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10
10-1
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 onto 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.
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 countrys 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
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 countrys 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 countrys 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, as the text explains (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 $1,000 billion by the end of 2006. 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
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: Chinas Managed Float
The closing case describes feature describes Chinas exchange rate policy. For nearly a
decade, China fixed its exchange rate to the dollar and bought or sold dollars to maintain
the exchange rate. By early 2005 though, the country was feeling pressure both at home
and abroad to let its currency, the yuan, float freely against the dollar. The following
questions can be helpful in directing the discussion:
QUESTION 1: Why do you think the Chinese government originally pegged the value of
the yuan against the U.S. dollar? What were the benefits of doing this to China? What
were the costs?
ANSWER 1: Most of the Chinese exports are made from dollar-denominated imported
materials and energy. By pegging to the dollar, China managed its foreign exchange risk
in these areas. It also mitigated the risk for investors coming into China. Also, Chinas
economy, through its peg to the dollar, has remained stable. It was not drawn into the
Asian meltdown in 1997. One of the costs of pegging is that the Chinese government has
to manage the peg. Thus, it is active in the foreign exchange markets. Another cost is that
the dollars movement, up or down, affects the Chinese economy.
QUESTION 2: Over the last decade, many foreign firms have invested in China, and
used their Chinese factories to produce goods for export. If the yuan is allowed to float
freely against the U.S. dollar on the foreign exchange markets, and appreciates in value,
how might this affects the fortunes of those enterprises?
ANSWER 2: Since they are moving raw materials into China, using Chinese labor, and
then exporting, their production costs will rise in China (yuan strengthening against the
dollar) in dollar terms. The value of their investment in China will increase as the dollar
weakens. Selling into the Chinese market may become more attractive to substitute for
exports. If the core production strategy for their Chinese operations is to use relatively
low-cost labor, that will no longer be possible unless productivity increases. They may
consider moving to another low-cost labor market.
QUESTION 3: How might a decision to let the yuan float freely affect future foreign
direct investment flows into China?
ANSWER 3: If the yuan appreciates against the dollar, FDI may be a more costly
venture. Even so, a company may still find it advantageous to set up an operation in
China, particularly if the company also plans to sell its product locally.
QUESTION 4: Under what circumstances might a decision to let the yuan float freely
destabilize the Chinese economy? What might the global implications of this be?
ANSWER 4: Chinas undervalued yuan is fueling a boom in Chinese exports to the
U.S., where jobs are being lost to the cheap Chinese imports. For its part, China is facing
the potential for a surge in inflation as the country expands the money supply in an effort
to maintain the artificial Yuan/dollar relationship. Many students will probably suggest
that if the yuan is allowed to float, China will see some of its manufacturing slow as
companies lose the benefit of cheap yuan exports. This could then translate into a
slowing economy. Other students may note that a stronger yuan would give the Chinese
more buying power, which might benefit foreign producers. Still other students may
bring up the huge foreign exchange reserves currently being held by China, and how a
floating yuan might affect the reserves.
QUESTION 5: Do you think the U.S. government should push the Chinese to let the
yuan float freely? Why?
ANSWER 5: China was being pressured to allow a floating yuan/dollar relationship
because there of a belief that, after years of rapid economic growth, the pegged exchange
rate undervalued the true value of the yuan by as much as 40 percent. Many students will
probably agree with this perspective. However, other students may point out that
consumers in the United States benefit from the pegged yuan.
QUESTION 6: What do you think the Chinese government should do? Let the float,
maintain the peg, or change the peg in some way?
ANSWER 6: In 2005, China finally caved in and announced that it would link its
currency to a basket of currencies that include the U.S. dollar, the euro, and the yen.
Along with its new system, China also agreed to revalue the yuan against the U.S. dollar
by 2.1 percent, and to let the yuan float by 0.3 percent per day against the dollar and 1.5
percent per day against other currencies. Many economists felt that while these moves
were a good start, more needed to be done. In fact, some U.S. senators felt that a 27.5
percent tariff should be imposed on all Chinese imports unless the yuan was further
depreciated relative to the dollar.
Another Perspective: Students can track the yuan since 2005 by going to
{http://www.oanda.com/convert/fxhistory}. Click on FX history and then enter the dates and
currencies you want to see.
