1. INTERNATIONAL ECONOMICS, 15E Robert Carbaugh © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

2. International Banking: Reserves, Debt and Risk Chapter 17 © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

3. Chapter Outline (1 of 2) Nature of International Reserves Demand for International Reserves Supply of International Reserves Foreign Currencies Gold Special Drawing Rights Facilities for Borrowing Reserves International Lending Risk © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

4. Chapter Outline (2 of 2) The Problem of International Debt Reducing Bank Exposure to Developing Nation Debt Debt Reduction and Debt Forgiveness The Eurodollar Market © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

5. Nature of International Reserves International reserves ◦ Enable nations to finance disequilibrium in their balance-of-payments positions  Deficit: monetary receipts fall short of monetary payments  Settled with international reserves ◦ Enable nations to sustain temporary balance-of- payments deficits  Until acceptable adjustment measures can operate to correct the disequilibrium © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

6. Demand for International Reserves (1 of 6) Demand for International Reserves ◦ Depends on  Monetary value of international transactions  Disequilibrium that can arise in balance-of-payments positions ◦ Contingent on  Speed and strength of the balance-of-payments adjustment mechanism  Overall institutional framework of the world economy © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

7. Demand for International Reserves (2 of 6) Exchange Rate Flexibility ◦ Automatic adjustment mechanisms that respond to payments disequilibrium ◦ Economic policies used to bring about payments equilibrium ◦ International coordination of economic policies © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

8. Demand for International Reserves (3 of 6) Exchange Rate Flexibility (cont.) Automatic adjustment mechanisms ◦ Prices, interest rates, incomes, and monetary flows ◦ The more efficient each of these adjustment mechanisms is  The smaller and more short-lived market imbalances will be and  The fewer reserves will be needed © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

9. Demand for International Reserves (4 of 6) Exchange Rate Flexibility (cont.) Changes in the degree of exchange-rate flexibility ◦ Inversely related to changes in the quantity of international reserves demanded ◦ More rapid and flexible exchange-rate adjustments requires smaller reserves © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

10. Figure 17.1- Demand for Int’l Reserves & Exchange Rate Flexibility © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

11. Demand for International Reserves (5 of 6) Other Determinants ◦ Choice & effectiveness of government policies  Adopted to correct payments imbalances  The greater a nation’s propensity to apply commercial policies to key sectors  Tariffs, quotas, and subsidies  The less will be its need for international reserves  Assuming that the policies are effective in reducing payments disequilibrium © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

12. Demand for International Reserves (6 of 6) Other Determinants ◦ International coordination of economic policies  Goal of economic cooperation:  Reduce the frequency and extent of payment imbalances  Reduce the demand for international reserves ◦ Quantity demanded of international reserves  Positively related to the level of world prices and income © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

13. Supply of International Reserves Total supply of international reserves ◦ Owned reserves  Gold, acceptable foreign currencies  Special drawing rights (SDRs) ◦ Borrowed reserves  Lenders:  Foreign nations with excess reserves  Foreign financial institutions  International agencies © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

14. Foreign Currencies (1 of 2) 1800s–1900s, reserve currencies ◦ The U.S. dollar ◦ The UK pound ◦ Trading nations have traditionally been willing to hold them as international reserve assets ◦ Since World War II, the U.S. dollar has been the dominant reserve currency © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

15. Foreign Currencies (2 of 2) The U.S. dollar as reserve currency ◦ Early 1950s - a dollar-shortage era  Massive development programs in Europe  Excess demand for the dollars ◦ Late 1950s, dollar glut  U.S. continued to provide reserves to the world through its payments deficits ◦ 1960s, liquidity problem ◦ 1970, creation of SDRs as reserve assets © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

16. Gold (1 of 9) Gold standard, historically ◦ International means of payments ◦ Unit of account ◦ Viable store of value ◦ Overall acceptability Monetary role of gold today ◦ Glittering ghost haunting efforts to reform the international monetary system © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

17. Gold (2 of 9) International Gold Standard, 1880 to 1914 ◦ Values of most national currencies were anchored in gold ◦ Gold coins circulated  Generally accepted means of payment ◦ Money supply  Fixed relation to the monetary stock of gold  Growth in monetary gold  Growth in the money supply  At a rate that corresponded to the growth in real national output © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

