ECON 352: International Finance

Topic 1: The Global Economy

Alexandre Dmitriev

The University of Auckland, S1 2018

Topics

Foreign Exchange: Currencies and Crises

Globalization of Finance: Debts and Deficits
Government and Institutions: Policies and Performance
References and Tools

References:
I Feenstra and Taylor (2017) Chapter 1
I Lawrence H.Summers ’It’s time to kill the $100 bill’, The Washington
Post, Friday Feb. 16th, 2016
I ’Cash Talk’, The Economist, Mar 3rd, 2016
Tools:
I FRED - economic data at the Federal Reserve Bank of St. Louis
(available at https://research.stlouisfed.org/fred2/ )
I Gapminder - global development facts
(available at http://www.gapminder.org/)
International Macroeconomics/Finance

Studies large-scale economic problems in interdependent economies

Focuses on key economy-wide variables
I E.g. exchange rates, prices, interest rates, income, wealth, the current
account
Examines the role of interconnections among nations
International Macro/Finance: The key elements

Different countries have different currencies. (Foreign exchange)

Countries are financially integrated with trade in goods, services and
assets. (Financial globalization)
Policies have cross-country implications. (International policy
transmission)
Part I: Foreign Exchange: Currencies and Crises

Countries have different currencies

Fluctuations in exchange rates affect the relative prices of home and
foreign:
I goods (such as autos and clothing)
I services (such as insurance and tourism)
I assets (such as equities and bonds)
Foreign Exchange: How Exchange Rates Behave
Key Topics

How are exchange rates determined?

Why do some exchange rates fluctuate sharply in the short run, while
others are almost constant?
I economists divide the countries into:
F those with fixed (or pegged) exchange rates
F those with floating (or flexible) exchange rates

What explains why exchange rates rise, fall, or stay flat in the long
run?
Foreign Exchange: How Exchange Rates Behave
China - U.S. exchange rate

China / U.S. Foreign Exchange Rate

8
(Chinese Yuan to One U.S. Dollar)

1
1985 1990 1995 2000 2005 2010 2015

Source: Board of Governors of the Federal Reserve System (US)

research.stlouisfed.org
Foreign Exchange: How Exchange Rates Behave
New Zealand - U.S. exchange rate

U.S. / New Zealand Foreign Exchange Rate

1.6

1.4
(U.S. Dollars to One New Zealand Dollar)

1.2

1.0

0.8

0.6

0.4

0.2
1980 1990 2000 2010

Source: Board of Governors of the Federal Reserve System (US)

research.stlouisfed.org
Foreign Exchange: Why Exchange Rates Matter
Key Topics:

How do exchange rates affect the real economy?

How do changes in exchange rates affect international prices, the
demand for goods from different countries, and hence the levels of
national output?
How do changes in exchange rates affect the values of foreign assets,
and hence change national wealth?
Foreign Exchange: When Exchange Rates Misbehave

Exchange rate crisis: a sudden and pronounced loss of currency’s

value against another currency following a period in which the
exchange rate had been fixed or relatively stable.
How to define a crisis?
I E.g. as an event in which a currency loses more than 30% of its value
in U.S. dollar terms over one year, having changed by less than 20%
each of the previous two years.
There have been more than 32 exchange rate crises in the 18-year
period from 1997 to 2015.
Foreign Exchange: When Exchange Rates Misbehave
Exchange rate crises (1997 to 2015)
Exchange Rate Crisis and Economic Crisis

Exchange rate crisis might lead to governments declaring default (i.e.,

a suspension of payments)
I Examples: Russia 1998; Argentina 2002
Exchange rate crisis is not an exclusive feature of
developing/emerging markets
I Example: Iceland 2008
Russia 1998: The Currency (RUR)

National Currency to US Dollar Spot Exchange Rate for the Russian Federation©

70

60
(US Dollar per National Currency Units)

50

40

30

20

10

0
2000 2005 2010 2015

Source: Organization for Economic Co-operation and Development

research.stlouisfed.org
Russia 1998: The Economy

Russia’s government defaulted on domestic debt

Russia’s government declared a moratorium on repayment of foreign
debt
Many banks closed as a result of the crisis
Inflation in 1998 reached 84%
On 9 October 1998, Russia appealed for international humanitarian
aid, including food.
Island 2008: The Currency (ISK)
Island 2008: The Economy

A financial crisis, and a government fiscal crisis

Real output per person shrank by more than 10%
Unemployment rose from 1% to 9%
When Exchange Rates Misbehave
Key Topics:

Why do exchange rate crises occur?

