Forum Nexus Finance Class Prof Brian Butlers Lectures Dec Jan 2010

Forum-NexusInternational Finance Class – Lecture #1 – Spain Dec 2009

Brian David ButlerBrian Butler is a specialist in international economic analysis, and is founder of the prestigious “GloboTrends“ (www.globotrends.com) online economics site, which has been featured as syndicated content on Nouriel Roubini’s RGE Monitor, Emerginvest.com, Business Week Exchange, Wikinvest.com, and other leading news outlets.

Brian earned an MBA with distinction from the Thunderbird School of Global Management and he has taught Finance, Economics and Global Trade at Thunderbird’s Global MBA program in Miami. Brian is currently a with Forum-Nexus study abroad

He previously worked as financial analyst for the Columbia University Business School and for NextLogics, a boutique investment and consulting firm focused on early stage endeavors with social impact.

A global citizen, Brian was born in Canada, raised in Switzerland (where he attended international schools), educated in the U.S., started his career with a Japanese company, moved to New York to work as a financial analyst, married a Brazilian, and has traveled extensively in Latin America, Asia, Europe and North America.

[email protected]@gmail.comLinkedIn/briandbutlerSkype: briandbutler

Questions:Finance:1. How many econ / finance majors? 2. Taken “international finance” before?3. Studied FX, foreign currencies?

Global Crisis:1. How many “understand” more or less

what happened so far2. In Europe?3. Predictions of what will happen in 6

months?

Group assignment

•Assume you are going to Europe in 6 months, and that you expect to spend 1000 Euros.

•What is your risk?•How could you avoid / limit that risk?

Group assignment

•Assume you are going to Europe in 6 months, and that you expect to spend 1000 Euros.

•What is your risk? How could you avoid / limit that risk?

1.Deposit $ in European bank now… grow to be 1000 euros in 6 months

2.Forward contract with Bank3.Futures / Options

Core of our class:

•International finance = risk •We will outline those risks, and offer:•Tools to protect•Hedging techniques:

▫Forward, Futures, options, etc…▫tools to PROTECT (and potentially

speculate)

Introduction to International Finance• Topics we will cover: What is “international

finance”?▫ International Financial Markets▫ The Foreign Exchange Market▫ Determination and Forecasting of Exchange Rates

(fundamentals: purchasing power parity and international Fisher effect)

▫ Protection against Exchange Rate Risk▫ The International Monetary System▫ The European Monetary Union (and the euro)▫ Fixed vs. Flexible Exchange Rate regimes

Introduction to International Finance•Topics we will cover:

▫The Balance of Payments▫National Income and the BOP▫Monetary and Fiscal Policies and the BOP▫Global Financial Markets (euromarkets)▫GLOBAL ECONOMIC CRISIS

Topics we will cover:• Why is the exchange rate xxx Euros per $US?

▫(PPP, IFE, other factors)▫(currency crises)

• What are key financial flows and why do they occur?▫(forex transactions; international lending; ‘hot

money’ flows)

Topics we will cover:

• What is the Sub-prime Mortgage Crisis? And what can you do about it?

• How can you deal with exchange risk?▫ (derivatives; operational hedging; diversifying)

• Who cares about the balance of payments?▫ (impact on XR, government policies)▫ (foreign debt problem; tequila crisis; Asia crisis)

• How do national economic policies affect the BOP and international firms?▫ ( Ms, G)

Themes to cover – Martin Wolf Book “Fixing Global Finance”1. Series of crises

▫ Financial liberalization = age of crises2. Response to crises:

▫ NO current account deficits▫ “smoke but don’t inhale” of global finance▫ USA as “borrower of last resort”▫ “savings glut”, Flood of “cheap credit”

3. US unique position:▫ US is “in trouble”? No…▫ Reserve currency▫ Borrow in own currency▫ Can NOT face Solvency crisis

4. Fixing global finance:▫ Must borrow only in own currency▫ Need for local-currency bond markets

What is “International Finance”?

International Finance

•Group: Discuss differences between:▫Portfolio investing▫FDI▫Which is “better”?

14

1.

2.

3.

Foreign Exchange Market

Domestic FinancialMarkets in OtherCountries—Short-Term

Domestic FinancialMarkets in OtherCountries—Long-Term

Deposits, Cash, Forwards, Futures

T-Bills, Deposits,Commercial Paper,Money Market Funds

Bonds, Stocks,ADRs, Deposits, CMOs

Banks, Companies, Brokers

Banks, Companies,Brokers


International Financial Markets

MARKET

INSTRUMENTS PARTICIPANTS

15

4.

5.

6.

7.

Euro-Currency Market

Euro-Bond Market

International MonetarySystem (IMF)

The Real Sector

Deposits, Euro CPEuroloans

Eurobonds, FloatingRate Notes,Euro-Equities

SDRs, $US, [Gold],Position in the Fund

Banks, Clients

Investment Banks Companies, Brokers

Central Banks,The Fund

International Financial Markets (cont.)

MARKET


Goods & Services

Consumers & Firms

Why Study “International Finance”?

Why?

•Why not just study “Finance”?▫NPV, cash flows, bonds▫If you understand domestic finance, isnt

International finance the same thing?

•Currencies•Gov’t default foreign investors•Understand macro-themes

What are the benefits of “International Finance”?

Benefits of Global Finance1. Serve international companies

▫Citi bank in Sao Paulo▫HSBC everwhere

2. Some countries don’t have DEEP enough capital markets

▫Needs of companies Bigger than Depth of capital markets

3. Efficiency, 4. Best practices (international competition

forces local monopolies to offer better rates)

Benefits of Global Finance

•“remember the remarkable prosperity of the past 25 years. Finance deserves some of the credit for that.”

source: http://www.economist.com/printedition/displayStory.cfm?Story_ID=12957709

What are the dangers of “International Finance”?

Dangers

•Fast money in, fast money OUT•Borrowing in foreign currencies

▫Discuss, WHY?

Challenge to students…

While we are in Europe together…

•Think critically •Challenge accepted assumptions•Look for trends (not facts & figures)•Educational journey…

Failure of “economic forecasting” profession

•Why didn’t predict worst crisis since Great Depression?

•Some exceptions (Nouriel Roubini, others..)

•But, in general, a few lone voices does not equal a profession (dismissed as quack, “Dr. Doom”, etc…)

Mis-diagnosis of the problem• Globally, during much of 2008, economic

growth appeared to be holding up

• IMF Projection▫In April 2008, eight months into the global crisis

if we date its start as August 2007, the IMF was forecasting only a mild slowdown in global growth in 2008 to 3.7, from the 4.9 percent that then was estimated for 2007.

• ECB▫Recall that the European Central Bank (ECB)

raised the target for its key refinancing rate on July 3, 2008, and the ECB was not alone in its inflation concerns at that time.

As late as 2008, the IMF forecasted growth in 2009

Failure of “economic forecasting” profession

Conclusion: highest trained, most respected, most influential did not predict collapse

Repeat challenge to students:

•Think critically, don’t accept “expert” forecasts, challenge accepted assumptions.

•With critical analysis, any one can learn to spot macro trends

•GET AHEAD OF THE TRENDS!!!▫Tools for investors▫Business leaders – position for threats /

opportunities

Impossible to Predict

•Currencies, when flexible, are impossible to predict▫Don’t believe anyone that tells you

otherwise▫Tools:

PPP, IFE Difference in interest rates between 2

countries to set forward rate, estimate future spot rate

Core of our class:

•Tools to protect•Hedging techniques:

▫Forward, Futures, options, etc…▫tools to PROTECT (and potentially

speculate)

Risk - in foreign currency

•Example: ▫Lets assume… you are a German company…

buying a container of furniture from Brazil (to resell at a fixed price in Germany)

▫You agree to pay 100,000 Reais (Brazilian currency) in 6 months to the Brazilian company for delivery

▫Assume the currency exchange rate is currently 2:1 (Reais to Euros)

▫What is your risk?

Risk - in foreign currency

• Example – Brazilian furniture ▫You fear that:▫What happens if the exchange rate goes from

2:1 to 1:1?▫Instead of needing 50,000 Euros to pay that

R$100,000 bill…▫You now need 100,000 Euros… ouch

▫Question: how could you have avoided that risk?

Avoiding Risk

1. Don’t buy foreign goods (avoid risk)2. Negotiate contract so currency is based

in YOUR currency (transfer risk)3. How else?

Guess…

Avoiding Risk1. Don’t buy foreign goods (avoid risk)2. Negotiate contract so currency is based in

YOUR currency (transfer risk)3. How else?

You could…1. Convert your money to R$ today…and deposit

that money in a Brazilian bank account (deposit hedge)

2. Contract with your bank to buy $R in 6 months at a fixed rate (2:1) for a fee (forward contract)

3. Buy a Future contract (similar) on exchange (if you can find one).

4. More… (coming class)

Forum-NexusInternational Finance Class – Lecture #2- Paris Dec 31st 2009

Assignments:

•Read Valdez. Ch 9, p 230-233 (Breton Woods to European Monetary Union)

•Plus:•Read Wolf “Fixing Global Finance” Ch 1

&2•Read Article from Wall Street Journal,

Currencies:

•Question:▫“Why is it “expensive” to come to Europe

and travel (shop, stay, enjoy)?▫Compared to US, Mexico, Brazil, etc…▫Why does it “seem” expensive here?

Global travel…How about if you went to Argentina? • at about 4-1 USD…. Everything SEEMS

cheap….hotels, restaurants, clothes shopping.

Or Iceland? Idea for (cheap) Global Travel… follow the crises

Watch from China = $10• is that “cheap”?• how about if you lived in China? Is it still

cheap?

Spain review

•Meeting at Stock Exchange•Interesting discussion about the Crisis &

recovery in Spain -- Hugo noted that Spain can not control monetary policy (lower interest rates). Who can explain? What is the impact on Spain? How was it different before Spain joined the Euro-zone?

Fixed vs. Flexible exchange rates

• Fixed exchange rates▫Any examples?

• Floating exchange rates▫Any examples?

• What system is active today? (globally)

• Important to INTERNATIONAL business managers to pay attention to changes▫why?

