The International Monetary System

The International Monetary System
10 chapter The International Monetary System McGraw-Hill/Irwin Global Business Today, 5e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.

Chapter 10: The International Monetary System
INTRODUCTION The international monetary system refers to the institutional arrangements that countries adopt to govern exchange rates. When the foreign exchange market determines the relative value of a currency, a floating system exists When the value of a currency is fixed to a reference country and then the exchange rate between that currency and other currencies is determined by the reference currency exchange rate, a pegged exchange rate system exists

A dirty float occurs when the value of a currency is determined by market forces, but with central bank intervention if it depreciates too rapidly against an important reference currency Countries that adopt a fixed exchange rate system fix their currencies against each other Prior to the introduction of the euro, some European Union countries operated with fixed exchange rates within the context of the European Monetary System (EMS)

Classroom Performance System When the foreign exchange market determines the relative value of a currency, a ________ exchange rate system exists. Fixed Floating Pegged Market Classroom Performance System Answer: b

THE GOLD STANDARD The origin of the gold standard dates back to ancient times when gold coins were a medium of exchange, unit of account, and store of value. Mechanics of the Gold Standard The practice of pegging currencies to gold and guaranteeing convertibility is known as the gold standard Under the gold standard one U.S. dollar was defined as equivalent to grains of "fine (pure) gold The exchange rate between currencies was based on the gold par value (the amount of a currency needed to purchase one ounce of gold)

The Strength of the Gold Standard The great strength of the gold standard was that it contained a powerful mechanism for simultaneously achieving balance-of-trade equilibrium (when the income a country’s residents earn from its exports is equal to the money its residents pay for imports) by all countries

The Period Between the Wars, The gold standard worked fairly well from the 1870s until the start of World War I, Then, in an effort to encourage exports and domestic employment, countries started regularly devaluing their currencies People lost confidence in the system and started to demand gold for their currency putting pressure on countries' gold reserves, and forcing them to suspend gold convertibility

THE BRETTON WOODS SYSTEM In 1944, representatives from 44 countries met at Bretton Woods, New Hampshire, to design a new international monetary system. The goal was to build an enduring economic order that would facilitate postwar economic growth. The agreement established two multinational institutions: the International Monetary Fund (IMF) to maintain order in the international monetary system the World Bank to promote general economic development

Under the new system: the US dollar was the only currency to be convertible to gold, and other currencies would set their exchange rates relative to the dollar devaluations were not to be used for competitive purposes a country could not devalue its currency by more than 10% without IMF approval

The Role of the IMF The IMF was responsible for executing the main goal of the Bretton Woods agreement, avoiding a repetition of the chaos that occurred between the wars through a combination of discipline and flexibility. Internet Extra: The IMF has an interactive web page designed especially for students. Go to { Click on For Students, then click on EconEd Online. Several interactive activities are available to help students learn more about the IMF and its activities. For example, to see how the IMF evaluates a country, click on The IMF in Action. This interactive exercise allows students to pick an online team to help analyze a member country’s economy.

Discipline A fixed exchange rate regime imposes discipline in two ways: the need to maintain a fixed exchange rate puts a brake on competitive devaluations and brings stability to the world trade environment a fixed exchange rate regime imposes monetary discipline on countries, thereby curtailing price inflation

Flexibility Although monetary discipline was a central objective of the agreement, it was recognized that a rigid policy of fixed exchange rates would be too inflexible The IMF stood ready to lend foreign currencies to members to tide them over during short periods of balance-of-payments deficit, when a rapid tightening of monetary or fiscal policy would hurt domestic employment

The Role of the World Bank The official name of the World Bank is the International Bank for Reconstruction and Development (IBRD). The bank lends money under two schemes: under the IBRD scheme, money is raised through bond sales in the international capital market borrowers pay what the bank calls a market rate of interest - the bank's cost of funds plus a margin for expenses. a second scheme is overseen by the International Development Agency, an arm of the bank created in 1960 IDA loans go only to the poorest countries

