The international financial system

 When Central Bank of TR purchases dollar foreign currency and sells TL domestic currency, its dollar international reserves increase, the monetary base and the money supply TL increas

Chapter 8

The International Financial

System

 When Central Bank of TR purchases dollar (foreign currency) and

sells TL (domestic currency), its dollar (international) reserves

increase, the monetary base and the money supply (TL) increases.

 When CBT sells dollars and purchases TL (dom currency), its dollar (international) reserves decrease, the monetary base and money supply decreases.

+TL1B

Unsterilized Intervention

and to the banking system, we call these

operations “unsterilized interventions” Why does the CB intervene?

currency ($) leads to

and

currency) against dollar (foreign curr.)

Sterilization: By doing an offsetting open market operation,

CB neutralizes the effect of the forex intervention on the money supply

 Example: If CB buys dollars and increases the TL reserves,

immediately CB also sells govt bonds at the same amount This leaves the monetary base and the money supply unchanged

Central Bank Assets Liabilities

change

(reserves+currency i.c.)

Sterilized

Foreign Exchange Intervention

 A sterilized purchase (sale) of foreign

currency leads to

Balance of Payments

(BOP)

Balance of Payments = Current Account +

Capital Account (Net Capital Inflows)

 Balance of payments shows the net

change in the foreign exchange

(dollar) reserves of an economy during

a certain time period.

Balance of Payments

1 Current Account :Inflows (+) Outflows (-)

1 +Net Foreign Tourism Revenues

2 +Banking & Insurance Net Revenue

3 +Construction & Transportation Net Revenue

4 +Workers’ Remittances + Paid Military Service

(interest+profit transfers)

countries)

Balance of Payments

 “Current Account (CA) Deficit” means that

CA balance is a negative number This is usually because the largest item “Trade

Balance” is negative For example,

Turkey’s 2008 (2007) January-March

exports are $33 ($24.4) bn, imports are

$49 ($33) bn, trade balance is -$16

(-$8.6) bn

Balance of Payments

2 Capital Account = Net Capital İnflows

=capital inflows – capital outflows

Foreigners (ind., firms, govts)

(Turkish) Residents

from Foreign residents (+borrowing, -lending)

Balance of Payments

 Capital Inflows: Two types:

of the firm, bank, etc Ex: Migros sale to British, Finansbank sale to NBG, ToyotaSA, are FDI

inflows Ülker purchase of Godiva is FDI

outflow

bonds, credits) Foreign investors buying stocks

at BIST, Turkish banks & firms borrowing from foreign banks are FPI inflows Turkish banks

lending to Azeri firms is FPI outflow

Balance of Payments

investor has a share in the investment

enough to control the decisions of the

company (maybe10%) In FPI, investor is only creditor, takes less risk (only default and int rate risk) Has small shares in

various companies.

Balance of Payments

 Except for year 2001, TR’s current account has been negative However, TR’s capital

account surplus is positive and usually

greater than its current account deficit

This means that there was a net dollar

inflow into TR This is why dollar has

depreciated against TL during 2002-2007

2000 2001 2002 2003 2004 2005 2006 2007

Current Account/GNP(%) -4.90 2.37 -0.99 -2.86 -5.17 -6.39 -6.62 -5.7

Exchange Rate Regimes

 Fixed exchange rate regime

value of one other currency (usually dollar or euro) CB intervenes daily by buying and

selling dollars to keep ER fixed

2001 ER was kept within a band Will explain below

Exchange Rate Regimes

 Floating exchange rate regime

 Value of a currency is allowed to freely fluctuate against all other currencies: no interventions in the forex market.

 Managed float regime (dirty float)

 Officially free floating, but from time to time, CB intervenes by buying and selling currencies

Because sometimes the E.Rates becomes very

volatile, during turbulances Turkey has followed managed float after 2001 A turbulance in 2006, others Turkey currently follows “inflation

targeting”, but still want to control ERs:

“impossible trinity”

How a Fixed Exchange Rate

Regime Works

TL/USD Suppose that for some reason demand for TL assets increases This increases value of TL

in the free forex market above the official parity: 1,20 TL/USD

increases the money (TL) supply This decreases the interest paid by TL assets, which reduces

demand for TL assets CB can buy dollars until

the free market ER is equal to the fixed 1,31

TL/USD CB’s international (forex) reserves

increase

How a Fixed Exchange

How a Fixed Exchange Rate

Regime Works

for TL assets decrease (maybe because FED

increases policy rates) TL loses value in the free forex market below the fixed parity

reduces money(TL) supply and increases the

interest rate on TL assets, which increases

demand for TL assets, which increases the value

of TL back to 1,31 TL/$

process If CB does not have enough reserves to defend the peg, then it must either float or

devalue TL to a lower level like 1,6 TL/$

How a Fixed Exchange Rate Regime Works

 No control over monetary policy

 Money supply influenced heavily by production of gold, gold discoveries and imports When gold

production rate (or imports) is smaller than (higher than) GDP growth rate, money supply increases slowly (fast), deflation (inflation)

happens (qty theory, MV=PY)

Bretton Woods System

 Bretton Woods System: 1944-1971

 Fixed exchange rates system using U.S dollar as

the reserve currency: $ 35 convertible per 1 ounce of gold (only for governments and CBs, not public).

