Mgnt 4670 Ch 11 Intl Monetary System (Fall 2007)

CHAPTER 11 THE GLOBAL MONETARY SYSTEM

International Monetary System The International Monetary System is: The structure within which foreign exchange rates are determined, international trade and capital flows are accommodated and balance of payments adjustments are made. The institutional arrangements that countries adopt to govern exchange rates of currencies used as money and monitor values to insure stability in currency value. All of the institutions, instruments and agreements which link together the money markets, world currencies, real estate, commodity and futures markets, etc. are a part of the International Monetary System.

TERMS Fixed exchange rate system : value of the currency is fixed by the government and related to another currency or range of currencies. It remains the same and is changed only under specific circumstances by the government. Role of Central Bank : Must keep reserves of both foreign and domestic currency on hand to buy or sell to the foreign exchange market in order to preserve fixed exchange rate. If the domestic currency drops below the established fixed value, the central bank will increase the price of the domestic currency by trading in foreign currency reserves to buy domestic currency. If the domestic currency rises above the established fixed value, the central bank will decrease the price of domestic currency by trading it in for foreign currency. Has a monetary policy that centers around managing the money supply.

WHY A FIXED RATE? Monetary discipline required. Destabilizing speculation less likely to impact fixed rates. Uncertainty in foreign exchange rates is limited; fixed rates are better for International Trade & Investment. Trade balance adjustments managed by the government.

TERMS Floating rate system : value of currency in relation to another currency is not determined by the government, but by the free market where it “floats”. Exchange rates between two currencies are thus influenced by market factors, such as inflation, interest rates, etc. and equilibrium is reached through market forces. Foreign exchange market determines the relative value of a currency. Dollar, Euro, Yen and Pound “float” against each other. Role of the Central Bank : Allows the mechanism of supply and demand in the foreign exchange market to equalize the exchange rate; Has an independent monetary policy that is not guided solely by exchange rate concerns.

WHY A FLOATING RATE? Trade balance adjustments made automatically through the foreign exchange market as a function of supply and demand. Adjustments to the foreign exchange rate are made in smaller, continuous movements, rather than occasional actions taken by the Central Bank. Greater ability to absorb shocks in the market, such as the oil crisis. Monetary policy is not limited by necessity to maintain exchange rate parity; government is free to use monetary policy to address other issues.

$MONEY, MONEY, MONEY$ Goods and Services have two types of value: Use value (what something is) Exchange value (what something is worth) Use value + exchange value = commodity Money: a commodity single out as a universal equivalent; a standard measure of the value of all commodities; the representation token which mediates the relationship between commodities.

$MONEY, MONEY, MONEY$ Money have certain characteristics: Portability Divisibility Convertibility Durability

History of Profit and Money Early civilizations : exchange between societies of whatever was needed/wanted. Major Empires through early feudalism : local forms of money (salt, grains, silver, cattle, etc); money is a vehicle through which goods are exchanged. Exchange is for survival. Late feudal through City-States (14 th -16 th centuries): rise of mercantilism and trade; profit is made in spices, silks, quest for gold and metals; gold and silver are media of exchange; balance of trade is favorable

History of Profit and Money Industrialism (17 th -19 th centuries): paper money as currency is created; profit is made on production; trade deficits are acceptable. Modern and post-modern (20-21 st centuries): profit is made on capital; fictitious wealth, rise of paramoney (credit cards, checks, etc.); trade deficits are acceptable. Value of money is no longer a face value reflection of use + worth. The globalized world is fueled by multiple currencies, of which many determine their value in the foreign exchange market.

The Gold Standard-1800’s In1800’s, major trading nations adopt the gold standard. The development of free trade led to need for a more formalized system for settling international balances. The gold standard is a monetary standard that pegs currencies to gold; currencies are guaranteed by being convertible to gold. This was a fixed rate, based on a determination made by each government about how much one ounce of gold would be worth in local currency. Each country had its own value. The value of two currencies could be determined by comparing the value of each individual currency in terms of gold. The amount of currency needed to purchase one ounce of gold is the gold par value. e.g. One ounce of gold was worth: US$20.67; £4.25. How do you determine the exchange rate between U.S. dollars and English pounds? $20.67/ounce of gold = $4.87 per GBP (English pound sterling) GBP4.25

The Gold Standard Each country had to maintain adequate reserves of gold to back the currency in circulation. Because it was linked to gold, the gold standard had the effect of limiting the rate at which an individual country could expand its money supply. Gold was considered an automatic mechanism to help all countries achieve balance-of-payment equilibrium.

Between the Wars 1914-1939 During WWI, gold standard abandoned because of world war. Post WWI, war heavy expenditures affected the value of dollars against gold. 1919-1929: many countries back on the gold standard. 1929-1933: no fixed standards because of the Depression era. 1934:US raised dollars to gold from $20.67 to $35 per ounce, causing devaluation of dollar to other currencies (more dollars needed to buy gold). Other countries followed suit and devalued their currencies. 1939: Gold Standard suspended due to start of WWII.

