1. Chapter 3 The International Monetary System
Multinational Business Finance
Chapter 3 The International Monetary System

2. History of the International Monetary System
The Gold Standard (1876 – 1913)
Gold has been a medium of exchange since 3000 BC
each country set the rate at which its currency unit could be converted to a weight of gold. (1ounce=28,35gram)
e.g. $20,67=1 ounce of gold, 4,2474£=1 ounce of gold
Expansionary monetary policy was limited to a government’s gold reserve.
the outbreak of WWI stopped the free movement of gold, this has caused the suspension of the operation of the Gold Standard

3. History of the International Monetary System
The Inter-War Years & WWII ( )
During this period, currencies were allowed to fluctuate over a fairly wide range in terms of gold
Increasing fluctuations in currency values, as speculators sold short weak currencies
The US adopted a modified gold standard in 1934
the US dollar was the only major trading currency that continued to be convertible to gold.

4. History of the International Monetary System
Bretton Woods and the International Monetary Fund (IMF) (1944)
As WWII drew to a close, the Allied Powers met at Bretton Woods, New Hampshire to create a post-war international monetary system
The Bretton Woods Agreement established a US dollar based international monetary system and created two new institutions the International Monetary Fund (IMF) and the World Bank

5. History of the International Monetary System
The International Monetary Fund is a key institution in the new international monetary system and was created to:
Help countries defend their currencies against cyclical, seasonal, or random occurrences
Assist countries having structural trade problems if they promise to take adequate steps to correct these problems
The International Bank for Reconstruction and Development (World Bank) helped fund post-war reconstruction and has since then supported general economic development

6. History of the International Monetary System
Eurocurrencies
domestic currencies of one country deposited in another country.
(e.g. Eurodollar market. Euro- means foreign here)
U.S.-dollar denominated deposits at foreign banks or foreign branches of American banks. By locating outside of the United States
Eurodollars escape regulation by the Federal Reserve Board.

7. History of the International Monetary System
Eurocurrency Interest Rates: Libor
In the Eurocurrency market, the reference rate of interest is the London Interbank Offered Rate (LIBOR)
This rate is the most widely accepted rate of interest used in standardized quotations, loan agreements, and financial derivatives transactions
There are Pibor, Mibor, Fibor, Stibor (Stockholm Interbank Offered Rate)

8. History of the International Monetary System
Fixed Exchange Rates ( )
The currency arrangement negotiated at Bretton Woods and monitored by the IMF worked fairly well during the post-WWII era of reconstruction and growth in world trade
The US dollar became the main reserve currency held by central banks
Eventually, the heavy overhang of dollars held by foreigners resulted in a lack of confidence in the ability of the US to met its commitment to convert dollars to gold

9. History of the International Monetary System
The lack of confidence forced President Richard Nixon to suspend official purchases or sales of gold by the US Treasury on August 15, 1971
This resulted in subsequent devaluations of the dollar
Most currencies were allowed to float to levels determined by market forces as of March, 1973

10. History of the International Monetary System
An Eclectic Currency Arrangement (1973 – Present)
Since March 1973, exchange rates have become much more volatile and less predictable than they were during the “fixed” period
There have been numerous, significant world currency events over the past 30 years

11. Exhibit 3.2 the U.S. Dollar Nominal Exchange Rate Index and Significant Events 1957-2008

12. The IMF’s Exchange Rate Regime Classifications
The International Monetary Fund classifies all exchange rate regimes into eight specific categories
Exchange arrangements with no separate legal tender
Currency board
Other conventional fixed peg
Pegged exchange rates within horizontal bands
Crawling pegs
Exchange rates within crawling pegs
Managed floating
Independent floating

13. Fixed Versus Flexible Exchange Rates
A nation’s choice of currency regime to follow depends on many variables:
inflation,
unemployment,
interest rate levels,
trade balances, and
economic growth.
The choice between fixed and flexible rates may change over time as priorities change.

