Lecture multinational financial management chapter 3 ngo thi ngoc huyen

and the U.K., $20.67 and ￡4.2474 can exchange for an ounce of gold, so the dollar/pound exchange rate was $20.67/ounce of gold / ￡4.2474 /ounce of gold = $4.8665/￡ – Since each governmen

FINANCIAL

MANAGEMENT

NGO THI NGOC HUYEN

THE INTERNATIONAL

CHAPTER

THREE

• Introduce the history of the international monetary system,

from the gold-standard system, Bretton Woods agreement, to modern international monetary systems

• Introduce the Eurocurrencies and their markets

• Compare different exchange rate regimes

• Introduce the capital mobility (the content in Ch 4)

• Analyze the exchange rate regimes for emerging markets:

currency boards and dollarization

• Introduce the history of the Euros

• Analyze the tradeoffs for international monetary systems

over the years

INTERNATIONAL MONETARY SYSTEM

HISTORY OF THE INTERNATIONAL

MONETARY SYSTEM

• The (classical) gold standard system (1876-1913)

– “Rules of the game” were simple: each country sets the rate at

which its currency could be converted to a weight of gold, or

said to set the par value for its currency in terms of gold

• For the U.S and the U.K., $20.67 and ￡4.2474 can exchange

for an ounce of gold, so the dollar/pound exchange rate was

($20.67/ounce of gold) / (￡4.2474 /ounce of gold) = $4.8665/￡

– Since each government agreed to buy or sell gold with anyone

at its announced rate, so exchange rates between currencies

were in effect “fixed”

• Maintaining adequate reserves of gold to back its currency’s

value was very important for a country under this system

– The system implicitly limits the rate at which any individual

country could expand its monetary supply

• Any growth in the amount of money was limited to the rate at

which official authorities could acquire addition gold

MONETARY SYSTEM

– The gold standard system can adjust the balance of

payments (BOP) by itself

• Surplus in BOP  increase of reserves of gold  government

increases monetary supply (expansionary monetary policy) 

IR↓ (international capital outflows), price level↑ (decrease of

export and increase of import)  decrease cash inflow to

reduce the surplus in BOP

• Deficit in BOP  decrease of reserves of gold  government

decreases monetary supply (contractionary monetary policy)

 IR↑ (attract international capital), price level↓ (increase of

export and decrease of import)  increase cash inflow to

decrease the deficit in BOP

※If all countries follow the above rule, it is impossible for a

country to have persistent surpluses or deficits for many years

– This classical gold standard system was in effect until the

outbreak of WWI, since the free movement of gold was

interrupted in the war

MONETARY SYSTEM

• The Inter-War Years & WWII (1914-1944)

– During WWI, many countries issue more currencies to support the war even without the increase of reserves of gold

– Therefore, currencies fluctuate over a fairly wide range in terms of gold and each other

– After WWI, the U.K tried to restore the gold standard system and maintain the same exchange rate between its currency and gold as that before WWI

– Since the reserves of gold did not increase for the U.K., but the outstanding amount of pound is several times than that before WWI, the pound is obviously overvalued at that rate

– International speculators sold short weak currencies to gain

profit, e.g., pound, which further reduced the reserves of gold

of these countries The reverse happened with strong currencies

MONETARY SYSTEM

– Short selling means that the investor sells an asset he does not own and later buy it back and delivery it to the buyer at a future date

– For overvalued currency (weak currency)  short sell currency to the government for gold (with more weight) 

if the currency really devalues  buy the currency back at the expense of gold (with less weight) and deliver the currency to the government  earn gold from the government

– For undervalued currency (strong currency)  buy currency from the government at the expense of gold (with less weight)  if the currency really revalues  sell the currency back to the government and obtain gold (with more weight)  earn gold from the government

