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International Financial Management

13th Edition

by Jeff Madura

Government Influence on Exchange Rates

Describe the exchange rate system used by various governments.

Describe the development and implications of a single European currency.

Explain how governments can use direct intervention to influence exchange rates.

Explain how governments can use indirect intervention to influence exchange rates.

Chapter Objectives

Exchange Rate Systems (1 of 9)

Exchange rate systems can be classified according to the degree of government control and fall into the following categories:

Fixed

Freely floating

Managed float

Pegged

Exchange Rate Systems (2 of 9)

Fixed Exchange Rate System

Exchange rates are either held constant or allowed to fluctuate only within very narrow boundaries.

Central bank can reset a fixed exchange rate by devaluing or reducing the value of the currency against other currencies.

Central bank can also revalue or increase the value of its currency against other currencies.

Exchange Rate Systems (3 of 9)

Fixed Exchange Rate System (cont.)

Bretton Woods Agreement 1944 – 1971 — Each currency was valued in terms of gold.

Smithsonian Agreement 1971 – 1973 — called for a devaluation of the U.S. dollar by about 8% against other currencies.

Advantages of fixed exchange rates

Insulate country from risk of currency appreciation.

Allow firms to engage in direct foreign investment without currency risk.

Disadvantages of fixed exchange rates

Risk that government will alter value of currency.

Country and MNC may be more vulnerable to economic conditions in other countries.

Exchange Rate Systems (4 of 9)

Freely Floating Exchange Rate System

Exchange rates are determined by market forces without government intervention.

Advantages of a freely floating system:

Country is more insulated from inflation of other countries.

Country is more insulated from unemployment of other countries.

Does not require central bank to maintain exchange rates within specified boundaries.

Disadvantages of a freely floating exchange rate system:

Can adversely affect a country that has high unemployment.

Can adversely affect a country with high inflation.

Exchange Rate Systems (5 of 9)

Managed Float Exchange Rate System

Governments sometimes intervene to prevent their currencies from moving too far in a certain direction.

Countries with floating exchange rates: Currencies of most large developed countries are allowed to float, although they may be periodically managed by their respective central banks. (Exhibit 6.1)

Criticisms of the managed float system: Critics suggest that managed float allows a government to manipulate exchange rates to benefit its own country at the expense of others.

Exhibit 6.1 Countries with Floating Exchange Rates and Their Currencies

Exchange Rate Systems (6 of 9)

Pegged Exchange Rate System

Home currency value is pegged to one foreign currency or to an index of currencies.

Limitations of pegged exchange rate

May attract foreign investment because exchange rate is expected to remain stable.

Weak economic or political conditions can cause firms and investors to question whether the peg will be broken.

Exchange Rate Systems (7 of 9)

Pegged Exchange Rate System (cont.)

Examples:

Europe’s Snake Arrangement 1972 - 1979

European Monetary System (EMS) 1979 - 1992

Mexico’s Pegged System 1994

China’s Pegged Exchange Rate 1996 - 2005

Venezuela’s Pegged Exchange Rate 2010

Exchange Rate Systems (8 of 9)

Pegged Exchange Rate System (cont.)

Currency Boards Used to Peg Currency Values

A system for pegging the value of the local currency to some other specified currency. The board must maintain currency reserves for all the currency that it has printed.

Interest Rates of Pegged Currencies

Interest rate will move in tandem with the interest rate of the currency to which it is tied.

Exchange Rate Risk of a Pegged Currency

Provides examples of countries that have pegged the exchange rate of their currency to a specific currency. Currencies are commonly pegged to the U.S. dollar or to the euro.

Classification of Pegged Exchange Rates (Exhibit 6.2)

Exhibit 6.2 Countries with Pegged Exchange Rates and the Currencies to Which They Are Pegged

Exchange Rate Systems (9 of 9)

Dollarization

Replacement of a foreign currency with U.S. dollars.

This process is a step beyond a currency board because it forces the local currency to be replaced by the U.S. dollar. Although dollarization and a currency board both attempt to peg the local currency’s value, the currency board does not replace the local currency with dollars.

A Single European Currency (1 of 5)

Monetary Policy in the Eurozone

European Central Bank — Based in Frankfurt and is responsible for setting monetary policy for all participating European countries

Objective is to control inflation in the participating countries and to stabilize (within reasonable boundaries) the value of the euro with respect to other major currencies.

Impact on Firms in the Eurozone — Prices of products are now more comparable among European countries.

Impact on Financial Flows in the Eurozone — Bond investors who reside in the eurozone can now invest in bonds issued by governments and corporations in these countries without concern about exchange rate risk, as long as the bonds are denominated in euros.

A Single European Currency (2 of 5)

Exposure of Countries within the Eurozone

A single European monetary policy prevents any individual European country from solving local economic problems with its own unique monetary policy.

Any given monetary policy used in the eurozone during a particular period may enhance conditions in some countries and adversely affect others.

Impact of Crises within the Eurozone — may affect the economic conditions of the other participating countries because they all rely on the same currency and same monetary policy.

A Single European Currency (3 of 5)

Impact of Crises within the Eurozone (cont.)

Lessons from Eurozone crisis

Financial problems of one bank can easily spread to other banks.

Banks in Eurozone frequently engage in loan participations. If companies have trouble repaying, all banks may be affected.

News about concerns in one area of Eurozone can trigger actions in other areas.

Eurozone country governments must rely on fiscal policy when they experience serious financial problems.

