The Hunt for Stable Exchange Rates - NYUpages.stern.nyu.edu/~rlevich/b403388/Chap02-RML.pdf1 Prof....

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Prof. Levich International Financial Management (Jan. 2002) Chapter 2, p. 1

The Hunt for Stable Exchange Rates

� Why are there government policies toward FX rates?» FX rate is usually the most important single price for small

open economies� Range of choices:

» Pure float � fixed rate � single currency» Trends in the 1980s and 1990s - More countries are floating,

but rhetoric favors fixed rates� Current examples of preference for fixing rates

» Currency Boards (some progressing toward “Dollarization”)» European Economic and Monetary Union (EMU)

� Driving forces underlying these trends� Risks for investors in newly stabilized regimes


Why Government Policies Toward FX Rates

� FX rate is usually the most important single price for small open economies» FX volatility often higher than desired � policies to peg rates» Promote exports or discourage imports � target rate level

� Exchange rate system influences scope for other macroeconomic policies» Floating rate: Allows the government some scope to

establish an independent monetary policy» Pegged rate: Requires a government willing to adopt

monetary policies of another nation� Exchange rate system for a country is part of the

country’s international economic/financial relations

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A Primer on Exchange Rate Systems and Macroeconomic Policy Constraints

Consider the Purchasing Power Parity formulaP(US) = P(UK) x Spot ($/£)

� Under pegged exchange rates» US inflation must match UK inflation» � US monetary policy similar to UK monetary policy» If pegged rate is credible, expected exchange rate change = 0» � US interest rate similar to UK interest rate» � pegging partners must have similar monetary policies

� Under floating exchange rates» US inflation and interest rates need not match UK values» A country can use monetary stimulus or low interest rate, and

let floating spot rate adjust to maintain PPP


The Range of Exchange Rate Systems

1. Pure float, free float, clean float

2. Dirty float, managed float3. Floating within a band, target

zone4. Sliding band5. Crawling band

6. Crawling peg7. Fixed (but adjustable)

exchange rate8. Currency board9. “Dollarization”10. Monetary union

Pure float � Fixed rate � Single currency

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1. Pure float, free float, clean float

� Main Features» FX rate freely determined by private demand and supply

� Main Benefits» FX rates adjust automatically to changes in D & S» No international reserves needed

� Main Shortcomings» FX rate volatility may limit trade and investment flows» Country needs to run its own monetary policy and establish

credible monetary and fiscal policies, otherwise (?)� Key Episodes

» No real examples, but US, Germany, Switzerland, and Japan come close


7. Fixed (but adjustable) exchange rate

� Main Features» Nominal rate is fixed, but no obligation to maintain it forever» No tight constraints on monetary or fiscal policymakers

� Main Benefits» Inspires macroeconomic discipline to maintain the peg» Option to devalue is like an”escape clause””

� Main Shortcomings» Exchange rate changes sometimes large and disruptive» Realignments delayed, one-way speculation against central bank

� Key Episodes» Bretton Woods: 1944-1973» Many emerging countries for last 20 years (e.g.Thailand 1997)

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The Bretton Woods Period, 1944-1973

� The Spirit of the Bretton Woods Agreement» Fix official par value of currency in terms of gold, or a

currency pegged to gold» Limit short-run variability to +/- 1% of par value, but allow

option to adjust par value unilaterally if IMF concurs» Currencies are convertible for current account transactions,

but some capital controls on speculative capital account transactions

» Countries can use reserves or borrowing from the IMF to finance temporary balance of payments deficits

» National macroeconomic policy autonomy permitted; countries can pursue their own price level and employment-growth objectives


The Bretton Woods Period, 1944-1973

� The Reality of the Bretton Woods Agreement» Industrial countries other than the US

� Countries fixed official par values in terms of US$� US$ became international reserve currency� To preserve the peg, domestic monetary policy had to be

subordinated to external exchange rate policy» United States

� Remained passive in the foreign exchange market; allowed free trade but no balance of payments or FX target level

– The redundancy problem: N countries � N-1 independent policies or rates; Nth country must stay passive

� U.S. needed to provide a stable price level for rest of world� U.S. needed to be international creditor and avoid fiscal deficits

– Because US debts could be converted to gold at fixed rate

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Why Did Bretton Woods Collapse?

