Chapter 6: Exchange rates and the international monetary system

(for first time possibly going to be contained in the exam, hence highly likely)

6.2 Markets for currencies

Foreign exchange market: Market for converting the currency of one country into that of
another country

International companies use the foreign exchange markets for several main reasons:

● To convert the payments they receive for exports

● To convert the payments they receive from foreign investments
● To convert the payments the receive from foreign licensing agreements
● When they need a foreign currency to pay for foreign products or services
● To engage in currency speculations

Exchange rates are determined by supply and demand. Supply and demand are
affected by

- Relative price differences

- Inflation / monetary supply
- Present Interest rates (for the spot exchanges) and future interest rates (for
forward exchanges)
- Productivity
- A rise in a country’s productivity improves its competitive positioning
and tends to lead to a rise in the demand for its currency
- A country with an account surplus will see its currency appreciate in
value
- Investor psychology
- Bandwagon effect - occurs when expectations by traders result in self-
fulfilling prophecies
- Sometimes government intervention can help reduce the effects
(example 2012 - 2013 Cypriot financial crisis)

Exchange rate: Rate at which one currency is converted into another

Hedging: Hedging is an investment technique designed to offset a potential loss on one

investment by purchasing a second investment that you expect to perform in the opposite
way. This is one of the reasons why companies engage in the foreign exchange market (to
insure against foreign exchange rate fluctuations).

Forward exchange: A type of foreign exchange transaction whereby a contract is made to

exchange one currency for another at a fixed date in the future at a specified exchange rate.
By buying or selling forward exchange, businesses protect themselves against a decrease in
the value of a currency they plan to sell at a future date.
Spot exchange rate: The exchange rate for which two parties agree to trade two currencies
at the present moment. The spot exchange rate is usually at or close to the current market
rate because the transaction occurs in real time and not at some point in the future.

6.3 Implications for managers:

- Companies need to protect themselves against three types of foreign exchange risk:
- Transaction exposure - The extent to which the income from individual
transactions is affected by fluctuations in foreign exchange values.
- Risk reduction by collecting payments early or late depending on
anticipated exchange rate movements.
- Translation exposure - The impact of currency exchange rate changes on the
reported financial statement of a company.
- Economic exposure - The extent to which a firm’s future international earning
power is affected by changes in exchange rates.
- Reducing economic exposure requires the company to distribute productive assets to
various locations so that the company#s financial assets are not severely affected by
changing exchange rates.

Overall, managers should a) forecast future exchange rates, b) establish good reporting
systems so the central finance function can regularly monitor the company’s exposure
position, c) produce monthly foreign exchange exposure reports

6.4 Institutions of the international monetary system

Previous institutions of the international monetary system:

Gold standard period: From the 1870s, under which each currency was linked to a
fixed amount of gold.

Bretton Woods system (1944 - 1973): The only currency that was convertible to gold
was the US dollar. Other countries set their exchange rates relative to the dollar. the
IMF was set up as part of the Bretton Woods agreement. The bretton woods system
worked well until the late 1960 when it began to collapse due to US inflationary
policies and rising productivity elsewhere, leading to a deterioration of the USA’s
foreign trade position and pressure on the value of the US dollar.

IMF: The IMF was designed to maintain order in the international monetary system. The

World Bank: Created to promote general economic development. Originally its focus was
Europe but now it shifted its role to help developing nations.

6.4.1. The Post-Bretton Woods system - 1973 to the present

Since 1973 countries can choose between four major exchange rate policies:
Floating exchange rate system: Exists when the foreign exchange rate market, or
supply and demand, determines the relative values of currencies. This is the system
used in the USA, the EU, Japan and UK.
“Dirty” float exchange system: When the value of a currency is determined by
market forces, but the central bank intervenes if it depreciates too rapidly
against an important reference currency. China has used this type of system
since 2005.

Advantages:
● No need for international management of exchange rates: Unlike fixed
exchange rates based on a metallic standard, floating exchange rates don’t
require an international manager such as the International Monetary Fund.
● No need for frequent central bank intervention.
● No need for elaborate capital flow restrictions: It is difficult to keep the parity
intact in a fixed exchange rate regime while portfolio flows are moving in and
out of the country. In a floating exchange rate regime, the macroeconomic
fundamentals of countries affect the exchange rate in international markets,
which, in turn, affect portfolio flows between countries. Therefore, floating
exchange rate regimes enhance market efficiency.
● Greater insulation from other countries’ economic problems: Under a fixed
exchange rate regime, countries export their macroeconomic problems to
other countries. Suppose that the inflation rate in the U.S. is rising relative to
that of the Euro-zone. Under a fixed exchange rate regime, this scenario
leads to an increased U.S. demand for European goods, which then
increases the Euro-zone’s price level. Under a floating exchange rate system,
however, countries are more insulated from other countries’ macroeconomic
problems. A rising U.S. inflation instead depreciates the dollar, curbing the
U.S. demand for European goods.

Disadvantages
● Higher volatility: Floating exchange rates are highly volatile. Additionally,
macroeconomic fundamentals can’t explain especially short-run volatility in
floating exchange rates.
● Use of scarce resources to predict exchange rates: Higher volatility in
exchange rates increases the exchange rate risk that financial market
participants face. Therefore, they allocate substantial resources to predict the
changes in the exchange rate, in an effort to manage their exposure to
exchange rate risk.
● Tendency to worsen existing problems: Floating exchange rates may
aggravate existing problems in the economy. If the country is already
experiencing economic problems such as higher inflation or unemployment,
floating exchange rates may make the situation worse.
● For example, if the country suffers from higher inflation, depreciation of its
currency may drive the inflation rate higher because of increased demand for
its goods; however, the country’s current account may also worsen because
of more expensive imports.
Fixed exchange system: A fixed exchange rate is a type of exchange rate regime
where a currency's value is fixed against either the value of another single currency,
to a basket of other currencies, or to another measure of value, such as gold. Some
EU countries used to operate like this before joining the euro.

