Money and finance in the global economy

Money and finance in the global economy • The international monetary system is the body of rules and procedures by which different national currencies are exchanged for each other in w

Money and finance in the global

economy

• The international monetary system is the body

of rules and procedures by which different

national currencies are exchanged for each other

in world trade

• The global financial system (GFS) refers to those financial institutions and regulations that act on

the international level

• The main players are private (banks, hedge funds etc) and public (central banks and government

departments) and international organizations

(the IMF, Bank for International Settlements etc)

Money and finance in the global

economy

• The international monetary system is

closely tied to the international finance

system

• Flows of international capital and FDI are conducted in money If there is a change in exchange rates they inevitably impact on the value of investment

The role of the international

monetary system

• It requires a nation, or a group of nations, to

maintain and manage it; leading nations might

agree to entrust an international organization to achieve this, see IMF and World Bank

• It has to determine the way to solve imbalances of national economies, by some agreed form of

adjustment

• It has to provide sufficient international liquidity

Countries need to rely on sufficient financial

reserves to meet sudden shocks

The post-Bretton Wood international monetary system

• Fixed exchange rates broke down in 1971 What followed were fluctuating exchange rates with no general rule on exchange rate adjustments

The dollar remains the key reserve currency,

although the system is based on some cooperation among the FED, the European Central Bank (the Bundesbank before 1999) and the Bank of Japan

• The IMF act as regulator of the world international monetary system

The post-Bretton Wood international monetary system

• Many countries have chosen either to create monetary unions (the euro), or to peg their currencies to the dollar (dollar peg as in many South East Asian countries

before 1997)

• Some countries manage their currencies with currency reserve boards, which means relinquishing control to

the IMF, which will cover their money supply with

dollars (for example Hong Kong in the 1990s, and

Argentina in early 2000s)

The International Monetary Fund

• The International Monetary Fund (IMF )

oversees exchange rates and balance of

payments It offers financial and technical

assistance when requested

• Its headquarters are located in Washington D.C.

and offices around the world It has currently 185 members.

• It came into existence in December 1945, when the first 29 countries signed its Articles of

Agreement

The International Monetary Fund

• An unwritten rule establishes that the IMF's

managing director must be European and that the president of the World Bank must be from the US

• The IMF is for the most part controlled by the major Western Powers, especially the US, with voting rights on the Executive board based on a quota which reflects its monetary stake in the institution

The post-Bretton Wood international monetary system

• The desirable objectives of the international monetary system are

• 1) exchange rate stability

• 2) being able to run an independent monetary (and more broadly economic) national policy, for example a fiscal deficit when needed to boost economic growth

• 3) enjoy freedom of capital flows, in order to have a

more efficient financial system, international investment etc As we shall see this third point is now being

challenged

The post-Bretton Wood international monetary system

Desirable objectives of IMS:

• 1) exchange rate stability;

• 2) independent monetary policy;

• 3) free capital flows

• The three objectives however are incompatible,

only two are achievable at the same time

• Under Bretton Woods there was 1 and 2, but not 3

• Currently most countries, have 2 and 3, but not 1

• The Euro means that each UE member state enjoys

1 and 3, but not 2

Flexible, fluctuating exchange rates

volatility

• They produce long periods of currency under or over-

evaluation, distorting trade

International monetary system: alternative

solutions

Possible alternatives:

•Return to gold Advocated by extreme neo-liberals

•Managed currencies Imply limitations to the free flow of capital see Tobin tax

•Regional monetary Unions

•Currency pegs

Financial markets are central

• Well functioning financial markets are a central feature of a modern market economy They allow resources to be taken from people who do not

need them or can not use them to people who need them and can use them

• 1) they mobilize savings, 2) they allocate capital,

to finance investment; 3) they pool risk and

distribute risks to those who can bear them; 4)

they monitor managers

Financial markets are risky and fragile

• Financial markets are fragile and vulnerable

• They suffer from inadequate information

• Banks have short term liabilities in domestic or

foreign currency, which are payable on demand, while most of their assets are long-term, and

subject to fluctuations

• Financial markets are liable to wild swings in

prices They tend towards herd behaviour

Capital flows in the global economy

Under Bretton Woods countries controlled their capital

market Free capital flows started to materialize

• with the Eurodollar market in the 1960s After the end of

Bretton Woods the situation gradually evolved with:

A) Liberalisation of financial markets Scrapping of capital

controls

B) Innovation in financial instruments (Derivates etc.)

