Class #4Last class in Spain

Brian David ButlerProfessor of international finance and global entrepreneurship with Forum-Nexus Study Abroad. Guest lecturer with the IQS Business School of the Ramon Llull University in Barcelona, and the Catholic University of Milan. Previously, Brian taught finance, economics and global trade courses at Thunderbird’s Global MBA program in Miami, and worked as a research analyst with the Columbia Business School in New York City. Brian currently lives in Recife, Brazil where he is teaching classes at the university Faculdade Boa Viagem.

A global citizen, Brian was born in Canada, raised in Switzerland (where he attended international British school), educated through university in the U.S., started his career with a Japanese company, moved to New York to work as an analyst, married a Brazilian, and has traveled extensively in Latin America, Asia, Europe and North America.

briandbutler@gmail.com

LinkedIn/briandbutler

Skype: briandbutler

Brian Butler is a specialist in international economic analysis, and is founder of the prestigious “GloboTrends“ (www.globotrends.com) online economics site, which has been featured as syndicated content on Nouriel Roubini’s RGE Monitor, Emerginvest.com, Business Week Exchange, Wikinvest.com, and other leading news outlets.

http://globotrends.pbworks.com/ , http://blog.globotrends.com/

Lecture Schedule*

* Does not include professional visits, *Subject to change, modification without warning

•Tues 22th – boat to Greece

•Mon 26th – Athens

•Tues 27th – Rhodes•Wed 28th – Rhodes•Thurs 29th – Rhodes EXAM

Observations while in Spain…

•This class –

•Each student - tell one thing about Spanish economy (or about the Euro, Greece, etc) they noticed so far + class discuss

•Note: observations should come from reading (wall street journal, etc)… any other sources?

Review…

Who can tell me… what is the difference between a liquidity crisis, and a solvency crisis for banks?

Liquidity SolvencyMoney flows? Enough $?(to cover short term debts?) (more than expenses?)

Who can tell me… what is the difference between a liquidity crisis, and a solvency crisis for banks?

Competitive Devaluations

Dr. Kishore Dash, January 20, 2007

“Beggar thy neighbor”

Last class we talked about “competitive devaluations”… what did we mean? When was this a problem? What is the danger?

http://mohammedfikri.files.wordpress.com/2010/02/bretton_woods_sign.jpg

Who can tell me what happened at Bretton Woods ? Did the financial world become more or less stable afterward? When did it fail? Why?

Dr. Kishore Dash, Thunderbird, January 20, 2007

“As Good as Gold”

•U.S. Dollar Pegged to Gold ($35 per ounce)

•All Other CurrenciesPegged to the dollar

During the Bretton Woods era…

Fixed vs. Flexible exchange rates

•What system is Better? Why?

▫Groups of 2-3 students, answer

Brief History – Key points

•Key point: there is NO “best” system•It all depends on what you want to

achieve…•History: Cycle from Fixed to Flexible to

Fixed to Flexible……(future?)

Fixed Fixed

Flexible Flexible

The gold standard (~1850–1914)Fixed exchange rates during the 1920s

Great Depression era

Post WWIIBretton Woods / IMF system (1944–1971)

1970’s –today: since U.S. left the gold/dollar standard

?????

Brief History – Key points

•QUESTION:▫Why change from flexible to fixed? (give 1

reason)▫Why change from fixed to flexible?

Fixed Fixed

Flexible Flexible

The gold standard (~1850–1914)Fixed exchange rates during the 1920s

Inter-war periodGreat Depression era

Post WWIIBretton Woods / IMF system (1944–1971)

1970’s –today: since U.S. left the gold/dollar standard

Brief History – Key points• ANSWER:

▫Why change from flexible to fixed? CONTROL, STABILITY, LOWER INFLATION,

END CHAOS Note: Too chaotic in depression… so fixed for

stability Note: Argentina = fixed to dollar was “brilliant”

at the time…but should have dropped sooner (not just in 2002)

▫Why change from fixed to flexible? EASE ADJUSTMENT PROCESS, IMPROVE

LOCAL MONETARY CONTROL, INCREASE GLOBAL FLOW OF FUNDS

FIXED system…

KEY QUESTION:

▫Under a fixed system, how do you increase exports?

▫….Group answer

FIXED system…

Answer▫ need to decrease prices, wages ▫ So exports more competitive▫Can’t adjust FX rates, so adjustment has to be painfully with wages, prices

• KEY POINT:▫ adjustment in fixed system is = painful process, slow, very unpopular!▫ political

What will the future hold?

….Fixed vs. Flexible ?

What will the future hold? ….Fixed vs. Flexible ?• Future… if crisis brought terrible volatility…

• Will we move toward era of FIXED FX?▫ emerging markets DOLLARIZE?▫ More countries to join the EURO?▫ US / euro move to fixed?▫ New Breton Woods?

• Or, move toward more flexibility?▫ “Dollar Bloc” move toward flexibility?▫ Europe abandon the Euro?

▫ Answer: no body knows what will happen, but HISTORY tells us the CHANGE = the only CONSTANT!!

Take away: Key points

•History: systems change•Business leaders NEED to watch carefully

for SHIFTS in political attitude, and be READY for potential shifts in the system

•Protect yourself!!

Fixed Fixed

Flexible Flexible

The gold standard (~1850–1914)Fixed exchange rates during the 1920s

Great Depression era

Post WWIIBretton Woods / IMF system (1944–1971)

1970’s –today: since U.S. left the gold/dollar standard

?????

