INTERNATIONAL BUSINESS Professor H. Michael Boyd, Ph.D.

2. Chapter 10International Monetary System

3. International Monetary System The institutional arrangements that govern exchange rates Evolved from the: ancient Gold Standard until its collapse in the 1930’s before the 1944 Bretton Woods system established the: fixed exchange system International Monetary Fund (IMF) and World Bank before it collapsed in 1973 resulting in today’s: mixed system of floating, managed and pegged currencies

4. Exchange Rate Systems Floating Exchange Rate Foreign exchange market forces determine the relative value of a currency against each other Some government intervention, but not required Euro, US Dollar, Japanese Yen, British Pound

5. Exchange Rate Systems Pegged Exchange Rate Value of the currency is fixed relative to a reference currency, such as the US dollar Exchange rate between that currency and the other currencies is determined by the reference currency exchange rate Requires government intervention

6. Exchange Rate Systems Managed-Float or “Dirty Float” Value of the currency is determined by market forces…. but the country’s central bank will intervene in the foreign exchange market Attempts to maintain the value of its currency against: an important reference currency or basket of currencies (Yuan to Euro, US$, Yen) within some trading range

7. Exchange Rate Systems Fixed Exchange Rate Values of a set of currencies are fixed against each other at some mutually agreed-on exchange rate European Monetary System (EMS) operated with this system before the introduction of the Euro For 25 years after WWII, industrial nations belonged to fixed exchange rate system before its collapse in 1973

8. Gold Standard Pegging the value of currencies to gold and guaranteeing their convertibility Gold coins as a medium of exchange dates back to ancient times International trade grew and it became inconvenient to ship and transport gold coins changed to paper currency redeemable for gold governments converted paper currency into gold on demand at a fixed exchange rate by 1880, most of the world’s major trading nations had adopted the gold standard Great Britain, Germany, Japan, United States

9. Gold Standard Strength of the Gold System A major argument in favor of the gold standard was it contained a powerful mechanism for achieving balance of trade equilibrium by all countries Occurs when the residents income of a country earned from exports is equal to the money it’s residents pay to other countries for imports (Current Account of the Balance of Payments is in balance)

10. Balance of Trade Equilibrium

11. End of the Gold Standard: 1918-1939 Nations abandoned gold standard at start of WWI in 1914 War costs led nations to print money creating inflation and higher prices at the end of WWI in 1918 Resulting in the U.S. (1919), Great Britain (1925), France(1928) to return to the gold standard Britain used old pre-war parity rate to lower their export prices in foreign markets US followed suit and changed gold/$ ratio devaluing the dollar to increase exports and decrease imports Other countries did similar competitive devaluations Resulted in lack of confidence in system Created a “run” on countries gold reserves By the start of WWII in 1939 the gold standard was dead

12. Bretton Woods: 1944 During WWII, 44 countries met in New Hampshire Agreed to an international monetary system: creation of World Bank and International Monetary Fund fixed exchange rate system policed by the IMF nations pegging currencies to gold at $35 per ounce only the US dollar was convertible into gold nations would defend their currency to maintain its value within 1% of the par value nations would not devalue currency for trade purposes if a currency was too weak to defend, a devaluation of no more than 10% was allowed ….larger than 10% required IMF approval

13. Role of the IMF Wanted to avoid problems following WWI and to maintain order in the international monetary system Created to police monetary system by ensuring maintenance of the fixed exchange rate regime Promote international monetary cooperation and facilitate growth of international trade Ensure monetary stability through combination of: discipline flexibility

14. Role of the IMF Discipline Fixed exchange rate imposes discipline: stops competitive devaluations and stabilizes world trade environment imposes monetary discipline on countries which curtails price inflation

15. Role of the IMF Flexibility Flexibility was needed in this rigid fixed exchange rate system that controlled money supply growth to allow a country to avoid high unemployment caused by a persistent B-O-P deficit IMF fostered this flexibility by serving as a lending facility allowing a system of adjustable parities