The “dollar bloc”• “currencies either pegged to the dollar or more or less

actively managed against it (a group that includes Japan)” Oil Exporters

Bahrain Oman Qatar Saudi Arabia UAE (Dubai included)

China Japan Russia Singapore Taiwan Malaysia Hong Kong Thailand India Others: Ecuador, Panama, more…. Used to be Argentina!

Sources: figure 6.6 from Wolf “Fixing Global Finance”And, Economist.com, May 23 2009, “Monetary Union in theGulf”

Dollar bloc:

•What is the impact on the Euro-zone?•How does the “dollar bloc” effect

exporters in Spain? France? Germany?•How about countries outside of the bloc,

such as Brazil?

Difficult Choices… the “Mundell Trilemma”

•Countries face a trade-off when deciding whether to fix or be flexible

•Can only have 2 of the following 3 …▫Monetary policy independence (interest rates)▫Fixed exchange rates (predictable, stable)▫Free flow of money (access to global capital)

Mundell Trilemma• example of USA- Country wants:

1.Monetary Policy control (US wants to have control of interest rates to heat-up / slow-down economy)

2.Open access to international finance (US wants access to external funding, example from China)

3.Fixed, predictable exchange rates (US would like this, but according to the Mundell Trilemma, they need to give up one, and this is the one that the US lives without)

Mundell Trilemma

•example of Spain joining Euro-Zone - Country wants:

Group assignment: discuss which 2 of 3 Mundell Trilemma options that Spain has opted to have, and which 1 of 3 that Spain had to give up (by electing to join the Euro-zone)

Mundell Trilemma• Country wants (example of Spain joining

Euro-Zone)

1.Open access to international finance (taken as a given, assumed)

2.Fixed, predictable exchange rates (Spain gets this by joining Euro-Zone)

3.What’s left over? (ie. What did they have to give up?). What does this mean for Spain? Greece? Ireland?

Fixed vs. Flexible exchange rates

•What system is Better? Why?

▫Groups of 2-3 students, answer

Brief History – Key points

•Key point: there is NO “best” system•It all depends on what you want to

achieve…•History: Cycle from Fixed to Flexible to

Fixed to Flexible……(future?)

Fixed Fixed

Flexible Flexible

The gold standard (~1850–1914)Fixed exchange rates during the 1920s

Great Depression era

Post WWIIBretton Woods / IMF system (1944–1971)

1970’s –today: since U.S. left the gold/dollar standard

?????

Brief History – Key points

•QUESTION:▫Why change from flexible to fixed? (give 1

reason)▫Why change from fixed to flexible?

Fixed Fixed

Flexible Flexible


Inter-war periodGreat Depression era



Brief History – Key points• ANSWER:

▫Why change from flexible to fixed? CONTROL, STABILITY, LOWER INFLATION,

END CHAOS Note: Too chaotic in depression… so fixed for

stability Note: Argentina = fixed to dollar was “brilliant”

at the time…but should have dropped sooner (not just in 2002)

▫Why change from fixed to flexible? EASE ADJUSTMENT PROCESS, IMPROVE

LOCAL MONETARY CONTROL, INCREASE GLOBAL FLOW OF FUNDS

FIXED system…

Painful ADJUSTMENT mechanism:

Example: Under the GOLD Standard:

If exports > imports… build up gold reservesIf imports > exports… run out of gold reserves

KEY QUESTION:

▫ Under a fixed system, how do you increase exports? (to stop burning through gold reserves)?

▫….Group answer

FIXED system…

Answer▫ need to decrease prices, wages ▫ So exports more competitive▫Can’t adjust FX rates, so adjustment has to be painfully with wages, prices

• KEY POINT:▫ adjustment in fixed system is = painful process, slow, very unpopular!▫

Forum-NexusInternational Finance Class – Lecture #3- Paris Jan 1st 2010

HAPPY NEW YEAR!!!!!

Review yesterdays class:

•We talked about fixed and flexible exchange rates, monetary policy, controls of global capital flows, the threats to the Euro, devaluation, “beggar thy neighbor”, competitive devaluations, and more…

•Any thoughts? questions?

GROUP ASSIGNMENT•Write down:

▫According to the Mundell Trilemma we discussed last class, what are the 3 things that countries want to achieve?

▫What 2 of 3 items did Spain elect to maintain? (which 1 did they give up?)

▫After WWII, at the Breton Woods conference, which 1 of 3 was given up (by the USA, and globally)?

▫In a system of fixed exchange rates, if a country wants to become more competitive with its exports, what must they do? How?

Review yesterdays class:

•We talked about China and which 2 of 3 that they have selected. Who can summarize? Why did they choose these 2? (and not the 3rd)?

• (do you think it will last 20 years from now?)

Currency basics:

Do you want a “strong” currency? Not necessarily….

•Producers - prefer weak currency – produce for exports

•Consumers – prefer strong currency – to purchase cheap imports, and afford foreign travel

•Government- it depends, but for full employment from exports, often prefer weak currency

FIXED system…

Answer▫ need to decrease prices, wages ▫ So exports more competitive▫Can’t adjust FX rates, so adjustment has to be painfully with wages, prices

• KEY POINT:▫ adjustment in fixed system is = painful process, slow, very unpopular!▫

Flexible Exchange Rates

Key point:Adjustment in currency FX rate; and

doesn’t require a fall in WAGES….

1. Excess supply of home currency in the foreign market

2. S>D cause price of home currency to decline, i.e., currency devalues

3. Imports decline and exports rise4. Trade balance re-establishes

What will the future hold? ….Fixed vs. Flexible ?• Future… if crisis brought terrible volatility…

• Will we move toward era of FIXED FX?▫ emerging markets DOLLARIZE?▫ More countries to join the EURO?▫ US / euro move to fixed?▫ New Breton Woods?

• Or, move toward more flexibility?▫ “Dollar Bloc” move toward flexibility?▫ Europe abandon the Euro?

▫ Answer: no body knows what will happen, but HISTORY tells us the CHANGE = the only CONSTANT!!

Take away: Key points

•History: systems change•Business leaders NEED to watch carefully

for SHIFTS in political attitude, and be READY for potential shifts in the system

•Protect yourself!!

Fixed Fixed

Flexible Flexible


Great Depression era



?????

Monetary Policy v Fiscal Policy

1.What is Monetary Policy?2.What is Inflation?3.What is Fiscal policy?

Monetary policy•“interest” = cost of money• Increase interest = increased cost of money

Leads to slow down of economy

•Decrease interest = decreased cost of money Leads to speed up of economy

•Group Question:▫“why would a government EVER want to

increase interest (increase the cost of money) and SLOW down the economy?” answer, turn in, then discuss

Inflation•2 ways to think about it:

1. A general rise in prices (ok, but not useful)2. A decrease in the value of money (better)…

less purchasing power for $1 in future (than now)

▫Example: $1 will buy 1 apple now, but only 1/10th of an apple in the future. This is inflation! Money is worth less (in terms of real goods) in the future

▫Question: if you think your money will be worth less in the future, what would you do today?

SPEND today!!!(don’t save)

Hyper-Inflation• Who has ever lived in a country with Hyper inflation?• What is it like?• How do consumers behave?• Do companies invest long term? Or short term? What

happens to wages? Union contracts?• Can you plan for the future?• What happens with interest rates? Why?

• Examples:▫ Zimbabwe (now)▫ Argentina, Brazil (recently), Latin America▫ Germany after WWI, Others…

Inflation – why bad

•Group assignment:▫“why is inflation bad?”

(a) from a savers perspective? (b) from a banks perspective?

Inflation: effect on life savings• What happens to your life savings during inflation?• Imagine if you had saved $1 mm USD in a

retirement account, and you expected to live comfortably for the next 30 years off of principal + interest… you could be comfortable… unless…

• Inflation!▫Remember: Inflation = decreased value of money in

future▫Your money will buy less (food, travel, clothing, etc)

• Conclusion: inflation = terrible for savers!!

Inflation: bad for banks•What if you were a bank and you loaned

out $10 mm USD to be paid back in 5 years. The borrower gets the money now, and pays back in the future.▫Why is inflation bad for the bank?

Remember: Inflation = decreased value of money in future. So, bank will be paid back in future with dollars worth less

Examples: student borrows student loan, or borrows money for house

On the other hand…

• why is inflation good for the borrower?

Inflation = 2nd biggest fear?• Inflation = 2nd biggest fear of central bank

▫In US, the Fed has “dual mandate” for growth (employment) and inflation

▫In Europe, the ECB only has one: fight inflation

▫Inflation targeting▫Generally want low but stable inflation (2-3% is

ok)

• Group question:▫What do you think is the #1 fear of central

bankers? (more than inflation)?

Deflation –

•If inflation = general increase in prices of goods and services▫What do you think deflation is?▫Why are central banks afraid of

“deflation”? Hints:

Japan’s “lost decade” of the 1990’s, and ongoing discussion during this Global

Economic Crisis (especially early 2009)

Deflation –

•Example: if house prices are falling, do you think a bank would want to lend money to a person to buy a home? Do people want to borrow money to invest in homes?

•This is the root of the problem with deflation: banks don’t want to lend, people don’t want to invest, economy stalls

Monetary Policy + deflation

•With fears of slowing economy, the Central Bank (Fed, ECB, etc) want to cut interest rates (make money cheaper to stimulate growth)… but what happens if the rates get cut to 0% and growth still hasn’t materialized? Can the Fed cut interest rates below 0%? No!

•This is essentially what happened in Japan for the “lost decade+”, and the fear of US, Europe in 2009

Monetary vs. Fiscal Policy

Group assignment;•Who can describe the difference?

Monetary vs. Fiscal Policy

• Monetary Policy:▫Think “interest rates”,▫Central Bank (FED, ECB, etc)▫Issue: inflation▫Milton Friedman

• Fiscal Policy▫Think “government spending”▫Fiscal Stimulus▫Issue: budget deficits▫John M. Keynes

Fiscal Policy

•Fiscal Policy▫Think “tax & spend”▫Trouble is = gov’t often spends, but forgets

about the tax part.▫Democracy, voters, upcoming election

▫Question- if government spends, doesn’t tax enough, runs deficits, and gets into debt trouble, what can they do?..... Leads to our discussion on the IMF (Breton Woods institution)

Forum-NexusInternational Finance Class – Lecture #4- Paris Jan 4th 2010

Review from last week• Post crisis -- How can Spain regain competitive edge? Why

doesn’t Spain drop out? What is the risk? competitive devaluations. Productivity, pay cuts. Danger of civil unrest.

