International Financial System - Example

International Financial System The international financial system is a generic name that refers to a collective mixture of institutions, issues and exchange-rate systems that handle the money (financial) component of an integrated world. The basis of the IFS institutional framework is found in the business, investors, financial markets and banks in local economies. This is supported at the international level by governments, central banks, the World Bank and the International Monetary Funds (IMF). Issues that the IFS has to handle include capital flows in economies, the role of international financial institutions and the conditionality they issue to different countries, and the issue s related to exchange rate regimes. Regarding exchange rate systems, IFS has to handle matters of Fixed and floating systems which are maintained by different players in the global financial architecture. Among the areas that the IFS is best evident is in the foreign exchange (For-ex) interventions whereby, central banks engages in international financial transactions for purposes of influencing the foreign exchange rates. The foreign exchange interventions can be carried out in two approaches; i.e. unsterilized FEI - this occurs when the central bank’s intervention allows the sale and purchase of the domestic currency, hence affecting the monetary base in an economy; and sterilised FEI - the central bank intervenes by offsetting operations in an open market but unlike the unsterilized FEI, this does not affect the monetary base. To facilitate an economy’s integration in the international financial system, countries maintain exchange rate regimes, which refers to the systems that are either fixed to a specific currency (e.g. the dollar) or are flexible or floating mainly based on the inflation index in the specific economy. Usually, exchange rate regimes are determined by prevailing economic policies and circumstances. For-ex crises on the other hand occur when the amount of foreign exchange reserves set aside by the central bank for purposes of defending a weak currency are low. When such a thing happens, the local currency suffers devaluation and this eventually leads to inflation locally and a decreased demand for the local currency as people shift their preference to a more stable currency, usually, the dollar. Faced with domestic challenges brought about by the International financial markets, some governments in an attempt to protect local economies use capital controls. This are defines as the restriction that governments impose of foreign investment. Through capital controls, government regulate the inflow and outflow of the capital account. Notably, the international financial systems are courtesy of factors such as globalisation and increased international trade. However, governments and independent institutions realised the need for global financial institutions to act as moderators of the different interests that diverse countries would bring into the global financial system. By definition, the global financial institutions are financial institutions of an international nature whose establishment (or charter) was done by more than one country and are hence subject to international law. Theoretically, such institutions are diverse in their composition and are hence objective in their role as independent adjudicators, interveners and advisors to different players in the global financial system. The two institutions that fall in the global financial institutions category are the IMF (helps different countries to maintain For-ex rates by giving loans to those that have problems with their balance of payments, and also acts as ‘lender of last resort’ during financial crises); and the World Bank (funds economic development projects in developing countries through issuing countries with long-term loans). Financial crises In every economy, financial markets and institution have an important role of channelling funds to individual or organisation that can invest or use the same in economically productive investments. A failure by the financial system to play such allocation well hinders the efficient operation of an economy and hampers growth. The asymmetric information concept has been cited as one of the main impediments that hinder optimal financial system functioning and has even been blamed for facilitating economic crises. Asymmetric information occurs when one party in a financial transaction “has much less accurate information than the other party”. For example, a borrower usually has a better understanding about the risk involved in an investment compared to the lender. Accordingly, lenders are often cautious about lending and these leads to two problems in the financial system namely adverse selection, and moral hazard. Adverse selection manifests itself in the financial market in that, when the borrower posses information that the lender doesn’t (i.e. the borrower has an information advantage over the lender), there is likely to be an advance selection problem when issuing loans. This is based on the reasoning that the lender may end up issuing loans to high-risk borrowers; denying loans to low-risk borrowers and hence denying them the chance to invest in what would have been economically beneficial projects; or rationing credit and by so doing, arbitrarily denying loans to some borrowers. Moral hazard on the other hand occurs because the borrower is not morally obligated to make the most use of the borrowed money in his investment