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INTERNATIONAL BUSINESS
ENVIRONMENT(Political Economy of International Business)
Session 5
International Business and the International
Monetary System
Today's questions
1. What is the International Monetary System (IMS)?
2. What has been the evolution of the IMS since the early XXth Century? What is the structure of the IMS today?
3. What are the economic and business implications of flexible exchange rates? Of a monetary union like the Eurozone?
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INTRODUCTION
Section 1
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Preliminary definitions
The foreign exchange market is a market for converting the currency of one country into that of another country
The exchange rate is the rate at which one currency is converted into another
The international monetary system is made up of the institutional arrangements that countries adopt to govern exchange rates
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The foreign exchange market
The foreign exchange market is a network of banks, brokers, and other foreign exchange dealers connected by electronic communications systems
The most important trading centers are London, New York, Tokyo, and Singapore
The US dollar is the most widely traded currency in the world (86% of all transactions)
Approximately USD 3,200 Bn are traded every day.
Purpose of foreign exchange markets
Conversion of the currency of one country into the currency of another
Insurance against foreign exchange risk
Speculation, i.e. profiting from shifts in exchange rate
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Foreign exchange instruments
Spot transactions involve the exchange of currency on the second day after the date on which the two dealers agree to the transaction
Outright forward transactions involve the exchange of currency three or more days after the date on which the dealers agree to the transaction
FX swaps are simultaneous spot and forward transaction
Currency swaps deal more with interest-bearing financial instruments (such as a bond), and they involve the exchange of principal and interest payments.
Options are the right but not the obligation to trade foreign currency in the future.
Futures contracts are agreements between two parties to buy or sell a particular currency at a particular price on a particular future date
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Exchange rates
Direct exchange rate
Direct quote
Price of the foreign currency in terms of home currency (e.g. USD/EUR)
Indirect exchange rate
Indirect quote
Price of the home currency in terms of the foreign currency (e.g. EUR/USD)
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Exchange rate determination
Exchange rates are determined by the demand and supply for different currencies, depending
on …
Inflation Interest ratesMarket psychology
(bandwagon effect)
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Foreign exchange regimes [1]
Fixed exchange rate : countries fix their currencies against each other
Floating exchange rate: the demand for a country’s currency is a function of the demand for (1) its goods and services and (2) for financial assets denominated in its currency
Dirty/Managed float: a country tries to hold the value of its currency within some range of a reference currency ( free float)
Pegged exchange rate: a country fixes the value of its currency relative to a reference currency
Currency board: a country commits to converting its domestic currency on demand into another currency at a fixed exchange rate
To make this commitment credible, the currency board holds reserves of foreign currency equal at the fixed exchange rate to at least 100% of the domestic currency issued
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Foreign exchange regimes [2]
Monetary unions (currency unions): two or more countries sharing a single currency monitored and controlled by one central bank
Lato sensu: different currencies having a fixed mutual exchange rate monitored and controlled by several central banks with closely coordinated monetary policies
Dollarization: use of a foreign currency in parallel to or instead of the domestic one (not only applied to usage of the USD)
Monetary dollarization: the use of foreign currency and deposits as money in parallel with national currency
Financial dollarization: the use of foreign currency for financial transactions
Real dollarization: the use of foreign currency for pricing wages, goods and services
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The foreign exchange policy
Under a floating exchange rate system, monetary authorities are able to manage the exchange rate of the domestic currency in order to influence domestic economic conditions
Inflation
Economic growth
External trade
Various tools include
Increasing domestic interest rates will lead to foreign capital inflow and therefore to an increase of the demand for that currency
Selling domestic currency against another one will lead to its depreciation
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THE INTERNATIONAL MONETARY SYSTEM – A
BRIEF HISTORY
Section 2
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A brief history of the IMS
Gold standard (late XIXth Century – 1914)
→ Currencies are pegged to / convertible into gold
Inter-war period
→ Various systems changing over time
Bretton Woods / Gold exchange standard (1944-1976)
→ All currencies are fixed to gold, but only the U.S. dollar is directly convertible to gold
Washington Consensus (1976 - ...)
