International Business (9th, Wild) - Notes for Chapter (10).doc

168 Ch 10: International Monetary System Chapter 10 International Monetary System Learning Objectives: 10.1 Describe the importance of exchange rates to business activities. 10.2 Outline the factors that help determine exchange rates. 10.3 Explain attempts to construct a system of fixed exchange rates. 10.4 Describe efforts to create a system of floating exchange rates Chapter Outline: Introduction Importance of Exchange Rates Desire for Stability and Predictability Efficient versus Inefficient Market View Efficient Market View Inefficient Market View Forecasting Techniques Fundamental Analysis Technical Analysis Difficulties of Forecasting What Factors Determine Exchange Rates? Law of One Price McCurrency Purchasing Power Parity Numerical Example Role of Inflation Impact of Money-Supply Decisions Impact of Unemployment and Interest Rates How Exchange Rates Adjust to Inflation Role of Interest Rates Fisher Effect Evaluating PPP Impact of Added Costs Impact of Trade Barriers Impact of Business Confidence and Psychology Fixed Exchange Rate Systems The Gold Standard Par Value Advantages of the Gold Standard Collapse of the Gold Standard Bretton Woods Agreement Fixed Exchange Rates Built-In Flexibility World Bank International Monetary Fund Special Drawing Right (SDR) Collapse of the Bretton Woods Agreement Smithsonian Agreement Final Days System of Floating Exchange Rates Jamaica Agreement Later Accords Today’s Exchange-Rate Arrangements Pegged Exchange-Rate Arrangement Currency Board European Monetary System How the System Worked Recent Financial Crises Developing Nations’ Debt Crisis Mexico’s Peso Crisis Southeast Asia’s Currency Crisis Russia’s Ruble Crisis Argentina’s Peso Crisis Future of the International Monetary System Implications for Business Strategy Forecasting Earnings and Cash Flows A comprehensive set of specially designed PowerPoint slides is available for use with Chapter 10. These slides and the lecture outline below form a completely integrated package that simplifies the teaching of this chapter’s material. Lecture Outline I. INTRODUCTION This chapter explores factors that determine exchange rates and various international attempts to manage them. It also presents different methods of forecasting exchange rates, and the functioning of the international monetary system. II. IMPORTANCE OF EXCHANGE RATES Exchange rates affect demand for products. When a country’s currency is weak, the price of its exports declines, making the exports more appealing on world markets. (See Figure 10.1) Devaluation is the intentional lowering of the value of a currency by the nation’s government. Gives domestic producers an edge on world markets, but also reduces citizens’ buying power. Revaluation is the intentional raising of the value of a nation’s currency. Increases the price of exports and reduces the price of imports. Exchange rates affect profits earned abroad when repatriated by the parent company into the home currency. Translating subsidiary earnings from a weak host country currency into a strong home currency reduces earnings, and vice versa. A. Desire for Stability and Predictability 1. Stability makes for accurate financial planning and cash flow forecasts. 2. Predictability reduces odds that a company will be caught off-guard by unexpected rate changes. Reduces the need for costly insurance (currency hedging) against possible adverse exchange rates. 3. Figure 10.2 shows how the value of the U.S. dollar has changed over time. The figure reveals the dollar’s periods of instability, which challenged the financial management capabilities of international companies. Before undertaking any international business activity, managers should forecast future exchange rates and consider the impact of currency values on earnings. B. Efficient versus Inefficient Market View 1. In an efficient market, prices of financial instruments quickly reflect new public information made available to traders. The efficient market view says prices of financial instruments reflect all publicly available information at any given time. 2. Forward exchange rates are accurate forecasts of future rates, and reflect market expectations about the future values of two currencies. (See Chapter 9) 3. Forward exchange rates reflect all relevant publicly available information at any given time and they are considered the best possible predictors of exchange rates. 4. The inefficient market view says prices of financial instruments do not reflect all publicly available information. Proponents believe that companies can search for information to improve forecasting. 5. This view is more compelling considering private information (e.g., if a currency trader holds privileged information, the trader can act on this information to make a profit). C. Forecasting Techniques 1. Fundamental Analysis Fundamental analysis employs statistical models based on fundamental economic indicators to forecast exchange rates. Economic variables in these models include inflation, interest rates, the money supply, tax rates, government spending, the nation’s balance-of-payments situation, and government intervention in foreign exchange markets. 