decisions thus exposing the lender to the risk of non-payment. To lessen such risks, lenders restrict the amounts of loans they give out, and this means that both lending and investments in the economy will be at sub-optimal levels. Used to understand financial crises, information asymmetry leads to limited access by firms and individuals hence leading to contracted economic activity which then jeopardises the functioning of the financial markets hence leading to a financial crisis. In advanced countries (i.e. industrialised countries) different dynamics contribute to financial crises. They include increasing interest rates, deteriorative bank revenues (reflected in balance sheets), declining stock markets, and increasing uncertainty in the financial markets. Collectively, these factors lead to adverse selection and moral hazard- associated problem, thus causing the economy to decline. A banking crisis is a likely outcome and this only worsens the adverse selection and moral hazard issues leading to further economic decline in a typical financial crisis. Dynamics in developing countries are a bit different in that adverse selection and moral hazard resulting from increased interest rates, declining bank revenues, declining stock markets and increased uncertainty in the markets lead to a foreign exchange crisis, which worsen the adverse selection and moral hazard problem further hence leading to a decline in the economic activity; this eventually leads to a banking crises, and ultimately, a financial crisis. An example of a financial crisis that can be explained using information asymmetry is the 1994-95 Mexican financial crisis. The crisis illustrates how monetary tightening by the United States affected the value of the Mexican peso, the domestic interest and increased the problems of moral hazard and adverse selection, and ultimately leading to a contraction in the domestic economy culminating in the financial crises (Kehoe, 2004: 138; Mishkin, 1998:21-22). You can read more about the Mexican financial crises from < (http://www0.gsb.columbia.edu/faculty/fmishkin/PDFpapers/w6390.pdf)> pages 18-20; and http://www.econ.umn.edu/~tkehoe/papers/Mexico1994-95.pdf Foreign exchange market The foreign exchange market is pegged on the US dollar, hence meaning that the foreign exchange rate is determined by the “price of a foreign currency” in US dollars. In other words, the foreign exchange market enables individuals, firms and governments to convert their local currencies into internationally acceptable currencies, which is usually the dollar. The rates are formed in a floating regime whereby changes in the demand and supply of a specific currency affects its relative cost compared to the dollar. Several factors affect the demand for foreign currency hence causing exchange rates to change. Such include increased imports demand, rising domestic incomes, rising inflation, and high interest rates. Usually, the identified factors push the price of the domestic currency higher thus appreciating its value. A demand for foreign currency especially when purchasing products or investing one’s economy is the case usually requires people to purchase dollars using their foreign currencies. The subsequent increased demand for the dollar leads to an increase in the supply of the same, and as this happen, the relative price of the US dollar to specific currencies depreciate. In the short-term, the demand and supply of the dollar relative to specific currencies affects the exchange rates; however, the changing rates can be self-correcting in the long-term since the local currencies appreciate as the demand for the dollar increases hence making imports and other offshore investments less attractive. The importance of the foreign exchange market is pegged on the fact that it is the largest (and oldest) financial market in the world, which makes trading on the international market easier. By using the US dollar as the standard of value, transactions from people, firms and governments using different currencies is made possible. Additionally, a nation’s economic well-being is reflected in its currency’s performance at the foreign exchange market since it shows the currency’s value when compared to others. Purchasing power parity (PPP) is defined as the “the application of the law of one price (LOOP) to entire economies”. The PPP presents a theory for exchange rate determination in the long-run. Through PPP, economists predict exchange rates adjustments to relative changes in price levels, to differential rates of inflation between countries. The law of LOOP, which PPP is based upon states that identical goods in a competitive market should be priced similarly. In the foreign exchange market, LOOP is translated to mean that similar goods, though sold in different countries, should sell at the same price in a competitive market, should their respective selling prices be converted to the same currency. In the long-run, exchange rates are also determined by relative differences in the: demand for imports and exports; trade barriers/trade policies; long-term real Gross Domestic Product (GDP) growth rates; long-term investment profitability; and productivity. In the short-run, the foreign exchange markets are moved by expectations of changes likely to happen relative to productivity, trade barriers, imports, exports and inflation. Differences in prevailing exchange rate and the expected exchange rate of the future also play an essential role in determining the exchange rate in the short-run. Read More