1 Part 1 Fundamentals of International Finance Lecture n° 3 A case for monetary integration, and...

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Part 1Fundamentals of

International Finance

Lecture n° 3A case for monetary integration,

and the European Union

International Finance

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Exchange rate management

Introduction Goals of the chapter :

Ask whether a flexible exchange rate system is desirable,Discuss the argument for greater exchange rate fixity

Flexible exchange rate systemImplies a minimum of insitutional designCarry weaknesses linked to this minimal framework :

• Uncertainty• Lack of discipline• Problems of volatility and misalignments

Case for more managed exchange ratesThen leads to problems of speculative attacks if monetary

policy is inconsistent with fixed exchange rate target.

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The case for flexible exchange rates - Arguments Defined as

« Rates of foreign exchange that are determined daily in the markets for foreign exchange by forces of demand and supply… »

Avoid the intervention of the government and the possible run out of reserves

Automatically adjusts the BOP disequilibria Speculators facilitate and smooth the adjustment of the

exchange rate, having a stabilising effect Confer monetary autonomy to a country Provide insulation from external shocks via exchange

rates adjustements, upward or downward.

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The case for flexible exchange rates - Challenges However, the argument for flexible exchange

rates have been seriously challenged to several extents.

Floating rates since 1973 have exhibited high volatility and spent long periods away from their long-run fundamental equilibrium level (misalignement)

Supply of foreign exchange

Demand for foreign exchange

Q of foreign exchange

Domestic price of foreign exchange

Se

q

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The case for flexible exchange rates - Challenges Exchange rate determination models do not seem to prove

empirically that fundamentals drive the exchange rate. Studies showed that same current account imbalances

persisted after the adoption of floating exchange rates in 1970 ’s and 1980 ’s.

Changes in prices caused by depreciation may not alter demand for the product (ex. Switzerland, Germany, Japan), in particular for high quality goods with few substitutes.

Monetary autonomy ? UK example in 1979-1981 where monetary tightness rise interest rates, causing a huge capital inflow, leading to exchange rate appreciation, affecting badly the tradeable sectors.-> few autonomy.

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The case for flexible exchange rates - Challenges Insulation from external shocks?

Full insulation : idea abandoned. Still a question on whether flexible rates better

insulate the domestic economy. Via, p.ex., appreciation of the rate in case of rise of foreign demand for domestic exports, and vice versa.

Empirical results are mixed. Overall : several exaggerated benefits for

flexible exchange rates.

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The benefits of greater exchange rate fixity Four arguments in favour of some degree of

exchange rate intervention :The discipline argument : helps to promote lower

inflation.The need to reduce exchange rate volatility : more

uncertainty can reduce the volume of trade.The desire to eliminate misalignments : long

period of over- and undervaluation - like displayed in the floating rates period - results in various cost for the real sector.

The benefits of a single currency

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Exchange rate fixity : The Discipline argument (1) Flexible rates tend to promote inflation (evidence

is mixed and theoretically unlikely) (2) Fixed exchange rate force countries to contain

inflation : one of the core arguments in favour of EMS.Consider 2 countries :

• UK : high inflation, and current account deficit• Germany : low inflation, and current account surplus• In theory : leads to a tendency of appreciation of the DM :

Bundesbank should sell DM against foreign currencies, expanding the monetary base, and reducing pressure on S.

• UK : should disinflate, buy Pounds against foreign currencies to reduce pressure of depreciation.

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The Discipline argument Asymmetry : Germany could sterilise (and avoid a

price rise) by selling bonds against DM, reducing back the monetary base. UK cannot sterilise much, soon running out of reserves. -> this asymmetry leads to a disinflationary bias.

And, the credibility bonus brought by the exchange rate target reduces the costs of disinflation in terms of unemployment : agents easily observe the exchange rate target and believe that inflation will fall -> they adapt their wage bargaining behaviour.

Exchange rate targets are more efficient (credible) disinflation tools than monetary growth targets.

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Exchange rate fixity : The Volatility argument Need to reduce exchange rate volatility : more

uncertainty can reduce the volume of trade. Foreign direct and long-run foreign investment

might also decline in greater exchange rate uncertainty.

Sudden changes in the value of reserve currencies can be problematic.

However, possible recourse to the forward market, but: only existing for large currencies, can be expensive.

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Exchange rate fixity : The Misalignment argument Floating rates have a tendency for persistent departures

from long-run equilibriumLong period of overvaluation and undervaluation cause

changes in the price of tradeables goods relative to non tradeables.

