Chapter 21 International Financial Management Chapter 2 The history of money and finance Michael Connolly School of Business Administration, University.

Chapter 2 1

International Financial Management

Chapter 2 The history of money and finance

Michael ConnollySchool of Business Administration,

University of Miami

Michael Connolly © 2007

Chapter 2 Page 2

Summary

The role of money Money and exchange rates The history of monies Foreign exchange history Banks and banking The international monetary

institutions History of stock exchanges

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The role of money Money serves three important roles

in an economy: It is a unit of account – a yardstick

by which to measure the value of goods and assets.

A medium of exchange to facilitate transactions, avoiding barter.

A store of value in which to temporarily hold liquid wealth.

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Money and exchange rates The Bank of England and the Banque de France, had

gold windows where they bought and sold gold at a fixed currency price in the 19th century. In doing so, their currency rates were fixed. For example, if the Bank of England sets ten pounds per ounce of gold as the buy/sell rate and the Banque of France 100 francs, the equilibrium exchange rate is set at 100 francs per 10 pounds or 10 francs a pound.

Arbitrage in gold kept the exchange rates within a narrow band of gold points. Let’s say the exchange rate falls to 9.5 francs a pound. A gold arbitrageur purchases 10 pounds for 95 francs, presents the 10 pounds to the Bank of England gold window in exchange for an ounce of gold. The arbitrageur then insures and ships the gold to the Banque de France, selling it for 100 francs, pocketing 5 francs less insurance and shipping as profit.

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Money and exchange rates With floating exchange rates, the exchange

rate moves roughly according to the relative purchasing power of monies. This is known as purchasing power parity.

Countries with high money growth experience higher rates of inflation and consequently,

Greater depreciations in their exchange rate.

A fixed exchange rate serves as a monetary anchor, while a floating exchange rate permits independent money growth.

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The history of monies Ancient Chinese monies: Circa 900-

500BC

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The history of monies Ancient Chinese monies: copper coins

used before 221 BC

Coin issued in 221 BC by the Qin Dynasty, the first feudal dynasty to unify China and its coins.

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The history of monies The Lydian Lion’s Head: circa 600-575

BC is thought by many to be the world’s first coin.

It was made of electrum, a precious alloy of gold and silver that consisting of about 54 percent gold, 44 percent silver, and 2 percent copper.

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The history of monies Ancient Chinese monies: The Yibi Circa

500BC

Made of copper and known as the creeping ant-nose coin.

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The history of monies Ancient Chinese monies: The Guinian (Ghost

face) copper coin circa B.C 400 to 300

Both the Yibi and the Guinian coin have the shape of shells, the earliest currency in China.

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The history of monies Ancient Chinese monies: Issued in 621

AD under the Tang Dynasty.

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The history of monies Ancient Chinese monies: The first

uniform paper money in the world, the Jiaozi, issued in 1023 under the Song Dynasty.

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The history of monies The first world money, the Spanish silver

dollar or “pieces of eight” minted in Spain, Mexico and Peru.

The Spanish peso contained 0.821791 troy ounce (25.560 grams) pure silver and was also used as domestic money in Asia, Latin America, America and Europe.

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The history of moniesThe last paper monies of the feudal dynasties: 1875 to1908

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Seigniorage The early definitions of seigniorage

referred to the difference in the value of a money, and its mint costs.

For example, say a silver coin has value $10 and its silver content and cost of manufacture is only 50 cents, then seigniorage is $9.50.

Seigniorage on paper money is generally greater due to the higher nominal values as money and the lower costs of printing in terms of paper, ink, anti-counterfeit measures such as filaments, water marks, color changing ink and the like.

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Seigniorage For example the US $100 bill costs

about 12 cents to manufacture. Consequently seigniorage is $99.88. These profits to the Treasury can be spent, just as with any other tax receipt.

The issue of money is usually the right of the sovereign government (i.e. the seigneur), so that the right to strike money has historically been used to finance wars and emergency expenditures by the “printing press.”

