Transcript FIN_250_Chap02_shrtnd_0

INTERNATIONAL
FINANCIAL
MANAGEMENT
Fifth Edition
EUN / RESNICK
McGraw-Hill/Irwin
Copyright © 2009 by The McGraw-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
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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
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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
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2-4
Bimetallism: Before 1875
Classical Gold Standard: 1875-1914
Interwar Period: 1915-1944
Bretton Woods System: 1945-1972
The Flexible Exchange Rate Regime: 1973Present
Bimetallism: Before 1875
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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)
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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
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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.
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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.
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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
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During this period in most major countries:
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The exchange rate between two country’s currencies would be
determined by their relative gold contents.
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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
$5 = £1
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For the entire period USD/Pound rate was in a range of 4.84$ and 4.90$
Classical Gold Standard:
1875-1914
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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
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Suppose Great Britain exported more to France than
France imported from Great Britain.
This cannot persist under a gold standard.
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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
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Classical Gold Standard:
1875-1914
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Ardent supporters of gold:
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There are shortcomings:
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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
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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
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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)
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Bretton Woods System:
1945-1972
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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
British
pound
German
mark
French
franc
Par
Value
U.S. dollar
Pegged at $35/oz.
Gold
2-17
Collepse of the Bretton Woods
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The system was programmed to collapse in the long run. To satisyf the
growing need for reserves, the US had to run balance of payments deficits
continuously.
This would reduce public confidence in the currency itself which is called
Triffin Paradox. [trade was positively correlated with the amount of dollars held by foreigners. Foreigners'
confidence in the U.S. dollar, however, was negatively correlated with the amount of dollars they held
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]
Bank of France bought gold from the US Treasury, unloading its dollar
holdings.
After this to protect the system;
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The US goverment taken some defence measures, Interest Equalization Tax and
Foreign Credit Restraint Program (lending limits to MNCs) (This also caused
Eurodollar market to increase more)
SDRs are created as a reserve money.
The Composition of the SDRs
Collepse of the Bretton Woods
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Because of Vietnam War and Great Society program in early 1970s it
became clear that the dollar was overvalued, particularly for Mark and
Yen.
German and Japan Cenral banks had to make massive interventions to
maintain their par values as the US was showing unwillingness to contral
its monetary expansion.
In August 1971, president Nixon suspended the convertibility of the dollar
into gold and imposed a 10 percent import surcharge.
To save the system again 10 countries had an agreement called
Smithsonian : 1)38$ 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.
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January 1976 IMF members met in Jamaica and came
out Jamaica Agreement which is:
1.
2.
3.
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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.
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Exchange rates are now more volatile.
Current Exchange Rate Arrangements
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Free Float
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Managed Float
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Such as the U.S. dollar or euro (through franc or mark).
No national currency
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About 25 countries combine government intervention with
market forces to set exchange rates.
Pegged to another currency
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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.
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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
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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:
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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?
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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
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Two main instruments of the EMS are ECU/EURO and Exchange Rate Mechanism.
What are the Different Denominations
of the Euro Notes and Coins ?
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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?
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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
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Austria,
Belgium,
Cyprus,
Finland,
France,
Germany,
Greece,
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Ireland,
Italy,
Luxembourg,
Malta,
The Netherlands,
Portugal,
Slovenia,
Spain
Value of the Euro in U.S. Dollars
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End of the currencies
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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
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Reduced transaction costs and elimination of exchange
rate uncertainty.
 Reducing hedging costs
 Comparison shopping
 Price transparancy will lead to Europe-wide competition
 Enhenced efficiency and competitiveness of the
European economy.
 Improves the continental capital markets
One currency should promote political cooperation and
peace in Europe.
The Long-Term Impact of the Euro
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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
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The main cost of monetary union is the loss of
national monetary and exchange rate policy
independence.
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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:
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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
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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
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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
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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
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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
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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)
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This is the first cross border flight of portfolio
capital: International mutual funds investment before
crises were 54 billion dollar !!!
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In a system like this:
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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)
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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
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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
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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
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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
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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)
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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:
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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

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.
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2-51
The unemployment rate rose above 20 percent
The inflation rate reached a monthly rate of 20 percent
The Argentinean Peso Crisis

There are at least three factors that are related to
the collapse of the currency board arrangement
and the ensuing economic crisis:
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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
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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
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Which Exchange Rate Regime is better?
Arguments in favor of flexible exchange rates:
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Arguments against flexible exchange rates:
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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