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CBM

International Finance
Spring 2010

By
Sarwat Ahson

Globalisation and Multinational firms

Unique dimensions of International Finance:

Foreign Exchange and Political Risks

Market Imperfections

Expanded Opportunity Set

Goal of International financial management:

Shareholder wealth maximization

Stakeholders Interests

Business Groups expansion

Trade Liberalization: WHO, EU, NAFTA

MNCs and their role in globalisation

International Monetary Systems

International monetary system can be defined as Institutional framework


within which international payments are made, movements of capital
accommodated, and exchange rates among currencies are determined.
The international monetary system went through the following stages of
evolution:

Bimetallism: Before 1875

Classical gold standard: 1875-1914

Interwar period: 1915-1944

Bretton Woods System: 1945-1972

Flexible Exchange Regime: Since 1973

Bimetallism

Both gold and silver were used as means of payment and the exchange rate among
currencies were determined by their gold or silver contents.

International Monetary Systems

International Gold Standard

There was a two way convertibility between gold and national currencies at a stable
ratio
Gold could be freely exported or imported

Shortcomings of Gold Standard

Gold alone was assured of unrestricted coinage

Supply of gold is restricted, so the growth of world trade and investment can be
seriously hampered for lack of sufficient monetary reserves.
National objectives may conflict with the goal of maintaining gold standard.

Interwar period

Characterized by economic nationalism, half hearted attempts and failure to restore


gold standard, economic and political instabilities, bank failures and panicky flights of
capital across borders.

International Monetary Systems

Bretton Woods System

IMF was launched as a result of Bretton Woods meeting between 44 countries


IMF embodied an explicit set of rules about the conduct of international monetary
policies and was responsible for enforcing these rules
A sister institution IBRD or World Bank was also created for financing individual
development projects
Under the Bretton Woods system, each country established a par value in relation to
the USD, which was pegged to gold at $35 an ounce. Each country was responsible for
maintaining its exchange rate within 1% of the adopted exchange rate by buying and
selling foreign exchange as necessary
In case of a fundamental disequilibrium, the par value of the currency may be changed
Bretton Woods system can be described as a gold-exchange standard. Only US dollar
was fully convertible to gold; other currencies were not directly convertible to gold.
Hence, most of reserves of various countries were in the form of USD

Advantages of Bretton Woods or Gold-Exchange system

Gold as well as foreign exchange can be used as an international means of payment

Foreign exchange reserves offset the deflationary effects of using gold

Foreign exchange reserves can earn interest for those nations holding it

Save transaction costs relating to shipping gold across countries

An ample supply of international monetary reserves coupled with stable exchange


rates provided an environment conducive to growth
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International Monetary Systems

Flaws of Bretton Woods or Gold-Exchange system

Triffins paradox as popularly known predicted the collapse of this system as it


inherently demanded US to run continuous balance of payment deficits and supply its
currency to the rest of the world
Various measures like Interest Equalization tax, Foreign credit restraint program (FCRP)
were taken by the US govt. to control outflow of dollars
In 1970, IMF created an artificial currency called SDR to relieve the pressure on USD a
a central reserve currency
SDR was designed to be the weighted average of 16 currencies of those countries
whose shares in world exports was greater than 1%. In 1981, however, the SDR was
simplified to contain only five major currencies: USD, Yen, Mark, Pound and Franc.
Since 1999, the basket has excluded Franc and Mark and replaced it with Euros
SDR was used as a reserve as well as denomination currency for international
transactions. It was more stable as it represented a basket of currencies
Various efforts were made in the early 70s to save the Bretton Woods system including
re-pricing of dollar to $38 and then $42 per ounce of gold, revaluation of other
currencies against dollar, broadening of band from 1% to 2.25%. However,
expansionary monetary policy and rising inflation in the US demanded a new
international monetary system

International Monetary Systems

Flexible Exchange Rate Regime

Flexible Exchange rate system was adopted in 1976 through Jamaica Agreement

The central banks were allowed to intervene and iron out shocks

Complete flexible exchange rate systems resulted in wide volatility in USD. In early 80s
due to inflow of dollars in the country (Interest rates were high), the dollar rose till 1985.
Subsequently, due to huge trade deficit and international pressure for dollar to devalue,
Plaza Accord was signed in which G5 countries agreed to make an effort to intervene in
the forex market to bring the value of dollar down.
The dollar decline again brought the G7 on the agreement table where Lourve
Agreement was signed, pledging greater exchange rate stability and closer coordination
on macroeconomic policies
Lourve agreement marked the inception of managed float system

