International Economics

International Economies

• Introduction

Since the early 1970s and more so after the early 1990s the world has witnessed a steady sequence of events that has partially changed the Global Economic Scenario. Starting from the early 70s the fixed exchange rate system has given way to the managed floating exchange rate system. The oil shocks of the 70s gave birth to the debt crisis of the developing countries in the early 80s. Starting from early 80s the world economy is going through a process of liberalization, privatization and globalization which became more pronounced in the 1990’s. In the wake of globalization the economics became more open allowing huge amount of capital inflows but at the same time the regulatory and supervisory mechanism of these countries could not keep pace with the changing financial and economic environment thus giving rise to series of financial crises from mid 90s to late 90s. These financial crises have forced the nations to adapt to a new and evolving financial architecture. Newly industrialized countries have emerged as an important economic force capturing a significant share of world export market from advanced nations. The multinational corporations have expanded their operations around the world. The booming capital markets around the world have given rise to new financial instruments and practices, that have deteriorated government’s supervision of internal monetary affairs. The world political and economic climate has significantly changed with the break up of former USSR, unification of Germany, formation of European Union, and Eastern European countries switching to market-oriented economic systems. On the trade front the successful completion of Uruguay Round of negotiation and formation of World Trade Organization has renewed the prospects of free international trade.

 

• International Financial Architecture

International financial architecture is a system, which aims at promoting economic growth while ensuring economic stability. The main focus of international financial architecture is to ensure global monetary and financial stability. Recent years have seen recurrence of financial crises in one form or other.

Historical Perspective Of International Financial Architecture

The genesis of the international financial architecture can be traced back to gold standard days which prevailed from 1875 to 1914. Under gold standard the standard unit of currency was fixed weight of gold or the value of a fixed rate of gold with paper money convertible on demand into gold. However, after first world war, the war ravaged countries engaged in competitive devaluation. As a result, the gold standard was finally abandoned in 1931. After the end of second world war a series of efforts were made to restore order to the international monetary system which resulted into Bretton Woods Agreement (1944), the main features of which were as follows:

1. 1. All national currencies were to be tied to the US dollar which in turn was pegged to gold [at $35 an ounce].
   2. Capital controls introduced during war time to remain.
   3. International institutions like World Bank and International Monetary Fund (IMF) were to be founded.

This system continued till 15th August 1971, when the US severed the link between gold and dollar. The underlying reason for doing so was that the potential dollar claims against US gold supply was seven times larger than what could be honored by US. This situation arose due to over-financing [Deficit Financing] of exports by US and picking up economic activity in war-torn economies. This led to dollar glut around the globe, loosened grip of Federal Reserve on money supply and subsequent inflation. After the collapse of Bretton Woods Agreement in 1971, the group of ten countries entered into an agreement known as Smithsonian Agreement with the objective of reinstituting a system of exchange rate at new par values, but this agreement lasted for only 14 months. In June 1972 Sterling was allowed to float against US dollar. In early 1973 the Swiss Franc and then the Japanese Yen was allowed to float against US dollar. Since then the IMF members have been free to choose any form of exchange arrangements except pegging their currency to gold. This was formalized in terms of Second Amendment to the Articles of Agreement of the IMF which became effective on 1st April 1978.

The decade of 1970s was a tumultuous decade in the history of financial markets. The first oil shock which occurred in 1973 saw price of oil being raised from $ 1.30 a barrel in 1970 to $ 10.72 per barrel in 1975. This resulted in massive transfer of wealth from US and oil importing developing countries to OPEC countries.

