8. international currency and currency crisis

Mrs. Charu Rastogi Asst. Prof.

8. International Currency and Currency Crisis -Euro Phases, Benefit and Cost, Euro and Implication for India, Trade Invoicing in Euro vs. Dollars, South East Asian Currency Crisis

International Business Management (101), MBS


Euro Phases; Benefits and Costs


Progress of European integration The European Union (EU) that we know today started out in 1952

as the European Coal and Steel Community (ECSC). The founding members were Belgium, Germany, France, Italy, Luxembourg and the Netherlands. The idea was to withdraw those resources that had been vital for the world wars - coal and steel - from national sovereignty in order to preserve lasting peace.

Encouraged by their success, the same six countries soon decided to integrate other sectors of their economies, such as agriculture, with the aim of removing trade barriers and of forming a common market. In 1958, these six countries established the European Economic Community (EEC) and the European Atomic Energy Community (Euratom). In 1967 the institutions of these three Communities were merged. In the course of time, other European countries joined the then European Communities (EC) - or, since the Maastricht Treaty (1993), the European Union - in several rounds of accession.


Progress of European integration The Treaty of Lisbon, which is an amending rather than a

constitutional treaty, entered into force on 1 December 2009. It amends the Treaty on the European Union (Maastricht) and the Treaty Establishing the European Community (Rome). It lays down a new institutional framework aimed at making today’s European Union of 27 Member States more democratic, more transparent and more efficient. It also seeks to enhance the coherence and visibility of the EU's action on the world stage.

Integration means in this context that the countries take joint decisions on many matters - approving "policies" - in a very vast field, ranging from agriculture to culture, from consumer affairs to competition and from the environment and energy to transport and trade.

The Single Market was to be formally completed at the end of 1992, but there is still work to be done in some areas - for example, creating a genuinely single market in financial services.


Preparation of Economic and Monetary Union In the 1960s, with European economic integration making

progress, the idea arose of creating a single currency. However, a single European Economic Community (EEC) currency

was not yet foreseen in the treaties. Moreover, at the time, all six EEC countries were part of a reasonably functioning international monetary system (the "Bretton Woods system"). Within this system, exchange rates of currencies were fixed but adjustable and remained relatively stable until the mid-1960s, both within the EEC and globally.

In 1969, the European Commission submitted a plan (the "Barre Plan") to follow up on the idea of a single currency because the Bretton Woods system was showing signs of increasing strain. On the basis of the Barre Plan, the Heads of State or Government called on the Council of Ministers to devise a strategy for the realisation of Economic and Monetary Union (EMU). The resulting Werner Report, published in 1970, proposed to create EMU in several stages by 1980. However, this process lost momentum in a context of considerable international currency unrest after the collapse of the Bretton Woods system in the early 1970s and under the pressure of divergent policy responses to the economic shocks of that period, in particular the first oil crisis.


Preparation of Economic and Monetary Union To counter this instability and the resulting exchange rate volatility among

the currencies, the nine members of the then EEC[1] relaunched the process of monetary cooperation in March 1979 with the creation of the European Monetary System (EMS). Its main feature was the exchange rate mechanism (ERM), which introduced fixed but adjustable exchange rates among the currencies of the EEC countries. Thus it required adjustments in monetary and economic policies as tools for exchange rate stability. Within the EMS framework, the participants succeeded in creating a zone of increasing monetary stability and gradually relaxing capital controls.

A further impetus for pursuing a single currency and EMU was provided by the adoption of the Single European Act in 1986. This Act set a timeframe for launching the Single Market and reaffirmed the need for achieving EMU.

In 1988 the European Council confirmed EMU as an objective and mandated a committee of monetary policy experts, in particular the governors of the EC central banks, to propose concrete steps leading to EMU.

The resulting Delors Report recommended that EMU be achieved in three steps. The legal basis for EMU still had to be created. The report led to negotiations that resulted in the Treaty on European Union, signed in Maastricht on 7 February 1992. This Treaty established the European Union (EU) and amended the founding treaties of the European Communities by adding a new chapter on economic and monetary policy. This new chapter laid down the foundations of EMU and set out a method and timetable for its realisation.

http://www.ecb.int/ecb/educational/facts/euint/html/ei_003.en.html


Three stages to Economic and Monetary Union On 1 July 1990 Stage One of Economic and Monetary Union (EMU) started.

It was characterised mainly by the abolition of all internal barriers to the free movement of goods, persons, services and capital within EU Member States.