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: New World Bank Chief Zoellick Tasked With Reputation Repair
Zoellick Discusses World Bank
Run Time: 11:48
Abstract: This video explores how the new head of the World Bank, Robert Zoellick, is
getting the institution back on track, and the challenges that lie ahead for the institution.
Key Concepts: World Bank, globalization, levels of economic development, corruption,
poverty
Notes: One hundred days into his reign as World Bank President, Robert Zoellick is
optimistic about the World Banks future. Zoellick, who took on the leadership position
of the institution following the departure of the often criticized Paul Wolfowitz, has spent
three months restoring faith in the organization. The World Bank had been the recipient
of significant criticism recently, particularly during the last part of Wolfowitzs
leadership. One key area that is continuing to plague the organization is corruption in
countries like Nigeria and the Philippines. Zoellick believes that the World Bank needs
to continue to fight corruption, and has stressed the need for transparency in nations
receiving aid. Zoellick also believes that the World Bank should embrace globalization
without leaving the worlds poorer nations behind. He is currently focusing on raising
money to create a fund for the worlds poorest countries.
The World Bank was founded in 1944. Its purpose at the time was to help rebuild a wartorn Europe. Today, the World Bank has evolved into the worlds largest poverty-fighting
institution, lending about $24 billion annually to nations in Africa, Asia, and Latin
America. Zoellick believes that to continue in its role as a leader in poverty relief, the
organization must change to fit with the changing global environment. Rather than being
a stand alone entity that simply provides loans, Zoellick believes the institution should
work together with organizations like the Gates Foundation to coordinate aid efforts.
Zoellick believes that customizing aid packages and other services to the particular
situation in a country will be vital in the future. He notes for example, that China is
taking advantage of the World Banks knowledge of environmental issues, but that World
Bank services in a country like Ghana would be entirely different. One of the goals
Zoellick has proposed is to identify how the World Bank can improve its role as a
knowledge and learning institution. He notes that the institutions public and private
sides need to be coordinated so that the whole is greater than the sum of the parts.
Zoellick also argues that the World Bank needs to continue to offer its services to socalled middle income countries like India, China, and Brazil. Some critics have argued
that these countries should no longer receive World Bank monies because they have their
own resources. Zoellick however, argues that since about 70 percent of the worlds poor
lives in these countries, the World Bank must remain involved. He also notes
maintaining close ties with these countries is more important than ever as they become
bigger players in Africa.
Discussion Questions:
1. What do you see as the main challenges for the World Bank today?
Answer: When Robert Zoellick was appointed to lead the World Bank, he spent the first
part of his tenure restoring confidence in the institution. Many students will probably
suggest that the institution must continue to earn respect in the world, and earn the right
to lead the world in fighting poverty. To that end, some students will probably suggest
that transparency in all dealings is essential. Other students may also point out that the
World Bank must continue to move away from being a single solution institution, and
toward becoming the type of institution that can work with a variety of public and private
organizations to provide coordinated, customized solutions for countries in need.
2. How has the World Bank evolved since its inception in 1944?
Answer: When the World Bank was initially conceived in 1944, it was charged with
helping to rebuild war-torn Europe. Over time, the World Bank evolved to become a
source of loans to countries in need of infrastructure improvements. Today, the
organization has become not only a source of loans, but also a source of knowledge and
expertise. The World Bank lends some $24 billion each year to countries in Africa, Asia,
and Latin America. World Bank President Robert Zoellick believes the institution now
must embrace globalization, yet be careful not to leave the poor behind.
3. Reflect on the World Bank as a knowledge and learning institution. In your opinion, is
there a need for this type of institution? Why or why not?
Answer: The World Bank is now being seen as not just a source of loans, but also as a
source of knowledge and learning. China, for example, is getting assistance from the
World Bank on environmental issues. Similarly, the World Bank has indicated that it
might get involved in Chinas health care. Most students will probably agree that an
institution offering this type of information could be very beneficial to poor nations that
may have few alternative sources of information. Some students might point out that the
by teaching countries how to grow, the World Bank can go beyond simply being a money
lending institution. In Africa, for example, the World Bank is helping with microfinancing, and in China, the focus is on combining growth with environmental safety.
