International Capital Market

Source: Jennifer L. Schenker, “Taking Microfinance to the Next Level,” Business Week (www.businessweek.com), February 26, 2008; Steve Hamm, “Setting Standards for Microfinance,” Business Week (www.businessweek.com), July 28, 2008; Keith Epstein and Geri Smith, “Microlending: It’s No Cure-All,” Business Week (www.businessweek.com), December 13, 2007; Grameen Bank Web site (www.grameen-info.org), select reports.

Forces Expanding the International Capital Market

Around 40 years ago, national capital markets functioned largely as independent markets. But since that time, the amount of debt, equity, and currencies traded internationally has increased dramatically. This rapid growth can be traced to three main factors:

■
Information Technology.
Information is the lifeblood of every nation’s capital market because investors need information about investment opportunities and their corresponding risk levels. Large investments in information technology over the past two decades have drastically reduced the costs, in both time and money, of communicating around the globe. Investors and borrowers can now respond in record time to events in the international capital market. The introduction of electronic trading after the daily close of formal exchanges also facilitates faster response times.

■
Deregulation.
Deregulation of national capital markets has been instrumental in the expansion of the international capital market. The need for deregulation became apparent in the early 1970s, when heavily regulated markets in the largest countries were facing fierce competition from less regulated markets in smaller nations. Deregulation increased competition, lowered the cost of financial transactions, and opened many national markets to global investing and borrowing.

■
Financial Instruments.
Greater competition in the financial industry is creating the need to develop innovative financial instruments. One result of the need for new types of financial instruments is

securitization

—the unbundling and repackaging of hard-to-trade financial assets into more liquid, negotiable, and marketable financial instruments (or
securities
). For example, a mortgage loan from a bank is not liquid or negotiable because it is a customized contract between the bank and the borrower. Thus banks cannot sell loans and raise capital for further investment because each loan differs from every other loan. But agencies of the

U.S.

government, such as the Federal National Mortgage Association (www.fanniemae.com), guarantee mortgages against default and accumulate them as pools of assets. They then sell securities in capital markets that are backed by these mortgage pools. When mortgage bankers participate in this process, they are able to raise capital for further investment.2

securitization

Unbundling and repackaging of hard-to-trade financial assets into more liquid, negotiable, and marketable financial instruments (or
securities
).

World Financial Centers

The world’s three most important financial centers are London, New York, and Tokyo. Traditional exchanges may become obsolete unless they continue to modernize, cut costs, and provide new customer services. In fact, trading over the Internet and other systems might increase the popularity of
offshore financial centers
.

Offshore Financial Centers

An

offshore financial center

is a country or territory whose financial sector features very few regulations and few, if any, taxes. These centers tend to be economically and politically stable and provide access to the international capital market through an excellent telecommunications infrastructure. Most governments protect their own currencies by restricting the amount of activity that domestic companies can conduct in foreign currencies. So companies can find it hard to borrow funds in foreign currencies and thus turn to offshore centers, which offer large amounts of funding in many currencies. In short, offshore centers are sources of (usually cheaper) funding for companies with multinational operations.

offshore financial center

Country or territory whose financial sector features very few regulations and few, if any, taxes.

Offshore financial centers fall into two categories:

■ Operational centers see a great deal of financial activity. Prominent operational centers include London (which does a good deal of currency trading) and

Switzerland

(which supplies a great deal of investment capital to other nations).

■ Booking centers are usually located on small island nations or territories with favorable tax and/or secrecy laws. Little financial activity takes place here. Rather, funds simply pass through on their way to large operational centers. Booking centers are typically home to offshore branches of domestic banks that use them merely as bookkeeping facilities to record tax and currency-exchange information.3 Some important booking centers are the Cayman Islands and the Bahamas in the Caribbean; Gibraltar, Monaco, and the Channel Islands in Europe; Bahrain and Dubai in the Middle East; and Singapore in Southeast Asia.

Global banking giant HSBC recently added Dubai, United Arab Emirates, to its list of key offshore banking centers. The Dubai office will serve customers from the Middle East, North Africa, and Pakistan. HSBC also chose Dubai as its offshore center for Sharia-compliant products and services (those complying with Islamic law). HSBC Bank International is based in Jersey, Channel Islands, and has four other offshore centers in Jersey, Hong Kong, Miami, and Singapore.

Source: Ali Haider/epa–CORBIS-NY.

Quick Study

1. What are the three main purposes of the
international capital market
? Explain each briefly.

2. Identify the factors expanding the international capital market. What is meant by the term
securitization
?

3. What is an
offshore financial center
? Explain its appeal to businesses.

Main Components of the International Capital Market

Now that we have covered the basic features of the international capital market, let’s take a closer look at its main components: the international bond, international equity, and Eurocurrency markets.

International Bond Market

The

international bond market

consists of all bonds sold by issuing companies, governments, or other organizations outside their own countries. Issuing bonds internationally is an increasingly popular way to obtain needed funding. Typical buyers include medium-sized to large banks, pension funds, mutual funds, and governments with excess financial reserves. Large international banks typically manage the sales of new international bond issues for corporate and government clients.

international bond market

Market consisting of all bonds sold by issuing companies, governments, or other organizations outside their own countries.

Types of International Bonds

One instrument used by companies to access the international bond market is called a

Eurobond

—a bond issued outside the country in whose currency it is denominated. In other words, a bond issued by a Venezuelan company, denominated in U.S. dollars, and sold in Britain, France, Germany, and the Netherlands (but not available in the United States or to its residents) is a Eurobond. Because this Eurobond is denominated in U.S. dollars, the Venezuelan borrower both receives the loan and makes its interest payments in dollars.

Eurobond

Bond issued outside the country in whose currency it is denominated.

Eurobonds are popular (accounting for 75 to 80 percent of all international bonds) because the governments of countries in which they are sold do not regulate them. The absence of regulation substantially reduces the cost of issuing a bond. Unfortunately, it increases its risk level—a fact that may discourage some potential investors. The traditional markets for Eurobonds are Europe and North America.

Companies also obtain financial resources by issuing so-called
foreign bonds
—bonds sold outside the borrower’s country and denominated in the currency of the country in which they are sold. For example, a yen-denominated bond issued by the German carmaker BMW in Japan’s domestic bond market is a foreign bond. Foreign bonds account for about 20 to 25 percent of all international bonds.

foreign bond

Bond sold outside the borrower’s country and denominated in the currency of the country in which it is sold.

Foreign bonds are subject to the same rules and regulations as the domestic bonds of the country in which they are issued. Countries typically require issuers to meet certain regulatory requirements and to disclose details about company activities, owners, and upper management. Thus BMW’s samurai bonds (the name for foreign bonds issued in Japan) would need to meet the same disclosure and other regulatory requirements that Toyota’s bonds in Japan must meet. Foreign bonds in the United States are called yankee bonds and those in the United Kingdom are called bulldog bonds. Foreign bonds issued and traded in Asia outside Japan (and normally denominated in dollars) are called dragon bonds.

Interest Rates: A Driving Force

Today, low interest rates (the cost of borrowing) are fueling growth in the international bond market. Low interest rates in developed nations are resulting from low levels of inflation, but also mean that investors earn little interest on bonds issued by governments and companies in domestic markets. Thus banks, pension funds, and mutual funds are seeking higher returns in the newly industrialized and developing nations, where higher interest payments reflect the greater risk of the bonds. At the same time, corporate and government borrowers in developing countries badly need capital to invest in corporate expansion plans and public works projects.

This situation raises an interesting question: How can investors who are seeking higher returns and borrowers who are seeking to pay lower interest rates both come out ahead? The answer, at least in part, lies in the international bond market:

■ By issuing bonds in the international bond market, borrowers from newly industrialized and developing countries can borrow money from other nations where interest rates are lower.

■ By the same token, investors in developed countries buy bonds in newly industrialized and developing nations in order to obtain higher returns on their investments (although they also accept greater risk).

Despite the attraction of the international bond market, many emerging markets see the need to develop their own national markets because of volatility in the global currency market. A currency whose value is rapidly declining can wreak havoc on companies that earn profits in, say, Indonesian rupiahs but must pay off debts in dollars. Why? A drop in a country’s currency forces borrowers to shell out more local currency to pay off the interest owed on bonds denominated in an unaffected currency.

International Equity Market

The

international equity market

consists of all stocks bought and sold outside the issuer’s home country. Companies and governments frequently sell shares in the international equity market. Buyers include other companies, banks, mutual funds, pension funds, and individual investors. The stock exchanges that list the greatest number of companies from outside their own borders are Frankfurt, London, and New York. Large international companies frequently list their stocks on several national exchanges simultaneously and sometimes offer new stock issues only outside their country’s borders. Four factors are responsible for much of the past growth in the international equity market.

international equity market

Market consisting of all stocks bought and sold outside the issuer’s home country.

Spread of Privatization

As many countries abandoned central planning and socialist-style economics, the pace of privatization accelerated worldwide. A single privatization often places billions of dollars of new equity on stock markets. When the government of Peru sold its 26 percent share of the national telephone company, Telefonica del Peru (www.telefonica.com.pe), it raised $1.2 billion. Of the total value of the sale, 48 percent was sold in the United States, 26 percent to other international investors, and another 26 percent to domestic retail and institutional investors in Peru.

Increased privatization in Europe is also expanding worldwide equity. Although Europe is traditionally more devoted to debt as a means of financing, an “equity culture” is taking root. As the European Union becomes more thoroughly integrated, investors will become more willing to invest in the stocks of companies from other European nations.

Economic Growth in Emerging Markets

Continued economic growth in emerging markets is contributing to growth in the international equity market. Companies based in these economies require greater investment as they succeed and grow. The international equity market becomes a major source of funding because only a limited supply of funds is available in these nations.

Activity of Investment Banks

Global banks facilitate the sale of a company’s stock worldwide by bringing together sellers and large potential buyers. Increasingly, investment banks are searching for investors outside the national market in which a company is headquartered. In fact, this method of raising funds is becoming more common than listing a company’s shares on another country’s stock exchange.

Advent of Cybermarkets

The automation of stock exchanges is encouraging growth in the international equity market. The term cybermarkets denotes stock markets that have no central geographic locations. Rather, they consist of global trading activities conducted on the Internet. Cybermarkets (consisting of supercomputers, high-speed data lines, satellite uplinks, and individual personal computers) match buyers and sellers in nanoseconds. They allow companies to list their stocks worldwide through an electronic medium in which trading takes place 24 hours a day.

Eurocurrency Market

All the world’s currencies that are banked outside their countries of origin are referred to as
Eurocurrency
and trade on the

Eurocurrency market

. Thus U.S. dollars deposited in a bank in Tokyo are called Eurodollars and British pounds deposited in New York are called Europounds. Japanese yen deposited in Frankfurt are called Euroyen, and so forth.

Eurocurrency market

Market consisting of all the world’s currencies (referred to as “Eurocurrency”) that are banked outside their countries of origin.

Because the Eurocurrency market is characterized by very large transactions, only the very largest companies, banks, and governments are typically involved. Deposits originate primarily from four sources:

■ Governments with excess funds generated by a prolonged trade surplus

■ Commercial banks with large deposits of excess currency

■ International companies with large amounts of excess cash

■ Extremely wealthy individuals

Eurocurrency originated in Europe during the 1950s—hence the “Euro” prefix. Governments across Eastern Europe feared they might forfeit dollar deposits made in U.S. banks if U.S. citizens were to file claims against them. To protect their dollar reserves, they deposited them in banks across Europe. Banks in the United Kingdom began lending these dollars to finance international trade deals, and banks in other countries (including

Canada

and Japan) followed suit. The Eurocurrency market is valued at around $6 trillion, with London accounting for about 20 percent of all deposits. Other important markets include Canada, the Caribbean, Hong Kong, and Singapore.

Appeal of the Eurocurrency Market

Governments tend to strictly regulate commercial banking activities in their own currencies within their borders. For example, they often force banks to pay deposit insurance to a central bank, where they must keep a certain portion of all deposits “on reserve” in non-interest-bearing accounts. Although such restrictions protect investors, they add costs to banking operations. The main appeal of the Eurocurrency market is the complete absence of regulation, which lowers the cost of banking. The large size of transactions in this market further reduces transaction costs. Thus banks can charge borrowers less, pay investors more, and still earn healthy profits.

Interbank interest rates
—rates that the world’s largest banks charge one another for loans—are determined in the free market. The most commonly quoted rate of this type in the Eurocurrency market is the London Interbank Offer Rate (LIBOR)—the interest rate that London banks charge other large banks that borrow Eurocurrency. The London Interbank Bid Rate (LIBID) is the interest rate offered by London banks to large investors for Eurocurrency deposits.

interbank interest rates

Interest rates that the world’s largest banks charge one another for loans.

An unappealing feature of the Eurocurrency market is greater risk; government regulations that protect depositors in national markets are nonexistent here. Despite the greater risk of default, however, Eurocurrency transactions are fairly safe because the banks involved are large with well-established reputations.

Foreign Exchange Market

Unlike domestic transactions, international transactions involve the currencies of two or more nations. To exchange one currency for another in international transactions, companies rely on a mechanism called the

foreign exchange market

—a market in which currencies are bought and sold and their prices are determined. Financial institutions convert one currency into another at a specific

exchange rate

—the rate at which one currency is exchanged for another. Rates depend on the size of the transaction, the trader conducting it, general economic conditions, and sometimes government mandate.

foreign exchange market

Market in which currencies are bought and sold and their prices are determined.

exchange rate

Rate at which one currency is exchanged for another.

In many ways, the foreign exchange market is like the markets for commodities such as cotton, wheat, and copper. The forces of supply and demand determine currency prices, and transactions are conducted through a process of bid and ask quotes. If someone asks for the current exchange rate of a certain currency, the bank does not know whether it is dealing with a prospective buyer or seller. Thus it quotes two rates: The bid quote is the price at which it will buy, and the ask quote is the price at which it will sell. For example, say that the British pound is quoted in U.S. dollars at $

1.9815

. The bank may then bid $1.9813 to buy British pounds and offer to sell them at $1.9817. The difference between the two rates is the bid–ask spread. Naturally, banks will buy currencies at a lower price than they sell them and earn their profits from the bid–ask spread.

Functions of the Foreign Exchange Market

The foreign exchange market is not really a source of corporate finance. Rather, it facilitates corporate financial activities and international transactions. Investors use the foreign exchange market for four main reasons.

Currency Conversion

Companies use the foreign exchange market to convert one currency into another. Suppose a Malaysian company sells a large number of computers to a customer in France. The French customer wants to pay for the computers in euros, the European Union currency, whereas the Malaysian company wants to be paid in its own ringgit. How do the two parties resolve this dilemma? They turn to banks that will exchange the currencies for them.

Companies also must convert to local currencies when they undertake foreign direct investment. Later, when a firm’s international subsidiary earns a profit and the company wants to return some of it to the home country, it must convert the local money into the home currency.

Currency Hedging

The practice of insuring against potential losses that result from adverse changes in exchange rates is called

currency hedging

. International companies commonly use hedging for one of two purposes:

currency hedging

Practice of insuring against potential losses that result from adverse changes in exchange rates.

1. To lessen the risk associated with international transfers of funds

2. To protect themselves in credit transactions in which there is a time lag between billing and receipt of payment.

Suppose a South Korean carmaker has a subsidiary in Britain. The parent company in Korea knows that in 30 days—say, on February 1—its British subsidiary will be sending it a payment in British pounds. Because the parent company is concerned about the value of that payment in South Korean won a month in the future, it wants to insure against the possibility that the pound’s value will fall over that period—meaning, of course, that it will receive less money. Therefore, on January 2 the parent company contracts with a financial institution, such as a bank, to exchange the payment in one month at an agreed-upon exchange rate specified on January 2. In this way, as of January 2 the Korean company knows exactly how many won the payment will be worth on February 1.

Currency Arbitrage

Currency arbitrage
is the instantaneous purchase and sale of a currency in different markets for profit. Suppose a currency trader in New York notices that the value of the European Union euro is lower in Tokyo than it is in New York. The trader can buy euros in Tokyo, sell them in New York, and earn a profit on the difference. Hightech communication and trading systems allow the entire transaction to occur within seconds. But note that if the difference between the value of the euro in Tokyo and the value of the euro in New York is not greater than the cost of conducting the transaction, the trade is not worth making.

currency arbitrage

Instantaneous purchase and sale of a currency in different markets for profit.

Currency arbitrage is a common activity among experienced traders of foreign exchange, very large investors, and companies in the arbitrage business. Firms whose profits are generated primarily by another economic activity, such as retailing or manufacturing, take part in currency arbitrage only if they have very large sums of cash on hand.

INTEREST ARBITRAGE

Interest arbitrage
is the profit-motivated purchase and sale of interest-paying securities denominated in different currencies. Companies use interest arbitrage to find better interest rates abroad than those that are available in their home countries. The securities involved in such transactions include government treasury bills, corporate and government bonds, and even bank deposits. Suppose a trader notices that the interest rates paid on bank deposits in

Mexico

are higher than those paid in Sydney, Australia (after adjusting for exchange rates). He can convert Australian dollars to Mexican pesos and deposit the money in a Mexican bank account for, say, one year. At the end of the year, he converts the pesos back into Australian dollars and earns more in interest than the same money would have earned had it remained on deposit in an Australian bank.

interest arbitrage

Profit-motivated purchase and sale of interest-paying securities denominated in different currencies.

Currency Speculation

Currency speculation
is the purchase or sale of a currency with the expectation that its value will change and generate a profit. The shift in value might be expected to occur suddenly or over a longer period. The foreign exchange trader may bet that a currency’s price will go either up or down in the future. Suppose a trader in London believes that the value of the Japanese yen will increase over the next three months. She buys yen with pounds at today’s current price, intending to sell them in 90 days. If the price of yen rises in that time, she earns a profit; if it falls, she takes a loss. Speculation is much riskier than arbitrage because the value, or price, of currencies is quite volatile and is affected by many factors. Similar to arbitrage, currency speculation is commonly the realm of foreign exchange specialists rather than the managers of firms engaged in other endeavors.

currency speculation

Purchase or sale of a currency with the expectation that its value will change and generate a profit.