• Director of Stock Exchange said… risk is in 1-2 years from now, when inflation picks up, and if the ECB is forced to raise interest rates BEFORE Spain's economy picks up. If Spain’s economy is still slow, and if rates go up, it could choke off recovery (politically raising anger v ECB, euro)

• Euro v Dollar - 2 weaknesses

Review from last week• What is inflation? why is it a problem? why do

central banks fight it? what tools do they use?• We talked about how central banks use Monetary

Policy (control of interest rates) to TARGET inflation.

• Questions:▫Who can remind me… what was my preferred

definition of inflation? Hyperinflation? Deflation?▫Is inflation good for borrowers? Or for lenders of

money? (think personally, and nationally – i.e China- USA relationship)

Themes to cover Today

1.Banking Business Model2.Pyramid of Promises

Commercial Banking (business model)

•Commercial Banking business model:• “Borrow short, lend long”

•Who can explain what this means?

Borrow Short

•Deposits are LIABILITIES for banks•They are BORROWING money from

clients•But, deposits can be withdrawn at any

time

•So… their Liabilities are short term (might owe money tomorrow)

Lend Long

•Banks invest in Long term Assets•Mortgages, for example… 30 years

duration

•So, money is borrowed short (term), but lent out long (term)

•What is the risk?

Lend Long

•Risk= profitable bank may not have money on hand to meet short term liabilities (withdrawals)

•This is called “Liquidity” crisis

Overcoming Banking Weakness of LiquidityFederal Insurance• As a result of this inherent weakness, banks are offered

federal insurance for the deposits. The government is forced to federally protect (guarantee) depositors that their money will be there if they want it. Or else, people would not trust the banks, and would not deposit their money. FDIC

Regulation• In exchange for this federal guarantee (that they

receive), the banks (give up) are subject to stiff regulation. One of the main requirements for deposit-taking banks is that they have to maintain a certain level of money on reserve at the (Federal Reserve). In the US, this reserve requirement is 10%.

http://globotrends.pbworks.com/Commercial-Banking

Getting around Regulations….Innovation•Wherever you see regulation, you will see

innovation (to get around the regulation). Banks are some of the most creative organizations when it comes to developing products to get around regulation. For example, there has been massive Innovation in the financial sector when it comes to the securitization of mortgages (which partly is to blame for the subprime lending crisis).

http://globotrends.pbworks.com/Commercial-Banking

Group Question

•Does regulation + bank guarantees… result in making the banking system more, or less risky?▫Ie. Do you think government guarantees

encourage risky behavior?

Moral Hazard

•Law of unintended consequences•Moral Hazard

▫Ex: fire insurance… less likely to smoke? Health insurance…. Less likely to be safe?

•“Moral hazard: One of two main sorts of MARKET FAILURE often associated with the provision of INSURANCE. The other is ADVERSE SELECTION. Moral hazard means that people with insurance may take greater risks than they would do without it because they know they are protected, so the insurer may get more claims than it bargained for.

The Economist.com

Solvency v Liquidity – QUIZ (extra credit)•Extra credit – 1 point in final grade

•In 20 words or less – what is a “Solvency” problem (for banks)

•In 20 words or less – what is a “Liquidity” problem (for banks)

•* think of the business model

Solvent: not Solvent•Ok NOT OK

ASSETS-Include home mortgages-subprime

Liabilities (Borrowing, debt)

Equity



Equity

Solvency v Liquidity• Insolvent: liabilities > assets (equity = 0)

▫Person: I owe more than Im worth▫Bank: assets loose value (subprime mortgages)▫Country: cant pay debts…default

• Illiquidity: long term asset, short term liability▫ I owe money NOW, but have money tied up in my

house, car, etc…▫Bank: lend long term, borrow short term▫Country: cant access credit markets to pay

imports

Solvency v Liquidity

•How does this relate to the Global Financial Crisis?

▫Anyone?

Solvency v Liquidity Timeline

•2007 – September 2008▫Problem = Solvency▫Mortgages (assets on

Banks balance sheet) worth less than anticipated… write down

▫Results: Hedge funds Funds go under (Bear Stearns)

▫Bankruptcy threat



Equity

Credit Crisis timeline – key dates in SeptemberSeptember 7, 2008: Federal takeover of Fannie Mae and Freddie

Mac[25][26] September 14, 2008: Merrill Lynch sold to Bank of America amidst

fears of a liquidity crisis and Lehman Brothers collapse[27] September 15, 2008: Lehman Brothers files for bankruptcy

protection[28] September 16, 2008: Moody's and Standard and Poor's downgrade

ratings on AIG's credit on concerns over continuing losses to mortgage-backed securities, sending the company into fears of insolvency.[29][30]

September 17, 2008: The US Federal Reserve loans $85 billion to American International Group (AIG) to avoid bankruptcy.

September 19, 2008: Paulson financial rescue plan unveiled after a volatile week in stock and debt markets.

September 25, 2008: Washington Mutual was seized by the Federal Deposit Insurance Corporation, and it's banking assets were sold to JP MorganChase for $1.9bn.

Solvency v Liquidity Timeline

•September 2008 - now▫Crisis CHANGED▫No longer just a SOLVENCY CRISIS▫Became a MIXED crisis of BOTH solvency

and liquidity▫How? Why? What does that mean?

▫Someone tell me again…what is “liquidity”?

Pyramid of Promises

•“Central feature of the financial system: it is a Pyramid of promises- often promises of long or even indefinite duration. This makes it remarkable that sophisticated finance systems exist”

•Promises may not be kept•Interest of those who make promises NOT

to keep them

Martin Wolf, “Fixing Global Finance”… based on McKinsey “Mapping Global Capital Markets”, 2005

What “promises”?• Financial assets represents “promises of

future, often contingent, receipts in return for current payments”

• Bonds▫Represent PROMISES of fixed payment (in

time), plus PROMISE of regular payments in between

• Equity (stocks)▫Represent PROMISES a share in future

corporate profits• Pensions

▫Represent PROMISES for a stream of income in retirement


What “promises”?• Life Insurance Policy

▫Represent PROMISES of payment after some fixed date or death

• Accident / Health Insurance Policy▫Represent PROMISES of payment if something

happens• Mutual Fund

▫Promises to return to investors the proceeds from mutual funds purchase of promises from corporations

• Options▫Is a promise to hand over a claim to a certain

promise under specific conditionsMartin Wolf, “Fixing Global Finance”… based on

McKinsey “Mapping Global Capital Markets”, 2005

Pyramid of “promises”?

•“As the financial system grows more complex… it piles PROMISES on PROMISES”.


Just how big is the MOUNTAIN of promises…?

•Amazing….


Size of Finance…• Size of the Financial sector: * data from McKinsey report 2005, "Mapping the global capital

market" and http://www.federalreserve.gov/releases/

• What is amazing is that the financial sector ballooned to the size that it has...with a worldwide total of $140 trillion in promises outstanding in 2005 (more in 2008/9).

• Of that total, the US was the prime holder of promises (assets). The US household sector held about $39 trillion (28% of world total), and with the US as a whole holding nearly $52 trillion (37% of all world financial assets, or promises).


Size of Finance…


Size of Finance…


Size of Finance…


Size of Finance…


Forum-NexusInternational Finance Class – Lecture #5- Paris Jan 5th 2010

“PYRAMID of Promises”


•Modern economies depend on pyramids of promises far more impressive and complex than those of stone constructed almost 5 thousand years ago”

•But, the system is extremely FRAGILE•Confidence that sustains them could be

misplaced•People could end up with promises NOT

WORTH the paper (they used to be) printed upon

Underneath that “PYRAMID”


•The “Foundation” of all of these PROMISES is = title to real assets▫Housing, land, property, factories,

machines, etc

▫Need to BELIEVE the original owner really ownes what they say they own.

▫So, key = property rights, law, institutions – for trust, and development of financial system

Themes to cover Today

1.Risk of borrowing in foreign currency2.Appreciation vs Depreciation3.Financial liberalization4.Series of crises

•Key lesson of international finance:

•Currencies change, so… ▫Borrowing money in foreign currency =

risky…. Why? Discuss

Understanding Risks:

•Risks

▫Account receivable Someone abroad OWES you money in THEIR

currency = Risky! FEAR…That you might end up receiving LESS

in your OWN currency (than you expected)

Understanding Risks:

•Risks

•Need to UNDERSTAND this, in order to understand…▫SE Asian Crisis ‘97▫Argentina Crisis ‘02▫Any and all currency crises… (this lesson =

key)

Terms you need to know….• Appreciation:

▫ Currency gets STRONGER vs other▫ Example:

US Dollar Appreciates Goes from 2.0 USD per Euro to 1.0 USD per Euro

So, it takes LESS US dollars to buy one Euro Goes from 1 usd buys 0.5 Euro…. Now; 1 usd buys 1

Euro So, it 1 USD buys MORE Euros

• Depreciation:▫ Currency gets WEAKER vs other▫ Example:

US dollar Depreciates Goes from 1.0 USD per Euro to 2.0 USD per Euro

So, it takes MORE US dollars to buy one Euro

Themes still to cover – Martin Wolf Book “Fixing Global Finance”

1.Macro factors▫ Brief summary / history

2.Series of crises▫ Financial liberalization = age of crises

3.Response to crises:▫ NO current account deficits▫ “smoke but don’t inhale” of global finance▫ USA as “borrower of last resort”▫ “savings glut”, Flood of “cheap credit”

4.US unique position:▫ Reserve currency▫ Borrow in own currency▫ Can NOT face Solvency crisis▫ US is “in trouble”?

5.Fixing global finance:▫ Must borrow only in own currency▫ Need for local-currency bond markets

Series of Crises

Series of Crises• Financial liberalization = series of crises?

• Finance is increasingly fragile. Barry Eichengreen of the University of California at Berkeley and Michael Bordo of Rutgers University identify 139 financial crises between 1973 and 1997 (of which 44 took place in high-income countries), compared with a total of only 38 between 1945 and 1971. Crises are twice as common as they were before 1914, the authors conclude.