2. Technical Analysis Technical analysis employs past trends in currency prices and other factors to forecast exchange rates. Using statistical models and past data trends, analysts estimate the conditions prevailing during changes in exchange rates and estimate the timing, magnitude, and direction of future changes. D. Difficulties of Forecasting Beyond problems with data used, failings can be traced to human error (e.g., people might miscalculate the importance of certain economic events, placing too much emphasis on some elements and ignoring others). III. WHAT FACTORS DETERMINE EXCHANGE RATES? To understand what determines rates, must know: (1) the law of one price and (2) purchasing power parity. Each tells the level at which an exchange rate should be. A. Law of One Price 1. Exchange rates do not guarantee or stabilize the buying power of a currency; purchasing power fluctuates. 2. Law of one price says an identical product must have an identical price in all countries when expressed in the same currency. Product must be identical in quality or content and be entirely produced within each country. 3. If price were not identical in each country, an arbitrage opportunity would arise. Traders would buy in the low-priced market and sell in the high-priced market; buying drives up the price in one market and drives down the price in the other. 4. The Economist publishes its “Big Mac Index” using the law of one price to determine the exchange rate between the U.S. dollar and other currencies. Fair predictor of the “direction” rates should move. B. Purchasing Power Parity NUMERICAL EXAMPLE - PPP is the relative ability of two countries’ currencies to buy the same “basket” of goods in those two countries. Tells how much of currency “A” a person in nation “A” needs to buy the same amount of products that someone in nation “B” can buy with currency “B.” Considers price levels in adjusting the relative values of the two currencies. Economic forces will push a market exchange rate toward that calculated by PPP or an arbitrage opportunity arises. Holds for internationally traded products not restricted by trade barriers and entailing few or no transportation costs. 2. Role of Inflation Inflation erodes purchasing power. If money is injected into an economy not producing greater output, a greater amount of money is spent on a static amount of products. Demand soon outstrips supply and prices rise. a. Impact of Money-Supply Decisions Governments manage the supply of and demand for currency with policies that influence the money supply. Monetary policy refers to activities that directly affect a nation’s interest rates or money supply. Governments buy or sell government securities on the open market to influence the money supply. Fiscal policy involves using taxes and government spending to influence the money supply indirectly. Governments can increase or lower taxes, or increase or decrease government spending. b. Impact of Unemployment and Interest Rates Threat of a company moving abroad for lower wages holds down wages at home. Companies then need not raise prices to pay higher wages, lowering inflationary pressures. Low unemployment puts upward pressure on wages. To maintain profit margins with higher labor costs, producers pass the cost of higher wages on to consumers in higher prices, causing inflationary pressure. Low interest rates encourage consumers and businesses to borrow and spend, causing inflationary pressure. c. How Exchange Rates Adjust to Inflation Exchange rates adjust to different rates of inflation across countries, which is necessary to maintain purchasing power parity between nations. For example, if inflation in Mexico is higher than in the United States, the exchange rate adjusts to reflect that a dollar will buy more pesos due to higher inflation in Mexico. U.S. goods become more expensive for Mexican firms, and Mexican goods become cheaper for U.S. companies. 3. Role of Interest Rates The interest rate a bank quotes a borrower is the nominal interest rate. a. Fisher Effect The Fisher effect is the principle that the nominal interest rate is the sum of the real interest rate and the expected rate of inflation over a specific period. The real rate of interest should be the same in all countries because of arbitrage. The International Fisher Effect is the principle that a difference in nominal interest rates supported by two countries’ currencies will cause an equal but opposite change in their spot exchange rates. Because real interest rates are theoretically equal across countries, any difference in interest rates in two countries is due to inflation. 