Download - Ch8 Parity Conditions in International Finance and Currency Forecasting

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CHAPTER 8

PARITY CONDITIONS IN INTERNATIONAL FINANCEAND CURRENCY FORECASTING

This chapter emphasizes that currency prices are determined in the same way that other asset prices are, by theinteraction of supply and demand curves. The key concept here is the relationship between inflation and exchange ratechanges --the internal devaluation of a currency (inflation) eventually leads to its external devaluation.

KEY POINTS

1. Inflation is the logical outcome of an expansion of the money supply in excess of real output growth. As the supplyof one commodity increases relative to supplies of all other commodities, the price of the first commodity mustdecline relative to the prices of other commodities. In other words, its value in exchange or exchange rate mustdecline. Similarly, as the supply of money increases relative to the supply of goods and services, the price of moneyin terms of goods and services must decline, i.e., the exchange rate between money and goods declines.

2. The international parallel to inflation is domestic currency depreciation relative to foreign currencies. In order tomaintain the same exchange rate between money and goods both domestically and abroad, the foreign exchangerate must decline by (approximately) the difference between the domestic and foreign rates of inflation. This ispurchasing power parity, which is itself based on the law of one price.

3. Although the nominal or actual money exchange rate may fluctuate all over the place, we would normally expectthe real or inflation-adjusted exchange rate to remain relatively constant over time. The same is true for nominalversus real rates of interest. However, although the prediction that real interest and exchange rates will remainconstant over time is a reasonable one ex ante, ex post we find that these real rates wander all over the place. Aswe will see in Chapter 11, a changing real exchange rate is the most important source of exchange risk forcompanies.

4. Four additional equilibrium economic relationships tend to hold in international financial markets: purchasing powerparity, the Fisher effect, international Fisher effect, interest rate parity, and the forward rate as an unbiased estimateof the future spot rate.

5. These equilibrium relationships are at the heart of a working knowledge of international financial management. Ipoint out to the students that they will be seeing them in many different guises--from the analysis of a firm's foreignexchange exposure to currency forecasting to the decision as to which currency to borrow or lend in.

The final section makes six key points about exchange rate forecasting:

1. The foreign exchange market is no different from any other financial market in its susceptibility to being profitablypredicted.

2. It is difficult to outperform the market's own forecasts of future exchange rates as embedded in interest and forwarddifferentials. However, while interest rates and forward rates provide unbiased forecasts of future exchange rates,these forecasts are highly inaccurate.

3. Those who have inside information about events that will affect the value of a currency or of a security shouldbenefit handsomely.

CHAPTER 8: PARITY CONDITIONS IN INTERNATIONAL FINANCE/CURRENCY FORECASTING 89

4. Those without such access will have to trust either to luck or to the existence of a market imperfection, such asgovernment intervention, to earn above average risk- adjusted profits.

5. Given the widespread availability of information and the many knowledgeable participants in the foreign exchangemarket, only the latter situation--government manipulation of exchange rates--holds the promise of superior returnsfrom currency forecasting. This is because when governments, for political purposes, spend money to controlexchange rates, that money flows into the hands of those who bet against the government. The trick is to predictgovernment actions.

6. The black-market rate is a good indicator of where the official rate is likely to go if the monetary authorities givein to market pressure. However, although the official rate can be expected to move toward the black-market rate,we should not expect to see it coincide with that rate because of the bias induced by government sanctions. Theblack-market rate seems to be most accurate in forecasting the official rate one month hence, and is progressivelyless accurate as a forecaster of the future official rate for longer time periods.

I usually bring in several currency column clippings from the Wall Street Journal to point out the effect of changinginflationary expectations or interest rates on foreign exchange rates.

The case "Oil Levies: The Economic Implications" is a useful exercise that illustrates the difference betweenoperating in a segmented national economy and operating in a world economy, while simultaneously demonstratingthe implications of the law of one price. It can be found immediately following this chapter.

The case "President Carter Lectures the Foreign Exchange Markets" helps students understand some of the policyimplications of the key parity conditions, particularly the relation between inflation, interest rates, and exchangerates. It also points out the trust factor that underlies the value of a currency. This case immediately follows the case"Oil Levies."

The cases “Indonesia's Currency Board Proposal” and “Brazil Defends the Real” help students understand thepolitical economy of currency changes by examining the intersection of politics and economics in currency values.

SUGGESTED ANSWERS TO CHAPTER 8 QUESTIONS

1. What are some reasons for deviations from purchasing power parity?

ANSWER. PPP might not hold because:

• The price indices used to measure PPP may use different weights or different goods and services.

• Arbitrage may be too costly, because of tariffs and other trade barriers and high transportation costs, or too risky,because prices could change during the time that an item is in transit between countries.

• Since some goods and services used in the indices are not traded, there could be price discrepancies betweencountries.

• Relative price changes could lead to exchange rate changes even in the absence of an inflation differential.

• Government intervention could lead to a disequilibrium exchange rate.

2. Under what circumstances can purchasing power parity be applied?

90 INSTRUCTORS MANUAL: FOUNDATIONS OF MULTINATIONAL FINANCIAL MANAGEMENT, 4TH ED.

ANSWER. The relative version of purchasing power parity holds up best in two circumstances: (a) over long periodsof time among countries with a moderate inflation differential since the general trend in the price level ratio will tendto dominate the effects of relative price changes, and (b) in the short run during periods of hyperinflation since withhigh inflation changes in the general level of prices quickly swamp the effects of relative price changes.

3. One proposal to stabilize the international monetary system involves setting exchange rates at their purchasingpower parity rates. Once exchange rates are correctly aligned (according to PPP), each nation would adjust itsmonetary policy so as to maintain them. What problems might arise from using the PPP rate as a guide to theequilibrium exchange rate?

ANSWER. The proposal to adjust monetary policy so as to maintain purchasing power parity assumes that the PPPrate is the equilibrium rate. This assumption ignores the many shortcomings of PPP as a theory of exchange ratedetermination. Deviations from PPP have prevailed throughout the history of floating rate regimes. Thus there is goodreason to believe that PPP provides a poor proxy for the equilibrium exchange rate at any point in time. If the PPPbenchmark is used as a proxy for the equilibrium exchange rate when there are equilibrium departures from PPP, thisguideline will interfere with long-run equilibration in the foreign exchange ma rket. Here is the basic problem: Domesticand foreign goods are not perfect substitutes, and hence issues of spatial arbitrage and the law of one price areirrelevant. Imagine that at the PPP exchange rate U.S. firms can't find buyers for their goods, while Japanese firms workovertime to meet the demand for their goods. Something will have to give, probably the real exchange rate. When acountry opens new markets, introduces new products, or experiences a favorable or unfavorable price shock for itstraditional exports, the real exchange rate will change. Monetary policy that stabilizes a disequilibrium exchange rateis clearly inappropriate.

4. Suppose the dollar/rupiah rate is fixed but Indonesian prices are rising faster than U.S. prices. Is the Indonesianrupiah appreciating or depreciating in real terms?

ANSWER. The rupiah's real value is rising since it is not depreciating to compensate for higher Indonesian inflation.

5. If the dollar is appreciating against the Polish zloty in nominal terms but depreciating against the zloty in real terms,what do we know about Polish and U.S. inflation rates?

ANSWER. The Polish inflation rate must be exceeding the U.S. inflation rate in order for the zloty to rise in real termseven as it is depreciating in nominal terms. This can be seen by studying Equation 8.6.

6. Suppose the nominal peso/dollar exchange rate is fixed. If the inflation rates in the Mexico and the United Statesare constant (but not necessarily equal in both countries), will the real value of the peso/dollar exchange rate alsobe constant over time?

ANSWER. No. In order for the real exchange rate to remain constant, the price levels in both countries must remainconstant. To see this, suppose that at time 0 the nominal exchange rate is 1, as is the real exchange rate. If U.S. inflationis 2% and Mexican inflation is 15%, then according to Equation 8.6, the peso's real exchange rate in one year will equal1.13 (1 x 1.15/1.02). This figure represents a 13% rise in the real value of the peso.

7. If the average rate of inflation in the world rises from 5% to 7%, what will be the likely effect on the U.S. dollar'sforward premium or discount relative to foreign currencies?

ANSWER. If inflation rises uniformly around the world, there will be no change in relative inflation rates and, hence,there should be no change in currency values and in the forward discount or premium on the dollar.

8. Comment on the following statement. "It makes sense to borrow during times of high inflation because you canrepay the loan in cheaper dollars."


ANSWER. According to the Fisher effect, interest rates adjust to take into account the effects of inflation on the realcost of repaying a loan. Thus, borrowing during times of inflation is profitable only if inflation turns out to be higherthan expected at the time the loan was made. By definition, however, it is impossible to expect to profit from theunexpected. Hence, this statement is inconsistent with elementary notions of market efficiency.

9. Which is likely to be higher, a 150% ruble return in Russia or a 15% dollar return in the United States?

ANSWER. Since both are stated in nominal terms in different currencies, they cannot be compared directly. Thecruzeiro return must be adjusted for Russian inflation and the dollar return for U.S. inflation to get the real returns.Alternatively, the nominal Russian return should be converted into dollars to get the nominal dollar return in Russia.

10.The interest rate in England is 12%, while in Switzerland it is 5%. What are possible reasons for this interest ratedifferential? What is the most likely reason?

ANSWER. Although there are several possible explanations for higher interest rates, the most likely explanation isthat inflation is expected to be higher in England than in Switzerland.

11.Over the period 1982-1988, Peru and Chile stand out as countries whose interest rates are not consistent with theirinflation experience. Specifically, Peru's inflation and interest rates averaged about 125% and 8%, respectively, overthis period, whereas Chile's inflation and interest rates averaged about 22% and 38%, respectively.

a. How would you characterize the real interest rates of Peru and Chile (e.g., close to zero, highly positive, highlynegative)?

ANSWER. Highly negative for Peru and highly positive for Chile.

b. What might account for Peru's low interest rate relative to its high inflation rate? What are the likely consequencesof this low interest rate?