Martin Wolf book, “Fixing Global Finance”

Series of Crises – 1990’s• Japanese recession - 1990 to 2003, collapse of a real estate bubble

and more fundamental problems halts Japan's once astronomical growth, “lost decade”

• United Kingdom - 1992 - devaluation of currency, "broke the bank of England“, currency speculating against the European currency unit peg

• Mexico crisis 1994 ”tequila crisis” - currency devaluation, debt crisis

• Asian Crisis 1997: SE Asia Crisis - 1997 & 1998 - currency devaluation, debt crisis

• South Korea - 1998 • Russia - 1998 • USA - Long term capital management - hedge fund meltdown - 1998

- causes were SE Asia Crisis of 1997, and Russia crisis of 1998• Brazil - 1999 - currency Real was pegged to US dollar, then forced

to float – currency crisis

http://globotrends.pbworks.com/history-of-economic-crisis-and-currency-devaluations

Series of Crises – 1990’s• Critical event: SE Asia Crisis 1997-1998

▫ Leading up to event: currencies were “pegged” to dollar

▫ Interest rates much lower in the US▫ Investors bet that peg would last▫ Borrow money abroad at low interest rates▫ Invest in SE Asia at higher rates▫ Make bigger returns, use money to pay back loans

abroad▫ Great way to make money!

• Unless….

• Group assignment: what is risk, what do you think happened?



• Unless….

▫ Peg was ultimately unsustainable▫ Speculators lined up to bet against ▫ Peg was broken, and local currencies fell, and fell,

and fell more… = “currency crisis”

▫ Group answer: Then, what do you think happened to the debt?



Debt crisis:▫ debts in foreign currency become too “expensive”

to pay back▫ Massive defaults

▫ “Debt crisis + Currency crisis” = TWIN Crisis!

Note: a similar thing happened in Argentina in 2001/2… can anyone tell me what happened? Based on this story of SE Asia, give it a try (repeat story, substitute “Argentina” for “Malaysia, Thailand, Indonesia, etc”



Lessons learned:▫ Dangers in borrowing abroad▫ Danger s in Relying on Foreign capital ▫ Must be free from Current Account deficits!

Current account deficits = dangerous!▫ Since financial liberalization: countries that run current

account deficits = crisis▫ Right, or wrong… this is the main lesson that was

learned (the hard way)▫ Who was watching?

China – right next door, ring-side seats to watch the damage! Decision: never to let that happen to them! For all SE Asia…

“never again!!”


Key event: Asian Crisis ‘97-98

•Group :▫Why was this important?▫Who was watching?▫What changed, what lessons were learned?


Changed international finance

▫Who was watching? China & all emerging markets

▫What key lesson was learned? Relying on foreign capital = dangerous


•How the world changed…

From that point on… …emerging markets try to be independent of

foreign capital…

How?▫If money comes in… send it back▫Export earnings sent back overseas -

response…

•“…we now see the phenomenon of capital markets trying to put money into emerging economies even as the governments of these economies, with even greater determination, recycle the funds in the form of foreign currency reserves”

Martin Wolf, Fixing Global Finance, p56

Key lesson

• •Risk in borrowing abroad… why?

Imagine…

•“The Indonesian rupiah lost 80% of its value almost overnight”

•“devastating effect on an economy”•“it is a horrifying story for a country that

had had no history of serious inflation”

▫Question: what do you think happened to companies that borrowed abroad (say, in US dollars)?

Martin Wolf, Fixing Global Finance

Question

•How does the “Asian Crisis of ‘97” lead to…▫Modern world of international finance▫Strange situation where money flows from

poor to rich? From China to USA

Answer• After the Asian Crisis of ‘97

▫Emerging markets no longer willing to accept international capital

• Ok, but how?• How do you “reject” international capital?

▫Dynamics of “how” will be covered in “Balance of Payments” discussion… (current account / capital account)

Summary ▫No “current account deficits

Fight to run “current account” surplus

▫Avoid devaluation Fight to keep currency “undervalued”

▫Send money back… buy US Treasuries (run “capital account” deficits)…

** don’t worry, this will make sense soon…

Current Account / Capital Account

•Terms to learn…

▫Current Account▫Capital Account▫Reserves▫Balance of Payments….

Lessons…

•“current account deficits have come to mean crisis”!

•“policy makers are (now) frightened of running current account deficits”


Current Account:• Approx:

▫Exports – imports▫in a basic sense, its exports - imports....so, if its

negative, then you are importing more than exporting...and you need to finance that deficit.

• So, if you have more imports than exports▫Deficit▫Must be “financed” by “capital account”

• Globally, must balance▫If some countries run surplus, then others

must run deficits

Current Account•From an economic standpoint…•A current account could also be described

as:

▫the current account surplus is determined by the gap between savings and investment

deficit: more aggregate spending than output. to get rid of a deficit...need to reduce aggregate

spending in relation to output a surplus is = more savings, than investment

Current Account Deficit• How does the country finance this excess

spending? ▫Answer: It borrows.

▫Q: what do we do when we spend more than we earn?

▫A: we use a credit card (borrow money that has to be paid later).

• The current account shows the amount of international lending or borrowing.

From the book…

•“If a collection of people spend more than their income on goods and services, they must be receiving loans or investment from elsewhere, to finance the excess of their imports over their exports”.

Martin Wolf, Fixing Global Finance

Country’s Balance Sheet:

•How does a country “finance” its current account deficit?

•In order to answer this question…

•First need to understand basic national accounts…

National “Balance Sheet”

• Key: must “balance”

• 3 Important parts (for our class discussion):▫Current account

Flow of goods and services, Roughly= exports - imports

▫Capital account Paying for the current account - Money flows Example: US government sells treasury bills

▫Reserves Foreign currency, gold, etc Used to finance gap between current & capital

accounts “below the line”


What is a “current account deficit?

▫Group assignment: write down the answer to this:

▫What is a “current account” When is it in “deficit”?

▫What is a “capital account” When is it in “deficit”?


•Current Account ▫Goods, services

(imports / exports, goods, services, gifts)

•Capital Account ▫Money

(financials, treasury bonds, IBM shares, etc).


•Key: must “balance”

If “current account” deficit,

then… by definition…

▫“capital account” = surplus


•GROUP:

▫So…If imports are > exports… what must be happening in the “capital account”?

Answer…

SURPLUS!! Money must be coming in from abroad to

finance the current account deficits!

National “Balance Sheet”• But…

▫What happens if you do NOT have money coming in from abroad

▫Note: just because you have a “current account” deficit… that doesn’t mean foreigners will pay the bill…

▫Group assignment: What happens? What must you do? (hint: 3rd part of national

accounts mentioned before)…

Answer:

▫You must then dip into the Reserves (if you have any) and pay the difference… (gold, foreign currency)

Follow up question:▫What if you don’t have enough reserves? Then

what? What can you do?

(What happens if you are running a current account deficit, and if foreigners SUDDEN STOP supplying capital, but… you do not have enough reserves to pay the bill?)

Forum-NexusInternational Finance Class – Lecture #6- Interlaken Jan 7th 2010Review for exam

Forum-NexusInternational Finance Class – Lecture #7- Milan Jan 11th 2010

Welcome to Italy!!

Exam review

•Trouble question: “What characteristic of the national accounts (balance sheet) has come to mean “crisis” to many countries in emerging markets (and must be avoided”?▫A. Capital account deficits▫B. Current account deficits

▫Right answer = ???

Summary lesson from ‘97 SE Asian Crisis:

▫No “current account deficits Fight to run “current account” surplus

▫Avoid devaluation Fight to keep currency “undervalued”

▫Send money back… buy US Treasuries (run “capital account”

deficits)…

Lessons…

•“current account deficits have come to mean crisis”!

•“policy makers are (now) frightened of running current account deficits”



• Key: must “balance”

• 3 Important parts (for our class discussion): Current account

▫Flow of goods and services, Roughly= exports - imports

Capital account▫Paying for the current account - Money flows▫Example: US government sells treasury bills

Reserves▫Foreign currency, gold, etc▫Used to finance gap between current & capital

accounts▫“below the line” Martin Wolf book, “Fixing Global Finance”

Must Balance!!

If not… pay out reserves..


154

1.

2.

3.

Foreign Exchange Market

Domestic FinancialMarkets in OtherCountries—Short-Term

Domestic FinancialMarkets in OtherCountries—Long-Term

Deposits, Cash, Forwards, Futures

T-Bills, Deposits,Commercial Paper,Money Market Funds

Bonds, Stocks,ADRs, Deposits, CMOs

Banks, Companies, Brokers



International Financial Markets

MARKET


155

4.

5.

6.

7.

Euro-Currency Market

Euro-Bond Market

International MonetarySystem (IMF)

The Real Sector

Deposits, Euro CPEuroloans

Eurobonds, FloatingRate Notes,Euro-Equities

SDRs, $US, [Gold],Position in the Fund

Banks, Clients

Investment Banks Companies, Brokers

Central Banks,The Fund

International Financial Markets (cont.)

MARKET


Goods & Services

Consumers & Firms

Question:

If you were a US based bank, with dollars to invest for 12 months…..where would you choose to deposit your money (to make the most return)?

Note: You can assume you have an account with a bank in London (HSBC, etc)… and its easy to switch from one account to the other (click of a button)

International Money Market Rates (Bid Side)

United Statesdollar

Englandsterling

Europeeuro

Switzerlandfranc

Japanyen

Eurocurrency Rate

LIBOR 12 months 3.2% 6.0% 5.3% 3.2% 1.1%

International Money Market Rates (Bid Side)

United Statesdollar

Englandsterling

Europeeuro

Switzerlandfranc

Japanyen

Eurocurrency Rate

LIBOR 12 months 3% 6.0% 5% 3.5% 1.1%

Expected appreciation / depreciation vs. US Dollar to

EQUATE choices…

x -3% -2% -0.5% +1.9%

Answer: it DEPENDS not just on the interest rate, but also on the expected change in foreign exchange rate as well.

You might be temped to choose the England (sterling) option of 5.99% because it’s the highest…but that currency might be expected to lose value (depreciate) over the next year…wiping out the expected gains.

