Chapter The International Monetary system 10

McGraw-Hill/Irwin International Business, 5/e © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved Turkeys 18 th IMF program Large and inefficient state sector heavy subsidies Government debt risen to 60% of gross domestic product Rampant inflation IMF focus Reduce inflation Stabilize value o f currency Privatization Reduction of subsidies Government reforms Reasons for failure

McGraw-Hill/Irwin International Business, 5/e © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved International monetary system (IMF) The institutional arrangements that countries adopt to govern exchange rates Dollar, Euro, Yen and Pound “float” against each other Floating exchange rate: Foreign exchange market determines the relative value of a currency

McGraw-Hill/Irwin International Business, 5/e © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved International monetary system (IMF) Some countries use other institutional arrangements to fix their currency’s value Pegged exchange rate Value fixed relative to a reference currency Dirty float Hold value within range of a reference currency Fixed exchange rate Set of currencies are fixed against each other at some mutually agreed upon exchange rate

McGraw-Hill/Irwin International Business, 5/e © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved The gold standard Roots in old mercantile trade. Inconvenient to ship gold, changed to paper- redeemable for gold. Want to achieve ‘balance-of-trade equilibrium USA Japan Gold Trade

McGraw-Hill/Irwin International Business, 5/e © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved Balance of trade equilibrium Trade Surplus Gold Increased money supply = price inflation. Decreased money supply = price decline. As prices decline, exports increase and trade goes into equilibrium.

McGraw-Hill/Irwin International Business, 5/e © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved Between the wars Post WWI, war heavy expenditures affected the value of dollars against gold US raised dollars to gold from $20.67 to $35 per ounce Dollar worth less? Other countries followed suit and devalued their currencies

McGraw-Hill/Irwin International Business, 5/e © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved Bretton Woods In 1944, 44 countries met in New Hampshire Countries agreed to peg their currencies to US$ which was convertible to gold at $35/oz. Agreed not to engage in competitive devaluations for trade purposes and defend their currencies Weak currencies could be devalued up to 10% w/o approval IMF and World Bank created

McGraw-Hill/Irwin International Business, 5/e © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved Role of the IMF Created to police monetary system by ensuring maintenance of the fixed-exchange rate Promote int’l monetary cooperation and facilitate growth of int’l trade Wanted to avoid problems following WW1, through A) Discipline Maintaining a fixed exchange rate imposes monetary discipline, curtails inflation Brake on competitive devaluations and stability to the world trade environment,

McGraw-Hill/Irwin International Business, 5/e © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved Role of the IMF B) Flexibility Lending facility: Lend foreign currencies to countries having balance-of-payments problems Adjustable parities: Allow countries to devalue currencies more than 10% if balance of payments was in “fundamental disequilibrium’ Persistent borrowings leads to IMF control of a country’s economic policy

McGraw-Hill/Irwin International Business, 5/e © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved Principal duties Surveillance of exchange rate policies (No longer fixed rate exchange) Financial assistance (including credits and loans) Technical assistance (expertise in fiscal/monetary policy)

McGraw-Hill/Irwin International Business, 5/e © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved Sources of funds 182 nations pay into fund according to the size of their economy Funds remain their property Borrower repays loan in 1 to 5 years, with interest No nation has ever defaulted; some are given extensions

McGraw-Hill/Irwin International Business, 5/e © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved Membership in the IMF Open to any country willing to agree to its rules and regulations Must pay a deposit (quota) Quota size reflects global importance of a nation’s economy Quota determines voting powers

McGraw-Hill/Irwin International Business, 5/e © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved Largest contributors Fig 10.0

McGraw-Hill/Irwin International Business, 5/e © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved Role of the World Bank International Bank for Reconstruction and Development (IBRD) Purpose: To fund Europe’s reconstruction and help 3d world countries. Overshadowed by Marshall Plan, Turns to ‘development’ Lending money raised by WB bond sales Agriculture Education Population control Urban development

McGraw-Hill/Irwin International Business, 5/e © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved Collapse of the fixed exchange system Pressure to devalue dollar led to collapse President Johnson financed both the Great Society and Vietnam by printing money High inflation and high spending on imports August 8, 1971, Nixon announces dollar no longer convertible into gold. Countries agreed to revalue their currencies against the dollar March 19, 1972, Japan and most of Europe floated their currencies In Bretton Woods fails when key currency (dollar) is under speculative attack Now have a managed-float system

McGraw-Hill/Irwin International Business, 5/e © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved Long term exchange rate trends Fig 10.1

McGraw-Hill/Irwin International Business, 5/e © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved The floating exchange rate Jamaica Agreement Floating rates acceptable Gold abandoned as reserve asset IMF quotas increased IMF continues role of helping countries cope with macroeconomic and exchange rate problems