4. Evaluating PPP PPP is better at predicting long-term exchange rates than short-term rates. Short-term forecasts, however, are most beneficial to managers. a. Impact of Added Costs PPP assumes no transportation costs, and thus overstates the threat of arbitrage. The presence of transportation costs can allow unequal prices between markets to persist, causing PPP to fail. b. Impact of Trade Barriers PPP assumes no trade barriers. But a high tariff or outright ban on a product can impair price leveling, causing PPP to fail to predict exchange rates accurately. c. Impact of Business Confidence and Psychology PPP overlooks business confidence and human psychology. Yet nations try to maintain confidence of investors, businesspeople, and consumers in their economies and currencies. IV. FIXED EXCHANGE RATE SYSTEMS A. The Gold Standard Gold was internationally accepted for paying for goods and services. Pros: its limited supply caused high demand and it can be traded, stored, and melted into coins or bars making a good medium of exchange. Cons: its weight made transport expensive, and if a ship sank, the gold was lost. Gold Standard was an international monetary system in which nations linked the value of their paper currencies to a specific value of gold. The gold standard operated from the early 1700s until 1939. 1. Par Value a. The value of a currency expressed in terms of gold. All nations fixing their currencies to gold also indirectly linked their currencies to one another. Thus, the gold standard was a fixed exchange rate system—one in which the exchange rate for converting one currency into another is fixed by international governmental agreement. b. The U.S. dollar was fixed at $20.67/oz of gold, the British pound at £4.2474/oz.; exchange rate was $4.87/£ ($20.67 ÷ £4.2474). 2. Advantages of the Gold Standard Reduced the risk in exchange rates because it locked exchange rates between currencies. Fixed exchange rates reduced the risks and costs of trade and grew as a result. b. Imposed strict monetary policies that required nations to convert paper currency into gold if demanded by holders of the currency. This forced nations to keep adequate gold reserves on hand. A nation could not let paper currency grow faster than the value of its gold reserves, which controlled inflation. c. Helped correct a nation’s trade imbalance. If a nation imports more than it exports, gold flowed out to pay for imports. The government must decrease the supply of paper currency in the domestic economy because it could not have paper currency in excess of gold reserves. As the money supply falls, so do prices of goods and services because fewer dollars are chasing the same supply of goods and services. Falling prices make its exports cheaper on world markets and exports rise until the nation’s international trade is in balance. In the case of a trade surplus, the inflow of gold supports an increase in the supply of paper currency. This increases the demand for and cost of goods and services; exports fall in reaction to their higher prices until trade is in balance. 3. Collapse of the Gold Standard a. Gold standard was violated when nations in the First World War financed the war by printing paper currency. This caused rapid inflation and caused nations to abandon the gold standard. b. Britain returned to the gold standard in the early 1930s at the same par value that existed before the war. The United States returned to the gold standard at a new, lower par value that reflected the inflation of previous years. c. The U.S. decision in 1934 to devalue its currency and Britain’s decision not to do so lowered the price of U.S. exports and increased the price of British goods imported; it had previously required $4.87 to purchase one British pound, but it now took $8.24 to buy a pound ($35.00 ÷ £4.2474). So, for example, this forced the cost of a £10 tea set exported from Britain to the United States to go from $48.70 before devaluation to $82.40 after devaluation. This drastically increased the price of imports from Britain (and other countries), lowering its export earnings. d. Countries retaliated against one another through “competitive devaluations” to improve their own trade balances. Faith in the gold standard vanished, as it was no longer an accurate indicator of a currency’s true value. B. Bretton Woods Agreement 1944 accord among nations to create a new international monetary system based on the value of the U.S. dollar. Designed to balance strict discipline of the gold standard with flexibility to manage temporary domestic monetary difficulties. Fixed Exchange Rates Incorporated fixed exchange rates by tying the value of the U.S. dollar directly to gold, and the value of other currencies to the value of the dollar. Fixed U.S. dollar par value at $35/oz of gold; other currencies had par values against the U.S. dollar, not gold. Members were to keep their currencies from deviating more than 1.0 percent above or below their par values. Extended the right to exchange gold for dollars only to national governments. 2. Built-In Flexibility a. Allowed devaluation only in extreme circumstances called fundamental disequilibrium—when a trade deficit causes a permanent negative shift in the balance of payments. b. Devaluation in such situations was to reflect a permanent economic change in a country, not temporary misalignments. 3. World Bank Created the World Bank (IBRD) to fund national economic development. a. World Bank’s immediate purpose was to finance European reconstruction after the Second World War. It later shifted its focus to the general financial needs of developing countries. b. World Bank finances economic development projects in Africa, South America, and Southeast Asia, and offers funds to countries unable to obtain capital for projects considered too risky. It often undertakes projects to develop transportation networks, power facilities, and agricultural and educational programs. 