Interest Rate Parity

•FX market in equilibrium ONLY when interest rate parity exists

•When deposits of all currencies offer the same EXPECTED rate of return

•Rate + expected (appreciation / depreciation) = rate

•Example: •US / Euro. If US interest = 5%, EU = 10%, but US dollar is expected to appreciate +5% = balance

Prof. Grosse, Financial Markets (p323-5)

Borrowing in Foreign Currencies….Where would you prefer to borrow?You have a factory in Brazil, and want to borrow

money to expand. You could…1.Borrow money locally at 10%2.Borrow money abroad (in US) at 5%

• Which would you choose?• What is the risk of borrowing abroad (in the US)?

– general comment 20 words or less

Note: fictional data based on current loan rates Brazil…• LIBOR + 1.5% for US = 2.5+1.5 = 4%• CDI + 2% for Brazil = 9.75 +2 = 11.75%

Questions:

1. Assume you borrow R$2mm for 1 year, and assume exchange rate is 2:1 today…. But moves to 4:1

2. How much will you owe in 1 year (in local currency)

▫ Local borrow (Brazil)? ▫ Foreign borrow (US)? ▫ Compute (teams)

3. Which is better? By how much?

Where would you prefer to borrow?• Local Brazil = $1.1 mm = R$2.2 mm• Foreign USA = $1.05 mm = R$2.1 mm• Difference = $50,000 USD (100,000R$)• (tempting to borrow abroad

▫ But,▫ What if FX rate goes from 2:1 to 4:1…▫ How much will you owe (in local

currency)?

Where would you prefer to borrow?• Local Brazil = $1.1 mm = R$2.2 mm• Foreign USA = $1.05 mm = R$2.1 mm• Difference = $50,000 USD (100,000R$)• (tempting to borrow abroad

▫ But,▫ What if FX rate goes from 2:1 to 4:1…▫ How much will you owe (in local currency)?

▫ Answer:▫ Locally – still just owe R2.2mm▫ But Foreign – would owe R4.2mm …. Double

▫ Conclusion: Borrowing Abroad = MUCH more RISK

Who can explain this….?

▫“Mexico Said to Price 150 Billion Yen in 10-Year Sovereign Samurai Bonds Mexico priced 150 billion yen ($1.7 billion) of 10-year Samurai bonds to yield 0.8 percentage point more than the yen swap rate, according to a banker with direct knowledge of the deal.”

•We talked about how its risky to borrow abroad in foreign currency. Discuss…

Bloomberg.com, Dec 2009

Facebook case study• In August 2007 Facebook was looking for financing to cover the cost of its

development of a more user-friendly interface for members on the internet. The company expects that this project will be ongoing for at least two years, through initial development and launch, plus upgrades. The total cost is expected to be on the order of $US 75 million.

• Facebook has been consulting with various banks to try to understand the alternative financing methods available. Barclays Bank in New York has offered a euro-currency financing package that would include funds in any currency chosen by Facebook, with an interest rate of LIBOR plus 1.0 percent per year. The company would pay the interest semi-annually, and the full principal at maturity in 2 years.

• Additional financing possibilities that have been mentioned include the issue of stock shares through an initial public offering in the US stock market, and issue of bonds either in the US or the euromarket. Relevant rates on these sources of funds appear in Table 1 below.

# = All interest costs are presented as annual percentage rates. The rates would have to be renegotiated annually each year during the project if bank loans were used. Facebook could expect to pay a spread of one percent per year over LIBOR or 1/8% over prime, plus the fees that are one-time, up-front payments on the financing, based on the principal value of the loan. To simplify the analysis, assume that the interest payments take place at the end of the period, if you wish. † = bonds are issued at fixed interest rate for two years. A Eurobond issued at a floating interest rate is called a Floating Rate Note (FRN). k* = Facebook's weighted average cost of capital.

Facebook case

•Euromarkets = cheaper to borrow, and better to deposit….almost always….because unregulated…so more competition as banks compete to offer better terms to clients.

International Financial Decisions•Finance projects in 3 basic ways:

1. Raise cash in home country and export finance to the foreign project

2. Raise cash by borrowing in the foreign country where the project is located

3. Borrow cash in 3rd country where the cost of debt is lowest

Ross/Westerfield/Jaffe - McGraw-Hill 7th edition – Corporate Finance Ch 31

Risks:1. Borrow locally for foreign investment: FX

risk of borrowing in “foreign” currency▫If a US firm raises cash for foreign project

by borrowing money in the US, it has FX risk

▫Hedge risk – sell foreign exchange forward▫But difficult beyond 1 year

2. Borrow in foreign for foreign investment▫Might be higher price of money, but less

risk FX


Short & Medium-term Financing• In raising short-term and medium-term cash,

US international firms have a choice between borrowing from US bank at the US interest rate, or borrowing Eurodollars in the Eurocurrency market

• Eurocurrency loans▫Short & Medium term▫Loans of Eurocurrency (Eurodollars) ▫Not a retail bank market. Customers =

governments and corporations▫Rates are on Floating-rate basis

Interest rates are set at fixed margin above LIBOR. Example: margin of 0.5 and LIBOR of 8% = 8.5%

loan Adjusted every 6 months

▫Maturities of 3-10 years possibleRoss/Westerfield/Jaffe - McGraw-Hill 7th edition – Corporate Finance Ch 31

International Bond Markets•Domestic bonds = issued by firm in its

home country•International bonds = issued by firms in

another currency•2 types of International Bonds

▫Foreign Bonds▫Eurobonds


Foreign Bonds• Bonds issued by foreign borrowers in a particluar

country’s local bond market• Issue and denominate in 1 foreign country• Nicknamed for country of issuance:

▫ Examples: Yankee bonds, Samurai bonds (Japan), Rembrandt bonds (Netherlands), Bulldog bonds (Britain)

▫ Example: a Swiss watch company issued US dollar-denominated bonds in US….

• Not that popular because:▫ Inside country with local regulations▫ Registered with local tax authorities▫ Transferring ownership of registered bond only via

legal transfer of legal name. Transfer agents are required.


Eurobonds• Denominated in any currency, Issued

simultaneously in many countries • (Euro just means “outside” the countries in

whose currencies are denominated, and does not mean Europe!)

• Typically syndicated in London• Important way to raise money for many

multinationals• Why popular?

▫Bearer bonds – ownership established by possession (no need to register)

▫Outside restrictions that apply to domestic offerings


Eurobonds•Underwriting:

▫Public issue with underwriting is similar to public debt sold in domestic bond markets

▫Borrower sells bonds to a group of (management) banks, who in turn sell the bonds to other banks (underwriters and sellers) who sell to dealers and fund investors.

▫Underwriters sell on a firm commitment basis = committed to buy at pre-negotiated price and attempt to sell them at higher price in the market.


Definitions•EuroCurrency

▫Money deposited in financial center outside of the country whose currency is involved

▫Example: “Eurodollar” = dollar deposited in bank outside of the USA. Example: a dollar deposit in Paris

▫But, not limited to Europe!! There exists a very large Eurodollar market in Tokyo, Hong Kong, Panama, Bahrain, etc..

▫For this reason, the Eurodollar market is often called the “international money market”


“international money market”

•Rivals domestic financial markets•Funding source for corporate borrowing,

and competing as deposit alternative… absorbing large amounts of savings from lenders (depositors)

•Now the largest and most important for international financial intermediation.

•Created / allowed by governments

Grosse/Kujawa – International Business, 3rd edition

Definitions• Euromarkets

▫Short term Eurocurrency market – bank deposits and loans. Example: In London, the Eurocurrency market is for bank deposits (and loans) denominated in dollars, yen, and others EXCEPT for British pounds

▫Long term euro bond market▫Each characterized by the issuance of instruments

(deposits or bonds) denominated in some currency other than that of the country where they are issued.

▫Euromarkets are generally unrestricted by governments


Definitions

•Euromarkets▫Short term Eurobond markets = long-term

counterpart of the Eurocurrency markets▫Regulation is minimal… so market depends

for protection on the reputations of the other participants (not on national securities laws)


Definitions

•Euromarkets▫Benefits:

Offer investors and borrowers in one country the opportunity to deal with borrowers and investors from many other countries

▫Opportunities: Offer substantial opportunities to virtually

any large or medium-sized firm when it deals in financial markets for either borrowing or lending.



Group projects due today!Last day in Milan!

Foreign Currency Exchange Rates (Bid)

Canadadollar

UK*sterling

Europe*euro

Switzerlandfranc

Japanyen

Spot Rate— (Closing Foreign currency units per US dollar)

1.0625 1.7863 1.4522 1.1090 108.84

Forward Rate—Closing Rates

1 month outright

1.0630 1.7822 1.4498 1.1086 108.652

3 months outright

1.0636 1.7749 1.4454 1.1080 108.281

6 months outright

1.0639 1.7638 1.4391 1.1066 107.716

12 months outright

1.0642 1.7493 1.4283 1.1043 106.453

*(U.S. dollars per foreign currency unit)

Market Exch Rates as of: Sept 2, 2008

Which currencies are expected to appreciate in the future? Which are expected to depreciate?

Foreign Currency Exchange Rates (Bid)

Canadadollar

UK*sterling

Europe*euro

Switzerlandfranc

Japanyen

Spot Rate— (Closing Foreign currency units per US dollar)

1.0625 1.7863 1.4522 1.1090 108.84

Forward Rate—Closing Rates

1 month outright

1.0630 1.7822 1.4498 1.1086 108.652

3 months outright

1.0636 1.7749 1.4454 1.1080 108.281

6 months outright

1.0639 1.7638 1.4391 1.1066 107.716

12 months outright

1.0642 1.7493 1.4283 1.1043 106.453

*(U.S. dollars per foreign currency unit)

Market Exch Rates as of: Sept 2, 2008

CDN depreciate

UK sterling depreciate

Euro depreciate

Swiss F appreciate

JPN yen appreciate

Determining FX rates•What determines the SPOT rate today?

▫Not an easy answer▫Many theories

Law of One Price: (LOP) – purchasing power parity theorem

Expectations theory of exchange rates

What determine the Forward rates (set today)?▫Interest-rate parity theorem


What determines the SPOT rate today? Purchasing Power Parity Theorem•$1 should have the same purchasing

power in each country. Apple costs the same whether buy in NY or in Tokyo.