ANSWER. Peru's nominal interest rate averaged around 8% during this period, even as its inflation rate approached130% annually. This highly negative real interest rate was due to government controls on the interest rate that couldbe paid on savings. As a result, Peruvian savings plummeted, a black market for capital arose, and those Peruvians whocould converted their money into dollars or other hard currencies likely to maintain their value.

c. What might account for Chile's high interest rate relative to its inflation rate? What are the likely consequences ofthis high interest rate?

ANSWER. Chile had undergone a period of rapid inflation prior to period shown in the exhibit. As a result, investorswere projecting a high rate of future inflation and this was reflected in the interest rate (remember, the Fisher effect saysnominal rates are based on expected future inflation). In addition, investors probably added an inflation risk premiumto the interest rate to compensate for inflation risk.

d. In Exhibit 8.12, Peru is shown as having a small interest differential and yet a large average exchange rate change.How would you reconcile this experience with the international Fisher effect and with your answer to part b?

ANSWER. The narrow interest differential owes to the government interest rate controls mentioned in part b. Theinternational Fisher effect refers to interest rates set in a free market. It says nothing about controlled interest rates.

12. A number of countries (e.g., Pakistan, Hungary, Venezuela) are shown in Exhibit 8.12 as having a small or negativeinterest rate differential and a large average annual depreciation against the dollar. How would you explain thesedata? Can you reconcile these data with the international Fisher effect?


ANSWER. As these countries have had fairly high inflation combined with controls that held their interest rates belowthose that would prevail in a free market. The large average annual depreciation can be explained by their rapidinflation, whereas the absence of the international Fisher effect is due to the interest rate controls. As noted in theanswer to question 11, part d, the IFE refers to interest rates set in a free market. It has nothing to say about controlledinterest rates.

13.The empirical evidence shows that there is no consistent relationship between the spot exchange rate and thenominal interest rate differential. Why might this be?

ANSWER. When the nominal interest rate differential rises (falls) because U.S. inflation is expected to increase(decrease), the value of the dollar can be expected to fall (rise). Alternatively, if the increase (decrease) in the nominalinterest differential is due to a change in the real interest rate, then the dollar can be expected to increase (decrease) invalue.

14.During 1988, the U.S. prime rate--the rate of interest banks charge on loans to their best customers--stood at 9.5%.Japan's prime rate, meanwhile, was about 3.5%. Pointing to that discrepancy, a number of commentators arguedthat the cost of capital must come down for U.S. business to remain competitive with Japanese companies. Whatadditional information would you need to properly assess this claim? Why might interest rates be lower in Japanthan in the U.S.?

ANSWER. To begin, 3.5% in yen is not the same as 9.5% in dollars. Absent government controls or subsidizedfinancing, the expected cost of the two loans should be about the same when measured in the same currency. This isthe international Fisher effect. Further, the generalized version of the Fisher effect says that the real cost of borrowingin different currencies should be about the same. The interest rates referred to in the question are nominal, not real.Absent government constraints on capital flows, the reason nominal interest rates differ is that lenders expect differentrates of inflation measured in different currencies. Thus, to properly assess this claim, you would need to subtract offexpected inflation from the interest rates and compare real interest rates. Given U.S. inflation of about 5% in 1988 andJapanese inflation of about -1%, it can be seen that real interest rates were about the same in both countries. The bottomline is that these nominal rate differences don't place U.S. companies at a competitive disadvantage.

15.In the late 1960s, Firestone Tire decided that Swiss francs at 2% were cheaper than U.S. dollars at 8% and borrowedabout SFr 500 million. Comment on this choice.

ANSWER. Firestone Tire was gambling that the 6% lower interest rate on the Swiss franc would not be offset byappreciation of the Swiss franc against the dollar. It lost its bet that the international Fisher effect would not hold. Whenit went to repay the loan several years later, the Swiss franc had more than doubled in value against the dollar.

16.Comment on the following quote from a story in the Wall Street Journal (August 27, 1984, p. 6) that discusses theimproving outlook for Britain's economy: "Recovery here will probably last longer than in the U.S. because thereisn't a huge budget deficit to pressure interest rates higher."

ANSWER. In a world characterized by a relatively free flow of capital, a higher real return in the United States willattract capital from England, thereby driving up rates there as well. Thus if real interest rates rise in the U.S., real ratesin the U.K. will also rise.

17.In early 1989, Japanese interest rates were about 4 percentage points below U.S. rates. The wide difference betweenJapanese and U.S. interest rates prompted some U.S. real estate developers to borrow in yen to finance theirprojects. Comment on this strategy.


ANSWER. The U.S. developers were gambling that the 400 basis point differential did not reflect market expectationsof dollar depreciation, which is what the international Fisher effect would argue for. In other words, the developerswere committing the economist's unpardonable sin of comparing apples (dollar interest rates) with oranges (yen rates).This policy also makes no sense from a currency risk standpoint since the developers had dollar cash inflows (from thereal estate rentals on their developments) and yen cash outflows on the mortgages, exposing them to considerableexchange risk. A rise in the value of the yen could conceivably cost them more than the savings on the lower yeninterest rates. Moreover, this rise was quite likely since the international Fisher effect says that international differencesin interest rates can be traced to expected changes in exchange rates, with low interest rate currencies expected toappreciate against high interest rate currencies. This is indeed what happened in the case of the yen.

18.In early 1990, Japanese and German interest rates rose while U.S. rates fell. At the same time, the yen and DM fellagainst the U.S. dollar. What might explain the divergent trends in interest rates?

ANSWER. According to the Fisher effect, the most likely cause for the rise in German and Japanese interest rates washigher expected inflation in those countries. At the same time, the fall in U.S. interest rates could be attributable to adecline in expected U.S. inflation. If so, then PPP would predict that the future value of the dollar should rise relativeto what was previously expected. Since these expectations would be immediately impounded in currency values, wewould expect the dollar to rise relative to the yen and DM. This scenario is consistent with what actually happened.

19.In late December 1990, one-year German Treasury bills yielded 9.1%, whereas one-year U.S. Treasury bills yielded6.9%. At the same time, the inflation rate during 1990 was 6.3% in the United States, double the German rate of3.1%.

a. Are these inflation and interest rates consistent with the Fisher effect?

ANSWER. Not if one assumes that future inflation will equal past inflation. In that case, the real interest rate inGermany will be approximately 6% (9.1% - 3.1%) and in the United States 0.6% (6.9% - 6.3%). More likely, what washappening was that the markets were anticipating a fall in U.S. inflation (because of tight money in the U.S. combinedwith the U.S. recession) and a rise in German inflation (given the costs of German unification). If so, then these ratesare consistent with the Fisher effect, which says that nominal interest rates are based on expected, not past inflation.

b. What might explain this difference in interest rates between the United States and Germany?

ANSWER. One possible answer was suggested in part a, namely that 1990 inflation was notconsidered a reasonable predictor of 1991 inflation. An alternative answer is that real interest rates in Germany wererising to attract the added capital needed to finance the enormous investment in eastern Germany.

20. The spot rate on the Deutsche mark is $0.63, and the 180-day forward rate is $0.64. What are possible reasons forthe difference between the two rates?

ANSWER. The relative values of the spot and forward rates suggest that the market believes the DM will appreciateagainst the dollar by about $0.01 over the next 180 days. The difference also indicates that the interest rate on dollarsexceeds the interest rate on DM. These explanations are consistent with each other since a higher U.S. dollar interestrate indicates higher expected U.S. inflation and an expected devaluation of the dollar.

21. Comment on the following headline that appeared in the Wall Street Journal (December 19, 1990, p. C10): "DollarFalls Across the Board as Fed Cuts Discount Rate to 6.5% From 7%." The discount rate is the interest rate the Fedcharges member banks for loans.

ANSWER. In cutting the discount rate, the Fed is easing monetary policy. This easing will likely bring with it higherfuture inflation which, via PPP, will cause future dollar depreciation. At the same time, the cut in the nominal U.S.interest rate was also a real cut (because expected future inflation is now higher). Both explanations predict that dollar


investments will be less attractive. In response, traders and investors will dump dollars today, causing the dollar to fallimmediately.

22. In late 1990, the U.S. government announced that it might try to reduce the budget deficit by imposing a 0.5%transfer tax on all sales and purchases of securities in the United States, with the exception of Treasury securities.It projected the tax would raise $10 billion in federal revenues--an amount arrived at by multiplying 0.5% by thevalue of the $2 trillion trading on the New York Stock Exchange each year.

a. What are the likely consequences of this tax? Consider its effects on trading volume in the United States and stockand bond prices.

ANSWER. This classic example of static revenue analysis assumes that making trading in the U.S. more expensiveand less profitable will not reduce the number of trades executed there. In fact, investors are likely to respond in oneof two ways: (a) they will shift their trading activity overseas to avoid the transfer tax and/or (b) they will reduce thenumber of trades they engage in. It is easy for traders to shift their activities to any market via a phone line and a faxmachine. So the U.S. government will collect less revenue, possibly far less, than it expected. Not surprisingly, thetransfer tax has strong support from the British financial services sector, which anticipates a jump in trading activityfor the City of London. In effect, a meaningful transfer tax will lead to the same type of regulatory arbitrage we haveseen in other times and places. For example, the Kennedy Administration adopted the Interest Equalization Tax, whichtaxed foreign borrowings in the U.S. in order to restrict capital outflows. The IET drove a wedge between the returnsfrom lending dollars in the U.S. and the returns from lending dollars held on deposit in Europe (Eurodollars). The netresult of the IET was to jump start the Eurodollar market, because lending Eurodollars did not incur the IET. Marketswill also be more volatile since investors will not trade on information that would justify small increases or decreasesin the prices of stocks. But as information continues to flow, a point will be reached where the benefits of doing thetrade will exceed the cost of the tax. The tax, in other words, will cause stock prices to move in bigger jumps, both upand down, than they now do. The result: a less liquid and more volatile market.

b. Why does the U.S. government plan to exclude its securities from this tax?

ANSWER. To the extent the transfer tax is effective, it will raise the cost of capital for American companies, sinceinvestors will demand to be compensated for the added costs of buying and selling securities. All investors care aboutis their net return after all taxes have been paid. Clearly, the government understands the harm its proposal can do sinceits proposal exempts federal debt from the tax. In effect, the proposal would raise capital costs for the private sectorwhile subsidizing federal debt creation. Sauce for the goose is evidently not sauce for the gander.

c. Critically assess the government's estimates of the revenue it will raise from this tax.