HISTORY OF THE INTERNATIONAL

MONETARY SYSTEM

– The countries with surplus in BOP, e.g., the U.S and France,

adopted the sterilized intervene (by issuing government bonds

to offset the increased monetary supply caused by the surplus

in BOP) to maintain the surplus and accumulate gold

continuously

– Therefore, the gold standard system cannot adjust BOP any

more, which is one of the reasons for the crash of the gold

standard system

– In 1931, the U.K ceased the conversion between the pound and

gold and left the gold standard system

– The U.S adopted a modified gold standard in 1934, in which

the U.S Treasury traded gold only with foreign central banks,

not with private citizens

– During WWII and its chaotic aftermath, the US$ was the only

trading currency that continued to be convertible

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 U.S

dollar-based international monetary system and created two new

institutions, the International Monetary Fund (IMF) and the

World Bank

– The International Monetary Fund is a key institution in the

new international monetary system and was created to:

• Render temporary assistance to member countries defend their

currencies against cyclical, seasonal, or random occurrences,

e.g., financial crisis

MONETARY SYSTEM

• Assist countries having structural BOP or exchange rate problems if they promise to take adequate steps to correct these problems

• Each member country of IMF should deposit some reserves at the IMF, in which 25% is gold (special drawing right, SDR, and 75% is the local currency (general drawing right, GDR)

• Member countries can borrow the gold tranche freely, but need

to pay interests for the GDR – Member countries may settle transactions among themselves by transferring SDRs

– When a country uses the GDR to pay for the deficit of its BOP, it uses the local currency to buy other currencies After the there is a surplus in BOP, the country buys back its local currency

– The International Bank for Reconstruction and Development (World Bank) helped fund post-war reconstruction and since then has supported general economic development

MONETARY SYSTEM

• Under the Bretton Woods Agreement

– All countries fixed the value of their currencies in terms of gold but were not required to exchange their currencies for gold

– Only the dollar remained convertible into gold (at $35 per ounce) (at this time point, 75% of gold is held by the U.S.)

– Each currency established its exchange rate with the dollar

– Participating countries agreed to maintain the value of their currencies within 1% of par by buying or selling foreign exchange or gold as needed

– Devaluation was not to be used as a competitive trade policy

– If a currency became too weak to defend, a devaluation of up to 10% was allowed without formal approval by the IMF

– However, large devaluations required IMF approval

※This is known as the gold-exchange standard system

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

– However, widely diverging monetary and fiscal policies,

differential rates of inflation, and various currency shocks

resulted in the system’s demise

– In fact, among 21 industrialized countries, currencies of 12

(4) countries revalue (devalue) relative to US$

– The U.S had consistent deficits in BOP in this period, that

generates the outflow of the US$ to other countries

• These outflows were partially due to the growing demand for

dollars from investors, businesses, and central banks of other

countries, because the US$ is the most important foreign

reserve currency in that period

• The U.S did not adopt the contractionary monetary policy

MONETARY SYSTEM

– Eventually, the large amount of dollars held by foreigners

resulted in a lack of confidence in the ability of the U.S to

meet its commitment to convert dollars to gold

– In 1962, France asked the U.S to pay off its debt in gold

– In 1968, the U.S held only 25% of the gold of the world

– The lack of confidence forced President Richard Nixon to

suspend official purchases or sales of gold by the U.S

Treasury on August 15, 1971 (the international monetary

system is from gold-exchange standard to dollar standard in

nature)

– This resulted in subsequent devaluations of the dollar, so in

Smithsonian Agreement in Dec 1971, ten countries agreed

that the US$ is devalued to $38/oz of gold

MONETARY SYSTEM

– By the late February 1973, the fixed-rate system no longer appeared feasible given the speculative flows of currencies

– The major foreign exchange markets were actually closed for several weeks in March 1973, and when they reopened, most currencies were allowed to float to levels determined

by market forces

– In June 1973, floating rates continued to drive the now freely floating US$ down by about 10%

MONETARY SYSTEM

• An Eclectic Currency Arrangement (1973-Present)

– Since March 1973, exchange rates have become much more volatile than they were during the “fixed” period

– Jamaica Agreement:

