WEEK 3 Regional Economic Integration and International Finance

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WEEK 3Regional Economic Integrationand
International Finance

• Intl Business

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Level of Economic Integration
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Economic Integration

• Free Trade Area
• All barriers to trade among members removed.
• Each country can determine own trade policies
  toward nonmembers.
• Customs Union
• Eliminates barriers among members and has a
  common external trade policy.
• Economic Union
• No barriers among members, common external
  policy, common monetary and fiscal policy,
  harmonized tax rates and common currency.
• Political Union
• Has a coordinating bureaucracy accountable to all
  citizens.

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Case for Regional Integration

• Economic
• Stimulates economic growth in countries
• Increases FDI and world production
• Countries specialize in those goods and services
  efficiently produced
• Additional gains from free trade beyond the
  international agreements such as GATT and WTO
• Political
• Economic interdependence creates incentives for
  political cooperation
• Together, the countries have more economic clout
  to enhance trade with other countries or trading
  blocs

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Impediments to Integration

• Although a nation may benefit, groups within a
  nation may be hurt.
• Concerns about national sovereignty.
• Debate
• Trade creation
• Trade diversion

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EU Evolution

• Product of two political factors
• Devastation of WWI and WWII and desire for peace.
• Desire for European nations to hold their own,
  politically and economically, on the world stage.
• 1951 - European Coal and Steel Community.
• 1957- Treaty of Rome establishes the European
  Community.
• 1994 - Treaty of Maastricht changes name to the
  European Union.

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EU Membership
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EU Growth

• 1957 Belgium, France, (West) Germany, Italy,
  Luxembourg, the Netherlands
• 1973 Denmark, Ireland, United Kingdom
• 1981 Greece
• 1986 Portugal, Spain
• 1995 Austria, Finland, Sweden
• 2004 Cyprus, Czech Republic, Estonia, Hungary,
  Latvia, Lithuania, Malta, Poland, Slovakia,
  Slovenia
• 2007 Bulgaria, Romania

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Benefits of the Euro

• Benefits
• Savings from using only one currency
• Easy to compare prices, resulting in lower prices
• Forces efficiency and slashing costs
• Creates liquid pan-Europe capital market
• Increases range of investments for individuals
  and institutions
• As of 2004, Euro strong against the dollar and
  expected to rise

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NAFTA
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NAFTA For/Against
AGAINST
FOR

• Loss of jobs to Mexico.
• Mexican firms have to compete against efficient
  US/Canada firms.
• Mexican firms become more efficient.
• Environmental degradation.
• Loss of national sovereignty.

• Enlarged and productive regional base.
• Labor-intensive industries move to Mexico.
• Mexico gets investment and employment.
• Increased Mexican income to buy US/Canada goods.
• Demand for goods increases jobs.
• Consumers get lower prices.

Impact of NAFTA has been muted. Small trade and
jobs gain for US.
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Andean PACT
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ANCOM Andean Pact

• Bolivia, Colombia, Ecuador, Peru, Venezuela
• Cartagana Agreement, 1969. One of oldest still
  in existence.
• Nearly failed. Rejuvenated in 1990 in the
  Galápagos Declaration.
• Changed from FTA to customs union in 1992.
• Still has many political and economic problems.

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The Mercosur

• 1988 Argentina, Brazil. 1990 Paraguay, Uruguay
  
• 1995 Agreed to move toward a full customs union.
• Trade quadrupled between 1990-1998.
• Has significant trade diversion issues.
• Economic problems, first in Brazil (1999), then
  in Argentina (2001) has put plans for the customs
  union on hold.

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ASEAN
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Association of Southeast Asian Nations

• Created in 1967.
• Economic, political and social cooperation.
• Little has been accomplished.
• Brunei, Indonesia, Laos, Malaysia, the
  Philippines, Myanmar, Singapore, Thailand and
  Vietnam.

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The Foreign Exchange Market

• Intl Business

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VW Peoples Car

• Volkswagen, Europes largest carmaker, reported
  a 95 drop in 2003 fourth-quarter profits
• The causes for the slump had many reasons
• The unprecedented rise in the value of the Euro
  against the dollar
• Volkswagens decision to only hedge 30 of its
  foreign currency exposure as opposed to the 70
  it had traditionally hedged

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Definitions

• Foreign Exchange Market
• A market for converting the currency of one
  country into the currency of another.
• Exchange Rate
• The rate at which one currency is converted into
  another.
• Foreign Exchange Risk
• The risk that arises from changes in exchange
  rates.