ANSWER. One of the axioms of tax economics is that you should try to tax behavior that won't change much inresponse to the imposition of the tax. Here, the government is considering a tax on one of the world's most quicklymoving targets. Currently, 12% of all trading orders in New York are from foreign clients--but most of these orderscould just as well be executed in London, Toronto, Tokyo, or Frankfurt. Moreover, U.S. institutions would surely shiftsome of their domestic business overseas to cut costs. As the case of the IET shows, when countries impose transactionsfees, they lose business to competing markets. The Swedish transfer tax was recently abolished after resourcefulSwedes successfully transferred much trading to London from Stockholm. And since Britain announced that it wouldabolish transfer taxes in 1991, both the Netherlands and Germany have decided to eliminate theirs too. Pressure isbuilding on France and Switzerland to abolish their transfer taxes, while Japan and Italy are cutting transfer taxes aswell. The net result is that the U.S. is unlikely to collect much revenue from the tax.

23. It has been argued that the U.S. government's economic policies, particularly as they affect the U.S. budget deficit,are severely constrained by the world's financial markets. Do you agree or disagree? Discuss.


ANSWER. True. In order to finance its huge budget deficits (which have recently turned into surpluses), the U.S.government has needed continual access to the world's capital markets. Given deficits, if investors begin to believe thatthe United States would pursue economic policies that are inflationary, they would immediately change the terms onwhich they are prepared to lend the U.S. government money. Inflationary policies, therefore, would lead to higherinterest rates, thereby worsening the budget deficit, hobbling economic growth, and even throwing the nation into arecession. At the same time, the value of the dollar would fall. The adverse political consequences of these two effects--higher interest rates and a falling dollar–actually constrained government policymakers to pursue economic policiesthat were regarded by the financial markets as being noninflationary. Of course, the U.S. government could always havepromised to maintain the value of the dollar, but such a pledge would be far more credible if backed by serious deficitreduction, such as how now happened. The actual deficit reduction is owed to rapid economic growth and the resultingjump in federal revenues. Rapid growth, in turn, has strengthened the U.S. dollar, as predicted.

President Clinton got a taste of bond investors' power in 1993 when, during the last month of his campaign,bondholders pushed up long-term interest rates by about 40 basis points in anticipation of his victory. Why? Becauseinvestors feared that he would honor his promise to reinvigorate the economy and put the unemployed back to workthrough traditional Democratic big government spending programs and regulations. Fearing that his policies andprograms would accelerate inflation, investors sold bonds, causing bond prices to fall and interest rates to rise. It wasthe bond market's way of warning Mr. Clinton that he would long be on probation, with his every move scrutinized bynervous investors. Conversely, bondholders tended to ignore the large budget deficits during the Reagan and Bushadministrations because they felt secure with fiscally conservative Republicans in the White House.

24.In 1991, the U.S. government imposed a stiff import tariff on the active-matrix LCD screens that now appear innext-generation laptop computers.

a. Assess the likely consequences of the import duty for U.S. laptop computer manufacturers.

ANSWER. U.S. laptop manufacturers will find their costs rising significantly, particularly since the active-matrix LCDscreen is already the most expensive component in a color laptop. Unfortunately, they will be unable to raise theirprices by much since they are facing competition from foreign laptop manufacturers, who pay no duty on assembledmachines containing active-matrix screens. Moreover, U.S. companies don't have the luxury of shifting to a U.S. active-matrix supplier since none exists. The result for U.S. manufacturers will be a steep decline in profits on laptops madein the United States.

b. How are these manufacturers likely to react to this import duty?

ANSWER. The key to answering this question is to recognize that the duty is imposed on the active-matrix screens,not on the computers. U.S. manufacturers will, and did, react by shifting manufacture of color laptops overseas and thenexporting the assembled machines duty-free to the United States. In June, 1993, the U.S. revoked its self-destructiveLCD duties. Almost immediately, Apple Computer, Compaq, and Toshiba announced that they would shift laptopproduction back to the U.S.

25."High real interest rates can be a cause for celebration, not alarm." Discuss.


ANSWER. The most likely reason for a rise in real interest rates is a pickup in economic activity. Historically, anincrease in real interest rates has usually signaled good economic times, while a real interest rate decrease has typicallysignaled economic decline. Specifically, real interest rates tend to be at their low point during a recession because ofthe low demand for capital. As the world economy comes out of recession, real rates typically rise. Hence, a high realinterest rate likely signifies that economic growth is picking up. Of course, if real interest rates rise because the supplyof capital is contracting, then high real rates would be a bad sign. But normally it is the demand for capital, not itssupply, that is the determining factor for real rates.

26.In an integrated world capital market, will higher interest rates in, say Japan, mean higher interest rates in, say, theUnited States?

ANSWER. The answer depends critically on whether we are talking about real rates or nominal rates. If nominalinterest rates rise in Japan because of higher expected Japanese inflation, this will have no effect on nominal U.S. ratesunless the U.S. is following similar inflationary policies. However, a rise in real interest rates in Japan will tend to pushup real rates in the United States through the process of international arbitrage, brought about by capital flows fromthe United States to Japan to take advantage of the higher real rates expected there.

27.German government bonds, or Bunds, currently are paying higher interest rates than comparable U.S. Treasurybonds. Suppose the Bundesbank eases the money supply to drive down interest rates. How is an American investorin Bunds likely to fare?

ANSWER. The answer is impossible to determine in advance. The fall in DM interest rates will increase the price ofBunds (bond prices move inversely with interest rates), giving U.S. investors a capital gain in DM. At the same time,however, the decline in DM interest rates and the easing of German monetary policy could lead to a weaker DM. Thenet effect on U.S. investors' dollar returns of the higher DM price of Bunds and the lower dollar value of the DM isuncertain. It depends on which of the two factors dominates.

28.In France in 1994, short-term interest rates and bond yields remained higher than in Germany, despite a betteroutlook for inflation in France. Does this situation indicate a violation of the Fisher effect? Explain.

ANSWER. No. The Fisher effect is based on expected future inflation. Investors were saying that they believed thatGermany would likely have a lower rate of inflation in the future, despite its higher current rate of inflation. Hence,investors accorded lower interest rates to Germany than to France. Investors believed that Germany would have a lowerfuture rate of inflation than France because of the macroeconomic situation in these countries at the time. Bothcountries had high unemployment rates in 1994 and people were calling for the monetary authorities in the twocountries to ease up on the money supply in order to boost economic growth, even if this led also led to higher inflation.Given France's much shorter history of monetary rectitude than Germany's and, hence, lesser degree of monetarycredibility, investors were clearly saying that they believed that French monetary authorities were less likely to resistthe pressures to reflate than the Bundesbank. This expectation was based on the historical willingness of Frenchauthorities to tolerate higher inflation in order to stimulate economic growth.

29.On February 15, 1993, President Clinton previewed his State of the Union message to Congress in a toughly-wordedtalk on television about how the growing federal budget deficit made tax increases necessary. Financial marketsreacted by pushing bond prices up and pummeling stock prices. President Clinton said that the rise in Treasury bondprices was a "very positive" response to his televised speech the night before. How would you interpret the reactionof the financial markets to President Clinton's speech?

ANSWER. News stories at the time reveal that the markets' reaction was driven by investor expectations that a taxincrease would reduce economic growth, thereby lowering both nominal and real interest rates. These stories areconsistent with the differing reactions of the stock and bond markets. Lower interest rates will boost bond prices, butif those lower rates are driven by expectations of slower economic growth, then stock prices will fall (since expectedfuture corporate earnings will be lower).


30. At the same time that it was talking down the dollar, the Clinton Administration was talking about the need for lowinterest rates to stimulate economic growth. Comment.

ANSWER. These objectives were inconsistent with each other. If foreign investors expect the dollar to fall in thefuture, then they will demand a higher U.S. interest rate to compensate themselves for their capital loss. Similarly,American investors will demand a higher dollar interest rate since their alternative is to invest in foreign bonds, whichwill provide them with a capital gain if and when the dollar falls. Moreover, dollar depreciation will also likely fuelinflation, which will push up interest rates.

31.In 1993 and early 1994, Turkish banks borrowed abroad at relatively low interest rates to fund their lending at home.The banks earned high profits because rampant inflation in Turkey forced up domestic interest rates. At the sametime, Turkey's central bank was intervening in the foreign exchange market to maintain the value of the Turkishlira. Comment on the Turkish banks' funding strategy.

ANSWER. This strategy, while profitable in the short run, exposes the Turkish banks to significant and predictableexchange risk. It will work only so long as the Turkish central bank is able to maintain a fixed nominal exchange ratein the face of high domestic inflation. In the process of doing so, the Turkish lira's real value will rise, putting pressureon exporters (who will see their goods priced out of world markets) and companies competing against imports.According to purchasing power parity, higher Turkish inflation will eventually lead to lira devaluation. If and whenthis happens, Turkish banks will find themselves facing a much higher lira cost of servicing their foreign debts. In fact,the Turkish lira did devalue, by 28% (in April, 1994), forcing a number of Turkish banks to the point of bankruptcy.The squeeze on Turkish banks was exacerbated when depositors, jittery over the banks' problems, began to withdrawcash. The Turkish central bank was forced to step to help guarantee banks' liquidity and calm depositors' nerves.

32.One idea to curb potentially destabilizing international movements of capital has been devised by James Tobin, aNobel Prize-winning economist. He proposes putting a small tax on foreign exchange transactions. He claims thathis "Tobin tax" would make short-term speculation more costly while having little effect on long-term investment.

a. Why would the Tobin tax have a disproportionate impact on short-term investments?

ANSWER. A given cost of buying and selling foreign exchange would be a larger percentage of annualized returnsover a short period of time. For example, a cost of 0.1% would have an annualized cost of 5.2% over a one-week period(0.1% x 52) but only a 0.02% annualized cost over a five-year period (0.1%/5). The larger the annualized cost thegreater the impact on a potential transaction.

b. Is the Tobin tax likely to accomplish its objective? Explain.