16. Role of the IMF Flexibility Lending Facility lend foreign currencies to countries to help them with short-term balance-of-payments deficits Adjustable Parities allow countries to devalue currencies by more than 10% if B of P was in fundamental disequilibrium permanent adverse shift in the demand for their products Persistent borrowing leads to IMF supervision

17. Principal Duties of IMF Surveillance of exchange rate policies Financial assistance with credits and loans Technical assistance in fiscal/monetary policy

18. IMF Annual Quotas Annual quota payments generate most of the IMF's funds Total of $341 B total at end of August 2008 US annual quota is $58 B Annual quotas for the 185 member nations are based on their relative size in the world economy Member's quota determines its: maximum financial commitment to the IMF, voting power access to IMF financing. funds remain property of contributing members Borrowing nation must repay loan in 1 to 5 years, with interest No nation has ever defaulted; some are given extensions

19. Largest Contributors to IMF

20. Role of the World Bank (International Bank for Reconstruction and Development) Formed to finance the rebuilding of Europe’s war-torn economies but was overshadowed by the US Marshall Plan Shifted focus to Third World “development” in 1950’s Lends money via bonds and loans often supporting agriculture education population control urban development

21. 1973 Collapse of the Fixed Exchange Rate System

22. What Led to the Collapse? Central Role of the US dollar in the Fixed Exchange Rate System As the only currency that could be converted into gold and serving as a reference currency…. ….any pressure on the US dollar to devalue would wreak havoc with the system

23. What Led to the Collapse? President Johnson financed both the Great Society and Vietnam War by increasing the money supply resulting in high inflation high spending on imports created B-o-P deficit increased market speculation for dollar devaluation Increase in inflation and the worsening US trade position gave rise to speculation in the foreign exchange markets that the dollar would be devalued To devalue the dollar under Bretton Woods required all countries agreed to simultaneously revalue their currency against the dollar But countries hesitated to revalue their currency because this would make their exports more expensive

24. What Led to the Collapse? President Nixon’s desire to reduce the US trade deficit and to pressure the other countries to revalue their currency announced the dollar was no longer convertible into gold levied an 10% tax on imports Countries finally agreed to revalue their currencies against the dollar by 8% and the US import tax was removed But a continued US trade deficit and inflation rate fueled speculation on a further dollar devaluation resulting in the other currencies appreciating against the dollar Other countries failed to keep their currencies from appreciating and abandoned fixed exchange rates and allowed their currencies to float against the dollar….game over for fixed exchange rates!

25. Floating Exchange Rate Regime

26. Floating Exchange Rate Regime Jamaica Agreement - 1976 Revised the IMF Articles of Agreement floating rates acceptable gold abandoned as reserve asset IMF annual quotas increased IMF continued role of helping countries cope with macroeconomic and exchange rate problems

27. Exchange Rates since 1973 Rates became more volatile and less predictable 1971 OPEC oil crisis and 400% price increase 1977-78 Loss of confidence in the dollar 1979 OPEC oil crisis and 200% price increase 1980-85 Unexpected rise in the dollar 1985-87 Rapid fall of the dollar 1992 Collapse of European Monetary System 1993-95 Rapid fall of the dollar 1997 Asian currency crisis 2008 Global credit crisis

28. Major Currencies Dollar Index 1973-2006 Value of the US dollar has been determined by both market forces and government intervention The frequency of government intervention in the foreign exchange market has resulted in a managed-float system

29. Fixed vs. Floating Exchange RatesWhich is Better?

30. Fixed vs. Floating Exchange Rates Floating: Arguments in Favor Monetary policy autonomy Allows a country to expand or contract it money supply Restores control to government to manage inflation and exchange rate parity Automatic trade balance adjustments Currency adjusts to correct trade imbalances

31. Fixed vs. Floating Exchange Rates Fixed: Arguments in Favor Monetary Discipline Government required to maintain fixed exchange parity and control monetary supply and inflation Speculation and Uncertainty limits destabilizing effects of speculation nurtures predictable exchange rate movements promotes growth of international trade and investment Trade Balance Adjustments exchange rates and trade balance are not always linked trade deficits are result of the balance between savings and investment and not by the external value of a its currency