Stage Two started with the establishment of the European Monetary Institute (EMI), the predecessor of the European Central Bank (ECB), on 1 January 1994. Stage Two was dedicated to technical preparations for the creation of the single currency, enforcement of fiscal discipline and enhanced convergence of the economic and monetary policies of the EU Member States. The ECB was established in June 1998, giving it half a year to implement the preparatory work of the EMI.


Three stages to Economic and Monetary Union On 1 January 1999 Stage Three, the final stage of EMU, started

with the irrevocable fixing of the conversion rates of the currencies of the 11 Member States initially participating, and with the introduction of the euro as the single currency. It is also since this date that the Governing Council of the ECB has been responsible for conducting the single monetary policy for the euro area. This was preceded by the EU Council meeting, in the composition of the Heads of State or Government, which in May 1998 confirmed that 11 of the 15 EU Member States at that time - Belgium, Germany, Ireland, Spain, France, Italy, Luxembourg, the Netherlands, Austria, Portugal and Finland - had fulfilled the criteria for the adoption of the single currency. On 1 January 2001 Greece joined the euro area.

The first changeover to the euro was completed on 1 January 2002 with the introduction of euro banknotes and coins. Slovenia became the 13th member of the euro area in January 2007. Cyprus and Malta joined on 1 January 2008, Slovakia on 1 January 2009 and Estonia on 1 January 2011.


Convergence and Economic and Monetary Union The euro area was established in 1999 as a currency area

initially comprising 11 of the then 15 EU Member States with more than 300 million people. In 1999 responsibility for monetary policy was transferred to the Eurosystem[1], which is headed by a supranational institution, the ECB. However, responsibility for economic policies has remained with the participating Member States, subject to a European framework.

Against this background, sustained convergence efforts by individual Member States were important for the creation of an environment of price stability in Europe. National economic policies contributed to achieving more similar economic conditions throughout the euro area. The smooth introduction of the euro was possible because certain key economic features of the countries concerned had converged towards the best existing benchmarks. Economic convergence facilitates the task of monetary policy, which is to maintain price stability in the euro area and thereby to contribute to non-inflationary growth. Looking forward, EU Member States that will adopt the euro in the future are also obliged to make sure that their economies converge with the euro area economy.

http://www.ecb.int/ecb/educational/facts/euint/html/ei_005.en.html


Convergence Criteria To ensure sustainable convergence, the Treaty on the Functioning of the European

Union (Lisbon Treaty - TFEU) sets criteria which must be met by each EU Member State before taking part in the third stage of Economic and Monetary Union (EMU).

The Member State must not be subject to a Council decision that an excessive budgetary deficit exists;

There must be a sustainable degree of price stability and an average inflation rate, observed over a period of one year before the examination; which does not exceed by more than one and a half percentage points that of the three best performing Member States in terms of price stability;

There must be a long-term nominal interest rate which does not exceed by more than two percentage points that of the three best performing Member States in terms of price stability;

The normal fluctuation margins provided for by the exchange rate mechanism must be respected without severe tensions for at least the last two years before the examination;

Each Member State should ensure that its national legislation, including the statute of its national central bank (NCB), is compatible with Articles 130 and 131 of the Treaty and with the Statute of the European System of Central Banks (ESCB Statute). This obligation applying to Member States with a derogation is also referred to as "legal convergence".

The convergence criteria are meant to ensure that economic development within EMU is balanced and does not give rise to tensions between the EU Member States. It must also be remembered that the criteria relating to government deficit and government debt must continue to be met after the start of the third stage of EMU (1 January 1999). A Stability and Growth Pact with this end in view was adopted at the Amsterdam European Council in June 1997.


Economic and Monetary Union Of the 27 EU Member States today, 17 (Belgium, Germany, Estonia,

Ireland, Greece, Spain, France, Italy, Cyprus, Luxembourg, Malta, the Netherlands, Austria, Portugal, Slovenia, Slovakia and Finland) have adopted the euro, meaning that they participate fully in Stage Three of EMU.

Two - Denmark and the United Kingdom - have a special status, which means that in protocols annexed to the Treaty establishing the European Community (EC Treaty) they were granted the exceptional right to choose whether or not to participate in Stage Three of EMU. They both notified the EU Council (Denmark in 1992 and the United Kingdom in 1997) that they did not intend to move to Stage Three, i.e. they did not wish to become part of the euro area for the time being.