• In Jan 1976, IMF meeting in Jamaica resulted in the

“legalization” of the floating exchange rate system already in effect, and gold was demonetized as a reserve asset

• Member countries can choose among different exchange rate regimes freely (the classifications of IMF’s exchange rate regime are introduced later)

• The special drawing right is no longer defined in terms of gold

The SDR is redefined every 5 years Today, SDR is the weighted average of four major currencies: 44% US$, 34%

Euro, 11% Japanese yen, and 11% British pound

• The SDR still serves as a unit of account for the IMF, so members can settle transactions among themselves by transferring SDRs

HISTORY OF THE INTERNATIONAL

MONETARY SYSTEM

• Each country’s foreign exchange reserves includes 1) SDR

in the form of deposits at the IMF; 2) its reserve position

at the IMF; 3) foreign exchange; 4) the official holdings of

gold

※Foreign exchange: the foreign asset of a country,

including the holdings of foreign currencies, securities,

notes, and deposits by the government and private citizens

(even these assets are deposited in foreign banks)

※Since Taiwan is not the member of the IMF, the foreign

exchange reserves of Taiwan means foreign exchange and

the official holdings of gold

EUROCURRENCIES AND

THEIR MARKETS

AND THEIR MARKETS

• Eurocurrencies

– These are domestic currencies of one country on deposit in a second country

– Thus, “Euro” means offshore rather than European zone

– In addition to Eurodollars, there are also Eurosterling, Euroyen, etc

– The Eurocurrency markets serve two valuable purposes for international corporations or corporations conducting international trade:

• Eurocurrency deposits are an efficient and convenient money market device for allocating excess corporate liquidity

• The Eurocurrency market is a major source of short-term bank loans to finance corporate working capital (investment in inventory and accounts receivable) needs, including export and import financing

AND THEIR MARKETS

– The history of the modern Eurodollar market

• During 1950s, investors or banks in communist countries, like Soviet Union and Eastern European countries, deposit their dollar holdings in Western European banks because they are afraid the deposits might be attached by the U.S with claims against communist governments

• In 1957, in order to improve the BOP, British imposed tight controls on U.K banks lending sterling to non-UK investors

or businesses U.K banks turned to conduct dollar lending business in order to maintain their leading position in world finance

• After WWII, due to the large financial help from the U.S to other countries and the surplus of BOP for European countries against the U.S., the amount of Eurodollars rises significantly

• During 1970s, with the rise of the oil price, oil output countries obtained large amount of US$ and deposited in the Eurodollar market

INTRODUCTION OF EUROCURRENCIES

AND THEIR MARKETS

– Eurocurrency Interest Rates: LIBOR and LIBID

• In the Eurocurrency market, the reference rate of interest is the

London Interbank Offered Rate (LIBOR) and London

Interbank Bid Rate (LIBID)

• For example, Eurodollar LIBOR (LIBID) is the mean of 16

multinational banks’ interbank offered (bid) rates for

Eurodollars sampled by the British Bankers Association (BBA)

at 11 a.m London time in London

– The bid rate is a rate at which a bank needs to pay for borrowing

money or accepting deposits

– The offer (or ask) rate is a rate at which a bank can earn for

lending money

– The bid-ask spread is one source of profit for banks

※BBA also collects the data of bid and ask rates for other

Eurocurrencies

AND THEIR MARKETS

• The bid-ask spread for Eurodollars is smaller than the bid-ask spread

for dollars

– The Eurodollar LIBOR is generally smaller than the loan rates in the

U.S because the Eurodollar market is a wholesale market

– The Eurodollar LIBID is generally higher than the deposit rates in the

U.S because foreign banks are not subject to the U.S regulations of the

reserves requirements and deposit insurance fees

» The Fed in the U.S asks a minimum percentage of reserves requirement

for the deposits of banks

» The deposit insurance is to against the liquidity risk for “run on the bank”

problems, in which many depositors lose confidence in banks and want to

withdraw money simultaneously

» Without the cost to prepare reserves requirements and deposit insurance,

foreign banks can provide a higher interest rate to borrow US$ or to accept

US$ deposits

– The narrower offer-bid spread is also an important reason for the

booming development of the Eurodollar market

DIFFERENT EXCHANGE RATE REGIMES

3-23

REGIME CLASSIFICATIONS

• The IMF classifies all exchange rate regimes into eight specific categories spanning the spectrum from rigidly fixed to independently floating

– Exchange arrangements with no separate legal tender (Ecuador, Panama, EU)

• Using the currency of other country as the legal tender (Ecuador, Panama, etc.)

