Ed5 02 World Trade and the International Monetary System(2)

Multinational Finance

Chapter 2World Trade and the International Monetary SystemLearning objectives

Integration of the worlds markets for goods, services, and financial instruments

Balance-of-payments statistics

Exchange rate systemsFixed versus floating, and everything in between

Recent history of international exchange ratesRecent currency crisesThe evolving role of the IMFButler / Multinational FinanceChapter 2 World Trade and the International Monetary System2-#

Chapter 2 describes the worlds markets for trade in goods, services, and financial instruments, emphasizing the international monetary system within which exchange rates are determined.

Chapter 2 Topics:2.1 Integration of the Worlds Marketsdiscusses the influence of regional trade pacts such as NAFTA, the European Union, ASEAN, and Mercosur.2.2 Balance-of-Payments Statisticsdiscusses the International Balance-of-Payments statistics maintained by the IMF.2.3 Exchange Rate Systemsdescribes exchange rate systems (fixed versus floating).2.4 A Brief History of the International Monetary Systemdescribes the international monetary system, including:The modern history of the international monetary systemCurrency crisesThe evolving role of the IMF in currency crisesIntegration of global markets for goods and services

Global trend toward free-market economies; particularly the industrialization of the Pacific Rim

1991 breakup of the Soviet Union; the reunification of Germany; and the migration of central and eastern European countries toward the European Union

1995 creation of the World Trade Organization (WTO)

Chinas emergence in international markets, Hong Kongs 1997 return to China, and Chinas 2001 entry into the WTO

1999 creation of the euro and its adoption by an expanding set of European countries Integration of the worlds marketsBalance-of-payments statisticsExchange rate systemsRecent history of international exchange ratesRecent market events U.S. merchandise tradeIntegration of financial marketsThe Bretton Woods Agreement Butler / Multinational FinanceChapter 2 World Trade and the International Monetary System2-#

The largest regional trade pacts are:

North American Free Trade Agreement (NAFTA): Canada, Mexico, US.

European Union (EU): The EU has 27 members, with 13 Eurozone members (as of 2007): Austria, Belgium, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg, Netherlands, Portugal, Slovenia, and Spain. Cyprus and Malta are scheduled to join the Eurozone in 2008.

Asia-Pacific Economic Cooperation Pact (APEC): Japan, Korea, China, others.

Assoc. of South-East Asian Nations (ASEAN): Singapore, Brunei, Malaysia, Thailand, Philippines, Indonesia, Vietnam, Burma, Laos, and Cambodia.

Mercosur: Argentina, Brazil, Paraguay, Uruguay; Bolivia and Chile are associate members, and Venezuela is in the process of joining.

Commonwealth of Independent States (CIS): Armenia, Azerbaijan, Belarus, Georgia, Kazakhstan, Kyrgyz Republic, Republic of Moldova, Russian Federation, Tajikistan, Turkmenistan, Ukraine, and Uzbekistan.

OPEC is a trade pact based on the petroleum industry:

Organization of Petroleum Exporting Countries (OPEC): Algeria, Indonesia, Iran, Iraq, Kuwait, Libya, Nigeria, Qatar, Saudi Arabia, United Arab Emirates, and Venezuela.Trade deficitExportsImportsU.S. Merchandise Trade ($ billions) Integration of the worlds marketsBalance-of-payments statisticsExchange rate systemsRecent history of international exchange ratesRecent market eventsU.S. merchandise trade Integration of financial marketsThe Bretton Woods Agreement

Butler / Multinational FinanceChapter 2 World Trade and the International Monetary System2-#

This figure (Figure 2.2 from the text) plots U.S. merchandise trade (imports and exports of goods) over the period 19722006.

The trade deficit is related to exchange rates, as a strong domestic currency leads to more imports, fewer exports, and a bigger trade deficit.