Today huge amounts of capital is exchanged every day on the foreign exchange market: in 2007 the daily volume of foreign currency transactions was $ 3.2 trillion

Liberalization of capital markets in the 1980s

and 1990s

• Since the late 1980s the IMF became a

strong supporter of free capital markets: it

advised countries that came under its

influence to dismantle controls over

cross-border lending and borrowing.

• The removal of capital controls would

increase the demand for services from the

City and Wall Street The US and Britain

pushed for capital liberalization

Liberalization of capital markets in

the 1980s and 1990s

• The EU during the 1980s turned towards capital liberalization During the late 1980s capital

controls had been removed in all the major

European countries Free capital movements were enshrined in the Maastricht Treaty

• The OECD adopted free capital flows as part of it Code of Liberalization of capital controls New member countries, such as Mexico and S.Korea, adopted the Code

Global finance: new developments,

opportunities and risks

• Today’s global financial movements are different from those of the past, since they have no relation with

international trade

• Financial globalisation has made all national economies closely interdependent It has also made available vast financial resources for developing countries

• A large share of global finance consists of short term

capital flows, which by definition are highly volatile and speculative Speculators can attack currencies whose

exchange rate is deemed to be non-credible

Free capital flows

• Global finance is unregulated and lacks institutional support (standards, supervision, lenders of last resort.

Tobin tax

• Already in 1978 James Tobin (a keynesian

economist from Yale) criticized “excessive”

financial capital mobility These flows constrained the ability of governments to pursue adequate

domestic economic policies

• He recommended a tax on international currency transactions: consisting in a small levy on each

transaction

• Tobin met with considerable opposition but his

suggestion is being reconsidered in the light of the recent massive global financial crises

Financial crises: general outline

How do they break out?

•Speculation fuelled by euphoria over the performance

of a single sector or of a particular country’s economy (herd psychology )

•Rise in profits and in investment

•Prices rise and the velocity of exchanges accelerates, generating a boom

Financial crises: general outline

• Ad one point the bubble bursts This can be the result of a single event such as a bank failure or a corporate bankruptcy

The large increase in prices and profits suddenly goes into reverse gear

Overreaction generates a “run on the countries”

Banks stop extending credit, and in fact demand payment for the credits they earlier had granted, i.e there is a credit squeeze Foreign capital

moves out Currencies are forced to devalue

Financial crises

1970s- early 1980s: Crisis in developing

countries, especially Latin America

Build-up of high debt levels with Western banks, which had used their lines of credit to recycle Petrodollars

Starting in 1979, Paul Volcker, the Fed Chairman, raised

interests drastically to fight US inflation

International banks followed suit, raised interest rates and the unsustainable debt of many countries position was

exposed

Japan: crisis of the 1990s

• At the end of the 1980s real estate prices rose by three times,

producing a real estate bubble This uncovered one of the unspoken factors of the Japanese economic miracle, i.e the power of big

speculators, with ties to the criminal world as well as top politicians

• Japan’s Central Bank responded first by raising interest rates and this determined a steep fall of house prices in 1991 This was not,

however, accompanied by economic recovery, rather it was followed

by a creeping recession.

• In the next stage, interest rates were loweredIn the next stage, interest rates were lowered, down to zero, in order to

jump start the economy The State launched big public expenditure

programs, borrowing large quantities of money.

programs, borrowing large quantities of money

• The economy did not react as hoped Japan’s economy was based on a low rate of private consumption GDP growth rates remained low,

below the economy’s growth potential In other workds Japan had

fallen into a deflationary trap.

Japan’s growth rate.

Japan’s economic crisis

• Japan’s economic problems were compounded by the fact that its banking sector became heavily indebted

• Stagnation also meant a rise in unemployment, which

reached 5% of the work force Investment and

consumption both were flat or negative

• Reflationary policies proved too weak

• Reforming the economy proved difficult, because of over regulation and structural rigidities

• Japanese society resisted steps towards liberalization The Japanese social model was called into question, but

reforming it was slow and painful

Japan’s economic crisis in the 1990s

• Two mistakes in economic policy (Krugman) :

• A) Government did not act consistently In 1997 after a few

years of slow recovery, fears were raised about the rise in public debt due to government deficits and projected pension costs As a result taxes were raised, growth was throttled and the country

plunged again in recession.

