1. International Business Environments and Operations Global Edition
Part 4
World Financial Environment

2. Chapter 10
The Determination of Exchange Rates

3. Chapter Objectives
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

4. International Monetary Fund
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
Through a process of surveillance, the IMF monitors the global economy as well as the economies of individual countries and advises on needed policy adjustments. In addition to surveillance, the IMF provides technical assistance—mainly to low- and middle-income countries—and lending to countries that have balance-of-payments problems.

5. 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.
This par value became a benchmark by which each country’s currency was valued against other currencies. Currencies were allowed to vary within 1 percent of their par value (extended to 2.25 percent in December 1971), depending on supply and demand. Additional moves from par value and formal changes in par value were possible with IMF approval.
Because of the U.S. dollar’s strength during the 1940s and 1950s and its large reserves in monetary gold, currencies of IMF member countries were denominated in terms of gold and U.S. dollars. By 1947, the United States held 70 percent of the world’s official gold reserves. Therefore, governments bought and sold dollars rather than gold. The understanding—though not set in stone—was that the United States would redeem dollars for gold. The dollar became the world benchmark for trading currency, and it has remained so, in spite of the move away from fixed rates to flexible exchange rates.

6. The IMF Today The Quota System Assistance Programs
Special Drawing Rights (SDRs)
The Global Financial Crisis and the SDR
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.
The IMF lends money to countries to help ease balance-of-payments difficulties.
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
Because of the global financial crisis, the G20 voted to significantly increase reserves available to the IMF to help countries in distress.

7. Evolution to Floating Exchange Rates
The Smithsonian Agreement
8% devaluation of the dollar
Revaluation of other currencies
Widening of exchange rate flexibility
The Jamaica Agreement
The IMF’s system was initially one of fixed exchange rates. Because the U.S. dollar was the cornerstone of the international monetary system, its value remained constant with respect to the value of gold. Other countries could change the value of their currency against gold and the dollar, but the value of the dollar remained fixed.
Exchange-rate flexibility was widened in 1971 from 1 percent to 2.25 percent from par value. This effort did not last, however. World currency markets remained unsteady during 1972, and the dollar was devalued again by 10 percent in early 1973.
The Jamaica Agreement of 1976 resulted in greater exchange-rate flexibility and eliminated the use of par values.

8. Exchange Rate Arrangements
The IMF surveillance and consultation programs are designed to monitor exchange-rate policies of countries and to see if they are acting openly and responsibly in exchange-rate policies.
The IMF classifies the currency regimes of countries according to the degree of flexibility—or lack thereof.

9. Exchange Arrangements with No Separate Legal Tender
Dollarization
Currency Board Arrangements
Pegged Arrangements
More Flexible Arrangements
Crawling Pegs
Managed Float
Independently Floating
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. Basically, the U.S. Federal Reserve Bank (the Fed) would have greater control over monetary decisions instead of the governments of the local countries so dollarizing. Prices and wages would be established in dollars instead of in the local currency, which would disappear. The concern is that this would result in a loss of sovereignty and could lead to severe economic problems if the United States decided to tighten monetary policy at the same time those countries needed to loosen policy to stimulate growth.
Other forms of fixed exchange-rate regimes are currency boards, conventional fixed-peg systems, and pegged exchange rates within crawling horizontal bands.
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.
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.
Flexible exchange-rate regimes include crawling pegs, exchange rates within crawling bands, managed floating rates, and independently floating rates.
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.
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 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. Exchange Rates: The Bottom Line
Countries may change the exchange-rate
regime they use, so managers need to
monitor country policies carefully.
What is really the bottom line in the preceding discussion, and why should managers be concerned about these issues? In the first place, the world can be divided into countries that basically let their currencies float according to market forces with minimal or no central bank intervention and those that do not but rely on heavy central bank intervention and control. Second, anyone involved in international business needs to understand how the exchange rates of countries with which they do business are determined, because exchange rates affect marketing, production, and financial decisions It is important for MNEs to understand the exchange-rate arrangements for the currencies of countries where they are doing business so they can forecast trends more accurately.
It is much easier to forecast a future exchange rate for a relatively stable currency pegged to the U.S. dollar, such as the Hong Kong dollar, than for a currency that is freely floating, such as the Japanese yen.