Classroom Performance System The gold standard was a ______ exchange rate system. Fixed Floating Pegged Market Classroom Performance System Answer: b

THE COLLAPSE OF THE FIXED EXCHANGE RATE SYSTEM U.S. macroeconomic policy decisions from 1965 to 1968 led to the collapse of the exchange rate system established in Bretton Woods. Under Johnson, the U.S. financed huge increases in welfare programs and the Vietnam War by increasing its money supply, leading to significant inflation Speculation that the dollar would have to be devalued relative to most other currencies, as well as underlying economics and some forceful threats by the U.S., forced other countries to increase the value of their currencies relative to the dollar However, because the system relied on an economically well managed U.S., when the U.S. began to print money, run high trade deficits, and experience high inflation, the system was strained to the breaking point

THE FLOATING EXCHANGE RATE REGIME The floating exchange rate regime that followed the collapse of Bretton Woods was formalized in January 1976 in Jamaica. The Jamaica Agreement The purpose of the Jamaica meeting was to revise the IMF's Articles of Agreement to reflect the new reality of floating exchange rates. Under the Jamaican agreement: floating rates were declared acceptable gold was abandoned as a reserve asset total annual IMF quotas - the amount member countries contribute to the IMF - were increased to $41 billion

Exchange Rates since 1973 Since 1973, exchange rates have become more volatile and less predictable in part because of: The oil crisis in 1971 The loss of confidence in the dollar that followed the rise of U.S. inflation in 1977 and 1978 The oil crisis of 1979 The unexpected rise in the dollar between 1980 and 1985 The partial collapse of the European Monetary System in 1992 The 1997 Asian currency crisis

FIXED VERSUS FLOATING EXCHANGE RATES Disappointment with floating rates in recent years has led to renewed debate about the merits of a fixed exchange rate system. The Case for Floating Exchange Rates The case for floating exchange rates has two main elements: monetary policy autonomy automatic trade balance adjustments

Classroom Performance System Floating exchange rates were deemed acceptable under The Bretton Woods Agreement The Gold Standard The Jamaica Agreement The Louvre Accord Classroom Performance System Answer: c

Monetary Policy Autonomy Advocates of a floating exchange rate regime argue that removal of the obligation to maintain exchange rate parity restores monetary control to a government Under a fixed system, a country's ability to expand or contract its money supply as it sees fit is limited by the need to maintain exchange rate parity

Trade Balance Adjustments Under the Bretton Woods system, if a country developed a permanent deficit in its balance of trade that could not be corrected by domestic policy, the IMF would agree to a currency devaluation Critics of this system argue that the adjustment mechanism works much more smoothly under a floating exchange rate regime

The Case for Fixed Exchange Rates The case for fixed exchange rates rests on arguments about monetary discipline, uncertainty, and the lack of connection between the trade balance and exchange rates. Monetary Discipline The need to maintain a fixed exchange rate parity ensures that governments do not expand their money supplies at inflationary rates

Speculation Critics of a floating exchange rate regime also argue that speculation can cause exchange rate fluctuations Uncertainty Speculation adds to the uncertainty surrounding future currency movements that characterizes floating exchange rate regimes Trade Balance Adjustments Advocates of floating exchange rates argue that floating rates help adjust trade imbalances

Who is Right? There is no real agreement as to which system is better We know that a fixed exchange rate regime modeled along the lines of the Bretton Woods system will not work A different kind of fixed exchange rate system might be more enduring and might foster the kind of stability that would facilitate more rapid growth in international trade and investment

EXCHANGE RATE REGIMES IN PRACTICE 19% of IMF members follow a free float policy 26% of IMF members follow a managed float system 22% of IMF members have no legal tender of their own the remaining countries use less flexible systems such as pegged arrangements, or adjustable pegs

The exchange rate policies of IMF members are shown in Figure 10.2.

