INBU 4200 INTERNATIONAL FINANCIAL MANAGEMENT

1
INBU 4200INTERNATIONAL FINANCIAL MANAGEMENT

• Lecture 2, Appendix 2
• History of the International Monetary System
  (With Focus on Exchange Rate Regimes).
• And The Euro-Zone (and the European Euro).

2
Recall from Lecture 2 the Definition of an
Exchange Rate Regime

• Defined The arrangement by which the price of a
  countrys currency is determined on foreign
  exchange markets.
• These arrangements range from
• Floating Rate
• Managed Rate (Dirty Float)
• Pegged Rate
• The particular arrangement is determining by
  individual governments.

3
History of Exchange Rate Regimes

• Over the past 200 years, the world has gone
  though major changes its global exchange rate
  environment.
• Starting with the gold standard in the 19th
  century to todays mixed system there are 3
  distinct periods
• Gold Standard 1816 - 1914
• Rates tied into gold contents.
• Bretton Woods 1945 1973
• Stable rates pegged to the U.S. dollar
• Mixed System 1973 the present
• But moving towards more flexibility (market
  determination) of rates.

4
Gold Standard 1816 - 1914

• During the 1800s, the industrial revolution
  brought about a vast increase in the production
  of goods and as a result widened the basis of
  world trade.
• At that time, trading countries believed that a
  necessary condition to facilitate world trade was
  a stable exchange rate system.
• Stable exchange rates were seen as necessary for
  encouraging and settling commercial transactions
  across borders (both by companies and by
  governments).
• So, by the second half of the 19th century, most
  major countries had adopted the gold standard
  exchange rate regime.

5
The Industrial Revolution and the British Empire

• The Industrial Revolution which began in the
  1760s was centered in Northwest England.
• The Industrial Revolution transformed Britain
  from an agricultural economy to one based on the
  application of power-driven machinery to
  manufacturing.
• As a result of Britains advantage in production,
  the amount of British products available for
  export increased.
• This was especially cotton textiles

6
The Dominance of the British Pound During the
Classical Gold Period

• Britains search for overseas markets for their
  manufactured goods (and for raw materials) was
  the incentive for overseas colonization in the
  1800s.
• During this period, Britain focused on markets in
  Asia and Africa.
• Trading posts were established in these colonies.
• Because of the dominance of the British Empire,
  the British pound became the worlds major
  trading currency.
• As one example, by 1914, 47 of the worlds
  holdings of international reserves was in the
  form of British pounds.

7
Basics of the Gold Standard

• The gold standard exchange rate regime required
  that each countrys national money be defined in
  terms of a specific weight of gold.
• As one example, during this period
• The U.S. dollar was defined as worth 0.0483 of
  an ounce of pure gold.
• And, the British pound was worth .23506
• Thus, the U.S. dollar British pound parity rate
  (ie.., the exchange rate) was about 4.8666 per
  pound sterling, or
• (.23506/.0483 4.8666)
• This was the gold standard exchange rate between
  these two currencies.

8
Examples of Some Countries Joining the Gold
Standard

• Country Date
• U.K. 1816
• Australia 1852
• Canada 1854
• Germany 1871
• France 1878
• U.S. 1879
• Japan 1897
• Russia 1897
• Mexico 1905

9
WWI (1914 1919)

• World War I (August 1914) marks the beginning of
  the end of the Gold Standard and the decline of
  the British pound.
• During the war, countries suspended the
  convertibility of their currencies into gold.
• During World War I and into the 1920s,
  governments let their currencies float. It was a
  time when speculators sold weak currencies and
  bought strong currencies.
• After the war, many countries suffered
  hyperinflation and economic recessions.
• As one policy solution, many countries turned to
  competitive devaluations in an attempt to
  stimulate their export sectors and gain
  advantages in world export markets.
• In reality, however, one countrys competitive
  devaluation was followed by another country
  currency devaluation (as an offset).

