International Financial Management - Example

Running Head: FINANCE Finance [Name Of Student] [Name Of Institution] FINANACE INTRODUCTION Monetary crises have become exceedingly significant and troublesome worldwide economic phenomenon of the 1990s. They take place when a tentative attack on a set exchange rate results in a depression (or spiky reduction) of the currency, or forces the establishment to preserve the peg by using huge volumes of global reserves or by harshly raising interest rates (IMF 1998). The core basis of a currency disaster is the market's anticipation that macroeconomic inequalities--particularly a rule fiscal shortfall, a present account scarcity, or a soaring rate of joblessness--are not sustainable and that a noteworthy regulation in the factual exchange rate is essential. Fixed exchange rate governments decrease the litheness of the supposed exchange rate and therefore hold back the essential alteration of the real exchange rate for the reason that they put the weight of alteration on moderately inflexible domestic prices and costs. Consequently, these governments are prone to crises since, without appropriate alteration, macroeconomic imbalances that are professed as indefensible will cause market weight on the currency to erect. In answer to such stress, the central bank firstly tries to secure the exchange rate by advertising foreign currency treasury or by elevating household interest rates (Sachs, 2000). Nevertheless, as the macroeconomic differences carry on and perhaps deteriorate, market pressure ultimately rocket into a full-blown exploratory attack. When the establishment realizes that accessible reserves cannot gratify personal demand at the current rate, or that senior interest rates are demanding too grave a toll on domestic monetary movement, the fixed rate will fall down (to a lessened fixed or depreciated elastic exchange rate point). a few fresh examples of monetary crises are the U.K. pound sterling of September 1992, the French franc crisis of July 1993, the Mexican peso in December 1994, the Thai baht in July 1997, and the Russian dilemma in August 1998. Recent crises have drawn attention, not only because of their increased frequency but because they have been experienced by a diverse group of countries, including several with large, well-developed economies. In emerging-market countries, these crises have severely disrupted economic activity in the affected country and also in neighbouring countries with trade or investment links (Resnick,2004). The economic impact of the currency crises in each of these countries was exacerbated by simultaneous crises in the banking and financial sectors, as investors tried to convert domestic assets--chiefly bank deposits, bonds, and equities--into foreign currency. THE CAUSES AND TIMING OF CRISES Pondering over the reasons and eras of currency crises has been the heart of latest theoretical study. The chief question this investigation deals with is whether feeble macroeconomic ground rules (i.e., unsound macroeconomic disproportions) are a compulsory or ample stipulation for a crisis. Previous theoretical models, acknowledged in the text as first-generation models, propose that catastrophes are rooted by the grouping of a fixed exchange rate and unending fiscal shortfall that are not sustainable at the existing exchange pace. In difference, new up to date models, also known as second-generation models, feature monetary crises to self-fulfilling exploratory activity generated by volatile transfers in investors' potential that effect in massive sales of domestic currency (Radelet, 1998). In these models, weak fundamentals may be a necessary, but not a satisfactory, situation for a crisis. A settlement of both the approaches is probable if the second-generation model is adapted to reproduce the reality that weak essentials will normally depreciate (i.e., macroeconomic imbalances will exacerbate) if the factual exchange rate does not alter. KRUGMAN FIRST-GENERATION MODEL The theoretical basis for the fundamentalist or "first-generation" view of currency crises is the pioneering model of Paul Krugman (1979). With this model, Krugman demonstrated that ongoing fiscal deficits financed by borrowing from the central bank (i.e., money creation) lead to reserve losses, which ultimately force the authorities to abandon the fixed exchange rate regime. In the Krugman model, reserves decline because the private sector is unwilling to hold the increase in the monetary base (Krugman, 2000). An important insight of this model is that the speculative attack and ensuing crisis occur before the process of excess money creation exhausts reserves. Forward-looking investors, anticipating the collapse and resulting exchange rate movement, have an incentive to attack the central bank and purchase its reserves before they run out. Left with no reserves, the central bank is forced to abandon the fixed-rate regime and allow the rate to float. The basic results of the model do not change if the fiscal deficit is financed by issuing debt rather than by money creation. Debt servicing increases the size of the deficits over time, and eventually, the private sector would not be willing to hold more debt. In that event, the authorities may have to resort to money creation to finance the deficits. SECOND-GENERATION SPECULATIVE ATTACK MODEL The next generation of models (e.g., Obstfeld 1994) was developed to demonstrate that a crisis could be caused by self-fulfilling speculative attacks rather than by deteriorating fundamentals. These models have two key elements. First, they adopt a more sophisticated view of government behavior. In particular, if a speculative