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Chapter
The International Monetary system
10
McGraw-Hill/IrwinInternational Business, 5/e
© 2005 The McGraw-Hill Companies, Inc., All Rights Reserved.
10-2
Turkeys 18th IMF program
Large and inefficient state sector heavy subsidies Government debt risen to 60% of gross domestic
product Rampant inflation IMF focus
Reduce inflation Stabilize value o f currency Privatization Reduction of subsidies Government reforms
Reasons for failure
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10-3
International monetary system (IMF)
The institutional arrangements that countries adopt to govern exchange rates
Dollar, Euro, Yen and Pound “float” against each other Floating exchange rate:
Foreign exchange market determines the relative value of a currency
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10-4
International monetary system (IMF)
Some countries use other institutional arrangements to fix their currency’s value Pegged exchange rate
Value fixed relative to a reference currency
Dirty float Hold value within range of a reference currency
Fixed exchange rate Set of currencies are fixed against each other at some
mutually agreed upon exchange rate
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10-5
The gold standard
Roots in old mercantile trade.
Inconvenient to ship gold, changed to paper- redeemable for gold.
Want to achieve ‘balance-of-trade equilibrium
USAJapan
Gold
Trade
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10-6
Balance of trade equilibrium
Trade Surplus
GoldIncreased
money supply = price
inflation.
Decreased money supply
= price decline.
As prices decline, exportsincrease and trade goes
into equilibrium.
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10-7
Between the wars
Post WWI, war heavy expenditures affected the value of dollars against gold
US raised dollars to gold from $20.67 to $35 per ounce
Dollar worth less?
Other countries followed suit and devalued their currencies
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10-8
Bretton Woods
In 1944, 44 countries met in New Hampshire Countries agreed to peg their currencies to
US$ which was convertible to gold at $35/oz. Agreed not to engage in competitive
devaluations for trade purposes and defend their currencies
Weak currencies could be devalued up to 10% w/o approval
IMF and World Bank created
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10-9
Role of the IMF
Created to police monetary system by ensuring maintenance of the fixed-exchange rate
Promote int’l monetary cooperation and facilitate growth of int’l trade
Wanted to avoid problems following WW1, through A) Discipline
Maintaining a fixed exchange rate imposes monetary discipline, curtails inflation
Brake on competitive devaluations and stability to the world trade environment
,
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10-10
Role of the IMF
B) Flexibility Lending facility:
Lend foreign currencies to countries having balance-of-payments problems
Adjustable parities:Allow countries to devalue currencies more
than 10% if balance of payments was in “fundamental disequilibrium’
Persistent borrowings leads to IMF control of a country’s economic policy
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10-11
Principal duties
Surveillance of exchange rate policies (No longer fixed rate exchange)
Financial assistance (including credits and loans)
Technical assistance (expertise in fiscal/monetary policy)
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10-12
Sources of funds
182 nations pay into fund according to the size of their economy
Funds remain their property Borrower repays loan in 1 to 5 years, with
interest No nation has ever defaulted; some are given
extensions
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10-13
Membership in the IMF
Open to any country willing to agree to its rules and regulations
Must pay a deposit (quota) Quota size reflects global importance of a
nation’s economy Quota determines voting powers
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10-14
Largest contributors
18.3
5.7 5.7 5.1 5.1
0
5
10
15
20
US Germany Japan Britain France
Percent
Fig 10.0
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10-15
Role of the World Bank
International Bank for Reconstruction and Development (IBRD)
Purpose: To fund Europe’s reconstruction and help 3d world countries.
