International Finance Chapter 19 McGraw-Hill/Irwin Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved.

Learning Objectives After this chapter, you should be able to: Explain how international trade is financed. Define and measure our balance of payments. List and discuss the different exchange rate systems. Summarize how we became a debtor nation. Explain American exceptionality from a historical perspective.

The Mechanics of International Finance International trade and finance are an extension of our nation’s economic activities beyond our borders. The balance of payments provides an accounting of our country’s international financial transactions.

The Balance of Payments Defined: the entire flow of U.S. dollars and foreign currencies into and out of the country. The balance of payments has 2 parts: The current account—a summary of all the goods and services produced during the current year that we buy from or sell to foreigners. The capital account—records the long-term transactions that we conduct with foreigners. The total of both accounts always equals zero.

U.S. Balance of Payments, 2009

U.S. Current Account Surpluses and Deficits, 1985-2009

U.S. Current Account Surpluses and Deficits U.S. Current Account Deficit as a Percentage of GDP, 1985–2009 Our current account deficit must be balanced by our capital account surplus. Our current account deficit has been rising rapidly since the early 1990s. The U.S. is faring worse than other countries.

Current Account Deficit or Surplus as Percentage of GDP, Selected Countries, 2008

Questions for Thought and Discussion How did this happen? Imports > Exports! We buy much more from foreign countries than they buy from us. To offset this, we must balance this by selling foreign countries U.S. stock, real estate, bonds, and other debt. Does it matter? How much longer can we go on selling off U.S. capital assets?

Exchange Rate Systems The basis for international finance is the exchange of well over 100 national currencies. A exchange rate is the price of a country’s currency in terms of another currency.

The Gold Standard (until 1933) A nation is on the gold standard when it defines its currency in terms of gold (at a fixed ratio). Until 1933, the U.S. dollar was worth 1/23 of an ounce of gold. When country A exports as much as it imports, no gold is transferred. But, when country A imports more than it exports, it has to ship the difference in gold.

The Gold Standard The gold standard was a self-correcting mechanism. A negative balance of trade caused an outflow of gold, a lower money supply, lower prices, and ultimately fewer imports and more exports. The gold standard will only work when the gold supply increases as quickly as the world’s need for money. World War II caused the need for a worldwide system that would lend some stability to how exchange rates were set.

The Gold Exchange Standard, 1944-1973 A Bretton Woods (New Hampshire) conference set up the International Monetary Fund (IMF) to supervise a system of fixed exchange rates, all of which were based on the U.S. dollar, which was based on gold. The U.S. held the largest stock of the world’s gold and stood ready to sell that gold at $35 an ounce. Dollars were convertible into gold at $35 an ounce. Other currencies were convertible into dollars, at fixed prices, so these currencies were indirectly convertible into gold.

The Gold Exchange Standard, 1944-1973 A country’s money supply was not tied to gold. No longer would trade deficits or surpluses automatically eliminate themselves. If a nation ran consistent trade deficits, it could devalue (lower) its currency relative to the dollar. This system worked well for 25 years after World War II. By the 1960s, U.S. gold stock dwindled, so other nations began to worry that the U.S. would not be able to redeem dollars at $35 an ounce. In 1971, President Nixon announced the U.S. would no longer redeem dollars for gold.

The Freely Floating Exchange Rate System, 1973 to the Present Hypothetical demand and supply for British Pounds The forces of supply and demand now set the exchange rates.

The Free Floating Exchange Rate System, 1973 to the Present D curve: represents the desire of Americans to exchange their dollars for pounds to buy British goods and services, stocks, bonds, real estate, and other assets. S curve: represents the desire of British citizens to purchase American goods, services, and financial assets. We don’t have completely free floating exchange rates because governments do intervene, usually for a limited time.

Exchange Rates: Foreign Currency per U.S. Dollar, April 8, 2010

International Exchange Rates, 1972-2010 Overall weighted average of U.S. dollar: decline since 2001. Japanese yen: relatively stable since mid-1990s. E.U. Euro: rose after inception on January 1, 1999, then U.S. dollar value rose. Euro has been replacing the U.S. dollar as an international currency, in part because of the EU’s great geographic expansion as new countries join.

Factors Influencing Exchange Rates The relative price levels between the two countries. The relative growth of the two countries economies. The relative level of interest rates in the two countries.

The Yen and the Yuan (Japanese and Chinese currency) The two biggest trade deficits of the U.S. are with China and Japan. These countries try to keep the value of their currencies low vis-à-vis the U.S. dollar to promote their exports. The Chinese are the big exception to the freely floating exchange rate system. By maintaining an undervalued yuan, the Chinese are able to make Chinese exports more attractive to American consumers by keeping down their prices. From, this point of view, global monetary policy is now made in Beijing, not Washington.

Hypothetical Supply and Demand for Dollars Relative to Yen If the supply of dollars outside the U.S. were to go up while the demand for dollars went down, what would happen to the price of the dollar relative to the yen? It would go down, in this case, from 100 yen to 80 yen.

The Falling Dollar and the U.S. Trade Deficit What should be pretty clear by now is that, as a nation, we have been living well beyond our means for more than 25 years. It also should be clear that the party can’t last forever. The U.S. quickly shifted from being the world’s largest creditor nation (which is good) to the largest debtor nation (which is not so good). What happened?

From Largest Creditor to Largest Debtor Foreign assets in the U.S. has been increasing at an increasing rate; this what foreigners own in the U.S. So the gap between what foreigners own in the U.S. and the U.S. stock of net foreign assets has been widening. Gap > $6 trillion in 2009. Over $1 trillion of American currency is abroad.

From Largest Creditor to Largest Debtor: How Did We Get There…and Why Worry? Main reason: mounting U.S. trade deficits; we are consumption junkies. We continue to station hundreds of thousands of troops abroad. The interest, rent, dividends, and profits we pay foreigners continues to grow as our debt mounts. Why Worry? We borrow almost $2 billion a day to finance our current account deficit, mostly from East Asian countries. If foreigners eventually want to hold fewer dollars, the value of the dollar will plunge. This puts upward pressure on prices and interest rates, and depress growth.

Editorial: American Exceptionality We are running unsustainably large budget deficits. We have been running huge trade deficits. Our defense spending is growing at an unsustainable pace, while our military is stretched to the breaking point. We are living well beyond our means, depending on the kindness of foreigners. We have lost most of our manufacturing base and are now losing our innovative edge as well.

Editorial: American Exceptionality, cont. Americans have one of the lowest savings rate of all nations. American students have among the lowest scores on international tests. We import 60% of our oil. We spend almost 2x per capita on healthcare as most other economically advanced nations. Considered together as a group of facts, could it be that that the game is almost up and we are on the wrong end of the score?