•Change in FX rates between currencies in is connected to the inflation rates

•Law of One Price: (LOP)▫Commodity will cost the same regardless of

country in which it is purchased▫If LOP does not hold, then arbitrage

opportunity… make money by moving product from country to country.


Expectations theory•Forward rate of exchange = expected

spot rate


What determine the Forward rates (set today)? Interest rate parity theorem•Interest rate differential will be equal to

the difference between the forward exchange rate and the spot exchange rate.

•Must prevail to prevent arbitrage


Interest rate parity theorem• International Fisher Effect

• The International Fisher effect is a hypothesis in international finance that says that the difference in the nominal interest rates between two countries determines the movement of the real exchange rate between their currencies, with the value of the currency of the country with the lower nominal interest rate increasing.

• To estimate future changes in FX rates...look at the difference in interest rates between the two countries. The country with the higher interest rate will see depreciation (their currency will depreciate).


Interest rate parity in the Forward Market • This theory states that the difference between the spot

exchange rate and the forward exchange rate must be set EXACTLY equal to the difference in the interest rates between two countries. If not, then a trader could make money risk-free arbitrage.

• Example: if the US dollar is trading with the Brazilian currency (the Real) at a R$2.0 to $1 USD spot rate, and if the forward rate was also 2:1, then a smart person could convert their money to Reais today at 2-1 ratio, and purchase a 1 year bond (denominated in Reais) at a higher interest rate, and also purchase a forward contract to guarantee that they could convert their money back to USD at a 2:1 rate.

• It would be a guaranteed money maker. • Everyone would want to do this because there would be no

risk, and you could make a higher interest rate. So, no, the bankers are smarter than this, and they don't sell a forward contract at the same rate as the spot contract. Instead, what they do is sell the forward contract at the exact rate that would eliminate all incentive to exploit this system. What rate do they use?


Interest rate parity theorem• look at the difference in interest rates

between the two countries, and then adjust the forward contract by this exact same amount.

• So, if Brazil offered 12%, and the US offered 10%, then the forward contract would have to adjust for the difference, or 2%.

• The Brazilian currency would have to decrease in value (depreciation) by 2%. So, the forward contract would be set at exactly R$2.04 to the $1 US dollar.

• In this case, the forward contract exactly offsets the advantage that an investor could get by moving their money into Brazil, so there is no arbitrage opportunity. The bank MUST set the forward rate this way.


Forum-NexusInternational Finance Class – Lecture #10- Venice Jan 14th 2010

Welcome to Venice!!

Review:

•Midterm exam•Case study

Facebook case study

•Euroloan▫Interest rate of LIBOR plus 1.0 percent per

year. The company would pay the interest semi-annually, and the full principal at maturity in 2 years.

•Additional financing possibilities include ▫issue of stock shares through an initial

public offering in the US stock market▫issue of bonds either in the US or the

euromarket

Facebook case study

•Facebook has no idea if it will be generating foreign currency income in the future, it is not excited about running any exchange rate risk

Notes:• # = All interest costs are presented as annual

percentage rates. The rates would have to be renegotiated annually each year during the project if bank loans were used. Facebook could expect to pay a spread of one percent per year over LIBOR or 1/8% over prime, plus the fees that are one-time, up-front payments on the financing, based on the principal value of the loan. To simplify the analysis, assume that the interest payments take place at the end of the period, if you wish.

• • † = bonds are issued at fixed interest rate for two

years. A Eurobond issued at a floating interest rate is called a Floating Rate Note (FRN).

Facebook case study

•My notes:▫EuroMarkets = cheaper to borrow, and

better to deposit….almost always….because unregulated…so more competition as banks compete to offer better terms to clients.

▫Eurocurrency loans mark to market (change rate) every 6 months

▫If you borrow in Yen, Pounds…you have exchange rate risk

Forum-NexusInternational Finance Class – Lecture #11- On boat Jan 17th 2010

Heading to Greece!!

Problems:

•The spot rate of foreign exchange between the US and the UK at time t = $1.50 /pound UK. If the interest rate in the US is 13% and in the UK is 8%, what would you expect the one-year forward rate to be if there is no immediate arbitrage opportunity?

•Spot = $1.50 /pound UK•US is 13%•UK is 8%•Difference = 5%

•UK should appreciate by 5% •US should depreciate by 5%

•one-year forward rate should reflect this… or else =immediate arbitrage opportunity

•So, what should the 1 year forward rate be??

•Spot = $1.50 /pound UK•UK should appreciate by 5% •US should depreciate by 5%

•10% = 0.15•5% = 0.075

•SO, is it $1.50 + 0.075??•Or, is it $1.50 – 0.075??

•Spot = $1.50 /pound UK•UK should appreciate by 5% •US should depreciate by 5%

•PLUS!•SO, is it $1.50 + 0.075 = $1.575 = 1 yr forward rate

• It must be! •Or else = risk free way to make $$$ (arbitrage)•question: what if 1-yr forward = $1.50 (not $1.575)

how could you take advantage and make risk-free profit?

•Spot = $1.50 /pound UK•Forward should be= $1.575 •Forward hypothetical = $1.50•US rate 1-yr deposit= 13%•UK rate 1-yr deposit= 8%

•Risk free money: Assuming the UK pound does not appreciate by 5% (assume the US dollar does not depreciate 5%) in the contractual forward rate…. Assume the banker is stupid and gives you 1.50 rate in 1- yr forward…. How do you make risk free profit?

•Spot = $1.50 /pound UK•Forward should be= $1.575 •Forward hypothetical = $1.50•US rate 1-yr deposit= 13%•UK rate 1-yr deposit= 8%

•Start in UK. Convert your money to US dollars. Deposit in US account at higher interest rate. Convert back to UK. Risk free profit of 5%

Interest rate parity theorem• Another Example (of how the forward rate is set

using the spot rate + interest rates of two countries): if the sport rate today is $1.40 / Euro, and the USD interest is 11.3%, and Euro interest is 6%, then the forward contract rate should be set at $1.4742 to eliminate opportunities for arbitrage. How is this rate calculated? Its easy, you first subtract 6% from 11.3% to get 5.3%. This is the amount by which the USD must depreciate. In this example, the forward exchange rate of the dollar is said to be at a Discount because it buys fewer Euros in the forward exchange rate than it does in the spot exchange rate. The Euro is said to be at a Premium.


Interest rate parity theorem•Problems with this theory• •While it does explain how forward

exchange rates are set, it has not proven to be very effective at predicting actual currency movements in the future. Contrary to the theory , currencies with high interest rates often appreciate rather than depreciate

• •


Derivatives•Central point of finance = risk is undesirable• Individuals who choose risky securities only

if the expected return compensated for the risk.

•Firms constantly look for ways to reduce their risk.

•Hedging = use of derivatives to reduce risk exposure

•Speculating = opposite (but if wrong… tools cut deep)


Derivatives•Financial instrument whose payoffs and values

are derived from or depend on something else

•Examples: forwards, futures, swaps, options•Why use derivatives: change firms risk

exposure•Derivatives are to finance, what scalpels are to

surgery. By using derivatives, the firm can cut away unwanted portions of risk


Types of FX Transactions• Spot

▫Today▫Agreement of FX rate today, for settlement in 2

days• Forward

▫Agree today about FX rate to use in future▫Usually 1-52 weeks

• Futures▫Similar to Forward contracts, but traded on

exchanges. Set dates, fixed quantities, marked to market

• Swap▫Sale (or purchase) of foreign currency today,

with simultaneous agreement to repurchase (resell) at some point in the future. Difference between 2 rates= swap rate


Forward v Future• A Forward contract – agreement by 2 parties to

sell an item for cash at a later date. The price is set at the time the agreement is signed. Cash changes hands on the date of delivery. Forward contracts generally are not traded on exchanges.

• Futures – also agreements for future delivery. ▫Advantages – liquidity. ▫Mark to market: if the price of a futures contract

falls on a particular day, every buyer of the contract must pay money to the clearinghouse. Every seller of the contract receives money from the clearing house. This prevents defaults.


Futures v Forwards…• Futures are publicly traded on exchanges• Futures are traded in blocks. With forwards, its

easier to specify exactly the dollar amount that you want to trade.

• Futures contracts expire at specified times (on the 3rd Wednesday of the quarter - March, June, September, December - and not in between. So, if you are looking to hedge currency exposure till the middle of July, you might not choose to use futures contracts because the contract will expire in June, and would leave you naked (exposed) until July.

• To buy/ trade futures contracts, an individual calls their stockbroker, who will require a "margin account" to insure against losses.

• In forward contracts, the individual calls their bank, and makes a private deal with their banker. No collateral is required, but you must have a bank that trusts you, and is willing to make the deal


Futures v Forwards…• Futures are not traded in every currency. Look on

the Chicago Mercantile exchange to see what is traded. Usually its dollar, euro, yen, and other major currencies. To trade less common currencies, it is sometimes difficult to find futures contracts traded on exchanges. Instead, you will likely need to use a forward.

• The good thing about Futures is that they trade on a very liquid market (easy to net out your position and trade your contract with someone else).

• Futures prices are quoted in daily papers, and online

• There is a middle man, called a "clearing house" in futures contracts

• Futures are "marked to market" on a daily basis, which results in many cash flows (daily), rather than just one big cash flow at the end (like with forward contracts)


Forward with FX• Example: if a company is importing and knows that

they must pay the foreign supplier in foreign currency at a time of 30 days in the future, that company might be afraid of a currency change , which would result in them owing much more money (in their local currency). To mitigate this risk, the company might want to "lock-in" an exchange rate in the future...by using a "forward" exchange. To do this, the importing company would make a deal with their local bank to buy the foreign currency at a specific rate (in 30 days in the future). By agreeing to "sell dollars forward", and to "buy foreign currency forward", the importer has guaranteed that they will have the right amount of foreign currency on hand in the future (to pay the supplier), and they have eliminated the risk. This is like buying insurance against the risk of FX fluctuations.


Forward with FX

•How to buy a forward contract•you need a relationship with a bank•and they have to trust you (there is no

collateral in a forward contract)•unlike a Futures market contract which

you purchase with a stock broker using stock as collateral (margin account)

•


Homework (on the boat reading assignment)

•Read from Martin Wolf book:•Chapter 4 and Chapter 5

▫(should take you about 2 – 3 hours, perfect way to pass time on the boat!!!!)

