11-international Monetary System Imf & World Bank-200109

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10-1

The International monetary system How does world Financial System Work ?

McGraw-Hill/Irwin International Business, 5/e

© 2005 The McGraw-Hill Companies, Inc., All Rights Reserved.

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 

McGraw-Hill/Irwin International Business, 5/e

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)



McGraw-Hill/Irwin International Business, 5/e

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 

International Business, 5/e

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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

McGraw-Hill/Irwin International Business, 5/e

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

McGraw-Hill/Irwin International Business, 5/e



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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