1 ECONOMICS 3150C Lecture 4 October 21

2 Fixed Exchange Rates: Policy Effectiveness B. of C. committed to maintaining value of exchange rate Consider case:  If B. of C. commitment to fixed exchange rate credible  [E*(e) – E*]/E* = 0 B. of C. loses control over R – any attempt to change R with no change in values of other variables, will impact E* Covered interest rate parity model: –R(C) = R(US) +  since B. of C. considered credible –If   R(C)  –M determined by need to maintain R(C) = R(US) +  and E* fixed –Monetary policy loses effectiveness with fixed exchange rates

3 Fixed Exchange Rates: Policy Effectiveness B. of C. committed to maintaining value of exchange rate Consider case:  Traditional D/S model  in D for C$,  in S of C$ –In absence of intervention, C$ depreciates in value (E  ) –To keep exchange rate constant, B. of C. either  M   R or intervenes directly and buys C$ (sells foreign assets) –Consider direct intervention: requirement for foreign asset reserves Problem: can B. of C. persist in buying C$? Traders expect depreciation, so  S of C$  compounds problem for B. of C.

4 E Q(C$) D for C$: exports S of C$: imports Direct Intervention: Sell foreign assets E0E0 SD

5 Flexible Exchange Rates Independent monetary policy – not constrained by need to keep exchange rate fixed at particular level –Fiscal policy ineffective Expansionary policy  R   E  EX and  IM   aggregate demand Combination of higher interest rates and appreciation of C$ neutralize expansionary effects of fiscal policy Ignoring effects on P and repercussions on aggregate D Degree of independence –US  M to stimulate economy and reduce UR (Canadian policy-makers likely to have same objective) US actions will lead to appreciation of C$ (  in US GDP   Canadian CU; and  R(US)   Canadian CA); which will reduce positive spillover effect from US Flexible rates will require B. of C. to follow lead of US Federal Reserve

6 Flexible Exchange Rates Automatic stabilizer –Increase in rate of inflation in US R(C) = R(US) + [E*(e)-E*]/E* +  [E*(e)-E*]/E* = %  E*(e) = %  P(C) - %  P(US) Assume %  P(C) = %  P(US) = %  P(D) =  initially  %  E*(e) = 0 Now assume %  P(US)   %  E*(e) < 0  E*  (appreciation) P(C) = P(D) [P(US)E*] 1-  %  P(C) = %  P(D) + (1- )[%  P(US) + %  E*(e)] %  P(C) =  If %  P(US)   %  E*   offsetting impact on %  P(C) –With fixed exchange rates If %  P(US)   %  P(C) 

7 Dollarization Problems with flexible exchange rates –Effectiveness of independent monetary policy –Trade costs –Competitiveness –Demand for bail-outs –Instability of foreign exchange markets: tendency to overshoot –78.5% appreciation in 5 years Problems with Dollarization –Loss of independent m.p. –Loss of automatic stabilizer –Economic performance and sovereignty

8 Optimum Currency Area High degree of economic integration Labor and capital mobility Similar economic structures Limited policy autonomy – large spillover effects Limited role for exchange rate movements to insulate against external shocks

9 Economic Integration Varying degrees of integration Preferential free trade arrangements – lower trade barriers among participating countries Free trade area –All trade barriers removed among participants –Each country retains own barriers against non-members –Sources of products need to be identified Definition of domestic product (domestic content requirements)

10 Economic Integration Customs Union –Common trade barriers against non-members –Trade creation vs. trade diversion Trade creation if tariffs blocked trade prior to customs union Trade diversion if customs union leads to substitution of imports from partner country from non-partner country (lower cost imports from outside union replaced by higher cost imports from union member) –Gains more likely if trade creation more prevalent than trade diversion  high pre-union tariff barriers; low tariffs with ROW; many countries part of customs union; closer geographically are members of union (transportation costs, tastes: lower obstacles to trade among members) Common market –Free movement of capital and labor –Harmonization of labor and other laws

11 Economic Integration Economic Union –Monetary union – single currency –Restrictions on fiscal policy –Harmonization of monetary policy, fiscal policy, tax rates –EU has had difficulty in dealing with economic and financial crisis – no single response as in the U.S. Political union Common perimeter for immigration purposes – Canada and US cooperate at all entry points into North America; same immigration rules

