International business

Angela gomez

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International Business

Sixteenth Edition

Chapter 10

The Determination of Exchange Rates

Learning Objectives (1 of 2)

10-1 Describe the International Monetary Fund and its role in determining exchange rates

10-2 Discuss the major exchange-rate arrangements that countries use

10-3 Identify the major determinants of exchange rates

Learning Objectives for the chapter.

Learning Objectives (2 of 2)

10-4 Show how managers try to forecast exchange-rate movements

10-5 Examine how exchange-rate movements influence business decisions

Learning Objectives for the chapter.

The International Monetary Fund (IMF)

Objective 10-1

International Monetary Fund

Purpose of the IMF

Learning Objective 1: Describe the International Monetary Fund and its role in determining exchange rates.

In 1944, toward the close of World War II, the major Allied governments met in Bretton Woods, New Hampshire, to determine what was needed to bring economic stability and growth to the postwar world. As a result of those meetings, the International Monetary Fund (IMF) came into official existence on December 27, 1945, with the goal of promoting exchange-rate stability and facilitating the international flow of currencies. The IMF began financial operations on March 1, 1947.2.

Twenty-nine countries initially signed the IMF agreement; there were 189 member countries as of April 28, 2016.3 The fundamental mission of the IMF is to:

foster global monetary cooperation,

secure financial stability,

facilitate international trade,

promote high employment and sustainable economic growth, and

reduce poverty around the world.

Determination of Exchange Rates

Objective 10-1

Brenton Woods Agreement

Quota System

Special Drawing Right (SDR)

The Smithsonian Agreement

Learning Objective 1: Describe the International Monetary Fund and its role in determining exchange rates.

Bretton Woods and the Principle of Par Value The Bretton Woods Agreement established a system of fixed exchange rates under which each IMF member country set a par value for its currency based on gold and the U.S. dollar. Because the value of the dollar was fixed at $35 per ounce of gold, the par value would be the same whether gold or the dollar was used as the basis.

The Quota System When a country joins the IMF, it contributes a certain sum of money, called a quota, broadly based on its relative size in the global economy.

Special Drawing Rights (SDRs) To help increase international reserves, the IMF created the special drawing right (SDR) in 1969 to help reinforce the fixed exchange-rate system that existed at that time. To support its currency in foreign-exchange markets, a country could use only U.S. dollars or gold to buy currency. However, the collapse of the Bretton Woods system, the move to floating exchange rates by most of the major currencies, and the growth of global capital markets as a source of funds for governments lessened the need for SDRs. Thus, the SDR is an international reserve asset created to supplement members’ official holdings of gold, foreign exchange, and IMF reserve positions. In addition, the SDR serves as the IMF’s unit of account—the unit in which the IMF keeps its records—and can be used for IMF transactions and operations. On January 1, 1981, the IMF began to use a simplified basket of four currencies for determining valuation, the U.S. dollar, the euro, the British pound, and the Japanese yen. In 2016, however, the Chinese renminbi (or yuan) will be added to the basket.

The IMF’s system was initially one of fixed exchange rates. Because the U.S. dollar was the cornerstone of the international monetary system, its value remained constant with respect to the value of gold. Other countries could change the value of their currency against gold and the dollar, but the value of the dollar remained fixed. On August 15, 1971, as the U.S. balance-of-trade deficit continued to worsen, U.S. President Richard Nixon announced that the United States would no longer trade dollars for gold unless other industrial countries agreed to support a restructuring of the international monetary system. That resulted in the Smithsonian Agreement in December 1971.

The Smithsonian Agreement The agreement resulted in:

An 8 percent devaluation of the dollar (an official drop in the value of the dollar against gold).

A revaluation of some other currencies (an official increase in the value of each currency against gold).

A widening of exchange-rate flexibility (from 1 to 2.25 percent on either side of par value).

This effort did not last, however. World currency markets remained unsteady during 1972, and the dollar was devalued again by 10 percent in early 1973 (the year of the Arab oil embargo and the start of fast-rising oil prices and global inflation). Major currencies began to float against each other, relying on the market to determine their value. The period from 1972–1981 led to the end of the Bretton Woods system and the move to flexible exchange rates.

Exchange Rate Arrangements

Objective 10-2

Hard Peg

Soft Peg

Floating arrangements

Learning Objective 2: Discuss the major exchange-rate arrangements that countries use.

Hard Peg There are two possibilities for countries that adopt a hard peg. The first, called dollarization, can occur when a country like Zimbabwe or Ecuador does not have its own currency but has adopted the U.S. dollar as its currency. The second example of the hard peg is a currency board, which is separate from a country’s central bank. It is responsible for issuing domestic currency, typically anchored to a foreign currency. If it does not have deposits on hand in the foreign currency, it cannot issue more domestic currency. Twelve countries now have currency boards, of which eight are anchored to the U.S. dollar.10 Hong Kong is a good example. Even though the HK dollar is locked onto the U.S. dollar, it moves up and down against other currencies since the U.S. dollar is a freely floating currency.