The other EU countries currently have a "derogation". Having a derogation means that a Member State has not yet met the conditions for the adoption of the euro and it is therefore exempt from some, but not all, of the provisions which normally apply from the beginning of Stage Three of EMU. This includes all provisions which transfer responsibility for monetary policy to the Governing Council of the ECB.


Benefits of Euro Low interest rates due to a high degree of price stability

The conduct of the single monetary policy by the Eurosystem is successful. The euro is as stable and credible as the best-performing currencies previously used in the euro area countries. This has established an environment of price stability in the euro area, exerting a moderating influence on price and wage-setting. As a consequence, inflation expectations and inflation risk premia have been kept low and stable, leading to low levels of market interest rates.

More price transparency Payments can be made with the same money in all countries of the

euro area, making travelling across these countries easier. Price transparency is good for consumers since the easy comparison of price tags makes it possible for consumers to buy from the cheapest supplier in the euro area, e.g. cars in different euro area countries. Therefore, price transparency created by the single currency helps the Eurosystem to keep inflation under control. Increased competition makes it more likely that available resources will be used in the most efficient way, spurring intra-euro area trade and thereby supporting employment and growth.


Benefits of Euro Removal of transaction costs

The launch of the euro on 1 January 1999 eliminated foreign exchange transaction costs and thus made possible considerable savings. Within the euro area, there are no longer any costs arising from: buying and selling foreign currencies on the foreign exchange

markets; protecting oneself against adverse exchange rate movements; cross-border payments in foreign currencies, which entail high fees; keeping several currency accounts that make account management

more difficult.

No exchange rate fluctuations With the introduction of the euro, exchange rate fluctuations

and therefore foreign exchange risks within the euro area have also disappeared. In the past, these exchange rate costs and risks hindered trade and competition across borders.


Financial Integration The bigger and ever more integrated financial system formed by

the euro area enables individuals and businesses to better exploit economies of scale and scope. Households can benefit from access to a larger variety of financial products – like mortgage loans for house purchases – at lower cost. Financial integration thus increases the potential for economic growth.

11 national large-value payment systems were originally linked in 1999 to form TARGET and were superseded in 2008 by a technically centralised, much more efficient system called TARGET2. In certain areas, work still needs to be done, for example when it comes to harmonising the way securities are moved from seller to buyer across Europe. This is what TARGET2-Securities will do.

Around 900 banks in 22 European countries are direct participants in TARGET2. They also enable a much larger number of banks to access it, with the result that around 56,000 banks worldwide can send and receive payments via TARGET2.


Key characteristics of the euro area Prior to the establishment of Monetary Union, the individual

countries that are now part of the euro area were relatively small and open economies. By contrast, the euro area forms a large, much more self-contained economy. The size of the euro area makes it comparable with the United States.

In terms of population, the euro area is one of the largest developed economies in the world, with 332 million citizens in 2011. By comparison, the populations of the United States and Japan were 312 and 129 million respectively.

In terms of share of world gross domestic product (GDP), the euro area was the second-largest single-currency economy in 2011, with 14.2%, behind the United States with 19.1%. Japan's share was 5.6%.

The fact that the euro area economy is far less open than the economies of the individual euro area countries tends to limit the impact of movements in external prices on domestic prices. However, the euro area is still more open than either the United States or Japan. Euro area exports of goods and services as a share of GDP were significantly higher in 2011 (24.7%) than the corresponding figures for the United States (13.9%) and Japan (15.9%).


Disadvantages of Euro With their own national currencies, countries

could adjust interest rates to encourage investments and large consumer purchases. The euro makes interest-rate adjustments by individual countries impossible, so this form of recovery is lost. Interest rates for all of Euroland are controlled by the European Central Bank.

They could also devalue their currency in an economic downturn by adjusting their exchange rate. This devaluation would encourage foreign purchases of their goods, which would then help bring the economy back to where it needed to be. Since there is no longer an individual national currency, this method of economic recovery is also lost. There is no exchange-rate fluctuation for individual euro countries.


Disadvantages of Euro A third way they could adjust to economic shocks was

through adjustments in government spending, such as unemployment and social welfare programs. In times of economic difficulty, when lay-offs increase and more citizens need unemployment benefits and other welfare funding, the government's spending increases to make these payments. This puts money back into the economy and encourages spending, which helps bring the country out of its recession. Because of the Stability and Growth Pact, governments are restricted to keeping their budget deficits within the requirements of the pact. This limits their freedom in spending during economically difficult times, and limits their effectiveness in pulling the country out of a recession.