• Example : persistent overvaluation, causing industries to become uncompetitive, but capital and labour are not easily convertible into other, non tradeable sectors

• -> overvaluation usually leads to unemployment and underutilisation of resources, and ultimately, to desindustrialisation.

Also : effect of misalignment on long-term debt accumulated in foreign currencies : can significantly change the return of project financed by borrowed currencies.

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Exchange rate fixity : The Single Currency Benefits of a single currency within any country are :

simplification of the profit-maximising computations of producers and traders

facilitated competition among competitors of the country

promotion of the integration of the economy into a connected series of markets for the factors of production

If single currency among different countries : accrued benefits due to the suppression of the transaction costs of exchanging currencies.

If exchange rate management : part of these listed benefits could be achieved, compared to a fixed rate regime.

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Single Currency

Costs of a single currency Costs : of a single currency across different countries:

loss of the exchange rateloss of the monetary policy

Loss of exchange rate : Eliminate the possibility of using the exchange rate as a

policy instrument to rectify external equilibria.• Example : External shock of price fall in steel leads

Belgium (large exporter) to a deficit on its current account. • Belgium should either deflate (allowing prices to fall) or let

the currency depreciate (or devalue if fixed exchange rate) in order to restore equilibrium.

• If prices are sticky and cannot fall to restore competitiveness, deflation (i rises, M falls) will create unemployement.

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Single Currency

Costs of a single currency - loss of exchange rate Example :

If Belgium is in a monetary union : no depreciation is allowed, the economy will go into recession.

Belgium has no longer a BOP problem, but has a regional problem within EMU.

Three factors mitigating the costs :Factor mobilityOpenness of the economyProduct diversification

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Single Currency

Costs of a single currency - Mitigation factors Factor mobility

The greater the mobility of capital and labour, the lower the cost of joining a monetary union.

Example : asymmetric demand shock : rise of D in region A, drop in region B. If prices are sticky downwards, region B will have unemployement, and inflationnary pressures in region A.

Solution : move unemployed workers from region B to region A.

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Single Currency

Costs of a single currency - Mitigation factors Openness of the economy

The loss of exchange is less costly if the economy is more open.

Reason : exchange rate changes are less effective at improving competitiveness because money illusion is reduced.

In fixed exchange rates, devaluation increase competitiveness via the drop real wages following the increase in prices of imported goods.

In open economies, workers anticipate this change and will adjust their demand of wage increase to offset the effect.

Product diversityA demand disturbance in one product is less likely to affect

significantly the exchange rate, if the diversfication is large.

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Single Currency

Costs of a single currency - Loss of monetary policy Costs : of a single currency across different countries:

loss of the exchange rateloss of the monetary policy

Loss of monetary policy : Eliminate the ability to conduct an individual monetary

policy, since monetary policy is directed from the centre rather than from individual countries.

Many believe that the more similar inflation rates countries have, the more appropriate candidates they are for a monetary union.

More generally : the closer degree of policy integration at macro level, the more easy it is to form a monatery union.

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Single Currency

Criteria for countries to benefit from a single currency Similar policy goals Similar macroeconomic performance Close inflation rates Conduction a lot a of trade transactions between

one another.

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European Monetary Union

Introduction European Union : case study for exchange rate co-

operation leading to a monetary union. Catalogue of lessons about benefits and costs of a single currency, and of advantages and disadvantages of different institutional structures.

History:European Monetary System (EMS) started in 1979 with

relatively flexible target zones, becoming progressively more rigid.

1987 - 1993 : rigid exchange rate fluctuation bands1993 : large speculative attacks, causing a large threat

on the system. Introduction of Euro postponed of 2 years.1999 : Euro as scriptural common currency2002 : Euro as fiduciary common currency

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The European Monetary System (EMS) Main objective of EMS : promotion of monetary

stability within Europe. Three immediate aims as established in 1979 :

Reduction of inflation in EU countriesPromotion of exchange rate stability to favor trade

flows and investmentsGradual convergence of economic policy, allowing

for more fixed exchange rates. Features of the EMS

Three main elements : the European Currency Unit (ECU), the Exchange Rate Mechanism (ERM) and the European Monetary Cooperation Fund (EMCF).

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The ECU : weighted average of all EU currencies, weights depending on the size of each country and its importance in intra-EU trade (DM, FRF, Sterling).