Key Date: Bretton Woods, 1944 In 1944, 44 countries met in New Hampshire Countries agreed to peg their currencies to US$ which was convertible to gold at $35/oz. Agreed not to engage in competitive devaluations for trade purposes and defend their currencies. Weak currencies could be devalued up to 10% w/o approval. IMF and World Bank created.

International Monetary Fund The International Monetary Fund (IMF) Articles of Agreement were heavily influenced by the worldwide financial collapse, competitive devaluations, trade wars, high unemployment, hyperinflation in Germany and elsewhere, and general economic disintegration that occurred between the two world wars Created to police monetary system by ensuring maintenance of the fixed-exchange rate Promote int’l monetary cooperation and facilitate growth of int’l trade The aim of the IMF was to try to avoid a repetition of that chaos through a combination of discipline and flexibility.

IMF: MAIN DUTIES TODAY Surveillance of exchange rate policies (No longer fixed rate exchange) Financial assistance (including credits and loans) Technical assistance (expertise in fiscal/monetary policy)

WORLD BANK International Bank for Reconstruction and Development (IBRD) Purpose: To fund Europe’s reconstruction and help 3d world countries. Overshadowed by Marshall Plan, World Bank mission turns to ‘development’ Lending money raised by WB bond sales Agriculture Education Population control Urban development

1945-73: FIXED EXCHANGE RATES: US $ IS Main Reserve 1945-1973: Fixed exchange rates  Countries continued to peg their currencies to US$ which was convertible to gold at $35/oz . U.S. dollar was the main reserve currency held by central banks and was the key to the web of exchange rates. The system of fixed exchange rates established at Bretton Woods worked well until the late 1960’s: The US dollar served as the reference point for all other currencies Any pressure to devalue the dollar would cause problems through out the world

1970’s: MONETARY SYSTEM UNDER PRESSURE: COLLAPSE OF THE FIXED EXCHANGE RATE Pressure to devalue dollar led to collapse President Johnson financed both the Great Society and Vietnam by printing money High inflation and high spending on imports August 8, 1971, Nixon announces dollar no longer convertible into gold. Countries agreed to revalue their currencies against the dollar March 19, 1972, Japan and most of Europe floated their currencies In 1973, Bretton Woods fails when key currency (dollar) is under speculative attack

1976: FLOATING EXCHANGE RATE REGIME Jamaica Agreement - 1976 Currencies will be allowed to Float Currencies are no longer fixed to the dollar Gold abandoned as reserve asset IMF quotas increased IMF continues role of helping countries cope with macroeconomic and exchange rate problems. . From this point on, the monetary system is an eclectic or “mixed bag” of methods which range from free float to a pegged system that is similar to fixed rates.

TODAY’S REGIME: ECLECTIC IMF MEMBER REGIME CHOICES, 2004 p. 380 6 th ed.

International Monetary System Evolution EARLY INDUSTRIAL/ WWI- POST WWII PAPER MONEY WWII (1945-73) Many forms of money Main World Trading Partners Adopt the Gold Standard IMF countries Adopt fixed rate Tied to the U.S. $ (which is backed by gold Mixed system with Major currencies being floated; Other currencies- various systems 1973 - NOW On and off The Gold Standard

FLOATING EXCHANGE RATE REGIME SINCE 1973 Since 1973, the world economy has suffered through numerous financial crises in various countries. The post 1973 period is characterized by more volatility. Oil crisis -1971 Loss of confidence in the dollar - 1977-78 Oil crisis – 1979, OPEC increases price of oil Unexpected rise in the dollar - 1980-85 Rapid fall of the dollar - 1985-87 and 1993-95 Partial collapse of European Monetary System - 1992 Asian currency crisis - 1997

FINANCIAL CRISES in the POST-BRETTON WOODS ERA A number of financial crisis have occurred in the past twenty five years, causing major shocks to the global economy and often needing help from the IMF. These three types of financial crises impacting the world monetary system are: Currency crisis when a speculative attack on a currency’s exchange value results in a sharp depreciation of the currency’s value or forces authorities to defend the currency Banking crisis Loss of confidence in the banking system leading to a run on the banks, capital flight occurs. Foreign debt crisis When a country cannot service its foreign debt obligations

Anatomy of CURRENCY CRISES Common causes of currency crises: High inflation Widening current account deficit Excessive expansion of domestic borrowing Asset price inflation (e.g. increases in stock prices or prices or real property) Fundamental flaws in governmental policy: actions of the Government can be too little, too late, or ineffective in dealing with currency crises.

Anatomy of CURRENCY CRISES Government action: example of too little, too late-- Governments defend home currency that is devaluating by using the foreign currency held in their reserves to buy back its home currency in order to strengthen it. This can cause drain foreign reserves to dangerously low levels so that foreign debts cannot be serviced. This causes other problems, especially a loss of confidence, which prompts investors to sell their holdings of the home currency; capital flight and panic can follow.

