Assignment 2.2 International Business

MGMK 4710

INTERNATIONAL BUSINESS

Chapter 10. The Determination of Exchange Rates

https://www.youtube.com/watch?v=uWIm4-iF7W4

I. INTRODUCTION

MNEs’ managers need to understand how exchange rates are set and what causes them to change. Governments around the world undertake actions to stabilize the value of various currencies. These actions include the creation of a multinational institution, the International Monetary Fund (IMF).

II. THE INTERNATIONAL MONETARY FUND

In 1944, the major powers met in Bretton Woods, NH, to discuss post-war economic needs. One of the results was the establishment of the International Monetary Fund (IMF).

A. Origin and Objectives

Twenty-nine countries initially signed the IMF agreement, and there were 187-member countries in July 2011. The IMF has four major objectives:

- To ensure stability in the international monetary system

- To promote international monetary cooperation & exchange-rate stability

- To facilitate balanced growth of international trade

- To provide resources to help countries in balance-of-payments difficulties or to assist with poverty reduction

The Bretton Woods Agreement established a system of fixed exchange rates under which the value of a country’s currency was determined based on gold and the U.S. dollar. Since then, the determination of exchange rates has evolved toward greater exchange-rate flexibility.

B. The IMF Today

Currency of reserve for the IMF. From its creation until the early 1970s, the U.S. dollar remained constant with respect to the value of gold, and other currencies operated within narrow bands of value relative to the dollar. After the US dollar started to change in value, the IMF created a unit of reserve called the Special Drawing Rights (SDRs). The SDR is used as the IMF’s unit of account (the unit in which the IMF keeps its records). The value of the SDR is based on the weighted average of four currencies. In 2010 those weights were: the U.S. dollar 41.9%, the euro 37.4%, the Japanese yen 9.4%, and the British pound 11.3%. Normally, the weights of each currency change every 5 years.

The Quota System. When a country joins the IMF, it contributes a certain sum of money, called a quota, relating to its GDP, monetary reserves, trade balance, and other economic indicators. At the end of 2010, the total funds held by the IMF was SDR 476.8 billion (U.S. $750 billion). It also forms the basis for the voting power of each country, as well as the allocation of its special drawing rights.

Assistance Programs. When a member country experiences economic difficulty, the IMF will negotiate loan criteria designed to help stabilize its economy. Funds are released in phases, allowing the IMF to monitor progress before releasing all of the funds.

III. EXCHANGE-RATE ARRANGEMENTS

The IMF has put in place surveillance and consultation programs designed to monitor the exchange-rate arrangements of member nations to be sure they act openly and responsibly with respect to their exchange-rate policies. There are three exchange-rate arrangements: Hard peg arrangement, soft peg arrangement, and floating arrangement:

- Hard Peg arrangement: It is the exchange rate system whereby the value of a country’s currency is anchored (tied) to a foreign currency (in Congo, from 1967 until 1975, Zaire 1 = US$2). This type of arrangement is in decline, as almost all currencies are fluctuating in value.

- Soft Peg arrangement: It is the exchange rate system in whereby a country ties the value of its currency to that of another currency or basket of currencies and allows exchange rates to vary plus or minus 1 percent from that value.

- Floating arrangement: It is the exchange rate system whereby currencies change according to market forces but may be subject to market intervention. Free-floating currencies are subject to intervention only in exceptional circumstances.

IV. DETERMINANTS OF EXCHANGE RATES

Several factors affect exchange rates. These include exchange rate regimes, central banks, existence of black markets, currency convertibility, inflation, and interest rates.

A. Exchange rate regimes:

Exchange rates either can float or be fixed:

- Floating-rate regime: It is a system whereby exchange rates respond to supply and demand of currencies. The value of a currency floats freely, unhampered by government intervention. In reality, when needed, governments intervene through their central banks

- Managed fixed rate regime: It is a system whereby central banks buy or sell currencies in the foreign exchange market to control the currency’s exchange rate. When central banks’ intervention does not work, a country may reevaluate or devalue its currency.

B. Influence from Central Banks

Each country has a central bank responsible for the policies affecting the value of its currency. The central bank in the United States is the Federal Reserve System, i.e., the Fed, a system of 12 regional banks. The New York Fed, representing both the Fed and the U.S. Treasury, is responsible for intervening in foreign-exchange markets to achieve dollar exchange-rate policy objectives. Central Banks intervene by selling or buying currencies in the Market. Selling U.S. dollars for foreign currency puts downward pressure on the dollar’s value; buying U.S. dollars for foreign currency puts upward pressure on the dollar’s value.

C. Black Markets

The less flexible (managed fixed rates) a country’s exchange-rate system, the more likely there will be a black market, i.e., a foreign exchange market that lies outside the official market. Black markets are underground markets where prices are based on supply and demand; the adoption of floating rates eliminates the need for their existence.

D. Currency Convertibility

Some countries with fixed exchange rates control access to their currencies. Fully convertible currencies are those that the government allows both residents and nonresidents to purchase in unlimited amounts. Hard currencies are normally fully convertible. Soft (or weak) currencies are not fully convertible and tend to be the currencies of developing nations. Most countries whose currencies are not fully convertible, have external convertibility, meaning that foreigners can convert their currency into the local currency and can convert back into their currency as well, whereas locals have limits in how much hard currencies they can buy.

E. Other determinants of exchange rates

- Inflation, Purchasing Power Parity and exchange rates: The theory of purchasing-power parity (PPP) states that a change in the comparative rates of inflation in two countries necessarily causes a change in their relative exchange rates in order to keep prices fairly similar.

- Interest Rates and Exchange Rates: Interest rates can have an impact on exchange rates. Specifically, investors will likely place their money (invest) in countries with higher interest rates in order to get a higher real return. A country that raises its interest rate is therefore likely to attract capital and see its currency rise in value due to increased demand.

V. BUSINESS IMPLICATIONS OF EXCHANGE-RATE CHANGES

Exchange-rate fluctuations can affect all areas of a company’s operations:

- Marketing Decisions: Exchange-rate changes can affect demand for a firm’s products, both at home and abroad. For instance, the strengthening of a country’s currency could create price competitiveness problems for exporters; on the other hand, importers would favor that situation.

- Production Decisions: Firms may choose to locate production operations in a country whose currency is weak because initial investment there is relatively inexpensive. It could also be a good base for exporting the firm’s output. Exchange-rate differentials contribute to this situation across industrialized nations, as well from industrialized to developing nations.

- Financial Decisions: Exchange-rate fluctuations can affect financial decisions in the areas of sourcing funds (both debt and equity), the cross-border remittance of funds, and the reporting of financial results.