Global Business Today 8e by Charles W.L. Hill © 2014 by McGraw-Hill Education.  This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner.  This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part. 

The International Monetary System Chapter 11 The International Monetary System

Question: What is the international monetary system? Answer: Introduction Question: What is the international monetary system? Answer: The international monetary system refers to the institutional arrangements that govern exchange rates Recall that the foreign exchange market is the primary institution for determining exchange rates

Introduction A floating exchange rate system exists in countries where the foreign exchange market determines the relative value of a currency Examples - the U.S. dollar, the European Union’s euro, the Japanese yen, and the British pound A pegged exchange rate system exists when the value of a currency is fixed to a reference country and then the exchange rate between that currency and other currencies is determined by the reference currency exchange rate Many developing countries have pegged exchange rates

Introduction A dirty float exists when the value of a currency is determined by market forces, but with central bank intervention if it depreciates too rapidly against an important reference currency China adopted this policy in 2005 With a fixed exchange rate system countries fix their currencies against each other at a mutually agreed upon value Prior to the introduction of the euro, some European Union countries operated with fixed exchange rates within the context of the European Monetary System (EMS)

Introduction Question: What role does the international monetary system play in determining exchange rates? Answer: To answer this question, we have to look at the evolution of the international monetary system The Gold Standard The Bretton Woods system

The Gold Standard Question: What is the Gold Standard? Answer: The origin of the gold standard dates back to ancient times when gold coins were a medium of exchange, unit of account, and store of value To facilitate trade, a system was developed so that payment could be made in paper currency that could then be converted to gold at a fixed rate of exchange

Mechanics of the Gold Standard The gold standard refers to the practice of pegging currencies to gold and guaranteeing convertibility Under the gold standard one U.S. dollar was defined as equivalent to 23.22 grains of "fine (pure) gold The exchange rate between currencies was based on the gold par value - the amount of a currency needed to purchase one ounce of gold

Strength of the Gold Standard The key strength of the gold standard was its powerful mechanism for simultaneously allowing all countries to achieve balance-of-trade equilibrium When the income a country’s residents earn from its exports is equal to the money its residents pay for imports Many people today believe the world should return to the gold standard.

1918 - 1939 The gold standard worked fairly well from the 1870s until the start of World War I After the war countries started regularly devaluing their currencies to try to encourage exports Confidence in the system fell, and people began to demand gold for their currency putting pressure on countries' gold reserves, and forcing them to suspend gold convertibility The Gold Standard ended in 1939

The Bretton Woods System A new international monetary system was designed in 1944 in Bretton Woods, New Hampshire The goal was to build an enduring economic order that would facilitate postwar economic growth The Bretton Woods Agreement established two multinational institutions The International Monetary Fund (IMF) to maintain order in the international monetary system The World Bank to promote general economic development

The Bretton Woods System Under the Bretton Woods Agreement The U.S. dollar was the only currency to be convertible to gold, and other currencies would set their exchange rates relative to the dollar Devaluations were not to be used for competitive purposes A country could not devalue its currency by more than 10% without IMF approval

The Role of the IMF The IMF was responsible for avoiding a repetition of the chaos that occurred between the wars through a combination of: Discipline A fixed exchange rate puts a brake on competitive devaluations and brings stability to the world trade environment A fixed exchange rate regime imposes monetary discipline on countries, thereby curtailing price inflation Internet Extra: The IMF has an interactive web page designed especially for students. Go to {http://www.imf.org/external/about.htm}. Click on For Students, then click on EconEd Online. Several interactive activities are available to help students learn more about the IMF and its activities. For example, to see how the IMF evaluates a country, click on What Does the IMF Do. This interactive exercise allows students to pick an online team to help analyze a member country’s economy.

