International Business Environments & Operations Daniels ● Radebaugh ● Sullivan International Business Environments and Operations 15e by Daniels, Radebaugh, and Sullivan Copyright © 2015 Pearson Education, Inc.

The Determination of Exchange Rates Chapter 9 The Determination of Exchange Rates Chapter 9: The Determination of Exchange Rates Copyright © 2015 Pearson Education, Inc.

Copyright © 2015 Pearson Education, Inc. Learning Objectives Describe the International Monetary Fund and its role in the determination of exchange rates Discuss the major exchange-rate arrangements that countries use Explain the European Monetary System and how the euro became the currency of the euro zone Identify the major determinants of exchange rates Show how managers try to forecast exchange-rate movements Explain how exchange-rate movements influence business decisions The Learning Objectives for this chapter are 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 Copyright © 2015 Pearson Education, Inc.

The International Monetary Fund-1 IMF is a multinational institution established in 1945 as part of the Bretton Woods Agreement to maintain order in the international monetary system. 187 members as of 2012. Bank of International Settlements (BIS) does the exchange rate settlements 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 The dollar became the world benchmark for trading currencies and continues in that role today Under the Bretton Woods system of par values, the dollar was fixed at $35 per ounce of gold. This became the benchmark against which all other currencies were valued. Under the agreement, currencies could fluctuate within a one percent band of their par value. Copyright © 2015 Pearson Education, Inc.

Copyright © 2015 Pearson Education, Inc. Goals of IMF The goals of the International Monetary Fund (IMF) are to ensure stability in the international monetary system promote international monetary cooperation and exchange-rate stability facilitate the balanced growth of international trade provide resources to help members in balance-of-payments difficulties or to assist with poverty reduction The IMF, which was created in 1945, was formed to promote exchange rate stability and facilitate the international flow of currencies. The IMF monitors the global economy and also the economies of individual nations and provides recommendations as needed. Most recently, the IMF has been involved in the crisis in Greece for example. Copyright © 2015 Pearson Education, Inc.

Copyright © 2015 Pearson Education, Inc. The IMF Today IMF Quota: the sum of the total assessments levied on member countries to form the pool of money (about $1 trillion) from which the IMF draws to make loans to member nations. National quotas are based upon countries’ GDP, monetary reserves, trade balances, and other economic indicators. Quotas form the basis for the voting power of each member nation—the higher the quota, the greater the number of votes. Now, 24 executive board members run IMF. Special Drawing Rights (SDR), an artificial international reserve asset created in 1969 to supplement IMF members’ existing reserves of gold and foreign exchange. The value of the SDR is based upon the weighted average of a basket of four currencies (2010): U.S. dollar-42%, Euro-37%, Japanese yen-9%, British pound-11%. IMF constantly monitors global economy through internal surveillance, policy suggestions are mandated accordingly. IMF lends money to ease balance-of-payments difficulties. The IMF relies on a quota system to generate funds to lend to countries in need. Quotas, which are based on the relative size of a country within the global economy, are important because they influence the voting power of each country. The larger the quota, the higher the voting power. The quota system was reformed in 2010 giving more quota shares to emerging markets. So, while the United States retained its top position, China now holds the number 3 spot, and the BRIC countries are among the largest shareholders in the Fund. Special drawing rights are an international reserve asset given to each country to help increase its reserves. They are also 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. Copyright © 2015 Pearson Education, Inc.

Global Financial Crisis and the IMF Asian Financial Crisis-late 1990s The global crisis in 2008-2009 raised concerns over global liquidity prompted the G20 to inject huge amounts of cash into the IMF Greece’s 2010-2011 financial crisis required assistance from the IMF and the EU the IMF required Greece to adopt very unpopular austerity measures The G20, mindful of the global financial crisis, voted to significantly increase reserves available to the IMF to help countries in distress. Greece has been a beneficiary of IMF funds, but continues to be quite unstable. Copyright © 2015 Pearson Education, Inc.

