The International Monetary System

Transcription

1 The International Monetary System 11 Learning objectives Describe the historical development of the modern global monetary system. Explain the role played by the World Bank and the IMF in the international monetary system. Compare and contrast the differences between a fixed and a floating exchange rate system. This chapter discusses the evolution of the international monetary system and the implications of this system for international business, focusing on the institutional context within which exchange rates move. The history of monetary systems includes a period with the gold standard, a fixed exchange rates system, and the current managed float system. Since WWII, the IMF and the World Bank have played an important role in the world economy The role of the IMF is to maintain order in the international monetary system to avoid a repetition of the competitive devaluations of the 1930s, and to control price inflation by imposing monetary discipline on countries. Identify exchange rate systems that are used in the world today and why countries adopt different exchange rate regimes. Understand the debate surrounding the role of the IMF in the management of financial crises. Explain the implications of the global monetary system for currency management and business strategy. IMF-mandated macro economic policies are under serious debate, with critics charging that at times the IMF imposes inappropriate conditions on developing nations. The opening case explores the recent debt crisis in Ireland that threatened the value of the euro. In order to prevent the crisis from spreading to other countries and to stabilize the euro, the IMF and the EU provided the troubled country with bailout assistance. The closing case examines explores the effect of the 2008 financial crisis on Latvia, and the IMF aid package the country was forced to accept. 11-1

2 OUTLINE OF CHAPTER 11: THE INTERNATIONAL MONETARY SYSTEM Opening Case: Ireland s Debt Crisis Introduction The Gold Standard Mechanics of the Gold Standard Strength of the Gold Standard The Period between the Wars, The Bretton Woods System The Role of the IMF The Role of the World Bank The Collapse of the Fixed Exchange Rate System The Floating Exchange Rate System. The Jamaica Agreement Exchange Rates Since 1973 Country Focus: The U.S. Dollar, Oil Prices, and Recycling Petrodollars Fixed versus Floating Exchange Rates The Case for Floating Exchange Rates The Case for Fixed Exchange Rates Who is Right? Exchange Rate Regimes in Practice Pegged Exchange Rates Currency Boards Crisis Management by the IMF Financial Crises in the Post-Bretton Woods Era Mexican Currency Crisis of 1995 The Asian Crisis Evaluating the IMF s Policy Prescriptions Country Focus: Turkey and the IMF Implications for Managers Currency Management Business Strategy Corporate-Government Relations 11-2

3 Management Focus: Airbus and the Euro Chapter Summary Critical Thinking and Discussion Questions Closing Case: Economic Turmoil in Latvia CLASSROOM DISCUSSION POINT Ask students how much their currency is worth. Try to get them to identify its value in terms of another currency. Then ask students how they might know the value of the currency. Students will probably indicate options like the posting at the currency kiosk at the airport, or the rates that are printed in the newspaper or are available online. Dig a little deeper, and try to get students to identify some of the factors that could influence the value of a currency. Next, ask students what happens to currency values each day, and why. Try to get students to recognize the idea of a floating exchange rate system. Finally, link this discussion to the evolution of the current international monetary system. OPENING CASE: Ireland s Debt Crisis The opening case explores the debt crisis in Ireland. After more than a decade of prosperity, Ireland was caught off guard by the global recession which caused demand for the country s exports to drop significantly. Unemployment surged and banks, burdened with high levels of bad debt teetered on the verge of collapse. A bailout from the Irish government helped avert disaster, but also pushed the country s budget deficit to over 30 percent of its GDP and public debt to about 180 percent of GDP. The International Monetary Fund (IMF) and European Union (EU) were ultimately forced to step to prevent the crisis from spreading and to shore up the value of the euro. Discussion of the case can revolve around the following questions. 1. Why was it so important for the IMF and EU to step in to help Ireland in 2010? What were the potential implications of Ireland s debt crisis for other EU countries? How might the crisis have impacted the entire international monetary system? 2. How did the bailout package help Ireland? What impact did it have the country s economy and prospects for future growth? 11-3