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Seigniorage More formally, seigniorage is the

residual finance of any fiscal deficit that is not completely covered by new borrowing. That is:

Where dM/dt is new seigniorage, (G-T) the fiscal and quasi-fiscal deficit, dB/dt new domestic borrowing, and dB*/dt new foreign borrowing.

dt

dB

dt

dBTG

dt

dM *

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Seigniorage It is often instructive to express new

seigniorage as a percentage of GDP, that is:

When deficits become large as a percent of GDP, say above 5 or 6%, it may become difficult to finance it by new borrowing, so resort to the printing press may take place, causing high inflation.

GDP

dt

dB

dt

dB

GDP

TG

GDPdt

dM

*

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Seigniorage There are, however, limits as to the

amount of seigniorage finance may take place.

This is because the demand for money collapses when inflation is high, so that real seigniorage collections, ΔM/P, decline after a certain point, yielding what is known as a “Laffer curve in seigniorage.”

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Seigniorage

M

M

P

M

P

M

100

Real seigniorage revenue as a percent of real money balances

Seigniorage tax rate (%)

0 /1

M

M

14.6%

13.8%

Between 1952 and 1995, China has issued new seigniorage at a 14.6% rate, collecting 13.8% in new real seigniorage revenue.Note: Technically speaking, the seigniorage tax rate is so that in the limit it approaches 1 or 100% when money growth approaches infinity.

M

M

1

CHINA

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Seigniorage

M

M

P

M

P

M

100

Real seigniorage revenue per annumas a percent of real money balances

Seigniorage tax rate (%)

0 /1

M

M

6.7%

3.1%

USA

1960-1995, averages.

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Seigniorage

100

Real seigniorage revenueas a percent of income

Seigniorage tax rate (%)

0 /1

Y

M

M

M

Y

M

14.6%

1.2%M

M

As a percent of GDP (Y), this represents an annual collections rate of 1.2%of GDP in China from 1952 to 2005.

CHINA

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Seigniorage

100

Real seigniorage revenueas a percent of annual income

Seigniorage tax rate (%)

0 /1

Y

M

M

M

Y

M

6.7%

0.36% M

M

As a percent of GDP (Y), this represents an annual collections rate of 0.36%of GDP in the United States from 1960 to 2005.

USA

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The revenue maximizing rate of seigniorage

In equilibrium, money demand, L, equals money supply, M. The demand for money, however, is inversely related to its rate of seigniorage issue (and inflation), so that we may write real revenue as determined by the rate of seigniorage issue times real money balances.

For simplicity, define so that the real revenue collected from seigniorage is:

Which is the money demand equation according to Philip Cagan, “The Monetary Dynamics of Inflation,” in Milton Friedman, editor Studies in the Quantity Theory of Money, Chicago: University of Chicago Press 1956.

k is a constant η is the income elasticity of demand for moneyy is real GDP α is the semi-elasticity of the demand for money with respect to the rate of seigniorage issue

M

M

ekyP

MR

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The revenue maximizing rate of seigniorage

The rate of seigniorage issue that maximizes real revenue from seigniorage is given by:

Or

Which yields the revenue maximizing issue of seigniorage equal to:

The greater the semi-elasticity of demand for money, the lower is the revenue maximizing rate of inflation, as illustrated graphically.

0

ekyyekyd

dR

01 ddR

1ˆ

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SeigniorageThe reason why a relatively high percent of seigniorage can be collected in China is due firstly, to the high real rate of growth in income, leading to increased demand for money, and secondly to a high income elasticity of demand for money. Thus, virtually no inflation has resulted.Summary Monetary Statistics for China: 1952-2005

Income elasticity of demand for money 1.8

Money growth 14.6%

Money/GDP 9.8%

Real seigniorage 13.8%

Inflation 0.1%

Real growth 8.1%

Seigniorage/GDP 1.2%

Money growth less real growth 6.5%

Increase in Cambridge K 6.3% Data sources:

Comprehensive Statistic Data and Materials on 50 Years of New China, China Statistics Press, 1999:189-190.

"China Statistic Yearbook 2005", China Statistics Press, 2006, chaps. 20,28.

"Statistic Communique of the People's Republic of China on the 2005 National Economic and Social Development", Feb.28, 2006.