attack occurred, the decision to abandon the fixed exchange rate regime would be based on the expected cost of a devaluation (or depreciation) versus that of defending the fixed rate. The cost of a devaluation includes the political and reputation damage of not honoring a commitment to maintain the fixed rate, the potential cost of bailing out domestic borrowers of foreign exchange (primarily domestic banks), and any possible damage to trade or foreign investment (Frankel, 2000). The cost of defending the fixed rate includes the employment and output losses as well as the larger fiscal deficits and debt payments resulting from higher interest rates and the overvalued real exchange rate. The government, therefore, would abandon the current fixed exchange rate if the cost of devaluing was less than the cost of defending the peg. Second, these models assume that the cost of defending the fixed rate increases with the strength of the speculative attack, which is determined by the market's expectation of devaluation. This expectation, in turn, reflects the market's understanding of the government's response to an attack. This circularity is the basis for a self-fulfilling attack: if the market believes that an attack will force a devaluation, then the attack will succeed because it will raise the cost of defending the fixed rate to an intolerable level (Krugman, 2000). The possibility of a self-fulfilling speculative attack highlights the fragility of a fixed exchange rate regime. This fragility is increased if the underlying fundamentals are weak because the cost of maintaining the peg would be greater. BANKING AND CURRENCY CRISES Although much of the theoretical research has focused on the issues of causation and timing of currency crises, another related and important area of research is the relationship between currency and banking crises. These have occurred simultaneously in many of the recent crises, especially those in Mexico and East Asia. Theoretically, the causal relationship between these types of crises could go either way (Sachs, 2000). A speculative attack on the exchange rate puts great stress on the banking system. Not only is the attack fuelled by the withdrawal of deposits, which could start a bank run, but to defend the currency, the central bank may have to raise interest rates, allowing the money supply to shrink as reserves are sold. The rise in interest rates and the accompanying slowdown in economic activity generally increase the number of non-performing loans. More importantly, as it defends the fixed rate, the central bank is less able to act as a lender of last resort and to increase the monetary base; thus, some illiquid as well as insolvent banks may close. Finally, if the defence is unsuccessful and the exchange rate depreciates or is devalued, domestic banks with large exposures to foreign exchange risk may fail. EVIDENCE Economists have been successful in developing theoretical models linking currency crises to economic fundamentals, speculative behaviour, and contagion. However, they have not been able to provide conclusive evidence on the role played by each of these factors in specific crises. Earlier empirical studies tried to identify variables that are associated with currency crises using different econometric techniques with a view to designing early-warning indicators that could help policy-makers avoid these crises. A large part of this literature focused on economic variables emphasized in first-generation crises models and did not incorporate speculative or contagion effects (Resnick,2004). The results obtained depend on the technique adopted, the quality and frequency of the data, and whether the data set used includes developing countries, developed countries, or both. Despite the inconclusive nature of the evidence, the variables identified in most empirical studies as good indicators of currency crises are real exchange rate overvaluation, low output and export growth, lending booms, and the ratio of broad money to international reserves. THE RECENT HISTORY OF MONETARY CRISES WESTERN EUROPE (1992-93) In the fall of 1992, the exchange rates of several European countries, most notably those of Italy, the United Kingdom, Sweden, and Norway, came under severe pressure and were either devalued or forced to float. The underlying causes of these crises were rising German interest rates and increasing unemployment and output gaps that the market judged to be politically too costly for governments to endure. Prevailing real exchange rate levels were widely perceived as misaligned; some adjustment seemed inevitable. The political uncertainty surrounding the outcome of the Danish and French referendums on the Maastricht treaty further undermined the credibility of commitments to maintain fixed exchange rates (Krugman, 2000). Based on the European experience, Krugman (1997) makes several remarks: first, the timing of the crises was largely unanticipated by the market; second, the importance of large market players in triggering speculative attacks is unclear; and third, the countries that left the European Monetary System performed significantly better in terms of both output and inflation than those countries that came under attack but remained in the system (e.g., the United Kingdom versus France). (Krugman, 2000) LATIN AMERICA (1994-95) The wave of crises in Latin America started in Mexico in December 1994 and soon spread to several other countries in the region. The source of the Mexican crisis can be traced back to large net capital inflows that averaged 7 per cent of GDP over the 1990-93 period. These inflows were caused in part by the decline in U.S. interest rates and