10
Interwar Period 1919 1939

• After WW I, various attempts were made to restore
  the classical gold standard.
• 1919 United States returned to a gold standard.
• 1925 Great Britain joined, followed by France
  and Switzerland.
• These attempts proved unsuccessful.
• Why During this time, most countries were more
  concerned with their national economies than
  exchange rate stability.
• Especially during the Great Depression (1929
  1930s)
• As a result, countries abandoned their attempts
  to return to an interwar gold standard.
• Britain and Japan dropped it in 1931, the U.S. in
  1933.
• Countries also erected high tariff walls to
  protect their domestic economy.
• During the depression years, world trade slowed
  and eventually declined to very low levels.

11
Bretton Woods July 1944

• As World War II was coming to an end, all 44
  allied countries met in Bretton Woods, New
  Hampshire (at the Mount Washington Hotel), to
  consider a new international monetary system.
• During this period
• The U.S. economy emerged as
• the worlds strongest.
• The Bretton Woods
• International
• Monetary System
• was agreed upon at these
• meetings.
• U.S. dollar becomes the
• key currency within this
• new arrangement

12
Bretton Woods Agreements

• At Bretton Woods, it was agreed that fixed
  exchange rates were necessary for restarting
  world trade and global investment.
• As noted, the U.S. dollar became the cornerstone
  of this new international monetary system.
• Key points of Bretton Woods were
• U.S. dollar is pegged to gold at 35 per ounce,
  and the
• Dollar is the only currency which is convertible
  into gold.
• All other countries peg their currencies to the
  U.S. dollar.
• Their par values are set in relation to the U.S.
  dollar
• Countries agree to support their exchange rates
  within or 1 of these established par values.
• This is done through the buying or selling of
  foreign exchange when market forces needed to be
  offset.

13
Examples of Bretton Woods Par Values

• Foreign currencies were linked (pegged) to the
  U.S. Dollar which in turn was linked (pegged) to
  gold

BRITISH POUND Par Value 2.80/
GERMAN MARK Par Value DM4.2/
ITALIAN LIRA Par Value Lit625/
JAPANESE YEN Par Value 360/
U.S. DOLLAR
GOLD 35 an ounce
14
Key Bretton Woods Agreements

• During the Bretton Woods period, countries agreed
  not to devalue their currencies for trade gaining
  purposes.
• Competitive devaluations were prohibited.
• However, currency devaluations were allowed in
  response to fundamental and chronic balance of
  payments disequilibrium.
• U.S. dollar, however, was the one currency which
  was not permitted to change its value.
• The Bretton Woods meetings also create
• International Monetary Fund (IMF).
• World Bank.

15
International Monetary Fund (IMF)

• The IMF is created to watch over the
  international monetary system and to ensure the
  maintenance of fixed-exchange rates.
• IMF agrees to lend a country hard currency when
  needed to defend their par values.
• Stated goal of the IMF at the time is to promote
  international monetary cooperation and facilitate
  the growth of international trade.
• Recall that stable exchange rates are seen as
  critical to this IMF goal.

16
World Bank

• The World Bank is also part of the 1944 Bretton
  Woods Agreement
• Initial goal of World Bank was to rebuild Europe
  and Asias war-torn economies through U.S.
  financial aid.
• World Bank manages Marshall aid funds to Europe
  and Asia.
• In later years, the World Bank turns to
  development issues.
• Today the World Bank lends money to developing
  countries for
• Agriculture
• Education
• Population issues (e.g., water supplies)
• Urban development

17
Assessment of Bretton Woods 1944- 1960s

• During its first two decades, the Bretton Woods
  International Monetary System appears to be
  successful.
• Exchange rates are relatively stable and world
  trade grows.
• Some countries, however, do devalue their
  currencies.
• This causes the U.S. dollar to effectively
  appreciate.

