The International Monetary System Chapter Eleven The International Monetary System

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 world’s four major currencies – dollar, euro, yen, and pound – are all free to float against each other

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

The Gold Standard Roots in old mercantile trade Inconvenient to ship gold, changed to paper- redeemable for gold Want to achieve ‘balance-of-trade equilibrium Trade USA Japan Gold

Balance of Trade Equilibrium Trade Surplus Gold Increased money supply = price inflation. Decreased money supply = price decline. As prices decline, exports increase and trade goes into equilibrium.

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

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

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

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-of-payments problems Adjustable parities: Allow countries to devalue currencies more than 10% if balance of payments was in “fundamental disequilibrium”

Role of the World Bank The official name for the world bank is the International Bank for Reconstruction and Development Purpose: To fund Europe’s 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

Collapse of the Fixed Exchange System The system of fixed exchange rates established at Bretton Woods worked well until the late 1960’s 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

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

The Floating Exchange Rate The Jamaica agreement revised the IMF’s 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

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

Long-Term Exchange Rate Trends From 1973 - 2003 Figure 11.1

Fixed Versus Floating Exchange Rates Monetary policy autonomy Restores control to government Trade balance adjustments Adjust currency to correct trade imbalances 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 Which side is right in the vigorous debate between those who favor a fixed exchange rate and those who favor a floating exchange rate? Economists cannot agree. Business, as a major player on the international trade and investment scene, has a large stake in the resolution of the debate. Would international business be better off under a fixed regime, or are flexible rates better? The evidence is not clear. We do, however, know that a fixed exchange rate regime modeled along the lines of the Bretton Woods system will not work. Speculation ultimately broke the system, a phenomenon that advocates of fixed rate regimes claim is associated with floating exchange rates! Nevertheless, a different kind of fixed exchange rate system might be more enduring and might foster the stability that would facilitate more rapid growth in international trade and investment

Exchange Rate Regimes Pegged Exchange Rates Currency Boards 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

Exchange Rate Policies for IMF Members 2004 Figure 11.2, p. 380

Crisis Management by the IMF The IMF’s activities have expanded because periodic financial crises have continued to hit many economies Currency crisis When a speculative attack on a currency’s exchange value results in a sharp depreciation of the currency’s 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 These crises tend to have common underlying macroeconomic causes: high relative price inflation rates, a widening current account deficit, excessive expansion of domestic borrowing, and asset price inflation (such as sharp increases in stock and property prices). At times, elements of currency, banking, and debt crises may be present simultaneously, as in the 1997 Asian crisis and the 2000–2002 Argentinean crisis (see the Country Focus).

Incidence of Currency and Banking Crises 1975 - 1997 Figure 11.3, p. 384

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

Russian Ruble Crisis Financial markets’ loss of confidence in Russia’s 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 ‘who’s in charge’

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

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

Decline of the Ruble

The Asian Crisis Factors leading to the Asian financial crisis of 1997 The investment boom Excess capacity The debt bomb Expanding imports

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

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

Evaluating the IMF Policy Prescriptions Inappropriate policies The IMF’s ‘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 This slide outlines many of the criticisms of the IMF,

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 company’s 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

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