CHAPTER 2 - INTERNATIONAL MONETARY SYSTEM (IMS) MNCs operate in a global market, buying/selling/producing in many different countries.

For example, GM sells cars in 150 countries, produces cars in 50 countries, so it has to deal with hundreds of currencies. What are the mechanics of how currency and capital flows internationally? International Monetary System - Institutional framework within which: 1. International payments are made 2. Movements of capital are accommodated 3. Ex-rates are determined An international monetary system is required to facilitate international trade, business, travel, investment, foreign aid, etc. For domestic economy, we would study Money and Banking to understand the domestic institutional framework of money, monetary policy, central banking, commercial banking, checkclearing, etc. To understand the flow of international capital/currency we study the IMS. IMS - complex system of international arrangements, rules, institutions, policies in regard to ex-rates, int'l payments, capital flows. IMS has evolved over time as int'l trade, finance, and business have changed, as technology has improved, as political dynamics change, etc. Example: evolution of the European Union and the Euro currency impacts the IMS. "Spontaneous Order." HISTORY OF THE IMS 1. BIMETALLISM (pre-1875) Commodity money system using both silver and gold (precious metals) for int'l payments (and for domestic currency). Why silver and gold? (Intrinsic Value, Portable, Recognizable, Homogenous/Divisible, Durable/Non-perishable). Why two metals and not one (silver standard or gold standard vs. bimetallism)? Some countries' currencies in certain periods were on either the gold standard (British pound) or the silver standard (German DM) and some on a bimetallic (French franc). Pound/Franc ex-rate was determined by the gold content of the two currencies. Franc/DM was determined by the silver content of the two currencies. Pound (gold) / DM (silver) rate was determined by their ex-rates against the Franc. Under a bimetallic standard (or any time when more than one type of currency is acceptable for payment), countries would experience "Gresham's Law" which is when "bad" money drives out "good" money. The more desirable, superior form of money is hoarded and withdrawn from circulation, and people use the inferior or bad money to make payments. The bad money circulates, the good money is hoarded. Under a bimetallic standard the silver/gold ratio was fixed at a legal rate. When the market rate for silver/gold differed substantially from the legal rate, one metal would be overvalued and one would be undervalued. People would circulate the undervalued (bad) money and hoard the overvalued (good) money.

