Copyright © 2011 Pearson Education Part 4 World Financial Environment 10-1

Copyright © 2011 Pearson Education 10-2 Chapter 10 The Determination of Exchange Rates

Copyright © 2011 Pearson Education To describe the international monetary fund and its role in the determination of exchange rates To discuss the major exchange-rate arrangements that countries use To explain how the European monetary system works and how the euro became the currency of the euro zone To identify the major determinants of exchange rates To show how managers try to forecast exchange-rate movements To explain how exchange rate movements influence business decisions 10-3

Copyright © 2011 Pearson Education Objectives of the IMF To ensure stability in the international monetary system To promote international monetary cooperation and exchange-rate stability To facilitate the balanced growth of international trade To provide resources to help members in balance-of- payments difficulties or to assist with poverty reduction 10-4

Copyright © 2011 Pearson Education The Bretton Woods Agreement established a par value, or benchmark value, for each currency initially quoted in terms of gold and the U.S. dollar. 10-5

Copyright © 2011 Pearson Education The Quota System: The IMF quota — the sum of the total assessment to each country — becomes a pool of money that the IMF can draw on to lend to other countries. It forms the basis for the voting power of each country — the higher its individual quota, the more votes a country has. Assistance Programs: The IMF lends money to countries to help ease balance-of-payments difficulties. Special Drawing Rights (SDRs): The SDR is an international reserve asset given to each country to help increase its reserves The unit of account in which the IMF keeps its financial records Currencies making up the SDR basket are the U.S. dollar, the euro, the Japanese yen, and the British pound 10-6

Copyright © 2011 Pearson Education Dollarization: Using the dollar as an exchange arrangement with no separate legal tender is also called dollarization of the currency. The idea would be for a country to take all of its currency out of circulation and replace it with dollars. Currency Board Arrangements: A currency board is an organization generally separate from a country ’ s central bank. Its responsibility is to issue domestic currency that is typically anchored to a foreign currency. If it does not have deposits on hand in the foreign currency, it cannot issue more domestic currency. 10-7

Copyright © 2011 Pearson Education Pegged Arrangements: In a conventional fixed-peg arrangement, a country pegs its currency to another currency or basket of currencies and allows the exchange rate to vary plus or minus 1 percent from that value. It is more similar to the original fixed exchange- rate system used by the IMF. This is the largest category of all, with 72 countries, or 37.5 percent of the total. 56 of the 72 countries in this category use either the dollar or the euro as the anchor. More Flexible Arrangements Crawling Pegs: In the case of a crawling peg and a crawling band, the country maintains the value of the currency within a very tight margin (or slightly looser in the case of a crawling band), but it changes the value of the currency as needed. Thus it tries to maintain the value of the currency but does not hold rigidly to that value as economic conditions change. 10-8

Copyright © 2011 Pearson Education Managed Float: With a managed float, countries allow their currencies to float, but they also intervene as necessary, based on economic conditions. This is far more flexible than countries that peg their currency and intervene in markets to keep their currencies at a set level, but it is not as flexible as the countries whose currencies are independently floating. Independently Floating: Independently floating means that the currency floats according to market forces without central bank intervention to determine a rate, although there may be some intervention to moderate rates of change in the value of the currency. 10-9

Copyright © 2011 Pearson Education Countries may change the exchange-rate regime they use, so managers need to monitor country policies carefully

Copyright © 2011 Pearson Education The European Monetary System and the European Monetary Union Pluses and Minuses of the Conversion to the Euro The Euro and Global Financial Crisis 10-11

Copyright © 2011 Pearson Education Playing it ‘The State Administration of Foreign Exchange’SAFE (Pegged exchange rate) The Global Financial Crisis and the Future of the CNY 10-12

Copyright © 2011 Pearson Education Non-intervention: Currency in a floating rate world Intervention: Currency in a fixed rate or managed floating rate world 10-13

