1. Part II Exchange Rate Behavior Existing spot exchange rates at other locations Existing cross exchange rates of currencies Existing inflation rate differential Future exchange rate movements Existing spot exchange rate Existing forward exchange rate Existing interest rate differential locational arbitrage triangular arbitrage purchasing power parity international Fisher effect covered interest arbitrage Fisher effect

2. Government Influence On Exchange Rates 6 6 Chapter South-Western/Thomson Learning © 2003

3. B6 - 3 Chapter Objectives To describe the exchange rate systems used by various governments; To explain how governments can use direct and indirect intervention to influence exchange rates; and To explain how government intervention in the foreign exchange market can affect economic conditions.

4. B6 - 4 Exchange Rate Systems Exchange rate systems can be classified according to the degree to which the rates are controlled by the government. Exchange rate systems normally fall into one of the following categories: ¤ fixed ¤ freely floating ¤ managed float ¤ pegged

5. B6 - 5 In a fixed exchange rate system, exchange rates are either held constant or allowed to fluctuate only within very narrow bands. The Bretton Woods era (1944-1971) fixed each currency’s value in terms of gold. The 1971 Smithsonian Agreement which followed merely adjusted the exchange rates and expanded the fluctuation boundaries. The system was still fixed. Fixed Exchange Rate System

6. B6 - 6 Pros: Work becomes easier for the MNCs. Cons: Governments may revalue their currencies. In fact, the dollar was devalued more than once after the U.S. experienced balance of trade deficits. Cons: Each country may become more vulnerable to the economic conditions in other countries. Fixed Exchange Rate System

7. B6 - 7 In a freely floating exchange rate system, exchange rates are determined solely by market forces. Pros: Each country may become more insulated against the economic problems in other countries. Pros: Central bank interventions that may affect the economy unfavorably are no longer needed. Freely Floating Exchange Rate System

8. B6 - 8 Pros: Governments are not restricted by exchange rate boundaries when setting new policies. Pros: Less capital flow restrictions are needed, thus enhancing the efficiency of the financial market. Freely Floating Exchange Rate System

9. B6 - 9 Cons: MNCs may need to devote substantial resources to managing their exposure to exchange rate fluctuations. Cons: The country that initially experienced economic problems (such as high inflation, increasing unemployment rate) may have its problems compounded. Freely Floating Exchange Rate System

10. B6 - 10 In a managed (or “dirty”) float exchange rate system, exchange rates are allowed to move freely on a daily basis and no official boundaries exist. However, governments may intervene to prevent the rates from moving too much in a certain direction. Cons: A government may manipulate its exchange rates such that its own country benefits at the expense of others. Managed Float Exchange Rate System

11. B6 - 11 In a pegged exchange rate system, the home currency’s value is pegged to a foreign currency or to some unit of account, and moves in line with that currency or unit against other currencies. The European Economic Community’s snake arrangement (1972-1979) pegged the currencies of member countries within established limits of each other. Pegged Exchange Rate System

12. B6 - 12 The European Monetary System which followed in 1979 held the exchange rates of member countries together within specified limits and also pegged them to a European Currency Unit (ECU) through the exchange rate mechanism (ERM). ¤ The ERM experienced severe problems in 1992, as economic conditions and goals varied among member countries. Pegged Exchange Rate System

13. B6 - 13 In 1994, Mexico’s central bank pegged the peso to the U.S. dollar, but allowed a band within which the peso’s value could fluctuate against the dollar. ¤ By the end of the year, there was substantial downward pressure on the peso, and the central bank allowed the peso to float freely. The Mexican peso crisis had just began... Pegged Exchange Rate System

14. B6 - 14 Currency Boards A currency board is a system for maintaining the value of the local currency with respect to some other specified currency. For example, Hong Kong has tied the value of the Hong Kong dollar to the U.S. dollar (HK$7.8 = $1) since 1983, while Argentina has tied the value of its peso to the U.S. dollar (1 peso = $1) since 1991.