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Foreign exchange history Bills of exchange were used primarily in

international trade, and is a written order by one person to pay another a specific sum on a specific date sometime in the future.

Since carrying large amounts of coins was risky, bills of exchange were used in order to facilitate currency and trade transactions.

The bill of exchange allowed trade to take place without the use of coinage, a precursor of the modern letter of credit (L/C).

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Foreign exchange history Furthermore, the bills were traded as financial

instruments in trade fairs. They were discounted and converted into foreign exchange.

The trade fairs were the precursors of modern stock and foreign exchanges.

An important feature of the foreign exchange market was an interest-bearing loan disguised as a foreign exchange transaction. Merchants and financiers were able to make loans evading usury laws using a sequence of two bill transactions – a precursor of today’s foreign exchange swap.

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Foreign exchange history An important 16th century development was the

appearance of a system of ‘betting’ on future exchange rates: a non-deliverable forward market. The betters made forecasts on future exchange rates.

The difference between the realized rate and the forecasted rate determined who won the bet and how much the loser would pay the winner.

This form of forward exchange still exists today in the form of non-deliverable futures (NDFs) in the Chinese yuan (formally Renminbi, the “People’s Currency) in Singapore and Hong Kong.

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Foreign exchange history The 1944 Bretton Woods sytem of

pegged but adjustable exchange rates triggered foreign exchange intervention in spot markets to maintain exchange rates near their “par” values.

Floating exchange rates began in the early 1970s, and global markets were being integrated. The resulting need of multinational businesses to hedge their currency exposures caused the rapid growth of foreign exchange trading in the 1980s and 1990s.

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Foreign exchange history London is still by far the largest FOREX

market today in terms of daily foreign exchange turnover.

In 2004, daily turnover net of double-counting on the London foreign exchange market was a staggering $753 billion in currency spots, swaps, forwards and options.

This represents 31% of daily foreign exchange transactions, compared to 19% in the United States, and 8% in Japan.

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Banks and banking The first modern bank was the Bank of

Amsterdam, founded in 1609. The Amsterdam bank was quickly followed by other major cities.

The Bank of Hamburg was formed in 1619 and the Bank of Sweden in 1656. Sweden issued the first European paper bank notes in 1661.

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Banks and banking The Bank of England was founded in

1694 as a commercial bank by William Paterson with the right to issue notes up to the amount of its capital, initially £1.2 million.

It was nationalized by Parliament in 1946. The shareholders received compensation and the Bank of England thereafter ceased its private business, becoming the banker of government

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Banks and banking Since 1977, The Bank of England has

the responsibility for setting monetary policy.

Prudential oversight of the British commercial banking system was simultaneously transferred to the Securities and Investments Board.

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Banks and banking In the United States, the Federal Reserve

Act established the Federal Reserve System (the FED) in 1913 with 12 districts.

The Federal Reserve Banks provide liquidity, clear transactions, and control the money supply.

The FED was established primarily as a reserve institution, a lender of last resort to prevent bank runs and liquidity crises.

The Federal Deposit Insurance Corporation (FDIC) insuring deposits was begun in March 1933.

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The international monetary institutions

The International Monetary Fund (IMF) was established in 1944 at the Bretton Woods Conference in New Hampshire.

Its purpose was to establish orderly exchange rate arrangements based on a par value system, to eliminate exchange controls, and to provide temporary short term balance of payments assistance via conditional loans to member countries that are short of foreign exchange reserves.

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The international monetary institutions

The World Bank, a sister institution of the IMF created in 1944 at the Bretton Woods Conference initially made long term development loans for projects such as dams, airports, rubber and concrete production, water systems, and the like.

It got involved in Structural Adjustment Loans (SALs) in the 1990s in tandem with the IMF requiring structural adjustments to economic policy. This could mean privatization of state enterprises, lifting price and exchange controls, and improving monetary and fiscal policies, for instance.

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The international monetary institutions

The Bank of International Settlements (BIS) is often referred to as the bank of central banks. Located in Basel, Switzerland,

It was established May 17, 1930 at the Hague convention. As such, it is the oldest international monetary organization.

