10-1
The International monetary system How does world Financial System Work ?
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10-2
Recapitulation Slide 9-5
Factors Influencing Currency Value Economic Factors 1. 2. 3. 4. 5. 6. 7. 8.
Balance of Payments Interest Rates Inflation Monetary and Fiscal Policy International Competitiveness Monetary Reserves Government Controls and Incentives Importance of Currency in World
Political Factors 9. Political Party and Leader Philosophies 10. Proximity of Elections or Change in leadership
Expectation Factors 11. Expectations 12. Forward Exchange Market Prices McGraw-Hill/Irwin McGraw-Hill/Irwin International Business, 5/e
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10-3
International monetary system
Some countries use institutional arrangements to fix their currency’s value
Pegged exchange rate
Managed float
Value fixed relative to a reference currency Hold value within range of a reference currency
Fixed exchange rate
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Set of currencies are fixed against each other at some mutually agreed upon exchange rate
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10-4
The gold standard ( Before 1944)
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e
ad
Roots in old mercantile trade. Inconvenient to ship gold, changed to paperredeemable for gold e.g.USA agreed to $20.67 per pound ratio. Want to achieve ‘balanceof-trade equilibrium Worked fairly well till inter-war years
Tr
Japan
Go
USA
ld
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10-5
Balance of trade equilibrium Decreased money supply = price decline.
Trade Surplus
As prices decline, exports increase and trade goes into equilibrium.
Gold
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Increased money supply = price inflation.
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10-6
Between the wars
Post WWI, war heavy expenditures affected the value of dollars against gold
US raised dollars to gold from $20.67 to $35 per ounce
Dollar worth less?
Other countries followed suit and devalued their currencies
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10-7
Bretton Woods Agreement Birth of organized International Monetary System-1944
To stop competitive devaluation there was no multinational institution till 1944 when 44 countries met in New Hampshire Countries agreed to peg their currencies to US$ 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 (IBRD) created
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10-8
Role of the IMF 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 Wanted to avoid problems following WW1, through A) Discipline Maintaining a fixed exchange rate imposes monetary discipline, curtails inflation Brake , on competitive devaluations and stability to the world trade environment McGraw-Hill/Irwin
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10-9
Role of the IMF
B) Flexibility Lending facility: Lend foreign currencies to countries having balance-of-payments problems Adjustable parities: Allow countries to devalue currencies more than 10% if balance of payments was in “fundamental disequilibrium’
Persistent borrowings leads to IMF control of a country’s economic policy
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10-10
Principal duties
Surveillance of exchange rate policies (No longer fixed rate exchange) Financial assistance (including credits and loans) Technical assistance (expertise in fiscal/monetary policy)
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10-11
Sources of funds
182 nations pay into fund according to the size of their economy Funds remain their property Borrower repays loan in 1 to 5 years, with interest No nation has ever defaulted; some are given extensions Unit of accounting of IMF reserve is SDR, its daily value in USD in posted on IMF website daily
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10-12
Membership in the IMF
Open to any country willing to agree to its rules and regulations Must pay a deposit (quota) Quota size reflects global importance of a nation’s economy Quota determines voting powers
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10-13
Largest contributors Fig 10.0
18.3 20 15 10
5.7
5.7
5.1
5.1
Percent
5 0
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US
Germany
Japan
Britain
France
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10-14
Role of the World Bank
International Bank for Reconstruction and Development (IBRD) Purpose: To fund Europe’s reconstruction and help 3d world countries. Overshadowed by Marshall Plan ( USA lent money to Europe directly) Turns to ‘development’ Lending money raised by WB bond sales Agriculture Education Population control Urban development
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10-15
Collapse of the fixed exchange system
Pressure to devalue dollar led to collapse President Johnson financed both the Great Society and Vietnam by printing money
August 8, 1971, Nixon announces dollar no longer convertible into gold.
