CH. 10 INTERNATIONAL MONETARY SYSTEM

1. CH. 10 INTERNATIONAL MONETARY SYSTEM By Wild, Wild, Han

2. THE POINT OF NO RETURN • January 1, 2002 – euros began circulating in Europe • Within 2 weeks, 95% of all cash transactions in euros • After 2 months, many of legacy currencies not legal • Eliminates exchange risk for companies in euro zone • Eurobond market creates a cheaper and deeper source of funding that paves way for growth

3. Ch. 10 INTERNATIONAL MONETARY SYSTEM • What determines exchange rates, forecasting techniques, attempts to manage exchange rates, and currency problems • I. HOW EXCHANGE RATES INFLUENCE BUSINESS ACTIVITIES • A. PRODUCTION AND MARKETING DECISIONS • 1. Exchange rates affect demand for products • A) When currency is weak, price of exports declines, exports rise • B) When currency is strong, price of exports rises, exports decline • C) When currency is weak, and cost of labor is low, and selling in strong currency market, can make good profit • 2. Devaluation - intentional lowering of value of currency by government • A) Gives companies competitive edge because export prices lower • B) Boosts exports to correct trade deficit • C) Disadvantage: reduces buying power and protects local companies from true competition • 3. Revaluation - intentional raising of currency by govt

4. B. FINANCIAL DECISIONS • 1. Pay dividends to shareholders in another country • A) When home currency is strong • B) Takes less of home currency to buy needed currency • 2. Earnings of subsidiary are translated into home currency to form consolidated statements • A) When translated into strong home currency, reduces amount of earnings • B) When translated into weak home currency, increases statement of earnings • C. DESIRE FOR STABILITY AND PREDICTABILITY • 1. Unfavorable movements in FX can be costly • 2. Managers prefer that FX be stable • 3. Can insure against unfavorable FX movements, but very expensive • 4. Mangers prefer that FX are predictable

5. II. WHAT FACTORS DETERMINE EXCHANGE RATES? • A. LAW OF ONE PRICE • 1. Identical product must have identical price in all countries, expressed in common denominator currency • A) Expected exchange rate: what identical product should cost in another country • If 1 kg of coal is DM1.5 in Germany and $1 in US • Then exchange rate should be DM1.5/$1 • B) Actual exchange: what is in currency markets • Example, could be DM1.2/$1; if convert $1 into DM, get DM1.2 • Need DM1.5, so need to convert $1.25 into DM expected exchange rate/actual exchange rate, or 1.5/1.2

6. C) Arbitrage opportunity • Price difference leads arbitrageurs to price in low price market and sell in high price market • When see inefficiency, move to correct it, inefficiency disappears • 2. Big MacCurrencies • A) Cost of Big Mac should be the same in all currencies • B) Economist publishes Big MacCurrency exchangerate index • C) Tells what exchange rate should be • D) Works in 8/12 industries • E) Predicts movements of FX rates • B. PURCHASING POWER PARITY • 1. Relative ability of 2 currencies to buy same basket of goods • A) 650 baht buy same basket of goods that cost $30 in US • B) Thai GNP/capita = 122,277 baht; US GNP/capita = 26,980 US $

7. C) If exchange rate is 41.45 baht = $1; then 122,277 baht/41.45 = $2.950 • D) Can Thai buy more or less with $2,950 in Thailand than consumer in US can buy with $26,980? • E) 650 baht buys same basket as $30 in US; thus, 650/$30 =21.67baht/$ • F) Purchasing Power Parity Rate of baht is 21.67/$ • G) Recalculate Thai GNP/capita at PPP: 122,277/21l67=$5,643 = real purchasing power of Thai consumers • H) This considers price levels in adjusting therelative values of 2 currencies • I) PPP principle: exchange rate between2 currencies is equal to ration of their pricelevels, or, PPP tells amount of Thaicurrency is needed to buy same amount inThailand as US consumer can buy with $1

