8. International Currency and Currency Crisis

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

Mrs. Charu Rastogi Asst. Prof.

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. Mrs. Charu Rastogi Asst. Prof.

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. Mrs. Charu Rastogi Asst. Prof.

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

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 andMrs. Charu Rastogi across borders.
competition Asst. Prof.

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.pd
f


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.

 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


Bubble 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


Real 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 Story
Policy 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 high
Economy becomes more fragile

Government buys excess domestic currency at fixed exchange rate
Hemorrhaging foreign reserves of central banks
Tide of fleeing capital does not stop
Authority ceases to defend fixed exchange rate
Currency floats and depreciates
Foreign 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


8. International Currency and Currency Crisis

More Related Content

What's hot (18)

Viewers also liked (19)

Similar to 8. International Currency and Currency Crisis (20)

More from Charu Rastogi (17)

Recently uploaded (20)

8. International Currency and Currency Crisis