32. Fixed vs. Floating Exchange RatesWho is Right?The evidence is not clear

33. Current Exchange Rate Regimes A range of different exchange rate policies exist as of 2006: 28% intervene on a limited basis as a managed float 26% peg their currency to other currency or basket of currencies 22% have no separate tender by giving up their own currency (Euro) 14% allow their currency to freely float 6% allow currency to fluctuate within a target zone as adjustable peg

34. Pegged Exchange Rates Country pegs the value of its currency to another major currency Popular among smaller nations Imposes monetary discipline and leads to low inflation Evidence suggests it moderates inflation Many countries operate with only a nominal peg and are willing to devalue their currency rather than pursue a tight monetary policy Difficult for a small nation to maintain a peg if capital is flowing out of the country and currency is under a speculative attack

35. Currency Boards Country commits to converting its currency on demand into another currency at a fixed exchange rate Country holds foreign currency reserves equal at the fixed exchange rate to at least 100% of domestic currency issued Country can issue additional domestic money only when there are foreign exchange reserves to back it Limits country from printing money and causing inflation Interest rates adjust automatically

36. Floating Rates and Globalization Is globalization causing drastic currency swings? Governments are increasingly reluctant to act together against big currency swings Big currency swings force firms to change where they produce and market their products Some central bankers are wondering if a modified system of fixed exchange rates should return

37. Crisis Management by the IMF Many observers thought the collapse of the Bretton Woods system in 1973 would diminish the role of the IMF within the international monetary system However, the activities of the IMF have expanded due to the periodic financial crises since 1973 IMF deals with three challenges currency crises banking crises foreign debt crises

38. Crisis Management by the IMF Currency Crisis Speculative attack on a currency’s exchange rate value results in: a sharp depreciation in the value of the currency forcing authorities/central bank to defend its currency and the prevailing exchange rate by: expending international currency reserves sharply increasing interest rates

39. Crisis Management by the IMF Banking Crisis The loss of confidence in the banking system that leads to a run on banks, as individuals and companies withdraw their deposits

40. Crisis Management by the IMF Foreign Debt Crisis Country cannot service its foreign debt obligations, whether private-sector or government debt Usually the result of macroeconomic causes: high relative price inflation a widening current account deficit excessive expansion of domestic borrowing asset price inflation

41. 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

42. Asian Financial Crisis of 1997 Causes Investment boom Cronyism and poor loans Lack of transparency in the financial sector Excess capacity in many sectors Dependence on speculative capital inflows Increasing debt service and current account deficits Currencies and debt tied to strengthening dollar Expanding imports Weak Japanese economy

43. Asian Financial Crisis of 1997 Several key Thai financial institutions on the verge of default Result of speculative overbuilding and poor loans Excessive dollar-denominated debt investment Deteriorating balance-of payments position Thailand asks IMF for help 17.2 billion in loans, given with restrictive conditions After Thai baht devaluation, currency speculation hit Malaysia Singapore Indonesia Korea

44. Usual IMF Policy Prescription As of 2006, the IMF was committing loans to 59 countries that have economic and currency crises IMF loan packages come with conditions attached : Tight macroeconomic policies cut public spending increase interest rates tighten monetary policy Deregulation of protected sectors Privatization of state-owned enterprises Improved financial reporting in financial institutions Policies are designed to cool overheated economies by reining in inflation and reducing government spending and debt

45. Evaluating the IMF Policy Criticisms “One size fits all” macroeconomic policy that is not appropriate for all countries with different problems IMF rescue packages exacerbate the moral hazard people behave recklessly because they know they will be saved if things go wrong lending banks that make bad business decisions could (and should) fail IMF has grown too powerful for and institution that lacks any real mechanism for accountability

46. International Monetary System Implications for Business Currency Management Firms must recognize the volatility of the system and adjust their foreign exchange transactions and policies Business Strategy Pursue strategies that provide flexibility to change and reduce economic exposure dispersing production to different locations contracting out manufacturing and shifting suppliers Government Relations Promote a stable international monetary system