Chapter Eleven

The International Monetary

System
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Introduction

• The international monetary system refers to the

institutional arrangements that govern exchange
rates.
• Floating exchange rates occur when the foreign
exchange market determines the relative value of a
currency
• The world’s four major currencies – dollar, euro,
yen, and pound – are all free to float against each
other
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 11 - 4

Introduction

• Pegged exchange rates occur when the value of a

currency is fixed relative to a reference currency
• Dirty float occurs when countries hold the value of
their currency within a range of a reference currency
• Fixed exchange rate occurs when a set of currencies
are fixed against each other at some mutually agreed
upon exchange rate
• Pegged exchange rates, dirty floats and fixed exchange
rates all require some degree of government
intervention
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 11 - 5

The Gold Standard

• Roots in old mercantile

Tr
ad
trade

e
• Inconvenient to ship
gold, changed to paper- Japan USA
redeemable for gold
• Want to achieve
‘balance-of-trade
equilibrium Go
ld

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 11 - 6

Balance of Trade Equilibrium

Decreased
money supply Trade Surplus
= price decline.

As prices decline, exports

increase and trade goes
into equilibrium.

Increased
Gold money supply
= price
inflation.
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 11 - 7

Between the Wars

• Post WWI, war heavy expenditures affected the value

of dollars against gold
• US raised dollars to gold from $20.67 to $35 per
ounce
- Dollar worth less?

• Other countries followed suit and devalued their

currencies

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 11 - 8

Bretton Woods

• In 1944, 44 countries met in New Hampshire

• Countries agreed to peg their currencies to US$ which
was convertible to gold at $35/oz
• Agreed not to engage in competitive devaluations for
trade purposes and defend their currencies
• Weak currencies could be devalued up to 10% w/o
approval
• Created the IMF and World Bank

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International Monetary Fund

• The International Monetary Fund (IMF) Articles of

Agreement were heavily influenced by the worldwide
financial collapse, competitive devaluations, trade
wars, high unemployment, hyperinflation in Germany
and elsewhere, and general economic disintegration
that occurred between the two world wars
• The aim of the IMF was to try to avoid a repetition of
that chaos through a combination of discipline and
flexibility

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International Monetary Fund

• Discipline
- Maintaining a fixed exchange rate imposes monetary
discipline, curtails inflation
- Brake on competitive devaluations and stability to the
world trade environment
• Flexibility
- Lending facility:
• Lend foreign currencies to countries having balance-of-
payments problems
- Adjustable parities:
• Allow countries to devalue currencies more than 10% if
balance of payments was in “fundamental disequilibrium”

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Role of the World Bank

• The official name for the world bank is the

International Bank for Reconstruction and
Development
• Purpose: To fund Europe’s reconstruction and help 3rd
world countries.
• Overshadowed by Marshall Plan, so it turns towards
development
- Lending money raised through WB bond sales
• Agriculture
• Education
• Population control
• Urban development

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 11 - 12

Collapse of the
Fixed Exchange System

• The system of fixed exchange rates established at

Bretton Woods worked well until the late 1960’s
- The US dollar was the only currency that could be
converted into gold
- The US dollar served as the reference point for all other
currencies
- Any pressure to devalue the dollar would cause problems
through out the world

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Collapse of the
Fixed Exchange System

• Factors that led to the collapse of the fixed exchange

system include
- President Johnson financed both the Great Society and Vietnam
by printing money
- High inflation and high spending on imports
- On August 8, 1971, President Nixon announces dollar no longer
convertible into gold
- Countries agreed to revalue their currencies against the dollar
- On March 19, 1972, Japan and most of Europe floated their
currencies
- In 1973, Bretton Woods fails because the key currency (dollar) is
under speculative attack

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 11 - 14

The Floating Exchange Rate

• The Jamaica agreement revised the IMF’s Articles of

Agreement to reflect the new reality of floating
exchange rates
- Floating rates acceptable
- Gold abandoned as reserve asset
- IMF quotas increased
• IMF continues role of helping countries cope with
macroeconomic and exchange rate problems

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 11 - 15

Exchange Rates Since 1973

• Exchange rates have been more volatile for a number

of reasons including:
- Oil crisis -1971
- Loss of confidence in the dollar - 1977-78
- Oil crisis – 1979, OPEC increases price of oil
- Unexpected rise in the dollar - 1980-85
- Rapid fall of the dollar - 1985-87 and 1993-95
- Partial collapse of European Monetary System - 1992
- Asian currency crisis - 1997