The Triffin Dilemma

0

10

20

30

40

50

60

70

1948

1950

1952

1954

1956

1958

1960

1962

1964

1966

1968

1970

1972

1974

Bill

ions

of U

S D

olla

rs

U.S. Gold Reserves, Line 88CA of IFS, CD-ROMU.S. Liabilities to Foreign Institutions, Line 1AND of IFS, CD-ROM.

� US inflation accelerated in 1960s, lost competitiveness, ran fiscal deficits and BOP deficits

� US debts (liabilities to foreigners) accumulated and exceeded US gold stock at $35/ounce -Triffin Dilemma

� US monetary policy no longer “fits” rest of world

� The “unholy trinity” - a country cannot at once have (1) pegged rates, (2) free capital movements, and (3) independent monetary policy


Post Bretton Woods Period, 1973-date

� “Limited Anarchy”» A mixture of free floating, managed floating, pegged rates,

currency boards, and movements toward monetary union» Slow realization that monetary independence is not a license

to have any monetary policy» Volatile monetary policy, with differences in fiscal policies,

technological changes, resource discoveries, … � volatile exchange rates that may impede trade and capital flows

» Countries need to plan and coordinate with other countries to maintain exchange rates with limited volatility

» Despite the desire for exchange rate stability, more countries allow their countries to float in the 1990s

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Exchange Rate Arrangements: 1984-99

Exchange Rate Arrangements Over the 1980s and 1990s

9481 84

73 67 66 66 66 65

22

19 16

1717 17 18 16 17

3256

67 85 90 95 97 99 100

0

20

40

60

80

100

120

140

160

180

200

1984 1991 1992 1993 1994 1995 1996 1997 1998

Num

ber o

f IM

F M

embe

rs

Pegged to Something Limited Flexibility Managed or Independent Floating


8. Currency Board

� Main Features» Strict fixed rate system with institutional (i.e. legal or

constitutional) constraint on monetary policy» Domestic money can be issued only when backed by inflows

of foreign exchange (Like a money market fund @ $1/share)

� Main Benefits» Very high monetary policy credibility

� Main Shortcomings» No separate monetary or exchange rate policy is available» Limited lender of last resort for local financial institutions

� Key Episodes» Currently: Hong Kong, Estonia, Argentina (1991-2002)» Historically: Many British and French colonies

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Exchange Rates in High Inflation Countries

Foreign Exchange Rates (Local Currency/US$) in Hyperinflationary Countries

110

1001,000

10,000100,000

1,000,00010,000,000

100,000,0001,000,000,000

10,000,000,000100,000,000,000

1,000,000,000,00010,000,000,000,000

100,000,000,000,000

1970 1972 1974 1976 1978 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998

Inde

x: 1

970

= 10

0

ARGENTINA BRAZIL ECUADOR

Argentina: 140% / year for 17 years

Brazil: 105% / year for 18 years

Ecuador: 33% / year for 17 years


Successful Currency Boards and Inflation

Consumer Price Inflation: 1990-1999Percentage Inflation at Annual Rate

-10

0

10

20

30

40

50

60

1990M1 1991M1 1992M1 1993M1 1994M1 1995M1 1996M1 1997M1 1998M1 1999M1

Monthly Observations (Source: IFS)

Per

cent

age

UNITED STATES ARGENTINA HONG KONG ESTONIA LATVIA

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8. Currency Board - Related Issues

� Conditions for starting a currency board» Current reserves must be adequate to redeem domestic

money stock (e.g. Ecuador 2000)» Country must forsake “printing press” fiscal finance

� Positive externalities» Rationalize domestic fiscal finance - ultimately, spending

must be linked to tax revenues, not money creation� Negative externalities

» International competitiveness linked to the pegging partner» If US$ appreciates against € or ¥, so does Argentine peso

� Remaining costs» Local interest rates higher than comparable rates in US$» Country retains the option to drop the currency board


Argentina/US$ Interest Rate Spread

• Short-term peso interest rates are typically 50-200 basis points or more greater than US$ rates• Currency board still subject to “speculative attack”

1997 1998 1999 2000

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Hong Kong/US$ Interest Rate Spread

• Hong Kong interest rates are typically very similar to US$ rates, except during political/financial crises• Currency board still subject to “speculative attack”

1993 1994 1995 1996 1997 1998 1999 2000


9. “Dollarization”

� Main Features» Extreme form of currency board» Implement by unilateral decision, or formal treaty agreement» Country completely abandons its monetary autonomy

