Chapter Eleven The International Monetary System

McGraw-Hill/Irwin International Business, 6/e © 2007 The McGraw-Hill Companies, Inc., All Rights Reserved. Introduction The international monetary system refers to the institutional arrangements that govern exchange rates. Floating exchange rates occur when the foreign exchange market determines the relative value of a currency The world’s four major currencies – dollar, euro, yen, and pound – are all free to float against each other

McGraw-Hill/Irwin International Business, 6/e © 2007 The McGraw-Hill Companies, Inc., All Rights Reserved. Introduction Pegged exchange rates occur when the value of a currency is fixed relative to a reference currency Dirty float occurs when countries hold the value of their currency within a range of a reference currency Fixed exchange rate occurs when a set of currencies are fixed against each other at some mutually agreed upon exchange rate Pegged exchange rates, dirty floats and fixed exchange rates all require some degree of government intervention

McGraw-Hill/Irwin International Business, 6/e © 2007 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, 6/e © 2007 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, 6/e © 2007 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, 6/e © 2007 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 Created the IMF and World Bank

McGraw-Hill/Irwin International Business, 6/e © 2007 The McGraw-Hill Companies, Inc., All Rights Reserved. International Monetary Fund The International Monetary Fund (IMF) Articles of Agreement were heavily influenced by the worldwide financial collapse, competitive devaluations, trade wars, high unemployment, hyperinflation in Germany and elsewhere, and general economic disintegration that occurred between the two world wars The aim of the IMF was to try to avoid a repetition of that chaos through a combination of discipline and flexibility

McGraw-Hill/Irwin International Business, 6/e © 2007 The McGraw-Hill Companies, Inc., All Rights Reserved. International Monetary Fund Discipline -Maintaining a fixed exchange rate imposes monetary discipline, curtails inflation -Brake on competitive devaluations and stability to the world trade environment 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”

McGraw-Hill/Irwin International Business, 6/e © 2007 The McGraw-Hill Companies, Inc., All Rights Reserved. Role of the World Bank The official name for the world bank is the International Bank for Reconstruction and Development Purpose: To fund Europe’s reconstruction and help 3rd world countries. Overshadowed by Marshall Plan, so it turns towards development -Lending money raised through WB bond sales Agriculture Education Population control Urban development

McGraw-Hill/Irwin International Business, 6/e © 2007 The McGraw-Hill Companies, Inc., All Rights Reserved. Collapse of the Fixed Exchange System The system of fixed exchange rates established at Bretton Woods worked well until the late 1960’s -The US dollar was the only currency that could be converted into gold -The US dollar served as the reference point for all other currencies -Any pressure to devalue the dollar would cause problems through out the world

McGraw-Hill/Irwin International Business, 6/e © 2007 The McGraw-Hill Companies, Inc., All Rights Reserved. Collapse of the Fixed Exchange System Factors that led to the collapse of the fixed exchange system include -President Johnson financed both the Great Society and Vietnam by printing money -High inflation and high spending on imports -On August 8, 1971, President Nixon announces dollar no longer convertible into gold -Countries agreed to revalue their currencies against the dollar -On March 19, 1972, Japan and most of Europe floated their currencies -In 1973, Bretton Woods fails because the key currency (dollar) is under speculative attack

McGraw-Hill/Irwin International Business, 6/e © 2007 The McGraw-Hill Companies, Inc., All Rights Reserved. The Floating Exchange Rate The Jamaica agreement revised the IMF’s Articles of Agreement to reflect the new reality of floating exchange rates -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, 6/e © 2007 The McGraw-Hill Companies, Inc., All Rights Reserved. Exchange Rates Since 1973 Exchange rates have been more volatile for a number of reasons including: -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, 6/e © 2007 The McGraw-Hill Companies, Inc., All Rights Reserved. Long-Term Exchange Rate Trends From

McGraw-Hill/Irwin International Business, 6/e © 2007 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, 6/e © 2007 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, 6/e © 2007 The McGraw-Hill Companies, Inc., All Rights Reserved. Exchange Rate Policies for IMF Members 2004

McGraw-Hill/Irwin International Business, 6/e © 2007 The McGraw-Hill Companies, Inc., All Rights Reserved. Crisis Management by the IMF The IMF’s activities have expanded because periodic financial crises have continued to hit many economies -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, 6/e © 2007 The McGraw-Hill Companies, Inc., All Rights Reserved. Incidence of Currency and Banking Crises

McGraw-Hill/Irwin International Business, 6/e © 2007 The McGraw-Hill Companies, Inc., All Rights Reserved. The Asian Crisis Factors leading to the Asian financial crisis of The investment boom -Excess capacity -The debt bomb -Expanding imports

McGraw-Hill/Irwin International Business, 6/e © 2007 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 billion in loans, given with restrictive conditions Following devaluation of Thai baht speculation hit other Asian currencies -Malaysia, Singapore, Indonesia, and Korea

McGraw-Hill/Irwin International Business, 6/e © 2007 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, 6/e © 2007 The McGraw-Hill Companies, Inc., All Rights Reserved. Evaluating the IMF Policy Prescriptions Inappropriate policies -The IMF’s ‘one-size-fits-all’ approach to macroeconomic policy is inappropriate for many countries Moral hazard -People behave recklessly when they know they will be saved if things go wrong Lack of Accountability -The IMF has become too powerful for an institution that lacks any real mechanism for accountability

McGraw-Hill/Irwin International Business, 6/e © 2007 The McGraw-Hill Companies, Inc., All Rights Reserved. Implications for Managers Currency management Business strategy -Faced with uncertainty about the future value of currencies, firms should utilize the forward exchange market to insure against exchange rate risk -Firms should pursue strategies that will increase the company’s strategic flexibility in the face of unpredictable exchange rate movements — that is, to pursue strategies that reduce the economic exposure of the firm Corporate-government relations