CHAPTER 4

1. CHAPTER 4 Foreign exchange and the international monetary system GETTY IMAGES

2. Learning Objectives • LO 4.1 Outline the nature and functions of foreign exchange markets, and the international monetary system and its institutions. • LO 4.2 Explain the forces that influence exchange rates. • LO 4.3 Assess the effectiveness of different exchange rate regimes in reconciling national policy goals and the goal of international monetary stability. • LO 4.4 Demonstrate the impact of exchange rates on international business decisions. • LO 4.5 Recommend strategies that international business can use to reduce foreign exchange rate risks.

3. The foreign exchange market • What is the foreign exchange market? • The foreign exchange market is a market for converting the currency of one country into that of another country. • What is an exchange rate? • The exchange rate is the rate at which one currency is converted into another. continued

4. The foreign exchange market International Financial Markets Figure 4.1 International Financial Markets continued

5. The foreign exchange market The nature of the foreign exchange market • A global network of banks, brokers and foreign exchange dealers connected by electronic communications systems. • Never sleeps. • A single market. • Exchange rates quoted worldwide are nearly the same. • If different US dollar/Japanese yen rates were being offered in New York and Tokyo, there would be an opportunity for arbitrage and the gap would close. continued

6. The foreign exchange market The functions of the foreign exchange market • Currency conversion • Currency conversion is the process of converting the currency of one country into the currency of another. • International businesses use foreign exchange markets when they pay for imported products or receive foreign payment. • Hedging • Hedging provides some insurance against foreign exchange risk. • Hedging is not without costs which include bank fees and the opportunity costs of foregone profits derived from exchange rate speculation. continued

7. The foreign exchange market The functions of the foreign exchange market • Carry trade: • Involves borrowing in one currency where the interest rates are low and then using the proceeds to invest in another currency where the interest rates are high. • Currency speculation: • Involves moving funds from one currency to another over the short term in the hope of profiting from changes in exchange rates. continued

8. The foreign exchange market Hedging • How does the market perform hedging? • Spot exchange rates: the rate at which a foreign exchange dealer converts one currency into another currency on any particular day. • Forward exchange rates: when two parties agree to exchange currency and execute the deal at some specific date in the future. • Foreign exchange swaps: the simultaneous purchase and sale of a given amount of foreign exchange for two different value dates. continued

9. The foreign exchange market Foreign exchange turnover by instrument, 2006–12 Figure 4.2 Foreign exchange turnover by instrument, September 2006–12 SOURCE: Reserve Bank of Australia, Statistical Tables, Exchange Rates, 2012, accessed via www.rba.gov.au/statistics/tables/index.html#exchange_rates on 28 November 2012.

10. Determination of the exchange rate • Exchange rates are determined by the demand and supply for different currencies. • Three factors impact on future exchange rate movements: • A country’s price inflation • A country’s interest rate • Market psychology continued

11. Determination of the exchange rate Prices and exchange rates • The law of one price • The law of one price states that in competitive markets free of transportation costs and barriers to trade, identical products sold in different countries must sell for the same price when their price is expressed in terms of the same currency. • Purchasing power parity (PPP) • PPP theory argues that given relatively efficient markets (markets in which few impediments to international trade and investment exist) the price of a ‘basket of goods’ should be roughly equivalent in each country. continued

12. Determination of the exchange rate Prices and exchange rates • Purchasing power parity (PPP) • A positive relationship exists between the inflation rate and the level of money supply. • When growth in the money supply is greater than growth in output, inflation will occur. • PPP suggests that changes in relative prices between countries will lead to exchange rate changes, at least in the short run. • Empirical testing of PPP theory indicates that it is not completely accurate in estimating exchange rate changes. continued

13. Determination of the exchange rate Interest rates and exchange rates • Interest rates also affect exchange rates. • The Fisher Effect is the theory that nominal interest rates (i) in each country equal the required real rate of interest (r) and expected rate of inflation (I) over the time period for which the funds are to be lent. That is, i = r + I. • The International Fisher Effect suggests that for any two countries, the spot exchange rate should change in an equal amount but in the opposite direction to the difference in nominal interest rates between countries. continued

14. Determination of the exchange rate Investor psychology and bandwagon effects • Exchange rates can also be affected by investor psychology. • The bandwagon effect occurs when expectations on the part of traders can turn into self-fulfilling prophecies, and traders can get on the bandwagon and move exchange rates based on group expectations. • Government intervention can prevent the bandwagon effect from starting, but it is not always effective.

