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Chapter 3 The International Monetary System

Multinational Business Finance. Chapter 3 The International Monetary System. History of the International Monetary System. The Gold Standard (1876 – 1913) Gold has been a medium of exchange since 3000 BC

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Chapter 3 The International Monetary System

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  1. Multinational Business Finance Chapter 3 The International Monetary System

  2. History of the International Monetary System • The Gold Standard (1876 – 1913) • Gold has been a medium of exchange since 3000 BC • each country set the rate at which its currency unit could be converted to a weight of gold. (1ounce=28,35gram) • e.g. $20,67=1 ounce of gold, 4,2474£=1 ounce of gold • Expansionary monetary policy was limited to a government’s gold reserve. • the outbreak of WWI stopped the free movement of gold, this has caused the suspension of the operation of the Gold Standard

  3. History of the International Monetary System • The Inter-War Years & WWII (1914-1944) • During this period, currencies were allowed to fluctuate over a fairly wide range in terms of gold • Increasing fluctuations in currency values, as speculators sold short weak currencies • The US adopted a modified gold standard in 1934 • the US dollar was the only major trading currency that continued to be convertible to gold.

  4. History of the International Monetary System • Bretton Woods and the International Monetary Fund (IMF) (1944) • As WWII drew to a close, the Allied Powers met at Bretton Woods, New Hampshire to create a post-war international monetary system • The Bretton Woods Agreement established a US dollar based international monetary system and created two new institutions the International Monetary Fund(IMF) and the World Bank

  5. History of the International Monetary System • The International Monetary Fund is a key institution in the new international monetary system and was created to: • Help countries defend their currencies against cyclical, seasonal, or random occurrences • Assist countries having structural trade problems if they promise to take adequate steps to correct these problems • The International Bank for Reconstruction and Development (World Bank) helped fund post-war reconstruction and has since then supported general economic development

  6. History of the International Monetary System • Eurocurrencies • domestic currencies of one country deposited in another country. (e.g. Eurodollar market. Euro- means foreign here) • U.S.-dollar denominated deposits at foreign banks or foreign branches of American banks. By locating outside of the United States • Eurodollars escape regulation by the Federal Reserve Board.

  7. History of the International Monetary System • Eurocurrency Interest Rates: Libor • In the Eurocurrency market, the reference rate of interest is the London Interbank Offered Rate (LIBOR) • This rate is the most widely accepted rate of interest used in standardized quotations, loan agreements, and financial derivatives transactions • There are Pibor, Mibor, Fibor, Stibor (Stockholm Interbank Offered Rate)

  8. History of the International Monetary System • Fixed Exchange Rates (1945-1973) • The currency arrangement negotiated at Bretton Woods and monitored by the IMF worked fairly well during the post-WWII era of reconstruction and growth in world trade • The US dollar became the main reserve currency held by central banks • Eventually, the heavy overhang of dollars held by foreigners resulted in a lack of confidence in the ability of the US to met its commitment to convert dollars to gold

  9. History of the International Monetary System • The lack of confidence forced President Richard Nixon to suspend official purchases or sales of gold by the US Treasury on August 15, 1971 • This resulted in subsequent devaluations of the dollar • Most currencies were allowed to float to levels determined by market forces as of March, 1973

  10. History of the International Monetary System • An Eclectic Currency Arrangement (1973 – Present) • Since March 1973, exchange rates have become much more volatile and less predictable than they were during the “fixed” period • There have been numerous, significant world currency events over the past 30 years

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

  12. The IMF’s Exchange Rate Regime Classifications • The International Monetary Fund classifies all exchange rate regimes into eight specific categories • Exchange arrangements with no separate legal tender • Currency board • Other conventional fixed peg • Pegged exchange rates within horizontal bands • Crawling pegs • Exchange rates within crawling pegs • Managed floating • Independent floating

  13. Fixed Versus Flexible Exchange Rates • A nation’s choice of currency regime to follow depends on many variables: • inflation, • unemployment, • interest rate levels, • trade balances, and • economic growth. • The choice between fixed and flexible rates may change over time as priorities change.

  14. Fixed Versus Flexible Exchange Rates • Fixed rate regime has advantages and disadvantages: • stability in international prices • inherent anti-inflationary nature of fixed prices • but: • Need for central banks to maintain large quantities of hard currencies and gold to defend the fixed rate • Fixed rates can become inconsistent with economic fundamentals as time goes.

  15. Attributes of the “Ideal” Currency • Possesses three attributes, often referred to as the Impossible Trinity: • Exchange rate stability: fixed exchange rate • Full financial integration: free capital movement • Monetary independence: independent interest rate policy, monetary policy, etc • Not possible to have all three simultaneous.

  16. Exhibit 3.4 The Impossible Trinity

  17. Emerging Markets and Regime Choices • Currency board regime when a country’s central bank commits to back its monetary base – its money supply – entirely with foreign reserves at all times. 1 Argentina Peso/ USD • This means that a unit of domestic currency cannot be introduced into the economy without an additional unit of foreign exchange reserves being obtained first. • Argentina moved from a managed exchange rate to a currency board in 1991 • In 2002, the country ended the currency board as a result of substantial economic and political turmoil

  18. Exhibit 3.6 The Currency Regime Choices for Emerging Markets

  19. Emerging Markets and Regime Choices • Dollarization is the use of the US dollar as the official currency of the country. • Panama has used the dollar as its official currency since 1907 • Ecuador replaced its domestic currency with the US dollar in September, 2000

  20. The Euro: Birth of a European Currency • In December 1991, the members of the European Union met at Maastricht, the Netherlands to finalize a treaty that changed Europe’s currency future. • This treaty set out a timetable and a plan to replace all individual ECU currencies with a single currency called the euro.

  21. The Euro: Birth of a European Currency • To prepare for the EMU, a convergence criteria was laid out whereby each member country was responsible for managing the following to a specific level: • Nominal inflation rates • Long-term interest rates • Fiscal deficits • Government debt • In addition, European Central Bank (ECB), was established in Frankfurt, Germany.

  22. Effects of the Euro • The euro affects markets in three ways: • Cheaper transactions costs in the Euro Zone • Currency risks and costs related to uncertainty are reduced • price transparency and increased price-based competition

  23. Achieving Monetary Unification • If the euro is to be successful, it must have a solid economic foundation. • The primary driver of a currency’s value is its ability to maintain its purchasing power. • So, The single largest threat to maintaining purchasing power is inflation.

  24. Exhibit 3.8 The Trade-offs between Exchange Rate Regimes

  25. Mini-Case Questions: The Revaluation of the Chinese Yuan • Many Chinese critics had urged China to revalue the yuan by 20% or more. What would the Chinese yuan’s value be in US dollars if it had indeed been devalued by 20%? • Do you believe that the revaluation of the Chinese yean was politically or economically motivated?

  26. Mini-Case Questions: The Revaluation of the Chinese Yuan (cont’d) 3. If the Chinese yuan were to change by the maximum allowed per day, 0.3% against the US dollar, consistently over a 30 or 60 day period, what extreme values might it reach? 4. Chinese multinationals would now be facing the same exchange rate-related risks borne by US, Japanese, and European multinationals. What impact do you believe this rising risk will have on the strategy and operations of Chinese companies in the near-future?

  27. Exhibit 3.3 World Currency Events, 1971–2008

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

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

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

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

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

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