Since the OPEC countries had limited absorptive capacity, therefore most of the dollars paid for import of oil found their way back to banks in western countries. Large accumulated US dollars with oil exporting countries were known as Petrodollars. Eurodollars are US dollars deposited in commercial banks outside the United States. The rising oil prices resulted in recessionary trends in major economies and a deteriorating balance of payment situation in developing countries. To overcome the balance of payment problem developing countries borrowed heavily from western commercial banks which were flush with petrodollars. The second round of price increase by OPEC countries, made the high level of debt unsustainable for the developing countries. The loans taken by developing countries were at variable interest rates tied to LIBOR, which increased sharply from 9.5 percent in 1978 to 16.6 percent in 1981. Similarly the US prime rate peaked to 20.5 percent in 1981. Funds raised from borrowings were utilized to pay for oil imports, the development of import substitution industries and financing large infrastructure projects. However, restrictive monetary policies, designed to deal with the inflationary impact of rising oil prices pushed up the cost of servicing existing debt as well as cost of new debt. All these factors led to debt crisis which first emerged in Mexico on 12th August 1982, when Mexico declared that it can no longer observe its formerly scheduled payments on it’s foreign debt. Subsequently many other countries like Brazil, Chile, Venezuela, Peru, Nigeria, Philippines, Turkey, Poland and Romania, reported some kind of problem.

All the debt crisis affected countries of Latin America went in for IMF’s Stabilization Program and World Bank’s Structural Adjustment Program (SAP). For low income countries facing a persistence balance of payment problem and which required highly concessional financial support on a long term basis, the IMF set up the Structural Adjustment Facility (SAF) in March 1986, which was subsequently renamed as Enhanced Structural Adjustment Facility (ESAF) in December 1987. The Stabilization Program of the IMF seeks to achieve fiscal consolidation and current account stabilization, while the World Bank’s Structural Adjustment Program (SAP) is a long term program aiming at raising GDP and facilitating the integration of borrowing country with the world economy. The following decade of the 90s also witnessed a series of financial crises, some major and some minor ones, beginning with the falling of exchange rate mechanism (ERM) of the European Monetary System in 1992-93, the Mexican Crisis in 1994, the East Asian Crisis in 1997, the Russian and Brazilian Crises in 1998 and later Argentine and Turkish crises in 2001, The Mexican crisis was a currency crisis which deteriorated in debt crisis mainly due to volatile capital flows. The Russian crisis was on account of Russia defaulting on its external and internal debt repayment in August 1998. Subsequently, Russia devalued its currency thereby disrupting international economy to a certain extent. The Brazilian crisis was precipitated by volatile international capital markets and its innovative “Real Plan” adopted in 1994 to control hyperinflation [more than 2,700 percent per year at that time]. This plan led to an acceleration in GDP growth, a dramatic decline in inflation but simultaneously led to an overvalued currency and a widening current account deficit. The inadequate fiscal consolidation led to higher interest rates and a consequent debt spiral. The Argentinian crisis was triggered by its refusal to pay almost $3 billion debt owed by it to IMF, in spite of having foreign
exchange reserves of over US $13 billion. The causes of crisis in Turkey in 2001 was a combination of portfolio losses and liquidity problems in few banks. This led to loss of confidence in Turkish banking system leading to a reversal of capital flows. The impact of this crisis in Turkey was that overnight the interest rates soared, culminating into a failure of the banking system. The Turkish Lira was devalued by 30 percent and the government adopted a floating exchange rate regime.

The major difference between the crises of 1980s and 1990s was that the crises of 1980s were caused by the inability of the indebted countries to service the debts which were largely in form of syndicated bank loans. The cause of the crisis lay in the domestic economic and fiscal policies, whereas the crises of the 1990s up to a large extent can be characterized as capital account crisis wherein the catalyst for the crises to emerge was sharp and quick reversal of capital flows which were largely in the form of short term bonds and portfolio flows.

Another striking features of the recent financial crisis were policy measures regarding capital flows failed to take into consideration the associated risks, inappropriate exchange rate policy, fragile domestic financial system and lack of transparency.

 

• Origin Of Developing Countries Debt Crisis

Now here we are going to discuss about the origin of the Developing Countries Debt Crisis and the East Asian Economic Crisis Of 1997. The factors which gave rise to debt crisis of the 1980s are as follows:

• • Tight Monetary Policies of advanced countries to combat inflation, which resulted in hardening of interest rates.
  • The First Oil Shock of 1973-74 and Second Oil Shock of 1979-80.
  • Poor and Inefficient Public Sector Investment in Developing Countries.
  • The World Wide Recession of 1974-75 followed by a milder but longer duration recession of 1980-82.
  • Capital flight from developing countries. The underlying factors for the capital flight were [1] Currency Overvaluation; [2] Interest Rate Ceilings; [3] High And Volatile Inflation; and [4] Taxation.
  • Appreciation of the dollar, which was caused by high rate of interest prevailing at 20.5 percent in 1981.
  • Excess loanable funds in advanced countries. As a result of oil shocks OPEC countries were flush with funds [Petrodollars], most of which were deposited in western banks. At the same time the US financial institutions were deregulated, giving them the operational freedom. This resulted in these banks advancing large quantum of loans to developing countries.