McGraw-Hill/Irwin International Business, 5/e © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved Exchange rates since 1973 More volatile: Oil crisis Loss of confidence in the dollar Oil crisis – 1979, OPEC increases price of oil Unexpected rise in the dollar Rapid fall of the dollar and Partial collapse of European Monetary System Asian currency crisis

McGraw-Hill/Irwin International Business, 5/e © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved Floating exchange rates Trade balance adjustments Monetary policy autonomy

McGraw-Hill/Irwin International Business, 5/e © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved Fixed exchange rates Monetary discipline Speculation Uncertainty Trade balance adjustments

McGraw-Hill/Irwin International Business, 5/e © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved Fixed versus floating exchange rates Floating: Monetary policy autonomy Restores control to government Trade balance adjustments Adjust currency to correct trade imbalances Fixed: Monetary discipline.Speculation Limits speculators Uncertainty Predictable rate movements Trade balance adjustments Argue no link between exchange rates and trade Link between savings and investment

McGraw-Hill/Irwin International Business, 5/e © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved IMF members exchange rate policy,2002 Fig 10.2

McGraw-Hill/Irwin International Business, 5/e © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved Exchange rate regimes Pegged Exchange Rates. Peg own currency to a major currency ($). Popular among smaller nations Evidence of moderation of inflation Currency Boards. Country commits to converting domestic currency on demand into another currency at a fixed exchange rate Country holds foreign currency reserves equal to 100% of domestic currency issued

McGraw-Hill/Irwin International Business, 5/e © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved Crisis management by the IMF Role has expanded to meet crisis Currency crisis when a speculative attack on a currency’s exchange value results in a sharp depreciation of the currency’s value or forces authorities to defend the currency Banking crisis Loss of confidence in the banking system leading to a run on the banks Foreign debt crisis When a country cannot service its foreign debt obligations

McGraw-Hill/Irwin International Business, 5/e © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved Incidence of currency and banking crisis Fig 10.3

McGraw-Hill/Irwin International Business, 5/e © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved Crises have common underlying causes Common causes: High inflation Widening current account deficit Excessive expansion of domestic borrowing Asset price inflation

McGraw-Hill/Irwin International Business, 5/e © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved Mexican currency crisis of 1995 Peso pegged to U.S. dollar Mexican producer prices rise by 45% without corresponding exchange rate adjustment Investments continued ($64B between Speculators began selling pesos and government lacked foreign currency reserves to defend it IMF stepped in

McGraw-Hill/Irwin International Business, 5/e © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved Russian Ruble crisis Financial markets loss of confidence in Russia’s ability to meet national and international payments Led to loss of international reserves and roll over of treasury bills reaching maturity Financial markets unable to determine ‘who’s in charge’

McGraw-Hill/Irwin International Business, 5/e © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved Russian Ruble crisis Persistent decline in value of ruble: High inflation Artificial low prices in Communist era Shortage of goods Liberalized price controls Too many rubles chasing too few goods Growing public-sector debt Refusal to raise taxes to pay for government

McGraw-Hill/Irwin International Business, 5/e © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved Government actions: Exacerbating the Situation Defacto devaluation of the ruble Unilateral restructuring of ruble-denominated public debt 90-day moratorium on foreign credits repayment Hike in interest rates to defend ruble Duma rejects measures designed to alleviate problems.

McGraw-Hill/Irwin International Business, 5/e © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved Decline of the Ruble

McGraw-Hill/Irwin International Business, 5/e © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved The Asian crisis Factors leading to the Asian financial crisis of 1997 The investment boom Excess capacity The debt bomb Expanding imports

McGraw-Hill/Irwin International Business, 5/e © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved The Asian crisis Mid 1997 several key Thai financial institutions were on the verge of default Result of speculative overbuilding Excess investment (dollar denominated debt) Deteriorating balance-of payments position Thailand asks IMF for help 17.2 billion in loans, given with restrictive conditions Following devaluation of Thai baht speculation hit other Asian currencies Malaysia Singapore Indonesia Korea

McGraw-Hill/Irwin International Business, 5/e © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved Problems in Asian Market Economies Cronyism. Too much money, dependence on speculative capital inflows. Lack of transparency in the financial sector. Currencies tied to strengthening dollar. Increasing current account deficits. Weakness in the Japanese economy

McGraw-Hill/Irwin International Business, 5/e © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved Evaluating the IMF policy prescriptions Inappropriate policies: “One size fits all’ Moral hazard: People behave recklessly when they know they will be saved if things go wrong Foreign lending banks could fail Foreign lending banks have paid price for rash lending Lack of Accountability IMF has grown too powerful

McGraw-Hill/Irwin International Business, 5/e © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved Impact on the countries Currency devaluation Declining investment Rising prices Rising unemployment Rising poverty Rising resentment?

McGraw-Hill/Irwin International Business, 5/e © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved Implications for business Currency management Business strategy Forward exchange market (months not years ahead) Strategic flexibility Corporate-government relations