Classroom Performance System The most common exchange rate policy among IMF members today is the Free float Managed float Fixed peg Adjustable peg Classroom Performance System Answer: b

Pegged Exchange Rates Under a pegged exchange rate regime a country will peg the value of its currency to that of another major currency Pegged exchange rates are popular among the world’s smaller nations There is some evidence that adopting a pegged exchange rate regime does moderate inflationary pressures in a country

Currency Boards A country that introduces a currency board commits itself to converting its domestic currency on demand into another currency at a fixed exchange rate To make this commitment credible, the currency board holds reserves of foreign currency equal at the fixed exchange rate to at least 100% of the domestic currency issued

CRISIS MANAGEMENT BY THE IMF Many of the original reasons for the IMF's existence have disappeared The IMF has redefined its mission, and now focuses on lending money to countries experiencing financial crises

Financial Crisis in the Post Bretton Woods Era A currency crisis occurs when a speculative attack on the exchange value of a currency results in a sharp depreciation in the value of the currency, or forces authorities to expend large volumes of international currency reserves and sharply increase interest rates in order to defend prevailing exchange rates

A banking crisis refers to a situation in which a loss of confidence in the banking system leads to a run on the banks, as individuals and companies withdraw their deposits A foreign debt crisis is a situation in which a country cannot service its foreign debt obligations, whether private sector or government debt.

Mexican Currency Crisis of 1995 The Mexican currency crisis of 1995 was a result of high Mexican debts, and a pegged exchange rate that did not allow for a natural adjustment of prices In order to keep Mexico from defaulting on its debt, a $50 billion aid package was created

The Asian Crisis The causes of the financial crisis that erupted across Southeast Asia during the fall of 1997 were sown in the previous decade when these countries were experiencing unprecedented growth. The Investment Boom Huge increases in exports helped fuel a boom in commercial and residential property, industrial assets, and infrastructure Often the investments were made on the basis of projections about future demand conditions that were unrealistic and significant excess capacity emerged

Excess Capacity Investments made on the basis of unrealistic projections about future demand conditions created significant excess capacity The Debt Bomb These investments were often supported by dollar-based debts. When inflation and increasing imports put pressure on the currencies, the resulting devaluations led to default on dollar denominated debts Expanding Imports By the mid 1990s, imports were expanding across the region

The Crisis By mid-1997, it became clear that several key Thai financial institutions were on the verge of default Foreign exchange dealers and hedge funds started to speculate against the Baht, selling it short After struggling to defend the peg, the Thai government abandoned its defense and announced that the Baht would float freely against the dollar

With its foreign exchange rates depleted, Thailand lacked the foreign currency needed to finance its international trade and service debt commitments, and was in desperate need of the capital the IMF could provide Following the devaluation of the Baht, speculation caused other Asian currencies including the Malaysian Ringgit, the Indonesian Rupaih and the Singapore Dollar to fall These devaluations were mainly driven by similar factors to those that underlay the earlier devaluation of the Baht--excess investment, high borrowings, much of it in dollar denominated debt, and a deteriorating balance of payments position

Evaluating the IMF’s Policy Prescription By 2005, the IMF was committing loans to some 59 countries that were struggling with economic and currency crises All IMF loan packages come with conditions attached, generally a combination of tight macroeconomic policy and tight monetary policy

Inappropriate Policies The IMF has been criticized for having a “one-size-fits-all” approach to macroeconomic policy that is inappropriate for many countries Moral Hazard The IMF has also been criticized for exacerbating moral hazard (when people behave recklessly because they know they will be saved if things go wrong)

Lack of Accountability The final criticism of the IMF is that it has become too powerful for an institution that lacks any real mechanism for accountability Observations As with many debates about international economics, it is not clear who is right Country Focus: Turkey’s and the IMF Summary This feature explores Turkey’s 18th IMF program. In May 2001, the IMF agreed to lend $8 billion to Turkey to help stabilize its economy and halt a sharp slide in the value of its currency. While initially the Turkish government resisted IMF mandates on economic policy, in 2003, the government passed an austerity budget. By 2005, significant progress had been made and today, the country appears to be on track for recovery, with lower inflation rates, an increase in privatization, and a budget surplus. The following questions can be helpful in directing the discussion: Suggested Discussion Questions 1. What led to Turkey’s financial crisis? What goals did the IMF establish as part of the loan agreement? 2. What are the challenges for a government to deal with a currency crisis like the one that Turkey experienced? 3. Was the IMF successful in Turkey?