12 European Union Treaty of Rome, 1957 –Customs union Single European Act, 1986 – amended Treaty of Rome –Eliminated internal barriers to trade, capital movements and labor migration Maastricht Treaty, 1993 –Single European currency and central bank –Convergence criteria: Country’s inflation rate in year before admission must be no more than 1.5% above average of three EU members with lowest rate of inflation Government deficit < 3% of GDP Government debt below or approaching 60% of GDP

13 European Union Financial crisis: Round 2 Speculation against Greece –Expected default on sovereign debt –Large budget deficits throughout decade –Large underground economy –Lack of confidence in government achieving EU goal of budget deficit <3% –Significant increase in interest rates: long-term government bond rates increased from 4.7% (Q3/09) to 8.3% (Q2/10) Does Greece meet conditions for currency area? Would Greece be better off outside Eurozone with ability to have own currency depreciate – to offset negative impacts of restrictive fiscal policy? No fiscal transfers within EU – compare to US and Canada

14 Sovereign Debt and Defaults Private debt – CCAA, ch. 11 –Convert debt into equity –Convert into new debt with lower face value and lower interest rates –Receive cash for fraction of value at maturity (pennies on the dollar) Sovereign debt –Conversion into equity not an option –Convert into new debt with lower face value and lower interest rates –Defer interest and principal payments, possible reduction in interest rate –Receive cash IMF: provides new loans to make payments on outstanding debt – loans generally made with conditions (re. macroeconomic policies – reduce debt, low inflation rate targets; microeconomic policies – privatization, deregulation)  beneficiaries are current creditors

15 European Union Greece: remaining in Eurozone –Labor mobility –Lower interest rates when investors have confidence in government –Spreads over Germany (long-term government bonds): 2007 – 28bp Q3, 2009 – 136bp Q2, 2010 – 552bp –No danger of depreciation threatening survival of borrowers in Euros (Southeast Asia crisis in 1997) Greece leaving Eurozone –Depreciation of currency to improve competitiveness – major export is tourism

16 European Union EU members created US$1 T fund to assist members roll-over maturing debt and finance budget deficits Interest rates set higher than borrowing costs for Germany Bail-out largely of EU banks who held most of debt of PIIGS

17 International Capital Markets Group of closely interconnected markets in which assets trade Foreign exchange markets part of international capital markets Debt, equity, futures, options, commodities, currencies, etc. China’s foreign reserves in excess of US$2 T –Reserves have grown as Bank of China drains money from economy through bond sales to reduce money supply and inflationary pressures Japan’s foreign reserves in excess of US$1 T

18 Demand for Financial Assets Relative expected rates of return – returns on financial assets denominated in different currencies must be compared in the same currency Risk – variability of expected return, default risk and expected losses in case of default, confidence in estimates –Comparison of expected return for same degree of risk –Diversification of portfolio to reduce overall risk for portfolio –Risk preference –Black Swans Liquidity: cost/speed of converting asset into cash –Precautionary motive for holding liquid assets

19 Diversification Risk reduction –Same expected return, lower risk for portfolio –Higher expected return, same degree of risk –Risk aversion Risks: –Default –Price variability –Exchange rate –Imperfect information Insurance markets – financial and non-financial risks: –Spread risks: re-insurance, insurance pools –Pooling of risks: insurance pools –Derivatives

20 Interdependence of Financial Markets Bubbles and collapses Herd effects – equilibrium and overshooting/undershooting Diversification – geographic, industry, asset class: purpose of diversification Contagion effects – spreading of economic shocks: open vs. closed financial markets –Is geographic diversification possible?

21 Interdependence of Financial Markets “We have more complexity today because of the sheer size of the capital markets and the presence of new and unpredictable players” (Robert Bruner, Dean of the business school at the U. of Virginia in Charlottesville) –Complex financial instruments: new generations of derivatives –Increasing use of leverage –New institutions: hedge funds –Globalization –Ineffective regulations –Rapid movement of capital

22 Financial Crisis Rocket scientists, derivatives and a free lunch Banks: more money in fees than direct lending Investors: searching for higher returns without more risk –Money for nothing and the ….. for free Leverage Shadow banking system Greed, trust, uncertainty Absence of regulatory oversight Central banks did not appreciate degree of interdependence between Lehman and all major financial institutions