Soft Peg There are several different types of soft pegs, but most countries in this category (44 out of 83) have adopted a conventional fixed-peg arrangement, whereby a country pegs its currency to another currency or basket of currencies and allows the exchange rate to vary plus or minus 1 percent from that value.11 Most countries use the U.S. dollar and the euro to anchor their pegs. In the other soft peg categories, the degree of flexibility increases, but the IMF determines that the currencies are not floating.

Floating Arrangement Currencies considered to be in a floating arrangement are either floating (36 countries) or free floating (29 countries). Floating currencies are those that generally change according to market forces but may be subject to market intervention with no predetermined direction in which the currency should move. Free floating currencies are subject to intervention only in exceptional circumstances. The major trading currencies, including the U.S. dollar, the Japanese yen, the British pound, and the euro, are freely floating currencies. Brazil and India, two of the BRIC countries, are considered to have floating currencies.

The Euro as a Floating Arrangement

Objective 10-2

The EMU (European Monetary Union)

Stability and Growth Pact Criteria

Learning Objective 2: Discuss the major exchange-rate arrangements that countries use.

According to the Treaty of Maastricht, countries had to meet certain criteria to comply with the ERM and be part of the European Monetary Union (EMU). Termed the “Stability and Growth Pact,” the criteria outlined in the treaty are:

Annual government deficit must not exceed 3 percent of GDP.

Total outstanding government debt must not exceed 60 percent of GDP, Rate of inflation must remain within 1.5 percent of the three best-performing EU countries.

Average nominal long-term interest rate must be within 2 percent of the average rate in the three countries with the lowest inflation rates.

Exchange-rate stability must be maintained, meaning that for at least two years the country concerned has kept within the “normal” fluctuation margins of the European Exchange Rate Mechanism.

The euro is administered by the European Central Bank (ECB). The ECB has been responsible for setting monetary policy and managing the exchange-rate system for all of Europe since January 1, 1999.

Determining Exchange Rates

Objective 10-3

The role of Central Banks

Central Bank Reserve Assets

Learning Objective 3: Identify the major determinants of exchange rates.

Currencies that float free respond to supply and demand conditions.

The Role of Central Banks Each country has a central bank responsible for the policies affecting the value of its currency, although countries with independent currency boards use them to control the currency value. In the United States, the New York Federal Reserve Bank, in close coordination with and representing the Federal Reserve System of 12 regional banks and the U.S. Treasury, is responsible for intervening in foreign-exchange markets to achieve dollar exchange-rate policy objectives and counter disorderly conditions in foreign-exchange markets. The U.S. Treasury is responsible for setting exchange-rate policy, whereas the Fed is the central bank and is responsible for executing foreign-exchange intervention. Further, the New York Fed serves as a fiscal agent in the United States for foreign central banks and official international financial organizations.

Central Bank Reserve Assets Central bank reserve assets are kept in three major forms: foreign-exchange reserves, IMF-related assets (including SDRs), and gold.

Central Banks and Exchange Rates

Objective 10-3

Central Banks and Intervention in the Market

Learning Objective 3: Identify the major determinants of exchange rates.

How Central Banks Intervene in the Market A central bank can intervene in currency markets in several ways. The U.S. Fed, for example, can use foreign currencies to buy dollars when the dollar is weak, or sell dollars for foreign currency when the dollar is strong. Central banks may coordinate actions with other central banks, make policy statements to influence markets, and intervene to reverse, resist, or support a market trend.

Different Attitudes Toward Intervention Government policies change over time, depending on economic conditions and the attitude of the prevailing administration in power, irrespective of whether the currency is considered to be freely floating.

Challenges with Intervention In general, it is very difficult, if not impossible, for intervention to have a lasting effect on the value of a currency. Given the daily volume of foreign exchange transactions, no one government can move the market unless its movements can change market psychology. Intervention may temporarily halt a slide, but the country cannot force the market to move in a direction it doesn’t want to go, at least for the long run.

Other Considerations on Exchange Rates

Objective 10-3

Black Markets and Exchange rates

Convertible Currencies

Hard and Soft Currencies

PPP and The Big Mac Index

Learning Objective 3: Identify the major determinants of exchange rates.

In many of the countries that do not allow their currencies to float according to market forces, a black market can parallel the official market and yet be aligned more closely with the forces of supply and demand. The less flexible a country’s exchange-rate arrangement, the more likely there will be a thriving black (or parallel) market, which exists when people are willing to pay more than the official rate for hard currencies, such as dollars and euros. In order for such a market to work, the government must control access to foreign exchange so it can control the price of its currency.

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 and Soft Currencies Hard currencies—such as the U.S. dollar, euro, British pound, and Japanese yen—are those that are fully convertible. Highly liquid and relatively stable in value over a short period of time, they are generally accepted worldwide as payment for goods and services. They are also desirable assets. Currencies that are not fully convertible, or soft currencies, have just the opposite characteristics: they are very unstable in value, not very liquid, and not widely accepted as payment for goods and services.