4. International Monetary Fund IMF was created to regulate fixed exchange rates and enforce the rules of the international monetary system. At the time of its formation, the IMF (www.imf.org) had just 29 members—189 countries belong today. Purposes of the IMF are to: Promote international monetary cooperation. Facilitate expansion and balanced growth of international trade. Promote exchange stability with orderly exchange arrangements, and avoid competitive exchange devaluation. Make resources temporarily available to members. Shorten the duration and lessen the degree of disequilibrium in the international balance of payments of member nations. 5. World financial reserves of dollars and gold grew scarce in the 1960s, at a time when the activities of the IMF demanded greater amounts of dollars and gold. The IMF reacted by creating what is called a special drawing right (SDR)—an IMF asset whose value is based on a weighted “basket” of five currencies, including the U.S. dollar, European Union (EU) euro, Chinese renminbi, Japanese yen, and British pound. Figure 10.3 shows the “weight” each currency contributes to the overall value of the SDR. 6. Collapse of the Bretton Woods Agreement Bretton Woods faltered in the 1960s because of U.S. trade and budget deficits. Nations holding U.S. dollars doubted the U.S. government had gold reserves to redeem all its currency held outside the United States. Demand for gold in exchange for dollars caused a large global sell-off of dollars. a. Smithsonian Agreement In 1971, the U.S. government held less than one-fourth of the amount of gold needed to redeem all U.S. dollars in circulation. The Smithsonian Agreement was to restructure and strengthen the international monetary system: (1) lowered the value of the dollar in terms of gold to $38/oz. of gold, (2) required that other countries increase the value of their currencies against the dollar, and (3) increased the 1 percent floatation band to 2.25 percent. b. Final Days Many nations abandoned the system in 1972 and 1973, and currency values floated freely against the dollar. V. SYSTEM OF FLOATING EXCHANGE RATES The new system of floating exchange rates was to be a temporary solution. Instead of the emergence of a new international monetary system, there emerged several efforts to manage exchange rates. 1. Jamaica Agreement IMF accord (1976) formalized the present system of floating exchange rates. Three main provisions included: (1) endorsement of a managed float system of exchange rates (This is in contrast to a free float system—a system in which currencies float freely against one another without governments intervening in currency markets); (2) elimination of gold as the primary reserve asset of the IMF; and (3) expansion of the IMF to act as a “lender of last resort” for nations with balance-of-payments difficulties. 2. Later Accords Between 1980 and 1985 the U.S. dollar rose against other currencies, pushing up prices of U.S. exports and adding to a U.S. trade deficit. a. The Plaza Accord (1985) was an agreement among the largest industrialized economies known as the G5 (Britain, France, Germany, Japan, and the United States) to act together in forcing down the value of the U.S. dollar. b. The Louvre Accord (1987) was an agreement among the G7 nations (the G5 plus Italy and Canada) that affirmed the dollar was appropriately valued and that they would intervene in currency markets to maintain its current market value. A. Today’s Exchange-Rate Arrangements Remains a managed float system, but some nations maintain more stable exchange rates by tying their currencies to other currencies 1. Pegged Exchange-Rate Arrangement a. Pegged exchange-rate arrangements “peg” a country’s currency to a more stable and widely used currency in international trade. b. Many small countries peg their currencies to the U.S. dollar, the EU euro, the special drawing right (SDR) of the IMF, or another individual currency. Belonging to this first category are the Bahamas, El Salvador, Iran, Malaysia, Netherlands Antilles, and Saudi Arabia. Other nations peg their currencies to groups, or “baskets,” of currencies. For example, Bangladesh and Burundi tie their currencies (the taka and Burundi franc, respectively) to those of their major trading partners. Other members of this second group are Botswana, Fiji, Kuwait, Latvia, Malta, and Morocco. 2. Currency Board a. A currency board is a monetary regime based on a commitment to exchange domestic currency for a specified foreign currency at a fixed exchange rate. The government is legally bound to hold an amount of foreign currency equal to the amount of domestic currency; this helps cap inflation. b. The currency board’s survival depends on sound budget policies. B. European Monetary System Europe looked for a system that could stabilize currencies and reduce exchange-rate risk. In 1979, they created the European Monetary System (EMS) to stabilize exchange rates. It was ended in 1999 when the EU adopted a single currency. 