International Corporate Finance

International Monetary System

International monetary system can be defined as the overall financial environment in which
multinational corporations and international investors operate. More specifically, it is the
institutional framework within which international payments are made, movements of capital are
accommodated, and exchange rates among currencies are determined.

In todays class meeting, we will discuss the history of international monetary system, special
features of European monetary system, currency crises, and difference between alternative
monetary systems.

Evolution of International Monetary System

The international monetary system went through 5 distinct stages of evaluation. They are:

Bimetallism (<1875)
Classical gold standard (1875-1914)
Interwar period (1915-1944)
Bretton Woods system (1945-1972)
Flexible exchange rate regime (>1972)

Bimetallism: During that period, both gold and silver were used as international means of
payment, and the exchange rates among currencies were determined by either their gold or silver
contents.

Example: British pound = gold standard

French franc=bimetallic

German mark=silver

How the exchange rate between British pound and French franc was determined? (Gold content)

How the exchange rate between German mark and French franc was determined? (Silver
content)

How the exchange rate between British pound and French franc was determined? (by their
exchange rates against franc)

Problem of Bimetallism: Bad money drives good money out of circulation (Gresham's Law)

Classical Gold Standard: The classical gold standard existed as the international monetary
system from 1875 to 1914. Under this system, gold is considered the only unrestricted coinage,

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gold can be converted with national currencies at a stable ratio, and gold can be freely exported
or imported. Under this standard, the exchange rate between two currencies will be determined
by their gold content.

Example: Suppose pound is pegged to gold at 6 pounds per ounce, whereas 1 ounce of gold is
worth 12 francs. What is the exchange rate between pound and franc?

6 pound = 1 ounce gold = 12 franc

6 pound = 12 franc

1 pound = 2 franc

Advantage of gold standard: misalignment of exchange rate will be automatically corrected by

cross-border flows of gold.

Example: Suppose currently one pound is trading for 1.80 francs instead of 2 francs.

Pound is undervalued and franc is overvalued

People will buy more pounds

If someone needs francs, it will be cheaper to buy gold in England, ship it to France, and then
buy franc, than buying francs directly. How?

Suppose you need to buy 1000 francs.

Direct purchase: 1000/1.80 = 555.56

Indirect purchase: buy 1000/12=83.33 ounce of gold from Bank of England, ship it to France,
and sell it to Bank of France for 1000 francs.

It will cost 83.33*6 =500 (this is profitable as long as shipping cost <55.56)

Advantage of gold standard: international imbalance of payments will be corrected

automatically.

Example: If in 2010, UK exported more to France and imported less from France, then there will
be trade imbalance between these 2 countries. Under the gold standard this imbalance won't
persist.

Higher export from UK => net flow of gold to UK => higher price level in UK => lower export
from UK

Advantage of gold standard: Hedge against price inflation

Disadvantage of gold standard: less growth of world trade & investment - scarce gold supply

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Disadvantage of gold standard: difficult to enforce

Interwar Period: Classical gold standard ended in 1914 when the war began. Exchange rates
fluctuated as countries widely used predatory depreciations of their currencies as a means of
gaining advantage in the world export market. Attempts were made to restore the gold standard,
but participants lacked the political will to follow the rules of the game. The result for
international trade and investment was profoundly detrimental.

Bretton Woods system: The purpose of this system was to maintain exchange rate stability
without the gold standard. Under this system, the US dollar was pegged to gold at $35/ounce and
other currencies were pegged to the US dollar. Each country was responsible for maintaining its
exchange rate within 1% of the adopted par value by buying and selling foreign exchanges as
necessary. Only US dollar was fully convertible to gold.

Advantages:

Countries can use both gold and foreign exchange as international means of payments
Earn interest on foreign exchange holdings
Save transaction cost
High growth of international trade and investment
Disadvantage: US experienced trade deficit

As a result, a new reserve asset has been created by IMF called Special Drawing Rights (SDR)

SDR is a basket currency comprising major individual currencies. In addition to gold and dollar,
countries could use SDR to make international payments. Currently SDR comprises of US
dollar, British pound, euro, and Japanese yen.

Problem of Bretton Woods: Became ineffective in rising inflation in the USA

Flexible exchange rate system: Under this system, flexible exchange rates were declared
acceptable to all IMF countries, gold was officially abandoned as international reserve asset, and
less-developed countries were given greater access to IMF funds.

Exchange rates became substantially volatile.

