caution! - wiwi.uni-siegen.de · 2. what is the international monetary system (ims)? what has been...

25/06/2011

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INTERNATIONAL BUSINESS

ENVIRONMENT

SESSION 6

Regulating International Exchange: the

International Monetary System

CAUTION!

25/06/2011 JG DITTER _ International Business Environment 2

SLIDES ARE NOT ENOUGH TO FULLY GRASP THE

COURSE CONTENTS

YOU ARE ADVISED TO:

Take notes and participate during the class

Read reference textbooks and other materials as

recommended

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The environment of international business (reminder)

INTERNATIONAL ENVIRONMENT

National trade

policies

Global economic regulation

Intl. monetary

system

Regional agreements

DOMESTIC / FOREIGN ENVIRONMENT

Culture

Political/legal systems

Economic system

Economic policies

FIRM

Structure Strategy Management


Today's questions

1. What are foreign exchange markets? What are their functions?

2. What is the International Monetary System (IMS)? What has been its evolution since the early XXth Century? What is its structure today?

What are the economic and business implications of fixed vs. flexible exchange rates? Of a monetary union like the Eurozone?

3. What is the role of the IMF in managing the IMS and fostering international exchange?

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AN INTRODUCTION TO THE INTERNATIONAL

MONETARY SYSTEM

Section 1


Preliminary definitions

The foreign exchange market (FOREX) is a market for converting the currency of one country into that of another country

The exchange rate is the rate at which one currency is converted into another

The international monetary system is made up of the institutional arrangements that countries adopt to govern exchange rates


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Exchange rates

Direct exchange rate

Direct quote

Price of the foreign currency in terms of home currency (e.g. USD/EUR)

Indirect exchange rate

Indirect quote

Price of the home currency in terms of the foreign currency (e.g. EUR/USD)


USD / EUR^

Quantity of EUR

Exchange rate determination (1)


Exchange rates are determined by the demand and supply for different

currencies

depending on

Inflation

Interest ratesMarket psychology

(bandwagon effect)

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Foreign exchange regimes (1)

Floating exchange rate: the demand for a country’s currency is a function of the demand for (1) its goods and services and (2) for financial assets denominated in its currency

Dirty/Managed float: a country tries to hold the value of its currency within some range of a reference currency ( free float)

Fixed exchange rate : countries fix their currencies against each other

The Central bank counteracts the demand and supply forces of the domestic currency, holding its value constant

Pegged exchange rate: a country fixes the value of its currency relative to a reference currency

Currency board: a country commits 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


Foreign exchange regimes (2)

Monetary unions (currency unions): two or more countries sharing a single currency monitored and controlled by one central bank

Lato sensu: different currencies having a fixed mutual exchange rate monitored and controlled by several central banks with closely coordinated monetary policies

Dollarization: use of a foreign currency in parallel to or instead of the domestic one (not only applied to usage of the USD)

Monetary dollarization: the use of foreign currency and deposits as money in parallel with national currency

Financial dollarization: the use of foreign currency for financial transactions

Real dollarization: the use of foreign currency for pricing wages, goods and services


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The foreign exchange policy

Under a "managed float" system, monetary authorities are able to control the exchange rate of the domestic currency in order to influence domestic economic conditions

Inflation

Economic growth

External trade

Various tools include

Increasing domestic interest rates will lead to foreign capital inflow and therefore to an increase of the demand for that currency (appreciation)

Selling domestic currency against another one will lead to its depreciation


The effects of currency variations


Higher price of imports Stimulus to exports

Decreased returns on investment Increased cost attractiveness

EXAMPLE:

CURRENCY DEPRECIATION

Inflationary pressure in the short-runImproved trade balance in the mid-run (J-curve, under

Marshall-Lerner Condition)

Portfolio investment outflowsPossible foreign direct investment inflow

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Foreign exchange risk


This risk usually affects businesses that export and/or import, but it can also affect investors

making international investments.

If money must be converted to another currency to make a certain investment, then any changes in

the currency exchange rate will cause that investment's value to either decrease or increase when the investment is sold and converted back

into the original currency.

http://www.investopedia.com/terms/f/foreignexchangerisk.asp

Floating exchange rates and business management

International Monetary System

Business strategyExchange movements can have a major impact on the competitive position of

businesses

Corporate-government relationsBusinesses can influence government

policy towards the international monetary system

Currency managementSpeculative buying and selling of

currencies can create volatile movements in exchange rates




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History of the IMS: key periods


Late XIXth Century – 1914

Gold Standard: currencies are pegged to / convertible into gold

Inter-war period

Various systems changing over time

1944-1976

Bretton Woods / Gold exchange standard: All currencies are fixed to gold, only the U.S. dollar is directly convertible to gold

1976 - ...

