International economics

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9 lecture
International financial system
 The financial system
A financial system is a set of institutions, such as banks, insurance
companies, and stock exchanges, that permit the exchange of
funds. Financial systems exist on firm, regional, and global levels.
Borrowers, lenders, and investors exchange current funds to finance
projects, either for consumption or productive investments, and to
pursue a return on their financial assets. The financial system also
includes sets of rules and practices that borrowers and lenders use
to decide which projects get financed, who finances projects, and
terms of financial deals.
The financial system has six parts, each of which plays a
fundamental role in our economy. Those parts are money, financial
instruments, financial markets, financial institutions, government
regulatory agencies, and central banks.
 Components of the financial system
• We use the first part of the system, money , to pay for our purchases and to store our
wealth.
• We use the second part, financial instruments , to transfer resources from savers to
investors and to transfer risk to those who are best equipped to bear it. Stocks,
mortgages, derivatives, and insurance policies are examples of financial instruments.
• The third part of our financial system, financial markets , allows us to buy and sell
financial instruments quickly and cheaply. The New York Stock Exchange is an
example of a financial market.
• Financial institutions , the fourth part of the financial system, provide a myriad of
services, including access to the financial markets and collection of information about
prospective borrowers to ensure they are creditworthy. Banks, securities firms, and
insurance companies are examples of financial institutions.
• Government regulatory agencies form the fifth part of the financial system. They are
responsible for making sure that the elements of the financial system—including its
instruments, markets, and institutions—operate in a safe and reliable manner.
• Finally, central banks , the sixth part of the system, monitor and stabilize the economy.
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The monetary system

• A monetary system is a system by which a government
provides money in a country's economy. Modern monetary
systems usually consist of the national treasury, the mint (the
primary producer of a country's coin currency), the central
banks and commercial banks.
• As a result, the monetary system is part of the financial
system.
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The international monetary and

financial system
The international monetary and financial system is the worldwide framework of
legal agreements, institutions, and both formal and informal economic actors
that together facilitate international flows of financial capital for purposes of
investment and trade financing.
Therefore, it is a set of internationally agreed rules, conventions and supporting
institutions that facilitate international trade, cross border investment and
generally the reallocation of capital between states that have different
currencies. It should provide means of payment acceptable to buyers and sellers
of different nationalities, including deferred payment.
 International monetary and financial system
To operate successfully, it needs to inspire confidence, to provide
sufficient liquidity for fluctuating levels of trade, and to provide means by
which global imbalances can be corrected.

In a global view, financial and monetary systems include the

International Monetary Fund, central banks, government treasuries
and monetary authorities, the World Bank, and major private
international banks.
In this chapter, we will focus on the role of IMF

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 The International Monetary Fund (IMF)
was created at the Bretton Woods conference as a weak kind of central
banks’ central bank, to make the new monetary system feasible and
workable. Its major purpose was to assist members that would have
structural trade problems or currencies that were highly unstable in
value. The IMF permitted its deficit members to buy with their local
currencies some of its own holdings of convertible currencies. These
deficit countries were expected to buy back, with gold or other
convertible currencies, the local currencies they had sold to the IMF after
they had improved their balance of payments. Thus, the IMF’s major
weapon is the power to declare its members ineligible to utilize its
holdings of international reserves.

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 The Operation of the IMF
• IMF is an international financial organization comprised of
190 member countries
• Its purposes, as stipulated in its Articles of Agreement, are
1. to promote international monetary cooperation
2. to facilitate the expansion of international trade
3. to promote exchange stability and a multilateral system of
payments
4. to make temporary financial resources available to members
under “adequate safeguards”
5. to reduce the duration and degree of international payments
imbalances
 Functions of the IMF
• In order to achieve its purposes and goals, the IMF does
three main functions: Lending, surveillance, and capacity
development.
1. Lending: IMF provides loans—including emergency
loans—to member countries experiencing actual or potential
balance of payments problems. The aim is to help them
rebuild their international reserves, stabilize their currencies,
continue paying for imports, and restore conditions for strong
economic growth, while correcting underlying problems.

