chapter The International Monetary System McGraw-Hill/Irwin Global Business Today, 5e © 2008 The...

chapter

The International Monetary System

McGraw-Hill/IrwinGlobal Business Today, 5e

© 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.

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Chapter 10: The International Monetary System

INTRODUCTION

The international monetary system refers to the institutional arrangements that countries adopt to govern exchange rates.

• When the foreign exchange market determines the relative value of a currency, a floating system exists • When the value of a currency is fixed to a reference country and then the exchange rate between that currency and other currencies is determined by the reference currency exchange rate, a pegged exchange rate system exists

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• A dirty float occurs when the value of a currency is determined by market forces, but with central bank intervention if it depreciates too rapidly against an important reference currency

• Countries that adopt a fixed exchange rate system fix their currencies against each other

• Prior to the introduction of the euro, some European Union countries operated with fixed exchange rates within the context of the European Monetary System (EMS)

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Classroom Performance System

When the foreign exchange market determines the relative value of a currency, a ________ exchange rate system exists.

a) Fixed

b) Floating

c) Pegged

d) Market

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THE GOLD STANDARD

The origin of the gold standard dates back to ancient times when gold coins were a medium of exchange, unit of account, and store of value.

Mechanics of the Gold Standard

• The practice of pegging currencies to gold and guaranteeing convertibility is known as the gold standard• Under the gold standard one U.S. dollar was defined as equivalent to 23.22 grains of "fine (pure) gold• The exchange rate between currencies was based on the gold par value (the amount of a currency needed to purchase one ounce of gold)

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The Strength of the Gold Standard

• The great strength of the gold standard was that it contained a powerful mechanism for simultaneously achieving balance-of-trade equilibrium (when the income a country’s residents earn from its exports is equal to the money its residents pay for imports) by all countries

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The Period Between the Wars, 1918-1939

• The gold standard worked fairly well from the 1870s until the start of World War I, • Then, in an effort to encourage exports and domestic employment, countries started regularly devaluing their currencies• People lost confidence in the system and started to demand gold for their currency putting pressure on countries' gold reserves, and forcing them to suspend gold convertibility

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THE BRETTON WOODS SYSTEM

In 1944, representatives from 44 countries met at Bretton Woods, New Hampshire, to design a new international monetary system.

The goal was to build an enduring economic order that would facilitate postwar economic growth.

The agreement established two multinational institutions:• the International Monetary Fund (IMF) to maintain order in the international monetary system• the World Bank to promote general economic development

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Under the new system:• the US dollar was the only currency to be convertible to gold,

and other currencies would set their exchange rates relative to the dollar

• devaluations were not to be used for competitive purposes

• a country could not devalue its currency by more than 10% without IMF approval

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The Role of the IMF

The IMF was responsible for executing the main goal of the Bretton Woods agreement, avoiding a repetition of the chaos that occurred between the wars through a combination of discipline and flexibility.

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Discipline

A fixed exchange rate regime imposes discipline in two ways:

• the need to maintain a fixed exchange rate puts a brake on competitive devaluations and brings stability to the world trade environment

• a fixed exchange rate regime imposes monetary discipline on countries, thereby curtailing price inflation

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Flexibility

• Although monetary discipline was a central objective of the agreement, it was recognized that a rigid policy of fixed exchange rates would be too inflexible

• The IMF stood ready to lend foreign currencies to members to tide them over during short periods of balance-of-payments deficit, when a rapid tightening of monetary or fiscal policy would hurt domestic employment

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The Role of the World Bank

The official name of the World Bank is the International Bank for Reconstruction and Development (IBRD).

The bank lends money under two schemes: • under the IBRD scheme, money is raised through bond sales in the international capital market• borrowers pay what the bank calls a market rate of interest - the bank's cost of funds plus a margin for expenses. • a second scheme is overseen by the International Development Agency, an arm of the bank created in 1960 • IDA loans go only to the poorest countries

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The gold standard was a ______ exchange rate system.

a) Fixed

b) Floating

c) Pegged

d) Market

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THE COLLAPSE OF THE FIXED EXCHANGE RATE SYSTEM

U.S. macroeconomic policy decisions from 1965 to 1968 led to the collapse of the exchange rate system established in Bretton Woods.