8. 2. Economic forces will push actual market exchange rate toward that determined by PPP • 3. Role of Inflation • A) Add money to economy without increasing output • B) People have more money to spend, D rises, S stays same, prices rise • C) Rising prices devours increase in money consumers have to spend • D) Inflation erodes purchasing power • E) Impact of Money-Supply Decisions: govt takes action • Monetary policy: government affects interestrates or money supply • Selling government securities reducesmoney supply • Government buys its own securities,increases money supply • Fiscal Policy: taxes and governmentspending • Increasing taxes reduces money supply • Lowering taxes increases money supply

9. F) Impact of Unemployment and Interest Rates • Global competition and mobility of firms keeps lid on wages • Wages controlled, prices don’t rise, hence, no inflation • As employment rises, wages go up, prices go up, inflation goes up • Low interest rates encourage borrowing, expand money supply, inflation up • High interest rates discourage borrowing, shrink money supple, inflation down • G) How Exchange Rates Adjust to Inflation • Exchange rates adjust to different rates of inflation • Higher inflation in Mexico reduces # of $ that a peso will buy and increases the # of pesos that a $ will buy • PP erodes where there is inflation, both consumers and companies • 4. Role of Interest Rates • A) Nominal: real interest rate + inflation • B) Banker charges additional interest for the inflation that is expected to take place during the loan period: Fisher effect • C) International Fisher effect: difference in nominal interest rates supported by 2 currencies will cause an equal but opposite change in their spot exchange rates

10. 5. Evaluating Purchasing Power Parity • A) PPP is better at predicting LT FX than ST, but firms need ST predictions • B) Impact of Added Costs • If add transportation costs, may destroy arbitrage opportunity • So difference in prices continues, does not equalize because costs too much to arbitrage • C) Impact of Trade Barriers • Trade barriers can keep arbitrage from taking place and equalizing prices • D) Impact of Business Confidence and Psychology • Confidence of investors in currency determine whether they will buy it • If enough people have confidence and buy currency, prices will go up

11. III. FORECASTING EXCHANGE RATES • A. EFFICIENT MARKET VIEW • 1. Market is efficient if prices of financial instruments quickly reflect new information • 2. In efficient currency market, forward exchange rates reflect all publicly available information • Forward exchange rates are accurate forecasts of future FX • B. INEFFICIENT MARKET VIEW • 1. Prices of financial instruments do not reflect all publicly available information • 2. Private information is available, individual can act on private information • 3. Forward rates do not reflect future prices

12. C. FORECASTING TECHNIQUES • 1. Fundamental Analysis: use statistical models based on economic indicators to forecast FX • 2. Technical Analysis: use charts of past trends in currency prices to forecast FX • D. DIFFICULTIES OF FORECASTING • 1. Growing industry • 2. Hard to do; hard to predict human element-expectations • IV. EVOLUTION OF THE INTERNATIONAL MONETARY SYSTEM • A. EARLY YEARS: THE GOLD STANDARD • 1. Gold was medium of exchange in international trade • Limited supply, resistant to corrosion, could be melted into bars • Easy, expensive to transport, lost or destroyed • Nations linked paper currency to specific values of gold • Britain first to do this, early 1700s-WWI

13. 2. Par Value • Price of currency relative to ounce of gold • Each nation agreed to convert its currency into gold at that rate • Calculation of par value based on PPP • Fixed exchange rate system: exchanges rates fixed to gold, or govt agreements • 3. Advantages of the Gold Standard • Reducing Exchange Rate Risk: stable rates, all fixed • Imposing Strict Monetary Policies: must manage money supply because have to convert paper currency on demand • Correcting Trade Imbalances: as gold flows out for imports, govt must decrease paper money so it stays in balance with goldreserves • As money supply falls, prices fall because D falls, prices of exports falls, exports rise untiltrade is in balance

14. 4. Collapse of the gold Standard • Nations printed currency to pay high expenses of WWI • Caused rapid inflation • After war, countries reset currency in terms of gold • US devalued currency from 4@0/oz to $35 to reflect devaluation of dollar due to inflation • Britain did not devalue to reflect inflation • Result was that British exports very high price • Led to retaliatory devaluations all over world, people trying to make their exports price competitive • Gold standard was dead • B. BRETTON WOODS AGREEMENT • 1. 1944, 44 nations met in New Hampshire and created new international monetary system • 2. Fixed exchange rate system based on US$ • 3. Built-in Flexibility: devaluation allowed under fundamental disequilibrium • 4. World Bank (International Bank for Reconstruction and Development, IBRD): loans for economic development