18
Example of the Stable Yen During Bretton Woods
362 to 358 Range
19
The Seeds of Bretton Woods Demise

• In the 1960s, Bretton Woods begins to unravel.
• President Lyndon Johnson tries to finance both
  his Great Society programs at home and the
  American war in Vietnam.
• This produces a large US Federal budget deficit,
  which, coupled with easy monetary policy, results
  in
• High inflation in the United States and
• An increase in U.S. spending for cheaper imports
• As a result, the United States balance of
  payments moves from a surplus into a deficit.
• Dollar is seen by the market as overvalued.
• Foreigners become concerned about holding
  overvalued U.S. dollars at a rate of 35 an
  ounce.
• Markets are suggesting it should take more than
  35 to buy 1 oz of gold.

20
U.S. Balance of Payments 1965 -

• By the mid-1960, the U.S. balance of payment is
  showing marked deterioration.
• And 1971, the U.S. merchandise trade balance
  actually moves into deficit.
• But, U.S. dollar is still pegged at 35 per
  ounce.
• And now is starting to be seen by markets as
  overvalued.

21
The Last Years of Bretton Woods 1970 -1973

• By 1970, financial markets are unwilling to hold
  the overvalued U.S. dollar.
• Dollars are sold on foreign exchange markets.
• This puts downward pressure on the exchange rate
  for dollars.
• And upward pressure on the exchange rate for
  foreign currencies.
• Central banks engage in massive intervention in
  an attempt to hold their Bretton Woods par
  values.
• They buy U.S. dollars as they are sold in
  markets.
• As a result, foreign holdings of dollars increase
  dramatically and eventually exceed U.S. gold
  holdings.
• By 1971, gold coverage for U.S. dollars had
  dropped to 22.
• Then, in August 1971, President Nixon suspends
  dollar convertibility into gold.
• In response, more dollars are sold on foreign
  exchange markets and the dollar trades lower in
  response (and foreign currencies appreciate).
• U.S. government expresses an interested in
  forging a new fixed exchange rate system, but
  one without gold.

22
Smithsonian Agreements, 1971

• In December 1971, ten major counties meet in
  Washington, D.C.
• Meeting results in the Smithsonian Agreements,
  whereby
• Key countries agree to revalue their currencies
  (e.g., yen 17, mark 13.5, pound and franc 9)
• In return, the U.S. agrees to raise the dollar
  price of gold from 35 to 38 an ounce.
• Combined, this was equivalent to a effective
  dollar devaluation of 8.57.
• However, this dollar devaluation had no
  significance because the dollar remained
  inconvertible.
• But currencies were also allowed to fluctuate
  or 2.25.

23
The Dollar Collapses, 1973

• 13 months after the Smithsonian Agreements, the
  dollar comes under renewed attack.
• February 1973, markets sell off dollars again.
• Central banks again intervene and buy dollars.
• On February, 12th, 1973 the dollar is devalued
  further to 42.
• But the price of gold on the London gold markets
  is 70 per ounce.
• Japan and Italy finally let their currencies
  float on February 13th.
• France and Germany continue to manage their
  currencies in relation to the dollar.
• In response to mounting speculative currency
  flows, foreign exchange markets are closed on
  March 1, 1973, and reopen on March 19, 1973.

24
The Collapse of Bretton Woods

• On March, 19th, 1973, when foreign exchange
  markets reopen, major countries float their
  currencies
• On March 19, 1973, the list floating their
  currencies includes Japan, Canada, and Western
  Europe.
• The Bretton Woods fixed exchange rate system
  effectively ends on this date.
• And by June 1973, the dollar floats down an
  average of 10 against the major currencies of
  the world.

25
1975 Jamaican Agreement

• In January 1975, IMF member countries meet for
  the first time since the end of Bretton Woods in
  Jamaica and agree to the following
• To officially accept flexible exchange rate
  regimes and,
• Agree, that central banks should intervene (e.g.,
  buy and sell their currencies) in foreign
  exchange markets to deal with unwarranted
  currency volatility.
• These meetings are referred to as the Jamaican
  Agreement.

