Exchange Rate Mechanisms - Leeds School of Business



Lecture Notes – 7 November 2012In this lecture we are going to talk quite a bit about Europe, Balance of Payments and currencies. Let’s start with Exchange Rate MechanismsExchange Rate MechanismsThere are two primary regimes for exchange rates currently:Floating exchange rate regimes – the value of a currency is allowed to float relative to the value of other currencies.Fixed exchange rate regimes – the value of a currency is pegged relative to the value of another currency or basket of currenciesFloating Exchange Rate RegimesThis is a pretty straightforward situation. The USD floats against the EUR. For the most part market forces determine where the exchange rate will go. On the other hand one of the largest market forces is the Fed Reserve and the ECB. We are not going to spend too much time discussing the USD. Fixed Exchange Rate RegimeWe are going spend our time talking about Fixed Exchange Rate regimes. Let’s start by a current situation in Europe. Here are some recent headlines regarding the Danish Krona.Danish Central Banker: Negative Deposit Rate Successful So Far (1 September 2012 WSJ)RBC Offers Negative Interest Rates on Danish Krone, Swiss Franc (9 October 2012 Bloomberg)Denmark cut its “deposit” rate to -20bps from +5bps this summer when the ECB cut its interest rate on reserves to zero. Why would you accept a negative interest rate in DKR. Let’s look at the Danish Krona. The Danish Krona entered into the “Exchange Rate Mechanism II” when the euro was created. It is officially pegged at 7.46038 DKR/EUR and is allowed to fluctuate roughly 1% around its peg. The Krona remains pegged to the Euro even though a referendum on joining the euro failed in 2000. Now support for officially joining the euro is almost non-existent. Irrespective of this it is officially pegged to the Euro.It is instructive to think about what happens to the supply and demand curves for a currency that is pegged. Remember last week I said that interest rates were not a good determinant of supply and demand for foreign exchange. In the case of a fixed exchange rate they are a very good determinant. If one can earn more interest in Denmark than one can in Europe then people will take their euros, buy DKR and save their money in Denmark rather than in Europe. When they need cash they can always unwind this transaction. Thus demand is increased for the Danish Krona. In a floating currency you would expect that this increased demand would strengthen the Krona – in this case the currency is pegged.In the absence of a crisis basically what has happened is that the smaller country has imported the monetary policy of the larger country. The smaller country needs to reduce the excess demand caused by the interest rate differential. The easiest way to do this would be to reduce interest rates. An alternative to this would be for the Danish Central Bank to carry out unsterilized selling of the DKR and buying of the EUR.Neither of these might be the best solution for Denmark. For example an undervalued currency might increase the chance of an asset bubble in property (which indeed happened from 1999-2007).On the other hand there is a crisis in Europe and a strong interest in moving ones money out of the euro and into a safer currency. Thus there is increased demand on DKR without there being an interest rate differential. So the Danish Central Bank needs to find a solution to this. The solution is the same – reduce interest rates. But the interest paid on reserves in euros is 0%. Thus the Danish Central Bank decides to pay negative interest rates. People may be willing to accept negative interest rates because they view that the crisis in the euro will end with a devaluation of the euro and a breaking of the peg.Why not hold the cash in Danish Krona under your mattress. This is ok and if interest rates were significantly negative then one might chose to do this but you cannot insure 1m DKR under your mattress. There are other risks. If a country wants to maintain a pegged currency then there is not much choice other than to import the monetary policy of the larger country. If the larger country pursues a more contractionary monetary policy and decreases its money supply then the smaller country must do the same in order to maintain the peg.The EuroLet’s consider the euro and the balance of payments. I’ve put a couple of links onto the web which are not required reading but will help as background to this part of the lecture. A main source is from a German economics think tank –ifo. This is a fairly conservative German economics research organization so you have to take some of the conclusions with that in mind. What we have just seen is that if a smaller country links its currency to a larger country then generally its takes on the monetary policy of the larger country. In particular interest rates need to be at similar levels. We should probably take a step back and talk about the beginnings of the Euro. This currency was created in 1999 (although the first bank notes did not appear until 2002). In order to join the euro there were strict criteria regarding all sorts of financial and monetary factors. For example,A debt ratio of < 60% of GDPGovernment budget deficits had to be under control <3% of GDPInflation had to be within a certain bandInterest rates had to be within a couple of percent of the European average Exchange rate stability - the country had to be in the exchange rate mechanism for at least two years before joining the Euro.Let’s look at a couple of criteria – government debt and budget deficits.Why would you need these criteria?These criteria were set up so that a country’s economy had converged with the rest of Europe before entering into the Euro. The danger of not having convergence was that the supply/demand curves for the exchange rates would not be sustainable.Note – there was lots of politics involved in the early stages of the Euro. The story is that Italy should never have been allowed to join the EU and several other countries did not meet the criteria. There are certain criteria that Greece did not meet and it is thought that they falsified their budget deficit numbers