• Sharing the same legal tender in a monetary union (EU)

– Currency board arrangements (HK)

• Maintaining the fixed exchange rate between the domestic

currency and a specified foreign currency by legislation

• In addition, issuing more domestic currencies only when

acquiring the specified foreign currency

• HK maintains about 7.8 HK dollars/US$ since 1983

THE IMF’S EXCHANGE RATE

REGIME CLASSIFICATIONS

– Other conventional fixed peg arrangements (China)

• The country pegs its currency at a fixed rate to a major currency or a

basket of currencies

• In addition, the exchange rate fluctuates within 1% around the

central rate

– Pegged exchange rates within horizontal bands (Denmark,

Hungary)

• Similar to the conventional fixed peg arrangements, but the margin

of fluctuation is wider than ±1%

– Crawling pegs (Nicaragua, Costa Rica)

• The country pegs its currency at a fixed, preannounced rate to a

major currency or a basket of currencies within a small fluctuation

range (usually smaller than 1%)

• The exchange rate is adjusted periodically or in response to changes

in selective quantitative indicators (e.g., the inflation rates in the

local country and in the major trading partners)

REGIME CLASSIFICATIONS

– Exchange rates within crawling pegs

• Similar to the crawling pegs, but the margin of fluctuation is

wider than ±1%

– Managed floating with no pre-announced path (Taiwan)

• The monetary authority attempts to influence the exchange rate

without specifying or pre-announcing exchange rate target

• Indicators for managing the rate includes the balance of payments

position, foreign reserves, parallel market developments, etc

• It is also called the dirty float

– Independent floating (U.S., Japan, Australia)

• The exchange rate is market-determined, with any official foreign

exchange market intervention aimed at moderating the rate of

change and preventing undue fluctuations in the exchange rate,

rather than at establishing a level for it

EXCHANGE RATES

• A nation’s choice as to which currency regime to follow reflects national priorities about all facets of the economy, including inflation, unemployment, interest rate levels, trade balances, and economic growth

• The choice among different exchange rate regimes may change over time as priorities change

• Next I will compare the advantages and disadvantages for the fixed and float exchange rate regimes

EXCHANGE RATES

• Fixed rate regime

– Advantages:

• Provide stability in international prices, which helps the growth of international trade and reduces risks for all businesses

• Fixed exchange rates are inherently anti-inflationary as long as the country follows the policy to increase the monetary supply only when acquiring additional foreign exchange reserves

– Problems:

• The restrictiveness is a burden for a country to pursue policies to alleviate internal economic problems, such as high unemployment

or slow economic growth

• Need for central banks to maintain large quantities of hard currencies and gold to defend the fixed rate

• Fixed rates could be maintained at rates that are inconsistent with economic fundamentals

• The fixed rates must be changed administratively or by legislation, usually with late response and at a too large a one-time cost

FIXED VERSUS FLEXIBLE

EXCHANGE RATES

• Float exchange rate regime

– Advantages

• The change of the exchange rate can adjust the balance of

payments automatically

• Central banks can maintain the independency about the

monetary policy, i.e., the associated decisions are

independent about foreign currencies

• It is not necessary for central banks to maintain large

quantities of foreign exchange reserves

– The reduction of foreign exchange reserves can be used to help

the economic development of the country

EXCHANGE RATES

– Disadvantages

• The fluctuation of the exchange rate may impede the

international trade and investment

• Central banks abuse the monetary independency to issue too

many currencies, which may result in serious inflation

• All nations incline to adopt the expansionary monetary policy

and the depreciation policy

– An expansionary monetary policy can stimulate the economic

growth

– A depreciation policy can maintain the competitive ability of export

※If all nations adopt these strategies, the international economy and

monetary system will be in disorder

• The foreign impact could affect the economic operation of the

local country through the exchange rate

DIFFERENT EXCHANGE RATE REGIMES

※ At first glance, it is surprised that currencies that are pegged had higher volatilities than those within limited flexibility regimes Please note that the declaration of a peg does not necessarily mean that the currency’s value never changed

