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**** The colour coding in these documents works as follows. Any text in blue comes from the text’s solutions manual. Comments from me are in green. BFC3240 International Finance Chapter 2 of ESM: Questions 4, 6, and 11. Problems 2 (ignore the last part of the question ‘ … and what is the value date of the AUD payment?’), 3, and 12.

4. Technical Float. What specifically does a floating rate of exchange mean? What is the role of government? A truly floating currency value means that the government does not set the currency’s value or intervene in the marketplace, allowing the supply and demand of the market for its currency to determine the exchange value. 6. De facto and de jure. What do the terms de facto and de jure mean in reference to the International Monetary Fund’s use of the terms? A country’s actual exchange rate practices is the de facto system. This may not be what IMF detect as ex-post system of the country, the de jure system and differs from what the country has announced to IMF as the official system.

11. Currency Boards. What is the difference between central banks and currency boards? A currency board is a monetary authority that is committed to adopt a pegged exchange rate while renouncing independent monetary policy. Similar to a central bank, a currency board issues notes and coins that it pegs to a foreign currency or a precious commodity. Unlike a central bank, a currency board is not the lender of last resort, and since it is not the government's bank it cannot influence interest rates or money supply. Examples include most Caribbean nations, Argentina from 1991 till 2002, and some members of the Commonwealth of Independent States after the collapse of the USSR. The important point is that a currency board does not conduct monetary policy – a country with a currency board system ‘imports’ the interest rate of the currency to which it’s pegged. It issues notes and coins, and strictly speaking must hold in reserves enough of the ‘peg’ foreign currency to cover the whole monetary base, which is notes and coins as well as banks’ deposits with the central bank. Problem 2 Aisha lives in Melbourne, Australia. She wins €150 in an online lottery on Thursday and wishes to convert the amount into Australian dollars (AUD). If the exchange rate is 0.5988 euros per AUD, how many AUDs does she get, and what is the value date of the AUD payment? S(EUR/AUD) = 0.5988. Aisha receives: EUR150/0.5988 = AUD250.50 Problem 3

In 1923, one ounce of gold cost 380 French francs (FRF). If, at the same time one ounce of gold could be purchased in Britain for GBP4.50, what was the exchange rate between the French franc and the British pound? S(FF/£) = 380/4.5 = 84.44 Problem 12 The Channel Tunnel or "Chunnel" passes underneath the English Channel between Great Britain and France, a land-link between the Continent and the British Isles. One side is therefore an economy of British pounds, the other euros. If you were to check the Chunnel's rail ticket Internet rates you would find that they would be denominated in U.S. dollars (USD). For example, a first class round trip fare for a single adult from London to Paris via the Chunnel through RailEurope may cost USD170.00. This currency neutrality, however, means that customers on both ends of the Chunnel pay differing rates in their home currencies from day to day. What is the British pound and euro denominated prices for the USD170.00 round trip fare in local currency if purchased on the following dates at the accompanying spot rates drawn from the Financial Times? Answers in blue: Round trip RailEurope train fare = $170.00 GBP spot Day Monday Tuesday Wednesday

EUR spot

Train fare in GBP

Train fare in EUR

(£/$)

(€/$)

(£)

(€)

0.5702 0.5712 0.5756

0.8304 0.8293 0.8340

£96.93 £97.10 £97.85

€ 141.17 € 140.98 € 141.78

Discussion questions: These questions relate to the additional reading “Poor dollar standard: has the downgrade shaken loyalty to the greenback?” The Economist August 13th, 2011, as well as the IMF’s summary of exchange rate arrangements for each country; see the pdf document “IMF annual report on exchange rate arrangements 2016” (in particular the table that starts on page 6) in the week 2 materials. 1. Why do you think that Saudi Arabia, Bahrain, Qatar and Venezuela peg to the dollar? These countries are oil producers. Oil is priced in dollars. It makes sense that these currencies are pegged to the dollar, in order to reduce export revenue volatility. Oil prices are volatile. If their currencies floated against the dollar, their domestic currency oil revenues would be even more volatile. So pegging to the dollar helps to minimise the volatility of oil revenues in domestic currency. After 2008 and the very low US interest rates, these countries experienced periods of serious inflationary pressures – when the oil price was strong, their economies were awash with money, but because they ‘imported’ US interest rates as a result of the dollar peg, they couldn’t use monetary policy to slow their economies down and moderate inflation by raising rates. If they had tried to raise interest rates, their economies would become even more awash with money – as they’d experience massive speculative capital inflows. 2. Which countries use other countries’ currencies (dollarisation), and what currency do they use? Why do you think these countries have dollarised? These countries use the dollar: Ecuador El Salvador Marshall Islands Micronesia Palau Panama Timor-Leste Zimbabwe These countries use the Euro: Kosovo Montenegro San Marino These countries use the Australian dollar: Kiribati Nauru Tuvalu

