Chapter 5 - Understanding the International Monetary System

1. Chapter 5 - Understanding the International Monetary System International Business by Ball, McCulloch, Frantz, Geringer, and Minor

2. Chapter Objectives • Explain the developments shaping the world monetary system • Understand balance of payments • Compare relative strengths and weaknesses of currencies • Identify the major foreign exchange markets of the world • Understand changes being caused in the FX markets • Understand the central reserve asset/national conflict of the U.S. dollar • Discuss the euro and its present state of acceptance by EU countries

3. A Brief Gold Standard History • From about A.D. 1200 to the present • Direction of the price of gold has been generally up. • During this time, the price of gold rose from about $21 per ounce to just under $200 in December 1976.

4. A Brief Gold Standard History • Most trading or industrial countries adopted the gold standard. • The gold standard is when countries agree to buy or sell gold for an established number of currency units. • However, a government cannot create money that is not backed by gold.

5. A Brief Gold Standard History • Return to the Gold Standard? • Argument that the U.S. dollar is currently a reserve asset of nations is unsustainable. • Because of its high value, gold is very portable.

6. Bretton Woods and the Gold Exchange Standard • In 1944, representative of the major Allied powers met at Bretton Woods, New Hampshire to plan for the future. • General consensus • Stable exchange rates were desirable. • Floating or fluctuating exchange rates had proved unsatisfactory. • The government controls of trade, exchange, and production, that had developed through WWII were wasteful and discriminatory.

7. Bretton Woods and the Gold Exchange Standard • To achieve its goals, the Bretton Woods Conference established • The International Monetary Fund (IMF) • The IMF Articles of Agreement entered into force in December 1945. • From 1945-1971, IMF agreement was the basis of the international monetary system. • The US$ was agreed to be the only central reserve asset. • An ounce of gold was agreed to be worth US$35.

8. Balance of Payment (BOP) • A country’s BOP is a very important indicator of what may happen to the country’s economy. • If country’s BOP is in deficit • Inflation is often the cause. • A company doing business there must adjust its pricing, inventory, accounting, and other practices to inflationary conditions. • The government may take measures to deal with inflation and the deficit.

9. Balance of Payments (BOP) • Actions the government may take to deal with inflation and the BOP deficit include • Market measures • Deflating the economy • Devaluing the currency • Nonmarket measures • Currency controls • Tariffs • Quotas

10. Balance of Payments (BOP) • Debits and Credits in International Transactions • International Debit Transactions • Involve payments by domestic residents to foreign residents. • International Credit Transactions • Involve payments by foreign residents to domestic residents.

11. Balance of Payments (BOP) • Examples of Debit Transactions • (from the U.S. Perspective) • Dividend, interest, and debt repayment services on foreign-owned capital in America. • Merchandise imports. • Purchases by Americans traveling abroad.

12. Balance of Payments (BOP) • Examples of Debit Transactions (cont’d) • Transportation services bought by Americans on foreign carriers. • Foreign investment by Americans. • Gifts by Americans to foreign residents. • Imports of gold.

13. Balance of Payments (BOP) • Double-Entry Accounting • The BOP is presented as double-entry accounting statement • Total credits and debits are always equal. • Statement of a country’s BOP is divided into several accounts. • Current Account • Capital Account • Official Reserves Account

14. Balance of Payments (BOP) • Current Account • Subaccounts include • Goods or merchandise • Services • Unilateral transfers

15. Balance of Payments (BOP) • Current Account • Goods or merchandise • Deals with “visibles,” such as autos, grain, machinery, and equipment. • The net balance on merchandise transactions is referred to as the country’s trade balance.

16. Balance of Payments (BOP) • Current Account • Services • Deals with “invisibles” that are exchanged or bought internationally. • Examples include dividends or interest on foreign investments, royalties on patents or trademarks held abroad, travel, insurance, banking, and transportation.

17. Balance of Payments (BOP) • Current Account • Unilateral transfers • Transfers with no quid pro quo. • Some of these transfers are made by private persons or institutions, and some by governments. • Some private unilateral transfers are for charitable, educational, or missionary purposes. • The largest government unilateral transfers are aid.

18. Balance of Payments (BOP) • Capital Account • Records the net changes in a nation’s international financial assets and liabilities over the BOP period. • Subaccounts include • Direct investment • Portfolio investment • International movements of short-term capital

19. Balance of Payments (BOP) • Capital Account • Direct investment • Investments in enterprises or properties located in one country that are effectively controlled by residents in another country.

20. Balance of Payments (BOP) • Capital Account • Direct investment • Effective control is assumed for BOP purposes • When residents of one country owns 50 percent or more of the voting stock of a company in another country. • When one resident or an organized group of residents of one country owns 25 percent or more of the voting stock of a company in another country.

21. Balance of Payments (BOP) • Capital Account • Portfolio investment • Includes all long-term—more than one year—investments that do not give the investors effective control over the object of the investment. • Such transactions typically involve the purchase of stocks or bonds of foreign issuers for investment—not control—purposes.

22. Balance of Payments (BOP) • Capital Account • International movements of short-term capital. • Involve changes in international assets and liabilities with an original maturity of one year or less. • Some of the fastest-growing types of short-term flows are for currency exchange rate and interest rate hedging in the forward, futures, option, and swap markets.

23. Balance of Payments (BOP) • Official Reserves Account • Total credits and debits must be equal because of the double-entry accounting system used to report the BOP. • Deals with the following • Gold imports and exports. • Changes in foreign exchange held by the government. • Changes in liabilities to foreign central banks.

