Money, Banking, and International Finance ( PDFDrive )

Money, Banking, and International Finance

Hegemony

A nation can exert relational and/or structural power over other nations. Relational power is one nation can force another nation to do something or not do it. Many sports, like football, soccer, or chess, are forms of relational power. For countries, a nation’s military strength determines its relational power. On the other hand, Structural power represents a nation’s ability to shape and influence the international institutions. All nations, political institutions, businesses, and people operate under the international institutions. Some nations possess structural power to affect the international institutions and change the rules in its favor.

The United States possesses both relational and structural powers. It gained both powers after World War II. The United States leads countries in technology, has the world’s largest economy, and possesses a strong military. Furthermore, the U.S. has the structural power to influence the World Bank and the International Monetary Fund. Of course, the United States helped create these institutions and became a large financial contributor.

A hegemony exceeds relational and structural powers. A hegemony is one country dominates other countries in international commerce. Hegemony is the richest and most powerful nation that establishes the institutions of international trade. Hegemony is a leader in industrial and agricultural production, has a strong financial system, and dominates international trade. Hence, the hegemony becomes a source of wealth, power, and economic growth. Modern world has seen three modern hegemonies. The United Provinces (or Holland) ruled international trade in the 18th century; Great Britain ruled the world during the 19th century, and the United States has dominated the world after World War II.

A hegemony is critical for free trade because international markets and institutions are public goods. Hegemony fosters free trade, ensures peace and security by protecting trade from pirates and rogue nations, balances nations’ powers, creates the system of international payments or the money system, and establishes the international institutions. These public goods are expensive to provide, and many nations can free ride on the international system without contributing to it. A free rider is a country that opens itself to international trade and benefits from trade without paying for the public goods that establish and maintain free trade.

A hegemony provides the international public goods, even supporting the free riders because the benefits outweigh the costs. When a hegemony rises, the world economy grows and prospers. Thus, the markets create wealth for all participating nations. For example, the United States supports a system of free trade. After World War II, the U.S. became the largest industrial producer because the European factories lay in ruins. Then the United States greatly benefited from international trade after creating the Bretton Woods System. The U.S. experienced a strong world demand for goods produced in its manufacturing industries during the 1950s and 1960s, leading to goods wages with a high living standard.

Costs of a hegemony, unfortunately, rise over time, weakening the hegemony's wealth and power. If the hegemony fails, then the public goods for international trade disappear, causing world trade to break down. Then the world’s economy stagnates and begins declining. An interesting twist for a hegemony is a rich and powerful nation gains control after a large war.

191

Money, Banking, and International Finance

2.Please define the following terms: current account, trade balance, financial account, and official settlement balance.

3.Why does a statistical discrepancy occur in the balance-of-payments accounts?

4.Please define and distinguish the three exchange rate regimes.

5.Identify the functions of the World Bank.

6.Identify the functions of the IMF.

7.If a country has a fixed rate regime and experiences a balance-of-payments deficit, please explain how the country must maintain this exchange rate. Furthermore, what happens if the government runs out of reserves and refuses to let the official exchange rate change?

8.Explain the J-curve Effect.

9.If a country has a managed float exchange rate regime and experiences a balance-of- payments surplus, please explain how the country must maintain this exchange rate. In your answer, include the actions of the central bank.

10.Why is capital flight disruptive to a country, and which four methods could an investor use to transfer his financial capital from a country experiencing a crisis?

11.Many foreign investors are worried over the U.S. government’s large trillion-dollar deficits, and the U.S. economy is plagued by massive trade deficits. What happens to the U.S. hegemony’s power if the U.S. dollar collapsed in value?

193

16.The Foreign-Currency Exchange Rate Markets

Many countries across the world use a flexible exchange rate regime. Consequently, this chapter builds upon a market's currency exchange rates, and explains how investors can calculate a cross exchange rate for two countries that rarely engage in trade. Moreover, investors can profit from arbitrage, when currency exchange rates differ between two or more markets. Then, students learn the supply and demand analysis to predict changes in a currency’s exchange rate because a country’s income, inflation, interest rates, etc. influence exchange rates. Finally, we expand the supply and demand analysis to include a pegged exchange rate and explain how a central bank devaluing its currency can trigger capital flight and a financial crisis.