Ecuador and Zimbabwe moved to dollarise following periods of financial crisis and hyperinflation. El Salvador dollarised in 2001; this was essentially the formalisation of a long-standing informal dollarisation. Panama has been dollarised since the foundation of the state. Kosovo, Montenegro and Timor-Leste adopted the euro (Kosovo and Montenegro) and the dollar (Timor-Leste) in post-conflict situations leading to political independence. Kosovo and Montenegro have applied for EU membership. Kiribati, Marshall Islands, Micronesia, Nauru, Palau, San Marino, and Tuvalu are all tiny little states (microstates) that would not have the resources to run their own currencies. These questions relate to the additional reading “When the prices are too damn high: Daily chart” The Economist (Online); London (Feb 5, 2018). What is the definition of hyperinflation from the Economists and Banker’s point of view? Many economists and central bankers would define “hyperinflation”, usually as a rise in consumer prices of at least 50% over a month. Why Venezuelan government went deep into deficit and made them print more money? And why it led to hyperinflation? Low oil prices, declining oil production and general economic mismanagement have left the Venezuelan government struggling to pay its bills, driving the budget deficit to nearly 20% of GDP. While this torrent of new cash has flooded the economy, domestic production of goods has collapsed and the cost of imports in local currency has soared—a combination that has made it virtually impossible for consumers to keep up with rising prices.

BFC3240 International Finance Questions for week 4 tutorials 1. From Chapter 3 of ESM: Question 13 (page 102), a, b, c, d, e, g, h Classifying Transactions. Classify the following as a transaction reported in a sub-component of the current account or the capital and financial accounts of the two countries involved: These explanations (from the solutions manual) are more detailed than necessary; I’ve written simple answers in green. a. A U.S. food chain imports wine from Chile. Debit to U.S. goods part of current account, credit to Chilean goods part of current account. Current account – goods. b. A U.S. resident purchases a euro-denominated bond from a German company. Debit to U.S. portfolio part of financial account; credit to German portfolio of financial account. Capital and financial account. c. Singaporean parents pay for their daughter to study at a U.S. university. Credit to U.S. current transfers in current account; debit to Singapore current transfers in current account. This answer is correct if the ‘payments’ are for living expenses for the daughter – this would be a transfer. However, if it’s to pay tuition fees, this would be a services export. d. A U.S. university gives a tuition grant to a foreign student from Singapore. If the student is already in the United States, no entry will appear in the balance of payments because payment is between U.S. residents. (A student already in the United States becomes a resident for balance of payments purposes.) Not relevant to BoP accounting. e. A British Company imports Spanish oranges, paying with eurodollars on deposit in London. A debit to the goods part of Britain’s current account; a credit to the goods part of Spain’s current account. Current account – goods. g. A London-based insurance company buys U.S. corporate bonds for its investment portfolio. A debit to the portfolio investment section of the British financial accounts; a credit to the portfolio investment section of the U.S. balance of payments. Capital and financial account – portfolio investment. h. An American multinational enterprise buys insurance from a London insurance broker. A debit to the services part of the U.S. current account; a credit to the services part of the British current account. Current account – services export from UK. 2. What does it mean when it is said that China had surpluses on current and capital & financial account? With these ‘twin surpluses’, how is it that China’s BoP balanced? (The BoP must always balance; ie sum to zero)