23 Offshore Banking and Eurocurrencies Offshore banking –Business conducted by the foreign branches, subsidiaries of a bank outside the home country of the bank Eurocurrencies –Bank deposits denominated in a currency other than the domestic currency of the country in which the bank or its foreign operations reside Offshore currencies Typical Eurocurrency deposit is non-negotiable time deposit with fixed term to maturity ranging from overnight to 5+ years US$ deposits in a bank in Canada (Canadian, US, other) – part of Eurodollars – Eurodollars: US $ deposits in banks outside US C$ deposits in a bank outside of Canada (Canadian, other) –Eurobanks: banks that trade in market for Eurocurrencies – take deposits, make loans Most Eurocurrency trading occurs in non-European centers

24 Eurocurrencies Euro-deposit rates – 3 months 08/26/0908/24/0807/14/08 U.S.0.30%5.48%2.81% Canada Euro Yen Pound

Euro Deposit Rates Today US: 0.27% Canada:1.03% Euro:0.77% Yen:0.17% Pound:0.65% 25

26 Rapid Growth of International Banking Reduction in trade costs  growth in international trade –Hedging currency risks Liberalization of capital markets –Growth of MNEs – banks have followed corporate customers abroad Circumvent restrictive domestic government regulations on financial activity – reserve requirements, interest rate ceilings, deposit insurance Political factors – desire by some depositors to hold currencies outside jurisdiction of countries that issue them – freezing accounts Money laundering – drugs, arms sales, bribes, other criminal activities

27 Creation of Eurocurrencies Bombardier sells US$65 M RJ to Jet Airways – Jet pays initial deposit of US$10 M by check drawn on U.S. bank branch in Mumbai (Citibank) Options for Bombardier –Convert to C$ at current spot rate (E) –Keep US $ (required for purchases of engines, avionics, consulting services, etc.) Buy US TBs Buy CD from US bank Buy Euro-US dollar deposit from Royal Bank branch in Montreal –Only this option leads to creation of Eurodollar deposit – no change in US money supply

28 Creation of Euro-US Dollars Bombardier –Asset: US$ Deposit with RB (Montreal) –Liability: US$ customer advances Jet Airways –Asset: US$ customer advance –Liability: US$ loan from Citi Citi (Mumbai) –Asset: US$ Loan to Jet Airways –Liability: US$ Loan from Citi (NY) Citi (NY) –Asset: +US$ Loan to Citi (Mumbai) –Asset: -US$ Deposits with Fed Royal Bank (Montreal) –Asset: US$ Deposit with DB (Frankfurt) –Liability: US$ Deposit of Bombardier Deutsche Bank (Frankfurt) –Asset: US$ Deposit with JPMorgan Chase (NY) –Liability: US$ Deposit of RB JPMorgan Chase (NY) –Asset: US$ deposits with Fed –Liability: US$ Deposit of DB

29 Vulnerabilities Absence of regulatory oversight Inter-bank lending (as in preceding example) – hierarchy of banks –“Offshore” bank in turn lends to another bank – interest rate on Eurodollar deposits increases as the money moves up the hierarchy of banks –At top of the hierarchy, much greater default risk than at bottom –If bank or ultimate borrower at top defaults, default could create domino effect – Royal’s exposure may be much different because of interbank lending Consider structure of CDOs, credit default swaps

30 Counter-Party Risks Derivatives –Exchange traded – rules, collateral –Private transactions – no rules (other than contracts), no collateral (other than specified in contracts) –CDS –Other risks related to assumptions entered into black boxes

31 Swaps and Comparative Advantage Two companies: –A (US multinational) can borrow medium-term (5-year bonds) at 100 basis points above US Government bonds (1.73%) and 150 basis points above Government of Canada bonds (2.32%) –B (Canadian multinational) can borrow medium-term at 200 basis points above US Government bonds and 100 basis points above Government of Canada bonds B has comparative advantage in Canada, A in US –A: US to Canada – 2:3; Canada to US – 3:2 –B: US to Canada – 2:1; Canada to US – 1:2 A needs to hedge against C$ revenues; B needs to hedge against US$ revenues –in absence of swap agreement, A issues debt in Canada at 3.82%, B issues debt in US at 3.73%

32 Swaps and Comparative Advantage (Cont’d) Swap agreement for five years: –A issues debt in US at 2.73%, B Issues debt in Canada initially at 3.32% (identical principal amounts involved) –A and B swap interest payments –Net interest rate for A: 2.73%(US) – 2.73%(US) %(C) = 3.32% in Canadian $ –Net interest rate for B: 3.32%(C) %(US) – 2.73%(C) = 2.73% in US $ Counter-party risk: A or B defaults –Swap market: financial institutions operate as intermediaries between floating-rate and fixed rate payers, and between payers in different currencies