A classic example of currency speculation unfolded in Southeast Asia in 1997. After news emerged in May about Thailand’s slowing economy and political instability, currency traders sprang into action. They responded to poor economic growth prospects and an overvalued currency, the Thai baht, by dumping the baht on the foreign exchange market. When the supply glutted the market, the value of the baht plunged. Meanwhile, traders began speculating that other Asian economies were also vulnerable. From the time the crisis first hit until the end of 1997, the value of the Indonesian rupiah fell by 87 percent, the South Korean won by 85 percent, the Thai baht by 63 percent, the Philippine peso by 34 percent, and the Malaysian ringgit by 32 percent.4 Although many currency speculators made a great deal of money, the resulting hardship experienced by these nations’ citizens caused some to question the ethics of currency speculation on such a scale. (We cover the Asian crisis and currency speculation in detail in Chapter 10.)

Foreign exchange brokerage workers in Tokyo, Japan, dress in traditional Japanese kimonos for the first trading day of the year. Average daily turnover on Tokyo’s foreign exchange market is about $240 billion. Yet this is still significantly lower than trading volume in the

U.K.

market ($1.33 trillion) and the U.S. market ($618 billion). Around $3.2 trillion worth of currency is traded on global foreign exchange markets every day.

Source: Eriko Sugita/Reuters–CORBIS-NY.

Quick Study

1. Describe the
international bond market
. What single factor is most responsible for fueling its growth?

2. What is the
international equity market
? Identify the factors responsible for its expansion.

3. Describe the
Eurocurrency market
. What is its main appeal?

4. For what four reasons do investors use the foreign exchange market?

How the Foreign Exchange Market Works

Because of the importance of foreign exchange to trade and investment, businesspeople must understand how currencies are quoted in the foreign exchange market. Managers must know what financial instruments are available to help them protect the profits earned by their international business activities. They must also be aware of government restrictions that may be imposed on the convertibility of currencies and know how to work around these and other obstacles.

Quoting Currencies

There are two components to every quoted exchange rate: the quoted currency and the base currency. If an exchange rate quotes the number of Japanese yen needed to buy one U.S. dollar (¥/$), the yen is the

quoted currency

and the dollar is the

base currency

. When you designate any exchange rate, the quoted currency is always the numerator and the base currency is the denominator. For example, if you were given a yen/dollar exchange rate quote of 110/1 (meaning that 110 yen are needed to buy one dollar), the numerator is 110 and the denominator is 1. We can also designate this rate as ¥ 110/$.

quoted currency

The numerator in a quoted exchange rate, or the currency with which another currency is to be purchased.

base currency

The denominator in a quoted exchange rate, or the currency that is to be purchased with another currency.

Direct and Indirect Rate Quotes

Table 9.1 lists exchange rates between the U.S. dollar and a number of other currencies as reported by the Wall Street Journal.5 There is one important note to make about this table. As we learned in Chapter 8, the currencies of nations participating in the single currency (euro) of the European Union are already out of circulation. To look up exchange rates for these nations, see the line reading “Euro area euro” in Table 9.1.

The second column of numbers in Table 9.1, under the heading “

Currency per U.S. $

,” tells us how many units of each listed currency can be purchased with one U.S. dollar. For example, find the row labeled “Japan (

Yen

).” The number

106.81

in the second column tells us that 106.81 Japanese yen can be bought with one U.S. dollar. We state this exchange rate as ¥ 106.81/$. Because the yen is the quoted currency, we say that this is a direct quote on the yen and an indirect quote on the dollar. This method of quoting exchange rates is called European terms because it is typically used outside the United States.

TABLE 9.1 Exchange Rates of Major Currencies

Country/Currency

U.S. $ Equivalent

Currency per U.S. $

Argentina (peso)

0.3319

3.0130   

Australian (dollar)

0.9556   

1.0465   

Bahrain (dinar)

2.6525   

0.3770   

Brazil (real)

0.621

1   

1.6100   

Canada (dollar)

0.9893

1.0108

   1-mos forward

0.9888   

1.0113   

   3-mos forward

0.9882   

1.0119   

   6-mos forward

0.9873   

1.0129   

Chile (peso)

0.001989   

502.77   

China (yuan)

0.1458   

6.8599   

Colombia (peso)

0.0005782   

1729.51   

Czech Rep. (koruna)

0.06724   

14.872   

Denmark (krone)

0.2109   

4.7416   

Ecuador U.S. (dollar)

1   
1   

Eqypt (pound)

0.1870   

5.3476   

Euro area (euro)

1.5737

0.6354

Hong Kong (dollar)

0.1282   

7.8021   

Hungary (forint)

0.006794   

147.19   

India (rupee)

0.02325   

43.0108   

Indonesia (rupiah)

0.0001090   

9174   

Israel (shekel)

0.3109   

3.2165   

Japan (yen)

0.009362   

106.81   

   1-mos forward

0.009379   

106.62   

   3-mos forward

0.0094

12   

106.25   

   6-mos forward

0.009465   

105.65   

Jordan (dinar)

1.4139   

0.7073   

Kenya (shilling)

0.01505   

66.450   

Kuwait (dinar)

3.7702   

0.2652   

Lebanon (pound)

0.0006634   

1507.39   

Malaysia (ringgit)

0.3082   

3.2446   

Mexico (peso)

0.0971

10.3029   

New Zealand (dollar)

0.7577   

1.3198   

Norway (krone)

0.1955   

5.1151   

Pakistan (rupee)

0.01403   

71.276   

Peru (new sol)

0.3566   

2.8043   

Philippines (peso)

0.0220   

45.475   

Poland (zloty)

0.4804   

2.0816   

Romania (leu)

0.4442   

2.2511   

Russia (ruble)

0.04267   

23.436   

Saudi Arabia (riyal)

0.2666   

3.7509   

Singapore (dollar)

0.7360   

1.3587   

Slovak Rep (koruna)

0.05196   

19.246   

South Africa (rand)

0.1291   

7.7459   

South Korea (won)

0.0010008   

999.20   

Sweden (krona)

0.1664   

6.0096   

Switzerland (franc)

0.9719

1.0289

   1-mos forward

0.9722   

1.0286   

   3-mos forward

0.9727   

1.0281   

   6-mos forward

0.9735   

1.0272   

Taiwan (dollar)

0.03290   

30.395   

Thailand (baht)

0.02975   

33.613   

Turkey (lira)

0.8166   

1.2245   

U.A.E. (dirham)

0.2723   

3.6724   

U.K. (pound)

1.9815   

0.5047

   1-mos forward

1.9769   

0.5058   

   3-mos forward

1.9675   

0.5083   

   6-mos forward

1.9547   

0.5116   

Uruguay (peso)

0.05190   

19.27   

Venezuela (b. fuerte)

0.46628742   

2.1446   

Vietnam (dong)

0.00006   

16850   

Source: Wall Street Journal (www.wsj.com), July 9, 2008.

The first column of numbers in Table 9.1, under the heading “U.S. $ Equivalent,” tells us how many U.S. dollars it costs to buy one unit of each listed currency. The first column following the words “Japan (Yen),” tells us that it costs $0.009362 to purchase one yen (¥)—less than one U.S. cent. We state this exchange rate as $0.009362/¥. In this case, because the dollar is the quoted currency, we have a direct quote on the dollar and an indirect quote on the yen. The practice of quoting the U.S. dollar in direct terms is called U.S. terms because it is used mainly in the United States.

Whether we use a direct or an indirect quote, it is easy to find the other: simply divide the quote into the numeral 1. The following formula is used to derive a direct quote from an indirect quote:

And for deriving an indirect quote from a direct quote:

And for deriving an indirect quote from a direct quote:

For example, suppose we are given an indirect quote on the U.S. dollar of ¥ 106.81/$. To find the direct quote, we simply divide ¥ 106.81 into $1:

$1 ÷ ¥ 106.81 = $0.009362/¥

Note that our solution matches the number in the first column of numbers in Table 9.1 following the words “Japan (Yen).” Conversely, to find the indirect quote, we divide the direct quote into 1. In our example, we divide $0.009362 into ¥ 1:

¥ 1 ÷ $0.009362 = ¥ 106.81/$

This solution matches the number in the second column of numbers in Table 9.1 following the words “Japan (Yen).”

Calculating Percent Change

Businesspeople and foreign exchange traders track currency values over time as measured by exchange rates because changes in currency values can benefit or harm current and future international transactions.
Exchange-rate risk (foreign exchange risk)
is the risk of adverse changes in exchange rates. Managers develop strategies to minimize this risk by tracking percent changes in exchange rates. For example, take PN as the exchange rate at the end of a period (the currency’s new price) and PO as the exchange rate at the beginning of that period (the currency’s old price). We now can calculate percent change in the value of a currency with the following formula:

exchange-rate risk (foreign exchange risk)

Risk of adverse changes in exchange rates.

Note: This equation yields the percent change in the base currency, not in the quoted currency.

Let’s illustrate the usefulness of this calculation with a simple example. Suppose that on February 1 of the current year, the exchange rate between the Norwegian krone (NOK) and the U.S. dollar was NOK 5/$. On March 1 of the current year, suppose the exchange rate stood at NOK 4/$. What is the change in the value of the base currency, the dollar? If we plug these numbers into our formula, we arrive at the following change in the value of the dollar:

Thus the value of the dollar has fallen 20 percent. In other words, one U.S. dollar buys 20 percent fewer Norwegian kroner on March 1 than it did on February 1.

To calculate the change in the value of the Norwegian krone, we must first calculate the indirect exchange rate on the krone. This step is necessary because we want to make the krone our base currency. Using the formula presented earlier, we obtain an exchange rate of $.20/NOK (1 ÷ NOK 5) on February 1 and an exchange rate of $.25/NOK (1 ÷ NOK 4) on March 1. Plugging these rates into our percent-change formula, we get:

Thus the value of the Norwegian krone has risen 25 percent. One Norwegian krone buys 25 percent more U.S. dollars on March 1 than it did on February 1.

How important is this difference to businesspeople and exchange traders? Consider that the typical trading unit in the foreign exchange market (called a round lot) is $5 million. Therefore, a $5 million purchase of kroner on February 1 would yield NOK 25 million. But because the dollar has lost 20 percent of its buying power by March 1, a $5 million purchase would fetch only NOK 20 million—5 million fewer kroner than a month earlier.

Cross Rates

International transactions between two currencies other than the U.S. dollar often use the dollar as a vehicle currency. For example, a retail buyer of merchandise in the Netherlands might convert its euros (recall that the Netherlands uses the European Union currency) to U.S. dollars and then pay its Japanese supplier in U.S. dollars. The Japanese supplier may then take those U.S. dollars and convert them to Japanese yen. This process was more common years ago, when fewer currencies were freely convertible and when the United States greatly dominated world trade. Today, a Japanese supplier may want payment in euros. In this case, both the Japanese and the Dutch companies need to know the exchange rate between their respective currencies. To find this rate using their respective exchange rates with the U.S. dollar, we calculate what is called a

cross rate

—an exchange rate calculated using two other exchange rates.

cross rate

Exchange rate calculated using two other exchange rates.

Cross rates between two currencies can be calculated using either currency’s indirect or direct exchange rates with another currency. For example, suppose we want to know the cross rate between the currencies of the Netherlands and Japan. Looking at Table 9.1 again, we see that the direct quote on the euro is € 0.6354/$. The direct quote on the Japanese yen is ¥ 106.81/$. To find the cross rate between the euro and the yen, with the yen as the base currency, we simply divide € 0.6354/$ by ¥ 106.81/$:

€ 0.6354/$ ÷ ¥ 106.81/$ = €

0.0059

/¥

Thus it costs 0.0059 euros to buy 1 yen.

We can also calculate the cross rate between the euro and the yen by using the indirect quotes for each currency against the U.S. dollar. Again, we see in Table 9.1 that the indirect quote on the euro to the dollar is $1.5737/€. The indirect quote on the yen to the dollar is $0.009362/¥. To find the cross rate between the euro and the yen, again with the yen as the base currency, we divide $1.5737/€ by $0.009362/¥:

$1.5737/€ ÷ $0.009362/¥ = €

168.09

/¥

We must then perform an additional step to arrive at the same answer as we did earlier. Because indirect quotes were used in our calculation, we must divide our answer into 1:

1 ÷ € 168.09/¥ = € 0.0059/¥

Again (as in our earlier solution), we see that it costs 0.0059 euros to buy 1 yen.

Table 9.2 shows the cross rates for major world currencies. When finding cross rates using direct quotes, currencies down the left-hand side represent quoted currencies; those across the top represent base currencies. Conversely, when finding cross rates using indirect quotes, currencies down the left side represent base currencies; those across the top represent quoted currencies. Look at the intersection of the “Euro” row (the quoted currency in our example) and the “Yen” column (our base currency). Note that our solutions for the cross rate between euro and yen match the listed rate of 0.0059 euros to the yen.

TABLE 9.2 Key Currency Cross Rates

Dollar

Euro

Pound

SFranc

Peso

Yen

CdnDlr

Canada
1.0108

1.5907

2.0029

0.9824

0.0981

0.0095

….

Japan
106.81
168.09

211.65

103.81

10.367

….

105.67

Mexico

10.303

16.214

20.415

10.013

….

0.0965

10.193

Switzerland
1.0289

1.6192

2.0388

….

0.0999

0.0096

1.0179

U.K.
0.5047

0.7942

….

0.4905

0.0490

0.0047

0.4993

Euro
0.6354
….

1.2591

0.6176

0.0617

0.0059

0.6286

U.S.
….
1.5737
1.9815
0.9719
0.0971
0.0094
0.9893
Source: Wall Street Journal (www.wsj.com), July 9, 2008.

Naturally, the exchange rate between the euro and the yen is quite important to both the Japanese supplier and Dutch retailer we mentioned earlier. If the value of the euro falls relative to the yen, the Dutch company must pay more in euros for its Japanese products. This situation will force the Dutch company to take one of two steps: Either increase the price at which it resells the Japanese product (perhaps reducing sales), or keep prices at current levels (thus reducing its profit margin). Ironically, the Japanese supplier will suffer if the yen rises too much. Why? Under such circumstances, the Japanese supplier can do one of two things: Allow the exchange rate to force its euro prices higher (thus maintaining profits) or reduce its yen prices to offset the decline of the euro (thus reducing its profit margin). Both the Japanese supplier and the Dutch buyer can absorb exchange rate changes by squeezing profits—but only to a point. After that point is passed, they will no longer be able to trade. The Dutch buyer will be forced to look for a supplier in a country with a more favorable exchange rate or for a supplier in its own country (or another European country that uses the euro).

Spot Rates

All the exchange rates we’ve discussed so far are called
spot rates
—exchange rates that require delivery of the traded currency within two business days. Exchange of the two currencies is said to occur “on the spot,” and the

spot market

is the market for currency transactions at spot rates. The spot market assists companies in performing any one of three functions:

spot rate

Exchange rate requiring delivery of the traded currency within two business days.

spot market

Market for currency transactions at spot rates.

1. Converting income generated from sales abroad into their home-country currency

2. Converting funds into the currency of an international supplier

3. Converting funds into the currency of a country in which they wish to invest

Buy and Sell Rates

The spot rate is available only for trades worth millions of dollars. That is why it is available only to banks and foreign exchange brokers. If you are traveling to another country and want to exchange currencies at your bank before departing, you will not be quoted the spot rate. Rather, banks and other institutions will give you a buy rate (the exchange rate at which the bank will buy a currency) and an ask rate (the rate at which it will sell a currency). In other words, you will receive what we described when introducing the foreign exchange market as bid and ask quotes. These rates reflect the amounts that large currency traders are charging, plus a markup.

For example, suppose you are leaving Mexico for a business trip to Canada and need to buy some Canadian dollars (C$). The bank will quote you exchange rate terms, such as peso 10.088/98 per C$. In other words, the bank will buy Canadian dollars at the rate of peso 10.088/C$ and sell them at the rate of peso 10.098/C$.

Forward Rates

When a company knows that it will need a certain amount of foreign currency on a certain future date, it can exchange currencies using a

forward rate

—an exchange rate at which two parties agree to exchange currencies on a specified future date. Forward rates represent the expectations of currency traders and bankers regarding a currency’s future spot rate. Reflected in these expectations are a country’s present and future economic conditions (including inflation rate, national debt, taxes, trade balance, and economic growth rate) as well as its social and political situation. The

forward market

is the market for currency transactions at forward rates.

forward rate

Exchange rate at which two parties agree to exchange currencies on a specified future date.

forward market

Market for currency transactions at forward rates.

To insure themselves against unfavorable exchange-rate changes, companies commonly turn to the forward market. It can be used for all types of transactions that require future payment in other currencies, including credit sales or purchases, interest receipts or payments on investments or loans, and dividend payments to stockholders in other countries. But not all nations’ currencies trade in the forward market, such as countries experiencing high inflation or currencies not in demand on international financial markets.

Forward Contracts

Suppose a Brazilian bicycle maker imports parts from a Japanese supplier. Under the terms of their contract, the Brazilian importer must pay 100 million Japanese yen in 90 days. The Brazilian firm can wait until one or two days before payment is due, buy yen in the spot market, and pay the Japanese supplier. But in the 90 days between the contract date and the due date, the exchange rate will likely change. What if the value of the Brazilian real goes down? In that case, the Brazilian importer will have to pay more reais (plural of real) to get the same 100 million Japanese yen. Therefore, our importer may want to pay off the debt before the 90-day term. But what if it does not have the cash on hand? What if it needs those 90 days to collect accounts receivable from its own customers?

To decrease its exchange-rate risk, our Brazilian importer can enter into a

forward contract

—a contract that requires the exchange of an agreed-upon amount of a currency on an agreed-upon date at a specific exchange rate. Forward contracts are commonly signed for 30, 90, and 180 days into the future, but customized contracts (say, for 76 days) are possible. Note that a forward contract requires exchange of an agreed-upon amount of a currency on an agreed-upon date at a specific exchange rate: The bank must deliver the yen, and the Brazilian importer must buy them at the prearranged price. Forward contracts belong to a family of financial instruments called
derivatives
—instruments whose values derive from other commodities or financial instruments. These include not only forward contracts, but also currency swaps, options, and futures (presented later in this chapter).

forward contract

Contract that requires the exchange of an agreed-upon amount of a currency on an agreed-upon date at a specific exchange rate.

derivative

Financial instrument whose value derives from other commodities or financial instruments.