1. How the System Worked The exchange rate mechanism (ERM) limited fluctuations of EU member currencies within a trading range (or target zone). The EMS was successful; currency realignments were infrequent and inflation was controlled. Problems arose in 1992 and the EMS was revised in 1993 to allow currencies to fluctuate in a wider band from the midpoint of the target zone. ERM II introduced in 1999 to link the euro to the currencies of nations applying for membership in the EU. C. Recent Financial Crises Despite nations’ best efforts to head off financial crises within the international monetary system, the world has seen several wrenching crises. 1. Developing Nations’ Debt Crisis a. By the early 1980s, developing countries (especially in Latin America) had amassed huge debts payable to large international commercial banks, the IMF, and the World Bank. To prevent a meltdown of the entire financial system, international agencies revised repayment schedules. b. In 1989, the Brady Plan called for large-scale reduction of poor nations’ debt, exchange of high-interest loans for low-interest loans, and debt instruments tradable on world financial markets. 2. Mexico’s Peso Crisis a. Rebellion and political assassination shook investors’ faith in Mexico’s financial system in 1993–1994. Mexico’s government responded slowly to the flight of portfolio investment capital. b. In late 1994, the Mexican peso was devalued, forcing a large loss of purchasing power on ordinary Mexican people. The IMF and private commercial banks in the United States provided about $50 billion in loans to shore up Mexico’s economy. c. Mexico repaid the loans ahead of schedule and once again has a sizable reserve of foreign exchange. 3. Southeast Asia’s Currency Crisis a. On July 11, 1997, the speculators sold off Thailand’s baht on world currency markets; the baht plunged and every other economy in the region was in a slump. b. The shock waves of Asia’s crisis could be felt throughout the global economy. Indonesia, South Korea, and Thailand needed IMF and World Bank funding. As incentives to begin economic restructuring, IMF loan packages came with strings attached. c. Crisis likely caused by a combination of: (1) Asian style capitalism (lax regulation, loans to friends and relatives, lack of financial transparency); (2) currency speculators and panicking investors; and (3) persistent current account deficits. 4. Russia’s Ruble Crisis a. Russia’s problems in the 1990s included: (1) spillover from the Southeast Asia crisis; (2) depressed oil prices; (3) falling hard currency reserves; (4) unworkable tax system; and (4) inflation. b. In 1996 as currency traders dumped the ruble, the Russian government attempted to defend the ruble on currency markets. The government received a $10 billion aid package from the IMF and promised to reduce debt, collect taxes, cease printing sums of currency, and peg its currency to the dollar. c. Things improved for a while, but then in mid-1998 the government found itself once again trying to defend the ruble. By late 1998, the IMF had lent Russia more than $22 billion. 5. Argentina’s Peso Crisis a. By late 2001, Argentina had been in recession for nearly 4 years. Argentina’s goods remained expensive because its currency was linked to a strong U.S. dollar through a currency board. b. The country finally defaulted on its $155 billion of public debt in early 2002, the largest default by any country ever. c. The government scrapped its currency board that linked the peso to the U.S. dollar and the peso quickly lost about 70 percent of its value on currency markets. Argentina has in many respects recovered. It has registered growth of around 9 percent a year and unemployment around 8 percent in 2008, down from a high of 25 percent in 2002. Argentina’s plan of boosting wages, imposing price controls, keeping the peso low, and increasing public spending seems to be working. Growth was expected to be around 4 percent to 5 percent but inflation soon reached double digits, hitting around 40 percent in 2016, cutting consumers’ purchasing power and increasing poverty. Though the economy had again shrunk in 2016, leaders were hopeful that the country would turn the corner and return to growth in 2017. As of 2012, another economic collapse was unlikely although Argentina was experiencing 26 percent inflation. D. Future of the International Monetary System 1. Recurring crises are raising calls for a new system designed to meet the challenges of a global economy. 2. Revision of the IMF and its policy prescriptions are likely; transparency on the part of the IMF is being increased to instill greater accountability. The IMF is increasing its surveillance of members’ macroeconomic policies and abilities in the area of financial sector analysis. 