26
Early Post Bretton Woods Years

• During the years immediately after the collapse
  of Bretton Woods, the dollar fluctuates, but no
  discernable trend is observed at first.
• Consensus view is that during these early years
  the new system works fairly well.
• And, by the end of 1973, the dollar actually
  recovers in response a strengthening U.S. balance
  of payments position brought about by the weak
  dollar.
• One potential problem, however, is the formation
  and success of OPEC in 1973.
• First OPEC imposes an oil embargo, followed by
• Oil prices increases from under 5 a barrel to
  around 30 by 1980.

27
Renewed U.S. Dollar Crisis, 1977-1978

• During the 1977-78 period, expansionary domestic
  monetary policy of the Carter administration
  leads to increasing rates of inflation and a
  deterioration of the U.S. balance of payments.
• Thus, the dollar comes under attack again.
• From early 1977 to October 1978, the dollar loses
  20 of its value.
• In response to the foreign exchange market
  instability, in March 1979, 9 members of the
  European Union establish the European Monetary
  System, with the goal of promoting exchange rate
  stability within this group.

28
Mid 1970s to Mid 1980s

• From the mid 1970s until 1980, the U.S. dollar
  continues to weaken against most currencies.
• This results from high inflation in the U.S. and
  continuing deterioration of the U.S. balance of
  payments.
• In April 1981, the U.S. Government announces that
  they will no longer intervene in foreign exchange
  markets to support the dollar.
• Thus, U.S. central bank intervention on behalf of
  the dollar comes to an end!
• However, from 1980 to February 1985, the dollar
  unexpectedly strengthens.
• Why?
• Relatively high U.S. interest rates attracted
  foreign capital inflows and more than offset the
  trade deficit outflow.

29
1985 Plaza Accord

• In September 1985, 5 countries (U.S. , U.K.,
  France, Germany and Japan) meet at the Plaza
  Hotel in New York.
• They sign the Plaza Accord, whereby
• Countries agree on coordinated intervention in
  foreign exchange markets to deal with the strong
  U.S. dollar and the U.S. trade deficit.
• They agree to sell U.S. dollars on foreign
  exchange markets (i.e., increase supply) and thus
  drive down its exchange rate.
• G7 felt a weak dollar was needed to offset U.S.
  trade deficit.
• In response to central bank intervention, the
  U.S. dollar weakens.
• Over the next ten years, the dollar continues to
  weaken as markets respond to a continuing
  worsening of the U.S. trade deficit.

30
Roller Coaster Decade of the 1980s
Strong Dollar Period 1980 - 1985
WEAK DOLLAR
31
1987 Louvre Accord

• In February 1987, G7 meet in Paris, France
  (Louvre Accord)
• Countries agree to engage in greater cooperate to
  achieve reasonable exchange rate stability, and
• To consult and also coordinate their
  macroeconomic policies.
• The dollar continues to be weak until the
  mid-1990s.

32
Mid 1990s to Early 2000s

• From 1996 through 2001 the dollar strengthens.
• Strong U.S. economic performance attracts capital
  inflows.
• Strong economic performance offsets trade deficit
  concerns.
• Beginning in 2002, however, the dollar weakens
  again.
• U.S. deficits become a concern again.

33
Where are we Today in Terms of Exchange Rate
Regimes?

• Mixed International Monetary System consisting
  of
• Floating exchange rate regimes
• Market forces determine the relative value of a
  currency.
• Managed (dirty float) rate regimes
• Governments managing their currencys value with
  regard to a reference currency.
• Market moves these currencies, but governments
  are managing the process and intervening when
  necessary.
• Pegged exchange rate regimes
• Government fixes (links) the value of its
  currency relative to a reference currency.
• Fewer of these regimes than in the past.

