Discussion Question
What is your assessment on the future of the Euro?
Multinational Business Finance, Fifteenth Edition, Chapter 2, The International Monetary System Multinational Business Finance Fifteenth Edition Chapter 2 The International Monetary System Copyright © 2019 Pearson Education, Inc. All Rights Reserved Slides in this presentation contain hyperlinks. JAWS users should be able to get a list of links by using INSERT+F7 If this PowerPoint presentation contains mathematical equations, you may need to check that your computer has the following installed: 1) MathType Plugin 2) Math Player (free versions available) 3) NVDA Reader (free versions available) 1 Learning Objectives (1 of 2) 2.1 Explore how the international monetary system has evolved from the days of the gold standard to today’s eclectic currency arrangement 2.2 Examine how the choice of fixed versus flexible exchange rate regimes is made by a country in the context of its desires for economic and social independence and openness 2.3 Describe the tradeoff a nation must make between a fixed exchange rate, monetary independence, and freedom of capital movements—the impossible trinity Copyright © 2019 Pearson Education, Inc. All Rights Reserved Learning Objectives (2 of 2) 2.4 Explain the dramatic choices the creation of a single currency for Europe—the euro—required of the European Union’s member states 2.5 Study the complexity of exchange rate regime choices faced by many emerging market countries today including China Copyright © 2019 Pearson Education, Inc. All Rights Reserved History of the International Monetary System (1 of 8) The Gold Standard (1876-1913) Gold has been a medium of exchange since 3000 B C “Rules of the game” were simple, each country set the rate at which its currency unit could be converted to a weight of gold Currency exchange rates were in effect “fixed” Expansionary monetary policy was limited to a government’s supply of gold Was in effect until the outbreak of W W I when the free movement of gold was interrupted Copyright © 2019 Pearson Education, Inc. All Rights Reserved Exhibit 2.1 The Evolution and Eras of the Global Monetary System For long description, see slide 42: Appendix 1 Copyright © 2019 Pearson Education, Inc. All Rights Reserved History of the International Monetary System (2 of 8) The Inter-War Years & W W I I (1914-1944) During this period, currencies were allowed to fluctuate over a fairly wide range in terms of gold and each other Increasing fluctuations in currency values became realized as speculators sold short weak currencies The U.S. adopted a modified gold standard in 1934 During W W I I and its chaotic aftermath the U.S. dollar was the only major trading currency that continued to be convertible Copyright © 2019 Pearson Education, Inc. All Rights Reserved History of the International Monetary System (3 of 8) Bretton Woods and the International Monetary Fund (1944) As W W I I drew to a close, the Allied Powers met at Bretton Woods, New Hampshire to create a post-war international monetary system The Bretton Woods Agreement established a U.S. dollar-based international monetary system and created two new institutions the International Monetary Fund (I M F) and the World Bank Copyright © 2019 Pearson Education, Inc. All Rights Reserved History of the International Monetary System (4 of 8) The International Monetary Fund is a key institution in the new international monetary system and was created to: Help countries defend their currencies against cyclical, seasonal, or random occurrences Assist countries having structural trade problems if they promise to take adequate steps to correct these problems Special Drawing Right (S D R) is the I M F reserve asset, currently a weighted average of four currencies The International Bank for Reconstruction and Development (World Bank) helped fund post-war reconstruction and has since then supported general economic development Copyright © 2019 Pearson Education, Inc. All Rights Reserved History of the International Monetary System (5 of 8) Fixed Exchange Rates (1945-1973) The currency arrangement negotiated at Bretton Woods and monitored by the I M F worked fairly well during the post-WWII era of reconstruction and growth in world trade However, widely diverging monetary and fiscal policies, differential rates of inflation and various currency shocks resulted in the system’s demise The U.S. dollar became the main reserve currency held by central banks, resulting in a consistent and growing balance of payments deficit which required a heavy capital outflow of dollars to finance these deficits and meet the growing demand for dollars from investors and businesses Copyright © 2019 Pearson Education, Inc. All Rights Reserved History of the International Monetary System (6 of 8) Eventually, the heavy overhang of dollars held by foreigners resulted in a lack of confidence in the ability of the U.S. to met its commitment to convert dollars to gold The lack of confidence forced President Richard Nixon to suspend official purchases or sales of gold by the U.S. Treasury on August 15, 1971 This resulted in subsequent devaluations of the dollar Most currencies were allowed to float to levels determined by market forces as of March 1973 Copyright © 2019 Pearson Education, Inc. All Rights Reserved History of the International Monetary System (7 of 8) The Floating Era (1973-1997) Since March 1973, exchange rates have become much more volatile and less predictable than they were during the “fixed” period There have been numerous, significant world currency events over the past 30 years The volatility of the U.S. dollar exchange rate index is illustrated in Exhibit 2.2 Copyright © 2019 Pearson Education, Inc. All Rights Reserved Exhibit 2.2 Bank for International Settlements Index of the Dollar For long description, see slide 44: Appendix 2 Source: BIS.org. Nominal exchange rate index (narrow definition) for the U.S. dollar (N N U S). Copyright © 2019 Pearson Education, Inc. All Rights Reserved 12 History of the International Monetary System (8 of 8) The Emerging Era (1997-present) Emerging market economics are multiplying in number and growing in complexity This results in a growing number of emerging market currencies Copyright © 2019 Pearson Education, Inc. All Rights Reserved I M F Classification of Currency Regimes (1 of 3) Exhibit 2.3 presents the I M F’s regime classification methodology in effect since January 2009 Category 1: Hard Pegs Countries that have given up their own sovereignty over monetary policy E.g., dollarization or currency boards Category 2: Soft Pegs A K A fixed exchange rates, with five subcategories of classification Copyright © 2019 Pearson Education, Inc. All Rights Reserved I M F Classification of Currency Regimes (2 of 3) Category 3: Floating Arrangements Mostly market driven, these may be free floating or floating with occasional government intervention Category 4: Residual The remains of currency arrangements that do not fit the previous categorizations Copyright © 2019 Pearson Education, Inc. All Rights Reserved Exhibit 2.3 I M F Exchange Rate Classifications (1 of 4) Rate Classification2009 de facto SystemDescription and Requirements Hard PegsArrangement with no Separate legal tenderThe currency of another country circulates as the sole legal tender (formal dollarization), as well as members of a monetary or currency union in which the same legal tender is shared by the members. Hard PegsCurrency board arrangementA monetary arrangement based on an explicit legislative commitment to exchange domestic currency for a specific foreign currency at a fixed exchange rate, combined with restrictions on the issuing authority. Restrictions imply that domestic currency will be issued only against foreign exchange and that it remains fully backed by foreign assets. Copyright © 2019 Pearson Education, Inc. All Rights Reserved Exhibit 2.3 I M F Exchange Rate Classifications (2 of 4) Rate Classification2009 de facto SystemDescription and Requirements Soft PegsConventional pegged arrangementA country formally pegs its currency at a fixed rate to another currency or a basket of currencies of major financial or trading partners. Country authorities stand ready to maintain the fixed parity through direct or indirect intervention. The exchange rate may vary plus or minus one percent around a central rate, or may vary no more than 2% for a six-month period. Soft PegsStabilized arrangementA spot market rate that remains within a margin of 2% for six months or more and is not floating. Margin stability can be met by either a single currency or basket of currencies (assuming statistical measurement). Exchange rate remains stable as a result of official action. Soft PegsIntermediate pegs: Crawling pegCurrency is adjusted in small amounts at a fixed rate or in response to changes in quantitative indicators (e.g., inflation differentials). Copyright © 2019 Pearson Education, Inc. All Rights Reserved Exhibit 2.3 I M F Exchange Rate Classifications (3 of 4) Rate Classification2009 de facto SystemDescription and Requirements Soft PegsCrawl-like arrangementExchange rate must remain with a narrow margin of 2% relative to a statistically defined trend for six months or more. Exchange rate cannot be considered floating. Minimum rate of change is greater than allowed under a stabilized arrangement. Soft PegsPegged exchange rate within horizontal bandsThe value of the currency is maintained within 1% of a fixed central rate, or the margin between the maximum and minimum value of the exchange rate exceeds 2%. This includes countries that are today members of the Exchange Rate Mechanism II (ERM II) system. Floating ArrangementsFloatingExchange rate is largely market determined without an ascertainable or predictable path. Market intervention may be direct or indirect, and serves to moderate the rate of change (but not targeting). Rate may exhibit more or less volatility. Copyright © 2019 Pearson Education, Inc. All Rights Reserved Exhibit 2.3 I M F Exchange Rate Classifications (4 of 4) Rate Classification2009 de facto SystemDescription and Requirements Floating ArrangementsFree floatingA floating rate is freely floating if intervention occurs only exceptionally, and confirmation of intervention is limited to at most three instances in a six-month period, each lasting no more than three business days. ResidualOther managed arrangementsThis category is residual, and is used when the exchange rate does not meet the criteria for any other category. Arrangements characterized by frequent shifts in policies fall into this category. Source: “Revised System for the Classification of Exchange Rate Arrangements,” by Karl Habermeier, Annamaria Kokenyne, Romain Veyrune, and Harald Anderson, I M F Working Paper WP/09/211, International Monetary Fund, November 17, 2009. Copyright © 2019 Pearson Education, Inc. All Rights Reserved I M F Classification of Currency Regimes (3 of 3) Exhibit 2.4 shows how these major regime categories translate in the global market. The vertical dashed line, the crawling peg, is the zone some currencies move into and out of depending on their relative currency stability. Copyright © 2019 Pearson Education, Inc. All Rights Reserved Exhibit 2.4 Taxonomy of Exchange Rate Regimes For long description, see slide 46: Appendix 3 Copyright © 2019 Pearson Education, Inc. All Rights Reserved A Global Eclectic As illustrated by Exhibit 2.5, the proportion of I M F member countries with floating regimes has been increasing. Soft pegs declined dramatically in 2016. Although the contemporary international monetary system is typically referred to as a “floating regime,” it is clearly not the case for the majority of the world’s nations. Copyright © 2019 Pearson Education, Inc. All Rights Reserved Exhibit 2.5 I M F Membership Exchange Rate Regime Choices For long description, see slide