INTERNATIONAL FINANCIAL MANAGEMENT Fifth Edition EUN RESNICK Mc

INTERNATIONAL FINANCIAL MANAGEMENT Fifth Edition EUN / RESNICK Mc. Graw-Hill/Irwin Copyright © 2009 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

The International Monetary System 2 Chapter Two Chapter Objective: This chapter serves to introduce the institutional framework within which: 1. International payments are made. 2. The movement of capital is accommodated. 3. Exchange rates are determined. 2 -1

Chapter Two Outline l l l l 2 -2 Evolution of the International Monetary System Current Exchange Rate Arrangements European Monetary System Euro and the European Monetary Union The Mexican Peso Crisis The Asian Currency Crisis The Argentine Peso Crisis Fixed versus Flexible Exchange Rate Regimes

Chapter Two Outline l l 2 -3 International Monetary System: Institutional framework within which international payments are made, movements of capital are accommodated, and exchange rates among currencies are determined. A complex whole of agreements, rules, institutions, mechanisms, and policies regarding exchange rates, international payments, and the flow of capital.

Evolution of the International Monetary System l l l 2 -4 Bimetallism: Before 1875 Classical Gold Standard: 1875 -1914 Interwar Period: 1915 -1944 Bretton Woods System: 1945 -1972 The Flexible Exchange Rate Regime: 1973 Present

Bimetallism: Before 1875 l l A “double standard” in the sense that both gold and silver were used as money. (free coinage was maintained) Some countries were on the gold standard, some on the silver standard, some on both. (mono-bi) l l 2 -5 While using both, some of the countries returned to one Coinage act of 1873. Both gold and silver were used as international means of payment and the exchange rates among currencies were determined by either their gold or silver contents.

Bimetallism: Before 1875 l l l 2 -6 British Pound (gold standard) vs. Franc (bimetal) exchanged currencies on gold content of the two currencies. Franc (bimetal) and German mark (silver standard) exchanged currencies on silver content of the currencies. British Pound (gold standard) vs. German mark (silver) exchanged currencies by their exchange rates against the franc.

Gresham’s Law: “bad”(abundant) money drives out “good” (scarce) money. l l Gresham’s Law implies that it would be the least valuable metal that would tend to circulate. Suppose that you were a citizen of Germany during the period when there was a 20 German mark coin made of gold and a 5 German mark coin made of silver. l 2 -7 If Gold suddenly and unexpectedly became much more valuable than silver, which coins would you spend if you wanted to buy a 20 -mark item and which would you keep?

Classical Gold Standard: 1875 -1914 : Gold constitutes treasure, and he who possesses it has all he needs in this world. Columbus l During this period in most major countries: l l The exchange rate between two country’s currencies would be determined by their relative gold contents. l l 2 -8 Gold alone was assured of unrestricted coinage There was two-way convertibility between gold and national currencies at a stable ratio. Gold could be freely exported or imported. Banknotes need to be backed by a gold reserve of a minimum stated ratio. Domestic money stock should rise and fall as gold flows in and out of the country.

Classical Gold Standard: 1875 -1914 For example, if the dollar is pegged to gold at U. S. $30 = 1 ounce of gold (28. 3495231 gr), and the British pound is pegged to gold at £ 6 = 1 ounce of gold, it must be the case that the exchange rate is determined by the relative gold contents: $30 = 1 ounce of gold = £ 6 $30 = £ 6 $5 = £ 1 2 -9 For the entire period USD/Pound rate was in a range of 4. 84$ and 4. 90$

Classical Gold Standard: 1875 -1914 l l 2 -10 Highly stable exchange rates under the classical gold standard provided an environment that was conducive to international trade and investment. Misalignment of exchange rates and international imbalances of payment were automatically corrected by the price-specie-flow mechanism. (David Hume’s idea, Scottish philosopher (17111776)

Price-Specie-Flow Mechanism l l Suppose Great Britain exported more to France than France imported from Great Britain. This cannot persist under a gold standard. l l l 2 -11 Net export of goods from Great Britain to France will be accompanied by a net flow of gold from France to Great Britain. This flow of gold will lead to a lower price level in France and, at the same time, a higher price level in Britain. The resultant change in relative price levels will slow exports from Great Britain and encourage exports from France.

Price-Specie-Flow Mechanism Higher prices cause export to decrease and imports to increase If Export is bigger than import + Balance of Trade Prices will go up Money Supply will Increase 2 -12

Classical Gold Standard: 1875 -1914 l Ardent supporters of gold: l l There are shortcomings: l l 2 -13 It is a hedge against price inflation. You can’t increase its quantity. Money creation will be automatic. The supply of newly minted gold is so restricted that the growth of world trade and investment can be hampered for the lack of sufficient monetary reserves. Even if the world returned to a gold standard, any national government could abandon the standard.