It does not do business with private individuals or corporations; only with central banks and international institutions.

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The history of the stock exchanges

The New York Stock Exchange established May 17, 1792 on Wall Street. Traders met at the old wooden wall, no longer in existence, but giving its name to the street.

The Dow Jones Industrial Average (DJIA) started out with 12 stocks in October 1928. Only General Electric remains of the original twelve. The S&P 500 Index covers the 500 most widely held companies.

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The history of the stock exchanges

The London Stock Exchange was established in 1773, formerly Jonathan’s Coffee House where trades met. Trading has since moved off the floor with the introduction of the Stock Exchange Automated Quotations (SEAQ) system.

The Footsie 100 Index is the Financial Times Stock Exchange Index of the 100 largest companies listed on the London Stock Exchange.

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The history of the stock exchanges

The Tokyo Stock Exchange was established on May 15, 1878. Japan's Nikkei 225 Index is an average of stock market prices similar to the Dow Jones Industrial Average.

The Paris Bourse was established in Paris by the order of the Royal council in 1724. In 1986, the futures exchange – Le MATIF - was established .

The CAC 40 Index is the acronym for “Compagnie des Agents de Change 40 Index,” 40 French companies listed on the Paris Stock Exchange.

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The history of the stock exchanges

The Frankfurt Stock Exchange dates from the 9th century when trade fairs were authorized. In 1585 it was organized as a bourse to fix exchange rates and by 1894 had became a formal stock exchange.

Its main index, the DAX consists of the 30 largest issues traded on the exchange.

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The history of the stock exchanges

The Shanghai Stock Exchange (SSE) was founded in 1904, mainly dealing in rubber shares. The Japanese occupation brought an end to its operations.

The modern Shanghai Stock Exchange was founded in 1990 but suffers from transparency, disclosure and monitoring issues that have put it into a serious slump from which it is just now recovering.

The Shanghai Composite Index is a composite of hard-currency B shares sold to foreigners and yuan-denominated A shares sold to Chinese.

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The history of the stock exchanges

The performances of the international stock markets indices are related.

In fact, this is one aspect of the

increased globalization of international trade and finance.

The following table reports the correlation between the monthly real rates of return on major world stock indices

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The history of the stock exchanges

Correlations between the monthly real rates of return of major stock indices: 1995-2004.

** Correlation is significant at the 0.01 level (2-tailed).* Correlation is significant at the 0.05 level (2-tailed).

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Conclusion Money serves as a medium of exchange,

a unit of account, and a store of value. Different monies must be converted into the same unit of account by the exchange rate in order to compare prices and rates of return.

This currency conversion gives rise to foreign exchange risk in investing and operating internationally. The foreign exchange markets have arisen to deal with spot and forward transactions in different monies, as well as currency options to either hedge or speculate.

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Conclusion The largest FOREX market remains

London. accounting for 31% of daily turnover in the foreign exchanges.

The exchange costs on the FOREX market are mainly the difference between the ask and the bid price of foreign currency – the bid-ask spread – as well as any commission associated with the conversion.

These costs are not insignificant, amounting to approximately a billion USD daily.

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Conclusion There is increasing financial integration

in the world financial markets, making for a more efficient distribution of worldwide finance.

The adoption of the euro by twelve countries as the same currency has removed exchange rate risk and conversion costs from the financial landscape of Europe.

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Conclusion The issue of seigniorage has been the “root of all evils” in

many emerging markets, especially developing countries in Latin America and Africa. Money has become worthless, so that “currency reforms” – a change of the monetary unit – have been necessary in Argentina, Bolivia, Peru, Mexico and Ecuador (which has officially dollarized)

It is often the “finance of last resort” when a government runs a high fiscal deficit it cannot finance by borrowing at home and abroad. It’s last resort is to print money – the “printing press.”

China and the United States have since the 1950s restrained the issue of seigniorage and consequently have had low inflation.

At the same time, China’s high income elasticity of demand for money and its high growth rate have allowed 1.2% of GDP to be collected as seigniorage revenues.