International Business, 4th Edition Griffin & Pustay Chapter 7: The International Monetary System and the Balance of Payments International Business, 4th Edition Griffin & Pustay ©2004 Prentice Hall

Chapter Objectives_1 Discuss the role of the international monetary system in promoting international trade and investment Explain the evolution and functioning of the gold standard Explain the evolution of the flexible exchange rate system ©2004 Prentice Hall

Chapter Objectives_2 Summarize the role of the World Bank Group and the International Monetary Fund in the post-World War II international monetary system established at Bretton Woods Describe the function and structure of the balance of payments accounting system Differentiate among the various definitions of a balance of payments surplus and deficit ©2004 Prentice Hall

The Gold Standard Countries agree to buy or sell their paper currencies in exchange for gold on the request of any individual or firm and to allow the free export of gold bullion and coins Adopted by the U.K. in 1821 Created a fixed exchange rate ©2004 Prentice Hall

Exchange Rates Exchange rate: price of a one currency in terms of a second currency Fixed exchange rate system: price of a given currency does not change relative to each other currency Under the gold standard, each country pegged the value of its currency to gold ©2004 Prentice Hall

The Collapse of the Gold Standard Economic pressures of WWI Countries suspended pledges to buy or sell gold at currencies’ par values Gold standard readopted in 1920s Dropped during Great Depression British pound allowed to float in 1931 Float: value determined by supply and demand ©2004 Prentice Hall

Map 7.1 The British Empire in 1913 ©2004 Prentice Hall

Figure 7.1 The Contraction of World Trade, 1929-1933 ©2004 Prentice Hall

The Bretton Woods Era 44 countries met in Bretton Woods, New Hampshire in 1944 Goal: to create a postwar economic environment to promote worldwide peace and prosperity Renewed gold standard on modified basis (dollar-based) Created International Bank for Reconstruction and Development and International Monetary Fund ©2004 Prentice Hall

International Bank for Reconstruction and Development World Bank Goal 1: to help finance reconstruction of European economies Accomplished in mid 1950s Goal 2: to build economies of the world’s developing countries ©2004 Prentice Hall

Figure 7.2 Organization of the World Bank Group International Bank for Reconstruction and Development Makes hard loans; $15 billion annually International Development Association Offers soft loans; $7 billion annually International Finance Corporation Promotes private sector development Multilateral Investment Guarantee Agency Provides political risk insurance ©2004 Prentice Hall

Objectives of the International Monetary Fund_1 To promote international monetary cooperation To facilitate the expansion and balanced growth of international trade To promote exchange stability, to maintain orderly exchange arrangements among members, and to avoid competitive exchange depreciation To assist in the establishment of a multilateral system of payments ©2004 Prentice Hall

Objectives of the International Monetary Fund_2 To give confidence to members by making the general resources of the IMF temporarily available to them and to correct maladjustments in their balances of payments To shorten the duration and lessen the degree of disequilibrium in the international balances of payments of members ©2004 Prentice Hall

Membership in the IMF Open to any country willing to agree to rules and regulations 184 country members as of August 2003 Membership requires payment of a quota ©2004 Prentice Hall

Relevance of the IMF Quota Quota size reflects global importance of country’s economy and political considerations The quota determines voting power serves as part of official reserves determines country’s borrowing power ©2004 Prentice Hall

Brazilian students protesting the IMF conditions for a $30 billion loan ©2004 Prentice Hall

The End of the Bretton Woods System Susceptible to speculative “runs on the bank” U.S. $ became only source of liquidity necessary to expand international trade Triffin Paradox: foreigners increased holdings of dollars Increased holdings decreased faith in U.S ability Increased demand for redeeming dollars for gold IMF created special drawing rights (SDRs) – paper gold Bretton Woods system ended August 15, 1971 ©2004 Prentice Hall

Post-Bretton Woods System Most currencies began to float Value of U.S. $ fell relative to most major currencies Group of Ten agreed to restore fixed exchange rate system with restructured rates of exchange ©2004 Prentice Hall

Table 7.1 The Groups of Five, Seven, and Ten Group of 5 Group of 7 Group of 10 % World GDP United States 32.5 Japan 13.6 Germany 6.0 United Kingdom 4.5 France 4.2 Italy 3.5 Canada 2.2 Netherlands 1.2 Switzerland .8 Belgium .7 Sweden ©2004 Prentice Hall

International Monetary System since 1971 Development of floating exchange rate system Supply and demand for a currency determine its price in the world market Managed float – central banks can affect supply and demand Legitimized in 1976 with the Jamaica Agreement ©2004 Prentice Hall