4 3. Discuss the costs and benefits of doing business in Ireland today. Would you invest in the country? Another Perspective: To extend this case discussion, consider several iglobe segments including After Bailout For Irish, Questions Linger Over Portugal, Spain, Ireland s New Leader Wrestles With Lingering Debt Problems, EU Bailout, and Global Economic Downturn Slams Ireland, Spares Poland. LECTURE OUTLINE FOR CHAPTER This lecture outline follows the Power Point Presentation (PPT) provided along with this instructor s manual. The PPT slides include additional notes that can be viewed by clicking on view, then on notes. The following provides a brief overview of each Power Point slide along with teaching tips, and additional perspectives. Slides What is the International Monetary System? The international monetary system refers to the institutional arrangements that countries adopt to govern exchange rates. Governments adopt various types of exchange rate systems including the pegged rate, the dirty float and the fixed rate. Slides The Gold Standard The system of exchange rates known as the gold standard dates back to ancient times when gold coins were a medium of exchange, unit of account, and store of value. Pegging currencies to gold and guaranteeing convertibility is central to the gold standard. In the 1880s, most of the world s trading nations followed this exchange rate system. Slides Strength of the Gold Standard The gold standard provides a powerful mechanism to pull trade imbalances between countries back into balance of trade equilibrium. Another Perspective: The Advantages Of The Gold Standard was the topic of a 1961 paper by former Federal Reserve Board Chairman, Alan Greenspan. The paper is available at { The gold standard worked fairly well from the 1870s until the start of World War I in 1914, but by 1939, the gold standard had collapsed. Slides The Bretton Woods System The Bretton Woods system established a fixed exchange rate system where all currencies were fixed to gold, but only the U.S. dollar was directly convertible to gold. Devaluations could not to be used for competitive purposes and a country could not devalue its currency by more than 10% without IMF approval. 11-4

5 The Bretton Woods system also provided for two multinational institutions the International Monetary Fund (IMF) and the World Bank (IBRD). Another Perspective: For more information about the Bretton Woods Agreement go to { and also at { Slides The IMF and the World Bank The IMF was charged with executing the main goal of the Bretton Woods agreement - avoiding a repetition of the chaos that occurred between the wars through a combination of discipline and flexibility. Another Perspective: The homepage of the IMF is available at { Students can click on either For First Time Visitors or on For Students to get a good overview of the IMF and its activities. The World Bank is also known as the International Bank for Reconstruction and Development (IBRD). Another Perspective: For more information on the World Bank, go to { Click on Data and Research to pull information on World Bank activities, or on Countries to explore World Bank activities by country. Slide The Collapse of the Fixed Exchange System The Bretton Woods worked well until the late 1960s, before collapsing. Slide The Floating Exchange Rate Regime The Jamaica Agreement was signed in 1976 following the collapse of Bretton Woods. The rules that were agreed on then are still in place today. Under the Jamaica agreement: floating rates were declared acceptable gold was abandoned as a reserve asset total annual IMF quotas were increased to $41 billion Slides Exchange Rates since 1973 Exchange rates have become more volatile and less predictable than they were between 1945 and Slide Fixed Versus Floating Exchange Rates The merit of a fixed exchange rate versus a floating exchange rate system continues to be debated. 11-5

6 The case for floating exchange rates has two main elements: 1. monetary policy autonomy 2. automatic trade balance adjustments Supporters of fixed exchange rates focus on monetary discipline, uncertainty, and the lack of connection between the trade balance and exchange rates. Slide Who is Right? There is no real agreement as to which system is better. Slides Exchange Rate Regimes in Practice Currently: 14% of IMF members follow a free float policy 26% of IMF members follow a managed float system 22% of IMF members have no legal tender of their own the remaining countries use less flexible systems such as pegged arrangements, or adjustable pegs Slide Pegged Exchange Rates A country following a pegged exchange rate system, pegs the value of its currency to that of another major currency. Slide 1124 Currency Boards Countries using a currency board commit to converting their domestic currency on demand into another currency at a fixed exchange rate. Slides Crisis Management by the IMF Today, the IMF focuses on lending money to countries experiencing financial crises. A currency crisis occurs when a speculative attack on the exchange value of a currency results in a sharp depreciation in the value of the currency, or forces authorities to expend large volumes of international currency reserves and sharply increase interest rates in order to defend prevailing exchange rates. A banking crisis refers to a situation in which a loss of confidence in the banking system leads to a run on the banks, as individuals and companies withdraw their deposits. A foreign debt crisis is a situation in which a country cannot service its foreign debt obligations, whether private sector or government debt. Slide Mexican Currency Crisis of 1995 The Mexican currency crisis of 1995 was a result of: high Mexican debts a pegged exchange rate that did not allow for a natural adjustment of prices 11-6

