472 P A R T V |
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currency, which leads to a fall in the money supply, also causes the interest rate on domestic deposits i D to rise. This increase in turn shifts the expected return on domestic deposits RD to the right. The central bank will continue purchasing domestic currency and selling foreign assets until the RD curve reaches RD2 and the equilibrium exchange rate is at Epar at point 2 in panel (a).
We have thus come to the conclusion that when the domestic currency is overvalued, the central bank must purchase domestic currency to keep the exchange rate fixed, but as a result it loses international reserves.
Panel (b) in Figure 2 shows how a central bank intervention keeps the exchange rate fixed at Epar when the exchange rate is initially undervalued; that is, when RF1 and the initial RD1 intersect at exchange rate E 1, which is above Epar. Here the central bank must sell domestic currency and purchase foreign assets, and this works like an open market purchase to raise the money supply and lower the interest rate on domestic deposits i D. The central bank keeps selling domestic currency and lowers i D until RD
shifts all the way to RD2, where the equilibrium exchange rate is at EparÑpoint 2 in panel (b). Our analysis thus leads us to the following result: When the domestic cur-
rency is undervalued, the central bank must sell domestic currency to keep the exchange rate fixed, but as a result, it gains international reserves.
As we have seen, if a countryÕs currency has an overvalued exchange rate, its central bankÕs attempts to keep the currency from depreciating will result in a loss of international reserves. If the countryÕs central bank eventually runs out of international reserves, it cannot keep its currency from depreciating, and then a devaluation must occur, meaning that the par exchange rate is reset at a lower level.
If, by contrast, a countryÕs currency has an undervalued exchange rate, its central bankÕs intervention to keep the currency from appreciating leads to a gain of international reserves. Because, as we will see shortly, the central bank might not want to acquire these international reserves, it might want to reset the par value of its exchange rate at a higher level (a revaluation) .
Note that if domestic and foreign deposits are perfect substitutes, as is assumed in the model of exchange rate determination used here, a sterilized exchange rate intervention would not be able to keep the exchange rate at Epar because, as we have seen earlier in the chapter, neither RF nor RD will shift. For example, if the exchange rate is overvalued, a sterilized purchase of domestic currency will still leave the expected return on domestic deposits below the expected return on foreign deposits at the par exchange rateÑso pressure for a depreciation of the domestic currency is not removed. If the central bank keeps on purchasing its domestic currency but continues to sterilize, it will just keep on losing international reserves until it finally runs out of them and is forced to let the value of the currency seek a lower level.
One implication of the foregoing analysis is that a country that ties its exchange rate to a larger countryÕs currency loses control of its monetary policy. If the larger country pursues a more contractionary monetary policy and decreases its money supply, this would lead to lower expected inflation in the larger country, thus causing an appreciation of the larger countryÕs currency and a depreciation of the smaller countryÕs currency. The smaller country, having locked in its exchange rate, will now find its currency overvalued and will therefore have to sell the larger countryÕs currency and buy its own to keep its currency from depreciating. The result of this foreign exchange intervention will then be a decline in the smaller countryÕs international reserves, a contraction of the monetary base, and thus a decline in its money supply. Sterilization of this foreign exchange intervention is not an option because this would
C H A P T E R 2 0 The International Financial System 473
just lead to a continuing loss of international reserves until the smaller country was forced to devalue. The smaller country no longer controls its monetary policy, because movements in its money supply are completely determined by movements in the larger countryÕs money supply.
Another way to see that when a country fixes its exchange rate to a larger countryÕs currency it loses control of its monetary policy is through the interest parity condition discussed in the previous chapter. There we saw that when there is capital mobility, the domestic interest rate equals the foreign interest rate minus the expected appreciation of the domestic currency. With a fixed exchange rate, expected appreciation of the domestic currency is zero, so that the domestic interest rate equals the foreign interest rate. Therefore changes in the monetary policy in the large country that affect its interest rate are directly transmitted to interest rates in the small country. Furthermore, because the monetary authorities in the small country cannot make their interest rate deviate from that of the larger country, they have no way to use monetary policy to affect their economy.