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 11 - 16

Long-Term Exchange Rate

Trends From 1973 - 2003

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Fixed Versus Floating
Exchange Rates
• Floating:
- Monetary policy autonomy
• Restores control to
government
- Trade balance adjustments
• Adjust currency to correct
trade imbalances
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• Fixed:
- Monetary discipline
- .Speculation
- Limits speculators
- Uncertainty
- Predictable rate movements
- Trade balance adjustments
- Argue no link between
exchange rates and trade
• Link between savings and
investment
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 11 - 18

Exchange Rate Regimes

• Pegged Exchange Rates

- Peg own currency to a major currency ($)
- Popular among smaller nations
- Evidence of moderation of inflation
• Currency Boards
- Country commits to converting domestic currency on
demand into another currency at a fixed exchange rate
- Country holds foreign currency reserves equal to 100% of
domestic currency issued

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 11 - 19

Exchange Rate Policies for

IMF Members 2004

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Crisis Management by the IMF

• The IMF’s activities have expanded because periodic

financial crises have continued to hit many economies
- Currency crisis
• When a speculative attack on a currency’s exchange value
results in a sharp depreciation of the currency’s value or
forces authorities to defend the currency
- Banking crisis
• Loss of confidence in the banking system leading to a run on
the banks
- Foreign debt crisis
• When a country cannot service its foreign debt obligations

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 11 - 21

Incidence of Currency and

Banking Crises 1975 - 1997

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 11 - 22

Mexican Currency
Crisis of 1995

• Peso pegged to U.S. dollar

• Mexican producer prices rise by 45% without
corresponding exchange rate adjustment
• Investments continued ($64B between 1990 -1994)
• Speculators began selling pesos and government
lacked foreign currency reserves to defend it
• IMF stepped in

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 11 - 23

Russian Ruble Crisis

• Financial markets’ loss of confidence in Russia’s

ability to meet national and international payments
- Led to loss of international reserves and roll over of
treasury bills reaching maturity
• Financial markets unable to determine ‘who’s in
charge’

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 11 - 24

Russian Ruble Crisis

• Persistent decline in value of ruble:

- High inflation
• Artificial low prices in Communist era
• Shortage of goods
• Liberalized price controls
- Too many rubles chasing too few goods
- Growing public-sector debt
• Refusal to raise taxes to pay for government

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Government Actions:
Exacerbating the Situation

• Defacto devaluation of the ruble

• Unilateral restructuring of ruble-denominated public
debt
• 90-day moratorium on foreign credits repayment
• Hike in interest rates to defend ruble
• Duma rejects measures designed to alleviate problems

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Decline of the Ruble

0
1992 1993 1994 1995
-1000

-2000

-3000

-4000

-5000

-6000

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 11 - 27

The Asian Crisis

• Factors leading to the Asian financial crisis of 1997

- The investment boom
- Excess capacity
- The debt bomb
- Expanding imports

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The Asian Crisis

• Mid 1997 several key Thai financial institutions were

on the verge of default
- Result of speculative overbuilding
- Excess investment (dollar denominated debt)
- Deteriorating balance-of payments position
• Thailand asks IMF for help
- 17.2 billion in loans, given with restrictive conditions
• Following devaluation of Thai baht speculation hit
other Asian currencies
- Malaysia, Singapore, Indonesia, and Korea

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Problems in Asian Market

Economies

• Cronyism
• Too much money, dependence on speculative capital
inflows
• Lack of transparency in the financial sector
• Currencies tied to strengthening dollar
• Increasing current account deficits
• Weakness in the Japanese economy

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Evaluating the IMF

Policy Prescriptions

• Inappropriate policies
- The IMF’s ‘one-size-fits-all’ approach to macroeconomic
policy is inappropriate for many countries
• Moral hazard
- People behave recklessly when they know they will be
saved if things go wrong
• Lack of Accountability
- The IMF has become too powerful for an institution that
lacks any real mechanism for accountability

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Implications for Managers

• Currency management
• Business strategy
- Faced with uncertainty about the future value of currencies,
firms should utilize the forward exchange market to insure
against exchange rate risk
- Firms should pursue strategies that will increase the
company’s strategic flexibility in the face of unpredictable
exchange rate movements — that is, to pursue strategies
that reduce the economic exposure of the firm
• Corporate-government relations

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 11 - 32

Looking Ahead to Chapter 12

• The Strategy of International Business

- Strategy and the Firm
- Global Expansion, Profitability, and Profit Growth
- Cost Pressures and Pressures for Local Responsiveness
- Choosing a Strategy

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