IMPLICATIONS FOR MANAGERS Currency Management Companies must recognize that the current system is a managed float system in which government intervention can help drive the foreign exchange market Under the present system, speculative buying and selling of currencies can create volatile movements in exchange rates

Business Strategy Exchange rate movements are difficult to predict, yet their movement can have a major impact on the competitive position of businesses One response to the uncertainty that arises from a floating exchange rate regime is to build strategic flexibility Management Focus: Airbus and the Euro Summary This feature describes how Airbus is protecting itself from exchange rate fluctuations. French aircraft maker Airbus prices its planes in dollars. However, because over half the company’s costs are in euros, the company has the potential to see significant fluctuations in its earnings if it does not hedge its foreign exchange exposure. The following questions can help in the discussion of the feature: Suggested Discussion Questions 1. What type of foreign exchange exposure does Airbus face? How can Airbus protect itself from its exposure to changing exchange rates? How does the company’s switch to more U.S. suppliers help the company? 2. Airbus has asked its European based suppliers to start pricing in U.S. dollars. What does Airbus hope to gain by this request? What does it mean for suppliers?

Corporate-Government Relations As major players in the international trade and investment environment, businesses can influence government policy towards the international monetary system

CRITICAL THINKING AND DISCUSSION QUESTIONS 1. Why did the gold standard collapse? Is there a case for returning to some type of gold standard? What is it? Answer: The gold standard worked reasonably well from the 1870s until the start of World War I in 1914, when it was abandoned. During the war several governments financed their massive military expenditures by printing money. This resulted in inflation, and by the war's end in 1918, price levels were higher everywhere. Several countries returned to the gold standard after World War I. However, the period that ensued saw so many countries devalue their currencies that it became impossible to be certain how much gold a currency could buy. Instead of holding onto another country's currency, people often tried to exchange it into gold immediately, least the country devalue its currency in the intervening period. This put pressure on the gold reserves of various countries, forcing them to suspend gold convertibility. As a result, by the start of World War II, the gold standard was dead. The great strength of the gold standard was that it contained a powerful mechanism for simultaneously achieving balance-of-trade equilibrium by all countries, as explained in the example provided on pages of the textbook. This strength is the basis for reconsidering the gold standard as a basis for international monetary policy.

CRITICAL THINKING AND DISCUSSION QUESTIONS 2. What opportunities might IMF lending policies to developing nations create for international businesses? What threats might they create? Answer: The IMF lending policies require the recipient countries to implement governmental reforms to stabilize monetary policy and encourage economic growth. One of the principal ways for a developing nation to spur economic growth is to solicit foreign direct investment and to provide a hospitable environment for the foreign investors. These characteristics of IMF lending policies work to the advantage of international businesses that are looking for investment opportunities in developing countries.

CRITICAL THINKING AND DISCUSSION QUESTIONS 3. Do you think the standard IMF policy prescriptions of tight monetary policy and reduced government spending are always appropriate for developing nations experiencing a currency crisis? How might the IMF change its approach? What would the implications be for international businesses? Answer: Critics argue that the tight macroeconomic policies imposed by the IMF in the recent Asian crisis are not well suited to countries that are suffering not from excessive government spending and inflation, but from a private-sector debt crisis with inflationary undertones. Anti-inflationary monetary policies and reductions in government spending usually result in a sharp contraction of demand, at least in the short run. In the longer term, the policies can promote economic growth and expansion of demand, which creates opportunities for international business.