Washington Consensus: floating exchange rates, currencies are not convertible to gold

The Gold Standard

Pegging currencies to gold and guaranteeing convertibility

Dates back to ancient times when gold coins were a medium of exchange, unit of account, and store of value

→Payment for imports was first made in gold or silver

→Later, as trade grew, payment was made in paper currency which was linked to gold at a fixed rate

Worked from the 1870s until the 1st World War


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The end of the Gold Standard

During the 1st World War, many governments financed their war expenditures by printing money, thus generating

inflation

People lost confidence and demanded gold for their currency, putting pressure on countries' gold reserves,

and forcing them to suspend gold convertibility

By 1939, the gold standard had come to an end


The inter-war period

No stable International Monetary System

Gold standard readopted in 1920s in US, UK, France,

Switzerland

Dropped during Great Depression

Hyperinflationary finance in Germany, Austria, Hungary,

Poland


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The Bretton Woods system

A fixed exchange rate system

All currencies are fixed to gold, but only the U.S. dollar is directly convertible to gold (35 USD/ounce)

Devaluations could not to be used for competitive purposes

A country cannot devalue its currency by more than 10% without IMF approval

Two multinational institutions

The International Monetary Fund (IMF): maintain order in the international monetary system

The World Bank: promote general economic development


The case for fixed exchange rates (1)

Supporters of fixed exchange rates focus on monetary discipline, uncertainty, and the lack of connection between the trade balance and exchange rates (see Mundell's incompatibility triangle)

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

Fixed exchange rates prevent "beggar-thy-neighbour" competitive devaluation policies aimed to generate a trade surplus

From a business standpoint, fixed exchange rates mean a reduction of obstacles to trade and capital flows


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The case for fixed exchange rates (2)(Mundell's incompatibility triangle)

Free movement of capital

Fixed exchange rates

Autonomous monetary

policy


The collapse of the Bretton Woods system

Bretton Woods worked well until the late 1960s

Huge increases in welfare programs and the Vietnam War were financed by increasing the money supply and causing significant inflation

Other countries increased the value of their currencies relative to the dollar, in response to speculation the dollar would be devalued

Because the system relied on an economically well managed U.S., the system was strained to the breaking point


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The end of Bretton Woods: Jamaica Agreements

IMF Jamaica meeting (1976)

Fixed exchange rate system is abandoned

IMF is in charge of overseeing global financial system

Total annual IMF quotas increased to

$41 billionPar values

against gold and USD are

abandoned


The IMS today: foreign exchange regimes in 2007


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The case for floating exchange rates

1. Monetary policy autonomy (see incompatibility triangle)

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

2. Automatic trade balance adjustments

Floating rates help adjust trade imbalances

→ Under the Bretton Woods system, a country's permanent trade deficit could not be corrected by domestic policy; the IMF would have to agree to a currency devaluation

3. From a business standpoint, floating exchange rates generate uncertainty and risks (exchange risks) as well as opportunities (competitiveness, attractiveness)


The case for monetary unions


A monetary (or currency) union is considered necessary when floating exchange rates could impede regional trade and the ability

to create an integrated economy (e.g. Eurozone)

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The case of the European Monetary Union




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Malta and Cyprus joined on

January 1, 2008

The euro is the official currency

in Kosovo and Montenegro

Slovenia joined on January 1,

2007

Slovakia joined on January 1,

2009

Estonia joined on January 1,

2011

The Eurozone today: an unstable setting


The eurozone remains a hybrid. It is a monetary union but not a political union, and so countries such as

Ireland have had to go it alone in bailing out struggling banks. There is a clear distinction between the US,

where the government has financial clout across all 50 states, and the EU.