 

• The East Asian Crisis [997]

Before the decade of 1990s the financial crises were in principle considered as events occurring in individual countries, but the financial crises of the 1990s viz. the Mexican crisis of 1994-95, the East Asian Crisis of 1997-98 and the Russian Crisis of 1998 were characterized by strong contagion or spillover effects in other countries; that is crisis in one country was rapidly transmitted to other countries. The financial crises can be broadly classified as Currency [Balance Of Payments] Crises and Banking crises. The currency crisis occurs when there is a run on official foreign exchange reserves, thus exerting downward pressure on the exchange rate in the economy. The “First Generation” currency crises models argue that a deterioration in economic fundamentals leads to a crisis in the external account. The “Second Generation” currency crisis models argue that currency crisis can even occur in countries with strong economic fundamentals due to overheating and generation of self-fulfilling expectations of he economy. Like currency crises bank crises can originate from fundamental weakness of several commercial banks.

Currency and Banking crises [Sometimes Called The “Twin Crises”] tend to be associated with each other and often take place together. Some of the possible links between these crises are as follows:

• • Currency crises can cause banking crises. A rapid depletion of foreign exchange reserves under a fixed exchange rate regime, typically forces the central bank to contract high powered money, thereby reducing liquidity [Monetary Aggregates], thereby increasing bankruptcies and thus inducing banking crises.

• • Banking crises can lead to currency crises. When the investors believe that serious banking crises are imminent, they will try to reconstruct their portfolio by moving away [Selling Of Domestic Assets] from domestic assets towards foreign assets. This results into drying up of liquidity into domestic markets. When central bank tries to inject liquidity into the system by bailing out troubled banks, the excessive money creation can lead to currency speculation and a run on foreign exchange reserves.

• • Currency and Banking crises can result from common factors. When an economic boom is financed by large scale capital inflows and bank credit, this creates a situation known as “Asset Bubble” in which the prices of the assets, both real and financial, are quite high with reference to the economic returns which they can generate. The end of the boom or asset bubble burst tend to be accompanied by both currency and banking crises.

Regarding the East Asian Crises there are two schools of thought. One school emphasize that the causes of the East Asian financial crises were the fundamental weakness of these economies; whereas the other school of thought emphasize that fundamental weakness in the international financial markets was the major source of crisis and contagion.

The East Asian Crises: Vulnerabilities And Trigger:

Globalization And Domestic Weakness: The way in which the economies of Thailand, Indonesia and Korea expanded in the 1980s and early 1990s made them vulnerable to external shocks. The following four developments acted as a catalyst in precipitating the crises.

1. 1. A surge in global flow of Private Capital, especially of short term nature.
   2. Macroeconomic policies that allowed large inflows of short-term, unhedged capital to fuel a domestic credit boom.
   3. Weak supervision and regulation of domestic financial markets and corporations having highly leveraged position.
   4. Mounting political uncertainty.

This combination led to investment in certain domestic non-tradable sectors such as real estate [Especially In Thailand] and in selected inefficient manufacturing sectors [As Was Done By Korean Chaebol Firms], which were already having highly leveraged balance sheets.

The level of indebtedness varied across countries. In Thailand financial institutions net foreign liabilities rose from 6 percent of domestic deposit liabilities in 1990 to 30 percent by 1996. In Indonesia corporations were the primary borrowers from foreign sources, while they also borrowed from domestic banks. Korean banks had large foreign borrowings, while Korean corporations borrowed heavily from domestic sources. On the other hand the countries with low short term external debt exposure [measured as a ratio to foreign exchange reserves], such as Malaysia and Philippines, were not affected much in the initial phase of the East Asian Crisis.