In our example, the Brazilian importer can use a forward contract to pay yen to its Japanese supplier in 90 days. It is always possible, of course, that in 90 days, the value of the real will be lower than its current value. But by locking in at the forward rate, the Brazilian firm protects itself against the less favorable spot rate at which it would have to buy yen in 90 days. In this case, the Brazilian company protects itself from paying more to the supplier at the end of 90 days than if it were to pay at the spot rate in 90 days. Thus it protects its profit from further erosion if the spot rate becomes even more unfavorable over the next three months. Remember, too, that such a contract prevents the Brazilian importer from taking advantage of any increase in the value of the real in 90 days that would reduce what the company owed its Japanese supplier.

PREMIUMS AND DISCOUNTS

As we have already seen, a currency’s forward exchange rate can be higher or lower than its current spot rate. If its forward rate is higher than its spot rate, the currency is trading at a premium. If its forward rate is lower than its spot rate, it is trading at a discount. Again, look at Table 9.1. Locate the row under “U.K. (pound)” labeled “1-mos forward.” This is the 30-day forward exchange rate for the British pound (GBP). Note that the rate of $1.9769/GBP is less than the spot rate of $1.9815/GBP (the spot rate quoted in the previous row of Table 9.1). The pound, therefore, is trading at a discount on the one-month forward contract. We know, then, that a contract to deliver British pounds in 30 days costs $0.0046 less per pound in 30 days than it does today. Likewise, the three- and six-month forward rates tell us that pounds cost $0.0140 and $0.0268 less in 90 and 180 days, respectively. Clearly, the pound is also trading at a discount on three- and six-month forward contracts.

Swaps, Options, and Futures

In addition to forward contracts, three other types of currency instruments are used in the forward market: currency swaps, options, and futures.

Currency Swaps

A

currency swap

is the simultaneous purchase and sale of foreign exchange for two different dates. Currency swaps are an increasingly important component of the foreign exchange market. Suppose a Swedish carmaker imports parts from a subsidiary in Turkey. The Swedish company must pay the Turkish subsidiary in Turkish lira for the parts when they are delivered tomorrow. It also expects to receive Turkish liras for cars sold in Turkey in 90 days. Our Swedish company exchanges kronor for lira in the spot market today to pay its subsidiary. At the same time, it agrees to a forward contract to sell Turkish lira (and buy Swedish kronor) in 90 days at the quoted 90-day forward rate for lira. In this way, the Swedish company uses a swap both to reduce its exchange-rate risk and to lock in the future exchange rate. In this sense, we can think of a currency swap as a more complex forward contract.

currency swap

Simultaneous purchase and sale of foreign exchange for two different dates.

Currency Options

Recall that a forward contract requires exchange of an agreed-upon amount of a currency on an agreed-upon date at a specific exchange rate. In contrast, a

currency option

is a right, or option, to exchange a specific amount of a currency on a specific date at a specific rate. In other words, whereas forward contracts require parties to follow through on currency exchanges, currency options do not.

currency option

Right, or option, to exchange a specific amount of a currency on a specific date at a specific rate.

Suppose a company buys an option to purchase Swiss francs at SF 1.02/$ in 30 days. If, at the end of the 30 days, the exchange rate is SF 1.05/$, the company would not exercise its currency option. Why? It could get SF 0.03 more for every dollar by exchanging at the spot rate in the currency market rather than at the stated rate of the option. Companies often use currency options to hedge against exchange-rate risk or to obtain foreign currency.

Currency Futures Contracts

Similar to a currency forward contract is a

currency futures contract

—a contract requiring the exchange of a specific amount of currency on a specific date at a specific exchange rate, with all conditions fixed and not adjustable.

currency futures contract

Contract requiring the exchange of a specific amount of currency on a specific date at a specific exchange rate, with all conditions fixed and not adjustable.

Quick Study

1. Explain how to calculate percent change in currency prices. Why is
exchange-rate risk
important to companies?

2. What is meant by the term
cross rate
? Explain how it is useful to businesses.

3. Explain how a
spot rate
and
forward rate
are used in the foreign exchange market.

4. What are the main differences between
currency swaps
, options, and futures?

Foreign Exchange Market Today

The foreign exchange market is actually an electronic network that connects the world’s major financial centers. In turn, each of these centers is a network of foreign exchange traders, currency trading banks, and investment firms. On any given day, the volume of trading on the foreign exchange market (comprising currency swaps and spot and forward contracts) has grown to an unprecedented $3.2 trillion—an amount greater than the yearly gross domestic product of many small nations.6 Several major trading centers and several currencies dominate the foreign exchange market.

Trading Centers

Most of the world’s major cities participate in trading on the foreign exchange market. But in recent years, just three countries have come to account for more than half of all global currency trading: the United Kingdom, the United States, and Japan. Accordingly, most of this trading takes place in the financial capitals of London, New York, and Tokyo.

London dominates the foreign exchange market for historic and geographic reasons. The United Kingdom was once the world’s largest trading nation. British merchants needed to exchange currencies of different nations, and London naturally assumed the role of financial trading center. London quickly came to dominate the market and still does so because of its location halfway between North America and Asia. A key factor is its time zone. Because of differences in time zones, London is opening for business as markets in Asia close trading for the day. When New York opens for trading in the morning, trading is beginning to wind down in London.

Figure 9.1 shows why it is possible to trade foreign exchange 24 hours a day (except weekends and major holidays). Exchanges in at least one of the three major centers (London, New York, and Tokyo) keep the market open for 22 hours a day. Trading does not stop during the two hours these exchanges are closed because other trading centers (including San Francisco and Sydney, Australia) remain open. Also, most large banks active in foreign exchange employ overnight traders to ensure continuous trading.

Important Currencies

Although the United Kingdom is the major location of foreign exchange trading, the U.S. dollar is the currency that dominates the foreign exchange market. Because the U.S. dollar is so widely used in world trade, it is considered a

vehicle currency

—a currency used as an intermediary to convert funds between two other currencies. The currencies most often involved in currency transactions are the U.S. dollar, European Union euro, Japanese yen, and British pound.

vehicle currency

Currency used as an intermediary to convert funds between two other currencies.

One reason the U.S. dollar is a vehicle currency is because the United States is the world’s largest trading nation. The United States is so heavily involved in international trade that many companies and banks maintain dollar deposits, making it easy to exchange other currencies with dollars. Another reason is that following the Second World War, all of the world’s major currencies were tied indirectly to the dollar because it was the most stable currency. In turn, the dollar’s value was tied to a specific value of gold—a policy that held wild currency swings in check. Although world currencies are no longer linked to the value of gold (see Chapter 10), the stability of the dollar, along with its resistance to inflation, helps people and organizations maintain their purchasing power better than their own national currencies. Even today, people in many countries convert extra cash from national currencies into dollars.

FIGURE 9.1 Financial Trading Centers by Time Zone

Institutions of the Foreign Exchange Market

So far, we have discussed the foreign exchange market only in general terms. We now look at the three main components of the foreign exchange market: the

interbank market

,
securities exchanges
, and the
over-the-counter market
.

Interbank Market

It is in the
interbank market
that the world’s largest banks exchange currencies at spot and forward rates. Companies tend to obtain foreign exchange services from the bank where they do most of their business. Banks satisfy client requests for exchange quotes by obtaining quotes from other banks in the interbank market. For transactions that involve commonly exchanged currencies, the largest banks often have sufficient currency on hand. Yet rarely exchanged currencies are not typically kept on hand and may not even be easily obtainable from another bank. In such cases, banks turn to foreign exchange brokers, who maintain vast networks of banks through which they obtain seldom traded currencies.

interbank market

Market in which the world’s largest banks exchange currencies at spot and forward rates.

In the interbank market, then, banks act as agents for client companies. In addition to locating and exchanging currencies, banks commonly offer advice on trading strategy, supply a variety of currency instruments, and provide other risk-management services. They also help clients manage exchange rate risk by supplying information on rules and regulations around the world.

But large banks in the interbank market use their influence in currency markets to get better rates for large clients. Small and medium-sized businesses often cannot get the best exchange rates because they deal only in small volumes of currencies and do so rather infrequently. A small company might get better exchange rate quotes from a discount international payment service.

CLEARING MECHANISMS

Clearing mechanisms are an important element of the interbank market. Foreign exchange transactions among banks and foreign exchange brokers happen continuously. The accounts are not settled after each individual trade, but are settled following a number of completed transactions. The process of aggregating the currencies that one bank owes another and then carrying out that transaction is called

clearing

. Years ago banks performed clearing every day or every two days, and physically exchanged currencies with other banks. Nowadays, clearing is performed more frequently and occurs digitally, which eliminates the need to physically trade currencies.

clearing

Process of aggregating the currencies that one bank owes another and then carrying out the transaction.

Securities Exchanges

Securities exchanges
specialize in currency futures and options transactions. Buying and selling currencies on these exchanges entails the use of securities brokers, who facilitate transactions by transmitting and executing clients’ orders. Transactions on securities exchanges are much smaller than those in the interbank market and vary with each currency. The leading exchange that deals in most major asset classes of futures and options is the CME Group, Inc. (www.cmegroup.com). The CME Group merged the futures and options operations of the Chicago Board of Trade (www.cbt.com), the Chicago Mercantile Exchange (www.cme.com), and the New York Mercantile Exchange (www.nymex.com). The CME Group’s foreign exchange marketplace is the world’s second largest electronic foreign exchange marketplace with more than $80 billion in daily liquidity.7

securities exchange

Exchange specializing in currency futures and options transactions.

Another exchange is the London International Financial Futures Exchange (www.euronext.com), which trades futures and options for major currencies. In the United States, trading in currency options occurs only on the Philadelphia Stock Exchange (www.phlx.com). It deals in both standardized options and customized options, allowing investors flexibility in designing currency option contracts.8

Over-the-Counter Market

The

over-the-counter (OTC) market

is a decentralized exchange encompassing a global computer network of foreign exchange traders and other market participants. All foreign exchange transactions can be performed in the OTC market where the major players are large financial institutions such as Goldman Sachs (www.gs.com).

over-the-counter (OTC) market

Decentralized exchange encompassing a global computer network of foreign exchange traders and other market participants.

GLOBAL MANAGER’S BRIEFCASE Managing Foreign Exchange

■ Match Needs to Providers. Analyze your foreign exchange needs and the range of service providers available. Find a provider that offers the transactions you undertake in the currencies you need and consolidate repetitive transfers. Many businesspeople naturally look to local bankers when they need to transfer funds abroad, but this may not be the cheapest or best choice. A mix of service providers sometimes offers the best solution.

■ Work with the Majors. Money-center banks (those located in financial centers) that participate directly in the foreign exchange market can have cost and service advantages over local banks. Dealing directly with a large trading institution is often more cost effective than dealing with a local bank because it avoids the additional markup that the local bank charges for its services.

■ Consolidate to Save. Save money by timing your international payments to consolidate multiple transfers into one large transaction. Open a local currency account abroad against which you can write drafts if your company makes multiple smaller payments in the same currency. Consider allowing foreign receivables to accumulate in an interest-bearing account locally until you repatriate them in a lump sum to reduce service fees.

■ Get the Best Deal Possible. If your foreign exchange activity is substantial, develop relationships with two or more money-center banks to get the best rates. Also, monitor the rates your company gets over time, as some banks raise rates if you’re not shopping around. Obtain real-time market rates provided by firms like Reuters and Bloomberg.

■ Embrace Information Technology. Every time an employee phones, e-mails, or faxes in a transaction, human error could delay getting funds where and when your company needs them. Embrace information technology in your business’s international wire transfers and drafts. Automated software programs available from specialized service providers reduce the potential for errors while speeding the execution of transfers.

The over-the-counter market has grown rapidly because it offers distinct benefits for business. It allows businesspeople to search freely for the institution that provides the best (lowest) price for conducting a transaction. It also offers opportunities for designing customized transactions. For additional ways companies can become more adept in their foreign exchange activities, see this chapter’s Global Manager’s Briefcase titled, “Managing Foreign Exchange.”

Currency Convertibility

Our discussion of the foreign exchange market so far assumes that all currencies can be readily converted to another in the foreign exchange market. A

convertible (hard) currency

is traded freely in the foreign exchange market, with its price determined by the forces of supply and demand. Countries that allow full convertibility are those that are in strong financial positions and have adequate reserves of foreign currencies. Such countries have no reason to fear that people will sell their own currency for that of another. Still, many newly industrialized and developing countries do not permit the free convertibility of their currencies. Let’s now take a look at why governments place restrictions on the convertibility of currencies and how they do it.

convertible (hard) currency

Currency that trades freely in the foreign exchange market, with its price determined by the forces of supply and demand.

Goals of Currency Restriction

Governments impose currency restrictions to achieve several goals. One goal is to preserve a country’s reserve of hard currencies with which to repay debts owed to other nations. Developed nations, emerging markets, and some countries that export natural resources tend to have the greatest amounts of foreign exchange. Without sufficient reserves (liquidity), a country could default on its loans and thereby discourage future investment flows. This is precisely what happened to Argentina several years ago when the country defaulted on its international public debt.

A second goal of currency restriction is to preserve hard currencies to pay for imports and to finance trade deficits. Recall from Chapter 5 that a country runs a trade deficit when the value of its imports exceeds the value of its exports. Currency restrictions help governments maintain inventories of foreign currencies with which to pay for such trade imbalances. They also make importing more difficult because local companies cannot obtain foreign currency to pay for imports. The resulting reduction in imports directly improves the country’s trade balance.

A third goal is to protect a currency from speculators. For example, in the wake of the Asian financial crisis years ago, some Southeast Asian nations considered controlling their currencies to limit the damage done by economic downturns. Malaysia stemmed the outflow of foreign money by preventing local investors from converting their Malaysian holdings into other currencies. Although the move also curtailed currency speculation, it effectively cut off Malaysia from investors elsewhere in the world.

A fourth (less common) goal is to keep resident individuals and businesses from investing in other nations. These policies can generate more rapid economic growth in a country by forcing investment to remain at home. Unfortunately, although this might work in the short term, it normally slows long-term economic growth. The reason is that there is no guarantee that domestic funds held in the home country will be invested there. Instead, they might be saved or even spent on consumption. Ironically, increased consumption can mean further increases in imports, making the balance-of-trade deficit even worse.

Policies for Restricting Currencies

Certain government policies are frequently used to restrict currency convertibility. Governments can require that all foreign exchange transactions be performed at or approved by the country’s central bank. They can also require import licenses for some or all import transactions. These licenses help the government control the amount of foreign currency leaving the country.

Some governments implement systems of multiple exchange rates, specifying a higher exchange rate on the importation of certain goods or on imports from certain countries. The government can thus reduce importation while ensuring that important goods still enter the country. It also can use such a policy to target the goods of countries with which it is running a trade deficit.

Other governments issue import deposit requirements that require businesses to deposit certain percentages of their foreign exchange funds in special accounts before being granted import licenses. In addition, quantity restrictions limit the amount of foreign currency that residents can take out of the home country when traveling to other countries as tourists, students, or medical patients.

Countertrade

Finally, one way to get around national restrictions on currency convertibility is

countertrade

—the practice of selling goods or services that are paid for, in whole or in part, with other goods or services. One simple form of countertrade is a
barter
transaction, in which goods are exchanged for others of equal value. Parties exchange goods and then sell them in world markets for hard currency. For example, Cuba once exchanged $60 million worth of sugar for cereals, pasta, and vegetable oils from the Italian firm Italgrani. And Boeing (www.boeing.com) has sold aircraft to Saudi Arabia in return for oil. We detail the many different forms of countertrade in Chapter 13.

countertrade

Practice of selling goods or services that are paid for, in whole or in part, with other goods or services.

Quick Study

1. What are the world’s main foreign exchange trading centers? Identify the currencies most used in the foreign exchange market.

2. Describe the three main institutions of the foreign exchange market.

3. What are the reasons for restrictions on currency conversion? Identify policies governments use to restrict currency conversion.

Bottom LineFOR BUSINESS

Well-functioning financial markets are essential to conducting international business. International financial markets supply companies with the mechanism they require to exchange currencies, and more. Here we focus only on the main implications of these markets for international companies.

International Capital Market and Businesses

The international capital market joins borrowers and lenders in different national capital markets. A company unable to obtain funds in its own nation may use the international capital market to obtain financing elsewhere and allow the firm to undertake an otherwise impossible project. This option can be especially important for firms in countries with small or emerging capital markets.

Similar to the prices of any other commodity, the “price” of money is determined by supply and demand. If its supply increases, its price (in the form of interest rates) falls. The international capital market opens up additional sources of financing for companies, possibly financing projects previously regarded as not feasible. The international capital market also expands lending opportunities, which reduces risk for lenders by allowing them to spread their money over a greater number of debt and equity instruments and benefiting from the fact that securities markets do not move up and down in tandem.

International Financial Market and Businesses

Companies must convert to local currencies when they undertake foreign direct investment. Later, when a firm’s international subsidiary earns a profit and the company wishes to return profits to the home country, it must convert the local money into the home currency. The prevailing exchange rate at the time profits are exchanged influences the amount of the ultimate profit or loss.

This raises an important aspect of international financial markets—fluctuation. International companies can use hedging in foreign exchange markets to lessen the risk associated with international transfers of funds and to protect themselves in credit transactions in which there is a time lag between billing and receipt of payment. Some firms also take part in currency arbitrage if there are times during which they have very large sums of cash on hand. Companies can also use interest arbitrage to find better interest rates abroad than those available in their home countries.

Businesspeople are also interested in tracking currency values over time because changes in currency values affect their international transactions. Profits earned by companies that import products for resale are influenced by the exchange rate between their currency and that of the nation from which they import. Managers who understand that changes in these currencies’ values affect the profitability of their international business activities can develop strategies to minimize risk.

