1. International Banking: Reserves, Debt, and Risk © 2011 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 1 PowerPoint slides prepared by: Andreea Chiritescu Eastern Illinois University

2. 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 © 2011 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

3. Demand for International Reserves 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 © 2011 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

4. Demand for International Reserves Demand for international reserves Exchange-rate flexibility Automatic adjustment mechanisms that respond to payments disequilibrium Economic policies used to bring about payments equilibrium International coordination of economic policies © 2011 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

5. Demand for International Reserves 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 © 2011 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

6. When exchange rates are fixed (pegged) by monetary authorities, international reserves are necessary for the financing of payment imbalances and the stabilization of exchange rates. With floating exchange rates, payment imbalances tend to be corrected by market-induced fluctuations in the exchange rate; the need for exchange-rate stabilization and international reserves then disappears. © 2011 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 The demand for international reserves and exchange-rate flexibility FIGURE 17.1

7. Demand for International Reserves 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 © 2011 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

8. Demand for International Reserves 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 © 2011 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

9. Demand for International Reserves 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 © 2011 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

10. 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 © 2011 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

11. Foreign Currencies 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 © 2011 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

12. Foreign Currencies 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 © 2011 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

13. © 2011 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 International reserves, 2006, all countries (in billions of SDRs*) TABLE 17.1

14. GLOBALIZATION Should SDRs replace the dollar as the world’s reserve currency? The United States dollar Main reserve currency in the world today Medium of exchange, unit of account, and store of value Wealth in dollar-denominated assets 64% of world’s official foreign exchange reserves 86% of daily foreign exchange trades Other reserve currencies The euro, the British pound, Japanese yen © 2011 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

15. GLOBALIZATION Should SDRs replace the dollar as the world’s reserve currency? Benefits for the U.S. Americans Can purchase products at a marginally cheaper rate Can borrow at lower interest rates for homes and automobiles The U.S. government Can finance larger deficits longer and at lower interest rates Can issue debt (securities) in its own currency Pushing exchange rate risk onto foreign lenders © 2011 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

16. GLOBALIZATION Should SDRs replace the dollar as the world’s reserve currency? Concerns Substantial dollar depreciation Losing purchasing power The U.S. - huge deficits and massive borrowing Volatility of the dollar Destabilizing effect that it can have on international trade and finance © 2011 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

17. GLOBALIZATION Should SDRs replace the dollar as the world’s reserve currency? 2009, China - Special Drawing Right (SDR) to replace the dollar New world reserve currency Based on a basket of currencies instead of just the dollar SDR: euro, yen, pound, and dollar Expand to include all major currencies SDR would be managed by the IMF © 2011 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

18. GLOBALIZATION Should SDRs replace the dollar as the world’s reserve currency? Benefits of SDRs China - cushion any depreciation in the dollar’s exchange value Help stabilize the value of China’s holdings of U.S. Treasury securities Support aggregate demand in the world Economic welfare of the world should not depend on the behavior of a single currency © 2011 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

19. GLOBALIZATION Should SDRs replace the dollar as the world’s reserve currency? Benefits of SDRs Currency risk - diversified through a basket reserve unit Enhancing stability and confidence throughout the world Equity U.S. can attract the savings of other countries even when the interest rates it pays are very low © 2011 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

20. GLOBALIZATION Should SDRs replace the dollar as the world’s reserve currency? Potential pitfalls of SDRs SDR is backed by nothing other than the good faith and credit of the IMF Who would determine the “right price” of the SDR? Add another step to each international transaction Convert local currency into SDRs © 2011 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

21. GLOBALIZATION Should SDRs replace the dollar as the world’s reserve currency? The U.S. and SDRs Americans would have to pay more for imported goods Interest rates on both private and governmental debt would increase Increased private cost of borrowing Weaker consumption, decreased investment, and slower growth © 2011 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

22. Gold 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 © 2011 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

23. Gold 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 © 2011 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

24. Gold U.S. and the gold standard 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 © 2011 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

25. Gold Gold exchange standard, dollar-gold system International monetary system as formulated by the IMF nations To economize on monetary gold stocks as international reserves The U.S – dominant economy Productive capacity and national wealth © 2011 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

26. Gold Gold exchange standard, dollar-gold system The United States Assume 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 © 2011 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

27. Gold Gold exchange standard, dollar-gold system 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 © 2011 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

28. Gold 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 © 2011 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

29. Special Drawing Rights SDR Created in 1970 by the IMF A new reserve asset Objective: to introduce into the payments mechanism a new type of international money In addition to the dollar and gold © 2011 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

30. Special Drawing Rights 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 © 2011 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

31. Special Drawing Rights Value of SDR Basket of currencies The U.S. dollar, Japanese yen, UK pound, and the euro The weights of the currencies reflect the amount of exports and imports of these countries during the previous five years © 2011 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

32. Facilities for Borrowing Reserves 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 © 2011 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

33. Facilities for Borrowing Reserves 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 © 2011 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

34. Facilities for Borrowing Reserves 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 © 2011 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

35. International Lending Risk 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 © 2011 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

36. International Lending Risk 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 © 2011 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

37. The Problem of International Debt 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 © 2011 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

38. The Problem of International Debt 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 © 2011 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

39. The Problem of International Debt 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 © 2011 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

40. The Problem of International Debt 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 © 2011 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

41. Reducing Bank Exposure to Developing- Nation Debt 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 © 2011 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

42. Reducing Bank Exposure to Developing- Nation Debt 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 © 2011 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

43. Reducing Bank Exposure to Developing- Nation Debt 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 © 2011 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 43

44. Debt Reduction and Debt Forgiveness 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 © 2011 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 44

45. Debt Reduction and Debt Forgiveness 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 © 2011 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 45

46. The Eurodollar Market 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 © 2011 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 46

47. The Eurodollar Market Eurodollar market Eurodollar deposits Redeposited 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 © 2011 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 47