15. The international monetary system • The international monetary system comprises the institutional arrangements that countries adopt unilaterally and multilaterally to govern exchange rates. • When the foreign exchange market alone determines the relative value of a currency, that country is adhering to a floating exchange rate system. continued

16. The international monetary system Exchange rate regimes in practice • Exchange rate regimes or systems range from fixed to free-floating exchange rate systems. • When the value of a currency is fixed to a reference currency and then the exchange rate between that currency and other currencies is determined by the reference currency exchange rate, a pegged exchange rate system exists. continued

17. The international monetary system Degree of flexibility of exchange rate regimes Figure 4.3 Degree of flexibility of exchange rate regimes continued

18. The international monetary system Exchange rate regimes in practice • A managed float or dirty float system occurs when the value of a currency is determined by market forces, but with central bank intervention. • Countries that adopt a fixed exchange rate system fix their currencies against each other. • A country that introduces a currency board commits itself to converting its domestic currency on demand into another currency at a fixed exchange rate. continued

19. The international monetary system Motives for managing the foreign exchange rate • Controlling inflation • Enhancing the international competitiveness of domestic industries • Correcting balance-of-payments deficits and limiting the impact on the economy of external financial crises. continued

20. The international monetary system Means for managing the foreign exchange rate • Foreign exchange reserves • These are reserves such as foreign currencies, gold, special credits and reserve positions with the International Monetary Fund (IMF) that central banks use to intervene in the foreign exchange market. • Internal balance • When the economy is operating at full capacity with near full employment and price stability. • External balance • When the current account balance is such that foreign debt obligations into the future are sustainable for a country or its trading partners. continued

21. The international monetary system Functions of an international monetary system • Adjustment • An international monetary system needs to provide an orderly adjustment mechanism by which countries can correct internal and external imbalances. • Liquidity • An international monetary system must also provide sufficient international liquidity. • Confidence • Confidence or credibility in a financial system underpins its stability. continued

22. The international monetary system The rise and fall of the Bretton Woods system • In 1944, representatives from 44 countries met at Bretton Woods, New Hampshire, to design a new international monetary system. • The goal was to build an enduring economic order that would facilitate postwar economic growth. • The agreement established two multinational institutions: • The International Monetary Fund (IMF), to maintain order in the international monetary system. • The World Bank, to promote general economic development. continued

23. The international monetary system The rise and fall of the Bretton Woods system • Under the Bretton Woods system: • The US dollar was the only currency to be convertible to gold, and other currencies would set their exchange rates relative to the dollar. • Devaluations were not to be used for competitive purposes. • A country could not devalue its currency by more than 10% without IMF approval. • The role of the IMF • The IMF was responsible for executing the main goal of the Bretton Woods agreement: avoiding a repetition of the chaos that occurred between the wars with a combination of discipline and flexibility. continued

24. The international monetary system The rise and fall of the Bretton Woods system • A fixed exchange rate regime imposes discipline in two ways: • The need to maintain a fixed exchange rate puts a brake on competitive devaluations and brings stability to the world trade environment. • A fixed exchange rate regime imposes monetary discipline on countries, thereby curtailing price inflation. continued

25. The international monetary system The rise and fall of the Bretton Woods system • Flexibility: • Although monetary discipline was a central objective of the agreement, it was recognised that a rigid policy of fixed exchange rates would be too inflexible. • The IMF stood ready to lend foreign currencies to members to tide them over during short periods of balance-of-payments deficit, when a rapid tightening of monetary or fiscal policy would hurt domestic employment. continued

26. The international monetary system The rise and fall of the Bretton Woods system • The demise of the Bretton Woods system • The special role of the US dollar • The US dollar occupied a central place in the Bretton Woods system. The system was vulnerable as it could not work if its key reserve currency came under speculative attack. continued

27. The international monetary system The rise and fall of the Bretton Woods system • The demise of the Bretton Woods system • The adjustment mechanism • The first shortcoming of the adjustment process was that even though the Bretton Woods system’s ‘rules of the game’ required both surplus and deficit countries to share the burden of adjustment, in practice the pressure and burden for adjustment fell on the deficit countries. • The second shortcoming, building from the first, was that the process of adjusting the exchange rate or peg was a discrete adjustment when a ‘fundamental disequilibrium’ was evident. continued