Interwar Period: 1915 -1944 l l 2 -14 Exchange rates fluctuated as countries widely used “predatory” depreciations of their currencies as a means of gaining advantage in the world export market. Attempts were made to restore the gold standard, but participants lacked the political will to “follow the rules of the game”. The result for international trade and investment was profoundly detrimental. Economic nationalism, economic and political instabilities, bank failures, panicky flights of capital across borders, 1929 Great Depression, all reasons required a new system.

Bretton Woods System: 1945 -1972 l l Named for a 1944 meeting of 44 nations at Bretton Woods, New Hampshire. The purpose was to design a postwar international monetary system. The goal was exchange rate stability without the gold standard. The result was the creation of the IMF-1945 and the World Bank. (International Bank for Reconstruction and Development, IBRD) 2 -15

Bretton Woods System: 1945 -1972 l l 2 -16 British delagates led by John Maynard Keynes proposed an international clearing union with a reserve asset called “bancor” The US delegate led by Harry Dexter White proposed a currency pool to which member countries would make contributions and from which they can barrow. (IMF like)

Bretton Woods System: Dollar based gold exchange standart 1945 -1972 German mark British pound r Pa lue Va Par Value French franc Va Pa lue r U. S. dollar Pegged at $35/oz. Gold 2 -17

Collepse of the Bretton Woods l l The system was programmed to collapse in the long run. To satisyf the growing need for reserves, the US had to run balance of payments deficits continuously. This would reduce public confidence in the currency itself which is called Triffin Paradox. [trade was positively correlated with the amount of dollars held by foreigners. Foreigners' ] confidence in the U. S. dollar, however, was negatively correlated with the amount of dollars they held l l Bank of France bought gold from the US Treasury, unloading its dollar holdings. After this to protect the system; l l The US goverment taken some defence measures, Interest Equalization Tax and Foreign Credit Restraint Program (lending limits to MNCs) (This also caused Eurodollar market to increase more) SDRs are created as a reserve money.

The Composition of the SDRs

Collepse of the Bretton Woods l l l Because of Vietnam War and Great Society program in early 1970 s it became clear that the dollar was overvalued, particularly for Mark and Yen. German and Japan Cenral banks had to make massive interventions to maintain their par values as the US was showing unwillingness to contral its monetary expansion. In August 1971, president Nixon suspended the convertibility of the dollar into gold and imposed a 10 percent import surcharge. To save the system again 10 countries had an agreement called Smithsonian : 1)38$ per ounce, 2)up to 10 pcnt revaluation of par values and 3)band expanded to 2. 25 1 year later again same problem gold 1 ounce gold 38 and 42. . .

The Flexible Exchange Rate Regime: 1973 -Present. l January 1976 IMF members met in Jamaica and came out Jamaica Agreement which is: 1. 2. 3. 2 -23 Flexible exchange rates were declared acceptable to the IMF members. Central banks were allowed to intervene in the exchange rate markets to iron out unwarranted volatilities. Gold was abandoned as an international reserve asset. Non-oil-exporting countries and less-developed countries were given greater access to IMF funds.

The Flexible Exchange Rate Regime: 1973 -Present. l 2 -24 Exchange rates are now more volatile.

Current Exchange Rate Arrangements l Free Float l l Managed Float l l Such as the U. S. dollar or euro (through franc or mark). No national currency l 2 -25 About 25 countries combine government intervention with market forces to set exchange rates. Pegged to another currency l l The largest number of countries, about 48, allow market forces to determine their currency’s value. Some countries do not bother printing their own currency. For example, Ecuador, Panama, and El Salvador have dollarized. Montenegro and San Marino use the euro.

Current Exchange Rate Arrangements 1. 2. 3. 4. 5. 6. 7. 8. l 2 -26 Exchange arrangemenets with no separate legal tender: Ecuador, El Salvador, Panama using the US dollar. Currency board: Legislative commitment to exchange domestic currency for a specified foreign currecy at a fixed exchange rate. Conventional fixed pegs: Saudi Arabia, Nigeria, Egypt, Ukraine. Pegged exchange rates within horizontal bands: There is a central bank and the fluctuation is wider at least 1 percent plus or minus. Crawling pegs: Adjusting the currency in small amounts at a fixed preannounced rate. Exchange rates within crawling bands. Managed floating with no preannounced path for the exchange rate: Algeria, Russia, Singapore, India Independent floating: market determined. Exhibit 2. 4 in your book page 36 -38

European Monetary System l l European countries maintain exchange rates among their currencies within narrow bands (+- 1. 125 Although Smithsonian Agreement requires 2. 25), and jointly float against outside currencies. Objectives: l l l 2 -27 To establish a zone of monetary stability in Europe. To coordinate exchange rate policies vis-à-vis (in comparition with) non-European currencies. To pave the way for the European Monetary Union.