24. Balance of Payments (BOP) • Temporary BOP deficit • Can be corrected by the country’s monetary policies or fiscal policies. • May be corrected by short-term IMF loans and advice.

25. Balance of Payments (BOP) • Fundamental BOP deficit • Too severe to be repaired by any monetary or fiscal policies the country can apply. • There are economic, social, and political limits to how much a country can deflate its economy or devalue its currency.

26. Gold Exchange Standard • Gold and Dollars Go Abroad • From 1958 through 1971, United States cumulative deficit was $56 billion. • Deficit was financed partly by use of the U.S. gold reserves. • Deficit partly financed by incurring liabilities to foreign central banks.

27. August 15, 1971, and the Next Two Years • By 1971, many more dollars were in the hands of foreign central banks than the gold held by the U.S. Treasury could cover.

28. August 15, 1971, and the Next Two Years • August 15, 1971 • President Nixon “closed the gold window.” • Currencies began to float. • Stated US$ value of 35 dollars per ounce of gold was now meaningless. • The gold exchange was ended.

29. August 15, 1971, and the Next Two Years • December 1971 • Smithsonian Accord was signed. • Agreement on trade obstacles reached along with new currency exchange rates. • This led to the devaluation of the US$. • However, new rates could not be maintained. • By 1973 currencies were floating.

30. 1973 to the Present • Two kinds of currency floats • Free (clean) float • Managed (dirty) float

31. 1973 to the Present • Currency Floats • Free (clean) Float • Closest approach to perfect competition. • No government intervention. • Billions of the product (units of money) are traded by thousands of buyers and sellers.

32. 1973 to the Present • Currency Floats • Managed (dirty) Float • Governments intervene in the currency markets as they perceive their national interests to be served. • Nations may explain their interventions in terms of “smoothing market irregularities” or “assuring orderly markets”

33. 1973 to the Present • Currency Areas • Currencies that float against each other and against the euro include the • U.S. dollar • Canadian dollar • Japanese yen • Swiss franc

34. 1973 to the Present • Currency Areas • Most currencies of developing countries are pegged (fixed) • In value to one of the major currencies. • To a currency basket such as the special drawing rights. • To some specially chosen currency mix or basket.

35. 1973 to the Present • Snake • In Europe during the mid-1970 a currency grouping called the “snake” was created. • The snake included several European currencies, led by the German deutsche mark. • The snake was so called because of how it appeared on a graph showing the member currencies floating against nonmember currencies.

36. 1973 to the Present • Snake • The snake was damaged by the departure of several currencies. • The systems inflexibility explains the snake’s ultimate demise. • The snake was the forerunner of the European Monetary System.

37. Experience with Floating • The euro • The 1997 Asian Financial Crisis • Study of Worldwide PPP • The Economist used the price of a Big Mac as its “basket” of goods.

38. Money Markets, Foreign Exchange • London is the world’s largest foreign exchange market. • It has 30 percent share of foreign exchange turnover. • New York is the second largest foreign exchange market. • Asia, Tokyo, Hong Kong, and Singapore are fighting for foreign exchange supremacy.

39. Money Markets, Foreign Exchange • Asian Currencies to the Rescue • Asian currencies are no longer thought of as exotic since their markets have emerged. • The more liquid currencies include the • Singapore dollar • Thai baht • Indonesian rupiah • Malaysian ringgit • Hong Kong dollar

40. Money Markets, Foreign Exchange • The US$ is the most traded currency. • The US$-deutsche mark market is the busiest, closely followed by the US$-yen. • Third, fourth, and fifth are US$-sterling, US$-Swiss franc, and mark-yen. • Virtually all trading in the Asian foreign exchange market is conducted through the dollar.

41. Money Markets, Foreign Exchange • SDRs in the Future • Special drawing rights (SDRs) • May be a step toward a truly international currency. • The US$ has been the closest thing to such a currency since gold in the pre-WWI gold standard system. • The objective was to make the SDR the principal reserve asset in the international monetary system.

42. Money Markets, Foreign Exchange • Value of the SDR • The SDR’s value is based on a basket of the following five currencies • U.S. dollar (41.3%) • euro Germany (19%) • euro France (10.3%) • Japanese yen (17%) • British pound (12.4%) • The percentages are changed periodically.

43. Money Markets, Foreign Exchange • Uses of the SDR • The SDR’s value remains more stable than that of any single currency. • Holders of SDRs include • The International Monetary Fund (IMF) • Most of the 181 members of the IMF • 16 official institutions • These institutions typically regional development or banking institutions prescribed by the IMF. • “Equity Issue”

44. Money Markets, Foreign Exchange • European Monetary System (EMS) • The European countries prefer fixed currency exchange rates to floating ones. • The EMS is a grouping of most Western European nations cooperating to maintain their currencies at fixed exchange rates.

45. Money Markets, Foreign Exchange • From the European Currency Unit (ECU) to the Euro • The ECU was established as the EMS bookkeeping currency. • The ECU was more popular than the SDR because • Neither the US$ nor the yen was included in the currency basket that determined its value. • Of active sponsorship of the ECU by European governments, banks, and businesses.

46. Money Markets, Foreign Exchange • The European Currency Unit (ECU) • The ECU was a weighted basket of currencies, and its uses include • Denominating bonds. • Calculating the EU budget. • Raising levies. • Distributing funds that were translated into domestic, national currencies.

47. Money Markets, Foreign Exchange • The European Currency Unit (ECU) • The euro has replaced the ECU and is supposed to replace some national currencies. • The euro will be a retail currency, whereas the ECU was only a wholesale and debt market currency