3. Ways must be found to integrate international financial markets to manage risks. The private sector must become involved in the prevention and resolution of financial crises. VI. IMPLICATION FOR BUSINESS STRATEGY Exchange rates influence all sorts of business activities for domestic and international companies. A weak currency (valued low relative to other currencies) lowers the price of a nation’s exports on world markets and raises the price of imports. Lower prices make the country’s exports more appealing on world markets. This gives companies the opportunity to take market share away from companies whose products are priced higher in comparison. Understanding this material improves managers’ knowledge of financial risks in international business. VII. FORECASTING EARNINGS AND CASH FLOW This knowledge must be paired with vigilance of financial market conditions to manage businesses in the global economy effectively. Quick Study Questions Quick Study 1 1. Q: For a country with a currency that is weakening (valued low relative to other countries), what will happen to the price of its exports and the price of its imports? A: Devaluation lowers the price of a country’s exports on world markets and increases the price of imports because the country’s currency is now worth less on world markets. 2. Q: Unfavorable movements in exchange rates can be costly for business, so managers prefer that exchange rates be what? A: Stable exchange rates improve the accuracy of financial planning, including cash flow forecasts. Predictable exchange rates reduce the likelihood that companies will be caught off-guard by sudden and unexpected rate changes. This reduces the need for costly insurance (usually by currency hedging) against possible adverse movements in exchange rates. 3. Q: The view that prices of financial instruments reflect all publicly available information at any given time is called what? A: The efficient market view states that prices of financial instruments reflect all publicly available information at any given time. Quick Study 2 1. Q: The principle that an identical item must have an identical price in all countries when price is expressed in a common currency is called what? A: The law of one price is a principle that an identical product must have an identical price in all countries when expressed in the same currency. This product must be identical in quality and content and be entirely produced within each country. If the price is not identical in each country, an arbitrage opportunity would arise—an opportunity to buy a product at a specific price in one country and sell it at a higher price in another country. The law of one price holds because if people were to attempt arbitrage, the greater demand for the product in the lower-priced market would increase its price there and the greater supply in the higher-priced market would lower its price there. The limitations of the law of one price are several. First, the law of one price requires that the products must be identical in quality and content in each country, and must be entirely produced within each particular country. This is very hard to accomplish in today’s global economy except for most raw materials, fruits and vegetables, and the like. The Big Mac index comes close to an ideal but it has its own limitations. Second, the products must be “tradable” in the sense that it is practical to buy the product in one country and sell it in another to take advantage of an arbitrage opportunity. For example, the Big Mac index fails in this regard. Third, using a single product to determine what a nation’s exchange rate should be is far too simplistic a method. Probably every economy is far too complex to have its exchange rate determined by a single product. 2. Q: A unique aspect of purchasing power parity in the context of exchange rates is that it is only useful when applied to what? A: Purchasing power parity is the relative ability of two countries’ currencies to buy the same “basket” of goods in those two countries. It tells us how much of currency “A” that a person in country “A” needs in order to buy the same amount of products that a person in country “B” can buy with currency “B.” Purchasing power parity holds for internationally traded products that are not restricted by trade barriers and that entail few or no transportation costs. 3. Q: What is the impact on purchasing power when growing demand for products outstrips a stagnant supply? A: As growing demand for products outstrips stagnant supply, prices will rise and devour any increase in the amount of money the consumers have to spend. 4. Q: What factors influence the power of purchasing power parity to accurately predict exchange rates? A: There are limitations to the PPP concept. First, purchasing power parity is better at predicting long-term exchange rates than short-term rates. Unfortunately, short-term forecasts are often more beneficial to managers. Second, although PPP assumes a world of no transportation costs, this is clearly unrealistic. If adding transportation costs to the cost of a product makes the product equally or more expensive in the otherwise cheaper market, trade will not occur. Thus, because of the absence of an arbitrage opportunity after transaction costs, no leveling of prices between the two markets will occur. Third, although PPP assumes no trade barriers, we know this to be false in reality. Trade might not occur if a high tariff on an import increases the cost of the product significantly. Of course, the same is true if importing the product is made illegal. Fourth, PPP overlooks business