In the next chapter, we extend our coverage of the international financial system to see how market forces (including interest rates and inflation) have an impact on exchange rates. We also conclude our study of the international financial system by looking at the roles of government and international institutions in managing movements in exchange rates.

Chapter Summary

1. Discuss the purposes, development, and financial centers of the international capital market.

■ The international capital market is meant to: (1) expand the supply of capital for borrowers, (2) lower interest rates for borrowers, and (3) lower risk for lenders.

■ Growth in the international capital market is due mainly to: (1) advances in information technology, deregulation of capital markets, and innovation in financial instruments.

■ London (U.K.), New York (U.S.), and Tokyo (Japan) are the world’s most important financial centers.

■
Offshore financial centers
handle less business but have few regulations and few if any taxes.

2. Describe the international bond, international equity, and Eurocurrency markets.

■ The
international bond market
consists of all bonds sold by issuers outside their own countries.

■ It is growing as investors in developed markets search for higher rates from borrowers in emerging markets, and vice versa.

■ The
international equity market
consists of all stocks bought and sold outside the home country of the issuing company.

■ Four factors driving growth in international equity are: (1) privatization, (2) greater issuance of stock by companies in emerging and developing nations, (3) greater international reach of investment banks, and (4) global electronic trading.

■ The
Eurocurrency market
consists of all the world’s currencies banked outside their countries of origin; its appeal is the lack of government regulation and lower cost of borrowing.

3. Discuss the four primary functions of the foreign exchange market.

■ The
foreign exchange market
is the market in which currencies are bought and sold and in which currency prices are determined.

■ One function of the foreign exchange market is that individuals, companies, and governments use it, directly or indirectly, to convert one currency into another.

■ Second, it is used as a hedging device to insure against adverse changes in exchange rates.

■ Third, it is used to earn a profit from the instantaneous purchase and sale of a currency (arbitrage) or other interest-paying security in different markets.

■ Fourth, it is used to speculate about a change in the value of a currency and thereby earn a profit.

4. Explain how currencies are quoted and the different rates given.

■ An exchange-rate quote between currency A and currency B (A/B) of 10/1 means that it takes 10 units of currency A to buy 1 unit of currency B (this is a direct quote of currency A and an indirect quote of currency B).

■ Exchange rates between two currencies can also be found using their respective exchange rates with a common currency; the resulting rate is called a
cross rate
.

■ An exchange rate that requires delivery of the traded currency within two business days is called a
spot rate
.

■ The
forward rate
is the rate at which two parties agree to exchange currencies on a specified future date; it represents the market’s expectation of a currency’s future value.

5. Identify the main instruments and institutions of the foreign exchange market.

■ A
forward contract
requires the exchange of an agreed-upon amount of a currency on an agreed-upon date at a specific exchange rate.

■ A
currency swap
is the simultaneous purchase and sale of foreign exchange for two different dates.

■ A
currency option
is the right to exchange a specific amount of a currency on a specific date at a specific rate; it is sometimes used to acquire a needed currency.

■ A
currency futures contract
requires the exchange of a specific amount of currency on a specific date at a specific exchange rate (no terms are negotiable).

■ The
interbank market
is where the world’s largest banks locate and exchange currencies for companies.

■
Securities exchanges
are physical locations at which currency futures and options are bought and sold (in smaller amounts than those traded in the interbank market).

■ The
over-the-counter
(OTC) market is an exchange that exists as a global computer network linking traders to one another.

6. Explain why and how governments restrict currency convertibility.

■ One main goal of currency restriction is that a government may be attempting to preserve the country’s hard currency reserves for repaying debts owed to other nations.

■ Second, convertibility might be restricted to preserve hard currency to pay for needed imports or to finance a trade deficit.

■ Third, restrictions might be used to protect a currency from speculators.

■ Fourth, restrictions can be an attempt to keep badly needed currency from being invested abroad.

■ Policies used to enforce currency restrictions include: (1) government approval for currency exchange, (2) imposed import licenses, (3) a system of multiple exchange rates, and (4) imposed quantity restrictions.

Talk It Over

1. What factors do you think are holding back the creation of a truly global capital market? How might a global capital market function differently from the present-day international market? (Hint: Some factors to consider are interest rates, currencies, regulations, and financial crises for some countries.)

2. The use of different national currencies creates a barrier to further growth in international business activity. What are the pros and cons, among companies and governments, of replacing national currencies with regional currencies? Do you think a global currency would be possible someday? Why or why not?

3. Governments dislike the fact that offshore financial centers facilitate money laundering. Do you think that electronic commerce makes it easier or harder to launder money and camouflage other illegal activities? Do you think offshore financial centers should be allowed to operate as freely as they do now, or do you favor regulation? Explain your answers.

Teaming Up

1. Research Project. Form a team with several of your classmates. Suppose you work for a firm that has $10 million in excess cash to invest for one month. Your group’s task is to invest this money in the foreign exchange market to earn a profit—holding dollars is not an option. Select the currencies you wish to buy at today’s spot rate, but do not buy less than $2.5 million of any single currency. Track the spot rate for each currency over the next month in the business press. On the last day of the month, exchange your currencies at the day’s spot rate. Calculate your team’s gain or loss over the one-month period. (Your instructor will determine whether, and how often, currencies may be traded throughout the month.)

2. Market Entry Strategy Project. This exercise corresponds to the MESP online simulation. For the country your team is researching, does it have a city that is an important financial center? What volume of bonds is traded on the country’s bond market? How has its stock market(s) performed over the past year? What is the exchange rate between its currency and that of your own country? What factors are responsible for the stability or volatility in that exchange rate? Are there any restrictions on the exchange of the nation’s currency? How is the forecast for the country’s currency likely to influence business activity in its major industries? Integrate your findings into your completed MESP report. (Hint: Good sources are the monthly International Financial Statistics and the annual Exchange Arrangements and Exchange Restrictions, both published by the IMF.)

Key Terms

base currency (p. 255)

bond (p. 246)

capital market (p. 246)

clearing (p. 263)

convertible (hard) currency (p. 264)

countertrade (p. 265)

cross rate (p. 258)

currency arbitrage (p. 254)

currency futures contract (p. 261)

currency hedging (p. 253)

currency option (p. 261)

currency speculation (p. 254)

currency swap (p. 261)

debt (p. 246)

derivative (p. 260)

equity (p. 246)

Eurobond (p. 250)

Eurocurrency market (p. 252)

exchange rate (p. 253)

exchange-rate risk (foreign exchange risk) (p. 257)

foreign bond (p. 251)

foreign exchange market (p. 253)

forward contract (p. 260)

forward market (p. 260)

forward rate (p. 259)

interbank interest rates (p. 253)

interbank market (p. 263)

interest arbitrage (p. 254)

international bond market (p. 250)

international capital market (p. 247)

international equity market (p. 251)

liquidity (p. 247)

offshore financial center (p. 249)

over-the-counter (OTC) market (p. 263)

quoted currency (p. 255)

securities exchange (p. 263)

securitization (p. 249)

spot market (p. 259)

spot rate (p. 259)

stock (p. 246)

vehicle currency (p. 262)

Take It to the Web

1. Video Report. Visit this book’s channel on YouTube (YouTube.com/MyIBvideos). Click on “Playlists” near the top of the page and click on the set of videos labeled “Ch 09: International Financial Markets.” Watch one video from the list and summarize it in a half-page report. Reflecting on the contents of this chapter, which aspects of international financial markets can you identify in the video? How might a company engaged in international business act on the information contained in the video?

2. Web Site Report. Visit the Web site of a financial institution or business periodical that publishes exchange rates among the world’s currencies. Compare the performance of the U.S. dollar against the European Union euro since July 9, 2008—the date of the information contained in Table 9.1.

Between that date and now, has the dollar fallen or risen in value against the euro? What is the exchange rate between the dollar and euro using: a) an indirect quote on the dollar, and b) a direct quote on the dollar? What percentage change has occurred in the value of the dollar against the euro? (Remember to mind your quoted and base currencies!)

Conducting Web-based research, what reasons lie behind the exchange-rate movement between the dollar and euro? Is the shift in the exchange rate due more to movement in the value of the dollar or the euro? Explain your answer. How has the exchange-rate change affected international business activity between the U.S. and European nations using the euro? Be specific.

Ethical Challenges

1. You are a U.S. senator serving on a subcommittee with the task of developing new regulations for U.S. firms doing business through offshore financial centers (OFCs). Bank deposits in offshore financial centers grew from the tens of billions of dollars a few decades ago to more than $1 trillion today. “Dirty money” obtained through drug trafficking, gambling, and other illicit activities use offshore financial centers to escape the same thing as respectable “clean capital”: national taxation and government regulations. Some experts argue that institutions such as international currency markets and offshore tax havens reduce stability and are hostile to the public interest. They say that people use such institutions to get beyond the reach of the law and undermine what they consider to be inefficient and bureaucratic attempts to impose a certain morality on people. As senator, what type of regulations do you support? What rationale do you give business leaders in your constituency who do business with OFCs? Do you think corporate use of OFCs to avoid home-country bureaucracies and taxes is ethical? Why or why not?

2. You are a member of the board of directors for one of the nation’s largest banks. Although recent banking deregulation is fostering greater competition in the industry, you are concerned about the direction in which banking is headed. The top management team of your bank is to meet soon with government officials to discuss the situation. The goal of government regulation of financial-services industries is to maintain the integrity and stability of financial systems, thereby protecting both depositors and investors. Regulations include prohibitions against insider trading, against lending by management to itself or to closely related entities (a practice called “self-dealing”), and against other transactions in which there is a conflict of interest. Yet in less than two decades deregulation has transformed the world’s financial markets. It spurred competition and growth in financial sectors and allowed capital to flow freely across borders, which boosted the economies of developing countries. What advice do you give your bank’s executives prior to meeting with the government? What do you see as the “dark side” of deregulation, in terms of business ethics? What do you think Adam Smith, one of the first philosophers of capitalism, meant when he warned against the dangers of “colluding producers”? Do you think this warning applies to the financial-services sector today?

PRACTICING INTERNATIONAL MANAGEMENT CASE Argentina Into the Abyss, Then Out, and Now Back In?

Argentina’s past President, Eduardo Duhalde, had summed it up perfectly. “Argentina is bust. It’s bankrupt. Business is halted, the chain of payments is broken, there is no currency to get the economy moving and we don’t have a peso to pay Christmas bonuses, wages, or pensions,” he said in a speech to Argentina’s Congress.

Although it was the star of Latin America in the 1990s, Argentina defaulted on its $155 billion of public debt in early 2002, the largest default by any country ever. After taking office in January 2002, President Duhalde implemented many measures to keep the country’s fragile economy from complete collapse after four years of recession. For 10 years the Argentine peso was fixed at parity to the dollar through a currency board. The president cut those strings immediately. But when it was allowed to float freely on currency markets, Argentina’s peso quickly lost two-thirds of its value and was trading at 3 pesos to the dollar. Then, strapped for cash, the government seized the savings accounts of its citizens and restricted how much they could withdraw at one time. Street protesters turned violent, beating up several politicians and attacking dozens of banks.

Local companies were having a difficult time, too. Many companies blamed their defaults on the requirement that they get authorization from the central bank to send money abroad. Stiff restrictions on foreign currency exchange forced importers to wait several months or more while the government authorized payments in dollars. Companies also struggled with new rules that raised taxes on exporters and other cash-rich firms to help the government pay for social services. Local firms also had a hard time obtaining funds to pay their debts to foreign suppliers. But the loss of confidence among non-Argentine businesses was more difficult to quantify. Many entered Argentina during a wave of free-market changes and privatizations in the 1990s. “If the government can just arbitrarily change contracts,” said a foreign diplomat in Buenos Aires, “how can you feel safe about any business relationship here in the coming months?”

The declining peso intensified problems for U.S. companies that fought to manage soaring debts and mounting losses from their Argentine operations. Argentine units of U.S. companies, which tend to collect revenues in pesos, had an increasingly difficult time repaying their dollar-denominated debts as the peso’s value fell. The government decreed that electricity and gas companies switch their contracts from dollars to less valuable pesos and then froze utility rates to protect consumers. But parent companies were unlikely to rescue their ailing operations in Argentina because the parents generally were not required to support the cash flow or debt service obligations of these independent subsidiaries.

The government, trying to lighten its debt load and restore credibility with the International Monetary Fund (www.imf.org), ordered $50 billion in dollar-denominated government debt (mostly domestic) swapped into pesos. The swap was aimed at unlocking $10 billion in IMF loans that were frozen when Argentina failed to meet certain economic targets. U.S. and European investors owned another $46 billion in government bonds, which were to be restructured in a separate transaction. Argentina’s government spent the previous decade amassing debts in dollars and other foreign currencies. But when the government cut loose the peso from the dollar in January 2002, the weak peso made the debt far more expensive to repay.

Argentina’s economic collapse was devastating. From 2001 through 2002 the economy shrank by 15 percent, unemployment shot up to 21 percent, and poverty engulfed 56 percent of its citizens. But then the economy improved and unemployment fell as fast as it rose. The government’s plan—stimulating demand by raising wages, imposing price controls, keeping the peso low, and public spending—worked well for a time but seems to be losing power. Argentina was expected to continue growing, but at a slower pace of around 4 to 5 percent. But inflation was running at 9 percent a year and again cutting into consumers’ and companies’ purchasing power and increasing poverty.

Argentina has in many respects recovered from its 2001–02 collapse and registered growth of around 9 percent a year. Unemployment had fallen from a high of 25 percent in 2002 to around 8 percent in 2008. Yet Argentina will continue to feel the aftereffects of its crisis for years. As of mid-2008 Argentina’s credit rating was downgraded and, later in the year, another economic collapse was unlikely, though not impossible.

Thinking Globally

1. Update the economic situation in Argentina to reflect recent events. How is the value of the peso faring? Do you think it was wise to cut the ties between the peso and the dollar? Why did Argentina peg its currency to the dollar in the first place? Do you think that the link between the peso and dollar contributed to Argentina’s problems? Explain.

2. How did local and international companies adapt to the business environment at the height of Argentina’s crisis? Did they pursue similar courses of action or design distinct strategies to deal with its effects? Be specific in your answer and give examples.

3. What was the impact on ordinary citizens immediately after the default and later as the economy recovered? What do the aftereffects of the crisis mean long-term for ordinary citizens’ spending power? What has it done to the value of their savings? In your opinion, has international aid helped or hurt the ordinary people of Argentina? Explain your answer.

Source: “Clouds Gather Again over the Pampas,” The Economist, August 23, 2008, pp. 30–31; “Who Needs Credit?” The Economist (www.economist.com), May 8, 2008; “Argentina Tops Household Consumption in Latin America,” The Economist (www.economist.com), June 29, 2006; “Country Risk” The Economist (www.economist.com), June 29, 2006.

(Wild 245)

Wild, John J., Kenneth L. Wild & Jerry C.Y. Han. International Business: The Challeng

10 International Monetary System

Learning Objectives
After studying this chapter, you should be able to

1 Explain how exchange rates influence the activities of domestic and international companies.

2 Identify the factors that help determine exchange rates and their impact on business.

3 Describe the primary methods of forecasting exchange rates.

4 Discuss the evolution of the current international monetary system and explain how it operates.

A LOOK BACK

Chapter 9 examined how the international capital market and foreign exchange market operate. We also explained how exchange rates are calculated and how different rates are used in international business.

A LOOK AT THIS CHAPTER

This chapter extends our knowledge of exchange rates and international financial markets. We examine factors that help determine exchange rates and explore rate-forecasting techniques. We discuss international attempts to manage exchange rates and review recent currency problems in Russia, Argentina, and other emerging markets.

A LOOK AHEAD

Chapter 11 introduces the topic of the last part of this book—international business management. We will explore the specific strategies and organizational structures that companies use in accomplishing their international business objectives.

Rise of the Euro

Brussels, Belgium — “Europe’s Big Idea,” “Ready, Set, Euros!,” cried the headlines that greeted the launch of Europe’s new currency, the euro. Not since the time of the Roman Empire had a currency circulated so widely in Europe. Greece even gave up its drachma, a currency it had used for nearly 3,000 years. Pictured below, a service station owner in Ljubljana, Slovenia, accepts a 50-euro banknote for the purchase of fuel. So far, 16 European countries have adopted the euro as their currency.

The euro traded around one-for-one against the dollar when it was first introduced. Its value has since risen significantly and in late 2008 bought around $1.57. The rise of the euro demonstrated confidence in the future expected growth and development of nations in the euro zone. It also boosted the status of the euro as a global currency, one that could perhaps rival the U.S. dollar. The value of euro notes in circulation worldwide ($840 billion) recently exceeded the value of U.S. dollars in circulation ($814 billion). But the U.S. dollar still accounts for around 65 percent of all currencies held by central banks, compared to around 25 percent for the euro.

Source: CORBIS-NY.

The main appeal of the euro is its long-term benefits for European business. Using a common currency for commercial transactions eliminates exchange-rate risk for companies in the euro zone, making financial aspects of business more predictable. It also improves competitiveness as mergers and acquisitions create synergies and economies of scale among companies.

But Europe’s exporters did not benefit from the strong euro because it raised prices of their products on world markets. Some European companies lost market share to competitors from countries with relatively weaker currencies and thus cheaper exports. As you read this chapter consider how the international monetary system affects managers’ decisions and the performance of companies.1

In Chapter 9, we explained the fundamentals of how exchange rates are calculated and how different types of exchange rates are used. This chapter extends our understanding of the international financial system by exploring factors that determine exchange rates and various international attempts to manage them. We begin by learning how exchange-rate movements affect a company’s activities. We then examine the factors that help determine currency values and, in turn, exchange rates. Next, we learn about different methods of forecasting exchange rates. We conclude this chapter by exploring the international monetary system and its performance.