ERM : exchange rates allowed to fluctuate up to 2.25% or 6% on either side of the central rate. July 1993 : fluctuation bands were extended to 15%. Currencies maintained within bands through

compulsory interventions by the monetary authorities.

Possibility for the central rate to be realigned (7 until 1987; DM and DG always revalued)

EMCF : provides credit for members to help in adjusting balance of payments problems, at short-term (9 months) or medium-term (2-5 years).

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The European Monetary System (EMS) The achievements of the ERM :

Stability of the exchange rates • The cost of higher interest rates volatility (to reduce

pressure on X rates) has been avoided thanks to the capital controls in the ERM in the 1980’s.

• Question of the benefits of exchange rates stability on the intra-EU trade. Khalid & Sapir (1990) find little evidence of the effect of X rate volatility on prices -> little impact on commercial trade activities

Reduction of inflation• Argument : due to asymmetry effect in fixed X rates

regime, deficit countries have to disinflate, whereas surplus countries could avoid inflationary policies by sterilisation.

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Reduction of inflation in EU - empirical evidence• Number of pieces of evidence which suggests that

ERM has worked asymmetrically.• Intervention within the system support the view that

Germany was the leader.• Inflation in initially higher inflation countries did

converge on German levels.• Idea of a reduced cost of disinflation (in terms of

unemployment), thanks to the credibility bonus brought by the pegging of currencies to low inflation countries (Germany).

• However, empirical evidence is mixed on this view. But high costs in ERM countries might be due to the nature of the labour markets (half way between high centralisation and high decentralisation).

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The European Monetary System (EMS) The stability of the ERM : why the ERM has been so

successful during such a long period of time? Five factors identified in the literature :

(1) Co-operation among ERM countries and the existence of the various financing facilities.

• ERM is part of a wider, institutionalized, co-operation framework among European countries : Single Economic Market (1992), Agricultural policy, … Financing facilities in provide Central Banks of large amount of money in case of speculative attacks.

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The European Monetary System (EMS) Five factors of stability for the ERM :

(2) Clever operational features in the design of the exchange bands :

• Co-existence of narrow bands (2.25%) and wider bands (6%), providing some flexibility for high inflation countries, allowing them to gradually adapt their economic policies.

• Wider bands can help realignments : a narrow band country (e.g. France) can realign (ex : +3.5%) while a wider band country may avoid realignment (since 3.5%< 6%). Therefore, speculator can expect the sense of realignment for France, but face greater uncertainty on the case of Italy -> reduce the probability of a speculative attack.

• Timing of realignment decided very quickly (until Sept 1992) decreased speculative pressures.

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(3) Luck. Several fortuitous circumstances promoted stability within ERM.

• Co-operation of policy goals among several ERM governments, focusing on disinflation and willing to accept the discipline implied by the system (in the 1980’s).

• UK was not a member : DM was the only large currency in the system, and policy disagreements - possibly - have been avoided.

• Strength of the dollar in the 1980’s reduced the pressure for appreciation on the DM. The dollar’s fall had then been managed according to the Plaza and Louvre agreements.

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(4) Existence of capital controls• Allow some monetary independence to the countries, by

preventing large capital flows if interest rates differentials. Ex. tight monetary policy of Spain in the late 1980’s (high interest rates). Peseta protected from depreciation pressures thanks to controls on capital inflows.

• Help to prevent speculative attacks, by reducing the amount of money flowing in or out of a currency. Allowed then to delay some realignment decisions and anti-inflation policy to develop (without deprecation as soon a inflation rises).

• Capital controls within ERM slowly eliminated by the end of the 1980’s.

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(5) Growing credibility of the exchange rate parities• Some authors argue that the system would have been

viable even without capital control, since it was credible, and realignments were not credible (the 1993 crisis proved the contrary).

Crises of the ERM - FactsSeptember 1992 : speculative attacks leading to the

departure of Italy and the UK from the system. Peseta devalued by 5%. Ireland, Portugal and Spain tightened their capital controls.

July 1993 : Several realignments of Ireland, Portugal and Spain. Pressure on the FRF and bands extended to 15%.

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Crises of the ERM - Triggering FactorsBreakdown in the economic policy agreement.

France wanted to focus on growth and unemployment, Germany trying to absorb the shock of the reunification. Recession on major industrialised countries.

Release of capital controls, according to the Delors plan to monetary union, implying lesser flexibility on exchange bands (2.25% for all) and no capital controls.