What Is the Euro? l l 2 -28 The euro is the single currency of the European Monetary Union which was adopted by 11 Member States on 1 January 1999. (Before ECU was available) These original member states were: Belgium, Germany, Spain, France, Ireland, Italy, Luxemburg, Finland, Austria, Portugal and the Netherlands.

What Is the Euro: Maastricht Treaty 1991 “convergence criterias” +from ecu to euro, ems to emu l 2 -29 Two main instruments of the EMS are ECU/EURO and Exchange Rate Mechanism.

What are the Different Denominations of the Euro Notes and Coins ? l l 2 -30 There are 7 euro notes and 8 euro coins. € 500, € 200, € 100, € 50, € 20, € 10, and € 5. The coins are: 2 euro, 1 euro, 50 euro cent, 20 euro cent, 10, euro cent, 5 euro cent, 2 euro cent, and 1 euro cent. The euro itself is divided into 100 cents, just like the U. S. dollar.

How Did the Euro Affect Contracts Denominated in National Currency? l l 2 -31 All insurance and other legal contracts continued in force with the substitution of amounts denominated in national currencies with their equivalents in euro. Once the changeover was completed by July 1, 2002, the legal-tender status of national currencies (e. g. German mark, Italian lira) was cancelled, leaving the euro as the sole legal tender in the euro zone.

Euro Area l l l l Austria, Belgium, Cyprus, Finland, France, Germany, Greece, l l l l 2 -32 Ireland, Italy, Luxembourg, Malta, The Netherlands, Portugal, Slovenia, Spain

Value of the Euro in U. S. Dollars 2 -33

End of the currencies l l 2 -34 On January 1, 2002, euro notes and coins were introduced to circulation while national bills and coins were being gradually withdrawn. As of July 1, 2002, the legal tender status of national currencies was canceled, leaving the euro as the sole legal tender it the euro zone countries.

The Benefits of Monetary Union l l 2 -35 Reduced transaction costs and elimination of exchange rate uncertainty. l Reducing hedging costs l Comparison shopping l Price transparancy will lead to Europe-wide competition l Enhenced efficiency and competitiveness of the European economy. l Improves the continental capital markets One currency should promote political cooperation and peace in Europe.

The Long-Term Impact of the Euro l l l 2 -36 As the euro proves successful, it will advance the political integration of Europe in a major way, eventually making a “United States of Europe” feasible. It is likely that the U. S. dollar will lose its place as the dominant world currency. The euro and the U. S. dollar will be the two major currencies. ? ? Is it? ? China, Arab World, India

Costs of Monetary Union l The main cost of monetary union is the loss of national monetary and exchange rate policy independence. l 2 -37 The more trade-dependent and less diversified a country’s economy is the more prone to asymmetric shocks that country’s economy would be.

Asymmetric shocks: l l 2 -38 When an economic supply or demand shock is different from one region to another, or when the shocks do not move in tandem (together). Example: If Germany has a positive aggregate demand shock and France has a negative aggregate demand shock, then these two countries are experiencing asymmetric shocks. Having similar, or symmetric, shocks is one of the criteria of an optimal currency area. (Theory of Robert Mondell, Colombia Uiversity in 1961) Asymmetric shocks make it difficult for the central bank of a monetary union to conduct monetary policy that is beneficial to each member of the union.

Costs of Monetary Union l l 2 -39 Finland, a country heavily dependent on the paper and pulp (wood) industries faces a sudden drop in world paper and pulp prices, hurting Finnish economy, causing unemployment and income decline while scarcely affecting other euro zone countries. This is called an asymmetric shock.

Costs of Monetary Union l l l 2 -40 If Finland had monetary independence, they lower domestic interest rates to stimulate the weak economy as well as letting its currency depreciate to boost foreigners’ demant for Finland products. As Finland in EMU, there is no monetary policy they can apply. They have to act with euro zone and ECB will not tune its policy depending on only one country. Without monetary solution, other options: lowering wage and price levels will have the same effects similar to the depreciation of the Finnish currency.

Costs of Monetary Union l l l 2 -41 Or if the capital flows freely across the euro zone and workers are willing to relocate these are also good for asymmetric shock absorbation. If the countries factor mobilitiy (capital, labor) is high in a region, the countries can have one currency. The theory of Robert Mundell, optimim currency areas. Asymetric shocks can be in a country but the flexibility of wage price and fiscal policy will have a successful response to these shocks.