See the lecture slides. Probably the easiest way to see how it works is to move the ‘change in reserves’ part of the equation to the other side of the equals sign. Then it’s clear that foreign currency reserves rise every quarter by the amount of the capital account surplus plus the current account surplus. Also in the period we look at in the lecture, net errors and omissions (NEO) was very substantial; in the appreciation phase against the dollar, positive, and in the recent depreciation phase, negative. Estimates of these ‘illegal’ (and therefore not measured) capital flows – whereby speculators and others are getting around capital controls – can be made solving for NEO in the BoP equation; see lecture slides

Discussions: Additional read: Why the Swiss unpegged the franc: The Economist explains The Economist (Online); London (Jan 18, 2015). 3. Why did the Swiss central bank ‘unpeg’ from the Euro? Do you think the Swiss central bank did the right thing in ‘unpegging’? Explain and discuss. According to this article, they unpegged the franc for three reasons.  



First, the Swiss people are angry that the Swiss National Bank (SNB) was building up such a large stock of foreign currency reserves – concerns about an increase in the money supply leading to hyperinflation. Second, at the time this article was written, QE was about to begin in the Eurozone. QE is usually associated with depreciation (so appreciation in the franc). For the SNB to maintain the cap as the euro’s value fell, they would have needed to intervene even more – creating even more Swiss francs to sell and buying more euro, thus accelerating their accumulation of foreign currency reserves. Third, the euro had already depreciated a lot against other currencies, so as a result of the peg, the franc depreciated with it. This would have assisted exports to noneurozone countries. So the thinking was (reading between the lines of the article), maybe we can abandon the euro cap without a serious impact on exports overall.

So to the question: did the SNB do the right thing in ‘unpegging’? Arguments/evidence ‘against’: As it says in article #1, inflation concerns were probably overdone given that ‘Swiss inflation is too low, not too high’. But the article refers to the fact that this was a ‘hot political issue’, so perhaps the decision was partly political rather than based purely on rational economic arguments. Associated with the announcement was a dramatic decline in the stock market, and downward revisions by analysts of GDP growth for Switzerland.  The stock market fell dramatically because Swiss goods would have suddenly become much more expensive in Eurozone countries – so the stock market certainly did not agree with the idea that because the franc had become weaker against currencies other than the euro, it was ‘not so overvalued’.  The effect of the decision on growth for the Swiss economy, as estimated by UBS analysts, was seen as potentially serious – a huge reduction in GDP growth for 2015

was predicted, from 1.8% to 0.5%. This seems to imply that the Eurozone is far and away Switzerland’s largest trading partner. But were the stock market and analysts too pessimistic about the effect on Swiss companies and the Swiss economy? It looks like it, from the information in the next article… Arguments/evidence ‘for’: During 2014, the euro had depreciated against other currencies, and of course the franc followed – down by 12% against the dollar (article #1). So the franc had depreciated against other currencies – keeping exports reasonably competitive amongst their other trading partner countries. Article #2 says that Switzerland has diversified its export base away from the Eurozone – from 55% to the Eurozone in 2005 to 44% now. Further, exports to the Eurozone haven’t declined as much as expected because “Switzerland has considerable ‘pricing power’ in much of what it exports”; that is, Swiss companies can pass on some of the increase in the value of the franc to their Eurozone customers (we look at this issue in a lot of detail when we do foreign exchange risks in weeks 8, 9 and 10). Article #1 says that exports would actually increase 1.5% that year. See the graph that goes with this article in the slides (slide #44) – a very strong currency over many years doesn’t seem to have adversely affected Switzerland’s export performance. Quite the opposite.

Additional read: Why China is cracking down on outbound deals Wildau, Gabriel. FT.com; London (Nov 30, 2016). 4. Why China decided to impose restrictions on outbound merger and acquisition at late 2016? What was the latest effort done by Chinse authorities to support Yuan before the new proposal? Was the restriction plan successful in halting renminbi to slide further? 

 

As China's economy slows, investors and business owners are diversifying into foreign assets. The flow of money out of China is creating downward pressure on the renminbi, which has depreciated 5.8 per cent in 2016, on track for its worst year to date. Depreciation pressure has prompted the central bank to withdraw foreign exchange reserves to support the currency. Official reserves fell to $3.12tn at the end of October 2016, their lowest level since March 2011. The Chinese were successful to halt the slide, but not completely due to cracking down outbound deal. As we learned in the lecture, almost 75% of the NEO was due to illegal capital outflow. The restriction of outbound deals only targeted the official and legal outflows. A combination of all capital restrictions which was explained in the lecture can be among the factors to explain the halt in depreciation of Yuan.