High inflation and high spending on imports
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
Now we have a managed-float system
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10-16
Long term exchange rate trends 1970-2001 Fig 10.1
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10-17
The floating exchange rate
Jamaica Agreement - 1976 Floating rates acceptable Gold abandoned as reserve asset IMF quotas increased (SDRs) IMF continues role of helping countries cope with macroeconomic and exchange rate problems
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10-18
Exchange rates since 1973
More volatile: 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
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10-19
Floating exchange rates (v/s fixed)
Trade balance adjustments Monetary policy autonomy
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10-20
Fixed exchange rates ( V/s floating)
Monetary discipline Reduce Speculation Reduce Uncertainty Trade balance adjustments easier
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10-21
Fixed versus floating exchange rates
Floating:
Monetary policy autonomy Restores control to government Trade balance adjustments Adjust currency to correct trade imbalances
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Fixed: Monetary discipline .Speculation Limits speculators Uncertainty Predictable rate movements Trade balance adjustments Argue no link between exchange rates and trade Link between savings and investment © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved.
10-22
IMF members exchange rate policy,2002 Fig 10.2
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10-23
Exchange rate regimes
Pegged Exchange Rates.
Peg own currency to a major currency ($). Popular among smaller nations Evidence of moderation of inflation
Currency Boards.
Country commits to converting domestic currency on demand into another currency at a fixed exchange rate Country holds foreign currency reserves equal to 100% of domestic currency issued
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10-24
Crisis management by the IMF
Role has expanded to meet crisis
Currency crisis
Banking 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 Loss of confidence in the banking system leading to a run on the banks
Foreign debt crisis
When a country cannot service its foreign debt obligations
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10-25
Incidence of currency and banking crisis Fig 10.3
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10-26
Crises have common underlying causes
Common causes:
High inflation Widening current account deficit Excessive expansion of domestic borrowing Asset price inflation
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10-27
Mexican currency crisis of 1995 Peso pegged to U.S. dollar Mexican producer prices rise by 45% without corresponding exchange rate adjustment Investments continued ($64B between 1990 -1994 Speculators began selling pesos and government lacked foreign currency reserves to defend it IMF stepped in 1995 by $50 Bill loan package
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10-28
Russian Ruble crisis
Financial markets loss of confidence in Russia’s ability to meet national and international payments
Led to loss of international reserves and roll over of treasury bills reaching maturity
Financial markets unable to determine ‘who’s in charge’
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10-29
Russian Ruble crisis
Persistent decline in value of ruble:
High inflation Artificial low prices in Communist era Shortage of goods Liberalized price controls Too many rubles chasing too few goods
Growing public-sector debt
Refusal to raise taxes to pay for government
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10-30
Government actions: Exacerbating the Situation
Defacto devaluation of the ruble Unilateral restructuring of rubledenominated public debt 90-day moratorium on foreign credits repayment Hike in interest rates to defend ruble Duma rejects measures designed to alleviate problems.
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10-31
Decline of the Ruble 0 -1000
1992
1993
1994
1995
-2000 -3000 -4000 -5000 -6000
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10-32
The Asian crisis
Factors leading to the Asian financial crisis of 1997 The investment boom Excess capacity The debt bomb Expanding imports
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10-33
The Asian crisis
Mid 1997 several key Thai financial institutions were on the verge of default
Thailand asks IMF for help
Result of speculative overbuilding Excess investment (dollar denominated debt) Deteriorating balance-of payments position $17.2 billion in loans, given with restrictive conditions
Following devaluation of Thai baht speculation hit other Asian currencies
Malaysia Singapore Indonesia Korea
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10-34
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
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10-35
Evaluating the IMF policy prescriptions
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
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10-36
Impact on the countries
Currency devaluation Declining investment Rising prices Rising unemployment Rising poverty Rising resentment?
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10-37
Implications for business
Currency management Business strategy
Forward exchange market (months not years ahead) Strategic flexibility
Corporate-government relations
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10-38
Reading References
International Business book by Hill & Jain Chapters 9 and 18 ( 5th Edition) International Business book by Ashwathapa Chapter 11
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