Copyright © 2011 Pearson Education Central Bank Reserve Assets How Central Banks Intervene in the Market: Central banks intervene in currency markets by buying and selling currency to affect its price. Depending on the market conditions, a central bank may do any of the following: Coordinate its action with other central banks or go it alone Enter the market aggressively to change attitudes about its views and policies Call for reassuring action to calm markets Intervene to reverse, resist, or support a market trend Announce or not announce its operations — be very visible or very discreet Operate openly or indirectly through brokers 10-14

Copyright © 2011 Pearson Education How Central Banks Intervene in the Market: Different attitudes toward intervention: Governments vary in their intervention policies by country and by administration. The global financial crisis has roiled foreign-exchange markets and forced many central banks to intervene to support their currencies. But the U.S. government is hesitant to directly intervene in the foreign-exchange market, preferring to allow the market to determine the correct value. According to the New York Fed, the United States intervened in foreign-exchange markets on eight different days in 1995, but only twice from August 1995 through December

Copyright © 2011 Pearson Education How Central Banks Intervene in the Market: Challenges with intervention: Given the daily volume of foreign-exchange transactions, no one government can move the market unless its movements can change the psychology of the market. Intervention may temporarily halt a slide, but it cannot force the market to move in a direction it doesn ’ t want to go. For that reason, it is important for countries to focus on correcting economic fundamentals instead of spending a lot of time and money on intervention. Bank for International Settlements Revisiting the BIS: The Bank for International Settlements in Basel, Switzerland, is owned by and promotes cooperation among a group of central banks

Copyright © 2011 Pearson Education A black market closely approximates a price based on supply and demand for a currency instead of a government controlled price

Copyright © 2011 Pearson Education Hard and soft currencies: A hard currency is a currency that is usually fully convertible and strong or relatively stable in value in comparison with other currencies. A soft currency is one that is usually not fully convertible and is also called a weak currency. Controlling Convertibility Licensing Multiple Exchange Rates Import Deposits Quantity Controls 10-18

Copyright © 2011 Pearson Education The Big Mac Index Short Run problems that affect PPP 10-19

Copyright © 2011 Pearson Education The Fisher Effect: The nominal interest rate is the real interest rate plus inflation. Because the real interest rate should be the same in every country, the country with the higher interest rate should have higher inflation. The International Fisher Effect: The IFE implies that the currency of the country with the lower interest rate will strengthen in the future. Other Factors in Exchange Rate Determination Confidence Information 10-20

Copyright © 2011 Pearson Education Fundamental and Technical Forecasting: Fundamental forecasting uses trends in economic variables to predict future exchange rates. Technical forecasting uses past trends in exchange rate movements to spot future trends. Dealing with biases Timing, Direction, Magnitude 10-21

Copyright © 2011 Pearson Education Institutional Setting: Does the currency float, or is it managed — and if so, is it pegged to another currency, to a basket, or to some other standard? What are the intervention practices? Are they credible? Sustainable? Fundamental Analyses: Does the currency appear undervalued or overvalued in terms of PPP, balance of payments, foreign-exchange reserves, or other factors? What is the cyclical situation in terms of employment, growth, savings, investment, and inflation? What are the prospects for government monetary, fiscal, and debt policy? 10-22

Copyright © 2011 Pearson Education Confidence Factors: What are market views and expectations with respect to the political environment, as well as to the credibility of the government and central bank? Circumstances: Are there national or international incidents in the news, the possibility of crises or emergencies, or governmental or other important meetings coming up? Technical Analyses: What trends do the charts show? Are there signs of trend reversals? At what rates do there appear to be important buy and sell orders? Are they balanced? Is the market overbought? Oversold? What is the thinking and what are the expectations of other market players and analysts? 10-23

Copyright © 2011 Pearson Education Latin America Emerging market currencies should strengthen as commodity prices recover Europe The euro is gaining popularity and will take market share away from the dollar as the prime reserve asset Asia China is moving forward to establish the yuan as a major world currency 10-24