Foreign Exchange Rates

Foreign-currency exchange market is traders exchange currency of one country for another country’s currency. Consequently, five parties need foreign currency. First, international banks specialize in foreign currencies. They transfer billions in foreign currencies with other banks. Second, any person or business engaged in international trade and commerce, especially imports and exports. Third, international travelers need foreign currency to pay for food, lodging, and entertainment in a foreign country. Fourth, central banks and governments use a cache of foreign currencies to finance balance-of-payments deficits or to manipulate their exchange rate. Finally, international investors invest in foreign countries, seeking greater profits in foreign countries.

Some international investors use hedging, where they invest in several countries to reduce their risk, while other investors use speculation, where they buy currency for a low price and sell for a high price. Speculation is a form of gambling because speculators gamble on future prices. Furthermore, investors could use arbitrage. Investors see a price difference of the same currency in two separate markets; thus, they buy currency for a low price and sell it for a higher price in the other market, reducing the price difference to zero between the markets.

Foreign exchange market is the largest market in the world, and traders exchanged nearly $3.2 trillion daily in 2007. Most transactions are electronic transfers between international banks, whereas transactions occur 24 hours per day, 7 days per week. Foreign exchange market has retail and wholesale markets. Retail market is a small market, where agents buy and sell foreign currencies, usually at booths at shopping malls, airports, and train and bus stations. Retailers display two exchange rates: Selling and buying price. Retailer always sells currency for a higher price than the buying price. Hence, the price spread reflects the retailers’ commission. On the other hand, the wholesale market comprises of a network of about 2,000 banks and brokerage firms. They buy and sell currencies with each other or with large corporations. Wholesale market uses an international clearing system where they exchange electronic deposits. International clearing system is similar to a clearinghouse for checks.

Supply and demand analysis for foreign currencies assumes no government interference and flexible exchange rates. For example, one U.S. dollar equals 3.0 Malaysian ringgits (or $1 = 3

194

Money, Banking, and International Finance

rm). How much would a one-liter of Coca-Cola costs in dollars if Coca-Cola costs 1.5 rm? Just multiply the ringgit price by the ratio ($1 / 3 rm) in Equation 1, which equals $0.50.

Investors and bankers can calculate an exchange rate for currencies that investors rarely trade. They calculate the cross rate to determine the exchange rate for these currencies. For example, the Mexican peso to U.S. dollar exchange rate is well established, while the peso-euro exchange rate is not. Since euros and U.S. dollars are widely traded, we can calculate the pesoeuro exchange rate. If the peso-U.S. dollar exchange rate equals 12.9 pesos per $1, and the euro- U.S. dollar is € 0.77 per $1, subsequently, we calculate the peso-euro exchange rate in Equation 2 as 16.8 per €. We use a trick – we retain the currency units; thus, the correct calculation has one of the currency units drop out, which is U.S. dollars in this case.

Using another example, a cross rate is the exchange rate between the Myanmar kyat and U.S. dollar. If one Malaysian ringgit equals 282.6 Myanmar kyats, then we use the U.S. dollarexchange rate to calculate the rarely traded exchanged rate. Consequently, we calculate the U.S. dollar-kyat exchange rate in Equation 3 as 847.8 kyats per $1.

Currency exchange rates are continually fluctuating, and a banker or investor can profit from price differences, called intermarket arbitrage. For example, a trader at Citibank has $100,000 and observes the following banks’ exchange rates. We denote the British pound by the symbol £.

First, we calculate the cross rate between Citibank and Credit Suisse in Equation 4, which equals $0.9625 per one euro. Then we compare this exchange rate to Deutsche Bank, equaling $0.97 per one euro. Since the exchange rates differ, then arbitrage exists, and we can profit from

195

Money, Banking, and International Finance

dollars while the U.S. dollar appreciated because one dollar buys more ringgits. Price of U.S. goods became more expensive while Malaysian goods became cheaper. Malaysian imports decrease while exports increase. Accordingly, U.S. exports and imports move in opposite directions. The U.S. exports fall while imports rise.