※ Not surprisingly, the freely floating regime currency volatilities were the highest

※ The freely falling classification is for those specific countries that suffered severe crisis (usually these countries adopt the pegged or managed floating regime)

※ Volatilities in the 1991-2001 period is not higher than those in other periods, although there were many exchange rate crises in the 1990s (Mexico in 1994, Asia

in 1997, Russia in 1998, Brazil in 1999)

※ Possible reasons: 1) the US$ problem in 1981-1985; 2) the weighted average method

CURRENCY

• Possesses three attributes, often referred to as the

Impossible Trinity:

– Exchange rate stability

• As the exchange rate is more stable, the investors and businesses suffer less exchange rate risk

– Full financial integration

• Complete freedom of moving funds from one country and currency to another in response to possible economic opportunities or risks

– Monetary independence

• Domestic monetary and interest rate policies can be set by individual country to pursue policies to limit inflation, combat recession, and enhance employment

※The forces of economics can not allow the simultaneous achievement of all three A country must give up one of the above three goals

Attributes of the “Ideal” Currency

• In 1998-2002, Malaysia maintained very tight controls over the capital flow, so

it retained it monetary independence and a stable exchange rate, but lack the

integration with global financial and capital market

• The force of the need of increased capital mobility pushes more countries

toward full financial integration such that their business can attract international

capital and their domestic economy can be stimulated

• Therefore, these countries are forced to adopt either purely floating (like the

U.S.) or integrated with other countries in monetary unions (like the EU)

EU US

Malaysia 1998-2002

CAPITAL MOBILITY

• The degree to which capital moves freely across borders is critically important to a country’s balance of payments

• The high capital mobility sometimes can help a country, but sometimes will hurt a country

– The financial account surplus has probably been one of the major reasons that the U.S dollar has been able to maintain its value over the past 20 years

– Other countries, e.g., Brazil in 1998-1999 and Argentina in 2001-2002, have experienced massive financial account outflows, which were major components of their economic and financial crisis

Some researchers argue that the post-1860 era can be divided into four distinct periods with regard to capital mobility

1860-1914: continuously increasing capital mobility as the gold standard system was adopted and international trade relations were expanded (gold standard system)

1914-1945: global economy was destructed, many isolationist economic policies, negative effect on capital movement between countries (WWI-WWII)

1945-1971: Bretton Woods era causes a great expansion of international trade, but only the slow and steady recovery of capital markets (Bretton Woods Agreement)

1971-2002: due to floating exchange rates and economic volatility, cross-border capital flows expand rapidly (Eclectic Currency Arrangement)

EXHIBIT 1 A STYLIZED VIEW OF CAPITAL

MOBILITY IN MODERN HISTORY

• Capital can be moved via international bank transfers (legal),

with physical currency, collectables or precious metals,

money laundering (the cross-border purchase of assets in a

way that hides the movement of money and its ownership),

or false invoicing of international trade transactions

(underinvoicing or overinvoicing of imports and exports,

where the difference is another kind of capital movement)

• Although no single accepted definition of capital flight

exists, it can be characterized as serious capital movement

occurring when residents lose confidence in the government

due to political or financial problems

Many heavily indebted countries have suffered capital flight,

deteriorating their debt service problems

EXCHANGE RATE REGIMES FOR EMERGING MARKETS

AND REGIME CHOICES

• During 1997-2005, the increased mobility pressures push emerging market countries to choose among more extreme types of exchange rate regimes