28. The international monetary system The rise and fall of the Bretton Woods system • The demise of the Bretton Woods system • The impossible trinity • The impossible trinity argument holds that it is not possible for a country to have simultaneously a fixed exchange rate regime, free cross-border capital flows and an independent monetary policy dedicated to domestic goals. continued

29. The international monetary system A role for the IMF • The role of the IMF came into question when the system of pegged exchange rates collapsed in the early 1970s. No longer does the IMF mandate and police a particular exchange rate regime. • Surveillance • Part of the IMF’s role involves monitoring and consulting members with regard to the national and international consequences of their economic and financial policies. • Lending • IMF lending provides financial assistance to countries with balance-of-payments difficulties. continued

30. The international monetary system A role for the IMF • Technical assistance • This assistance includes the provision of research, expertise and training. • Lending  • IMF lending provides financial assistance to countries with balance-of-payments difficulties. • Based on conditionality. continued

31. The international monetary system A role for the IMF • The IMF’s role is not without its critics. The criticisms include matters of conditionality and ‘mission creep’, inappropriate policies, moral hazard and governance. • Conditionality and mission creep • Critics argue that the IMF, via conditionality, oversteps the mark by attempting to micromanage economies. • Mission creep describes the situation where an organisation expands its activities beyond its original mandate. continued

32. The international monetary system A role for the IMF • Inappropriate policies • Another criticism of the IMF is that its ‘one-size-fits-all’ approach to macroeconomic policy is inappropriate for many countries. • Moral hazard • More risky and unsustainable borrowings. • Moral hazard arises when people behave recklessly because they know they will be saved if things go wrong. continued

33. The international monetary system A role for the IMF • Governance • Fast-growing economies, particularly in Asia, remain under-represented relative to their weight in the world economy. • IMF in the global financial architecture • The IMF’s fundamental objective remains one of maintaining international monetary stability to facilitate the expansion of international trade and investment. However, the global financial architecture has changed. The rules-based system of Bretton Woods has been virtually replaced by a ‘non-system’ that allows governments to have more control.

34. Focus on managerial implications • How to set prices in the different currencies? • Exchange rate risk can significantly alter the attractiveness of different investments and deals over time. continued

35. Focus on managerial implications Foreign exchange risk • Foreign exchange risk is usually divided into three main categories: • Transaction exposure is the extent to which the income from individual transactions is affected by fluctuations in foreign exchange values. • Translation exposure is the impact of currency exchange rate changes on the reported financial statements of a company. • Economic exposure is the extent to which a firm’s future international earning power is affected by changes in exchange rates. continued

36. Focus on managerial implications Reducing translation and transaction exposures • Lead strategy • An attempt to collect foreign currency receivables early when a foreign currency is expected to depreciate and to pay foreign currency payables before they are due when a currency is expected to appreciate. • Lag strategy • An attempt to delay collection of foreign currency receivables if that currency is expected to appreciate and to delay payables if that currency is expected to depreciate. continued

37. Focus on managerial implications Reducing economic exposure • The key to reducing economic exposure is to distribute the firm’s productive assets to various locations so the firm’s long-term financial wellbeing is not severely affected by changes in exchange rates (hedging through production choices). • In general, reducing economic exposure necessitates that the firm ensures its assets are not too concentrated in countries where likely rises in currency values will lead to damaging increases in the foreign prices of the goods and services they produce. continued

38. Focus on managerial implications Other steps for managing foreign exchange risk • Central control of exposure is needed to protect resources efficiently and ensure that each sub-unit adopts the correct mix of strategies. • Firms should distinguish between, on the one hand, transaction and translation exposure and, on the other, economic exposure. • An attempt should be made to forecast future exchange rate movements. continued

39. Focus on managerial implications Other steps for managing foreign exchange risk • Firms need to establish good reporting systems so the central finance function (or the in-house foreign exchange centre) can regularly monitor the firm’s exposure positions. • The firm should produce monthly foreign exchange exposure reports.

40. Summary of main themes • We discussed how the foreign exchange market works. • We looked at the forces that determine the exchange rate. • We examined the different types of exchange rate regimes in place, and how and why governments intervene in the foreign exchange market. • We discussed the role and functions of the international monetary system in reconciling the policy trade-offs of governments and the potentially destabilising impacts of policy spillovers. continued

41. Summary of main themes • The chapter illustrates how challenging this role is by examining the Bretton Woods system and discussing an appropriate role for the International Monetary Fund (IMF). • The final section examines the task of setting competitive price with variable exchange rates and the strategies that international business could adopt to manage the different foreign exchange rate risk exposures.