The factors which prompted these crisis-affected countries to borrow from abroad were-

• • Explicit or Implicit Government guarantees of financial institutions liabilities motivated excessive risk-taking by these institutions which was passed on to the rest of the domestic economy.
  • De facto fixed exchange rate regime generated a perception that foreign currency denominated loans were not risky for domestic borrowers or lenders.
  • There was significant funding cost difference between domestic and foreign funding; the domestic cost of borrowing was significantly higher.

These inflows were fed into the corporations which made them highly vulnerable to change in interest and foreign exchange rates. In all of the crisis affected countries the corporate sector had grown rapidly relying heavily on bank finance: Despite the fact that the productivity in the manufacturing sector in many East Asian Countries had started declining in the pre-crisis period, the corporate debt equity ratio began to rise to high levels. For example the debt equity ratio of Korean Companies was more than 317 percent at the and of 1996, twice the US ratio and four times the Taiwanese ratio. The top 30 Korean Chabelos [Corporations] had even higher leverage exceeding 400 percent at the end of 1996.

Another factor which lead to the crisis in East Asian countries lack of regulations and supervision necessary to manage integration with global external finance. Political uncertainty in these countries also played a role in precipitating the crisis.

In brief the rising global liquidity fed huge amount of capital into an institutional setting of poor regulation, limited transparency and related party lending often with negligible due diligence from foreign lenders. Government guarantees of bank liabilities and a promise of fixed exchange rates fed into a credit boom that macroeconomic policy failed to manage. The risks undertaken by East Asian Countries left them exposed to shock in several ways:

• • Widening current account deficits, financed by short term, unhedged capital inflows exposed the economics to sudden reversal in capital flows.
  • Expansion of lending into risky investments of low rates of return and inflated values often with currency and maturity mismatches exposed banks, non-bank financial institutions and corporations to foreign exchange and interest rate risks.
  • Corporations with low incentive to use capital efficiently became more leveraged when provided with an additional funding options from abroad. This exposed them to both interest and exchange rate shocks.

The Crisis And The Aftermath

In 1996 the Thailand’s exports contracted by 1 percent after growing 20 percent in 1995, At the same time the current account deficit, which was financed by short term capital inflows had reached to a high of 8 percent of GDP in 1996. Simultaneously several finance companies and a few commercial banks experienced serious difficulties and the central bank chose to provide equity support. The stock market peaked in February 1996 and fell by 30 percent by year end. Perception began to take hold in the market that the exchange rate was misaligned despite rising interest rates. The Thai government intervened heavily to support the ply when the Baht came under serious attack for the first time in February 1997, to the extent that the central bank eventually issued some US $ 23 billion in forward exchange contracts at a time when foreign exchange rates were hovering around US $ 25 billion. This led to further capital outflows and a decline in foreign exchange reserves. Finally on July 2, 1997, the government yielded to market forces and abandoned the peg, thus allowing Baht devaluation.

The Thai Baht devaluation triggered withdrawal of capital from the Association of South East Asian Nations [ASEAN] region and several other East Asian Countries as financial panic spread. After Thailand devalued the Baht the Philippines allowed the Peso to freely float and Malaysia abandoned the defense of the Ringgit peg and Indonesia allowed the Rupiah to float. Under exchange market pressure, Taiwan floated the new Taiwan dollar on October 17, 1997. When the Hong Kong dollar came under speculative attack, the Hong Kong monetary authority allowed the interest rate to rise, leading to a sharp fall in Hong Kong index, and transmitting these falls to European and American stock exchanges. Korea officially abandoned the exchange rate band and moved to a floating system in mid December.

These events show how the crisis spread from one country to another. Contagion produced simultaneous falls in exchange rates and stock prices leading to massive capital outflows. It is estimated that during the crisis period capital outflows amounted to US $ 100 billion.

Lessons From East Asian Crisis

We are going to briefly discuss about the lessons learned from East Asian financial crisis regarding prevention, managing, resolving the crises.