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Functions of the Foreign Exchange Market

• Currency Conversion
• Companies receiving payment in foreign currencies
  need to convert to their home currency.
• Companies paying foreign businesses for goods or
  services.
• Companies invest spare cash for short term in
  money market accounts.
• Speculation taking advantage changing exchange
  rates.

• Insuring Against FX Risk
• Spot exchange rate rate of currency exchange on
  a particular day.
• Forward exchange rate two parties agree to
  exchange currencies on a specific future date.
• Currency swapsimultaneous purchase and sale of a
  given amount of FX for two different value dates.

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The Hierarchy of International Financial Centers
Note Size of dots (squares) indicates cities
relative importance
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Currency Conversion

• A higher dollar price for euros will raise the
  dollar costs of European goods.
• Dollar price of BMW 100,000 euros x 1/.91

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Economic Theories of Exchange Rate Determination

• Exchange rates are determined by the demand and
  supply of one currency relative to the demand and
  supply of another
• Price and exchange rates
• Law of One Price
• Example US/EU exchange rate 1 ?.79. A
  jacket selling for 50 in NYC should retail for
  ?39.4 in Paris (50x.79).
• Purchasing Power Parity (PPP)
• Money supply and price inflation
• Interest rates and exchange rates
• Investor psychology and Bandwagon effects

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Foreign Exchange Market

• Exchange rate is the price of one currency in
  terms of another. (e.g. 1.00 US dollar .91
  euro 1.00 US dollar 117 yen)
• Demand for US dollars The demand for dollars
  arises from the foreign demand of U.S. exports
  and investments. As dollars become cheaper, all
  US goods fall in price, increasing demand for US
  dollars.
• Supply of US dollars The demand for foreign
  currency represents a supply of U.S. dollars. If
  the value of the dollar rises, Americans can buy
  more euros. American consumers will respond by
  demanding more imports, thereby supplying a
  larger quantity of dollars.
• Equilibrium Given market demand and supply
  curves, we can predict the equilibrium price of
  the dollar like any other commodity.

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Foreign Exchange Market

• Over 1.5 trillion is traded daily, 87 is in US
  dollars.

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Factors Influencing Currency Value
Economic Factors 1. Balance of Payments
2. Interest Rates 3. Inflation 4. Monetary
and Fiscal Policy 5. International
Competitiveness 6. Monetary Reserves
7. Government Controls and Incentives
8. Importance of Currency in World Political
Factors 9. Political Party and Leader
Philosophies 10. Proximity of Elections or Change
in leadership Expectation Factors 11.
Expectations 12. Forward Exchange Market Prices
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Money Supply and Inflation

• PPP theory predicts that changes in relative
  prices will result in a change in exchange rates.
• A country with high inflation should expect its
  currency to depreciate against the currency of a
  country with a lower inflation rate.
• Inflation occurs when the money supply increases
  faster than output.

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Interest Rates and Exchange Rates

• Theory says that interest rates reflect
  expectations about future exchange rates.
• Fisher Effect (I rl).
• International Fisher Effect
• For any two countries, the spot exchange rate
  should change in an equal amount but in the
  opposite direction to the difference in nominal
  interest rates between the two countries.

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Exchange Rate Forecasting

• Efficient market where prices reflect all
  available public information.
• Early studies seem to confirm the efficient
  market theory, but recent studies have challenged
  it.
• Inefficient market where prices do not reflect
  all available information.
• Use fundamental (economic theory) or technical
  (price/volume data) analysis to predict the
  exchange rates.
• Analysis suggest that professional forecasters
  are no better than forward exchange rates in
  predicting future spot rates.

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Currency Convertibility

• Freely convertible.
• Externally convertible.
• Not convertible.
• Preserve foreign exchange reserves.
• Service international debt.
• Purchase imports.
• Government afraid of capital flight.
• Political decision.
• Many countries have some kind of restrictions.
• Countertrade.
• Barter-like agreements where goods/services are
  traded for goods/services.
• Helps firms avoid convertibility issue.