• B) Politicians failed to address the real weakness which lay in the banking system Banks had suffered from the fall in real estate stock and, following that, they had exposed themselves by lending

to the State Protracted recession compounded the problem.

• Recapitalization of the banks was carried out in 1998, with a State injection of $ 500 bn.

Japan recovers?

• First signs of recovery of the Japanes economy

had to wait until 2003 In that year GDP grew by more than 2% and the deflationary spiral began to loosen

• Japanese exports benefited from the rise in US

trade deficit and from the strong performance of China Big flows of Japanese FDI to China

Interest rates remained very low, leaving Japanese monetary policy almost defenceless against the

new economic crisis of 2008

Financial crises – 1990s

• 1992-3 Crisis in the European Exchange Rate

Mechanism (ERM) The Italian Lira and the

pound sterling devalue

• 1994-5, a boom in Mexico attracts short term

capital flows from the US

In December 1994 the Mexican peso devalues,

following an abrupt crisis of confidence in the

Mexican economy President Clinton leads a

recovery effort, sustained by US Treasury funds as well as by the IMF In 1995 Mexico’s GDP fell by 6%

Financial crises –East Asia

• 1997-2000 – Crisis in South and South-east Asia Possible background causes: growing Chinese competition with the exports of the Asian Tigers casts doubts on the durability

of the boom Overvaluation of Asian

currencies.

The origins of the Asian crisis

• Asian economies had liberalized their capital markets

since the early 1990s This factor is seen by some as the origins of the subsequent financial crisis

• Rapid capital liberalization was deeply unsettling to the paradigms of the Asian model, which was based on

government “soft control” of the economy

• Liberalization was not accompanied by regulation, i.e by new rules and standards to govern capital markets (for

example transparency, reserve requirements for banks

etc)

• The combination of semi-fixed exchange rates (dollar

peg) and capital liberalization was also potentially deeply unsettling

The origins of the crisis

• The Asian capitalist model is different from the American

or European models Although each country had its own specific features, there were some common trends The

Asian model can be described as a developmental State,

based on close links between the government, banks and other businesses in the industrial and service sectors Often loans were granted on a personal basis, on the basis of

close connections  hence the term “crony capitalism” A more benign interpretation speaks of “alliance capitalism”

• Bad loans of Asian banks had reached astronomic

proportions

The origins of the crisis

• There was a strong resistance to liberalization of

inward flows of FDI, which possibly aggravated the crisis South Korea for example, even after the crisis has broken out, ruled out allowing its banks to

borrow long-term, rather than short term Although short term debts were one of the keys to the current crisis, long term borrowing meant leaving the door open for FDI to penetrate the S Korean economy

• Many bad or dubious debts were concealed to

everybody until the end

Asia’s financial crisis: 1997-8

• Japan had already incurred into financial and

economic difficulties since the early 1990s

Japan’s crisis had originated from bad loans of its banking system and had developed into a full scale recession, with a protracted fall in the

economy’s demand

• Speculation on shares is hit by a crisis of

confidence In the preceding decade, high

growth rates had been customary for South East Asian countries This record of success prevents

a stronger reaction to the crisis.

Asia’s financial crisis: 1997-8

• Throughout the 1990s East Asia was booming Large inflows of foreign capital, about $90 bn a year of short term capital fuel the boom, plus FDI inflows as well.

• By 1997 prosperity brought its own problems, there was

rising prices and exports from East Asia faltered.

• Banks were becoming highly indebted There was a real estate bubble At this point investors got nervous and

started moving out their capital from these countries.

• This generated a sell-off Currencies devalued Stock

markets collapse and the real estate market crumbled.

• The outflow of foreign capital from Indonesia, Maleysia, the Philippines, S Korea and Thailand in 1997 was $12

bn From net creditors they turned net debtors

(-$100bn ,io.e 10% of their combined GDP).