Chapter 3 The International Monetary System

Multinational Business Finance

History of the International Monetary System• The Gold Standard (1876 – 1913) • Gold has been a medium of exchange since 3000

BC• each country set the rate at which its currency

unit could be converted to a weight of gold. (1ounce=28,35gram)

• e.g. $20,67=1 ounce of gold, 4,2474£=1 ounce of gold

• Expansionary monetary policy was limited to a government’s gold reserve.

• the outbreak of WWI stopped the free movement of gold, this has caused the suspension of the operation of the Gold Standard

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History of the International Monetary System The Inter-War Years & WWII (1914-1944)

During this period, currencies were allowed to fluctuate over a fairly wide range in terms of gold

Increasing fluctuations in currency values, as speculators sold short weak currencies

The US adopted a modified gold standard in 1934

the US dollar was the only major trading currency that continued to be convertible to gold.

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History of the International Monetary SystemBretton Woods and the International

Monetary Fund (IMF) (1944) As WWII drew to a close, the Allied

Powers met at Bretton Woods, New Hampshire to create a post-war international monetary system

The Bretton Woods Agreement established a US dollar based international monetary system and created two new institutions the International Monetary Fund (IMF) and the World Bank

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History of the International Monetary System

The International Monetary Fund is a key institution in the new international monetary system and was created to:▪ Help countries defend their currencies against cyclical,

seasonal, or random occurrences ▪ Assist countries having structural trade problems if

they promise to take adequate steps to correct these problems

The International Bank for Reconstruction and Development (World Bank) helped fund post-war reconstruction and has since then supported general economic development

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History of the International Monetary SystemEurocurrencies

domestic currencies of one country deposited in another country.

(e.g. Eurodollar market. Euro- means foreign here)

U.S.-dollar denominated deposits at foreign banks or foreign branches of American banks. By locating outside of the United States

Eurodollars escape regulation by the Federal Reserve Board. 3-6

Eurocurrency Interest Rates: Libor In the Eurocurrency market, the

reference rate of interest is the London Interbank Offered Rate (LIBOR)

This rate is the most widely accepted rate of interest used in standardized quotations, loan agreements, and financial derivatives transactions

There are Pibor, Mibor, Fibor, Stibor (Stockholm Interbank Offered Rate)

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History of the International Monetary System

History of the International Monetary System Fixed Exchange Rates (1945-1973)

The currency arrangement negotiated at Bretton Woods and monitored by the IMF worked fairly well during the post-WWII era of reconstruction and growth in world trade

The US dollar became the main reserve currency held by central banks

Eventually, the heavy overhang of dollars held by foreigners resulted in a lack of confidence in the ability of the US to met its commitment to convert dollars to gold

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History of the International Monetary System

The lack of confidence forced President Richard Nixon to suspend official purchases or sales of gold by the US Treasury on August 15, 1971

This resulted in subsequent devaluations of the dollar

Most currencies were allowed to float to levels determined by market forces as of March, 1973

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History of the International Monetary SystemAn Eclectic Currency Arrangement

(1973 – Present) Since March 1973, exchange rates have

become much more volatile and less predictable than they were during the “fixed” period

There have been numerous, significant world currency events over the past 30 years

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Exhibit 3.2 the U.S. Dollar Nominal Exchange Rate Index and Significant Events 1957-2008

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The IMF’s Exchange Rate Regime Classifications The International Monetary Fund classifies

all exchange rate regimes into eight specific categories Exchange arrangements with no separate legal

tender Currency board Other conventional fixed peg Pegged exchange rates within horizontal bands Crawling pegs Exchange rates within crawling pegs Managed floating Independent floating

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Fixed Versus Flexible Exchange Rates A nation’s choice of currency regime to

follow depends on many variables: inflation, unemployment, interest rate levels, trade balances, and economic growth.

The choice between fixed and flexible rates may change over time as priorities change.

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Fixed Versus Flexible Exchange Rates Fixed rate regime has advantages

and disadvantages: stability in international prices inherent anti-inflationary nature of fixed

prices but:

Need for central banks to maintain large quantities of hard currencies and gold to defend the fixed rate

Fixed rates can become inconsistent with economic fundamentals as time goes.

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Attributes of the “Ideal” CurrencyPossesses three attributes, often

referred to as the Impossible Trinity: Exchange rate stability: fixed

exchange rate Full financial integration: free capital

movement Monetary independence: independent

interest rate policy, monetary policy, etcNot possible to have all three

simultaneous.3-15

Exhibit 3.4 The Impossible Trinity

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Emerging Markets and Regime Choices Currency board regime when a country’s central bank commits to back its

monetary base – its money supply – entirely with foreign reserves at all times. 1 Argentina Peso/ USD

This means that a unit of domestic currency cannot be introduced into the economy without an additional unit of foreign exchange reserves being obtained first. Argentina moved from a managed exchange rate to

a currency board in 1991 In 2002, the country ended the currency board as a

result of substantial economic and political turmoil3-17

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Exhibit 3.6 The Currency Regime Choices for Emerging Markets

Emerging Markets and Regime ChoicesDollarization is the use of the US

dollar as the official currency of the country. Panama has used the dollar as its official

currency since 1907 Ecuador replaced its domestic currency

with the US dollar in September, 2000

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The Euro: Birth of a European Currency In December 1991, the members of

the European Union met at Maastricht, the Netherlands to finalize a treaty that changed Europe’s currency future.

This treaty set out a timetable and a plan to replace all individual ECU currencies with a single currency called the euro.

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The Euro: Birth of a European Currency To prepare for the EMU, a

convergence criteria was laid out whereby each member country was responsible for managing the following to a specific level: Nominal inflation rates Long-term interest rates Fiscal deficits Government debt

In addition, European Central Bank (ECB), was established in Frankfurt, Germany.

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Effects of the Euro

The euro affects markets in three ways: Cheaper transactions costs in the

Euro Zone Currency risks and costs related to

uncertainty are reduced price transparency and increased

price-based competition 3-22

Achieving Monetary Unification If the euro is to be successful, it

must have a solid economic foundation.

The primary driver of a currency’s value is its ability to maintain its purchasing power.

So, The single largest threat to maintaining purchasing power is inflation.

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Exhibit 3.8 The Trade-offs between Exchange Rate Regimes

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Mini-Case Questions: The Revaluation of the Chinese Yuan

1. Many Chinese critics had urged China to revalue the yuan by 20% or more. What would the Chinese yuan’s value be in US dollars if it had indeed been devalued by 20%?

2. Do you believe that the revaluation of the Chinese yean was politically or economically motivated?

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Mini-Case Questions: The Revaluation of the Chinese Yuan (cont’d)

3. If the Chinese yuan were to change by the maximum allowed per day, 0.3% against the US dollar, consistently over a 30 or 60 day period, what extreme values might it reach?

4. Chinese multinationals would now be facing the same exchange rate-related risks borne by US, Japanese, and European multinationals. What impact do you believe this rising risk will have on the strategy and operations of Chinese companies in the near-future?

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Exhibit 3.3 World Currency Events, 1971–2008

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Exhibit 3.3 World Currency Events, 1971–2008 (cont.)

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Exhibit 3.5 The Ecuadorian Sucre Exchange Rate, November 1998–March 2000

Exhibit 3.1 U.S. Dollar-Denominated Interest Rates, June 2005

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Exhibit 3.7 The U.S. Dollar/Euro Spot Exchange Rate, 1999–2008 (Monthly Average)

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Exhibit 1 Monthly Average Exchange Rates: Chinese Renminbi per U.S. Dollar