Chapter Eleven The International Monetary System 11 - 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 11 - 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 11 - The Gold Standard McGraw-Hill/Irwin International Business, 6/e e ad Tr • Roots in old mercantile trade • Inconvenient to ship gold, changed to paper- redeemable for gold • Want to achieve ‘balance-of-trade equilibrium Japan USA Go ld © 2007 The McGraw-Hill Companies, Inc., All Rights Reserved 11 - Balance of Trade Equilibrium Decreased money supply = price decline Trade Surplus As prices decline, exports increase and trade goes into equilibrium Gold McGraw-Hill/Irwin International Business, 6/e Increased money supply = price inflation © 2007 The McGraw-Hill Companies, Inc., All Rights Reserved 11 - Between the Wars • Post WWI, war heavy expenditures affected the value of dollars against gold • US raised dollars to gold from $20.67 to $35 per ounce - Dollar worth less? • Other countries followed suit and devalued their currencies McGraw-Hill/Irwin International Business, 6/e © 2007 The McGraw-Hill Companies, Inc., All Rights Reserved 11 - Bretton Woods • In 1944, 44 countries met in New Hampshire • Countries agreed to peg their currencies to US$ which was convertible to gold at $35/oz • Agreed not to engage in competitive devaluations for trade purposes and defend their currencies • Weak currencies could be devalued up to 10% w/o approval • Created the IMF and World Bank McGraw-Hill/Irwin International Business, 6/e © 2007 The McGraw-Hill Companies, Inc., All Rights Reserved 11 - International Monetary Fund • The International Monetary Fund (IMF) Articles of Agreement were heavily influenced by the worldwide financial collapse, competitive devaluations, trade wars, high unemployment, hyperinflation in Germany and elsewhere, and general economic disintegration that occurred between the two world wars • The aim of the IMF was to try to avoid a repetition of that chaos through a combination of discipline and flexibility McGraw-Hill/Irwin International Business, 6/e © 2007 The McGraw-Hill Companies, Inc., All Rights Reserved 11 - 10 International Monetary Fund • Discipline - Maintaining a fixed exchange rate imposes monetary discipline, curtails inflation - Brake on competitive devaluations and stability to the world trade environment • Flexibility - Lending facility: • Lend foreign currencies to countries having balance-ofpayments problems - Adjustable parities: • Allow countries to devalue currencies more than 10% if balance of payments was in “fundamental disequilibrium” McGraw-Hill/Irwin International Business, 6/e © 2007 The McGraw-Hill Companies, Inc., All Rights Reserved 11 - 18 Exchange Rate Regimes • Pegged Exchange Rates - Peg own currency to a major currency ($) - 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 11 - 19 Exchange Rate Policies for IMF Members 2004 McGraw-Hill/Irwin International Business, 6/e © 2007 The McGraw-Hill Companies, Inc., All Rights Reserved 11 - 20 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 11 - 21 Incidence of Currency and Banking Crises 1975 - 1997 McGraw-Hill/Irwin International Business, 6/e © 2007 The McGraw-Hill Companies, Inc., All Rights Reserved 11 - 22 Mexican Currency Crisis of 1995 • Peso pegged to U.S dollar • Mexican producer prices rise by 45% without corresponding exchange rate adjustment • Investments continued ($64B between 1990 -1994) • Speculators began selling pesos and government lacked foreign currency reserves to defend it • IMF stepped in McGraw-Hill/Irwin International Business, 6/e © 2007 The McGraw-Hill Companies, Inc., All Rights Reserved 11 - 23 Russian Ruble Crisis • Financial markets’ loss of confidence in Russia’s ability to meet national and international payments - Led to loss of international reserves and roll over of treasury bills reaching maturity • Financial markets unable to determine ‘who’s in charge’ McGraw-Hill/Irwin International Business, 6/e © 2007 The McGraw-Hill Companies, Inc., All Rights Reserved 11 - 24 Russian Ruble Crisis • Persistent decline in value of ruble: - High inflation • Artificial low prices in Communist era • Shortage of goods • Liberalized price controls - Too many rubles chasing too few goods - Growing public-sector debt • Refusal to raise taxes to pay for government McGraw-Hill/Irwin International Business, 6/e © 2007 The McGraw-Hill Companies, Inc., All Rights Reserved 11 - 25 Government Actions: Exacerbating the Situation • Defacto devaluation of the ruble • Unilateral restructuring of ruble-denominated public debt • 90-day moratorium on foreign credits repayment • Hike in interest rates to defend ruble • Duma rejects measures designed to alleviate problems McGraw-Hill/Irwin International Business, 6/e © 2007 The McGraw-Hill Companies, Inc., All Rights Reserved 11 - 26 Decline of the Ruble McGraw-Hill/Irwin International Business, 6/e © 2007 The McGraw-Hill Companies, Inc., All Rights Reserved 11 - 27 The Asian Crisis • Factors leading to the Asian financial crisis of 1997 - 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 11 - 28 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 - 17.2 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 11 - 29 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 11 - 30 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 11 - 31 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 McGraw-Hill/Irwin International Business, 6/e © 2007 The McGraw-Hill Companies, Inc., All Rights Reserved 11 - 32 Looking Ahead to Chapter 12 • The Strategy of International Business - Strategy and the Firm Global Expansion, Profitability, and Profit Growth Cost Pressures and Pressures for Local Responsiveness Choosing a Strategy McGraw-Hill/Irwin International Business, 6/e © 2007 The McGraw-Hill Companies, Inc., All Rights Reserved ... intervention McGraw -Hill/ Irwin International Business, 6/e © 2007 The McGraw -Hill Companies, Inc., All Rights Reserved 11 - The Gold Standard McGraw -Hill/ Irwin International Business, 6/e e ad... McGraw -Hill/ Irwin International Business, 6/e © 2007 The McGraw -Hill Companies, Inc., All Rights Reserved 11 - 16 Long-Term Exchange Rate Trends From 1973 - 2003 McGraw -Hill/ Irwin International Business, ... McGraw -Hill/ Irwin International Business, 6/e © 2007 The McGraw -Hill Companies, Inc., All Rights Reserved 11 - 19 Exchange Rate Policies for IMF Members 2004 McGraw -Hill/ Irwin International Business,