ANSWER. No. A Tobin tax would be easy to avoid by moving currency trades to a country that does not tax them.It could also be avoided in other ways. For example, rather than trade DM for dollars, say, traders might agree to swapGerman bunds for U.S. Treasury bonds. It should also be noted that speculators who attack a currency expect returnsfar greater than the cost of a Tobin tax. Moreover, it would not necessarily solve problems such as those in East Asia,where the biggest sellers of local currency were not speculators but local firms trying desperately to hedge or repaydebts denominated in dollars.

SUGGESTED SOLUTIONS TO CHAPTER 8 PROBLEMS

1. From base price levels of 100 in 1987, West German and U.S. price levels in 1988 stood at 102 and 106,respectively. If the 1987 $:DM exchange rate was $0.54, what should the exchange rate be in 1988? In fact, theexchange rate in 1988 was DM 1 = $0.56. What might account for the discrepancy? (Price levels were measuredusing the consumer price index.)

98INSTRUCTORS MANUAL: FOUNDATIONS OF MULTINATIONAL FINANCIAL MANAGEMENT, 4TH ED.ANSWER . If e1981 is the dollar value of the German mark in 1988, then according to purchasing power parity

e1988/.54 = 106/102

or e1988 = $.5612. The discrepancy between the predicted rate of $.5612 and the actual rate of $.56 is insignificant andhence needs no explaining. Historically, however, discrepancies between the PPP rate and the actual rate havefrequently occurred. These discrepancies could be due to mismeasurement of the relevant price indices. Estimates basedon narrower price indices reflecting only traded goods prices would probably be closer to the mark, so to speak.Alternatively, it could be due to a switch in investors' preferences from dollar to non-dollar assets.

2. Two countries, the United States and England, produce only one good, wheat. Suppose the price of wheat is $3.25in the United States and is £1.35 in England.

a. According to the law of one price, what should the $:£ spot exchange rate be?

ANSWER. Since the price of wheat must be the same in both nations, the exchange rate, e, is 3.25/1.35 or e = $2.4074.

b. Suppose the price of wheat over the next year is expected to rise to $3.50 in the United States and to £1.60 inEngland. What should the one-year $:£ forward rate be?

ANSWER. In the absence of uncertainty, the forward rate, f, should be 3.50/1.60 or f = $2.1875.

c. If the U.S. government imposes a tariff of $0.50 per bushel on wheat imported from England, what is the maximumpossible change in the spot exchange rate that could occur?

ANSWER. If e is the exchange rate, then wheat selling in England at £1.35 will sell in the United States for 1.35e +.5, where .5 is the U.S. tariff on English wheat. In order to eliminate the possibility of arbitrage, 1.35e + .5 must begreater than or equal to $3.25, the price of wheat in the U.S. or e > $2.0370. Thus the maximum exchange rate changethat could occur is (2.4074 - 2.0370)/2.4074 = 15.38%. This solution assumes that the pound and dollar prices of wheatremain the same as before the tariff.

3. In February 1985, Bolivian inflation reached a monthly peak of 182%. What was the annualized rate ofinflation in Bolivia for that month?

ANSWER. The annualized rate of inflation is found as the solution to (1 + i)12 - 1, where i is the monthly inflation rate.Hence, the annualized Bolivian inflation rate, in percentage terms, was (2.82)12 -1 = 25,292,257%.

4. In early 1996, the short-term interest rate in France was 3.7%, and forecast French inflation was 1.8%. At the sametime, the short-term German interest rate was 2.6% and forecast German inflation was 1.6%.

a. Based on these figures, what were the real interest rates in France and Germany?

ANSWER. The French real interest rate was 1.037/1.018 - 1 = 1.87%. The corresponding real rate in Germany was1.026/1.016 - 1 = 0.98%.

b. To what would you attribute any discrepancy in real rates between France and Germany?

ANSWER. The most likely reason for the discrepancy is the inclusion of a higher inflation risk component in theFrench real interest rate than in the German real rate. Other possibilities are the effects of currency risk or transactionscosts precluding this seeming arbitrage opportunity.


5. In July, the one-year interest rate is 12% on British pounds and 9% on U.S. dollars.

a. If the current exchange rate is $1.63:£1, what is the expected future exchange rate in one year?

ANSWER. According to the international Fisher effect, the spot exchange rate expected in one year equals 1.63 x1.09/1.12 = $1.5863.

b. Suppose a change in expectations regarding future U.S. inflation causes the expected future spot rate to decline to$1.52:£1. What should happen to the U.S. interest rate?

ANSWER. If rus is the unknown U.S. interest rate, and assuming that the British interest rate stayed at 12% (becausethere has been no change in expectations of British inflation), then according to the IFE, 1.52/1.63 = (1+rus)/1.12 orrus = 4.44%.

6. If expected inflation is 100% and the real required return is 5%, what will the nominal interest rate be accordingto the Fisher effect?

ANSWER. According to the Fisher effect, the relationship between the nominal interest rate, r, the real interest ratea, and the expected inflation rate, i, is 1 + r = (1 + a)(1 + i). Substituting in the numbers in the problem yields 1 + r =1.05 x 2 = 2.1, or r = 110%.

7. Suppose that in Japan the interest rate is 8% and inflation is expected to be 3%. Meanwhile, the expected inflationrate in France is 12%, and the English interest rate is 14%. To the nearest whole number, what is the best estimateof the one-year forward exchange premium (discount) at which the pound will be selling relative to the Frenchfranc?

ANSWER. Based on the numbers, Japan's real interest rate is about 5% (8% - 3%). From that, we can calculateFrance's nominal interest rate as about 17% (12% + 5%), assuming that arbitrage will equate real interest rates acrosscountries and currencies. Since England's nominal interest rate is 14%, for interest rate parity to hold, the pound shouldsell at around a 3% forward premium relative to the French franc.

8. Chase Econometrics has just published projected inflation rates for the United States and Germany for the next fiveyears. U.S. inflation is expected to be 10% per year, and German inflation is expected to be 4% per year. If thecurrent exchange rate is DM 1 = $0.50, what should the exchange rates for the next five years be?

ANSWER. According to PPP, the exchange rate for the DM at the end of year t should equal .5(1.10/1.04)t. Hence,projected exchange rates for the next 5 years are .5288, .5594, .5916, .6258, .6619.

9. During 1995, the Mexican peso exchange rate rose from Mex$5.33/U.S.$ to Mex$7.64/U.S.$. At the same time,U.S. inflation was approximately 3% in contrast to Mexican inflation of about 48.7%.

a. By how much did the nominal value of the peso change during 1995?

ANSWER. During 1995, the peso fell from $0.1876 (1/5.33) to $0.1309 (1/7.64), which is equivalent to a devaluationof 30.24% ((0.1309 - 0.1876)/0.1876)

b. By how much did the real value of the peso change over this period?

100INSTRUCTORS MANUAL: FOUNDATIONS OF MULTINATIONAL FINANCIAL MANAGEMENT, 4TH ED.ANSWER. Using Equation 8.6, the real value of the peso by the end of 1995 was $0.1890:

0.1890 = 1.03

1.487 x 0.1309 =

)i + (1)i + (1

e = e th

tf

t’t

Based on this real exchange rate, the peso has appreciated during 1995 by 0.72% ((0.1890 - 0.1876)/0.1876). In otherwords, the real exchange rate stayed virtually constant, implying the purchasing power parity held during the year.

10.The inflation rate in Great Britain is expected to be 4% per year, and the inflation rate in France is expected to be6% per year. If the current spot rate is £1 = FF 12.50, what is the expected spot rate in two years?

ANSWER. Based on PPP, the expected value of the pound in two years is 12.5 x (1.06/1.04)2 = FF12.99.

11.If the $:¥ spot rate is $1 = ¥218 and interest rates in Tokyo and New York are 6% and 12%, respectively, what isthe expected $:¥ exchange rate one year hence?

ANSWER. According to the international Fisher effect, the dollar spot rate in one year should equal 218(1.06/1.12)= ¥206.32.

12.Suppose three-year deposit rates on Eurodollars and Eurofrancs (Swiss) are 12% and 7%, respectively. If the currentspot rate for the Swiss franc is $0.3985, what is the spot rate implied by these interest rates for the franc three yearsfrom now?

ANSWER. If rus and rsw are the associated Eurodollar and Eurofranc nominal interest rates, then the international Fishereffect says that

et/e0 = (1 + rus)t/(1 + rsw) t

where et is the period t expected spot rate and e0 is the current spot rate (SFr1 = $e). Substituting in the numbers givenin the problem yields e3 = $0.3985 x (1.12/1.07)3 = $0.4570.

13.Suppose that on January 1, the cost of borrowing French francs for the year is 18%. During the year, U.S. inflationis 5%, and French inflation is 9%. At the same time, the exchange rate changes from FF 1 = $0.15 on January 1 toFF 1 = $0.10 on December 31. What was the real U.S. dollar cost of borrowing francs for the year?

ANSWER. During the year, the franc devalued by (.15 - .10)/.15 = 33.33%. The nominal dollar cost of borrowingFrench francs, therefore, was .18(1 - .3333) - .3333 = -21.33% (see Chapter 12). For each dollar's worth of francsborrowed on January 1, it cost only $0.7867 to repay the principal plus interest. With U.S. inflation of 5% during theyear, the real dollar cost of repaying the principal and interest is $0.7867/1.05 = $0.7492. Subtracting the original $1borrowed, we see that the real dollar cost of repaying the franc loan is -$0.2508 or a real dollar interest rate of -25.08%.

14.In late 1990, following Britain's entry into the exchange-rate mechanism of the European Monetary System, 10-yearBritish Treasury bonds yielded 11.5%, and the German equivalent offered a yield of just 9%. Under terms of itsentry, Britain established a central rate against the DM of DM 2.95 and pledged to maintain this rate within a bandof plus and minus 6%.

a. By how much would sterling have to fall against the DM over a 10-year period for the German bond to offer ahigher overall return than the British one? Assume the Treasuries are zero-coupon bonds with no interest paid untilmaturity.