•(you should have already read 1-3!!!)

Forum-NexusInternational Finance Class – Lecture #12- Greece Jan 19th 2010

Heading to Greece!!

Remember… Homework (on the boat reading assignment)

•Read from Martin Wolf book:•Chapter 4 and Chapter 5

▫(should take you about 2 – 3 hours, perfect way to pass time on the boat!!!!)

•(you should have already read 1-3!!!)

Key concepts– Martin Wolf Book “Fixing Global Finance”1. Series of crises

▫ Financial liberalization = age of crises2. Response to crises:

▫ NO current account deficits▫ “smoke but don’t inhale” of global finance▫ USA as “borrower of last resort”▫ “savings glut”, Flood of “cheap credit”

3. US unique position:▫ US is “in trouble”? No…▫ Reserve currency▫ Borrow in own currency▫ Can NOT face Solvency crisis

4. Fixing global finance:▫ Must borrow only in own currency▫ Need for local-currency bond markets

Next Assignment

•Everyone must read•“Legacy of the crisis” section of

▫Martin Wolf “Fixing Global Finance”▫p 55-57

•Next class (in Turkey) – turn in ½ page report

•1 person will be chosen to present to class…

Remember…Current Account:• Approx:

▫Exports – imports▫in a basic sense, its exports - imports....so, if its

negative, then you are importing more than exporting...and you need to finance that deficit.

• So, if you have more imports than exports▫Deficit▫Must be “financed” by “capital account”

• Globally, must balance▫If some countries run surplus, then others

must run deficits

Questions

• If you have a current account deficit, you must have a capital account (_______)?

•But, do foreigners HAVE to send you money? (do they need to buy US treasuries)?

•What happens if foreigners decide NOT to send you money? (what must happen to the current account)? When?

How do you cut a current account deficit?

You must… cut imports vs exports Or, boost exports vs. imports

▫ QUESTION: this sounds easy… but HOW does a country do this? (GROUP)….

Answer:

1. Local prices must come down relative to foreign prices

A. Wage cuts - slow, painfulB. Efficiency gains - slowC. Productivity gains - slowD. Currency devaluation – fast, painful (why,

for whom?)

Currency devaluation

FAST Makes imports more expensive Makes exports more competitive

Medium Term Over time…. Exports rise, imports fall…

current account goes back to balance

Why is it not immediate??

Time to adjust

•Supply chains•Factories fixed•Move location•Ramp-up local production•Change local buying patterns

•Example: If US currency crashed tomorrow, how long would it take for US to start producing all toys, furniture, etc (rather than importing from China)?

But, what if devaluation doesn’t solve the problem (not enough time to structurally change imports v exports)?

1. Question:

▫ Who can you turn to if your country faces situation outlined above (running a current account deficit, and if foreigners SUDDEN STOP supplying capital, but… you do not have enough reserves to pay the bill?)

▫ Who is there to “help”?

Call for help!

•IMF▫Lender of last resort▫The IMF (international monetary fund)

came into existence after WWII in what was called the Breton Woods agreements that created both the IMF and the World Bank.

IMF – “business model”• IMF as a "Bank" (not a "fund")

▫Its interesting that the IMF (international monetary fund) acts more like a bank, but the World Bank acts more like a fund.

▫Actually, the IMF acts more like a "credit union”...the 185 member countries put money in on deposit, and they receive interest payments back. The interest payments are small, because the IMF is seen as a high quality borrower (and there is a social cause behind the mission). The money borrowed then gets re-loaned out to countries in trouble.

IMF – “business model”

•The IMF receives its major inputs of funding from the member countries (quotas), but then sustains itself by making loans (investments). In a simplified sense, the IMF gets money from its members at very low interest rates, and then turns around and loans that money out to countries in trouble at higher interest rates (short term loans at higher rates).

IMF – “business model”

•Profits from Crisis?•In a strange way, the IMF is only

profitable when there is a period of economic uncertainty or turmoil. If there is not a crisis, then there is no one taking the loans, and the IMF can not call on the quotas from its members.

IMF – “conditionalities”

•The first thing is that a country will have to make guarantees to the IMF that they will make hard policy changes to fix the underlying structural problems that caused the crisis (to fix the imbalance in the current account, they may have to raise taxes, raise interest rates, and other drastic measures).

•Why is this controversial?

Unpopular… scapegoat

•Countries that are democracies are often reluctant to make the hard structural reforms that are necessary to fix their own internal balance of payments problems. Raising interest rates and taxes might help the governments books balance, but it would effectively slow down the economy and put people out of work.

“Conditionalities” – why?• You can think of the IMF as the tip of the

iceberg in international lending.

• They are the most visible part, but behind them there are government and commercial loans that makeup a bulk of the debt package to a developing country. IMF conditionalities and structural adjustment programs are necessary to give international confidence to the capital markets that a country is implementing the necessary structural changes that will ensure that future loans to the country will not be made in vain.

“Conditionalities” – why?•For example, without an IMF agreement, the

Paris club in international lending governments will not meet with a debtor nation to reschedule (reduce) the debt payments. Its only after a country has already made a deal with the IMF (and accepted their conditionalities) that the other lenders will agree to meet with the country to reschedule their debt. For this reason, the IMF loans are extremely important in that they send a signal (to the rest of the iceberg of international lenders).

Why is the IMF avoided “at all costs”?• IMF

▫Lender of last resort

Group assignment:▫But why is the IMF lending avoided at all

costs by borrowers? What were the lessons of the debt/ currency crises in SE Asia / Latin America?

▫Why are countries so reluctant to turn to the IMF for help?

Conditionalities - controversial• But it is these very same structural adjustment

programs (conditionalities) that make the IMF loans so controversial. From a mercantilist or structuralist perspective (of the borrowing countries), these conditionalities are seen as a weapon of the developed western nations to force the developing countries to conform to liberal economic policies (such as privatizations, lowering of trade barriers, deregulation of industries, floating exchange rates, increasing FDI, balancing budgets, removing price controls, and fighting corruption). These liberal goals are often called the “Washington Consensus

Conditionalities - controversial

•The mercantilists of the borrowing nations argue that the conditions dictated by the IMF limit their national sovereignty by placing external controls on how they are supposed to run their internal economy.

Conditionalities - controversial• One of the most controversial conditions of

the loans is that borrowing nations must cut back on government spending. These “austerity” measures are often blamed for the cutting of social programs that benefit the poor. For this reason, many blame the IMF for placing the needs of the rich over the needs of the poor. By requiring the borrowing nations must balance their budgets, the IMF is often blamed for the cut backs in social programs in these countries (such as education, public health, and other development projects for the poor).

Conditionalities - controversial• Another criticism of the IMF is that they often

recommend that a country should raise taxes and cut spending in order to balance their budgets. But economists of Keynesian school of thought argue that this is the exact opposite of what a country in recession needs. Keynes would argue that in order to jump start the economy, they actually need to do the opposite – cut taxes and increase government spending.

• The IMF is therefore often criticized for making an economic recession into a depression as increased taxes and decreased spending slows the economy and decreases the chances for a quick recovery.

IMF & Asian Crisis ‘97

•Key lessons…

•What do you think was learned?•Who was watching?•What has changed?

Forum-NexusInternational Finance Class – Lecture #13- Greece Jan 21st 2010

Welcome to Greece!!

Understanding Greek challenges• In a macro sense:• Facing 2 deficit challenges1. Current account deficits – remember line of trucks importing as we

exited the boat in Greece – importing more than exporting. So, by definition… capital account must be in surplus to pay for current account deficit. Importing capital.

Money came in not from foreigners investing in FDI (as was noted during speech with Metaxa this morning), but instead much $ came in from tourists. Tourism = importing capital (capital account surplus). But, remember what has to happen if the capital account switches from surplus to deficits? The current account must move from deficit to surplus. How? If currency can devalue (as they are apart of Euro zone)… then competitiveness must increase – either more efficient or lower wages… politically and socially painful process that could take YEARS!!

Understanding Greek challenges2. Budget deficits - remember national balance sheet – assets

(income) and liabilities (spending). For Greece, a bit part of income came from tourism, which dropped off significantly with the crisis. But, spending remained “too high”. Structural, difficult to bring down

Governments weak, short term thinking. Difficult to fix structural troubles with budget. Need to cut costs. But, strong unions, and impatient democratic voters. Politicians that try to raise taxes or cut spending (fire teachers) are thrown out

As opposed to governments in countries like Ireland that have made steps to address difficult structural troubles

Understanding Greek challenges• In a macro sense:• Facing 2 deficit challenges1.Current account deficits – remember line of trucks

importing as we exited the boat in Greece – importing more than exporting. So, by definition… capital account must be in surplus to pay for current account deficit. Importing capital.

2.Budget deficits - remember national balance sheet – assets (income) and liabilities (spending). For Greece, a bit part of income came from tourism, which dropped off significantly with the crisis. But, spending remained “too high”. Structural, difficult to bring down

What conditions did the IMF tie to its loans after SE Asian Crisis of ‘97-98?

Raise taxes Cut spending Goal of IMF: recipe to balance budget

why this was unpopular?

Unpopular: Higher taxes + lower government spending = drag on economy, slower growth

Lesson: avoid the IMF at all costs!!! Trouble….. Shift from collective insurance to self-insurance (accumulation of reserves)

Assignment

•Everyone was supposed to have read:•“Legacy of the crisis” section of

▫Martin Wolf “Fixing Global Finance”▫p 55-57

•Due TODAY– turn in ½ page report

•Discuss…


Legacy of the Crises (2 lessons)1. Danger in capital flows

▫avoid current account deficits▫ Result: countries try to run current account

surplus + capital account deficits (sending $ abroad)

Due to FEAR (of current account deficits) money flows from poor to rich

2. Avoid IMF▫Conditionalities unpopular

▫ How to avoid the IMF? ▫ Focus on self-insurance (build up own stock pile

of reserves) reserves


Legacy of the Crises - #1 (danger in capital flows)

•Goal: keep FX undervalued for:▫Avoid risk of devaluation in future (don’t

get caught with debts in foreign currency)▫Exports to increase▫Avoid Current account deficit (keep

imports low, exports high)▫Never have to call on the IMF!!!


