FINANCIAL ENVIRONMENT CHAPTER OVERVIEW Development of Today’s International Development of Today’s International Monetary System Fixed Versus Floating Exchange Rates Fixed Versus Floating Exchange Rates Foreign Exchange and Foreign Exchange Rates Foreign Exchange and Foreign Exchange Rates Balance of Payments Balance of Payments Economic and Financial Turmoil Around the World Economic and Financial Turmoil Around the World 1

2Introduction  Foreign exchange is the monetary mechanism allowing the transfer of funds from one nation to another.  The existing international monetary system always affects companies as well as individuals whenever they buy or sell products and services traded across national borders.  Although international marketers have to operate in a currently existing international monetary system for international transactions and settlements, they should understand how the scope and nature of the system has changed and how it has worked over time.

3 Introduction  The 1990s – particularly, the second half of the decade – proved to be one of the most turbulent periods in recent history.  The adoption of the euro as a common currency in the European Union in 1999 is just one example of the many changes taking place in today’s business world.

4 1. Development of Today’s International Monetary System  Post-World War II developments had long-range effects on international financial arrangements.  The negotiations to establish the postwar international monetary system took place at the resort of Bretton Woods in New Hampshire in 1944 which established the International Monetary Fund (IMF).  President Richard Nixon suspended the convertibility of the dollar to gold on August 15, 1971.

5 1. Development of Today’s International Monetary System  The IMF oversees the international monetary system and its functions are as follows: –To promote international monetary cooperation –To facilitate the expansion and balanced growth of international trade –To promote exchange stability and to maintain orderly exchange arrangements –To assist in the establishment of a multilateral system of payments in respect to current transactions between member nations; to eliminate foreign exchange restrictions

6 1. Development of Today’s International Monetary System

7 –To make available the general resources of the fund temporarily available to members under adequate safeguards; help members to correct maladjustments in the balance of payments –To shorten the duration and lessen the degree of disequilibrium in the international balance of payments to members –The IMF created special drawing rights (SDRs) in 1969.

8 1. Development of Today’s International Monetary System  The value of SDRs is determined by a weighted average of a basket of four currencies: the U.S. dollar, Japanese yen, European Union’s euro, and the British pound.  After the Asian financial crisis, the IMF has worked on policies to overcome or even prevent future crises.  Another creation of the Bretton Woods Agreement was the International Bank for Reconstruction and Development (World Bank), supporting economic development and poverty reduction projects.

9 2. Fixed Versus Floating Exchange Rates  Two kinds of currency floats encompass free/clean float (allows no government intervention) and managed float (allows limited government intervention).  In March 1973, the major currencies began to float in the foreign exchange markets.  Today, the global economy is dominated by three major currency blocs: The U.S. dollar, the Japanese yen, and the EU’s euro.

10 3. Foreign Exchange and Foreign Exchange Rates  One of the most fundamental determinants of the exchange rate is Purchasing Power Parity (PPP).  Formula for PPP: (1 + Infl Britain ) (1 + Infl Britain ) R t = R 0 * _____________ (1 + Infl U.S. ) (1 + Infl U.S. ) WhereR = the exchange rate quoted in a currency Infl =Inflation rate t =time period

11 3. Foreign Exchange and Foreign Exchange Rates  The Economist publishes a PPP study (Big Mac Index) every year based on McDonald’s Big Mac hamburger (see Exhibit 3-2).

12 3. Foreign Exchange and Foreign Exchange Rates  Factors influencing Foreign Exchange Rates (see Exhibit 3-3): –Macroeconomic Factors: Relative inflation, balance of payments, foreign exchange reserves, economic growth, government spending, money supply growth, and interest rate policy. –Political Factors: Exchange rate control, election year or leadership change. –Random Factors: Unexpected and/or unpredicted events, fear of uncertainty, etc.  Many countries attempt to maintain a lower value for their currency in order to encourage exports.

13 3. Foreign Exchange and Foreign Exchange Rates

14 3. Foreign Exchange and Foreign Exchange Rates  Spot versus forward exchange rates  Hard currencies are the world’s strongest and represent the world’s leading economies.  To avoid the risk of currency fluctuations, companies use hedging.  Target exchange rate  Exchange rate pass through

15 3. Foreign Exchange and Foreign Exchange Rates

16 4. Balance of Payments  The balance of payment (BOP) of a nation summarizes all the transactions that take place between its residents and and the residents of other countries over a specified time period, usually a month, quarter, or year.  The BOP transactions contain three categories (see Exhibit 3-5): –Current account –Capital account –Official reserves

17 4. Balance of Payments

18 4. Balance of Payments  The BOP in capital account, the mirror image of the BOP in the current account, summarizes financial transactions and is divided into short -and long-term capital accounts.  Direct investments are controlled by residents of other nations.  Portfolio investment includes long-term investments that do not give the investors effective control over the investment.

19 4. Balance of Payments  There are three balances to identify on the BOP statement of a country: –Balance of merchandise trade account –The current account (including merchandise trade, trade in services, and unilateral transfers) –The basic balance (the current account and the long- term capital)  The internal market adjustment refers to movement of prices and income in a country.  The external market adjustment concerns exchange rates or a nation’s currency and its value with respect to the currencies of other nations.

20 5. Economic and Financial Turmoil Around the World  The Asian financial crisis in the latter half of the 1990s escalated into the biggest threat to global prosperity.  China’s devaluation of its currency (yuan) triggered the Asian financial crisis in  Because of this financial crisis, Thailand lost almost 60 percent of its baht’s purchasing power in dollar terms in  The Malaysian ringgit lost some 40 percent of its value during the same period.

21 5. Economic and Financial Turmoil Around the World  The Korean won depreciated 50 percent against the U.S. dollar.  The acceleration in Asia economic growth since 2000 can be largely credited to the Japanese economic recovery and China’s surging import demand.  The South American Financial Crisis took place in 2001 when Argentina defaulted and lost nearly 40 percent of its currency value.  The Argentina crisis also hurt Brazil.

22 5. Economic and Financial Turmoil Around the World

23 5. Economic and Financial Turmoil Around the World  Responses to the regional financial crises. –Consumer response to the recession (see Exhibit 3-7) –Corporate response to the recession  Pull-out  Emphasize a product’s value  Change the product mix  Repackage the goods  Maintain stricter inventory  Look outside the region for expansion opportunities  Increase advertising in the region  Increase local procurement

24 5. Economic and Financial Turmoil Around the World