Transcript Chapter 3 The International Monetary System

Multinational Business Finance
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The Gold Standard (1876 – 1913)
• Gold has been a medium of exchange since 3000 BC
• each country set the rate at which its currency unit could be
converted to a weight of gold. (1ounce=28,35gram)
• e.g. $20,67=1 ounce of gold, 4,2474£=1 ounce of gold
• Expansionary monetary policy was limited to a government’s
gold reserve.
• the outbreak of WWI stopped the free movement of gold,
this has caused the suspension of the operation of the Gold
Standard
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The Inter-War Years & WWII (1914-1944)
 During this period, currencies were allowed to fluctuate
over a fairly wide range in terms of gold
 Increasing fluctuations in currency values, as speculators
sold short weak currencies
 The US adopted a modified gold standard in 1934
 the US dollar was the only major trading currency that
continued to be convertible to gold.
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Bretton Woods and the International
Monetary Fund (IMF) (1944)
 As WWII drew to a close, the Allied Powers met at
Bretton Woods, New Hampshire to create a postwar international monetary system
 The Bretton Woods Agreement established a US
dollar based international monetary system and
created two new institutions the International
Monetary Fund (IMF) and the World Bank
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 The International Monetary Fund is a key institution in
the new international monetary system and was
created to:
▪ Help countries defend their currencies against cyclical,
seasonal, or random occurrences
▪ Assist countries having structural trade problems if they
promise to take adequate steps to correct these problems
 The International Bank for Reconstruction and
Development (World Bank) helped fund post-war
reconstruction and has since then supported general
economic development
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
Eurocurrencies
 domestic currencies of one country deposited in
another country.
(e.g. Eurodollar market. Euro- means foreign here)
 U.S.-dollar denominated deposits at foreign
banks or foreign branches of American banks. By
locating outside of the United States
 Eurodollars escape regulation by the Federal
Reserve Board.
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
Eurocurrency Interest Rates: Libor
 In the Eurocurrency market, the reference rate of
interest is the London Interbank Offered Rate
(LIBOR)
 This rate is the most widely accepted rate of
interest used in standardized quotations, loan
agreements, and financial derivatives transactions
 There are Pibor, Mibor, Fibor, Stibor (Stockholm
Interbank Offered Rate)
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
Fixed Exchange Rates (1945-1973)
 The currency arrangement negotiated at Bretton Woods
and monitored by the IMF worked fairly well during the
post-WWII era of reconstruction and growth in world trade
 The US dollar became the main reserve currency held by
central banks
 Eventually, the heavy overhang of dollars held by
foreigners resulted in a lack of confidence in the ability of
the US to met its commitment to convert dollars to gold
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 The lack of confidence forced President Richard Nixon to
suspend official purchases or sales of gold by the US
Treasury on August 15, 1971
 This resulted in subsequent devaluations of the dollar
 Most currencies were allowed to float to levels determined
by market forces as of March, 1973
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An Eclectic Currency Arrangement (1973 –
Present)
 Since March 1973, exchange rates have become
much more volatile and less predictable than they
were during the “fixed” period
 There have been numerous, significant world
currency events over the past 30 years
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
The International Monetary Fund classifies all
exchange rate regimes into eight specific categories
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Exchange arrangements with no separate legal tender
Currency board
Other conventional fixed peg
Pegged exchange rates within horizontal bands
Crawling pegs
Exchange rates within crawling pegs
Managed floating
Independent floating
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
A nation’s choice of currency regime to follow depends
on many variables:
 inflation,
 unemployment,
 interest rate levels,
 trade balances, and
 economic growth.

The choice between fixed and flexible rates may change
over time as priorities change.
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Fixed rate regime has advantages and
disadvantages:
 stability in international prices
 inherent anti-inflationary nature of fixed prices
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but:
 Need for central banks to maintain large
quantities of hard currencies and gold to defend
the fixed rate
 Fixed rates can become inconsistent with
economic fundamentals as time goes.
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Possesses three attributes, often referred to
as the Impossible Trinity:
 Exchange rate stability: fixed exchange rate
 Full financial integration: free capital movement
 Monetary independence: independent interest
rate policy, monetary policy, etc
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Not possible to have all three simultaneous.
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Currency board regime
when a country’s central bank commits to back its monetary
base – its money supply – entirely with foreign reserves at all
times.
1 Argentina Peso/ USD
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This means that a unit of domestic currency cannot be
introduced into the economy without an additional unit of
foreign exchange reserves being obtained first.
 Argentina moved from a managed exchange rate to a
currency board in 1991
 In 2002, the country ended the currency board as a result
of substantial economic and political turmoil
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
Dollarization is the use of the US dollar as
the official currency of the country.
 Panama has used the dollar as its official currency
since 1907
 Ecuador replaced its domestic currency with the
US dollar in September, 2000
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
In December 1991, the members of the
European Union met at Maastricht, the
Netherlands to finalize a treaty that changed
Europe’s currency future.
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This treaty set out a timetable and a plan to
replace all individual ECU currencies with a
single currency called the euro.
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To prepare for the EMU, a convergence criteria was
laid out whereby each member country was
responsible for managing the following to a
specific level:
 Nominal inflation rates
 Long-term interest rates
 Fiscal deficits
 Government debt
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In addition, European Central Bank (ECB), was
established in Frankfurt, Germany.
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The euro affects markets in three ways:
 Cheaper transactions costs in the Euro Zone
 Currency risks and costs related to
uncertainty are reduced
 price transparency and increased price-
based competition
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If the euro is to be successful, it must have a
solid economic foundation.
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The primary driver of a currency’s value is its
ability to maintain its purchasing power.
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So, The single largest threat to maintaining
purchasing power is inflation.
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1.
2.
Many Chinese critics had urged China to
revalue the yuan by 20% or more. What
would the Chinese yuan’s value be in US
dollars if it had indeed been devalued by
20%?
Do you believe that the revaluation of the
Chinese yean was politically or economically
motivated?
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3. If the Chinese yuan were to change by the maximum allowed
per day, 0.3% against the US dollar, consistently over a 30 or
60 day period, what extreme values might it reach?
4. Chinese multinationals would now be facing the same
exchange rate-related risks borne by US, Japanese, and
European multinationals. What impact do you believe this
rising risk will have on the strategy and operations of
Chinese companies in the near-future?
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