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 Functions of the IMF
• Under normal circumstances, the amount of resources an IMF
member can access is determined by its quota amount.
• Through a complex process involving lending “tranches,” a member
can borrow up to 145% of its quota annually and 435%
cumulatively.
• in recent years, this limit has been exceeded.
• A country requesting access to IMF resources has to sign a letter of
intent committing itself to a certain set of policy changes. These policy
changes are known as conditionalities
• Conditionality is a central feature the IMF lending.
• Whether a country meets the conditionalities of a lending arrangement
is determined by a process of IMF monitoring or surveillance.
 The Special Drawing Rights (SDR)
•The SDR is an international reserve asset, created by the IMF in 1969 to
supplement its member countries’ official reserves.
•Special drawing rights (SDR) are an artificial currency instrument created by the
International Monetary Fund, which uses them for internal accounting purposes.
•The SDR was Created in response to concerns about the limitations of gold and
dollars as the sole means of settling international accounts, SDRs augment
international liquidity by supplementing the standard reserve currencies.
•The value of the SDR is calculated from a weighted basket of major currencies,
including the U.S. dollar, the euro, Japanese yen, Chinese yuan, and British
pound.
•The SDR interest rate (SDRi) provides the basis for calculating the interest rate
charged to member countries when they borrow from the IMF.

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 The role of the SDR
• The SDR was created as a supplementary international reserve
asset in the context of the Bretton Woods fixed exchange rate
system. The collapse of the Bretton Woods system in 1973 and the
shift of major currencies to floating exchange rate regimes
lessened the reliance on the SDR as a global reserve asset.
Nonetheless, SDR allocations can play a role in providing liquidity
and supplementing member countries’ official reserves, as was the
case amid the global financial crisis.
• The SDR serves as the unit of account of the IMF and other
international organizations.

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 The role of the SDR
• About SDR 456 billion approved on August 2, 2021
(effective on August 23, 2021). This most recent
allocation was to address the long-term global need
for reserves, and help countries cope with the impact
of the COVID-19 pandemic.

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 Functions of the IMF
2. Surveillance: The IMF monitors the international monetary system and global
economic developments to identify risks and recommend policies for growth and
financial stability. The Fund also undertakes a regular health check of the
economic and financial policies of its 190 member countries. In addition, the IMF
identifies possible risks to the economic stability of its member countries and
advises their governments on possible policy adjustments.
In November 2008, the G20 asked the IMF and the Financial Stability Board (FSB)
to collaborate on regular Early Warning Exercises. The EWE is part of the IMF’s
efforts to strengthen surveillance, especially the analysis of economic, financial,
fiscal, and external risks as well as cross-sectoral and cross-border spillovers.

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 Functions of the IMF
3- Capacity development: The IMF provides technical
assistance and training to governments, including central
banks, finance ministries, revenue administrations, and
financial sector supervisory agencies. These capacity
development efforts are centered on the IMF’s core areas of
expertise ranging from taxation through central bank
operations to the reporting of macroeconomic data. Such
training also helps countries tackle cross-cutting issues, such
as income inequality, gender equality, corruption, and climate
change.

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 IMF Quota System
• The IMF can be thought of as a global credit union in
which countries’ shares are determined by their
quotas
• Quotas are the paid subscriptions to the IMF and
roughly reflect their relative sizes in the world
economy.
• Quotas determine both the amount members can
borrow from the IMF and their voting power within the
IMF
Figure 19.2 IMF quotas, 2019 (percentage shares above 0.90)

Source: www.imf.org.
 Internationalization of Financial
Markets
The growing internationalization of financial markets has become an important trend. Before
the 1980s, U.S. financial markets were much larger than financial markets outside the United
States,
The extraordinary growth of foreign financial markets has been the result of both large
increases in the pool of savings in foreign countries such as Japan and the deregulation of
foreign financial markets, American corporations and banks are now more likely to tap
international capital markets to raise needed funds, and American investors often seek
investment opportunities abroad.
However, Modern global financial sector is characterized by complexity of structures and
such uncontrolled dynamics, that is objectively prone to loss of stability. Furthermore, the
world of finance has reached a point where "hidden structures" appeared. These features
have played a vital role in creating different global economic crises.