Current exchange Rate Arrangements:

Free float: Allow market forces to determine the currency's value. Here intervention occurs only
exceptionally. Example: USA, UK, Canada

Managed float: Combine government intervention with market forces to set exchange rates.
Example: Mexico, Brazil, India

Pegged to another currency: Such as US dollar or euro. Example: Bulgaria, Hong kong.

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No national currency: Do not print their own currency. Example: Panama, Ecuador

Currency Board: Monetary arrangement to exchange domestic currency for a specified foreign
currency at a fixed exchange rate. Here domestic currency is fully backed by foreign assets
leaving little room for discretionary monetary policy.

Conventional Peg: Exchange rate publicly fixed to another currency or basket of currencies.
Country buys or sells foreign exchange or uses other means to control the price of the currency
(e.g., Saudi Arabia, Jordan, and Morocco).

Stabilized arrangement: A spot market exchange rate that remains within a margin of 2 percent
for six months or more and is not floating (e.g., China, Angola, and Lebanon).

Crawling Peg: Like the conventional peg, but the crawling peg is adjusted in small amounts at a
fixed rate of change or in response to changes in macro indicators, (e.g., Bolivia, Iraq, and
Nicaragua).

European Monetary Union (EMU): EMU was created in 1999 with launching of the euro.
EMU was created to establish monetary stability in the European zone.

Benefits of monetary union:

Reduce transaction cost

Eliminate exchange rate uncertainty
Develop capital market
Promote political cooperation and peace
Costs of monetary union:

Loss of national monetary and exchange rate policy independence

The Mexican Peso Crisis:

On December 20, 1994, the Mexican government announced a plan to devalue the peso
against the dollar by 14 percent.

Foreign investors started to sell pesos as well as Mexican stocks and bonds.

By early January 1995, the peso had fallen against dollar by 40%.

International investors reduced their holdings og emerging market securities

The peso crisis rapidly spreaded to other Latin American and Asian financial markets.

USA, IMF, and BIS put together $53 billion to bail out Mexico which helped Mexican
economy to stabilize.

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 The Mexican Peso crisis is unique in that it represents the first serious international
financial crisis touched off by cross-border flight of portfolio capital.

Two lessons emerge:

It is essential to have a multinational safety net in place to safeguard the world

financial system from such crises.

An influx of foreign capital can lead to an overvaluation in the first place.

The Asian currency crisis:

The Asian currency crisis turned out to be far more serious than the Mexican peso crisis
in terms of the extent of the contagion and the severity of the resultant economic and
social costs.

Due to massive depreciation of local currencies, corporations with foreign currency debts
were driven to extreme financial distress and forced to defauilt.

The region experienced a deep, widespread recession. Investors from developed countries
also suffered large capital loss. For example, LTCM experienced a near bankruptcy due
to its exposure to Russian bonds.

Origin:

As capital markets were opened, large inflows of private capital resulted in a

credit boom in the Asian countries.

Fixed or stable exchange rates also encouraged un-hedged financial transactions

and excessive risk taking by both borrowers and lenders.

The real exchange rate rose, which led to a slowdown in export growth.

Also, Japans recession (and yen depreciation) hurt.

Lessons:

A fixed but adjustable exchange rate is problematic in the face of integrated

international financial markets.

A country can attain only two the of three conditions:

A fixed exchange rate.

Free international flows of capital.

Independent monetary policy.

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 China and India were not affected much by the Asian crisis. Why?

Hong Kong was less affected by the Asian crisis. Why?

Can RMB be a global currency like dollar and euro?

The Argentine Peso Crisis:

In 1991, when peso was first linked to US dollar at parity, initially it was positive for the
economy as inflation was curtailed. However, as US dollar was appreciated, peso became
appreciated which hurt export from Argentina and caused economic downturn. Eventually peso-
dollar parity ended in 2002.

Fixed vs. flexible exchange rate system:

Under a flexible exchange rate regime, if a country is experiencing a balance-of-payments deficit

then the external value of that countrys currency will simply depreciate to the level at which
there is no excess supply of the currency.

Example: See Exhibit 2.14 in your text

Suppose the exchange rate is $1.60/ at the moment

Demand for British pound is higher than supply

Dollar will simply depreciate to new level, $1.80/ at which the excess demand for British pound
will disappear

Under a fixed exchange rate system, the government may have to take expansionary or
contractionary monetary and fiscal policies to correct the balance-of-payments deficit or surplus.

Example: See Exhibit 2.14 in your text

Suppose the exchange rate is $1.60/ at the moment

Demand for British pound is higher than supply

US government has to take contractionary monetary and fiscal policies

Demand curve will shift from D to D* until the excess demand for British pound disappears

Enjoy rest of the week!

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