A rigid policy of fixed exchange rates would be too inflexible The Role of the IMF Flexibility A rigid policy of fixed exchange rates would be too inflexible So, the IMF was ready to lend foreign currencies to members to tide them over during short periods of balance-of-payments deficits A country could devalue its currency by more than 10 percent with IMF approval

The Role of the World Bank The World Bank lends money in two ways Under the IBRD scheme, money is raised through bond sales in the international capital market and borrowers pay what the bank calls a market rate of interest - the bank's cost of funds plus a margin for expenses. Under the International Development Agency scheme, loans go only to the poorest countries The official name of the World Bank is the International Bank for Reconstruction and Development (IBRD).

The Collapse of the Fixed System Question: What caused the collapse of the Bretton Woods system? Answer: The collapse of the Bretton Woods system can be traced to U.S. macroeconomic policy decisions (1965 to 1968) During this time, the U.S. financed huge increases in welfare programs and the Vietnam War by increasing its money supply which then caused significant inflation Speculation that the dollar would have to be devalued relative to most other currencies forced other countries to increase the value of their currencies relative to the dollar

The Collapse of the Fixed System The Bretton Woods system relied on an economically well managed U.S. When the U.S. began to print money, run high trade deficits, and experience high inflation, the system was strained to the breaking point The Bretton Woods Agreement collapsed in 1973

The Floating Exchange Rate Regime Question: What followed the collapse of the Bretton Woods exchange rate system? Answer: Following the collapse of the Bretton Woods agreement, a floating exchange rate regime was formalized in 1976 in Jamaica The rules for the international monetary system that were agreed upon at the meeting are still in place today

Under the Jamaican agreement The Jamaica Agreement At the Jamaica meeting, the IMF's Articles of Agreement were revised to reflect the new reality of floating exchange rates Under the Jamaican agreement Floating rates were declared acceptable Gold was abandoned as a reserve asset Total annual IMF quotas - the amount member countries contribute to the IMF - were increased to $41 billion (today, this number is $383 billion)

Exchange Rates Since 1973 Since 1973, exchange rates have become more volatile and less predictable because of: The oil crisis in 1971 The loss of confidence in the dollar after U.S. inflation jumped between 1977 and 1978 The oil crisis of 1979 The rise in the dollar between 1980 and 1985 The partial collapse of the European monetary system in 1992 The 1997 Asian currency crisis The global financial crisis of 2008-2010 and the EU sovereign debt crisis during 2010-2011 Country Focus: The U.S. Dollar, Oil Prices, and Recycling Petrodollars Summary This feature explores what oil producing nations are likely to do with the dollars they have earned. In 2008, oil prices reached new highs as a result of higher than expected demand, tight supplies, and perceived geopolitical risks. Since oil is priced in dollars, oil producers have seen their dollar reserves increase significantly. Now, speculation abounds as to what will happen to the petrodollars. Some believe that the dollars will go toward public infrastructure projects, others think that it is more likely that investments will be made in dollar denominated assets like U.S. bonds, stocks, and real estate, or in non-dollar denominated assets such as European or Japanese bonds and stocks. Discussion of the feature can revolve around the following questions: Suggested Discussion Questions 1. With oil prices at record highs, there is significant speculation as to what oil producing states will do with the dollars they are earning. Discuss how a decision to invest in non-dollar denominated assets could affect the value of the U.S. dollar. Suggested Discussion Points: As a result of higher demand from countries like China and India, tight supplies and perceived geo-political risks, oil prices reached a new high in 2008. For oil producing countries, this has proved to be an unexpected windfall. In 2007, the countries together earned over $1 trillion. Most students will probably recognize that if the countries decide to invest their earnings in non-dollar denominated assets, the value of the dollar could drop sharply. 2. How could a decision by oil producing countries to invest their petrodollars in public infrastructure projects help the value of the dollar? Suggested Discussion Points: If the oil producing states invest the petrodollars in public infrastructure projects such as roads, telecommunications systems, and education, the U.S. dollar could actually rise in value. The infrastructure investments are likely to generate economic growth in the nations, which could then translate into market opportunities for U.S. firms. Lecture Note: To extend this discussion, consider {http://www.businessweek.com/globalbiz/content/oct2009/gb2009106_736291.htm} and {http://www.businessweek.com/magazine/content/08_14/b4078084895408.htm?chan=search}. Video Note: The iGlobes Oil and Gas Prices Rise Due to Pipeline Shutdown and Oil Market Focuses Attention on Middle East Conflict fit in well with this feature.