How Exchange Rates Influence Business Activities

Movement in a currency’s exchange rate affects the activities of both domestic and international companies. For example, exchange rates influence demand for a company’s products in the global marketplace. A country with a currency that is weak (valued low relative to other currencies) will see a decline in the price of its exports and an increase in the price of its imports. Lower prices for the country’s exports on world markets can give companies the opportunity to take market share away from companies whose products are priced high in comparison.

Furthermore, a company improves profits if it sells its products in a country with a strong currency (one that is valued high relative to other currencies), while sourcing from a country with a weak currency. For example, if a company pays its workers and suppliers in a falling local currency and sells its products in a rising currency, the company benefits by generating revenue in the strong currency while paying expenses in the weak currency. Yet managers must take care not to view this type of price advantage as permanent because doing so can jeopardize a company’s long-term competitiveness.

Exchange rates also affect the amount of profit a company earns from its international subsidiaries. The earnings of international subsidiaries are typically integrated into the parent company’s financial statements in the home currency. Translating subsidiary earnings from a weak host country currency into a strong home currency reduces the amount of these earnings when stated in the home currency. Likewise, translating earnings into a weak home currency increases stated earnings in the home currency.

Figure 10.1 shows exchange rates between the U.S. dollar and several major currencies. Since around 2001, the value of the U.S. dollar has fallen against the British pound and European Union euro. The low value of the dollar lowered prices of U.S. exports to other countries and raised prices of imports into the United States. The value of the U.S. dollar versus the Japanese yen is mixed recently, with periods of rising value and periods of falling value.

FIGURE 10.1 Exchange Rates of Major World Currencies

*Value is U.S. dollars per pound.

Prior to 1999, data for the Euro represents the German mark.

Source: Economic Report of the President, Table B110, multiple years.

The intentional lowering of the value of a currency by the nation’s government is called

devaluation

. The reverse, the intentional raising of its value by the nation’s government, is called

revaluation

. These concepts are not to be confused with the terms weak currency and strong currency, although their effects are similar.

devaluation

Intentionally lowering the value of a nation’s currency.

revaluation

Intentionally raising the value of a nation’s currency.

Devaluation lowers the price of a country’s exports on world markets and increases the price of its imports because the value of the country’s currency is now lower on world markets. Thus a government might devalue its currency to give its domestic companies an edge over competition from other countries. But devaluation reduces the buying power of consumers in the nation. It can also allow inefficiencies to persist in domestic companies because there is now less pressure to be concerned with production costs. Revaluation has the opposite effects: It increases the price of exports and reduces the price of imports.

Desire for Stability and Predictability

Unfavorable movements in exchange rates can be costly for domestic and international companies alike. Although methods do exist for insuring against potentially adverse movements in exchange rates, most of these are too expensive for small and medium-sized businesses. Moreover, as the unpredictability of exchange rates increases, so too does the cost of insuring against the accompanying risk. By contrast, stable exchange rates improve the accuracy of financial planning and make cash flow forecasts more precise.

Managers also prefer that movements in exchange rates be predictable. Predictable exchange rates reduce the likelihood that companies will be caught off-guard by sudden and unexpected rate changes. They also reduce the need for costly insurance (usually by currency hedging) against possible adverse movements in exchange rates. Rather than purchasing insurance, companies would be better off spending their money on more productive activities, such as developing new products or designing more efficient production methods.

Figure 10.2 shows how the value of the U.S. dollar has changed over time. The figure reveals the dollar’s periods of instability that challenged the financial management capabilities of international companies.

FIGURE 10.2 Value of U.S. Dollar over Time

Source: Economic Report of the President, Table B110, multiple years.
Quick Study

1. Why are exchange rates important to managers’ decisions?

2. Explain the difference between
devaluation
and
revaluation
.

3. Why is it desirable for exchange rates to be stable and predictable?

What Factors Determine Exchange Rates?

To improve our knowledge of the factors that help determine exchange rates, we must first understand two important concepts: the

law of one price

and
purchasing power parity
. Each of these concepts tells us the level at which an exchange rate should be. While discussing these concepts, we will examine some factors that affect actual levels of exchange rates.

Law of One Price

An exchange rate tells us how much of one currency we must pay to receive a certain amount of another. But it does not tell us whether a specific product will actually cost us more or less in a particular country (as measured in our own currency). When we travel to another country, we discover that our own currency buys more or less than it does at home. In other words, we quickly learn that exchange rates do not guarantee or stabilize the buying power of our currency. Thus we can lose purchasing power in some countries while gaining it in others. For example, a restaurant meal for you and a friend that costs $60 in New York might cost you 13,000 yen (about $80) in Japan and 500 pesos (about $30) in Mexico. Compared to your meal in New York, you’ve suffered a loss of purchasing power in Japan but benefited from increased purchasing power in Mexico.

The
law of one price
stipulates that an identical product must have an identical price in all countries when the price is expressed in a common currency. For this principle to apply, products must be identical in quality and content in each country and be entirely produced within each country.

law of one price

Principle that an identical item must have an identical price in all countries when the price is expressed in a common currency.

For example, suppose coal mined within the United States and Germany is of similar quality in each country. Suppose further that a kilogram of coal costs €1.5 in Germany and $1 in the United States. Therefore, the law of one price calculates the expected exchange rate between the euro and dollar to be €1.5/$. However, suppose the actual euro/dollar exchange rate as witnessed on currency markets is €1.2/$. A kilogram of coal still costs $1 in the United States and €1.5 in Germany. But to pay for German coal with dollars denominated after the change in the exchange rate, one must convert not just $1 into euros, but $1.25 (the expected exchange rate divided by the actual exchange rate, or €1.5 ÷ $1.2). Thus the price of coal is higher in Germany than in the United States.

Moreover, because the law of one price is being violated in our example, an arbitrage opportunity arises—that is, an opportunity to buy a product in one country and sell it in a country where it has a higher value. For example, one could earn a profit by buying coal at $1 per kilogram in the United States and selling it at $1.25 (€1.5) per kilogram in Germany. But note that as traders begin buying in the United States and selling in Germany, greater demand drives up the price of U.S. coal, whereas greater supply drives down the price of German coal. Eventually, the price of coal in both countries will settle somewhere between the previously low U.S. price and the previously high German price.

If it seems that the arbitrage opportunity would disappear for the same reason that it arose, that is essentially the case. Some companies constantly seek new opportunities as they themselves arbitrage old ones out of existence. In other words, it is the nature of arbitrage to even out excessive fluctuation by destroying its own profitability.

McCurrency

The usefulness of the law of one price is that it helps us determine whether a currency is overvalued or undervalued. Each year, The Economist magazine publishes what it calls its “Big Mac Index” of exchange rates (see Figure 10.3). This index uses the law of one price to determine the exchange rate that should exist between the U.S. dollar and other major currencies. It employs the McDonald’s Big Mac as its single product to test the law of one price. Why the Big Mac? Because each one is fairly identical in quality and content across national markets and almost entirely produced within the nation in which it is sold.

FIGURE 10.3 Big Mac Index

Source: “The Big Mac Index,” The Economist (www.economist.com), July 24, 2008.

According to the most recent Big Mac index, the average price of a Big Mac was $3.57 in the United States. The cheapest Big Mac was found in Malaysia at a dollar-equivalent price of $1.70; the most expensive was found in Norway at $7.88. Therefore, according to the Big Mac index, Malaysia’s ringgit was undervalued by 52 percent ({[(3.57 –1.70) / 3.57]× – 100} = –52 percent). By contrast, Norway’s krone is overvalued by 121 percent ({[(3.57 – 7.88) / 3.57] × – 100} = –121 percent).2

Such large discrepancies between a currency’s exchange rate on currency markets and the rate predicted by the Big Mac index are not surprising. For one thing, the selling price of food is affected by subsidies for agricultural products in most countries. Also, a Big Mac is not a “traded” product in the sense that one can buy Big Macs in low-priced countries and sell them in high-priced countries. Prices can also be affected because Big Macs are subject to different marketing strategies in different countries. Finally, countries impose different levels of sales tax on restaurant meals.

The drawbacks of the Big Mac index reflect the fact that applying the law of one price to a single product is too simplistic a method for estimating exchange rates. Nonetheless, academic studies find that currency values tend to change in the direction suggested by the Big Mac index.3

Purchasing Power Parity

We introduced the concept of purchasing power parity in Chapter 4 when we discussed economic development. This concept is also useful in determining at what level an exchange rate should be. Recall that
purchasing power parity
(PPP) is the relative ability of two countries’ currencies to buy the same “basket” of goods in those two countries. Thus, although the law of one price holds for single products, PPP is meaningful only when applied to a basket of goods. Let’s look at an example to see why this is so.

Suppose 650 baht in Thailand will buy a bag of groceries that costs $30 in the United States. What do these two numbers tell us about the economic conditions of people in Thailand as compared with people in the United States? First, they help us compare the
purchasing power
of a Thai consumer with that of a consumer in the United States. But the question is: Are Thai consumers better off or worse off than their counterparts in the United States? To address this question, suppose the
GNP per capita
of each country is as follows:

Thai GNP/capita = 122,277 baht

U.S. GNP/capita = 26,980 dollars

Suppose also the
exchange rate
between the two currencies is 41.45 baht = 1 dollar. With this figure, we can translate 122,277 baht into dollars: 122,277 ÷ 41.45 = $2,950. We can now restate our question: Do prices in Thailand enable a Thai consumer with $2,950 to buy more or less than a consumer in the United States with $26,980?

We already know that 650 baht will buy in Thailand what $30 will buy in the United States. Thus we calculate 650 ÷ 30 = 21.67 baht per dollar. Note that whereas the exchange rate on currency markets is 41.45 baht/$, the
purchasing power parity rate
of the baht is 21.67/$. Let’s now use this figure to calculate a different comparative rate between the two currencies. We can now recalculate Thailand’s GNP per capita at PPP as follows: 122,277 ÷ 21.67 = 5,643. Thai consumers on average are not nearly as affluent as their counterparts in the United States. But when we consider the goods and services that they can purchase with their baht—not the amount of U.S. dollars that they can buy—we see that a GNP per capita at PPP of $5,643 more accurately portrays the real purchasing power of Thai consumers.

Our new calculation considers price levels in adjusting the relative values of the two currencies. In the context of exchange rates, the principle of purchasing power parity can be interpreted as the exchange rate between two nations’ currencies that is equal to the ratio of their price levels. In other words, PPP tells us that a consumer in Thailand needs 21.67 units (not 41.45) of Thai currency to buy the same amount of products as a consumer in the United States can buy with one dollar.

As we can see in this example, the exchange rate at PPP (21.67/$) is normally different from the actual exchange rate in financial markets (41.45/$). Economic forces, says PPP theory, will push the actual market exchange rate toward that determined by purchasing power parity. If they do not, arbitrage opportunities will arise. Purchasing power parity holds for internationally traded products that are not restricted by trade barriers and that entail few or no transportation costs. To earn a profit, arbitrageurs must be certain that the basket of goods purchased in the low-cost country would still be lower-priced in the high-cost country after adding transportation costs,
tariffs
, taxes, and so forth. Let’s now see what impact inflation and interest rates have on exchange rates and purchasing power parity.

Role of Inflation

Inflation is the result of the supply and demand for a currency. If additional money is injected into an economy that is not producing greater output, people will have more money to spend on the same amount of products as before. As growing demand for products outstrips stagnant supply, prices will rise and devour any increase in the amount of money that consumers have to spend. Therefore, inflation erodes people’s purchasing power.

IMPACT OF MONEY-SUPPLY DECISIONS

Because of the damaging effects of inflation, governments try to manage the supply of and demand for their currencies. They do this through the use of two types of policies designed to influence a nation’s money supply. Monetary policy refers to activities that directly affect a nation’s interest rates or money supply. Selling government securities reduces a nation’s money supply because investors pay money to the government’s treasury to acquire the securities. Conversely, when the government buys its own securities on the open market, cash is infused into the economy and the money supply increases.

Fiscal policy involves using taxes and government spending to influence the money supply indirectly. For example, to reduce the amount of money in the hands of consumers, governments increase taxes—people are forced to pay money to the government coffers. Conversely, lowering taxes increases the amount of money in the hands of consumers. Governments can also step up their own spending activities to increase the amount of money circulating in the economy or cut government spending to reduce it.

IMPACT OF UNEMPLOYMENT AND INTEREST RATES

Many industrialized countries are very effective at controlling inflation. Some economists claim that international competition is responsible for keeping inflation under control. They reason that global competition and the mobility of companies to move anywhere that costs are lowest keeps a lid on wages. Because wages are kept under control, companies do not raise prices on their products, thus containing inflation.

Other key factors in the inflation equation are a country’s unemployment and interest rates. When unemployment rates are low, there is a shortage of labor, and employers pay higher wages to attract employees. To maintain reasonable profit margins with higher labor costs, they then usually raise the prices of their products, passing the cost of higher wages on to the consumer and causing inflation.

Interest rates (discussed in detail later in this chapter) affect inflation because they affect the cost of borrowing money. Low interest rates encourage people to take out loans to buy items such as homes and cars and to run up debt on credit cards. High interest rates prompt people to cut down on the amount of debt they carry because higher rates mean larger monthly payments on debt. Thus one way to cool off an inflationary economy is to raise interest rates. Raising the cost of debt reduces consumer spending and makes business expansion more costly.

HOW EXCHANGE RATES ADJUST TO INFLATION

An important component of the concept of purchasing power parity is that exchange rates adjust to different rates of inflation in different countries. Such adjustment is necessary to maintain purchasing power parity between nations. Suppose that at the beginning of the year the exchange rate between the Mexican peso and the U.S. dollar is 8 pesos/$ (or $0.125/peso). Also suppose that inflation is pushing consumer prices higher in Mexico at an annual rate of 20 percent, whereas prices are rising just 3 percent per year in the United States. To find the new exchange rate (Ee) at the end of the year, we use the following formula:

Ee = Eb(1 + i1)/(1 + i2),

where Eb is the exchange rate at the beginning of the period,i 1 is the inflation rate in country 1, and i2 is the inflation rate in country 2. Plugging the numbers for this example into the formula, we get:

Ee = 8pesos/$[(1 + 0.20)/(1 + 0.03)] = 9.3pesos/$

It is important to remember that because the numerator of the exchange rate is in pesos, the inflation rate for Mexico must also be placed in the numerator for the ratio of inflation rates. Thus we see that the exchange rate adjusts from 8 pesos/$ to 9.3 pesos/$ because of the higher inflation rate in Mexico and the corresponding change in currency values. Higher inflation in Mexico reduces the number of U.S. dollars that a peso will buy and increases the number of pesos that a dollar will buy. In other words, whereas it had cost only 8 pesos to buy a dollar at the beginning of the year, it now costs 9.3 pesos.

In our example, companies based in Mexico must pay more in pesos for any supplies bought from the United States. But U.S. companies will pay less, in dollar terms, for supplies bought from Mexico. Also, tourists from the United States would be delighted as vacationing in Mexico becomes less expensive, but Mexicans will find the cost of visiting the United States more expensive.

This discussion illustrates at least one of the difficulties facing countries with high rates of inflation. Both consumers and companies in countries experiencing rapidly increasing prices see their purchasing power eroded. Developing countries and countries in transition are those most often plagued by rapidly increasing prices.

Role of Interest Rates

To see how interest rates affect exchange rates between two currencies, we must first review the connection between inflation and interest rates within a single economy. We distinguish between two types of interest rates: real interest rates and nominal interest rates. Let’s say that your local bank quotes you an interest rate on a new car loan. That rate is the nominal interest rate, which consists of the real interest rate plus an additional charge for inflation. The reasoning behind this principle is simple: The lender must be compensated for the erosion of its purchasing power during the loan period caused by inflation.

FISHER EFFECT

Suppose your bank lends you money to buy a delivery van for your home-based business. Let’s say that, given your credit-risk rating, the bank would normally charge you 5 percent annual interest. But if inflation is expected to be 2 percent over the next year, your annual rate of interest will be 7 percent: 5 percent real interest plus 2 percent to cover inflation. This principle that relates inflation to interest rates is called the

Fisher effect

—the principle that the nominal interest rate is the sum of the real interest rate and the expected rate of inflation over a specific period. We write this relation between inflation and interest rates as:

Nominal Interest Rate = Real Interest Rate + Inflation Rate

Fisher effect

Principle that the nominal interest rate is the sum of the real interest rate and the expected rate of inflation over a specific period.

If money were free from all controls when transferred internationally, the real rate of interest should be the same in all countries. To see why this is true, suppose that real interest rates are 4 percent in Canada and 6 percent in the United States. This situation creates an arbitrage opportunity: Investors could borrow money in Canada at 4 percent, lend it in the United States at 6 percent, and earn a profit on the 2 percent spread in interest rates. If enough people took advantage of this opportunity, interest rates would go up in Canada, where demand for money would become heavier, and down in the United States, where the money supply was growing. Again, the arbitrage opportunity would disappear because of the same activities that made it a reality. That is why real interest rates must theoretically remain equal across countries.

We demonstrated earlier the relation between inflation and exchange rates. The Fisher effect clarifies the relation between inflation and interest rates. Now, let’s investigate the relation between exchange rates and interest rates. To illustrate this relation, we refer to the
international Fisher effect
—the principle that a difference in nominal interest rates supported by two countries’ currencies will cause an equal but opposite change in their spot exchange rates. Recall from Chapter 9 that the spot rate is the rate quoted for delivery of the traded currency within two business days.

International Fisher effect

Principle that a difference in nominal interest rates supported by two countries’ currencies will cause an equal but opposite change in their spot exchange rates.

Because real interest rates are theoretically equal across countries, any difference in interest rates in two countries must be due to different expected rates of inflation. A country that is experiencing inflation higher than that of another country should see the value of its currency fall. If so, the exchange rate must be adjusted to reflect this change in value. For example, suppose nominal interest rates are 5 percent in Australia and 3 percent in Canada. Expected inflation in Australia, then, is 2 percent higher than in Canada. The international Fisher effect predicts that the value of the Australian dollar will fall by 2 percent against the Canadian dollar.