Integration of financial markets

An increase in cross-border financing

Increasingly interdependent national financial markets, including cooperative linkages among securities exchanges

An increasing number of cross-border mergers, acquisitions, and joint ventures Integration of the worlds marketsBalance-of-payments statisticsExchange rate systemsRecent history of international exchange ratesRecent market eventsU.S. merchandise tradeIntegration of financial markets The Bretton Woods Agreement Butler / Multinational FinanceChapter 2 World Trade and the International Monetary System2-#

The gradual erosion of international capital flow barriers has had several consequences:

An increase in cross-border financing as MNCs raise capital in whichever market and in whatever currency offers the most attractive ratesIncreasingly interdependent national financial marketsAn increasing number of cross-border partnerships, including many international mergers, acquisitions, and joint venturesAn increasing number of cooperative linkages among securities exchanges

Globalization: Global integration in markets for goods, services, and capital is having an enormous effect on individuals, businesses, and governments. The Bretton Woods Agreement

World Bank - which now includesInternational Bank for Reconstruction and DevelopmentInternational Development AssociationInternational Finance CorporationMultilateral Investment Guarantee AgencyIntl Centre for Settlement of Investment Disputes

International Monetary Fund (IMF)Responsible for ensuring the stability of the international financial systemCompiles balance-of-payments statisticsRecent market eventsU.S. merchandise tradeIntegration of financial marketsThe Bretton Woods Agreement Integration of the worlds marketsBalance-of-payments statisticsExchange rate systemsRecent history of international exchange ratesButler / Multinational FinanceChapter 2 World Trade and the International Monetary System2-#

The Bretton Woods Conference created the World Bank (formally, the International Bank for Reconstruction and Development)

The World Bank Group (www.worldbank.org) now includes:

International Bank for Reconstruction and Development (IBRD)Promotes development in poor-but-creditworthy countries through loans, guarantees, and advisory servicesInternational Development Association (IDA) Provides zero-interest loans or credits to the poorest countriesInternational Finance Corporation (IFC) Promotes private sector investment in developing countriesMultilateral Investment Guarantee Agency (MIGA) Promotes investment in developing countries by offering political risk insurance to investors and lendersInternational Centre for Settlement of Investment Disputes (ICSID) Facilitates the settlement of investment disputes between governments and foreign investorsThe U.S. Balance of Payments20002010

Goods: Exports 7721293Goods: Imports -1224-1937 Trade Balance-452-644

Services: Credit292541Services: Debit-219-393 Balance on Goods & Services-379-496

Income: Credit353662Income: Debit-331-499 Balance on Goods, Servs, & Income -357-333

Current transfers: Net-53-137 Current Account-410-470

Source: IMF (www.imf.org).Integration of the worlds markets Balance-of-payments statisticsExchange rate systemsRecent history of international exchange ratesThe U.S. balance of payments Trade balances in OECD countries


This is a part of Figure 2.3 from the text.

The trade balance measures whether a particular country is a net importer or exporter of goods

A trade surplus (trade deficit) indicates that residents are exporting more (less) than they are importingTrade surpluses are desirable because higher exports translate into higher employment in the domestic economy

The current account is a broader measure of import-export activity that includes:

Trade balance on goods Trade balance on servicesOther transfers (royalties, travel and tourism, employee compensation, individual investment and interest income, etc.)The U.S. balance of payments20002010

Capital account: Net10

Direct Investment Abroad-178-346Direct Invest from Abroad 308194Portfolio Investment Assets-278-144Portfolio Invest Liabilities552757Other Investment Assets-150-533Other Investment Liabilities156293

Financial Account409237

Net Errors and Omissions0235

Source: IMF(www.imf.org).Integration of the worlds markets Balance-of-payments statisticsExchange rate systemsRecent history of international exchange ratesThe U.S. balance of payments Trade balances in OECD countries


The financial account covers cross-border transactions associated with changes in ownership of financial assets and liabilities.

Direct Investment Equity capitalReinvested earningsIntercompany transactions between affiliated enterprises

Portfolio Investment Long-term debt and equity securitiesMoney market instrumentsDerivatives instruments

Other Investment Foreign currency transactionsBank deposits and loansTrade credits

The financial account is the net of these direct, portfolio, and other investment transactions. Balance of trade (2011 PPP estimates from www.cia.gov)

GDP inGDP perTrade surplus perbillionscapitaGDPcapitaGermany$3,085 $37,900 6.6%$2,506 Australia$918 $40,800 3.2%$1,320 Korea$1,554 $31,700 2.2%$685 China$11,300 $8,400 2.1%$173 Brazil$2,284 $11,600 1.4%$158 Japan$4,389 $34,300 0.1%$48 India$4,463 $3,700 -3.4%-$127Canada$1,389 $40,300 -0.6%-$261U.K.$2,250 $35,900 -7.1%-$2,545U.S.$15,040 $48,100 -5.3%-$2,568Greece$306 $27,600 -12.8%-$3,536Integration of the worlds markets Balance-of-payments statisticsExchange rate systemsRecent history of international exchange ratesThe U.S. balance of paymentsTrade balances in OECD countries


This is similar to Figure 2.4 in the text, but uses 2011 estimates rather than 2010 data.