also by the widespread reforms to the Mexican economy, including the liberalization, of capital account transactions that raised expected returns on Mexican assets (Krugman, 2000). As a result of these inflows, inflation increased and the real exchange rate appreciated by approximately 25 per cent over this period. While this real exchange rate movement was part of an equilibrating process, it increased the likelihood that the magnitude of these inflows (and the accompanying current account deficits) would lessen and possibly reverse (Radelet, 1998). Doubts about the sustainability of these inflows arose over the course of 1994 owing to several factors including uncertainty about monetary and fiscal policy before the Mexican presidential election in August, political assassinations, and the uprising in the state of Chiapas. As net capital inflows slowed and then receded, the momentum of inflation, together with the existing target-zone exchange rate system, hindered the required reversal of the real exchange rate appreciation. This caused speculative pressure on the peso to build and further reduced capital inflows (Moreno, 2000). When the crisis occurred, it happened concurrently with a general banking crisis. Weakly regulated Mexican banks with unhedged short-term foreign currency liabilities and non-performing longer-term loans were unable to service their foreign debts. The Mexican government also experienced a debt crisis, since it was unable to roll over its short-term, U.S.-dollar-linked debt. The manifestation of these crises was a sharp depreciation of the currency and a plunge in asset prices. More significantly, the crises caused a sharp contraction in domestic demand, a large increase in unemployment, and a burst of inflation. To prevent a default and further distress, a large bailout package was provided by the United States and the International Monetary Fund (IMF). Consequently, capital inflows resumed, and the economy soon recovered (Krugman, 2000). One of the countries attacked soon after the Mexican crisis was Argentina because its currency was also seen as being overvalued, and unemployment was relatively high. Argentina had been on a currency board fixed exchange rate system since 1991. While Argentina, assisted by the World Bank and the IME was able to fend off the attack successfully, the liquidity of the banking system declined sharply. Brazil also suffered contagion effects from the Mexican crisis and was forced to devalue its currency (Frankel, 2000). EAST ASIA (1997) The monetary disasters in East Asia were, first and the leading, crises surrounded by financial mediators--mainly banks--precipitated by shaky levels of classified scrounges that spawned outsized increases in fair play prices and ground values. even though the state of affairs varied transversely country to country, there are more than a few likely explanations of the untenable levels of private loans (Sachs, 2000). These comprise insufficiently synchronized and administered banking systems, wealth account liberalization that makes possible short-term group speculation and inter-bank lending from overseas, and different forms of administration interference in bank lending pronouncements. The extreme bank lending stimulated a bang in asset marketplace in these countries. Dilapidated economic enlargement due to a protracted stagnation of the Japanese financial system, the deteriorating of the yen, the rising competitiveness of Chinese exports, minor prices for product exporters, and political unsteadiness flickered the expected downturn in asset prices. As a result, a great percentage of domestic loans developed as non-performing, and this shaped doubts about the capacity of the financial authorities to preserve the fixed rate, for two rationales (Krugman, 2000). Foremost, governments were steadfast to reimburse the depositors and perhaps the shareholders of the banks, and these bailouts would be funded partially by government borrowing from the classified region or the central bank. Second, a lot of of the non-performing loans were overseas currency loans that the domestic banks had invested by interbank borrowing from out of the country (Radelet, 1998). By supercilious accountability for these overseas store loans, the regime was forced to examine them either by dropping reserves or by escalating its foreign currency loan borrowing. The first state in the area to undergo an assault on its exchange rate was Thailand, which drifted the baht on 2 July 1997. Malaysia, Indonesia, and the Philippines were the next victims. Indonesia, which emerged unenthusiastic to fulfill with IMF conditions for crisis assistance, experienced the most complicatedness in demanding to re-establish firmness. afterward, the currencies of Hong Kong and South Korea were molested by this crisis. Hong Kong, with its currency panel exchange rate rule, well-built banking system, and the fiscal backing of China, endured the stress (Sachs, 2000). However, South Korea, the eleventh biggest economy in the globe finally surrendered. Its main banks and businesses were too extremely leveraged and too open to the elements to overseas currency to endure the advanced interest rates and sensible exchange rate movements required fending off the speculative assault. Accordingly, a colossal IMF-led package was essential to avoid a non-payment and the additional grief it would cause. IMPACT OF CURRENCY CRISES ON REAL ACTIVITY An important characteristic of recent currency crises, primarily those in Latin America and East Asia, is the large negative impact that these crises had on economic activity. Several factors are responsible for the decline in economic