Legacy of the Crises – part 1

•But, if “dollar bloc” ALL fight to keep currency LOW vs Dollar

▫See chart next page…


The “dollar bloc”• “currencies either pegged to the dollar or more or less

actively managed against it (a group that includes Japan)” Oil Exporters

Bahrain Oman Qatar Saudi Arabia UAE (Dubai included)

China Japan Russia Singapore Taiwan Malaysia Hong Kong Thailand India Others: Ecuador, Panama, more…. Used to be Argentina!

Sources: figure 6.6 from Wolf “Fixing Global Finance”And, Economist.com, May 23 2009, “Monetary Union in theGulf”

Legacy of the Crises – part 1

•And, if ALL are determined to run current account surpluses….

•Question:▫Who MUST run current account deficits

(remember, by definition SOMEONE must)!!


Legacy of the Crises – Part I

•Answer:• The ONLY country on the planet that was

willing and ABLE to run deficits (on a large scale) was the USA

• Question: ▫why can the USA run large current account

deficits without running the risk of a twin crisis (currency crisis + debt crisis)? ….

We will try to answer this question TODAY


Legacy of the Crises – part 2 (avoid the IMF at all costs)

•“The overall consequence of these policies has been gigantic accumulations of foreign-currency reserves”

•Remember…▫What are foreign-currency reserves?▫Why do they accumulate in a massive scale

since ‘97-’98 Asian Crisis?



•3 Important parts (for our class discussion):

Current account▫Flow of goods and services, Roughly=

exports - imports

Capital account▫Paying for the current account - Money flows▫Example: US government sells treasury bills

Reserves▫Foreign currency, gold, etc▫Used to finance gap between current &

capital accounts▫“below the line” Martin Wolf book, “Fixing Global Finance”

Must Balance!!

If deficit…

pay out reserves.

If surplus..

Build up reserves.

Foreign reserves = I.O.U’s (2008-09)

https://www.cia.gov/library/publications/the-world-factbook/rankorder/2188rank.html

Legacy of the Crises

•By March 2007:

Both Taiwan & South Korea held more reserves than the entire Eurozone!

▫When? Almost all between 2000-2007


Foreign reserves = I.O.U’s

•“Gigantic accumulations of foreign – currency reserves, which are also, by definition, huge official capital OUTFLOWS!”

•Who can explain this?


Foreign reserves = I.O.U’s• Important concept to understand…• Foreign currency reserves are NOT = a big

pile of money.• Instead, they are a big pile of I.O.U’s• Example:

▫China buys Treasury bills▫ = promise to pay in future (remember the

“pyramid of promises”?)▫China alone is sitting on a pile of $1 trillion +

I.O.U.’s▫Question: what is the risk (to China)?

Forum-NexusInternational Finance Class – Lecture

Welcome to Turkey!!

China – USA

▫Question: what is the risk (to China) with respect to their accumulation of foreign-currency reserves?

The two risks to China:

#1. If the US dollar were to Depreciate

#2. Secondary: If the US inflation were to rise

•Who can explain these two threats? (to China and to the USA)

2 threats:

#1. If the US dollar were to Depreciate

▫ How would this effect Chinese reserves? Remember: Think of China like a “bank”,

and the US like a “borrower” If a bank lends abroad to foreign borrower,

what happens if foreign currency devalues?

Group…

If a bank lends abroad to foreign borrower, what happens if foreign currency devalues?

Bank still gets back SAME amount of foreign currency, but…

Bank gets back LESS than they anticipated (in local currency terms)…

2nd threat : Inflation in USA

Question: who remembers my preferred definition of “inflation”?

Inflation

•How to think about it:▫(ok definition, but not useful)

A general rise in prices

▫(better definition) A decrease in the value of money in the

future … less purchasing power for $1 in future (than now)

QUESTION

•Group assignment:▫“why is inflation bad?”

(b) from a banks perspective?

Inflation: bad for banks• What if you were a bank and you loaned out

$10 mm USD to be paid back in 5 years. The borrower gets the money now, and pays back in the future.

▫Why is inflation bad for the bank? Remember: Inflation = decreased value of money

in future So, bank will be paid back in future with dollars

worth less

▫On the other hand why is this good for the borrower?

2nd threat (TO) China’s foreign-currency reserves : Inflation

Group:tell me…

why is US inflation a threat to China’s accumulation of US debt (Treasuries, etc)

2nd threat (TO) China’s foreign-currency reserves : Inflation

why is US inflation a threat to China’s accumulation of US debt (Treasuries, etc)

Answer:remember: inflation is = decrease in value of money in the future.

remember: US treasury purchases = China giving US $$ today in exchange for promise to pay in future.

But, inflation = threat that the $$ in future is worth less in real terms!

Think about this…

•Yes, China is the “banker”, and the US is the “borrower”, but…

▫“if you owe your bank a hundred pounds, you have a problem, but if you owe a million, it has”

John Maynard Keynes

▫“if you owe your bank a billion pounds, everybody has a problem”

The EconomistMartin Wolf book, “Fixing Global Finance”

But, that assumes… The assumption is that the US might

“default” on its debt...

Is that possible? Lets consider….

Think about this: “One trillion dollars is 7% of US GDP. And

we will be running trillion-dollar deficits for a very long time.”

“Buddy, Can You Spare $5 Trillion?”, John Mauldin, July 10, 2009

“Buddy, Can You Spare $5 Trillion?”, John Mauldin, July 10, 2009

That’s a lot of debt!

•So, I ask again:

The assumption is that the US might “default” on its debt...

Is that a risk??

No!

The US does NOT face a “solvency” crisis in the foreseeable future (due to excessive borrowing from abroad)

Who can explain this?

If devaluation of the US dollar…•“US…runs no danger of adverse currency

mis-matches.•In the US, “currency mismatches work in

exactly the opposite direction; the country has assets denominated in foreign currency and liabilities denominated in domestic currency”

•“The more unwilling the rest of the world is to hold the dollar, the more solvent the US becomes”


If the US Balance Sheet: (just looking at

external financing)

• Assets

▫Foreign currency

Investment abroad FDI Portfolio Earning foreign

currency

•Liabilities

▫Local currency

Foreign gov’t buy US Treasuries is US dollars!

So, what happens if US dollar “depreciates”?

(does US become more, or less “Solvent”?)

Solvency v Liquidity

•Insolvent: liabilities > assets (equity = 0)▫Person: I owe more than Im worth▫Bank: assets loose value (subprime

mortgages)▫Country: cant pay debts…default

So, what happens if US dollar “depreciates”?

(does US become more, or less “Solvent”?)

If devaluation of the US dollar…•“US liabilities that are denominated in

currency units are measured in the countries own currency”

•“if it wishes to improve its balance sheet position (and so its solvency), all the US needs to do is allow the value of the dollar to fall against other currencies”


US Balance Sheet: with Depreciation of US currency•Assets

▫Foreign currency Investment abroad FDI Portfolio Earning foreign

currency

•Liabilities

▫Local currency Foreign gov’t

buy US Treasuries is US dollars!

If US dollar DEPRECIATES… US becomes MORE solvent!

Threat to China -

•If the US were to devalue its currency…

•“are an elegant, painless, and entirely legal way for the US to default” (without actually defaulting)


Exorbitant privilege

“exorbitant”:•Back in 1965, Valery

Giscard d’Estaing, then French finance minister, described the ability of the US to borrow cheaply and without limit in its own currency as an “exorbitant privilege”

Real threat to the USA•Might loose “exorbitant privilege”

•“You Don’t know how luck you are, babe”

▫Able to borrow (seemingly) unlimited ▫In own currency▫At a very low rate

▫(and invest abroad at higher returns, and run NO risk of insolvency!)

Imagine a world where…

•The US were to try and pay for▫Obama stimulus▫Economic recovery▫Future Social Security / Health care

reforms

▫Without external financing (at low rates, in own currency)

▫Ouch!!

Demographics & the Debt

By 2050; a third of the rich world’s population will be over 60

“The demographic bill is likely to be (10x) ten times bigger than the fiscal cost of the financial crisis.”

The Economist, June 2009

Question:

•From the US perspective:

▫Other than currency devaluation, what is the other way in which they could legally diminish their debts?

Answer:

•Inflation

Inflation▫“A decrease in the value of money in the

future … less purchasing power for $1 in future (than now)”

▫Bad for a bank (in this case, China): they will be paid back in future with dollars worth less

Inflation

remember:

▫ US treasury purchases = China giving US $$ today in exchange for promise to pay in future.

But, inflation = threat that the $$ in future is worth less in real terms!

Risks to US

•In reality, the US does NOT want to follow either of these paths (inflation, currency devaluation)

•Why?

•Group answer:

Risks to US

•Note:

▫If foreigners fear the threat of inflation / devaluation… they would:

Demand higher % Compensate for RISK

This would add COST to US borrowing in the future (remember the ticking demographic bomb?)

Lesson: don’t push China

•Yes, reforms are needed, but…

•$2 trillion in “risky” loans to US = politically difficult problem for Chinese government

•Especially with unemployment ticking upward due to the “US-caused” global economic crisis!

Sovereign Wealth funds• Search for “better” returns (than 1-3% on US

Treasuries)

• Reach for yield

• Bad investments in US banks (lost lots of $$ at beginning of crisis ‘07-‘09)

• Politically unpopular

• Pressure on China domestically (doesn’t help to also have US pressure on them internationally!)

Challenge for China• Unemployment = key issue

• Some 20 million + unemployed since crisis began

• Can not afford to appreciate currency, and lose international competitiveness of production

• Result: government stimulus = more capacity, more production…. ▫But, fear ?

Fixing Global Finance

Key:

Develop local – currency debt markets for emerging markets

Don’t borrow in foreign currencies!

Fixing Global Finance1. Limits to export-oriented growth

▫ What worked for JPN, South Korea, might not work for China / India

2. Develop local financial markets▫ Develop local – currency debt markets for

emerging markets▫ Don’t borrow in foreign currencies!

3. Reform global institutions▫ IMF – pooled insurance vs self insurance▫ Additional resources / bite.

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