confidence and human psychology. The confidence of businesspeople and consumers impacts the value of a nation’s currency. Confidence in a nation’s economic outlook encourages companies to invest and consumers to increase their spending. Currency traders can also influence the exchange rate of a nation’s currency. If traders believe a currency is overvalued, they can sell the currency on currency markets—thereby causing its value to fall and the exchange rate to adjust accordingly. Quick Study 3 1. Q: The gold standard is an example of what type of international monetary system? A: In the earliest days of international trade, gold was the internationally accepted currency for payments of goods and services. The gold standard was an international monetary system in which nations linked the value of their paper currencies to specific values of gold. The value of a currency expressed in terms of gold is called its par value. Because each nation fixed its currency to gold, it also indirectly linked its own currency to those of other nations. Thus, the gold standard was called a fixed exchange rate system—one in which the exchange rate for converting one currency into another is fixed by international governmental agreement. 2. Q: What are the main advantages of the gold standard? A: There are three main advantages associated with an international monetary system based on the gold standard. First, because the gold standard maintained highly fixed exchange rates between currencies, it drastically reduced exchange-rate risk. Second, because the gold standard requires governments to convert paper currency into gold if demanded by holders of the currency, governments must always have adequate gold reserves on hand to pay them. Thus, a government cannot allow the volume of its paper currency to grow faster than its gold reserves. This created an effective tool in helping nations control inflation. Third, the gold standard also helped nations to correct trade imbalances. Suppose a nation is importing more than it is exporting. As gold flows, out to pay for imports, the government must decrease the supply of paper currency in the domestic economy because it cannot have paper currency in excess of gold reserves. As the money supply falls, so do prices of goods and services in the country because demand is falling while supply is unchanged. The falling prices of the country’s goods make its exports cheaper on world markets. Exports rise until the nation’s international trade is once again in balance. The fundamental principle of the gold standard was violated when nations involved in the First World War needed to finance their enormous war expenses by printing additional paper currency. This caused rapid inflation for these nations and caused them to abandon the gold standard altogether. Britain returned to the gold standard in the early 1930s at the same par value that existed before the war. However, the United States returned to the gold standard at a new, lower par value that reflected the inflation of previous years. The decision by the United States to devalue its currency and Britain’s decision not to do so lowered the price of U.S. exports on world markets and increased the price of British (and other nations’) goods imported into the United States. Countries retaliated against one another through “competitive devaluations” to improve their own trade balances. Faith in the gold standard vanished--it no longer indicated a currency’s true value. 3. Q: What is the name of the international monetary system that formed in 1944 following the demise of the gold standard? A: The Bretton Woods agreement was an accord among nations to create a new international monetary system based on the value of the U.S. Dollar. Quick Study 4 1. Q: An exchange rate system in which currencies float against one another with governments intervening to stabilize currencies at target rates is called what? A: A managed float system is one in which currencies float against one another, with governments intervening to stabilize their currencies at particular target exchange rates. 2. Q: What do we call the arrangement whereby a nation lets its currency float within a margin around the value of another more stable currency? A: A free float system is an arrangement whereby a nation lets its currency float within a margin around the value of another more stable currency. 3. Q: A currency board is a monetary regime based on an explicit commitment to exchange domestic currency for what? A: The currency board is a monetary regime based on an explicit commitment to exchange domestic currency for a specified foreign currency at a fixed exchange rate. Teaming Up 1. Q: Suppose you and several classmates are a marketing team assembled by your Brazil-based firm to estimate demand in the U.S. market for its newly developed product. The market research firm you hired requires $150,000 to perform a thorough study. But your group is informed that the total research budget for the year is 3 million Brazilian real and that no more than 20 percent of the budget can be spent on any one project. (3a.) If the current exchange rate is 5 real/$, will you have the market study conducted? Why or why