activity. First, most central banks initially respond to a sustained speculative attack by raising short-term interest rates sharply and by allowing a sizable decline in the domestic money supply. Not only does aggregate demand fall as a result, but also this puts tremendous stress on the domestic banking system (Sachs, 2000). Second, when a devaluation or depreciation occurs, it increases the cost of importing required inputs and also the burden of foreign currency debt. Third, currency and banking crises often occur concurrently and precipitate broader financial crises or panics as asset prices collapse, interest rates rise, and liquidity declines sharply. As wealth falls, domestic borrowing and foreign lending come to a standstill, and output growth slows further or more likely declines. In the longer term, however, the resulting depreciation of the real exchange rate will serve to restore demand for domestic output and reduce the macroeconomic imbalances that were the underlying cause of the crisis (Moreno, 2000). CONCLUSION Currency crises in the 1990s, especially those in emerging markets, have been very disruptive to economic activity, affecting not only the country experiencing the crisis, but also those with trade, investment, and geographic links. A review of the theoretical literature and the empirical evidence indicates that the primary causes of these crises are macroeconomic imbalances (mainly, fiscal or current account deficits or output gaps) that are economically or politically unsustainable at the prevailing real exchange rate together with a fixed nominal exchange rate that hinders the necessary adjustment of the real rate. Although crises could be the result of external shocks (e.g., a deterioration of the terms of trade or an increase in the world interest rate), (Frankel, 2000)these imbalances have generally been the outcome of macroeconomic and financial policies, primarily fiscal and monetary policies, and more recently, policies governing financial intermediaries, that are inconsistent with the fixed nominal rate. In the past, most of the blame for a currency crisis was placed on the government's fiscal and monetary policies. Increasingly, however, the blame is being shifted to the inadequate regulation and supervision of the financial sector and to the fixed exchange rate regime itself. Not only is an inflexible nominal exchange rate an impediment to real exchange rate adjustment, but it also attracts speculative activity because it is an easy target. Furthermore, the government's commitment to a fixed exchange rate often encourages excessive risk-taking on the part of domestic borrowers and foreign lenders of foreign currency because they interpret this commitment as insurance against exchange rate risk. Hence, when a crisis produces a sharp movement in the exchange rate, it has a severe impact on the financial sector and government finances (Radelet, 1998). A country can reduce the likelihood of a crisis by moving to a more flexible exchange rate (as Canada did in 1951, and again in 1970), when economic conditions are favourable. Exchange rate flexibility is not a substitute for sound macroeconomic and financial policies: monetary policy geared towards attaining low inflation; prudent fiscal policy; and effective regulation and supervision of the financial sector. REFERENCES Calvo, Guillermo, and Enrique Mendoza. 1996. "Mexico's Balance of Payments Crises: A Chronicle of a Death Foretold." Journal of International Economics 41, pp. 235-264. Resnick, Eun :International Financial Management. (3rd eition), Chapter 2 and Chapter 6. McGraw-Hill, 2004. Feenstra, Robert. "World Trade Flows, 1970-1992, with Production and Tariff Data". National Bureau of Economic Research Working Paper No. 5910, January, 1997. Flood, 2000. "Speculative Attacks: Fundamentals and Self-Fulfilling Prophecies," NBER Working Paper 5789, 1996. Frankel, 2000 "Currency Crashes in Emerging Markets: An Empirical Treatment". Journal of International Economics (December 2000) Frenkel, 2002: "Currency Crashes in Emerging Markets: Empirical Indicators," Journal of International Economics, 41, November 2002, pp. 351-67. Gross, 2003: "European Monetary Integration: from the European Monetary System to Economic and Monetary Union", chapter 5, Longman, New York. Krugman, P. 2000: " Are Currency Crises Self-Fulfilling?" NBER Macroeconomics Annual, MIT Press. Revised Edition Krugman, Paul 2000. "A Model of Balance of Payments Crises." Journal of Money, Credit and Banking, 11, pp. 311-325. McKinnon, Ronald, and Huw Pill. 1997. "Overborrowing: A Decomposition of Credit and Currency Risk." Unpublished manuscript. Harvard Business School (November). Moreno, Ramon. 2000. "Macroeconomic Behavior during Periods of Speculative Pressure or Realignment: Evidence from Pacific Basin Economies." Federal Reserve Bank of San Francisco Economic Review 3, pp. 3-15. Obstfeld, Maurice. 2003: "The Logic of Currency Crises." In Monetary and Fiscal Policy in an Integrated Europe, eds. Barry Eichengreen, Jeffry Frieden, and Jurgen von Hagen, pp. 62-90. New York: Springer. Radelet, Steven and Jeffrey Sachs. "The East Asian Financial Crisis: Diagnosis, Remedies, Prospects". Brookings Papers on Economic Activity 1 (1998). Sachs, 2000 "Understanding the Asian Financial Crisis". In The Asian Financial Crisis: Lessons for a Resilient Asia, ed. Wing Thye Woo, Jeffrey Sachs and Klaus Schwab. MIT Press, 2000. Sachs, 2000. "Financial Crises in Emerging Markets: The Lessons from 1995." Brookings Papers on Economic Activity 0(1), pp. 147-198. Sachs, 2000. "Financial Crises in Emerging Markets: the Lessons from 1995". Brooking Papers on Economic Activity, 147-215. Read More