B416 The Evolution Of Global Economies Lecture 8 Political & Economical Environment + Exchange Rate...

B416: The Evolution of Global Economies

Lecture 8 : Political & Economical

Environment + Exchange Rate Regimes

Learning Outcomes

By the end of this lecture, you should understand the following:

• To discuss the philosophy and practices of the political environment

• To profile trends in contemporary political systems

• To explain the idea of political risk and approaches to managing it

• To discusses the institutions of exchange rate regimes. • To understand the differences between these regimes we

explain the policy trilemma. • An overview of the different exchange rate regimes since

the second half of the 19th century. • An overview of the money organizations that coordinate

international monetary policy. 2

3

IntroductionPolitical and Legal Factors Influencing International Business Operations

• Every country has its own political and legal environment • Companies must determine where, when, and how to adjust their business practices

without undermining the basis for success

4

Spectrum AnalysisThe Political Spectrum

5

The Standard of FreedomMap of Political Freedom, 2010

6

Democracy: Recession and RetreatFreedom in the World: Number of Electoral Democracies

7

Democracy: Recession and RetreatFreedom in the World: Gains and Declines

Economic Transition

• Economic transition, for example for Central and Eastern European countries is a multi-dimensional trajectory

• The slides below focus on only two dimensions:

– Degree of state ownership (none – total)

– Degree of market intervention (none – total)

Sta

te o

wner

ship

Market interventionnone

none

total

tota

l

USA: public

spending is

30% of

GDP;

North Korea,

Cuba: also

there private

production &

incentives.capitalism

communism

USA

N.Korea

Cuba

Extremes fit

no country:

Economic Transition

Sta

te o

wner

ship


none

total

tota

l

A country in

transition is

changing the

mix of state

ownership/

market

intervention

in the

medium run.

Many

different

paths are

possible.capitalism

communism

USA

N. Korea

Cuba

Welfare state

capitalism

Market

socialism?

Economic Transition

Sta

te o

wner

ship


none

total

tota

l Privatisation

is one-

dimensional,

while

transition

has more

dimensions.

capitalism

communism

USA

N. Korea

Cuba

Welfare state

capitalism

Market

socialism?

pri

vat

isat

ion

Economic Transition

Economic Transition

• Transition involves a series of steps at the institutional, micro-economic and macroeconomic level

• Adjustments require reallocation of capital, services and labor between sectors of the economy

• Initial phase of decline in production is to be expected• Two strategies of reform

– big bang approach: achieves necessary steps of transition in a short period of time, leads to large initial declines of production (Poland is the prime example)

– gradual approach: tries to systematically sequence the steps to be taken and to minimize transition pain and output loss (successor states of the former Soviet Union).

GDP per capita, PPP (constant 2005 international $)index, 1990 = 100

0

50

100

150

200

1990 1995 2000 2005 2010

Poland

Russi

a

Slovaki

a

Romani

a Ukraine

Economic Transition; big bang vs gradualism

Policy trilemma summarized

fixed exchange rate

fixed exchange rate

fixed exchange rate

capital mobility

capital mobility

capital mobility

policy independence

policy independence

policy independence

fixed exchange rate

fixed exchange rate

fixed exchange rate

capital mobility

capital mobility

capital mobility

policy independence

policy independence

policy independence

International monetary regimes

• Policy makers must thus compromise when choosing a monetary regime. Their choices have changed over time.

• The main international monetary regimes are:

now1870 1914 1945 1971

Gold Standard

fixed exchange rate

regime, currencies

pegged to gold,

global capital market

(London)

World Wars and

Recession

gold standard

broken, beggar-

thy-neighbour,

capital controls

Bretton Woods

fixed exchange

rates (pegged

to dollar - to

gold), initial

capital controls

Floating Rates

managed

floating and

some pegging,

capital market

liberalization

Gold Standard (±1870 – 1914)• Over time many countries valued their currencies in

terms of gold; this established a fixed exchange rate between the currencies.

• As gold could be freely imported and exported, countries did not have independence of monetary policy.

• The system worked well but had a number of drawbacks:

Inflation determined by random discoveries of gold

Danger of deflation and unemployment

Countries with large gold supplies can influence the world economy

Restrictions on monetary policy

• The system collapsed at the start of World War I when countries had to finance the war effort.

World wars and recession (1914 - 1945)• After the World War I countries concentrated on

restoring their national economies. These efforts were exacerbated by the great depression.

• Countries were no longer willing to give up their policy autonomy. Hence, they instituted capital controls and/or gave up the fixed exchange rate.

• The focus on domestic policy goals was ultimately detrimental to the economy. Competitive beggar-thy-neighbour devaluations caused the international trade system to collapse and put millions of people out of a job.

Bretton Woods (1945 - 1971)• The experience between the world wars taught policy makers

the benefits of an orderly international economic system. They devised a new system (Bretton Woods) in which the US dollar was the international reserve currency. Other countries fixed the exchange rate to the US dollar, which in turn was fixed to gold.