7 Slides The Asian Crisis The 1997 Southeast Asian financial crisis was caused by a series of events that took place in the previous decade. Slides Evaluating the IMF Policy Prescriptions Critics of the IMF worry: the one-size-fits-all approach to macroeconomic policy is inappropriate for many countries the IMF is exacerbating moral hazard (when people behave recklessly because they know they will be saved if things go wrong) The IMF has become too powerful for an institution without any real mechanism for accountability Slides Implications for Managers The present floating rate system mandates that firms carefully manage their foreign exchange transactions and exposures. Managers must recognize that the current international monetary system is a managed float system in which government intervention can help drive the foreign exchange market. Managers need strategic flexibility. Companies should promote an international monetary system that facilitates international growth and development. CRITICAL THINKING AND DISCUSSION QUESTIONS QUESTION 1: Why did the gold standard collapse? Is there a case for returning to some type of gold standard? What is it? ANSWER 1: The gold standard worked reasonably well from the 1870s until the start of World War I in 1914, when it was abandoned. During the war several governments financed their massive military expenditures by printing money. This resulted in inflation, and by the war's end in 1918, price levels were higher everywhere. Several countries returned to the gold standard after World War I. However, the period that ensued saw so many countries devalue their currencies that it became impossible to be certain how much gold a currency could buy. Instead of holding on to another country's currency, people often tried to exchange it into gold immediately, lest the country devalue its currency in the intervening period. This put pressure on the gold reserves of various countries, forcing them to suspend gold convertibility. As a result, by the start of World War II, the gold standard was dead. The great strength of the gold standard was that it contained a powerful mechanism for simultaneously achieving balance-of-trade equilibrium by all countries. This strength is the basis for reconsidering the gold standard as a basis for international monetary policy. 11-7

8 QUESTION 2: What opportunities might current IMF lending policies to Third World nations create for international businesses? What threats might they create? ANSWER 2: The IMF lending policies require the recipient countries to implement governmental reforms to stabilize monetary policy and encourage economic growth. One of the principal ways for a developing nation to spur economic growth is to solicit foreign direct investment and to provide a hospitable environment for the foreign investors. These characteristics of IMF lending policies work to the advantage of international businesses that are looking for investment opportunities in developing countries. QUESTION 3: Do you think the standard IMF policy prescriptions of tight monetary policy and reduced government spending are always appropriate for developing nations experiencing a currency crisis? How might the IMF change its approach? What would the implications be for international business? ANSWER 3: Critics argue that the tight macroeconomic policies imposed by the IMF in the recent Asian crisis are not well suited to countries that are suffering not from excessive government spending and inflation, but from a private-sector debt crisis with inflationary undertones. Anti-inflationary monetary policies and reductions in government spending usually result in a sharp contraction of demand, at least in the short run. In the longer term, the policies can promote economic growth and expansion of demand, which creates opportunities for international business. QUESTION 4: Debate the relative merits of fixed and floating exchange rate regimes. From the perspective of an international business, what are the most important criteria for choosing between the systems? Which system is the more desirable for an international business? ANSWER 4: The case for fixed exchange rates rests on arguments about monetary discipline, speculation, uncertainty, and the lack of connection between the trade balance and exchange rates. In terms of monetary discipline, the need to maintain fixed exchange rate parity ensures that governments do not expand their money supplies at inflationary rates. In terms of speculation, a fixed exchange rate regime precludes the possibility of speculation. In terms of uncertainty, a fixed rate regime introduces a degree of certainty in the international monetary system by reducing volatility in exchange rates. Finally, in terms of trade balance adjustments, critics question the closeness of the link between the exchange rate and the trade balance. The case for floating exchange rates has two main elements: monetary policy autonomy and automatic trade balance adjustments. In terms of the former, it is argued that a floating exchange rate regime gives countries monetary policy autonomy. Under a fixed rate system, a country s ability to expand or contract its money supply as it sees fit is limited by the need to maintain exchange rate parity. In terms of the later, under the Bretton Woods system, if a country developed a permanent deficit in its balance of trade that could not be corrected by domestic policy, the IMF would agree to a currency devaluation. Critics of this system argue that the adjustment 11-8

