Fourth Edition

1. International Business Fourth Edition

2. CHAPTER 10 The International Monetary System

3. Chapter Focus • Explain how the international monetary system works. • Review the system’sevolution. • The gold standard. • Bretton Woods - 1944. • Reasons for the Bretton Woods failure. • The present system. • Float versus fixed. • Implications for business.

4. The International Monetary System • The institutional arrangements that countries adopt to govern exchange rates. • Dollar, Euro, Yen and Pound “float” against each other. • Floating exchange rate: • Foreign exchange market determines the relative value of a currency. • Some countries use other institutional arrangements to fixtheir currency’s value.

5. Some countries use: • Pegged exchange rate. • Value of currency is fixed relative to a reference currency. • Dirty float. • Hold currency value within some range of a reference currency. • Fixed exchange rate. • Set of currencies are fixed against each other at some mutually agreed upon exchange rate. Require some degree of government intervention.

6. Pegging currencies to gold and guaranteeing convertibility. Roots in mercantile trade. Inconvenient to ship gold, changed to paper - redeemed for gold. Seeking a “balance of trade” equilibrium. The Gold Standard

7. Decreased money supply = price decline. Trade Surplus As prices decline, exports increase and trade goes into equilibrium. Increased money supply = price inflation. Gold Balance of Trade Equilibrium

8. Period Between the Wars: 1918-1939 • Countries abandoned gold standard at start of WWI. • Costs of war led countries to print money resulting in inflation. • U.S. (‘19), Great Britain (‘25), & France(‘28) returned to gold standard at end of war. • Britain used old rate and priced exports out of the market. • U.S. did same. Then changed gold/$ ratio devaluing the dollar to increase exports. • Other countries did same. No faith in currencies. • Run on countries gold reserves. • 1939 - End of gold standard.

9. Bretton Woods • 1944: • 44 countries meet in New Hampshire. • Fixed exchange rates deemed desirable. • Agree to peg currencies to US dollar that is convertible to gold at $35/oz. • Promise not to devalue currency for trade purposes and will defend currencies. • Created: • World Bank • International Monetary Fund.

10. Bretton Woods

11. The Role of the IMF • Want to avoid problems following WWI. • Discipline: • Fixed rate imposes discipline: • Need to maintain rate stops competitive devaluations. • Imposes monetary discipline, curtailing inflation. • Flexibility: • Lending facility: • Lend foreign currencies to countries having balance-of-payments problems. • Adjustable parities: • Allow countries to devalue currencies more than 10% if B of P was in “fundamental disequilibrium’.

12. IBRD raises money in bond market and lends at ‘market rate’. International Development Agency raises money through subscriptions and lends to very poor countries. The Role of the World Bank • International Bank for Reconstruction and Development (IBRD). • Rebuild Europe’s war-torn economies. • Overshadowed by the Marshall Plan. • Turns to ‘development’. • Lending money to Third World nations. • Agriculture. • Education. • Population control. • Urban development.

13. Largest Contributors

14. Collapse of the Fixed Exchange Rate System • Collapsed in 1973. • Pressure to devalue dollar led to collapse. • President Johnson financed both the Great Society and Vietnam by printing money. • High inflation. • High spending on imports. • President Nixon took dollar off gold standard and kept 10% import tax. • Countries agreed to revalue their currencies against the dollar. • Bretton Woods fails when key currency (dollar) is under speculative attack. • Now have amanaged-floatsystem.

15. The Floating Exchange Rate Regime • Jamaica Agreement - 1967 • Floating rates acceptable. • Gold abandoned as reserve asset. • IMF quotas increased. • IMF continues role of helping countries cope with macroeconomic and exchange rate problems.

16. Exchange Rates Since 1973 • More volatile: • Oil crisis -1971. • Loss of confidence in the dollar - 1977-78. • Oil crisis - 1979. • Unexpected rise in the dollar - 1980-85. • Rapid fall of the dollar - 1985-87 and 1993-95. • Partial collapse of European Monetary System - 1992. • Asian currency crisis - 1997.

17. US Dollar Movements

18. Floating: Monetary policy autonomy. Restores control to government. Trade balance adjustments. Adjust currency to correct trade imbalances. Fixed: Monetary discipline. Speculation. Limits speculators. Uncertainty. Predictable rate movements. Trade balance adjustments. Argue no linkage between exchange rates and trade. Linkage between savings and investment. Fixed versus Floating Exchange Rates Which system is better? Evidence is unclear.

19. IMF Members’ Exchange Rate Policies, 2000 Figure 10.2

20. Target Zones: The European Monetary System in Retrospect • An exchange rate system based on target zones involving a group of countries trying to keep their currencies within a predetermined ‘zone’, of other currencies in the group. • Created in 1979: • Create stability by reducing volatility and inflation. • Control inflation by imposing monetary discipline. • Coordinate exchange rates between EU and non-EU currencies such as the dollar and yen. • Created the European currency unit (Ecu) and the exchange rate mechanism (ERM) to achieve objectives.

21. Ecu was a basket of EU currencies. One Ecu = defined % of national currencies. Each national currency given rate versus the Ecu. Mandatory intervention into FX market when currency fluctuates. Defend against speculation. System performance: 1992: pound and lira hit by speculation. Britain and Italy withdraw from EMS. Changed EMS: Fluctuation bands increased to 15%. Intervention no longer required. Performance good. Euro introduced. The Ecu and the ERM

22. Crisis Management by the IMF • Role has expanded to meet crisis. • Currency crisis. • Banking crisis. • Foreign debt crisis.

23. Incidence of Currency Crises1975-1997 Number of Currency Crises per Country Figure 10.3a

24. Incidence of Banking Crises 1975-1997 Number of Banking Crises per Country

25. Mexican Currency Crises of 1995 • Peso pegged to U.S. dollar. • Mexican producer prices rise by 45% without corresponding exchange rate adjustment. • Investments continued ($64B between 1990 -1994. • Speculators began selling pesos and government lacked foreign currency reserves to defend it. • IMF stepped in.

26. Peso Movements 94 95

27. Russian Ruble Crisis • Persistent decline in value of ruble: • High inflation. • Artificial low prices in Communist era. • Shortage of goods. • Liberalized price controls. • Too many rubles chasing too few goods. • Growing public-sector debt. • Refusal to raise taxes to pay for government services.

28. Government ActionsExacerbating the Situation • Defacto devaluation of the ruble. • Unilateral restructuring of ruble-denominated public debt. • 90-day moratorium on foreign credits repayment. • Hike in interest rates to defend ruble. • Duma rejects measures designed to alleviate problems.

29. Decline of the Ruble Rubles/dollar

30. Asian Crisis • 1997: • Investment boom. • Excess capacity. • Debt. • Expanding imports.

31. Impact of the Asian Financial Crisis on US Imports

32. Devalued Currency 1997 1998

33. Evaluating the IMF’s Policy Prescriptions • Inappropriate policies: • “One size fits all’. • Moral hazard: • People behave recklessly when they know they will be saved if things go wrong. • Foreign lending banks could fail. • Foreign lending banks have paid price for rash lending. • Lack of Accountability. • IMF has grown too powerful. Unclear as to the appropriateness of IMF actions.

34. Implications for Business • Currency management. • Business strategy. • Forward exchange market (months not years ahead). • Strategic flexibility. • Corporate-government relations.