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

5Understanding theUnderstanding the

InternationalInternational Monetary SystemMonetary System

International Businessby Ball, McCulloch, Frantz,

Geringer, and Minor McGraw-Hill/Irwin Copyright © 2006 The McGraw-Hill Companies, Inc. All rights reserved.

This chapter covers:

•Historical and present uses of gold

•Developments shaping the world monetary system

•Balance of payments

•Purchasing power parity theory

•Major foreign currency markets

•Currency conflict and SDR

•The euro

Chapter ObjectivesChapter Objectives Understand the historical and present uses and

attractiveness of gold Explain the developments shaping the world monetary

system Explain activities of the International Monetary Fund Explain the purposes of the World Bank and its IFC 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 countries5-2

Convertible CurrenciesConvertible Currencies

Currencies readily convertible in the market Also called

“hard” currencies

Most developing countries are not convertible

5-3

Gold Standard HistoryGold Standard History

From about 120 to present price of gold generally up

Rise in value interrupted around 1980 Early 2002 gold regained safe haven status Most trading and industrial countries

adopted the gold standard Each country set a certain number of units of

its currency per ounce of gold Comparison of the numbers of units from

country to country known as exchange rate Gold standard ended during World War I5-4

Bretton Woods and the Gold Exchange Bretton Woods and the Gold Exchange StandardStandard

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.

5-5

Bretton Woods and the Gold Exchange Bretton Woods and the Gold Exchange StandardStandard

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

5-6

International Monetary FundInternational Monetary Fund

Abandoned objective of fixed exchange rate 1970s

Exercises “firm surveillance” over exchange rate policies of members Board of governors regularly examine policies

and performance Board reviews economic outlook and exchange

rate developments Coordinates with the World Bank to correct

economic problems

5-7

World BankWorld Bank

International Bank for Reconstruction and Development (IBRD)

Consists of International Finance Corporation (IFC) International Development Association (IDA) Multilateral Investment Guarantee Agency

(MIGA) International Center for Settlement of

Investment Disputes (ICSID) Other Multilateral Development Banks

African, Asian, European, Inter-American5-8

Bank for International SettlementsBank for International Settlements

Located in Basel, Switzerland Functions

Forum for international monetary cooperation

Center for research Banker for central banks Agent with regard to various international

financial arrangements Chair of U.S. Federal Reserve represents U.S.

5-9

Balance of PaymentsBalance of Payments

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.

5-10

Balance of PaymentsBalance of Payments

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 Quotas5-11

International TransactionsInternational Transactions Debits involve payments

by domestic residents to foreign residents

Dividend, interest and debt repayment services

Merchandise imports Transportation

services Foreign investments Gifts to foreign

residents Imports of gold

5-12

Credits involve payments by foreign residents to domestic residents

The BOP is presented as double-entry accounting statement

Total credits and debits are always equal.

BOP AccountsBOP Accounts

Current Account Goods or

merchandise Services Unilateral transfers

Capital Account Direct investments Portfolio

investments Short-term capital

flows5-13

Official Reserves Account Gold imports and

exports Increases or

decreases in foreign exchange held by government

Decreases or increases in liabilities to foreign central banks

Balance of Payment DeficitBalance of Payment Deficit

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.

Fundamental BOP deficit too severe to be repaired by monetary or fiscal policies IMF permits countries’

currencies to be devalued

5-14

Gold Exchange StandardGold 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. The gold standard ends

By 1971, many more dollars were in the hands of foreign central banks than the gold held by the U.S. Treasury could cover.

5-15

Currency Exchange RatesCurrency Exchange Rates

Two attempts made to set fixed currency exchange rates December 1971 and February 1973 Speculators felt banks had pegged rates

incorrectly March 1973 floating currency exchange

rates developed Clean float depends on competition with no

government intervention Dirty float governments intervene and manage

currency market to smooth irregularities5-16

Group of Seven (G7)Group of Seven (G7)

Plaza Accord Result of concern over

U.S. trade deficit Group of Five included

Britain, France, Germany, Japan, U.S.

Met in 1985 to set the US$ at the “right” exchange rate

Canada and Italy added to become G7 Meet yearly to

coordinate economic policy

5-17

Currency AreasCurrency 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.

In Europe during the mid-1970 a currency grouping called the “snake” was created led by German deutsche mark

The snake was so called because of how it appeared on a graph showing the member currencies floating against nonmember currencies.