4. Discuss the notion of the World Bank as a facilitator or liaison between the public and
private sectors, between aid organizations, and so forth. What unique qualities does the
World Bank possess that would help it in this type of role?
Answer: Poverty has been receiving more attention recently, thanks in part to the efforts
of various well-known individuals who are publicizing the plight of the poor. Bill Gates
for example, has established the Gates Foundation which is working to help relieve
poverty in places like Africa. Most students will probably suggest that the World Bank is
uniquely qualified to help coordinate these efforts. The World Bank has been working
with the governments of many poor countries for years, and not only has a wealth of
knowledge about the situation in different countries, but also the global leadership
position to bring these efforts together. Some students may suggest that by working
together these efforts can be more beneficial than they could be independently.
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:
Title 10: Tough Job
Summary
The International Monetary Fund (IMF) was established at the end of World War II in
Bretton Woods, New Hampshire, to help Europe and the world economy recover from
war and depression. More recently, the IMFs role has changed to that of a lender of last
resort to countries in economic distress. With this change has come a host of accusations
suggesting that recipients of IMF loans have been required to cut back on spending for
the poor. Newly appointed head of the IMF, Rodrigo Rato, denies these accusations.
Rato defends the IMFs actions arguing that the IMF simply stepped in to help countries
when no one else would. He suggests that spending cutbacks required by the IMF were
not directed at the poor, rather they were simply an effort to rein in government spending
and get a country on a budget. Rato has also stated that he believes in forgiving debt held
by the very poorest nations so long as they follow an IMF program to stay fiscally on
track.
Furthermore, Rato suggests that while the U.S. may not be a recipient of IMF aid, it is
important for the U.S. to understand its mission, both from an ethical standpoint, and
because as citizens of the global economy, the U.S. stands to gain from less prosperous
economies. In other words, the American economy needs the world, and the world needs
the American economy. Rato has also called on the U.S. to reduce its debt, fearing that
the country will not be able to carry such a burden in the longer term.
Discussion Questions
1. Consider the role of the IMF today as compared to its role when it was first
established. In which situation has the IMF been more successful? Why?
2. The IMF has come under considerable fire from those who believe that its actions
target the poor. What alternatives, if any, are available to the countries that have
requested IMF aid? What would happen to the poor in these nations if the IMF had not
stepped in? How would you respond to these critics?
3. IMF head, Rato, has called on the U.S. to not only understand the mission of the IMF,
but also to reduce its own debt load. Why do you think Rato has chosen to make these
statements?
4. There is some movement toward forgiving debt held by the very poorest nations in the
world. The IMFs position would seem to be that this is appropriate so long as the
countries in question agree to an IMF program to maintain their recovery. Do you agree
with this plan? Would this type of assistance help make these countries more productive
members of the global economy? Why or why not?
globalEDGE Exercise Questions
Use the globalEDGE site {http://globalEDGE.msu.edu/} to complete the following
exercises:
Exercise 1
The quality of life in emerging markets sometimes is impacted by the countrys 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
and to identify potential systemic weaknesses that could lead to crises. Locate and
download the latest report to prepare a summary of what the IMF sees as the
developments and vulnerabilities facing emerging market countries.
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 Researchs Megatopics are an effective way to stay informed on
important topics in international finance. Find a Megatopics report focusing on global
growth centers. Which country (or countries) is included in your report? Is the report on
established or emerging economies? 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 {http://globaledge.msu.edu/ResourceDesk/}. This resource is located under the
globalEDGE category Money: Finance. Be sure to check the Resource Desk only
checkbox of the search function on the globalEDGE website.
Search Phrase: Global Financial Stability Report
Resource Name: IMF: Global Financial Stability Report
Website: {http://www.imf.org/external/pubs/ft/GFSR/index.htm}
globalEDGE Category: Money: Finance
Exercise 2
The Megatopics reports are accessible by searching for the phrase Deutsche Bank
Research at {http://globaledge.msu.edu/ResourceDesk/}. 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.
The special topic of Global Growth Centres is found toward the bottom. Be sure to
check the Resource Desk only checkbox of the search function on the globalEDGE
website.
Search Phrase: Deutsche Bank Research
Resource Name: Deutsche Bank Research
Website: {http://www.dbresearch.de/}
globalEDGE Category: Money: Finance