11. The Euro The European Monetary System and the European Monetary Union
Pluses and Minuses of the Conversion to the Euro
The Euro and Global Financial Crisis
One of the most ambitious examples of an exchange arrangement with no separate legal tender is the creation of the euro. The decision to move to a common currency in Europe has eliminated currency as a barrier to trade. To replace each national currency with a single European currency called the euro, the countries had to converge their economic policies first. It is not possible to have different monetary policies in each member country and one currency.
The EMS was set up as a means of creating exchange-rate stability within the European Community (EC) at the time. A series of exchange-rate relationships linked the currencies of most members through a parity grid. As the countries narrowed the fluctuations in their exchange rates, the stage was set for the replacement of the EMS with the Exchange Rate Mechanism (ERM) and full monetary union. To be part of the European Monetary Union, euro applicants must comply with the criteria outlined in the Stability and Growth Pact.
The criteria that are part of the Growth and Stability Pact include measures of deficits, debt, inflation, and interest rates.
The United Kingdom, Sweden, and Denmark are the only members of the original 15 EU countries that opted not to adopt the euro. The euro is being administered by the European Central Bank (ECB), which was established on July 1, The ECB has been responsible for setting monetary policy and for managing the exchange-rate system for all of Europe since January 1, The move to the euro has been smoother than predicted. It is affecting companies in a variety of ways. Banks had to update their electronic networks to handle all aspects of money exchange, such as systems that trade global currencies, buy and sell stocks, transfer money between banks, manage customer accounts, or print out bank statements. However, many companies also believe the euro will increase price transparency (the ability to compare prices in different countries) and eliminate foreign-exchange costs and risks. Foreign-exchange costs are narrowing as companies operate in only one currency in Europe, and foreign-exchange risks between member states are also disappearing, although there are still foreign-exchange risks between the euro and nonmember currencies—such as the U.S. dollar, British pound, Swiss franc, and so on.
The Euro and Global Financial Crisis:
During the global financial crisis, investors fled to dollars as a safe-haven currency and returned to euros when their appetite for risk increased. The role of the European Central Bank is to protect the euro against the ravages of inflation. Thus interests in Europe on average are likely to be higher than they are in the United States, especially during the crisis when the U.S. was keeping interest rates low to stimulate economic growth. Therefore, the spread in interest rates between the euro and dollar widened, favoring the euro as a place to invest funds.

12. The Chinese Yuan Playing it SAFE
The Global Financial Crisis and the Future of the CNY
Unlike the euro, the Chinese yuan (CNY)—also known as the renminbi (RMB)—is not an independently floating currency, but rather has a pegged exchange rate. Going back to 1994, the Chinese government decided to fix the value of the yuan to the U.S. dollar at ¥ Now fast-forward to 2009, and the exchange rate is about ¥6.83, which is only 21 percent higher than it was 15 years earlier. China now has the largest foreign-exchange reserves
due to a huge trade surplus and the inflow of foreign direct investment. By generating a huge trade surplus and attracting foreign investment, China built up foreign-exchange reserves that approached $2 trillion in 2009, nearly doubling the reserves of second-place Japan. In a floating-rate world, that type of mismatch in trade and investment flows would ordinarily result in a currency rising in value against its trading partners, but not so with China, which strictly controls the value of the CNY.
In 2005, China delinked the yuan from the dollar in favor of a currency basket. The basket is largely denominated by the dollar, the euro, the yen, and the won. These currencies were selected because of the impact they have on China’s foreign trade, investment, and foreign debt.
SAFE:
The State Administration of Foreign Exchange (SAFE) is responsible for establishing foreign-exchange trading guidelines in China and managing Chinese reserves.
China is trying to increase the importance of the yuan in the global economy and reduce the importance of and reliance on the U.S. dollar.

13. Determining Exchange Rates
Non-intervention: Currency in a floating rate world
Intervention: Currency in a fixed rate or managed floating rate world
Currencies that float freely respond to supply and demand conditions free from government intervention.
Demand for a country’s currency is a function of the demand for that country’s goods and services and financial assets.