CRITICAL THINKING AND DISCUSSION QUESTIONS 4. Debate the relative merits of fixed and floating exchange rate regimes. From the perspective of an international business, what are the most important criteria in a choice between the systems? Which system is the more desirable for an international business? Answer: The case for fixed exchange rates rests on arguments about monetary discipline, speculation, uncertainty, and the lack of connection between the trade balance and exchange rates. In terms of monetary discipline, the need to maintain fixed exchange rate parity ensures that governments do not expand their money supplies at inflationary rates. In terms of speculation, a fixed exchange rate regime precludes the possibility of speculation. In terms of uncertainty, a fixed rate regime introduces a degree of certainty in the international monetary system by reducing volatility in exchange rates. Finally, in terms of trade balance adjustments, critics question the closeness of the link between the exchange rate and the trade balance. The case for floating exchange rates has two main elements: monetary policy autonomy and automatic trade balance adjustments. In terms of the former, it is argued that a floating exchange rate regime gives countries monetary policy autonomy. Under a fixed rate system, a country’s ability to expand or contract its money supply as it sees fit is limited by the need to maintain exchange rate parity. In terms of the later, under the Bretton Woods system, if a country developed a permanent deficit in its balance of trade that could not be corrected by domestic policy, the IMF would agree to a currency devaluation. Critics of this system argue that the adjustment mechanism works much more smoothly under a floating exchange rate regime. They argue that if a country is running a trade deficit, the imbalance between the supply and demand of that country’s currency in the foreign exchange markets will lead to depreciation in its exchange rate. An exchange rate depreciation should correct the trade deficit by making the country’s exports cheaper and its imports more expensive. It is a matter of personal opinion in regard to which system is better for an international business. We do know, however, that a fixed exchange rate regime modeled along the lines of the Bretton Woods system will not work. Nevertheless, a different kind of fixed exchange rate system might be more enduring and might foster the kind of stability that would facilitate more rapid growth in international trade and investment.

CRITICAL THINKING AND DISCUSSION QUESTIONS 5. Imagine that Canada, the United States, and Mexico decide to adopt a fixed exchange rate system. What would be the likely consequences of such a system for (a) international businesses and (b) the flow of trade and investment among the three countries? Answer: In theory, a fixed exchange rate system similar to the ERM of the European Monetary System should impose monetary discipline, remove uncertainty, limit speculation, and promote trade and investment among member countries. Therefore, for international businesses, such a system should be positive, and the three countries should see increased trade and investment.

CRITICAL THINKING AND DISCUSSION QUESTIONS 6. Reread the Opening Case, then answer the following questions: a) Why do you think the Chinese government originally pegged the value of the Yuan against the U.S. dollar? What were the benefits of doing this for China? What were the costs? b) Over the last decade, many foreign firms have invested in China and used their Chinese factories to produce goods for export. If the Yuan is allowed to float freely against the U.S. dollar on the foreign exchange markets and appreciates in value, how might this affect the fortunes of those enterprises? c) How might a decision to let the Yuan float freely affect future foreign direct investment flows into China? d) Under what circumstances might a decision to let the Yuan freely destabilize the Chinese economy? What might be the global implications of this be? e) Do you think the U.S. government should push the Chinese to let the Yuan float freely? Why? f) What do you think the Chinese government should do? Let the Yuan float, maintain the peg, or change the peg in some way? Answer: China’s decision to peg its currency to the U.S. dollar provided for a more stable currency for China, the Yuan moved in lockstep with the value of the dollar, a currency that would be far more stable than the Yuan. However, the decision led to a situation that was not popular with the U.S. or other developed nations, as, over the next decade, the Yuan became undervalued by as much as 40 percent. This trend allowed China to increase its exports dramatically, while at the same time making it more difficult for foreign exporters to sell their products to China. Foreign companies manufacturing in China were able to capitalize on the undervalued Yuan, and reap the benefits of “cheap” exports. Recently, after years of rapid economic growth stimulated by exports, and amassing a stockpile of dollars valued at more than $700 billion, China faced significant pressure for currency revaluation. China’s decision to abandon its peg will probably result in some slowdown in its exports, however, some American politicians believe that China needs to reduce its control over the Yuan even further. But, China must be careful how quickly it moves, a sudden shift in its policy could scare investors off. At the moment, China is an attractive investment destination, however a stronger, and a less stable Yuan could change that.

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