Chapter 33: International Finance

Chapter 33International Finance33-1Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Chapter ObjectivesFinancing international tradeThe balance of paymentsExchange rate systemsGlobalization of the U.S. dollarGrowing foreign ownership of American assets33-2Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.The Mechanics of International FinanceInternational trade and finance are an extension of our nation’s economic activities beyond our bordersThe balance of payments includes the “balance of trade” which has been negative since the mid-1970s along with investment income, transfers of funds abroad, and capital inflows and outflows 33-3Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.The Balance of PaymentsThe entire flow of U.S. dollars and foreign currencies into and out of the country constitutes the balance of paymentsThe balance of payments has two partsThe current account – a summary of all the goods and services produced during the current year that we buy from or sell to foreignersThe capital account – records the long-term transactions that we conduct with foreignersThe total of both accounts will always be zero 33-4Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.33-5Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.1. Current account 2. Merchandise 3. Exports + 790 4 Imports - 1,249 5. Balance of trade - 459 6. Services 7. Exports + 308 8. Imports - 220 9. Balances of services + 128 10. Income from investments 11. Income receipts + 343 12. Income payments - 361 13. Net investment income - 18 14. Net unilateral transfers abroad - 50 15 Balance on current account - 399 16. Capital account 17. Capital inflows + 898 18. Capital outflows - 430 19. Balance on capital account + 468 20. Statistical discrepancy - 69 21. Totals 0 U.S. Balance of Payments, 2000 (in $billions)Current Account Surpluses and Deficits, 1965-200033-6Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.What Does It Matter?We buy much more from foreigners than they buy form usIn effect, they lend or give us the money to make up the difference between our imports and our exportsWe are essentially selling them a piece of the (American) rock consisting of corporate stock, real estate, corporate and government bonds and other debt instrumentsShould this continue for another three or four decades, foreign investors will own most of America33-7Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Exchange Rate SystemsThe basis for international finance is the exchange of well over 100 national currenciesA exchange rate is the price of a country’s currency in terms of another currency33-8Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.The Gold StandardA nation is on the gold standard when it defines its currency in terms of goldWhen country A exports as much as it imports no gold is transferredBut, when country A imports more than it exports, it has to ship the difference in gold33-9Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.The Gold StandardA self-correcting mechanismThe gold standard was a self-correcting mechanismA negative balance of trade caused an outflow of gold, a lower money supply, lower prices, and ultimately fewer imports and more exportsThe gold standard will only work when the gold supply increases as quickly as the world’s need for moneyWith the breakdown of the gold standard in the 1930s, protectionism returned With World War II came the need for a world wide system that would lend some stability to how exchange rates were set33-10Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.The Gold Exchange Standard, 1934-73The Bretton Woods (New Hampshire) conference set up the International Monetary Fund (IMF) to supervise a system of fixed exchange rates, all of which were based on the U.S. dollar, which was based on goldThe dollar was defined as being worth 1/35 of an ounce of gold ($35 and ounce)Dollars were convertible into gold at $35 an ounceOther currencies were convertible into dollars, at fixed prices, so these currencies were indirectly convertible into gold33-11Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.The Gold Exchange Standard, 1934-73This was short of a gold standard because the money supplies of these nations were not tied to gold and no longer would trade deficits or surpluses automatically eliminate themselvesIf a nation ran consistent trade deficits it could devalue its currency relative to the dollarThis system worked well for 25 years after World War II33-12Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.The Gold Exchange Standard, 1934-73The United States held the largest stock of gold in the world and stood ready to sell that gold at $35 an ounceThe U.S. dollar was literally as good as goldHowever, our balance of payments deteriorated badly in the 1950s and 1960sThe U.S. gold stock dwindled as foreign governments found themselves with increasing stocks of dollarsOther nations began to be concerned about the U.S. government’s ability to redeem the dollars at $35 an ounceThe were afraid that the United States would be forced to devalue the dollar making their dollars less valuable In 1971 President Nixon announced the U.S. would no longer redeem dollars for goldThe dollar would now float along with every other currency Now the forces of supply and demand would determine exchange rates33-13Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Deterioration of the U.S. Balance of Payments The U.S. balances of payments deteriorated badly in the 1950s and 1960s because of Renewed foreign competition after the warMilitary and foreign aid spendingIncreasing private investment abroadInflationOil price shocksThe productivity factor33-14Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.The Freely Floating Exchange Rate System, 1973 to the Present33-15Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.The forces of supply and demand now set the exchange ratesThe demand curve for marks represents the desire of