� Main Benefits» Absolute credibility - domestic monetary authorities cannot

“surprise” the public� Main Shortcomings

» Like the currency board, no flexibility to use monetary or exchange rate policy to adjust to macroeconomic shocks

» If unilateral choice � no influence on monetary policy� Key Episodes

» Panama, several Caribbean islands, considered by Argentina

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“Dollarization” versus Currency Board

� Costs of Dollarization - “Seigniorage”» Local interest rate - production cost of money (~0)» Country uses paper currency to buy interest bearing assets» For Argentina ~ $700 million per year ~ 0.2% of GDP» Seigniorage then accrues to USA; NPV = $14-66 billion

� Benefits of Dollarization» Lower cost of funds

� Devaluation risk � 0; Sovereign default risk remains > 0» Currency crises, speculative attacks(Tequila effect) ruled out

� These result in output losses that are never recovered� For Argentina, 1995 Tequila effect cost ~ 14% of GDP

� For Argentina, GDP benefits > seigniorage costs


Argentina and Panama Compared

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Implications for Investors� Currency Boards

» Investors and depositors earn a devaluation and default risk premium for holding assets in these countries

» If country maintains currency board� Investor earns added return (for exposure to added risk)

» If country advances to Dollarization plan� Domestic currency assets are redeemed with hard-currency

dollar assets; possible capital gains on longer term instruments» If country abandons currency board (Argentina 2002)

� Investors face capital losses and possible capital controls� Dollarization countries

» Investors and depositors earn a default risk for holding assets in these countries

» Exposed to risk of individual banks and the banking system» Exposed to political risks, skill of supervisory agencies


10. Monetary Union

� Main Features» Group of states or nations mutually agree on a single money» Single monetary policy for entire union

� Main Benefits» No exchange rate risk across members» Stimulus to trade and financial flows across members

� Main Shortcomings» No possibility to use separate monetary policy for any region» Forces adjustment onto (1) factor mobility, (2) price and wage

flexibility, and (3) fiscal transfers when shocks hit one region� Key Episodes

» U.S. since mid-1800s; European Monetary Union (1999+)

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The theory of optimum currency areas

� One central bank � one money � one monetary policy� What is the optimal number of central banks, moneys

and monetary policies for an economic region?» Efficiency cost of changing money

� 1 central bank - very high efficiency� 1,000 central banks - very low efficiency

» Tailoring monetary policy to a region� 1 central bank - low efficiency, one policy for the whole world� 1,000 central banks - higher efficiency, policies for small regions

� Conclusion: pick “N” central banks to optimize “efficiency / tailoring” trade-off


Criteria for designing currency areas: Regions A and B

� One central bank and one currency where:» High labor and capital factor mobility within region» Business cycles are in phase (no need for multiple monetary

policies)» Trade / GDP is high; need for capital flows high» LOGIC OF ABOVE: No need to have exchange rate between

A & B to accommodate different business conditions in A & B, because factors move or fiscal policies shift to speed adjustment

� Two central banks and two currencies linked by adjustable peg or float when:» Factors are immobile between countries» Business cycles are out-of-phase (two money policies useful)» LOGIC: Need an exchange rate to act as an elastic buffer when

other links (factor mobility) between A and B are unavailable

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The path to EMU

� Origins with EFTA, EEC, EC, EU in 1950s � 1979 - European Monetary System (EMS)

» A cooperation arrangement among 8 EU nations to fix European cross exchange rates within limits [The Exchange Rate Mechanism – ERM]

» Initially, a failure - 11 realignments from 1979-1987» Then 5 years of no realignments» Mid-1992 & 1993 - serious crisis, large realignments, UK

drops out, bands widened for Italy» Crisis puts future of EMU in serious doubt


The path to EMU

� 1991 - Maastricht Treaty, sets EU on path to EMU» Convergence criteria

� Budget deficit < 3% of GDP� Public debt < 60% of GDP� Inflation within 1.5% of lowest 3 countries� Long-term bond yield within 2% of lowest 3 countries� No devaluation against other EMS countries for 2 years

» If all criteria are met, then country can enter EMU� 1992-1998

» Countries make substantial progress on convergence, but very few actually (strictly) satisfy all criteria

» Euro-fudge: May 1998, EU decides that countries making “substantial progress toward convergence” are accepted

» May 1998 – EMU 11 selected, ECB President selected

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EMU Arrives !!!

