Chapter 10 The International Monetary and Financial Environment International Business Strategy, Management & the New Realities by Cavusgil, Knight and Riesenberger International Business: Strategy, Management, and the New Realities

Currencies and Exchange Rates There are some 175 currencies in use worldwide. Currency regimes are simplifying – many countries in Europe use the euro; several countries have adopted the dollar. Exchange rate: the price of one currency expressed in terms of another. Exchange rate fluctuations impact company profitability in various ways International Business: Strategy, Management, and the New Realities

International Business: Strategy, Management, and the New Realities Currency Risk Currency risk arises from changes in the price of one currency relative to another, complicating international transactions. Issues: ● Currency exposure ● Asset valuation ● Foreign taxation ● Inflationary and transfer pricing For example, If a supplier’s currency appreciates, you pay a larger amount of your currency for your purchase. If a foreign buyer’s currency depreciates, you receive a smaller payment amount in your currency International Business: Strategy, Management, and the New Realities

The Four Risks of International Business

Convertible and Nonconvertible Currencies Convertible currency can be readily exchanged for other currencies. Hard currencies are the most convertible currencies; e.g., U.S. dollar, Japanese yen, Canadian dollar, British pound, and the European euro. Most transactions use these currencies and nations prefer to hold them as reserves because of their strength and stability. A nonconvertible currency is not acceptable for international transactions International Business: Strategy, Management, and the New Realities

International Business: Strategy, Management, and the New Realities Capital Flight Capital flight: The (often rapid) sale of holdings in a nation’s currency or conversion into a foreign currency. Governments impose restrictions on currency convertibility to prevent capital flight and preserve their supply of hard currencies. Capital flight diminishes a country’s ability to service debt/ pay for imports. In 1979-1983, some $90 billion left Mexico when foreign lenders lost confidence in the Mexican economy and investors withdrew their investments International Business: Strategy, Management, and the New Realities

Foreign Exchange Markets Foreign exchange: all forms of internationally-traded monies including currency, bank deposits, checks, and electronic transfers. Foreign exchange market: the global marketplace for buying and selling national currencies Exchange rates fluctuate constantly. E.g., yen-dollar exchange rate: 1985 - 240 yen to the U.S. dollar. 1988 - 125 yen to the dollar (nearly 50% appreciation). Result: Decrease in Japanese exports to U.S.; Increase in U.S. exports to Japan International Business: Strategy, Management, and the New Realities

How Exchange Rates are Determined In a free market, the “price” of any currency (rate of exchange) is determined by supply and demand: The greater the supply of a currency, the lower its price The lower the supply of a currency, the higher its price The greater the demand for a currency, the higher its price The lower the demand for a currency, the lower its price International Business: Strategy, Management, and the New Realities

Appreciation and Depreciation: Example Euro appreciation: If the euro-dollar exchange rate goes from one euro = $1.25 to one euro = $1.50, the euro becomes expensive to Americans Euro depreciation: If the euro-dollar exchange rate goes from one euro = $1.25 to one euro = $1.00, the euro then becomes cheaper to Americas International Business: Strategy, Management, and the New Realities

Factors That Influence the Supply and Demand of a Currency Economic growth Interest rates and inflation Market psychology Government action International Business: Strategy, Management, and the New Realities

International Business: Strategy, Management, and the New Realities 1. Economic Growth The increase in value of the goods and services produced by an economy. Typically measured as the annual increase in real GDP. Innovation and entrepreneurship drive business activity and demand. International Business: Strategy, Management, and the New Realities

2. Interest Rates and Inflation Inflation: a rise in the prices of goods and services. Reduces the purchasing power of the affected currency Interest rates and inflation are positively related. I.e., high inflation = high interest rates, because investors expect a return that exceeds inflation rate. Where inflation or interest rates are rising, the value of the currency generally falls International Business: Strategy, Management, and the New Realities

International Business: Strategy, Management, and the New Realities 3. Market Psychology Herding: the tendency of investors to mimic each others’ actions Momentum trading: investors buy stocks whose prices have been rising and sell stocks whose prices have been falling- usually done via computers set to do massive buying/selling when asset prices reach certain levels. For example, in early 2000s, Argentina experienced a massive flight of capital investment when the government announced it would default on its international bank loans. International Business: Strategy, Management, and the New Realities

International Business: Strategy, Management, and the New Realities 4. Government Action Governments intervene to influence the value of their own currencies. E.g., the Chinese government regularly intervenes to keep the renminbi undervalued, ensuring that Chinese exports remain strong. Intervention is conducted via the nation’s Central Bank, by buying and selling currency in the foreign exchange market International Business: Strategy, Management, and the New Realities

Valuation of Currency Affects Trade Surplus or Deficit Trade surplus: country’s exports exceed its imports; may result when currency is undervalued. Trade deficit: nation's imports exceed its exports, causing net outflow of foreign exchange. Balance of trade: difference between the value of a nation’s exports and its imports. International Business: Strategy, Management, and the New Realities

The Bretton Woods Agreement Signed by 44 countries in 1944 Pegged value of the dollar to an established value of gold, at $35 per ounce. U.S. government agreed to buy and sell gold to maintain the fixed rate. All other signatories pegged their currencies to the U.S. dollar, and agreed to maintain this value via central bank intervention. System kept exchange rates stable for 25 years. Broke down in early 1970s International Business: Strategy, Management, and the New Realities

The Bretton Woods Legacy Instituted the concept of ‘international monetary cooperation’ among central banks. Established the concept of fixing exchange rates to minimize currency risk. Created the International Monetary Fund (IMF) and the World Bank, agencies that aim to stabilize currencies and reduce global poverty. International Business: Strategy, Management, and the New Realities

The Exchange Rate System Today Most advanced economies (e.g., Europe, Japan, U.S.) use the floating exchange rate system. The value of a currency ‘floats’ according to market forces, with little government intervention. Many developing economies and emerging markets use the fixed exchange rate system. The value of a currency is set at a specified rate to the value of another currency, or basket of currencies. E.g., China, African countries. International Business: Strategy, Management, and the New Realities

Monetary and Financial Systems International monetary system: the institutional framework, rules, and procedures by which national currencies are exchanged for one another. Global financial system: the collection of financial institutions that facilitate and regulate the flows of investment and capital funds worldwide, incorporating the national and international banking systems, the international bond market, national stock markets, and the market of bank deposits denominated in foreign currencies. Has become huge since the 1990s. E.g., 15% of U.S. equity funds are invested abroad International Business: Strategy, Management, and the New Realities

Globalization of Finance Advantages: Reduces cost of capital for firms More financing alternatives for firms More investment opportunities for people More financing options for emerging markets and developing economies Facilitating trends: Monetary and financial deregulation worldwide New technologies and the Internet Growing role of single-currency systems, e.g., euro International Business: Strategy, Management, and the New Realities

Risks in the Globalization of Finance Contagion: tendency of a financial or monetary crisis in one country to spread rapidly to others due to worldwide financial integration. E.g., SE Asia crisis in late 1990s Capital flows are much more volatile than FDI-type investments Financial instability is worsened due to underdeveloped regulatory frameworks, and insufficient monitoring of banking and financial sectors. International Business: Strategy, Management, and the New Realities