Manufacturing in Mexico

As the CFO for a MNC computer hardware company, you have to advise your president on investment decisions. The president of your company is considering developing mainframe computers in the company’s Mexican facility. By Monday, September 10, 2012, prepare an executive memorandum for the president outlining the pros and cons of pursuing this venture. You must identify and evaluate at least eight different variables that can influence your decision. Include a discussion on the macroeconomic role of the World Bank and IMF in facilitating your manufacturing base in Mexico. Use the  University’s online library and the Internet to support your findings.

The executive memorandum should be your own—original and free from plagiarism. Submit it as a Microsoft Word document, not exceeding two pages, double-spaced, in Arial 12 pt font. Be sure to include a bibliography.

All written assignments and responses should follow APA rules for attributing sources.

Submit your executive memorandum to the M1: Assignment 1 Dropbox.

Module 1 Readings and Assignments Save Time On Research and Writing Hire a Pro to Write You a 100% Plagiarism-Free Paper. Get My Paper Complete the following readings early in the module: · Read the online lectures for   Module 1. · From the textbook Multinational financial management, read the chapters listed. · Introduction: Multinational enterprise and multinational financial management · The determination of exchange rates · The international monetary system · Refer to the Reading Recommendations document in the Doc Sharing Area for a list of recommended books and Web links. Please note: Additional readings and academic research should be a major component of all graduate level work. It is expected that students will supplement their required textbooks and resource material readings into the weekly module learning topics with individual self-directed research into the academic body of knowledge. Full-text scholarly journals may be found at the Argosy University online library. Assignment Summary: Module 1 Due Date Assignment 1: Manufacturing in Mexico Monday, September 10, 2012 Assignment 2: Discussion Question Sunday, September 9, 2012-Wednesday, September 12, 2012 Module 2 Readings and Assignments Complete the following readings early in the module: · Read the online lectures for Module 2. · From the textbook Multinational financial management, read the chapters listed. · Parity conditions in international finance and currency forecasting · The balance of payments and international economic linkages · Country risk analysis · Refer to the Reading Recommendations document in the Doc Sharing Area for a list of recommended books and Web links. Please note: Additional readings and academic research should be a major component of all graduate level work. It is expected that students will supplement their required textbooks and resource material readings into the weekly module learning topics with individual self-directed research into the academic body of knowledge. Full-text scholarly journals may be found at the Argosy University online library. Assignment Summary: Module 2 Due Date Assignment 1: Deficit balance of payments Monday, September 17, 2012 Assignment 2: Discussion Question Sunday, September 16, 2012-Wednesday, September 19, 2012 Module 3 Readings and Assignments Complete the following readings early in the module: · Read the online lectures for Module 3. · From the textbook Multinational financial management, read the chapters listed.  · The foreign exchange market · Currency futures and options markets · Swaps and interest rate derivatives · Refer to the Reading Recommendations document in the Doc Sharing Area for a list of recommended books and Web links. Note: Additional readings and academic research should be a major component of all graduate level work. Students should supplement their required textbooks and resource material readings with individual self-directed research into the academic body of knowledge. Full-text scholarly journals can be found at the Argosy University online library. Assignment Summary: Module 3 Due Assignment 1: Malaysian futures market Sunday, September 23, 2012 Assignment 2: Discussion Question Sunday, September 23, 2012-Wednesday, September 26, 2012 Module 4 Readings and Assignments Complete the following readings early in the module: · Read the online lectures for Module 4. · From the textbook Multinational financial management, read the chapters listed. · Measuring and managing translation and transaction exposure · Measuring and managing economic exposure · Refer to the Reading Recommendations document in the Doc Sharing Area for a list of recommended books and Web links. Note: Additional reading and research is a major component of all graduate level work. As students, you should supplement your required readings with self-directed research into the academic body of knowledge. You can find full-text scholarly journals at the Argosy University online library. Assignment Summary: Module 4 Due Assignment 1: Midterm team assessment Saturday, September 29, 2012 ,Monday, October 1, 2012 Assignment 2: Discussion Question Sunday, September 30, 2012-Wednesday, October 3, 2012 Module 5 Readings and Assignments Complete the following readings early in the module: · Read the online lectures for Module 5. · From the textbook Multinational financial management, read the chapters listed. · International financing and national capital markets · The euromarkets · Refer to the Reading Recommendations document in the Doc Sharing Area for a list of recommended books and Web links. Note: Additional reading and research is a major component of all graduate level work. As students, you should supplement your required readings with self-directed research into the academic body of knowledge. You can find full-text scholarly journals at the Argosy University online library. Assignment Summary: Module 5 Due Assignment 1: European capital market Monday, October 8, 2012 Assignment 2: Discussion Question Sunday, October 7, 2012-Wednesday, October 10, 2012 Module 6 Readings and Assignments Complete the following readings early in the module: · Read the online lectures for Module 6. · From the textbook Multinational financial management, read the chapters listed. · The cost of capital for foreign investments · International portfolio investment · Financing foreign trade · Refer to the Reading Recommendations document in the Doc Sharing Area for a list of recommended books and Web links. Note: Additional readings and academic research is a major component of all graduate level work. As students, you should supplement your required textbooks and resource material readings with self-directed research into the academic body of knowledge. You can find full-text scholarly journals at the Argosy University online library. Assignment Summary and Grading Criteria: Module 6 Due Date Assignment 1: Cost of capital Monday, October 15, 2012 Assignment 2: Discussion Question Sunday, October 14, 2012-Wednesday, October 17, 2012 Module 7 Readings and Assignments Complete the following readings early in the module: · Read the online lectures for Module 7. · From the textbook Multinational financial management, read the chapters listed. · Corporate strategy and foreign direct investment · Capital budgeting for the multinational corporation · Current asset management and short-term financing · Refer to the Reading Recommendations document in the Doc Sharing Area for a list of recommended books and Web links. Note: Additional reading and research is a major component of all graduate level work. As students, you should supplement your required readings with self-directed research into the academic body of knowledge. You can find full-text scholarly journals at the Argosy University online library. Assignment Summary: Module 7 Due Assignment 1: Corporate finance strategy Monday, October 22, 2012 Assignment 2: Discussion Question Sunday, October 21, 2012-Wednesday, October 24, 2012 Module 8 Readings and Assignments Complete the following readings early in the module: Assignment Summary and Grading Criteria: Module 8 Due Date Assignment 1: Final Paper – Team Project Friday, October 26, 2012 Assignment 2: Discussion Question Thursday, October 25, 2012-Friday, October 26, 2012

CHAPTER 1 Introduction: Multinational Enterprise and Multinational Financial Management

What is prudence in the conduct of every private family can scarce be folly in that of a great kingdom. If a foreign country can supply us with a commodity cheaper than we ourselves can make it, better buy it of them with some part of the produce of our own industry employed in a way in which we have some advantage.

Adam Smith (1776)
LEARNING OBJECTIVES
• To understand the nature and benefits of globalization
• To explain why multinational corporations are the key players in international economic competition today
• To understand the motivations for foreign direct investment and the evolution of the multinational corporation (MNC)
• To identify the stages of corporate expansion overseas by which companies gradually become MNCs
• To explain why managers of MNCs need to exploit rapidly changing global economic conditions and why political policymakers must also be concerned with the same changing conditions
• To identify the advantages of being multinational, including the benefits of international diversification
• To describe the general importance of financial economics to multinational financial management and the particular importance of the concepts of arbitrage, market efficiency, capital asset pricing, and total risk
• To characterize the global financial marketplace and explain why MNC managers must be alert to capital market imperfections and asymmetries in tax regulations
KEY TERMS
absolute advantage
arbitrage
arbitrage pricing theory (APT)
capital asset pricing model (CAPM)
capital market imperfections
comparative advantage
creative destruction
economies of scale
efficient market
financial economics
financing decision
foreign direct investment (FDI)
global economy
global manager
globalization
international diversification
internationalization
investment decision
investment flows
market efficiency
multinational corporation (MNC)
reverse foreign investment
risk arbitrage
systematic (nondiversifiable) risk
tax arbitrage
terms of trade [from appendix]
total risk
unsystematic (diversifiable) risk
A key theme of this book is that companies today operate within a global marketplace and can ignore this fact only at their peril. The internationalization of finance and commerce has been brought about by the great advances in transportation, communications, and information-processing technology. This development introduces a dramatic new commercial reality—the global market for standardized consumer and industrial products on a previously unimagined scale. It places primary emphasis on the one great thing all markets have in common—the overwhelming desire for dependable, world-class products at aggressively low prices. The international integration of markets also introduces the global competitor, making firms insecure even in their home markets.
The transformation of the world economy has dramatic implications for business. American management, for example, is learning that the United States can no longer be viewed as a huge economy that does a bit of business with secondary economies around the world. Rather, the United States is merely one economy, albeit a very large one, that is part of an extremely competitive, integrated world economic system. To succeed, U.S. companies need great flexibility; they must be able to change corporate policies quickly as the world market creates new opportunities and challenges. Big Steel, which was virtually the antithesis of this modern model of business practice, paid the price for failing to adjust to the transformation of the world economy. Similarly, non-U.S. companies are finding that they must increasingly turn to foreign markets to source capital and technology and sell their products.
Today’s financial reality is that money knows no national boundary. The dollar has become the world’s central currency, with billions switched at the flick of an electronic blip from one global corporation to another, from one central bank to another. The international mobility of capital has benefited firms by giving them more financial options, while at the same time complicating the job of the chief financial officer by increasing its complexity.
Because we operate in an integrated world economy, all students of finance should have an international orientation. Indeed, it is the rare company today, in any country, that does not have a supplier, competitor, or customer located abroad. Moreover, its domestic suppliers, competitors, and customers likely have their own foreign choices as well. Thus, a key aim of this book is to help you bring to bear on key business decisions a global perspective, manifested by questions such as, Where in the world should we locate our plants? Which global market segments should we seek to penetrate? and Where in the world should we raise our financing? This international perspective is best captured in the following quotation from an ad for J.P. Morgan, the large, successful New York bank (known as J.P. Morgan Chase & Co. since its December 2000 merger with Chase Manhattan): “J.P. Morgan is an international firm with a very important American business.”
1.1 THE RISE OF THE MULTINATIONAL CORPORATION
Despite its increasing importance today, international business activity is not new. The transfer of goods and services across national borders has been taking place for thousands of years, antedating even Joseph’s advice to the rulers of Egypt to establish that nation as the granary of the Middle East. Since the end of World War II, however, international business has undergone a revolution out of which has emerged one of the most important economic phenomena of the latter half of the twentieth century: the multinational corporation.
A multinational corporation (MNC) is a company engaged in producing and selling goods or services in more than one country. It ordinarily consists of a parent company located in the home country and at least five or six foreign subsidiaries, typically with a high degree of strategic interaction among the units. Some MNCs have upward of 100 foreign subsidiaries scattered around the world. The United Nations estimates that at least 35,000 companies can be classified as multinational.
Based in part on the development of modern communications and transportation technologies, the rise of the multinational corporation was unanticipated by the classical theory of international trade as first developed by Adam Smith and David Ricardo. According to this theory, which rests on the doctrine of comparative advantage, each nation should specialize in the production and export of those goods that it can produce with highest relative efficiency and import those goods that other nations can produce relatively more efficiently.
Underlying this theory is the assumption that goods and services can move internationally but factors of production, such as capital, labor, and land, are relatively immobile. Furthermore, the theory deals only with trade in commodities—that is, undifferentiated products; it ignores the roles of uncertainty, economies of scale, transportation costs, and technology in international trade; and it is static rather than dynamic. For all these defects, however, it is a valuable theory, and it still provides a well-reasoned theoretical foundation for free-trade arguments (see Appendix 1A). But the growth of the MNC can be understood only by relaxing the traditional assumptions of classical trade theory.
Classical trade theory implicitly assumes that countries differ enough in terms of resource endowments and economic skills for those differences to be at the center of any analysis of corporate competitiveness. Differences among individual corporate strategies are considered to be of only secondary importance; a company’s citizenship is the key determinant of international success in the world of Adam Smith and David Ricardo.
This theory, however, is increasingly irrelevant to the analysis of businesses in the countries currently at the core of the world economy—the United States, Japan, the nations of Western Europe, and, to an increasing extent, the most successful East Asian countries. Within this advanced and highly integrated core economy, differences among corporations are becoming more important than aggregate differences among countries. Furthermore, the increasing capacity of even small companies to operate in a global perspective makes the old analytical framework even more obsolete.
Not only are the “core nations” more homogeneous than before in terms of living standards, lifestyles, and economic organization, but their factors of production tend to move more rapidly in search of higher returns. Natural resources have lost much of their previous role in national specialization as advanced, knowledge-intensive societies move rapidly into the age of artificial materials and genetic engineering. Capital moves around the world in massive amounts at the speed of light; increasingly, corporations raise capital simultaneously in several major markets. Labor skills in these countries no longer can be considered fundamentally different; many of the students enrolled in American graduate schools are foreign, and training has become a key dimension of many joint ventures between international corporations. Technology and know-how are also rapidly becoming a global pool, with companies such as General Electric, Morgan Stanley, Electronic Data Systems, Cisco Systems, McKinsey & Co., and IBM shifting software writing, accounting, engineering, and other skilled services to countries such as India and China.
Against this background, the ability of corporations of all sizes to use these globally available factors of production is a far bigger factor in international competitiveness than broad macroeconomic differences among countries. Contrary to the postulates of Smith and Ricardo, the very existence of the multinational enterprise is based on the international mobility of certain factors of production. Capital raised in London on the Eurodollar market may be used by a Swiss-based pharmaceutical firm to finance the acquisition of German equipment by a subsidiary in Brazil. A single Barbie doll is made in 10 countries—designed in California; with parts and clothing from Japan, China, Hong Kong, Malaysia, Indonesia, Korea, Italy, and Taiwan; and assembled in Mexico—and sold in 144 countries. Information technology also makes it possible for worker skills to flow with little regard to borders. In the semiconductor industry, the leading companies typically locate their design facilities in high-tech corridors in the United States, Japan, and Europe. Finished designs are transported quickly by computer networks to manufacturing plants in countries with more advantageous cost structures. In effect, the traditional world economy in which products are exported has been replaced by one in which value is added in several different countries.
The value added in a particular country—product development, design, production, assembly, or marketing—depends on differences in labor costs and unique national attributes or skills. Although trade in goods, capital, and services and the ability to shift production act to limit these differences in costs and skills among nations, differences nonetheless remain based on cultural predilections, historical accidents, and government policies. Each of these factors can affect the nature of the competitive advantages enjoyed by different nations and their companies. For example, at the moment, the United States has some significant competitive advantages. For one thing, individualism and entrepreneurship—characteristics that are deeply ingrained in the American spirit—are increasingly a source of competitive advantage as the creation of value becomes more knowledge intensive. When inventiveness and entrepreneurship are combined with abundant risk capital, superior graduate education, better infrastructure, and an inflow of foreign brainpower, it is not surprising that U.S. companies—from Boston to Austin, from Silicon Alley to Silicon Valley—dominate world markets in software, biotechnology, Internet-related business, microprocessors, aerospace, and entertainment. Also, U.S. firms are moving rapidly forward to construct an information superhighway and related multimedia technology, whereas their European and Japanese rivals face continued regulatory and bureaucratic roadblocks.
Recent experiences also have given the United States a significant competitive advantage. During the 1980s and 1990s, fundamental political, technological, regulatory, and economic forces radically changed the global competitive environment. A brief listing of some of these forces includes the following:
• Massive deregulation
• The collapse of communism
• The sale of hundreds of billions of dollars of state-owned firms around the world in massive privatizations designed to shrink the public sector
• The revolution in information technologies
• The rise in the market for corporate control with its waves of takeovers, mergers, and leveraged buyouts
• The jettisoning of statist policies and their replacement by free-market policies in Third World nations
• The unprecedented number of nations submitting themselves to the exacting rigors and standards of the global marketplace
These forces have combined to usher in an era of brutal price and service competition. The United States is further along than other nations in adapting to this new world economic order, largely because its more open economy has forced its firms to confront rather than hide from competitors. Facing vicious competition at home and abroad, U.S. companies—including such corporate landmarks as IBM, General Motors, Walt Disney, Xerox, American Express, Coca-Cola, and Kodak—have been restructuring and investing heavily in new technologies and marketing strategies to boost productivity and expand their markets. In addition, the United States has gone further than any other industrialized country in deregulating its financial services, telecommunications, airlines, and trucking industries. The result: Even traditionally sheltered U.S. industries have become far more competitive in recent years, and so has the U.S. workforce. The heightened competitiveness of U.S. firms has, in turn, compelled European and Japanese rivals to undergo a similar process of restructuring and renewal.
Perhaps the most dramatic change in the international economy over the past decade has been the rise of China as a global competitor. From 1978, when Deng Xiaoping launched his country’s economic reform program, to 2003, China’s gross domestic product rose by more than 700%, the most rapid growth rate of any country in the world during this 25-year period. Since 1991, China has attracted the largest amount of foreign investment among developing countries each year, with annual foreign investment by the late 1990s exceeding $50 billion. Since 2002, China has been the world’s number-one destination for foreign direct investment (FDI), which is the acquisition abroad of companies, property, or physical assets such as plant and equipment, attracting $72.4 billion in FDI flows in 2005. About 400 out of the world’s 500 largest companies have now invested in China.
The transformation of China from an insular nation to the world’s low-cost site for labor-intensive manufacturing has had enormous effects on everything from Mexico’s competitiveness as an export platform to the cost of furniture and computers in the United States to the value of the dollar to the number of U.S. manufacturing jobs. China’s rapid growth and resulting huge appetite for energy and raw materials have also resulted in stunning increases in the prices of oil, steel, and other basic commodities. Most important, hundreds of millions of consumers worldwide are benefiting from the low prices of China’s goods and more than a billion Chinese are escaping the dire poverty of their past.
The prime transmitter of competitive forces in this global economy is the multinational corporation. In 2005, for example, 58% of China’s exports were by foreign companies manufacturing in China.1 What differentiates the multinational enterprise from other firms engaged in international business is the globally coordinated allocation of resources by a single centralized management. Multinational corporations make decisions about market-entry strategy; ownership of foreign operations; and design, production, marketing, and financial activities with an eye to what is best for the corporation as a whole. The true multinational corporation emphasizes group performance rather than the performance of its individual parts. For example, in 2003, Whirlpool Corporation launched what it billed as the world’s cheapest washing machine, with an eye on low-income consumers who never thought they could afford one. Whirlpool designed and developed the Ideale washing machine in Brazil, but it manufactures the Ideale in China and India, as well as Brazil, for sale in those and other developing countries.
Mini-Case General Electric Globalizes Its Medical Systems Business

One of General Electric’s key growth initiatives is to globalize its business. According to its Web site, “Globalization no longer refers only to selling goods and services in global markets. Today’s most valuable innovations and solutions are envisioned, designed, built and offered on a global scale.”2
A critical element of General Electric’s global strategy is to be first or second in the world in a business or to exit that business. For example, in 1987, GE swapped its RCA consumer electronics division for Thomson CGR, the medical equipment business of Thomson SA of France, to strengthen its own medical unit. Together with GE Medical Systems Asia (GEMSA) in Japan, CGR makes GE number one in the world market for X-ray, CAT scan, magnetic resonance, ultrasound, and other diagnostic imaging devices, ahead of Siemens (Germany), Philips (Netherlands), and Toshiba (Japan).
General Electric’s production is also globalized, with each unit exclusively responsible for equipment in which it is the volume leader. Hence, GE Medical Systems (GEMS) now makes the high end of its CAT scanners and magnetic resonance equipment near Milwaukee (its headquarters) and the low end in Japan. The middle market is supplied by GE Medical Systems SA (France). Engineering skills pass horizontally from the United States to Japan to France and back again. Each subsidiary supplies the marketing skills to its own home market.
The core of GEMS’s global strategy is to “provide high-value global products and services, created by global talent, for global customers.”3 As part of this strategy, “GE Medical Systems focuses on growth through globalization by aggressively searching out and attracting talent in the 150 countries in which we do business worldwide.”4
GEMS also grows by acquiring companies overseas in order to “broaden our ability to provide product and service solutions to our customers worldwide. Through several key acquisitions, we’ve strengthened our position in our existing markets, and entered new and exciting markets.”5 For example, in April 2003, GE announced that it would acquire Instrumentarium, a Finnish medical technology company, for $2.1 billion. According to the press release,
The combination of Instrumentarium and GE offerings will further enable GE Medical Systems to support healthcare customers with a broad range of anesthesia monitoring and delivery, critical care, infant care and diagnostic imaging solutions and help ensure the highest quality of care.6
A year later, in April 2004, GE spent $11.3 billion to acquire Amersham, a British company that is a world leader in medical diagnostics and life sciences. According to the press release, the acquisition will enable GE to “become the world’s best diagnostic company, serving customers in the medical, pharmaceutical, biotech and bioresearch markets around the world.”7 The combined GEMS and Amersham is now known as GE Healthcare.
In line with GE’s decision to shift its corporate center of gravity from the industrialized world to the emerging markets of Asia and Latin America,8 Medical Systems has set up joint ventures in India and China to make low-end CAT scanners and various ultrasound devices for sale in their local markets. These machines were developed in Japan with GEMS’s 75% joint venture GE Yokogawa Medical Systems, but the design work was turned over to India’s vast pool of inexpensive engineers through its joint venture WIPRO GE Medical Systems (India). At the same time, engineers in India and China were developing low-cost products to serve markets in Asia, Latin America, and the United States, where there is a demand from a cost-conscious medical community for cheaper machines. In 2002, GEMS derived almost $1 billion in revenue from sales to China.
Although it still pursues geographic market expansion, GE’s globalization drive now focuses on taking advantage of its global reach to find less expensive materials and intellectual capital abroad. In material procurement, GE bought $4.8 billion in materials and components abroad in 2000, up from $3.1 billion in 1999 and $1.5 billion in 1997, producing annual savings in excess of $1 billion. On the human capital side, General Electric has established global research and development (R&D) centers in Shanghai, China; Munich, Germany; and Bangalore, India. GE now has thousands of Indian scientists and engineers working at its technology center in Bangalore. By sourcing intellect globally, GE has three times the engineering capacity for the same cost. For Medical Systems, the ability to produce in low-cost countries has meant bringing to market a low-priced CAT scanner for $200,000 (most sell for $700,000–$1 million) and still earning a 30% operating margin.
Questions
1. What advantages does General Electric seek to attain from its international business activities?
2. What actions is it taking to gain these advantages from its international activities?
3. What risks does GE face in its foreign operations?
4. What profit opportunities for GE can arise out of those risks?
Evolution of the Multinational Corporation
Every year, Fortune publishes a list of the most admired U.S. corporations. Year in and year out, most of these firms are largely multinational in philosophy and operations. In contrast, the least admired tend to be national firms with much smaller proportions of assets, sales, or profits derived from foreign operations. Although multinationality and economic efficiency do not necessarily go hand in hand, international business is clearly of great importance to a growing number of U.S. and non-U.S. firms. The list of large American firms that receive 50% or more of their revenues and profits from abroad and that have a sizable fraction of their assets abroad reads like a corporate Who’s Who: Motorola, Gillette, Dow Chemical, Colgate-Palmolive, McDonald’s, and Hewlett-Packard. In 2000, Apple Computer earned more than 90% of its profit overseas, while Pfizer earned over 100% of its profit abroad.
Industries differ greatly in the extent to which foreign operations are of importance to them. For example, oil companies and banks are far more heavily involved overseas than are tobacco companies and automakers. Even within industries, companies differ markedly in their commitment to international business. For example, in 2000, ExxonMobil had 69% of its sales, 63% of its assets, and 60% of its profits abroad. The corresponding figures for Chevron were 45%, 53%, and 52%. Similarly, General Motors generated 61% of its income overseas, in contrast to a loss on overseas operations for Ford. These and other examples of the importance of foreign operations to U.S. business are shown in Exhibit 1.1.
The degree of internationalization of the American economy is often surprising. For example, analysts estimate that about 60% of the U.S. film industry’s revenues came from foreign markets in 1997. The film industry illustrates other dimensions of internationalization as well, many of which are reflected in Total Recall, a film that was made by a Hungarian-born producer and a Dutch director, starred an Austrian-born leading man (now the governor of California) and a Canadian villain, was shot in Mexico, and was distributed by a Hollywood studio owned by a Japanese firm.
Exhibit 1.2 provides further evidence of the growing internationalization of
American business. It shows that overseas investment by U.S. firms and U.S. investment by foreign firms are in the hundreds of billions of dollars each year. The stock of foreign direct investment by U.S. companies reached $2.79 trillion in 2007 (with profits of $349 billion), while the stock of direct investment by foreign companies in the United States exceeded $2.57 trillion that year. Worldwide, the stock of FDI reached $12.0 trillion in 2006, as shown in Exhibit 1.3. Moreover, these investments have grown steadily over time, facilitated by a combination of factors: falling regulatory barriers to overseas investment; rapidly declining telecommunications and transport costs; and freer domestic and international capital markets in which vast sums of money can be raised, companies can be bought, and currency and other risks can be hedged. These factors have made it easier for companies to invest abroad, to do so more cheaply, and to experience less risk than ever before. A brief discussion of the various consideration that have prompted the rise of the multinational corporation follows.
Exhibit 1.1 Selected Large U.S. Multinationals

Source: Forbes. June 30, 2001.
Search for Raw Materials.
Raw materials seekers were the earliest multinationals, the villains of international business. They were the firms—the British, Dutch, and French East India Companies, the Hudson’s Bay Trading Company, and the Union Miniere Haut-Katanga—that first grew under the protective mantle of the British, Dutch, French, and Belgian colonial empires. Their aim was to exploit the raw materials that could be found overseas. The modern-day counterparts of these firms, the multinational oil and mining companies, were the first to make large foreign investments, beginning in the early years of the twentieth century. Hence, large oil companies such as British Petroleum and Standard Oil, which went where the dinosaurs died, were among the first true multinationals. Hard-mineral companies such as International Nickel, Anaconda Copper, and Kennecott Copper were also early investors abroad.
Exhibit 1.2 Annual u.s. Foreign Direct Investment Inflows and OuTFLOWS: 1960–2007

Source: “International Economic Accounts: Operations of Multinational Companies,” http://www.bea.gov/international/index.htm, Bureau of Economic Analysis, U.S. Department of Commerce.
1 Salil Tripathi, “The Dragon Tamers.” The Guardian, August 11, 2006.
2 http://savelives.gecareers.com/abtus_growth.html.
3 Ibid.
4 Ibid.
5 Ibid.
6 http://www.gemedicalsystems.com/company/acquisitions/index.html.
7 http://www5.amershambiosciences.com’aptrix/upp01077.nsf/Content’about_us_press_releases_2004_080404.
8 In 2005, GE said it expected 60% of its revenue growth over the next decade to come from emerging markets, compared with 20% in the previous decade.
Market Seeking.
The market seeker is the archetype of the modern multinational firm that goes overseas to produce and sell in foreign markets. Examples include IBM, Volkswagen, and Unilever. Similarly, branded consumer-products companies such as Nestlé, Levi Strauss, MacDonald’s, Procter & Gamble, and Coca-Cola have been operating abroad for decades and maintain vast manufacturing, marketing, and distribution networks from which they derive substantial sales and income. The rationale for the market seeker is simple: Foreign markets are big, even relative to the U.S. market. For example, 96% of the world’s consumers, who command two-thirds of its purchasing power, are located outside the United States.
Exhibit 1.3 The Stock of Worldwide Foreign Direct Investment: 1980–2006

Source: http://stats.unctad.org/FDI/TableViewer/TableView.aspx, United Nations Conference on Trade and Development.
Although there are some early examples of market-seeking MNCs (e.g., Colt Firearms, Singer, Coca-Cola, N.V. Philips, and Imperial Chemicals), the bulk of foreign direct investment took place after World War II. This investment was primarily a oneway flow—from the United States to Western Europe—until the early 1960s. At that point, the phenomenon of reverse foreign investment began, primarily with Western European firms acquiring U.S. firms. More recently, Japanese firms have begun investing in the United States and Western Europe, largely in response to perceived or actual restrictions on their exports to these markets.
Although foreign markets may be attractive in and of themselves, MNCs possess certain firm-specific advantages. Such advantages may include unique products, processes, technologies, patents, specific rights, or specific knowledge and skills. MNCs find that the advantages that were successfully applied in domestic markets can also be profitably used in foreign markets. Firms such as Wal-Mart, Toys ‘R’ Us, and Price/Costco take advantage of unique process technologies—largely in the form of superior information gathering, organizational, and distribution skills—to sell overseas.
The exploitation of additional foreign markets may be possible at considerably lower costs. For example, after successfully developing a drug, pharmaceutical companies enter several markets, obtain relevant patents and permissions, and begin marketing the product in several countries within a short period of time. Marketing of the product in multiple countries enables the pharmaceutical company to extract revenues from multiple markets and, therefore, cover the high costs of drug development in a shorter period of time as compared to marketing within a single country.
In some industries, foreign market entry may be essential for obtaining economies of scale, or the unit cost decreases that are achieved through volume production. Firms in industries characterized by high fixed costs relative to variable costs must engage in volume selling just to break even. These large volumes may be forthcoming only if the firms expand overseas. For example, companies manufacturing products such as computers that require huge R&D expenditures often need a larger customer base than that provided by even a market as large as the United States in order to recapture their investment in knowledge. Similarly, firms in capital-intensive industries with enormous production economies of scale may also be forced to sell overseas in order to spread their overhead over a larger quantity of sales.
L.M. Ericsson, the Swedish manufacturer of telecommunications equipment, is an extreme case. The manufacturer is forced to think internationally when designing new products because its domestic market is too small to absorb the enormous R&D expenditures involved and to reap the full benefit of production scale economies. Thus, when Ericsson developed its revolutionary AXE digital switching system, it geared its design to achieve global market penetration.
Some companies, such as Coca-Cola, McDonald’s, Nestlé, and Procter & Gamble, take advantage of enormous advertising expenditures and highly developed marketing skills to differentiate their products and keep out potential competitors that are wary of the high marketing costs of new-product introduction. Expansion into emerging markets enables these firms to enjoy the benefits of economies of scale as well as exploit the premium associated with their strong brand names. According to the chief executive officer of L’Oréal, the French firm that is the world’s largest cosmetics company, “The increase in emerging-market sales has a turbo effect on the global growth of the company.”9 Similarly, companies such as Nestlé and Procter & Gamble expect their sales of brand-name consumer goods to soar as disposable incomes rise in the developing countries in contrast to the mature markets of Europe and the United States. The costs and risks of taking advantage of these profitable growth opportunities are also lower today now that their more free-market–oriented governments have reduced trade barriers and cut regulations. In response, foreign direct investment in emerging markets by multinationals has soared over the past decade (see Exhibit 1.4).
Cost Minimization.
Cost minimizer is a fairly recent category of firms doing business internationally. These firms seek out and invest in lower-cost production sites overseas (e.g., Hong Kong, Taiwan, and Ireland) to remain cost competitive both at home and abroad. Many of these firms are in the electronics industry. Examples include Texas Instruments, Intel, and Seagate Technology. Increasingly, companies are shifting services overseas, not just manufacturing work. As of June 2007, GE had about 13,000 employees in India to handle accounting, claims processing, customer service, software operations, and credit evaluation and research. Similarly, companies such as AOL (customer service), American Express (finance and customer service), and British Airways (accounting) are shifting work to India, Jamaica, Hungary, Morocco, and the Philippines for savings of up to 60%, while Chrysler has announced plans to expand its engineering centers in China and Mexico and to open others in India and Russia to cut its engineering costs and to build business ties in those big, developing markets.
Exhibit 1.4 Flows of Foreign Direct Investment to Developing Countries: 1970–2006 (billions of U.S. dollars)

Source: Data from UNCTAD, at http://stats.unctad.org/fdi.
The offshoring of services can be done in two ways—internally, through the establishment of wholly owned foreign affiliates, or externally, by outsourcing a service to a third-party provider. Exhibit 1.5 categorizes and defines different variants of offshoring and outsourcing.
Exhibit 1.5 Offshoring and Outsourcing—Some Definitions

Source: UNCTAD, World Investment Report 2004: The Shift Towards Services, Table IV.1.
Mini-Case The Debate over Outsourcing

In early 2004, White House economist Gregory Mankiw had the misfortune of stating publicly what most economists believe privately—that outsourcing of jobs is a form of international trade and is good for the U.S. economy because it allows Americans to buy services less expensively abroad. Critics of outsourcing immediately called on President Bush to fire Dr. Mankiw for seeming insensitive to workers who have lost their jobs. It is obvious to these critics that outsourcing, by exporting white-collar American jobs to foreign countries, is a major cause of U.S. unemployment. Related criticisms are that outsourcing costs the United States good jobs and is a one-way street, with the United States outsourcing jobs to foreign countries and getting nothing in return.
These critics fail to see the other side of the coin. First, outsourcing increases U.S. productivity and enables U.S. companies to realize net cost savings on the order of 30 to 50%. Through outsourcing, a firm can cut its costs while improving its quality, time to market, and capacity to innovate and use the abilities of its remaining workers in other, more productive tasks, thereby making it more competitive. Second, it will come as a real surprise to most critics that far more private services are outsourced by foreigners to the United States than away from it. In other words, just as U.S. firms use the services of foreigners, foreign firms make even greater use of the services of U.S. residents. Private services include computer programming, management consulting, engineering, banking, telecommunications, legal work, call centers, data entry, and so on. Exhibit 1.6 shows that in 2007, U.S. firms bought about $144 billion of those services from foreigners, but the value of the services Americans sold to foreigners was far higher, more than $223 billion, resulting in a trade surplus in services of about $79 billion. Finally, outsourced jobs are responsible for less than 1% of unemployment. Estimates in 2004 were that white-collar outsourcing costs the United States about 100,000 jobs each year.10 In contrast, the U.S. economy loses an average of 15 million jobs annually. However, those jobs are typically replaced by even more jobs, with about 17 million new jobs created each year.11
Exhibit 1.6 More Work is Outsourced to the United States Than Away from It

Source: U.S. Bureau of Economic Analysis
This creation of new jobs and workers’ ability to move into them are the hallmarks of a flexible economy—one in which labor and capital move freely among firms and industries to where they can be most productive. Such flexibility is a significant strength of the U.S. economy and results in higher productivity, which is the only way to create higher standards of living in the long run. Protectionism would only diminish that flexibility. Rather, the focus should be on increasing flexibility, which means improving the performance of the U.S. education system and encouraging the entrepreneurship and innovation that give the United States its competitive edge.
Questions
1. What are the pros and cons of outsourcing?
2. How does outsourcing affect U.S. consumers? U.S. producers?
3. Longer term, what is the likely impact of outsourcing on American jobs?
4. Several states are contemplating legislation that would ban the outsourcing of government work to foreign firms. What would be the likely consequences of such legislation?
Over time, if competitive advantages in product lines or markets become eroded due to local and global competition, MNCs seek and enter new markets with little competition or seek out lower production cost sites through their global-scanning capability. Costs can then be minimized by combining production shifts with rationalization and integration of the firm’s manufacturing facilities worldwide. This strategy usually involves plants specializing in different stages of production—for example, in assembly or fabrication—as well as in particular components or products.
One strategy that is often followed by firms for which cost is the key consideration is to develop a global-scanning capability to seek out lower-cost production sites or production technologies worldwide. In fact, firms in competitive industries have to continually seize new, nonproprietary, cost-reduction opportunities, not to earn excess returns but to make normal profits and survive.
Application Honda Builds an Asian Car Factory