Bretton Woods System of Fixed Exchange Rates. Under the Bretton Woods system, exchange rates were supposed to change only when a country was experiencing a Òfundamental disequilibriumÓ; that is, large persistent deficits or surpluses in its balance of payments. To maintain fixed exchange rates when countries had balance-of- payments deficits and were losing international reserves, the IMF would loan deficit countries international reserves contributed by other members. As a result of its power to dictate loan terms to borrowing countries, the IMF could encourage deficit countries to pursue contractionary monetary policies that would strengthen their currency or eliminate their balance-of-payments deficits. If the IMF loans were not sufficient to prevent depreciation of a currency, the country was allowed to devalue its currency by setting a new, lower exchange rate.
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A notable weakness of the Bretton Woods system was that although deficit coun- |
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tries losing international reserves could be pressured into devaluing their currency or |
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pursuing contractionary policies, the IMF had no way to force surplus countries to |
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revise their exchange rates upward or pursue more expansionary policies. Particularly |
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troublesome in this regard was the fact that the reserve currency country, the United |
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States, could not devalue its currency under the Bretton Woods system even if the dol- |
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lar was overvalued. When the United States attempted to reduce domestic unem- |
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ployment in the 1960s by pursuing an inflationary monetary policy, a fundamental |
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disequilibrium of an overvalued dollar developed. Because surplus countries were not |
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willing to revise their exchange rates upward, adjustment in the Bretton Woods sys- |
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tem did not take place, and the system collapsed in 1971. Attempts to patch up the |
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Bretton Woods system with the Smithsonian Agreement in December 1971 proved |
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unsuccessful, and by 1973, America and its trading partners had agreed to allow |
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exchange rates to float. |
Managed Float |
Although exchange rates are currently allowed to change daily in response to market |
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forces, central banks have not been willing to give up their option of intervening in |
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the foreign exchange market. Preventing large changes in exchange rates makes it eas- |
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ier for firms and individuals purchasing or selling goods abroad to plan into the |
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future. Furthermore, countries with surpluses in their balance of payments frequently |
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do not want to see their currencies appreciate, because it makes their goods more |
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expensive abroad and foreign goods cheaper in their country. Because an appreciation |
C H A P T E R 2 0 The International Financial System 475
when a currency fell outside the limits, with the central bank with the weak currency giving up international reserves and the one with the strong currency gaining them. Central bank intervention was also very common even when the exchange rate was within the limits, but in this case, if one central bank intervened, no others were required to intervene as well.
A serious shortcoming of fixed exchange rate systems such as the Bretton Woods system or the European Monetary System is that they can lead to foreign exchange crises involving a Òspeculative attackÓ on a currencyÑmassive sales of a weak currency or purchases of a strong currency to cause a sharp change in the exchange rate. In the following application, we use our model of exchange rate determination to understand how the September 1992 exchange rate crisis that rocked the European Monetary System came about.
Application |
The Foreign Exchange Crisis of September 1992 |
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In the aftermath of German reunification in October 1990, the German cen- |
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tral bank, the Bundesbank, faced rising inflationary pressures, with inflation |
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having accelerated from below 3% in 1990 to near 5% by 1992. To get mon- |
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etary growth under control and to dampen inflation, the Bundesbank raised |
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German interest rates to near double-digit levels. Figure 3 shows the conse- |
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quences of these actions by the Bundesbank in the foreign exchange market |
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for sterling. Note that in the diagram, the pound sterling is the domestic cur- |
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rency and RD is the expected return on sterling deposits, whereas the foreign |
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currency is the German mark (deutsche mark, DM), so RF is the expected |
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return on mark deposits. |
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The increase in German interest rates i F shifted the RF schedule right- |
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ward to RF2 in Figure 3, so that the intersection of the RD1 and the RF2 sched- |
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ules at point 1 was below the lower exchange rate limit (2.778 marks per |
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pound, denoted Epar ) under the exchange rate mechanism. To lower the |
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value of the mark relative to the pound and restore the pound/mark |
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exchange rate to within the ERM limits, either the Bank of England had to |
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pursue a contractionary monetary policy, thereby raising British interest rates |
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to i D2 and shifting the RD1 schedule to the right to point 2, or the Bundesbank |
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could pursue an expansionary monetary policy, thereby lowering German |
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interest rates, which would shift the RF schedule to the left to move back to |
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point 1. (The shift in RD to point 2 is not shown in the figure.) |
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The catch was that the Bundesbank, whose primary goal was fighting |
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inflation, was unwilling to pursue an expansionary monetary policy, and the |
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British, who were facing their worst recession in the postwar period, were |
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unwilling to pursue a contractionary monetary policy to prop up the pound. |
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This impasse became clear when in response to great pressure from other |
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members of the EMS, the Bundesbank was willing to lower its lending rates |
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by only a token amount on September 14 after a speculative attack was |
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mounted on the currencies of the Scandinavian countries. So at some point |
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in the near future, the value of the pound would have to decline to point 1 . |
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Speculators now knew that the appreciation of the mark was imminent and |
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F I G U R E 3 Foreign Exchange
Market for British Pounds in 1992
The realization by speculators that the United Kingdom would soon devalue the pound increased the expected return on foreign (German mark, DM) deposits and shifted R2F rightward to RF3. The result was the need for a much greater purchase of pounds by the British central bank to raise the interest rate to i D3 to keep the exchange rate at 2.778 German marks per pound.