In the long term, monetary unions do not survive without political union, and so […] there are pressures both for closer integration and for disintegration. The

crisis could strengthen those who argue that the halfway house is inherently unstable and will remain so

until there is fiscal as well as monetary union. On the other hand, the growing threat of recession may make

some countries question the value of remaining in a monetary union.

http://www.guardian.co.uk/business/2008/oct/06/creditcrunch.eu

http://www.guardian.co.uk/business/2008/oct/06/creditcrunch.eu

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Other cases of monetary unions


West AfricanEconomic and Monetary Union

Benin, Burkina Faso, Cote d'Ivoire, Guinea-Bissau, Mali, Niger, Senegal, and Togo

CFA franc (XOF)(fixed to EUR)

1 EUR =655.957 CFA francs

Central AfricanEconomic and Monetary Community

Cameroon, Central African Republic, Chad, Republic of the Congo, Equatorial Guinea, Gabon

CFA franc (XAF)(fixed to EUR)

1 EUR =655.957 CFA francs

Eastern CaribbeanCurrency Union

Antigua and Barbuda, Dominica, Grenada, St. Kitts and Nevis, St. Lucia, and St. Vincent and the Grenadines, Anguilla and Montserrat

Eastern Caribbean dollar (XCD)(pegged to USD)

1 USD = 2.7 EC$

REGULATING THE INTERNATIONAL MONETARY

SYSTEM: THE INTERNATIONAL MONETARY FUND

Section 2


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Introduction example: Belarus


Belarus said it had asked the International Monetary Fund for an emergency loan of up to $US8 billion, hoping to stave off a financial crisis in the ex-Soviet

republic. The government announcement came a day after it froze prices on a number of basic foodstuffs until July 1 and a week after a 36% devaluation of

the rouble failed to persuade banks and Belarussians to resume trading at official rates. It signals the growing economic pressure on President Alexander

Lukashenko, who spent heavily ahead of elections last year and promised to raise wages sharply while rejecting the need for Western help.

The IMF issued $US3.5 billion in loans to Belarus from 2009 to 2010 and has sent a mission to assess the situation in the country of almost 10 million

people, long shielded by the government's Soviet-style economic policies. "In my view the IMF will respond positively," said analyst Ivan Tchakarov. "At the

end of the day they have to agree on the conditions and the conditions will be very strict, very stringent, but they will be purely macroeconomic conditions

and will not relate to political issues or sanctions."

Conditions could include the liberalising of the exchange rate. Even after the central bank move last week, the black market quotes the rouble at about

6,000 per dollar, much weaker than the official rate of 4,970 per dollar.

Business Spectator, 1 Jun 2011

The International Monetary Fund (IMF)


Means: combination of discipline and flexibility

Impose monetary discipline on countries, thereby curtailing price inflation

Put a brake on competitive devaluations and bring stability to the world trade environment

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

UN agency created in July 1944, based in Washington (US)

Objectives:

Avoid a repetition of the chaos that occurred between the wars

Assist the reconstruction of the world's international payment system

Stabilize exchange rates

… promote international exchange

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The IMF after Bretton Woods

Since many of the original reasons for the IMF no longer existed, the organization had

to redefine its mission

Critics claim that IMF policies in these countries have

actually made the situation worse

Now focuses on lending money to countries

experiencing financial crises, using IMF deposits (Special

Drawing Rights)


The IMF today

187 members in 2010

Objectives: foster global monetary cooperation, secure financial stability, facilitate international trade, promote high employment and sustainable economic growth, reduce poverty

Means

Surveillance: follow up of members' macroeconomic policies, in particular those with an impact on exchange rates and the balance of payments

Conditional loans to countries that experience serious financial and economic difficulties, using IMF deposits (Special Drawing Rights)

http://www.imf.org/external/np/exr/facts/glance.htm


http://www.imf.org/external/np/exr/facts/glance.htm

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The organisation of the IMF (http://www.imf.org/external/about/govstruct.htm)


The quota system


Upon joining, each member of the IMF is assigned a quota, based broadly on

its relative size in the world economy

http://www.imf.org/external/about/govstruct.htm

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Special Drawing Rights

USD44%

EUR34%

JPY11%

GBP11%


The Special Drawing Right (SDR) is an international reserve asset based on a basket of currencies. It was created by the IMF in 1969 to supplement the

existing official reserves of member countries.

http://www.imf.org/external/about/sdr.htm

IMF loans

Concessional loans to low-income countries (LICs)

Extended Credit Facility (ECF): main tool for providing medium-term support to LICs with protracted balance of payments problems

Standby Credit Facility (SCF): financial assistance to LICs with short-term balance of payments needs

Rapid Credit Facility (RCF): rapid financial assistance (limited conditionality) to LICs facing an urgent balance of payments need

Non concessional loans

Stand-By Arrangements (SBA): designed to help countries address short-term balance of payments problems

