In this chapter, you will explore what factors determine ...learnline.cdu.edu.au/units/lbaresources/bus/bco301/3...nation’s exports. •Devaluation, which entails lowering the value

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In this chapter, you will explore what factors determine exchange rates and recent attempts to manage them.You will also:•Learn how exchange rates affect all sorts of business activities.•Examine different methods of forecasting exchange rates.•And understand how the international monetary system functions.

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Exchange rates can increase or decrease world prices and, therefore, demand of a nation’s exports.•Devaluation, which entails lowering the value of a currency, reduces the price of exports on world markets and increases the price of imports.•Revaluation, which involves raising the value of a currency, increases the price of exports on world markets and reduces the price of imports.

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Exchange rates are used to translate earnings abroad into the home currency.•Translating subsidiary earnings from a weak host country currency into a strong home currency reduces earnings.•On the other hand, translating earnings from a strong host country currency into a weak home currency increases earnings.

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Stable exchange rates improve the accuracy of forecasts and financial planning.Predictable exchange rates lessen the odds for surprises, and reduce the need for costly currency hedging practices.

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This figure reveals periods of stability and instability of the U.S. dollar over time. For the past 50 years the USA dollarHas been the international currency.

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Stable exchange rates do not guarantee a currency’s buying power because purchasing power fluctuates.•Suppose the same dinner costs you $60 in New York, $80 in Japan, and $30 in Mexico.•This means that your dollars lost purchasing power in Japan and gained purchasing power in Mexico.

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Answer:Devaluation is the intentional lowering of the value of a currency by the nation’s government. It lowers the price of a country’s exports and increases the price of imports because the country’s currency is now worth less on world markets. But devaluation also reduces a currency’s buying power. Revaluation is the intentional raising of the value of a currency by the nation’s government. It increases the price of a country’s exports and lowers the price of imports. Revaluation boosts a currency’s buying power.eva uat o boosts a cu e cy s buy g powe .

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The law of one price says that an identical product must have an identical price in all countries when expressed in a common currency.If price were not identical in each country, arbitrage traders would buy the product in a low-priced market and sell it in a high-priced market.

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The Economist magazine uses the law of one price to explore the overvaluation or undervaluation of currencies.

• It compares the price of a Big Mac sandwich in the United States with its price in other nations.

• Despite its simplicity, the index is a fairly good predictor of the direction, although perhaps not the magnitude, that rates will move in the future.

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Purchasing power parity (or PPP) is the relative ability of two countries’ currencies to buy the same “basket” of goods in those two countries.•PPP considers price levels in adjusting the relative values of two currencies.•Economic forces push a market exchange rate toward that calculated by PPP or an arbitrage opportunity arises.

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If money is injected into an economy that is not producing greater output, a greater amount of money is spent on a static amount of products. Demand for products soon outstrips their supply, prices rise, and inflation then erodes purchasing power.

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• Monetary policy involves buying or selling government securities on the open market to influence the money supply and, therefore, the rate of inflation.

• Fiscal policy involves using taxes and government spending to influence the money supply indirectly.

• High rates of employment puts upward pressure on wages. To maintain profit margins with higher labor costs, producers then pass the cost of higher wages on to consumers in the form of higher priceson to consumers in the form of higher prices.

• Low interest rates encourage consumers and businesses to borrow and spend money, which adds to inflationary pressures.

• Exchange rates adjust to different rates of inflation between countries. If inflation in Mexico is higher than that in the United States, the peso is losing more value than is the dollar. The peso/dollar exchange rate will adjust to reflect a now less valuable peso.p

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• The Fisher effect is the principle that the nominal interest rate is the sum of the real interest rate plus the expected rate of inflation over a specific period.

• The international Fisher effect is the principle that a difference in nominal interest rates supported by two countries’ currencies will cause an equal but opposite change in their spot exchange rates.

• Because real interest rates are theoretically equal across countries, inflation must be the cause of any difference in interest rates between two countries.

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Several factors may explain why PPP is a better predictor of long-term exchange rates than short-term rates.•It assumes no added costs, such as transportation costs between nations. This can overstate the presence of arbitrage opportunities. Such costs between markets can allow unequal prices to persist and PPP to fail.•It assumes no trade barriers. But a high tariff or outright ban on a product can impair price leveling and cause PPP to fail to predict exchange rates accurately.•It overlooks business confidence and human psychology. Yet, nations try to maintain the confidence of investors, businesspeople, and consumers in their economies and their currencies.

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The principle known as the Purchasing power parity can be interpreted as the exchange rate between two nations’ currencies that is equal to the ratio of their price levels.