→ Floating exchange rates, currencies are not convertible to gold
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The Gold Standard
Pegging currencies to gold and guaranteeing convertibility
Dates back to ancient times when gold coins were a medium of exchange, unit of account, and store of value
→Payment for imports was first made in gold or silver
→Later, as trade grew, payment was made in paper currency which was linked to gold at a fixed rate
Worked from the 1870s until the 1st World War
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The end of the Gold Standard
During the 1st World War, many governments financed their war expenditures by printing money, thus generating
inflation
People lost confidence and demanded gold for their currency, putting pressure on countries' gold reserves,
and forcing them to suspend gold convertibility
By 1939, the gold standard had come to an end
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The inter-war period
No stable International Monetary System
Gold standard readopted in 1920s in US, UK, France,
Switzerland
Dropped during Great Depression
Hyperinflationary finance in Germany, Austria, Hungary,
Poland
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The Bretton Woods system
A fixed exchange rate system
All currencies are fixed to gold, but only the U.S. dollar is directly convertible to gold (35 USD/ounce)
Devaluations could not to be used for competitive purposes
A country cannot devalue its currency by more than 10% without IMF approval
Two multinational institutions
The International Monetary Fund (IMF): maintain order in the international monetary system
The World Bank: promote general economic development
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The case for fixed exchange rates
Supporters of fixed exchange rates focus on monetary discipline, uncertainty, and the lack of connection between the trade balance and exchange rates
Having to maintain a fixed exchange rate parity ensures that governments do not expand their money supplies at inflationary rates
Fixed exchange rates prevent "beggar-thy-neighbour" competitive devaluation policies aimed to generate a trade surplus
From a business standpoint, fixed exchange rates mean a reduction of obstacles to trade and capital flows
Speculation that is associated with floating exchange rates can cause uncertainty in the business environment
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Mundell's incompatibility triangle
Free movement of capital
Fixed exchange rates
Independent monetary
policy
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The IMF
UN agency created in July 1944, based in Washington (US)
Objectives:
Avoid a repetition of the chaos that occurred between the wars
Assist the reconstruction of the world's international payment system
Stabilize exchange rates
Means: combination of discipline and flexibility
Impose monetary discipline on countries, thereby curtailing price inflation
Put a brake on competitive devaluations and brought stability to the world trade environment
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
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The quota system
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Upon joining, each member of the IMF is assigned a quota, based broadly on its relative size in the world economy
The World Bank
The WB today gathers 186 members, its current President is Robert Zoellick (US)
UN affiliate set up to finance projects supporting the economic development of its member nations.
Foundations laid at the UN monetary and financial conference at BrettonWoods in 1944.
Officially came to life in 1946
It comprises two institutions:
International Bank for Reconstruction and Development (IBRD)
International Development Association (IDA)
Activities
In the post-war era, the bank made loans for the reconstruction of Europe.
Later, the emphasis shifted from Europe to the developing world
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The collapse of the Bretton Woods system
Bretton Woods worked well until the late 1960s when
Huge increases in welfare programs and the Vietnam War were financed by increasing the money supplyand causing significant inflation
Other countries increased the value of their currencies relative to the dollar, in response to speculation the dollar would be devalued
Because the system relied on an economically well managed U.S., the system was strained to the breaking point
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Jamaica Agreements
IMF Jamaica meeting (1976)
Fixed exchange rate system is
abandoned
IMF is in charge of overseeing global financial system
Total annual IMF quotas increased to
$41 billion Par values against gold and USD are
abandoned
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A case for floating exchange rates?
1. Monetary policy autonomy
Under a fixed system, a country's ability to expand or contract its money supply as it sees fit is limited by the need to maintain exchange rate parity
2. Automatic trade balance adjustments
Floating rates help adjust trade imbalances
→ Under the Bretton Woods system, a country's permanent trade deficit could not be corrected by domestic policy; the IMF would have to agree to a currency devaluation
3. From a business standpoint, floating exchange rates generate uncertainty and risks as well as opportunities (competitiveness, attractiveness)
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Exchange rates and business management
International Monetary
System
Business strategyExchange movements can have a major impact on the competitive
position of businesses
Corporate-government relations
Businesses can influence government policy towards the international monetary system
Currency managementSpeculative buying and selling of
currencies can create volatile movements in exchange rates
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Exchange rate movements and business
Example ofcurrency devaluation
Higher price of imports
Inflationary pressure in the
short-run
Import substitution, stimulus to
exports
Improved trade balance in the
mid-run(J-curve, under
Marshall-Lerner Condition)
Decreased expected
returns on investment
Short-term investment
outflows
Decreased earnings vs.Increased
attractiveness
Foreign direct investment
inflows?