 International Monetary Fund (IMF)

 World Bank

 General Agreement on Tariffs and Trade (GATT)

 Became World Trade Organization

How Bretton Woods 71) Worked

(1944- Exchange rates adjusted (devaluation or revaluation) only when countries experience a ‘fundamental disequilibrium’ (large and persistent deficits (or surpluses) in their balance

of payments)

 Loans from IMF to the deficit countries to cover loss in

their international reserves

 IMF encourages contractionary monetary and fiscal policies

 Devaluation happens only if IMF loans are not sufficient

 IMF cannot force surplus countries (Ger) to revalue.

 U.S could not devalue the dollar during 1960s (Vietnam war) The surplus countries did not want to revalue

System collapsed in 1971 (Nixon).

Managed Float

(1971-now)

(developed) allowed exchange rates to float

 Allow Small daily changes in response to market

 Interventions to prevent large fluctuations

exports, growth and employment Increases

current account deficit and risk of a BOP crisis

imports and stimulates inflation Inflation

increases uncertainty and reduces long-run

growth rate

European Monetary

System

regime within Europe Before the euro in 1999,

as a preparation for euro

currency in international financial transactions:

political entity Especially considering the

“sovereign debt crisis” in Greece, Spain, Italy, Portugal and France (?) casts shadow on the future of euro There is no “exit clause” for

http://www.reuters.com/article/2012/07/23/us-eurozone-exit-idU SBRE86M04J20120723

European Monetary

System

Community fixed exchange rates with one

another and floated against the U.S dollar

 ECU value was tied to a basket of specific

amounts of European currencies: “Exchange

Rate Mechanism (ERM)” ECU value fluctuated

within limits If it goes beyond limits, Central

Banks intervene in the market by buying the

weak currency and selling the strong currency

Currency or BOP Crises

involving speculative attacks: massive sales of

the weak domestic currency and purchases of the strong currency (dollar or euro), “capital flight”

sharp devaluation of the weak currency

East Asia 1997-98, Mexico 1994, Russia 98

What Happens Before a

Currency Crisis? MICRO

risks

 Before the crisis: Banks and financial institutions take

excessive risks of three types:

 Exchange Rate risk: Dollar (forex) liabilities (debt) are much

larger than dollar (forex) assets

 Maturity Mismatch (Liquidity) Risk: Avg Maturity of

Liabilities are much shorter than avg maturity of assets Banks

always transform liquid liabilities into illiquid assets, but there is

a healthy limit to this

 Excessive Leverage: banks finance assets by either equity

(own funds) or debt If Leverage=Assets/ Equity is very high, too much debt=too little equity causes risk of bankruptcy

“capital adequacy ratio”

Moral Hazard: if the Central Bank follows Fixed ER policy,

transfers the ER risk to the govt Encourages banks take more

ER risk by borrowing in dollar, lending in TL.

What Happens Before a

Currency (or BOP) Crisis?

MACRO risks

 Fiscal Deficits: Government has high Budget

Deficits and relatively short-term Foreign Debt: Mexico 1994, Brazil 1999, Argentina 2002,

Turkey 2001 Not in Asian 1997 crisis

 High current account deficits (CAD)/GDP If

CAD cannot be financed by capital inflows, then BOP is negative

very risky situation

What Happens During a

Currency (or BOP) Crisis?

 During the Crisis: Speculators force the CB to

“float” or “devalue” by quickly selling TL assets

and buying dollar assets: speculative attack

Their objective is to make profit from a potential devaluation

defend the domestic currency (raise int rates) But when the CB runs out of dollars, then the CB cannot defend the value of TL anymore So it is forced to float the TL(domestic currency) and

What Happens During a

Currency (or BOP) Crisis?

 Self-fulfilling Prophecies: When creditors panic

and start to believe that the domestic country is

unable to repay its debts and the domestic

currency will be devalued, they stop lending to the country: “sudden stop” Independent from initial fundamentals, this belief makes itself real.