• At the start of the Bretton Woods system capital flows were still highly restricted. Later on most countries gave up on their policy independence.

• In every fixed exchange rate regime there is one degree of monetary freedom (the n-1 problem). In the Bretton Woods system the US could determine its own monetary policy.

• The system collapsed in the 1970s because a monetary expansion in the US caused “too much” inflation.

Floating rates (1971 - now)• At this moment many countries let the value of their currency be

determined by market forces.

• There are, however, still large differences between countries:

De facto exchange rate regimes; # of countries, April 2010

0 5 10 15 20 25 30 35 40 45

No separate legal tender

Currency board

Conventional peg

Stabilized arrangement

Crawling peg

Crawl-like arrangement

Pegged rate with band

Other managed arrangement

Floating

Free floating

Ecuador

Hong Kong

Venezuela, Niger, Morocco, Cameroon

China, Bangladesh

Nicaragua

Ethiopia

Belarus

Russia, Singapore, Egypt

Indonesia, India, Pakistan, Philippines

Australia, UK, USA, Eurozone

International Monetary Fund (IMF)• The IMF was established in 1946 with a fourfold objective:

The balanced expansion of world trade

Stability of exchange rates

Avoidance of competitive devaluations

Orderly correction of balance of payment problems

• To perform its tasks the IMF employs three main functions:

Surveillance: The IMF gives annual policy advice to its members

Technical assistance: Give members training and assistance for fiscal and monetary policies

Financial assistance: Conditional on the implementation of a policy program, countries with balance of payments problems may get financial support.

International Monetary Fund (IMF)Decisions within the IMF are taken according to a weighted-voting system, equiproportional to the quota the country pays (in Special Drawing Rights or major currencies).

IMF voting power (% of total), before and after reforms

0 2 4 6 8 10 12 14 16 18

Venezuela

S Korea

Brazil

Spain

Mexico

Australia

Switzerland

India

Belgium

Netherlands

Russia

Canada

Saudi Arabia

Italy

China

France

UK

Germany

Japan

USA

2-Mar-11

pre-Singapore

(+25%)

(+20%)

(+75%)

World Bank

• The World Bank, also established after WW II, has as its main objective to fight poverty.

• The World Bank consists of five institutions:International Bank for Reconstruction and

Development (IBRD)International Development Association (IDA)International Finance Corporation (IFC)Multilateral Investment Guarentee Agency (MIGA)International Centre for Settlement of Investment

Disputes (ICSID)• Decisions of the World Bank are also taken by

weighted votes

Criticism on IMF and World Bank

• Recently the IMF and World Bank have been criticised for depending too much on competition and market forces and being political tools of Western governments.

• In response the World Bank has switched from macro to micro policies, e.g. investing in clean water and education. Keep in mind that fighting poverty is extremely difficult and mistakes are easily made by all participants.

• The IMF has greatly increased its transparency in response to its critics. It is also too easy to blame the IMF for a country’s financial troubles – remember that the IMF enters the stage usually after financial troubles emerge.

Bank of International Settlements (BIS)

• The BIS is the bank of the Central Banks. Its tasks have changed regularly over time:

Settle punitive payments of Germany (1930s)

Implementing the Bretton Woods system (1945 – 71)

Managing cross border capital flow (1970s and 80s)

Regulatory supervision (Basel Capital Accord)

• The BIS also performs regular banking functions, such as foreign exchange and gold transactions, and trustee and agency functions.

Concluding remarks on Exchange Rate Regimes

• According to the Marshall-Lerner condition, a depreciation of the domestic currency will improve the current account balance

• Policy makers may have three different objectives:

– 1. monetary policy independence,

– 2. a fixed exchange rate and

– 3. international capital mobility.

• The policy trilemma indicates that only two of these objectives can be reached at the same time.

• Over time policy makers made different choices. The

– Gold Standard - gave up on objective 1

– Recession period - gave up on objectives 2 or 3

– Bretton Woods era - gave up on objectives 1 or 3

– floating rates era - gave up on objective 2

• The most important International Money Organizations are the IMF, the World Bank, and the BIS

And Now…Work Outside the Lecture

Preparation

For

Padagogic

Style

Preparation

Time Budget

Individual

TaskGroup Task Output Week 8 Preparation Activity

Read Chapters 1, 6, 11, 13 & 15 from Core Text

Book: The Age of the Economist

Read Chapter 3, 4 & 10 International Business -

14th Edition by Daniels, Radebaugh &

Sullivan, (available via DawsonEra)

Seminar 8 30 Minutes Read above Material + Seminar material

Workshop 8 1 HourOnline Collaboration Activities relating Final

Assignment

2 HourLecture 8

B416 The Evolution Of Global Economies Lecture 8 Political & Economical Environment + Exchange Rate...

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