Exchange Rates Since 1973 Major Currencies Dollar Index 1973-2012

Fixed vs. Floating Exchange Rates Question: Which is better – a fixed exchange rate system or a floating exchange rate system? Answer: Disappointment with floating rates in recent years has led to renewed debate about the merits of a fixed exchange rate system

The Case for Floating Rates Monetary Policy Autonomy The removal of the obligation to maintain exchange rate parity restores monetary control to a government With a fixed system, a country's ability to expand or contract its money supply is limited by the need to maintain exchange rate parity A floating exchange rate system provides two attractive features: Monetary policy autonomy Automatic trade balance adjustments

The Case for Floating Rates Trade Balance Adjustments The balance of payments adjustment mechanism works more smoothly under a floating exchange rate regime Under the Bretton Woods system (fixed system), IMF approval was needed to correct a permanent deficit in a country’s balance of trade that could not be corrected by domestic policy alone

The Case for Fixed Rates Monetary Discipline Because a fixed exchange rate system requires maintaining exchange rate parity, it also ensures that governments do not expand their money supplies at inflationary rates Speculation A fixed exchange rate regime prevents destabilizing speculation A fixed exchange rate system is attractive because: It imposes monetary discipline It limits speculation It limits uncertainty There is a lack of connection between the trade balance and exchange rates

The Case for Fixed Rates Uncertainty The uncertainty associated with floating exchange rates makes business transactions more risky Trade Balance Adjustments Floating rates help adjust trade imbalances

Who is Right? There is no real agreement as to which system is better History shows that a fixed exchange rate regime modeled along the lines of the Bretton Woods system will not work A different kind of fixed exchange rate system might be more enduring and might foster the kind of stability that would facilitate more rapid growth in international trade and investment

Exchange Rate Regimes in Practice Currently, there are several different exchange rate regimes in practice 21% of IMF members allow their currencies to float freely 23% of IMF members follow a managed float system 5% of IMF members have no legal tender of their own (excluding EU countries that use the euro) The remaining countries use less flexible systems such as pegged arrangements, or adjustable pegs

Pegged Exchange Rates Under a pegged exchange rate regime countries peg the value of their currency to that of other major currencies Popular among the world’s smaller nations There is some evidence that adopting a pegged exchange rate regime moderates inflationary pressures in a country

Currency Boards A country with a currency board commits to converting its domestic currency on demand into another currency at a fixed exchange rate The currency board holds reserves of foreign currency equal at the fixed exchange rate to at least 100% of the domestic currency issued Additional domestic notes and coins can be introduced only if there are foreign exchange reserves to back it

Crisis Management by the IMF Question: What has been the role of the IMF in the international monetary systems since the collapse of Bretton Woods? Answer: The IMF has redefined its mission, and now focuses on lending money to countries experiencing financial crises in exchange for enacting certain macroeconomic policies Membership in the IMF has grown to 188 countries in 2012, 52 of which has some type of IMF program in place

Financial Crises Post-Bretton Woods Three types of financial crises that have required involvement by the IMF are A currency crisis - occurs when a speculative attack on the exchange value of a currency results in a sharp depreciation in the value of the currency, or forces authorities to expend large volumes of international currency reserves and sharply increase interest rates in order to defend prevailing exchange rates