Zimbabwe’s official rate of inflation rocketed to over 100,000 percent in 2008. Here, a citizen holds a new 10 million Zimbabwe dollar (ZWD) note just withdrawn from a local bank in Harare, Zimbabwe. A loaf of bread at the time cost about 3 million ZWD. Although it was once a model nation for others to emulate in Africa, Zimbabwe faces a crumbling infrastructure and shortages of food, fuel, and other necessities due to poor economic policies. GDP per capita fell from about $200 in 1996 to around $9 in 2007.

Source: CORBIS-NY.

Evaluating Purchasing Power Parity

Purchasing power parity is better at predicting long-term exchange rates (more than 10 years), but accurate forecasts of short-term rates are most beneficial to international managers. Even short-term plans must assume certain things about future economic and political conditions in different countries, including added costs, trade barriers, and investor psychology.

IMPACT OF ADDED COSTS

There are many possible reasons for the failure of PPP to predict exchange rates accurately. For example, PPP assumes no transportation costs. Suppose that the same basket of goods costs $100 in the United States and 1,350 kroner ($150) in Norway. Seemingly, one could make a profit through arbitrage by purchasing these goods in the United States and selling them in Norway. However, if it costs another $60 to transport the goods to Norway, the total cost of the goods once they arrive in Norway will be $160. Thus no shipment will occur. Because no arbitrage opportunity exists after transportation costs are added, there will be no leveling of prices between the two markets and the price discrepancy will persist. Thus even if PPP predicts that the Norwegian krone is overvalued, the effect of transportation costs will keep the dollar/krone exchange rate from adjusting. In a world in which transportation costs exist, PPP does not always correctly predict shifts in exchange rates.

IMPACT OF TRADE BARRIERS

PPP also assumes no barriers to international trade. However, such barriers certainly do exist. Governments establish trade barriers for many reasons, including helping domestic companies remain competitive and preserving jobs for their citizens. Suppose the Norwegian government in our earlier example imposes a 60 percent tariff on the $100 basket of imported goods or makes its importation illegal. Because no leveling of prices or exchange-rate adjustment will occur, PPP will fail to predict exchange rates accurately.

IMPACT OF BUSINESS CONFIDENCE AND PSYCHOLOGY

Finally, PPP overlooks the human aspect of exchange rates—the role of people’s confidence and beliefs about a nation’s economy and the value of its currency. Many countries gauge confidence in their economies by conducting a business confidence survey. The largest survey of its kind in Japan is called the tankan survey. It gauges business confidence four times each year among 10,000 companies.

Investor confidence in the value of a currency plays an important role in determining its exchange rate. Suppose several currency traders believe that the Indian rupee will increase in value. They will buy Indian rupees at the current price, sell them if the value increases, and earn a profit. However, suppose that all traders share the same belief and all follow the same course of action. The activity of the traders themselves will be sufficient to push the value of the Indian rupee higher. It does not matter why traders believed the price would increase. As long as enough people act on a similar belief regarding the future value of a currency, its value will change accordingly.

That is why nations try to maintain the confidence of investors, businesspeople, and consumers in their economies. Lost confidence causes companies to put off investing in new products and technologies and to delay the hiring of additional employees. Consumers tend to increase their savings and not increase their debts if they have lost confidence in an economy. These kinds of behaviors act to weaken a nation’s currency.

Quick Study

1. Define the
law of one price
and explain its limitations.

2. What is
purchasing power parity
in the context of exchange rates?

3. Briefly explain how both inflation and interest rates influence exchange rates.

4. What are the limitations of purchasing power parity in predicting exchange rates?

Forecasting Exchange Rates

Before undertaking any international business activity, managers should estimate future exchange rates and consider the impact of currency values on earnings. This section explores two distinct views regarding how accurately future exchange rates can be predicted by forward exchange rates—the rate agreed upon for foreign exchange payment at a future date. We also take a brief look at different techniques for forecasting exchange rates.

Efficient Market View

A great deal of debate revolves around the issue of whether markets themselves are efficient or inefficient in forecasting exchange rates. A market is efficient if prices of financial instruments quickly reflect new public information made available to traders. The

efficient market view

thus holds that prices of financial instruments reflect all publicly available information at any given time. As applied to exchange rates, this means that forward exchange rates are accurate forecasts of future exchange rates.

efficient market view

View that prices of financial instruments reflect all publicly available information at any given time.

Recall from Chapter 9 that a forward exchange rate reflects a market’s expectations about the future values of two currencies. In an efficient currency market, forward exchange rates reflect all relevant publicly available information at any given time; they are considered the best possible predictors of exchange rates. Proponents of this view hold that there is no other publicly available information that could improve the forecast of exchange rates over that provided by forward rates. To accept this view is to accept that companies do waste time and money collecting and examining information believed to affect future exchange rates. But there is always a certain amount of deviation between forward and actual exchange rates. The fact that forward exchange rates are less than perfect inspires companies to search for more accurate forecasting techniques.

Inefficient Market View

The

inefficient market view

holds that prices of financial instruments do not reflect all publicly available information. Proponents of this view believe companies can search for new pieces of information to improve forecasting. But the cost of searching for further information must not outweigh the benefits of its discovery.

inefficient market view

View that prices of financial instruments do not reflect all publicly available information.

Naturally, the inefficient market view is more compelling when the existence of private information is considered. Suppose a single currency trader holds privileged information regarding a future change in a nation’s economic policy—information that she believes will affect its exchange rate. Because the market is unaware of this information, it is not reflected in forward exchange rates. Our trader will no doubt earn a profit by acting on her store of private information.

Now that we understand the two basic views related to market efficiency, let’s look at the specific methods that companies use to forecast exchange rates.

Forecasting Techniques

The issue of whether markets are efficient or inefficient forecasters of exchange rates leads to the question of whether experts can improve on the forecasts of forward exchange rates in either an efficient or inefficient market. As we have already seen, some analysts believe that forecasts of exchange rates can be improved by uncovering information not reflected in forward exchange rates. In fact, companies exist to provide exactly this type of service. There are two main forecasting techniques based on this belief in the value of added information—fundamental analysis and technical analysis.

Fundamental Analysis

Fundamental analysis
uses statistical models based on fundamental economic indicators to forecast exchange rates. These models are often quite complex, with many variations reflecting different possible economic conditions. These models include economic variables such as inflation, interest rates, money supply, tax rates, and government spending. Such analyses also often consider a country’s balance-of-payments situation (see Chapter 7) and its tendency to intervene in markets to influence the value of its currency.

fundamental analysis

Technique that uses statistical models based on fundamental economic indicators to forecast exchange rates.

Technical Analysis

Another method of forecasting exchange rates is

technical analysis

—a technique that uses charts of past trends in currency prices and other factors to forecast exchange rates. Using highly statistical models and charts of past data trends, analysts examine conditions that prevailed during changes in exchange rates and they try to estimate the timing, magnitude, and direction of future changes. Many forecasters combine the techniques of both fundamental and technical analyses to arrive at potentially more accurate forecasts.

technical analysis

Technique that uses charts of past trends in currency prices and other factors to forecast exchange rates.

Difficulties of Forecasting

The business of forecasting exchange rates is a rapidly growing industry. This trend seems to provide evidence that a growing number of people believe it is possible to improve on the forecasts of exchange rates embodied in forward rates. Difficulties of forecasting remain, however. Despite highly sophisticated statistical techniques in the hands of well-trained analysts, forecasting is not a pure science. Few, if any, forecasts are ever completely accurate because of unexpected events that occur throughout the forecast period.

Beyond the problems associated with the data used by these techniques, failings can be traced to the human element involved in forecasting. For example, people might miscalculate the importance of economic news becoming available to the market, placing too much emphasis on some elements and ignoring others.

So far, we have seen the importance of exchange rates between currencies, why companies try to manage shifting exchange rates, and the difficulties of forecasting rates. For a look at several approaches companies can use to counter the effects of a strong or weak currency, see this chapter’s Global Manager’s Briefcase titled, “Adjusting to Currency Swings.”

GLOBAL MANAGER’S BRIEFCASE Adjusting to Currency Swings

A strong and rising currency makes a nation’s exports more expensive. Here’s how companies can export successfully despite a strong currency.

■ Prune Operations. Cut costs and boost efficiency by downsizing staff and reworking factories at home to maintain production levels, and pursue customers abroad when export earnings decline.

■ Adapt Products. Win customer business and loyalty by tailoring your products to the needs of global customers and your company may retain their business despite your higher prices.

■ Source Abroad. Source abroad for raw materials and other inputs to the production process—your supplier will likely earn an extra profit and you’ll get a better deal than is available domestically.

■ Freeze Prices. A last resort may be to freeze prices of goods in foreign markets—this might boost overall profits if sales improve.

A weak and falling currency makes a nation’s imports more expensive. Here’s how companies can adjust to a weak currency.

■ Source Domestically. Source domestically for raw materials and components to lower the cost of production inputs, avoid exchange-rate risk, and shorten the supply chain.

■ Grow at Home. Fight for the business of domestic customers now that imported products of foreign competitors are priced high because of their relatively strong currencies.

■ Push Exports. Exploit the price advantage you get from your country’s weak currency by expanding your reach and depth abroad—people love a good bargain in all countries.

■ Reduce Expenses. Counteract the rising cost of imported energy by using the latest communication and transportation technologies to reduce air travel, cut utility bills, and slash shipping costs.

Quick Study

1. What are the two market views regarding exchange-rate forecasting? Explain each briefly.

2. Identify the two main methods of forecasting exchange rates. What are the difficulties of forecasting?

Evolution of the International Monetary System

So far in this chapter, we have discussed how companies are affected by changes in exchange rates and why managers prefer exchange rates to be stable and predictable. We saw how inflation and interest rates affect currency values, and in turn exchange rates, in different countries. We also learned that despite attempts to forecast exchange rates accurately, difficulties remain.

For all these reasons, governments develop systems designed to manage exchange rates between their currencies. Groups of nations have created both formal and informal agreements to control exchange rates between their currencies. The present-day

international monetary system

is the collection of agreements and institutions that govern exchange rates. In this section, we briefly trace the evolution of the current international monetary system and examine its performance.

international monetary system

Collection of agreements and institutions that govern exchange rates.

Early Years: The Gold Standard

In the earliest days of international trade, gold was the internationally accepted currency for payment of goods and services. Using gold as a medium of exchange in international trade has several advantages. First, the limited supply of gold made it a commodity in high demand. Second, because gold is highly resistant to corrosion, it can be traded and stored for hundreds of years. Third, because it can be melted into either small coins or large bars, gold is a good medium of exchange for both small and large purchases.

But gold also has its disadvantages. First, the weight of gold made transporting it expensive. Second, when a transport ship sank at sea, the gold sank to the ocean floor and was lost. Thus merchants wanted a new way to make their international payments without the need to haul large amounts of gold around the world. The solution was found in the

gold standard

—an international monetary system in which nations linked the value of their paper currencies to specific values of gold. Britain was the first nation to implement the gold standard in the early 1700s.

gold standard

International monetary system in which nations linked the value of their paper currencies to specific values of gold.

Par Value

The gold standard required a nation to fix the value (price) of its currency to an ounce of gold. The value of a currency expressed in terms of gold is called its par value. Each nation then guaranteed to convert its paper currency into gold for anyone demanding it at its par value. The calculation of each currency’s par value was based on the concept of purchasing power parity. This provision made the purchasing power of gold the same everywhere and maintained the purchasing power of currencies across nations.

All nations fixing their currencies to gold also indirectly linked their currencies to one another. Because the gold standard fixed nations’ currencies to the value of gold, it is called a

fixed exchange-rate system

—one in which the exchange rate for converting one currency into another is fixed by international governmental agreement. This system and the use of par values made calculating exchange rates between any two currencies a very simple matter. For example, under the gold standard the U.S. dollar was originally fixed at $20.67/oz of gold and the British pound at £4.2474/oz. The exchange rate between the dollar and pound was $4.87/£ ($20.67 ÷ £4.2474).

fixed exchange-rate system

System in which the exchange rate for converting one currency into another is fixed by international agreement.

Advantages of the Gold Standard

The gold standard was quite successful in its early years of operation. In fact, this early record of success is causing some economists and policy makers to call for its rebirth today. Three main advantages of the gold standard underlie its early success.

First, the gold standard drastically reduces the risk in exchange rates because it maintains highly fixed exchange rates between currencies. Deviations that do arise are much smaller than they would be under a system of freely floating currencies. The more stable exchange rates are, the less companies are affected by actual or potential adverse changes in them. Because the gold standard significantly reduced the risk in exchange rates and, therefore, the risks and costs of trade, international trade grew rapidly following its introduction.

Second, the gold standard imposes strict monetary policies on all countries that participate in the system. Recall that the gold standard requires governments to convert paper currency into gold if demanded by holders of the currency. If all holders of a nation’s paper currency decided to trade it for gold, the government must have an equal amount of gold reserves to pay them. That is why a government cannot allow the volume of its paper currency to grow faster than the growth in its reserves of gold. By limiting the growth of a nation’s money supply, the gold standard also was effective in controlling inflation.

Third, the gold standard can help correct a nation’s trade imbalance. Suppose Australia is importing more than it is exporting (experiencing a trade deficit). As gold flows out of Australia to pay for imports, its government must decrease the supply of paper currency in the domestic economy because it cannot have paper currency in excess of its gold reserves. As the money supply falls, so do prices of goods and services in Australia because demand is falling (consumers have less to spend), whereas the supply of goods is unchanged. Meanwhile, falling prices of Australian-made goods causes Australian exports to become cheaper on world markets. Exports will rise until Australia’s international trade is once again in balance. The exact opposite occurs in the case of a trade surplus: The inflow of gold supports an increase in the supply of paper currency, which increases demand for, and therefore the cost of, goods and services. Thus exports will fall in reaction to their higher price until trade is once again in balance.

Collapse of the Gold Standard

Nations involved in the First World War needed to finance their enormous war expenses, and they did so by printing more paper currency. This certainly violated the fundamental principle of the gold standard and forced nations to abandon the standard. The aggressive printing of paper currency caused rapid inflation for these nations. When the United States returned to the gold standard in 1934, it adjusted its par value from $20.67/oz of gold to $35.00/oz to reflect the lower value of the dollar that resulted from inflation. Thus the U.S. dollar had undergone devaluation. Yet Britain returned to the gold standard several years earlier at its previous level, which did not reflect the effect inflation had on its currency.

Because the gold standard links currencies to one another, devaluation of one currency in terms of gold affects the exchange rates between currencies. The decision of the United States to devalue its currency and Britain’s decision not to do so lowered the price of U.S. exports on world markets and increased the price of British goods imported into the United States. For example, whereas it had previously required $4.87 to purchase one British pound, it now required $8.24 ($35.00 ÷ £4.2474). This forced the cost of a £10 tea set exported from Britain to the United States to go from $48.70 before devaluation to $82.40 after devaluation. This drastically increased the price of imports from Britain (and other countries), lowering its export earnings. As countries devalued their currencies in retaliation, a period of “competitive devaluation” resulted. To improve their trade balances, nations chose arbitrary par values to which they devalued their currencies. People quickly lost faith in the gold standard because it was no longer an accurate indicator of a currency’s true value. By 1939, the gold standard was effectively dead.

Bretton Woods Agreement

In 1944, representatives from 44 nations met in the New Hampshire resort town of Bretton Woods to lay the foundation for a new international monetary system. The resulting
Bretton Woods Agreement
was an accord among nations to create a new international monetary system based on the value of the U.S. dollar. The new system was designed to balance the strict discipline of the gold standard with the flexibility that countries needed to deal with temporary domestic monetary difficulties. Let’s now take a brief look at the most important features of that system.

Bretton Woods Agreement

Agreement (1944) among nations to create a new international monetary system based on the value of the U.S. dollar.

Fixed Exchange Rates

The Bretton Woods Agreement incorporated fixed exchange rates by tying the value of the U.S. dollar directly to gold and the value of other currencies to the value of the dollar. The par value of the U.S. dollar was fixed at $35/oz of gold. Other currencies were then given par values against the U.S. dollar instead of gold. For example, the par value of the British pound was established as $2.40/£. Member nations were expected to keep their currencies from deviating more than 1 percent above or below their par values. The Bretton Woods Agreement also improved on the gold standard by extending the right to exchange gold for dollars only to national governments, rather than anyone who demanded it.

Built-In Flexibility

The new system also incorporated a degree of built-in flexibility. For example, although competitive currency devaluation was ruled out, large devaluation was allowed under the extreme set of circumstances called

fundamental disequilibrium

—an economic condition in which a trade deficit causes a permanent negative shift in a country’s balance of payments. In this situation, a nation can devalue its currency more than 10 percent. Yet devaluation under these circumstances should accurately reflect a permanent economic change for the country in question, not temporary misalignments.

fundamental disequilibrium

Economic condition in which a trade deficit causes a permanent negative shift in a country’s balance of payments.

World Bank

To provide funding for countries’ efforts toward economic development, the Bretton Woods Agreement created the
World Bank
—officially called the International Bank for Reconstruction and Development (IBRD). The immediate purpose of the World Bank (www.worldbank.org) was to finance European reconstruction following the Second World War. It later shifted its focus to the general financial needs of developing countries. The World Bank finances many types of economic development projects in Africa, South America, and Southeast Asia. The World Bank also offers funds to countries that are unable to obtain capital from commercial sources for certain projects that are considered too risky. The bank often undertakes projects to develop transportation networks, power facilities, and agricultural and educational programs.

International Monetary Fund

The Bretton Woods Agreement established the
International Monetary Fund
(IMF) as the agency to regulate the fixed exchange rates and enforce the rules of the international monetary system. At the time of its formation, the IMF (www.imf.org) had just 29 members—today 185 countries belong. Included among the main purposes of the IMF are:4

■ Promoting international monetary cooperation.

■ Facilitating expansion and balanced growth of international trade.

■ Promoting exchange stability, maintaining orderly exchange arrangements, and avoiding competitive exchange devaluation.

■ Making the resources of the fund temporarily available to members.

■ Shortening the duration and lessening the degree of disequilibrium in the international balance of payments of member nations.