In this figure, national GDP is translated at PPP (purchasing power parity) exchange rates rather than at actual exchange rates.

The figure is sorted on trade deficit per capita.Germany had an estimated 2011 trade surplus of $2,506 for every working-age man or woman in the country. Greece had an estimated 2011 trade deficit of $3,536 for every working-age man or woman in the country. Exchange rate systems

Pegged or fixed exchange rate systems

Forges a direct link between inflation differentials and employment levels

Can result in large adjustments

Floating exchange rate systems

Allows exchange rates to adjust for inflation differences

Allows employment levels and wages to equalize through the exchange rate mechanismIntegration of the worlds marketsBalance-of-payments statistics Exchange rate systemsRecent history of international exchange ratesPegged vs floating exchange rate systems Major events in forex historyThe EU and the Eurozone


Fixed and floating exchange rate systems are endpoints on a continuum of flexibility.

In pegged or fixed systems, governments maintain currency values at official exchange rates. If they can be maintained, these systems are attractive because the value of foreign currency cash flows is predictable.There are two problems with fixed exchange rate systems:Fixed exchange rates link wage levels and employment to cross-country inflation differentials. Corrections to a fixed exchange rate system are usually large. (The more inflexible the system, the bigger the correction.)

Floating systems allow values to fluctuate according to supply and demand, without direct interference by government authorities. The main disadvantage is it is difficult to know how much a future foreign currency cash flow will be worth in a floating rate system. The good news is that transaction exposures to currency risk can be effectively managed with financial market instruments. IMF Classifications of Exchange Rate Regimes

Hard pegSoft pegFloating arrangementsAfricaDjiboutiLibya, Zimbabwe Egypt, Kenya, Nigeria, S. Africa, CAEMC, WAEMCSudan, Uganda

Asia-Hong China, Mongolia,Afghanistan, Australia, India,Pacific Kong Nepal, Sri Lanka,Indonesia, Japan, Korea, Vietnam Malaysia, Pakistan, Singapore,N. Zealand, Philippines, Thailand

Europe Bulgaria,Croatia, Denmark,Czech Rep., Hungary, Iceland,LithuaniaRussiaNorway, Poland, Sweden,Switzerland, U.K., Eurozone

Middle EastIran, Iraq, Kuwait, Israel, TurkeySaudi Arabia, UAE

Americas EcuadorArgentina, Costa Brazil, Canada, Chile, Colombia, Mexico, United States,

Source: IMF (www.imf.org).Integration of the worlds marketsBalance-of-payments statistics Exchange rate systemsRecent history of international exchange ratesPegged vs floating exchange rate systems Major events in forex historyThe EU and the Eurozone


Acronyms WAEMU: West African Economic and Monetary Union: Benin, Burkina, Faso, Ivory Coast, Guinea-Bissau, Mali, Niger, Senegal, and TogoCAEMC: Central African Economic and Monetary Union: Cameroon, Central African Rep., Chad, Congo, Equatorial Guinea, and GabonEurozone: Austria, Belgium, Cyprus, Estonia, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg, Malta, the Netherlands, Portugal, Slovakia, Slovenia, and Spain

Here are IMF definitions of currency arrangements:Hard pegs: Exchange arrangements with no separate legal tender, and currency board arrangementsSoft pegs: Conventional peg arrangements, stabilized arrangements, crawling pegs, crawl-like arrangements, and pegs within horizontal bandsFloating arrangements: 'Floating' (largely market determined and without exchange rate targets) 'Free floating' (market determined with very infrequent intervention)

Major events in the history of FX rates

1946 Bretton Woods Conference

IMF and World Bank created

1971Exchange rate turmoil begins the modern era of floating exchange rates

Jamaica Agreement (1976)

European Exchange Rate Mechanism (1979)

1991Treaty of Maastricht

Introduction of the euro (1999)

Euro begins public circulation (2002)Integration of the worlds marketsBalance-of-payments statistics Exchange rate systemsRecent history of international exchange ratesPegged vs floating exchange rate systemsMajor events in forex history The EU and the Eurozone


The next several slides describe each of these events.Major events in the history of FX rates