Table7.2 Key Central Banks Country Bank Canada Bank of Canada European Union European Central Bank Japan Bank of Japan United Kingdom Bank of England United States Federal Reserve Bank ©2004 Prentice Hall

European Union Believed flexible system would hinder ability to create integrated economy Created European Monetary System to manage currency relationships ERM participants maintained fixed exchange rates among their currencies Facilitated creation and adoption of Euro ©2004 Prentice Hall

Map 7.2 Exchange Rate Arrangements, 2002 ©2004 Prentice Hall

Other Post-World War II Conferences Plaza Accord Louvre Accord ©2004 Prentice Hall

International Debt Crisis OPEC quadrupled world oil prices Resulted in inflationary pressures in oil-importing countries Exchange rates adjusted Transfer of wealth Countries borrowed more than they could repay Crisis approaches Baker Plan (1985) Brady Plan (1989) ©2004 Prentice Hall

Figure 7.4 The Asian Contagion ©2004 Prentice Hall

Balance of Payments (BOP) Accounting System Double entry bookkeeping system Measures and records all economic transactions between residents of one country and residents of all other countries during specified time period Provides understanding of performance of each country’s economy in international markets Signals fundamental changes in country competitiveness Assists policy makers in designing appropriate public policies ©2004 Prentice Hall

BOP Statistics Identify emerging markets Warn of possible new policies Indicate reductions in a country’s foreign-exchange reserves Signal increased riskiness of lending to particular countries ©2004 Prentice Hall

Aspects of the BOP Accounting System Records international transactions made in some time period Records only economic transactions Records transactions between residents of one country and all other countries Residents include individuals, businesses, government agencies, nonprofit organizations Uses a double-entry system ©2004 Prentice Hall

Major Components of the BOP Accounting System Current Account Capital Account Official Reserves Errors and Omissions ©2004 Prentice Hall

Current Account Four types of transactions Exports and imports of goods Exports and imports of services Investment income Gifts ©2004 Prentice Hall

Table 7.3 BOP Entries, Current Account Debit Credit Goods Buy Sell Services Dividends and interest Pay Receive Gifts Give ©2004 Prentice Hall

Current Account Balances Balance on merchandise trade Difference between a country’s exports and imports of goods Balance on services trade Difference between a country’s exports of services and its imports of services Current account balance Measures the net balances resulting from merchandise trade, service trade, investment income, and unilateral transfers ©2004 Prentice Hall

Capital Account Records capital transactions (purchases and sales of assets) Foreign Direct Investment Portfolio Investment ©2004 Prentice Hall

Table 7.4 Capital Account Transactions Maturity Motivation Typical Investments Portfolio (short-term) One year or less Investment in or facilitation of international commerce Checking account balances Time deposits Commercial paper Bank loans Portfolio (long-term) More than one year Investment income Government bills, notes, bonds Corporate stocks, bonds Foreign Direct Investment Indeterminate Active control of organization Foreign subsidiaries Foreign factories Joint ventures ©2004 Prentice Hall

Table 7.5 BOP Entries, Capital Account Debt (Outflow) Credit (Inflow) Portfolio (short-term) Receiving a payment from a foreigner Making a payment to a foreigner Buying a short-term foreign asset Selling a domestic short-term asset to a foreigner Portfolio (long-term) Buying back a short-term domestic asset from its foreign owner Selling a short-term foreign asset acquired previously Buying back a long-term domestic asset from its foreign owner Selling a domestic long-term asset to a foreigner Foreign direct investment Buying a foreign asset for purposes of control Selling a long-term foreign asset previously acquired Buying back from its foreign owner a domestic asset Selling a domestic asset to a foreigner ©2004 Prentice Hall

Official Reserves Account Records level of official reserves Four types of assets Gold Convertible currencies SDRs Reserve positions at the IMF ©2004 Prentice Hall

Errors and Omissions BOP must balance Current Account + Capital Account + Official Reserves Account = 0 Current Account + Capital Account + Official Reserves Account + Errors and Omissions = 0 ©2004 Prentice Hall

Table 7.6 U.S. BOP, 2002 (in billions of dollars) ©2004 Prentice Hall

Figure 7. 6 Media event for the first shipment of U. S Figure 7.6 Media event for the first shipment of U.S. citrus fruit to China ©2004 Prentice Hall

Figure 7.6 Trade Between the U.S. and Its Major Trading Partners, 2002 ©2004 Prentice Hall

Figure 7.7 The U.S. BOP According to Various Reporting Measures ©2004 Prentice Hall