BUS 466: International Finance CH 2

Professor Mark J. Perry

Examples: a) From 1837-1860 the legal silver/gold ratio was 16/1 and the market ratio was 15.5/1. One oz of gold would trade for 15.5 oz. of silver in the market, but one oz of gold would trade for 16 oz of silver at the legal/official rate. Gold was overvalued at the legal rate, silver was undervalued. Gold circulated and silver was hoarded (or not minted into coins), putting the US on what was effectively a gold standard. b) Page 27 in book, France went from a bimetallic standard to effectively a gold standard after the discovery of gold in US and Australia in the 1800s. The fixed legal ratio was out of line with the true market rate. Gold became more abundant, lowering its scarcity/value, silver became more valuable. Only gold circulated as a medium of exchange. 2. CLASSICAL GOLD STANDARD (1875-WWI). For about 40 years most of the world was on an international gold standard, ended with WWI when most countries went off gold standard. London was the financial center of the world, most advanced economy with the most int'l trade. Gold Standard exists when most countries: 1. Use gold coins as the primary medium of exchange. 2. Have a fixed ex-rate between ounce of gold and currency. 3. Allow unrestricted gold flows - gold can be exported/imported freely. 4. Banknotes had to be backed with gold to assure full convertibility to gold. 5. Domestic money stock had to rise and fall with gold flows. Under a gold standard, ex-rates would be kept in line by cross-country gold flows. Any mis-alignment of ex-rates would be corrected by gold flows. Payments could in effect be made by either gold or banknotes. If market ex-rates ever deviated from the official ex-rate, it would be cheaper to pay in gold than in banknotes. Example: Suppose that the U.K. Pound is pegged to gold at: 6/oz., and the French franc is pegged to gold at FF12/oz., then the ex-rate should be FF2/Pound. If the market rate was FF1.80/, then the pound is undervalued in the market (one pound should buy 2 FF, it only buys 1.8 FF). Arbitrage would re-align the ex-rate: 1. Take 500 and buy 83.33 oz of gold (500 / 6) in U.K. 2. Sell the gold for FF1000 in France (83.33 oz. x 12) 3. Sell 1000 FF for 555.56 (FF1000 / 1.8FF/), for an arbitrage profit of 55.56 Arbitrage would appreciate the , depreciate the FF, and the ex-rate would be restored at 2FF/. Also under gold standard, int'l. balance of payments get corrected automatically. Suppose that UK has a trade surplus (X > M) with France (M > X), which has a trade deficit. UK sold more to France than it bought, France bought more from UK than it sold, which brings about a flow of gold from ______ to _______. The increased (decreased) gold in UK (France) brings about ________ in UK and _______ in France. As time goes on, Exports from UK will ____ because British prices are now _____, Imports will
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_____ because French prices are ______. The trade surplus of UK will _____ and France's deficit will _______. Market forces automatically correct trade deficits/surpluses, this adjustment mechanism is known as the price-specie-flow mechanism. Advantages of Gold Standard: 1. Ultimate hedge against inflation. Because of its fixed supply, gold standard creates price level stability, eliminates abuse by central bank/hyperinflation. 2. Automatic adjustment in Balance of Payments due to price-specie-flow mechanism. Disadvantages of Gold Standard: 1. Possible deflationary pressure. With a fixed supply of gold (fixed money supply), output growth would lead to deflation. 2. An international gold standard has no commitment mechanism, or enforcement mechanism, to keep countries on the gold standard if they decide to abandon gold. 3. INTERWAR PERIOD: 1915-1944 When WWI started, countries abandoned the gold standard, suspended redemption of banknotes for gold, and imposed embargoes on gold exports (no gold could leave the country). After the war, hyperinflationary finance followed in many countries such as Germany, Austria, Hungary, Poland, etc. Price level increased in Germany by 1 trillion times!! Why hyperinflation then?? What are the costs of inflation?? US (1919), UK(1925), Switzerland, France returned to the gold standard during the 1920s. However, most central banks