ANSWER. An investment of DM 1 in the zero-coupon British Treasury bond will return (1/e0)(1.115)10e10 DM in 10years where e0 is the current DM spot price of a pound and e10 is the spot rate in 10 years. To find the amount of sterlingdepreciation at which returns are equalized, we set this return equal to the DM return on investing in the German zero:

(1/e0)(1.115)10e10 = 1.0910

Solving for the relation between the current and future spot values of sterling that will equalize the two returns we gete10/e0 = 0.7971. In other words, the pound would have to depreciate by 20.29% over the next 10 years before the higherreturn on sterling would be offset by the exchange loss.

b. How does the exchange rate established in Part a compare to the lower limit that the British government is pledgedto maintain for sterling against the DM?

ANSWER. The lower limit on sterling under the ERM is £1 = DM 2.7730 (.94 x 2.95). Given an initial rate of £1 =DM 2.95, a 20.29% devaluation yields a rate of £1 = DM 2.3514, far below the lower limit.

c. What accounts for the difference between the two rates? Does this difference violate the international Fisher effect?

ANSWER. Clearly, the market is somewhat skeptical that Britain will uphold its end of the agreement. In other words,the market is betting that Britain will allow the pound to depreciate by more than 6% against the central rate. Thedifference in rates doesn't violate the international Fisher effect, which deals with the market's expectations, not withgovernment promises that may not be fulfilled.

15.Assume the interest rate is 16% on pounds sterling and 7% on Deutsche marks. At the same time, inflation isrunning at an annual rate of 3% in Germany and 9% in England.

a. If the Deutsche mark is selling at a one-year forward premium of 10% against the pound, is there an arbitrageopportunity? Explain.

ANSWER. According to interest rate parity, with a DM rate of 7% and a 10% forward premium on the DM againstthe pound, the equilibrium pound interest rate should be

1.07 x 1.10 - 1 = 17.7%

Since the pound interest rate is only 16%, there is an arbitrage opportunity. It involves borrowing pounds at 16%,converting them into DM, investing them at 7%, and then selling the proceeds forward, locking in a pound return of17.7%.

b. What is the real interest rate in Germany? in England?

ANSWER. The real interest rate in Germany is 1.07/1.03 -1 = 3.88%. The real interest rate in England is 1.16/1.09-1 = 6.42%.

c. Suppose that during the year the exchange rate changes from DM2.7/£1 to DM2.65/£1. What are the real costs toa German company of borrowing pounds? Contrast this cost to its real cost of borrowing DM.

ANSWER. At the end of one year, the German company must repay £1.16 for every pound borrowed. However, sincethe pound has devalued against the DM by 1.85% (2.65/2.70 - 1 = -1.85%), the effective cost in DM is 1.16 x (1 -0.0185) - 1 = 13.85%. In real terms, given the 3% rate of German inflation, the cost of the pound loan is found as1.1385/1.03 -1 = 10.54%.

102 INSTRUCTORS MANUAL: FOUNDATIONS OF MULTINATIONAL FINANCIAL MANAGEMENT, 4THED.

As shown above, the real cost of borrowing DM equals 3.88%, which is significantly lower than the real cost ofborrowing pounds. What happened is that the pound loan factored in an expected devaluation of about 9% (16% - 7%),whereas the pound only devalued by about 2%. The difference between the expected and actual pound devaluationaccounts for the approximately 7% higher real cost of borrowing pounds.

d. What are the real costs to a British firm of borrowing DM? Contrast this cost to its real cost of borrowing pounds.

ANSWER. During the year, the DM appreciated by 1.89% (2.70/2.65 - 1) against the pound. Hence, a DM loan at 7%will cost 9.02% in pounds (1.07 x 1.0189 - 1). In real pound terms, given a 9% rate of inflation in England, this loanwill cost the British firm 0.02% (1.0902/1.09 - 1) or essentially zero. As shown above, the real interest on borrowingpounds is 6.42%.

16.Assume the interest rate is 11% on pounds sterling and 8% on Deutsche marks. If the Deutsche mark is selling ata one-year forward premium of 4% against the pound, is there an arbitrage opportunity? Explain.

ANSWER. In order for there to be no arbitrage opportunity, the return on investing in sterling, 11%, must equal thesterling return on investing in DM, .08 + .04 + 0.08 x .04 = 12.32% (or 1.08 x 1.04 -1). According to these numbers,there is an arbitrage incentive of 1.32% for investing in DM.

17.Suppose the Eurosterling rate is 15%, and the Eurodollar rate is 11.5%. What is the forward premium on the dollar?Explain.

ANSWER. According to interest rate parity, if P is the forward premium on the dollar, then

(1.115)(1 + P) = 1.15, or P = 3.14%.

18.If the Swiss franc is $0.68 on the spot market and the 180-day forward rate is $0.70, what is the annualized interestrate in the United States over the next six months? The annualized interest rate in Switzerland is 2%.

ANSWER. According to interest rate parity,

(1 + rus)/(1 + rsw) = f1/e0

where f1 and e0 are the SFr forward and spot rates. Substituting in the numbers and recalling that everything must beconverted to a semi -annual basis, we have (1 + .5rus)/1.01 = .70/.68, or 1 + .5rus = 1.0397. The solution is rus = 7.94%.

19.The interest rate in the United States is 8%; in Japan the comparable rate is 2%. The spot rate for the yen is$0.007692. If interest rate parity holds, what is the 90-day forward rate on the Japanese yen?

ANSWER. According to the IRPT, the 90-day forward rate on the yen should equal

$.007692[(1 + .08/4)/(1 + .02/4)] = $.0078

20.Suppose the spot rates for the Deutsche mark, pound sterling, and Swiss franc are $0.32, $1.13, and $0.38,respectively. The associated 90-day interest rates (annualized) are 8%, 16%, and 4%; the U.S. 90- day rate(annualized) is 12%. What is the 90-day forward rate on an ACU (ACU 1 = DM 1 + £1 + SFr 1) if interest parityholds?

ANSWER. The key to working this problem is to recognize that the forward rate for a sum of currencies is just the sumof the forward rates for each individual currency. Also note that the forward rates are for 90 days. Hence, the interestrates must be divided by 4 to convert them into quarterly values. Assuming interest parity, the forward rate for the


pound is $1.13 x 1.03/1.04 = $1.1191, the forward rate for the DM is .32 x 1.03/1.02 = $.3231, and the forward rateon the Swiss franc is $.38 x 1.03/1.01 = $.3875. If interest parity holds, the 90-day forward rate on an ACU must,therefore, equal $1.1191 + $.3231 + $.3875 = $1.8297.

21.Suppose that three-month interest rates (annualized) in Japan and the United States are 7% and 9%, respectively.If the spot rate is ¥142:$1 and the 90-day forward rate is ¥139:$1:

a. Where would you invest?

ANSWER. The dollar return from a three-month investment in Japan can be found by converting dollars to yen at thespot rate, investing the yen at 1.75% (7%/4), and then selling the proceeds forward for dollars. This yields a dollarreturn equal to 142 x 1.0175/139 = 1.0395 or 3.95%. This return significantly exceeds the 2.25% (9%/4) returnavailable from investing in the United States.

b. Where would you borrow?

ANSWER. The flip side of a lower return in the United States is a lower borrowing cost. Borrow in the United States.

c. What arbitrage opportunity do these figures present?

ANSWER. Absent transaction costs that would wipe out the yield differential, it makes sense to borrow dollars in NewYork at 2.25% and invest them in Tokyo at 3.95%.

d. Assuming no transaction costs, what would be your arbitrage profit per dollar or dollar-equivalent borrowed?

ANSWER. The profit would be a 1.7% (3.95% - 2.25%) return per dollar borrowed.

22.Here are some prices in the international money markets:

Spot rateForward rate (one year)Interest rate (DM)Interest rate ($)

= $0.75/DM= $0.77/DM= 7% per year= 9% per year

a. Assuming no transaction costs or taxes exist, do covered arbitrage profits exist in the above situation? Describethe flows.

ANSWER. The annual dollar return on dollars invested in Germany is (1.07 x 0.77)/0.75 - 1 = 9.85%. This returnexceeds the 9% return on dollars invested in the United States by 0.85% per annum. Hence arbitrage profits can beearned by borrowing dollars or selling dollar assets, buying DM in the spot market, investing the DM at 7%, andsimultaneously selling the DM interest and principal forward for one year for dollars.

b. Suppose now that transaction costs in the foreign exchange market equal 0.25% per transaction. Do unexploitedcovered arbitrage profit opportunities still exist?

ANSWER. In this case, the return on arbitraging dollars falls to

1.07 x 0.77/0.75 x 0.99752 - 1.09 = 0.30%

Thus, arbitraging from dollars to DM, while still profitable, is only marginally so. If the buying and selling of securitiesinvolve transaction costs of 0.25% as well, then arbitrage profits will be negative and no capital flows will occur.


c. Suppose no transaction costs exist. Let the capital gains tax on currency profits equal 25%, and the ordinary incometax on interest income equal 50%. In this situation, do covered arbitrage profits exist? How large are they?Describe the transactions required to exploit these profits.

ANSWER. In this case, the after-tax interest differential in favor of the U.S. is (0.09 x 0.50 - 0.07 x .50)/(1 + .07 x .50)= (0.045 - 0.035)/1.035 = 0.97%, while the after-tax forward premium on the DM is (.77 - .75).75/.75 = 2%. Since theafter-tax forward premium exceeds the after-tax interest differential, dollars will continue to flow to Germany as before.

23. On checking the Telerate screen, you see the following exchange rate and interest rate quotes:

Currency 90-day interest rates annualized Spot rates 90-day forward rates

Dollar 4.99% - 5.03%

Swiss franc 3.14% - 3.19% $0.711 - 22 $0.726 - 32

a. Can you find an arbitrage opportunity?

ANSWER. Yes. There are two possibilities: Borrow dollars and lend in Swiss francs or borrow Swiss francs and lendin dollars. The profitable arbitrage opportunity lies in the former: Lend Swiss francs financed by borrowing U.S.dollars.

b. What steps must you take to capitalize on it?

ANSWER . Borrow dollars at 1.2575% for 90 days (5.03%/4), convert these dollars into francs at the ask rate of $0.722,lend the francs at 0.785% for 90 days (3.14%/4), and immediately sell the francs forward for dollars at the buy rate of$0.726.

c. What is the profit per $1,000,000 arbitraged?