5. Why do you think that Chinese firms had a lot of dollar-denominated debt? Why were many such firms rushing to pay it down after the RMB started to depreciate against the dollar? Borrowing in dollars would have been a no-brainer for Chinese firms during the period of predictable rise in the yuan… particularly after 2008 when US interest rates were very low.

More importantly, the cost of servicing dollar debt as well as the size of the principal in yuan would have fallen as the dollar fell against the yuan. Profit-enhancing! It seems that many firms have paid down their dollar debt; this suggests that such firms were expecting the yuan to continue depreciating. When the yuan falls, the prior benefits of dollar debt go into reverse; the yuan value of dollar-denominated debt rises – and interest payments (in yuan) would have risen. For Chinese firms with dollar revenues as well as dollar debt, this wouldn’t have been a major problem because a rising cost of debt in dollars would have been offset by dollar revenues rising – a hedge position. (We will revisit the issue of foreign currency debt as a hedge in week 10.) But there’s a lot of reportage that suggests that a lot of Chinese firms’ dollar borrowing was unhedged. Also (incredibly) it seems that some Chinese firms were borrowing in dollars purely for speculative purposes.

BFC3240 International Finance Questions for week 5 tutorials Chapter 5 of ESM: Problems 7, 9 Chapter 6 of ESM: Problems 2, 4 and 5 Additional questions Question 1 Suppose that Indonesian prices are rising faster than US prices (and the US is a very important trading partner of Indonesia). (a) Suppose the Indonesian rupiah is pegged (soft peg) to the dollar. Is the Indonesian rupiah appreciating or depreciating in real terms relative to the US dollar? (b) What effect will this have on Indonesia’s external balance, and what can the Indonesian authorities do about this? (c) Suppose the dollar/rupiah exchange rate is floating. What does RPPP say should happen to the value of the rupiah relative to the US dollar? This question relate to the additional readings: Question 2 To what extent do you think the arguments in additional reading #1 explain why, despite falling unemployment, wages in many developed countries have stagnated in the last few years?

Chapter 5 Problem 7 The Asian financial crisis which began in July 1997 wreaked havoc throughout the currency markets of East Asia. a. Which of the following currencies had the largest depreciations or devaluations during the July to November period? July 1997

November 1997

(per US$)

(per US$)

yuan

8.40

8.40

Hong Kong

dollar

7.75

7.73

Indonesia

rupiah

2,400

3,600

Korea

won

900

1,100

Malaysia

ringgit

2.50

3.50

Philippines

peso

27

34

Singapore

dollar

1.43

1.60

Taiwan

dollar

27.80

32.70

Thailand

baht

25.0

40.0

Country

Currency

China

The exchange rates given in this problem are direct from the perspective of the Asian countries; that is, the US dollar is the foreign currency. (You see this because it says they are ‘per US$’, so we have RMB/USD, HKD/USD etc). So the relevant formula is the one that gives appreciation or depreciation for the domestic currency (see slide 18 of the week 5 lecture slides):

Amount of depreciation/appreciation = China: no change Hong Kong: (7.75-7.73)/7.73 Indonesia (2400-3600)/3600 Korea (900-1100)/1100 Malaysia (2.50-3.50)/3.50 Philippines (27-34)/34 Singapore (1.43-1.60)/1.60 Taiwan (27.80-32.70)/32.70 Thailand (25-40)/40

Beginning rate – ending rate Ending rate = +0.26% = -33.33% = -18.18% = -28.57% = - 20.59% = -10.63% = -14.98% = -37.50%

Alternatively, take the reciprocal of the exchange rates and use the formula for appreciation or deprecation of the foreign currency (see slide 19 of the week 5 lectures slides). Problem 9 Use the following spot and forward bid-ask rates for the U.S. dollar/euro (US$/€) exchange rate from December 10, 2010, to answer the following questions. Period

US$/€ Bid Rate

US$/€ Ask Rate

Mid-rate

spot 1 month

1.3231 1.3230