Honda and other automakers attempting to break into Asia’s small but potentially fast-growing auto markets face a problem: It is tough to start small. Automakers need big volumes to take full advantage of economies of scale and justify the cost of building a modern car plant. But outside of Japan and China, few Asian countries offer such scale. Companies such as General Motors and Ford are relying on an export strategy in all but the largest Asian markets to overcome this hurdle. GM, exports cars throughout Asia from a large plant in Thailand. However, the success of an export strategy depends on Asian countries fully embracing free trade, something that may not happen soon. Honda has decided to follow a different strategy. It is essentially building a car factory that spans all of Asia, putting up plants for different components in small Asian markets all at once: a transmission plant in Indonesia, engine-parts manufacturing in China, and other components operations in Malaysia. Honda assembles cars at its existing plants in the region. Its City subcompact, for example, is assembled in Thailand from parts made there and in nearby countries. By concentrating production of individual components in certain countries, Honda expects to reap economies of scale that are unattainable by setting up major factories in each of the small Asian markets. A sharp reduction in trade barriers across Asia that took effect in 2003 makes it easier for Honda to trade among its factories in Asia. Nonetheless, Asian countries are still expected to focus on balancing trade so that, in any given nation, an increase in imports is offset by an increase in exports. If so, Honda’s web of Asian manufacturing facilities could give it an advantage over its rivals in avoiding trade friction.
9 Christina Passariello, “LOréal Net Gets New-Markets Lift,” Wall Street Journal, February 14, 2008, C7.
10 See, for example, Jon E. Hilsenrath, “Behind Outsourcing Debate: Surprisingly Few Hard Numbers,” Wall Street Journal, April 12, 2004, A1.
Knowledge Seeking.
Some firms enter foreign markets in order to gain information and experience that is expected to prove useful elsewhere. Beecham, an English firm (now part of GlaxoSmithKline), deliberately set out to learn from its U.S. operations how to be more competitive, first in the area of consumer products and later in pharmaceuticals. This knowledge proved highly valuable in competing with American and other firms in its European markets.
The flow of ideas is not all one way, however. As Americans have demanded better-built, better-handling, and more fuel-efficient small cars, Ford of Europe has become an important source of design and engineering ideas and management talent for its U.S. parent, notably with the hugely successful Taurus.
In industries characterized by rapid product innovation and technical break-throughs by foreign competitors, it is imperative to track overseas developments constantly. Japanese firms excel here, systematically and effectively collecting information on foreign innovation and disseminating it within their own research and development, marketing, and production groups. The analysis of new foreign products as soon as they reach the market is an especially long-lived Japanese technique. One of the jobs of Japanese researchers is to tear down a new foreign product and analyze how it works as a base on which to develop a product of their own that will outperform the original. In a bit of a switch, Data General’s Japanese operation is giving the company a close look at Japanese technology, enabling it to quickly pick up and transfer back to the United States new information on Japanese innovations in the areas of computer design and manufacturing.
11 These estimates appear in “Trade and Jobs,” Remarks by Governor Ben S. Bernanke at the Distinguished Speaker Series, Fuqua School of Business, Duke University, Durham, N.C., March 30, 2004.
12 See, for example, Benjamin I. Cohen, Multinational Firms and Asian Exports (New Haven, Conn.: Yale University Press, 1975); and Alan Rugman, “Risk Reduction by International Diversification,” Journal of International Business Studies, Fall 1976, pp. 75-80.
Keeping Domestic Customers.
Suppliers of goods or services to multinationals often will follow their customers abroad in order to guarantee them a continuing product flow. Otherwise, the threat of a potential disruption to an overseas supply line—for example, a dock strike or the imposition of trade barriers—can lead the customer to select a local supplier, which may be a domestic competitor with international operations. Hence, comes the dilemma: Follow your customers abroad or face the loss of not only their foreign but also their domestic business. A similar threat to domestic market share has led many banks; advertising agencies; and accounting, law, and consulting firms to set up foreign practices in the wake of their multinational clients’ overseas expansion.
Exploiting Financial Market Imperfections.
An alternative explanation for foreign direct investment relies on the existence of financial market imperfections. The ability to reduce taxes and circumvent currency controls may lead to greater project cash flows and a lower cost of funds for the MNC than for a purely domestic firm.
An even more important financial motivation for foreign direct investment is likely to be the desire to reduce risks through international diversification. This motivation may be somewhat surprising because the inherent riskiness of the multinational corporation is usually taken for granted. Exchange rate changes, currency controls, expropriation, and other forms of government intervention are some of the risks that purely domestic firms rarely, if ever, encounter. Thus, the greater a firm’s international investment, the riskier its operations should be.
Yet, there is good reason to believe that being multinational may actually reduce the riskiness of a firm. Much of the systematic or general market risk affecting a company is related to the cyclical nature of the national economy in which the company is domiciled. Hence, the diversification effect resulting from operating in a number of countries whose economic cycles are not perfectly in phase should reduce the variability of MNC earnings. Several studies indicate that this result, in fact, is the case.12 Thus, because foreign cash flows generally are not perfectly correlated with those of domestic investments, the greater riskiness of individual projects overseas can well be offset by beneficial portfolio effects. Furthermore, because most of the economic and political risks specific to the multinational corporation are unsystematic, they can be eliminated through diversification.
The Process of Overseas Expansion by Multinationals
Studies of corporate expansion overseas indicate that firms become multinational by degree, with foreign direct investment being a late step in a process that begins with exports. For most companies, the globalization process does not occur through conscious design, at least in the early stages. It is the unplanned result of a series of corporate responses to a variety of threats and opportunities appearing at random overseas. From a broader perspective, however, the globalization of firms is the inevitable outcome of the competitive strivings of members of oligopolistic industries. Each member tries both to create and to exploit monopolistic product and factor advantages internationally while simultaneously attempting to reduce the competitive threats posed by other industry members.
To meet these challenges, companies gradually increase their commitment to international business, developing strategies that are progressively more elaborate and sophisticated. The sequence normally involves exporting, setting up a foreign sales subsidiary, securing licensing agreements, and eventually establishing foreign production. This evolutionary approach to overseas expansion is a risk-minimizing response to operating in a highly uncertain foreign environment. By internationalizing in phases, a firm can gradually move from a relatively low-risk, low-return, exportoriented strategy to a higher-risk, higher-return strategy emphasizing international production. In effect, the firm is investing in information, learning enough at each stage to improve significantly its chances for success at the next stage. Exhibit 1.7 depicts the usual sequence of overseas expansion.
Exhibit 1.7 Typical Foreign Expansion Sequence

Exporting.
Firms facing highly uncertain demand abroad typically will begin by exporting to a foreign market. The advantages of exporting are significant: Capital requirements and start-up costs are minimal, risk is low, and profits are immediate. Furthermore, this initial step provides the opportunity to learn about present and future supply and demand conditions, competition, channels of distribution, payment conventions, financial institutions, and financial techniques. Building on prior successes, companies then expand their marketing organizations abroad, switching from using export agents and other intermediaries to dealing directly with foreign agents and distributors. As increased communication with customers reduces uncertainty, the firm might set up its own sales subsidiary and new service facilities, such as a warehouse, with these marketing activities culminating in the control of its own distribution system.
Overseas Production.
A major drawback to exporting is the inability to realize the full sales potential of a product. By manufacturing abroad, a company can more easily keep abreast of market developments, adapt its products and production schedules to changing local tastes and conditions, fill orders faster, and provide more comprehensive after-sales service. Many companies also set up research and development facilities along with their foreign operations; they aim to pick the best brains, wherever they are. The results help companies keep track of the competition and design new products. For example, the Japanese subsidiary of Loctite, a U.S. maker of engineering adhesives, devised several new applications for sealants in the electronics industry.
Setting up local production facilities also shows a greater commitment to the local market, a move that typically brings added sales and provides increased assurance of supply stability. Certainty of supply is particularly important for firms that produce intermediate goods for sale to other companies. A case in point is SKF, the Swedish ball-bearing manufacturer. It was forced to manufacture in the United States to guarantee that its product, a crucial component in military equipment, would be available when needed. The Pentagon would not permit its suppliers of military hardware to be dependent on imported ball bearings because imports could be halted in wartime and are always subject to the vagaries of ocean shipping.
Thus, most firms selling in foreign markets eventually find themselves forced to manufacture abroad. Foreign production covers a wide spectrum of activities from repairing, packaging, and finishing to processing, assembly, and full manufacture. Firms typically begin with the simpler stages—packaging and assembly—and progressively integrate their manufacturing activities backward—to production of components and subassemblies.
Because the optimal entry strategy can change over time, a firm must continually monitor and evaluate the factors that bear on the effectiveness of its current entry strategy. New information and market perceptions change the risk-return trade-off for a given entry strategy, leading to a sequence of preferred entry modes, each adapted on the basis of prior experience to sustain and strengthen the firm’s market position over time.
Associated with a firm’s decision to produce abroad is the question of whether to create its own affiliates or to acquire going concerns. A major advantage of an acquisition is the capacity to effect a speedy transfer overseas of highly developed but underutilized parent skills, such as a novel production technology. Often, the local firm also provides a ready-made marketing network. This network is especially important if the parent is a late entrant to the market. Many firms have used the acquisition approach to gain knowledge about the local market or a particular technology. The disadvantage is the cost of buying an ongoing company. In general, the larger and more experienced a firm becomes, the less frequently it uses acquisitions to expand overseas. Smaller and relatively less-experienced firms often turn to acquisitions.
Regardless of its preferences, a firm interested in expanding overseas may not have the option of acquiring a local operation. Michelin, the French manufacturer of radial tires, set up its own facilities in the United States because its tires are built on specially designed equipment; taking over an existing operation would have been out of the question.13 Similarly, companies moving into developing countries often find they are forced to begin from the ground up because their line of business has no local counterpart.
Licensing.
An alternative, and at times a precursor, to setting up production facilities abroad is to license a local firm to manufacture the company’s products in return for royalties and other forms of payment. The principal advantages of licensing are the minimal investment required, faster market-entry time, and fewer financial and legal risks. But the corresponding cash flow is also relatively low, and there may be problems in maintaining product quality standards. The licensor may also face difficulty controlling exports by the foreign licensee, particularly when, as in Japan, the host government refuses to sanction restrictive clauses on sales to foreign markets. Thus, a licensing agreement may lead to the establishment of a competitor in third-country markets, with a consequent loss of future revenues to the licensing firm. The foreign licensee may even become such a strong competitor that the licensing firm will face difficulty entering the market when the agreement expires, leading to a further loss of potential profits.
For some firms, licensing alone is the preferred method of penetrating foreign markets. Other firms with diversified innovative product lines follow a strategy of trading technology for both equity in foreign joint ventures and royalty payments.
Trade-offs Between Alternative Modes of Overseas Expansion.
There are certain general circumstances under which each approach—exporting, licensing, or local production—will be the preferred alternative for exploiting foreign markets.
Multinationals often possess intangible capital in the form of trademarks, patents, general marketing skills, and other organizational abilities.14 If this intangible capital can be embodied in the form of products without adaptation, then exporting generally would be the preferred mode of market penetration. When the firm’s knowledge takes the form of specific product or process technologies that can be written down and transmitted objectively, then foreign expansion usually would take the licensing route.
Often, however, this intangible capital takes the form of organizational skills that are inseparable from the firm itself. A basic skill involves knowing how best to service a market through new-product development and adaptation, quality control, advertising, distribution, after-sales service, and the general ability to read changing market desires and translate them into salable products. Because it would be difficult, if not impossible, to unbundle these services and sell them apart from the firm, the firm would attempt to exert control directly via the establishment of foreign affiliates. However, internalizing the market for an intangible asset by setting up foreign affiliates makes economic sense if—and only if—the benefits from circumventing market imperfections outweigh the administrative and other costs of central control.
A useful means to judge whether a foreign investment is desirable is to consider the type of imperfection that the investment is designed to overcome.15 Internalization, and hence FDI, is most likely to be economically viable in those settings in which the possibility of contractual difficulties makes it especially costly to coordinate economic activities via arm’s-length transactions in the marketplace.
Such “market failure” imperfections lead to both vertical and horizontal direct investment. Vertical direct integration—direct investment across industries that are related to different stages of production of a particular good—enables the MNC to substitute internal production and distribution systems for inefficient markets. For instance, vertical integration might allow a firm to install specialized cost-saving equipment in two locations without the worry and risk that facilities may be idled by disagreements with unrelated enterprises. Horizontal direct investment—investment that is cross-border but within an industry—enables the MNC to utilize an advantage such as know-how or technology and avoid the contractual difficulties of dealing with unrelated parties. Examples of contractual difficulties include the MNC’s inability to price know-how or to write, monitor, and enforce use restrictions governing technology-transfer arrangements. Thus, foreign direct investment makes most sense when a firm possesses a valuable asset and is better off directly controlling use of the asset rather than selling or licensing it.
13 Once that equipment became widespread in the industry, Michelin was able to expand through acquisition (which it did, in 1989, when it acquired Uniroyal Goodrich).
14 Richard E. Caves, “International Corporations: The Industrial Economics of Foreign Investment,” Economica, February 1971, pp. 1–27.
A Behavioral Definition of the Multinational Corporation
Regardless of the foreign entry or global expansion strategy pursued, the true multinational corporation is characterized more by its state of mind than by the size and worldwide dispersion of its assets. Rather than confine its search to domestic plant sites, the multinational firm asks, “Where in the world should we build that plant?” Similarly, multinational marketing management seeks global, not domestic, market segments to penetrate, and multinational financial management does not limit its search for capital or investment opportunities to any single national financial market. Hence, the essential element that distinguishes the true multinational is its commitment to seeking out, undertaking, and integrating manufacturing, marketing, R&D, and financing opportunities on a global, not domestic, basis. For example, IBM’s superconductivity project was pioneered in Switzerland by a German scientist and a Swiss scientist who shared a Nobel Prize in physics for their work on the project. Similarly, the Web site of Daimler-Chrysler (now Daimler AG), a German company, states that “DaimlerChrysler has a global workforce, a global shareholder base, globally known brands and a global outlook.”
Necessary complements to the integration of worldwide operations include flexibility, adaptability, and speed. Indeed, speed has become one of the critical competitive weapons in the fight for world market share. The ability to develop, make, and distribute products or services quickly enables companies to capture customers who demand constant innovation and rapid, flexible response. Exhibit 1.8 illustrates the combination of globally integrated activities and rapid response times of Dell Inc., which keeps not more than two hours of inventory in its plants, while sourcing for components across the globe and assembling built-to-order computers for its customers within five days.
Another critical aspect of competitiveness in this new world is focus. Focus means figuring out and building on what a company does best. This process typically involves divesting unrelated business activities and seeking attractive investment opportunities in the core business. For example, by shedding its quintessentially British automobile business and focusing on engines, Rolls-Royce has become a world-class global company, selling jet engines to 42 of the top 50 airlines in the world and generating 80% of its sales abroad.
Exhibit 1.8 HOW DELL REDUCES THE ORDER-TO-DELIVERY CYCLE

Mini-Case ARCO Chemical Develops a Worldwide Strategy

In the 1980s, ARCO Chemical shed its less successful product lines. At one point, revenue shrank from $3.5 billion annually to $1.5 billion. But by stripping down to its most competitive lines of business, ARCO could better respond to the global political and economic events constantly buffeting it. Around the world, it now can take advantage of its technological edge within its narrow niche—mostly intermediate chemicals and fuel additives. This strategy paid off: By 1992, more than 40% of ARCO’s $3 billion in sales were made abroad, and it now makes about half of its new investment outside the United States. It also claims half the global market for the chemicals it sells.
ARCO Chemical went global because it had to. The company’s engineering resins are sold to the auto industry. In the past, that meant selling exclusively to Detroit’s Big Three in the U.S. market. Today, ARCO Chemical sells to Nissan, Toyota, Honda, Peugeot, Renault, and Volkswagen in Japan, the United States, and Europe. It also deals with Ford and General Motors in the United States and Europe. ARCO must be able to deliver a product anywhere in the world or lose the business.
Global operations also have meant, however, that ARCO Chemical faces increasingly stiff competition from abroad in addition to its traditional U.S. competitors such as Dow Chemical. European companies have expanded operations in America, and Japanese competitors also began to attack ARCO Chemical’s business lines. In 1990, Japan’s Asahi Glass began a fierce price-cutting campaign in both Asia and Europe on products for which ARCO Chemical is strong.
In response, ARCO set up production facilities around the world and entered into joint ventures and strategic alliances. It counterattacked Asahi Glass by trying to steal one of Asahi’s biggest customers in Japan. ARCO’s joint venture partner, Sumitomo Chemical, supplied competitive intelligence, and its knowledge of the Japanese market was instrumental in launching the counterattack.
In July 1998, ARCO Chemical was acquired by Lyondell Petrochemical. This acquisition was driven by Lyondell’s desire to expand into high-growth global markets for ARCO’s products as well as the opportunity to gain significant integration benefits with Equistar Chemicals, LP, a joint venture among Lyondell, Millennium Chemicals, and Occidental Petroleum Corporation. According to Lyondell’s 1998 Annual Report:
ARCO Chemical was a perfect fit with Lyondell’s core businesses. Among the benefits: substantial integration for propylene and other raw materials provided by Equistar and Lyondell; a global infrastructure providing a platform for future growth; and leading positions in high growth markets for chemicals and synthetics. The acquisition provides us with a business that has less cyclical earnings and cash flows.
Consolidation is a positive trend that will continue to enhance the efficiency of the industry by allowing companies to spread overhead, distribution and research and development costs over a larger asset base. It will result in increased globalization and competition, which benefits both customers and investors. Lyondell will continue to be a leader in driving these changes. The acquired business provides significant strategic benefits to Lyondell, including:
• A preeminent, global market position in propylene oxide and derivatives, driven by an advantaged technology position
• Vertical integration with propylene, ethylene, and benzene produced by Equistar as well as integration with methanol produced by Lyondel
• Reduced cyclicality of Lyondell’s earnings through a broadened product mix in markets that are less cyclical than olefins and polymers
• A platform for future domestic and international growth with a worldwide infrastructure of manufacturing facilities and service centers
Questions
1. What was ARCO Chemical’s rationale for globalizing?
2. What advantages has ARCO Chemical realized from its global operations?
3. What threats have arisen from ARCO Chemical’s globalizing efforts? What are some ways in which ARCO Chemical has responded to these threats?
4. How has globalization affected, and been affected by, industry consolidation?
In this world-oriented corporation, a person’s passport is not the criterion for promotion. Nor is a firm’s citizenship a critical determinant of its success. Success depends on a new breed of businessperson: the global manager.
15 These considerations are discussed by William Kahley, “Direct Investment Activity of Foreign Firms,” Economic Review, Federal Reserve Bank of Atlanta, Summer 1987, pp. 36–51.
The Global Manager
In a world in which change is the rule and not the exception, the key to international competitiveness is the ability of management to adjust to change and volatility at an ever faster rate. In the words of former General Electric Chairman Jack Welch, “I’m not here to predict the world. I’m here to be sure I’ve got a company that is strong enough to respond to whatever happens.”16
The rapid pace of change means that new global managers need detailed knowledge of their operations. Global managers must know how to make the products, where the raw materials and parts come from, how they get there, the alternatives, where the funds come from, and what their changing relative values do to the bottom line. They must also understand the political and economic choices facing key nations and how those choices will affect the outcomes of their decisions.
In making decisions for the global company, managers search their array of plants in various nations for the most cost-effective mix of supplies, components, transport, and funds. All this is done with the constant awareness that the options change and the choices must be made again and again.
The problem of constant change disturbs some managers. It always has; nevertheless, today’s global managers have to anticipate it, understand it, deal with it, and turn it to their company’s advantage. The payoff to thinking globally is a quality of decision making that enhances the firm’s prospects for survival, growth, and profitability in the evolving world economy.
16 Quoted in Ronald Henkoff, “How to Plan for 1995,” Fortune, December 31, 1990, p. 70.
1.2 THE INTERNATIONALIZATION OF BUSINESS AND FINANCE
The existence of global competition and global markets for goods, services, and capital is a fundamental economic reality that has altered the behavior of companies and governments worldwide. For example, Tandon Corp., a major California-based supplier of disk drives for microcomputers, cut its U.S. workforce by 39% and transferred production overseas in an effort to achieve “cost effectiveness in an extremely competitive marketplace.”17 As the president of Tandon put it, “We can wait for the Japanese to put us out of business or we can be cost-effective.”18 Increasingly, companies are bringing an international perspective to bear on their key production, marketing, technology, and financial decisions. This international perspective is exemplified by the following statement in General Electric’s 1999 Annual Report, which explains why globalization is one of its key initiatives:
Globalization evolved from a drive to export, to the establishment of global plants for local consumption, and then to global sourcing of products and services. Today, we are moving into its final stages—drawing upon intellectual capital from all over the world—from metallurgists in Prague, to software engineers in Asia, to product designers in Budapest, Monterrey, Tokyo, Paris and other places around the globe … Our objective is to be the “global employer of choice,” and we are striving to create the exciting career opportunities for local leaders all over the world that will make this objective a reality. This initiative has taken us to within reach of one of our biggest and longest-running dreams—a truly global GE. (p. 2)
The forces of globalization have reached into some unlikely places. For example, at Astro Apparels India, a clothing factory in Tirupur, India, that exports T-shirts to American brands such as Fubu, employees begin their workday with an unusual prayer: “We vow to manufacture garments with high value and low cost, and meet our delivery. Let us face the challenge of globablization and win the world market.”19
This prayer captures the rewards of globalization—and what it takes to succeed in such a world. It is also a timely one, for on January 1, 2005, a quota system that for 30 years restricted exports from poor countries to rich ones ended. Indian companies hope that with the ending of quotas, they can use their low labor costs to boost textile exports more than fourfold by 2010, to $50 billion. However, the Indian textile industry also faces hurdles in battling China for market share, including low productivity (which negates the advantage of Indian labor costs that are 15% lower than China’s), a lack of modern infrastructure, and small-scale plants that find it difficult to compete with China’s integrated megafactories.
Yet, despite the many advantages of operating in a world economy, many powerful interest groups feel threatened by globalization and have fought it desperately.
Political and Labor Union Concerns About Global Competition
Politicians and labor leaders, unlike corporate leaders, usually take a more parochial view of globalization. Many instinctively denounce local corporations that invest abroad as job “exporters,” even though most welcome foreign investors in their own countries as job creators. However, many U.S. citizens today view the current tide of American asset sales to foreign companies as a dangerous assault on U.S. sovereignty.20 They are unaware, for example, that foreign-owned companies account for more than 20% of industrial production in Germany and more than 50% in Canada, and neither of those countries appears to have experienced the slightest loss of sovereignty. Regardless of their views, however, the global rationalization of production will continue, as it is driven by global competition. The end result will be higher living standards brought about by improvements in worker productivity and private sector efficiency.
Despite the common view that U.S. direct investment abroad comes at the expense of U.S. exports and jobs, the evidence clearly shows the opposite. By enabling MNCs to expand their toeholds in foreign markets, such investments tend to increase U.S. exports of components and services and to create more and higher-paying jobs in the United States.21 Ford and IBM, for example, would be generating less U.S.-based employment today had they not been able earlier to invest abroad—both by outsourcing the production of parts to low-wage countries such as Mexico and by establishing assembly plants and R&D centers in Europe and Japan.
Similarly, the argument that poor countries drain jobs from rich countries and depress wages for all—a major theme of 1999’s “Battle in Seattle” over reductions in trade barriers sponsored by the World Trade Organization (WTO)—is demonstrably false. The fact is that as poor countries prosper, they buy more of the advanced goods produced by the richer countries that support higher-paying jobs. At the same time, despite claims to the contrary, globalization has not exploited and further impoverished those already living lives of desperate poverty.
Indeed, the growth in trade and investment flows since the end of World War II has raised the wealth and living standards of developed countries while lifting hundreds of millions of people around the world out of abject poverty. The Asian tigers are the most obvious example of this phenomenon. According to then-President Ernesto Zedillo of Mexico, “Every case where a poor nation has significantly overcome poverty has been achieved while engaging in production for export and opening itself to the influx of foreign goods, investment, and technology; that is, by participating in globalization.”22 Moreover, by generating growth and introducing values such as accountability, openness, and competition, globalization has been a powerful force for spreading democracy and freedom in places as diverse as Mexico, Korea, and Poland.
Another concern of many antiglobalists, their preoccupation with income equality, reflects a fundamental economic fallacy, namely, that there is only so much global income to go around—so, if the United States is consuming $14 trillion worth of goods and services annually, that is $14 trillion worth of goods and services that Africa cannot consume. However, American consumption does not come at the expense of African consumption: The United States consumes $14 trillion of goods and services each year because it produces $14 trillion annually. Africa could consume even more goods and services than the United States simply by producing more.
Opponents of free trade and globalization also claim that competition by Third World countries for jobs and investment by multinational corporations encourages a “race to the bottom” in environmental and labor standards. However, this concern ignores the fact that the surest way to promote higher environmental standards for a country is to raise its wealth. The economic growth stimulated by expanded trade and capital flows will help developing countries to better afford the cleaner environment their wealthier citizens will now demand. Similarly, although protestors claim that Nike and other apparel makers contract out work to foreign “sweatshops” where underpaid workers toil in unhealthful conditions, conditions in factories where Nike goods are made are, comparatively speaking, progressive for their countries. Statistics that show very low employee turnover in such factories indicate that workers do not have better prospects. Moreover, although employees of U.S. affiliates in developing countries are paid much less than equivalent U.S. employees, they are paid significantly more than the average local wage.
Protectionists often disguise their opposition to free trade by promoting the concept of “fair trade,” which seeks to reduce Third World competitiveness by imposing Western labor conditions and environmental standards in trade treaties. However, although the goal of, say, eradicating child labor is a noble one, it has often had disastrous consequences. Although it would have been better if poor children in Pakistan did not spend their days stitching together soccer balls instead of going to school, closing down their factories forced many of them into far less appealing professions.
The evidence is clear that the surest way to improve the lives of the many desperately poor workers in developing countries is to pursue market-opening reforms that further globalization and facilitate wealth creation. Fierce competition for workers has led to soaring private sector wages and benefits in China. Conversely, as North Korea shows, economic isolation is the fast track to poverty, disease, poor working conditions, environmental degradation, and despair. As such, protectionist governments in the West victimize the Third World entrepreneurs and their employees who have begun to make a better life for themselves by selling their goods in Western markets.
The economic purpose of free trade is to allocate resources to their highest valued use. This process is not painless. Like technological innovation, globalization unleashes the forces of creative destruction, a process described by economist Joseph Schumpeter more than 50 years ago. Schumpeter’s oft-repeated phrase conveys the essence of capitalism: continuous change—out with the old, in with the new. When competing for customers, companies adopt new technologies, improve production methods, open new markets, and introduce new and better products. In this constantly churning world, some industries advance, others recede, jobs are gained and lost, businesses boom and go bust, and some workers are forced to change jobs and even occupations. But the process of globalization creates more winners than losers. Consumers clearly benefit from lower prices and expanded choice. But workers and businesses overall also benefit from doing what they are best suited for and by having new job and investment opportunities. The end result is economic progress, with economies emerging from the turmoil more efficient, more productive, and wealthier.
Application The European Union Pays a Price to Stop Creative Destruction

Over the past quarter century, Europe has been stagnant, with slow economic growth, a declining share of world trade, waning competitiveness, and high unemployment. Many economists and businesspeople traced this “Euro-sclerosis” to the structural rigidities that grew out of the attempt by European governments to shelter their constituents from the forces of creative destruction. Over the past 20 years, the European Union has attempted to reverse its economic decline by dismantling the economic barriers that fragmented its economy—from Europe 1992, which created a single European market for goods, labor, and capital, to the European Monetary Union with its single currency, the euro. Despite these initiatives, Europe’s economy remains less free than that of the United States and this continues to have serious ramifications for its performance. As shown in Exhibit 1.9a, the U.S. economy has grown much more rapidly than that of the core EU-1523 nations, while
Exhibit 1.9A REAL GDP GROWTH UNITED STATES VERSUS CORE EU-IS 1996 = 100

Source: European Commission: Eurostat. http://epp.eurostat.ec.europa.eu/U.S. Department of Labor Statistics.
Exhibit 1.9B UNEMPLOYMENT RATE: UNITED STATES VERSUS EU

Source: European Commission: Eurostat. http://epp.eurostat.ec.europa.eu/U.S. Department of Labor Statistics.
Exhibit 1.9C LABOR PRODUCTIVITY GROWTH UNITED STATES VERSUS EU 1995 = 100

Source: OECD Productivity Database, U.S. Department of Labor, Bureau of Labor Statistics.
Europe’s relatively inflexible labor markets have produced an unemployment rate 3 to 5 percentage points higher (see Exhibit 1.9b). Perhaps the clearest evidence of Europe’s loss in competitiveness shows up in productivity figures. Europe’s productivity (output per hour worked) grew by only 1.5% per annum from 1995 to 2005, in contrast to U.S. productivity growth of 2.9% annually (Exhibit 1.9c). This may be the most telling statistic on the cause of Europe’s economic problems as it reflects most directly on the extent to which government policies promote a dynamic economy.
The simple fact is that Europe continues to shelter too many workers and managers from competition by restrictive labor policies and expensive social welfare programs. The EU now stands at a crossroads as it debates further economic liberalization. A worrisome problem is that some member states are attempting to preserve and even expand social protections by imposing uniform labor practices and social programs throughout the EU. Other members are promoting pro-growth policies, such as increasing labor market flexibility and reducing the burden of taxation and regulation on business. Depending on which of these competing visions wins out, Europe will either liberalize its economy further to compete in a globalized world or it will retreat further into its past and face persistent high unemployment, sluggish growth, and permanently lower living standards.
Free trade has a moral basis as well, which was spelled out by President George W. Bush in May 2001:
Open trade is not just an economic opportunity, it is a moral imperative. Trade creates jobs for the unemployed. When we negotiate for open markets, we are providing new hope for the world’s poor. And when we promote open trade, we are promoting political freedom. Societies that are open to commerce across their borders will open to democracy within their borders, not always immediately, and not always smoothly, but in good time.
The growing irrelevance of borders for corporations will force policymakers to rethink old approaches to regulation. For example, corporate mergers that once would have been barred as anticompetitive might make sense if the true measure of a company’s market share is global rather than national.
International economic integration also reduces the freedom of governments to determine their own economic policy. If a government tries to raise tax rates on business, for example, it is increasingly easy for business to shift production abroad. Similarly, nations that fail to invest in their physical and intellectual infrastructure—roads, bridges, R&D, education—will likely lose entrepreneurs and jobs to nations that do invest. Capital—both financial and intellectual—will go where it is wanted and stay where it is well treated. In short, economic integration is forcing governments, as well as companies, to compete. After America’s 1986 tax reform that slashed income tax rates, virtually every other nation in the world followed suit. In a world of porous borders, governments found it difficult to ignore what worked. Similarly, big U.S. mutual funds are wielding increasing clout in developing nations, particularly in Latin America and Asia. In essence, the funds are trying to do overseas what they are already doing domestically: pressure management (in this case governments) to adopt policies that will maximize returns. The carrot is more money; the stick is capital flight. Simply put, the globalization of trade and finance has created an unforgiving environment that penalizes economic mismanagement and allots capital and jobs to the nations delivering the highest risk-adjusted returns. As markets become more efficient, they are quicker to reward sound economic policy—and swifter to punish the profligate. Their judgments are harsh and cannot be appealed.
Application
The Asian Tigers Fall Prey to World Financial Markets
For years, the nations of East Asia were held up as economic icons. Their typical blend of high savings and investment rates, autocratic political systems, export-oriented businesses, restricted domestic markets, government-directed capital allocation, and controlled financial systems were hailed as the ideal recipe for strong economic growth, particularly for developing nations. However, by summer 1997, the financial markets became disenchanted with this region, beginning with Thailand. Waves of currency selling left the Thai baht down 40% and the stock market down 50%. Thailand essentially went bankrupt. Its government fell and the International Monetary Fund (IMF) put together a $17 billion bailout package, conditioned on austerity measures. What the financial markets had seen that others had not was the rot at the core of Thailand’s economy. Thais had run up huge debts, mostly in dollars, and were depending on the stability of the baht to repay these loans. Worse, Thai banks, urged on by the country’s corrupt political leadership, were shoveling loans into money-losing ventures that were controlled by political cronies. As long as the money kept coming, Thailand’s statistics on investment and growth looked good, but the result was a financially troubled economy that could not generate the income necessary to repay its loans.
Investors then turned to other East Asian economies and saw similar flaws there. One by one, the dominoes fell, from Bangkok to Kuala Lumpur, Jakarta to Manila, Singapore to Taipei, Seoul to Hong Kong. The Asian tigers were humbled as previously stable currencies were crushed (see Exhibit 1.10a), local stock markets crashed (see Exhibit 1.10b), interest rates soared, banking systems tottered, economies contracted, bankruptcies spread, and governments were destabilized. The international bailout for the region grew to over $150 billion, crowned by $60 billion for South Korea, as the United States and other developed nations poured in funds for fear that the events in East Asia would spin out of control, threatening the world financial system with ruin and leading to a global recession. How to stave off such crises?
Exhibit 1.10A CURRENCY DEVALUATIONS

Source: Southwest Economy, March/April 1998, Federal Reserve Bank of Dallas.
Exhibit 1.10B STOCK MARKET DROP