1946Bretton Woods Conference

Dollar is convertible into gold at $35/ounce

Other currencies are pegged to the dollar

The IMF and the World Bank also were created

Integration of the worlds marketsBalance-of-payments statistics Exchange rate systemsRecent history of international exchange ratesPegged vs floating exchange rate systemsMajor events in forex history The EU and the Eurozone


Bretton Woods was named after the New Hampshire site at which it took place. The agreement lasted from 1946 until 1971.Under Bretton Woods, the price of an ounce of gold was set at $35. Only dollars were convertible into gold at the official par value of $35/ounce. Other nations agreed to maintain a fixed exchange rate for their currency in terms of the dollar or gold (e.g., the German mark was set equal to 1/140th of an ounce of gold, or about $0.25). Other nations were not required to exchange their currency for gold, but pledged to intervene in the FX markets if their currency moved more than 1 percent from the official rate.US inflation rose in the 1960s with ambitious social programs and the Vietnam warInflation caused gold to rise above $35/oz. Speculators bought gold at the $35/oz price, putting enormous pressure on the dollar.U.S. drops gold standard in 1971. Many currencies are already floating. Dec 1971 - G10 ((Belgium, Canada, France, Italy, Japan, the Netherlands, Sweden, U.K., U.S., and W. Germany) signs Smithsonian AgreementDevalued the U.S. dollar to $38 per ounce of gold Revalued other currencies relative to the dollarEstablished a 4.5 percent band to promote monetary stabilityMajor events in the history of FX rates

1971Exchange rate turmoil

U.S. dollar falls off the gold standard

Most currencies float on world markets

1976Jamaica Agreement

Floating rates are declared acceptable

1979European Monetary System (EMS)

European Exchange Rate Mechanism (ERM) established to maintain EEC currencies within a 2.25% band around central rates

European currency unit (ECU) createdIntegration of the worlds marketsBalance-of-payments statistics Exchange rate systemsRecent history of international exchange ratesPegged vs floating exchange rate systemsMajor events in forex history The EU and the Eurozone


1976 Jamaica AgreementFloating rates are declared acceptable, officially acknowledging the system already in place and legitimizing the basis for the system still used today.

In 1979, EEC replaced the snake with the European Monetary System (EMS)Central bank cooperation used to maintain FX values within 2.25 percent of central rates. The U.K. was subsequently admitted with a 6 percent band. ERM was centered around the European currency unit (ECU), a basket of currencies weighted by each members proportion of intra-European trade and relative GNP. EMS members fight to keep their currencies within the ERM limits.Bands are periodically adjusted to reflect exchange rate volatility.Major events in the history of FX rates

1991Treaty of Maastricht

EC members agree to a broad agenda of economic, financial and monetary reforms

A single European currency is proposed as the ultimate goal of monetary union

1999Introduction of the euro

Emu-zone currencies pegged to the euro

European bonds convert to the euro

2002Euro begins public circulation

The euro is now a major international currencyIntegration of the worlds marketsBalance-of-payments statistics Exchange rate systemsRecent history of international exchange ratesPegged vs floating exchange rate systemsMajor events in forex history The EU and the Eurozone


The Treaty of Maastricht was signed by EU governments in Dec 1991.

May 1992Denmark rejected the Treaty in a close popular vote

September 1992EU currencies in crisisSuccess of the French referendum on the treaty, scheduled for September 20, was also in doubt. The British pound fell below its EMS floor. Italy suspended trading in the lire after the lire fell below its EMS floor. Finland and Sweden intervened when their currencies fell against the DM. Finland eventually gave up and allowed the markka to float. Sweden raised its key lending rate to 500 percent per annum (inflation was less than 10 percent) in an effort to defend the krona.

August 1993currency crisisERM bands widened to 15 percent, more like a floating rate system, allowing more divergence in monetary policies within the ERM.

January 1999 euro replaces the ECU as the EU currency unit

January 2002euro begins public circulation

July 2002euro replaces the national currencies of participantsIntegration of the worlds marketsBalance-of-payments statistics Exchange rate systemsRecent history of international exchange ratesPegged vs floating exchange rate systemsMajor events in forex historyThe EU and the Eurozone

The EU and the EurozoneEurozone members:Austria, Belgium, Cyprus, Estonia, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg, Malta, the Netherlands, Portugal, Slovakia, Slovenia, and Spain Chose not to participate:Denmark, Sweden, and U.K.Planned expansion:Bulgaria, Czech Republic, Hungary, Latvia, Lithuania, Poland, and RomaniaButler / Multinational FinanceChapter 2 World Trade and the International Monetary System2-#

There were 27 members in the European Union as of June 2007 (see map), with 17 of these participating in the euro. Member states are: Austria, Belgium, Bulgaria, Czech Republic, Cyprus, Denmark, Estonia, Finland, France, Germany, Greece, Hungary, Ireland, Italy, Latvia, Lithuania, Luxembourg, Malta, the Netherlands, Poland, Portugal, Romania, Slovakia, Slovenia, Spain, Sweden, United Kingdom.

