Intro to Accounting for Foreign Currency:

1. Intro to Accounting for Foreign Currency: Overview Floating vs Fixed Rates Economic Effects of a Floating Rate System

2. The Concept of “Foreign Exchange” Foreign exchange involves the exchange of one currency for another. Direct and indirect rates of exchange are quoted for this purpose

3. International Foreign Exchange- History1800s and early 1900s • In 1800s, pound sterling was the reserve currency of the world. • Most currencies were linked to sterling and/or gold. • Exchange rates were thus fixed!

4. International Foreign Exchange- HistoryThe Depression Years (1930-1940) • Depression years saw many currency devaluations as countries tried to compete in weak global markets. • Rather than face severe economic decline, UK abandoned the gold standard. As a result, Sterling lost its seat as the world’s reserve currency.

5. The Beginning of the End for Fixed Rates of Currency Exchange In the 1930s, many countries followed UK’s example. Starved for gold reserves, and facing severe deflation, they abandoned the gold standard and let their currencies devalue and/or float.

6. The Depression Years in the USA (1930-1940)- Confiscation! • In the US, in 1933, with half of all banks closed, and unemployment at 25% • To stop hoarding and devalue US $, American citizens were required to sell their gold at a price of $ 28 per ounce. • Thereafter, American citizens were not allowed to own gold, except in the form of jewelry.

7. The Depression Years in the USA (1930-1940)- Then Devaluation! The confiscated gold was then used to back the issuance of much more currency (convertible at $35/oz) - in the hope of reviving the economy, and mitigating deflation. It didn’t work- the country stayed in depression for ten painful years. The depression finally ended with the advent of WWII.

8. International Foreign Exchange- History1944-1967 • During WWII, the USA produced arms and sold them to the Allies in exchange for physical gold and promissory notes. • By the end of WWII, much of the gold in the world was now stored in American vaults. • This imbalance created a need for some other monetary basis. As a result, the “Bretton Woods” agreement emerged.

9. Under Bretton Woods: The US $ was tied to gold. Other currencies were linked, at a fixed rate of exchange, to the dollar. The dollar thus became the new reserve currency of the world. Moreover, the world returned to fixed rates of currency exchange, now orchestrated by the US Federal Reserve.

10. Under Bretton Woods; For more than 20 years, the system worked well and responsively. There was also rapid expansion of the world economy, including the development of many new products and markets, and rising standards of living in many industrialized countries.

11. International Foreign Exchange- HistoryThe Inflation Years 1967-1980 • In the mid 1960s, trouble began as world economies became overextended and equity markets peaked. • In the mid 1960s, The USA became involved in Vietnam. By 1967, the war was in full swing. • The war was contentious and divisive. For this reason, it could not be paid for with tax increases. • As a result, much more paper was needed to finance the war than gold reserves would allow.

12. The inflationary years: The US thus printed paper in much larger quantities than its gold reserves could justify. When markets became aware of the increased amounts of currency, a few countries began to come to the “gold window” to exchange US $ for gold. Soon, massive amounts of gold began to leave the country.

13. International Foreign Exchange- HistoryThe Inflation Years (1967-1980) • In 1974, to stop the gold drain, President Nixon, without warning, quickly abandoned the gold standard and closed the gold window. The “Bretton Woods” agreement collapsed. • In its place the “Floating Rate” system we have today developed.

14. International Foreign Exchange- HistoryThe Concept of a “Floating Rate” • From 1974 on, the US $, and thus most other currencies, were no longer backed by gold. Paper money, although formally a form of credit, is now really backed by nothing except “faith”, i.e., the collective willingness of society to accept it in trade for real goods and services. • Advantages of floating rate currencies: • No reserve of gold is needed to back currency. • Countries have greater freedom to create money and stimulate demand. • Floating rates in currency markets assure that disparate inflation rates will not disrupt capital flows and trade.

15. International Foreign Exchange- HistoryThe Concept of “Floating Rate” • Disadvantages of a floating rate system- • No restraint on governments’ propensity to devalue currency- usually to finance govt spending or to avoid politically unpalatable economic pain. • Can induce greater asset price volatility, especially when coupled with a fractional reserve money-creating mechanism (i.e., the creation of credit). • Foreign exchange rate volatility and risk are now directly borne by market agents, i.e., companies, investors, etc.

16. Traditionally: • Fiat currency, including paper, while theoretically a valid form of money, has always become worthless over time (example: China, Rome). • The ancient Chinese Empire, for example, was forced to abandon fiat currency because they found it was “inflationary”. In other words, such money could not hold its value. • The US is no exception! The US $ has lost 98% of its value over the last 100 years!

17. The Behavioral Impact of Floating rates of exchange: Floating rates create new forms of investment risk that investors seek to avoid. They can also motivate governments to spend far more than they take in, without immediate political or economic consequence. The long-term results, however, can be painful (e.g., Japan 1990-2006)

18. Causes of Exchange Rate Movements • Only well understood reason: Inflation • Other possibilities: • Trade imbalances • Demand and supply of investment cash flows • Fiscal deficits • Economic growth • Interest rates • Political turmoil and stability • ………………and so on.

19. Euro Versus US Dollar

20. Japanese Yen Versus US Dollar

21. British Pound Versus US Dollar

22. Mexican Peso Versus US Dollar

23. Floating rates also greatly increase the complexity of measuring changes in real economic wealth.

24. The Problem of Making Sound Economic Judgements in a World of Floating Rates • One way is to value things in terms of something traditionally monetary and real, e.g., gold. • Example: • You buy a house for $ 200,000. • It appreciates to $ 380,000 over 5 years, or 90% • $/oz of Gold increases from $265 to 590 (125%) • House in gold oz: Before= 755 oz, After=644 oz • Conclusion: House depreciated 15% in terms of gold.

25. Gold Versus US Dollar

26. Light Crude Oil Versus US Dollar

27. The Problem With Floating Rates • Another example: • You get a 25% raise over 5 years. • Gold appreciates 125% • Gasoline increases from $ 1.25 to $ 2.50 (100%). • Houses and many other real goods and services increase 100% or more in the same 5 years. • Conclusion: You may have actually taken a significant pay cut while “feeling” your income, and wealth, was increasing!

28. An example of the measurement problems inherent in a floating rate system • Has the national debt really grown? What if: • Total government debt has grown nominally by about 1/3 (6 trillion in 2002 to 8 trillion (?) in 2006) in 4 years? • The value of the dollar, in terms of gold has decreased by more than 50% over the same time frame. • In terms of gold, the national debt has thus shrunk considerably.

29. The Problem with Currency Devaluation (revaluation) from an Accounting Standpoint • One of the assumptions behind all financial reports is that the monetary unit is the same. • If currency changes value over time, the monetary units ($) represented on financial statements are not the same. • As such, they cannot be added or interpreted meaningfully.