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International Finance - Exam 1
Terms in this set (62)
What was the General Agreement of Tariffs and Trade (GATT)?
Set of rules to reduce and eliminate barriers to trade through tariffs, quotas, etc. Multilateral agreement between nations to reduce barriers to trade. Simple set of rules.
Explain the World Trade Organization
The Uruguay round established the WTO in 1995 and established an institution to replace GATT with greater power to enforce rules of trade. WTO is made up of regional trade agreements (EU, NAFTA, Mercorsur)
Institution to oversee trade with power to enforce rules.
Explain the nature of global trade.
After 2007, decrease in trade, with modest recovery from increased protectionism. Weak trade outlook for 2017 (growth of between 1.8-3.1%)
Explain current nature of capital flows.
1. After WWII, many countries imposed capital flow restrictions.
2. 1980s saw capital flow liberalization
3. Post 2008 - capital flows have declined from protectionism and regulation, screening and monitoring
What is capital flow?
Allows for free flow of capital in and out of country by foreigners and residents.
Describe the complexities of international business.
1. Multiple currencies
2. Country borders
3. Different laws and regulations
How do you calculate the current account balance?
Credits - Debits
If the Current Account balance is positive there is a ____ and a net ____ of foreign currency
surplus ; inflow
If the Current Account balance is negative there is a ____ and a net ____ of foreign currency
deficit ; outflow
How do you calculate the financial account balance?
Net acquisition of assets - net acquisition of liabilities
If the Financial Account balance is positive, there is a net ____ of foreign currency
If the Financial Account balance is negative, there is a net ____ of foreign currency
If a government buys reserves, there is an ___ of foreign currency
If a government sells reserves, there is an ___ of foreign currency
How do you calculate the reserve balance?
Net Acquisition - Net Sales
If the reserve balance is positive, there is a net ____ of foreign currency
If the reserve balance is negative, there is a net ___ of foreign currency
Explain the recent nature of US BOP.
Increasing and rising deficit in the current account. Increase in liabilities, countering the CA deficit (foreigners are buyers of financial assets)
Explain the changes in China's BOP in recent years.
Up until 2014: China was a net exporter, leading to a current account surplus. Increase in net liabilities to foreigners that generated inflows of foreign currency. Huge amount of reserves (peaked at $4T)
2015/2016: Capital controls imposed to stop outflow of foreign currency. Government started selling reserves to prevent devaluation. Outflow of foreign currency from decrease in net liabilities and increase in acquiring foreign assets.
Under FIXED exchange.... if BOP before reserves is greater than 0...
There is an outflow of foreign currency, no demand for domestic currency and government must sell reserves. Should consider devaluing currency.
Under FIXED exchange.... if BOP before reserves is less than 0...
There is an inflow of foreign currency, excess demand for domestic currency and government must buy reserves and would want to revalue currency.
The current account is also equal to...
National Savings - National Investment
Explain the process of the J-Curve with a devaluation.
1. Currency contract period where there are no short term price/volume adjustments and there is an increase the trade deficit.
2. Pass through period where the exchange rate is passed on to consumers and prices adjust and trade deficit starts decreasing
3. Quantity adjustment period where price/volume fully adjusts and balance of trade improves
What is the International Monetary System?
Set of agreements/institutions that define how international payments are made, how capital mobility is accomplished and how exchange rates are determined.
Explain the currency system prior to Bretton Woods.
Currencies floated and had difficulty finding equilibrium. US and UK required to hold gold now, not everyone. Failed because countries few money supply faster than gold reserves, which led to competitive devaluation.
Explain the Gold Standard's 3 Principles
Gold alone was unrestricted coinage. There was to be free import/export of gold. Required two way convertibility.
What are the advantages / disadvantages of the gold standard.
Advantage: non-inflationary since money supply growth was limited to growth of gold reserves.
Disadvantage: governments couldn't use monetary policy to fight inflation
Explain Bretton Woods.
Only the US convertible to gold whereas other countries set fixed exchange rates but could hold USD or gold. Creation of Bank for Reconstruction and Development and the IMF
What does the IMF provide?
Temporary assistance for countries to defend currency and help country with structural problems (lend money) and impose conditionality criteria.
Discuss the failure of Bretton Woods.
US money supply rose above gold reserves
What is an SDR?
Special drawing right, created by the IMF to supplement reserves and represents a basket of currencies
If wanting to depreciate domestic currency, non-sterilized interventions by central banks involves...
Buy foreign currency and domestic money supply increases
If wanting to appreciate domestic currency, non-sterilized interventions by central banks involves...
Sell foreign currency and domestic money supply decreases
If wanting to depreciate domestic currency, sterilized interventions by central banks involves...