Exchange Rate, Et |
RD1 |
RF1 |
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( DM/£ ) |
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RF |
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RF |
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3 |
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2 |
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Epar = 2.778 |
1 |
2 |
3 |
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1 |
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i D |
i D |
i D |
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1 |
2 |
3 |
Expected Return ( in £ terms )
hence that the value of foreign (mark) deposits would rise in value relative to the pound. As a result, the expected return on mark deposits increased sharply, shifting the RF schedule to RF3 in Figure 3.
The huge potential losses on pound deposits and potential gains on mark deposits caused a massive sell-off of pounds (and purchases of marks) by speculators. The need for the British central bank to intervene to raise the value of the pound now became much greater and required a huge rise in British interest rates, all the way to i D3. After a major intervention effort on the part of the Bank of England, which included a rise in its lending rate from 10% to 15%, which still wasnÕt enough, the British were finally forced to give up on September 16: They pulled out of the ERM indefinitely, allowing the pound to depreciate by 10% against the mark.
Speculative attacks on other currencies forced devaluation of the Spanish peseta by 5% and the Italian lira by 15%. To defend its currency, the Swedish central bank was forced to raise its daily lending rate to the astronomical level of 500%! By the time the crisis was over, the British, French, Italian, Spanish, and Swedish central banks had intervened to the tune of $100 billion; the Bundesbank alone had laid out $50 billion for foreign exchange intervention. Because foreign exchange crises lead to large changes in central banksÕ holdings of international reserves and thus affect the official reserve asset items in the balance of payments, these crises are also referred to as balance-of- payments crises.
The attempt to prop up the European Monetary System was not cheap for these central banks. It is estimated that they lost $4 to $6 billion as a result of
C H A P T E R 2 0 The International Financial System 477
exchange rate intervention during the crisis. What the central banks lost, the speculators gained. A speculative fund run by George Soros ran up $1 billion of profits during the crisis, and Citibank traders are reported to have made $200 million. When an exchange rate crisis comes, life can certainly be sweet for exchange rate speculators.
Recent Foreign Exchange Crises in Emerging Market Countries: Mexico 1994, East Asia 1997, Brazil 1999, and Argentina 2002
Major currency crises in emerging market countries have been a common occurrence in recent years. We can use Figure 3 to understand the sequence of events during the currency crises in Mexico in 1994, East Asia in 1997, Brazil in 1999, and Argentina in 2002. To do so, we just need to recognize that dollars are the foreign currency, so that RF is the expected return on dollar deposits, while RD is the expected return on deposits denominated in the domestic currency, whether it was pesos, baht, or reals. (Note that the exchange rate label on the vertical axis would be in terms of dollars/domestic currency and that the label on the horizontal axis would be expected return in the domestic currencyÑsay, pesos.)
