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1、PresenterTao WuCTP Training ProgramMacroeconomic Management and Financial Sector IssuesCT14.05Content Outline Definition of currency internationalization Objectives and benefits of currency internationalization Costs of currency internationalization Evolution of an international currency RMB Interna
2、tionalization2Definition of Currency Internationalization3MMFDefinition of International Currency A national currency is regarded “internationalized” if it plays the role of money outside the country where it is issued. Medium of exchange; Unit of account; Store of value; Method of payment. For an o
3、perational definition, it may be useful to identify qualifications for an international currency. Capital account convertibility; no restrictions on currency trading, spot or forward; Little or no restrictions on foreigners access to domestic financial markets; Large volume of trade and financial as
4、sets from the originating country; The issuer has the bargaining power to denominate trade in its currency; Well developed financial market with a large variety of risk-hedging instruments; breadth and liquidity; Stability of value: long-run price stability (low inflation) and low exchange variabili
5、ty.4Capital Account Convertibility Capital account convertibility may be a precondition, but it does not automatically lead to currency internationalization (CI). IMF defines the term “convertible” as “freely usable for the settlements of international transactions”. Unless the currency is widely us
6、ed in international transactions, it does not function as a global unit of exchange. The degree of a currencys actual usage is the most critical criterion: Its share in the denomination of international trade and financial assets; Foreign holdings of the currency as international reserves. By this s
7、tandard, even Japanese yen is yet a fully fledged international currency.5International Reserves (% of Total)6Source: IMF Annual Reports01020304050607080901976197819801982198419861988199019921994199619982000200220042006US DollarDMFFEuroPoundYenCHFQualifications for International Reserves Size of GDP
8、The U.S dollar is dominantEuro quickly became the second key currency Stability of valueThe prospect of the economyEuro vs. Yen Financial developmentMay not be so criticalEuro vs. British pound7Financial Asset Denomination (Money Market, % of Total)8Source: BIS Quarterly Review: various issues.0.0%1
9、0.0%20.0%30.0%40.0%50.0%60.0%70.0%80.0%90.0%1989199019911992199319941995199619971998199920002001200220032004200520062007US dollarEuroPound sterlingYenAustralian dollarSwedish kronaCanadian dollarSingapore dollarFinancial Asset Denomination The US dollar has lost its dominance. The euro has become th
10、e dominant currency. The pound sterling has lost its key currency position despite London being a global financial center.9Trade DenominationUnited StatesUnited KingdomJapanGermanyFranceAustraliaExportImportExportImportExportImportExportImportExportImportExportImport1980US $96.0 85.0 17.0 29.0 65.7
11、93.0 7.2 32.3 20.3 37.1 Euro.Yen 0.2 1.0 0.1 1.3 29.4 2.4 0.0 0.0 0.1 0.7 Home96.0 85.0 76.0 38.0 29.4 2.4 82.5 43.0 60.5 37.1 Other3.8 14.0 6.9 31.7 4.9 4.6 10.3 24.7 19.1 25.1 1992US $92.0 80.0 22.0 22.0 46.6 74.5 7.3 18.4 16.5 23.1 Euro.Yen 1.5 3.0 0.7 2.4 40.1 17.0 0.3 1.7 0.8 1.3 Home92.0 80.0
12、62.0 43.0 40.1 17.0 77.0 55.9 54,646.7 Other6.5 17.0 15.3 32.6 13.3 8.5 15.4 24.0 28.1 28.9 2000US $29.0 34.0 52.4 70.7 42.6 57.2 68.0 51.4 Euro21.0 19.0 6.1 1.2 44.6 32.9 0.3 2.3 Yen .36.1 23.5 .0.8 5.2 Home46.0 42.0 36.1 23.5 44.6 32.9 28.6 28.3 Other4.0 5.0 5.4 4.6 12.8 9.9 2.3 12.8 2003US $90.3
13、48.0 68.324.1 33.9 33.6 46.9 67.5 47.9 Euro2.0 9.3 4.663.0 55.2 52.7 45.3 1.4 9.4 Yen .38.9 25.0.9 3.6 Home90.3 38.9 2563.0 55.2 52.7 45.3 27.8 32.6 Other7.7 3.8 2.112.9 10.9 13.7 7.8 2.4 6.5 10Source: Bank of Korea, Kawai (2008), Kamps (2006), EURCDeterminants of Trade Invoicing Traded goods are mo
14、re likely to be invoiced by exporters currenciesExchange rate risk is more critical for exporters. Producer currency pricing is more likely if traded goods are more differentiated.Demand uncertainty is lower for more differentiated goods. More homogeneous goods such as oil and other primary commodit
15、ies are likely to be invoiced in a very few key currencies.11Objectives and Benefits of Currency Internationalization12MMF1. Reducing foreign exchange rate risks Domestic agents engaged in foreign trade may be able to reduce foreign exchange rate risks to the extent that their exports and imports ar
16、e invoiced in their own currencies. Domestic borrowers (financial institutions and firms) could also borrow in their own currencies, thereby avoiding currency mismatch in their balance sheets. The 1997 Asian financial crisis demonstrated that macroeconomic shocks could be amplified by the balance sh
17、eet aggravation in the banking sector.Yet with the development of financial derivative products, such benefits become lower.132. Collecting seigniorage revenues Countries having major international currencies also reap the benefits of collecting seigniorage revenues from foreign holdings of their cu