System’s inflexibility led to ultimate demise.5-18

Experience with FloatingExperience with Floating

Fears that banking and money systems would not be able to handle amounts and directions of currency flows were unfounded

January 1999 new major currency, the euro, joined the world market

Floating exchange rates create big uncertainties for international business managers

Asian financial crisis in 1997 reduced Asian reliance on U.S. economy

Forecasting float direction includes measuring inflation with purchasing power parity (PPP)

5-19

Big MacCurrenciesBig MacCurrencies

5-20

Money Markets, Foreign ExchangeMoney 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

5-21

Money Markets, Foreign ExchangeMoney Markets, Foreign Exchange

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

Singapore fourth largest currency trading center

5-22

Most traded currency US$ Busiest currency trades

US$ - euro first, then US$ - yen US$ - British sterling US$ - Swiss franc Euro – yen

Virtually all Asian trade is through the US$

Rates not quoted in US$ are called cross rates

Special Drawing Rights (SDRs)Special Drawing Rights (SDRs)

SDRs in the future 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.

Value based on a basked of four currencies US dollar, euro, Japanese yen, British pound Percentage of each changes periodically Calculated daily by the IMF

5-23

Uses of SDRUses of 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.

Not likely to become principal reserve asset

5-24

European Monetary SystemEuropean Monetary System European countries prefer

fixed exchange rates EMS created in 1979

Replaced the snake with a more flexible system

European Currency Unit (ECU) established as bookkeeping currency

more popular than the SDR

Euro has replaced ECU and 12 national currencies Euro is supervised by

the European Central Bank

5-25

Transition to the EuroTransition to the Euro

Began on January 1, 1999

Coins and notes of 12 countries replaced Circulated side by

side until January 1, 2002

Exchanged old for new at commercial banks

Twelve countries now called the “eurozone”

All under European Central Bank

Figure 5.6

5-26

Fast Facts on the IMFFast Facts on the IMF

Current Membership: 184 countries

Staff: approximately 2,690 from 141 countries

Total Quotas: $316 billion (as of 12/31/03)

Loans Outstanding: $107 billion to 87 countries, of which $10 billion to 60 on concessional terms (as of 12/31/03)

Technical Assistance provided: 356 person years during FY2003

Surveillance Consultations concluded: 136 countries during FY2003, of which 96 voluntarily published their staff reports

IMF LoansIMF Loans

Canada’s BOP DataCanada’s BOP Data

CountryCountry GDP - per capitaGDP - per capita Afghanistan purchasing power parity - $700 (2003 est.) Albania purchasing power parity - $4,500 (2003 est.) Algeria purchasing power parity - $5,900 (2003 est.) American Samoa purchasing power parity - $8,000

(2000 est.) Andorra purchasing power parity - $19,000 (2000 est.)

Angola purchasing power parity - $1,900 (2003 est.) Anguilla purchasing power parity - $8,600 (2001 est.) Antigua and Barbuda purchasing power parity - $11,000

(2002 est.) Argentina purchasing power parity - $11,200 (2003 est.)

Armenia purchasing power parity - $3,900 (2003 est.) Aruba purchasing power parity - $28,000 (2002 est.) Australia purchasing power parity - $28,900 (2003 est.) Austria purchasing power parity - $30,000 (2003 est.)

Warning Signs of Foreign Currency Warning Signs of Foreign Currency

Exchange FraudExchange Fraud Stay Away From

Opportunities That Sound Too Good to Be True

Avoid Any Company that Predicts or Guarantees Large Profits

Stay Away From Companies That Promise Little or No Financial Risk

Don't Trade on Margin Unless You Understand What It Means

Source: www.cftc.gov

Question Firms That Claim To Trade in the "Interbank Market"

Be Wary of Sending or Transferring Cash on the Internet, By Mail or Otherwise

Currency Scams Often Target Members of Ethnic Minorities

Be Sure You Get the Company's Performance Track Record

Don't Deal With Anyone Who Won't Give You Their Background

Two Types of SDRsTwo Types of SDRs

General allocations of SDRs Have to be based on a

long-term global need to supplement existing reserve assets. General allocations are considered every five years, although decisions to allocate SDRs have been made only twice.

Source: www.imf.org

Special one-time allocation of SDRs Approved by the IMF's

Board of Governors in September 1997. Its intent is to enable all members of the IMF to participate in the SDR system on an equitable basis and correct for the fact that countries that joined the Fund subsequent to 1981 have never received an SDR allocation.

Euro CoinsEuro Coins

Euro coins have one common side and one national side. They can be used anywhere within the euro area, regardless of the country of issue.

There are coins in denominations of €2, €1, 50 cent, 20 cent, 10 cent, 5 cent, 2 cent and 1 cent. There are 100 cent to €1.

Euro coins are also available for Monaco, San Marino and Vatican City (example).

Source: www.euro.gov.uk