The expectation is that all 27 member states will eventually adopt the euro, although Denmark, Sweden, and the U.K. may continue to opt out. New members of the EU are expected to adopt the euro once their economies meet the convergence criteria. Candidates for further EU enlargement (in dark gray on the map) include Croatia, Iceland, Macedonia (a part of the former Yugoslavia), Montenegro, and Turkey.

Au: please see last two bullets in the notes for this section. please clarifyRecent currency crises

Mexican peso crisis of 1995

Asian contagion of 1997

Korea, Indonesia, and Thailand

Russian ruble crisis in 1998

Brazilian real crisis in 1998

Argentinian peso crisis of 2002Integration of the worlds marketsBalance-of-payments statisticsExchange rate systems Recent history of international exchange ratesRecent currency crises Causes and consequencesCountries in crisis Currency crises and the IMFButler / Multinational FinanceChapter 2 World Trade and the International Monetary System2-#

The next several slides describe each of these crises. Currency crises

Contributing factors in each crisis

A fixed or pegged exchange rate system that overvalued the local currency

A large amount of foreign currency debt

Consequences of currency crises

Currency crises have a pronounced negative short-term impact on the local economy

A market-based exchange rate can have an invigorating long-term impact on the local economy and on the local stock marketIntegration of the worlds marketsBalance-of-payments statisticsExchange rate systems Recent history of international exchange ratesRecent currency crisesCauses and consequences Countries in crisis Currency crises and the IMFButler / Multinational FinanceChapter 2 World Trade and the International Monetary System2-#

The contributing factors were present in each of the currency crisis on the following slides. Most of these countries also had large current account (the trade balance on goods, services, and income) deficits.

A positive stock market response to the currency depreciation was seen in each country to varying degrees.

Mexican peso($/peso)Mexican stock market value(Dec 1993 = 1.00; in pesos)The Mexican Peso Crisis of 1995Integration of the worlds marketsBalance-of-payments statisticsExchange rate systems Recent history of international exchange ratesRecent currency crisesCauses and consequencesCountries in crisis Currency crises and the IMFButler / Multinational FinanceChapter 2 World Trade and the International Monetary System2-#

This slide appears as Figure 2.8 in the text.

Mexico had balanced its budget and reduced inflation from 150 percent in 1987 to 27 percent. Mexico still faced two problems:Foreign currency reserves fell from $30 billion to only $5 billion during 1994 as the government pegged the peso at artificially high levels.Banks and the government had rolled over $23 billion of short-term peso debt into similar short-term tesebonos whose principal was indexed to the dollar. These obligations rose and fell with the value of the dollar.

December 1994 through January 1995: The peso falls 50 percent against the dollar, doubling the peso value of Mexicos tesebono obligations

Mexicos peso crisis was severe, but relatively short-lived. A $40 billion IMF rescue package ensured liquidity.The low peso value increased exports by 30 percent and decreased imports by 10 percent, resulting in a current account surplus of $7.4 billion (from a deficit of $18.5 billion in 1994). By 2000, the Mexican stock market had recovered to its pre-crisis level.

This is a good time to introduce the concept of moral hazard.IMF bailouts change the expectations and hence the behaviors of borrowers (governments) and lenders.

Thailands 1997 currency crisisIntegration of the worlds marketsBalance-of-payments statisticsExchange rate systems Recent history of international exchange ratesRecent currency crisesCauses and consequencesCountries in crisis Currency crises and the IMFStock market(Dec 1995 = 1.00; in bhat)Thai bhat($/bhat)Butler / Multinational FinanceChapter 2 World Trade and the International Monetary System2-#

This slide appears as part of Figure 2.10 in the text.

Thailand suffered from:a large current account deficit (8 percent of GDP)massive short-term foreign currency borrowings used to support speculative property venturesdeclining competitiveness brought on by rising wages

Thailands property and stock markets fell during 1997. By the end of the year, the Thai stock market had lost more than 50 percent of its value.