14. The Role of Central Banks
Central Bank Reserve Assets
How Central Banks Intervene in the Market
Different attitudes toward intervention
Challenges with intervention
Revisiting the BIS
Central banks control policies that affect the value of currencies; the Federal Reserve Bank of New York is the central bank in the United States.
Central bank reserve assets are kept in three major forms: gold, foreign-exchange reserves, and IMF-related assets. Foreign exchange is 98 percent of reserve assets worldwide.
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
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 2006.
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.
The BIS: The Bank for International Settlements in Basel, Switzerland, is owned by and promotes cooperation among a group of central banks.
Although only 55 central banks or monetary authorities are shareholders in the BIS—11 of which are the founding banks and are from the major industrial countries—the BIS has dealings with some 140 central banks and other international financial institutions worldwide. The BIS acts as a central banker’s bank. It gets involved in swaps and other currency transactions between the central banks in other countries. It is also a gathering place where central bankers can discuss monetary cooperation and is increasingly getting involved with other multilateral agencies, such as the IMF, in providing support during international financial crises.

15. Black Markets A black market closely approximates a
price based on supply and demand for a
currency instead of a government
controlled price.

16. Foreign Exchange Convertibility and Controls
Hard and soft currencies
Controlling Convertibility
Licensing
Multiple Exchange Rates
Import Deposits
Quality Controls
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.
Licensing occurs when a government requires that all foreign-exchange transactions be regulated and controlled
by it.
In a multiple exchange-rate system, a government sets different exchange rates for different types of transactions.
Advance import deposit—a government requires deposit of money prior to the release of foreign exchange to pay for
imports; varies to as long as a year in advance.
Quantity controls—the government limits the amount of foreign currency that can be used in a specific transaction.

17. Exchange Rates and Purchasing Power Parity
The Big Mac Index
Short Run problems that affect PPP
Purchasing power parity (PPP) is a well-known theory that seeks to define relationships between currencies. In essence, it claims that a change in relative inflation (meaning a comparison of the countries’ rates of inflation) between two countries must cause a change in exchange rates to keep the prices of goods in two countries fairly similar. An interesting illustration of the PPP theory for estimating exchange rates is the “Big Mac index” of currencies used by The Economist each year. Because the Big Mac is sold in more than 31,000 restaurants serving more than 58 million people in 118 countries every day, it is easy to use it to compare prices. PPP would suggest that the exchange rate should leave hamburgers costing the same in the United States as abroad. However, the Big Mac sometimes costs more and sometimes less, demonstrating how far currencies are under- or overvalued against the dollar. The Big Mac price in dollars is found by converting the price of a Big Mac in the local currency into dollars at the current exchange rate. The Big Mac index, also known as “McParity,” has its supporters, but there also are detractors. Even though McParity may hold up in the long run, as some studies have
shown, there are short-run problems that affect PPP:
• The theory of PPP falsely assumes there are no barriers to trade and that transportation costs are zero.
• Prices of the Big Mac in different countries are distorted by taxes. European countries with high value-added taxes are more likely to have higher prices than countries with low taxes.
• The Big Mac is not just a basket of commodities; its price also includes non-traded costs, such as rent, insurance, and so on.
• Profit margins vary by the strength of competition: The higher the competition, the lower the profit margin and, therefore, the price.

18. Exchange Rates and Interest Rates
The Fisher Effect
The International Fisher Effect
Other Factors in Exchange Rate Determination
Confidence
Information
Although inflation is the most important medium-term influence on exchange rates, interest rates are also important. Interest rate differentials, however, have both short-term and long-term components to them. In the short term, exchange rates are strongly influenced by interest rates.
In the long term, however, there is a strong relationship between inflation, interest rates, and exchange rates. To understand this interrelationship between interest rates and exchange rates, we need to understand two key finance theories: the Fisher Effect and the International Fisher Effect.
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.
International Fisher Effect: The IFE implies that the currency of the country with the lower interest rate will strengthen in the future.
Other key factors affecting exchange-rate movements are confidence and technical factors, such as the release of economic statistics.
Confidence:
In times of turmoil, people prefer to hold currencies considered safe. During the last quarter of 2008, the dollar rose dramatically in value due to its status as a safe-haven currency. Even though the crisis started in the United States in 2007 with the subprime mortgage problems, the banking crisis in the latter part of 2008 resulted in capital being withdrawn from emerging markets and deposited in dollars due to the safe-haven status of the dollar.
Information:
The release of information can influence currency values. That is why services such as Bloomberg are so important, because they carry up-to-date financial news that traders can follow as they try to figure out what will happen to exchange rates.