SPECIAL DRAWING RIGHT (SDR)

World financial reserves of dollars and gold grew scarce in the 1960s, at a time when the activities of the IMF demanded greater amounts of dollars and gold. The IMF reacted by creating what is called a

special drawing right (SDR)

—an IMF asset whose value is based on a weighted “basket” of four currencies, including the U.S. dollar, European Union euro, Japanese yen, and British pound. Figure 10.4 shows the “weight” each currency contributes to the overall value of the SDR. The value of the SDR is set daily and changes with increases and declines in the values of its underlying currencies. Today there are more than 21 billion SDRs in existence worth about $29 billion (1 SDR equals about $1.56).5 The significance of the SDR is that it is the unit of account for the IMF. Each nation is assigned a quota based on the size of its economy when it enters the IMF. Payment of this quota by each nation provides the IMF with the funds it needs to make short-term loans to members.

special drawing right (SDR)

IMF asset whose value is based on a “weighted basket” of four currencies.

Collapse of the Bretton Woods Agreement

The system developed at Bretton Woods worked quite well for about 20 years—an era that boasted unparalleled stability in exchange rates. But in the 1960s the Bretton Woods system began to falter. The main problem was that the United States was experiencing a trade deficit (imports were exceeding exports) and a budget deficit (expenses were outstripping revenues). Governments that were holding dollars began to doubt that the U.S. government had an adequate amount of gold reserves to redeem all its paper currency held outside the country. When they began demanding gold in exchange for dollars, a large sell-off of dollars on world financial markets followed.

FIGURE 10.4 Valuation of the SDR

Source: Data obtained from Special Drawing Rights section, International Monetary Fund Web Site (www.imf.org).

SMITHSONIAN AGREEMENT

In August 1971 the U.S. government held less than one-fourth of the amount of gold needed to redeem all U.S. dollars in circulation. In late 1971 the United States and other countries reached the so-called

Smithsonian Agreement

to restructure and strengthen the international monetary system. The three main accomplishments of the Smithsonian Agreement were: (1) to lower the value of the dollar in terms of gold to $38/oz, (2) to increase the values of other countries’ currencies against the dollar, and (3) to increase to 2.25 percent from 1 percent the band within which currencies were allowed to float.

Smithsonian Agreement

Agreement (1971) among IMF members to restructure and strengthen the international monetary system created at Bretton Woods.

FINAL DAYS

The success of the Bretton Woods system relied on the U.S. dollar remaining a strong reserve currency. High inflation and a persistent trade deficit had kept the dollar weak, however, which demonstrated a fundamental flaw in the system. The weak U.S. dollar strained the capabilities of central banks in Japan and most European countries to maintain exchange rates with the dollar. Because these nations’ currencies were tied to the U.S. dollar, as the dollar continued to fall, so too did their currencies. Britain left the system in the middle of 1972 and allowed the pound to float freely against the dollar. The Swiss abandoned the system in early 1973. In January 1973 the dollar was again devalued, this time to around $42/oz of gold. But even this move was not enough. As nations began dumping their reserves of the dollar on a massive scale, currency markets were temporarily closed to prevent further selling of the dollar. When markets reopened, the values of most major currencies were floating against the U.S. dollar. The era of an international monetary system based on fixed exchange rates was over.

Quick Study

1. How did the
gold standard
function? Briefly describe its evolution and collapse.

2. Describe the most important features of the
Bretton Woods Agreement
.

3. What factors led to the demise of the monetary system created at Bretton Woods?

A Managed Float System Emerges

The Bretton Woods system collapsed because of its heavy dependence on the stability of the dollar. As long as the dollar remained strong, it worked well. But when the dollar weakened, it failed to perform properly. Originally, the new system of floating exchange rates was viewed as a temporary solution to the shortcomings of the Bretton Woods and Smithsonian Agreements. But no new coordinated international monetary system was forthcoming. Rather, there emerged several independent efforts to manage exchange rates.

Jamaica Agreement

By January 1976, returning to a system of fixed exchange rates seemed unlikely. Therefore, world leaders met to draft the so-called
Jamaica Agreement
—an accord among members of the IMF to formalize the existing system of floating exchange rates as the new international monetary system. The Jamaica Agreement contained several main provisions. First, it endorsed a

managed float system

of exchange rates—that is, a system in which currencies float against one another, with governments intervening to stabilize their currencies at particular target exchange rates. This is in contrast to a

free float system

—a system in which currencies float freely against one another without governments intervening in currency markets.

Jamaica Agreement

Agreement (1976) among IMF members to formalize the existing system of floating exchange rates as the new international monetary system.

managed float system

Exchange-rate system in which currencies float against one another, with governments intervening to stabilize their currencies at particular target exchange rates.

free float system

Exchange-rate system in which currencies float freely against one another, without governments intervening in currency markets.

Second, gold was no longer the primary reserve asset of the IMF. Member countries could retrieve their gold from the IMF if they so desired. Third, the mission of the IMF was augmented: Rather than being the manager of a fixed exchange-rate system only, it was now a “lender of last resort” for nations with balance-of-payment difficulties. Member contributions were increased to support the newly expanded activities of the IMF.

Later Accords

Between 1980 and 1985 the U.S. dollar rose dramatically against other currencies, pushing up prices of U.S. exports and adding once again to a U.S. trade deficit. The world’s five largest industrialized nations known as the “G5” (Britain, France, Germany, Japan, and the United States) arrived at a solution. The Plaza Accord was a 1985 agreement among the G5 nations to act together in forcing down the value of the U.S. dollar. The Plaza Accord caused traders to sell the dollar, and its value fell.

By February 1987 the industrialized nations were concerned that the value of the U.S. dollar was now in danger of falling too low. Meeting in Paris, leaders of the “G7” nations (the G5 plus Italy and Canada) drew up another agreement. The Louvre Accord was a 1987 agreement among the G7 nations that affirmed that the U.S. dollar was appropriately valued and that they would intervene in currency markets to maintain its current market value. Once again, currency markets responded and the dollar stabilized.

Today’s Exchange-Rate Arrangements

Today’s international monetary system remains in large part a managed float system, whereby most nations’ currencies float against one another and governments engage in limited intervention to realign exchange rates. Within the larger monetary system, however, certain countries try to maintain more stable exchange rates by tying their currencies to other currencies. Let’s take a brief look at two ways nations attempt to do this.

Pegged Exchange-Rate Arrangement

Think of one country as a small lifeboat tethered to a giant cruise ship as it navigates choppy monetary waters. Many economists argue that rather than let their currencies face the tides of global currency markets alone, developing economies should tie them to other, more stable currencies. Pegged exchange-rate arrangements “peg” a country’s currency to a more stable and widely used currency in international trade. Countries then allow the exchange rate to fluctuate within a specified margin (usually 1 percent) around a central rate.

Many small countries peg their currencies to the U.S. dollar, European Union euro, the special drawing right (SDR) of the IMF, or other individual currency. Belonging to this first category are the Bahamas, El Salvador, Iran, Malaysia, Netherlands Antilles, and Saudi Arabia. Other nations peg their currencies to groups, or “baskets,” of currencies. For example, Bangladesh and Burundi tie their currencies (the taka and Burundi franc, respectively) to those of their major trading partners. Other members of this second group are Botswana, Fiji, Kuwait, Latvia, Malta, and Morocco.

Currency Board

A

currency board

is a monetary regime that is based on an explicit commitment to exchange domestic currency for a specified foreign currency at a fixed exchange rate. The government with a currency board is legally bound to hold an amount of foreign currency that is at least equal to the amount of domestic currency. Because a currency board restricts a government from issuing additional domestic currency unless it has the foreign reserves to back it, it helps cap inflation.

currency board

Monetary regime that is based on an explicit commitment to exchange domestic currency for a specified foreign currency at a fixed exchange rate.

Thanks to a currency board, the country of Bosnia-Herzegovina has built itself a strong and stable currency. A currency board’s survival depends, however, on wise budget policies.6 Argentina had a currency board from 1991 until it was abandoned in early 2002, when the peso was allowed to float freely on currency markets. Other nations with currency boards include Brunei Darussalam, Bulgaria, Djibouti, Estonia, and Lithuania.

European Monetary System

Following the collapse of the Bretton Woods system, leaders of many European Union (EU) nations did not give up hope for a system that could stabilize currencies and reduce exchange-rate risk. Their efforts became increasingly important as trade between EU nations continued to expand. In 1979, these nations created the European monetary system (EMS). The EMS was established to stabilize exchange rates, promote trade among nations, and keep inflation low through monetary discipline. The system was phased out when the EU adopted a single currency.

How the System Worked

The mechanism that limited the fluctuations of European Union members’ currencies within a specified trading range (or target zone) was called the exchange rate mechanism (ERM). Members were required to keep their currencies within 2.25 percent of the highest- and lowest-valued currencies. To illustrate, suppose that a weakening French franc were about to reach the 2.25 percent variation in its exchange rate with the German mark. The central banks of both France and Germany were to drive the value of the French franc higher—forcing the exchange rate away from the 2.25 percent fluctuation limit. How did they do so? By buying up French francs on currency markets, thereby increasing demand for the franc and forcing its value higher.

The EMS was quite successful in its early years. Currency realignments were infrequent and inflation was fairly well controlled. But in late 1992, both the British pound and the Italian lira had been on the lower fringe of the allowable 2.25 percent fluctuation range with the German mark for some time. Currency speculators began unloading their pounds and lira. The central banks of neither Britain nor Italy had enough money to buy their currencies on the open market. As their currencies’ values plummeted, they were forced to leave the ERM. The EMS was revised in late 1993 to allow currencies to fluctuate 15 percent up or down from the midpoint of the target zone. Although the Italian lira returned to the ERM in November 1996, the British pound remained outside the ERM. Many European nations moved to the euro as their currency (see Chapter 8), which eliminated the need for the ERM.

Of the three nations (Britain, Denmark, and Sweden) opting out of the euro, Denmark is the only one participating in what is called the exchange rate mechanism II (ERM II). The ERM II (in which membership is voluntary) was introduced January 1, 1999, and continues to function today. The aim of ERM II is to support nations that seek future membership in the European monetary union (see Chapter 8) by linking their currencies to the euro. The euro acts as an anchor of a hub and spokes model, to which a currency is linked on a bilateral basis. The currencies of participating countries have a central rate against the euro with acceptable fluctuation margins of 15 percent, although narrower margins can be arranged. Future accession countries to the EU will be obliged to join the single currency once they satisfy the criteria of the Maastricht Treaty.

Recent Financial Crises

Despite the best efforts of nations to head off financial crises within the international monetary system, the world has experienced several wrenching crises in recent years. Let’s examine the most prominent of these.

Developing Nations’ Debt Crisis

By the early 1980s certain developing countries (especially in Latin America) had amassed huge debts payable not only to large international commercial banks but also to the IMF and the World Bank. In 1982 Mexico, Brazil, and Argentina announced that they would be unable to pay interest on their loans. At the same time, many of these countries were also experiencing runaway inflation. Many countries in Africa were facing similar problems.

To prevent a meltdown of the entire financial system, international agencies stepped in with a number of temporary solutions to the crisis. Repayment schedules were revised to put off repayment further into the future. Then, in 1989, U.S. Treasury Secretary Nicholas Brady unveiled the Brady Plan. The Brady Plan called for large-scale reduction of the debt owed by poorer nations, the exchange of old loans for new low-interest loans, and the making of debt instruments (based on these loans) that would be tradable on world financial markets. This last feature allowed a debtor country to receive a loan from an institution and then use it to buy special securities (called “Brady Bonds”) on financial markets. Funds for these new loans came from private commercial banks and were backed by the IMF and the World Bank.

Thousands of Argentinean farmers demonstrate against government policies near Gualeguaychu, in the Entre Rios province of Argentina. The International Monetary Fund (IMF) helped Argentina out of a recent financial crisis. Yet ordinary people strongly protested prescriptions of the IMF that called for high interest rates to prevent foreign investors from fleeing. As a result, many people lost their jobs and had their savings wiped out by a falling currency. Should the IMF have the power to dictate policies for countries that need aid?

Source: Ivan Franco/CORBIS-NY.

Mexico’s Peso Crisis

Armed rebellion in the poor Mexican state of Chiapas and the assassination of a presidential candidate shook investors’ faith in Mexico’s financial system in 1993 and 1994. Capital flowing into Mexico was mostly in the form of stocks and bonds (portfolio investment) rather than factories and equipment (foreign direct investment). Portfolio investment fled Mexico for the United States as the Mexican peso grew weak and U.S. interest rates rose. A lending spree by Mexican banks, coupled with weak banking regulations, also played a role in delaying the government’s response to the crisis. In late 1994 the Mexican peso was devalued, forcing a loss of purchasing power on the Mexican people.

In response to the crisis, the IMF and private commercial banks in the United States stepped in with about $50 billion in loans to shore up the Mexican economy. Thus Mexico’s peso crisis contributed to an additional boost in the level of IMF loans. Mexico repaid the loans ahead of schedule and once again has a sizable reserve of foreign exchange.

Southeast Asia’s Currency Crisis

The roar of the “four tiger” economies and those of other high-growth Asian nations suddenly fell silent in the summer of 1997. For 25 years the economies of five Southeast Asian countries—Indonesia, Malaysia, the Philippines, Singapore, and Thailand—had wowed the world with growth rates twice those of most other countries. Even though many analysts projected continued growth for the region, and even though billions of dollars in investment flooded in from the West, savvy speculators were pessimistic.

On July 11, 1997, the speculators struck, selling off Thailand’s baht on world currency markets. The selling forced an 18 percent drop in the value of the baht before speculators moved on to the Philippines and Malaysia. By November the baht had plunged another 22 percent and every other economy in the region was in a slump. The shock waves of Asia’s crisis could be felt throughout the global economy.

Suddenly, countries thought to be strong emerging market economies—“tigers” to be emulated by other developing countries—were in need of billions of dollars to keep their economies from crumbling. When the dust settled, Indonesia, South Korea, and Thailand all needed IMF and World Bank funding. As incentives for these countries to begin the long process of economic restructuring, IMF loan packages came with a number of strings attached. For example, the Indonesian loan package involved three long-term goals to help put the Indonesian economy on a stronger footing: (1) to restore the confidence of international financial markets, (2) to restructure the domestic financial sector, and (3) to support domestic deregulation and trade reforms.

What caused the crisis in the first place? Well, it depends on who you ask. Some believe it was caused by an Asian style of capitalism. They say that blame lies with poor regulation, the practice of extending loans to friends and relatives who are poor credit risks, and a lack of transparency regarding the financial health of banks and companies. Others point to poor management of these nations’ short-term debt obligations. Still others argue that persistent current account deficits in these countries are what caused the large dumping of these nations’ currencies. What really caused the crisis is probably a combination of all these forces.7

Russia’s Ruble Crisis

Russia had a whole host of problems throughout the 1990s—some were constant, others were intermittent. For starters, Russia was not immune to the events unfolding across Southeast Asia in the late 1990s. As investors became wary of potential problems in other emerging markets worldwide, stock market values in Russia plummeted. Another problem contributing to Russia’s problems was depressed oil prices. Because Russia depends on oil production for a large portion of its GDP, the low price of oil on world markets cut into the government’s reserves of hard currency. Also cutting into the government’s coffers was an unworkable tax collection system and a large underground economy—meaning that most taxes went uncollected.

There also was the problem of inflation. We learned earlier in this chapter how an expanded amount of money chasing the same amount of goods forces prices higher. This is exactly what happened when Russia released prices in 1992. As prices skyrocketed, people dug beneath their mattresses where they had stashed their rubles during times when there were no goods to purchase. We also saw earlier how inflation eats away at the value of a nation’s currency. Russia saw inflation take its exchange rate from less than 200 rubles to the dollar in early 1992 to more than 5,000 to the dollar in 1995.

Then in early 1996 as currency traders dumped the ruble, the Russian government found itself attempting to defend the ruble on currency markets. As its foreign exchange reserves dwindled in a hopeless effort, the government asked for, and received, a $10 billion aid package from the IMF. In return, Russia promised to reduce its debt (which was averaging about 7 percent of GDP), collect taxes owed it, cease printing inflation-stoking sums of currency, and peg its currency to the dollar.

Things seemed to improve for a while, but then in mid-1998 the government found itself once again trying to defend the ruble against speculative pressure on currency markets. In a single day the government spent $1 billion trying to prop up the ruble’s value, forcing its hard currency reserves to shrivel to $14 billion. As it grew obvious that the government would soon be bankrupt, the IMF stepped in and promised Russia another $11 billion. But when it was alleged that some of the IMF loan had been funneled into offshore bank accounts, the IMF held up distribution of the money. On August 17, 1998, badly strapped for cash, the government announced that it would allow the ruble to devalue by 34 percent by the end of the year. It also declared a 90-day foreign-debt moratorium and announced a de facto default on the government’s domestic bond obligations. On August 26, the Russian Central Bank announced that it would no longer be able to support the ruble on currency markets. In less than one month, its value fell 300 percent. Inflation shot up to 15 percent a month in August from 0.2 percent in July and reached 30 percent in the first week of September. By the time it was all over in late 1998, the IMF had lent Russia more than $22 billion.

Argentina’s Peso Crisis

Argentina was the star of Latin America in the early and mid-1990s. Yet by late 2001, Argentina had been in recession for nearly four years, mainly because of Brazil’s devaluation of its own currency in 1999—making Brazil’s exports cheaper on world markets. Meanwhile, Argentina’s goods remained relatively expensive because its own currency was linked to a very strong U.S. dollar through a currency board. As a result, Argentina saw much of its export business dry up and the economy slowed significantly. By late 2001, the IMF had already promised $48 billion to rescue Argentina.

Things came to a head when the country began running out of money to service its debt obligations. The country finally defaulted on its $155 billion of public debt in early 2002, the largest default ever by any country. The government scrapped its currency board that linked the peso to the U.S. dollar, and the peso quickly lost around 70 percent of its value on currency markets. The government, strapped for cash, seized the savings accounts of its citizens and restricted how much they could withdraw at a time.