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 Crises and Responses
Mexico in 1994 and 1995. Thailand, Indonesia, the Philippines, Malaysia, and South
Korea in 1997. Russia in 1998. Brazil in 1999. Argentina in 2001. The United States
and the United Kingdom in 2007 to 2009. These are examples of recurrent crises that
have recently plagued the world economy. At the time, each of these crises was
described by some as unexpected, but as it turns out, there are good reasons to
expect crises to occur with some regularity. Why? Unlike markets for most goods and
services, financial markets are characterized by what economists term
“imperfections.” Because of these imperfections, we cannot be assured of economic
or allocative efficiency in markets for financial products. Furthermore, the
imperfections tend to make financial markets somewhat unstable, with “booms” of one
kind or another being followed by “busts.” The purpose of this chapter is to help you
understand why this is so and what role it has played in crises.

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 Types of Crises

• In order to get beyond popular descriptions of crises, we need to

understand the different types of crises
• Six types of crises are listed in Table 20.1
1. Hyperinflation
2. Balance of payments and currency crises
3. Asset price deflation
4. Banking crises
5. External debt crises
6. Domestic debt crises
• These can occur one at a time or in combinations
 Table 20.1
Types of crises
 Hyperinflation
• Hyperinflation is a period of rapid increases in the price
level of a country, typically defined to be 40 percent or
more
• Generally speaking, periods of hyperinflation are
associated with rapid expansions of the money supply
 Balance of Payments and Currency Crises
• Balance of payments and currency crises consist of large
devaluations or rapid depreciation in the value of domestic currencies
• Periods of hyperinflation can contribute to currency crashes
• Significant degrees of inflation can cause asset owners to move out domestic-
currency-denominated assets in to foreign-currency-denominated assets to
maintain portfolio values
• This causes a decrease in the demand for the domestic currency, lowering its
value
 Asset Price Deflation
• Asset price deflation involves a large and sustained
decline in the prices of financial assets
• This typically follows behind large increases in asset
prices or asset price bubbles
• The last significant episode of international asset price
deflation took place between 2007 and 2009
 Banking Crises
• Banking crises involve the occurrence of bank runs, mergers,
closures,, or government takeovers of banking institutions
• In general, banking sectors are particularly fragile components of
financial systems
• This reflects their involvement in maturity transformation
• Maturity transformation involves banks borrowing short term and lending
long term
• Bank runs can be set off by asset price deflation.
 External Debt Crises

• External debt crises involve sovereign default on debt

obligations to foreign creditors or the substantial
restructuring of this debt.
• The classic case of this is Mexico’s defaulting in 1982 on
its foreign debt, setting of a global debt crisis
• Debt crises tend to follow large capital inflows
 Domestic Debt Crises
• Domestic debt crises involve sovereign default on debt
obligations to domestic creditors or substantial restructuring of this
debt
• With banking crises and external debt crises, preceding capital
inflows are often a contributing factor
• Argentina in 2001 combined a banking crises, a currency crisis,
both external and domestic debt crises, and asset price deflation
 Contagion and Systemic Risk
• Contagion refers to crises beginning in one country and “spreading” to other
countries
• This can occur through a few different mechanisms
• Shifts in expectations and confidence (herding or informational cascades)(An
information cascade occurs when a person makes a decision based solely
on the decisions of other people, while ignoring their own personal
knowledge to the contrary).
• Asset prices (financial linkage)
• Capital flight is the outflow of capital from a country due to negative monetary
policies, such as currency depreciation (sudden stops)
• Sudden stops, surprise financial announcements can work together to cause
contagion
 Contagion and Systemic Risk

• When contagion takes on global or near-global characteristics, it

becomes what is known as systemic risk
• These episodes are rare but characterized the Great Depression of the
1930s and the 2007-2009 crisis
• It is becoming clear that increased financial globalization has increased
the possibility of systemic risk
• This is indicated by the volume of a number of key financial markets
being multiples of global GDP
Thank You