15. B6 - 15 Currency Boards For a currency board to be successful, it must have credibility in its promise to maintain the exchange rate. It has to intervene to defend its position against the pressures exerted by economic conditions, as well as by speculators who are betting that the board will not be able to support the specified exchange rate.

16. B6 - 16 Exposure of a Pegged Currency to Interest Rate Movements A country that uses a currency board does not have complete control over its local interest rates, as the rates must be aligned with the interest rates of the currency to which the local currency is tied. Note that the two interest rates may not be exactly the same because of different risks.

17. B6 - 17 A currency that is pegged to another currency will have to move in tandem with that currency against all other currencies. So, the value of a pegged currency does not necessarily reflect the demand and supply conditions in the foreign exchange market, and may result in uneven trade or capital flows. Exposure of a Pegged Currency to Exchange Rate Movements

18. B6 - 18 Dollarization Dollarization refers to the replacement of a local currency with U.S. dollars. Dollarization goes beyond a currency board, as the country no longer has a local currency. For example, Ecuador implemented dollarization in 2000.

19. B6 - 19 € A Single European Currency In 1991, the Maastricht treaty called for a single European currency. On Jan 1, 1999, the euro was adopted by Austria, Belgium, Finland, France, Germany, Ireland, Italy, Luxembourg, Netherlands, Portugal, and Spain. Greece joined the system in 2001. By 2002, the national currencies of the 12 participating countries will be withdrawn and completely replaced with the euro.

20. B6 - 20 Within the euro-zone, cross-border trade and capital flows will occur without the need to convert to another currency. European monetary policy is also consolidated because of the single money supply. The Frankfurt-based European Central Bank (ECB) is responsible for setting the common monetary policy. € A Single European Currency

21. B6 - 21 The ECB aims to control inflation in the participating countries and to stabilize the euro within reasonable boundaries. The common monetary policy may eventually lead to more political harmony. Note that each participating country may have to rely on its own fiscal policy (tax and government expenditure decisions) to help solve local economic problems. € A Single European Currency

22. B6 - 22 As currency movements among the European countries will be eliminated, there should be an increase in all types of business arrangements, more comparable product pricing, and more trade flows. It will also be easier to compare and conduct valuations of firms across the participating European countries. € A Single European Currency

23. B6 - 23 Stock and bond prices will also be more comparable and there should be more cross-border investing. However, non- European investors may not achieve as much diversification as in the past. Exchange rate risk and foreign exchange transaction costs within the euro-zone will be eliminated, while interest rates will have to be similar. € A Single European Currency

24. B6 - 24 Since its introduction in 1999, the euro has declined against many currencies. This weakness was partially attributed to capital outflows from Europe, which was in turn partially attributed to a lack of confidence in the euro. Some countries had ignored restraint in favor of resolving domestic problems, resulting in a lack of solidarity. € A Single European Currency

25. B6 - 25 € A Single European Currency €/£ €/$ €/ 100 ¥ €/ SwF (Swiss Franc)  strengthens € weakens 

26. B6 - 26 Government Intervention Each country has a government agency (called the central bank) that may intervene in the foreign exchange market to control the value of the country’s currency. In the United States, the Federal Reserve System (Fed) is the central bank.

27. B6 - 27 Government Intervention Central banks manage exchange rates ¤ to smooth exchange rate movements, ¤ to establish implicit exchange rate boundaries, and/or ¤ to respond to temporary disturbances. Often, intervention is overwhelmed by market forces. However, currency movements may be even more volatile in the absence of intervention.

28. B6 - 28 Direct intervention refers to the exchange of currencies that the central bank holds as reserves for other currencies in the foreign exchange market. Direct intervention is usually most effective when there is a coordinated effort among central banks. Government Intervention

29. B6 - 29 Government Intervention Quantity of £ S1S1 D1D1 D2D2 Value of £ V1V1 V2V2 Fed exchanges $ for £ to strengthen the £ Quantity of £ S2S2 D1D1 Value of £ V2V2 V1V1 Fed exchanges £ for $ to weaken the £ S1S1

30. B6 - 30 When a central bank intervenes in the foreign exchange market without adjusting for the change in money supply, it is said to engaged in nonsterilized intervention. In a sterilized intervention, Treasury securities are purchased or sold at the same time to maintain the money supply. Government Intervention