Are they an inevitable consequence of deeper fundamental problems
in an economy?
Are they an avoidable result of “animal spirits”—irrational forces in
financial markets?
Why are these crises so economically and politically costly?
What steps might be taken to prevent crises, and at what cost?
Part II: Globalization of Finance: Debts and Deficits
Deficits and Surpluses: The Balance of Payments:

At the national level, economic measurements such as income,

expenditure, deficit, and surplus, are important barometers of
economic performance.
I The income measure is called gross national disposable income
F The expenditure measure is called gross national expenditure
F The difference between the two is a key macroeconomic aggregate
called the current account
U.S. Income, Expenditure, and the Current Account

Note: The table shows data for the United States from 1990 to 2012 in billions
of U.S. dollars.
U.S. Income, Expenditure, and the Current Account

Note: The table shows data for the United States from 1990 to 2012 in billions
of U.S. dollars.
Global Imbalances
Deficits and Surpluses: The Balance of Payments
Key Topics:

How do different international economic transactions contribute to

current account imbalances?
How are these imbalances financed? How long can they persist?
Why are some countries in surplus and others in deficit?
What role do current account imbalances perform in a
well-functioning economy?
Why are these imbalances the focus of so much policy debate?
Debtors and Creditors: External Wealth

Total wealth or net worth is equal to your assets minus your liabilities.
From an international perspective, a country’s net worth is called its
external wealth.
External wealth is a country’s net credit position with the rest of the
world. I.e. the difference between country’s foreign assets (what it is
owed by the rest of the world) and its foreign liabilities (what it owes
to the rest of the world).
I Positive external wealth makes a country a creditor nation;
I Negative external wealth makes it a debtor nation.
External Wealth: U.S. vs Argentina
Debtors and Creditors: External Wealth
Key Topics:

What forms can a nation’s external wealth take and does the
composition of wealth matter?
What explains the level of a nation’s external wealth and how does it
change over time?
How important is the current account as a determinant of external
wealth?
How does the current account relate to the country’s present and
future economic welfare?
Darlings and Deadbeats: Defaults and Other Risks

Sovereign governments can repudiate debt without legal penalty

Government can hurt creditors by expropriation or changing
regulations
Country risk is the difference in the interest paid on a sovereign
country’s bond and a (relatively) safe U.S. Treasury bond.
An example: On January 8, 2016, the Financial Times reported:
I Poland’s investment-grade government bond (grade A−) had a country
risk of +1.48%
I Turkey’s junk-grade government bond (grade BBB−) had a country
risk of +3.38%.
Darlings and Deadbeats: Defaults and Other Risks
Key Topics:

Why do countries default?

And what happens when they do?
What are the determinants of risk premiums?
How do risk premiums affect macroeconomic outcomes such as
output and exchange rates?
Part III: Government and Institutions

Government actions influence economic outcomes:

I decisions about exchange rates
I macroeconomic policies
I debt repayment
Economics:
I studies policies, rules and norms, or regimes in which policy choices are
made
I focuses on institutions - the overall legal, political, cultural, and social
structures that influence economic and political actions
Government and Institutions
Policies and Performance:

We will focus on there features of the broad macroeconomic

environment:
I restrictions to capital mobility
I a choice between a fixed and a floating exchange rate regime
I the quality of governance
Government and Institutions
Integration and Capital Controls:

We will often divide countries into three groups:

Advanced countries
I high levels of income per person that are well integrated into the global
economy
Emerging markets
I mainly middle-income countries that are growing and becoming more
integrated into the global economy
Developing countries
I mainly low-income countries that are not yet well integrated into the
global economy
Government and Institutions
Financial Globalization:
Integration and Capital Controls
Key questions:

Why have so many countries pursued policies of financial openness?