Financial Crises Post-Bretton Woods A banking crisis - refers to a situation in which a loss of confidence in the banking system leads to a run on the banks, as individuals and companies withdraw their deposits A foreign debt crisis - a situation in which a country cannot service its foreign debt obligations, whether private sector or government debt Crises that are particularly significant are: The 1995 Mexican currency crisis The 1997 Asian currency crisis The 2010 crisis in Ireland Country Focus: The Mexican Currency Crisis of 1995  Summary  This feature explores the Mexican currency crisis of 1995. The crisis was a result of high Mexican debts, and a pegged exchange rate that did not allow for a natural adjustment of prices. In order to keep Mexico from defaulting on its debt, a $50 billion aid package was put together by the International Monetary Fund, the U.S. government, and the Bank for International Settlements. Thanks to the financial bailout, Mexico was able to get its economy back on track by 1997. The following questions can be helpful in directing the discussion:  Suggested Discussion Questions  1. What led to Mexico’s 1995 financial crisis? What challenges face governments dealing with a financial crisis like the one that Mexico experienced?  Discussion Points: Several factors contributed to the financial crisis in Mexico including rising producer prices, a large trade deficit, and increased government spending and debt. The situation came to a head when investors, who had been pouring money into Mexico, suddenly withdrew their investments after the Mexican government announced that, despite earlier promises, it would no longer maintain its pegged exchange rate. The peso quickly dropped in value ending up about 40 percent below what it had been. Some students will probably suggest that one of the biggest challenges for governments facing a financial crisis is the domino effect it seems to have throughout the economy. In the case of Mexico, IMF assistance to stabilize the situation meant that the country had to follow what initially seemed to be unattractive policies.  2. Why did the United States provide assistance to Mexico? Why was it important to the United States to stabilize Mexico?  Discussion Points: The United States joined forces with the Bank for International Settlements and the IMF to provide assistance to Mexico following the collapse of the peso in late 1994. Most students will probably suggest that the United States was concerned about the stability of Mexico and the implications of the currency crisis on U.S. firms and the U.S. economy. The strategy worked, and Mexico was able to stabilize the peso and work toward recovering from the crisis.  Lecture Note: To extend the discussion of this feature and what can be learned from Mexico’s experiences, consider {http://www.businessweek.com/stories/1999-03-14/why-countries-shouldnt-break-their-currency-promises}.

Putting it into Practice Meltdown in Iceland: An overheated economy? To learn more about Iceland’s financial crisis, consider {http://www.businessweek.com/managing/content/oct2009/ca20091013_717732.htm}.

Evaluating the IMF’s Policies Question: How successful is the IMF at getting countries back on track? Answer: In 2012, 52 countries were working IMF programs All IMF loan packages come with conditions attached, generally a combination of tight macroeconomic policy and tight monetary policy Many experts have criticized these policy prescriptions for three reasons

Evaluating the IMF’s Policies Inappropriate Policies The IMF has been criticized for having a “one-size-fits-all” approach to macroeconomic policy that is inappropriate for many countries Moral Hazard The IMF has also been criticized for exacerbating moral hazard (when people behave recklessly because they know they will be saved if things go wrong)

Evaluating the IMF’s Policies Lack of Accountability The final criticism of the IMF is that it has become too powerful for an institution that lacks any real mechanism for accountability Question: Who is right? Answer: As with many debates about international economics, it is not clear who is right Country Focus: Turkey’s and the IMF Summary This feature explores Turkey’s 18th IMF program. In May 2001, the IMF agreed to lend $8 billion to Turkey to help stabilize its economy and halt a sharp slide in the value of its currency. While initially the Turkish government resisted IMF mandates on economic policy, in 2003, the government passed an austerity budget. By 2005, significant progress had been made and today, the country appears to be on track for recovery, with lower inflation rates, an increase in privatization, and a budget surplus. The following questions can be helpful in directing the discussion: Suggested Discussion Questions 1. What led to Turkey’s financial crisis? What goals did the IMF establish as part of the loan agreement? Discussion Points: Several factors led to Turkey’s financial crisis including a large and inefficient state sector and a subsidized agricultural sector, both of which were financed through debt. The IMF pushed for accelerated privatization of inefficient sectors, and a reduction in agricultural subsidies. In addition, the IMF called for pension reform and tax increases. 2. What are the challenges for a government to deal with a financial crisis like the one that Turkey experienced? Discussion Points: Students will probably suggest that one of the biggest challenges for governments facing a financial crisis is the domino effect it seems to have throughout the economy. In the case of Turkey, IMF assistance to stabilize the situation meant that the country had to follow what initially seemed to be unattractive policies. 3. Was the IMF successful in Turkey? Discussion Points: After several rocky attempts, most students will probably agree that the IMF’s programs in Turkey are finally beginning to show results. Inflation is down from over 80 percent a year in the 1990s to just 4 percent in 2007, economic growth is up, and the privatization program has continued to move along. In addition, government spending seems to be under control. In deed the government has a budget surplus in the period 2003-2006. Lecture Note: Today, Turkey is being viewed as a model of success. To extend the discussion of this feature and what can be learned from Turkey’s experiences, consider {http://www.businessweek.com/magazine/content/10_23/b4181013635512.htm}, {http://www.businessweek.com/globalbiz/content/mar2010/gb20100326_199869.htm}, and {http://www.businessweek.com/globalbiz/content/oct2008/gb20081015_089719.htm}.