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Sudden movements in exchange rates can be disruptive both for domestic and international companies
The J-curve
Trade balance
Time
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Food for thought ...
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?Why are French firms more affected by a strong euro than German ones
?
Production outsourced in
Central European Countries
R&D, design and assembly in
Germany
Price competitiveness
(Eurozone markets)
Non-price competitiveness
(Emerging markets)
Actual foreign exchange regimes (2007)
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A new role for the IMF
Since many of the original reasons for the IMF no longer
exist, the organization has redefined its mission
Critics claim that IMF policies in these countries have
actually made the situation worse
The IMF now focuses on lending money to countries
experiencing financial crises, using IMF deposits (Special
Drawing Rights)
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A new role for the IMF (ctd)
186 members in 2006
Objectives: foster global monetary cooperation, secure financial stability, facilitate international trade, promote high employment and sustainable economic growth, reduce poverty
Means
Surveillance: follow up of members' macroeconomic policies, in particular those with an impact on exchange rates and the balance of payments
Conditional loans to countries that experience serious financial and economic difficulties using IMF deposits (Special Drawing Rights)
http://www.imf.org/external/np/exr/facts/glance.htm
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Spécial Drawing Rights (SDRs)
USD44%
EUR34%
JPY11%
GBP11%
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The Special Drawing Right (SDR) is an international reserve asset, created by the IMF in 1969 to supplement the existing official reserves of member countries.
IMF facilities (http://www.imf.org/external/np/exr/facts/howlend.htm)
Concessional loans to low-income countries (LICs)
Extended Credit Facility (ECF): main tool for providing medium-term support to LICs with protracted balance of payments problems
Standby Credit Facility (SCF): financial assistance to LICs with short-term balance of payments needs
Rapid Credit Facility (RCF): rapid financial assistance (limited conditionality) to LICs facing an urgent balance of payments need
Non concessional loans
Stand-By Arrangements (SBA): designed to help countries address short-term balance of payments problems
Flexible Credit Line (FCL): for countries with very strong fundamentals, policies, and track records of policy implementation, crisis prevention purposes
Extended Fund Facility: established in 1974 to help countries address longer-term balance of payments problems requiring fundamental economic reforms
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IMF structural adjustment programmes
IMF loans
Conditionality: reduce domestic fiscal imbalances
Tax increasePrice
liberalisationMarket
deregulationTrade
liberalisation
Privatisation of state owned
companies
Export-led growthStagnation of domestic demand
Social hardship
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The IMF in question?
Support to military dictatorship(1970-80s)
Economic and social hardship caused by
structural adjustment programmes
Moral hazard exacerbation
An institution dominated by
developed economies and the "big business"?
Government in need of capital tend to refuse conditional IMF loans, crowding-out the institution's resources
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"The IMF is hurting the poor ..."
Turkey and Latvia were in the news last week, having joined the roster of governments whose IMF disbursements are being withheld because they find it politically impossible to impose the required punishments on their citizens. The IMF sees these measures as necessary and pre-determined – in most cases by the borrowing countries' having run-
up unsustainable external or budget imbalances. But in fact the IMF has a long track record – dating back decades – of imposing unnecessary and often harmful conditions
on borrowing countries.
Latvia missed a 200 million euro disbursement from the IMF in March for not cutting its budget enough. According to press reports, the government wants to run a budget
deficit of 7% of GDP for this year, and the IMF wants 5%. Latvia is already cutting its budget by 40%, and is planning to close some public hospitals and schools in order to
make the IMF's targets, prompting street protests.
In almost all of its standby arrangements negotiated over the last year, the IMF has included conditions that will reduce output and employment in situations where
economies are already shrinking.
http://www.guardian.co.uk/commentisfree/cifamerica/2009/may/13/imf-us-congress-aid
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The global crisis: a new authority for the IMF?