In addition to the chance of economic shock within Euroland countries, there is also the chance of political shock. The lack of a single voice to speak for all euro countries could cause problems and tension among participants. There will always be the potential risk that a member country could collapse financially and adversely affect the entire system.


Euro Crisis and the Impact on India


Euro Crisis and India Indian economy has lot to do how world economy does

as US and Europe are our major trade partner. U.S. financial institutions hold considerable European

financial assets that could plummet in value if the euro zone enters a full-on crisis. For example, European debt makes up almost half of all money-market fund holdings.

Direct exposure to the so-called PIIGS countries profiled above is limited, but exposure to France and Germany is high, and given, for example, France’s tight linkages with the Italian financial system, a Italian default could roil France and the U.S. in turn.

The crisis is also leading to heavy spending cuts and reduced borrowing that hurts our exports to Europe & US, further endangering the Indian economy.


More Information on Euro Zone Crisis and Its Impact on India PDF attached with mail Source: http://finmin.nic.in/workingpaper/

euro_zone_crisis.pdf


Trade Invoicing in Euro vs. Dollar


Trade Invoicing: Euro vs Dollar Exporters decide the currency for invoicing

trade transactions With prices contracted in advance, exporters want

to keep demand for their goods predictable Choose an invoicing currency that keeps prices of

goods similar to the prices of competitors. This is called ‘herding’. This motive is strongest with goods that are close substitutes and where shifting among suppliers is easiest

They use currencies that provide hedging benefits and low transactions costs


Trade Invoicing: Euro vs Dollar The dollar continues to be the dominant

currency of choice in international trade The euro’s role has grown, mainly in

transactions of countries in geographical proximity

Currency use driven by: Issuing “country” size, exchange rate regimes, composition of goods traded, transaction costs, macro co-movement. “Herding” and “Hedging” motives.

The currency used in invoicing matters for country susceptibility to shocks and for country monetary policy effectiveness


South East Asian Currency Crisis


The Financial Crisis – Abridged Western investors loaned money to banks in East

Asia. Those banks funneled the loans to investment

projects at low rates of interest and took very little in collateral.

When these investments did not perform, currency speculators bet that the baht was overvalued and began to sell baht on the open market.

The value of the baht fell causing other investors to worry about currencies in the rest of Asia.

Pandemonium struck.


Before it started… From 1985 to 1996, growth rate averaging almost

9% annually - increased pressure on Thailand's currency, the baht

From 1985 until July 1997, Baht was pegged at 25 US$


Here come the speculators… Currency speculators in developing countries

began to notice Thailand was running a massive current account deficit - 8.4% of GDP in 1996. This was the result of the Chinese 1994 devaluation and

the decline of the Japanese Yen against the dollar by 35%.

Thai goods were becoming relatively more expensive abroad relative to Chinese goods and very expensive in Japan (Thailand's most important market) where consumers could now afford much less.

As word started to leak that many investment in these markets were non-performing and many investments went sour, institutional investors became less likely to lend money to banks or finance corporations.


Lack of foreign investment should have led naturally to a decline in the baht on foreign exchange markets. After all, there was less demand for it.

But the Bank of Thailand needed to maintain the value of the baht, so it started to sell foreign currency to prop up the baht.

This action was causing Thailand to deplete its foreign reserves.

Thailand could have raised interest rates to raise the currency value, but this would have made it expensive to invest in Thailand -- just as Thailand was entering a recession.

Notice: It was not just the current account deficit, it was the fact that currency speculators did not believe Thailand could attract enough investment to maintain it.

Here come the speculators…


Here come the speculators… Currency speculators began to bet that the

government would rather let the value of the currency decline rather than turn the screws on the domestic economy.

A devaluation of the baht would hurt the government's reputation, but also hurt Thai banks and businesses who held their savings in baht or were owed money in baht.

Speculators began to sell short: They borrowed baht on the international market, expecting the value to decline, and promised to sell them for dollars at the current rate. After the baht fell, they could pay back that baht loan at a substantial profit.


Inside Thailand…. But it wasn't just speculators: Local businessmen

borrowed baht to pay of loans that were denominated in dollars. Middle class Thais sold their holdings of Thai government bonds and began to buy US Treasury bills denominated in dollars.

The baht's value began to fall and the Government now had two choices. Let the value of the baht fall all the way to its natural level Or defend it all costs by selling foreign reserves. Instead, Thailand hedged as long as it could. Its President

Chavilit pledged to defend the peg and on the July 1, 1997 made a formal statement that Thailand would not abandon the peg.


Inside Thailand…. The very next day Thailand devalued, but

readjusted to a new peg. They did not let their currency float.