not? A: The answer is no. Converting real into dollars at an exchange rate of 5 real/$, we arrive at $600,000 (3,000,000/5 real/$ = $600,000). The research project costing $150,000 is 25 percent of the total research budget of $600,000 ($150,000/$600,000 = 0.25). This exceeds the cutoff figure of 20 percent for the cost of any single research project. (3b.) If the exchange rate changes to 3 real/$, will you have the study conducted? Why or why not? A: The answer is yes. Converting real into dollars at an exchange rate of 3 real/$, we arrive at $1,000,000 (3,000,000 real/3 real/$ = $1,000,000). The research project costing $150,000 is 15 percent of the total research budget of $1,000,000 ($150,000/$1,000,000 = 0.15). This is below the cutoff figure of 20 percent for the cost of any single research project. (3c.) At what exchange rate do you change your decision from rejecting the proposed research project to accepting the project? A. The threshold exchange rate at which the project decision changes from “accept” to “reject” is 4 real/$. We can set up the problem as an equation which is .20x = $150,000. (The .20x is the 20 percent cutoff figure and the $150,000 is the cost of the project.) Solving the equation and dividing $150,000 by 0.20 gives us a figure of $750,000—the total research budget stated in dollars. Then, dividing the research budget stated in real (3 million real) by that stated in dollars ($750,000), we arrive at a real/$ exchange rate of 4 real/$. Ethical Challenges 1. Q: You are the chair of an IMF task force. Your job is to reevaluate the policy of bailing out national governments that suffer losses in the private sector. Current policy is to enlist the governments of industrialized countries in bailing out emerging nations in the midst of financial crises. Taxpayers in industrial countries typically foot the bill for IMF activities, with total loans running into the many billions of dollars. Recent examples are the bailouts of Mexico, Indonesia, and Thailand. Some critics call this system a kind of “remnant socialism” that rescues financial institutions and investors from their own mistakes with money from taxpayers. For instance, the financial crisis in Thailand was largely a private-sector affair. Thai banks and insurance companies were heavily in debt and the central bank had recklessly pledged its foreign exchange reserves to shore up the currency. As chair of the task force, what is your position on this dilemma? Do you believe that the current system socializes losses (the government bails them out) and privatizes profits? Explain exactly who benefits from such bailouts. What is an alternative to an IMF bailout? A: Students might look at the recent events in the U.S. financial system meltdown for ideas on this topic. They may research articles around the time of the Southeast Asian crisis to understand who benefits and loses when losses are socialized—the argument that private financial institutions earn healthy returns when times are good and taxpayers do not share in these gains (though stockholders in these companies do). The question is why should taxpayers bear losses when these institutions make bad investments? The companies may be more cautious if they know taxpayers would not bail them out. This may be a good question to pose as a debate between classmates playing the roles of proponents of private financial institutions on one side, and taxpayers on the other. Practicing International Management Case Banking on Forgiveness 1. This item can be assigned as a Discussion Question in MyManagementLab. Student responses will vary. Q: The World Bank and the IMF had once argued that the leniency of debt forgiveness would make it more difficult for the lenders themselves to borrow cheaply on the world’s capital markets. If you were a World Bank donor, would you support the HIPC Debt Initiative or argue against it? Explain your answer. A: This question could set up a debate between groups arguing for and against debt relief. Students arguing for debt relief must explain the benefits (humanitarian, economic, etc.) that debt forgiveness is expected to have for the debtors and lenders. Students arguing against debt forgiveness must explain the harm to the institutional lenders and lending countries from the debt forgiveness and explain why debtor nations would be better off mired in crippling debt that denies their people basic health care and education. 2. Q: In negotiating the HIPC Debt Initiative, the World Bank and the IMF worked closely together. At one point, however, the plan came to a standstill when the two organizations produced different figures for Uganda’s coffee exports, with the IMF giving a more optimistic forecast and so arguing against the need for debt relief. In your opinion, is there any benefit to these organizations working together? Explain. Which organization do you think should play a greater role in aiding economic development? Why? A: Students should be encouraged to visit the Web sites of the International Monetary Fund and World Bank and gather other printed documents they publish in order to gain a fuller understanding of these organizations’ activities before answering this question. -