Current Exchange Rate Arrangements

Fixed Exchange Rate

Managed Exchange Rate

Flexible Exchange Rate

International Monetary Systems

European Monetary System

European Monetary System was created in 1979 to establish a European zone of monetary stability; pave
way for eventual monetary union; coordinate exchange rate policies vis-a-vis non-EMS currencies
The two main instruments of EMS were: European Currency Unit and Exchange Rate Mechanism
European Currency Unit (ECU) was a basket of currency constructed as a weighted average of the
currencies of member countries of EU. It served as the accounting unit of EMS and played an important
role in the workings of exchange rate mechanism
Exchange Rate Mechanism (ERM) referred to the procedure by which EMS member countries manage
their exchange rates
In 1991, Maastricht Treaty was signed which stated that European Union will exchange rates among
member countries by Jan 1, 1999 and subsequently introduce a common currency called Euro
To pave way for European Monetary Union (EMU), the member countries of European Union agreed to
closely coordinate their fiscal, monetary and exchange rate policies. Specifically, each country pledged to
strive to:

Keep the ratio of government budget deficits to GDP ratio below 3%

Keep gross public debts below 60% of GDP

Achieve a high degree of Price stability

Maintain Exchange rate ranges within prescribed ranges of ERM


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International Monetary Systems

The Euro

Currently, 16 member states have adopted Euro, voluntarily giving up their monetary
sovereignty

Benefits of Euro

Reduced transaction costs

Elimination of uncertainty

Reduction in hedging costs of companies involved in intra-Euro trade

Euro is managed and administered by Frankfurt based European Central Bank (ECB),
whose objective is to maintain price stability

Development of continental capital markets with depth and liquidity comparable to US


markets
Lastly, promotion of peace and political cooperation in Europe

Costs of Monetary Union

The major cost of Euro is the loss of national monetary and exchange rate policy
independence.

International Monetary Systems

The Mexican Peso Crisis

In Dec 1994, Mexican Peso was devalued by 14% against dollar


Resulted in loss of confidence and the currency depreciated by 40% against dollar,
forcing the Govt. to float the peso
Flight of capital resulted in destabilizing and contagious effects on the world economy.
More than $45 billion invested in mutual funds in Mexico were withdrawn
Clinton administration as well as IMF put together a bailout package of $53 billion to
restore stability to the market
Lessons to be learnt: Multinational safety net and less reliance on foreign funds

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International Monetary Systems

The Asian Currency Crisis

In July 1997, Thai bhat devalued resulting in chaos in the region with Korean won,
Factors responsible for the onset of the crisis were:

A weak domestic financial system

Free international capital flows

Contagion effects of changing market sentiment

Inconsistent economic policies

In 1996 alone, $93 billion were received by 5 Asian countries: Indonesia, Korea, Malaysia, Philippines and Thailand
Large capital inflows led to credit boom. Fixed Exchange rates also encouraged unhedged financial transactions and
poor risk management policies prevailed
A booming economy with fixed or nominal exchange rate resulted in slow down in exports
Pressure on Thai bhat resulted in government devaluing its currency. The resulting loss of confidence caused flight of
capital from the region. Fear became self-fulfilling
IMF designed a bailout package imposing a set of austerity measures such as raising interest rates and reducing
government expenditure. These contractionary measures resulted in deep and prolonged recession in the Asian
economies.
Lessons to be learnt: Countries choosing financial liberalization should strengthen their domestic financial markets
first; Financial sector regulation and supervision should be strengthened; Financial sector decision making should be
based on merit as opposed to political considerations; and a higher level of transparency and disclosure of the
economy should be achieved

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International Monetary Systems

Fixed Vs Flexible Exchange rates


Fixed

Flexible

No autonomy of monetary and


fiscal policies

Governments can follow


autonomous monetary and fiscal
policies

Stability promotes international


trade

Flexibility may lead to uncertainty


resulting in retarding foreign trade

Ideal Monetary System


A good monetary system should provide:

Liquidity (monetary reserves)

Adjustment (restores BoP)

Prevent crisis of confidence

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