Speculators thought they could invest more, local Thais began to pull out their savings,

By the end of the summer, the Thai baht would drop from 25 baht to the dollar to 63 baht to the dollar. Finance models tell us that a normal devaluation to make Thai companies cost competitive would have been 15%.

But loss of confidence caused it to drop farther ---a loss of confidence caused by the Thai President's decision.


What happened in Thailand… Mid-May ‘97: Thai Baht was hit by massive

speculative attack Spark: End-June ‘97, Thai Prime Minister declared

that he would not devaluate the Baht Thai Government failed to defend the Baht

against International speculators Financial Crisis hits….


What happened in Thailand… Booming Thai Economy ground to a halt,

contracted by 1.9% Massive lay-offs in Finance, Real Estate &

Construction: unemployment rate all-time high Huge numbers of workers returning to their

villages in the countryside and 600,000 foreign workers sent back

Stock market dropped 75%, Baht reached 56 US$ in Jan ‘98


Who were hit… Primary Casualty: Thailand, Indonesia, South

Korea Fairly hurt: Hong Kong, Malaysia, Laos and

Philippines Most Asian countries’ currencies fall significantly

relative to the US$ Fear of Financial Contagion


What happened in Indonesia… Drastic devaluation of the rupiah: from 2,000

to 18,000 for 1 US$ Sharp price increase Widespread rioting: 500 deaths in Jakarta

alone Governor, Bank Indonesia was sacked President Suharto was forced to step down in

May 1998 after 30 years in power


What happened in S.Korea… Drastic devaluation of the won: from 1,000 to

1,700 for 1 US$

Credit rating of the country (Moody’s): A1 to B2

National Debt-to-GDP ratio more than doubled

Major setback in Automobile industry


What happened in Philippines.. Growth dropped to virtually zero in 1998

Peso fell significantly, from 26/US$ to even 55/US$

President Joseph Estrada was forced to resign


What happened in Japan… 40% of Japan’s export go to Asia, so it was

affected even if the economy was strong

Japanese Yen fell to 147 as mass selling began

GDP real growth rate slowed from 5% to 1.6%

Some companies went Bankrupt

Being world’s largest currency holder, Japan could bounce back quickly


What happened in US... Markets did not collapse, but were severely hit

NYSE briefly suspended trading, for the first time

Dow Jones Industrial Average suffered as 3rd biggest point losses ever


Why it happened… Part 1 Let’s hear to what Paul Krugman was trying to say

since 1994… "Asian economic miracle”.. Result of capital investment (high interest rate to

attract foreign investment) Growth in productivity, without much

improvement in Total Factor productivity needed for long-term prosperity


Why it happened… Part 2Bubble Theory

bubble fueled by "hot money”

More and more was required as the size of the bubble grew

short-term capital flow was expensive and often highly conditioned for quick profit

Development money went in a largely uncontrolled manner to people closest to the political power


Why it happened… Part 3Real Estate Speculation:

Excessive real estate speculation

Chinese effect:

Competition from China due to its export-oriented reforms in 90’s

Western importers found cheaper manufacturers in China whose currency was depreciated relative to the US$


Why it happened… the Complete StoryPolicy that distorts the incentives within the lender-

borrower relationship

Artificially high Interest rate to attract investors

Large quantities of available credit

Highly-Leveraged economic climate

Asset prices pushed up to unsustainable level, and eventually collapse

Default on Debt obligation

Panic among Lenders

Large withdrawal of credit

Credit crunch and further bankruptcies

Depreciative pressure on credit rates

Potential Collapse of the market Government enters…..


Why it happened… the complete story

Government is forced to raise Domestic interest rate to exceedingly highEconomy becomes more fragile

Government buys excess domestic currency at fixed exchange rateHemorrhaging foreign reserves of central banksTide of fleeing capital does not stopAuthority ceases to defend fixed exchange rateCurrency floats and depreciatesForeign currency-denominated liabilities grew substantially (in domestic currency terms)More bankruptcies Further deepening of the crisis


Before we close… Let’s see what happened to our Thai friends…

IMF unveiled a $17 billion rescue package, and another bailout package of $3.9 billion

subject to conditionality for reorganizing and restructuring, establishing strong regulatory frameworks

Tax revenue balanced the budget in 2004, 4 years ahead of schedule

Baht reached 33/US$ by 2007


Sub-Prime Crisis 2007 Watch Video on: http://www.youtube.com/watch?

v=bx_LWm6_6tA


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