19. Forecasting Exchange Rate Movements
Fundamental and Technical Forecasting
Dealing with biases
Timing, Direction, Magnitude
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.
There are some biases that can skew forecasts:
• Overreaction to unexpected and dramatic news events
• Illusory correlation—that is, the tendency to see correlations or associations in data that are not statistically present but are expected to occur on the basis of prior beliefs
• Focusing on a particular subset of information at the expense of the overall set of information
• Insufficient adjustment for subjective matters, such as market volatility
• The inability to learn from one’s past mistakes, such as poor trading decisions
• Overconfidence in one’s ability to forecast currencies accurately
Good treasurers and bankers develop their own forecasts of what will happen to a particular currency and use fundamental or technical forecasts of outside forecasters to corroborate them.
Managers need to be concerned with the timing, magnitude, and direction of an exchange-rate movement.
For countries whose currencies are not freely floating, the timing is often a political decision and is not so easy to predict. Although the direction of a change can probably be predicted, the magnitude is difficult to forecast.

20. Fundamental Factors to Monitor
Institutional Setting
Fundamental Analyses
Confidence Factors
Circumstances
Technical Analyses
For freely fluctuating currencies, the law of supply and demand determines market value. Your ability to forecast exchange rates depends on your time horizon. In general, the best predictors of future exchange rates are interest rates for short-term movements, inflation for medium-term movements, and current account balances for long-term movements. However, very few currencies in the world float freely without any government intervention.
Assuming governments use a rational basis for managing these values, managers can monitor the same factors the governments follow to try to predict values:
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?
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?

21. Business Implications of Exchange Rate Changes
Marketing Decisions
Production Decisions
Financial Decisions
Marketing managers watch exchange rates because they can affect demand for a company’s products at home and abroad. Strengthening of a country’s currency value could create problems for exporters. Exchange-rate changes can also affect production decisions. Companies might locate production in a weak-currency country because:
• Initial investment there is relatively cheap.
• Such a country is a good base for inexpensive exportation.
Exchange rates can influence the sourcing of financial resources, the cross-border remittance of funds, and the reporting of financial results.

22. Future:
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
After the first election of President da Silva in Brazil, the real steadily strengthened against the dollar. In the latter part of 2008, however, the real plummeted as investors pulled money out of Brazil and other emerging markets. The real has since recovered, but there has been significant intervention by the Brazilian central bank. Another thing is clear at this point: South American currencies strengthened with the rise in commodity prices. As commodity prices dropped in the wake of the global economic crisis, so did the value of their currencies. As commodity prices recover, so too should the value of the emerging market currencies.
The euro will continue to succeed as a currency and will eventually take away market share from the dollar as a prime reserve asset. The countries that joined the EU since 2004 have been pushing the EMU to allow them to switch to the euro. Slovenia was recently allowed to adopt the euro as its currency. The EU will allow other countries to adopt the euro as the countries come into convergence with the ERM. Increasing trade links throughout Europe with non–euro-zone countries will dictate closer alliance with the euro.
No Asian currency can compare with the dollar in the Americas and the euro in Europe. In fact, it is far more likely that the dollar will continue to be the benchmark in Asia insofar as Asian economies rely heavily on the U.S. market for a lot of their exports. The Chinese decided to delink the yuan-to-dollar peg in 2005 and widened the trading band in These adjustments have had very little impact, and many countries insist that China is still practicing currency manipulation.
The trend will continue to lead to greater flexibility in exchange-rate regimes, whether as managed floats or as freely floating currencies. Even countries that lock on to the dollar will float against every other currency in the world as the dollar floats. Capital controls will continue to fall, and currencies will move more freely from country to country.

23. All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted, in any form or by any means, electronic, mechanical, photocopying, recording, or otherwise, without the prior written permission of the publisher. Printed in the United States of America.