ANSWER. The profit is $1,000,000 x [(1.00785/0.722) x 0.726 - 1.012575] = $858.66.

24. On checking the Reuters screen, you see the following exchange rate and interest rate quotes:

Currency 90-day interest rates Spot rates 90-day forward rates

Pound 7 7/16 - 5/16% ¥159.9696-9912/£ ¥145.5731-8692/£

Yen 2 3/8 - 1/4%

a. Can you find an arbitrage opportunity?

ANSWER. There are two alternatives: (1) Borrow yen at 2 3/8%/4, convert the yen into pounds at the spot ask rateof ¥159.9912/£, invest the pounds at 7 5/16%/4. and sell the expected proceeds forward for yen at the forward bid rateof ¥145.5731/£, or (2) borrow pounds at 7 7/16%/4, convert the pounds into yen at the spot bid rate of ¥159.9696/£,invest the yen at 2 1/4%/4, and sell the proceeds forward for pounds at the forward ask rate of ¥145.8692/£. The firstalternative will yield a loss of -¥7.94 per ¥100 borrowed, indicating that this is not a profitable arbitrage opportunity:

(100/159.9912) x (1.0183) x 145.5731 - 100 x 1.0059 = -7.94


Switching to alternative 2, the return per £100 borrowed is £8.42, indicating that this is a very profitable arbitrageopportunity:

100 x 159.9696 x 1.0056/145.8692 - 100 x 1.0186 = 8.42

b. What steps must you take to capitalize on it?

ANSWER. The steps to be taken have already been outlined in the answer to part a.

b. What is the profit per £1,000,000 arbitraged?c.

ANSWER. Based on the answer to part a, the profit is £84,200 (8.42 x 10,000).

25. Suppose today's exchange rate is $0.62/DM. The 6-month interest rates on dollars and DM are 6% and 3%,respectively. The 6-month forward rate is $0.6185. A foreign exchange advisory service has predicted that the DMwill appreciate to $0.64 within six months.

a. How would you use forward contracts to profit in the above situation?

ANSWER. By buying DM forward for six months and selling it in the spot market, you can lock in an expected profitof $0.0215 (0.64 - 0.6185) per DM bought forward. This is a semiannual percentage return of 3.48% (0.0215/0.6185).Whether this profit materializes depends on the accuracy of the advisory service's forecast.

b. How would you use money market instruments (borrowing and lending) to profit?

ANSWER. By borrowing dollars at 6% (3% semiannually), converting them to DM in the spot market, investing theDM at 3% (1.5% semiannually), selling the DM proceeds at an expected price of $0.64/DM, and repaying the dollarloan, you will earn an expected semiannual return of 1.77%:

Return per dollar borrowed = (1/0.62) x 1.015 x 0.64 - 1.03 = 1.77%

c. Which alternatives (forward contracts or money market instruments) would you prefer? Why?

ANSWER. The return per dollar in the forward market is substantially higher than the return using the money marketspeculation. Other things being equal, therefore, the forward market speculation would be preferred.

INSTRUCTORS MANUAL: FOUNDATIONS OF MULTINATIONAL FINANCIAL MANAGEMENT, 4TH ED.106

SUGGESTED ANSWERS TO OIL LEVIES:THE ECONOMIC IMPLICATIONS

1. Suppose the tariff were levied solely on imported crude. In an integrated world economy, who will be hurt? Whowill benefit? Why? What will be the longer-term consequences?

ANSWER. The appropriate response to this question depends on the basic insight that the U.S. economy is integratedwith the world economy. It clearly illustrates the implications of the law of one price. Specifically, U.S. refineriescompete directly with foreign counterparts in pricing products to distributors of gasoline, heating oil, diesel fuel, andother refined products. This competition ensures that U.S. refined product prices are equilibrated with world prices,without reference to U.S. crude oil prices. If domestic refineries were to raise their prices above world prices, theywould quickly lose their customers to refineries operating in the Caribbean, Canada, and Europe. In this case, theburden of the tax would be borne by domestic refineries. A $5 import fee would allow domestic oil producers to raisetheir prices an equivalent amount, raising their profitability. However, the import fee leaves unchanged the world priceof refined products. As a result, domestic refineries would be unable to pass on the higher cost of crude oil to theircustomers. Refinery profit margins would be reduced by the amount of the tariff. Following the imposition of such atax, imports of refined products would rise while imports of crude oil and the utilization of domestic refinery capacitywould decline. This result is the reverse of what happened in the U.S. when a $2-a-barrel oil import fee was lifted in1976. As then, wholesale prices of refined products would be left virtually unchanged.

2. If a $10-a-barrel tariff were levied on imported refined products (but no tariff were levied on crude oil), who wouldbenefit? Who would be hurt? Why? What will be the longer-term consequences?

ANSWER. If a $10-a-barrel tax were levied on imported refined products, domestic refined product prices would beelevated above the world level by $10 a barrel compared with just $5 a barrel for crude oil. In such a case, distributorsof refined products would be forced to pay a price equal to the world price plus the tax for their supplies. This wouldwiden profit margins for U.S. refineries and shift the mix of imports toward crude oil and away from refined products.Before-tax profit margins for domestic oil refiners would rise by the amount of the tax. But since many users of refinedproducts compete directly or indirectly with foreign suppliers of goods and services, profit margins throughout the restof the economy would be squeezed. The process of arbitrage does not stop at refined product markets. Domesticproduction facilities that face foreign competition will find it difficult if not impossible to pass on higher energy pricesto their customers. Such an overall energy tax would thus hurt most those industries that are energy intensive and alsoface foreign competition.

To put it differently, to the extent possible, American consumers will try to obtain the cheaper foreign oil in whateverform possible. If imports of crude oil at world prices are blocked by a crude oil tax, then foreign crude oil will bedisplaced by imports of refined products. If a tax raises prices of imported refined products above the world level, thenforeign oil embodied in products--be it foreign-sourced steel, aluminum, automobiles, plastics or fertilizer--will besought. Longer-term, American firms competing against foreign firms with access to lower cost refined products willeither emigrate or evaporate. That is, they will shift production abroad or they will exit the business.

Perhaps the industry that would be least affected by the tariff would be the overnight delivery industry (e.g., FederalExpress). Since all shipping companies operating in the U.S. would be subject to the same cost increase, they couldsimultaneously raise their prices without being subject to a loss of competitive position. Moreover, since demand forovernight shipment is time-sensitive, not price-sensitive, the impact on the overall market would be minimal.

OIL LEVIES: THE ECONOMIC IMPLICATIONS 107

Although tariffs would raise profits for the U.S. refining industry in the short run, the industry's long-run prognosiswould be troublesome. The higher current profits would draw more capital into the industry, capacity would expand,and prices and profits would decline over time until once again the profitability of the refining industry was no greaterthan that of any other industry. If at a later date the government decided to end the tariff, the refining industry wouldbe stuck with an enormous amount of excess capacity, prices would fall, and many firms would go bankrupt as theindustry downsized. This scenario actually describes what happened after the entitlements program, which was asubsidy for refiners, was ended.

3. What would be the economic consequences of the combined $5-a-barrel tariff on imported crude and a $10-a-barreltariff on refined oil products? How will these tariffs affect domestic consumers, oil producers, refiners, companiescompeting against imports, and exporters?

ANSWER. In this instance, the price of refined products would rise by $10 a barrel, while the price of crude wouldrise by $5 a barrel. U.S. refiners would enjoy an added $5-a-barrel profit on refined products (after subtracting off theirhigher crude costs) and domestic oil producers would also gain by $5 per barrel. The effects of these higher prices onconsumers would be similar to those described in the preceding answer.

4. How would these proposed import levies affect foreign suppliers to the United States of crude oil and refinedproducts?

ANSWER. Foreign suppliers of crude oil and refined products would be hurt by these tariffs. Their volume of exportsto the U.S. would drop and they could wind up bearing some of the tax. However, their sales to foreign firms that makeenergy-intensive goods for export to the U.S. should rise.

5. During the 1970s price controls on crude oil--but not on refined products --were in effect in the United States.Based on your previous analysis, what differences would you expect to see between heating oil and gasoline pricesin New York and in Rotterdam (the major refining center in northwestern Europe)?

ANSWER. The evidence from this time period provides clearcut support of a global refined product market operatingvirtually independently from the domestic crude oil market. During the entire period of price controls, heating oil pricesin New York and Rotterdam were within the per-gallon shipping cost of three cents to 6.5 cents between the twomarkets. Moreover, the spot prices in the two markets were left essentially unchanged when domestic crude oil priceswere decontrolled in 1981. On January 12, 1981, a gallon of heating oil sold for $0.97 in Rotterdam and $1.02 in NewYork. Oil prices were decontrolled on January 28, and on February 2, a gallon of heating oil again sold for $0.97 inRotterdam and $1.02 in New York.


SUGGESTED ANSWERS TO PRESIDENT CARTER LECTURESTHE FOREIGN EXCHANGE MARKETS

1. How were financial markets likely to respond to President Carter's lecture? Explain.

ANSWER. Skeptically. Markets are in fact marvelously efficient systems for collecting and assessing information,and as such their judgments are not stupid but smart. Time and again markets have demonstrated their ability to outwitWall Street hotshots, central bankers, economic advisers, and especially politicians.

2. At the time President Carter made his remarks, the inflation rate was running at about 10% annually andaccelerating as the Federal Reserve continued to pump up the money supply to finance the growing governmentbudget deficit. Meanwhile, the interest rate on long-term Treasury bonds had risen to about 8.5%. Was PresidentCarter correct in his assessment of the positive effects on the dollar of the higher interest rates? Explain. Note thatduring 1977, the movement of private capital had switched to an outflow of $6.6 billion in the second half of theyear, from an inflow of $2.9 billion in the first half.

ANSWER. Interest rates were high because the market was expecting continued high inflation owing to rapid growthof the U.S. money supply. As such, the international Fisher effect tells us that the high U.S. interest rate was forecastingdepreciation of the dollar, not appreciation. If these high nominal rates actually indicated high real rates, then moneyshould have been flowing into the United States, not out of it as was happening.