Buy foreign currency and domestic money supply increases and then sell bonds and domestic money supply decreases
If wanting to appreciate domestic currency, sterilized interventions by central banks involves...
Sell foreign currency and domestic money supply decreases and then buy bonds and domestic money supply increases
What is the impossible trinity?
The idea that we cannot have all three of the following: monetary independence, exchange rate stability, and free capital mobility
Third World Debt Crisis
Cause: low interest rates caused excessive spending and loans were in USD. Borrowing used for consumption not investment. When interest rates and dollar value rose, Mexico defaulted on debt (plus other countries).
Solution: Debt negotiation and IMF conditionality
Lesson: governments can go bankrupt
Mexican Currency Crisis
Cause: Mexico had large current account deficit driven by spending instead of investment. Foreigners invested in peso denominated assets. Mexican political uncertainty and devaluation caused foreigners to pull money out of Mexico.
Solution: Abide by conditionality, credit lines from IMF and NAFTA
Asian Currency Crisis
Cause: Current account deficit due to high investment and fixed exchange rate caused currencies to appreciate with dollar against rest of world, making it hard to export. Thailand devalued, investors pulled investments out of the area. Severe recession.
Solution: IMF bailout for Indonesia, Korea and Thailand, conditionality criteria
Lesson: fixed exchange rate hurts flexibility & portfolio investment is fickle
Argentine Peso Crisis
Cause: Fixed exchange rate set 1:1 with dollar. US dollar appreciated and Argentine exports became less attractive. Run on banks from government printing too much money. Lost confidence in government's ability to keep ratio.
Solution: No traditional IMF agreements, shut out of international markets, holdouts.
Lesson: governments can go bankrupt, write bond contracts to avoid holdout
US Financial Crisis
Cause: Fed lowered rates, favored mortgage lending and house price boom (subprime borrowers allowed to borrow). Securitization of mortgages. Increase in rates showed weaknesses of subprime market. Eventual bankruptcies.
Lesson: interconnection of global financial institutions
What is eurocurrency?
Deposit in a bank of one country denominated in the currency of another country (basically, a USD in a bank in the UK, or a pound deposited in a US bank, etc.) NOT the Euro
What is the eurocurrency market?
Wholesale or interbank market (>$1M). Cheaper for banks to borrow in eurocurrency and there are no reserve requirements.
Advantages of eurocurrency market?
Deposits are convenient way for corporations to hold excess cash in short term. Loans are a source of short term funding for corporations. The market is relatively free of government regulation and interference.
What is LIBOR?
The interest rate banks charge bank borrowers (changes everyday)
Eurocurrency Market Crisis
With the subprime crisis, default risk of banks increased and led to flight to quality as investors preferred to earn US treasury RF rate. Banks began to report lower rates than actually paying. Spread between rates widened (was probably wider)
Lesson: be aware of easily manipulated rates and prices
Difference of LIBOR dollar rate less the US treasury rate. Reached 400 bps
Low tax rates in Cyprus, new government increased expenditures and government continued with loose fiscal policy after mild '09 recession. Greek bailout hurt Cyprus. Downgraded their debt to below investment grade.
First solution (voted down): tax on all depositors to save two largest banks but would upset depositors.
Second solution: insured depositors did not lose, uninsured depositors lost all, capital controls meant euro not the same in Cyprus as elsewhere.
What is the spot market?
The foreign exchange is delivered when the agreement takes place
What is the (outright) forward market?
The exchange rate and quantity are agreed today, but the exchange is delivered and payment made at pre-specified future date
What is the swap market?
Agreement to both purchase and sell a certain amount of foreign exchange at two pre-specified dates (ex. dealer buys currency in the spot market and sells same amount in forward market) TWO transactions at the same time
What is a non deliverable forward?
Similar to forward but settlement is in US dollars and no the actual currency in transaction
Foreign exchange market overview?
Daily turnover is ~$5T, swap and spots are most common. Dollar is most traded followed by euro and yen
$ needed for one unit of foreign currency
Foreign currency needed for one $
How much of home currency needed for 1 unit of foreign
How much foreign currency needed for 1 unit of home currency
What does a fixed exchange rate imply about a country's money supply?
Country's money supply limited to the amount of gold held by its central bank. Change in gold needs to match change in currency.
What was the difference between pure gold system and interwar years?
First all countries had to back currency with gold. But after only US and UK.
What did Iceland do?
Let the banks fail for foreign creditors and save domestic creditors. Imposed capital controls. Devalued currency to restart economic growth.
What did Ireland do?
Saved the entire banking system. Government became indebted. Could only use fiscal austerity since no control over monetary supply.
What is Germany concerned about?
The CB should be independent and not involved in countries fiscal policy. By purchasing sovereign bonds, the CB is indirectly financing the spending of the governments, violating rules of independence.
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