FDI 7

14 flashcards · Other · by Daniel F.

currency crisis (type of financial crisis)
serious doubt exists as to whether a country's central bank has sufficient foreign exchange reserves to maintain the country's fixed exchange rate accompanied by a speculative attacks due to a one-way speculative gamble often culminates in a sharp devaluation of the currency or a switch to flexible exchange rates leading to massive depreciation of the currency
Moral hazard
situation in which one party gets involved in a risky activity knowing that it is protected against the risk and the other party will incur the cost parties have incomplete information about each other e.g. insured person engages in risk because of insurance
Free-rider problem
situation where those who benefit from a common resource do not pay for of, which results in an underprovision of this good or service more likely to happen when groups are large
Archetypical currency crisis: theory
What happens Loss of confidence in economy/currency. Expectation of a future devaluation makes domestic assets less attractive for investors. speculative attack - (Large-scale) sales of domestic financial assets Decline in relative demand for the country's currency and exchange rate pressure. In response Central bank tries to fight attack by Raising interest rates makes domestic assets more attractive raises demand for local currency Selling foreign reserve assets against local currency to incr…
Reason for speculative attacks is that investors have (almost) nothing to lose (one way speculative gamble)
Sell domestic currency Protected if devaluation actually happens If devaluation does not happen and exchange rates remain stable: Tiny loss from forgoing foreign interest earnings
currency crisis: causes
investors may lose confidence in a currency because of Overlending/overborrowing overspending by government -> debt accumulation overlending to private sector: cheap money is not used for low quality investment or only consumption investors realize the rising risk of default -> loss of confidence, lending stop and capital outflow forces that cause loss of confidence Rise in foreign interest rate -> increased costs of servicing foreign debt -> risk of credit default -> loss of confidence -> Priv…
Contagion
Spread of a currency crisis to other countries Because of economic links between countries If a crisis country devaluates its currency, other countries exporting similar products will lose competitiveness products from the country with crisis are too cheap to compete with If investors lose money in a crisis country, they may be unable/unwilling to continue lending to other countries. because of overreaction by foreign leaders and self-fulfilling expectations investors (falsely) perceive other c…
Currency crises: Resolutions
Rescue packages additional low-interest loans to: Compensate for the lack of private lending (to finance imports, investments). Restore investor confidence by replenishing foreign reserves and signal international support. Limit contagion to other countries. Enforce policy changes. downside May encourage moral hazard encourage excessive borrowing/lending in expectation of a bail-out debt restructuring Changes in terms of conditions of existing debt Pushing repayments schedule to the future (deb…
Currency crises: prevention
Better bank regulation, supervision and risk management To prevent overlending “crony capitalism” excessive borrowing in foreign currency Capital controls prevent excessive capital inflows and overborrowing/overlending discourage short-term borrowing limit contagion from/to other countries
Monetary policy independence with fixed exchange rates
Monetary policy is an important instrument to steer the economy but under fixed exchange rates countries have no control over monetary policy The money supply must be adjusted to defend the exchange rate e.g. money supply increases quantity theory of money: inflation domestic goods less competitive demand for domestic currency falls downward pressure for domestic currency to depreciate central bank prevents this by buying domestic currency and selling foreign currency money supply decreases the…
Policy trilemma TO LEARN
Country has to choose two out of three Fixed exchange rate (facilitates trade and international investment). Monetary policy independence (important instrument to steer the economy). International capital mobility (more efficient allocation of savings and investment, risk-diversification).
Controlling inflation under fixed exchange rates
suppose home inflation is relatively higher Higher domestic inflation makes domestic goods less competitive net exports down pressure on currency to depreciate to prevent this: lower the money supply inflation down Implies that under fixed exchange rates countries are committed to have similar inflation rates. Fixed rates create a disciplinary effect on countries. This provides effective inflation control.
Exchange rate variability
creates uncertainty: increases transaction costs, discourages trade and FDI and causes welfare losses cause price fluctuations: inefficient reallocation of production resources Fixed exchange rates minimize/eliminate this variability
Flexible exchange rates vs Fixed exchange rates
Flexible exchange independent monetary policy no need to defend exchange rate less susceptible to speculative attacks welfare losses due to greater exchange rate variability Fixed exchange rates disciplinary effect in terms of inflation no exchange rate risk in developing countries with unstable economic and political environments, vulnerability to speculative attacks and currency crises Conclusion: A managed floating exchange rate system is a reasonable compromise