Chapter Eleven

The International Monetary System

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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 worlds four major currencies dollar, euro, yen, and pound are all free to float against each other
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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
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The Gold Standard

Roots in old mercantile trade Inconvenient to ship gold, changed to paperredeemable for gold Want to achieve balance-of-trade equilibrium

Japan

USA

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Balance of Trade Equilibrium

Decreased money supply = price decline.

Trade Surplus

As prices decline, exports increase and trade goes into equilibrium.

Gold

Increased money supply = price inflation.

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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

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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

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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
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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

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Role of the World Bank

The official name for the world bank is the International Bank for Reconstruction and Development Purpose: To fund Europes reconstruction and help 3rd world countries. Overshadowed by Marshall Plan, so it turns towards development
- Lending money raised through WB bond sales
Agriculture Education Population control Urban development

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Collapse of the Fixed Exchange System

The system of fixed exchange rates established at Bretton Woods worked well until the late 1960s
- The US dollar was the only currency that could be converted into gold - The US dollar served as the reference point for all other currencies - Any pressure to devalue the dollar would cause problems through out the world

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Collapse of the Fixed Exchange System

Factors that led to the collapse of the fixed exchange system include
- President Johnson financed both the Great Society and Vietnam by printing money - High inflation and high spending on imports - On August 8, 1971, President Nixon announces dollar no longer convertible into gold - Countries agreed to revalue their currencies against the dollar - On March 19, 1972, Japan and most of Europe floated their currencies - In 1973, Bretton Woods fails because the key currency (dollar) is under speculative attack
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The Floating Exchange Rate

The Jamaica agreement revised the IMFs Articles of Agreement to reflect the new reality of floating exchange rates
- Floating rates acceptable - Gold abandoned as reserve asset - IMF quotas increased

IMF continues role of helping countries cope with macroeconomic and exchange rate problems
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Exchange Rates Since 1973

Exchange rates have been more volatile for a number of reasons including:
Oil crisis -1971 Loss of confidence in the dollar - 1977-78 Oil crisis 1979, OPEC increases price of oil Unexpected rise in the dollar - 1980-85 Rapid fall of the dollar - 1985-87 and 1993-95 Partial collapse of European Monetary System - 1992 Asian currency crisis - 1997

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Long-Term Exchange Rate Trends From 1973 - 2003

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Fixed Versus Floating Exchange Rates

Floating:
- Monetary policy autonomy
Restores control to government

Fixed:
Monetary discipline .Speculation Limits speculators Uncertainty Predictable rate movements Trade balance adjustments Argue no link between exchange rates and trade
Link between savings and investment

- Trade balance adjustments

Adjust currency to correct trade imbalances

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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

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Exchange Rate Policies for IMF Members 2004

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Crisis Management by the IMF

The IMFs activities have expanded because periodic financial crises have continued to hit many economies
- Currency crisis
When a speculative attack on a currencys exchange value results in a sharp depreciation of the currencys 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

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Incidence of Currency and Banking Crises 1975 - 1997

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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

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Russian Ruble Crisis

Financial markets loss of confidence in Russias 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 whos in charge

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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

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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

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Decline of the Ruble

0 -1000 -2000 -3000 -4000 -5000 -6000 1992 1993 1994 1995

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The Asian Crisis

Factors leading to the Asian financial crisis of 1997

The investment boom Excess capacity The debt bomb Expanding imports

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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

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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

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Evaluating the IMF Policy Prescriptions

Inappropriate policies
- The IMFs 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

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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 companys 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
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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

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