3. Comment on the consequences of a reduction in U.S. oil imports for the value of the U.S. dollar. Next, considerthat President Carter's energy policy involved heavily taxing U.S. oil production, imposing price controls ondomestically produced crude oil and gasoline, and providing rebates to users of heating oil. How was this energypolicy likely to affect the value of the dollar?

ANSWER. Oil imports were slowing down because U.S. economic growth was slowing down. According to theasset-market model of exchange rate determination, this made the U.S. a less attractive place to invest money in andput downward pressure on the dollar. Cutting oil imports by slowing down economic growth is equivalent to burningdown the barn to get rid of the mice. If President Carter really wanted to pursue sensible economic policies that wouldlead to fewer oil imports, he should have offered up an energy program that increased incentives for domestic oilproduction and for domestic energy conservation. Instead, his policies taxed domestic production and subsidizeddomestic consumption. The resulting distortion in investment and consumption patterns reduced U.S. economicefficiency and caused the dollar to decline.

4. What were the likely consequences of the slowdown in U.S. economic growth for the value of the dollar? the U.S.trade balance?

ANSWER . Chapter 2 showed that healthy economies have strong currencies and sick economies have weak currencies.Rapidly growing economies use more of the world's resources, and this shows up in the trade figures as a larger tradedeficit. But this does not normally lead to a depreciation of the growing economy's currency. Normally what happensis that a growing economy attracts investment and foreign capital, which offsets the larger trade deficit. The result isa stronger currency, not a weaker one. This theory was borne out in the early 1980s when the rapid growth of the U.S.economy resulted in a large trade deficit and a soaring dollar.

5. If President Carter had listened to the financial markets, instead of trying to lecture them, what might he haveheard? That is, what were the markets trying to tell him about his policies?

PRESIDENT CARTER LECTURES THE FOREIGN EXCHANGE MARKETS 109

ANSWER. The flight from the dollar was a massive vote by the financial markets of no confidence in the CarterAdministration's economic policies. The markets were telling him that they thought his policies were inflationary andanti-growth. Dollar-denominated assets were marked down because the markets saw that the dollar's value was erodingboth at home and in relation to other currencies abroad. At the same time that the inflation rate was declining inGermany, Japan, and even the U.K., it was accelerating in the United States. Yet the Federal Reserve was continuingto pump reserves into the banking system, leading to expectations of higher inflation down the road. Simply put, thedollar was not declining because the U.S. was importing too much oil or growing too fast; the dollar was decliningbecause too many dollars were being printed and because the world had lost confidence in the Carter Administration'seconomic policies. The markets were clearly telling him it was time for a change in his policies. By October 1979, themessage had gotten loud enough that President Carter's newly appointed chairman of the Federal Reserve Board, PaulVolcker, instituted a new monetary policy that dramatically slowed down the growth of the U.S. money supply. Butit was not until Ronald Reagan became president that the United States instituted pro-growth economic policies--in theform of big tax cuts and a reduction in the anti-business policies and rhetoric so common under Jimmy Carter.

INSTRUCTORS MANUAL: FOUNDATIONS OF MULTINATIONAL FINANCIAL MANAGEMENT, 4TH ED.110

SUGGESTED ANSWERS TO RESCUING THE INDONESIANRUPIAH WITH A CURRENCY BOARD

1. What monetary policies could Suharto follow that would restore the rupiah's pre-crisis value? What problemswould those policies face?

ANSWER. Indonesia could reduce the rupiah money supply sufficiently to maintain its pre-crisis value. However, adramatic shrinkage of the rupiah money supply would force up interest rates. The high interest rates, in turn, wouldslow Indonesia’s economic growth. On the other hand, not acting to restrict the rupiah money supply will increase thecurrency risk associated with holding rupiahs, which would result in high interest rates as well. In other words, highinterest rates reflect the risk associated with holding rupiah. The only way to get interest rates down is to create aninstitutional arrangement that would increase trust in the rupiah. A currency board is one such possible arrangement.

2. What are the costs and benefits of a debt moratorium?

ANSWER. The benefits are obvious: A debt moratorium would eliminate debt service payments until Indonesia andits companies are able to make them. However, a moratorium would ruin the country's reputation as a borrower foryears to come. Still, at some point, concern for the real economy could outweigh concern for its credit reputation.

3. How does undermining the social contract between Suharto and the middle class affect the value of the rupiah?

ANSWER. The rupiah’s value is underpinned by trust in the stability of Indonesia’s monetary and economic policies,which, in turn, depends on political stability. Hence, anything that calls into question the political stability of Indonesiawill also create doubts about the rupiah’s value. Given the massive corruption of Suharto’s regime, there is littlegoodwill toward him. Suharto’s hold on power has been maintained only by delivering the goods to the middle classin the form of steady economic growth and prosperity. However, once Suharto has to make tough economic choicesthat deliver pain rather than gain, the middle class–whose acquiescence is necessary for the success of any economicreforms–is likely to reject those measures. At the same time, failure to make the needed economic reforms will putdownward pressure on the rupiah, as investors and other see that the rupiah’s current value cannot be maintained longterm without those changes being put in place. The bottom line is that anything seen as undermining the social contractbetween Suharto and the middle class will indicate that Indonesia won’t be able to make the economic reforms essentialto preserving the rupiah’s value. In response, people will attempt to flee the rupiah and its value will tumble.

4. How does a weak banking system affect the prospects for a currency board?

ANSWER. With a currency board, there is no central bank to act as a lender of last resort and bail out a failing bank.Thus, if the banking system is already in trouble, the establishment of a currency board will virtually guarantee thatthe banking system will fail. Knowing this, the currency board’s credibility would be called into question right fromthe outset. The result would could be a classic run on the bank as depositors rush to pull their rupiah from the banksand convert them into dollars.

5. Should the IMF withhold disbursements if Indonesia doesn't honor its commitments? What are the pros and cons?

ANSWER. One compelling argument in favor of withholding disbursements is that the IMF's credibility in similarsituations elsewhere would be compromised if it disburses funds and this could undermine the IMF’s ability to enforceits programs around the world. On the other hand, blocking the loan could shatter already fragile investor confidenceand push an already volatile nation into civil strife. For instance, the IMF continued to approve loans to Russia duringits presidential election in 1996, despite the nation's failure to live up to IMF conditions, as a way to bolster PresidentBoris Yeltsin against his Communist opponent. On balance, the pros have it. Continuing disbursements would onlywork temporarily to hold Indonesia together. As Russia shows, without the needed reforms, problems only get worse.

INDONESIA’S CURRENCY BOARD PROPOSAL 111

6. Did the IMF's prescription for Indonesia make sense? Explain.

ANSWER. According to the case, the IMF demanded that Suharto restructure the banking system, maintain a tightmonetary policy, raise sales taxes, cut food, fuel, and electricity subsidies, end government funding of several huge,money-losing investments, and disband domestic monopolies, cartels, and special entitlements that had enriched hischildren and cronies. These reforms all make sense since they would improve economic efficiency, except possiblyfor the sales tax increase. A tax increase would add to government revenues, thereby reducing its incentive to curbspending on projects whose rationale depends more on opportunities for further corruption than on sound economics.

7. Why had Suharto found it so hard to implement the IMF's provisions?

ANSWER. As mentioned above, Suharto’s hold on power depended on his ability to deliver prosperity and risingstandard of living to the average Indonesian. Implementing the IMF’s program would promise–at least in the shortterm–exactly the opposite. Suharto understood that his survival was questionable if he introduced economic reformsthat led to lower standards of living and higher unemployment in the short run even if these policies would provebeneficial in the longer run. As Keynes famously said, “In the long run, we’re all dead.” Suharto was also reluctant toimplement the IMF’s reforms because many of them would hurt his family and cronies by ending the corrupt benefitshis inner circle had long enjoyed. Naturally, they lobbied strongly against these reforms and had his ear. It was toughfor Suharto to resist the entreaties of his family and friends, particularly given his ill health.

8. What suggestions do you have for stemming the rupiah's slide and strengthening its value?

ANSWER. Most of the IMF reforms should be implemented since they would increase investor confidence and bolsterthe rupiah’s value. Indonesia should also decide which banks are in condition to remain open and shut down the rest.Otherwise, the bad banks will continue to squander money on bad investments, just like the bankrupt S&Ls did in theUnited States. Other suggestions are to begin negotiations on restructuring the country's foreign debt since they're notbeing serviced anyway and to work with the IMF to stabilize the rupiah. This latter suggestion would probably leadto the development of a currency board.

9. Did cuts in fuel and food subsidies make sense?

ANSWER. In general, such cuts make sense because they lead to an increase in economic efficiency. However, theymay not in the case of Indonesia at this time because such cuts would just exacerbate the pain and suffering alreadybeing endured by the Indonesian populace. The Indonesians have already suffered a dramatic drop in reduction in livingstandards (see the near doubling in the price of food shown in Exhibit I 3.3) and cutting off subsidies for thesenecessities might push the population over the edge and result in a revolution, which would benefit no one.

10. Should Indonesia have established a currency board? What considerations would you weigh in that decision? Ifyou decide against a currency board, what alternative would you suggest?

ANSWER. On balance, a currency board makes sense. A fixed exchange rate system cannot work without the absolutecommitment providing by the mechanism of a currency board. Floating the rupiah, as was done, subjects its value toall types of speculation based on the lack of a firm commitment to a particular set of monetary, economic, and politicalpolicies. The added risk associated with this uncertainty lowers the rupiah’s value relative to where it would be basedsolely on its economic fundamentals. The danger, as suggested in the case, is that the nation's wealthy elite, includingPresident Suharto's inner circle, would trade their rupiah for dollars and deposit them overseas. As a result, Indonesia'sdollar reserves would disappear, interest rates would skyrocket, and the economy would be battered even more.However, Suharto’s inner circle seems to have had ready access to the national treasury already, so a currency boardwould probably add little to that access. The benefits of a stable currency are many: lower inflation, increased investorconfidence, and aid economic growth. The other potential problems pointed to–higher interest rates, a run on the bank,and capital outflows–are already present and unlikely to be worsened by a currency board.


SUGGESTED ANSWERS TO BRAZIL FIGHTS A REAL BATTLE

1. How does Brazil hope to control its trade deficit through a tight monetary policy? What alternatives are availableto control the trade deficit?