• Under Johnson, the U.S. financed huge increases in welfare programs and the Vietnam War by increasing its money supply, leading to significant inflation • Speculation that the dollar would have to be devalued relative to most other currencies, as well as underlying economics and some forceful threats by the U.S., forced other countries to increase the value of their currencies relative to the dollar• However, because the system relied on an economically well managed U.S., when the U.S. began to print money, run high trade deficits, and experience high inflation, the system was strained to the breaking point

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THE FLOATING EXCHANGE RATE REGIME

The floating exchange rate regime that followed the collapse of Bretton Woods was formalized in January 1976 in Jamaica. The Jamaica Agreement

The purpose of the Jamaica meeting was to revise the IMF's Articles of Agreement to reflect the new reality of floating exchange rates.Under the Jamaican agreement:• floating rates were declared acceptable• gold was abandoned as a reserve asset• total annual IMF quotas - the amount member countries contribute to the IMF - were increased to $41 billion

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Exchange Rates since 1973

Since 1973, exchange rates have become more volatile and less predictable in part because of:• The oil crisis in 1971• The loss of confidence in the dollar that followed the rise of U.S. inflation in 1977 and 1978• The oil crisis of 1979• The unexpected rise in the dollar between 1980 and 1985• The partial collapse of the European Monetary System in 1992• The 1997 Asian currency crisis

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FIXED VERSUS FLOATING EXCHANGE RATES

Disappointment with floating rates in recent years has led to renewed debate about the merits of a fixed exchange rate system.

The Case for Floating Exchange Rates The case for floating exchange rates has two main elements:• monetary policy autonomy• automatic trade balance adjustments

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Floating exchange rates were deemed acceptable under

a) The Bretton Woods Agreement

b) The Gold Standard

c) The Jamaica Agreement

d) The Louvre Accord

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Monetary Policy Autonomy

• Advocates of a floating exchange rate regime argue that removal of the obligation to maintain exchange rate parity restores monetary control to a government

• Under a fixed system, a country's ability to expand or contract its money supply as it sees fit is limited by the need to maintain exchange rate parity

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Trade Balance Adjustments

• Under the Bretton Woods system, if a country developed a permanent deficit in its balance of trade that could not be corrected by domestic policy, the IMF would agree to a currency devaluation

• Critics of this system argue that the adjustment mechanism works much more smoothly under a floating exchange rate regime

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The Case for Fixed Exchange Rates

The case for fixed exchange rates rests on arguments about monetary discipline, uncertainty, and the lack of connection between the trade balance and exchange rates.

Monetary Discipline

• The need to maintain a fixed exchange rate parity ensures that governments do not expand their money supplies at inflationary rates

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Speculation

• Critics of a floating exchange rate regime also argue that speculation can cause exchange rate fluctuations

Uncertainty

• Speculation adds to the uncertainty surrounding future currency movements that characterizes floating exchange rate regimes

Trade Balance Adjustments

• Advocates of floating exchange rates argue that floating rates help adjust trade imbalances

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Who is Right?

• There is no real agreement as to which system is better • We know that a fixed exchange rate regime modeled along the lines of the Bretton Woods system will not work• A different kind of fixed exchange rate system might be more enduring and might foster the kind of stability that would facilitate more rapid growth in international trade and investment

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EXCHANGE RATE REGIMES IN PRACTICE

• 19% of IMF members follow a free float policy

• 26% of IMF members follow a managed float system

• 22% of IMF members have no legal tender of their own

• the remaining countries use less flexible systems such as pegged arrangements, or adjustable pegs

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The exchange rate policies of IMF members are shown in Figure 10.2.

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The most common exchange rate policy among IMF members today is the

a) Free float

b) Managed float

c) Fixed peg

d) Adjustable peg

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Pegged Exchange Rates

• Under a pegged exchange rate regime a country will peg the value of its currency to that of another major currency• Pegged exchange rates are popular among the world’s smaller nations • There is some evidence that adopting a pegged exchange rate regime does moderate inflationary pressures in a country

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Currency Boards

• A country that introduces a currency board commits itself to converting its domestic currency on demand into another currency at a fixed exchange rate

• To make this commitment credible, the currency board holds reserves of foreign currency equal at the fixed exchange rate to at least 100% of the domestic currency issued

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CRISIS MANAGEMENT BY THE IMF

• Many of the original reasons for the IMF's existence have disappeared

• The IMF has redefined its mission, and now focuses on lending money to countries experiencing financial crises

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Financial Crisis in the Post Bretton Woods Era

• A currency crisis occurs when a speculative attack on the exchange value of a currency results in a sharp depreciation in the value of the currency, or forces authorities to expend large volumes of international currency reserves and sharply increase interest rates in order to defend prevailing exchange rates

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• A banking crisis refers to a situation in which a loss of confidence in the banking system leads to a run on the banks, as individuals and companies withdraw their deposits

• A foreign debt crisis is a situation in which a country cannot service its foreign debt obligations, whether private sector or government debt.