Exchange Rate Arrangements-1 The Smithsonian Agreement 8% devaluation of the dollar revaluation of other currencies widening of exchange rate flexibility The Jamaica Agreement provided greater exchange rate flexibility eliminated the use of par values Under the Jamaica Agreement countries selected and maintained their own exchange rate arrangements In the early 1970s, the United States was in trouble. The country’s large balance-of-trade deficit made it difficult to maintain the fixed exchange rate system prompting then President Richard Nixon to abandon the Bretton Woods system in 1971. A new system, the Smithsonian Agreement was then established, followed by the Jamaica Agreement in 1976. Copyright © 2015 Pearson Education, Inc.

Exchange Rate Arrangements-2 Refers to the monetary system/discipline that determines the value of a currency is in international markets. Usually, weaker currencies are tied to stronger currencies. Each country declares in advance as to what it will during the year. Current system includes: Independently floating (about 40 countries) Pegged arrangement: hard, soft and free-float Various forms of pegs possible, single currency, composite Par value, band issue Bipolar/Tripolar monetary system?-USD, Eurozone and Yen Renminbi continues to be pegged with US Dollar

Exchange Rate Arrangements-3 Exchange Rate Arrangements and Anchors The Table shows different exchange rate arrangements and anchors. Copyright © 2015 Pearson Education, Inc.

IMF Financial Discipline The IMF manages global exchange rate discipline through currency pegging. Hard peg value is locked into something and does not change dollarization currency boards Soft peg more flexible than hard peg Chinese Yuan is an example Floating floating or free floating change according to market forces What type of arrangement do countries choose? There are three possibilities: hard peg, soft peg, or floating. Countries can adopt a currency in place of their own. Countries that use the dollar as an exchange arrangement with no separate legal tender are practicing dollarization of the currency. Another option for countries with a hard peg is the currency board. 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. Most countries following a soft peg arrangement use a conventional fixed-peg arrangement, whereby a country pegs its currency to another currency or basket of currencies and allows the exchange rate to vary plus or minus one percent from that value. It’s more similar to the original fixed exchange-rate system used by the IMF. Floating regimes include floating systems that change according to market forces but may be subject to market intervention, or freely floating systems where intervention is rare. Because countries can change their systems, it’s important for managers to monitor exchange regimes in each country. Copyright © 2015 Pearson Education, Inc.

Factors Determining the Value of a Currency Currency is like a commodity and the laws of demand and supply will hold A complex set of factors/variables simultaneously (thus a dynamic view) influence the value of the currency. They are: BOP statistics (trade and reserve) Interest rate differentials Inflation differentials Fiscal and monetary policy Business cycles Political events Psychological (confidence) factors

Determining Exchange Rates The Equilibrium Exchange Rate and How it Moves This Figure shows the equilibrium exchange rate in the market and then a movement to a new equilibrium level as the market changes. Copyright © 2015 Pearson Education, Inc.

Balance of Payments Account (BOP) What type of arrangement do countries choose? There are three possibilities: hard peg, soft peg, or floating. Countries can adopt a currency in place of their own. Countries that use the dollar as an exchange arrangement with no separate legal tender are practicing dollarization of the currency. Another option for countries with a hard peg is the currency board. 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. Most countries following a soft peg arrangement use a conventional fixed-peg arrangement, whereby a country pegs its currency to another currency or basket of currencies and allows the exchange rate to vary plus or minus one percent from that value. It’s more similar to the original fixed exchange-rate system used by the IMF. Floating regimes include floating systems that change according to market forces but may be subject to market intervention, or freely floating systems where intervention is rare. Because countries can change their systems, it’s important for managers to monitor exchange regimes in each country. Copyright © 2015 Pearson Education, Inc.

Interest Rate Differential Government affects Money Supply through Interest rate Open market operations-buying and selling of government bonds Reserve ratio (for deposits in banks) The DIFFERENTIAL of the interest rates between two countries (or more) will determine the exchange rate Also, consider money as an asset. People tend to keep assets in stronger currencies.

