Presentation on theme: "Chapter 3 The International Monetary System"— Presentation transcript:
1Chapter 3 The International Monetary System Multinational Business FinanceChapter 3 The International Monetary System
2History of the International Monetary System The Gold Standard (1876 – 1913)Gold has been a medium of exchange since 3000 BCeach country set the rate at which its currency unit could be converted to a weight of gold. (1ounce=28,35gram)e.g. $20,67=1 ounce of gold, 4,2474£=1 ounce of goldExpansionary monetary policy was limited to a government’s gold reserve.the outbreak of WWI stopped the free movement of gold, this has caused the suspension of the operation of the Gold Standard
3History of the International Monetary System The Inter-War Years & WWII ( )During this period, currencies were allowed to fluctuate over a fairly wide range in terms of goldIncreasing fluctuations in currency values, as speculators sold short weak currenciesThe US adopted a modified gold standard in 1934the US dollar was the only major trading currency that continued to be convertible to gold.
4History of the International Monetary System Bretton Woods and the International Monetary Fund (IMF) (1944)As WWII drew to a close, the Allied Powers met at Bretton Woods, New Hampshire to create a post-war international monetary systemThe Bretton Woods Agreement established a US dollar based international monetary system and created two new institutions the International Monetary Fund (IMF) and the World Bank
5History of the International Monetary System The International Monetary Fund is a key institution in the new international monetary system and was created to:Help countries defend their currencies against cyclical, seasonal, or random occurrencesAssist countries having structural trade problems if they promise to take adequate steps to correct these problemsThe International Bank for Reconstruction and Development (World Bank) helped fund post-war reconstruction and has since then supported general economic development
6History of the International Monetary System Eurocurrenciesdomestic currencies of one country deposited in another country.(e.g. Eurodollar market. Euro- means foreign here)U.S.-dollar denominated deposits at foreign banks or foreign branches of American banks. By locating outside of the United StatesEurodollars escape regulation by the Federal Reserve Board.
7History of the International Monetary System Eurocurrency Interest Rates: LiborIn the Eurocurrency market, the reference rate of interest is the London Interbank Offered Rate (LIBOR)This rate is the most widely accepted rate of interest used in standardized quotations, loan agreements, and financial derivatives transactionsThere are Pibor, Mibor, Fibor, Stibor (Stockholm Interbank Offered Rate)
8History of the International Monetary System Fixed Exchange Rates ( )The currency arrangement negotiated at Bretton Woods and monitored by the IMF worked fairly well during the post-WWII era of reconstruction and growth in world tradeThe US dollar became the main reserve currency held by central banksEventually, the heavy overhang of dollars held by foreigners resulted in a lack of confidence in the ability of the US to met its commitment to convert dollars to gold
9History of the International Monetary System The lack of confidence forced President Richard Nixon to suspend official purchases or sales of gold by the US Treasury on August 15, 1971This resulted in subsequent devaluations of the dollarMost currencies were allowed to float to levels determined by market forces as of March, 1973
10History of the International Monetary System An Eclectic Currency Arrangement (1973 – Present)Since March 1973, exchange rates have become much more volatile and less predictable than they were during the “fixed” periodThere have been numerous, significant world currency events over the past 30 years
11Exhibit 3.2 the U.S. Dollar Nominal Exchange Rate Index and Significant Events 1957-2008
12The IMF’s Exchange Rate Regime Classifications The International Monetary Fund classifies all exchange rate regimes into eight specific categoriesExchange arrangements with no separate legal tenderCurrency boardOther conventional fixed pegPegged exchange rates within horizontal bandsCrawling pegsExchange rates within crawling pegsManaged floatingIndependent floating
13Fixed Versus Flexible Exchange Rates A nation’s choice of currency regime to follow depends on many variables:inflation,unemployment,interest rate levels,trade balances, andeconomic growth.The choice between fixed and flexible rates may change over time as priorities change.
14Fixed Versus Flexible Exchange Rates Fixed rate regime has advantages and disadvantages:stability in international pricesinherent anti-inflationary nature of fixed pricesbut:Need for central banks to maintain large quantities of hard currencies and gold to defend the fixed rateFixed rates can become inconsistent with economic fundamentals as time goes.
15Attributes of the “Ideal” Currency Possesses three attributes, often referred to as the Impossible Trinity:Exchange rate stability: fixed exchange rateFull financial integration: free capital movementMonetary independence: independent interest rate policy, monetary policy, etcNot possible to have all three simultaneous.
17Emerging Markets and Regime Choices Currency board regimewhen a country’s central bank commits to back its monetary base – its money supply – entirely with foreign reserves at all times Argentina Peso/ USDThis means that a unit of domestic currency cannot be introduced into the economy without an additional unit of foreign exchange reserves being obtained first.Argentina moved from a managed exchange rate to a currency board in 1991In 2002, the country ended the currency board as a result of substantial economic and political turmoil
18Exhibit 3.6 The Currency Regime Choices for Emerging Markets
19Emerging Markets and Regime Choices Dollarization is the use of the US dollar as the official currency of the country.Panama has used the dollar as its official currency since 1907Ecuador replaced its domestic currency with the US dollar in September, 2000
20The Euro: Birth of a European Currency In December 1991, the members of the European Union met at Maastricht, the Netherlands to finalize a treaty that changed Europe’s currency future.This treaty set out a timetable and a plan to replace all individual ECU currencies with a single currency called the euro.
21The Euro: Birth of a European Currency To prepare for the EMU, a convergence criteria was laid out whereby each member country was responsible for managing the following to a specific level:Nominal inflation ratesLong-term interest ratesFiscal deficitsGovernment debtIn addition, European Central Bank (ECB), was established in Frankfurt, Germany.
22Effects of the Euro The euro affects markets in three ways: Cheaper transactions costs in the Euro ZoneCurrency risks and costs related to uncertainty are reducedprice transparency and increased price-based competition
23Achieving Monetary Unification If the euro is to be successful, it must have a solid economic foundation.The primary driver of a currency’s value is its ability to maintain its purchasing power.So, The single largest threat to maintaining purchasing power is inflation.
24Exhibit 3.8 The Trade-offs between Exchange Rate Regimes
25Mini-Case Questions: The Revaluation of the Chinese Yuan Many Chinese critics had urged China to revalue the yuan by 20% or more. What would the Chinese yuan’s value be in US dollars if it had indeed been devalued by 20%?Do you believe that the revaluation of the Chinese yean was politically or economically motivated?
26Mini-Case Questions: The Revaluation of the Chinese Yuan (cont’d) 3. If the Chinese yuan were to change by the maximum allowed per day, 0.3% against the US dollar, consistently over a 30 or 60 day period, what extreme values might it reach?4. Chinese multinationals would now be facing the same exchange rate-related risks borne by US, Japanese, and European multinationals. What impact do you believe this rising risk will have on the strategy and operations of Chinese companies in the near-future?