What are the potential economic benefits of removing capital controls
and adopting such policies?
If there are benefits, why has this policy change been so slow to occur
since the 1970s?
Are there any potential costs that offset the benefits? If so, can
capital controls benefit the country that imposes them?
The Curious Case of Zimbabwe
Exchange rate and Capital Control

For years, Zimbabwe imposed capital controls.

I In theory, U.S. dollars could be traded for Zimbabwe dollars (ZWD)
only through official channels at an official rate.
I Black market rate was different.
I Old Mutual Implied Rate (OMIR) was different.
F OMIR took the daily price of shares in the insurance company Old
Mutual that traded in the London and Harare stock markets;
F Derived from it a notional daily ZWD/GBP exchange rate
The Curious Case of Zimbabwe
Exchange rate and Capital Control: ZWD vs USD
10
ZWD vs USD Eschange Rate History
32

1031
1030
1029
1028
1027
1026
First Zimbabwean dollars per US dollar

1025
1024
1023
1022
1021
1020
1019
1018
1017
1016
1015 Official
1014 Parallel
1013
OMIR/UN
1012
1011
1010
109
108
107
106
105
104
1000
100
10
1
1/1/01 1/1/02 1/1/03 1/1/04 1/1/05 1/1/06 1/1/07 1/1/08 1/1/09
Date
Independence and Monetary Policy
The Choice of Exchange Rate Regimes (Data for 2010)
Independence and Monetary Policy
The choice of exchange rate regime:

Despite the abundance of currencies, we also see new forms of monetary

organization:
Some countries have adopted of a common currency with shared
policy responsibility
I EMU
Other countries have chosen to use currencies over which they have
no policy control:
I Dollarization in El Salvador and Ecuador
I Zimbabwe: uses USD, SAR, EUR or BWP.
The choice of exchange rate regime:
Key questions:

Why do so many countries insist on the “barbarism” of having their

own currency (as John Stuart Mill put it)?
Why do some countries create a common currency or adopt another
nation’s currency as their own?
Why do some of the countries that have kept their own currencies
maintain a fixed exchange rate with another currency?
And why do others permit their exchange rate to fluctuate over time,
making a floating exchange rate their regime choice?
Institutions and Economic Performance
Key questions:

Role of Institutions - summarized recently in “Why Nations Fail” -

Daron Acemoglu and James Robinson (2012)
Some nations had inclusive institutions that protected property rights
and allowed all people to participate in growth.
Other nations had extractive institutions that allowed a small elite to
control the economic and political systems and uses its power to
extract wealth from the society at everyone else’s expense.
Institutions and Economic Performance
The Quality of Governance:

The legal, political, social, cultural, ethical, and religious institution matter
for economic outcomes:
The World Bank’s composite Worldwide Governance
Indicator
A proxy for institutional quality:

The index measures:

I voice and accountability,
I political stability,
I government effectiveness,
I regulatory quality,
I rule of law,
I control of corruption.
Color coding:
I Green indicates a country that is in the top 25%, yellow next 25%,
orange next 25%, and red bottom 25%.
I Dark green and dark red are the top and bottom 10%, respectively.
The Wealth of Nations
The World Bank’s composite Worldwide Governance Indicator
Institutions and Economic Performance: The Quality of
Governance

Recent research seeks to find deep historical origins for the divergence
of institutions (and hence incomes), including:
I actions of colonizing powers,
I types of legal codes that different countries developed,
I resource endowments.
Institutions and Economic Performance
Key topics:

Governance matters: it explains large differences between countries in

their economic outcomes.
Poor governance generally means that a country is poorer and is
subject to more macroeconomic shocks. It may also be subject to
more political shocks and a general inability to conduct policy in a
consistent way.
One size may not fit all, and policies that work well in a stable
well-governed country may be less successful in an unstable
developing country with poor governance.
Concluding Remarks

Global macroeconomy is increasingly integrated

Understanding the economic linkages between different countries is a
prerequisite to understanding:
I the fluctuations in currencies,
I the causes of crises,
I the determinants of global imbalances,
I the problems of economic policy making,
I the origins of the growing gap between rich and poor countries.