Part 5 and 6 paris finance class summer 2010 forum nexus

Classes #4 + #5Paris

Brian David ButlerProfessor of international finance and global entrepreneurship with Forum-Nexus Study Abroad. Guest lecturer with the IQS Business School of the Ramon Llull University in Barcelona, and the Catholic University of Milan. Previously, Brian taught finance, economics and global trade courses at Thunderbird’s Global MBA program in Miami, and worked as a research analyst with the Columbia Business School in New York City. Brian currently lives in Recife, Brazil where he is teaching classes at the university Faculdade Boa Viagem.

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

[email protected]

LinkedIn/briandbutler

Skype: briandbutler

Brian 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.

http://globotrends.pbworks.com/ , http://blog.globotrends.com/

Find my slides:

www.slideshare.net/briandbutler

Lecture Schedule*

* Does not include professional visits, *Subject to change, modification without warning

•Tues 22th – boat to Greece

•Mon 26th – Athens

•Tues 27th – Rhodes•Wed 28th – Rhodes•Thurs 29th – Rhodes EXAM

Observations of France / Euro… ?

•volunteers - tell one thing about French economy (or about the Euro, Greece, etc) they noticed so far + class discuss

•Note: observations should come from reading (wall street journal, etc)… any other sources?

Team Project

Who are your team members?

•Today, after class… give me your list of team members:

•3-4 per group•Separate groups for :

▫Grad students / undergrad▫4 week students (through Rhodes), 3 week

students (leaving after Milan)

Team Project• This team project is designed to provide students

with the opportunity to review the benefits and drawbacks for countries in the Euro zone, and to evaluate the threats and challenges facing the Euro in the near future as a result of the global economic crisis / fiscal debt crisis now facing the European Union. Teams will be made up of 3-4 students each.

• Due date: last class before Final Exam▫ 3 week – Tues July 20th ▫ 4 week – Wed July 28th

Team Project• I. Country Selection• ALL Students are required to include in their analysis:

▫ the UK; ▫ at least one country from the Forum-Nexus trip (Spain,

France, Italy or Greece); ▫ at least one of the 'East-central' European states: Czech

Republic, Hungary, Poland, Slovakia, Slovenia);

Grad Students must also include:▫ AND at least one of the Balkans: (Albania, Bosnia and

Herzegovina, Bulgaria ,Croatia, Macedonia, Montenegro, Romania, Serbia)

▫ AND at least one of the Baltic States: (Estonia, Latvia, Lithuania),

Team Project - II. Analysis• An in-depth analysis will be completed, looking at the Euro zone

countries. Students must include in their report:▫ During a crisis: What are the benefits /drawbacks to countries

for being inside / outside of the Euro-zone? (You need to relate this discussion relate to our class lectures on 'fixed vs. flexible exchange rates)

▫ Students must highlight the risks of borrowing abroad, and relate this discussion to class lectures on this topic.

▫ Make recommendations for how they think the fiscal crisis in Europe should be handled, as well as predictions for the long-term sustainability of the currency union (will the Euro survive?).

▫ For extra credit, students will be asked to Compare and contrast the experience of 'Ireland vs. Iceland' during the global economic crisis (with relation to 'fixed, flexible exchange rates', and to 'borrowing in foreign currencies'

Team Project - III. Recommendations & Predictions for future• Graduate Students:

▫ The project report should be between 8 and 11 pages long (Font: Arial, 12; Line Spacing: 1.5).

• Undergrad:▫ The project report should be between 6 and 8 pages long

(Font: Arial, 12; Line Spacing: 1.5).

How to turn in:- either (hand written, neatly!) or computer, email:

Resources:1. Lectures2. Text Book: “An Introduction to Global Financial Markets”

(Valdez), chapter 11, “European Economic and Monetary Union” 2007, (suggested focus: p. 287-305). Pay special attention to “EMU – the benefits” – p 287, and “The counter arguments” – p289

3. Handout article: “Holding Together, A special report on the euro area”, from the Economist, June 13th 2009 (p 1-16)

*Grad Students only:▫ Read handout: “Country Forecast, Economies in Transition,

Eastern Europe”, from EIU, May 2009 (p. 5-10)

Group Project, “The Euro Zone – before, during and after the Global Economic Crisis”

Grading:• 30% of final grade for course• comparative (one team compared to others)

• there is no “right answer”, but grading will be based upon:

▫ Cover all required topics▫ Answer the questions asked▫ Additional insights▫ Strength of arguments (pro / con)▫ Depth of analysis▫ Be concise! ▫ Ability to capture “heart” of issue

Group Project, “The Euro Zone – before, during and after the Global Economic Crisis”

Who are your team members?