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In an efficient market, prices of financial instruments quickly adjust to reflect new public information coming available to traders.The efficient market view says that prices of financial instruments reflect all publicly available information at any given time.•This implies that forward exchange rates are the best possible predictors of future exchange rates and it is worthless to seek additional information.The inefficient market view says that prices of financial instruments do not reflect all publicly available information and that additional information can improve forecasts.•This view is more compelling considering private information, such as when a currency trader who holds privileged information acts on this information to earn a profit.

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Fundamental analysis uses statistical models based on economic indicators to forecast exchange rates.•Such indicators include inflation, interest rates, the money supply, tax rates, government spending, and a nation’s balance-of-payments situation.Technical analysis uses past trends in currency prices and other factors to forecast exchange rates.•Using past data trends, analysts examine conditions that prevailed during past changes in exchange rates and estimate the timing, magnitude, and direction of future changes.Forecasting difficulties include flawed data and human error.•For example, a forecaster may underestimate the importance of certain economic events and overestimate the importance of others.

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Companies facing a strong or rising home-country currency may wish to:•Prune operations to cut costs and boost efficiency.•Adapt products to better suit international customers.•Source abroad for inputs if this reduces costs.•Freeze prices to keep sales moving.Companies facing a weak or falling home-country currency may wish to:S d i ll h h l h i d id h i k•Source domestically to shorten the supply chain and avoid exchange rate risk.

•Grow at home against the higher priced imports of competitors.•Push exports to exploit the price advantage gained from a weak currency.•Reduce expenses by using the latest communication and transport technologies.

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The gold standard was a fixed exchange rate system that linked the paper currencies of nations to specific values of gold and, indirectly, to one another. The gold standard offered several advantages.

• First, fixed exchange rates between currencies reduced exchange rate riskand, in turn, helped expand world trade.

• Second, the gold standard imposed strict monetary policies on nations by forcing them to convert their paper currency into gold upon demand by holders of the currency This tightly controlled inflation because nationsholders of the currency. This tightly controlled inflation because nations could not let the value of their paper currency grow faster than the value of their gold reserves.

• Third, the system helped correct a nation’s trade imbalances. For example, a nation experiencing a trade deficit would see its supply of gold (the accepted medium of exchange) go to pay for imports and would need to decrease the value of its paper currency in circulation. As the money supply fell, so would prices for goods and services because fewer dollars would be available to purchase a static supply of products. Falling domestic prices would make the nation’s exports cheaper on world markets. Exports would then increase until the nation’s trade was again balanced.

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• Nations violated the gold standard by printing excessive amounts of paper currency during the First World War. This caused rapid inflation and forced governments to abandon the gold standard.

• Britain later returned to the gold standard, but at the pound’s value that existed prior to the war. The United States also returned to the gold standard, but at the dollar’s lower value that accounted for inflation and a devalued dollar. This reduced world prices of U.S. exports and increased prices of British exports.t s e po ts.

• Many nations then engaged in competitive devaluations to improve their own trade balances. The gold standard was no longer a true indicator of currency values and the system collapsed.

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The Bretton Woods Agreement aimed to balance the strict discipline of the gold standard with the flexibility needed to manage temporary monetary difficulties. It had four main features.•First, it fixed the exchange rate between gold and the U.S. dollar, and tied other currencies to the value of the dollar instead of gold. Currencies could deviate no more than 1 percent above or below their predetermined values.•Second, it built flexibility into the system by allowing a nation to devalue its currency if a trade deficit caused a permanent negative shift in its balance ofcurrency if a trade deficit caused a permanent negative shift in its balance of payments.•Third, it created the World Bank to fund national economic development efforts, such as projects to develop transportation networks, power facilities, educational systems, and agricultural programs.•Fourth, it created the International Monetary Fund to regulate exchange rates and enforce the rules of the international monetary system.y y

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The Bretton Woods system faltered in 1971 when nations holding paper dollars doubted that the U.S. had enough gold to redeem all of its currency held abroad.•In fact, the U.S. government held less than one-fourth of the amount of gold it needed. A global sell-off of dollars erupted as nations demanded gold in exchange for paper dollars. Markets calmed after nations agreed to increase the value of their currencies against the dollar.•But a persistent trade deficit and high inflation in the United States kept the dollar weak on currency markets Around the world governments had difficultydollar weak on currency markets. Around the world, governments had difficulty maintaining their own exchange rates with a continually weaker dollar and abandoned the system.