Argentina has in many respects recovered from its 2001–2002 collapse. It has registered growth of around 9 percent a year and unemployment fell from a high of 25 percent in 2002 to around 8 percent in 2008. The government’s plan—stimulating demand by raising wages, imposing price controls, keeping the peso low, and boosting public spending—seemed to be working. Argentina was expected to continue growing at a slower pace of around 4 to 5 percent, but inflation was running at 9 percent a year and cutting into purchasing power. As of mid-2008 Argentina’s credit rating was downgraded, although another economic collapse was unlikely.8

Future of the International Monetary System

Recurring crises in the international monetary system are raising calls for a new system that is designed to meet the challenges of a global economy. Many believe that the vestiges of the IMF created by the Bretton Woods Agreement are no longer adequate to insulate the world’s economies from disruptions in a single country or small group of countries.

Meanwhile, leaders of many developing and newly industrialized countries are bemoaning what global capital has done to their economies. Although some call for the elimination of the IMF and its replacement by institutions not yet clearly defined, more likely is revision of the IMF and its policy prescriptions. Efforts have already been made to develop internationally accepted codes of good practice to allow comparisons of countries’ fiscal and monetary practices. Countries have also been encouraged to be more open and clear regarding their financial policies. Transparency on the part of the IMF is also being increased to instill greater accountability on the part of its leadership. The IMF also is increasing its efforts at surveillance of member nations’ macroeconomic policies and increasing its abilities in the area of financial-sector analysis.

Yet orderly ways must still be found to integrate international financial markets so that risks are better managed. Moreover, the private sector must become involved in the prevention and resolution of financial crises. Policy makers are concerned with the way money floods into developing economies when growth is strong and then just as quickly heads for the exits at the first sign of trouble. Furthermore, some argue that because the IMF bails out debtor countries, private-sector banks do not exercise adequate caution when loaning money in risky situations: After all, the IMF will be there to pay off the loans of debtor countries. Greater cooperation and understanding among the IMF, private-sector banks, and debtor nations are needed.

Quick Study

1. Why did the world shift to a
managed float system
of exchange rates? Briefly describe the performance of this system.

2. What was the purpose of the European monetary system? Describe how it functioned and performed.

3. What role did the International Monetary Fund have in assisting nations during recent financial crises?

Bottom Line FOR BUSINESS

Recent financial crises underscore the need for managers to fully understand the complexities of the international financial system. But this knowledge must be paired with vigilance of financial market conditions to manage businesses effectively. Here we focus on the main implications for business strategy and forecasting earnings and cash flows.

Implications for Business Strategy

Exchange rates influence all sorts of business activities for domestic and international companies. A weak currency (valued low relative to other currencies) lowers the price of a nation’s exports on world markets and raises the price of imports. Lower prices make the country’s exports more appealing on world markets. This gives companies the opportunity to take market share away from companies whose products are priced high in comparison.

Although a government might devalue its currency to give domestic companies an edge over competition from other countries, devaluation reduces consumers’ buying power. It might also allow inefficiencies to persist in domestic companies because it can lessen concern for production costs. A company improves its profits if it is selling in a country with a strong currency (one that is valued high relative to other currencies) while paying workers in a country with a weak currency. But companies that benefit from a temporary price advantage caused by exchange rates must not grow complacent about their own long-term competitiveness.

Forecasting Earnings and Cash Flows

Exchange rates also affect the amount of profit a company earns from its international subsidiaries. The earnings of international subsidiaries are typically integrated into the parent company’s financial statements in the home currency. Translating subsidiary earnings from a weak host country currency into a strong home currency reduces the amount of these earnings when stated in the home currency. Likewise, translating earnings into a weak home currency increases stated earnings in the home currency.

Sudden, unfavorable movements in exchange rates can be costly for both domestic and international companies. On the other hand, stable exchange rates improve the accuracy of financial planning, including cash flow forecasts. Although companies can insure (usually by currency hedging) against potentially adverse movements in exchange rates, most available methods are too expensive for small and medium-sized businesses. Moreover, as the unpredictability of exchange rates increases, so too does the cost of insuring against the accompanying risk.

Managers also prefer movements in exchange rates to be predictable. Predictable exchange rates reduce the likelihood that companies will be caught off guard by sudden and unexpected rate changes. They also reduce the need for costly insurance against possible adverse movements in exchange rates. Rather than purchasing insurance, companies would be better off spending their money on more productive activities, such as developing new products or designing more efficient production methods.

As we saw in this chapter, not only are a company’s financial decisions affected by events in international financial markets, but so too are production and marketing decisions. The next chapter begins our in-depth look at the main aspects of managing an international business. Our understanding of national business environments, international trade and investment, and the international financial system will serve us well as we embark on our tour of the nuances of international business management.

Chapter Summary

1. Explain how exchange rates influence the activities of domestic and international companies.

■ When a country’s currency is weak (valued low relative to other currencies), the price of its exports on world markets declines (making exports more appealing on world markets) and the price of imports rises, and vice versa.

■ A company can improve profits if it sells in a country with a strong currency (one that is valued high relative to other currencies) while paying workers at home in its own weak currency.

■ The intentional lowering of a currency’s value by the nation’s government is called
devaluation
; this lowers the price of a country’s exports on world markets and increases the price of imports.

■ The intentional raising of a currency’s value by the nation’s government is called
revaluation
; this increases the price of exports and reduces the price of imports.

■ Translating subsidiary earnings from a weak host country currency into a strong home currency reduces the amount of these earnings when stated in the home currency, and vice versa.

2. Identify the factors that help determine exchange rates and their impact on business.

■ The
law of one price
says that when price is expressed in a common currency, an identical product must have an identical price in all countries.

■ The concept of
purchasing power parity
(PPP) can be interpreted as the exchange rate between two nations’ currencies that is equal to the ratio of their price levels.

■ Inflation occurs when money is injected into a static economy, or when employers raise wages to attract employees and then pass increased labor costs on to consumers.

■ Interest rates affect inflation by affecting the cost of borrowing money: Low interest rates encourage spending and higher debt, whereas high rates prompt savings and lower debt.

■ Because real interest rates are theoretically equal across countries, a rate difference between two countries must be due to different expected rates of inflation.

■ A country that is experiencing inflation higher than that of another country should see the relative value of its currency fall.

3. Describe the primary methods of forecasting exchange rates.

■ A forward exchange rate is the rate agreed upon for foreign exchange payment at a future date.

■ The
efficient market view
says that prices of financial instruments reflect all publicly available information at any given time; meaning forward exchange rates accurately forecast future exchange rates.

■ The
inefficient market view
says that prices of financial instruments do not reflect all publicly available information, meaning forecasts can be improved by information not reflected in forward exchange rates.

■ One forecasting technique based on a belief in the value of added information is
fundamental analysis
, which uses statistical models based on fundamental economic indicators to forecast exchange rates.

■ A second forecasting technique is
technical analysis
, which employs charts of past trends in currency prices and other factors to forecast exchange rates.

4. Discuss the evolution of the current international monetary system and explain how it operates.

■ The
Bretton Woods Agreement
(1944) created an international monetary system based on the value of the U.S. dollar and used the
gold standard
to link paper currencies to specific values of gold.

■ The most important features of the Bretton Woods system were fixed exchange rates, built-in flexibility, funds for economic development, and an enforcement mechanism.

■ The
World Bank
funds poor nations’ economic development projects such as the development of transportation networks, power facilities, and agricultural and educational programs.

■ The
International Monetary Fund
(IMF) regulates fixed exchange rates and enforces the rules of the international monetary system.

■ The
Jamaica Agreement
(1976) endorsed a
managed float system
of exchange rates in which currencies float against one another with limited government intervention to stabilize currencies at a target exchange rate.

■ In a
free float system
currencies float freely without government intervention.

■ Within today’s managed float system, certain countries try to maintain more stable exchange rates by tying their currencies to another country’s stronger currency.

Talk It Over

1. Describe briefly the advantages and disadvantages of both floating and fixed exchange-rate systems. Do you think the world will move toward an international monetary system more characteristic of floating or fixed exchange rates in the future? Explain your answer.

2. Do you think an international monetary system with currencies valued on the basis of gold would work today? Why or why not? Do you think implementing a global version of the old European monetary system would work today? Why or why not?

3. The activities of the IMF and the World Bank largely overlap each other. Devise a plan that reduces this duplication of services and assigns distinct responsibilities. Would you have them assume a greater role on the environment and corruption? Describe and justify your proposed solution.

Teaming Up

1. Research Project. Suppose you and several classmates are a marketing team assembled by your Brazil-based firm to estimate demand in the U.S. market for its newly developed product. The market research firm your team hired requires $150,000 to perform a thorough study. But your group is informed that the total research budget for the year is 3 million Brazilian real and that no more than 20 percent of the budget can be spent on any one project.

a. If the current exchange rate is 5 real/$, will your group have the market study conducted? Why or why not?

b. If the exchange rate changes to 3 real/$, will your group have the study conducted? Why or why not?

c. At what exchange rate do you change your group’s decision from rejecting the proposed research project to accepting the project?

2. Market Entry Strategy Project. This exercise corresponds to the MESP online simulation. For the country your team is researching, is it a member of the IMF? Does it participate in a regional monetary system to manage exchange rates? How have inflation and interest rates affected the nation’s exchange rate with other currencies? What impact has the country’s exchange rate had on its imports and exports? How has the exchange rate recently affected: (a) the activities of companies operating in the country and (b) the purchasing power of consumers? What is the forecasted exchange rate for the coming weeks, months, and year? (Hint: Good sources are the IMF’s monthly International Financial Statistics and annual Exchange Arrangements and Exchange Restrictions.) Integrate your findings into your completed MESP report.

Key Terms

Bretton Woods Agreement (p. 286)

currency board (p. 289)

devaluation (p. 275)

efficient market view (p. 282)

Fisher effect (p. 280)

fixed exchange-rate system (p. 285)

free float system (p. 288)

fundamental analysis (p. 283)

fundamental disequilibrium (p. 286)

gold standard (p. 285)

inefficient market view (p. 283)

international Fisher effect (p. 280)

international monetary system (p. 284)

Jamaica Agreement (p. 288)

law of one price (p. 276)

managed float system (p. 288)

revaluation (p. 275)

Smithsonian Agreement (p. 288)

special drawing right (SDR) (p. 287)

technical analysis (p. 283)

Take It to the Web

1. Video Report. Visit this book’s channel on YouTube (YouTube.com/MyIBvideos). Click on “Playlists” near the top of the page and click on the set of videos labeled “Ch 10: International Monetary System.” Watch one video from the list and summarize it in a half-page report. Reflecting on the contents of this chapter, which aspects of the international monetary system can you identify in the video? How might a company engaged in international business act on the information contained in the video?

2. Web Site Report. Use the Internet to research the economic crisis that struck Argentina in recent years. Identify as many potential contributing factors to the crisis as you can. What are current conditions in Argentina’s exchange rate, inflation, and debt load? What effect has the crisis had on Brazil and other South American economies? Do you think Argentina’s involvement in the trading bloc MERCOSUR had anything to do with its problems?

Update how Argentina’s companies, investors, and citizens are faring. How did the crisis affect companies’ earnings and future projects? Are investors gaining renewed confidence and returning to Argentina? Are Argentines seeing the rebound of their currency’s purchasing power? What is the IMF currently doing to aid Argentina’s economy?

Ethical Challenges

1. You are the senior economic advisor for currency analysis with the United Nations (UN). The President of Malaysia has accused currency speculators with conspiring to devalue the Malaysian ringgit and wants the UN to create a formal policy designed to prevent similar financial crises in the future. Some years ago, when currency speculators turned their backs on Malaysia and forced a devaluation of the ringgit: then prime minister Mahathir Mohamad denounced currency speculators as “immoral” and argued that currency trading should take place only to facilitate deals between countries. Although most observers dismissed these comments as coming from a man known for his outspoken tirades against Western investors, others contend that the prime minister’s rhetoric voices a genuine concern. Do you think an international policy that restricts currency trading can prevent future problems? What other implications might stem from such a policy? Is it ethical for global currency speculators to bet against national currencies, perhaps sending whole economies into a tailspin while they profit? Or do you think that currency speculators perform a valuable service by correcting overvalued or undervalued currencies?

2. You are the chair of an International Monetary Fund (IMF) task force. Your job is to reevaluate the policy of bailing out national governments that suffer major losses in the private sector. Current policy is to enlist the help of industrialized countries in bailing out emerging nations in the midst of financial crises. Taxpayers in industrial countries typically foot the bill for IMF activities, with total loans running into the many billions of dollars. Recent examples are the bailouts of Mexico, Indonesia, and Thailand. Some critics call this system a kind of “remnant socialism” that rescues financial institutions and investors from their own mistakes with money from taxpayers. For instance, the financial crisis in Thailand was largely a private-sector affair. Thai banks and insurance companies were heavily in debt, and the central bank had recklessly pledged its foreign exchange reserves to shore up the currency. As chair of the task force, what is your position on this dilemma? Do you believe that the current system socializes losses (the government bails them out) and privatizes profits? Explain exactly who benefits from such bailouts. What is an alternative to an IMF bailout?

PRACTICING INTERNATIONAL MANAGEMENT CASE Banking On Forgiveness

When James Wolfensohn became head of the World Bank, he bluntly admitted the bank had “screwed up” in Africa. Decades of loans had erected a vast modern infrastructure (dams, roads, and power plants) for Africa’s poor, but the gap between rich and poor did not narrow. In fact, the policies of the bank and global financial regulators had created a new crisis in sub-Saharan Africa: These nations were now mired in debt they could not possibly repay. Africa’s total debt at the time almost equaled the annual gross national product of the entire continent. For instance, in Mozambique, where 25 percent of all children die from infectious disease before the age of five, the government was spending twice as much paying off debt as it was spending on health care and education.

But just when many countries were receiving debt relief, the debate over aid versus loans arose again. Groups debated how to prevent economic collapses and debt problems in the developing world, and how to use dwindling aid more efficiently. Some countries wanted to give more foreign aid but wanted the money to be given as grants to financially and politically stable nations. They also wanted World Bank funds to be given to poor nations as grants and not loans nations would need to repay.

Other nations feared that giving the money away as grants would drain the World Bank’s coffers, as well as their own. They acknowledged they may not be able to do as much for the least-developed countries, but that the role of the World Bank, after all, is to act as a bank and not a donor. Support for this view was World Bank data that showed more than 95 percent of all loans are repaid and that poor nations are more careful with loans than they are with handouts.

For years, nongovernmental organizations (NGOs), such as advocacy group Oxfam International, had lobbied the Bank and the International Monetary Fund (IMF) to write off loans to their poorest borrowers, calling for “debt forgiveness” or “debt relief.” Fortunately for the African people and their advocates, the new head of the bank put debt forgiveness at the top of his agenda. In the fall of 1996 the World Bank and IMF announced a plan to reduce the external debt of the world’s poorest, most heavily indebted countries. The purpose of the plan, called the Heavily Indebted Poor Countries (HIPC) Debt Initiative, is to slash overall debt stocks by 50 percent, lower poor nations’ debt service, and boost social spending in poor nations. The HIPC has identified 41 countries in Africa, Latin America, Asia, and the Middle East that may qualify for debt reduction. But debt relief is not automatic. The international banking community is using debt as both a carrot and a stick: Whereas nations with good reform records will get relief, those without reforms will not get relief.

Then, in 2006, the world’s largest international lending institutions launched the Multilateral Debt Relief Initiative (MDRI) to work alongside the HIPC initiative and help countries reach their debt-relief goals. As of 2006, 32 of the 41 countries identified for assistance have had their debt service obligations reduced by one-half. For those countries, debt service as a percentage of exports fell from 16.6 percent in 1999 to 6.4 percent by 2006. And those nations have seen their debt service as a percentage of GDP drop from 4.6 percent to 1.9 percent over the same period.

One success story is Uganda. Uganda was the first country declared eligible for assistance in 1997 and was the first to receive debt relief under the HIPC Initiative in 1998. The decision to begin the program with Uganda was not an arbitrary one. While under the brutal dictatorship of Idi Amin, Uganda was treated as a pariah by creditors. But then President Yoweri Musevini led the country through a decade-long process of economic reform. Uganda became a model country, boasting a steady growth rate of around 5 percent, with coffee as its main export. By offering debt relief to Uganda, the World Bank and IMF rewarded Uganda’s exemplary track record by reducing its debt to the lowest possible level—about twice the value of its exports. Savings from the debt-relief program are pledged to improve health care and to make primary education available to all Ugandan families.

Thinking Globally

1. In negotiating the HIPC Debt Initiative, the World Bank and the IMF worked closely together. At one point, however, the plan came to a standstill when the two organizations produced different figures for Uganda’s coffee exports, with the IMF giving a more optimistic forecast and so arguing against the need for debt relief. In your opinion, is there any benefit to these organizations working together? Explain. Which organization do you think should play a greater role in aiding economic development? Why?

2. The World Bank and the IMF had once argued that the leniency of debt forgiveness would make it more difficult for the lenders themselves to borrow cheaply on the world’s capital markets. If you were a World Bank donor, would you support the HIPC Debt Initiative or argue against it? Explain your answer.

3. At the time the HIPC Initiative was being developed, some critics argued it fell short. For example, Harvard economist Jeffrey Sachs claimed the need for debt relief was obvious 10 years earlier. The carrot, said Sachs, is simply too little, too late, and that the situation for some countries was so grim that entire external indebtedness, not just half, should be written off. Do you think the World Bank and the IMF should write off the entire debt of countries? What are the pros and cons of this approach for debt relief?

Source: “Heavily Indebted Poor Countries (HIPC) Initiative and Multilateral Debt Relief Initiative (MDRI)—Status of Implementation,” World Bank Web site (www.worldbank.org), September 27, 2007; “HIPC-at-a-Glance Guide,” World Bank Web site (www.worldbank.org), Fall 2007.

(Wild 272)

Wild, John J., Kenneth L. Wild & Jerry C.Y. Han. International Business: The Challenges of Globalization, 5th Edition. Pearson Learning Solutions. .es of Globalization, 5th Edition. Pearson Learning Solutions. .