The international financial system

Chapter The International Financial System (Unsterilized) Foreign Exchange Intervention and Money Supply Central Bank Assets International Reserves ($) Liabilities +TL1B Reserves (or Currency in Circulation) +TL1B  To control the ExchRate, CBs might want to intervene in the forex mkt:  When Central Bank of TR purchases dollar (foreign currency) and sells TL (domestic currency), its dollar (international) reserves increase, the monetary base and the money supply (TL) increases  When CBT sells dollars and purchases TL (dom currency), its dollar (international) reserves decrease, the monetary base and money supply decreases Unsterilized Intervention  When CB purchases or sells foreign currency from and to the banking system, we call these operations “unsterilized interventions” Why does the CB intervene?  An unsterilized purchase (sale) of foreign currency ($) leads to  a gain (loss) in international ($) reserves,  an increase (decrease) in the money supply, and  a depreciation (appreciation) of TL (domestic currency) against dollar (foreign curr.) Effect of an Unsterilized Purchase of Foreign S $/TL Currency exch Rate 0.83 0.76 D 0.62 D’ D’’ Qty of TL assets Sterilized Foreign Exchange Intervention Central Bank Assets International Reserves Liabilities +TL1m Monetary Base no change (reserves+currency i.c.) Government Bonds -TL1m  Since unsterilized interventions raise Mspply and might cause inflation, CBs usually sterilize forex interventions Sterilization: By doing an offsetting open market operation, CB neutralizes the effect of the forex intervention on the money supply  Example: If CB buys dollars and increases the TL reserves, immediately CB also sells govt bonds at the same amount This leaves the monetary base and the money supply unchanged Sterilized Foreign Exchange Intervention  A sterilized purchase (sale) of foreign currency leads to  a gain (loss) in international reserves,  No change in the money supply, Balance of Payments (BOP) Balance of Payments = Current Account + Capital Account (Net Capital Inflows)  Balance of payments shows the net change in the foreign exchange (dollar) reserves of an economy during a certain time period Balance of Payments Current Account :Inflows (+) Outflows (-) Trade Balance = +Exports – İmports Services Balance +Net Foreign Tourism Revenues +Banking & Insurance Net Revenue +Construction & Transportation Net Revenue +Workers’ Remittances + Paid Military Service Net Income from Foreign Capital (interest+profit transfers) Unilateral transfers (Aid to or from other countries) Balance of Payments  “Current Account (CA) Deficit” means that CA balance is a negative number This is usually because the largest item “Trade Balance” is negative For example, Turkey’s 2008 (2007) January-March exports are $33 ($24.4) bn, imports are $49 ($33) bn, trade balance is -$16 ($8.6) bn Balance of Payments Capital Account = Net Capital İnflows inflows – capital outflows =capital +Purchases of Domestic (Turkish) assets by Foreigners (ind., firms, govts) – Purchases of Foreign Assets by Domestic (Turkish) Residents Credits: + Net Borrowing of Turkish Residents from Foreign residents (+borrowing, -lending) 10 IMF Critics Privatization: Critics argue foreign companies take over sectors (monopolize) and increase dependency of domestic economy to foreign firms Fear of default Critics argue that one of the objectives of the IMF is to ensure that high-risk, high-return loans from international banks to less-developed countries are repaid 41 IMF Critics Instead of financial reform, IMF prescribes contractionary macroeconomic policies This causes the IMF to be a profitable scapegoat for domestic politicians as anti-growth, antiemployment IMF is seen as a foreign entity interfering with domestic policy Do you agree? 42 IMF as a Lender of Last Resort  IMF can prevent contagion of crises “herding behavior” in financial markets causes contagion  IMF bailouts may cause excessive risk-taking (moral hazard) for domestic banks and their international creditors This will increase risk of crisis in the future 43 IMF Stand-By Arrangements with TR Figure Stand-By Arrangements Cases in Turkey (1960-2004) 2008 Karagöl, Erdal and Metin Özcan, Kıvılcım, “The Economic Determinants of IMF Standy Aggreements in Turkey” 44 World Bank  Mission: Established after WWII to provide funds to reduce poverty and promote development in the world Provides loans for infrastructural projects in health, education, agriculture, energy  Critics: Stiglitz, Caufield: Too quick and unregulated free market reforms prevent economic development 45 Balance-of-Payments Considerations  Current account deficits in Turkey suggest that Turkish producers are not competitive maybe because the TL is too strong (maybe b/c they are not productive)  CADs increases the risk of a BOP crisis CB may reduce interest rates for this purpose: expansionary policy  Expansionary (contractionary) policy reduces (increases) interest rates and decreases (increases) value of TL 46 Balance-of-Payments Considerations  But expansionary policy increases risk of inflation for two reasons:  Prices of imported goods (tradables) increase (energy)  Since money supply increases, real value of money (in terms of goods and services) decreases 47 Exchange-Rate Targeting in TR ER targeting (Crawling Peg) Policy applied in Turkey 1999-2001 as a method to bring inflation under control Tradable goods’ prices are quoted in dollars, so rate of inflation fell  ER targeting keeps the ER in a pre-specified band Ex: (1,50 TL/$ ± 0,20 TL/$) for a specific period Allows lira to move within the band  We floated after the 2001 crisis 48 Advantages of Exchange-Rate Targeting  Automatic rule for conduct of monetary policy (Fixed ER) of short-run benefits of Prevents temptation expansionary policy (Ex: election economics) Reduces political pressure on the CB to expand the money supply 49 Exchange-Rate Targeting for Emerging Market  Political and monetary institutions Countries are weak Not much to gain from independent mon policy But much to lose from irresponsible politicians (high inflation 1977-2003)  Helps tie the hands of the govt from conducting expansionary policies  BUT!!! Costs of a currency crisis much higher than these benefits 50 Disadvantages of Exchange-Rate Targeting  Moral Hazard: Banks take on too much exchange rate risk expecting the govt to defend the peg İncreases financial fragility  Then economy becomes vulnerable to speculative attacks on currency İnt creditors suddenly sell lira assets, capital flight Force the CB to devalue  Loss of independent control of money supply Cannot fix both ER and money supply Cannot respond to domestic shocks  Shocks to anchor country (US or Germany) are transmitted to domestic country 51 Currency Boards  Extreme case of fixed ER policy  Domestic currency is backed 100% by a foreign currency  CB establishes a fixed exchange rate and stands ready to exchange currency at this rate (Ex: TL/$)  Money supply can expand only when CB’s dollar reserves increase Decreases the possibility of a speculative attack-currency crisis 52 Currency Boards (cont’d)  Stronger commitment by central bank  Loss of independent monetary policy and increased exposure to shock from anchor country  Loss of ability to create money and act as lender of last resort  Applied in Argentina (1991-2002), Bulgaria (1997), Bosnia (1998), Hong Kong (1983), Estonia (1992), Lithuania (1994) 53 Dollarization  Totally giving up domestic currency and adoption of another currency (dollar)  Ecuador dollarized in 2000  15 EU countries “euroized” after 2002 12 EU member countries are not in “eurozone” UK, Denmark and Sweden chose not to join  Completely avoids possibility of speculative attacks on domestic currency  Loss of independent monetary policy and increased exposure to shocks from anchor country (US) 54 Dollarization (cont’d)  Inability to create money and act as lender of last resort  Loss of seignorage revenue earned from purchasing bonds with printed currency $30bn per year for US  Ex: “President Carlos Menem of Argentina has advocated replacing the Argentine peso with the dollar Dollarization would benefit Argentina because it would eliminate the peso-dollar exchange-rate risk, lower interest rates, and stimulate economic growth” March 12, 1999 by Steve H Hanke and Kurt Schuler, ”A Dollarization Blueprint for Argentina”, CATO Foreign Policy Briefing No 52 55 ... imbalances in the economy will cause another crisis in the future If the borrowing country believes that IMF will bail them out even if they not follow prescribed policies, then the country will... pound fell even further 31 32 European ER Crisis of September 1992  Sept 16: British floated the pound: 10% devaluation against the DM They also quit the ERM and did not join the euro  George... neutralizes the effect of the forex intervention on the money supply  Example: If CB buys dollars and increases the TL reserves, immediately CB also sells govt bonds at the same amount This leaves the