 Contagion: Currency or financial crisis in one

country spreads to other countries that are similar:

 in 1997 from Thailand to Malaysia, Indonesia, South

Korea, Philippines

 İn 1998 Russia to Brazil and 1999 and 2001 in Turkey,

then 2002 in Argentina

European ER Crisis of

September 1992

pressures led Bundesbank to increase interest rates

pound depreciated below the official ERM parity 2.778 DM/pound To correct this, either British had to increase rates or Germans had to

decrease rates Neither wanted to do the necessary action b/c Britain was in recession

and sold massive amounts of pound assets and bought DM assets: speculative attack on

pound Demand for pound fell even further

European ER Crisis of

September 1992

devaluation against the DM They also quit the ERM and did not join the euro

mln

2002, East Asia 1997, Mexico 1994, Brazil 1999

fixed ER policies

crises were both due to unsustainable

government budget deficits and debt

Capital Controls

by forcing a devaluation

to find ways around them

such as roads, infrastructure

country before one year (Tobin Tax on

short-term capital)

Capital Controls (cont’d)

lending boom and excessive risk taking by

financial intermediaries (1997 Asian Crisis)

and supervision Turkey has been successful in reforming the banking system after the 2001

crisis

was to maintain the fixed exchange rate system called “Bretton Woods” (1944-71) by lending to the countries that had balance of payments

deficits

1971 and IMF became an institution that provides financial and technical assistance to member

countries

 Of course, during a credit arrangement, IMF asks the borrowing country to write a commitment letter in

which the country’s government commits to the

policies prescribed by IMF Because if these policies

are not followed, the same imbalances in the economy will cause another crisis in the future If the borrowing country believes that IMF will bail them out even if

they do not follow prescribed policies, then the

country will never solve its problems and this is moral

IMF Credits: (billion$,

IMF Critics

sell its debt and cannot preserve the value of

their currency, IMF lends if the following

conditions are promised by the borrower:

1 Reduce government expenditures or

increase taxes (contractionary fiscal p.)so

that you need to borrow less Joseph Stiglitz and other critics: such measures during a crisis can only deepen the crisis and recession They argue that government should increase

expenditures and aggregate demand so that the economy is brought out of recession

IMF Critics

2 Increase interest rates This helps protect

the value of domestic currency from depreciation However, according to Stiglitz, this causes otherwise sound firms to go

bankrupt because they cannot repay their debt with higher interest rates and “Debt deflation”: Real value of nominal debt increases

3 Trade and Financial Liberalization: Critics:

The industrialized countries of today did not have liberal trade and financial systems when they were industrializing 200 years ago

Foreign banks take over the weak banking systems in less developed countries.

IMF Critics

4 Privatization: Critics argue foreign

companies take over sectors

(monopolize) and increase dependency of domestic economy to foreign firms.

5 Fear of default Critics argue that one of

the objectives of the IMF is to ensure that high-risk, high-return loans from

international banks to less-developed

countries are repaid.

IMF Critics

6 Instead of financial reform, IMF

prescribes contractionary macroeconomic policies This causes the IMF to be a profitable scapegoat for domestic politicians as anti-growth,

anti-employment IMF is seen as a foreign entity interfering with domestic policy Do you agree?

IMF as a Lender of Last

Resort

 IMF can prevent contagion of crises

“herding behavior” in financial markets causes contagion.

 IMF bailouts may cause excessive taking (moral hazard) for domestic

risk-banks and their international creditors This will increase risk of crisis in the

future.

IMF Stand-By Arrangements

with TR

Figure 1 Stand-By Arrangements Cases in Turkey (1960-2004)

2008 Karagöl, Erdal and Metin Özcan, Kıvılcım, “The Economic Determinants of IMF Standy Aggreements in Turkey”

Actual

0 0.5

1

1955 1960 1965 1970 1975 1980 1985 1990 1995 2000

Actual

World Bank

to reduce poverty and promote development in the world Provides loans for infrastructural

projects in health, education, agriculture, energy

unregulated free market reforms prevent

economic development

Balance-of-Payments

Considerations

 Current account deficits in Turkey suggest that Turkish producers are not competitive maybe because the TL is too strong

(maybe b/c they are not productive).

 CADs increases the risk of a BOP crisis CB may reduce interest rates for this

purpose: expansionary policy.

 Expansionary (contractionary) policy

reduces (increases) interest rates and

decreases (increases) value of TL.

money (in terms of goods and services)

decreases

Exchange-Rate Targeting in TR

 ER targeting (Crawling Peg) Policy

applied in Turkey 1999-2001 as a method to bring inflation under control Tradable goods’ prices are quoted in

dollars, so rate of inflation fell

 ER targeting keeps the ER in a

pre-specified band Ex: (1,50 TL/$ ± 0,20 TL/$) for a specific period Allows lira to move within the band.

 We floated after the 2001 crisis.