Source: Southwest Economy, March/April 1998, Federal Reserve Bank of Dallas.
The answer is financial markets that are open and transparent, leading to investment decisions that are based on sound economic principles rather than cronyism or political considerations.
What is the bright side of the awesome power wielded by the global financial markets? Simply this: These markets bring economic sanity even to nations run by corrupt elites. Global markets have no tolerance for regimes that suppress enterprise, reward cronies, or squander resources on ego-building but economically dubious, grandiose projects. Indeed, although Asian business still has a long way to go, the forced restructuring that had already occurred resulted by summer 2000, three years later, in a dramatic recovery of the Asian economies.
Paradoxically, however, even as people are disturbed at the thought of their government losing control of events, they have lost faith in government’s ability to solve many of their problems. One result has been the collapse of communism in Eastern Europe and the spread of free-market economics in developed and developing countries alike. Rejecting the statist policies of the past, they are shrinking, closing, pruning, or privatizing state-owned industries and subjecting their economies to the rigors of foreign competition. In response to these changes, developing countries in 1996, just prior to the Asian currency crisis, received more than $240 billion in new foreign investment. Five years earlier, by contrast, they were exporting savings, as they paid service costs on their large foreign debts and as local capital fled hyperinflation and confiscatory tax and regulatory regimes. These dramatic shifts in policy—and the rewards they have brought to their initiators—have further strengthened the power of markets to set prices and priorities around the world. Contrary to the claims of its opponents, the reality is that globalization—by forcing governments to compete—has promoted a race to the top by pushing countries toward policies that promote faster economic growth, lower inflation, and greater economic freedom.
17 “Tandon to Reduce U.S. Work Force, Concentrate Abroad,” Wall Street Journal, March 1984, p. 22.
17 Ibid.
19 John Larkin, “The Other Textile Tiger,” Wall Street Journal, December 20, 2004, p. A12.
Consequences of Global Competition
The stresses caused by global competition have stirred up protectionists and given rise to new concerns about the consequences of free trade. For example, the sudden entry of three billion people from low-wage countries such as China, Mexico, Russia, and India into the global marketplace is provoking anxiety among workers in the old industrial countries about their living standards. As the accompanying application of the U.S. auto industry indicates, companies and unions are quite rational in fearing the effects of foreign competition. It disrupts established industry patterns, and it limits the wages and benefits of some workers by giving more choice to consumers while raising the wages and benefits of others. The U.S.-Canada trade agreement, which ended tariff barriers by 2000, has caused major disruption to Canada’s manufacturing industry. Plants are closing, mergers are proliferating, and both domestic and multinational companies are adjusting their operations to the new continental market. Similarly, the North American Free Trade Agreement (NAFTA), which created a giant free-trade area from the Yukon to the Yucatán, has forced formerly sheltered companies, especially in Mexico, to cut costs and change their way of doing business. It led U.S. companies to shift production both into and out of Mexico, while confronting American and Canadian workers with a new pool of lower-priced (but also less productive) labor.
Application Japanese Competition Affects the U.S. Auto Industry
Beginning in the late 1970s, Japanese competition steadily eroded the influence of the Big Three U.S. automakers in the auto industry. During the 1980s, Japanese auto companies raised their U.S. market share eight points, to 28%, versus 65% for Detroit and 5% for Europe.
The tough Japanese competition was a big factor in the sales and profit crunch that hit the Big Three. General Motors, Ford, and Chrysler responded by shutting down U.S. plants and by curbing labor costs. Thus, Japanese competition has limited the wages and benefits that United Auto Workers (UAW) union members can earn, as well as the prices that U.S. companies can charge for their cars. Both unions and companies understand that in this competitive environment, raising wages and car prices leads to fewer sales and fewer jobs. One solution, which allows both the Big Three and the UAW to avoid making hard choices—sales volume versus profit margin, and jobs versus wages and benefits—is political: Limit Japanese competition through quotas, tariffs, and other protectionist devices and thereby control its effects on the U.S. auto industry. Unfortunately, American consumers get stuck with the tab for this apparent free lunch in the form of higher car prices and less choice.
The best argument against protectionism, however, is long-term competitiveness. It was, after all, cutthroat competition from the Japanese that forced Detroit to get its act together. The Big Three swept away layers of unneeded management, raised productivity, and dramatically increased the quality of their cars and trucks. They also shifted their focus toward the part of the business in which the Japanese did not have strong products but which just happened to be America’s hottest and fastest-growing automotive segment—light trucks, which includes pickups, minivans, and sport-utility vehicles. Combined with a strong yen and higher Japanese prices, these changes helped Detroit pick up three percentage points of market share in 1992 and 1993 alone, mostly at the expense of Japanese nameplates. By 1994, the Japanese share of the U.S. auto market, which peaked at 29% in 1991, had fallen to 25%.
Although the recent jump in oil prices and their lack of fuel-efficient cars has hurt the Big Three, the inescapable fact is that Japanese automakers forced Detroit to make better cars at better prices. Handicapping the Japanese could not possibly have had the same effect.
So it is all the more encouraging that political leaders keep trying to stretch borders. The world’s long march toward a global economy has accelerated considerably over the past two decades as evidenced by the U.S.-Canada-Mexico free-trade pact, the European Community’s drive to create a truly common market, and China’s entrance into the WTO. The greater integration of national economies is likely to continue despite the stresses it causes as politicians worldwide increasingly come to realize that they either must accept this integration or watch their respective nations fall behind.
Application Ross Perot Fights NAFTA, and President Clinton Responds

In November 1993, the North American Free Trade Agreement (NAFTA) was signed into law but not before it stirred spirited opposition among unions and politicians. The best-known critic of NAFTA was Ross Perot, the billionaire Texan who launched a multimillion-dollar campaign against the free-trade treaty. He claimed that if NAFTA were ratified, the United States would hear a “giant sucking sound” as businesses rushed to Mexico to take advantage of its lower wages, putting nearly six million U.S. jobs at risk.
This argument ignores the economic theory of trade as well as its reality. If it is true that American factory workers are paid about eight times as much as their Mexican counterparts, it is also true that they are about eight times as productive. As Mexican workers become more productive, their pay will rise proportionately. This prediction is borne out by economic history. Like critics of NAFTA in 1993, many in 1986 feared a giant sucking sound from south of another border—the Pyrenees. Spain, with wages less than half those of its northern neighbors, and Portugal, with wages about a fifth of Europe’s norm, were about to join the European Community. Opponents said their low wages would drag down wages or take away jobs from French and German workers.
What happened? Job creation in France and Germany exceeded job creation in Spain and Portugal. More important, workers got to trade up to better jobs because opening trade allows all countries to specialize where their advantage is greatest. Specialization raises incomes. It is the reason all parties benefit from trade. Again the evidence bears this assertion out: By 1993, French and German wages had doubled; Spanish and Portuguese wages increased slightly faster. Put simply, countries do not grow richer at one another’s expense. If allowed to trade freely, they grow richer together—each supplying the other with products, markets, and the spur of competition.
After numerous appeals by NAFTA supporters that he speak out in favor of the treaty, President Bill Clinton finally responded. On September 14, 1993, he gave the following eloquent argument for open borders and open markets:
I want to say to my fellow Americans, when you live in a time of change, the only way to recover your security and to broaden your horizons is to adapt to the change, to embrace it, to move forward. Nothing we do in this great capital can change the fact that factories or information can flash across the world, that people can move money around in the blink of an eye. Nothing can change the fact that technology can be adopted, once created, by people all across the world and then rapidly adapted in new and different ways by people who have a little different take on the way that technology works.
For two decades, the winds of global competition have made these things clear to any American with eyes to see. The only way we can recover the fortunes of the middle class in this country so that people who work harder and smarter can at least prosper more, the only way we can pass on the American dream of the past 40 years to our children and their children for the next 40 is to adapt to the changes that are occurring.
In a fundamental sense, this debate about NAFTA is a debate about whether we will embrace these changes and create the jobs of tomorrow or try to resist these changes, hoping we can preserve the economic structures of yesterday. I tell you, my fellow Americans, that if we learn anything from the collapse of the Berlin Wall and the fall of the governments in Eastern Europe, even a totally controlled society cannot resist the winds of change that economics and technology and information flow have imposed in this world of ours. That is not an option. Our only realistic option is to embrace these changes and create the jobs of tomorrow.
Based in large part on the existence of NAFTA, total trade (exports plus imports) with Mexico rose from $81.5 billion in 1993 to $232.1 billion in 2002. After 1994, NAFTA made investors feel more secure in their property rights and foreign investment soared as foreign companies rushed to take advantage of Mexico as a low-cost export platform adjacent to the world’s wealthiest market.
Mini-Case Democrats Turn Protectionist

In fall 1993, President Clinton was lobbying hard for passage of NAFTA but facing tough opposition from Ross Perot among others. To help get out the administration’s message and build congressional and popular support, Vice President Al Gore agreed to go on CNN’s Larry King Live to debate—and discredit—the Texas billionaire. During the debate, Al Gore talked about the critical importance of NAFTA to the future of the United States. “This is a major choice for our country of historic proportions,” Gore said. “Sometimes we do something right; the creation of NATO, the Louisiana Purchase, Thomas Jefferson did the right thing there, the purchase of Alaska. These were all extremely controversial choices, but they made a difference for our country. This is such a choice.” Elaborating, Gore then said, “This is a choice between the politics of fear and the politics of hope. It’s a choice between the past and the future.” The reviews for Gore’s performance were solid, with most observers agreeing that he won the debate.
Seven years later, however, when Al Gore was running in the Democratic presidential primary against Senator Bill Bradley, he and his supporters hammered Bradley for the latter’s support of NAFTA (while neglecting his own role in NAFTA’s passage). A story in the New York Times helped explain Gore’s conversion:
Many officials from the powerful industrial unions in Illinois, Michigan, Missouri, Ohio, Pennsylvania and Wisconsin—the auto workers, the steelworkers and the machinists—say that if Gore hopes to motivate union activists to campaign for him and union members to vote for him in primaries and in the general election, he must address labor’s concerns on manufacturing and the related subject of trade. “It’s one thing for the vice president to get the AFL-CIO’s endorsement, and it’s quite another to mobilize our members,” said George Becker, president of the United Steelworkers of America. Becker met with Gore last week to press him on trade and manufacturing. “I have one overall goal in life,” Becker said, “and that is to reverse the trend of de-industrializing America and to stop these insane trade laws that force our manufacturers to compete against impossible odds.”
In 2004, virtually all the Democratic presidential hopefuls came out strongly against free trade, thereby reversing the position the Democratic Party had taken while Bill Clinton was president. Howard Dean, John Kerry, John Edwards, and Wesley Clark abandoned their past positions on trade and joined Richard Gephardt, a longtime critic of free trade and favorite of labor unions, in resisting efforts to lower trade barriers with Mexico and other nations in South America and Asia. Of the top-tier Democratic presidential candidates, only Joseph Lieberman continued to push the Clinton emphasis on forging trade agreements: “We cannot put a wall around America,” he said.
During the 2008 Democratic presidential primaries, both Barack Obama and Hillary Clinton criticized free trade in general and denounced NAFTA in particular. According to Senator Obama, “If you travel through Youngstown and you travel through communities in my home state of Illinois, you will see entire cities that have been devastated as a consequence of trade agreements.” Both pledged to withdraw from NAFTA if Mexico and Canada refused to renegotiate the treaty. This pledge was made despite the difficulty in discerning NAFTA’s harmful impact from the data: From January 1, 1994, when NAFTA took effect, to 2008, the U.S. economy gained 26 million new jobs (a 21% increase in employment), while real (inflation-adjusted) hourly compensation (wages and benefits) of U.S. workers rose by 26%.
Questions
1. What might explain the candidates’ and Democratic Party’s reversal of position on free trade? Which voting constituencies would be most likely to reject free trade? Why?
2. What leverage do the trade unions have in persuading Al Gore and other Democratic candidates to pay attention to their anti–free-trade position? Explain why these particular unions might be particularly powerful.
3. What trade-offs did Al Gore and other Democrats face in accommodating labor? Explain.
4. How can U.S. manufacturers compete with foreign producers? Are they doomed, as suggested by the president of the United Steelworkers of America? Explain.
5. Are the unions and their members right to be concerned about the effects of free-trade policies? What are these effects that they are concerned about? Who would be helped and who would be hurt if the unions got their way on trade? Explain.
Application The Myth of a Deindustrializing America

The share of workers employed in manufacturing in the United States has declined steadily since 1960, from 26% then to about 11% in 2006. It is an article of faith among protectionists that these manufacturing jobs have been lost to low-cost labor in China, India, Mexico, Brazil, and the rest of the developing world. According to the critics the answer to these job losses and the hollowing out of American industry is protectionism.
The truth turns out to be more complex. In fact, manufacturing jobs are disappearing worldwide. A study of employment trends in 20 economies found that between 1995 and 2002, more than 22 million factory jobs disappeared.24 Moreover, the United States has not even been the biggest loser. As Exhibit 1.11 shows, that distinction goes to Brazil, which lost almost 20% of its manufacturing jobs during that period. China, the usual villain, saw a 15% drop. In fact, the real culprit is higher productivity.
All over the world, factories are becoming more efficient. As a result of new equipment, better technology, and better manufacturing processes, factories can turn out more products with fewer workers. Indeed, between 1995 and 2002, factory production worldwide jumped 30% even as factory employment fell by 11%. In the United States, even as millions of factory jobs were lost, factory output has more than doubled in the past 30 years. Indeed, despite China being acclaimed as the new workshop of the world, the United States remains the world’s largest manufacturer. Because of its higher productivity, the United States manufactures twice as many goods as China even though China has around six times as many manufacturing workers.
Manufacturing is being transformed the same way that farming was. In 1910, one out of every three American workers was a farmer. By 2007, with the advent of tractors and other technology, it was one in 70 even as U.S. food output increased dramatically. As such, postponing the expiration date of some U.S. manufacturing jobs through protectionist policies diverts resources from new, growing industries and instead directs them toward keeping dying U.S. industries alive for a little while longer.
Exhibit 1.11 WINNERS AND LOSERS: PERCENTAGE CHANGE IN MANUFACTURING EMPLOYMENT FROM 1995 TO 2002

Exhibit 1.12 HOW LOGITECH’S $40 MOUSE IS DISSECTED

It is also important to distinguish between the outsourcing of manufacturing and the outsourcing of the value added associated with manufactured products. Consider, for example, the wireless mouse named Wanda sold by Logitech International SA, a Swiss-American company headquartered in California. The mice are made in Suzhou, China, and sold to American consumers for around $40. As Exhibit 1.12 shows, of this amount, Logitech takes about $8, distributors and retailers take around $15, and parts suppliers get $14. China’s take from each mouse is just $3, which must cover wages, power, transport, and other overhead costs. Indeed, Logitech’s Fremont, California, marketing staff of 450 earns far more than the 4,000 Chinese workers in Suzhou.25
Exhibit 1.13 U.S. Unemployment Rates and New Job Creation

Source: U.S. Bureau of Labor Statistics.
Exhibit 1.14A Real Compensation per Hour and Output per Hour for American Nonfarm Workers: 1959–2007

Source: Department of Labor, Bureau of Labor Statistics.
Exhibit 1.14B How Real Compensation per Hour varies with output per Hour for American Nonfarm Workers: 1959–2007

Ultimately, the consequences of globalization are an empirical issue. If the anti–free traders were right, the United States, with one of the most liberal trading regimes in the world and facing intense competitive pressure from low-cost imports across a range of industries, would be losing jobs by the millions. Instead, as Exhibit 1.13 shows, the United States created more than 45 million jobs since 1980, when the competitive pressure from foreign imports intensified dramatically. The U.S. unemployment rate also fell during this period, from 7.1% in 1980 to 4.6% in 2006. Moreover, according to the foes of globalization, intensifying competition from low-cost foreign workers is driving down average worker compensation in the United States, both in absolute terms and also relative to foreign workers. Once again, the facts are inconsistent with the claims. Exhibit 1.14a shows that U.S. worker compensation has steadily risen—and it shows why. The answer is productivity: As output per hour (the standard measure of worker productivity) has gone up, so has real hourly worker compensation. According to Exhibit 1.14b, on average, 66% of productivity gains have gone to higher worker compensation. The key to higher compensation, therefore, is increased productivity, not trade protectionism. In fact, increased trade leads to higher productivity and, therefore, higher average wages and benefits. Moreover, Exhibit 1.15 shows that over time the income advantage Americans enjoy relative to the world overall has risen not fallen, from 5.4 in 1970 to 6.7 in 2006. These empirical facts point to a larger reality: Globalization is not a zero-sum game, in which for some to win others must lose. Instead, international trade and investment expand the total economic pie, enabling nations to get richer together.
Exhibit 1.15 Growing Pay Advantage Enjoyed by Americans

20 The importance of foreign investment in the United States is indicated by a few facts: Four of America’s six major music labels are now foreign owned; Goodyear is the last major American-owned tire manufacturer; by 2006, Japanese auto companies had the capacity to build 4.3 million cars a year in their U.S. plants, more than 25% of the total in a typical sales year; four of Hollywood’s largest film companies are foreign owned; and in July 1995, Zenith, the last of the 21 companies manufacturing televisions in the United States that was American owned, was purchased by the South Korean firm LG Group.
21 Research on this point using detailed plant-level data is summarized in Howard Lewis and J. David Richardson, Why Global Commitment Really Matters. Washington, D.C.: Institute for International Economics, 2001.
22 Quoted in Mortimer B. Zuckerman, “A Bit of Straight Talk,” U.S. News and World Report, July 3, 2000, p. 60.
23 The term “EU-15” refers to the 15 nations that comprised the European Union prior to May 1, 2004: Austria, Belgium, Denmark, France, Finland, Germany, Greece, Ireland, Italy, Luxembourg, Netherlands, Portugal, Spain, Sweden and United Kingdom. On May 1, 2004, 10 new members joined the EU on May 1, 2004: Cyprus, Czech Republic, Estonia, Hungary, Latvia, Lithuania, Malta, Poland, Slovakia, Slovenia.
24 Joseph G. Carson, “U.S. Economic and Investment Perspective—Manufacturing Payrolls Declining Globally: The Untold Story (Parts 1 and 2).” New York: AllianceBernstein Institutional Capital Management, October 10 and 24, 2003.
25 Information on Logitech’s Wanda mouse appears in Andrew Higgins, “As China Surges, It Also Proves a Buttress to American Strength,” Wall Street Journal, January 30, 2004, A1.
1.3 Multinational Financial Management: Theory and Practice
Although all functional areas can benefit from a global perspective, this book concentrates on developing financial policies that are appropriate for the multinational firm. The main objective of multinational financial management is to maximize shareholder wealth as measured by share price. This means making financing and investment decisions that add as much value as possible to the firm. It also means that companies must manage effectively the assets under their control.
The focus on shareholder value stems from the fact that shareholders are the legal owners of the firm and management has a fiduciary obligation to act in their best interests. Although other stakeholders in the company do have rights, these are not coequal with the shareholders’ rights. Shareholders provide the risk capital that cushions the claims of alternative stakeholders. Allowing alternative stakeholders coequal control over capital supplied by others is equivalent to allowing one group to risk another group’s capital. This undoubtedly would impair future equity formation and produce numerous other inefficiencies.
A more compelling reason for focusing on creating shareholder wealth is that those companies that do not are likely to be prime takeover targets and candidates for a forced corporate restructuring. Conversely, maximizing shareholder value provides the best defense against a hostile takeover: a high stock price. Companies that build shareholder value also find it easier to attract equity capital. Equity capital is especially critical for companies that operate in a riskier environment and for companies that are seeking to grow.
Last, but not least, shareholders are not the only beneficiaries of corporate success. By forcing managers to evaluate business strategies based on prospective cash flows, the shareholder value approach favors strategies that enhance a company’s cash-flow generating ability—which is good for everyone, not just shareholders. Companies that create value have more money to distribute to all stakeholders, not just shareholders. Put another way, you have to create wealth before you can distribute it. Thus, there is no inherent economic conflict between shareholders and stakeholders. Indeed, most financial economists believe that maximizing shareholder value is not merely the best way, it is the only way to maximize the economic interests of all stakeholders over time.
Although an institution as complex as the multinational corporation cannot be said to have a single, unambiguous will, the principle of shareholder wealth maximization provides a rational guide to financial decision making. However, other financial goals that reflect the relative autonomy of management and external pressures also are examined here.
Criticisms of the Multinational Corporation
Critics of the MNC liken its behavior to that of an octopus with tentacles extended, squeezing the nations of the world to satisfy the apparently insatiable appetite of its center. Its defenders claim that only by linking activities globally can world output be maximized. According to this view, greater profits from overseas activities are the just reward for providing the world with new products, technologies, and know-how.
This book’s focus is on multinational financial management, so it does not directly address this controversy. It concentrates instead on the development of analytical approaches to deal with the major environmental problems and decisions involving overseas investment and financing. In carrying out these financial policies, however, conflicts between corporations and nation-states will inevitably arise.
A classic case is that of General Motors-Holden’s Ltd. The General Motors wholly owned Australian affiliate was founded in 1926 with an initial equity investment of A$3.5 million. The earnings were reinvested until 1954, at which time the first dividend, for A$9.2 million, was paid to the parent company in Detroit. This amount seemed reasonable to GM management, considering the 28 years of forgoing dividends, but the Australian press and politicians denounced a dividend equal to more than 260% of GM’s original equity investment as economic exploitation and imperialism.26
More recently, Brazil, facing one of its periodic balance-of-payments crises, chose to impose stringent controls on the removal of profits by MNCs, thereby affecting the financial operations of firms such as Volkswagen and Scott Paper. In addition, companies operating in countries as diverse as Canada and Chile, Italy and India, and the United States and Uruguay have faced various political risks, including price controls and confiscation of local operations. This book examines modifying financial policies to align better with national objectives in an effort to reduce such risks and minimize the costs of the adjustments.
This text also considers the links between financial management and other functional areas. After all, the analysis of investment projects is dependent on sales forecasts and cost estimates, and the dispersal of production and marketing activities affects a firm’s ability to flow funds internationally as well as its vulnerability to expropriation.
26 Reported in, among other places, Sidney M. Robbins and Robert B. Stobaugh, Money in the Multinational Enterprise (New York: Basic Books, 1973), p. 59.
Functions of Financial Management
Financial management is traditionally separated into two basic functions: the acquisition of funds and the investment of those funds. The first function, also known as the financing decision, involves generating funds from internal sources or from sources external to the firm at the lowest long-run cost possible. The investment decision is concerned with the allocation of funds over time in such a way that shareholder wealth is maximized. Many of the concerns and activities of multinational financial management, however, cannot be categorized so neatly.
Internal corporate fund flows such as loan repayments often are undertaken to access funds that are already owned, at least in theory, by the MNC itself. Other flows, such as dividend payments, may take place to reduce taxes or currency risk. Capital structure and other financing decisions frequently are motivated by a desire to reduce investment risks as well as financing costs. Furthermore, exchange risk management involves both the financing decision and the investment decision. Throughout this book, therefore, the interaction between financing and investment decisions is stressed because the right combination of these decisions is the key to maximizing the value of the firm to its shareholders.
Theme of This Book
Financial executives in multinational corporations face many factors that have no domestic counterparts. These factors include exchange and inflation risks; international differences in tax rates; multiple money markets, often with limited access; currency controls; and political risks, such as sudden or creeping expropriation.
When companies consider the unique characteristics of multinational financial management, they understandably emphasize the additional political and economic risks faced when going abroad. But a broader perspective is necessary if firms are to take advantage of being multinational.
The ability to move people, money, and material on a global basis enables the multinational corporation to be more than the sum of its parts. By having operations in different countries, the MNC can access segmented capital markets to lower its overall cost of capital, shift profits to lower its taxes, and take advantage of international diversification of markets and production sites to reduce the riskiness of its earnings. Multinationals have taken the old adage “don’t put all your eggs in one basket” to its logical conclusion.
Operating globally confers other advantages as well: It increases the bargaining power of multinational firms when they negotiate investment agreements and operating conditions with foreign governments and labor unions; it gives MNCs continuous access to information on the newest process technologies available overseas and the latest research and development activities of their foreign competitors; and it helps them diversify their funding sources by giving them expanded access to the world’s capital markets.
Application General Electric Discusses the Risks and Benefits of Globalization
In its 2007 Annual Report (p. 51), General Electric explains the pluses and minuses of its global activities as follows:
Our global activities span all geographic regions and primarily encompass manufacturing for local and export markets, import and sale of products produced in other regions, leasing of aircraft, sourcing for our plants domiciled in other global regions and provision of financial services within these regional economies. Thus, when countries or regions experience currency and/or economic stress, we often have increased exposure to certain risks, but also often have new profit opportunities. Potential increased risks include, among other things, higher receivable delinquencies and bad debts, delays or cancellations of sales and orders principally related to power and aircraft equipment, higher local currency financing costs and slowdown in established financial services activities. New profit opportunities include, among other things, more opportunities for lower cost outsourcing, expansion of industrial and financial services activities through purchases of companies or assets at reduced prices and lower U.S. debt financing costs.
In summary, this book emphasizes the many opportunities associated with being multinational without neglecting the corresponding risks. To properly analyze and balance these international risks and rewards, we must use the lessons to be learned from domestic corporate finance.
Relationship to Domestic Financial Management
In recent years, an abundance of new research has been conducted in the area of international corporate finance. The major thrust of this work has been to apply the methodology and logic of financial economics to the study of key international financial decisions. Critical problem areas, such as foreign exchange risk management and foreign investment analysis, have benefited from the insights provided by financial economics—a discipline that emphasizes the use of economic analysis to understand the basic workings of financial markets, particularly the measurement and pricing of risk and the intertemporal allocation of funds.
By focusing on the behavior of financial markets and their participants rather than on how to solve specific problems, we can derive fundamental principles of valuation and develop from them superior approaches to financial management, much as a better understanding of the basic laws of physics leads to better-designed and better-functioning products. We also can better gauge the validity of existing approaches to financial decision making by seeing whether their underlying assumptions are consistent with our knowledge of financial markets and valuation principles.
Three concepts arising in financial economics have proved to be of particular importance in developing a theoretical foundation for international corporate finance: arbitrage, market efficiency, and capital asset pricing. Throughout the remainder of the book, we rely on these concepts, which are briefly described in the next sections.
Arbitrage.
Arbitrage traditionally has been defined as the purchase of assets or commodities on one market for immediate resale on another in order to profit from a price discrepancy. In recent years, however, arbitrage has been used to describe a broader range of activities. Tax arbitrage, for example, involves the shifting of gains or losses from one tax jurisdiction to another to profit from differences in tax rates. In a broader context, risk arbitrage, or speculation, describes the process that leads to equality of risk-adjusted returns on different securities, unless market imperfections that hinder this adjustment process exist.
The concept of arbitrage is of particular importance in international finance because so many of the relationships between domestic and international financial markets, exchange rates, interest rates, and inflation rates depend on arbitrage for their existence. In fact, it is the process of arbitrage that ensures market efficiency.
Market Efficiency.
An efficient market is one in which the prices of traded securities readily incorporate new information. Numerous studies of U.S. and foreign capital markets have shown that traded securities are correctly priced in that trading rules based on past prices or publicly available information cannot consistently lead to profits (after adjusting for transaction costs) in excess of those due solely to risk taking.
The predictive power of markets lies in their ability to collect in one place a mass of individual judgments from around the world. These judgments are based on current information. If the trend of future policies changes, people will revise their expectations, and prices will change to incorporate the new information.
To say that markets are efficient, however, is not to say that they never blunder. Swept up by enthusiasm or urged on by governments, investors appear to succumb periodically to herd behavior and go to excess, culminating in a financial crisis. In the 1980s, for example, an international banking crisis developed as a result of overly optimistic lending to developing nations, and in the 1990s the Asian crisis was associated with overly optimistic lending to the rapidly growing Asian tigers. To date, these crises have been resolved, albeit with much pain. Between crisis and resolution, however, is always uncharted territory, with the everpresent potential of panic feeding on itself and spreading from one nation to another, leading to global instability and recession, such as has occurred with the subprime lending crisis that began in 2007. What we can say about markets, however, is that they are self-correcting; unlike governments, when investors spot problems, their instinct is to withdraw funds, not add more. At the same time, if a nation’s economic fundamentals are basically sound, investors will eventually recognize that and their capital will return.
Capital Asset Pricing.
Capital asset pricing refers to the way in which securities are valued in line with their anticipated risks and returns. Because risk is such an integral element of international financial decisions, this book briefly summarizes the results of more than two decades of study on the pricing of risk in capital markets. The outcome of this research has been to posit a specific relationship between risk (measured by return variability) and required asset returns, now formalized in the capital asset pricing model (CAPM) and the more general arbitrage pricing theory (APT).
Both the CAPM and the APT assume that the total variability of an asset’s returns can be attributed to two sources: (1) marketwide influences that affect all assets to some extent, such as the state of the economy, and (2) other risks that are specific to a given firm, such as a strike. The former type of risk is usually termed systematic, or nondiversifiable, risk, and the latter, unsystematic, or diversifiable, risk. Unsystematic risk is largely irrelevant to the highly diversified holder of securities because the effects of such disturbances cancel out, on average, in the portfolio. On the other hand, no matter how well diversified a stock portfolio is, systematic risk, by definition, cannot be eliminated, and thus the investor must be compensated for bearing this risk. This distinction between systematic risk and unsystematic risk provides the theoretical foundation for the study of risk in the multinational corporation and is referred to throughout the book.
The Importance of Total Risk
Although the message of the CAPM and the APT is that only the systematic component of risk will be rewarded with a risk premium, this does not mean that total risk—the combination of systematic and unsystematic risk—is unimportant to the value of the firm. In addition to the effect of systematic risk on the appropriate discount rate, total risk may have a negative impact on the firm’s expected cash flows.27
The inverse relation between risk and expected cash flows arises because financial distress, which is most likely to occur for firms with high total risk, can impose costs on customers, suppliers, and employees and thereby affect their willingness to commit themselves to relationships with the firm. For example, potential customers will be nervous about purchasing a product they might have difficulty getting serviced if the firm goes out of business. Similarly, a firm struggling to survive is unlikely to find suppliers willing to provide it with specially developed products or services, except at a higher-than-usual price. The uncertainty created by volatile earnings and cash flows also may hinder management’s ability to take a long view of the firm’s prospects and make the most of its opportunities.
In summary, total risk is likely to affect a firm’s value adversely by leading to lower sales and higher costs. Consequently, any action taken by a firm that decreases its total risk will improve its sales and cost outlooks, thereby increasing its expected cash flows.
These considerations justify the range of corporate hedging activities that multinational firms engage in to reduce total risk. This text focuses on those risks that appear to be more international than national in nature, including inflation risk, exchange risk, and political risk. As we will see, however, appearances can be deceiving, because these risks also affect firms that do business in only one country. Moreover, international diversification may actually allow firms to reduce the total risk they face. Much of the general market risk facing a company is related to the cyclical nature of the domestic economy of the home country. Operating in several nations whose economic cycles are not perfectly in phase should reduce the variability of the firm’s earnings. Thus, even though the risk of operating in any one foreign country may be greater than the risk of operating in the United States (or other home country), diversification can eliminate much of that risk.
What is true for companies is also true for investors. International diversification can reduce the riskiness of an investment portfolio because national financial markets tend to move somewhat independently of one another. Investors today have options to invest internationally that did not exist in the past. They can invest in multinational firms, foreign stocks and bonds, securities of foreign firms issued domestically, and mutual funds that hold portfolios of foreign stocks and bonds.
27 The effect of total risk is discussed in Alan C. Shapiro and Sheridan Titman, “An Integrated Approach to Corporate Risk Management,” Midland Corporate Finance Journal, Summer 1985, pp. 41–56.
The Global Financial Marketplace
Market efficiency has been greatly facilitated by the marriage of computers and telecommunications. The resulting electronic infrastructure melds the world into one global market for ideas, data, and capital, all moving at almost the speed of light to any part of the planet. Today, there are more than 200,000 computer terminals in hundreds of trading rooms, in dozens of nations, that light up to display an unending flow of news. Only about two minutes elapse between the time a president, a prime minister, or a central banker makes a statement and the time traders buy or sell currency, stocks, and bonds according to their evaluation of that policy’s effect on the market.
The result is a continuing global referendum on a nation’s economic policies, which is the final determinant of the value of its currency. Just as we learn from television the winner of a presidential election weeks before the electoral college even assembles, so, too, do we learn instantly from the foreign exchange market what the world thinks of our announced economic policies even before they are implemented. In a way, the financial market is a form of economic free speech. Although many politicians do not like what it is saying, the market presents judgments that are clear eyed and hard nosed. It knows that there are no miracle drugs that can replace sound fiscal and monetary policies. Thus, cosmetic political fixes will exacerbate, not alleviate, a falling currency.
The Role of the Financial Executive in an Efficient Market
The basic insight into financial management that we can gain from recent empirical research in financial economics is the following: Attempts to increase the value of a firm by purely financial measures or accounting manipulations are unlikely to succeed unless there are capital market imperfections or asymmetries in tax regulations.
Rather than downgrading the role of the financial executive, the net result of these research findings has been to focus attention on those areas and circumstances in which financial decisions can have a measurable impact. The key areas are capital
budgeting, working capital management, and tax management. The circumstances to be aware of include capital market imperfections, caused primarily by government regulations, and asymmetries in the tax treatment of different types and sources of revenues and costs.
The value of good financial management is enhanced in the international arena because of the much greater likelihood of market imperfections and multiple tax rates. In addition, the greater complexity of international operations is likely to increase the payoffs from a knowledgeable and sophisticated approach to internationalizing the traditional areas of financial management.
1.4 Outline of the Book
This book is divided into six parts.
• Part I: Environment of International Financial Management
• Part II: Foreign Exchange and Derivatives Markets
• Part III: Foreign Exchange Risk Management
• Part IV: Financing the Multinational Corporation
• Part V: Foreign Investment Analysis
• Part VI: Multinational Working Capital Management
The following sections briefly discuss these parts and their chapters.
Environment of International Financial Management
Part I examines the environment in which international financial decisions are made. Chapter 2 discusses the basic factors that affect currency values. It also explains the basics of central bank intervention in foreign exchange markets, including the economic and political motivations for such intervention. Chapter 3 describes the international monetary system and shows how the choice of system affects the determination of exchange rates. Chapter 4 is a crucial chapter because it introduces five key equilibrium relationships—among inflation rates, interest rates, and exchange rates—in international finance that form the basis for much of the analysis in the remainder of the text. Chapter 5 analyzes the balance of payments and the links between national economies, while Chapter 6 discusses the subject of country risk analysis, the assessment of the potential risks and rewards associated with making investments and doing business in a country—a topic of great concern these days.
Foreign Exchange and Derivatives Markets
Part II explores the foreign exchange and derivative markets used by multinational corporations to manage their currency and interest rate risks. Chapter 7 describes the foreign exchange market and how it functions. Foreign currency futures and options contracts are discussed in Chapter 8. Chapter 9 analyzes interest rate and currency swaps and interest rate forwards and futures and how these derivatives can be used to manage risk.
Foreign Exchange Risk Management
Part III discusses foreign exchange risk management, a traditional area of concern that is receiving even more attention today. Chapter 10 discusses the likely impact that an exchange rate change will have on a firm (its exposure) from an accounting perspective and then analyzes the costs and benefits of alternative financial techniques to hedge against those exchange risks. Chapter 11 examines exposure from an economic perspective and presents marketing, logistic, and financial policies to cope with the competitive consequences of currency changes. As part of the analysis of economic exposure, the relationship between inflation and currency changes and its implications for corporate cash flows is recognized.
Financing the Multinational Corporation
Part IV focuses on laying out and evaluating the medium- and long-term financing options facing the multinational firm, then on developing a financial package that is tailored to the firm’s specific operating environment. Chapter 12 describes the alternative external, medium- and long-term debt-financing options available to the multinational corporation. Chapter 13 discusses the international capital markets—namely, the Eurocurrency and Eurobond markets. Chapter 14 seeks to determine the cost-of-capital figure(s) that MNCs should use in evaluating foreign investments, given the funding sources actually employed.
Foreign Investment Analysis
Part V analyzes the foreign investment decision process. Chapter 15 begins by discussing the nature and consequences of international portfolio investing—the purchase of foreign stocks and bonds. In Chapter 16, the strategy of foreign direct investment is discussed, including an analysis of the motivations for going abroad and those factors that have contributed to business success overseas. Chapter 17 presents techniques for evaluating foreign investment proposals, emphasizing how to adjust cash flows for the various political and economic risks encountered abroad, such as inflation, currency fluctuations, and expropriations. It also discusses how companies can manage political risks by appropriately structuring the initial investment and making suitable modifications to subsequent operating decisions.
Multinational Working Capital Management
Part VI examines working capital management in the multinational corporation. The subject of trade financing is covered in Chapter 18. Chapter 19 discusses current asset management in the MNC, including the management of cash, inventory, and receivables. It also deals with current liability management, presenting the alternative shortterm financing techniques available and showing how to evaluate their relative costs. Chapter 20 describes the mechanisms available to the MNC to shift funds and profits among its various units, while considering the tax and other consequences of these maneuvers. The aim of these maneuvers is to create an integrated global financial planning system.
Questions
1. a. What are the various categories of multinational firms?
b. What is the motivation for international expansion of firms within each category?
2. a. How does foreign competition limit the prices that domestic companies can charge and the wages and benefits that workers can demand?
b. What political solutions can help companies and unions avoid the limitations imposed by foreign competition?
c. Who pays for these political solutions? Explain.
3. a. What factors appear to underlie the Asian currency crisis?
b. What lessons can we learn from the Asian currency crisis?
4. a. What is an efficient market?
b. What is the role of a financial executive in an efficient market?
5. a. What is the capital asset pricing model?
b. What is the basic message of the CAPM?
c. How might a multinational firm use the CAPM?
6. Why might total risk be relevant for a multinational corporation?
7. A memorandum by Labor Secretary Robert Reich to President Bill Clinton suggested that the government penalize U.S. companies that invest overseas rather than at home. According to Reich, this kind of investment hurts exports and destroys well-paying jobs. Comment on this argument.
8. Are multinational firms riskier than purely domestic firms? What data would you need to address this question?
9. Is there any reason to believe that MNCs may be less risky than purely domestic firms? Explain.
10. In what ways do financial markets grade government economic policies?
Web Resources
http://www.wto.org Web site of the World Trade Organization (WTO). Contains news, information, and statistics on international trade.
http://www.worldbank.org Web site of the World Bank. Contains economic and demographic data on 206 countries (organized in “Country At-A-Glance” tables), various economic forecasts, and links to a number of other data sources.
http://www.bea .gov Web site of the Bureau of Economic Analysis (BEA). Contains data and articles on U.S. international trade, capital flows, and other international economic matters.
http://www.wsj.com Web site of the Wall Street Journal, the foremost business newspaper in the United States. Contains domestic and international business news.
http://www.ft.com Web site of the Financial Times, the foremost international business newspaper, published in London. Contains a wealth of international financial news and data.
http://www.economist.com Web site of The Economist. Contains stories on the economic and political situations of countries and international business developments, along with various national and international economic and financial data.
http://www.oecd.org Web site of the Organisation for Economic Co-operation and Development (OECD). Contains news, analyses, and data on international finance and economics.
http://www.cob.ohio-state.edu/dept/fin/fdf/osudata.htm Web site run by the Finance Department of Ohio State University. Contains a detailed listing of and links to many different Web sites related to finance and economics.
http://www.census.gov/ipc/www/idb/ Contains the International Data Base (IDB), which is a computerized data bank with statistical tables of demographic and socioeconomic data for 227 countries and areas of the world.
http://www.economy.com/dismal/ Covers more than 65 economic releases from more than 15 countries. Also contains numerous stories dealing with international finance and economics.
http://www.reportgallery.com Web site that contains links to annual reports of more than 2,200 companies, many of which are multinationals.
http://www.sec.gov/ Web site of U.S. Securities and Exchange Commission. Contains company filings of companies including 10-K and 10-Q.
http://www.unctad.org/Templates/StartPage.asp?intItemID=2068 Web site of the United Nations Conference on Trade and Development. Contains information on international trade statistics.
http://epp.eurostat.ec.europa.eu/portal/page?_pageid=1090,30070682,109033076576&dad=portal&schema=PORTAL Web site of the Eurostat Database from the European Commission. Contains economic data for EU and Non-EU nations.
http://www.bls.gov/ Web site of the Bureau of Labor Statistics within U.S. Department of Labor. Contains historical U.S. labor, productivity and inflation data.
Web Exercises
1. Who are the major trading partners of the United States? Which countries are the top five exporters to the United States? Which countries are the top five importers of U.S. goods? Good references are the WTO site and the BEA site.
2. Who are the major recipients of U.S. overseas investment? Which countries are the major sources of foreign investment in the United States? A good reference is the BEA site.
3. Go to the Web sites of companies such as the ones listed here and examine their international business activity. For example, what importance do these companies appear to place on international business? What percentage of sales revenues, assets, and income do these companies derive from their foreign operations? What percentage of their sales and income comes from exports? Is their foreign activity increasing or decreasing? How many countries and continents do these companies operate on? Which countries are listed as locations of the company’s foreign subsidiaries? What is the headquarters country of each company? Much of this information can be gleaned from the annual reports of the companies, which can be found at http://www.reportgallery.com.