31. B6 - 31 Nonsterilized Intervention Federal Reserve Banks participating in the foreign exchange market $C$ To Strengthen the C$: Federal Reserve Banks participating in the foreign exchange market $C$ To Weaken the C$:

32. B6 - 32 Sterilized Intervention Federal Reserve Banks participating in the foreign exchange market $C$ To Strengthen the C$: Federal Reserve Banks participating in the foreign exchange market $C$ To Weaken the C$: $ Financial institutions that invest in Treasury securities T - securities Financial institutions that invest in Treasury securities $ T - securities

33. B6 - 33 Some speculators attempt to determine when the central bank is intervening, and the extent of the intervention, in order to capitalize on the anticipated results of the intervention effort. Government Intervention

34. B6 - 34 Central banks can also engage in indirect intervention by influencing the factors that determine the value of a currency. For example, the Fed may attempt to increase interest rates (and hence boost the dollar’s value) by reducing the U.S. money supply. ¤ Note that high interest rates adversely affects local borrowers. Government Intervention

35. B6 - 35 Governments may also use foreign exchange controls (such as restrictions on currency exchange) as a form of indirect intervention. Government Intervention

36. B6 - 36 Exchange Rate Target Zones Many economists have criticized the present exchange rate system because of the wide swings in the exchange rates of major currencies. Some have suggested that target zones be used, whereby an initial exchange rate will be established with specific boundaries (that are wider than the bands used in fixed exchange rate systems).

37. B6 - 37 Exchange Rate Target Zones The ideal target zone should allow rates to adjust to economic factors without causing wide swings in international trade and fear in the financial markets. However, the actual result may be a system no different from what exists today.

38. B6 - 38 Intervention as a Policy Tool Like tax laws and money supply, the exchange rate is a tool which a government can use to achieve its desired economic objectives. A weak home currency can stimulate foreign demand for products, and hence local jobs. However, it may also lead to higher inflation.

39. B6 - 39 Intervention as a Policy Tool A strong currency may cure high inflation, since the intensified foreign competition should cause domestic producers to refrain from increasing prices. However, it may also lead to higher unemployment.

40. B6 - 40 Impact of Government Actions on Exchange Rates Government Intervention in Foreign Exchange Market Government Monetary and Fiscal Policies Relative Interest Rates Relative Inflation Rates Relative National Income Levels International Capital Flows Exchange Rates International Trade Tax Laws, etc. Quotas, Tariffs, etc. Government Purchases & Sales of Currencies

41. B6 - 41 Impact of Central Bank Intervention on an MNC’s Value E (CF j,t )=expected cash flows in currency j to be received by the U.S. parent at the end of period t E (ER j,t )=expected exchange rate at which currency j can be converted to dollars at the end of period t k=weighted average cost of capital of the parent Direct Intervention Indirect Intervention

42. B6 - 42 Exchange Rate Systems ¤ Fixed Exchange Rate System ¤ Freely Floating Exchange Rate System ¤ Managed Float Exchange Rate System ¤ Pegged Exchange Rate System ¤ Currency Boards ¤ Exposure of a Pegged Currency to Interest Rate and Exchange Rate Movements ¤ Dollarization Chapter Review

43. B6 - 43 Chapter Review A Single European Currency ¤ Membership ¤ Euro Transactions ¤ Impact on European Monetary Policy ¤ Impact on Business Within Europe ¤ Impact on the Valuation of Businesses in Europe ¤ Impact on Financial Flows ¤ Impact on Exchange Rate Risk ¤ Status Report on the Euro

44. B6 - 44 Chapter Review Government Intervention ¤ Reasons for Government Intervention ¤ Direct Intervention ¤ Indirect Intervention Exchange Rate Target Zones

45. B6 - 45 Chapter Review Intervention as a Policy Tool ¤ Influence of a Weak Home Currency on the Economy ¤ Influence of a Strong Home Currency on the Economy How Central Bank Intervention Can Affect an MNC’s Value