Part II Exchange Rate Behavior Existing spot exchange rates at other locations locational arbitrage Existing spot exchange rate Existing cross exchange rates of currencies triangular arbitrage covered interest arbitrage Existing forward exchange rate Existing inflation rate differential Fisher effect covered interest arbitrage purchasing power parity Existing interest rate differential Future exchange rate movements international Fisher effect

Government Influence on Exchange Rates CHAPTER 6 Government Influence on Exchange Rates © 2000 South-Western College Publishing 1

Chapter Objectives To describe the exchange rate systems used by various governments; To explain how governments can use direct intervention to influence exchange rates; To explain how governments can use indirect intervention to influence exchange rates; and To explain how government intervention in the foreign exchange market can affect economic conditions.

Exchange Rate Systems Exchange rate systems can be classified according to the degree to which exchange rates are controlled by the government. Exchange rate systems normally fall into one of the following categories: fixed freely floating managed float pegged

Fixed Exchange Rate Systems In a fixed exchange rate system, exchange rates are either held constant or allowed to fluctuate only within very narrow boundaries. Examples: Bretton Woods era (1944-1971) Smithsonian Agreement (1971) Pros: Work becomes easier for the MNCs. Cons: The government may alter the value of a specific currency. In fact, the dollar was devalued more than once after the United States experienced balance of trade deficits.

Freely Floating Exchange Rate Systems In a freely floating exchange rate system, exchange rates are determined by market forces without intervention by governments. Pros: ¤ World stability is enhanced as problems experienced by one country may not easily spread to other countries. ¤ No intervention policies are needed and governments are not restricted by exchange rate boundaries when setting new policies. ¤ Less capital flow restrictions are needed, thus enhancing the efficiency of the financial market.

Freely Floating Exchange Rate Systems Cons: ¤ The MNCs will need to devote substantial resources to managing exposure to exchange rate fluctuations. ¤ The country that initially experienced economic problems (such as high inflation, increasing unemployment rate) may have its problems compounded.

US dollar - excessive fluctuations ?

Managed Float Exchange Rate Systems A managed float or “dirty” float exchange rate system resembles the freely floating system in that rates are allowed to fluctuate freely on a daily basis. Yet, it is like the fixed system in that governments may intervene to prevent the rates from moving too much in one direction. It has been pointed out that a government can manipulate exchange rates such that its own country benefits at the expense of others. Examples: Korea (1997), Russia (1997)

Pegged Exchange Rate Systems In a pegged exchange rate system, the home currency’s value is pegged to a foreign currency or to some unit of account, and moves in line with that currency or unit against other currencies. Examples: Malaysia and Thailand before the Asian crisis The European Economic Community’s snake arrangement (1972-1979) The European Monetary System’s exchange rate mechanism (ERM) (1979-1999)

Current systems

The Euro is born

The Euro On January 1, 1999, the euro was introduced. At January 1 2002, the national currencies of the participating countries were withdrawn from the financial system and replaced with the euro. The Frankfurt-based European Central Bank is responsible for setting a common monetary policy. It aims to control inflation and to stabilize the value of the euro. As currency movements among the European countries will be eliminated, more long-term business arrangements between firms of European countries will be encouraged.

Euro banknotes

The Euro Non-European firms can also compare European products and European firms more easily, as their values are denominated in the same currency. Cross-border investing may increase due to the elimination of exchange rate risk. However, non-European investors may not achieve as much diversification as in the past.

Euro - a bumpy ride ?

Government Intervention Each country has a government agency (called the central bank) that may intervene in the foreign exchange markets to control the value of the country’s currency. In Euroland, the European Central Bank (ECB) is the central bank. Central banks manage exchange rates to smooth exchange rate movements, to establish implicit exchange rate boundaries, and/or to respond to temporary disturbances.

Government Intervention Direct intervention refers to the exchange of currencies that the central bank holds as reserves for other currencies in the foreign exchange market. Example: To strengthen the dollar, the Fed will exchange foreign currencies for dollars. Direct intervention is usually most effective when there is a coordinated effort among central banks.

Effects of Direct Central Bank Intervention in the Foreign Exchange Market Value of £ Quantity of £ V2 V1 S D2 D1 Value of £ Quantity of £ V1 V2 S2 D S1

Government Intervention When the change in money supply is not adjusted for, the intervention is said to be nonsterilized. A sterilized intervention occurs when Treasury securities are bought or sold simultaneously to maintain the money supply. Some speculators attempt to determine when the central bank is intervening, and the extent of the intervention, in order to capitalize on the anticipated results.

Government Intervention The central bank can also intervene indirectly by influencing the factors that determine a currency’s value, such as interest rates. Note that high interest rates adversely affects local borrowers, and may weaken the economy. Some governments also use foreign exchange controls (such as restrictions on the exchange of the currency) as a form of indirect intervention.

Exchange Rate Target Zones Many economists have criticized the present system because of the wide swings in the exchange rates of major currencies. It has been suggested that target zones be used, whereby an initial exchange rate will be established with specific boundaries. The ideal target zone should allow rates to adjust to economic factors without causing wide swings in international trade and fear in financial markets. However, the actual result may be a system no different from what exists today.

Intervention as a Policy Tool The exchange rate is a tool, like tax laws and money supply, with which the government can use to achieve its desired economic objectives. A weak home currency can stimulate foreign demand for products (and hence local jobs), but may lead to higher inflation. A strong currency is a possible cure for high inflation, but may cause higher unemployment.

Impact of Government Actions on Exchange Rates Government Intervention in Foreign Exchange Market Government Monetary and Fiscal Policies Relative National Income Levels Tax Laws, etc. Quotas, Tariffs, etc. Government Purchases & Sales of Currencies

Impact of Central Bank Intervention on an MNC’s Value Direct intervention Indirect intervention E (CFj,t ) = expected cash flows in currency j to be received by the U.S. parent at the end of period t E (ERj,t ) = expected exchange rate at which currency j can be converted to dollars at the end of period t k = the weighted average cost of capital of the U.S. parent

Chapter Review Exchange Rate Systems Fixed Exchange Rate System Freely Floating Exchange Rate System Managed Float Exchange Rate System Pegged Exchange Rate System Europe’s Exchange Rate Mechanism Currency Boards Impact of Exchange Rates on Countries with Pegged Currencies

Chapter Review A Single European Currency Impact on European Monetary Policy Impact on Business Within Europe Impact on the Valuation of Businesses in Europe Impact on Financial Flows Impact on Exchange Rate Risk Government Intervention Reasons for Government Intervention Direct Intervention Indirect Intervention

Chapter Review Exchange Rate Target Zones Intervention as a Policy Tool Influence of a Weak Home Currency on the Economy Influence of a Strong Home Currency on the Economy How Central Bank Intervention Can Affect an MNC’s Value