9 mechanism works much more smoothly under a floating exchange rate regime. They argue that if a country is running a trade deficit, the imbalance between the supply and demand of that country s currency in the foreign exchange markets will lead to depreciation in its exchange rate. An exchange rate depreciation should correct the trade deficit by making the country s exports cheaper and its imports more expensive. It is a matter of personal opinion in regard to which system is better for an international business. We do know, however, that a fixed exchange rate regime modeled along the lines of the Bretton Woods system will not work. Nevertheless, a different kind of fixed exchange rate system might be more enduring and might foster the kind of stability that would facilitate more rapid growth in international trade and investment. QUESTION 5: Imagine that Canada, the US, and Mexico decide to adopt a fixed exchange rate system. What would be the likely consequences of such a system for (a) international businesses, and (b) the flow of trade and investment between all three countries? ANSWER 5: Were North America to adopt a common currency, it would become increasingly attractive for foreign investment and would increase trade and investment among the three countries. The exchange rates between Canada and the U.S. have been relatively stable for a long time, but that is not the case with Mexico (Mexican currency crisis of 1995). Trade and investment flows between the U.S. and Mexico would increase both ways, as would they between Canada and Mexico. Mexico would become more attractive to FDI, especially as a location for production for the North American market QUESTION 6: Reread the Country Focus on the U.S. dollar, oil prices and recycling petrodollars, then answer the following questions: a) What will happen to the value of the U.S. dollar if oil producers decide to invest most of their earnings from oil sales in domestic infrastructure projects? b) What factors determine the relative attractiveness of the dollar, euro, and yen denominated assets to oil producers flush with petrodollars? What might lead them to direct more funds towards non-dollar denominated assets? c) What will happen to the value of the dollar if OPEC members decide to invest more of their petrodollars towards non-dollar assets, such as euro denominated stocks and bonds? d) In addition to oil producers, China is also accumulating a large stock of dollars, currently estimated to total $1.4 trillion. What would happen to the value of the dollar if China and oil producing nations all shifted out of dollar denominated assets at the same time? What would be the consequences for the United States economy? ANSWER 6: a) If oil producers decide to invest their earnings in domestic infrastructure projects, it would be expected that the countries involved would see a boost in economic growth, and an increase in imports. This would put downward pressure on the dollar as the petrodollars are sold, or are invested in the local community, however the expected increase in imports that should result from greater economic growth would increase the demand for dollars. b) The relative attractiveness of an investment whether it is denominated in dollars, euro, or yen depends on expected returns and the degree of risk associated with the investment. When considering different currencies, it would be important to consider expected shifts 11-9

10 in the exchange rate. So, for example, if the dollar was expected to depreciate relative to the euro or yen, non-dollar denominated assets might be more attractive all else being equal. c) Oil producers have significantly increased their holdings of dollars as a result of higher oil prices. Should OPEC members decide to sell their dollars to invest in non-dollar denominated assets such as euro denominated stocks or bonds, we would expect to see downward pressure on the dollar. d) If China and the oil producers simultaneously decide to sell off their dollars, there would be significant downward pressure on the dollar. This downward pressure would probably cause considerable pessimism among investors, and the U.S. economy, and the world economy in general, would likely suffer. CLOSING CASE: Economic Turmoil in Latvia The closing case explores how Latvia s economic fortunes have changed since At the time, the country was enjoying an economic boom, but critics worried that the economy was becoming overheated. By 2008, financial institutions were in trouble, and at least one major company was nationalized. Eventually, Latvia was pushed into accepting assistance from the IMF. Discussion of the case can revolve around the following questions: QUESTION 1: What kind of crisis was Latvia experiencing in 2008, a currency crisis, a banking crisis, or a debt crisis? ANSWER 1: In 2008, Latvia s largest private bank, Parex, requested government assistance. The bank which, like many others, had aggressively extended loans during the country s economic boom years, suddenly found itself on the brink of collapse. While the government tried to save the bank through an injection of 200 million lats it was ultimately forced to nationalize the institution. However, this move only increased fears that the lat would have to be devalued and investors began to pull their currency out. Currency speculators put additional pressure on the currency by selling it short. The IMF and EU then provided assistance to the country to help it pull out of its currency crisis. QUESTION 2: If the IMF had not stepped in with support, what do you think might have occurred? ANSWER 2: Most students will probably suggest that had the IMF not stepped in to help Latvia in 2008 the country would have gone into an economic tailspin. In addition, both Sweden and Finland, which had large stakes in Latvian banks, would have experienced negative consequences, and the European Union as a whole would have been affected