18、rrencies. Chinn and Frankel (2007) find that the shares are determined by the economic size of the country, inflation rate, exchange rate variability, and the size of the relevant financial center. As far as emerging economies are concerned, since they are well behind in terms of these determinants,
19、 this benefit is likely to be insignificant. 143. Developing domestic financial institutions Domestic financial institutions may gain an edge over their external competitions in dealing in their own currency. Once a number of financial assets denominated in their own currencies are issued and freely
20、 exchanged for foreign currencies, more opportunities in global financial intermediation open up for domestic financial institutions. Some policy makers consider currency utilization as a way to develop the financial institutions.154. Establishing an international financial center Some emerging econ
21、omies may find it necessary to internationalize their currencies to hold a regional financial center somewhere on their soil.For example, Korea has been pursuing internationalization of its currency in the expectation of hosting an international financial hub. However, CI does not necessarily lead t
22、o the establishment of a financial center.In the case of the euro, a fully developed international financial center is located in London.Singapores non-internationalization policy also illustrates that CI is not a necessary condition for the development of a financial center. Restrictions of cross-b
23、order asset-side bank lending of Singapore dollars to non-residents or to residents where Singapore dollars were to be used outside Singapore, until the late 1990s.16Summary of Objectives/Benefits Laying the foundation for a reserve currency Avoiding “original sin” Improving competitiveness of expor
24、ts of financial services as regional or global financial center countries Speeding up financial deepening Reducing foreign exchange rate risks Seigniorage revenues Holding smaller amounts of reserves17Benefits may not be large for emerging economies Demand for international currency is market driven
25、Currency denomination is determined by economic fundamentals and foreign demand CI is not a necessary condition for a regional financial center. Examples: Euro and Singapore dollar. Smaller reserve holdings are not necessarily related to CIAustralia has contracted a swap with the US Fed18Costs of Cu
26、rrency Internationalization19MMFI. Costs involved with capital account liberalization and financial deregulation One of the necessary conditions for CI is liberalization of capital account transactions. Deregulation of cross border investments would provide a level playing field for both foreign and
27、 domestic market participants.Foreign investors are not subject to any restrictions in buying and selling domestic financial instruments in both domestic and offshore marketsLikewise, domestic residents are accorded the same opportunities to participate in foreign financial markets both as lenders a
28、nd borrowers.20Effects of Capital Account LiberalizationGrowth Benefits Financial liberalization leads to flows of capital from (advanced) economies with low rates of return on capital to (emerging and developing) economies with higher returns, thereby complementing limited domestic savings and lowe
29、ring the cost of capital to augment domestic investment in the latter. Kose et al. (2006) argue that there are certain threshold conditions emerging economies are to meet in order to reap growth benefits from financial market opening such as developed financial markets, high quality of institutions
30、and governance, and trade integration. Question: Is the country suffering from a lack of domestic saving?21Effects of Capital Account LiberalizationFinancial Stability Increasing capital account liberalization has increased the volatility of capital flows, posing serious impediments to financial sta
31、bility.Since the eruption of the 2008 crisis, capital flows in many East Asian economies with fully and partially open capital accounts have become more unstable than before, causing a high degree of fluctuations of stock prices and exchange rates.To large foreign private and institutional investors
32、 operating out of East Asias regional financial markets, their investments in an individual emerging economy often accounts for a very small share of their total global investments, yet possibly a large part of the local markets and can therefore easily dictate movements of financial prices includin
33、g the exchange rate.22Effects of Capital Account Liberalization International Reserve Holdings In theory, countries with internationalized currencies and free floating would not need to hold as much reserves as countries with insular currencies, because they can use their own currencies to substitut