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Strategies to Reduce Risk

• These tactics are primarily designed to protect
  short-term cash flows from adverse changes in
  exchange rates
• Companies should use forward exchange rate
  contracts and buy swaps
• Firms can also use a lead strategy
• An attempt to collect foreign currency
  receivables when a foreign currency is expected
  to depreciate
• Paying foreign currency payables before they are
  due when a currency is expected to appreciate
• Firms can also use a lag strategy
• An attempt to delay the collection of foreign
  currency receivables if that currency is expected
  to appreciate
• Delay paying foreign currency payables if the
  currency is expected to depreciate

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International Monetary System
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The International Monetary System

• The institutional arrangements that countries
  adopt to govern exchange rates.
• Dollar, Euro, Yen and Pound float against each
  other.
• Foreign exchange market determines the relative
  value of a currency.
• Some countries use other institutional
  arrangements to fix their currencys value.

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• Some countries use
• Pegged exchange rate.
• Value of currency is fixed relative to a
  reference currency.
• Dirty float.
• Hold currency value within some range of a
  reference currency.
• Fixed exchange rate.
• Set of currencies are fixed against each other at
  some mutually agreed upon exchange rate.

Require some degree of government intervention.
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The Gold Standard
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Bretton Woods

• 1944
• 44 countries meet in New Hampshire.
• Fixed exchange rates deemed desirable.
• Agree to peg currencies to US dollar that is
  convertible to gold at 35/oz.
• Promise not to devalue currency for trade
  purposes and will defend currencies.
• Created
• World Bank
• International Monetary Fund.

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Bretton Woods
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The Role of the IMF

• Want to avoid problems following WWI.
• Discipline
• Fixed rate imposes discipline
• Need to maintain rate stops competitive
  devaluations.
• Imposes monetary discipline, curtailing
  inflation.
• Flexibility
• Lending facility
• Lend foreign currencies to countries having
  balance-of-payments problems.
• Adjustable parities
• Allow countries to devalue currencies more than
  10 if B of P was in fundamental
  disequilibrium.

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The Role of the World Bank

• International Bank for Reconstruction and
  Development (IBRD).
• Rebuild Europes war-torn economies.
• Overshadowed by the Marshall Plan.
• Turns to development.
• Lending money to Third World nations.
• Agriculture.
• Education.
• Population control.
• Urban development.

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Collapse of the Fixed Exchange Rate System

• Collapsed in 1973.
• Pressure to devalue dollar led to collapse.
• President Johnson financed both the Great Society
  and Vietnam by printing money.
• High inflation.
• High spending on imports.
• President Nixon took dollar off gold standard and
  kept 10 import tax.
• Countries agreed to revalue their currencies
  against the dollar.
• Bretton Woods fails when key currency (dollar) is
  under speculative attack.
• Now have a managed-float system.

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Fixed versus Floating Exchange Rates

• Floating
• Monetary policy autonomy.
• Restores control to government.
• Trade balance adjustments.
• Adjust currency to correct trade imbalances.

• Fixed
• Monetary discipline.
• Speculation.
• Limits speculators.
• Uncertainty.
• Predictable rate movements.
• Trade balance adjustments.
• Argue no linkage between exchange rates and
  trade.
• Linkage between savings and investment.

Which system is better? Evidence is unclear.
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Long-Term Exchange Rate Trends From 1973 - 2003
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Mexican Currency Crises of 1995

• Peso pegged to U.S. dollar.
• Mexican producer prices rise by 45 without
  corresponding exchange rate adjustment.
• Investments continued (64B between 1990 -1994.
• Speculators began selling pesos and government
  lacked foreign currency reserves to defend it.
• IMF stepped in.

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Asian Crisis

• 1997
• Investment boom.
• Excess capacity.
• Debt.
• Expanding imports.

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Evaluating the IMFs Policy Prescriptions

• Inappropriate policies
• One size fits all.
• Moral hazard
• People behave recklessly when they know they will
  be saved if things go wrong.
• Foreign lending banks could fail.
• Foreign lending banks have paid price for rash
  lending.
• Lack of Accountability.
• IMF has grown too powerful.