� January 1, 1999» Irrevocable conversion rates between EMU 11 and the Euro (€)

are set. National currencies remain legal tender.» European System of Central Banks (ESCB) = ECB + former

national central banks starts conducting monetary policy» All members of ESCB are “independent bodies” pledged to carry

out Treaty functions – primarily, ‘maintain price stability’� January 1, 1999 – January 1, 2002

» Changeover period for financial instruments, accounts, prices …� January 1, 2002

» Bank notes begin circulating, dual arrangements� July 1, 2002 (at the latest)

» Euro (€) the only legal tender; legacy currencies withdrawn


Euro (€) Coins and Notes

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The Ins, the Outs, and the Wannabees

� 12 Ins (In EMU)» Austria, Belgium, Finland, France, Germany, Ireland, Italy,

Luxembourg, Netherlands, Portugal, Spain + Greece (in 2001)� 3 Outs (In EU, but not EMU)

» Britain (Not in ERM2, referendum needed to join)» Denmark (In ERM2, could vote to join)» Sweden (Not in ERM2, no plans to join)

� Wannabees» Cyprus, Czech Republic, Estonia, Hungary, Malta, Poland,

Slovenia (2003-06); Latvia, Lithuania, Slovakia (2005-06)» Bulgaria, Romania (2007-10); Turkey (2010-12)


Benefits and Risks to EMU

� Benefits of EMU» 12 countries share one money and one central bank» One money � No Euro exchange risk or transaction costs» Promotes capital mobility, price competition around EMU» Scale economies - one large European capital market

� Risks of EMU» EMU is economic and monetary union, not political union so

countries retain national sovereignty on many issues» What if shocks are uneven? Suppose Spain is in recession

when German economy is accelerating? One monetary policy cannot fit all countries at all times

» Will process of making monetary policy lead to divisions?» Limited scope for fiscal transfers to aid slower economies

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EMU and Investment Strategies

� For the “Ins”» All government bonds denominated in EUR are not priced to

earn the same yield» Credit risk structure of EMU government issues» Buy the high yield bonds, when confidence that they will

remain within EMU is high� For the “Outs”

» The convergence trade� Buy the high yielding bond on expectations that it will achieve

stable exchange rates, and eventual EMU membership� Risky when devaluations offset all or more than the yield

differential


The Yield Structure of EMU BondsTen-year spreads, Financial Times, April 25, 2000

Country Bid YieldSpread vs. Germany

Austria 5.59 0.27Belgium 5.59 0.27Germany 5.32 0.00Denmark 5.65 0.33Spain 5.55 0.23Finland 5.51 0.19France 5.42 0.10UK 5.32 0.00Greece 6.12 0.80Ireland 5.54 0.22Italy 5.62 0.30Netherlands 5.47 0.15Norway 6.1 0.78Portugal 5.61 0.29Sweden 5.45 0.13

• Not all EMU government bonds carry the same yield, even though all bonds are denominated in EUR (€)

• Volume outstanding and liquidity varies across issues

• Italy (24%), Germany (23%), France (21%) of EMU gov’t debt outstanding in Feb. 2000

• Perceived credit risk differences; chance of withdrawing from EMU, and re-denominating debt in new national currency

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• For the Out’s, consider the old convergence trade to earn the yield spread

• But watch out for the exchange rate change• Only buy the high interest rate asset when you’re confident that the yield pick-up > FX change.

Source: Deutsche Bank Global FX Outlook, April 21, 2000


Driving Forces Underlying FX Trends

� Desire for FX stability» European cross rates vanish under EMU» Endless cycle of hyperinflation and devaluation ceases with

currency board or full dollarization� Promote political stability and cooperation – in EMU� Promote trade and capital movements � Import monetary policy credibility

» In Italy, Argentina, Hong Kong, Estonia� Insulation against contagion and real output shocks

» Speculative attacks on currencies costly to the real economy

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Risks for Investors in Newly Stabilized Regimes

� Currency Board and Dollarized Economies» External (US) shocks impact real exchange rate» Above changes competitiveness» Risk that currency board is abandoned

� EMU» Asymmetric shock may lead country to withdraw from EMU

� These probabilities may be priced in EMU spreads» ECB may lack independence or fail in its mission» Risk that expansion of EMU alters its original mission of

price stability» These risks effect investment value of euro vs. other FX

units

The Hunt for Stable Exchange Rates - NYUpages.stern.nyu.edu/~rlevich/b403388/Chap02-RML.pdf1 Prof....

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