11 QUESTION 3: Could the Latvian government have headed off the 2008 crisis? What actions could I have taken to do this? What might the economic and political consequences of those actions have been? ANSWER 3: Aggressive lending practices by Latvian banks put the institutions as risk for the situation that Parex found itself in when the economic crisis that had begun in the United States spread to the rest of the world. Hindsight is of course 20/20, but some students will probably suggest that better regulations requiring less risky types of loans could have helped to prevent the 2008 crisis. Other students may wonder whether the crisis might have been averted had the government raised interest rates when the economy showed signs of overheating. Still other students may question Latvia s decision to peg its currency to the euro rather than let it float freely. QUESTION 4: What do you think the short-term consequences of the IMF policies will be for Latvia? What might the long term consequences be? ANSWER 4: Latvia s bailout package arranged by the IMF requires the country to implement many austerity measures including wage cuts and reductions in government spending. In addition, taxes and interest rates will increase. Most students will recognize that while these policies could push the country into a recession in the short run, they should ultimately help Latvia be in a stronger position in the long run. Another Perspective: To extend this case discussion, consider { and { INTEGRATING iglobes There are several iglobe video clips that can be integrated with the material presented in this chapter. In particular, you might consider the following: Title: IMF, World Bank Members Mull Third World Aid Run Time: 6:25 Abstract: This video explores efforts by the International Monetary Fund and the World Bank to get commitments of money from developed countries, and then disperse the funds to developing economies in need of assistance during the current economic downturn. Key Concepts: global capital markets, the International Monetary Fund, the World Bank, global economy, political economy 11-11

12 Notes: The World Bank and International Monetary Fund (IMF) together with finance ministers from around the world met recently in Washington, D.C. to discuss how to fix the floundering global economy. Usually the annual meetings of the two institutions are relatively routine, but this year, the meetings held a certain level of urgency. The global economy is in a tailspin suffering from the worst recession since the Great Depression. Finance ministers in Washington had two main objectives: getting promised funds from some countries, and dispersing the funds to other countries. Several developing countries have applied to the IMF for aid, but before the IMF can disperse any funds, it needs to raise some money. At a meeting of the G-20 earlier in the month, world leaders agreed to give an additional $1 trillion in aid to the IMF. However, so far, the money has not been forthcoming. The IMF is still waiting for several countries including the United States, Japan, and some European countries to proceed with their pledges. Meanwhile, the developing economies that were affected early on in the financial crisis are hoping to receive their aid soon. The Eastern European countries, whose banks were directly linked to those in the United States and Western Europe, are in particularly desperate shape. They need the funds to help stabilize their banking system and stimulate their economies. In addition to these countries, some highperforming countries like Mexico, Poland, and Columbia have also requested aid. Simon Johnson of the MIT Sloan School of Management believes the real challenge for the IMF will be to disburse the funds it acquires in such a way that countries, and indeed the world, are stabilized. The United States is ready to lead the way toward an economic recovery. U.S. Treasury Secretary Timothy Geithner has asked the industrialized countries to make good on their commitments to the IMF, and start the reform of the global financial system. Geithner noted that the recovery in the United States was dependent on recovery in other markets. Leaders from other nations suggested that the United States also take action. They want the country to fix its banking industry, and in particular remove toxic assets from their balance sheets. One bright spot at the meeting was the news that conditions in the markets may be stabilizing, and in some areas even improving. Discussion Questions: 1. What is the International Monetary Fund (IMF)? What is its role in the global economy? How is the IMF different from the World Bank? 2. Why is the IMF slow to respond to countries that have asked for assistance? What guarantees are there that IMF funds will actually help the global economy? 3. Some Eastern European countries have put in a particularly urgent request for funds from the IMF. Why are these countries in such dire straits? What does your response tell you about the interdependency of the global economy? 4. How does the United States see its role in the move to economic recovery? Why is the United States pushing for IMF funds to be quickly deployed to countries in need? 11-12