1. 1. Avoid large current account deficits financed through short-term private capital inflows.
   2. Aggressively regulate and supervise financial systems to ensure that banks and corporations manage risk prudently.
   3. Put in place incentives for sound corporate finance so as to avoid high leverage ratios and excessive reliance on foreign borrowings.
   4. Mobilize timely external liquidity to restore market confidence.
   5. Establish domestic and international resolution mechanisms for assets and liabilities of nonviable banks and corporations.

 

• Economic Integration

Economic integration is an agreement among nations to decrease or eliminate trade barriers. Depending upon the terms and intensity of the agreement the economic integration can be classified as a preferential trade arrangement, a free trade area, a custom union, a common market or an economic union.

Preferential trade arrangement is an arrangement between participating nations to lower trade barriers among themselves. A free trade agreement the participating nations remove the trade barriers among themselves and each participating nation has autonomy to define its own barriers on trade with non members. In a custom union each members country lowers as abolish the trade barriers prevailing among member countries and the member countries also adopt a unified system of tariffs while dealing with non members. A more advanced form of economic integration is creation of common market in which the barriers against movement of labor and capital of the member countries in also eliminated. The most advanced and complete form of economic integration is Economic union in which their is unification and harmonization of member countries fiscal, monetary and trade policies.

 

• Tariff And Non-Tariff Barriers To Trade

Tariff are most commonly used as a fool for trade restraint. A tariff is a custom duty as a tax imposed on imports or exports. Tariff on imports are more common than exports as most nations would like to increase exports and decrease or restrict imports. Depending on the purpose of the tariff they are classified as Protective and Revenue Tariff. The Protective Tariffs are imposed from foreign competitors whereas the objective of revenue tariff is to generate tax revenue for the government. The protective tariff is mostly used by advanced or developed countries where as revenue tariff is used by developing countries. The net effect of tariff is that it makes the imported goods costlier as compared to domestically produced goods thus giving a competitive advantage to domestic producers in terms of price.

Depending on the way tariff are calculated they can be classified as specific, ad valorem and compound tariff. A specific tariff is calculated in terms of fixed amount of money per unit of the imparted product, such as Rs. 2000 for every computer are Rs. 45,000 for every tractor below 30 horse power. In this method the price of the product is immaterial. An ad valorem tariff is calculated on the basis of the price of the product. It is calculated in percentage terms of the price of the product, such as a TV set costing $ 2000 and attracting custom duty of 10% the tariff would be $ 200.

A compound tariff as a combination of specific and ad valorem tariff. The multilateral trade negotiations have forced nations across the globe to case trade barriers specially forcing the nations to lower the tariff rates. These are many different ways in which the government can restrict trade without using tariffs. Some of the non tariff measures to restrict trade are as follows.

Quotas: A quota to the limitation set on number of units of a commodity that crosses national boundaries. Depending upon whether a good is imported or exported, the quota is referred to as an import quota or export quota.

Import quota imposes a restriction on supply of foreign product, thereby causing its price to rise which in turn make domestic product cheaper. An unilateral quota is a quota imposed by importing country without consultation with the exporting countries where as the bilateral or multilateral quota is imposed by an importing country after negotiations with the exporting countries.

A tariff quota combines the characteristics of tariff and quota. It sets a limit on the quantity of a product which can be imported at concessional or nil custom duty, any quantity beyond the set limit would invite additional tariff.

Export quotas are imposed by exporting countries to limit the export of certain items. Some of the reasons for imposing export quotas are:

• • Excessive export of the commodity/product can cause shortage in the domestic market thereby increasing prices.
  • To control the supply in international markets so that price of that particular commodity can be manipulated.
  • To control the supply of technology which can be used for dual purposes.

Another form of non tariff trade barrier is subsidy whereby the national government protect the domestic producers by supplying with the inputs below casts. Another form of subsidy is to purchase the goods at substantial higher cost.

Other non tariff trade barriers include government purchase policy where an explicit are implicit preferences are given to domestic producers. Non tariff trade barriers can also arise administrative and technical regulations such as health and safety standards, marketing and packaging standards and customs procedure and valuation.

 

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