This post is in continuation to my previous post "The euro area's debt crisis", below you can find a series of discussion I had with Karthick and Yeshwant. I thought it is worth posting it for two reason, one, I could register our discussion so that it doesn't get lost, two, I felt the discussion would immensely benefit fellow readers too. Happy reading :) as always, your comments, thoughts, questions are most welcome.
You didn't talk about the rise of Euro crisis. A Little of history of why Euro? could help. Why some countries opted out/were opted out ? I would like to know was Germany/France hesitant against Euro and if so why ?
The purpose of the write up (Euro Debt Crises) was essentially to highlight the mounting public debt by countries in the Euro zone and gross fiscal irresponsibility by the ECB. We have discussed enough about the birth of the crises, it all started off with mortgage defaults which ultimately lead to failure of the banking system in the west, and that had a contagion effect. Still if you are interested, we can work on a detailed cover story analyzing the birth of the crises, well, “why Euro” is a topic in itself :), could not have done justice with just a para on it.
Well, Germany isn't opposing the Euro publicly, but somewhere the insiders want to dump the Euro as they feel it is an unnecessary financial burden, the fundamental question raised is, why the average German taxpayer should pay for making up the losses of Greece, Spain, Portugal? which could otherwise be used to fuel their own economic growth. Some even argue that the weak Euro is the reason behind Germany's recovery :-) (Very political and controversial).
The countries in the Euro zone wanted to leverage the financial strength of stronger Euro nations like that of the Germany and France to raise money from the international markets to fund their budget deficits (which is used for large scale bank bailouts), otherwise it is virtually impossible for Greece or Portugal to raise money at tolerable / sustainable rates of interest, given their fiscal position.
Restructuring a insolvent country's debt. What does this mean ?
Sovereign Insolvency is when a country is unable to service its debt obligations. Restructuring is nothing but revisiting the rate of interest and bond tenure in order to make the debt repayable which would otherwise become a bad debt.
We cannot see this only in the light of Sovereign debts/Fiscal deficits. I guess UK, Italy too run huge deficits. The problem is unequal distribution of wealth and supply [goods, Man power]
Not just the UK, even the US runs mammoth deficits, but the US and UK have their respective dollar and pound to fall back upon. Since the dollar is considered a global reserve currency, the global trade is dominated by the dollar and pound, hence it is easier for the US to raise money from the international markets to fund its deficits or even print money (though this would result in hyperinflation). And the Euro was proposed to challenge the virtual monopoly of the dollar and rest is history.
This brings us to the fundamental question, how was the value for Euro as a currency determined ? How is exchange rate determined for the first time? I understand later, it is the open market operations that determine. Still, How is china able to control it's remnibi internally ? Isn't it a violation to set currency exchanges if they were part of WTO ?
Well, there are primarily two ways by which value of a currency could be determined (This calls for a separate, more serious discussion in itself), one, exchange or market determined which is referred to as free float two, a fixed exchange rate regime also known as Pegged system. A lot depends on capital account and current account convertibility as well. Please be informed that interest rates, bond yields have a very important role to play in determining the value of a currency.
If a currency is free-floating, its exchange rate is allowed to vary against that of other currencies and is determined by the market forces of supply and demand (which is what is sustainable in my opinion). A movable or adjustable peg system is a system of fixed exchange rates, but with a provision to devalue the currency. For example, between 1994 and 2005, the Chinese renminbi was pegged to the United States dollar at renminbi 8.2768 to $1. China was not the only country to do this, from the end of World War II until 1967, Western European countries all maintained fixed exchange rates with the US dollar based on the Bretton Woods system.
The China is able to control remnibi internally through open market operations, i.e the Govt would buy dollar from the currency market if it wants devalue remnibi and sell the dollar if it wants the remnibi to appreciate. This is an internal issue and the WTO has no direct control over open market operations to my knowledge.
Even India resorts to buying and selling of dollar through the RBI in order to avoid the Rupee from appreciating. This is much politically motivated, we can have a separate thread to discuss its wide implications.
As in how can they value and devalue their currency just by buying/selling dollars. I am sure there is lot more factors into it like Balance of Payments, etc
Indeed, a country can very much manipulate the value of its currency by buying and selling dollars in the open market, but it is not as easy as said, this is just a stop gap arrangement. In the long term, the value of a currency is purely dependent on the demand and supply mechanism which in turn is largely dependent on the Balance of Payments. For example, if a country has strong export growth year on year, the aggregate demand for that country's currency grows in the international market, as a result the currency appreciates and if the vice versa happens, currency depreciates.
Because if that is the case, why does India and other 3rd world countries not go for a pegged system..?
I have clearly said that a pegged system is indeed not sustainable at all, unless and until the economy happens to be export driven like that of China, or if the currency is backed by a cartel of nations like that of the Euro.
A pegged currency makes the system more vulnerable to a Currency Crises, it's consequences are disastrous and unexplainable. Such crises may result in hyperinflation or extreme deflation. Therefore, for a domestic demand driven economy like that of India or any 3rd world country for that matter, implementing a pegged system is without a doubt "Suicidal".
China on the other hand has a very strong hold on exports, Chinese products have become household for the West, with such strong export growth and BOP, Current account & Capital account surplus, China is able to afford a pegged system.
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