34
Post Bretton Woods Summary

• Since March 1973, the major currencies of the
  world operate under a floating exchange rate
  system.
• A growing number of other currencies have also
  moved to a floating rate system.
• Thus more and more, market forces are driving
  currency values.
• The Post Bretton Woods period has resulted
  exchange rates become much more volatile and less
  predictable then they were during previous fixed
  exchange rate eras.
• This currency volatility complicates the
  management of global companies.

35
The Euro-Zone A Currency Union

• As of January 1, 2007, 13 countries within the 25
  member European Union have adopted a single
  currency, the euro, as their legal tender.
• In essence, the national currencies of these 13
  countries has been replaced by the euro.
• As one example

36
The Euro Time Line Pre Euro

• 1979 European Monetary System is created.
• Recall this period was one of increasing exchange
  rate instability.
• The EMS was designed to promote exchange rate
  stability within the European Community.
• European currencies were tied (pegged) to one
  another.
• But essentially they were all linked to the
  German mark.
• Series of crises followed within the EMS, but it
  survives
• 1991 Maastricht Treaty signed.
• Calls for the adoption of a single currency in
  Europe by 1999.
• But countries needed to meet specified economic
  and financial criteria before they could adopt
  the single currency.
• And some countries elect not to join the euro
  curreny zone (U.K. ops out).

37
The Euro Time Line Introducing the Euro

• January 1, 1999. The European Monetary Union
  (EMU) is created.
• Eleven countries irrevocably lock their national
  currencies to the euro.
• For Example 1,936.27 Italian lira 1 euro
  1.95583 German marks 1 euro, etc.
• These locked rates were based on the exchange
  rates between these national currencies on
  January 1, 1999.
• The euro starts trading on foreign exchange
  markets.
• January 1, 2002. euro notes and coins are
  introduced into circulation and over a short
  period of time all national money is withdrawn.
• Greece joins the Euro zone on January 1, 2002,
  and Slovenia joins on January 1, 2007, bringing
  the current number of countries in the euro zone
  to 13.
• The U.K., Denmark, and Sweden remain out.

38
Countries in the Euro-Zone Today

• Whose in the Euro-zone (12)
• Austria, Belgium, Finland, France, Germany,
  Greece, Ireland, Italy, Luxembourg, Netherlands,
  Portugal, Spain.
• Whose out of Euro Zone (But in the EU)
• The U.K., Denmark, Sweden and the 10 countries
  that joined the European Union on May 1, 2004.
• Cyprus, Czech Republic, Estonia, Hungary, Latvia,
  Lithuania, Malta, Poland, Slovakia,  Slovenia
• Bulgaria and Romania hope to join the EU by 2007.

39
The European Central Bank

• As part of the European Monetary Union, the
  European Central Bank (ECB) was created.
• Headquartered in Frankfurt, Germany
• It is modeled after the German Bundesbank.
• Thus, the ECB is highly independent and low
  inflation becomes its main objective.
• See http//www.ecb.int/home/html/index.en.html
• Primary objective of the ECB is to maintain
  price stability within the euro-zone.
• Price stability is defined in the ECB charter at
  less than 2
• This inflation targeting goal is achieved through
  ECB interest rate policies.
• But many (even in Europe) see the ECB as
  operating within too narrow a mandate.
• Especially true with high rates of unemployment
  in key euro zone countries.

40
The Euro-Zone and Exchange Rate Risk

• In essence, the single currency of the eurozone
  has removed exchange rate issues for transactions
  within the euro-zone itself.
• However, the euro itself is still a floating
  currency against the other currencies of the
  world.
• Thus, exchange rate issues exist for foreign
  companies (e.g., American firms and U.K. firms)
  doing business in the euro-zone and euro-zone
  countries doing business outside of the singe
  currency area.
• This is important to remember.

41
The Euro Exchange Rate Jan 1, 1999 -

• Note Exchange rate on first trading day 1.18
  (American Terms)
• Source http//fx.sauder.ubc.ca/