4. Based on your review of The Economist, the Wall Street Journal, and the Financial Times, which countries appear to be giving foreign investors concerns? What are these concerns?
5. Visit the Bureau of Labor Statistics Web site at http://www.bls.gov. What are the sectors that have added the most jobs from 1990 to 2005?
6. Visit the Web site of Dell Inc. (www.dell.com). From the home page, visit Dell’s site for three other countries. What similarities and differences do you see in the products, prices, and other details when comparing the various country sites? How would you account for these similarities and differences?
Appendix 1A
The Origins And Consequences of International Trade
Underlying the theory of international trade is the doctrine of comparative advantage. This doctrine rests on certain assumptions:
• Exporters sell undifferentiated (commodity) goods and services to unrelated importers.
• Factors of production cannot move freely across countries. Instead, trade takes place in the goods and services produced by these factors of production.
As noted at the beginning of Chapter 1, the doctrine of comparative advantage also ignores the roles of uncertainty, economies of scale, and technology in international trade; and it is static rather than dynamic. Nonetheless, this theory helps explain why nations trade with one another, and it forms the basis for assessing the consequences of international trade policies.
To illustrate the main features of the doctrine of comparative advantage and to distinguish this concept from that of absolute advantage, suppose the United States and the United Kingdom produce the same two products, wheat and coal, according to the following production schedules, where the units referred to are units of production (labor, capital, land, and technology). These schedules show how many units it costs to produce each ton in each country:28
Wheat

Coal

U.S.
2 units/ton
1 unit/ton
U.K.
3 units/ton
4 units/ton
These figures show clearly that the United States has an absolute advantage in both mining coal and growing wheat. That is, in using fewer units of production per ton produced, the United States is more efficient than the United Kingdom in producing both coal and wheat. However, although the United Kingdom is at an absolute disadvantage in both products, it has a comparative advantage in producing wheat. Put another way, the United Kingdom’s absolute disadvantage is less in growing wheat than in mining coal. This lesser disadvantage can be seen by redoing the production figures to reflect the output per unit of production for both countries:
Wheat

Coal

U.S.
0.5 ton/unit
1 ton/unit
U.K.
0.33 ton/unit
0.25 ton/unit
Productivity for the United States relative to the United Kingdom in coal is 4:1 (1/0.25), whereas it is “only” 1.5:1 (0.5/0.33) in wheat.
In order to induce the production of both wheat and coal prior to the introduction of trade, the profitability of producing both commodities must be identical. This condition is satisfied only when the return per unit of production is the same for both wheat and coal in each country. Hence, prior to the introduction of trade between the two countries, the exchange rate between wheat and coal in the United States and the United Kingdom must be as follows:
U.S.
1 ton wheat = 2 tons coal
U.K.
1 ton wheat = 0.75 ton coal
The Gains from Trade
Based on the relative prices of wheat and coal in both countries, there will be obvious gains to trade. By switching production units from wheat to coal, the United States can produce coal and trade with the United Kingdom for more wheat than those same production units can produce at home. Similarly, by specializing in growing wheat and trading for coal, the United Kingdom can consume more coal than if it mined its own. This example demonstrates that trade will be beneficial even if one nation (the United States here) has an absolute advantage in everything. As long as the degree of absolute advantage varies across products, even the nation with an across-the-board absolute disadvantage will have a comparative advantage in making and exporting some goods and services.
The gains from trade for each country depend on exactly where the exchange rate between wheat and coal ends up following the introduction of trade. This exchange rate, which is known as the terms of trade, depends on the relative supplies and demands for wheat and coal in each country. However, any exchange rate between 0.75 and 2.0 tons of coal per ton of wheat will still lead to trade because trading at that exchange rate will allow both countries to improve their ability to consume. By illustration, suppose the terms of trade end up at 1:1—that is, one ton of wheat equals one ton of coal.
Each unit of production in the United States can now provide its owner with either one ton of coal to consume or one ton of wheat or some combination of the two. By producing coal and trading for wheat, each production unit in the United States now enables its owner to consume twice as much wheat as before. Similarly, by switching from mining coal to growing wheat and trading for coal, each production unit in the United Kingdom will enable its owner to consume 0.33 tons of coal, 33% (0.33/0.25 = 133%) more than before.
28 The traditional theory of international trade ignores the role of technology in differentiating products, but it leaves open the possibility of different production technologies to produce commodities.
Specialized Factors of Production
So far, we have assumed that the factors of production are unspecialized. That is, they can easily be switched between the production of wheat and coal. However, suppose that some factors such as labor and capital are specialized (i.e., relatively more efficient) in terms of producing one commodity rather than the other. In that case, the prices of the factors of production that specialize in the commodity that is exported (coal in the United States, wheat in the United Kingdom) will gain because of greater demand once trade begins, whereas those factors that specialize in the commodity that is now imported (wheat in the United States, coal in the United Kingdom) will lose because of lower demand. This conclusion is based on the economic fact that the demand for factors of production is derived from the demand for the goods those factors produce.
The gains and losses to the specialized factors of production will depend on the magnitude of the price shifts after the introduction of trade. To take an extreme case, suppose the terms of trade become 1 ton of wheat equals 1.95 tons of coal. At this exchange rate, trade is still beneficial for both countries but far more so for the United Kingdom than the United States. The disparity in the gains from trade can be seen as follows: By producing coal and trading it for wheat, the United States can now consume approximately 2.5% more wheat than before per ton of coal.29 On the other hand, the United Kingdom gains enormously. Each unit of wheat traded for coal will now provide 1.95 tons of coal, a 160% (1.95/0.75 − 1) increase relative to the earlier ratio.
These gains are all to the good. However, with specialization comes costs. In the United States, the labor and capital that specialized in growing wheat will be hurt. If they continue to grow wheat (which may make sense because they cannot easily be switched to mining coal), they will suffer an approximate 2.5% loss of income because the wheat they produce now will buy about 2.5% less coal than before (1.95 tons instead of 2 tons). At the same time, U.S. labor and capital that specialize in mining coal will be able to buy about 2.5% more wheat. Although gains and losses for specialized U.S. factors of production exist, they are relatively small. The same cannot be said for U.K. gains and losses.
As we saw earlier, U.K. labor and capital that specialize in growing wheat will be able to buy 160% more coal than before, a dramatic boost in purchasing power. Conversely, those factors that specialize in mining coal will see their wheat purchasing power plummet, from 1.33 (4/3) tons of coal before trade to 0.5128 (1/1.95) tons of wheat now. These figures translate into a drop of about 62% (0.5128/1.33 = 38%) in wheat purchasing power.
This example illustrates a general principle of international trade: The greater the gains from trade for a country overall, the greater the cost of trade to those factors of production that specialize in producing the commodity that is now imported. The reason is that in order for trade to make sense, imports must be less expensive than the competing domestic products. The less expensive these imports are, the greater will be the gains from trade. By the same token, however, less expensive imports drive down the prices of competing domestic products, thereby reducing the value of those factors of production that specialize in their manufacture.
It is this redistribution of income—from factors specializing in producing the competing domestic products to consumers of those products—that leads to demands for protection from imports. However, protection is a double-edged sword. These points are illustrated by the experience of the U.S. auto industry.
As discussed in the chapter, the onslaught of Japanese cars in the U.S. market drove down the price and quantity of cars sold by American manufacturers, reducing their return on capital and forcing them to be much tougher in negotiating with the United Auto Workers. The end result was better and less expensive cars for Americans but lower profits for Detroit automakers, lower wages and benefits for U.S. autoworkers, and fewer jobs in the U.S. auto industry.
The U.S. auto industry responded to the Japanese competition by demanding, and receiving, protection in the form of a quota on Japanese auto imports. The Japanese response to the quota—which allowed manufacturers to raise their prices (why cut prices when you can’t sell more cars anyway?) and increase their profit margins—was to focus on making and selling higher-quality cars in the U.S. market (as these carried higher profit margins) and shifting substantial production to the United States. In the end, protection did not help U.S. automakers nearly as much as improving the quality of their cars and reducing their manufacturing costs. Indeed, to the extent that protection helped delay the needed changes while boosting Japanese automaker profits (thereby giving them more capital to invest), it may well have hurt the U.S. auto industry.
29 With trade, the United States can now consume 1/1.95 = 0.5128 tons of wheat per ton of coal, which is 2.56% more wheat than the 0.5 tons it could previously consume (0.5128/0.50 = 1.0256).
Monetary Prices and Exchange Rates
So far, we have talked about prices of goods in terms of each other. To introduce monetary prices into the example we have been analyzing, suppose that before the opening of trade between the two nations, each production unit costs $30 in the United States and £10 in the United Kingdom. In this case, the prices of wheat and coal in the two countries will be as follows:
Wheat

Coal

U.S.
$60/ton
$30/ton
U.K.
£30/ton
£40/ton
These prices are determined by taking the number of required production units and multiplying them by the price per unit.
Following the introduction of trade, assume the same 1:1 terms of trade as before and that the cost of a unit of production remains the same. The prices of wheat and coal in each country will settle at the following, assuming that the exported goods maintain their prices and the prices of the goods imported adjust to these prices so as to preserve the 1:1 terms of trade:
Wheat

Coal

U.S.
$30/ton
$30/ton
U.K.
£30/ton
£30/ton
These prices present a potential problem in that there will be equilibrium at these prices only if the exchange rate is $1 = £1. Suppose, however, that before the introduction of trade, the exchange rate is £1 = $3. In this case, dollar-equivalent prices in both countries will begin as follows:
Wheat

Coal

U.S.
$60/ton
$30/ton
U.K.
$90/ton
$120/ton
This is clearly a disequilibrium situation. Once trade begins at these initial prices, the British will demand both U.S. wheat and coal, whereas Americans will demand no British coal or wheat. Money will be flowing in one direction only (from the United Kingdom to the United States to pay for these goods), and goods will flow only in the opposite direction. The United Kingdom will run a massive trade deficit, matched exactly by the U.S. trade surplus. Factors of production in the United Kingdom will be idle (because there is no demand for the goods they can produce), whereas U.S. factors of production will experience an enormous increase in demand for their services.
This is the nightmare scenario for those concerned with the effects of free trade: One country will sell everything to the other country and demand nothing in return (save money), leading to prosperity for the exporting nation and massive unemployment and depression in the importing country. However, such worries ignore the way markets work.
Absent government interference, a set of forces will swing into play simultaneously. The British demand for dollars (to buy U.S. coal and wheat) will boost the value of the dollar, making U.S. products more expensive to the British and British goods less expensive to Americans. At the same time, the jump in demand for U.S. factors of production will raise their prices and hence the cost of producing U.S. coal and wheat. The rise in cost will force a rise in the dollar price of U.S. wheat and coal. Conversely, the lack of demand for U.K. factors of production will drive down their price and hence the pound cost of producing British coal and wheat. The net result of these adjustments in the pound:dollar exchange rate and the cost of factors of production in both countries is to make British products more attractive to consumers and U.S. products less competitive. This process will continue until both countries can find their comparative advantage and the terms of trade between coal and wheat are equal in both countries (say, at 1:1).
Tariffs
Introducing tariffs (taxes) on imported goods will distort the prices at which trade takes place and will reduce the quantity of goods traded. In effect, tariffs introduce a wedge between the prices paid by domestic customers and the prices received by the exporter, reducing the incentive of both to trade. To see this, suppose Mexican tomatoes are sold in the United States at a price of $0.30 per pound. If the United States imposes a tariff of, say, $0.15 per pound on Mexican tomatoes, then Mexican tomatoes will have to sell for $0.45 per pound to provide Mexican producers with the same pre-tariff profits on their tomato exports to the United States. However, it is likely that at this price, some Americans will forgo Mexican tomatoes and either substitute U.S. tomatoes or do without tomatoes in their salads. More likely, competition will preclude Mexican tomato growers from raising their price to $0.45 per pound. Suppose, instead, that the price of Mexican tomatoes, including the tariff, settles at $0.35 per pound. At this price, the Mexican tomato growers will receive only $0.20 per pound, reducing their incentive to ship tomatoes to the American market. At the same time, the higher price paid by American customers will reduce their demand for Mexican tomatoes. The result will be fewer Mexican tomatoes sold in the U.S. market. Such a result will benefit American tomato growers (who now face less competition and can thereby raise their prices) and farmworkers (who can now raise their wages without driving their employers out of business) while harming U.S. consumers of tomatoes (including purchasers of Campbell’s tomato soup, Ragu spaghetti sauce, Progresso ravioli, and Heinz ketchup).
Ultimately, the effects of free trade are beneficial for an economy because it promotes increased competition among producers. This leads to lower prices for consumers, greater productivity and rising wages for workers, and higher living standards for the country overall.
CHAPTER 2 The Determination of Exchange Rates

Experience shows that neither a state nor a bank ever have had the unrestricted power of issuing paper money without abusing that power.

David Ricardo (1817)
LEARNING OBJECTIVES
• To explain the concept of an equilibrium exchange rate
• To identify the basic factors affecting exchange rates in a floating exchange rate system
• To calculate the amount of currency appreciation or depreciation associated with a given exchange rate change
• To describe the motives and different forms and consequences of central bank intervention in the foreign exchange market
• To explain how and why expectations affect exchange rates
KEY TERMS
appreciation
ask rate
asset market model
bid rate
central bank
currency board
depreciation
devaluation
dollarization
equilibrium exchange rate
exchange rate
fiat money
floating currency
foreign exchange market intervention
forward rate
freely floating exchange rate
liquidity
monetary base
monetize the deficit
moral hazard
nominal exchange rate
open-market operation
pegged currency
real (inflation-adjusted) exchange rate
real interest rate
reference currency
revaluation
seignorage
spot rate
sterilization
unsterilized intervention
Economic activity is globally unified today to an unprecedented degree. Changes in one nation’s economy are rapidly transmitted to that nation’s trading partners. These fluctuations in economic activity are reflected, almost immediately, in fluctuations in currency values. Consequently, multinational corporations, with their integrated cross-border production and marketing operations, continually face devaluation or revaluation worries somewhere in the world. The purpose of this chapter and the next one is to provide an understanding of what an exchange rate is and why it might change. Such an understanding is basic to dealing with currency risk.
This chapter first describes what an exchange rate is and how it is determined in a freely floating exchange rate regime—that is, in the absence of government intervention. The chapter next discusses the role of expectations in exchange rate determination. It also examines the different forms and consequences of central bank intervention in the foreign exchange market. Chapter 3 describes the political aspects of currency determination under alternative exchange rate systems and presents a brief history of the international monetary system.
Before proceeding further, here are definitions of several terms commonly used to describe currency changes. Technically, a devaluation refers to a decrease in the stated par value of a pegged currency, one whose value is set by the government; an increase in par value is known as a revaluation. By contrast, a floating currency—one whose value is set primarily by market forces—is said to depreciate if it loses value and to appreciate if it gains value. However, discussions in this book will use the terms devaluation and depreciation, and revaluation and appreciation interchangeably.
2.1 Setting the Equilibrium Spot Exchange Rate
An exchange rate is, simply, the price of one nation’s currency in terms of another currency, often termed the reference currency. For example, the yen/dollar exchange rate is just the number of yen that one dollar will buy. If a dollar will buy 100 yen, the exchange rate would be expressed as ¥100/$, and the yen would be the reference currency. Equivalently, the dollar/yen exchange rate is the number of dollars one yen will buy. Continuing the previous example, the exchange rate would be $0.01/¥ (1/100), and the dollar could now be the reference currency.
Exchange rates can be for spot or forward delivery. A spot rate is the price at which currencies are traded for immediate delivery; actual settlement takes place two days later. A forward rate is the price at which foreign exchange is quoted for delivery at a specified future date. The foreign exchange market, where currencies are traded, is not a physical place; rather, it is an electronically linked network of banks, foreign exchange brokers, and dealers whose function is to bring together buyers and sellers of foreign exchange.
To understand how exchange rates are set, it helps to recognize that they are marketclearing prices that equilibrate supplies and demands in the foreign exchange market. The determinants of currency supplies and demands are first discussed with the aid of a two-currency model featuring the U.S. dollar and the euro, the official currency of the 16 countries that participate in the European Monetary Union (EMU). The members of EMU are often known collectively as Euroland, the term used here. Later, the various currency influences in a multicurrency world will be studied more closely.
Demand for a Currency
The demand for the euro in the foreign exchange market (which in this two-currency model is equivalent to the supply of dollars) derives from the American demand for Euroland goods and services and euro-denominated financial assets. Euroland prices are set in euros, so in order for Americans to pay for their Euroland purchases, they must first exchange their dollars for euros. That is, they will demand euros.
An increase in the euro’s dollar value is equivalent to an increase in the dollar price of Euroland products. This higher dollar price normally will reduce the U.S. demand for Euroland goods, services, and assets. Conversely, as the dollar value of the euro falls, Americans will demand more euros to buy the less-expensive Euroland products, resulting in a downward-sloping demand curve for euros. As the dollar cost of the euro (the exchange rate) falls, Americans will tend to buy more Euroland goods and so will demand more euros.
Supply of a Currency
Similarly, the supply of euros (which for the model is equivalent to the demand for dollars) is based on Euroland demand for U.S. goods and services and dollar-denominated financial assets. In order for Euroland residents to pay for their U.S. purchases, they must first acquire dollars. As the dollar value of the euro increases, thereby lowering the euro cost of U.S. goods, the increased Euroland demand for U.S. goods will cause an increase in the Euroland demand for dollars and, hence, an increase in the amount of euros supplied.1
In Exhibit 2.1, e is the spot exchange rate (dollar value of one euro, that is, €1 = $e), and Q is the quantity of euros supplied and demanded. Since the euro is expressed in terms of dollars, the dollar is the reference currency. The euro supply (S) and demand (D) curves intersect at e0, the equilibrium exchange rate. The foreign exchange market is said to be in equilibrium at e0 because both the demand for euros and the supply of euros at this price is Q0.
Exhibit 2.1 Equilibrium Exchange Rates

Before continuing, it should be noted that the notion of a single exchange rate is a convenient fiction. In reality, exchange rates—both spot rates and forward rates—are quoted in pairs, with a dealer (usually a bank foreign exchange trader) standing willing to buy foreign exchange at the bid rate or to sell foreign exchange at the ask rate. As might be expected, the bid rate is always less than the ask rate, enabling dealers to profit from the spread between the bid and ask rates by buying low and selling high. Chapter 7 describes the mechanics of the foreign exchange market in greater detail.
1 This statement holds provided the price elasticity of Euroland demand, E, is greater than 1. In general, E = − (ΔQ/Q)/(ΔP/P), where Q is the quantity of goods demanded, P is the price, and ΔQ is the change in quantity demanded for a change in price, ΔP. If E > 1, then total spending goes up when price declines.
Factors That Affect the Equilibrium Exchange Rate
As the supply and demand schedules for a currency change over time, the equilibrium exchange rate will also change. Some of the factors that influence currency supply and demand are inflation rates, interest rates, economic growth, and political and economic risks. Section 2.2 shows how expectations about these factors also exert a powerful influence on currency supplies and demands and, hence, on exchange rates.
Relative Inflation Rates.
Suppose that the supply of dollars increases relative to its demand. This excess growth in the money supply will cause inflation in the United States, which means that U.S. prices will begin to rise relative to prices of goods and services in Euroland. Euroland consumers are likely to buy fewer U.S. products and begin switching to Euroland substitutes, leading to a decrease in the amount of euros supplied at every exchange rate. The result is a leftward shift in the euro supply curve to S’ as shown in Exhibit 2.2. Similarly, higher prices in the United States will lead American consumers to substitute Euroland imports for U.S. products, resulting in an increase in the demand for euros as depicted by D’. In effect, both Americans and residents of Euroland are searching for the best deals worldwide and will switch their purchases accordingly as the prices of U.S. goods change relative to prices of goods in Euroland. Hence, a higher rate of inflation in the United States than in Euroland will simultaneously increase Euroland exports to the United States and reduce U.S. exports to Euroland.
Exhibit 2.2 Impact of U.S. Inflation on the Equilibrium Exchange Rate

A new equilibrium rate e1 > e0 results. In other words, a higher rate of inflation in the United States than in Europe will lead to a depreciation of the dollar relative to the euro or, equivalently, to an appreciation of the euro relative to the dollar. In general, a nation running a relatively high rate of inflation will find its currency declining in value relative to the currencies of countries with lower inflation rates. This relationship will be formalized in Chapter 4 as purchasing power parity (PPP).
Relative Interest Rates.
Interest rate differentials will also affect the equilibrium exchange rate. A rise in U.S. interest rates relative to Euroland rates, all else being equal, will cause investors in both nations to switch from euro- to dollar-denominated securities to take advantage of the higher dollar rates. The net result will be depreciation of the euro in the absence of government intervention.
It should be noted that the interest rates discussed here are real interest rates. The real interest rate equals the nominal or actual interest rate minus the rate of inflation. The distinction between nominal and real interest rates is critical in international finance and will be discussed at length in Chapter 4. If the increase in U.S. interest rates relative to Euroland rates just reflects higher U.S. inflation, the predicted result will be a weaker dollar. Only an increase in the real U.S. interest rate relative to the real Euroland rate will result in an appreciating dollar.
Relative Economic Growth Rates.
Similarly, a nation with strong economic growth will attract investment capital seeking to acquire domestic assets. The demand for domestic assets, in turn, results in an increased demand for the domestic currency and a stronger currency, other things being equal. Empirical evidence supports the hypothesis that economic growth should lead to a stronger currency. Conversely, nations with poor growth prospects will see an exodus of capital and weaker currencies.
Political and Economic Risk.
Other factors that can influence exchange rates include political and economic risks. Investors prefer to hold lesser amounts of riskier assets; thus, low-risk currencies—those associated with more politically and economically stable nations—are more highly valued than high-risk currencies.
Application The Ruble Is Rubble
From the breakup of the former Soviet Union in 1991 on, the Russian government had difficulty managing its finances. By spending more than it was collecting in revenues, Russia faced persistent budget deficits financed by issuing short-term Treasury bills and printing rubles. By late 1997, the combination of rapidly increasing debt issuance and falling commodity prices (a major source of Russia’s revenue and foreign exchange comes from exports of oil, timber, gold, and other commodities) increased investors’ doubts that Russia would be able to service its growing debt burden, including $160 billion in foreign debt. Sensing a great opportunity, speculators launched a series of attacks against the Russian ruble. The Russian government responded by repeatedly raising interest rates, which eventually reached 150% by the middle of May 1998. To help support the ruble, the International Monetary Fund (IMF) put together a $23 billion financial package, contingent on Russia’s implementing an adjustment program that stressed boosting tax revenues. When the Russian parliament balked at the tax collection measures, the IMF withheld its funds. Despite the high interest rates it was paying, the government had difficulty persuading investors to roll over their short-term government debt. The stock market sank to new lows, interest rates remained high, and investors began transferring money out of Russia.
Facing accelerating capital flight and mounting domestic problems, the Russian government announced a radical policy shift on August 17, 1998. The key measures included abandonment of its currency supports, suspension of trading in treasury bills combined with a mandatory restructuring of government debt, and a 90-day moratorium on the repayment of corporate and bank debt to foreign creditors (i.e., default). In response, the Russian ruble plunged in value (see Exhibit 2.3). Rather than dealing with the root causes of the financial crisis, the government reverted to previously discarded administrative measures. It imposed extensive controls on the foreign exchange market, increasingly financed its debt by printing more rubles, and forced exporters to surrender 75% of their export earnings. The crisis and the government’s subsequent actions resulted in a steep rise in inflation and a deep recession in Russia, causing a continuing sharp decline in the ruble’s value, shown in Exhibit 2.3.
Exhibit 2.3 The RublE Is Rubble

Source: Pacific Exchange Rate Service, pacific.commerce.ubc.ca/xr/plot.html. ©2000 by Prof. Werner Antweiler, University of British Columbia, Vancouver BC, Canada. Time period shown in diagram: 1/Jan/1998–31/Dec/1999.
Calculating Exchange Rate Changes
Depending on the current value of the euro relative to the dollar, the amount of euro appreciation or depreciation is computed as the fractional increase or decrease in the dollar value of the euro. For example, if the €/$ exchange rate goes from €1 = $0.93 to €1 = $1.09, the euro is said to have appreciated by the change in its dollar value, which is (1.09 − 0.93)/0.93 = 17.20%.
The general formula by which we can calculate the euro’s appreciation or depreciation against the dollar is as follows:

Substituting in the numbers from the previous example (with e0 = $0.93 and e1 = $1.09) yields the 17.20% euro appreciation.
Alternatively, we can calculate the change in the euro value of the dollar. We can do this by recognizing that if e equals the dollar value of a euro (dollars per euro), then the euro value of a dollar (euros per dollar) must be the reciprocal, or 1/e. For example, if the euro is worth $0.93, then the dollar must be worth €1.08 (1/0.93). The change in the euro value of the dollar between time 0 and time 1 equals 1/e1 − 1/e0. In percentage terms, the dollar is said to have depreciated (appreciated) against the euro by the fractional decrease (increase) in the euro value of the dollar:

Employing Equation 2.2, we can find the increase in the euro exchange rate from $0.93 to $1.09 to be equivalent to a dollar depreciation of 14.68% [(0.93 − 0.99)/0.99 =−0.1468]. (Why don’t the two exchange rate changes equal each other?2)
Application Calculating Yen Appreciation Against the Dollar
During 2007, the yen went from $0.0084161 to $0.0089501. By how much did the yen appreciate against the dollar?
Solution. Using Equation 2.1, the yen has appreciated against the dollar by an amount equal to (0.0089501 − 0.0084161)/0.0084161 = 6.34%.
By how much has the dollar depreciated against the yen?
Solution. An exchange rate of ¥1 = $0.0084161 translates into an exchange rate of $1 = ¥118.82 (1/0.0084161 = 118.82). Similarly, the exchange rate of ¥1 = $0.0089501 is equivalent to an exchange rate of $1 = ¥111.73. Using Equation 2.2, the dollar has depreciated against the yen by an amount equal to (111.73 − 118.82)/118.2 =−5.97%.
Application
Calculating Dollar Appreciation Against the Thai Baht
On July 2, 1997, the Thai baht fell 17% against the U.S. dollar. By how much has the dollar appreciated against the baht?
Solution. If e0 is the initial dollar value of the baht and e1 is the post-devaluation exchange rate, then we know from Equation 2.1 that (e1 − e0)/e0 =—17%. Solving for e1 in terms of e0 yields e1 = 0.83e0. From Equation 2.2, we know that the dollar’s appreciation against the baht equals (e0 − e1)/e1 or (e0 − 0.83e0)/0.83e0 = 0.17/.83 = 20.48%.
Application
Calculating Yugoslav Dinar Devaluation Against the Dollar
April 1, 1998, was an ill-fated date in Yugoslavia. On that day, the government devalued the Yugoslav dinar, setting its new rate at 10.92 dinar to the dollar, from 6.0 dinar previously. By how much has the dinar devalued against the dollar?
Solution. The devaluation lowered the dinar’s dollar value from $0.1667 (1/6) to $0.0916 (1/10.92). According to Equation 2.1, the dinar has devalued by (0.0916 − 0.1667)/0.1667 = −45%.
By how much has the dollar appreciated against the dinar?
Solution. Applying Equation 2.2, the dollar has appreciated against the dinar by an amount equal to (10.92 − 6)/6 = 82%.
Application Calculating Afghani Appreciation Against the Pakistani Rupee
The afghani, Afghanistan’s currency, has a perverse tendency to go up whenever sitting governments fall. So as soon as commentators labeled Osama bin Laden the prime suspect in the September 11 World Trade Center attack, currency traders figured that the Taliban would become a target of the United States, bringing prospects of a new government and, perhaps, economic development—and a rise in the afghani’s value. So it has. Under the Taliban, the exchange rate—quoted as the number of Pakistani rupees it takes to buy 100,000 afghanis—fell to around 85 rupees. September 11 galvanized the market. By mid-November 2001, military gains by the Northern Alliance opposition pushed the exchange rate up to 165. By how much had the afghani appreciated against the rupee?
Solution. Applying Equation 2.1, the afghani appreciated against the rupee by an amount equal to (165 − 85)/85 = 94%.
Similarly, between September 11 and mid-November, the dollar went from 78,000 to 34,000 afghanis. By how much did the dollar depreciate against the afghani during this two-month period?
Solution. According to Equation 2.2, the dollar depreciated during this period by an amount equal to (34,000 − 78,000)/78,000 =—56%. Equivalently, the afghani appreciated against the dollar by [(129% ((1/34,000 − 1/78,000)/(1/78,000)].
2 The reason the euro appreciation is unequal to the amount of dollar depreciation depends on the fact that the value of one currency is the inverse of the value of the other one. Hence, the percentage change in currency value differs because the base from which the change is measured differs.
2.2 EXPECTATIONS AND THE ASSET MARKET MODEL OF EXCHANGE RATES
Although currency values are affected by current events and current supply and demand flows in the foreign exchange market, they also depend on expectations—or forecasts—about future exchange rate movements. And exchange rate forecasts, as we will see in Chapter 4, are influenced by every conceivable economic, political, and social factor.
The role of expectations in determining exchange rates depends on the fact that currencies are financial assets and that an exchange rate is simply the relative price of two financial assets—one country’s currency in terms of another’s. Thus, currency prices are determined in the same manner that the prices of assets such as stocks, bonds, gold, or real estate are determined. Unlike the prices of services or products with short storage lives, asset prices are influenced comparatively little by current events. Rather, they are determined by people’s willingness to hold the existing quantities of assets, which in turn depends on their expectations of the future worth of these assets. Thus, for example, frost in Florida can bump up the price of oranges, but it should have little impact on the price of the citrus groves producing the oranges; instead, longer-term expectations of the demand and supply of oranges govern the values of these groves.
Similarly, the value today of a given currency, say, the dollar, depends on whether or not—and how strongly—people still want the amount of dollars and dollar-denominated assets they held yesterday. According to this view—known as the asset market model of exchange rate determination—the exchange rate between two currencies represents the price that just balances the relative supplies of, and demands for, assets denominated in those currencies. Consequently, shifts in preferences can lead to massive shifts in currency values.
For example, during the 1990s, the Cold War ended and the United States became the sole global power. Following a brief recession, the U.S. economy innovated and grew rapidly while Japan and Europe largely stagnated. Capital was attracted to the United States by the strength of its economy, the high after-tax real rate of return, and the favorable political climate—conditions superior to those attainable elsewhere. Foreigners found the United States to be a safer and more rewarding place in which to invest than elsewhere, so they added many more U.S. assets to their portfolios. In response, the dollar soared in value against other currencies.
The desire to hold a currency today depends critically on expectations of the factors that can affect the currency’s future value; therefore, what matters is not only what is happening today but what markets expect will happen in the future. Thus, currency values are forward looking; they are set by investor expectations of their issuing countries’ future economic prospects rather than by contemporaneous events alone. Moreover, in a world of high capital mobility, the difference between having the right policies and the wrong ones has never been greater. This point is illustrated by the Asian currency crisis of 1997.
Mini-Case Asian Currencies Sink in 1997
During the second half of 1997, and beginning in Thailand, currencies and stock markets plunged across East Asia, while hundreds of banks, builders, and manufacturers went bankrupt. The Thai baht, Indonesian rupiah, Malaysian ringgit, Philippine peso, and South Korean won depreciated by 40% to 80% apiece. All this happened despite the fact that Asia’s fundamentals looked good: low inflation; balanced budgets; well-run central banks; high domestic savings; strong export industries; a large and growing middle class; a vibrant entrepreneurial class; and industrious, well-trained, and often well-educated workforces paid relatively low wages. But investors were looking past these positives to signs of impending trouble. What they saw was that many East Asian economies were locked on a course that was unsustainable, characterized by large trade deficits, huge short-term foreign debts, overvalued currencies, and financial systems that were rotten at their core. Each of these ingredients played a role in the crisis and its spread from one country to another.
Loss of Export Competitiveness. To begin, most East Asian countries depend on exports as their engines of growth and development. Along with Japan, the United States is the most important market for these exports. Partly because of this, many of these countries had tied their currencies to the dollar. This tie served them well until 1995, promoting low inflation and currency stability. It also boosted exports at the expense of Japan as the dollar fell against the yen, forcing Japanese companies to shift production to East Asia to cope with the strong yen. Currency stability also led East Asian banks and companies to finance themselves with dollars, yen, and Deutsche marks—some $275 billion worth, much of it short term—because dollar and other foreign currency loans carried lower interest rates than did their domestic currencies. The party ended in 1995, when the dollar began recovering against the yen and other currencies. By mid-1997, the dollar had risen by more than 50% against the yen and by 20% against the German mark. Dollar appreciation alone would have made East Asia’s exports less price competitive. But their competitiveness problem was greatly exacerbated by the fact that during this period, the Chinese yuan depreciated by about 25% against the dollar.3 China exported similar products, so the yuan devaluation raised China’s export competitiveness at East Asia’s expense. The loss of export competitiveness slowed down Asian growth and caused utilization rates—and profits—on huge investments in production capacity to plunge. It also gave the Asian central banks a mutual incentive to devalue their currencies. According to one theory, recognizing these altered incentives, speculators attacked the East Asian currencies almost simultaneously and forced a round of devaluations.4
Moral Hazard and Crony Capitalism. Another theory suggests that moral hazard—the tendency to incur risks that one is protected against—lies at the heart of Asia’s financial problems. Specifically, most Asian banks and finance companies operated with implicit or explicit government guarantees. For example, the South Korean government directed the banking system to lend massively to companies and industries that it viewed as economically strategic, with little regard for their profitability. When combined with poor regulation, these guarantees distorted investment decisions, encouraging financial institutions to fund risky projects in the expectation that the banks would enjoy any profits, while sticking the government with any losses. (These same perverse incentives underlay the savings and loan fiasco in the United States during the 1980s.) In Asia’s case, the problem was compounded by the crony capitalism that is pervasive throughout the region, with lending decisions often dictated more by political and family ties than by economic reality. Billions of dollars in easy-money loans were made to family and friends of the well connected. Without market discipline or risk-based bank lending, the result was overinvestment—financed by vast quantities of debt—and inflated prices of assets in short supply, such as land.5
This financial bubble persists as long as the government guarantee is maintained. The inevitable glut of real estate and excess production capacity leads to large amounts of nonperforming loans and widespread loan defaults. When reality strikes, and investors realize that the government doesn’t have the resources to bail out everyone, asset values plummet and the bubble is burst. The decline in asset values triggers further loan defaults, causing a loss of the confidence on which economic activity depends. Investors also worry that the government will try to inflate its way out of its difficulty. The result is a self-reinforcing downward spiral and capital flight. As foreign investors refuse to renew loans and begin to sell off shares of overvalued local companies, capital flight accelerates and the local currency falls, increasing the cost of servicing foreign debts. Local firms and banks scramble to buy foreign exchange before the currency falls further, putting even more downward pressure on the exchange rate. This story explains why stock prices and currency values declined together and why Asian financial institutions were especially hard hit. Moreover, this process is likely to be contagious, as investors search for other countries with similar characteristics. When such a country is found, everyone rushes for the exit simultaneously and another bubble is burst, another currency is sunk.
The standard approach of staving off currency devaluation is to raise interest rates, thereby making it more attractive to hold the local currency and increasing capital inflows. However, this approach was problematic for Asian central banks. Raising interest rates boosted the cost of funds to banks and made it more difficult for borrowers to service their debts, thereby further crippling an already sick financial sector. Higher interest rates also lowered real estate values, which served as collateral for many of these loans, and pushed even more loans into default. Thus, Asian central banks found their hands were tied and investors recognized that.
The Bubble Bursts. These two stories—loss of export competitiveness and moral hazard in lending combined with crony capitalism—explain the severity of the Asian crisis. Appreciation of the dollar and depreciation of the yen and yuan slowed down Asian economic growth and hurt corporate profits. These factors turned ill-conceived and overleveraged investments in property developments and industrial complexes into financial disasters. The Asian financial crisis then was touched off when local investors began dumping their own currencies for dollars and foreign lenders refused to renew their loans. It was aggravated by politicians, such as those in Malaysia and South Korea, who preferred to blame foreigners for their problems rather than seek structural reforms of their economies. Both foreign and domestic investors, already unnerved by the currency crisis, lost yet more confidence in these nations and dumped more of their currencies and stocks, driving them to record lows.
This synthesized story is consistent with the experience of Taiwan, which is a net exporter of capital and whose savings are largely invested by private capitalists without government direction or guarantees. Taiwanese businesses also are financed far less by debt than by equity. In contrast to its Asian competitors, Taiwan suffered minimally during 1997, with the Taiwan dollar (NT$) down by a modest 15% (to counteract its loss of export competitiveness to China and Japan) and its stock market actually up by 17% in NT$ terms.
“The way out,” said Confucius, “is through the door.” The clear exit strategy for East Asian countries was to restructure their ailing financial systems by shutting down or selling off failing banks (e.g., to healthy foreign banks) and disposing of the collateral (real estate and industrial properties) underlying their bad loans. Although the restructuring has not gone as far as it needs to, the result so far is fewer but stronger and better-capitalized banks and restructured and consolidated industries and a continuation of East Asia’s strong historical growth record. However, progress has been slow in reforming bankruptcy laws, a critical element of reform. Simply put, governments must step aside and allow those who borrow too much or lend too foolishly to fail. Ending government guarantees and politically motivated lending will transform Asia’s financial sector and force cleaner and more transparent financial transactions. The result will be better investment decisions—decisions driven by market forces rather than personal connections or government whim—and healthier economies that attract capital for the right reasons.
Questions
1. What were the origins of the Asian currency crisis?
2. What role did expectations play in the Asian currency crisis?
3. How did the appreciation of the U.S. dollar and depreciation of the yuan affect the timing and magnitude of the Asian currency crisis?
4. What is moral hazard and how did it help cause the Asian currency crisis?
5. Why did so many East Asian companies and banks borrow dollars, yen, and Deutsche marks instead of their local currencies to finance their operations? What risks were they exposing themselves to?
3 For a discussion of the role that the Chinese yuan devaluation played in the Asian crisis, see Kenneth Kasa, “Export Competition and Contagious Currency Crises,” Economic Letter, Federal Reserve Bank of San Francisco, January 16, 1998.
4 See C. Hu and Kenneth Kasa, “A Dynamic Model of Export Competition, Policy Coordination, and Simultaneous Currency Collapse,” working paper, Federal Reserve Bank of San Francisco, 1997.
5 This explanation for the Asian crisis is set forth in Paul Krugman, “What Happened to Asia?” MIT working paper, 1998.
The Nature of Money and Currency Values
To understand the factors that affect currency values, it helps to examine the special character of money. To begin, money has value because people are willing to accept it in exchange for goods and services. The value of money, therefore, depends on its purchasing power. Money also provides liquidity—that is, you can readily exchange it for goods or other assets, thereby facilitating economic transactions. Thus, money represents both a store of value and a store of liquidity. The demand for money, therefore, depends on money’s ability to maintain its value and on the level of economic activity. Hence, the lower the expected inflation rate, the more money people will demand. Similarly, higher economic growth means more transactions and a greater demand for money to pay bills.
The demand for money is also affected by the demand for assets denominated in that currency. The higher the expected real return and the lower the riskiness of a country’s assets, the greater is the demand for its currency to buy those assets. In addition, as people who prefer assets denominated in that currency (usually residents of the country) accumulate wealth, the value of the currency rises.
Because the exchange rate reflects the relative demands for two moneys, factors that increase the demand for the home currency should also increase the price of the home currency on the foreign exchange market. In summary, the economic factors that affect a currency’s foreign exchange value include its usefulness as a store of value, determined by its expected rate of inflation; the demand for liquidity, determined by the volume of transactions in that currency; and the demand for assets denominated in that currency, determined by the risk-return pattern on investment in that nation’s economy and by the wealth of its residents. The first factor depends primarily on the country’s future monetary policy, whereas the latter two factors depend largely on expected economic growth and political and economic stability. All three factors ultimately depend on the soundness of the nation’s economic policies. The sounder these policies, the more valuable the nation’s currency will be; conversely, the more uncertain a nation’s future economic and political course, the riskier its assets will be, and the more depressed and volatile its currency’s value.
Application The Peso Problem
On December 20, 1994, Mexico devalued its peso by 12.7%. Two days later, the government was forced to let the peso float freely, whereupon it quickly fell an additional 15%. By March 1995, the peso had fallen over 25% more, a total of more than 50% altogether (see Exhibit 2.4). Even President Clinton’s dramatic rescue package involving $52 billion in loans and loan guarantees from the United States and various international financial institutions could halt the freefall only temporarily. The story of the peso’s travails illustrates the importance of credibility in establishing currency values. This credibility depends, in part, on the degree of consistency between the government’s exchange rate policy and its other macroeconomic objectives.
Exhibit 2.4 The PESO’S Plunge

Until the devaluation, Mexico had a system under which the peso was allowed to fluctuate within a narrow band against the dollar. Pegging the peso to the dollar helped stabilize Mexico’s economy against hyperinflation. The credibility of this exchange rate regime depended on people believing that Banco de Mexico (Mexico’s central bank) would defend the currency to keep it within this band. As long as investors had confidence in the country’s economic future, this policy worked well. However, that confidence was shaken during 1994 by an armed uprising in the state of Chiapas, assassinations of leading Mexican politicians (including the frontrunning presidential candidate), and high-level political resignations. Another source of concern was the enormous trade deficit, which was about 8% of gross domestic product (GDP) for 1994.
The trade deficit jeopardized future growth: To attract the dollars needed to finance this deficit, the government had to keep interest rates high, especially because interest rates were rising in the United States and around the world. Foreign investors began to bet that this situation was unsustainable, that in order to continue to finance the deficit, Mexico would have to raise interest rates so much that it would damage its economy. Such a rise was unlikely given the political difficulties the government was already facing. At the same time, under pressure from an administration facing a tough election, the central bank permitted a monetary expansion of more than 20% during 1994, leading to fears of rising inflation. Sensing that something had to give, many investors ran for the exits, draining Banco de Mexico’s dollar reserves.
Here is where Mexico made a fundamental error. The central bank did not allow the supply of pesos to fall, even though the various political shocks—and the economic uncertainties they created—reduced the demand for pesos. As investors sold pesos to Banco de Mexico for dollars, reducing the supply of pesos to the level actually demanded, the central bank—fearing that a reduced supply of pesos would cause interest rates to rise (a politically costly step)—put these pesos back into circulation by buying an offsetting amount of government notes and bonds from the public (a process known as sterilization; see Section 2.3). The result was a continuing excess supply of pesos that the central bank kept buying up with its shrinking dollar reserves. Despite this inherent conflict between Mexico’s monetary policy and its exchange rate policy, many investors trusted the government’s adamant promise to maintain the peso’s link with the dollar.
Mexico’s devaluation, therefore, represented an enormous gamble that foreign investors would not lose confidence in the country’s financial markets. The payoff was swift and bloody: The Mexican stock market plunged 11% and interest rates soared as investors demanded higher returns for the new risk in peso securities. At the same time, investors rushed to cash in their pesos, causing Banco de Mexico to lose half its dollar reserves in one day. The next day, the government caved in and floated the peso. It also announced a tightened monetary policy to bolster the peso’s value, along with a package of market-oriented structural reforms to enhance Mexican competitiveness and restore investor confidence. Despite the soundness of these new policies, they were too late; the government’s loss of credibility was so great that the peso’s fall continued until the U.S. rescue plan. Simply put, with the devaluation, Mexico sacrificed its most valuable financial asset—market confidence.
Mexico’s peso problem quickly translated into faltering investor confidence in other countries that, like Mexico, suffered from political turmoil and depended on foreign investors to finance their deficits—including Canada, Italy, and other Latin American nations viewed as having overvalued currencies.
Central Bank Reputations and Currency Values
As the example of Mexico indicates, another critical determinant of currency values is central bank behavior. A central bank is the nation’s official monetary authority; its job is to use the instruments of monetary policy, including the sole power to create money, to achieve one or more of the following objectives: price stability, low interest rates, or a target currency value. As such, the central bank affects the risk associated with holding money. This risk is inextricably linked to the nature of a fiat money, which is nonconvertible paper money. Until 1971, every major currency was linked to a commodity. Today, no major currency is linked to a commodity. With a commodity base, usually gold, there was a stable, long-term anchor to the price level. Prices varied a great deal in the short term, but they eventually returned to where they had been.
With a fiat money, there is no anchor to the price level—that is, there is no standard of value that investors can use to find out what the currency’s future value might be. Instead, a currency’s value is largely determined by the central bank through its control of the money supply. If the central bank creates too much money, inflation will occur and the value of money will fall. Expectations of central bank behavior also will affect exchange rates today; a currency will decline if people think the central bank will expand the money supply in the future.
Viewed this way, money becomes a brand-name product whose value is backed by the reputation of the central bank that issues it. And just as reputations among automobiles vary—from the Mercedes-Benz to the Yugo—currencies come backed by a range of quality reputations—from the dollar, Swiss franc, and Japanese yen on the high side to the Mexican peso, Thai baht, and Russian ruble on the low side. Underlying these reputations is trust in the willingness of the central bank to maintain price stability.
The high-quality currencies are those expected to maintain their purchasing power because they are issued by reputable central banks. A reputable central bank is one that the markets trust to do the right thing, and not merely the politically expedient thing, when it comes to monetary policy. This trust, in turn, comes from history: Reputable banks, such as the Bundesbank (Germany’s central bank), have developed their credibility by having done hard, cruel, and painful things for years in order to fight inflation. In contrast, the low-quality currencies are those that bear little assurance that their purchasing power will be maintained. As in the car market, high-quality currencies sell at a premium, and low-quality currencies sell at a discount (relative to their values based on economic fundamentals alone). That is, investors demand a risk premium to hold a riskier currency, whereas safer currencies will be worth more than their economic fundamentals would indicate.
Price Stability and Central Bank Independence.
Because good reputations are slow to build and quick to disappear, many economists recommend that central banks adopt rules for price stability that are verifiable, unambiguous, and enforceable—along with the independence and accountability necessary to realize this goal.6 Focus is also important. A central bank whose responsibilities are limited to price stability is more likely to achieve this goal. For example, the Bundesbank—a model for many economists—managed to maintain such a low rate of German inflation because of its statutory commitment to price stability, a legacy of Germany’s bitter memories of hyperinflation in the 1920s, which peaked at 200 billion percent in 1923. Absent such rules, the natural accountability of central banks to government becomes an avenue for political influence. For example, even though the U.S. Federal Reserve is an independent central bank, its legal responsibility to pursue both full employment and price stability (aims that conflict in the short term) can hinder its effectiveness in fighting inflation. The greater scope for political influence in central banks that do not have a clear mandate to pursue price stability will in turn add to the perception of inflation risk.
This perception stems from the fact that government officials and other critics routinely exhort the central bank to follow “easier” monetary policies, by which they mean boosting the money supply to lower interest rates. These exhortations arise because many people believe that (1) the central bank can trade off a higher rate of inflation for more economic growth and (2) the central bank determines the rate of interest independently of the rate of inflation and other economic conditions. Despite the questionable merits of these beliefs, central banks—particularly those that are not independent—often respond to these demands by expanding the money supply.
Central banks that lack independence are also often forced to monetize the deficit, which means financing the public sector deficit by buying government debt with newly created money. Whether monetary expansion stems from economic stimulus or deficit financing, it inevitably leads to higher inflation and a devalued currency.
Independent central bankers, on the other hand, are better able to avoid interference from politicians concerned by short-term economic fluctuations. With independence, a central bank can credibly commit itself to a low-inflation monetary policy and stick to it. Absent such a credible commitment, households and businesses will rationally anticipate that monetary policy would have an inflationary bias, resulting in high inflation becoming a self-fulfilling prophecy.7
The link between central bank independence and sound monetary policies is borne out by the empirical evidence.8 Exhibit 2.5a shows that countries whose central banks are less subject to government intervention tend to have lower and less volatile inflation rates and vice versa. The central banks of Germany, Switzerland, and the United States, identified as the most independent in the post–World War II era, also showed the lowest inflation rates from 1951 to 1988. Least independent were the central banks of Italy, New Zealand, and Spain, countries wracked by the highest inflation rates in the industrial world. Moreover, Exhibit 2.5b indicates that this lower inflation rate is not achieved at the expense of economic growth; rather, central bank independence and economic growth seem to go together.
The idea that central bank independence can help establish a credible monetary policy is being put into practice today, as countries that have been plagued with high inflation rates are enacting legislation to reshape their conduct of monetary policy. For example, New Zealand, England, Mexico, Canada, Chile, and Bolivia all have passed laws that mandate an explicit inflation goal or that give their central banks more independence. The focus on creating credible institutions—by granting central banks independence and substituting rules for discretion over monetary policy—has caused inflation to abate worldwide.
Exhibit 2.5 Central Bank Independence, Inflation, and Economic Growth*

* Inflation and economic growth rates calculated for the period 1951–1988.
Source: Adapted from J. Bradford DeLong and Lawrence H. Summers. “Macroeconomic Policy and Long-Run Growth,” Economic Review, Federal Reserve Bank of Kansas City, Fourth Quarter 1992, pp. 14–16.
Application Inflation Dies Down Under
In Germany and Switzerland, long seen as bastions of sound money, inflation rose during the early 1990s. However, Australia and New Zealand, so often afflicted by high inflation, boasted the lowest rates among the nations comprising the Organization for Economic Cooperation and Development (OECD), which consists of all the industrialized nations in the world (see Exhibit 2.6).
Exhibit 2.6 Inflation Dies Down Under

Sources: International Financial Statistics and OECD, various years.
The cure was simple: Restrict the supply of Australian and New Zealand dollars. To increase the likelihood that it would stick to its guns, the Reserve Bank of New Zealand was made fully independent in 1990 and its governor, Donald Brash, was held accountable for cutting inflation to 0%–2% by December 1993. Failure carried a high personal cost: He would lose his job. Exhibit 2.6 shows why Mr. Brash kept his job; by 1993, inflation had fallen to 1.3%, and it has since then held at about 2%. At the same time, growth averaged a rapid 4% a year.
The job of New Zealand’s central banker was made easier by the government’s decision to dismantle one of the OECD’s most taxed, regulated, protectionist, and comprehensive welfare states and transform it into one of the most free-market oriented. By slashing welfare programs and stimulating economic growth through its market reforms and tax and tariff cuts, the government converted its traditionally large budget deficit into a budget surplus and ended the need to print money to finance it. To ensure continued fiscal sobriety, in 1994 parliament passed the Fiscal Responsibility Act, which mandates budgetary balance over the business cycle.
Evidence that even the announcement of greater central bank independence can boost the credibility of monetary policy comes from England. This example shows that institutional change alone can have a significant impact on future expected inflation rates.
Application The Bank of England Gains Independence
On May 6, 1997, within days of the Labour Party’s landslide victory, Britain’s new Chancellor of the Exchequer announced a policy change that he described as “the most radical internal reform to the Bank of England since it was established in 1694.” The reform granted the Bank of England independence from the government in the conduct of monetary policy, meaning that it was now free to pursue its policy goals without political interference and charged it with the task of keeping inflation to 2.5%. The decision was a surprise, coming as it did from the Labour Party, a party with a strong socialist history that traditionally was unsympathetic to low-inflation policies, which it viewed as destructive of jobs. Investors responded to the news by revising downward their expectations of future British inflation. This favorable reaction can be seen by examining the performance of index-linked gilts, which are British government bonds that pay an interest rate that varies with the British inflation rate. One can use the prices of these gilts to estimate the inflation expectations of investors.9 Exhibit 2.7 shows how the expected inflation rate embodied in three different index-linked gilts—maturing in 2001, 2006, and 2016—responded to the Chancellor’s announcement of independence. Over the two-week period surrounding the announcement, the expected inflation rate dropped by 0.60% for the 2016 gilt and by somewhat less for the shorter-maturity gilts. These results indicate that the market perceived that enhanced central bank independence would lead to lower future inflation rates. Consistent with our earlier discussion on the inverse relation between inflation and currency values, the British pound jumped in value against the U.S. dollar and the Deutsche mark on the day of the announcement.
Exhibit 2.7 British Inflation Expectations Fall as the Bank of England Gains Its Independence

Source: Mark M. Spiegel. “British Central Bank Independence and Inflation Expectations,” FRBSF Economic Letter, Federal Reserve Bank of San Francisco, November 28, 1997.
Currency Boards.
Some countries, such as Argentina, have gone even further and established what is in effect a currency board. Under a currency board system, there is no central bank. Instead, the currency board issues notes and coins that are convertible on demand and at a fixed rate into a foreign reserve currency. As reserves, the currency board holds high-quality, interest-bearing securities denominated in the reserve currency. Its reserves are equal to 100%, or slightly more, of its notes and coins in circulation. The board has no discretionary monetary policy. Instead, market forces alone determine the money supply.
Over the past 150 years, more than 70 countries (mainly former British colonies) have had currency boards. As long as they kept their boards, all of those countries had the same rate of inflation as the country issuing the reserve currency and successfully maintained convertibility at a fixed exchange rate into the reserve currency; no board has ever devalued its currency against its anchor currency. Currency boards are successfully operating today in Estonia, Hong Kong, and Lithuania. Argentina dropped its currency board in January 2002.
In addition to promoting price stability, a currency board also compels government to follow a responsible fiscal (spending and tax) policy. If the budget is not balanced, the government must convince the private sector to lend to it; it no longer has the option of forcing the central bank to monetize the deficit. By establishing a monetary authority that is independent of the government and is committed to a conservative monetary policy, currency boards are likely to promote confidence in a country’s currency. Such confidence is especially valuable for emerging economies with a past history of profligate monetary and fiscal policies.
Mini-Case Argentina’s Bold Currency Experiment and Its Demise
Argentina, once the world’s seventh-largest economy, has long been considered one of Latin America’s worst basket cases. Starting with Juan Peron, who was first elected president in 1946, and for decades after, profligate government spending financed by a compliant central bank that printed money to cover the chronic budget deficits had triggered a vicious cycle of inflation and devaluation. High taxes and excessive controls compounded Argentina’s woes and led to an overregulated, arthritic economy. However, in 1991, after the country had suffered nearly 50 years of economic mismanagement, President Carlos Menem and his fourth Minister of Economy, Domingo Cavallo, launched the Convertibility Act. (The first Minister of Economy, Miguel Roig, took one look at the economy and died of a heart attack six days into the job.) This act made the austral (the Argentine currency) fully convertible at a fixed rate of 10,000 australs to the dollar, and by law the monetary supply had to be 100% backed by gold and foreign currency reserves, mostly dollars. This link to gold and the dollar imposed a straitjacket on monetary policy. If, for example, the central bank had to sell dollars to support the currency, the money supply automatically shrank. Better still, the government could no longer print money to finance a budget deficit. In January 1992, the government knocked four zeros off the austral and renamed it the peso, worth exactly $1.
By effectively locking Argentina into the U.S. monetary system, the Convertibility Act had remarkable success in restoring confidence in the peso and providing an anchor for inflation expectations. Inflation fell from more than 2,300% in 1990 to 170% in 1991 and 4% in 1994 (see Exhibit 2.8). By 1997, the inflation rate was 0.4%, among the lowest in the world. Argentine capital transferred overseas to escape Argentina’s hyperinflation began to come home. It spurred rapid economic growth and led to a rock-solid currency. In response to the good economic news, stock prices quintupled, in dollar terms, during the first year of the plan. And the price of Argentina’s foreign debt rose from 13% of its face value in 1990 to 45% in 1992.
Exhibit 2.8 Argentina Ends Hyperinflation

Source: International Financial Statistics, various issues.
The likelihood that the Convertibility Act marked a permanent change in Argentina and would not be revoked at a later date—an important consideration for investors—was increased by the other economic actions the Argentine government took to reinforce its commitment to price stability and economic growth: It deregulated its economy, sold off money-losing state-owned businesses to the private sector, cut taxes and red tape, opened its capital markets, and lowered barriers to trade. In September 1994, the Argentine government announced a sweeping privatization plan designed to sell off all remaining state-owned enterprises—including the national mint, the postal service, and the country’s main airports.
Since then, however, the Argentine economy suffered from a series of external shocks and internal problems. External shocks included falling prices for its agricultural commodities, the Mexican peso crisis in late 1994, the Asian currency crisis of 1997, and the Russian and Brazilian financial crises of 1998–1999. The financial shocks led investors to reassess the risk of emerging markets and to withdraw their capital from Argentina as well as the countries in crisis. The devaluation of the Brazilian real in early 1999—which increased the cost of Argentine goods in Brazil and reduced the cost of Brazilian goods to Argentines—hurt Argentina because of the strong trade ties between the two countries. Similarly, the strong appreciation of the dollar in the late 1990s made Argentina’s products less competitive, both at home and abroad, against those of its trading partners whose currencies were not tied to the dollar.
Internal problems revolved around rigid labor laws that make it costly to lay off Argentine workers and excessive spending by the Argentine government. In a decade that saw GDP rise 50%, public spending rose 90%. Initially, the growth in government spending was funded by privatization proceeds. When these proceeds ran out, the government turned to tax increases and heavy borrowing. The result was massive fiscal deficits, a rising debt burden, high unemployment, economic stagnation, capital flights, and a restive population.
On June 14, 2001, Domingo Cavallo, the treasury secretary for a new Argentine president, announced a dramatic change in policy to stimulate Argentina’s slumping economy, then in its fourth year of recession. Henceforth, the peso exchange rate for exporters and importers would be an average of a dollar and a euro, that is, P1 = $0.50 + €0.50. With the euro then trading at about $0.85, exporters would now receive around 8% more pesos for the dollars they exchanged and importers would have to pay around 8% more for the dollars they bought. Financial markets panicked, fearing that this change was but a prelude to abandonment of the currency board. In response, Cavallo said that his new policy just amounted to a subsidy for exporters and a surcharge on imports and not an attempt to devalue the peso.
Over the next six months, Argentina’s bold currency experiment unraveled amidst political and economic chaos brought about by the failure of Argentine politicians to rein in spending and to reform the country’s labor laws. During the two-week period ending January 1, 2002, Argentina had five different presidents and suspended payments on its $132 billion in public debt, the largest sovereign debt default in history. On January 6, 2002, President Eduardo Duhalde announced that he would end Argentina’s decade-long currency board system. The collapse of the currency board had devastating consequences. Over the next week, the Argentine peso plunged by 50% against the dollar. By year’s end, the peso had depreciated 70%, the government had imposed a draconian banking freeze that sparked violent rioting, and a severe economic contraction took the Argentine economy back to 1993 levels. In effect, forced to choose between the economic liberalization and fiscal discipline that was necessary to save its currency board and the failed economic policies of Peronism, Argentina ultimately chose the latter and wound up with a disaster.
Questions
1. What was the impetus for Argentina’s currency board system?
2. How successful was Argentina’s currency board?
3. What led to the downfall of Argentina’s currency board?
4. What lessons can we learn from the experience of Argentina’s currency board?
The downside of a currency board is that a run on the currency forces a sharp contraction in the money supply and a jump in interest rates. High interest rates slow economic activity, increase bankruptcies, and batter real estate and financial markets. For example, Hong Kong’s currency board weathered the Asian storm and delivered a stable currency but at the expense of high interest rates (300% at one point in October 1997), plummeting stock and real estate markets, and deflation. Short of breaking the Hong Kong dollar’s peg to the U.S. dollar, the government can do nothing about deflation. Instead of being able to ease monetary policy and cut interest rates during a downturn, Hong Kong must allow wages and prices to decline and wait for the global economy to recover and boost demand for the city’s goods and services. Argentina, on the other hand, abandoned its currency board in an attempt to deal with its recession.
One lesson from Argentina’s failed currency board experiment is that exchange rate arrangements are no substitute for good macroeconomic policy. The latter takes discipline and a willingness to say no to special interests. The peso and its currency board collapsed once domestic and foreign investors determined that Argentina’s fiscal policies were unsound, unlikely to improve, and incompatible with the maintenance of a fixed exchange rate. Another lesson is that a nation cannot be forced to maintain a currency arrangement that has outlived its usefulness. As such, no fixed exchange rate system, no matter how strong it appears, is completely sound and credible.
Dollarization.
The ultimate commitment to monetary credibility and a currency good as the dollar is dollarization—the complete replacement of the local currency with the U.S. dollar. The desirability of dollarization depends on whether monetary discipline is easier to maintain by abandoning the local currency altogether than under a system in which the local currency circulates but is backed by the dollar. The experience of Panama with dollarization is instructive. Dollarization began in Panama more than 100 years ago, in 1904. Annual inflation averaged 1% from 1987 to 2007, lower than in the United States; there is no local currency risk; and 30-year mortgages are readily available. These are unusual conditions for a developing country, and they stem from dollarization. The downside of dollarization is the loss of seignorage, the central bank’s profit on the currency it prints. However, this loss is acceptable if the alternative is monetary chaos.
That is what Ecuador decided in 2000. Ecuador’s new government—faced with a plunging currency, accelerating capital flight, a bankrupt banking system, huge budget deficits, in default to foreign creditors, and with its economy in a nosedive—unveiled an economic reform package on January 9, 2000. The centerpiece of that program was the planned replacement of the currency it had used for the past 116 years, the sucre, with the U.S. dollar. As Exhibit 2.9 demonstrates, the announcement of dollarization was enough, by itself, to stabilize the foreign exchange market. The next day, the sucre traded at the new official level of 25,000 per dollar. It remained there, despite nationwide strikes and two changes of government, until September 9, 2000, when Ecuador officially replaced the sucre with the dollar. During the period leading up to that date, some capital returned to Ecuador and the economy began to grow again.
Dollarization by itself, of course, is no guarantee of economic success. It can provide price stability; however, like a currency board, it is not a substitute for sound economic policies. Even the United States, which by definition is dollarized, has its economic ups and downs. To achieve stable economic growth, what is needed are the types of political and economic reforms discussed in Chapter 6. But what dollarization can do is provide the macroeconomic stability that will enhance the impact of these reforms.
Expectations and Currency Values.
The importance of expectations and central bank reputations in determining currency values was dramatically illustrated on June 2, 1987, when the financial markets learned that Paul Volcker was resigning as chairman of the Federal Reserve Board. Within seconds after this news appeared on the ubiquitous video screens used by traders to watch the world, both the price of the dollar on foreign exchange markets and the prices of bonds began a steep decline. By day’s end, the dollar had fallen 2.6% against the Japanese yen, and the price of Treasury bonds declined 2.3%—one of the largest one-day declines ever. The price of corporate bonds fell by a similar amount. All told, the value of U.S. bonds fell by more than $100 billion.
Exhibit 2.9

Source: Pacific Exchange Rate Service, pacific.commerce.ubc.ca/xi/plot.html. © 2000 by Prof. Werner Antweiler, University of British Columbia, Vancouver BC, Canada. Time period shown in diagram: 1 Jan 1999-9 Sep 2000.
The response by the financial markets reveals the real forces that are setting the value of the dollar and interest rates under our current monetary system. On that day, there was no other economic news of note. There was no news about American competitiveness. There was no change in Federal Reserve (Fed) policy or inflation statistics; nor was there any change in the size of the budget deficit, the trade deficit, or the growth rate of the U.S. economy.
What actually happened on that announcement day? Foreign exchange traders and investors simply became less certain of the path U.S. monetary policy would take in the days and years ahead. Volcker was a known inflation fighter. Alan Greenspan, the incoming Fed chairman, was an unknown quantity. The possibility that he would emphasize growth over price stability raised the specter of a more expansive monetary policy. Because the natural response to risk is to hold less of the asset whose risk has risen, investors tried to reduce their holdings of dollars and dollar-denominated bonds, driving down their prices in the process.
The import of what happened on June 2, 1987, is that prices of the dollar and those billions of dollars in bonds were changed by nothing more or less than investors changing their collective assessment of what actions the Fed would or would not take. A critical lesson for businesspeople and policymakers alike surfaces: A shift in the trust that people have for a currency can change its value now by changing its expected value in the future. The level of interest rates is also affected by trust in the future value of money. All else being equal, the greater the trust in the promise that money will maintain its purchasing power, the lower interest rates will be. This theory is formalized in Chapter 4 as the Fisher effect.
Application President Clinton Unnerves the Currency Markets
In early 1994, the U.S. dollar began a steep slide, particularly against the yen (see Exhibit 2.10), that “baffled” President Clinton. He believed that the U.S. economy was stronger than it had been in decades, and therefore the dollar’s weakness was a market mistake. “In the end, the markets will have to respond to the economic realities,” the president said. His critics, however, described the dollar’s travails as a global vote of “no confidence” in his policies. They pointed to President Clinton’s erratic handling of foreign affairs (e.g., Bosnia, Haiti, Somalia, North Korea, Rwanda) and threatened trade sanctions against Japan and China, along with his administration’s tendency to use a weak dollar to bludgeon Japan into opening its markets without any concern that dollar weakness could boost inflation. Investors also noted White House resistance to the Federal Reserve Board’s raising interest rates to stem incipient inflation as well as President Clinton’s appointment of two suspected inflation doves to the Federal Reserve Board. Even worse, the Clinton administration did not appear to be particularly bothered by the dollar’s drop. In June 1994, the administration did and said nothing to support the dollar as it fell to a 50-year low against the yen. At a meeting with reporters on June 21, for example, Treasury Secretary Lloyd Bentsen rebuffed three attempts to get him to talk about the dollar; he would not even repeat the usual platitudes about supporting the dollar.
Exhibit 2.10 The Clinton Dollar

