million

 Reserve Ratio = 20%,  Money multiplier = 5 September 4, int'l money notes a.p. palasvirta, ph.d. 22 Reserves = $1 billion Loan Portfolio = $4 billion Checking deposits Savings Deposits $4.8 billion GICs Bank capital = 200 million

 Leverage  Measured by the debt/equity ratio or debt ratio  Measure of risk Manufacturing firms usually D/E = 1 or D/TA = 0.5 Banks D/E =.96/.04 = 24 or D/TA = 0.96 The liabilities (deposits) in a bank are guaranteed (insured) by the government Banks can lever quite a bit because of this  CIBC balance sheet CIBC balance sheet September 4, int'l money notes a.p. palasvirta, ph.d. 23

 Advantages  Purchasing power parity allowed to hold Trend line reflects relative inflation  International prices adjust automatically Prices more transparent  Allows an independent monetary policy  Disadvantages  Exchange rate volatility increases  Higher costs due to need to hedge volatility September 4, int'l money notes a.p. palasvirta, ph.d. 24

Gold, foreign exchange T-bills 70 – 80% Cash, currency Commercial bank reserves held at BOC September 4, int'l money notes a.p. palasvirta, ph.d. 25 Assets Liabilities

 Independent European Central Bank  convergence criteria  nominal inflation < 1.5% above avg of 3 with lowest in previous year  long-term interest < 2.0 % above avg of 3 with lowest in previous year  fiscal deficit no more than 3 % of GDP  debt no more than 60% of GDP September 4, int'l money notes a.p. palasvirta, ph.d. 26

 Advantages  One monetary policy  No exchange rate risk Costs of trade much lower  Financial market integration (money & capital)  Disadvantages  Loss of sovereignty on monetary/fiscal policy  Loss of national currency September 4, int'l money notes a.p. palasvirta, ph.d. 27

 Belgium (franc)  Germany (deutschemark)  Spain (peseta)  France (franc)  Ireland (punt)  Luxembourg (franc)  Italy (lira)  Netherlands (guilder)  Austrian (shilling)  Portugal (escudo)  Finland (markka)  Vatican City (lira)  Greece (drachma)  Slovenia (tolar) September 4, int'l money notes a.p. palasvirta, ph.d. 28

 Bulgaria (Lev)  Czech Republic (Koruna)  Denmark (krone)  Estonia (Kroon)  Hungary (Forint)  Latvia (Lats)  Lithuania (Litas)  Poland (Zloty)  Romania (Leu)  Slovakia (Koruna)  Sweden (krona)  United Kingdom (pound) September 4, int'l money notes a.p. palasvirta, ph.d. 29

 Price for current delivery  Price of one currency in terms of another  Delivery no later than four business days  Price market determined  fluctuates to reflect new information September 4, int'l money notes a.p. palasvirta, ph.d. 30

 Current demand for CD by holders of foreign currency  foreigners want to buy something Canadian  Current supply from Canadians holding CD demanding foreign exchange  Canadians want to buy something foreign September 4, int'l money notes a.p. palasvirta, ph.d. 31

 e 0, Can terms = CD/USD =  CD cost of the USD  e 0, us terms = USD/CD =  USD cost of the CD  exchange rates exchange rates September 4, int'l money notes a.p. palasvirta, ph.d. 32

 Croatia  Macedonia  Turkey September 4, int'l money notes a.p. palasvirta, ph.d. 33

 Deposits held in other than the domestic currency  A usd account at a Chartered Bank is a eurocurrency deposit Off-balance-sheet account Chartered bank would hold a liability to the depositor which is matched equally by an asset which is a deposit to an U.S. bank for the same amount September 4, int'l money notes a.p. palasvirta, ph.d. 34

 Eurocurrency interest rates  PIBOR (Paris), MIBOR (Madrid), SIBOR (Singapore)  Off-balance-sheet lending in currencies other than home currency Wholesale market Between multinationals Large banks Central banks Narrow spread Low risk Large amounts ($500,000) or more September 4, int'l money notes a.p. palasvirta, ph.d. 35