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Mexican Currency Crisis of 1995

• The Mexican currency crisis of 1995 was a result of high Mexican debts, and a pegged exchange rate that did not allow for a natural adjustment of prices

• In order to keep Mexico from defaulting on its debt, a $50 billion aid package was created

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The Asian Crisis

The causes of the financial crisis that erupted across Southeast Asia during the fall of 1997 were sown in the previous decade when these countries were experiencing unprecedented growth. The Investment Boom

• Huge increases in exports helped fuel a boom in commercial and residential property, industrial assets, and infrastructure• Often the investments were made on the basis of projections about future demand conditions that were unrealistic and significant excess capacity emerged

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Excess Capacity

• Investments made on the basis of unrealistic projections about future demand conditions created significant excess capacity The Debt Bomb

• These investments were often supported by dollar-based debts. When inflation and increasing imports put pressure on the currencies, the resulting devaluations led to default on dollar denominated debts

Expanding Imports

• By the mid 1990s, imports were expanding across the region

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The Crisis

• By mid-1997, it became clear that several key Thai financial institutions were on the verge of default

• Foreign exchange dealers and hedge funds started to speculate against the Baht, selling it short

• After struggling to defend the peg, the Thai government abandoned its defense and announced that the Baht would float freely against the dollar

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• With its foreign exchange rates depleted, Thailand lacked the foreign currency needed to finance its international trade and service debt commitments, and was in desperate need of the capital the IMF could provide

• Following the devaluation of the Baht, speculation caused other Asian currencies including the Malaysian Ringgit, the Indonesian Rupaih and the Singapore Dollar to fall

• These devaluations were mainly driven by similar factors to those that underlay the earlier devaluation of the Baht--excess investment, high borrowings, much of it in dollar denominated debt, and a deteriorating balance of payments position

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Evaluating the IMF’s Policy Prescription

• By 2005, the IMF was committing loans to some 59 countries that were struggling with economic and currency crises

• All IMF loan packages come with conditions attached, generally a combination of tight macroeconomic policy and tight monetary policy

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Inappropriate Policies

• The IMF has been criticized for having a “one-size-fits-all” approach to macroeconomic policy that is inappropriate for many countries Moral Hazard

• The IMF has also been criticized for exacerbating moral hazard (when people behave recklessly because they know they will be saved if things go wrong)

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Lack of Accountability

• The final criticism of the IMF is that it has become too powerful for an institution that lacks any real mechanism for accountability

Observations

• As with many debates about international economics, it is not clear who is right

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IMPLICATIONS FOR MANAGERS

Currency Management

• Companies must recognize that the current system is a managed float system in which government intervention can help drive the foreign exchange market• Under the present system, speculative buying and selling of currencies can create volatile movements in exchange rates

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Business Strategy

• Exchange rate movements are difficult to predict, yet their movement can have a major impact on the competitive position of businesses

• One response to the uncertainty that arises from a floating exchange rate regime is to build strategic flexibility

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Corporate-Government Relations

• As major players in the international trade and investment environment, businesses can influence government policy towards the international monetary system

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CRITICAL THINKING AND DISCUSSION QUESTIONS

1. Why did the gold standard collapse? Is there a case for returning to some type of gold standard? What is it?

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2. What opportunities might IMF lending policies to developing nations create for international businesses? What threats might they create?

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3. Do you think the standard IMF policy prescriptions of tight monetary policy and reduced government spending are always appropriate for developing nations experiencing a currency crisis? How might the IMF change its approach? What would the implications be for international businesses?

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4. Debate the relative merits of fixed and floating exchange rate regimes. From the perspective of an international business, what are the most important criteria in a choice between the systems? Which system is the more desirable for an international business?

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5. Imagine that Canada, the United States, and Mexico decide to adopt a fixed exchange rate system. What would be the likely consequences of such a system for (a) international businesses and (b) the flow of trade and investment among the three countries?

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CRITICAL THINKING AND DISCUSSION QUESTIONS6. Reread the Opening Case, then answer the following questions:a) Why do you think the Chinese government originally pegged the value of the Yuan against the U.S. dollar? What were the benefits of doing this for China? What were the costs?b) Over the last decade, many foreign firms have invested in China and used their Chinese factories to produce goods for export. If the Yuan is allowed to float freely against the U.S. dollar on the foreign exchange markets and appreciates in value, how might this affect the fortunes of those enterprises?c) How might a decision to let the Yuan float freely affect future foreign direct investment flows into China?d) Under what circumstances might a decision to let the Yuan freely destabilize the Chinese economy? What might be the global implications of this be?e) Do you think the U.S. government should push the Chinese to let the Yuan float freely? Why?f) What do you think the Chinese government should do? Let the Yuan float, maintain the peg, or change the peg in some way?

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