Source: http://www.oanda.com/.
One investment banker summed up the problem. In order to reverse the dollar’s decline, he said, “The U.S. administration must convince the market that it doesn’t favor a continuing dollar devaluation and that it won’t use the dollar as a bargaining chip in trade negotiations with Japan or other countries in the future.”10 Simply put, the administration needed to make credible its belated claim that it saw no advantage in a lower dollar. Finally, investors were not pleased with President Clinton’s domestic economic policy, a policy that sought to sharply boost taxes, spending (on a huge new health care entitlement program), and regulation. Such a policy was unlikely to encourage the high savings and investment and reduced government spending necessary for low inflation and vigorous long-term U.S. economic growth.
By mid-1995, the Clinton Administration, pushed by the Republican takeover of Congress in November 1994, shifted its economic policies to favor a balanced budget and a stable dollar and away from talk of a trade war with Japan. At the same time, rapid growth combined with low inflation made the United States a magnet for capital. In contrast, Japan and Europe exhibited feeble growth. The result was a dramatic turnaround in the fortunes of the dollar.
Mini-Case The U.S. Dollar Sells Off
On September 3, 2003, the finance ministers of the Group of Seven (G7)11 industrialized countries endorsed “flexibility” in exchange rates, a code word widely regarded as an encouragement for China and Japan to stop managing their currencies. Both countries had been actively intervening in the foreign exchange market to weaken their currencies against the dollar and thereby improve their exports. China and Japan had been seen buying billions of dollars in U.S. Treasury bonds. The G7 statement prompted massive selling of the U.S. dollar and dollar assets. The dollar fell 2% against the yen, the biggest one-day drop that year, and U.S. Treasury bonds saw a steep decline in value as well.
Questions
1. How did China and Japan manage to weaken their currencies against the dollar?
2. Why did the U.S. dollar and U.S. Treasury bonds fall in response to the G7 statement?
3. What is the link between currency intervention and China and Japan buying U.S. Treasury bonds?
4. What risks do China and Japan face from their currency intervention?
6 See, for example, W. Lee Hoskins, “A European System of Central Banks: Observations from Abroad,” Economic Commentary, Federal Reserve Bank of Cleveland, November 15, 1990.
7 In 2004, Edward Prescott and Finn Kydland won the Nobel Prize in economics for, among other things, their insights into the relationship between central bank credibility and a low-inflation monetary policy.
8 See, for example, Alberto Alesina, “Macroeconomics and Politics,” in NBER Macroeconomic Annual, 1988 (Cambridge, Mass.: MIT Press, 1988).
9 The methodology used to compute these inflation expectations is described in detail in Mark M. Spiegel, “Central Bank Independence and Inflation Expectations: Evidence from British Index-Linked Gilts,” Economic Review, Federal Reserve Bank of San Francisco, 1998, No. 1, pp. 3–14.
2.3 The Fundamentals of Central Bank Intervention
The exchange rate is one of the most important prices in a country because it links the domestic economy and the rest-of-world economy. As such, it affects relative national competitiveness.
How Real Exchange Rates Affect Relative Competitiveness
We already have seen the link between exchange rate changes and relative inflation rates. The important point for now is that an appreciation of the exchange rate beyond that necessary to offset the inflation differential between two countries raises the price of domestic goods relative to the price of foreign goods. This rise in the real or inflation-adjusted exchange rate—measured as the nominal (or actual) exchange rate adjusted for changes in relative price levels—proves to be a mixed blessing. For example, the rise in the value of the U.S. dollar from 1980 to 1985 translated directly into a reduction in the dollar prices of imported goods and raw materials. As a result, the prices of imports and of products that compete with imports began to ease. This development contributed significantly to the slowing of U.S. inflation in the early 1980s.
However, the rising dollar had some distinctly negative consequences for the U.S. economy as well. Declining dollar prices of imports had their counterpart in the increasing foreign currency prices of U.S. products sold abroad. As a result, American exports became less competitive in world markets, and American-made import substitutes became less competitive in the United States. Domestic sales of traded goods declined, generating unemployment in the traded-goods sector and inducing a shift in resources from the traded- to the non–traded-goods sector of the economy.
Alternatively, home currency depreciation results in a more competitive traded-goods sector, stimulating domestic employment and inducing a shift in resources from the nontraded- to the traded-goods sector. The bad part is that currency weakness also results in higher prices for imported goods and services, eroding living standards and worsening domestic inflation. Exhibit 2.11 presents the various advantages and disadvantages of a strong dollar and a weak dollar.
Exhibit 2.11 Advantages and Disadvantages of a Strong Dollar and a Weak Dollar

From its peak in mid-1985, the U.S. dollar fell by more than 50% during the next few years, enabling Americans to experience the joys and sorrows of both a strong and a weak currency in less than a decade. The weak dollar made U.S. companies more competitive worldwide; at the same time, it lowered the living standards of Americans who enjoyed consuming foreign goods and services. The dollar hit a low point in 1995 and then began to strengthen, largely based on the substantial success that the United States had in taming inflation and the budget deficit and in generating strong economic growth. Exhibit 2.12 charts the value of the U.S. dollar from 1970 to 2008. Despite its substantial rise in the late 1990s, and more recent decline, the dollar is still below the level it achieved back in 1970.
Foreign Exchange Market Intervention
Exhibit 2.12 Tracking the Value of the dollar: 1970–2008

JP Morgan narrow effective exchange rate index and Federal Reserve major currencies index. Data are monthly averages, through June 2005. Source: JP Morgan (through October 2001) and Federal Reserve Statistical Release (November 2001 through June 2008).
Depending on their economic goals, some governments will prefer an overvalued domestic currency, whereas others will prefer an undervalued currency. Still others just want a correctly valued currency, but economic policymakers may feel that the rate set by the market is irrational; that is, they feel they can better judge the correct exchange rate than the marketplace can. The tradeoffs faced by governments in terms of their exchange rate objectives are illustrated by the example of China’s yuan.
Mini-Case A Yen for Yuan
On April 6, 2005, the U.S. Senate voted 67 to 33 to impose a 27.5% tariff on all Chinese products entering the United States if Beijing did not agree to revalue the yuan by a like amount. Almost two years earlier, on September 2, 2003, U.S. Treasury Secretary John Snow had traveled to Beijing to lobby his Chinese counterparts to revalue what was then and still is widely regarded as an undervalued yuan. In the eyes of U.S. manufacturers and labor unions, a cheap yuan gives China’s exports an unfair price advantage over American competitors in the world market and is accelerating the movement of manufacturing jobs to China. One piece of evidence of this problem is the widening U.S. trade deficit with China, which reached $162 billion in 2004 (on about $200 billion in total imports from China). Similarly, Japan, South Korea, and many European and other nations were pushing for China to abandon its fixed exchange rate because a weak U.S. dollar, which automatically lowered the yuan against other currencies, was making already inexpensive Chinese goods unfairly cheap on global markets, hurting their own exports.
China rejected calls for it to revalue its currency and said it would maintain the stability of the yuan. Since 1996, China has fixed its exchange rate at 8.28 yuan to the dollar. During 2004, the dollar depreciated significantly against the euro, giving Chinese companies a competitive advantage against European manufacturers. A massive rise in China’s foreign exchange reserves (reserves rose 47% in 2004, to reach $609.9 billion by the end of the year) is evidence that the Chinese government had been holding its currency down artificially. Politicians and businesspeople in the United States and elsewhere have been calling for the yuan to be revalued, which it almost certainly would in a free market. (Economists estimate that the yuan is currently undervalued by 20% to 30% against the dollar.)
The Chinese government is resisting the clamor for yuan revaluation because of the serious problems it faces. China is often referred to as a “bicycle economy,” meaning that it needs to keep moving forward just to avoid falling down. As the country becomes more market oriented, its money-losing state-owned enterprises must lay off millions of workers. Only flourishing businesses can absorb this surplus labor. The Chinese government is concerned that allowing the yuan to appreciate would stifle the competitiveness of its exports, hurt farmers by making agricultural imports cheaper, and imperil the country’s fragile banking system, resulting in millions of unemployed and disgruntled Chinese wandering the countryside and threatening the stability of its regime. It also justified a weak yuan as a means of fighting the threat of deflation.
Nonetheless, keeping China’s currency peg is not risk free. Foreign currency inflows are rising as investors, many of whom are ordinary Chinese bringing overseas capital back home, bet that China will be forced to revalue its yuan. They are betting on the yuan by purchasing Chinese stocks, real estate, and treasury bonds. To maintain its fixed exchange rate, the Bank of China must sell yuan to buy up all these foreign currency inflows. This intervention boosts China’s foreign exchange reserves but at the expense of a surging yuan money supply, which rose 19.6% in 2003 and 14.6% in 2004. For a time, a rising domestic money supply seemed an appropriate response to an economy that appeared to be on the verge of deflation. More recently, however, rapid money supply growth has threatened inflation and led to roaring asset prices, leading to fears of a speculative bubble in real estate and to excessive bank lending. The latter is particularly problematic as Chinese banks are estimated to already have at least $500 billion in nonperforming loans to bankrupt state companies and unprofitable property developers.
Another risk in pursuing a cheap currency policy is the possibility of stirring protectionist measures in its trading partners. For example, ailing U.S. textile makers lobbied the Bush administration for emergency quotas on Chinese textiles imports, while other manufacturers sought trade sanctions if Beijing would not allow the yuan to rise. Similarly, European government officials have spoken of retaliatory trade measures to force a revalued yuan.
On July 21, 2005, the People’s Bank of China (PBOC) announced a revaluation of the yuan (from 8.28 to 8.11 to the dollar) and a reform of the exchange rate regime. Under the reform, the PBOC would incorporate a reference basket of currencies when choosing its target rate for the currency.
Questions
1. Why is China trying to hold down the value of the yuan? What evidence suggests that China is indeed pursuing a weak currency policy?
2. What benefits does China expect to realize from a weak currency policy?
3. Other things being equal, what would a 27.5% tariff cost American consumers annually on $200 billion in imports from China?
4. Currently, imports from China account for about 10% of total U.S. imports. A 25% appreciation of the yuan would be the equivalent of what percent dollar depreciation? How significant would such a depreciation likely be in terms of stemming America’s appetite for foreign goods?
5. What policy tool is China using to maintain the yuan at an artificially low level? Are there any potential problems with using this policy tool? What might China do to counter these problems?
6. Does an undervalued yuan impose any costs on the Chinese economy? If so, what are they?
7. Suppose the Chinese government were to cease its foreign exchange market intervention and the yuan climbed to five to the dollar. What would be the percentage gain to investors who measure their returns in dollars?
8. Currently, the yuan is not a convertible currency, meaning that Chinese individuals are not permitted to exchange their yuan for dollars to invest abroad. Moreover, companies operating in China must convert all their foreign exchange earnings into yuan. Suppose China were to relax these currency controls and restraints on capital outflows. What would happen to the pressure on the yuan to revalue? Explain.
9. By how much did the yuan appreciate against the dollar on July 21, 2005?
10. What has happened to the yuan exchange rate since July 21, 2005, and how has it affected the U.S. trade deficit with China?
No matter which category they fall in, most governments will be tempted to intervene in the foreign exchange market to move the exchange rate to the level consistent with their goals or beliefs. Foreign exchange market intervention refers to official purchases and sales of foreign exchange that nations undertake through their central banks to influence their currencies.
For example, review Section 2.1 and suppose the United States and Euroland decide to maintain the old exchange rate e0 in the face of the new equilibrium rate e1. According to Exhibit 2.2, the result will be an excess demand for euros equal to Q3 −−− Q2: this euro shortage is the same as an excess supply of (Q3 − Q2)e0 dollars. Either the Federal Reserve (the American central bank), or the European Central Bank (the central bank for Euroland), or both will then have to intervene in the market to supply this additional quantity of euros (to buy up the excess supply of dollars). Absent some change, the United States will face a perpetual balance-of-payments deficit equal to (Q3 − Q2)e0 dollars, which is the dollar value of the Euroland balance-of-payments surplus of (Q3 − Q2) euros.
Mechanics of Intervention.
Although the mechanics of central bank intervention vary, the general purpose of each variant is basically the same: to increase the market demand for one currency by increasing the market supply of another. To see how this purpose can be accomplished, suppose in the previous example that the European Central Bank (ECB) wants to reduce the value of the euro from e1 to its previous equilibrium value of e0. To do so, the ECB must sell an additional (Q3 − Q2) euros in the foreign exchange market, thereby eliminating the shortage of euros that would otherwise exist at e0. This sale of euros (which involves the purchase of an equivalent amount of dollars) will also eliminate the excess supply of (Q3 − Q2)e0 dollars that now exists at e0. The simultaneous sale of euros and purchase of dollars will balance the supply and demand for euros (and dollars) at e0.
If the Fed also wants to raise the value of the dollar, it will buy dollars with euros. Regardless of whether the Fed or the ECB initiates this foreign exchange operation, the net result is the same: The U.S. money supply will fall, and Euroland’s money supply will rise.
Application Switzerland Tries to Stimulate Its Economy by Weakening Its Currency
In March 2003, the Swiss National Bank cut short-term interest rates effectively to zero in an attempt to revive its sinking economy. Once interest rates hit zero, the Swiss central bank had no room to trim rates further to stimulate economic growth and fight deflation. As a substitute for lower interest rates to fight recession and deflation, the Swiss National Bank began weakening its currency (see Exhibit 2.13) by selling Swiss francs in the foreign exchange market. A weakened Swiss franc increases the competitiveness of Swiss exports—45% of the country’s total output of goods and services—by making them relatively less expensive in foreign markets.
Exhibit 2.13 Falling Franc

Sterilized versus Unsterilized Intervention.
The two examples just discussed are instances of unsterilized intervention; that is, the monetary authorities have not insulated their domestic money supplies from the foreign exchange transactions. In both cases, the U.S. money supply will fall, and the Euroland money supply will rise. As noted earlier, an increase (decrease) in the supply of money, all other things held constant, will result in more (less) inflation. Thus, the foreign exchange market intervention will not only change the exchange rate, it will also increase Euroland inflation, while reducing U.S. inflation. Recall that it was the jump in the U.S. money supply that caused this inflation. These money supply changes will also affect interest rates in both countries.
To neutralize these effects, the Fed and/or the ECB can sterilize the impact of their foreign exchange market intervention on the domestic money supply through an open-market operation, which is just the sale or purchase of Treasury securities. For example, the purchase of U.S. Treasury bills (T-bills) by the Fed supplies reserves to the banking system and increases the U.S. money supply. After the open-market operation, therefore, the public will hold more cash and bank deposits and fewer Treasury securities. If the Fed buys enough T-bills, the U.S. money supply will return to its preintervention level. Similarly, the ECB could neutralize the impact of intervention on the Euroland money supply by subtracting reserves from its banking system through sales of euro-denominated securities.
For example, during a three-month period in 2003 alone, the Bank of China issued 250 billion yuan in short-term notes to commercial banks to sterilize the yuan created by its foreign exchange market intervention. The Bank of China also sought to mop up excess liquidity by raising its reserve requirements for financial institutions, forcing banks to keep more money on deposit with it and make fewer loans.
The net result of sterilization should be a rise or fall in the country’s foreign exchange reserves but no change in the domestic money supply. These effects are shown in Exhibit 2.14a, which displays a steep decline in Mexico’s reserves during 1994, while its money supply, measured by its monetary base (currency in circulation plus bank reserves), followed its usual growth path with its usual seasonal variations. As mentioned earlier, Banco de Mexico sterilized its purchases of pesos by buying back government securities. Conversely, Argentina’s currency board precluded its ability to sterilize changes in reserves, forcing changes in Argentina’s monetary base to closely match changes in its dollar reserves, as can be seen in Exhibit 2.14b.
The Effects of Foreign Exchange Market Intervention
Exhibit 2.14 Mexico and Argentina Follow Different Monetary Policies

Source: Wall Street Journal, May 1, 1995, p. A14. Reprinted by permission. ©1995 Dow Jones & Company, Inc. All rights reserved worldwide.
The basic problem with central bank intervention is that it is likely to be either ineffectual or irresponsible. Because sterilized intervention entails a substitution of foreign currency-denominated securities for domestic currency securities,12 the exchange rate will be permanently affected only if investors view domestic and foreign securities as being imperfect substitutes. If this is the case, then the exchange rate and relative interest rates must change to induce investors to hold the new portfolio of securities. For example, if the Bank of Japan sells yen in the foreign exchange market, investors would find themselves holding a larger share of yen assets than before. At prevailing exchange rates, if the public considers assets denominated in yen and in dollars to be imperfect substitutes for each other, people would attempt to sell these extra yen assets to rebalance their portfolios. As a result, the value of the yen would fall below its level absent the intervention.
If investors consider these securities to be perfect substitutes, however, then no change in the exchange rate or interest rates will be necessary to convince investors to hold this portfolio. In this case, sterilized intervention is ineffectual. This conclusion is consistent with the experiences of Mexico as well as those of the United States and other industrial nations in their intervention policies. For example, Exhibit 2.15 shows that a sequence of eight large currency interventions by the Clinton administration between 1993 and 2000 had little effect on the value of the dollar or its direction; exchange rates appear to have been moved largely by basic market forces. Similarly, Mexico ran through about $25 billion in reserves in 1994, and Asian nations ran through more than $100 billion in reserves in 1997 to no avail.
Sterilized intervention could affect exchange rates by conveying information or by altering market expectations. It does this by signaling a change in monetary policy to the market, not by changing market fundamentals, so its influence is transitory.
Exhibit 2.15 THE VISIBLE HAND

Note: Episodes typically involved more than one sale or purchase of dollars over days or weeks. Sources: WSJ Market Data Group, Jeffrey A. Frankel, Wall Street Journal, July 23, 2002, p. A2.
On the other hand, unsterilized intervention can have a lasting effect on exchange rates, but insidiously—by creating inflation in some nations and deflation in others. In the example presented earlier, Euroland would wind up with a permanent (and inflationary) increase in its money supply, and the United States would end up with a deflationary decrease in its money supply. If the resulting increase in Euroland inflation and decrease in U.S. inflation were sufficiently large, the exchange rate would remain at e0 without the need for further government intervention. But it is the money supply changes, and not the intervention by itself, that affect the exchange rate. Moreover, moving the nominal exchange rate from e1 to e0 should not affect the real exchange rate because the change in inflation rates offsets the nominal exchange rate change.
If forcing a currency below its equilibrium level causes inflation, it follows that devaluation cannot be much use as a means of restoring competitiveness. A devaluation improves competitiveness only to the extent that it does not cause higher inflation. If the devaluation causes domestic wages and prices to rise, any gain in competitiveness is quickly eroded. For example, Mexico’s peso devaluation led to a burst of inflation, driving the peso still lower and evoking fears of a continuing inflation-devaluation cycle.
Application Britain Pegs the Pound to the Mark
In early 1987, Nigel Lawson, Britain’s Chancellor of the Exchequer, began pegging the pound sterling against the Deutsche mark (DM). Unfortunately, his exchange rate target greatly undervalued the pound. In order to prevent sterling from rising against the DM, he had to massively intervene in the foreign exchange market by selling pounds to buy marks. The resulting explosion in the British money supply reignited the inflation that Prime Minister Margaret Thatcher had spent so long subduing. With high inflation, the pound fell against the mark and British interest rates surged. The combination of high inflation and high interest rates led first to Lawson’s resignation in October 1989 and then to Thatcher’s resignation a year later, in November 1990.
Of course, when the world’s central banks execute a coordinated surprise attack, the impact on the market can be dramatic—for a short period. Early in the morning on February 27, 1985, for example, Western European central bankers began telephoning banks in London, Frankfurt, Milan, and other financial centers to order the sale of hundreds of millions of dollars; the action—joined a few hours later by the Federal Reserve in New York—panicked the markets and drove the dollar down by 5% that day.
But keeping the market off balance requires credible repetitions. Shortly after the February 27 blitzkrieg, the dollar was back on the rise. The Fed intervened again, but it was not until clear signs of a U.S. economic slowdown emerged that the dollar turned down in March.
10 Quoted in the Wall Street Journal, June 24, 1994, p. C1.
11 The G7 consists of Canada, France, Germany, Italy, Japan, the United Kingdom, and the United States.
12 Central banks typically hold their foreign exchange reserves in the form of foreign currency bonds. Sterilized intervention, therefore, involves selling off some of the central bank’s foreign currency bonds and replacing them with domestic currency ones. Following the intervention, the public will hold more foreign currency bonds and fewer domestic currency bonds.
2.4 The Equilibrium Approach to Exchange Rates
We have seen that changes in the nominal exchange rate are largely affected by variations or expected variations in relative money supplies. These nominal exchange rate changes are also highly correlated with changes in the real exchange rate. Indeed, many commentators believe that nominal exchange rate changes cause real exchange rate changes. As defined earlier, the real exchange rate is the price of domestic goods in terms of foreign goods. Thus, changes in the nominal exchange rate, through their impact on the real exchange rate, are said to help or hurt companies and economies.
Disequilibrium Theory and Exchange Rate Overshooting
One explanation for the correlation between nominal and real exchange rate changes is supplied by the disequilibrium theory of exchange rates.13 According to this view, various frictions in the economy cause goods prices to adjust slowly over time, whereas nominal exchange rates adjust quickly in response to new information or changes in expectations. As a direct result of the differential speeds of adjustment in the goods and currency markets, changes in nominal exchange rates caused by purely monetary disturbances are naturally translated into changes in real exchange rates and can lead to exchange rate “overshooting,” whereby the short-term change in the exchange rate exceeds, or overshoots, the long-term change in the equilibrium exchange rate (see Exhibit 2.16). The sequence of events associated with overshooting is as follows:
• The central bank expands the domestic money supply. In response, the price level will eventually rise in proportion to the money supply increase. However, because of frictions in the goods market, prices do not adjust immediately to their new equilibrium level.
• This monetary expansion depresses domestic interest rates. Until prices adjust fully, households and firms will find themselves holding more domestic currency than they want. Their attempts to rid themselves of excess cash balances by buying bonds will temporarily drive down domestic interest rates (bond prices and interest rates move inversely).
• Capital begins flowing out of the country because of the lower domestic interest rates, causing an instantaneous and excessive depreciation of the domestic currency. In order for the new, lower domestic interest rates to be in equilibrium with foreign interest rates, investors must expect the domestic currency to appreciate to compensate for lower interest payments with capital gains. Future expected domestic currency appreciation, in turn, requires that the exchange rate temporarily over-shoot its eventual equilibrium level. After initially exceeding its required depreciation, the exchange rate will gradually appreciate back to its new long-run equilibrium.
This view underlies most popular accounts of exchange rate changes and policy discussions that appear in the media. It implies that currencies may become overvalued or undervalued relative to equilibrium, and that these disequilibria affect international competitiveness in ways that are not justified by changes in comparative advantage.
However, the disequilibrium theory has been criticized by some economists in recent years, in part because one of its key predictions has not been upheld. Specifically, the theory predicts that as domestic prices rise, with a lag, so should the exchange rate. However, the empirical evidence is inconsistent with this predicted positive correlation between consumer prices and exchange rates.
Exhibit 2.16 Exchange Rate Overshooting According to the Disequilibrium Theory of Exchange Rates

13 The most elegant presentation of a disequilibrium theory is in Rudiger Dornbusch, “Expectations and Exchange Rate Dynamics,” Journal of Political Economy, December 1976, pp. 1161-1176.
The Equilibrium Theory of Exchange Rates and Its Implications
In place of the disequilibrium theory, some economists have suggested an equilibrium approach to exchange rate changes.14 The basis for the equilibrium approach is that markets clear—supply and demand are equated—through price adjustments. Real disturbances to supply or demand in the goods market cause changes in relative prices, including the real exchange rate. These changes in the real exchange rate often are accomplished, in part, through changes in the nominal exchange rate. Repeated shocks in supply or demand thereby create a correlation between changes in nominal and real exchange rates.
The equilibrium approach has three important implications for exchange rates. First, exchange rates do not cause changes in relative prices but are part of the process through which the changes occur in equilibrium; that is, changes in relative prices and in real exchange rates occur simultaneously, and both are related to more fundamental economic factors.
Second, attempts by government to affect the real exchange rate via foreign exchange market intervention will fail. The direction of causation runs from the real exchange rate change to the nominal exchange rate change, not vice versa; changing the nominal exchange rate by altering money supplies will affect relative inflation rates in such a way as to leave the real exchange rate unchanged.
Finally, there is no simple relation between changes in the exchange rate and changes in international competitiveness, employment, or the trade balance. With regard to the latter, trade deficits do not cause currency depreciation, nor does currency depreciation by itself help reduce a trade deficit.
Some of the implications of the equilibrium approach may appear surprising. They conflict with many of the claims that are commonly made in the financial press and by politicians; they also seem to conflict with experience. But according to the equilibrium view of exchange rates, many of the assumptions and statements commonly made in the media are simply wrong, and experiences may be very selective.
Econometric testing of these models is in its infancy, but there is some evidence that supports the equilibrium models, although it is far from conclusive. According to the disequilibrium approach, sticky prices cause changes in the nominal exchange rate to be converted into changes in the real exchange rate. But as prices eventually adjust toward their new equilibrium levels, the real exchange rate should return to its equilibrium value. Monetary disturbances, then, should create temporary movements in real exchange rates. Initial decreases in the real exchange rate stemming from a rise in the money supply should be followed by later increases as nominal prices rise to their new equilibrium level.
Statistical evidence, however, indicates that changes in real exchange rates tend, on average, to be nearly permanent or to persist for very long periods of time. The evidence also indicates that changes in nominal exchange rates—even very short-term, day-to-day changes—are largely permanent. This persistence is inconsistent with the view that monetary shocks, or even temporary real shocks, cause most of the major changes in real exchange rates. On the other hand, it is consistent with the view that most changes in real exchange rates are due to real shocks with a large permanent component. Changes in real and nominal exchange rates are also highly correlated and have similar variances, supporting the view that most changes in nominal exchange rates are due to largely permanent, real disturbances.
An alternative explanation is that we are seeing the effects of a sequence of monetary shocks, so that even if any given exchange rate change is temporary, the continuing shocks keep driving the exchange rate from its long-run equilibrium value. Thus, the sequence of these temporary changes is a permanent change. Moreover, if the equilibrium exchange rate is itself constantly subject to real shocks, we would not expect to see reversion in real exchange rates. The data do not allow us to distinguish between these hypotheses.
Another feature of the data is that the exchange rate varies much more than the ratio of price levels. The equilibrium view attributes this “excess variability” to shifts in demand and/or supply between domestic and foreign goods; the shifts affect the exchange rate but not relative inflation rates. Supply-and-demand changes also operate indirectly to alter relative prices of foreign and domestic goods by affecting the international distribution of wealth.
Although the equilibrium theory of exchange rates is consistent with selected empirical evidence, it may stretch its point too far. Implicit in the equilibrium theory is the view that money is just a unit of account—a measuring rod for value—with no intrinsic value. However, because money is an asset, it is possible that monetary and other policy changes, by altering the perceived usefulness and importance of money as a store of value or liquidity, could alter real exchange rates. The evidence presented earlier that changes in anticipated monetary policy can alter real exchange rates supports this view. Moreover, the equilibrium theory fails to explain a critical fact: The variability of real exchange rates has been much greater when currencies are floating than when they are fixed. This fact is easily explained, if we view money as an asset, by the greater instability in relative monetary policies in a floating rate system. The real issue then is not whether monetary policy—including its degree of stability—has any impact at all on real exchange rates but whether that impact is of first- or second-order importance.
Despite important qualifications, the equilibrium theory of exchange rates provides a useful addition to our understanding of exchange rate behavior. Its main contribution is to suggest an explanation for exchange rate behavior that is consistent with the notion that markets work reasonably well if they are permitted to work.
14 See, for example, Alan C. Stockman, “The Equilibrium Approach to Exchange Rates,” Economic Review, Federal Reserve Bank of Richmond, March-April 1987, pp. 12-30. This section is based on his article.
CHAPTER 3 The International Monetary System

The monetary and economic disorders of the past fifteen years … are a reaction to a world monetary system that has no historical precedent. We have been sailing on uncharted waters and it has been taking time to learn the safest routes.
Milton Friedman

Winner of Nobel Prize in Economics
Learning Objectives
• To distinguish between a free float, a managed float, a target-zone arrangement, and a fixed-rate system of exchange rate determination
• To describe how equilibrium in the foreign exchange market is achieved under alternative exchange rate systems, including a gold standard
• To identify the three categories of central bank intervention under a managed float
• To describe the purposes, operation, and consequences of the European Monetary System
• To describe the origins, purposes, and consequences of the European Monetary Union and the euro
• To identify the four alternatives to devaluation under a system of fixed exchange rates
• To explain the political realities that underlie government intervention in the foreign exchange market
• To describe the history and consequences of the gold standard
• To explain why the postwar international monetary system broke down
• To describe the origins of and proposed mechanisms to deal with the various emerging market currency crises that have occurred during the past two decades
Key Terms
austerity
Bank for International Settlements (BIS)
“beggar-thy-neighbor” devaluation
Bretton Woods Agreement
Bretton Woods system
clean float
Common Market
conditionality
dirty float
euro
European Central Bank
European Community (EC)
European Currency Unit (ECU)
European Monetary System (EMS)
European Monetary Union (EMU)
European Union (EU)
exchange-rate mechanism (ERM)
fiat money
fixed-rate system
free float
G-5 nations
G-7 nations
gold standard
International Bank for Reconstruction and Development (World Bank)
International Monetary Fund (IMF)
international monetary system
lender of last resort
Louvre Accord
Maastricht criteria
Maastricht Treaty
managed float
monetary union
moral hazard
optimum currency area
par value
Plaza Agreement
price-specie-flow mechanism
privatization
seigniorage
Smithsonian Agreement
Special Drawing Right (SDR)
Stability and Growth Pact
target-zone arrangement
Over the past six decades, increasing currency volatility has subjected the earnings and asset values of multinational corporations, banks, and cross-border investors to large and unpredictable fluctuations in value. These currency problems have been exacerbated by the breakdown of the postwar international monetary system established at the Bretton Woods Conference in 1944. The main features of the Bretton Woods system were the relatively fixed exchange rates of individual currencies in terms of the U.S. dollar and the convertibility of the dollar into gold for foreign official institutions. These fixed exchange rates were supposed to reduce the riskiness of international transactions, thus promoting growth in world trade.
However, in 1971, the Bretton Woods system fell victim to the international monetary turmoil it was designed to avoid. It was replaced by the present regime of rapidly fluctuating exchange rates, resulting in major problems and opportunities for multinational corporations. The purpose of this chapter is to help managers, both financial and nonfinancial, understand what the international monetary system is and how the choice of system affects currency values. It also provides a historical background of the international monetary system to enable managers to gain perspective when trying to interpret the likely consequences of new policy moves in the area of international finance. After all, although the types of government foreign exchange policies may at times appear to be limitless, they are all variations on a common theme.
3.1 Alternative Exchange Rate Systems
The international monetary system refers primarily to the set of policies, institutions, practices, regulations, and mechanisms that determine the rate at which one currency is exchanged for another. This section considers five market mechanisms for establishing exchange rates: free float, managed float, target-zone arrangement, fixed-rate system, and the current hybrid system.
As we shall see, each of these mechanisms has costs and benefits associated with it. Nations prefer economic stability and often equate this objective with a stable exchange rate. However, fixing an exchange rate often leads to currency crises if the nation attempts to follow a monetary policy that is inconsistent with that fixed rate. At the same time, a nation may decide to fix its exchange rate in order to limit the scope of monetary policy, as in the case of currency boards described in Chapter 2. On the other hand, economic shocks can be absorbed more easily when exchange rates are allowed to float freely, but freely floating exchange rates may exhibit excessive volatility, which hurts trade and stifles economic growth. The choice of a particular exchange rate mechanism depends on the relative importance that a given nation at a given point in time places on the trade-offs associated with these different systems.
Free Float
We already have seen that free-market exchange rates are determined by the interaction of currency supplies and demands. The supply-and-demand schedules, in turn, are influenced by price level changes, interest differentials, and economic growth. In a free float, as these economic parameters change—for example, because of new government policies or acts of nature—market participants will adjust their current and expected future currency needs. In the two-country example of Germany and the United States, the shifts in the euro supply-and-demand schedules will, in turn, lead to new equilibrium positions. Over time, the exchange rate will fluctuate randomly as market participants assess and react to new information, much as security and commodity prices in other financial markets respond to news. These shifts and oscillations are illustrated in Exhibits 3.1 and 3.2a for the dollar/euro exchange rate; Dt and St are the hypothetical euro demand and supply curves, respectively, for period t. Exhibit 3.2b shows how the dollar/euro exchange rate actually changed during a seven-day period in May 2008. Such a system of freely floating exchange rates is usually referred to as a clean float.
Managed Float
Exhibit 3.1 Supply and Demand Curve ShifTS

Not surprisingly, few countries have been able to long resist the temptation to intervene actively in the foreign exchange market in order to reduce the economic uncertainty associated with a clean float. The fear is that too abrupt a change in the value of a nation’s currency could imperil its export industries (if the currency appreciates) or lead to a higher rate of inflation (if the currency depreciates). Moreover, the experience with floating rates has not been encouraging. Instead of reducing economic volatility, as they were supposed to do, floating exchange rates appear to have increased it. Exchange rate uncertainty also reduces economic efficiency by acting as a tax on trade and foreign investment. Therefore, most countries with floating currencies have attempted, through central bank intervention, to smooth out exchange rate fluctuations. Such a system of managed exchange rates, called a managed float, is also known as a dirty float.
Exhibit 3.2A Fluctuating Exchange Rates

Exhibit 3.2B ACTUAL CHANGES in the Dollar/Euro Exchange rate: May 1–9, 2008

Source: St. Louis Federal Reserve Bank Web site. http://research.stlouisfed.org/fred2/
Managed floats fall into three distinct categories of central bank intervention. The approaches, which vary in their reliance on market forces, are as follows:
1.
Smoothing out daily fluctuations.
Governments following this route attempt only to preserve an orderly pattern of exchange rate changes. Rather than resisting fundamental market forces, these governments occasionally enter the market on the buy or sell side to ease the transition from one rate to another; the smoother transition tends to bring about longer-term currency appreciation or depreciation. One variant of this approach is the “crawling peg” system used at various times by some countries, such as Poland, Russia, Brazil, and Costa Rica. Under a crawling peg, the local currency depreciates against a reference currency or currency basket on a regular, controlled basis. For example, during the 1990s, the Polish zloty depreciated by 1% a month against a basket of currencies. Currently, the Costa Rican colon depreciates by about 0.7% per month against the dollar.
2.
“Leaning against the wind.”
This approach is an intermediate policy designed to moderate or prevent abrupt short- and medium-term fluctuations brought about by random events whose effects are expected to be only temporary. The rationale for this policy—which is primarily aimed at delaying, rather than resisting, fundamental exchange rate adjustments—is that government intervention can reduce for exporters and importers the uncertainty caused by disruptive exchange rate changes. It is questionable, however, whether governments are more capable than private forecasters of distinguishing between fundamental and temporary (irrational) values.
3.
Unofficial pegging.
This strategy evokes memories of a fixed-rate system. It involves resisting, for reasons clearly unrelated to exchange market forces, any fundamental upward or downward exchange rate movements. Thus, Japan historically has resisted revaluation of the yen for fear of its consequences for Japanese exports. With unofficial pegging, however, there is no publicly announced government commitment to a given exchange rate level.
Target-Zone Arrangement
Many economists and policymakers have argued that the industrialized countries could minimize exchange rate volatility and enhance economic stability if the United States, Germany, and Japan linked their currencies in a target-zone system. Under a target-zone arrangement, countries adjust their national economic policies to maintain their exchange rates within a specific margin around agreed-upon, fixed central exchange rates. Such a system existed for the major European currencies participating in the European Monetary System and was the precursor to the euro, which is discussed later in this chapter.
Fixed-Rate System
Under a fixed-rate system, such as the Bretton Woods system, governments are committed to maintaining target exchange rates. Each central bank actively buys or sells its currency in the foreign exchange market whenever its exchange rate threatens to deviate from its stated par value by more than an agreed-on percentage. The resulting coordination of monetary policy ensures that all member nations have the same inflation rate. Put another way, for a fixed-rate system to work, each member must accept the group’s joint inflation rate as its own. A corollary is that monetary policy must become subordinate to exchange rate policy. In the extreme case, those who fix their exchange rate via a currency board system surrender all control of monetary policy. The money supply is determined solely by people’s willingness to hold the domestic currency.
With or without a currency board system, there is always a rate of monetary growth (it could be negative) that will maintain an exchange rate at its target level. If it involves monetary tightening, however, maintaining the fixed exchange rate could mean a high interest rate and a resultant slowdown in economic growth and job creation.
Under the Bretton Woods system, whenever the commitment to the official rate became untenable, the rate was abruptly changed and a new rate was announced publicly. Currency devaluation or revaluation, however, was usually the last in a string of temporizing alternatives for solving a persistent balance-of-payments deficit or surplus. These alternatives, which are related only in their lack of success, included foreign borrowing to finance the balance-of-payments deficit, wage and price controls, import restrictions, and exchange controls. The last have become a way of life in many developing countries. Nations with overvalued currencies often ration foreign exchange, whereas countries facing revaluation (an infrequent situation) may restrict capital inflows.
In effect, government controls supersede the allocative function of the foreign exchange market. The most drastic situation occurs when all foreign exchange earnings must be surrendered to the central bank, which, in turn, apportions these funds to users on the basis of government priorities. The buying and selling rates need not be equal, nor need they be uniform across all transaction categories. Exhibit 3.3 lists the most frequently used currency control measures. These controls are a major source of market imperfection, providing opportunities as well as risks for multinational corporations.
Exhibit 3.3 TyPICAL CURRENCY CONTROL MEASURES

