1. International Business Environments & Operations
Daniels ● Radebaugh ● Sullivan
International Business Environments and Operations 15e by Daniels, Radebaugh, and Sullivan
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2. The Determination of Exchange Rates
Chapter 9
The Determination of Exchange Rates
Chapter 9: The Determination of Exchange Rates
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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
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Introduction
Learning Objective:
Describe the International Monetary
Fund and its role in the determination of
exchange rates
Learning Objective : To describe the International Monetary Fund and its role in the determination of exchange rates.
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5. The International Monetary Fund
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.
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6. The International Monetary Fund
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.
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The IMF Today
The Quota System
every member contributes a quota
Assistance Programs
the IMF lends money to ease balance-of-payments difficulties
Special drawing rights (SDRs)
the IMF’s unit of account
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.
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8. The Global Financial Crisis and the IMF
The global crisis in raised concerns over global liquidity
prompted the G20 to inject huge amounts of cash into the IMF
Greece’s 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.
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9. 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
provided greater exchange rate flexibility
eliminated the use of par values
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 A new system, the Smithsonian Agreement was then established, followed by the Jamaica Agreement in 1976.
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10. Exchange Rate Arrangements
Under the Jamaica Agreement countries selected and maintained their own exchange rate arrangements
The IMF monitors the exchange rate policies of countries to see if they are acting openly and responsibly
The IMF requires countries to identify how they base their exchange rate mechanism.
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11. Exchange Rate Arrangements
Exchange Rate Arrangements and Anchors
The Table shows different exchange rate arrangements and anchors.
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12. Three Choices: Hard Peg, Soft Peg, or Floating
Learning Objective:
Discuss the major exchange-rate arrangements that countries use
Learning Objective : To discuss the major exchange-rate arrangements that countries use.
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13. Three Choices: Hard Peg, Soft Peg, or Floating
The IMF classifies currencies into three categories
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.
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The Euro
Learning Objective:
Explain the European Monetary System and how the euro became the currency of the euro zone
Learning Objective : To explain how the European Monetary System works and how the euro became the currency of the euro zone.
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The Euro
The European Monetary System (EMS)
established to create exchange rate stability within the European Community
European Monetary Union (EMU)
outlined the criteria for euro applicants
the U.K., Sweden, and Denmark opted not to adopt the euro
The European Central Bank (ECB)
sets monetary policy for the adopters of the euro
The EU countries agreed to political and monetary union with the Treaty of Maastricht in As part of this agreement the countries decided to replace individual currencies with a single currency, the euro. The Growth and Stability Pact provides the criteria that must be met to be part of the EMU. It includes measures of deficits, inflation, debt, interest rates, and exchange rate stability. Today, 17 of the 27 EU countries have adopted the euro, and others are working toward meeting the criteria.
The new currency required companies to update their systems, but should also provide greater price transparency, and eliminate foreign exchange costs and risks.
During the global financial crisis, investors fled to dollars as a safe-haven currency and only returned to euros when they were willing to incur more risk. Currently, the financial crisis in Greece is threatening the future of the euro. Moreover, instability in Spain, Portugal, and Italy could also be problematic.
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16. Determining Exchange Rates
Learning Objective:
Identify the major determinants of exchange rates
Learning Objective : To identify the major determinants of exchange rates.
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17. Determining Exchange Rates
Currency in a floating rate world
demand for a country’s currency is a function of the demand for that country’s goods and services and financial assets
In a free float system, currencies are determined by supply and demand without government intervention.
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18. 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.
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19. Determining Exchange Rates
Currency in a fixed rate or managed floating rate world
Role of central banks
reserve assets
intervening in the market
attitudes toward intervention
The Bank for International Settlements (BIS)
the central banks’ bank
coordinates central bank intervention
Fixed exchange rates do not automatically change in value according to supply and demand. Instead, they are regulated by central banks like the Federal Reserve in the United States and the European Central Bank in the EU.
While central banks maintain reserve assets in gold, foreign exchange reserves, and IMF-related assets, the vast majority of reserve assets is foreign exchange. Central banks use these reserves as they intervene in markets by buying and selling currency to influence its price. Keep in mind that governments vary in their intervention policies by country and by administration.
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Black Markets
A black market closely approximates a price based on supply and demand for a currency instead of a government controlled price
Black markets often exist in countries that strictly regulate and control the convertibility of their currencies.
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21. 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.
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22. 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
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.
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23. Exchange Rates and Interest Rates
The Fisher Effect
links inflation and interest rates
The International Fisher Effect (IFE)
links interest rates and exchange rates
Other Factors in Exchange Rate Determination
confidence
information
Interest rate differentials can have an important effect on exchange rates especially in the short term. The Fisher Effect suggests that 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.
According to the International Fisher Effect, the currency of the country with the lower interest rate will strengthen in the future. In other words, interest rate differentials are unbiased predictors of future changes in spot rates.
In addition to interest rates and inflation, exchange rates can be affected by confidence and technical factors.
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24. Forecasting Exchange Rate Movements
Learning Objective:
Show how managers try to forecast exchange-rate movements
Learning Objective : To show how managers try to forecast exchange-rate movements.
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25. Fundamental and Technical Forecasting
Forecasting exchange rates
Fundamental forecasting
uses trends in economic variables to predict future rates
Technical forecasting
uses past trends in exchange rates to spot future trends
Biases can skew forecasts
Timing, direction, and magnitude of exchange rate movements are important to consider
It’s hard to know what will happen to currencies in the future. There are two main approaches to forecasting exchange rates: fundamental forecasting and technical forecasting. Keep in mind that neither approach works well – in fact, all forecasting tends to be imprecise making it difficult for multinationals to develop operating strategies.
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26. Fundamental Factors to Monitor
The institutional setting
Fundamental analyses
Confidence factors
Circumstances
Technical analyses
Firms can try to monitor certain fundamental factors as a way to gain some insight as to what might happen with currencies in the future.
For freely floating exchange rates, the best predictor of future exchange rates are interest rates for short-term movements, inflation rates for medium-term movements, and current account balances for long-term movements. However, since most currencies are managed at least to some degree, there are other factors to consider as well.
Firms should consider the institutional setting and whether, for example, the currency floats or is managed, and how intervention is handled. Fundamental analyses can provide insight as to whether the currency is overvalued or undervalued in terms of PPP.
Confidence factors can give some indication about market expectations.
It’s also important to consider whether there any national or international events or crises that could impact a currency’s value.
Finally, technical analyses can provide information about what trends might be emerging.
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27. Business Implications of Exchange Rate Changes
Learning Objective:
Explain how exchange-rate movements influence business decisions
Learning Objective : To explain how exchange rate movements influence business decisions.
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28. 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.
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29. 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.
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