WHAT HAPPENS WHEN THERE IS FINANCIAL CRISIS IN A COUNTRY? In a globalized world, countries are highly interdependent and therefore are impacted by financial crisis in a specific country. When there is crisis in one country and that country’s money loses its value (devaluates), financial panic can occur that lead to similar devaluations at about the same time by other, often nearby countries. This is known as CONTAGION. If countries cannot stop the devaluation themselves the may ask for help from the IMF.

MEXICO CRISIS: 1995 Peso pegged to U.S. dollar. Mexican producer prices rise by 45% without corresponding exchange rate adjustment. Changes in prices Significant increase in public and private sector debt Growing trade deficit ($17 billion) Import more than export Investments continued ($64B between 1990 -1994) Speculators began selling pesos. Government responds by selling dollars to buy pesos but it lacked foreign currency reserves to defend it. Impact on supply and demand Foreign investors panic and sell peso denominated assets. Government devalues the peso which drops from Ps 3.46/US$ to Ps5.50/US$. Collapse of the peso leads to contagion, “tequila” effect in Central and South America.

MEXICO CRISIS: 1995 IMF stepped in and did the following: $18 billion dollar loan, supplemented by a loan from the U.S. government. Demanded that the Mexican government tighten controls and reduce public spending drastically. Helped to renegotiate loans which Mexican government was unable to service.

MEXICO CRISIS: Impact on Wal-Mart Wal-Mart had 63 stores stocked with goods imported from the U.S. The drop in the peso meant that imports from the U.S. cost more. Sales dropped by 16% because Mexican consumers did not spend as much because of recession. Wal-Mart suspended its plans to build 25 more stores.

ASIAN CRISIS Background: Unprecedented growth in 70’s and 80’s Industrial policies of governments hinge upon export of labor-intensive, low-cost manufactured goods. Liberalization of banking occurs and financial sector develops (“emerging market funds”). Above liberalization fuels investment boom in commercial and residential property and industrial assets. Governments implement policies that bring about huge infrastructure projects. Government encourages investors to put money into certain projects to meet “national goals” (Korea, Indonesia) As a result of the above, wages increase so citizens have more disposable income. Changes in Income

ASIAN CRISIS Results: Quality of investments declines. Economic forecasts based on expansion are unrealistic. Excess capacity in factories is created (e.g. semi-conductors in Korea). Residential and commercial property stands idle but developers must continue to service debt secured to build projects (e.g. Thailand). Demand for imports increases dramatically because of increase in individual disposable income and because of increase in capital equipment and materials needed for construction of factories and residential and commercial property. Result is outflow of foreign currency and trade deficit. Import more than export

ASIAN CRISIS Consequences: Currencies come under attack. Investors start converting local currency into dollars and leaving the country. Increased demand for dollars and increase in supply of local currency continues to devalue local currencies even more. Impact on supply and demand Governments try to defend them unsuccessfully. Stock markets weaken or plunge.

ASIAN CRISIS Repercussions: Prices in factories and real estate holdings drop and facilities are underutilized. Investors have heavy debts to service (especially in dollar-denominated debt) and defaults begin to occur. Huge current account deficit (balance of trade) is created. Investor confidence drops and portfolio investors flee (CAPITAL FLIGHT).

ASIAN CRISIS Asia countries must ask for help from IMF. Thailand is the first, followed by Indonesia, and finally Korea. Example of Thailand Thailand: Unable to defend the baht, it announces it will allow it to float freely. The baht which had been pegged for 13 years at the exchange rate of $1 = Bt25 drops to $1 = Bt55. Thailand cannot finance international trade or service its debts anymore

ASIAN CRISIS IMF gives 17.2 billion in loans in Thailand with following conditions for the Thai government: Taxes must be raised. Public spending must be cut. Certain state-owned businesses must be privatized. Interests rates must be raised. Similar programs are developed for Indonesia and Korea. IMF loans Indonesia $37 billion. IMF loans Korea $20 billion.

ASIAN CRISIS Problems in Asian Market Economies: Cronyism Too much money, dependence on speculative capital inflows Lack of transparency in the financial sector. Currencies tied to strengthening dollar Increasing current account deficits Weakness in the Japanese economy Too much, too fast

CRITIQUE OF IMF POLICIES Inappropriate policies: “One size fits all’ Moral hazard: People behave recklessly when they know they will be saved if things go wrong-- Foreign lending banks could fail Foreign lending banks have paid price for rash lending Lack of Accountability IMF has grown too powerful

IMPLICATIONS FOR BUSINES Currency management is essential. Business strategy must have provision for complications of the international monetary system Faced with uncertainty about the future value of currencies, firms should utilize the forward exchange market to insure against exchange rate risk Firms should pursue strategies that will increase the company’s strategic flexibility in the face of unpredictable exchange rate movements — that is, to pursue strategies that reduce the economic exposure of the firm Governments have tremendous power and influence which they can wield in the international monetary system. Corporate-government relations are essential.

Mgnt 4670 Ch 11 Intl Monetary System (Fall 2007)

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Mgnt 4670 Ch 11 Intl Monetary System (Fall 2007)