In Mexico in March 1994, political instability (the assassination of the ruling partyÕs presidential candidate) sparked investorsÕ concerns that the peso might be devalued. The result was that the expected return on dollar deposits rose, thus moving the RF schedule from R1F to R2F in Figure 3. In the case of Thailand in May 1997, the large current account deficit and the weakness of the Thai financial system raised similar concerns about the devaluation of the domestic currency, with the same effect on the RF schedule. In Brazil in late 1998 and Argentina in 2001, concerns about fiscal situations that could lead to the printing of money to finance the deficit, and thereby raise inflation, also meant that a devaluation was more likely to occur. The concerns thus raised the expected return on dollar deposits and shifted the RF schedule from R1F to R2F. In all of these cases, the result was that the intersection of the RD1 and R2F curves was below the pegged value of the domestic
currency at Epar.
To keep their domestic currencies from falling below Epar, these countriesÕ central banks needed to buy the domestic currency and sell dollars to raise interest rates to iD2 and shift the RD curve to the right, in the process losing international reserves. At first, the central banks were successful in containing this speculative attack. However, when more bad news broke, speculators became even more confident that these countries could not defend their currencies. (The bad news was everywhere: in Mexico, with an uprising in Chiappas and revelations about problems in the banking system; in Thailand, there was a major failure of a financial institution; in Brazil, a worsening fiscal situation was reported, along with a threat by a governor to default on his stateÕs debt; and in Argentina, a full-scale bank panic and an actual default on the government debt occurred.) As a result, the expected returns on dollar deposits shot up further, and RF moved much farther to the right, to R3F; and
478 P A R T V |
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the central banks lost even more international reserves. Given the stress on the economy from rising interest rates and the loss of reserves, eventually the monetary authorities could no longer continue to defend the currency and were forced to give up and let their currencies depreciate. This scenario happened in Mexico in December 1994, in Thailand in July 1997, in Brazil in January 1999, and in Argentina in January 2002.
Concerns about similar problems in other countries then triggered speculative attacks against them as well. This contagion occurred in the aftermath of the Mexican crisis (jauntily referred to as the ÒTequila effectÓ) with speculative attacks on other Latin American currencies, but there were no further currency collapses. In the East Asian crisis, however, fears of devaluation spread throughout the region, leading to a scenario akin to that depicted in Figure 3. Consequently, one by one, Indonesia, Malaysia, South Korea, and the Philippines were forced to devalue sharply. Even Hong Kong, Singapore, and Taiwan were subjected to speculative attacks, but because these countries had healthy financial systems, the attacks were successfully averted.
As we saw in Chapter 8, the sharp depreciations in Mexico, East Asia, and Argentina led to full-scale financial crises that severely damaged these countriesÕ economies. The foreign exchange crisis that shocked the European Monetary System in September 1992 cost central banks a lot of money, but the public in European countries were not seriously affected. By contrast, the public in Mexico, Argentina, and the crisis countries of East Asia were not so lucky: The collapse of these currencies triggered by speculative attacks led to the financial crises described in Chapter 8, producing severe depressions that caused hardship and political unrest.
Capital Controls
Controls on Capital Outflows
Because capital flows have been an important element in the currency crises in Mexico and East Asia, politicians and some economists have advocated that capital mobility in emerging market countries should be restricted with capital controls in order to avoid financial instability. Are capital controls a good idea?
Capital outflows can promote financial instability in emerging market countries, because when domestic residents and foreigners pull their capital out of a country, the resulting capital outflow forces a country to devalue its currency. This is why some politicians in emerging market countries have recently found capital controls particularly attractive. For example, Prime Minister Mahathir of Malaysia instituted capital controls in 1998 to restrict outflows in the aftermath of the East Asian crisis.
Although these controls sound like a good idea, they suffer from several disadvantages. First, empirical evidence indicates that controls on capital outflows are seldom effective during a crisis because the private sector finds ingenious ways to evade them and has little difficulty moving funds out of the country.7 Second, the evidence
7See Sebastian Edwards, ÒHow Effective are Capital Controls?Ó Journal of Economic Perspectives, Winter 2000; vol. 13, no. 4, pp. 65Ð84.
Controls on Capital Inflows
C H A P T E R 2 0 The International Financial System 479
suggests that capital flight may even increase after controls are put into place, because confidence in the government is weakened. Third, controls on capital outflows often lead to corruption, as government officials get paid off to look the other way when domestic residents are trying to move funds abroad. Fourth, controls on capital outflows may lull governments into thinking they do not have to take the steps to reform their financial systems to deal with the crisis, with the result that opportunities are lost to improve the functioning of the economy.