Austerity brought about by a combination of reduced government expenditures and increased taxes can be a permanent substitute for devaluation. By reducing the nation’s budget deficit, austerity will lessen the need to monetize the deficit. Lowering the rate of money supply growth, in turn, will bring about a lower rate of domestic inflation (disinflation). Disinflation will strengthen the currency’s value, ending the threat of devaluation. However, disinflation often leads to a short-run increase in unemployment, a cost of austerity that politicians today generally consider to be unacceptable.
The Current System of Exchange Rate Determination
The current international monetary system is a hybrid, with major currencies floating on a managed basis, some currencies freely floating, and other currencies moving in and out of various types of pegged exchange rate relationships. Exhibit 3.4 presents a currency map that describes the various zones and blocs linking the world’s currencies as of July 31, 2006.
3.2 A Brief History of the International Monetary System
Almost from the dawn of history, gold has been used as a medium of exchange because of its desirable properties. It is durable, storable, portable, easily recognized, divisible, and easily standardized. Another valuable attribute of gold is that short-run changes in its stock are limited by high production costs, making it costly for governments to manipulate. Most important, because gold is a commodity money, it ensures a longrun tendency toward price stability. The reason is that the purchasing power of an ounce of gold, or what it will buy in terms of all other goods and services, will tend toward equality with its long-run cost of production.
For these reasons, most major currencies, until fairly recently, were on a gold standard, which defined their relative values or exchange rates. The gold standard essentially involved a commitment by the participating countries to fix the prices of their domestic currencies in terms of a specified amount of gold. The countries maintained these prices by being willing to buy or sell gold to anyone at that price. For example, from 1821 to 1914, Great Britain maintained a fixed price of gold at £4.2474 per ounce. The United States, from 1834 to 1933, maintained the price of gold at $20.67 per ounce (with the exception of the Greenback period from 1861 to 1878). Thus, from 1834 to 1914 (with the exception of 1861 to 1878), the dollar:pound exchange rate, referred to as the par exchange rate, was perfectly determined at

Exhibit 3.4 Exchange Rate Arrangements (as of July 31, 2006)

The value of gold relative to other goods and services does not change much over long periods of time, so the monetary discipline imposed by a gold standard should ensure long-run price stability for both individual countries and groups of countries. Indeed, there was remarkable long-run price stability in the period before World War I, during which most countries were on a gold standard. As Exhibit 3.5 shows, price levels at the start of World War I were roughly the same as they had been in the late 1700s before the Napoleonic Wars began.
This record is all the more remarkable when contrasted with the post–World War II inflationary experience of the industrialized nations of Europe and North America. As shown in Exhibit 3.6, 1995 price levels in all these nations were several times as high as they were in 1950. Even in Germany, the value of the currency in 1995 was only one-quarter of its 1950 level, whereas the comparable magnitude was less than one-tenth for France, Italy, and the United Kingdom. Although there were no episodes of extremely rapid inflation, price levels rose steadily and substantially.
The Classical Gold Standard
A gold standard is often considered an anachronism in our modern, high-tech world because of its needless expense; on the most basic level, it means digging up gold in one corner of the globe for burial in another corner. Nonetheless, until recently, discontent with the current monetary system, which produced more than two decades of worldwide inflation and widely fluctuating exchange rates, prompted interest in a return to some form of a gold standard. (This interest has abated somewhat with the current low inflation environment.)
To put it bluntly, calls for a new gold standard reflect a fundamental distrust of government’s willingness to maintain the integrity of fiat money. Fiat money is nonconvertible paper money backed only by faith that the monetary authorities will not cheat (by issuing more money). This faith has been tempered by hard experience; the 100% profit margin on issuing new fiat money has proved to be an irresistible temptation for most governments.
By contrast, the net profit margin on issuing more money under a gold standard is zero. The government must acquire more gold before it can issue more money, and the government’s cost of acquiring the extra gold equals the value of the money it issues. Thus, expansion of the money supply is constrained by the available supply of gold. This fact is crucial in understanding how a gold standard works.
Exhibit 3.5 Wholesale Price Indices: Pre–World War I

Exhibit 3.6 CONSUMER PRICE INDICES (CPI): POST-WORLD WAR II

Under the classical gold standard, disturbances in the price level in one country would be wholly or partly offset by an automatic balance-of-payments adjustment mechanism called the price-specie-flow mechanism. (Specie refers to gold coins.) To see how this adjustment mechanism worked to equalize prices among countries and automatically bring international payments back in balance, consider the example in Exhibit 3.7.
Suppose a technological advance increases productivity in the non-gold-producing sector of the U.S. economy. This productivity will lower the price of other goods and services relative to the price of gold, and the U.S. price level will decline. The fall in U.S. prices will result in lower prices of U.S. exports; export prices will decline relative to import prices (determined largely by supply and demand in the rest of the world). Consequently, foreigners will demand more U.S. exports, and Americans will buy fewer imports.
Starting from a position of equilibrium in its international payments, the United States will now run a balance-of-payments surplus. The difference will be made up by a flow of gold into the United States. The gold inflow will increase the U.S. money supply (under a gold standard, more gold means more money in circulation), reversing the initial decline in prices. At the same time, the other countries will experience gold outflows, reducing their money supplies (less gold, less money in circulation) and, thus, their price levels. In final equilibrium, price levels in all countries will be slightly lower than they were before because of the increase in the worldwide supply of other goods and services relative to the supply of gold. Exchange rates will remain fixed.
Thus, the operation of the price-specie-flow mechanism tended to keep prices in line for those countries that were on the gold standard. As long as the world was on a gold standard, all adjustments were automatic; and although many undesirable things might have happened under a gold standard, lasting inflation was not one of them.
Gold does have a cost, however—the opportunity cost associated with mining and storing it. By the late 1990s, with inflation on the wane worldwide, the value of gold as an inflation hedge had declined. Central banks also began selling their gold reserves and replacing them with U.S. Treasury bonds, which, unlike gold, pay interest. The reduced demand for gold lowered its price and its usefulness as a monetary asset. However, with financial system risk on the rise, culminating in the subprime debacle of 2007–2008, a declining dollar, and inflation resurfacing, gold reemerged as a safe haven from market turmoil. From March 2002 to March 2008, the price of gold rose from about $300/oz to more than $1,000/oz.
Exhibit 3.7 The Price-Specie-Flow Mechanism

How the Classical Gold Standard Worked in Practice: 1821–1914
In 1821, after the Napoleonic Wars and their associated inflation, England returned to the gold standard. From 1821 to 1880, more and more countries joined the gold standard. By 1880, most nations of the world were on some form of gold standard. The period from 1880 to 1914, during which the classical gold standard prevailed in its most pristine form, was a remarkable period in world economic history. The period was characterized by a rapid expansion of virtually free international trade, stable exchange rates and prices, a free flow of labor and capital across political borders, rapid economic growth, and, in general, world peace. Advocates of the gold standard harken back to this period as illustrating the standard’s value.
Opponents of a rigid gold standard, in contrast, point to some less-than-idyllic economic conditions during this period: a major depression during the 1890s, a severe economic contraction in 1907, and repeated recessions. Whether these sharp ups and downs could have been prevented under a fiat money standard cannot be known.
The Gold Exchange Standard and Its Aftermath: 1925–1944
The gold standard broke down during World War I and was briefly reinstated from 1925 to 1931 as the Gold Exchange Standard. Under this standard, the United States and England could hold only gold reserves, but other nations could hold both gold and dollars or pounds as reserves. In 1931, England departed from gold in the face of massive gold and capital flows, owing to an unrealistic exchange rate, and the Gold Exchange Standard was finished.
Competitive Devaluations.
After the devaluation of sterling, 25 other nations devalued their currencies to maintain trade competitiveness. These “beggar-thy-neighbor” devaluations, in which nations cheapened their currencies to increase their exports at others’ expense and to reduce imports, led to a trade war. Many economists and policymakers believed that the protectionist exchange rate and trade policies fueled the global depression of the 1930s.
Bretton Woods Conference and the Postwar Monetary System.
To avoid such destructive economic policies in the future, the Allied nations agreed to a new postwar monetary system at a conference held in Bretton Woods, New Hampshire, in 1944. The conference also created two new institutions—the International Monetary Fund (IMF) and the International Bank for Reconstruction and Development (World Bank)—to implement the new system and to promote international financial stability. The IMF was created to promote monetary stability, whereas the World Bank was set up to lend money to countries so they could rebuild their infrastructure that had been destroyed during the war.
Role of the IMF.
Both agencies have seen their roles evolve over time. The IMF now oversees exchange rate policies in member countries (currently totaling 182 nations) and advises developing countries about how to turn their economies around. In the process, it has become the lender of last resort to countries that get into serious financial trouble. It explores new ways to monitor financial health of member nations so as to prevent another Mexico-like surprise. Despite these efforts, the IMF was blindsided by the Asian crisis and wound up leading a $118 billion attempt to shore up Asian financial systems. It was also blindsided by the Russian crisis a year later. Critics argue that by bailing out careless lenders and imprudent nations, IMF rescues make it too easy for governments to persist with bad policies and for investors to ignore the risks these policies create. In the long run, by removing from governments and investors the prospect of failure—which underlies the market discipline that encourages sound policies—these rescues magnify the problem of moral hazard and so make imprudent policies more likely to recur.1 Moral hazard refers here to the perverse incentives created for international lenders and borrowers by IMF bailouts. Anticipating further IMF bailouts, investors underestimate the risks of lending to governments that persist in irresponsible policies.
In theory, the IMF makes short-term loans conditional on the borrower’s implementation of policy changes that will allow it to achieve self-sustaining economic growth. This is the doctrine of conditionality. However, a review of the evidence suggests that the IMF creates long-term dependency. For example, 41 countries have been receiving IMF credit for 10 to 20 years, 32 countries have been borrowing from the IMF for between 20 and 30 years, and 11 nations have been relying on IMF loans for more than 30 years. This evidence explains why IMF conditionality has little credibility.
1 As economist Allan H. Meltzer puts it, “Capitalism without failure is like religion without sin. It doesn’t work. Bankruptcies and losses concentrate the mind on prudent behavior.”
Role of the World Bank.
The World Bank is looking to expand its lending to developing countries and to provide more loan guarantees for businesses entering new developing markets. But here, too, there is controversy. Specifically, critics claim that World Bank financing allows projects and policies to avoid being subject to the scrutiny of financial markets and permits governments to delay enacting the changes necessary to make their countries more attractive to private investors. Moreover, critics argue that the World Bank should take the money it is now lending to countries such as China with investment grade ratings and to poor countries that achieve little from the loans and reallocate these freed-up funds to poor countries that make credible efforts to raise their living standards. In this way, the World Bank would accomplish far more poverty reduction with its resources.
Role of the Bank for International Settlements.
Another key institution is the Bank for International Settlements (BIS), which acts as the central bank for the industrial countries’ central banks. The BIS helps central banks manage and invest their foreign exchange reserves and, in cooperation with the IMF and the World Bank, helps the central banks of developing countries, mostly in Latin America and Eastern Europe. The BIS also holds deposits of central banks so that reserves are readily available.
Application Competitive Devaluations in 2003
Unfortunately, despite Bretton Woods, competitive devaluations have not disappeared. According to the Wall Street Journal (June 6, 2003, p. B12), “A war of competitive currency devaluations is rattling the $1.2 trillion-a-day global foreign exchange market…. The aim of the devaluing governments: to steal growth and markets from others, while simultaneously exporting their problems, which in this case is the threat of deflation.”
Currency analysts argue that the environment in 2003—of slow growth and the threat of deflation—encouraged countries such as Japan, China, and the United States to pursue a weak currency policy. For example, analysts believe that the Bush administration looked for a falling dollar to boost U.S. exports, lift economic growth, battle deflationary pressure, push the Europeans to cut interest rates, and force Japan to overhaul its stagnant economy.
The weapons in this war included policy shifts, foreign exchange market intervention, and interest rates. For example, the foreign exchange market widely viewed the Bush administration as having abandoned the long-standing strong-dollar policy and welcoming a weaker dollar.
Japan tried to keep its currency from rising against the dollar by selling a record ¥3.98 billion ($33.4 billion) in May 2003 alone. A strong yen hurts Japanese exports and growth and aggravates deflationary tendencies. On the other hand, if Japan succeeded in pushing down the yen sufficiently, South Korea and Taiwan could try to devalue their currencies to remain competitive.
China, meanwhile, stuck with an undervalued yuan to bolster its economy. Another currency analyst attributed Canadas growth since 1993 to an undervalued Canadian dollar: “They’ve been the beggar-thy-neighbor success story.”2 On June 5, 2003, the European Central Bank entered the competitive devaluation fray by cutting the euro interest rate by a half percent-age point. From mid-2002 to mid-2003, the euro had appreciated by 27% against the dollar, making European business less profitable and less competitive and hurting European growth.
The ultimate fear: an ongoing round of competitive devaluations that degenerates into the same kind of pre-Bretton Woods protectionist free-for-all that brought on the Great Depression.
2 Michael R. Sesit, “Currency Conflict Shakes Market,” Wall Street Journal, June 6, 2003, B12.
The Bretton Woods System: 1946–1971
Under the Bretton Woods Agreement, implemented in 1946, each government pledged to maintain a fixed, or pegged, exchange rate for its currency vis-à-vis the dollar or gold. As one ounce of gold was set equal to $35, fixing a currency’s gold price was equivalent to setting its exchange rate relative to the dollar. For example, the Deutsche mark (DM) was set equal to 1/140 of an ounce of gold, meaning it was worth $0.25 ($35/140). The exchange rate was allowed to fluctuate only within 1% of its stated par value (usually less in practice).
The fixed exchange rates were maintained by official intervention in the foreign exchange markets. The intervention took the form of purchases and sales of dollars by foreign central banks against their own currencies whenever the supply-and-demand conditions in the market caused rates to deviate from the agreed-on par values. The IMF stood ready to provide the necessary foreign exchange to member nations defending their currencies against pressure resulting from temporary factors.3 Any dollars acquired by the monetary authorities in the process of such intervention could then be exchanged for gold at the U.S. Treasury, at a fixed price of $35 per ounce.
These technical aspects of the system had important practical implications for all trading nations participating in it. In principle, the stability of exchange rates removed a great deal of uncertainty from international trade and investment transactions, thus promoting their growth for the benefit of all the participants. Also, in theory, the functioning of the system imposed a degree of discipline on the participating nations’ economic policies.
For example, a country that followed policies leading to a higher rate of inflation than that experienced by its trading partners would experience a balance-of-payments deficit as its goods became more expensive, reducing its exports and increasing its imports. The necessary consequences of the deficit would be an increase in the supply of the deficit country’s currency on the foreign exchange markets. The excess supply would depress the exchange value of that country’s currency, forcing its authorities to intervene. The country would be obligated to “buy” with its reserves the excess supply of its own currency, effectively reducing the domestic money supply. Moreover, as the country’s reserves were gradually depleted through intervention, the authorities would be forced, sooner or later, to change economic policies to eliminate the source of the reserve-draining deficit. The reduction in the money supply and the adoption of restrictive policies would reduce the country’s inflation, thus bringing it in line with the rest of the world.
In practice, however, governments perceived large political costs accompanying any exchange rate changes. Most governments also were unwilling to coordinate their monetary policies, even though this coordination was necessary to maintain existing currency values.
The reluctance of governments to change currency values or to make the necessary economic adjustments to ratify the current values of their currencies led to periodic foreign exchange crises. Dramatic battles between the central banks and the foreign exchange markets ensued. Those battles invariably were won by the markets. However, because devaluation or revaluation was used only as a last resort, exchange rate changes were infrequent and large.
In fact, Bretton Woods was a fixed exchange rate system in name only. Of 21 major industrial countries, only the United States and Japan had no change in par value from 1946 to 1971. Of the 21 countries, 12 devalued their currencies more than 30% against the dollar, four had revaluations, and four were floating their currencies by mid-1971 when the system collapsed. The deathblow came on August 15, 1971, when President Richard Nixon, convinced that the “run” on the dollar was reaching alarming proportions, abruptly ordered U.S. authorities to terminate convertibility even for central banks. At the same time, he devalued the dollar to deal with America’s emerging trade deficit.
The fixed exchange rate system collapsed along with the dissolution of the gold standard. There are two related reasons for the collapse of the Bretton Woods system. First, inflation reared its ugly head in the United States. In the mid-1960s, the Johnson administration financed the escalating war in Vietnam and its equally expensive Great Society programs by, in effect, printing money instead of raising taxes. This lack of monetary discipline made it difficult for the United States to maintain the price of gold at $35 an ounce.
Second, the fixed exchange rate system collapsed because some countries—primarily West Germany, Japan, and Switzerland—refused to accept the inflation that a fixed exchange rate with the dollar would have imposed on them. Thus, the dollar depreciated sharply relative to the currencies of those three countries.
3 The IMF supplemented its foreign exchange reserves in 1969 by creating a new reserve asset, the Special Drawing Right or SDR. The SDR serves as the IMF’s unit of account. It is a currency basket whose value is the weighted average of the currencies of five nations (United States, Germany, France, Japan, and Great Britain; the euro is the currency used for France and Germany). The weights, which are based on the relative importance of each country in international trade, are updated periodically.
The Post–Bretton Woods System: 1971 to the Present
In December 1971, under the Smithsonian Agreement, the dollar was devalued to 1/38 of an ounce of gold, and other currencies were revalued by agreed-on amounts vis-à-vis the dollar. After months of such last-ditch efforts to set new fixed rates, the world officially turned to floating exchange rates in 1973.
Application OPEC and the Oil Crisis of 1973-1974
October 1973 marked the beginning of successful efforts by the Organization of Petroleum Exporting Countries (OPEC) to raise the price of oil. By 1974, oil prices had quadrupled. Nations responded in various ways to the vast shift of resources to the oil-exporting countries. Some nations, such as the United States, tried to offset the effect of higher energy bills by boosting spending, pursuing expansionary monetary policies, and controlling the price of oil. The result was high inflation, economic dislocation, and a misallocation of resources without bringing about the real economic growth that was desired. Other nations, such as Japan, allowed the price of oil to rise to its market level and followed more prudent monetary policies.
The first group of nations experienced balance-of-payments deficits because their governments kept intervening in the foreign exchange market to maintain overvalued currencies; the second group of nations, along with the OPEC nations, wound up with balance-of-payments surpluses. These surpluses were recycled to debtor nations, setting the stage for the international debt crisis of the 1980s.
Exhibit 3.8 charts the ups and downs of the dollar against the Japanese yen and British pound from 1973 to early 2008. During 1977 and 1978, the value of the dollar plummeted, and U.S. balance-of-payments difficulties were exacerbated as the Carter administration pursued an expansionary monetary policy that was significantly out of line with other strong currencies. The turnaround in the dollar’s fortunes can be dated to October 6, 1979, when the Fed (under its new chairman, Paul Volcker) announced a major change in its conduct of monetary policy. From then on, in order to curb inflation, it would focus its efforts on stabilizing the money supply, even if that meant more volatile interest rates. Before this date, the Fed had attempted to stabilize interest rates, indirectly causing the money supply to be highly variable.
This shift had its desired effect on both the inflation rate and the value of the U.S. dollar. During President Ronald Reagan’s first term in office (1981–1984), inflation plummeted and the dollar rebounded extraordinarily. This rebound has been attributed to vigorous economic expansion in the United States and to high real interest rates (owing largely to strong U.S. economic growth) that combined to attract capital from around the world.
The dollar peaked in March 1985 and then began a long downhill slide. The slide is largely attributable to changes in government policy and the slowdown in U.S. economic growth relative to growth in the rest of the world.
By September 1985, the dollar had fallen about 15% from its March high, but this decline was considered inadequate to dent the growing U.S. trade deficit. In late September 1985, representatives of the Group of Five, or G-5 nations (the United States, France, Japan, Great Britain, and West Germany), met at the Plaza Hotel in New York City. The outcome was the Plaza Agreement, a coordinated program designed to force down the dollar against other major currencies and thereby improve American competitiveness.
The policy to bring down the value of the dollar worked too well. The dollar slid so fast during 1986 that the central banks of Japan, West Germany, and Britain reversed their policies and began buying dollars to stem the dollar’s decline.
Exhibit 3.8 Value of the U.S. Dollar in Terms of Yen and Pounds: 1973–2008

Source: Federal Reserve Bank of St. Louis, http://research.stlouisfed.org/fred/categories/95.
Believing that the dollar had declined enough and in fact showed signs of “overshooting” its equilibrium level, the United States, Japan, West Germany, France, Britain, Canada, and Italy—also known as the Group of Seven, or G-7 nations—met again in February 1987 and agreed to an ambitious plan to slow the dollar’s fall. The Louvre Accord, named for the Paris landmark where it was negotiated, called for the G-7 nations to support the falling dollar by pegging exchange rates within a narrow, undisclosed range, while they also moved to bring their economic policies into line.
As always, however, it proved much easier to talk about coordinating policy than to change it. The hoped-for economic cooperation faded, and the dollar continued to
Beginning in early 1988, the U.S. dollar rallied somewhat and then maintained its strength against most currencies through 1989. It fell sharply in 1990 but then stayed basically flat in 1991 and 1992, while posting sharp intrayear swings. The dollar began falling again in 1993, particularly against the yen and DM, and it fell throughout most of 1994 and 1995 before rallying again in 1996. The dollar continued its upward direction through December 2001 owing to the sustained strength of the U.S. economy. Even after the U.S. economy began to slow in late 2000, it still looked strong compared to those of its major trading partners. However, in 2002, the sluggishness of the U.S. economy and low U.S. interest rates, combined with the fear of war in Iraq (and later the actual war) and concerns over the large U.S. trade and budget deficits, resulted in a significant decline in the value of the dollar relative to the euro and other currencies. This decline continued through early 2008 despite U.S. economic recovery in the mid-2000s. The dollar then rose in mid-2008 as it became a safe haven currency during the global economic crisis. The dollar’s future course is unpredictable given the absence of an anchor for its value.
Exhibit 3.9 Effects of Government Actions and Statements on the Value of the 1987 Dollar

Application Swiss Franc Provides a Safe Haven After September 11
Following the terrorist attacks on the World Trade Center and the Pentagon, the Swiss franc soared in value as investors sought a safe haven no longer provided by the United States. The Swiss franc rose still further after Afghanistan’s Taliban leaders declared a holy war against the United States and the United States faced a bioterrorism threat from anthrax (see Exhibit 3.10). However, the ensuing war in Afghanistan and military successes there, combined with renewed prospects for a U.S. recovery, brought a reminder of American strength—and a stronger dollar. As the Swiss franc lost some of its luster, it fell toward its pre–September 11 value.
Exhibit 3.10 The Swiss Franc Rises and Then Falls in the Aftermath of September 11, 2001

Source: U.S. Federal Reserve System. Rates are noon buying rates in New York City for cable transfers. Data for 9/11/01 are missing owing to the shutdown of financial trading in New York City following the destruction of the World Trade Center.
Application Global Financial Crisis Boosts the Dollar
In 2008, the United States faced its worst financial crisis since the Great Depression. However, an observer would not know that from watching the dollar. Rather than sinking under the weight of hundreds of billions of dollars in mortgage write-offs, trillions of dollars in lost wealth from plummeting stock prices and home values, a financial sector that required a $700 billion bailout, and a tanking economy, the dollar jumped in value against most other currencies (see Exhibit 3.11). The reason is simple: The dollar benefited from the global flight from risky assets, and the corresponding demand for U.S. Treasury bonds, as well as the unwinding of risky investments made with borrowed dollars, all of which increased the demand for dollars. Moreover, it was clear that economic and banking woes were not unique to the United States. Amid the financial crisis, the U.S. dollar reclaimed its status as the world’s safe haven during tumultuous times.
Exhibit 3.11 U.S. Dollar Rises on Global Financial Crisis

Source: Federal Reserve Bank of St. Louis
Assessment of the Floating-Rate System
At the time floating rates were adopted in 1973, proponents said that the new system would reduce economic volatility and facilitate free trade. In particular, floating exchange rates would offset international differences in inflation rates so that trade, wages, employment, and output would not have to adjust. High-inflation countries would see their currencies depreciate, allowing their firms to stay competitive without having to cut wages or employment. At the same time, currency appreciation would not place firms in low-inflation countries at a competitive disadvantage. Real exchange rates would stabilize, even if permitted to float in principle, because the underlying conditions affecting trade and the relative productivity of capital would change only gradually; and if countries would coordinate their monetary policies to achieve a convergence of inflation rates, then nominal exchange rates would also stabilize.
Increasing Currency Volatility.
The experience to date, however, is disappointing. The dollar’s ups and downs have had little to do with actual inflation and a lot to do with expectations of future government policies and economic conditions. Put another way, real exchange rate volatility has increased, not decreased, since floating began. This instability reflects, in part, nonmonetary (or real) shocks to the world economy, such as changing oil prices and shifting competitiveness among countries, but these real shocks were not obviously greater during the 1980s or 1990s than they were in earlier periods. Instead, uncertainty over future government policies has increased.
Given this evidence, a number of economists and others have called for a return to fixed exchange rates. To the extent that fixed exchange rates more tightly constrain the types of monetary and other policies governments can pursue, this approach should make expectations less volatile and, hence, promote exchange rate stability.
Requirements for Currency Stability.
Although history offers no convincing model for a system that will lead to long-term exchange rate stability among major currencies, it does point to two basic requirements. First, the system must be credible. If the market expects an exchange rate to be changed, the battle to keep it fixed is already lost. Second, the system must have price stability built into its very core. Without price stability, the system will not be credible. Recall that under a fixed-rate system, each member must accept the group’s inflation rate as its own. Only a zero rate of inflation will be mutually acceptable. If the inflation rate is much above zero, prudent governments will defect from the system.
Even with tightly coordinated monetary policies, freely floating exchange rates would still exhibit some volatility because of real economic shocks. However, this volatility is not necessarily a bad thing because it could make adjustment to these shocks easier. For example, it has been argued that flexible exchange rates permitted the United States to cope with the buildup in defense spending in the early 1980s and the later slowdown in defense spending. Increased U.S. defense spending expanded aggregate U.S. demand and shifted output toward defense. The stronger dollar attracted imports and thereby helped satisfy the civilian demand. As the United States cut back on defense spending, the weakening dollar helped boost U.S. exports, making up for some of the decline in defense spending. To the extent that this argument is correct, the dollar’s movements helped buffer the effects of defense spending shifts on American living standards.
Individual countries can peg their currencies to the dollar or other benchmark currency. However, the Asian and other crises demonstrate that the only credible system for such pegging is a currency board or dollarization. Every other system is too subject to political manipulation and can be too easily abandoned. Even a currency board can come unglued, as we saw in the case of Argentina, if the government pursues sufficiently wrong-headed economic policies.
An alternative system for a fixed-rate system is monetary union. Under monetary union, individual countries replace their local currencies with a common currency. An example of monetary union is the United States, with all 50 states sharing the same dollar. In a far-reaching experiment, Europe embarked on monetary union in 1999, following its experiences with the European Monetary System.
3.3 THE EUROPEAN MONETARY SYSTEM AND MONETARY UNION
The European Monetary System (EMS) began operating in March 1979. Its purpose was to foster monetary stability in the European Community (EC), also known as the Common Market. As part of this system, the members established the European Currency Unit, which played a central role in the functioning of the EMS. The European Currency Unit (ECU) was a composite currency consisting of fixed amounts of the 12 European Community member currencies. The quantity of each country’s currency in the ECU reflects that country’s relative economic strength in the European Community. The ECU functioned as a unit of account, a means of settlement, and a reserve asset for the members of the EMS. In 1992, the EC became the European Union (EU). The EU currently has 25 member states.
The Exchange Rate Mechanism
At the heart of the system was an exchange rate mechanism (ERM), which allowed each member of the EMS to determine a mutually agreed-on central exchange rate for its currency; each rate was denominated in currency units per ECU. These central rates attempted to establish equilibrium exchange values, but members could seek adjustments to the central rates.
Central rates established a grid of bilateral cross-exchange rates between the currencies. Nations participating in the ERM pledged to keep their currencies within a 15% margin on either side of these central cross-exchange rates (±2.25% for the DM/guilder cross rate). The upper and lower intervention levels for each currency pair were found by applying the appropriate margin to their central cross-exchange rate.
The original intervention limits were set at 2.25% above and below the central cross rates (Spain and Britain had 6% margins) but were later changed. Despite good intentions, the ERM came unglued in a series of speculative attacks that began in 1992. By mid-1993, the EMS had slipped into a two-tiered system. One tier consisted of a core group of currencies tightly anchored by the DM. That tier included the Dutch guilder; the French, Belgian, and Luxembourg francs; and at times the Danish krone. The other tier consisted of weaker currencies such as those of Spain, Portugal, Britain, Italy, and Ireland.
Lessons from the European Monetary System
A review of the European Monetary System and its history provides valuable insights into the operation of a target-zone system and illustrates the problems that such mechanisms are likely to encounter. Perhaps the most important lesson the EMS illustrates is that the exchange rate stability afforded by any target-zone arrangement requires a coordination of economic policy objectives and practices. Nations should achieve convergence of those economic variables that directly affect exchange rates—variables such as fiscal deficits, monetary growth rates, and real economic growth differentials.
Although the system helped keep its member currencies in a remarkably narrow zone of stability between 1987 and 1992, it had a history of ups and downs. By January 12, 1987, when the last realignment before September 1992 occurred, the values of the EMS currencies had been realigned 12 times despite heavy central bank intervention. Relative to their positions in March 1979, the Deutsche mark and the Dutch guilder soared, while the French franc and the Italian lira nose-dived. Between 1979 and 1988, the franc devalued relative to the DM by more than 50%.
The reason for the past failure of the European Monetary System to provide the currency stability it promised is straightforward: Germany’s economic policymakers, responding to an electorate hypersensitive to inflation, put a premium on price stability; in contrast, the French pursued a more expansive monetary policy in response to high domestic unemployment. Neither country was willing to permit exchange rate considerations to override political priorities.
The experience of the EMS also demonstrates once again that foreign exchange market intervention not supported by a change in a nation’s monetary policy has only a limited influence on exchange rates.
The Currency Crisis of September 1992
The same attempt to maintain increasingly misaligned exchange rates in the EMS occurred again in 1992. And once again, the system broke down—in September 1992.
The Catalyst.
The catalyst for the September currency crisis was the Bundesbank’s decision to tighten monetary policy and force up German interest rates both to battle inflationary pressures associated with the spiraling costs of bailing out the former East Germany and to attract the inflows of foreign capital needed to finance the resulting German budget deficit. To defend their currency parities with the DM, the other member countries had to match the high interest rates in Germany (see Exhibit 3.12). The deflationary effects of high interest rates were accompanied by a prolonged economic slump and even higher unemployment rates in Britain, France, Italy, Spain, and most other EMS members.
As the costs of maintaining exchange rate stability rose, the markets began betting that some countries with weaker economies would devalue their currencies or withdraw them from the ERM altogether rather than maintain painfully high interest rates at a time of rising unemployment.
The High Cost of Intervention.
To combat speculative attacks on their currencies, nations had to raise their interest rates dramatically: 15% in Britain and Italy, 13.75% in Spain, 13% in France, and an extraordinary 500% in Sweden. They also intervened aggressively in the foreign exchange markets. British, French, Italian, Spanish, and Swedish central banks together spent the equivalent of roughly $100 billion trying to prop up their currencies, with the Bank of England reported to have spent $15 billion to $20 billion in just one day to support the pound. The Bundesbank spent another $50 billion in DM to support the ERM. All to no avail.
On September 14, the central banks capitulated but not before losing an estimated $4 billion to $6 billion in their mostly futile attempt to maintain the ERM. Despite these costly efforts, Britain and Italy were forced to drop out of the ERM, and Spain, Portugal, and Ireland devalued their currencies within the ERM. In addition, Sweden, Norway, and Finland were forced to abandon their currencies’ unofficial links to the ERM.
Abandonment of the Exchange Rate Mechanism in August 1993
The final straw was the currency crisis of August 1993, which actually was touched off on July 29, 1993, when the Bundesbank left its key lending rate, the discount rate, unchanged. Traders and investors had been expecting the Bundesbank to cut the discount rate to relieve pressure on the French franc and other weak currencies within the ERM. As had happened the year before, however, the Bundesbank largely disregarded the pleas of its ERM partners and concentrated on reining in 4.3% German inflation and its fast-growing money supply. Given the way the ERM worked, and the central role played by the Deutsche mark, other countries could not both lower interest rates and keep their currencies within their ERM bands unless Germany did so.
The Catalyst.
The French franc was the main focus of the ERM struggle. With high real interest rates, recession, and unemployment running at a post–World War II high of 11.6%, speculators doubted that France had the willpower to stay with the Bundesbank’s tight monetary policy and keep its interest rates high, much less raise them to defend the franc. Speculators reacted logically: They dumped the French franc and other European currencies and bought DM, gambling that economic pressures, such as rising unemployment and deepening recession, would prevent these countries from keeping their interest rates well above those in Germany. In other words, speculators bet—rightly, as it turned out—that domestic priorities would ultimately win out despite governments’ pledges to the contrary.
Governments Surrender to the Market.
Despite heavy foreign exchange market intervention (the Bundesbank alone spent $35 billion trying to prop up the franc), the devastating assault by speculators on the ERM forced the franc to its ERM floor. Other European central banks also intervened heavily to support the Danish krone, Spanish peseta, Portuguese escudo, and Belgian franc, which came under heavy attack as well.
It was all to no avail, however. Without capital controls or a credible commitment to move to a single currency in the near future, speculators could easily take advantage of a one-sided bet. The result was massive capital flows that overwhelmed the central banks’ ability to stabilize exchange rates. Over the weekend of July 31 to August 1, the EU finance ministers agreed essentially to abandon the defense of each other’s currencies and the European Monetary System became a floating-rate system in all but name only.
Exhibit 3.12 Defending the Erm Required High Interest rates in Europe