14. Fixed Versus Flexible Exchange Rates
Fixed rate regime has advantages and disadvantages:
stability in international prices
inherent anti-inflationary nature of fixed prices
but:
Need for central banks to maintain large quantities of hard currencies and gold to defend the fixed rate
Fixed rates can become inconsistent with economic fundamentals as time goes.

15. Attributes of the “Ideal” Currency
Possesses three attributes, often referred to as the Impossible Trinity:
Exchange rate stability: fixed exchange rate
Full financial integration: free capital movement
Monetary independence: independent interest rate policy, monetary policy, etc
Not possible to have all three simultaneous.

16. Exhibit 3.4 The Impossible Trinity

17. Emerging Markets and Regime Choices
Currency board regime
when a country’s central bank commits to back its monetary base – its money supply – entirely with foreign reserves at all times Argentina Peso/ USD
This means that a unit of domestic currency cannot be introduced into the economy without an additional unit of foreign exchange reserves being obtained first.
Argentina moved from a managed exchange rate to a currency board in 1991
In 2002, the country ended the currency board as a result of substantial economic and political turmoil

18. Exhibit 3.6 The Currency Regime Choices for Emerging Markets

19. Emerging Markets and Regime Choices
Dollarization is the use of the US dollar as the official currency of the country.
Panama has used the dollar as its official currency since 1907
Ecuador replaced its domestic currency with the US dollar in September, 2000

20. The Euro: Birth of a European Currency
In December 1991, the members of the European Union met at Maastricht, the Netherlands to finalize a treaty that changed Europe’s currency future.
This treaty set out a timetable and a plan to replace all individual ECU currencies with a single currency called the euro.

21. The Euro: Birth of a European Currency
To prepare for the EMU, a convergence criteria was laid out whereby each member country was responsible for managing the following to a specific level:
Nominal inflation rates
Long-term interest rates
Fiscal deficits
Government debt
In addition, European Central Bank (ECB), was established in Frankfurt, Germany.

22. Effects of the Euro The euro affects markets in three ways:
Cheaper transactions costs in the Euro Zone
Currency risks and costs related to uncertainty are reduced
price transparency and increased price-based competition

23. Achieving Monetary Unification
If the euro is to be successful, it must have a solid economic foundation.
The primary driver of a currency’s value is its ability to maintain its purchasing power.
So, The single largest threat to maintaining purchasing power is inflation.

24. Exhibit 3.8 The Trade-offs between Exchange Rate Regimes

25. Mini-Case Questions: The Revaluation of the Chinese Yuan
Many Chinese critics had urged China to revalue the yuan by 20% or more. What would the Chinese yuan’s value be in US dollars if it had indeed been devalued by 20%?
Do you believe that the revaluation of the Chinese yean was politically or economically motivated?

26. Mini-Case Questions: The Revaluation of the Chinese Yuan (cont’d)
3. If the Chinese yuan were to change by the maximum allowed per day, 0.3% against the US dollar, consistently over a 30 or 60 day period, what extreme values might it reach?
4. Chinese multinationals would now be facing the same exchange rate-related risks borne by US, Japanese, and European multinationals. What impact do you believe this rising risk will have on the strategy and operations of Chinese companies in the near-future?

27. Exhibit 3.3 World Currency Events, 1971–2008

28. Exhibit 3.3 World Currency Events, 1971–2008 (cont.)

29. Exhibit 3.5 The Ecuadorian Sucre Exchange Rate, November 1998–March 2000

30. Exhibit 3.1 U.S. Dollar-Denominated Interest Rates, June 2005

31. Exhibit 3.7 The U.S. Dollar/Euro Spot Exchange Rate, 1999–2008 (Monthly Average)

32. Exhibit 1 Monthly Average Exchange Rates: Chinese Renminbi per U. S
Exhibit 1 Monthly Average Exchange Rates: Chinese Renminbi per U.S. Dollar