Advantages:
- Avoids Currency Fluctuations. If the value of currencies fluctuate
significantly this can cause problems for firms engaged in trade. For
example if a UK firm is exporting to the US, a rapid appreciation in
Sterling would make its exports uncompetitive and therefore may go
out of business. If a firm relied on imported raw materials a
devaluation would increase the costs of imports and would reduce
profitability
- Stability encourages investment. The uncertainty of exchange rate
fluctuations can reduce the incentive for firms to invest in export
capacity. Some Japanese firms have said that the UK’s reluctance to
join the Euro and provide a stable exchange rates maker the UK a
less desirable place to invest.
- Keep inflation Low. Governments who allow their exchange rate to
devalue may cause inflationary pressures to occur. This is because
Aggregate Demand increases, import prices increase and firms have
less incentive to cut costs.
- A rapid appreciation in the exchange rate will badly effect
manufacturing firms who export, this may also cause a worsening of
the current account.
- Joining a fixed exchange rate may cause inflationary expectations to
be lower

Cons:
- Need to maintain the fixed exchange rate. This requires large amounts of
reserves as the country's government or central bank is constantly buying or
selling the domestic currency. China is a perfect example. Before withdrawing
from the fixed rate scheme in 2010, Chinese foreign exchange reserves grew
significantly each year in order to maintain the U.S. dollar peg rate. The pace
of growth in reserves was so rapid it took China only a couple of years to
overshadow Japan's foreign exchange reserves. As of January 2011, it was
announced that Beijing owned $2.8 trillion in reserves – more than double
that of Japan at the time.
- The problem with huge currency reserves is that the massive amount of funds
or capital that is being created can create unwanted economic side effects –
namely higher inflation. The more currency reserves there are, the wider the
monetary supply – causing prices to rise. Rising prices can cause havoc for
countries that are looking to keep things stable. As of December 2010,
China's consumer price inflation had moved to around 5%
- Conflict with other objectives. To maintain a fixed level of the exchange rate
may conflict with other macroeconomic objectives.
- If a currency is falling below its band the government will have to intervene. It
can do this by buying sterling but this is only a short term measure.
 - The most effective way to increase the value of a currency is to raise interest
rates. This will increase hot money flows and also reduce inflationary
pressures. However higher interest rates will cause lower AD and economic
growth, if the economy is growing slowly this may cause a recession and
rising unemployment
- Less Flexibility. It is difficult to respond to temporary shocks. For example an
oil importer may face a balance of payments deficit if oil price increases, but
in a fixed exchange rate there is little chance to devalue.
- Join at the Wrong Rate. It is difficult to know the right rate to join at. If the rate
is too high, it will make exports uncompetitive. If it is too low, it could cause
inflation.
- Current Account Imbalances. Fixed exchange rates can lead to current
account imbalances. For example, an overvalued exchange rate could cause
a current account deficit.

Pegged exchange rate system: A pegged exchange rate system is a hybrid of fixed
and floating exchange rate regimes. Typically, a country will "peg" its currency to a
major currency such as the U.S. dollar. The US dollar is then the “target rate”. The
actual exchange rate will be allowed to fluctuate in a fixed range around that initial
target rate. Pegged exchange rates are typically used by smaller countries.This limits
fluctuations within a narrow band relative to the other currency. The pegged policy
seeks to stabilise import and export prices. Also many developing nations with high
inflation see advantages in pegging their currencies with, say, the Euro, which
traditionally has low inflation.

Common currency policy: Here a country gives up its monetary policy and relies on
another country or common central bank to manage inflation and exchange rate. The
Euro itself is such a common currency.

6.5 managing exchange risks - implications for managers

Strategic FDI: This also involves organising activities in such a way that the currencies of
revenues and expenses match. For example, in 1998 Toyota set up its new factory in France
rather than expand its UK operation. The reason? It wanted to expand sales into the euro
zone. Since parts of the production was also taking place in France, it reduced the exchange
risk exposure.

Risk diversification: This involves reducing risk exposure by working with a number of
different currencies. A company can then offset losses in one region by gains in other
regions and currencies.

An additional response is to use financial markets to offset currency risk. Two approaches
that are frequently used:

- Currency hedging: This involves undertaking transactions that protect the trader and
investor from exposure to the fluctuations of the currency spot rate.
- Currency swap: This is a currency exchange transaction between two companies in
which one currency is converted into another in Time 1, with the agreement to revert
it back to the original currency at a specific Time 2 in the future
- Companies must realise that the foreign exchange system that is currently in place is
a mixed system where government intervention and speculation can influence
exchange rates
- Speculative buying and selling of currencies can create a volatile situation that
companies need to protect themselves against
- Companies need to protect against economic exposure. In 2007 / 2008, many
companies faced the challenge of dealing with weak US Dollar. Some foreign
suppliers decided that, rather than beaing the risk of passing on the higher prices to
consumers, they were willing to accept smaller profits
- Companies need to keep in mind that they can influence a country’s monetary policy.
Exporters in the USA, for example, have sometimes lobbied for devaluations in the
dollar to make exports more attractive in foreign markets