1. International Financial Management Vicentiu Covrig 1 International Monetary System (chapter 2)

2. International Financial Management Vicentiu Covrig 2 International Monetary System  International monetary system: institutional framework within which international payments are made, movements of capital are accommodated, and exchange rates among currencies are determined  To buy foreign goods and services you need foreign money/currency/exchange  Foreign exchange rate: the price of one country’s currency in units of another currency

3. International Financial Management Vicentiu Covrig 3 Evolution of the International Monetary System Bimetallism: Before 1875 - Both gold and silver were used as international means of payment and the exchange rates among currencies were determined by either their gold or silver contents. Classical Gold Standard: 1875-1914 - The exchange rate between two country’s currencies would be determined by their relative gold contents

4. International Financial Management Vicentiu Covrig 4 Ex: if the dollar is pegged to gold at U.S.$20.67 = 1 ounce of gold, and the British pound is pegged to gold at £4.2474 = 1 ounce of gold, it must be the case that the exchange rate is determined by the relative gold contents: Ex: Let’s assume that the current market exchange rate is $5 per £. Using the information from the above example, how would you take advantage of this situation?

5. International Financial Management Vicentiu Covrig 5 Highly stable exchange rates under the classical gold standard provided an environment that was conducive to international trade and investment Shortcomings: - as more gold is discovered or brought into the country money supply increases leading to inflation -the supply of newly minted gold is so restricted that the growth of world trade and investment can be hampered for the lack of sufficient monetary reserves

6. International Financial Management Vicentiu Covrig 6 Interwar Period: 1915-1944 - exchange rates fluctuated as countries widely used “predatory” depreciations of their currencies as a means of gaining advantage in the world export market - weakening/deterioration/depreciation/devaluation of a currency refers to a drop in foreign exchange value of a currency. The opposite of devaluation is revaluation/appreciation -attempts were made to restore the gold standard, but participants lacked the political will to “follow the rules of the game”

7. International Financial Management Vicentiu Covrig 7  Bretton Woods System: 1945-1972 -named for a 1944 meeting of 44 nations at Bretton Woods, New Hampshire -the purpose was to design a postwar international monetary system -the goal was exchange rate stability without the gold standard -the result was the creation of the IMF and the World Bank - under the Bretton Woods system, the U.S. dollar was pegged to gold at $35 per ounce and other currencies were pegged to the U.S. dollar - each country was responsible for maintaining its exchange rate within ±1% of the adopted par value by buying or selling foreign reserves as necessary

8. International Financial Management Vicentiu Covrig 8  The Flexible Exchange Rate Regime: 1973-Present - flexible exchange rates were declared acceptable to the IMF members - Central banks were allowed to intervene in the exchange rate markets to iron out unwarranted volatilities. - gold was abandoned as an international reserve asset - non-oil-exporting countries and less-developed countries were given greater access to IMF funds

9. International Financial Management Vicentiu Covrig 9 Current Exchange Rate(XR) Arrangements Free Float - The largest number of countries, about 48, allow market forces to determine their currency’s value Managed Float - About 25 countries combine government intervention with market forces to set exchange rates Pegged to another currency - Such as HK dollar to the U.S. dollar No national currency - Some countries do not bother printing their own, they just use the U.S. dollar. For example, Ecuador has recently dollarized

10. International Financial Management Vicentiu Covrig 10 The Euro The euro is the single currency of the European Monetary Union which was adopted by 11 Member States on 1 January 1999 These member states are: Belgium, Germany, Spain, France, Ireland, Italy, Luxemburg, Finland, Austria, Portugal and the Netherlands Greece joined the club in 2001 The euro itself is divided into 100 cents Monetary policy conducted by European Central Bank

11. International Financial Management Vicentiu Covrig 11 Benefits and costs of Monetary Union (Euro) Benefits - reduced transaction costs - elimination of the XR risk - promote cross-border investments and mergers - increase the depth and liquidity of the European financial markets - promote political cooperation Costs - Loss of monetary and XR independence

12. International Financial Management Vicentiu Covrig 12 The Mexican Peso Crisis On December 20, 1994, the Mexican government announced a plan to devalue the peso against the dollar by 14 percent. This decision changed currency trader’s expectations about the future value of the peso. In their rush to get out the peso fell by as much as 40 percent. Faced with an international crises, US administration and IMF put together a $53 billion bail-out plan that stabilized the markets The Mexican Peso crisis is unique in that it represents the first serious international financial crisis touched off by cross-border flight of portfolio capital

13. International Financial Management Vicentiu Covrig 13 Why the peso devaluation was bad for foreign investors?

14. International Financial Management Vicentiu Covrig 14 The Asian Crisis The Asian currency crisis turned out to be far more serious than the Mexican peso crisis in terms of the extent of the contagion and the severity of the resultant economic and social costs On July 2, 1997 the Thai baht was suddenly devalued Within days was followed by Philippine peso,Malaysian ringgit, Indonesian rupiah By the end of 1997, Thai baht and Korean won lost 50% of the value; Indonesian rupiah fell 80% Many firms with foreign currency bonds were forced into bankruptcy The region experienced a deep, widespread recession with annual industrial reduction declines between 10 to 20%

15. International Financial Management Vicentiu Covrig 15 Currency Crises Explanations In theory, a currency’s value mirrors the monetary and fiscal policies, and the fundamental strength of its underlying economy, relative to other economies. -the monetary and fiscal policies were too lax suggesting a weaker currency -large inflows of capital during the years before the crisis that (i) didn’t result in currency appreciation and (ii) was wasted in unprofitable investments - fixed XR encouraged unhedged financial transactions -poor corporate governance -poor credit and risk management of the financial institutions

16. International Financial Management Vicentiu Covrig 16 Lessons from the currency crises A country can control only two out of the following three conditions: (i) a fixed exchange rate, (ii) free international flow of capital (no capital control) (iii) independent monetary policy Liberalization of financial markets when combined with weak financial institutions, property rights and business laws creates problems Fiscal and monetary discipline is very important Better financial disclosure is important

17. International Financial Management Vicentiu Covrig 17 Learning outcomes Discuss the exchange rate arrangements under the Classical Gold Standard; under the Bretton Woods System Understand the differences between fixed and floating exchange rates Discuss the current exchange rate arrangements Discuss the European Monetary System Know background information about the Euro Benefits and costs of the European Monetary Union Provide a brief discussion of the Mexican and Asian crises Discuss several factors responsible for the onset and development of the currency crises Lessons from the currency crises Recommended end-of-chapter questions: 4, 5, 9, 12