Flexible Credit Line (FCL): for countries with very strong fundamentals, policies, and track records of policy implementation, crisis prevention purposes

Extended Fund Facility: established in 1974 to help countries address longer-term balance of payments problems requiring fundamental economic reforms

(http://www.imf.org/external/np/exr/facts/howlend.htm)25/06/2011 JG DITTER _ International Business Environment 40

http://www.imf.org/external/about/sdr.htm

http://www.imf.org/external/np/exr/facts/howlend.htm

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The IMF in action ...

http://www.imf.org/external/mmedia/view.asp?eventID=226

What are the problems faced by the fictitious economy described in

this movie? What does the IMF do to help solve these problems?

According to you, why are IMF "therapies" often criticised? What are their possible shortcomings?

What are the implications of IMF action from an business standpoint?


Structural adjustment programmes (SAPs)

IMF loans

Conditionality: reduce domestic fiscal imbalances

Tax increasePrice

liberalisationMarket

deregulationTrade

liberalisation

Privatisation of state owned

companies

Pressure on domestic demandExport-led growth




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SAPs vs. the Washington Consensus

1. Fiscal policy discipline

2. Redirection of public spending toward education, health and infrastructure investment

3. Tax reform – Flattening the tax curve

4. Interest rates that are market determined and positive (but moderate) in real terms

5. Competitive exchange rates

6. Trade liberalization –replacement of quantitative restrictions with low and uniform tariffs

7. Openness to foreign direct investment

8. Privatization of state enterprises;

9. Deregulation – abolition of regulations that impede market entry or restrict competition, except for those justified on safety, environmental and consumer protection grounds, and prudent oversight of financial institutions

10. Legal security for property rights


The IMF in question

Support to military dictatorship(1970-80s)

Economic and social hardship caused by

structural adjustment programmes

Moral hazard exacerbation

An institution dominated by

developed economies and the "big business"?

Government in need of capital would turn down conditional IMF loans, crowding-out the institution's resources


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"The IMF is hurting the poor ..."

Turkey and Latvia were in the news last week, having joined the roster of governments whose IMF disbursements are being withheld because they find it politically impossible to impose the required punishments on their citizens. The IMF sees these measures as necessary and pre-determined – in most cases by the borrowing countries' having run-

up unsustainable external or budget imbalances. But in fact the IMF has a long track record – dating back decades – of imposing unnecessary and often harmful conditions

on borrowing countries.

Latvia missed a 200 million euro disbursement from the IMF in March for not cutting its budget enough. According to press reports, the government wants to run a budget

deficit of 7% of GDP for this year, and the IMF wants 5%. Latvia is already cutting its budget by 40%, and is planning to close some public hospitals and schools in order to

make the IMF's targets, prompting street protests.

In almost all of its standby arrangements negotiated over the last year, the IMF has included conditions that will reduce output and employment in situations where

economies are already shrinking.

http://www.guardian.co.uk/commentisfree/cifamerica/2009/may/13/imf-us-congress-aid


The global crisis: a new authority for the IMF?

→ Supporting global fiscal stimulus

→ Lender of last resort: more than USD 280 Bn lent to countries hit by the crisis—including Greece, Ireland, Portugal, Romania, and Ukraine—and extended credit to Mexico, Poland, and Colombia.

→ Helping low-income countries fight the crisis

→ Reinforcing multilateralism

→ Reforming the international financial system

→ Rethinking macroeconomic principles

http://www.imf.org/external/about/onagenda.htm









http://www.imf.org/external/about/onagenda.htm

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A limited influence?


Many prominent academic economists see a basic contradiction in the global system of oversight on trade and currency. “Many of us would like to see the

WTO-style commitments — with people’s feet being held to the fire — at other international agencies, like the IMF,” said Jagdish Bhagwati, a Columbia

University economist. […]

World leaders set up two institutions after World War II, now known as the WTO and the IMF, to reduce the risk of another Great Depression. Unlike its

predecessor, which had weak arbitration panels whose rulings could be easily blocked by the losing country, the trade organization has had powerful tribunals

since 1995. These tribunals can clear the way for the imposition of sanctions running into the billions of dollars. […]

The monetary fund has not acquired similar powers to the trade organization. IMF policies call for it to disclose documents and information on a timely basis,

with the deletion only of market-moving information. But under the rules a member country may decide to withhold a report […]