34、e for dollar liquidity.Countries with internationalized currencies e.g. U.K., Euro Area, Canada and Australia hold very small amounts of FOREX reserves, borrowing externally to finance their current account deficits, although there are exceptions such as Japan. But a countrys capacity for external f
35、inancing is likely to be determined by its economic fundamentals (debt sustainability), not by its currency status.Example: Australia23Effects of Capital Account LiberalizationSummary Little robust empirical evidence on economic growth Many empirical studies show financial market instability caused
36、by capital account liberalization Small country dilemma Free floating cannot fully deflect external shocks24II. Increase in exchange rate volatility Since CI predisposes the emergence of offshore currency markets, emerging economies may have to endure an increase in the volatility of their exchange
37、rates. The exchange rate would move responding to changes in the foreign demand for the domestic currency resulting from foreign shocks not associated with domestic conditions of the economy. The opposite could be the case: by enlarging the foreign exchange market, CI can actually contribute to more
38、 stabilization of the exchange rate. Whether CI will lead to increased volatility of the exchange rate or not is therefore an empirical question. 25III. Increased vulnerability to currency crisis Some emerging economies may become more vulnerable to currency crises if foreign investors hold widely d
39、omestic-currency financial instruments.If foreign investors are hit by a liquidity squeeze, they may be forced to sell domestic-currency assets, putting pressure on the exchange rate to depreciate. CI can result in providing speculators with more instruments to be used for speculative attacks on the
40、 currency. After the foreign investors intentionally raise funds by issuing financial debts or take a short position denominated in the domestic currency, they can sell the domestic currency in the foreign exchange market to drive the exchange rate down.26IV. Complications for monetary policy manage
41、ment An additional source of money demand by foreigners may complicate the monetary authorities management of monetary policy. If the monetary authorities change money supply without taking into consideration external demand, they may not able to set the level of money supply that it intended to tar
42、get in the domestic economy; German and Japan in 70s. Possible counter-argument: monetary policys main operating target is the interest rate, not the money stock, if inflation targeting is the framework of monetary policy operation. Indeed, the difficulty of conducting autonomous or independent mone
43、tary policy is not due to CI per se, but more generally due to capital account liberalization: the Impossible Trinity (Mundell 1963).27Costs of CI can be large Costs involved with lifting restrictions on capital account transactions together with deregulation of the domestic financial system. Increa
44、se in volatility of exchange rate Increase in financial vulnerability Complications in management of monetary policy When the benefits are balanced against costs of internationalization, strong case for CI in emerging economies cannot be made.28Evolution of an International Currency29MMFEvolution of
45、 an International CurrencyHow to transform an insular currency into an international medium of exchange? De facto process : the Australian dollar De jure process : the Japanese yen Why has Japan failed to elevate the yen to reserve currency status? Why has the euro been accepted as a reserve currenc
46、y from the beginning? Has the British pound eclipsed as a key currency?30Experience of Japanese Yen Despite strong initiatives from the Japanese government, the international status of yen had changed very little in the past two decades. Even within East Asia, Japanese Yen has not been able to becom
47、e the dominant currency in trade settlement. U.S. dollar is much more widely used, even in Japanese trade with East Asia than is the yen. East Asia remains a very strong dollar zone. For instance, In 2002, 80.6% of Korean imports and 86.3% of exports were invoiced in U.S. dollar, and only 12-13% of
48、imports and 5.2% of exports were invoiced in Yen, although Japan is at least as important a trading partner as the US. Why?31Experience of Japanese Yen The choice of invoice currency was determined by various factors, including market power, matching of product exports and material imports, internat
49、ional price setting practice, preferences of importers and exporters, etc. In particular, a) raw materials constitute a large share of Japans imports; b) the currencies of Asia tended to fluctuate more with the yen than with the USD; c) there is little need for yen loans because most trade is not de
50、nominated in yen. Determinants of currency choice in financial transactions: the level of interest rates, market expectations about prospective exchange rate movements, etc. Currency choice of reserve holdings: the most important factor seems to be exchange rate management practice. 32Evolution of a