•Today, after class… give me your list of team members:

•3-4 per group•Separate groups for :

▫Grad students / undergrad▫4 week students (through Rhodes), 3 week

students (leaving after Milan)

Euro vs EU

European Union & Eurozone

http://en.wikipedia.org/wiki/Eurozone

Group assignment Questions:

1. Which has a bigger population – the US or EU?

2. Which is a bigger economy? (US / EU)?3. Of the EU… what % is the Eurozone

economy?


By population:•EU is approx 50% bigger by population than the USA•Eurozone approx same size (slightly larger) – on much smaller LAND! -- more concentrated population

By economy:•EU and US approx same size (EU slightly larger)• Eurozone approx 75% economy of EU

Question:

•If the US and EU have approximately the same size economy, but the EU has approx 50% more people… what does that tell you?

•Why is it like this? What part of the EU accounts for the difference?

•Which regions of the EU are the richest?

EU + the Eurozone

what do you notice? What stands out?


Which country is this?

16 Eurozone members:AustriaBelgiumFinlandFranceGermanyGreeceIrelandItalyLuxembourgNetherlandsPortugalSlovakiaSloveniaSpain+ 2 islands: Malta and Cyprus

Question: which BIG countries are NOT on this LIST? Hint: look at map…

16 Eurozone members:

Not (yet) EurozoneAll member states of the EU, except for Denmark, the United Kingdom (and perhaps Sweden) are obliged to adopt the euro as their sole currency when they meet the criteria.

Estonia will join the eurozone on 1 January 2011.[2]

http://en.wikipedia.org/wiki/Enlargement_of_the_eurozone

Requirements to join

• two years in the European Exchange Rate Mechanism (ERM II) -- which fixes the acceding country's national currency's exchange rate to the euro, within a specified band (normally ±15%).

•and keeping inflation inline with the EU average.

•EU’s ceilings of ▫3 per cent budget deficit / gross domestic

product▫and 60 per cent debt / GDP



Who might be next?ERM II members

▫ Estonia▫ Lithuania▫ Latvia▫ Denmark

Obliged to join ▫ Bulgaria▫ Romania▫ Czech Republic▫ Hungary▫ Poland▫ Sweden (ERM loophole, referendum)

Not obliged to join ▫ United Kingdom▫ Denmark


Estonia will join the eurozone on 1 January 2011.[2]

•Pegged / Floating…

http://en.wikipedia.org/wiki/Enlargehttp://en.wikipedia.org/wiki/International_status_and_usage_of_the_euroment_of_the_eurozone

Pegged (“fixed”) to the EURO

Free floating EU members – the rest•The BIG 2 -- Poland and the Czech

Republic:•Benefit during crisis:

▫“Poland’s real effective exchange rate, allowing for differences in unit labour costs, fell by almost 20 per cent between 2008 and 2009. That speedy boost to competitiveness helped it to become the only European Union state to evade recession last year

▫Who can explain this?http://www.ft.com/cms/s/0/54fdc05e-6692-11df-aeb1-00144feab49a.html

IMF Lending in Europe

http://www.imf.org/external/region/eur/map/index.htm

(from North to South)•Latvia: $2.35b Dec 23, 2008•Belarus: $2.46b Jan 12, 2009•Poland* $20.58b May 6, 2009•Ukraine: $16.4b Nov 5, 2008•Hungary: $15.7b Nov 6, 2008•Romania: $17.1b May 4, 2009•Bosnia + Herzegovina $1.57b 2009•Serbia: $4b, May 15, 2009•Greece* 2010 $145 b, May 2010

Others:•Turkey 2009•Iceland 2007

Observe…

•Look at the 2 maps… what do you see ?•Similar countries OUTSIDE EURO + those

that needed IMF help during credit crisis (2007-)

•Coincidence? Causality?

