INTERNATIONAL FINANCE Lecture 13

Review Relative Interest Rate Relative Income Level Expectations Speculating on Anticipated Exchange Rates

Government Influence on Exchange Rates Lecture 13

Lecture Objectives To describe the exchange rate systems used by various governments; To explain how governments can use direct and indirect intervention to influence exchange rates; and

Exchange at $0.52/NZ$ 4. Holds $20,912, Holds NZ$40 million Exchange at $0.50/NZ$ Speculating on Anticipated Exchange Rates Chicago Bank expects the exchange rate of the New Zealand dollar to appreciate from its present level of $0.50 to $0.52 in 30 days. 1. Borrows $20 million Borrows at 7.20% for 30 days Lends at 6.48% for 30 days 3. Receives NZ$40,216,000 Returns $20,120,000 Profit of $792,320

Speculating on Anticipated Exchange Rates Chicago Bank expects the exchange rate of the New Zealand dollar to depreciate from its present level of $0.50 to $0.48 in 30 days. Exchange at $0.48/NZ$ 4. Holds NZ$41,900, Holds $20 million Exchange at $0.50/NZ$ 1. Borrows NZ$40 million Borrows at 6.96% for 30 days Lends at 6.72% for 30 days 3. Receives $20,112,000 Returns NZ$40,232,000 Profit of NZ$1,668,000

Speculating on Anticipated Exchange Rates  Exchange rates are very volatile, and a poor forecast can result in a large loss. One well-known bank failure, Franklin National Bank in 1974, was primarily attributed to massive speculative losses from foreign currency positions.

Exchange Rate Systems Exchange rate systems can be classified according to the degree to which the rates are controlled by the government: – fixed – freely floating – managed float – pegged

System: Rates are held constant or allowed to fluctuate within very narrow bands only. Examples: Bretton Woods era ( ), Smithsonian Agreement (1971) MNCs know the future exchange rates. Fixed Exchange Rate System

In a fixed exchange rate system, exchange rates are either held constant or allowed to fluctuate only within very narrow boundaries. A fixed exchange rate would be beneficial to a country for the following reasons. – First, exporters and importers could engage in international trade without concern about exchange rate movements of the currency to which their local currency is linked. – Any firms that accept the foreign currency as payment would be insulated from the risk that the currency could depreciate over time.

Fixed Exchange Rate System In addition, any firms that need to obtain that foreign currency in the future would be insulated from the risk of the currency appreciating over time. Another benefit is that firms could engage in direct foreign investment, without concern about exchange rate movements of that currency. They would be able to convert their foreign currency earnings into their home currency without concern that the foreign currency denominating their earnings might weaken over time. Thus, the management of an MNC would be much easier.

Bretton Woods Agreement Bretton Woods Agreement, lasted from 1944 to 1971, that period is sometimes referred to as the Bretton Woods era. Each currency was valued in terms of gold; for example, the U.S. dollar was valued as 1/35 ounce of gold. Since all currencies were valued in terms of gold, their values with respect to each other were fixed. Governments intervened in the foreign exchange markets to ensure that exchange rates drifted no more than 1 percent above or below the initially set rates.

Smithsonian Agreement By 1971, it appeared that some currency values would need to be adjusted to restore a more balanced flow of payments between countries. In December 1971, a conference of representatives from various countries concluded with the Smithsonian Agreement, which called for a devaluation of the U.S. dollar by about 8 percent against other currencies. In addition, boundaries for the currency values were expanded to within 2.25 percent above or below the rates initially set by the agreement. By March 1973, most governments of the major countries were no longer attempting to maintain their home currency values within the boundaries established by the Smithsonian Agreement.

Advantages of Fixed Exchange Rates to MNCs. In a fixed exchange rate environment, MNCs may be able to engage in International trade Direct foreign investment International finance without worrying about the future exchange rate.

Advantages of Fixed Exchange Rates to MNCs : Example When General Motors (GM) imported materials from foreign countries during the Bretton Woods era, it could anticipate the amount of dollars it would need to pay for the imports. When the dollar was devalued in the 1970 ‘s however, GM needed more dollars to purchase the imports.

Disadvantages of Fixed Exchange Rates to MNCs One disadvantage of a fixed exchange rate system is that there is still risk that the government will alter the value of a specific currency. The government will devalue or revalue its currency. A second disadvantage is that from a macro viewpoint, a fixed exchange rate system may make each country and its MNCs more vulnerable to economic conditions in other countries.

Disadvantages of Fixed Exchange Rates to MNCs : Example Assume that there are only two countries in the world: the United States and the United Kingdom. Also assume a fixed exchange rate system and that these two countries trade frequently with each other. If the United States experiences a much higher inflation rate than the United Kingdom, U.S. consumers should buy more goods from the United Kingdom and British consumers should reduce their imports of U.S. goods (due to the high U.S. prices).

Disadvantages of Fixed Exchange Rates to MNCs : Example This reaction would force U.S. production down and unemployment up. It could also cause higher inflation in the United Kingdom due to the excessive demand for British goods relative to the supply of British goods produced. Thus, the high inflation in the United States could cause high inflation in the United Kingdom.

Disadvantages of Fixed Exchange Rates to MNCs : In the mid- and late 1960s, the United States experienced relatively high inflation and was accused of “exporting” that inflation to some European countries. A high unemployment rate in the United States will cause a reduction in U.S. income and a decline in U.S. purchases of British goods. Consequently, productivity in the United Kingdom may decrease and unemployment may rise. In this case, the United States may “export” unemployment to the United Kingdom