ANSWER. A tight monetary policy will raise real interest rates and slow down growth, which should act to curbimports without affecting exports. However, increased real interest rates could also lead to a capital inflow. Since theflip side of a capital inflow is a current-account deficit, this policy might not work. Alternatively, Brazil could–andshould–cut its massive government deficit, which is the equivalent of dissaving. Given the fundamental macroeconomicidentity–savings - investment = exports - imports–cutting the budget deficit–by raising savings relative to investment–should reduce Brazil’s current-account deficit.

2. How will Brazil's tight money policy affect its fiscal deficit? How will it affect Brazil's real (inflation-adjusted)interest rates, both short-term and long-term rates?

ANSWER. By raising interest rates, it raises the cost of rolling over government debt and therefore boosts the deficit.A tight monetary policy will also boost real short-term rates. However, if the policy is credible–that is, if people believethat the anti-inflationary monetary policy will be permanent–both nominal and real long-term rates should decline.Nominal rates should decline because of the Fisher effect. The decline in real rates would come about by eliminatingthe inflation risk premium that people demand for lending currencies subject to high and volatile rates of inflation. Theissue is whether a tight monetary policy is credible in the face of a large and growing budget deficit. The fear is thata growing deficit will eventually lead the Brazilian government to once again monetize its deficit.

3. Why have Brazil's interest rates generally fallen in recent years?

ANSWER. Brazil’s Real Plan has succeeded at ending hyperinflation by pegging the currency to dollar, which forcedBrazil to tightly control the growth its money supply. As the data show, limited money supply growth drove downBrazilian inflation. Lower inflation, in turn, reduced inflationary expectations and, through the Fisher effect, led tolower nominal interest rates.

4. How would reform and privatization of the social security system improve Brazil's savings rate? What would bethe likely consequences of this improvement for Brazil's current-account balance and the real's value? Explain.

ANSWER. One of Brazil’s fundamental problems is its bloated pension system, especially for government employees.Under this program, many civil servants are able to retire at age 45 with a fat pension, then take a second job. The resultof this and other government programs rife with waste is that Brazil is running a huge and growing budget deficit.Reforming the social security system would reduce the government deficit, which would raise the net savings rate inBrazil and lower the current-account deficit. Privatizing the system would raise savings still more by forcing peopleto realize that the way to increase their retirement benefits is to save more today rather than lobby politicians for highersocial security benefits. The real’s value would undoubtedly rise for several reasons. First, by taking decisive actionto rectify a politically touchy issue, the Brazilian government would demonstrate that it had the will to do the right thingeven it was politically unpopular. Second, reducing the budget deficit would lessen the chances that Brazil will revertat a later date to monetizing the deficit. Investors would correctly infer from the greater likelihood of Brazilian fiscaland monetary discipline a lower future rate of inflation and a stronger real.

5. What are the costs and benefits of using currency controls to defend the real?

ANSWER. On the positive side, currency controls would reduce currency speculation and, hence, exchange ratevolatility. But these benefits would come at a steep cost. Currency controls would raise the cost of capital to Brazilianfirms, making them less competitive and reducing Brazilian investment. They would also boost the cost of credit toconsumers. The net effect would be to slow down economic growth and raise unemployment.

BRAZIL FIGHTS A REAL BATTLE 113

6. Why might speculators view the real as being overvalued? Based on the data in the case, what is your best estimateas to the real's degree of overvaluation?

ANSWER. We can see what has happened to the real value of the real by using the economic data in Exhibit I 4.2.According to these data, the value of the real at the end of 1993, just after the Real Plan was implemented, was 0.119/$or $8.40/real. At the end of 1997, the real was worth $0.90 (1/1.116). Over this same period, we can use the sameeconomic data to compute cumulative Brazilian inflation of 1,541%, in contrast to cumulative U.S. inflation over thisperiod of 11.1% (cumulative inflation from year 1 through year n equals (1 + i 1)(1 + i2)...(1 + in), where ij is the inflationrate in year j). Using Equation 8.6, the real value of the real by the end of 1997 was $13.23:

13.23 = 1.11116.41 x 0.90 =

)i + (1)i + (1

e = e th

tf

t’t

Based on this real exchange rate, the real has appreciated over the period 1994 through 1997 by 58% ((13.23 -8.40)/8.40). This would be a best guess as to the degree of overvaluation. Underlying this estimate is the assumptionthat the purchasing power parity exchange rate is the correct rate. Some indication of the validity of purchasing powerparity for Brazil is that over the preceding three-year period 1991-1993, the real value of the real rose by only 6.7%,an insignificant amount considering the extraordinary rate of Brazilian inflation. In other words, virtually all of Brazil’shyperinflation during this period was offset by real devaluation.

7. What are the tradeoffs that President Cardoso must consider in deciding whether to accelerate the real'sdepreciation?

ANSWER. President Cardoso’s popularity has been built on economic stability. Devaluing the real would jeopardizethat stability and his popularity. On the other hand, the sky-high interest rates designed to pull in the foreign investmentneeded to finance Brazil’s budget deficit are likely to throw Brazil into recession. The need for foreign capital stemsfrom the fact that Brazil savings are inadequate to finance its budget deficit and it can no longer monetize this deficitif it wishes to preserve the real’s value. In addition, the high real value of the real is also hurting Brazil’s exports. Theonly way out of this bind is to reduce its budget deficit or float the real. Reducing the deficit will make powerful specialinterest groups angry. Floating the real will make exporters happy but the consequences are likely to be veryunpleasant: increased currency volatility, a return to the inflation of the past, and a flight of capital from the country.

8. Could Brazil have avoided the recessionary impacts of its monetary policy if it had devalued the real instead?

ANSWER. No. It would have wound up with high inflation and high interest rates, as evidenced by the Asian countriesthat devalued as well as by Mexico. In fact, on January 13, 1999, Brazil devalued the real after facing huge outflowsof capital in the wake of the failure by Brazil’s Congress to pass necessary fiscal reforms. In particular, Congressrefused several times to reform the civil service pension plan. This failure caused the real to lose credibility and capitaloutflows accelerated. Although many commentators argued that devaluation would lower interest rates, it led insteadto higher interest rates as capital outflows again accelerated for fear that Brazil’s monetary discipline would erode andbring with it higher inflation. Of course, the devaluation was expected to boost prices as well, especially of importedgoods and goods that competed with imports. Moreover, to regain credibility, the government was forced to raiseinterest rates to stem the daily devaluation. Although the government originally intended to devalue the real by onlyabout 8%, the real had lost 41% of its value by the end of January. This episode again points out the difficulty thatcentral banks have in controlling the amount of devaluation of their currencies, largely because by dropping theircommitment to a fixed rate they lose credibility with the market. They are also signaling that their governments don’thave the will to make tough political choices and implement meaningful economic reforms, opening the possibility thatthe economic situation could get a lot worse in the future.


9. What would a Brazilian devaluation do to the currencies and economies of Argentina and Chile, its neighbors andlargest trading partners?

ANSWER. The impact on the Argentine and Chilean pesos will differ because of their different currency setups. SinceArgentina has a currency board, devaluation of the real would not affect the Argentine peso’s value. It would raise therisk on investing in Argentina since Brazil is Argentina’s biggest trading partner. The result would be an economicdownturn in Argentina fueled by a loss of exports to Brazil, added competition from cheaper Brazilian imports bothat home and abroad, and a contracting money supply and higher real interest rates in Argentina. Since Brazil is alsoan important trading partner for Chile, Brazilian devaluation would adversely affect its economy as well. However,since the Chilean peso is free to float, it would be expected to fall in value against the U.S. dollar as well and so its tradeand economy would not be as adversely affected as would Argentina’s.

10. What is the link between Brazil's budget deficits and its hyperinflationary environment?

ANSWER. Brazil historically has monetized its huge budget deficits. As the deficits rose, so did the amount of moneyprinted to finance them. In turn, hyperinflation increased the government’s interest expense on its issued debt and ledto still higher deficits.

11. What mix of fiscal and monetary policy would you recommend to President Cardoso? Should he devalue or defendthe real?

ANSWER. The real issue is not defense of the real but rather whether Brazil will make serious structural changes inits economy, particularly a major reduction in the size and cost of its public sector. Failure to make these changes willguarantee that Brazil will be forced to devalue the real in the future, whatever its current success in defending the realtoday. If Brazil reforms its public sector, and especially its social security system, its economy will strengthen and thepressure on the real will diminish. If it doesn’t, nothing will save the real. In line with this view, Brazil should cut itspublic sector, privatize social security, accelerate the privatization of its state-owned businesses, reduce tax rates andregulations, and implement a currency board tied to the dollar like its neighbor Argentina. A currency board wouldeliminate the possibility of Brazil running an independent monetary policy but this is a good thing considering howBrazil historically has abused its monetary discretion. The only route to macroeconomic stability in Brazil is a monetaryregime that does not allow politicians discretion. Such a regime in turn will force Brazil to largely eliminate its publicsector deficit. Doing so will require a combination of spending cuts and tax increases totaling about 6% of GDP, whichwould be a huge shock to the economy. Although the Brazilian economy would be thrown into recession, it will go intorecession anyway because of the high interest rates needed to finance the budget deficit under the current system. Inany event, absent this restructuring, Brazil will be forced by hard arithmetic to monetize its deficits once again: At thereal interest rates currently prevailing–on the order of 25-30%–just servicing its debts will eventually take over 100%of Brazil’s GDP (two-thirds of the government’s debt floats with the current interest rate so a rise in rates boosts debtservicing charges and the budget deficit). Long before this happened the government would start monetizing the deficitagain. The result will be a return to the old inflation-devaluation cycle, adding to the risk of investing in Brazil andreducing the efficiency of its economic activity. At the same time, investors concerned about the government’s abilityto service its debts will demand still higher interest rates or just avoid buying government debt at any price. EitherBrazil will default or it will have to cut its public sector deficit to a sustainable level and follow a sound monetarypolicy. Default will just push the problem back a few years. So Brazil buys nothing by trying to avoid this economicshock because it will occur in any event. The difference is that by instituting fundamental monetary and fiscal reformtoday, Brazil’s economy will be much healthier and stronger in the future.

Download - Ch8 Parity Conditions in International Finance and Currency Forecasting

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