engaged in a process called "sterilization" where they would counteract and neutralize the price-specie-flow adjustment mechanism. Central banks would match inflows of gold with reductions in the domestic MS, and outflows of gold with increases in MS, so that the domestic price level wouldn't change. Adjustment mechanism would not be allowed to work. If the US had a trade surplus, there would be a gold inflow which should have increased US prices, making US less competitive. Sterilization would involve contractionary monetary policy to offset the gold inflow. In the 1930s, what was left of the gold standard faded - countries started abandoning the gold standard, mostly because of the Great Depression, bank failures, stock market crashes. Started in US, spread to the rest of the world. Also, escalating protectionism (trade wars) brought int'l trade to a standstill. (SmootHawley Act in 1930), slowing int'l gold flows. US went off gold in 1933, France lasted until 1936. Between WWI and WWII, the gold standard never really worked, it never received the full commitment of countries. Also, it was period of political instability, the Great Depressions, etc. So there really was no stable, coherent IMS, with adverse effects on int'l trade, finance and investment. 4. BRETTON WOODS SYSTEM: 1945-1972 At the end of WWII, 44 countries nations met at Bretton Woods, N.H. to develop a postwar IMS. The International Monetary Fund (IMF) and the World Bank were created as part of a comprehensive plan to start a new IMS. The IMF was to supervise the rules and policies of a new fixed ex-rate regime, the
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World Bank was responsible for financing development projects for developing countries (power plants, roads, infrastructure investments). IMS established by Bretton Woods was a dollar-based, gold-exchange standard of fixed exchange rates. The US dollar was pegged to gold at a fixed price of $35/ounce, and then each currency had a fixed ex-rate with the $. See Exhibit 2.1 on p. 30. Examples: $2.80/, DM4.20/$, FF3.50/$, etc. Each country was supposed to maintain the fixed rate within 1% of the agreed upon rate, by buying/selling currency. To increase the foreign exchange value of DM, the central bank would ____ DMs with $; to decrease the value of DM it would ____ DMs for $. US $ was convertible to gold, the other currencies were not. Countries held $ and gold for IMS payments. A country with a "fundamental disequilibrium" could be allowed to change its fixed rate with the $. Advantages of Gold-Exchange System/Bretton Woods in SR: 1. Economizes on scarce resources (gold) by allowing foreign reserves ($s) to be used for IMS payments. Easier to transfer dollars vs. shipping gold overseas under pure gold std. 2. By holding $ instead of gold as reserves, foreign central banks can earn interest vs. non-interest bearing gold. 3. Ex-rate stability reduced currency risk, provided a stable IMS, facilitated int'l trade and investment, led to strong economic growth around the world in 50s and 60s. In long run, Bretton Woods (gold-exchange system) was unstable. There was no way to: 1) devalue the reserve currency ($) even when it became overvalued or 2) force a country to revise its ex-rate upward (appreciate its currency). A country could agree, or be pressured into devaluation, but there was no way to "revalue" a currency upward (appreciate through contractionary policy). In the 1960s, US pursued expansionary monetary policy (printed money) to reduce unemployment, resulting in the dollar being overvalued and foreign currencies being undervalued according to the fixed ex-rate system. There was no way to devalue the $, and other countries were not willing to revalue their ex-rates upward (appreciate). Why? Bretton Woods started to collapse in 1971, temporary measure (Smithsonian Agreement) didn't work, fixed ex-rate regime was abandoned in 1973. Also, Nixon put wage and price controls went into effect in 1971, were then lifted, first oil shock started in 1973 (Arab oil embargo after Nixon gave $2.5B to Israel after Egypt attacked), oil prices doubled, no way to stabilize the dollar. 1973- fixed ex-rates/Bretton Woods were abandoned. 5. FLEXIBLE EXCHANGE RATES: 1973-PRESENT IMF members met in Jamaica in 1976 to agree to a new IMS including:

BUS 466: International Finance CH 2

Professor Mark J. Perry

a. Flexible ex-rates allowed, central banks could intervene in currency markets. (Under fixed ex-rates, you lose control over your monetary policy. Monetary policy must be committed to maintaining the fixed ex-rate, and cannot be used to pursue other macroeconomic goals) b. Gold was abandoned as a reserve asset. c. Developing countries were to get more assistance from IMF. IMF was to provide assistance to countries facing BP/currency difficulties. (Brazil example). IMF provides grants and loans to countries with problems under the conditions that they follow IMF's policy prescriptions - "strings attached to aid." Reduced budget deficits, reduced govt. spending/cutting subsidies, contractionary monetary policy, i.e. responsible fiscal and monetary policies. Advantages of Flexible Ex-Rates: a. Countries have control over monetary policy b. A true market value is established for currency, fluctuates daily to reflect market forces of S and D. c. Flexible ex-rates maintain BP equilibrium. Example: U.S. has trade deficit, M>X, excess dollars in world currency markets, $ depreciates, appreciates, US exports will go up, restore trade balance. Disadvantages: a. More Volatility, see page 33, Exhibit 2.3. MNCs must be concerned about currency risk. b. Potential abuse by central bank, reckless monetary expansion. Major currencies like $, Yen, etc. are freely floating ex-rates, changing daily to reflect market forces. Most of the rest of the world is under some type of system of "pegged ex-rates" or "managed floating," where central bank intervention is required to maintain a certain level of ex-rates. One system results in trading 1:1 with the dollar (Panama, Bahamas, Belize 2:1, Liberia), other systems trade within a certain band (range). See page 36-37, Exhibit 2.4. Currencies pegged to $, FF, SDRs, others. 36 are independently floating, no pegging or targeting. More than 40 have "managed floating" systems that combine market forces with pegging. European Monetary System has been replaced by the Euro, the single currency in Europe (1 ECU = 1 Euro). See Exhibit 2.5 on p. 39. To qualify for euro, countries had to meet certain economic criteria: 1) Deficits/GDP less than 3%, 2) Price level stability - low and stable inflation, etc. Of the 15 countries in the European Union, three countries decided not to join (UK, Denmark, and Sweden). As of Jan 1, 1999: 1) the 12 countries fixed their ex-rates against each other and against the Euro, and 2) the Euro became a unit of account. For example, 3.35FF/DM. 6.55 FF/Euro. FF and DM will float against the $, and Yen, but will be fixed against each other and against the Euro. Fixed ex-rate system for the 12 countries. Euro currency (euro as a medium of exchange) started to circulate on Jan. 1, 2002. Old currency and Euros BOTH circulated for the first 6 months, then old currency was taken out of circulation and only Euros now exist.
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Changes: 1) Stores now quote prices in Euros. 2) Payment in Euros can be made with charge cards and checking accounts 3) Euro currency options are now traded 4) Stock prices/indexes are quoted in Euros. 5) European Central Bank (ECB) established to conduct monetary policy in Europe. Governing Council made up of 12 ECB governors, one from each country, and 6 member Executive Board. See official Euro web site (in English) at: http://europa.eu.int/euro/entry.html or the website of the European Central Bank (Frankfurt, Germany) at: http://www.ecb.int See the $/ ex-rate on p. 41. Euro started at $1.18/ in 1999, depreciated to $0.83/ in 2000 (why?), then started to appreciate, now it's trading at: __________. Main Advantages of Euro (): 1. Significant reduction in transaction costs for consumers, businesses, governments, etc. (estimated to be .4% of European GDP, about $50B!) European Saying: If you travel through all 15 countries and exchange money in each country but don't spend it, you end up with 1/2 of the original amount! 2. Elimination of currency risk, which will save companies hedging costs. 3. Promote corporate restructuring via M&A activity (mergers and acquisitions), encourage optimal business location decisions. Main Disadvantage of Euro: Loss of control over domestic monetary policy and exchange rate determination. Suppose that the Finnish economy is not well-diversified, and is dependent on exports of paper/pulp products, it might be prone to "asymmetric shocks" to its economy. If there is a sudden drop in world paper/pulp prices, the Finnish economy could go into recession, unemployment could increase. If independent, Finland could use monetary stimulus to lower interest rates and lower the value of its currency, to stimulate the domestic economy and increase exports. As part of EU, Finland no longer has those options, it is under the EU Central Bank, which will probably not adjust policy for the Eurozone to accommodate Finland's recession. Finland may have a prolonged recession. There are also limits to the degree of fiscal stimulus through tax cuts, since budget deficits cannot exceed 3% of GDP, a requirement to maintain membership in EMU (to discourage irresponsible fiscal behavior). General Consensus: Euro has been a success, and will likely emerge as the second global currency, with the Yen as a junior partner. The success of the Euro may encourage other areas to explore cooperative monetary arrangements (Asia, S. America). Three world currencies at some point (, , $)? See "Will the U.K. Join the Euro Club?" on p. 57.

CURRENCY CRISES
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BUS 466: International Finance CH 2

Professor Mark J. Perry

Trilema: A country can attain only 2 of the following 3 conditions at one time: a) fixed exchange rate, b) free international flows of capital, and c) independent monetary policy. If you have an independent monetary policy and free capital flows (U.S., U.K., Euro), then you can't maintain a fixed exchange rate, it will float. To maintain a fixed ex-rate and allow free capital flows, you cannot have independent monetary policy, like Hong Kong (7.8 HK$ to one USD) or Argentina (used to be 1:1) with currency boards. If you maintain a fixed ex-rate and pursue independent monetary policy, then you have to impose capital controls, like China. To avoid currency crises, a country can have: a) a really fixed ex-rate or b) a flexible ex-rate, but NOT a fixed yet adjustable ex-rate when int'l. capital markets are integrated. See Friedman article. Updated: September 12, 2006

BUS 466: International Finance CH 2

Professor Mark J. Perry