Inflation Differential Inflation is given by the price index. It reduces the value of a currency Generally, forward rate of a currency is determined by discounting a currency with the prevailing inflation rate Again, DIFFERENTIAL between two (or more) countries is important

Fiscal and Monetary Policy Fiscal Policy-policy of the government regarding REVENUE and EXPENDITURE Surplus/Deficit = Revenue - Expenditure Monetary Policy-policy of the government regarding Money Supply (see earlier slides) Budget Deficit, Trade Deficit, and Government Debt matters-FX market respects responsible governments

Business Cycle, Political Events and Psychological Factors U.S. business cycle: 5-7 years of high and 3-5 years of low A currency is more demanded when an economy is on a rising curve (and vice versa) Business Cycle and Politics-what is the relationship? Political instability negatively affects a currency Confidence and faith in the currency is important-despite a huge budget deficit, trade deficit and debt the mighty U.S. Dollar prevails-do you know why?

Foreign Exchange Convertibility and Controls Hard currencies U.S. dollar, euro, British pound, Japanese yen Soft currencies developing countries Countries can control convertibility through licenses multiple exchange rate systems advance import deposits quantity controls Fully convertible currencies can be purchased in unlimited amounts by both residents and nonresidents of a country. Hard currencies are usually fully convertible and strong or relatively stable in value compared to other currencies. In contrast, soft currencies aren’t fully convertible. Soft currencies are sometimes called weak currencies. Governments might try to conserve scarce foreign exchange by imposing exchange restrictions. Licensing occurs when a government requires that all foreign exchange transactions be regulated and controlled by it. Governments can also use multiple exchange rate systems to set different rates for different types of transactions. Governments might also demand advance import deposits prior to releasing foreign exchange to pay for imports. Finally, quantity controls can be used to limit the amount of foreign currency that can be used in a specific transaction. Copyright © 2015 Pearson Education, Inc.

Exchange Rates and Purchasing Power Parity Purchasing power parity (PPP) a change in relative inflation between two countries must cause a change in exchange rates to keep the prices of goods in the countries fairly similar The Big Mac Index A black market closely approximates a price based on supply and demand for a currency instead of a government controlled price Relative rates of inflation, differences in real rates of inflation, and confidence in the government’s ability to manage the political and economic environment all influence exchange rates. The Big Mac Index can be used to test PPP. The theory suggests that the price of a burger should be the same from country to country after exchange rates. If prices aren’t the same, then the foreign currency is undervalued or overvalued relative to the dollar. Note that if the domestic inflation rate is lower than that in the foreign country, the domestic currency should be stronger than that of the foreign currency. Copyright © 2015 Pearson Education, Inc.

Business Implications of Exchange Rate Changes Marketing Decisions when the value of a country’s currency rises, exporting becomes more difficult as the product becomes more expensive in foreign markets Production Decisions might locate production in a weak currency country because the initial investment is cheap and it will make a good base for exports Financial Decisions currency rates influence sourcing, cross-border remittance of funds, and the reporting of financial results Why do firms need to bother trying to predict exchange rate changes? Well, they can dramatically affect operating strategies and profits. Exchange rates changes can affect marketing, production, and financial decisions. Copyright © 2015 Pearson Education, Inc.

The Future: The Dollar, The Euro, The Yen, The Yuan Europe the euro should take market share away from the dollar as the prime reserve asset assuming the problems in Greece and other countries are controlled Asia China is moving forward to establish the yuan as a major world currency Latin America emerging market currencies should strengthen as commodity prices recover The dollar, the euro, the yen, and the yuan will all play a role in the global economy in the future. At this point it is difficult to say just what will happen though. The dollar will probably maintain its position as a benchmark currency in the world, especially given that the euro continues to be a question mark given the problems in Greece and some of the other unstable EU countries like Spain, Portugal, Ireland, and Italy. The Japanese yen will probably not have as much power as the dollar or the euro, but remains one of the most widely traded currencies in the world. However, the yuan could become a major currency. While it’s still not floating freely, it’s going through a significant liberalization process, and could become influential in the future. Similarly, the Brazilian real is emerging as a key currency in Latin America. Copyright © 2015 Pearson Education, Inc.

Chapter 9: Discussion Questions Discuss the role of IMF in a global economy. What is IMF? What are their goals? How does it manage global monetary stability? What is a peg rate system? Explain the current global pegging exchange rate arrangement. What is convertibility of a currency? How governments intervene FX, and why? Explain. How do we determine the value of a currency? Explain the factors that determine the value of a currency. I may ask you to explain one or more specific factors.

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