The IMF assembled a rescue package worth $17 billion.

IMF loans usually require:fiscal and monetary restraintfinancial market liberalizationstructural reforms

Stock market(Dec 1995 = 1.00; in rupiah)Indonesian rupiah($/rupiah)Indonesias 1997 currency crisisIntegration of the worlds marketsBalance-of-payments statisticsExchange rate systems Recent history of international exchange ratesRecent currency crisesCauses and consequencesCountries in crisis Currency crises and the IMFButler / Multinational FinanceChapter 2 World Trade and the International Monetary System2-#

This slide appears as part Figure 2.10 in the text.

Like Thailand, Indonesia had a pegged exchange ratea large current account deficitmassive short-term foreign currency debt, much of it used for speculative property ventures

The IMF assembled a rescue package worth $43 billion for Indonesia.

The rupiah fell steadily throughout the second half of 1997, losing more than 75 percent of its value against the dollar.

Investors lost confidence in Indonesias ability to repay its foreign currency debt, and Indonesias stock market fell by 33 percent near the end of 1997.

The lower value of the rupiah eventually reinvigorated Indonesias economy, and the stock market is now up nearly 300 percent from its 1995 value.

Stock market(Dec 1995 = 1.00; in won)Korean won($/won)Koreas 1997 currency crisisIntegration of the worlds marketsBalance-of-payments statisticsExchange rate systems Recent history of international exchange ratesRecent currency crisesCauses and consequencesCountries in crisis Currency crises and the IMFButler / Multinational FinanceChapter 2 World Trade and the International Monetary System2-#


Like Thailand and Indonesia, South Koreas economic situation was undermined by a pegged exchange rate, a large current account deficit, and large short-term foreign currency obligations.

In contrast to Thailand and Indonesia, the Korean economy was in relatively good shape. Much of the foreign currency debt had been invested in export industries that stood to gain from a drop in the won, as opposed to the speculative property ventures that were popular in Thailand and Indonesia.

Nevertheless, the won fell nearly 50 percent at the end of 1997, and the Korean stock market lost more than 50 percent of its value between September 1997 and September 1998.

The Korean economy has recovered from the crisis, and the Korean stock market is about 250 percent higher than its value in 1995.

Long term stock market effects in these Asian countries: Korea and Indonesia have largely recoveredThailand is still struggling

Russias stock market value(Dec 1995 = 1.0; in rubles)Russian ruble($/rubles)Russias Currency Crisis of 1998Integration of the worlds marketsBalance-of-payments statisticsExchange rate systems Recent history of international exchange ratesRecent currency crisesCauses and consequencesCountries in crisis Currency crises and the IMFButler / Multinational FinanceChapter 2 World Trade and the International Monetary System2-#

This slide appears as Figure 2.11 in the text. (Note: that Russias troubled equity privatization during 1992-1996 is described in Chapter 18.)

Russia successfully placed the ruble in a crawling peg in July 1993, which reduced inflation from 1,700 percent in 1992 to 15 percent in 1997. By July 1998, the ruble succumbed to speculative pressure from the pegged exchange rate, the large currency account deficit, and large Eurodollar borrowings by the government.The IMF assembled a rescue package of $23 billion.The ruble was allowed to float in August 1998, at which time Russia defaulted on $40 billion of foreign currency debt.

The Russian economy initially struggled, although the stock market quickly recovered because of the lower value of the ruble. GDP fell from $804 billion in 1991 to $282 billion in 1998, resulting in a 1998 budget deficit of nearly 10 percent.Russia repaid its IMF loan in 2004.

Currency value: $/real(Dec 1997 = 1.0)Brazils stock market value(Dec 1997 = 1.0; in reals)Brazils 1999 currency crisisIntegration of the worlds marketsBalance-of-payments statisticsExchange rate systems Recent history of international exchange ratesRecent currency crisesCauses and consequencesCountries in crisis Currency crises and the IMFButler / Multinational FinanceChapter 2 World Trade and the International Monetary System2-#


Brazil is the worlds 5th largest country both in population and landmass. Brazil had financed its budget deficits with foreign currency debt, accumulating a balance of more than $250 billion. Brazil spent $50 billion supporting the reals crawling peg in 1998. Brazil ran out of foreign currency reserves in November 1998, and negotiated a $42 billion IMF loan. The Brazilian real was nevertheless devalued in November 1998 and allowed to float shortly thereafter. By 2002, Brazil owed more than $16 billion to the IMF. After several years of severe recession, Brazil was able to repay its IMF loans during 2005.