Overshadowed by Marshall Plan, Turns to ‘development’
Lending money raised by WB bond sales Agriculture Education Population control Urban development
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10-16
Collapse of the fixed exchange system
Pressure to devalue dollar led to collapse President Johnson financed both the Great Society
and Vietnam by printing money High inflation and high spending on imports
August 8, 1971, Nixon announces dollar no longer convertible into gold. Countries agreed to revalue their currencies against the
dollar March 19, 1972, Japan and most of Europe floated their
currencies In 1973. Bretton Woods fails when key currency (dollar)
is under speculative attack Now have a managed-float system
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10-17
Long term exchange rate trends 1970-2001
Fig 10.1
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10-18
The floating exchange rate
Jamaica Agreement - 1976 Floating rates acceptable Gold abandoned as reserve asset IMF quotas increased
IMF continues role of helping countries cope with macroeconomic and exchange rate problems
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10-19
Exchange rates since 1973
More volatile: Oil crisis -1971 Loss of confidence in the dollar - 1977-78 Oil crisis – 1979, OPEC increases price of oil
Unexpected rise in the dollar - 1980-85 Rapid fall of the dollar - 1985-87 and 1993-95 Partial collapse of European Monetary System -
1992 Asian currency crisis - 1997
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10-20
Floating exchange rates
Trade balance adjustments
Monetary policy autonomy
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10-21
Fixed exchange rates
Monetary discipline Speculation Uncertainty Trade balance
adjustments
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10-22
Fixed versus floating exchange rates
Floating: Monetary policy
autonomy Restores control to
government Trade balance
adjustments Adjust currency to
correct trade imbalances
Fixed: Monetary discipline .Speculation Limits speculators Uncertainty Predictable rate movements Trade balance adjustments Argue no link between
exchange rates and trade Link between savings and
investment
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10-23
IMF members exchange rate policy,2002
Fig 10.2
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10-24
Exchange rate regimes
Pegged Exchange Rates. Peg own currency to a major currency ($). Popular among smaller nations Evidence of moderation of inflation
Currency Boards. Country commits to converting domestic currency
on demand into another currency at a fixed exchange rate
Country holds foreign currency reserves equal to 100% of domestic currency issued
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10-25
Crisis management by the IMF
Role has expanded to meet crisis Currency crisis
when a speculative attack on a currency’s exchange value results in a sharp depreciation of the currency’s value or forces authorities to defend the currency
Banking crisis Loss of confidence in the banking system leading to a
run on the banks Foreign debt crisis
When a country cannot service its foreign debt obligations
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10-26
Incidence of currency and banking crisis
Fig 10.3
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Crises have common underlying causes
Common causes: High inflation Widening current account deficit Excessive expansion of domestic borrowing Asset price inflation
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10-28
Mexican currency crisis of 1995
Peso pegged to U.S. dollar Mexican producer prices rise by 45% without
corresponding exchange rate adjustment Investments continued ($64B between 1990 -1994 Speculators began selling pesos and government
lacked foreign currency reserves to defend it IMF stepped in
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10-29
Russian Ruble crisis
Financial markets loss of confidence in Russia’s ability to meet national and international payments Led to loss of international reserves and roll over
of treasury bills reaching maturity Financial markets unable to determine ‘who’s
in charge’
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10-30
Russian Ruble crisis
Persistent decline in value of ruble: High inflation
Artificial low prices in Communist era Shortage of goods Liberalized price controls
Too many rubles chasing too few goods
Growing public-sector debt Refusal to raise taxes to pay for government
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10-31
Government actions: Exacerbating the Situation
Defacto devaluation of the ruble Unilateral restructuring of ruble-denominated
public debt 90-day moratorium on foreign credits
repayment Hike in interest rates to defend ruble Duma rejects measures designed to alleviate
problems.
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Decline of the Ruble
-6000
-5000
-4000
-3000
-2000
-1000
0
1992 1993 1994 1995
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10-33
The Asian crisis
Factors leading to the Asian financial crisis of 1997
The investment boom Excess capacity The debt bomb Expanding imports
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The Asian crisis
Mid 1997 several key Thai financial institutions were on the verge of default Result of speculative overbuilding Excess investment (dollar denominated debt) Deteriorating balance-of payments position
Thailand asks IMF for help 17.2 billion in loans, given with restrictive conditions
Following devaluation of Thai baht speculation hit other Asian currencies Malaysia Singapore Indonesia Korea
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Problems in Asian Market Economies
Cronyism. Too much money, dependence on speculative
capital inflows. Lack of transparency in the financial sector. Currencies tied to strengthening dollar. Increasing current account deficits. Weakness in the Japanese economy
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Evaluating the IMF policy prescriptions
Inappropriate policies: “One size fits all’ Moral hazard:
People behave recklessly when they know they will be saved if things go wrong Foreign lending banks could fail Foreign lending banks have paid price for rash
lending Lack of Accountability
IMF has grown too powerful
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10-37
Impact on the countries
Currency devaluation Declining investment Rising prices Rising unemployment Rising poverty Rising resentment?
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10-38
Implications for business
Currency management Business strategy
Forward exchange market (months not years ahead)
Strategic flexibility Corporate-government relations