International Finance

## Terms, definitions

* Asset-liability mismatch: financial terms of an institution's assets and liabilities do not correspond
	+ Currency mismatch: a bank that chose to borrow entirely in US dollars and lend in Russian rubles - if the value of the ruble were to fall dramatically, the bank would lose money
	+ Maturity mismatch: A bank has, for instance, substantial long-term assets (such as fixed-rate mortgages) funded by short-term liabilities, such as deposits; If short-term interest rates rise, the short-term liabilities re-price at maturity, while the yield on the longer-term, fixed-rate assets remains unchanged
	+ Interest rate mismatch: bank borrows at one interest rate but lends at another. For example, a bank might borrow money by issuing floating interest rate bonds, but lend money with fixed-rate mortgages.
* Covered/uncovered: Unlike covered interest arbitrage, uncovered interest arbitrage involves no hedging of foreign exchange risk with the use of forward contracts or any other contract

## CA & balance of payment

* CA = X + NTR – M
* CA = (S–I) + (T–G)
* Deficits may lead to the government raising interest rates or reducing public expenditure to reduce expenditure on Imports. Alternatively, deficits may lead to calls for protection against foreign imports or capital controls to defend the exchange rate.
* Net export surplus
* Change in the value of the net claims of a country on the rest of the world (change in net foreign assets, thus an intertemporal phenomenon). After all, an exporting country must be acquiring foreign assets of equal value
* Difference between country’s total income and consumption, where the total income is called the GNP and is measured as the sum of: the value of the products produced within borders + net international factor payments (interest and dividend earnings on the economy’s net foreign assets)
* Current account = Change in resident holdings of foreign assets (gross outflow)–Change in resident liabilities to non-residents (gross inflow) = Net capital outflow = Saving – investment
* It’s important to ask where the CA imbalance comes from (gov. deficit), where the private sector is borrowing from
* Current accounts capture the net financial flows that arise from trade in real goods and services.
* The distinction between saving and financing implies that the current account says nothing about the extent to which domestic investment is financed from abroad.
* A balanced current account only implies that domestic production equals domestic spending, not that domestic saving “finances” domestic investment.
* The distinction between saving and financing implies that countries running current account surpluses are not financing those running current account deficits.
* It is not uncommon to tie the current account surplus to the accumulation of official reserves.
* It is monetary policy that underpins the term structure of market interest rates. And it is the relationship between market interest rates and the unobservable natural rate that underpins credit creation and the availability of external financing in general. In other words, it is monetary policy that ultimately sets the price of leverage in a given currency area.
* Borrowing through overseas subsidiaries are normally not included in balance-of-payments measures of capital inflows, which capture residence-based transactions.
* Balance of payments data split capital flows into four main types of instrument — foreign direct investment (FDI), portfolio equity, portfolio debt and ‘other’ — mainly loans and deposits from abroad

Capital account balance

* Net sales of assets to foreigners. Hence, capital and current account sum to zero

### Saving vs. financing

* According to the ‘‘excess saving’’ view, global current account surpluses, especially in Asia, led to the financial crisis in two ways. First, current account surpluses in those economies, and the corresponding net capital outflows, financed the credit boom in the deficit countries at the epicentre of the crisis, above all the United States. Second, the ex ante excess of saving over investment reflected in those current account surpluses put downward pressure on world interest rates, especially on US dollar assets, in which much of the surpluses were invested. This, in turn, fuelled the credit boom and risk-taking, thereby sowing the seeds of the global financial crisis
* Financing and saving coincide only in non-monetary economies. Financing is a gross cash-flow concept, and denotes access to purchasing power - saving is simply income not consumed → it is gross, not net, capital flows that finance credit booms
* In an economy without any investment, saving, by definition, is also zero. And yet that economy may require a lot of financing, such as that needed to fund any gap between income from sales and payments for factor inputs
* During financial booms the credit-to-GDP gap tends to rise substantially This means that the net change in the credit stock exceeds income by a considerable margin, and hence saving by an even larger one, as saving is only a small portion of that income.
* The real cause of the financial crisis was not ‘‘excess saving’’ but the ‘‘excess elasticity’’ of the international monetary and financial system: the monetary and financial regimes in place failed to restrain the build-up of unsustainable credit and asset price booms (‘‘financial imbalances’’) → The financial crisis reflected disruptions in financing channels, in borrowing and lending patterns, about which saving and investment flows are largely silent.