15. 5. International Monetary Fund: enforcement agency • SDR: IMF asset whose value is based on basket of currencies • 6. Collapse of the Bretton Woods Agreement • A) Worked for 20 years • B) In 1960s people began demanding gold for $, US only had 1/4 of gold needed • C) Smithsonian Agreement, 1971; US$ allowed to devalue • D) US had high inflation and trade deficit, people lost confidence in US$ • E) January 1973, nations began dumping dollars,when market opened, currencies floating against dollar • C. MANAGED FLOAT SYSTEM • 1. Jamaica Agreement, 1976 • Managed float-governments intervene • Not on gold standard • 2. Plaza Accord, 1985 • G5 nations: Britain, France, Germany, Japan, Us met to force down dollar • Dollar dropped severely • 3. Louvre Accord, 1987 • G7 nations (G% plus Italy and Canada) agreed to maintain value of dollar • G8 (Russia) meet each year

16. D. TODAY’S EXCHANGE RATE ARRANGEMENTS • Managed float system • Governments intervene • 1. Pegged Exchange Rate Arrangement • Many small countries peg their currency to US%, FF, or basket of currencies • 2. Limited Flexibility Exchange Rate Arrangement • Currencies float within a 2.25% band of the dollar • Bahrain, Qatar, Saudi Arabia, UAE • 3. More flexible Exchange Rate Arrangement • Linked to other currencies or baskets but fluctuate with a greater margin than 2.25% • Israel pegged to basket, but can fluctuate 7%

17. E. EUROPEAN MONETARY SYSTEM • 1. Maastricht treaty and european monetary union, 1991 • January 1999, own central bank and currency • Economic conditions: low inflation, low debt, low interest • 2. Benefits of monetary union • Elimination of exchange rate risk • Helps shoppers and trade • 3. Management implications of the euro • A) Price differences more obvious • B) Train staff to deal with euro • C) Euro debt instruments will grow • D) Dual ledgers until Jan 2002 when coins and currency introduced

18. F. RECENT FINANCIAL CRISES • 1. Developing Nations’ Debt Crisis, early 1980s • A) Many LDC high debt, high inflation • B) Bank for International Settlement (BIS) helped • C) Restructured loans • 2. Mexico’s Peso Crisis • A) Political and economic problems • B) Portfolio capital flowed out of Mexico • C) IMF and US banks supplied $50B loans • D) Mexico paid back loans, now strong • 3. Southeast Asia’s Currency Crisis, Summer 1997 • Savvy speculators knew currencies overvalued • July 11, 1997, sold baht, dropped 18%, then 22% • Indonesia, Malaysia, Philippines, Singapore, Thailand • US stock market dropped 522 points in one day • Indonesia, S.Korea, Thailand needed IMF and World Bank funding

19. 4. Russia’s Ruble Crisis • Investors wary in 1990s, market plummeted • Depressed oil prices hurt government’s reserves of hard currency • Government’s tax system not working • Inflation depressed value of ruble • 1996 IMF package worth $10 B: reduce debt, collect taxes, cease printing paper currency, peg currency to dollar • 1998 government going bankrupt, ruble fell 300% in 1 month • IMF loaned another $11 B • 5. Argentina’s Peso Crisis • Brazil devalued her currency; but Argentina’s currency linked to US$ • This hurt Argentina’s exports • Argentina in recession for 4 years • 2002 defaulted on $155 public debt • Disconnected from US$, peso fell 70% • Unemployment 25%; economy shrinking 10%

20. G. FUTURE OF THE INTERNATIONAL MONETARY SYSTEM • 1. IMF Reform • A) Codes of good practice to compare countries’ monetary and fiscal policies • B) Countries be more open regarding financial policies • C) IMF increases surveillance of economic policies • D) Integrate international financial markets • E) Private sector must be more involved and responsible • 2. One World, Ready or Not-globalization of world’s economies