18. Gold (3 of 9) International Gold Standard (cont.) ◦ 1934, the Gold Reserve Act  U.S. government - title to all monetary gold  Required citizens to turn in their private holdings to the U.S. Treasury ◦ The U.S. dollar - devalued in 1934  Official price of gold was raised from $20.67 to $35 per ounce © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

19. Gold (4 of 9) Gold Exchange Standard ◦ International monetary system as formulated by the IMF nations  Gold served as the primary reserve asset (the dollar- gold system) ◦ To economize on monetary gold stocks as international reserves ◦ The U.S – dominant economy  Productive capacity and national wealth © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

20. Gold (5 of 9) Gold Exchange Standard (cont.) ◦ The United States  Assumed the role of world banker  The dollar - chief reserve currency of the international monetary system  Responsibility for buying and selling gold at a fixed price to foreign official holders of dollars  The dollar – convertible to gold  All other currencies – pegged to the dollar © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

21. Gold (6 of 9) Gold Exchange Standard (cont.) ◦ 1968, two-tier gold system  Official tier - central banks could buy and sell gold for monetary purposes at the official price of $35 per ounce  Private market - gold as a commodity could be traded at the free-market price © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

22. Gold (7 of 9) Demonetization of Gold ◦ August 1971, President Richard Nixon  The United States was suspending its commitment to buy and sell gold at $35 per ounce  U.S. stock of monetary had declined to $11 billion  Deteriorating U.S. balance-of-payments position ◦ January 1, 1975  The official price of gold was abolished as the unit of account for the international monetary system  Ban on individual ownership of gold for U.S. residents also ended © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

23. Gold (8 of 9) Should the U.S. Return to the Gold Standard? ◦ When U.S. moved from gold standard, moved to fiat currency standard in which dollar bills circulate as legal tender backed by government ◦ Not redeemable into gold ◦ Fiat money given value by  relative scarcity and  faith placed in it by people that use it ◦ Concern that unlimited money can be printed © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

24. Gold (9 of 9) Should the U.S. Return to the Gold Standard? (cont.) ◦ Under gold standard, government could print money only if backed by gold ◦ But gold standard presents problems  Limit government’s ability to manage economy  Federal Reserve could not increase money supply during inflation  All countries would need to readopt gold standard  U.S. does not possess enough told to pay current debts to foreign investors © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

25. Special Drawing Rights (1 of 2) Special Drawing Rights (SDR) ◦ Created in 1970 by the IMF at Bretton Woods ◦ A new reserve asset ◦ Objective: to introduce into the payments mechanism a new type of international money  In addition to the dollar and gold ◦ 1970s, Bretton Woods system had collapsed ◦ Major currencies shifted to floating exchange © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

26. Special Drawing Rights (2 of 2) SDR today ◦ Limited use as a reserve asset ◦ Main function: unit of account of the IMF and some other international organizations ◦ Some of the IMF’s member nations peg their currency values to the SDR ◦ Potential claim on the freely usable currencies of IMF members © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

27. Facilities for Borrowing Reserves (1 of 3) IMF Drawings ◦ The transactions by which the fund makes foreign-currency loans available ◦ Deficit nations  Do not borrow from the fund  Purchase with their own currency the foreign currency required to help finance deficits  Reverse the transaction when the balance-of-payments position improves © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

28. Facilities for Borrowing Reserves (2 of 3) General Arrangements to Borrow, 1962 ◦ G-10 agreed to lend the fund up to a maximum of $6 billion ◦ Do not provide a permanent increase in the supply of world reserves  Once the loans are repaid, world reserves revert back to their original levels ◦ World reserves - more flexible and adaptable to the needs of deficit nations © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

29. Facilities for Borrowing Reserves (3 of 3) Swap Arrangements ◦ Bilateral agreements between central banks ◦ Each government provides for an exchange of currencies to help finance temporary payments disequilibrium ◦ The nation requesting the swap  Expected to use the funds to help ease its payments deficits and discourage speculative capital outflows  Repay within a stipulated period of time, normally within 3 to 12 months © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