Americans to exchange their dollars for marksAmericans would want marks to buy German goods and services, stocks, bonds, real estate, and other assetsLikewise, the supply curve of marks represents the desire of German citizens to purchase American goods, services, and financial assetsWe don’t have completely free floating exchange rates because governments do intervene, usually for a limited time 33-16Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.The Freely Floating Exchange Rate System, 1973 to the PresentThe relative price levels between the two countriesThe relative growth of the two countries economies’The relative level of interest rates in the two countries33-17Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Factors Influencing Exchange RatesInternational Exchange Rates, 1970-200033-18Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Exchange Rates: Foreign Currency per American Dollar, January 31, 200033-19Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.How Well Do Freely Floating Exchange Rates Work?Until 1973 most countries had fixed exchange rates because they feared flexible rates would fluctuate wildlyWhile there has certainly been some ups and downs, most notably with the dollar, we can still say so far so goodWhile far from perfect, this may be the best system we have known33-20Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.The EuroOn January 1, 1999, most of Western Europe introduced a single currency, the euroWhat the members of the euro area are doing is attempting to move toward a unified market with a single currency, just like the one we’ve long enjoyed in the United StatesThe euro was worth $1.17 in the beginning but now is in the 85 cents to 95 cents range33-21Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.The EuroThe decline in the value of the euro apparently hasn’t hurt the economies of the 11-member nationsTheir rate of economic growth picked up in 1999 and 2000Their unemployment rates declinedThe euro has fostered the continued unification of the European market and may have given added impetus to the growing prosperity of its membersThe main reason for the Euro’s decline has been the remarkable strength of the American economy33-22Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.The EuroThe European Central Bank, which came into existence on January 1, 1999, now has a dilemmaIt can stem the decline of the euro by raising interest rates, thereby making the euro more attractiveBut raising interest rates might undermine economic growth33-23Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Hypothetical Supply and Demand for Dollars Relative to the Yen33-24Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.If the supply of dollars outside the United States were to go up, while the demand for dollars went down, what would happen to the price of the dollar relative to the yen? It would go down, in this case, from 100 yen to 80 yenRunning up a Tab in the Global EconomyWhat should be pretty clear by now is that, as a nation, we have been living well beyond our means for more than 20 yearsIt also should be clear that the party can’t last foreverThe United States quickly shifted from being the world’s largest creditor nation (which is good) to the largest debtor nation (which is bad)33-25Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.From Largest Creditor to Largest DebtorDuring the second half of the 19th century our country was a classic debtor nationWe imported manufactured goodsWe exported agricultural goodsWe borrowed capital in order to industrialize33-26Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.From Largest Creditor to Largest DebtorOn the eve of World War I, with the process of industrialization largely completed, we finally became a creditor nationThis position has now been turned around33-27Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.From Largest Creditor to Largest DebtorHow did we go from the largest creditor nation to the largest debtor so quickly?The main reason is the mounting trade deficitsWe continue to station hundreds of thousands of troops abroad and extend billions of dollars in military aid each yearThe interest, rent, dividends, and profits we pay foreigners continues to grow as our debt mounts33-28Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.U.S. Assets Abroad and Foreign Assets in the United States, 1983-200033-29Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.The gap is getting bigger every yearSomething’s Gotta GiveMost likely the dollar will declineThis will make our exports cheaper, so foreigners will buy more from usThe lowered-valued dollar will make imported goods and services more expensive, so we’ll import lessWhen the dollar falls (and it will) our exports will rise, our imports will fall, and so our trade deficit will shrink 33-30Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Living Beyond Our MeansThe U.S. Treasury depends on foreign savers to finance the deficitWe are living for today and not worrying about tomorrowWe are a nation of consumption junkiesWe are selling of the rock piece by pieceIt seems as though everyone – the British, the Japanese, the Dutch, the Canadians, the Germans – owns a piece of the rock33-31Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Will Foreigners Soon Own America?Foreigners have been using their holdings of U.S. dollars to buy up large chunks of AmericaThe good news is that foreigners own no more than 15%The bad news is that, at the rate we are going, foreigners will own more than one-third within 15 yearsForeign banks hold about 20% of banking assets in the United States and provide about 30% of all business loansGreat Britain owns more of us than any other country33-32Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Closing Quote“America has been selling off the family jewels to pay for a night on the town”Representative John D. Bryant, D-Texas33-33Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.