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RecapThe gold standard linked nations’ paper currencies to specific values of gold and, indirectly, to one another. First, fixed exchange rates between currencies reduced exchange rate risk. Second, it imposed strict monetary policies on nations by forcing them to convert their paper currencies into gold upon demand by holders of the currency. This tightly controlled inflation because nations could not let their paper currency grow faster than the value of their gold reserves. And third, the system helped correct trade imbalances because a nation experiencing a trade t e syste helped co ect t ade imbalances because a at o e pe e c g a t adedeficit would need to decrease its domestic supply of paper currency, which would lower domestic prices, which would lower prices for the nation’s exports, which would increase exports until trade was once again balanced.

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•The free float system of exchange rates that emerged from the ashes of the Bretton Woods Agreement was meant to be temporary.•In 1976, the Jamaica Agreement formalized a managed float system of exchange rates in which governments were to stabilize their currencies around target exchange rates.•Later agreements arose as needed and nations agreed to continue intervening in currency markets to stabilize exchange rates.

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Today, the international monetary system remains a managed float system. But some governments achieve more stable exchange rates by tying their currencies to those of other countries.•A country that ties its currency to a more stable and widely used currency in international trade follows a “pegged” exchange rate arrangement. Countries commonly peg their currencies to the dollar, the euro, or the special drawing right of the IMF. Some nations peg their currency to a “basket” of several currencies.•A country that commits to exchange domestic currency for a specified foreign•A country that commits to exchange domestic currency for a specified foreign currency at a fixed exchange rate uses a currency board. The government is legally bound to hold a stated amount of foreign currency that is equal to the amount of domestic currency to help cap inflation.•The European monetary system stabilized currencies and reduced exchange-rate risk from 1979 until 1999, when the European Union adopted its single currency, the euro. Members kept their currencies trading within a specific range. Despite experiencing problems in the early 1990s, the system made currency realignments infrequent and controlled inflation well.

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Despite efforts to manage the international monetary system and stabilize currencies, some nations have experienced wrenching financial crises.

• By the early 1980s, it appeared that developing nations may default on huge debts owed to global commercial banks, the IMF, and the World Bank. Repayment schedules were revised to prevent a global financial meltdown. The Brady Plan of 1989 called for large reductions in poor nations’ debts, new lower-interest loans, and the issuance of marketable debt instruments.

• When social unrest struck Mexico in 1993 its government responded slowly• When social unrest struck Mexico in 1993, its government responded slowly to the departure of foreign investment. Mexico devalued its peso in 1994, forcing it to lose purchasing power. The IMF and private U.S. banks needed to lend Mexico around $50 billion, which it repaid ahead of schedule.

• Southeast Asia fell into a severe economic slump in 1997 after currency traders sold massive amounts of regional currencies on world markets. In the end, Indonesia, South Korea, and Thailand needed IMF and World Bank funding. The crisis was likely due to crony capitalism, a lack of financial transparency, currency speculators, panicking investors, and persistent current account deficits across the region.

• Russia experienced problems due to spillover from the Southeast Asia crisis, depressed oil prices (Russia’s main export), falling hard currency reserves, and high inflation. Currency traders dumped the ruble on currency markets in 1996. By late 1998, the IMF had lent Russia more than $22 billion.

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y ,• And after a four-year-long recession, Argentina defaulted on its $155 billion

of public debt in 2002. A currency board that linked Argentina’s peso to a strong U.S. dollar had made its exports very expensive on world markets. Argentina scrapped its currency board and the peso fell by around 70 percent. The country is since recovering through a plan of boosting wages, imposing price controls, keeping the peso low, and increasing public spending.

More recently, some nations in the European Union had let their debt soar to unsustainable levels. In 2010, the IMF and European Union organized a bailout for Greece, but the Greek people reacted with anger and protests to the austerity measures forced upon them. By mid 2011, Portugal had also received a bailout and Ireland and Spain looked as though they may be next. These financial crises underscore the need for managers to fully understand the complexities of the international financial system.

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Recurring crises are raising calls for a new international monetary system that is designed to meet today’s challenges. Many critics want the IMF to increase transparency and accountability, better mange financial risks and monitor flows of “hot” money, and revise its policy prescriptions. The private sector can also play a larger role in preventing and resolving financial crises through more careful lending practices and by cooperating more with the IMF and national governments.

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A Managed float exchange rate system is one in which currencies float against one another, with governments intervening to stabilize their currencies at particular exchange rates.

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In this Topic, you will explore how companies select their international strategies and structures.You will also:•Learn about the variety of strategies that companies use in international business.•Examine the organizational structures used in international operations.•And understand factors relevant to selecting these strategies and structures.g g

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