Implications for Managers Question: What are the implications of the international monetary system for managers? Answer: The international monetary system affects international managers in three ways Currency management Business strategy Corporate-government relations

The current exchange rate system is a managed float Currency Management Currency Management The current exchange rate system is a managed float Government intervention and speculative activity influence currency values Firms can protect themselves from exchange rate volatility through forward markets and swaps

Business Strategy Business Strategy The forward market can offer some protection from volatile exchange rates in the shorter term Firms can protect themselves from exchange rate uncertainty over the longer term by building strategic flexibility into their operations that minimizes economic exposure Firms can disperse production to different locations Firms can outsource manufacturing Exchange rate movements can have a major impact on the competitive position of businesses. Management Focus: Airbus and the Euro Summary This feature describes how Airbus is protecting itself from exchange rate fluctuations. French aircraft maker Airbus prices its planes in dollars. However, because over half the company’s costs are in euros, the company has the potential to see significant fluctuations in its earnings if it does not hedge its foreign exchange exposure. The following questions can help in the discussion of the feature: Suggested Discussion Questions 1. What type of foreign exchange exposure does Airbus face? How can Airbus protect itself from its exposure to changing exchange rates? How does the company’s switch to more U.S. suppliers help the company? Discussion Points: Students should easily recognize the transaction exposure facing Airbus. Some students will point out that economic exposure is also a problem for the company. Airbus can hedge its transaction exposure in the foreign exchange markets using forward contracts, however to manage its economic exposure, the company is trying to reduce its costs by shifting to American suppliers, and asking European suppliers to price in dollars. 2. Airbus has asked its European based suppliers to start pricing in U.S. dollars. What does Airbus hope to gain by this request? What does it mean for suppliers? Discussion Points: Airbus’ decision to ask suppliers to price their components in dollars is an effort to control exchange rate risk. The company prices its planes in dollars, but was paying for components in a variety of currencies. By shifting to a strictly dollar run business, the company not only consolidates all of its transactions and so hedges its exposure more easily and cheaply, it also increases the proportion of its costs that are in dollars. For American suppliers, the shift to pricing in dollars is beneficial because it eliminates exchange rate risk. For other suppliers however, the shift may mean an introduction of exchange rate risk. Teaching Tip: Students can learn more about Airbus by going to the company’s web site at {http://www.airbus.com/en/}. Lecture Note: Fluctuating exchange rates have had both positive and negative implications for Airbus. To learn more, consider {http://www.businessweek.com/news/2010-05-21/airbus-pernod-daimler-earnings-swell-on-euro-drop-update2-.html} and {http://www.businessweek.com/globalbiz/content/dec2007/gb2007123_911979.htm}.

Putting it into Practice Differences in borrowing costs within the EU are giving Volkswagen an edge over rivals Continued instability within some EU markets is creating differences in the borrowing costs for companies. To learn more, go to “VW Bets Rivals in a Europe Of Haves and Have-Nots,” The Wall Street Journal 12/14/12, A1.

Corporate-Government Relations Corporate-Governance Relations Firms can influence government policy towards the international monetary system Firms should focus their efforts on encouraging the government to: Promote the growth of international trade and investment Adopt an international monetary system that minimizes volatile exchange rates