FINA2330 tutorial 8
International finance
Currency board: monetary policy
Hong Kong adopts currency board, where 1
USD corresponds to 7.75 – 7.85 HKD
HKMA intervenes whenever the exchange rate
reaches the boundary. If HKD weaken, so HKMA
needs to sell USD denominated assets and
purchase HKD to stop depreciation.
International reserve balance has decreased
significantly.
Little flexibility in implementing monetary
policies
Policy trilemma
Why it is impossible to enjoy the advantages of these
three features together?
1. Flexibility in monetary policy
2. Freedom in capital flow
3. Fixed exchange rate
HKD has 2 and 3,
USD, EUR and JPY have 1 and 2.
CNY: 1 and partially 3 (restrictions in CNY holdings
abroad, managed float)
1992 Sterling crisis
GBP pegged to Deutsche Mark from 1990, but broken by
September 1992 due to strong depreciation pressure at
the UK:
Very high inflation rate relative to Germany
Reluctance to raise interest rate due to risk of recession
Reluctance for Germany to lower interest rates
Expecting depreciation, George Soros shorted billions of
GBP, forcing intervention from Bank of England. Soros
eventually succeeded and profits from depreciation.
Forward vs futures
Both involves purchasing the underlying at a fixed price
by expiration date, useful in hedging risks.
Forward is a private agreement between two parties
Future is a standardized agreement, tradable in
exchanges, investors enjoy much higher liquidity and
lower default risk in general
Futures more popular than forwards nowadays.
Practice Question 8 Q1
1) If a country's central bank eventually runs out of international
reserves, it cannot keep its currency from ________ and a
________ must occur in which the par exchange value is reset at
a ________ level.
A) appreciating; revaluation; higher
B) depreciating; revaluation; higher
C) depreciating; devaluation; lower
D) appreciating; devaluation; lower
Practice Question 8 Q1
1) If a country's central bank eventually runs out of international
reserves, it cannot keep its currency from ________ and a
________ must occur in which the par exchange value is reset at
a ________ level.
A) appreciating; revaluation; higher
B) depreciating; revaluation; higher
C) depreciating; devaluation; lower
D) appreciating; devaluation; lower
When a central bank exhausts its reserves, it can no longer intervene in the
foreign exchange market to support its currency. If the currency is under
downward pressure, it will depreciate. In a fixed exchange rate system, this
often leads to a devaluation, where the official value is formally reduced to a
lower level.
Practice Question 8 Q2
Policymakers may not want to see their country's currency
appreciate because
A) this would hurt consumers in their country by making
foreign goods more expensive.
B) this would hurt domestic businesses by making foreign
goods cheaper in their country.
C) this would increase inflation in their country.
D) this would decrease the wealth of the country.
Practice Question 8 Q2
Policymakers may not want to see their country's currency
appreciate because
A) this would hurt consumers in their country by making foreign
goods more expensive.
B) this would hurt domestic businesses by making foreign goods
cheaper in their country.
C) this would increase inflation in their country.
D) this would decrease the wealth of the country.
Currency appreciation makes exports more expensive and
imports cheaper, hurting domestic firms.
Practice Question 8 Q4
(I) Controls on capital outflows may increase capital flight by
weakening confidence in the government.
(II) (II) Controls on capital outflows are an inadequate substitute
for financial reform to deal with currency crises.
A) (I) is true; (II) false.
B) (I) is false; (II) true.
C) Both are true.
D) Both are false.
Practice Question 8 Q4
(I) Controls on capital outflows may increase capital flight by
weakening confidence in the government.
(II) (II) Controls on capital outflows are an inadequate substitute
for financial reform to deal with currency crises.
A) (I) is true; (II) false.
B) (I) is false; (II) true.
C) Both are true.
D) Both are false.
Imposing controls on capital outflows often signals that the government is
desperate to stop a run on the currency or reserves. The result can be
increased capital flight and higher incentives to evade the rules.
Capital controls can buy time and reduce immediate pressure on the
exchange rate, but they do not fix the underlying causes of a currency crisis
(weak fiscal/monetary policy, insolvent banks, poor balance sheets, loss of
investor confidence). Lasting stability requires financial and structural reforms
Practice Question 8 Q13
By the end of 2012, China had accumulated more than $3
trillion of international reserves. How did China accomplish
this? Is the policy sustainable?
Practice Question 8 Q13
China consistently receives trade surplus in huge scale,
which leads to strong CNY appreciation pressure.
China adopts managed float regime, where People’s
bank of China frequently bought foreign assets to limit
CNY appreciation. Too high exchange rate at CNY is not
good for local economy, particularly in exports sector.
This allows accumulation of international reserves at
Chinese government.
Practice Question 8 Q13
However, this increase in international reserves is not
sustainable in long run
Increasing labour costs slow down exports growth
As Chinese economy grows, capital flow to abroad also
rises significantly, which also uses international reserves.
Balance of payment surplus is expected to fall.