Price of ringgits $ per ringgit

Quantity of ringgits

Figure 1. Demand function for Malaysian ringgits

We show the exchange rates for Points A and B in Equations 8. We write the currency price first while the standard exchange ratio is in brackets. As we move from Point A to Point B, the Malaysian ringgits depreciate while the U.S. dollar appreciates.

Supply function for ringgits originates from the Malaysian consumers who buy U.S. products. U.S. firms sell products and services to Malaysian consumers, which are U.S. exports. The Malaysian consumers need U.S. dollars to pay for it. Consequently, they have a demand for dollars, converting ringgits to U.S. dollars supply ringgits on the exchange market. Demand for ringgits in one market simultaneously creates a supply of U.S. dollars in another market, and vice-versa.

We show the supply function for Malaysian ringgits in Figure 2. As we move from Point A to Point B, the ringgit exchange rate rises. Consequently, the ringgit appreciated while the U.S. dollar depreciated. Price of U.S. goods became cheaper while Malaysian goods become more expensive. The U.S. imports decrease while U.S. exports increase. Malaysia experiences the opposite pattern. Its imports rise while its exports fall.

197

Money, Banking, and International Finance

Exchange rate fluctuations alter prices of all goods, services, and assets that businesses, people, and government trade on the international markets. Analysts use appreciation and depreciation to compare two currencies. As one currency appreciates, the other must depreciate because these terms are relative to one another. When analysts refer to a weak or strong U.S. dollar, analysts compare the U.S. dollar to a basket of currencies from industrialized countries. A weak U.S. dollar means the value of the dollar decreased relative to a basket of other currencies, such as the British pound, euro, and Japanese yen. A strong U.S. dollar is the opposite.

Factors that Shift Demand and Supply Functions

Many factors influence supply and demand functions for foreign exchange rates. Several factors include interest rates, inflation, income, and actions by central banks. For instance, interest rates affect investment and financial capital inflows and outflows for a country, while inflation affects a country’s prices and hence its trade flows. Inflation is a continual increase of prices. Furthermore, a growing economy creates higher incomes, and greater demands for normal goods, which are most products. Finally, central banks could influence exchange rates by buying and selling currencies.

Real interest rate affects the currency exchange rates. Real interest rate means economists subtracted the country’s inflation rate from the nominal interest rate. For example, we show the Malaysian ringgit exchange market in Figure 4, and the original market price and quantity are P* and Q*. If Malaysia has a greater real interest rate than the United States, then U.S. investors increase their demand for ringgits; they want to earn the greater interest rate. Demand for ringgits rises and shifts rightward. Furthermore, Malaysian citizens invest more within their country, decreasing the supply of ringgits on the international markets. When the supply and demand both shift, either the market quantity or price becomes indeterminate. In this case, market price increases while market quantity becomes indeterminate. Consequently, the U.S. dollar depreciates while the ringgit appreciates.

We can use a trick to determine which variable becomes indeterminate. First, shift the demand function. Then draw three supply function shifts, where the first one shifts a little, the second shifts a little more, and the third shifts a lot. Consequently, one variable always moves in one direction while the other can increase and decrease, making it indeterminate.

Inflation rates of countries could impact the foreign exchange market. For example, Mexico experiences a greater inflation than the United States. We depict the U.S. dollar exchange market in Figure 5. Market price and quantity are P* and Q*. Higher inflation rate causes the prices of Mexican goods to become expensive while prices for U.S. goods become relatively cheaper. Therefore, Mexicans increase their demand for U.S. goods, increasing the demand for U.S. dollars. On the other side of the border, the U.S. citizens buy more domestic goods, decreasing their demand for Mexican goods. Hence, the supply for U.S. dollars decreases and shifts leftward. Consequently, the U.S. dollar appreciates while the peso depreciates. In this case, the equilibrium quantity for U.S. dollars becomes indeterminate.

199