Although most economists find the arguments against controls on capital outflows persuasive, controls on capital inflows receive more support. Supporters reason that if speculative capital cannot come in, then it cannot go out suddenly and create a crisis. Our analysis of the financial crises in East Asia in Chapter 8 provides support for this view by suggesting that capital inflows can lead to a lending boom and excessive risk taking on the part of banks, which then helps trigger a financial crisis.
However, controls on capital inflows have the undesirable feature that they may block from entering a country funds that would be used for productive investment opportunities. Although such controls may limit the fuel supplied to lending booms through capital flows, over time they produce substantial distortions and misallocation of resources as households and businesses try to get around them. Indeed, just as with controls on capital outflows, controls on capital inflows can lead to corruption. There are serious doubts whether capital controls can be effective in todayÕs environment, in which trade is open and where there are many financial instruments that make it easier to get around these controls.
On the other hand, there is a strong case for improving bank regulation and supervision so that capital inflows are less likely to produce a lending boom and encourage excessive risk taking by banking institutions. For example, restricting banks in how fast their borrowing could grow might have the impact of substantially limiting capital inflows. Supervisory controls of this type, focusing on the sources of financial fragility rather than the symptoms, can enhance the efficiency of the financial system rather than hampering it.
The Role of the IMF
The International Monetary Fund was originally set up under the Bretton Woods system to help countries deal with balance-of-payments problems and stay with the fixed exchange rate by lending to deficit countries. With the collapse of the Bretton Woods system of fixed exchange rates in 1971, the IMF has taken on new roles.
The IMF continues to function as a data collector and provide technical assistance to its member countries. Although the IMF no longer attempts to encourage fixed exchange rates, its role as an international lender has become more important recently. This role first came to the fore in the 1980s during the third-world debt crisis, in which the IMF assisted developing countries in repaying their loans. The financial crises in Mexico in 1994Ð1995 and in East Asia in 1997Ð1998 led to huge loans by the IMF to these and other affected countries to help them recover from their financial crises and to prevent the spread of these crises to other countries. This role, in which the IMF acts like an international lender of last resort to cope with financial instability, is indeed highly controversial.
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International Finance and Monetary Policy |
Should the IMF Be
an International
Lender of Last
Resort?
As we saw in Chapter 17, in industrialized countries when a financial crisis occurs and the financial system threatens to seize up, domestic central banks can address matters with a lender-of-last-resort operation to limit the degree of instability in the banking system. In emerging market countries, however, where the credibility of the central bank as an inflation-fighter may be in doubt and debt contracts are typically short-term and denominated in foreign currencies, a lender-of-last-resort operation becomes a two-edged swordÑas likely to exacerbate the financial crisis as to alleviate it. For example, when the U.S. Federal Reserve engaged in a lender-of-last-resort operation during the 1987 stock market crash (Chapter 17), there was almost no sentiment in the markets that there would be substantially higher inflation. However, for a central bank having less inflation-fighting credibility than the Fed, central bank lending to the financial system in the wake of a financial crisisÑeven under the lender-of-last-resort rhetoricÑmay well arouse fears of inflation spiraling out of control, causing an even greater currency depreciation and still greater deterioration of balance sheets. The resulting increase in moral hazard and adverse selection problems in financial markets, along the lines discussed in Chapter 8, would only worsen the financial crisis.
Central banks in emerging market countries therefore have only a very limited ability to successfully engage in a lender-of-last-resort operation. However, liquidity provided by an international lender of last resort does not have these undesirable consequences, and in helping to stabilize the value of the domestic currency, it strengthens domestic balance sheets. Moreover, an international lender of last resort may be able to prevent contagion, the situation in which a successful speculative attack on one emerging market currency leads to attacks on other emerging market currencies, spreading financial and economic disruption as it goes. Since a lender of last resort for emerging market countries is needed at times, and since it cannot be provided domestically, there is a strong rationale for an international institution to fill this role. Indeed, since MexicoÕs financial crisis in 1994, the International Monetary Fund and other international agencies have stepped into the lender-of-last-resort role and provided emergency lending to countries threatened by financial instability.