Mundell Trilemma

Decisions countries must make…

Difficult Choices… the “Mundell Trilemma”

•Countries face a trade-off when deciding whether to fix or be flexible

•Can only have 2 of the following 3 …▫Monetary policy independence (interest rates)▫Fixed exchange rates (predictable, stable)▫Free flow of money (access to global capital)

Mundell Trilemma• example of USA- Country wants:

1.Monetary Policy control (US wants to have control of interest rates to heat-up / slow-down economy)

2.Open access to international finance (US wants access to external funding, example from China)

3.Fixed, predictable exchange rates (US would like this, but according to the Mundell Trilemma, they need to give up one, and this is the one that the US lives without)

Mundell Trilemma

•example of Spain joining Euro-Zone - Country wants:

Group assignment: discuss which 2 of 3 Mundell Trilemma options that Spain has opted to have, and which 1 of 3 that Spain had to give up (by electing to join the Euro-zone)

Mundell Trilemma• Country wants (example of Spain joining

Euro-Zone)

1.Open access to international finance (taken as a given, assumed)

2.Fixed, predictable exchange rates (Spain gets this by joining Euro-Zone)

3.What’s left over? (ie. What did they have to give up?). What does this mean for Spain? Greece? Ireland?

Review:

•We talked about fixed and flexible exchange rates, monetary policy, controls of global capital flows, the threats to the Euro, devaluation, “beggar thy neighbor”, competitive devaluations, and more…

•Any thoughts? questions? (this will be on the exam)

GROUP ASSIGNMENT

•Write down:▫According to the Mundell Trilemma, what are the 3 things that countries want to achieve?

▫What 2 of 3 items did Spain elect to maintain? (which 1 did they give up?)

GROUP ASSIGNMENT

•Write down:

▫After WWII, at the Breton Woods conference, which 1 of 3 was given up (by the USA, and most western countries)?

China + Mundell Trilemma

•China:

▫Which 2 of 3 that they have selected. Who can guess? Why did they choose these 2? (and not the 3rd)?

▫Hint: peg with dollar

•(do you think it will last 20 years from now?)

International money markets

Arbitrage + international money markets

Borrowing in Foreign Currencies….Where would you prefer to borrow?You have a factory in Brazil, and want to borrow

money to expand. You could…1.Borrow money locally at 10%2.Borrow money abroad (in US) at 5%

• Which would you choose?• What is the risk of borrowing abroad (in the US)?

– general comment 20 words or less

Note: fictional data based on current loan rates Brazil…• LIBOR + 1.5% for US = 2.5+1.5 = 4%• CDI + 2% for Brazil = 9.75 +2 = 11.75%

New problem…

Question:

If you were a US based investor, with dollars to invest for 12 months…..where would you choose to deposit your money (to make the most return)?

Note: You can assume you have an account with a bank in London (HSBC, etc)… and its easy to switch from one account to the other (click of a button)

International Money Market Rates (Bid Side)

United Statesdollar

Englandsterling

Europeeuro

Switzerlandfranc

Japanyen

Eurocurrency Rate

LIBOR 12 months

3.2% 6.0% 5.3% 3.2% 1.1%

Where would you invest??

International Money Market Rates (Bid Side)

United Statesdollar

Englandsterling

Europeeuro

Switzerlandfranc

Japanyen

Eurocurrency Rate

LIBOR 12 months

3.2% 6.0% 5.3% 3.2% 1.1%

Right?? … maybe not!!

Need to consider….

•You might be temped to choose the England (sterling) option of 6% because it’s the highest…

•but that currency might be expected to lose value (depreciate) over the next year…wiping out the expected gains.

Need to consider….

•Answer: it DEPENDS not just on the interest rate, but also on the expected change in foreign exchange rate as well.

International Money Market Rates (Bid Side)

United Statesdollar

Englandsterling

Europeeuro

Switzerlandfranc

Japanyen

Eurocurrency Rate

LIBOR 12 months 3% 6.0% 5% 3.5% 1.1%

Expected appreciation /

depreciation vs. US Dollar to EQUATE

choices…

x -3% -2% -0.5% +1.9%

Which would you choose now??

Answer…

•You wouldn’t care (all investment options would appear neutral)

•Foreign exchange markets are in “equilibrium”

Controlling the economy

2 tools – monetary + fiscal policy

Monetary vs. Fiscal Policy

Group assignment;•Who can describe the difference?

Monetary vs. Fiscal Policy

• Monetary Policy:▫Think “interest rates”,▫Central Bank (FED, ECB, etc)▫Issue: inflation▫Milton Friedman

• Fiscal Policy▫Think “government spending”▫Fiscal Stimulus▫Issue: budget deficits▫John M. Keynes

Fiscal Policy

•Fiscal Policy▫Think “tax & spend”▫Trouble is = gov’t often spends, but forgets

about the tax part.▫Democracy, voters, upcoming election

▫Question- if government spends, doesn’t tax enough, runs deficits, and gets into debt trouble, what can they do?..... Leads to our discussion on the IMF (Breton Woods institution)

Monetary policy

•“interest” = cost of money•Increase interest = increased cost of

money Leads to slow down of economy

•Decrease interest = decreased cost of money

Leads to speed up of economy

Monetary policy – to speed up economy (lower interest rates, print money)

http://www.daily-bourse.fr/images/analyses/2009/03/30/Cartoon%20Emergency.gif

Monetary policy

•Group Question:▫“why would a government EVER want to increase interest (increase the cost of money) and SLOW down the economy?” answer, turn in, then discuss

Inflation•2 ways to think about it:

1. A general rise in prices (ok, but not useful)2. A decrease in the value of money (better)…

less purchasing power for $1 in future (than now)

▫Example: $1 will buy 1 apple now, but only 1/10th of an apple in the future. This is inflation! Money is worth less (in terms of real goods) in the future

▫Question: if you think your money will be worth less in the future, what would you do today?