→ Emergency lending to emerging markets
→ Helping low-income countries fight the crisis
→ Supporting global fiscal stimulus
→ Reforming the international financial system
http://www.imf.org/external/about/onagenda.htm
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The case for monetary unions
A monetary (or currency) union is considered necessary when floating exchange rates could impede regional trade and the ability to create an integrated economy (e.g. Eurozone)
Dollarization is implemented in countries suffering from a weak and unstable currency (inflationary) and/or tightly bound to a larger economy (e.g. Ecuador, Panama)
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Monetary unions: success factors (OCA concept)
Optimum Currency Area
Free movement of people within the area
Countries agreeing to accept the costs of the
common monetary policy
Countries agreeing on the way to deal with
shocks
Countries agreeing to compensate for adverse
shocks
Countries open to international trade and trading with each other
Countries whose production and exports are widely diversified
and of similar structure
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The case of the European Monetary Union
08/10/1970: Werner's project for a European economic and monetary union
1971-1979: currency "snake" (semi-pegged system)
Snake in the tunnel (1097-73): European currencies pegged to the USD
Snake outside the tunnel (1973-79): European currencies pegged to one another
1979-1999: European Monetary System (EMS)
Currency basket (ECU)
Exchange Rate Mechanism (ERM): fixed currency exchange rate margins (2.25%), exchange rates are variable within those margins
1992-1999: EMS served as a basis for the European Monetary Union (EMU)
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The euro: achievements and shortcomings
Achievements :
Better balance of power within the EU (ECB decisions apply to all member states)
Lower interest rates
No more exchange costs/risks
Improved price transparency at European level
Currency stability, no more speculation crises within the zone
Shortcomings:
"Hidden" inflation following the enforcement of the euro (?)
The euro has not been able to boost economic growth and solve the unemployment issue in Europe
No economic convergence and limited coordination among Member States
Increasing divergences/imbalances among Member States
No incentive to reform?
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A political issue?
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The eurozone remains a hybrid. It is a monetary union but not a political union, and so countries such as
Ireland have had to go it alone in bailing out struggling banks. There is a clear distinction between the US,
where the government has financial clout across all 50 states, and the EU.
In the long term, monetary unions do not survive without political union, and so *…+ there are pressures both for closer integration and for disintegration. The
crisis could strengthen those who argue that the halfway house is inherently unstable and will remain so
until there is fiscal as well as monetary union. On the other hand, the growing threat of recession may make
some countries question the value of remaining in a monetary union.
http://www.guardian.co.uk/business/2008/oct/06/creditcrunch.eu
CURRENT ISSUES
Section 3
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Since 1973, a series of crises
Banking crises refer to a situation in which a loss of confidence in the banking system leads to a "run on the banks", as individuals and companies withdraw their deposits
Currency crises occurs when a speculative attack on the exchange value of a currency results in a sharp depreciation in the value of the currency, or forces authorities to expend large volumes of international currency reserves and sharply increase interest rates in order to defend prevailing exchange rates
Foreign debt crises are situations in which a country cannot service its foreign debt obligations, whether private sector or government debt
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Since 1973, a series of crises (ctd)
Latin American debt crisis (1980s)
Black Monday (October 19, 1987): global stock market crash
Japanese real estate bubble collapse (1990s)
EMS currency crises (1992-93)
Mexican currency crisis (1994)
Southeast Asian financial crisis (1997)
Russian debt crisis (1998), leading to the collapse of LTCM
Turkish financial crisis (2001)
Dotcom bubble burst (2001)
Argentine currency crisis (2002)
"Subprime" crisis ... leading to global recession (2007-2009)
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Current issues [1]
Chinese authorities have kept that currency persistently weak. They’ve done this mainly by trading renminbi [or yuans] for dollars, which they have accumulated
in vast quantities. And in recent months China has carried out what amounts to a beggar-thy-neighbor devaluation, keeping the yuan-dollar exchange rate fixed even as the dollar has fallen sharply against other major currencies. This has given Chinese exporters a growing competitive advantage over their rivals,
especially producers in other developing countries.
What makes China’s currency policy especially problematic is the depressed state of the world economy. Cheap money and fiscal stimulus seem to have averted a
second Great Depression. But policy makers haven’t been able to generate enough spending, public or private, to make progress against mass
unemployment. And China’s weak-currency policy exacerbates the problem, in effect siphoning much-needed demand away from the rest of the world into the
pockets of artificially competitive Chinese exporters.