30. International Lending Risk (1 of 2) Credit risk ◦ Financial ◦ The probability that part or all of the interest or principal of a loan will not be repaid ◦ The larger the potential for default on a loan  The higher the interest rate that the bank must charge the borrower © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

31. International Lending Risk (2 of 2 Country risk - Political ◦ Closely related to political developments in a country  Government’s views concerning international investments and loans Currency risk - Economic ◦ Associated with currency depreciations and appreciations as well as exchange controls © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

32. Problem of International Debt (1 of 4) Concern: insufficient international lending ◦ After the oil shocks in 1974–1975 and 1979– 1980  Oil-importing developing nations might not be able to obtain loans to finance trade deficits  Resulting from the huge increases in the price of oil  Able to borrow dollars from commercial banks 1980s, commercial banks ◦ Part of an international debt problem ◦ Lent so much to developing nations © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

33. Problem of International Debt (2 of 4) Debt service/export ratio ◦ Indicator of debt burden ◦ Scheduled interest and principal payments as a percentage of export earnings  Interest rate that the nation pays on its external debt  Growth in its exports of goods and services ◦ Rule of international finance – a nation’s debt burden rises if the interest rate on the debt exceeds the rate of growth of exports © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

34. Problem of International Debt (3 of 4) Dealing with Debt Servicing Difficulties A nation has debt-servicing problems because ◦ May have pursued improper macroeconomic policies that contribute to large balance-of- payments deficits ◦ May have borrowed excessively or on unfavorable terms ◦ May have been affected by adverse economic events that it could not control © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

35. Problem of International Debt (4 of 4) Options for a nation facing debt-servicing difficulties ◦ Cease repayments on its debt ◦ Service its debt at all costs ◦ Debt rescheduling ◦ Obtain emergency loans from the IMF  Conditionality – borrowers must adopt austerity programs to shore up economies and put finances in order © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

36. Reducing Bank Exposure to Developing Nation Debt (1 of 3) Stability of the international financial system ◦ Threatened when developing nations cannot meet their debt obligations to foreign banks Banks - improve their financial position ◦ Increasing their capital base ◦ Setting aside reserves to cover losses ◦ Reducing new loans to debtor nations © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

37. Reducing Bank Exposure to Developing Nation Debt (2 of 3) Banks - improve their financial position ◦ Liquidate developing-nation debt  Loan sales to other banks in the secondary market ◦ Debt buyback  Government of the debtor nation buys the loans from the commercial bank at a discount ◦ Debt-for-debt swaps  Bank exchanges its loans for securities issued by the debtor nation’s government  Lower interest rate or discount © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

38. Reducing Bank Exposure to Developing Nation Debt (3 of 3) Banks - improve their financial position ◦ Debt/equity swaps  Commercial bank sells its loans at a discount to the developing-nation government  For local currency, which it then uses to finance an equity investment in the debtor nation ◦ Debt reduction ◦ Debt forgiveness © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

39. Debt Reduction and Debt Forgiveness (1 of 2) Debt reduction ◦ Voluntary scheme that lessens the burden on the debtor nation to service its external debt  Use of negotiated modifications in the terms and conditions of the contracted debt  Debt reschedulings  Retiming of interest payments  Improved borrowing terms  Debt/equity swaps  Debt buybacks © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

40. Debt Reduction and Debt Forgiveness (2 of 2) Debt forgiveness ◦ Arrangement that reduces the value of contractual obligations of the debtor nation  Markdowns of developing-nation debt  Write-offs of developing-nation debt  Abrogation of existing obligations to pay interest © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

41. The Eurodollar Market (1 of 2) Eurodollar market ◦ Eurocurrency market ◦ Financial intermediary  Brings together lenders and borrowers ◦ Bank deposit liabilities  Time deposits  Denominated in U.S. dollars and other foreign currencies in banks outside the United States ◦ Transactions in dollars  Three-fourths of the volume of transactions © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

42. The Eurodollar Market (2 of 2) Eurodollar market (cont.) ◦ Eurodollar deposits  Re-deposited in other foreign banks, lent to business enterprises, invested, or retained to improve reserves or overall liquidity  Free of regulation by the host country ◦ Eurodollars increase the efficiency of international trade and finance  Internationally accepted medium of exchange, store of value, standard of value © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.