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Economic and Monetary Union - plan Delors report (1989), basis of the Maastricht

Treaty : Monetary union to be achieved by a gradualist and

parallel approach:• Parallel : economic convergence to achieve at the same

time as monetary union (the one needing the other)• Gradualist : economic integration is a slow process

Stage 1 : all countries join ERM with 2.25% fluctuation bands, capital controls removed, single financial area.

• Stage 1 began on July 1, 1990.• Maastricht Treaty signed in December 1991, setting a

timetable for the whole process.• Stage 1 was supposed to be completed by end of 1993,

but the exchange rate crises set back the process.

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Delors report (1989), basis of the Maastricht Treaty : Stage 2 : exchange rate commitment more stringent.

Realignments expected to be more infrequent. Creation of a central European body in charge of the monetary policy.

• Started in January 1994.• The European Monetary Institute (EMI) was created to

co-ordinate monetary policy.Stage 3 : irrevocable fixing of the exchanges rates,

replacement of the national currencies. Monetary policy fully transferred to the European Central Bank.

• From January 1997. • Adoption of the Euro of 11 members in January 1999,

Greece joined in 2001.

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Delors report (1989), basis of the Maastricht Treaty : Stage 3 : Convergence criteria

• Inflation max 1.5% above the average of the 3 lowest inflation countries.

• Interest rates on LT government bonds max 2% above the average of interest rates in the 3 lowest inflation countries.

• Government deficit does not exceed 3% of the GDP.• Government debt to GDP ratio does not exceed 60%.• The exchange rate must have been fixed within its

ERM without a realignment for at least 2 years.• The statutes of the central banks should be

compatible with those of the ECB.

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Costs and Benefits of the EMUBenefits

The European Commission estimated to gains to 10% of the EU GNP. Benefits should come from :suppression of transaction costs (0.5%)greater monetary stabilityelimination of the exchange rate riskEmerson (1990) : single currency will promote

efficiency, stability, and equity by better and most efficient allocation of the resources and more relevant price signaling. Weak econometric evidence, but large support from survey data.

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Costs and Benefits of the EMUCosts

Depends on several factors :The extent to which the area in question suffers

from asymmetrical shocks (see Reichlin): newer and poorer countries of the union could have more problems than the others.

However, opinions are mixed regarding the likelihood of occurrence of asymmetrical shocks in single currency zones.

Business cycles might also have adverse effects. Cycles are the outcome of 3 factors : shocks - propagation mechanisms - and policy response.

Shocks and cycles could both be costly for the EMU.

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European Monetary Policy and ECB Main goal : provide an institutional structure that

helps to provides the objectives of stability and low inflation within the union.The European Central Bank is established in

Frankfurt, according to the Treaty. It is modeled after the US Federal Reserve System. The ECB is independent from the governments and dominates the country central banks, which continue to regulate bank within their borders.

All financial market intervention and the issuance of euros is the sole responsibility of the ECB.

ECB is free of political pressure (like the Fed and the Bundesbank) to safeguard the price stability and the anti-inflation policy.

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Fiscal policy and EMU Fiscal autonomy is useful to individual countries if

they are affected by asymmetric shocks (since monetary policy is no longer available).

However, the constraints on the public debt to GDP ratio limit the fiscal autonomy of the EC members.

In a limited fiscal autonomy framework, the EU central budget should play a greater role, toequalise the effect on different regions (transfer

fiscal resources to badly affected regions)provide an automatic stabilisation for regions

suffering from a temporary loss of incomespread the costs of a adverse shocks over the entire

area.

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The transition to Euro Eleven member states of the EU initiated the EMU,

adopting the Euro on Jan 4th 1999, replacing their national currencies on the financial markets. Countries are : Austria, Belgium, Finland, France,

Germany, Ireland, Italy, Luxembourg, the Netherlands, Portugal, Spain, and Greece 2 years later. UK, Sweden, and Denmark choose to keep their national currencies.

The final fixed rates have been determined on Dec. 31, 1998.

The value of Euro against the $ slid steadily following its introduction, from $1.19 in Jan 1999, to $0.87 in Feb 2002. Its lowest was $0.825 in Nov. 2000.

The fiduciary introduction of the Euro started Jan 1st, 2002. Since the spring 2002, the Euro gained in value against the $.

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1 Part 1 Fundamentals of International Finance Lecture n° 3 A case for monetary integration, and...

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