New York Times, November 15, 2009
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Current issues [2]
*…+ last week the dollar neared $1.50 against the euro, compared with $1.25 in March. The weakness of the dollar, if sustained, could force American consumers to get used
to paying more for many imported goods as well as trips to their favorite vacation spots. But there is also an upside: a weak dollar could prove beneficial to the
American economy by aiding long-suffering manufacturers, rebuilding a stronger industrial base and lifting exports even if it makes life harder for trading partners
around the world, especially in Europe. *…+
If the dollar does keep falling and the euro keeps rising, it could increase trade tensions with Europe, especially big exporters like Germany, which have already been
hard hit by the global economic slump. “The strength of the euro is coming at absolutely the wrong time,” said Jens Nagel, head of the international department of the German Exporters Association in Berlin. *…+ “It has two sides, like it always does,”
said Carl Martin Welcker, owner of a machine tools maker, Schütte, in Cologne, Germany. “On the one hand, it makes our machines significantly more expensive,”
said Mr. Welcker, whose equipment churns out 80 percent of the world’s spark plugs. “On the other hand, we’re seeing international companies move production back to
the U.S., which helps our sales there.”
New York Times, October 18, 2009
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Current issues [3]
*…+ with Germany and France poised to record strong growth in the third quarter and Italy looking well placed to return to growth, the question of whether Britain should join [the euro] is being raised once again. The argument in favour is that Britain has paid a high price for staying out. Initially, the pound was too strong,
making British exports dearer and adding to the imbalances in the economy between an over-mighty City and a struggling manufacturing sector. Now sterling
is weak against the euro amid concerns about the vulnerability of British banks and the size of the black hole in the government's finances. [Moreover, A raft of large UK companies could follow Cadbury onto the takeover block as overseas predators cash in on the weakness of the pound and the UK's liberal markets.]
Inside the eurozone, there is collective security against a systemic crisis in the banking system; outside the eurozone Britain is simply a middle-ranking economic
power with a bloated financial sector and a huge debt.
Guardian, Monday 26 October 2009
Observer, Sunday 24 January 2010
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Current issues [4]
After simmering for months, the Greek sovereign-debt crisis has boiled over. The promise of a rescue by the IMF and the country’s euro-zone partners, worth €45 billion ($60 billion) or more, is no longer enough to persuade many private investors to hold Greek public bonds. Opposition to the bail-out in Germany meant that
market confidence had all but vanished by April 27th, when Standard and Poor’s (S&P) slashed its rating of Greek government
bonds to BB+, just below investment grade. The rating agency also lowered its rating on Portugal, to A-; a day later it downgraded
Spain from AA+ to AA. *…+
Do the rumblings in Greece signal a wider retreat by investors from sovereign debt? Defensive Eurocrats point out that the public
finances of the euro area as a whole are no worse than America’s. *…+ But the zone is not a single fiscal entity and investors are wary
of countries whose finances or growth prospects are worse than average. America [also] has the great advantage of issuing the
world’s reserve currency.
The Economist, 29 April 2010
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An intrinsically unbalanced system?
While there were many causes of the [current global economic and financial] crisis, its intensity and scope reflected unprecedented disequilibria. Large and unsustainable current account imbalances across major economic areas were
integral to the buildup of vulnerabilities in many asset markets. In recent years, the international monetary system failed to promote timely and orderly
economic adjustment.
This failure has ample precedents. Over the past century, different international monetary regimes have struggled to adjust to structural changes, including the integration of emerging economies into the global economy. In all
cases, systemic countries failed to adapt domestic policies in a manner consistent with the monetary system of the day. As a result, adjustment was
delayed, vulnerabilities grew, and the reckoning, when it came, was disruptive for all.
http://www.bank-banque-canada.ca/en/speeches/2009/sp191109.html
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A need for a better regulation …
Adjustment mechanism for dealing
with global imbalances.
Regulation of international capital
flows
Nature and role of reserve currency
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New regulation bodies: the G-20
The Group of 20, or G-20, is an international body that meets to discuss economic issues. It is a forum for cooperation and consultation on matters pertaining to the international financial system
It gathers finance ministers and central bank governors from 19 of the world's largest national economies, plus the European Union
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Its members -- 19 countries with some of the world's biggest industrial and emerging economies, plus the European Union --represent about 90 percent of the world's gross national product, 80 percent of world trade (including trade within the European Union) and two-thirds of the global population