## Debt dynamics

* Capital inflow (i.e. demand for your currency) - appreciation of exchange rate; capital outflows (away from Ems) produce significant currency depreciation

## Exchange rate dynamics

* Portfolio capital flows are not, in either the short or long run, passive and accommodating, but an independent and dominant force in setting exchange rates.
* It is clear that the overwhelming majority of foreign exchange transactions are related to capital: the average daily value of currency transactions was around $1.9 trillion – enough to accommodate world trade 40 times over
* If it is the case that capital flows have no lasting effect on foreign exchange prices then, for all intents and purposes, currency demand arises only from import-export transactions. Imports thus translate into home currency supply. When they export, this creates a demand for their currency as foreigners buy it to obtain the home country’s goods and services: exports are home currency demand.
* PK: the role of the exchange rate as an asset class per se and the driving role of expectations in short-term financial markets, both in the short and the long run - Once the exchange rate is considered an asset class per se and market actors are acknowledged to be the driving force of exchange rates, their relationship to fundamentals becomes creative rather than reactive

### Mainstream & heterodox theories

* The neoclassical view of the exchange rate as a market equilibrating price, which stands in a causal and permanent relationship with underlying ‘fundamentals’ and remains firmly embedded in the classical dichotomy.
* The implication of the Neoclassical approach is that our focus should be on trade flows rather than portfolio capital.
* Mainstream theories
	+ Purchasing power parity: given a constant real exchange rate – the nominal exchange rate of two countries is only determined by their relative price levels
	+ The monetary model: the analytical focus of mainstream exchange rate theory shifted to the exchange rate as equilibrating price on asset markets as a short-run phenomenon, which temporarily misaligns the exchange rate from its long-run path determined by goods market arbitrage. Maintaining the basic principle that a floating exchange rate should be determined by some contemporary market-clearing mechanism, exchange rate movements in these models result from the need to restore equilibrium in money markets, such as in the flexible price monetary approach
	+ The Dornbusch model, portfolio balance, Mundell-Fleming, currency substitution, fundamentalists versus chartists
	+ Microstructure studies: Evans and Lyons’s order flow approach acknowledges that the price of the exchange rate is the result of the quotes set by dealer banks based on the information they receive and influenced by the structure they operate in; one of the most important pieces of information and thus driver of the exchange rate are private order flows received from clients that are incorporated in the publicly observable price
* Covered interest parity theorem: forward rates are determined by differentials in interest rates in the respective currencies, as arbitrage operations restore return equality in short-term money markets. However, while for mainstream economists forward rates are a reflection of rational exchange rate expectations, which equilibrate short-term money markets, post-Keynesians view covered interest parity as a pure arithmetic operation as banks charge their customers forward rates that simply reflect the spot rate plus a mark up incorporating the interest rate differential

## Macroeconomic trilemma

* Privatization of exchange rate risk through reserve accumulation

### Global Financial Cycle and Transmission Mechanisms

* When the US raises interest rate (monetary policy), this is transmitted through the global financial cycle. Mechanism: trade and balance sheets denominated in $ - i.e. credit costs/availability is linked to the Fed's rate. The $'s expensiveness directly affects foreign firms' debt.
* Liquidity cycles of $, € and Yen are comoving completely synchronized so replacing the $ with the Yen as the main currency wouldn't change too much
* 5 stylised empirical features of the financial cycle stand out

1. The financial cycle is best captured by the joint behaviour of credit and property prices
2. It is much longer, and has a much larger amplitude, than the traditional business cycle.
3. It is closely associated with systemic banking crises, which tend to occur close to its peak
4. It permits the identification of the risks of future financial crises in real time and with a good lead
5. It is highly dependent of the financial, monetary and real-economy policy regimes in place.