• Is there a benefit to being inside? This is the theme of your Group Project for the semester

http://www.ft.com/cms/s/0/54fdc05e-6692-11df-aeb1-00144feab49a.html

Pegged outside really hurt…

•The adjustment by the Baltic states of Lithuania, Latvia and Estonia – not in the eurozone but with currencies pegged to the euro – has been even more painful. Latvia’s economy shrank, peak to trough, by almost a quarter.


Free floating EU members

•countries with free-floating currencies, such as Poland and the Czech Republic:

•Benefit during crisis:▫“Poland’s real effective exchange rate,

allowing for differences in unit labour costs, fell by almost 20 per cent between 2008 and 2009. That speedy boost to competitiveness helped it to become the only European Union state to evade recession last year


Danger for those that borrowed in Euros…

•“Many aspiring euro entrants – including countries not yet inside the EU such as Croatia – already have high levels of euro borrowing and partly euro-ised economies.


…(on the other hand)

•Speed benefit:▫As Greece’s debt problems grew, EU

members took months to respond and overcome opposition to involving the International Monetary Fund.

▫Eastern countries outside the euro, such as Latvia, Hungary and Romania, were able quickly to agree IMF support programmes when they ran into financing difficulties.


…(on the other hand)

•Devaluation benefit:▫countries with free-floating currencies, such

as Poland and the Czech Republic, showed the benefits.

▫Poland’s real effective exchange rate, allowing for differences in unit labour costs, fell by almost 20 per cent between 2008 and 2009. That speedy boost to competitiveness helped it to become the only European Union state to evade recession last year


Review…

Who can tell me… what is the difference between a liquidity crisis, and a solvency crisis for banks?

Competitive Devaluations

Dr. Kishore Dash, January 20, 2007

“Beggar thy neighbor”

Last class we talked about “competitive devaluations”… what did we mean? When was this a problem? What is the danger?

http://mohammedfikri.files.wordpress.com/2010/02/bretton_woods_sign.jpg

Who can tell me what happened at Bretton Woods ? Did the financial world become more or less stable afterward? When did it fail? Why?

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

?????

FIXED system…

KEY QUESTION:

▫Under a fixed system, how do you increase exports?

▫….Group answer

Mundell Trilemma

Decisions countries must make…

Who can tell me: what is the “Mundell Trilemma”? What are the 3 factors a country wants? Why?

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:

Who can tell me: Example – USAWhy does the US want all three? Which 2 did they choose? (now vs. past)

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)

Who can tell me: Example – USAWhy does the US want all three? Which 2 did they choose? (now vs. past)

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)

Who can tell me: Example – Spain or France:Why does Spain want all three? Which 2 did they choose? (now vs. past)

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?

GROUP ASSIGNMENT

•Write down:

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

China + Mundell Trilemma

•China:

▫Which 2 of 3 that they have selected. Who can guess? Why did they choose these 2? (and not the 3rd)?

▫Hint: peg with dollar

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

Review:

•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? (this will be on the exam)

Controlling the economy

2 tools – monetary + fiscal policy

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)

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

Monetary policy – to speed up economy (lower interest rates, print money)

http://www.daily-bourse.fr/images/analyses/2009/03/30/Cartoon%20Emergency.gif

Monetary policy

•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)

Inflation: effect on life savings

•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”?

Deflation

http://www.marketfolly.com/2009/06/commodity-inflation-versus-asset.html

Deflation

http://futureproofkilkenny.org/?page_id=907

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 2009-10

Review• 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)

Series of Crises

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)

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?


http://thebodegablog.files.wordpress.com/2009/12/asean-map.gif


• 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!!”

Martin Wolf book, “Fixing Global Finance”

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 -

Money Flows….

•Question: do you think money should flow from

▫A, Rich countries to Poor ones?

▫B, From Poor countries to Rich ones?

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)

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Part 5 and 6 paris finance class summer 2010 forum nexus

Education