Purchasing Power Parity (PPP) The PPP exchange rate is the rate at which the currency of one country would have to be converted into that of another country to buy the same amount of goods and services in each country. Examining the difference between the PPP exchange rate and the market exchange rate helps us understand how trade relations might be affected.

The “Big Mac Index” An illustration of the PPP theory is the “Big Mac index” of currencies used by The Economist each year. Since 1986, the British periodical The Economist has used the price of a Big Mac to estimate the exchange rate between the dollar and another currency (see Table 10.2 for a sample of countries). Because the Big Mac is sold in more than 36,000 McDonald’s restaurants in more than 100 countries every day, it is easy to use it to compare prices. PPP would suggest that the exchange rate should leave hamburgers costing the same in the United States as abroad. However, the Big Mac sometimes costs more and sometimes less, demonstrating how far currencies are under- or overvalued against the dollar.

The Big Mac Index

Objective 10-3

Table 10.2 The Big Mac Index

Source: Based on The Big Mac Index, http://www.economist.com/bigmac (accessed January 7, 2016).

Learning Objective 3: Identify the major determinants of exchange rates.

This table shows the price of Big Mac’s across the world to illustrate PPP.

Exchange Rates and Interest Rates

Objective 10-3

The International Fisher Effect

Learning Objective 3: Identify the major determinants of exchange rates.

The International Fisher Effect The bridge from interest rates to exchange rates can be explained by the International Fisher Effect (IFE), the theory that the interest-rate differential is an unbiased predictor of future changes in the spot exchange rate. For example, if the IFE predicts that nominal interest rates in the United States are higher than those in Japan, the dollar’s value should fall in the future by that interest-rate differential, which would be an indication of a weakening, or depreciation, of the dollar.

Forecasting Exchange Rate Movements

Objective 10-4

Technical Forecasting and Fundamental Forecasting

Biases in Forecasting

Learning Objective 4: Show how managers try to forecast exchange-rate movements.

Managers can forecast exchange rates by using either of two approaches: fundamental or technical. Fundamental forecasting uses trends in economic variables to predict future rates. The data can be plugged into an econometric model or evaluated on a more subjective basis. Technical forecasting uses past trends in exchange rates themselves to spot future rate trends. Technical forecasters, or chartists, assume that if current exchange rates reflect all facts in the market, then under similar circumstances future rates will follow the same patterns.

Dealing with Biases. Some biases exist that can skew forecasts:

Overreaction to unexpected and dramatic news events.

Illusory correlation—that is, the tendency to see correlations or associations in data that are not statistically present but are expected to occur on the basis of prior beliefs.

Focusing on a particular subset of information at the expense of the overall set of information.

Insufficient adjustment for subjective matters, such as market volatility.

The inability to learn from one’s past mistakes, such as poor trading decisions.

Overconfidence in one’s ability to forecast currencies accurately.

Exchange Rates: Factors to Monitor

Objective 10-4

Institutional Setting

Fundamental Analyses

Confidence Factors

Circumstances

Technical analyses

Learning Objective 4: Show how managers try to forecast exchange-rate movements.

Institutional Setting

Does the currency float, or is it managed—and if so, is it pegged to another currency, to a basket, or to some other standard?

What are the intervention practices? Are they credible? Sustainable?

Fundamental Analyses

Does the currency appear undervalued or overvalued in terms of PPP, balance of payments, foreign-exchange reserves, or other factors?

What is the cyclical situation in terms of employment, growth, savings, investment, and inflation?

What are the prospects for government monetary, fiscal, and debt policy?

Confidence Factors

What are market views and expectations with respect to the political environment, as well as to the credibility of the government and central bank?

Circumstances

Are there national or international incidents in the news, the possibility of crises or emergencies, or governmental or other important meetings coming up?

Technical Analyses

What trends do the charts show? Are there signs of trend reversals?

At what rates do there appear to be important buy and sell orders? Are they balanced?

Is the market overbought? Oversold?

What is the thinking and what are the expectations of other market players and analysts?

Business Implications of Exchange Rates

Objective 10-5

Marketing Decisions

Production Decisions

Financial Decisions

Learning Objective 5: Examine how exchange-rate movements Influence business decisions.

Marketing Decisions Marketing managers watch exchange rates because they can affect demand for a company’s products at home and abroad. For example, in 2013, as the Indian rupee plunged in value against the U.S. dollar, Indian small importers were in trouble because they didn’t have the financial strength to deal with the currency fluctuations. In most cases, they had to pay their suppliers in U.S. dollars; when the rupee fell, they had to come up with more rupees to convert into dollars to pay the suppliers, and they were struggling to do so.

Production Decisions: Exchange-rate changes can also affect the location of production, although it will be only one of many variables companies consider.

Financial Decisions: Exchange rates can affect financial decisions primarily in sourcing financial resources, remitting funds across national borders, and reporting financial results. In the first area, a company might be tempted to borrow money in places where interest rates are lowest. However, recall that interest-rate differentials often are compensated for in money markets through exchange-rate changes.