Source: Data from OECD and Federal Reserve, September 30, 1992.
A Postmortem on the EMS.
The currency turmoil of 1992 to 1993 showed once again that a genuinely stable European Monetary System, and eventually a single currency, requires the political will to direct fiscal and monetary policies at that European goal and not at purely national ones. In showing that they lacked that will, European governments proved once again that allowing words to run ahead of actions is a recipe for failure.
On the other hand, despite its problems, the EMS did achieve some significant success. By improving monetary policy coordination among its member states, the EMS succeeded in narrowing inflation differentials in Europe. Inflation rates tended to converge toward Germany’s lower rate as other countries adjusted their monetary policies to more closely mimic Germany’s low-inflation policy (see Exhibit 3.13). For example, in 1980, the gap between the highest inflation rate (Italy’s 21.2%) and the lowest (West Germany’s 5.2%) was 16 percentage points. By 1990, the gap had narrowed to less than 4 percentage points.
To summarize, the EMS was based on Germany’s continuing ability to deliver low inflation rates and low real interest rates. As long as Germany lived up to its end of the bargain, the benefits to other EMS members of following the Bundesbank’s policies would exceed the costs. But once the German government broke that compact by running huge and inflationary deficits, the costs to most members of following a Bundesbank monetary policy designed to counter the effects of the government’s fiscal policies exceeded the benefits. Put another way, the existing exchange rates became unrealistic given what would have been required of the various members to maintain those exchange rates. In the end, there was no real escape from market forces.
European Monetary Union
Exhibit 3.13 The European Monetary System Forces Convergence toward Germany’s Inflation Rate

Many politicians and commentators pointed to the turmoil in the EMS as increasing the need for the European Union to move toward monetary union. This view prevailed and was formalized in the Maastricht Treaty. Under this treaty, the EU nations would establish a single central bank with the sole power to issue a single European currency called the euro as of January 1, 1999. On that date, conversion rates would be locked in for member currencies, and the euro would became a currency, although euro coins and bills would not be available until 2002. All went as planned. Francs, marks, guilders, schillings, and other member currencies were phased out until, on January 1, 2002, the euro replaced them all.
Maastricht Convergence Criteria.
In order to join the European Monetary Union, European nations were supposed to meet tough standards on inflation, currency stability, and deficit spending. According to these standards, known as the Maastricht criteria, government debt could be no more than 60% of gross domestic product (GDP), the government budget deficit could not exceed 3% of GDP, the inflation rate could not be more than 1.5 percentage points above the average rate of Europe’s three lowest-inflation nations, and long-term interest rates could not be more than 2 percentage points higher than the average interest rate in the three lowest-inflation nations. The restrictions on budget deficits and debt, codified in the Stability and Growth Pact, were designed to impose fiscal discipline on imprudent governments and stop them from undermining the euro. It should be noted that most countries, including Germany, fudged some of their figures through one-time maneuvers (redefining government debt or selling off government assets) or fudged the criteria (Italy’s debt/GDP ratio was 121%) in order to qualify. Nonetheless, on May 2, 1998, the European parliament formally approved the historic decision to launch the euro with 11 founder nations—Germany, France, Italy, Spain, the Netherlands, Belgium, Finland, Portugal, Austria, Ireland, and Luxembourg. Britain, Sweden, and Denmark opted out of the launch. On January 1, 2001, Greece became the twelfth country to join the euro-zone, followed by Slovenia (2007), then Cyprus and Malta (2008), and Slovakia (2009). Britain is currently debating whether to join EMU and retire the pound sterling (see Mini-Case: Britain—In or Out for the Euro, p. 134).
Launch of the Euro.
As planned, on January 1, 1999, the 11 founding member countries of the European Monetary Union (EMU) surrendered their monetary autonomy to the new European Central Bank and gave up their right to create money; only the European Central Bank is now able to do so. Governments can issue bonds denominated in euros, just as individual American states can issue dollar bonds. However, like California or New York, member nations are unable to print the currency needed to service their debts. Instead, they can only attract investors by convincing them they have the financial ability (through taxes and other revenues) to generate the euros to repay their debts. The conversion rates between the individual national currencies and the euro are presented in Exhibit 3.14.
EMU and the European Welfare State.
The truth is that monetary union is as much about reining in the expensive European welfare state and its costly regulations as it is about currency stability. Because of high taxes, generous social welfare and jobless benefits, mandatory worker benefit packages, and costly labor market regulations that make it expensive to hire and difficult to fire workers—all of which reduce incentives to work, save, invest, and create jobs—and diminished competitiveness—fostered by onerous regulations on business as well as state subsidies and government protection to ailing industries—job growth has been stagnant throughout Western Europe for three decades. (Western Europe failed to create a single net new job from 1973 to 1994, a period in which the United States generated 38 million net new jobs.) As a result, the European unemployment rate in the late 1990s was averaging about 12% (in contrast to less than 5% for the United States). However, although crucial for strong and sustained economic growth, limiting the modern welfare state is politically risky; too many people live off the state.
Exhibit 3.14 Conversion Rates for the Euro

Enter the Maastricht Treaty. European governments could blame the strict Maastricht criteria they had to meet to enter the EMU for the need to take the hard steps that most economists believe are necessary for ending economic stagnation: curbing social welfare expenditures, including overly generous pension, unemployment, and health care benefits and costly job creation programs; reducing costly regulations on business; increasing labor market flexibility (primarily by lowering the cost to companies of hiring and firing workers and relaxing collective-bargaining rules); cutting personal, corporate, and payroll taxes (the latter exceed 42% of gross wages in Germany); and selling off state-owned enterprises (a process known as privatization). Thus, the greatest benefit from monetary union likely will be the long-term economic gains that come from the fiscal discipline required for entry. If, however, Europe does not take this opportunity to reform its economic policies, the costs of monetary union will be high because member nations no longer will be able to use currency or interest rate adjustments to compensate for the pervasive labor market rigidities and expensive welfare programs that characterize the modern European economy.
Application Sweden Rejects the Euro
On September 14, 2003, Swedish voters soundly rejected a proposal to adopt the euro and kept the krona, despite the overwhelming support of the nation’s business and political establishment and a last-minute wave of sympathy following the stabbing death of the country’s popular and pro-euro foreign minister, Anna Lindh. A critical reason for the defeat: fears that adhering to the budget rules necessary to become a member of EMU would force Sweden to become more competitive and cut taxes. That, in turn, would compel Sweden to slash its generous and expensive cradle-to-grave social welfare system. Moreover, when Swedish voters went to the polls, the Swedish economy was stronger than the Euroland economy, its budget was in surplus (in contrast to large Euroland deficits), and unemployment was well below the Euroland average. The European Central Bank was criticized for keeping interest rates too high for too long, stifling growth, and Euroland cooperation on fiscal policy was in disarray (with the rules for budget deficits under the Maastricht criteria flouted by France and Germany). The perception that Sweden was conducting economic policy more intelligently than Euroland and with superior results made joining EMU less appealing as well.
Fortunately, Europe has begun to enact structural changes such as tax cuts and pension reforms to stimulate growth. For example, France, Germany, and Portugal have enacted cuts in personal and corporate taxes. In addition, Germany is starting to revamp its costly retirement, health care, and welfare systems and modify its rigid labor laws, while France and Italy are attempting to overhaul their expensive pension systems. Nonetheless, there is strong resistance to these necessary changes. One sign of this resistance is that in March 2005, largely at the behest of France and Germany, which had violated the 3% of GDP budget deficit ceiling for three years in a row, the EU finance ministers agreed to render almost meaningless the rules of the Stability and Growth Pact. Another is the rejection of the European constitution in May-June 2005 by France and the Netherlands, largely because of concerns that it threatened the European welfare state.
Application Budget Dispute Topples Italy’s Government
In October 1997, Italian Prime Minister Romani Prodi, a Socialist, resigned after his allies in the Communist Party refused to tolerate welfare cuts the government said were vital to enable Italy to stay within the strict budgetary constraints necessary for its entry into the European Monetary Union. The fall of Prodi’s 17-month-old government ended Italy’s first leftist-dominated government since the end of World War II. Although the Communist Party backed down after a national outcry, and Prodi’s government was reconstituted, this episode reveals the difficulties European governments faced in getting their citizens to accept painful budget cuts to conform to the Maastricht criteria.
Consequences of EMU.
Although the full impact of the euro has yet to be felt, its effects have already been profound. Business clearly benefits from EMU through lower cross-border currency conversion costs. For example, Philips, the giant Dutch electronics company, estimates that a single European currency saves it $300 million a year in currency transaction costs. Overall, the EU Commission estimates that prior to the euro, businesses in Europe spent $13 billion a year converting money from one EU currency to another. Ordinary citizens also bore some substantial currency conversion costs. A tourist who left Paris with 1,000 francs and visited the other 11 EU countries, exchanging her money for the local currency in each country but not spending any of it, would have found herself with fewer than 500 francs when she returned to Paris. Multinational firms will also find corporate planning, pricing, and invoicing easier with a common currency.
Adoption of a common currency benefits the European economy in other ways as well. It eliminates the risk of currency fluctuations and facilitates cross-border price comparisons. Lower risk and improved price transparency encourage the flow of trade and investments among member countries and has brought about greater integration of Europe’s capital, labor, and commodity markets and a more efficient allocation of resources within the region as a whole. Increased trade and price transparency, in turn, has intensified Europe-wide competition in goods and services and spurred a wave of corporate restructurings and mergers and acquisitions.
Once the euro arrived, companies could no longer justify, or sustain, large price differentials within Euroland. Many companies have responded by changing their pricing policies so as to have single pan-European prices, or at least far narrower price differentials than in the past. Similarly, big retailers and manufacturers are increasingly buying from their suppliers at a single euro price, as opposed to buying locally in each country in which they operate.
The evidence so far appears to show that EMU has resulted in a lower cost of capital and higher than expected cash flows for the firms in countries that adopted the euro. The lower cost of capital is particularly pronounced for firms in countries with weak currencies prior to EMU. Such countries suffered from credibility problems in their monetary policies that resulted in high real interest rates before adopting the euro. The lower cost of capital and higher expected cash flows have had their predicted effect on corporate investment, with one study showing that investments for EMU firms have grown 2.5% more annually than for non-EMU firms after 1999.4
On a macroeconomic level, monetary union—such as exists among the 50 states of the United States, where the exchange rate between states is immutably set at 1—provides the ultimate in coordination of monetary policy. Inflation rates under monetary union converge, but not in the same way as in the EMS. The common inflation rate is decided by the monetary policy of the European Central Bank. It would tend to reflect the average preferences of the people running the bank, rather than giving automatic weight to the most anti-inflationary nation as in the current system. Thus, for the European Monetary Union to be an improvement over the past state of affairs, the new European Central Bank must be as averse to inflation as Europe’s previous de facto central bank—the Bundesbank.
To ensure the European Monetary Union’s inflation-fighting success, the new central bankers must be granted true independence along with a statutory duty to devote monetary policy to keeping the price level stable.
Even now, after being in existence for more than a decade, independence of the European Central Bank is an unsettled issue. Germans, who favor a strong, fiercely independent ECB modeled on the Bundesbank, fear the French will politicize it by using it to push job creation and other schemes requiring an expansionist (and, hence, inflationary) monetary policy. Many French see the Germans as favoring price stability over compassion for the unemployed. This dispute points out a hard reality: The ECB will find it difficult to be tough on inflation without the benefit of a uniformly prudent fiscal policy across all its member states.
Another important issue in forming a monetary union is that of who gets the benefits of seigniorage—the profit to the central bank from money creation. In other words, who gets to spend the proceeds from printing money? In the United States, the answer is the federal government. In the case of Europe, however, this issue has not been resolved.
An unspoken reason for strong business support for European Monetary Union is to boost growth by breaking the grip of government and unions on European economies. As described earlier, meeting the Maastricht criteria—particularly the one dealing with the reduced budget deficit—was expected to help diminish the role of the state in Europe and its tax-financed cradle-to-grave benefits. Many economists believe that only by cutting back on government and its generous—and increasingly unaffordable—social welfare programs and costly business and labor market regulations can the stagnant economies of Western Europe start to grow again and create jobs.
4 Arturo Bris, Yrjö Koskinen, and Mattias Nilsson, “The Real Effects of the Euro: Evidence from Corporate Investments,” Yale University, working paper, June 2004 (http://faculty.som.yale.edu/~ab364/euroinv ). This paper also summarizes much of the earlier evidence on the corporate effects of the euro.
Performance of the Euro.
The euro was born in optimism given the size and economic potential of the European Union (see Exhibit 3.15). However, reality set in quickly. Although many commentators believed that the euro would soon replace the U.S. dollar as the world’s de facto currency, Exhibit 3.16 shows that until 2002, the euro mostly fell against the dollar. The euro’s decline during this period has been attributed to the robustness of the U.S. economy combined with the slowness of many European countries in performing the necessary restructuring of their economies that the euro was supposed to initiate. As one currency analyst said, “The U.S. economy is considered flexible, dynamic and productive; that contrasts with a view of Europe as a region burdened with high taxes, labor and product rigidities and bloated bureaucracies.”5
Following the terrorist attacks on the United States on September 11, the euro rose briefly as the United States looked to be a relatively riskier place to invest in. But the euro soon reversed course as it became clear that Euroland’s economic environment was worse than earlier thought and investors became more optimistic about U.S. economic growth reviving. Beginning in 2002, however, continuing slow U.S. growth, large U.S. budget deficits, and aggressive Fed lowering of U.S. interest rates, combined with higher yields on euro-denominated securities and signs of significant structural reform in European economies, led to a dramatic rise in the value of the euro. This rise has been greater than many expected, particularly given the continuing sluggish European economic growth and the U.S. economic recovery since 2002.
One explanation for the dollar’s large decline has been the large and growing U.S. trade deficit. This deficit has now reached a point at which it is unsustainable (see Chapter 5) and so must be corrected. One such corrective is a large fall in the value of the dollar, which translates into a rise in the euro. Moreover, the euro has risen more than it otherwise would since 2002 because it must shoulder a disproportionate share of the dollar’s decline. The reason is that—as we have already seen—several U.S. trading partners, such as China and Japan, have resisted a rise in their currencies. In the interlocking world of foreign exchange, if the yuan cannot appreciate against the dollar, then other currencies, and especially the euro, have to compensate by appreciating even more to make up for the fixed yuan. Suppose, for example, that the dollar must decline by 10% to reach its appropriate trade-weighted value. If the yuan remains pegged to the dollar, then other currencies must rise by more than 10% against the dollar to achieve overall balance. However, the euro fell substantially after France (and the Netherlands) rejected a proposed European constitution.
Exhibit 3.15 COMPARATIVE STATISTICS FOR THE EMU COUNTRIES

Source: CIA World Factbook, 2006 Estimate.
Exhibit 3.16 The Euro’S ROLLERCOASTER Ride

Source: U.S. Federal Reserve System. Rates are noon buying rates in New York City for cable transfers. Data for 9/11/01 are missing owing to the shutdown of financial trading in New York City following the destruction of the World Trade Center.
Application The French Say Non to a European Constitution and the Euro Responds
On Sunday, May 29, 2005, French voters resoundingly rejected a proposed constitution for the European Union. The concern expressed by most of these non voters was that the constitution would force open their borders wider, accelerating economic competition and further endangering their treasured social welfare programs. Three days later, Dutch voters rejected the constitution by an even larger margin. In response, the euro fell dramatically against the dollar (see Exhibit 3.17). The rejection of the European constitution underscored Europe’s political woes and the myriad challenges facing the euro and the Euroland economies. Sunday’s non by 55% of French voters led investors to reassess the prospects of Europe’s ability to manage a common currency without a unified government to back it up. Most important, currency traders worried that the French and Dutch votes were part of a broader populist protest against free trade and free markets that would slow the pace of economic integration and reform in Euroland. That would make Europe a less desirable place to invest, reducing the demand for euros. The French and Dutch votes reinforced the view that Europe was unwilling and unable to make tough economic and political decisions. We saw earlier that even before the constitution problems arose, EMU countries had fudged rules to limit government spending considered key to underpinning the currency. They had also fought over a rule to remove cross-border barriers to services industries, with France and other nations seeking protection from low-cost service providers. As can be seen in Exhibit 3.16, the fear that Europe would reverse course on economic liberalization in response to persistently high unemployment and stagnant economic growth had already resulted in a falling euro earlier in the year.
Exhibit 3.17 The Euro Tumbles in Response to the “No” Vote on the European Constitution in 2005

Mini-Case The Euro Reacts to New Information
According to an article in the Wall Street Journal (October 8, 1999),
The European Central Bank left interest rates unchanged but made clear it is seriously considering tightening monetary policy. The euro fell slightly on the ECB’s announcement around midday that it would hold its key refinancing rate steady at 2.5%. But it rebounded as ECB President Wim Duisenberg reinforced expectations that a rate rise is in the works.
In the same story, the Wall Street Journal reported that “the Bank of England didn’t elaborate on its decision to leave its key repo rate unchanged at 5.25%.” At the same time, “sterling remains strong, which reduces the threat of imported inflation as well as continuing to pressure U.K. manufacturers. That could work against higher interest rates, which could send sterling even higher.”
Questions
1. Explain the differing initial and subsequent reactions of the euro to news about the European Central Bank’s monetary policy
2. How does a strong pound reduce the threat of imported inflation and work against higher interest rates?
3. Which U.K. manufacturers are likely to be pressured by a strong pound?
4. Why might higher pound interest rates send sterling even higher?
5. What tools are available to the European Central Bank and the Bank of England to manage their monetary policies?
On May 1, 2004, the European Union welcomed 10 new countries, bringing total EU membership to 25 nations with a combined population of 455 million. Most of the new members come from the former East Bloc, with two from the Mediterranean area: Cyprus, Czech Republic, Estonia, Hungary, Latvia, Lithuania, Malta, Poland, Slovakia, and Slovenia. As part of the admissions bargain, countries joining the EU are obligated to strive toward the eventual adoption of the euro upon fulfillment of the convergence criteria. Integration into the monetary union represents a key step toward full economic integration within the EU and has the potential to deliver considerable economic benefits to the new members. In particular, it helps countries reap the full benefits of the EU’s single market, as it works in parallel with the free movement of goods, labor, services, and capital, favoring an efficient allocation of resources. Moreover, the process and prospect of joining EMU may contribute to anchor expectations and support the implementation of sound macroeconomic and structural policies.
5 Michael R. Sesit, “The Dollar Crash That Hasn’t Happened,” Wall Street Journal, July 6, 2001, p. A6.
Optimum Currency Area
Most discussion of European monetary union has highlighted its benefits, such as eliminating currency uncertainty and lowering the costs of doing business. The potential costs of currency integration have been overlooked. In particular, as the discussion of U.S. military spending shifts indicated, it may sometimes pay to be able to change the value of one currency relative to another. Suppose, for example, that the worldwide demand for French goods falls sharply. To cope with such a drop in demand, France must make its goods less expensive and attract new industries to replace its shrinking old ones. The quickest way to do this is to reduce French wages, thereby making its workers more competitive. But this reduction is unlikely to be accomplished quickly. Eventually, high unemployment might persuade French workers to accept lower pay. But in the interim, the social and economic costs of reducing wages by, say, 10% will be high. In contrast, a 10% depreciation of the French franc would achieve the same thing quickly and relatively painlessly.
Conversely, a worldwide surge in demand for French goods could give rise to French inflation, unless France allowed the franc to appreciate. In other words, currency changes can substitute for periodic bouts of inflation and deflation caused by various economic shocks. Once France has entered monetary union and replaces the franc with the euro, it no longer has the option of changing its exchange rate to cope with these shocks. This option would have been valuable to the ERM, which instead became unglued because of the huge economic shock to its fixed parities brought about by the absorption of East Germany into the German economy.
Taking this logic to its extreme would imply that not only should each nation have its own currency, but so should each region within a nation. Why not a southern California dollar, or indeed a Los Angeles dollar? The answer is that having separate currencies brings costs as well as benefits.
The more currencies there are, the higher the costs of doing business and the more currency risk exists. Both factors impair the functions of money as a medium of exchange and a store of value, so maintaining more currencies acts as a barrier to international trade and investment, even as it reduces vulnerability to economic shocks.
According to the theory of the optimum currency area, this trade-off becomes less and less favorable as the size of the economic unit shrinks. So how large is the optimum currency area? No one knows. But some economists argue that Europe is not an optimum currency area and so might be better off with four or five regional currencies than with only one.6 Similarly, some have argued that the United States, too, might do better with several regional currencies to cushion shocks such as those that afflicted the Midwest and the Southwest during the 1980s and the Northeast and California in the 1990s. Nonetheless, the experience with floating exchange rates since the early 1970s will likely give pause to anyone seriously thinking of pushing this idea further. Those experiences suggest that exchange rate changes can add to economic volatility as well as absorb it. At the same time, economic flexibility—especially of labor markets—is critical to reducing the costs associated with currency union. This flexibility can be attained only through further deregulation; privatization; freer trade; labor market and social welfare reform; and a reduction in economic controls, state subsidies, and business regulations. Absent these changes, especially to reduce the rigidities of Europe’s labor market, European Monetary Union will intensify economic shocks because their effects can no longer be mitigated by exchange rate adjustments.
The great hope of enthusiasts for Europe’s single currency, as for its single market, was that it would unleash pressures that would force its members to reform their sclerotic economies to make them more flexible and competitive. Such competitive pressures were unleashed, but the core euro countries, especially France, Germany, and Italy, have responded by first initiating and then resisting the reforms that the euro and single market made necessary. As predicted, the result has been greater vulnerability to economic shocks and difficult economic times.
Such difficulty brought speculation in 2005 that EMU would break apart over its handling of monetary policy. The ECB is trying to steer the economy of a region in which the four largest nations—Germany, France, Italy, and Spain—are growing at very different rates. As a result, the ECB cannot apply an optimal interest rate for any one country. For example, some economists argue that Italy, being in a recession, could use interest rates close to zero, and France and Germany with their slow growth could use interest rates of 1% to 1.5%. Booming Spain, on the other hand, might be better off with an interest rate of 3%. Instead, the ECB’s key short-term rate is 2%, too low for Spain and too high for Italy, Germany, and France. Viewing these problems, some economists claim that Britain has benefited from staying out of the euro because the Bank of England can still set interest rates in line with its own particular facts and circumstances.
Mini-Case Britain—In or Out for the Euro
The interminable debate in Britain over whether to join the European Monetary Union reached a fever pitch in early 2003. That was when Chancellor of the Exchequer Gordon Brown had promised to make his recommendation to Prime Minister Tony Blair as to whether economic conditions were such as to warrant the move. Although Prime Minister Blair was likely to accept Chancellor Brown’s judgment, he also had to pay attention to the intense debate over the euro. This debate went way beyond party lines, splitting political parties and raising passions in a way few other issues do. Business was similarly divided over the merits of EMU. The economy, and how it could be affected by adopting the euro, was central to this debate.
Euro-skeptics pointed out that by adopting the euro, Britain would trade control over its own interest rates and monetary policy for a single vote on the governing council of the European Central Bank in Frankfurt, which sets interest rates for Euroland as a whole. Shocks to the economy, such as the terrorist attacks of September 11 or a drop in the housing market, make it harder for the ECB to find the right rate. After euro entry, given the limitation on deficits, the British government could face a stark choice between cutting public spending or raising taxes. For many opponents, monetary union would also mean more EU-generated regulation. Moreover, skeptics argued, the benefits of EMU were not readily apparent insofar as Britain had lower unemployment, lower inflation, and higher growth than Euroland.
Despite this dismal view of Britain’s prospects if it joined EMU, equally passionate euro enthusiasts argued that Britain was paying a high price for its economic isolation. They pointed out that foreign investment, a cornerstone of Britain’s economic prosperity, was in jeopardy. Thousands of foreign businesses, employing hundreds of thousands of workers, had brought new skills and innovations to Britain, raising productivity and boosting prosperity. However, since the advent of the euro, Britain’s share of foreign investment in Europe had fallen precipitously. The pro-euro camp’s explanation for this sharp decline was that multinationals locating in Britain now had to bear transaction costs and exchange rate uncertainty that they could avoid by basing themselves in EMU countries. Similarly, euro supporters argued that Britain’s trade with the European Union, half its overall trade, was stagnating because of these same currency costs and risks. Meanwhile, euro countries were seeing their trade with one another rise dramatically. Supporters, therefore, argued that joining EMU would lead to greater stability and shared growth in the EU. Joining EMU would also facilitate greater economic efficiency and increase competition by allowing British companies and consumers to compare prices and wages more easily with their Euroland counterparts. Skeptics, on the other hand, argued that Britain’s lighter regulatory and tax burden was more important for investors and businesses than the euro, and these advantages would be lost if Britain joined EMU.
Questions
1. Discuss the pros and cons for Britain of joining EMU.
2. Commentators pointed to the fact that many people in Britain have variable-rate mortgages, as opposed to the fixed-rate mortgages more common in Europe. Britain also has the most flexible labor markets in Europe. How would these factors likely affect Britain’s economic costs and benefits of adopting the euro?
3. What types of British companies would most likely benefit from joining EMU?
4. Some large multinationals warned that they only chose to invest in Britain on the assumption it would ultimately adopt the euro. Why would multinationals be interested in Britain adopting the euro?
6 See, for example, Geoffrey M.B. Tootell, “Central Bank Flexibility and the Drawbacks to Currency Unification,” New England Economic Review, May–June 1990, pp. 3–18; and Paul Krugman, “A Europe-Wide Currency Makes No Economic Sense,” Los Angeles Times, August 5, 1990, p. D2.
3.4 Emerging Market Currency Crises
As we saw in the last chapter, the decade of the 1990s was punctuated by a series of currency crises in emerging markets. First was the Mexican crisis in 1994 to 1995. That was followed by the Asian crisis two years later in 1997, then the Russian crisis of 1998, and the Brazilian crisis of 1998 to 1999.
Transmission Mechanisms
The problem with these currency crises is that they tend to be contagious, spreading from one nation to another. There are two principal routes of contagion: trade links and the financial system. Contagion is exacerbated by a common debt policy.
Trade Links.
Contagion can spread from one emerging market to another through their trade links. For example, when Argentina is in crisis, it imports less from Brazil, its principal trading partner. As Brazil’s economy begins to contract, its currency will likely weaken. Before long, the contagion will spread from Brazil to its other emerging market trade partners.
Financial System.
The second and more important transmission mechanism is through the financial system. As we saw in the case of the Asian currency crisis, trouble in one emerging market often can serve as a wake-up call to investors who seek to exit other countries with similar risky characteristics. For example, Argentina’s problems, which stem from its large budget deficit, focused investor attention on Brazil’s unresolved fiscal problems. Financial contagion can also occur because investors who are leveraged up start selling assets in other countries to make up for their initial losses. Investors may also become more risk averse and seek to rebalance their portfolios by selling off a portion of all their risky assets.
Debt Policy.
Crisis-prone countries tend to have one thing in common that promotes contagion: They issue too much short-term debt that is closely linked to the U.S. dollar. When times are good, confident investors gladly buy short-term emerging market bonds and roll them over when they come due. However, when the bad times come and currencies tumble, the cost of repaying dollar-linked bonds soars, savvy investors rush for the exits, and governments find their debt-raising capacity vanishes overnight. Things quickly spiral out of control.
Origins of Emerging Market Crises
The sequence of currency crises has prompted policymakers to seek ways to deal with them. Many of their crisis-fighting proposals involve increasing the International Monetary Fund’s funding and giving it and possibly new international agencies the power to guide global financial markets. However, these proposals could exacerbate the two principal sources of these crises.
Moral Hazard.
A number of economists believe that by bailing out first Mexico and then the Asian countries, the IMF actually helped fuel these crises by creating a moral hazard in lending behavior. Specifically, economists such as Milton Friedman and Allan Meltzer have argued that the Mexican bailout encouraged investors to lend more money on less stringent terms to the Asian countries than they would have otherwise because of their belief that the IMF would bail them out if trouble hit. The $118 billion Asian bailout by the IMF ($57 billion for South Korea alone) reinforced the view of foreign investors that they were operating with an implicit guarantee from the IMF, which led to the Russian currency crisis and then the Brazilian crisis. At the same time, the provision of an IMF safety net gives recipient governments less incentive to adopt responsible fiscal and monetary policies.
In the case of the Brazilian real crisis, most observers had believed for a long time that the currency was overvalued. When speculators attacked the real in the wake of the Asian currency crisis, the IMF tried to prevent a crisis by providing $41 billion in November 1998 to boost Brazil’s reserves in return for Brazil’s promise to reduce its budget deficit. That strategy broke down, however, when Brazil failed to deliver on promised fiscal reforms and investor confidence collapsed. On January 15, 1999, Brazil floated its currency and began implementing reforms. Arguably, without the IMF bailout package, Brazil would have been forced to act on its fiscal reforms sooner. IMF conditionality once again failed to work.
Fundamental Policy Conflict.
Underlying the emerging market currency crises is a fundamental conflict among policy objectives that the target nations have failed to resolve and that IMF assistance has only allowed them to drag out. These three objectives are a fixed exchange rate, independent domestic monetary policy, and free capital movement. As we saw in Chapter 2, any two of these objectives are possible; all three are not. Speculators recognized that the attempts by Mexico, Indonesia, Thailand, South Korea, Brazil, Russia, and other countries to achieve these three objectives simultaneously were unsustainable and attacked their currencies, resulting in the inevitable breakdowns in their systems.
Policy Proposals for Dealing with Emerging Market Crises
There are three possible ways to avoid these financial crises. One is to impose currency controls; another is to permit currencies to float freely; and the third is to permanently fix the exchange rate by dollarizing, adopting a common currency as the participants in EMU have done, or establishing a currency board.
Currency Controls.
Some economists have advocated abandoning free capital movement, as Malaysia has done, as a means of insulating a nation’s currency from speculative attacks. However, open capital markets improve economic welfare by channeling savings to where they are most productive. Moreover, most developing nations need foreign capital and the know-how, discipline, and more efficient resource allocation that come with it. Finally, the long history of currency controls should provide no comfort to its advocates. Currency controls have inevitably led to corruption and government misallocation of foreign exchange, hardly prescriptions for healthy growth.
Freely Floating Currency.
With a freely floating currency, the exchange rate is set by the interplay of supply and demand. As Milton Friedman points out, with a floating exchange rate, there never has been a foreign exchange crisis. The reason is simple: The floating rate absorbs the pressures that would otherwise build up in countries that try to peg the exchange rate while simultaneously pursuing an independent monetary policy. For example, the Asian currency crisis did not spill over to Australia and New Zealand because the latter countries had floating exchange rates.
Permanently Fixed Exchange Rate.
Through dollarization, establishment of a currency board, or monetary union, a nation can fix its exchange rate permanently. The key to this system’s viability is the surrender of monetary independence to a single central bank: the European Central Bank for the countries using the euro and the Federal Reserve for countries such as Ecuador and Panama that have dollarized. The Federal Reserve is also the de facto central bank for countries such as Argentina (until 2002) and Hong Kong that have dollar-based currency boards. It is this loss of monetary independence that is the fundamental difference between a truly fixed-rate and a pegged-rate system such as existed under Bretton Woods. In a truly fixed-rate system, the money supply adjusts to the balance of payments. If there is a balance-of-payments deficit, the supply of currency falls; with a surplus, it rises. With a pegged-rate system, on the other hand, governments can avoid—at least temporarily—allowing their money supply to adjust to a balance-of-payments deficit by borrowing from abroad or running down their foreign exchange reserves to maintain the pegged rate. With a persistent deficit, however, fueled by excessive growth of the money supply, an explosion is inevitable.
Adherence to either a truly fixed exchange rate or a floating exchange rate will help avert foreign exchange crises. Which mechanism is superior depends on a variety of factors. For example, if a country has a major trading partner with a long history of a stable monetary policy, then tying the domestic currency to the partner’s currency would probably be a good choice. In any event, the choice of either system will eliminate the need for the IMF or other international agency to intervene in or usurp the market.
Better Information.
Little noticed in the discussion of emerging market crises is that financial market collapses in Argentina and Turkey in 2001 were not particularly contagious. For example, debt-rating agencies elevated Mexican bonds to investment grade right in the middle of the Argentine debacle. Similarly, Brazilian and Russian bond prices soared from investor perceptions that their economies were improving. A natural conclusion is that information about emerging markets is improving, allowing investors to distinguish the good ones from the bad. Taking this experience to its logical conclusion suggests that the best way to reduce financial market contagion in the future is to develop and disseminate better information about emerging market policies and their consequences. This course of action is exactly what one would expect free markets to undertake on their own, without the need for government intervention.
That being said, contagion can still be a problem when a crisis in one country forces portfolio managers to sell assets in other emerging countries. For example, a sell-off of Brazilian assets in early 2002, sparked by the rise of leftist Brazilian presidential candidate Lula da Silva, meant that some money managers had to sell their holdings in other emerging markets to meet margin calls or redemptions resulting from Brazil. Similarly, contagion can result from investors demanding higher risk premiums for bearing emerging market risk.
3.5 Summary and Conclusions
This chapter examined the process of exchange rate determination under five market mechanisms: free float, managed float, target-zone system, fixed-rate system, and the current hybrid system. In the last four systems, governments intervene in the currency markets in various ways to affect the exchange rate.
Regardless of the form of intervention, however, fixed rates do not remain fixed for long. Neither do floating rates. The basic reason that exchange rates do not remain fixed in either a fixed- or floating-rate system is that governments subordinate exchange rate considerations to domestic political considerations.
We saw that the gold standard is a specific type of fixed exchange rate system, one that requires participating countries to maintain the value of their currencies in terms of gold. Calls for a new gold standard reflect a fundamental lack of trust that monetary authorities will desist from tampering with the integrity of fiat money.
Finally, we concluded that intervention to maintain a disequilibrium rate is generally ineffective or injurious when pursued over lengthy periods of time. Seldom have policymakers been able to outsmart, for any extended period, the collective judgment of currency buyers and sellers. The current volatile market environment, which is a consequence of unstable U.S. and world financial conditions, cannot be arbitrarily directed by government officials for long.
Examining the U.S. experience since the abandonment of fixed rates, we found that free-market forces did correctly reflect economic realities thereafter. The dollar’s value dropped sharply between 1973 and 1980 when the United States experienced high inflation and weakened economic conditions. Beginning in 1981, the dollar’s value rose when American policies dramatically changed under the leadership of the Federal Reserve and a new president but fell when foreign economies strengthened relative to the U.S. economy. Nonetheless, the resulting shifts in U.S. cost competitiveness have led many to question the current international monetary system.
The principal alternative to the current system of floating currencies with its economic volatility is a fixed exchange rate system. History offers no entirely convincing model for how such a system should be constructed, but it does point to two requirements. To succeed in reducing economic volatility, a system of fixed exchange rates must be credible, and it must have price stability built into its very fabric. Otherwise, the market’s expectations of exchange rate changes combined with an unsatisfactory rate of inflation will lead to periodic battles among central banks and between central banks and the financial markets. The recent experiences of the European Monetary System point to the costs associated with the maintenance of exchange rates at unrealistic levels. These experiences also point out that, in the end, there is no real escape from market forces. Most European nations have responded to this reality by forming a monetary union and adopting the euro as their common currency. Some developing nations have gone further and abandoned their currencies altogether by dollarizing, either explicitly or implicitly through a currency board.
A final lesson learned is that one must have realistic expectations of a currency system. In particular, no currency system can achieve what many politicians seem to expect of it—a way to keep all the benefits of economic policy for their own nation while passing
(Shapiro 99-139)
Shapiro. Multinational Financial Management, 9th Edition. John Wiley & Sons. .