13 INTEGRATING VIDEOS There are also several longer video clips that can be integrated with the material presented in this chapter. In particular, you might consider the following from International Business DVD Volume 6: Title: Bank Launches Partnership for Green Accounting Learning Objectives The purpose of this video is to help you: Understand the nature of natural capital and environmental sustainability. Examine the concept of green accounting. Explore how multinational companies have and are destroying valuable ecosystems in developing countries. Recognize the importance of managing resources to promote economic growth. Key Words Globalization Environmental sustainability Social responsibility Levels of economic development Impact of multinational companies on host countries Ethics World Bank Synopsis The World Bank is launching a new program designed to help developing countries better manage their natural capital. The World Bank is concerned that without the proper knowledge of how to value natural resources, these countries could lose their ecosystems, and with them potential economic benefits. In many developing countries, valuable forests, wetlands, coral reefs, and other ecosystems have been damaged irreversibly by multinational companies that invested in the countries hoping to make a quick profit. Now, however, the World Bank wants to ensure that developing countries recognize the true economic potential of their biodiversity and what the possible loss could be if their ecosystems are destroyed. The World Bank s new program, which is being offered in partnership with the United Nation s Environmental Program, involves providing developing countries with the tools for green accounting. The goal is to ensure that a country s finance minister has a full understanding of the economic implications of decisions that involve the nation s natural resources. It is hoped that this will help avoid the type of exploitation by multinational companies that can limit future economic growth in a country, and degrade the environment. India and Columbia are the first countries to participate in the new program. If it is successful it will be expanded to include additional countries

14 Identifying exactly how to value natural capital is a difficult task. While mechanisms to assess the cost of air pollution and other types of environmental degradation have been developed, valuing natural capital is a new challenge requiring new tools. Since it is not always easy to understand the ecosystems themselves, this task becomes even more complicated. Moreover, because there is not a market price for most ecosystems, it can be difficult to understand and determine the economic impact of different investment decisions on the natural resources. Countries that can successfully protect their assets and plan into the longer term have a greater chance for economic development. Discussion Questions 1. Explain the concept of natural capital. Why is the World Bank concerned about protecting the natural capital of developing countries? 2. What is green accounting? How is the World Bank working to identify the necessary tools for the task? Why is it so difficult to value natural capital? 3. What role do multinational companies play in the environmental degradation taking place in many developing countries? Why do developing countries permit investments by the companies? What responsibilities do these companies have to the host countries? 4. Discuss how companies can use green accounting methods and tools to incorporate social and environmental goals with their business strategies. How might promoting a greener approach to strategy help companies be more profitable in the long run? INCORPORATING globaledge EXERCISES Use the globaledge site { to complete the following exercises: Exercise 1 The quality of life in specific markets sometimes is impacted by the country s financial and fiscal policies. As such, the Global Financial Stability Report is a semi-annual report published by the International Capital Markets division of the International Monetary Fund (IMF). The report aims to provide a regular assessment of global financial markets. Locate and download the latest information to prepare a summary of the top 3 countries that export and import capital

15 Exercise 2 An important element to understanding the international monetary system is keeping updated on current growth trends worldwide. A German colleague told you yesterday that Deutsche Bank Research s Megatopics are an effective way to stay informed on important topics in international finance. Find a Megatopics report for analysis. Is the report on an established or emerging economy? What are the key takeaways from your chosen report? Answers to the Exercises Exercise 1 The reports are accessible by searching for the phrase Global Financial Stability Report at This resource is located under the globaledge category Money: Finance. The report s statistical appendix contains the information required for this exercise. Be sure to click on the Resource Desk link to search this area of the globaledge website. Search Phrase: Global Financial Stability Report Resource Name: IMF: Global Financial Stability Report Website: globaledge Category: Money: Finance Exercise 2 The Megatopics reports are accessible by searching for the phrase Deutsche Bank Research at This resource is located under the globaledge category Money: Finance. After clicking the English button at the top right of the webpage, the Megatopics reports are located to the lower right of the screen. Be sure to click on the Resource Desk link to search this area of the globaledge website. Search Phrase: Deutsche Bank Research Resource Name: Deutsche Bank Research Website: globaledge Category: Money: Finance 11-15