However, support from an international lender of last resort brings risks of its own, especially the risk that the perception it is standing ready to bail out irresponsible financial institutions may lead to excessive risk taking of the sort that makes financial crises more likely. In the Mexican and East Asian crises, governments in the crisis countries used IMF support to protect depositors and other creditors of banking institutions from losses. This safety net creates a well-known moral hazard problem because the depositors and other creditors have less incentive to monitor these banking institutions and withdraw their deposits if the institutions are taking on too much risk. The result is that these institutions are encouraged to take on excessive risks. Indeed, critics of the IMFÑmost prominently, the Congressional Commission headed by Professor Alan Meltzer of Carnegie-Mellon UniversityÑcontend that IMF lending in the Mexican crisis, which was used to bail out foreign lenders, set the stage for the East Asian crisis, because these lenders expected to be bailed out if things went wrong, and thus provided funds that were used to fuel excessive risk taking.8
An international lender of last resort must find ways to limit this moral hazard problem, or it can actually make the situation worse. The international lender of last resort can make it clear that it will extend liquidity only to governments that put the
8See International Financial Institution Advisory Commission, Report (IFIAC: Washington, D.C., 2000).
C H A P T E R 2 0 The International Financial System 481
proper measures in place to prevent excessive risk taking. In addition, it can reduce the incentives for risk taking by restricting the ability of governments to bail out stockholders and large uninsured creditors of domestic financial institutions. Some critics of the IMF believe that the IMF has not put enough pressure on the governments to which it lends to contain the moral hazard problem.
One problem that arises for international organizations like the IMF engaged in lender-of-last-resort operations is that they know that if they donÕt come to the rescue, the emerging market country will suffer extreme hardship and possible political instability. Politicians in the crisis country may exploit these concerns and engage in a game of chicken with the international lender of last resort: They resist necessary reforms, hoping that the IMF will cave in. Elements of this game were present in the Mexican crisis of 1995 and were also a particularly important feature of the negotiations between the IMF and Indonesia during the Asian crisis.
The IMF would produce better outcomes if it made clear that it will not play this game. Just as giving in to ill-behaved children may be the easy way out in the short run, but supports a pattern of poor behavior in the long run, some critics worry that the IMF may not be tough enough when confronted by short-run humanitarian concerns. For example, these critics have been particularly critical of the IMFÕs lending to the Russian government, which resisted adopting appropriate reforms to stabilize its financial system.
The IMF has also been criticized for imposing on the East Asian countries socalled austerity programs that focus on tight macroeconomic policies rather than on microeconomic policies to fix the crisis-causing problems in the financial sector. Such programs are likely to increase resistance to IMF recommendations, particularly in emerging market countries. Austerity programs allow these politicians to label institutions such as the IMF as being anti-growth, rhetoric that helps the politicians mobilize the public against the IMF and avoid doing what they really need to do to reform the financial system in their country. IMF programs focused instead on microeconomic policies related to the financial sector would increase the likelihood that the IMF will be seen as a helping hand in the creation of a more efficient financial system.
An important historical feature of successful lender-of-last-resort operations is that the faster the lending is done, the lower is the amount that actually has to be lent. An excellent example occurred in the aftermath of the stock market crash on October 19, 1987 (Chapter 17). At the end of that day, in order to service their customersÕ accounts, securities firms needed to borrow several billion dollars to maintain orderly trading. However, given the unprecedented developments, banks were very nervous about extending further loans to these firms. Upon learning this, the Federal Reserve engaged in an immediate lender-of-last-resort operation, with the Fed making it clear that it would provide liquidity to banks making loans to the securities industry. Indeed, what is striking about this episode is that the extremely quick intervention of the Fed not only resulted in a negligible impact of the stock market crash on the economy, but also meant that the amount of liquidity that the Fed needed to supply to the economy was not very large.
The ability of the Fed to engage in a lender-of-last-resort operation within a day of a substantial shock to the financial system is in sharp contrast to the amount of time it has taken the IMF to supply liquidity during the recent crises in emerging market countries. Because IMF lending facilities were originally designed to provide funds after a country was experiencing a balance-of-payments crisis and because the conditions for the loan had to be negotiated, it took several months before the IMF made