Brazils crisis was similar to other currency crisesA crawling peg overvalued the Brazilian realA large amount of foreign currency debt (~ $250 billion)

Argentinas stock market value(Dec 1998 = 1.0; in pesos)Currency value: $/peso(Dec 1998 = 1.0)Argentinas 2002 currency crisisIntegration of the worlds marketsBalance-of-payments statisticsExchange rate systems Recent history of international exchange ratesRecent currency crisesCauses and consequencesCountries in crisis Currency crises and the IMFButler / Multinational FinanceChapter 2 World Trade and the International Monetary System2-#


Argentina placed the peso in a currency board in 1991This cured hyperinflation (3000 percent per year in 1989). A severe recession began in 1998 because of the overvalued peso.Argentina financed its large budget deficits with foreign currency debt. By 2002, the government owed $150 billion in foreign currency debt.

January 2002 currency crisisThe peso began to float in January 2002 despite a $40 billion IMF line of credit. The stock market welcomed the event, nearly doubling in value around the time of the crisis.The economic crisis remains, with low productivity and high unemployment.

Argentinas crisis was similar to other currency crisesA crawling peg overvalued the Argentinian pesoA large amount of foreign currency debt (~ $150 billion) The debate over IMF lending

Proponents of IMF lending policies believeShort term loans help countries overcome temporary financial crises

Critics of IMF lending believeFiscal constraints and capital market liberalizations increase economic and financial risksIMF loans can leave a legacy of debt that can last for decadesIMF loans are often spent trying to support an unsustainable exchange rateIMF remedies benefit developed countries and not the country in crisisIntegration of the worlds marketsBalance-of-payments statisticsExchange rate systems Recent history of international exchange ratesRecent currency crisesCauses and consequencesCountries in crisisCurrency crises and the IMF Butler / Multinational FinanceChapter 2 World Trade and the International Monetary System2-#

The IMFs evolution from short-term lender to lender of last resort has sparked an active debate about the IMFs role during currency crises.

Both sides are interested in ensuring the stability of the international financial system. The sides differ in the means to this end.

Proponents of IMFs policies believe short-term loans can help countries overcome temporary crises (as in Mexico) and prevent the crises from spreading to other countries.

Opponents argue that the medicine prescribed by the IMF worsens these crises. IMF lending and moral hazard

Moral hazard

The existence of a contract can change the behaviors of parties to the contract

The IMFs challenge

Develop policies that promote economic stability

Ensure that the consequences of poor investment decisions are borne by investors and not by taxpayers Integration of the worlds marketsBalance-of-payments statisticsExchange rate systems Recent history of international exchange ratesRecent currency crisesCauses and consequencesCountries in crisisCurrency crises and the IMF Butler / Multinational FinanceChapter 2 World Trade and the International Monetary System2-#

In the absence of IMF bailouts, lenders must assess the risks and expected returns of their investments and then bear the consequences.

The expectation of an IMF bailout creates a moral hazard in that it changes the expectations and hence the behaviors of borrowers, lenders, and governments.

The challenge for the IMF is in developing policies that both promote economic stability and ensure that the consequences of poor investment decisions are borne by investors and not taxpayers. The global financial crisis of 2008

Began in the U.S. real estate market

Lax lending requirements were promoted by the government and industrySecuritization of home loans into collateralized debt obligations (CDOs); resold to investors

A crisis of confidence and liquidity

Illiquidity in the subprime CDO market spilled over to other markets including real estate, stocks, bonds, commercial paper, and bank lending.Integration of the worlds marketsBalance-of-payments statisticsExchange rate systems Recent history of international exchange ratesRecent currency crisesCauses and consequencesCountries in crisisCurrency crises and the IMF Butler / Multinational FinanceChapter 2 World Trade and the International Monetary System2-#

Many countries experienced large budget deficits caused by the drop in tax revenues and the increase in expenses from fiscal stimulus programs. Asset illiquidity and an increase in default risk caused some government bondsmost notably those of Greece and Icelandto drop sharply in price.

Ed5 02 World Trade and the International Monetary System(2)

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Transcript of Ed5 02 World Trade and the International Monetary System(2)