New York Times, March 14, 2010

THE INTERNATIONAL MONETARY SYSTEM'S

DEFICIENCIES

Section 3


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Since 1973, a series of crises

Banking crises refer 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

Currency crises 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

Foreign debt crises are situations in which a country cannot service its foreign debt obligations, whether private sector or government debt


Since 1973, a series of crises (ctd)

Latin American debt crisis (1980s)

Black Monday (October 19, 1987): global stock market crash

Japanese real estate bubble collapse (1990s)

EMS currency crises (1992-93)

Mexican currency crisis (1994)

Southeast Asian financial crisis (1997)

Russian debt crisis (1998), leading to the collapse of LTCM

Turkish financial crisis (2001)

Dotcom bubble burst (2001)

Argentine currency crisis (2002)

"Subprime" crisis ... leading to global financial crisis (2007-2009)

European foreign debt crisis (2008 - ...)


http://en.wikipedia.org/wiki/File:Nizhny-Novgorod-Inkombank-1465.jpg

http://stockbreakthroughs.com/wp-content/uploads/2009/01/istock-global-exchange.jpg

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Undervalued yuan

Weakening US Dollar

Pressure on Brazilian real, Turkishlira, etc.

Strong euro

Current issues: currency and BoP imbalances


Currency wars?

China has been criticised by the EU and, especially, by the US for keeping its currency at an artificially low level, meaning that its exports are cheaper

worldwide and hindering export-led recovery from recession in the developed world. But Wen Jiabao […] predicted social unrest in China if there was a rapid

rise in the yuan. "Many of our exporting companies would have to close down," Wen said. "Migrant workers would have to return to their villages. If China saw

social and economic turbulence, then it would be a disaster for the world."

His remarks come amid fears of a "currency war" between western nations and the developing world and as the head of the International Monetary Fund

waded into the row, warning governments against using exchange rates as a weapon. Dominique Strauss-Kahn told the Financial Times: "There is clearly the idea beginning to circulate that currencies can be used as a policy weapon." He added: "Translated into action, such an idea would represent a very serious risk

to the global recovery… Any such approach would have a negative and very damaging longer-run impact."

http://www.guardian.co.uk/business/2010/oct/06/currency-war-warning-imf-chief











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The euro and the European debt crisis

Single currencySingle monetary policy

(low) interest rates at Eurozone level

Large amounts of cheap money available

Real estate bubble, private debt(Ireland, Spain)

Unrestrained public spending, public debt

(Greece, Portugal)

The euro and the European debt crisis


During the years of easy money, wages and prices in the crisis countries rose much faster than in the rest of Europe. Now that the money is no

longer rolling in, those countries need to get costs back in line.

But that’s a much harder thing to do now than it was when each European nation had its own currency. Back then, costs could be

brought in line by adjusting exchange rates — e.g., Greece could cut its wages relative to German wages simply by reducing the value of the

drachma in terms of Deutsche marks.

Now that Greece and Germany share the same currency, however, the only way to reduce Greek relative costs is through some combination of German inflation and Greek deflation. And since Germany won’t accept

inflation, deflation it is.

The problem is that deflation — falling wages and prices — is always and everywhere a deeply painful process. It invariably involves a

prolonged slump with high unemployment. And it also aggravates debt problems, both public and private, because incomes fall while the debt

burden doesn’t.

By PAUL KRUGMAN, New York Times, April 30, 2010

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A "euro trap"?

Debt / competitiveness crisis

Austerity and competitive deflation

Depressive impactSide effects on trade partners

DevaluationQuit eurozone

Inflation, higher interest ratesRun on banks

Costs of introducing new currency

Debt restructuring

Lost assets for European banks

The irish example

New York Times, June 28, 2010

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A two-layer Europeh

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A need for a better regulation …

Adjustment mechanism for dealing

with global imbalances.

Regulation of international capital

flows

Nature and role of reserve currency


http://www.economist.com/blogs/dailychart/2011/05/europes_economies

http://www.economist.com/blogs/dailychart/2011/05/europes_economies

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An emerging forum: the G-20 (http://www.g20.org/index.aspx)

The Group of 20, or G-20, is an international body that meets to discuss economic issues. It is a forum for cooperation and consultation on matters pertaining to the international financial system

It gathers finance ministers and central bank governors from 19 of the world's largest national economies, plus the European Union

Its members represent about 90 percent of the world's gross national product, 80 percent of world trade (including trade within the European Union) and two-thirds of the global population


http://www.g20.org/index.aspx

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