in order to make things look visibly better than they did. Basically they booked the assets of the public pension schemes to their accounts without booking the future liabilities that these assets were supposed to cover. Greece joined the Euro at the beginning of 2001. It was part of the exchange rate mechanism where Greece pegged the Drachma to the Euro in December 1998.Let’s take a look at Greece before it joined the euro.There is some data worth looking at. The first is the trade deficit. With ever increasing imports relative to exports what would you expect to happen to the foreign exchange rate?Now look at Greek and German interest rates.With Greek interest rates higher than German ones – what would you expect to happen to the foreign exchange rate?Finally we look at the Drachma vs Deutsche Mark exchange rate from 1969 until the Deutsche Mark entered the Euro in 1998.So in 1998 Greece joins what is called the Exchange Rate Mechanism II which pegged the Drachma against the Euro.What we just learned was the smaller country generally imports the monetary policy of the larger country. Interest rates did not completely harmonize but for the most part Greece went from having interest rates significantly higher than Germany to having interest rates within a few percent of Germany. Before Greece joined the Euro we saw interest rates on the order of 25-30% in the mid 1990’s. In Germany the equivalent rate was 10-15%.After Greece joined the Euro they saw interest rates fall to be less than 10% and in the mid-2000’s they were around 5%. Basically Greece imported the monetary policy of the rest of the Eurozone – this was dominated by Germany and a few other countries. What happens. Let’s consider an example. Let’s say that I can afford 2,000 dollars on a mortgage. If interest rates are 15% then I can afford a 150K mortgage. If interest rates are 5% then I can afford a $375K mortgage.So what happens when interest rates fall significantly in an economy? It booms. The question is what do you spend your money on. What you saw in Greece were several things:An increase in imports with a corresponding deterioration in the current account,An increase in property pricesAn increase in public sector spending – public sector wages rose 50% from 1999 and 2007.How did Greece and other countries finance this spending boom? We know that interest rates have dropped rapidly and the perceived credit risk of Greece fell substantially with its entry into the EUR.Before 2007 companies, individuals and the government were able to finance their current account deficit through voluntary lending from other countries in Europe. Basically if you were selling a BMW to an individual in Greece not only did you sell him the car but you also gave him financing to be able to purchase the car.In addition you had a property boom in Greece that would have allowed individuals in Greece to potentially take money out of their homes and pay for spending. Now in 2007 you had a financial crisis in the US and Europe. One of the things that happened is that the interbank market dried up. Let’s look at the interbank market between European banks prior to 2007.Let’s say you have a Greek Bank with a loan to a customer in Greece and financing this loan by borrowing via the interbank market in Europe. So we haveAssetLiabilitiesLoan to Greek CustomerLoan from Other European Bank1m EUR1m EURWhat happens if the European bank wants it loan bank?Well you can either recall your loan from the Greek customer, in the US you could borrow reserves from other Greek banks (but of course they are all in the same situation) or you can borrow from your central bank. Or There have been two bailouts of Greece so farMay 2010 the European Union and the IMF provided a 110bn EUR bailout loanIn March 2012 another 130bn EUR bailout was agreed and 90bn dollars of debt was written offThere’s another story behind Greece, Ireland, Portugal and Spain.Let’s go back to those bank loans. What happened to them? Over the past 3 years the Greek central bank has stepped in with the equivalent of discount loans. Remember what happens when the Greek Central Bank makes a discount loan. It deposits electronic money into a bank’s reserve account.The rate that the bank pays on the loan is 1%.So at the beginning of the crisis – the Greek Central Bank – or in some sense the ECB has stepped in and has been financing the Greek Banks in the absence of an interbank market willing to lend to Greek Banks.The ECB has to have rules regarding these sort of loans. There are no rules regarding the amount of money creation of a country’s central bank to the size of the country. The only restrictions are that it follows the ECB rules for lending to commercial banks which basically states that the banks have to post collateral against the loans. There are restrictions on the collateral but government bonds of Greece, Ireland and Portugal are acceptable. In fact ABS paper created by the banks themselves has been accepted. The other thing going on in Greece is the following round-trip.Let’s say the Greek government needs money. So the Greek central bank creates electronic money and lends it commercial banks in Greece. The commercial banks can then buy Greek government bonds which then transfers the money back to the government. In addition these bonds then end up back at the central bank as collateral for the money that has been lent to the banks. For the most part this money is spent on imports from other European countries into Greece.The money is currently ending up in the creditor countries but right now economic activity is low and the money is kept within bank accounts at the Bundesbank. This money then shows up most of the time as something called Target Claims in Germany and other European countries. Target stands for – Trans-European Automated Real-Time Gross Settlement Express Transfer.Here are the current balances…This is part of the real crisis in Europe. There are nearly 1tr dollars of money owed between central banks. The cost of this money is 1% to commercial banks and significantly undercuts market rates for lending to the periphery countries. ................
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