Costs of Monetary Union l l 2 -42 In the US high degree of capital and labor mobility is available. It would be suboptimal if each 50 states to issue its own currency. Unemloyed living in Helsinki not very likely to move to Milan due to cultural, religious, linguistic and other barriers but for the US? If the euro zone experiences a major asymmetric shocks, a successful response will require wage, price and fiscal flexibility.

The Mexican Peso Crisis l l l 2 -43 On 20 December, 1994, the Mexican government announced a plan to devalue the peso against the dollar by 14 percent. This decision changed currency trader’s expectations about the future value of the peso. Early 1995 the peso fell against the US dollar by as much as 40 percent.

The Mexican Peso Crisis (1994) l This is the first cross border flight of portfolio capital: International mutual funds investment before crises were 54 billion dollar !!! l In a system like this: l l 2 -44 1. Having multinational safety net in place to safeguard the world financial system is important. 2. Foreign capital influx causes a higher domestic inflation and overvalued money, that hurts trade balances.

The Asian Currency Crisis (1997) l l l 2 -45 The Asian currency crisis turned out to be far more serious than the Mexican peso crisis in terms of the extent of the contagion and the severity of the resultant economic and social costs. Many firms with foreign currency bonds were forced into bankruptcy. The region experienced a deep, widespread recession.

The Asian Currency Crisis l l 2 -46 Weak domestic financial system, free international capital flows, contagion effects of changing market sentiment (feeling), inconcistent economic policies are all the factors behind the Asian Currency Crises. The liberalisation cause the Asian countries inflow of foreign capital. Credit boom directed to speculation on real estate, stock market.

The Asian Currency Crisis l l l 2 -47 Fixed or stable exchange rates encourage unhedged financial transactions and excessive risk taking by lenders/borrowers. Asset prices declined, than quality of banks’ loan portfolios (collateral) Crony capitalism is not new for Asia too. (poor risk managemend and supervision, political influence, suboptimal allocation of resources. . . )

The Asian Currency Crisis l l 2 -48 Booming economy with a fixed or stable nominal exchange rate inevitably brought about an appreciation of the real exchange rate. Caused in a marked slowdown in export growt. Yen’s depreciation against the dollar hurt Japan’s neighbours more. Panickly flight of capital from the Asian countries cause the crisis to become extended. IMF intervention

Lessons from Asian Currency Crisis l l 2 -49 Countries first strengthen their domestic financial system and then liberalize their financial markets. Financial sector regulations and supervision is the most important. Basel Committee on Banking Supervision rules. . . Encourage foreign direct investment and equity and long term bond investment discourage short term investment even by using Tobin tax “incompatible trinity” or “trilemma” a country can attain only two of the following three conditions: 1. a fixed exchange rate system 2. free international flows of capital 3. an independent monetary policy.

The Argentinean Peso Crisis (2002) l l In 1991 the Argentine government passed a convertibility law that linked the peso to the U. S. dollar at parity. (currency board) The initial economic effects were positive: l l l 2 -50 Argentina’s chronic inflation was curtailed (limited) Foreign investment poured in As the U. S. dollar appreciated on the world market the Argentine peso became stronger as well.

The Argentinean Peso Crisis l The strong peso hurt exports from Argentina and caused a protracted (extended) economic downturn that led to the abandonment of peso– dollar parity in January 2002. l l 2 -51 The unemployment rate rose above 20 percent The inflation rate reached a monthly rate of 20 percent

The Argentinean Peso Crisis l There at least three factors that are related to the collapse of the currency board arrangement and the ensuing economic crisis: l l 2 -52 Lack of fiscal discipline Labor market inflexibility Contagion from the financial crises in Brazil and Russia Argentina refused to pay its debts and offered to pay only %25 of NPV of the debts. Foreign bondholders have rejected this.

Currency Crisis Explanations l l 2 -53 In theory, a currency’s value mirrors the fundamental strength of its underlying economy, relative to other economies. In the long run. In the short run, currency trader’s expectations play a much more important role. In today’s environment, traders and lenders, using the most modern communications, act by fight-or-flight instincts. For example, if they expect others are about to sell Brazilian currency for U. S. dollars, they want to “get to the exit first”. Thus, fears of depreciation become self-fulfilling prophecies.

Fixed versus Flexible Exchange Rate Regimes l Which Exchange Rate Regime is better? Arguments in favor of flexible exchange rates: l l l Arguments against flexible exchange rates: l l 2 -54 Easier external adjustments. National policy autonomy (independence). Exchange rate uncertainty may hamper international trade. No safeguards to prevent crises.

End Chapter Two 2 -55