Chapter 3 The International Monetary System Multinational Business Finance Chapter 3 The International Monetary System

History of the International Monetary System The Gold Standard (1876 – 1913) Gold has been a medium of exchange since 3000 BC each country set the rate at which its currency unit could be converted to a weight of gold. (1ounce=28,35gram) e.g. $20,67=1 ounce of gold, 4,2474£=1 ounce of gold Expansionary monetary policy was limited to a government’s gold reserve. the outbreak of WWI stopped the free movement of gold, this has caused the suspension of the operation of the Gold Standard

History of the International Monetary System The Inter-War Years & WWII (1914-1944) During this period, currencies were allowed to fluctuate over a fairly wide range in terms of gold Increasing fluctuations in currency values, as speculators sold short weak currencies The US adopted a modified gold standard in 1934 the US dollar was the only major trading currency that continued to be convertible to gold.

History of the International Monetary System Bretton Woods and the International Monetary Fund (IMF) (1944) As WWII drew to a close, the Allied Powers met at Bretton Woods, New Hampshire to create a post-war international monetary system The Bretton Woods Agreement established a US dollar based international monetary system and created two new institutions the International Monetary Fund (IMF) and the World Bank

History of the International Monetary System The International Monetary Fund is a key institution in the new international monetary system and was created to: Help countries defend their currencies against cyclical, seasonal, or random occurrences Assist countries having structural trade problems if they promise to take adequate steps to correct these problems The International Bank for Reconstruction and Development (World Bank) helped fund post-war reconstruction and has since then supported general economic development

History of the International Monetary System Eurocurrencies domestic currencies of one country deposited in another country. (e.g. Eurodollar market. Euro- means foreign here) U.S.-dollar denominated deposits at foreign banks or foreign branches of American banks. By locating outside of the United States Eurodollars escape regulation by the Federal Reserve Board.

History of the International Monetary System Eurocurrency Interest Rates: Libor In the Eurocurrency market, the reference rate of interest is the London Interbank Offered Rate (LIBOR) This rate is the most widely accepted rate of interest used in standardized quotations, loan agreements, and financial derivatives transactions There are Pibor, Mibor, Fibor, Stibor (Stockholm Interbank Offered Rate)

History of the International Monetary System Fixed Exchange Rates (1945-1973) The currency arrangement negotiated at Bretton Woods and monitored by the IMF worked fairly well during the post-WWII era of reconstruction and growth in world trade The US dollar became the main reserve currency held by central banks Eventually, the heavy overhang of dollars held by foreigners resulted in a lack of confidence in the ability of the US to met its commitment to convert dollars to gold

History of the International Monetary System The lack of confidence forced President Richard Nixon to suspend official purchases or sales of gold by the US Treasury on August 15, 1971 This resulted in subsequent devaluations of the dollar Most currencies were allowed to float to levels determined by market forces as of March, 1973

History of the International Monetary System An Eclectic Currency Arrangement (1973 – Present) Since March 1973, exchange rates have become much more volatile and less predictable than they were during the “fixed” period There have been numerous, significant world currency events over the past 30 years

Exhibit 3.2 the U.S. Dollar Nominal Exchange Rate Index and Significant Events 1957-2008

The IMF’s Exchange Rate Regime Classifications The International Monetary Fund classifies all exchange rate regimes into eight specific categories Exchange arrangements with no separate legal tender Currency board Other conventional fixed peg Pegged exchange rates within horizontal bands Crawling pegs Exchange rates within crawling pegs Managed floating Independent floating

Fixed Versus Flexible Exchange Rates A nation’s choice of currency regime to follow depends on many variables: inflation, unemployment, interest rate levels, trade balances, and economic growth. The choice between fixed and flexible rates may change over time as priorities change.

Fixed Versus Flexible Exchange Rates Fixed rate regime has advantages and disadvantages: stability in international prices inherent anti-inflationary nature of fixed prices but: Need for central banks to maintain large quantities of hard currencies and gold to defend the fixed rate Fixed rates can become inconsistent with economic fundamentals as time goes.

Attributes of the “Ideal” Currency Possesses three attributes, often referred to as the Impossible Trinity: Exchange rate stability: fixed exchange rate Full financial integration: free capital movement Monetary independence: independent interest rate policy, monetary policy, etc Not possible to have all three simultaneous.

Exhibit 3.4 The Impossible Trinity

Emerging Markets and Regime Choices Currency board regime when a country’s central bank commits to back its monetary base – its money supply – entirely with foreign reserves at all times. 1 Argentina Peso/ USD This means that a unit of domestic currency cannot be introduced into the economy without an additional unit of foreign exchange reserves being obtained first. Argentina moved from a managed exchange rate to a currency board in 1991 In 2002, the country ended the currency board as a result of substantial economic and political turmoil

Exhibit 3.6 The Currency Regime Choices for Emerging Markets

Emerging Markets and Regime Choices Dollarization is the use of the US dollar as the official currency of the country. Panama has used the dollar as its official currency since 1907 Ecuador replaced its domestic currency with the US dollar in September, 2000

The Euro: Birth of a European Currency In December 1991, the members of the European Union met at Maastricht, the Netherlands to finalize a treaty that changed Europe’s currency future. This treaty set out a timetable and a plan to replace all individual ECU currencies with a single currency called the euro.

The Euro: Birth of a European Currency To prepare for the EMU, a convergence criteria was laid out whereby each member country was responsible for managing the following to a specific level: Nominal inflation rates Long-term interest rates Fiscal deficits Government debt In addition, European Central Bank (ECB), was established in Frankfurt, Germany.

Effects of the Euro The euro affects markets in three ways: Cheaper transactions costs in the Euro Zone Currency risks and costs related to uncertainty are reduced price transparency and increased price-based competition

Achieving Monetary Unification If the euro is to be successful, it must have a solid economic foundation. The primary driver of a currency’s value is its ability to maintain its purchasing power. So, The single largest threat to maintaining purchasing power is inflation.

Exhibit 3.8 The Trade-offs between Exchange Rate Regimes

Mini-Case Questions: The Revaluation of the Chinese Yuan Many Chinese critics had urged China to revalue the yuan by 20% or more. What would the Chinese yuan’s value be in US dollars if it had indeed been devalued by 20%? Do you believe that the revaluation of the Chinese yean was politically or economically motivated?

Mini-Case Questions: The Revaluation of the Chinese Yuan (cont’d) 3. If the Chinese yuan were to change by the maximum allowed per day, 0.3% against the US dollar, consistently over a 30 or 60 day period, what extreme values might it reach? 4. Chinese multinationals would now be facing the same exchange rate-related risks borne by US, Japanese, and European multinationals. What impact do you believe this rising risk will have on the strategy and operations of Chinese companies in the near-future?

Exhibit 3.3 World Currency Events, 1971–2008

Exhibit 3.3 World Currency Events, 1971–2008 (cont.)

Exhibit 3.5 The Ecuadorian Sucre Exchange Rate, November 1998–March 2000

Exhibit 3.1 U.S. Dollar-Denominated Interest Rates, June 2005

Exhibit 3.7 The U.S. Dollar/Euro Spot Exchange Rate, 1999–2008 (Monthly Average)

Exhibit 1 Monthly Average Exchange Rates: Chinese Renminbi per U. S Exhibit 1 Monthly Average Exchange Rates: Chinese Renminbi per U.S. Dollar