Banks lend heavily to governments. Performance is related to whether that government can repay its debts.

A Single European Currency (4 of 5)

Impact of Crises within the Eurozone (cont.)

ECB Role in Resolving Economic Crises

In recent years the bank’s role has expanded to include providing credit for eurozone countries that are experiencing a financial crisis.

The ECB imposes restrictions intended to help resolve the country’s budget deficit problems over time.

A Single European Currency (5 of 5)

Impact on a Country that Abandons the Euro

Would allow a country to set its own exchange rate to encourage purchasers of exports.

Would possibly be expelled from the European Union, which would almost certainly reduce its trade with other European Union countries.

Impact of Abandoning the Euro on Eurozone Conditions

Investors may fear other countries abandoning the euro and reduce investments in the eurozone.

Critics agree that the threat of abandonment creates more problems than actual abandonment.

Government Intervention (1 of 5)

Reasons for Government Intervention

Smoothing exchange rate movements

If a central bank is concerned that its economy will be affected by abrupt movements in its home currency’s value, it may attempt to smooth the currency movements over time.

Establishing implicit exchange rate boundaries

Some central banks attempt to maintain their home currency rates within some unofficial, or implicit, boundaries.

Responding to temporary disturbances

A central bank may intervene to insulate a currency’s value from a temporary disturbance.

Government Intervention (2 of 5)

Direct Intervention (Exhibit 6.3)

To force the dollar to depreciate, the Fed can intervene directly by exchanging dollars that it holds as reserves for other foreign currencies in the foreign exchange market.

By “flooding the market with dollars” in this manner, the Fed puts downward pressure on the dollar.

If the Fed desires to strengthen the dollar, it can exchange foreign currencies for dollars in the foreign exchange market, thereby putting upward pressure on the dollar.

Exhibit 6.3 Effects of Direct Central Bank Intervention in the Foreign Exchange Market

Government Intervention (3 of 5)

Direct Intervention (cont.)

Reliance on reserves

The potential effectiveness of a central bank’s direct intervention is the amount of reserves it can use.

Frequency of Intervention

Number of direct interventions has declined from 97 different days in 1989 to no more than 20 days in a year

Coordinated Intervention

Intervention more likely to be effective when it is coordinated by several central banks.

Government Intervention (4 of 5)

Direct Intervention (cont.)

Nonsterilized versus sterilized intervention (See Exhibit 6.4)

When the Fed intervenes in the foreign exchange market without adjusting for the change in the money supply, it is engaging in a nonsterilized intervention.

In a sterilized intervention, the Fed intervenes in the foreign exchange market and simultaneously engages in offsetting transactions in the Treasury securities markets.

Speculating on direct intervention

Some traders in the foreign exchange market attempt to determine when Federal Reserve intervention is occurring and the extent of the intervention in order to capitalize on the anticipated results of the intervention effort.

Exhibit 6.4 Forms of Central Bank Intervention in the Foreign Exchange Market

Government Intervention (5 of 5)

Indirect Intervention

The Fed can affect the dollar’s value indirectly by influencing the factors that determine it.

Indirect Intervention

Indirect Intervention (cont.)

Government Control of Interest Rates by increasing or reducing interest rates.

Government Use of Foreign Exchange Controls such as restrictions on the exchange of the currency.

Intervention Warnings intended to warn speculators. The announcements could discourage additional speculation and might even encourage some speculators to unwind (liquidate) their existing positions in the currency.

Intervention as a Policy Tool

A weak home currency can stimulate foreign demand for products. (See Exhibit 6.5)

A strong home currency can encourage consumers and corporations of that country to buy goods from other countries. (See Exhibit 6.6)

Exhibit 6.5 How Central Bank Intervention Can Stimulate the U.S. Economy

Exhibit 6.6 How Central Bank Intervention Can Reduce Inflation

SUMMARY (1 of 4)

Exchange rate systems can be classified as fixed rate, freely floating, managed float, and pegged. In a fixed exchange rate system, exchange rates are either held constant or allowed to fluctuate only within very narrow boundaries. In a freely floating exchange rate system, exchange rate values are determined by market forces without intervention. In a managed float system, exchange rates are not restricted by boundaries but are subject to government intervention. In a pegged exchange rate system, a currency’s value is pegged to a foreign currency or a unit of account and moves in line with that currency (or unit of account) against other currencies.

SUMMARY (2 of 4)

Numerous European countries use the euro as their home currency. The single currency allows international trade among firms in the eurozone without foreign exchange expenses and without concerns about future exchange rate movements. However, countries that participate in the euro do not have complete control of their monetary policy because a single policy is applied to all countries in the eurozone. In addition, being part of the eurozone may render some countries more susceptible to a crisis occurring in some other eurozone country.

SUMMARY (3 of 4)

Governments can use direct intervention by purchasing or selling currencies in the foreign exchange market, thereby altering demand and supply conditions and hence the currencies’ equilibrium values. When a government purchases a currency in the foreign exchange market, it puts upward pressure on that currency’s equilibrium value. When a government sells a currency in the foreign exchange market, it puts downward pressure on the currency’s equilibrium value.

SUMMARY (4 of 4)

Governments can use indirect intervention by influencing the economic factors that affect equilibrium exchange rates. A common form of indirect intervention is to increase interest rates in order to attract more international capital flows, which may cause the local currency to appreciate. However, indirect intervention is not always effective.

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