International Financial Management: INBU 4200

Fall Semester 2004Lecture 2

The International Monetary System

(Chapter 2)

Web SITES FOR FOREIGN NEWS

• China– http://www.chinadaily.com.cn/

• Japan– http://www.japantimes.co.jp/

• United Kingdom– http://www.timesonline.co.uk/

WHAT IS THE INTERNATIONAL MONETARY SYSTEM

• It is the overall financial environment in which global businesses operate, and thus comprises the following:

– International Money and Capital Markets

– Foreign Exchange Markets

EVOLUTION OF THE INTERNATIONAL MONETARY

SYSTEM• Over the last 200+ years, the IMS has

evolved through many stages:

• Some Important Stops Along the Way:– Classical Gold Standard (1875 – 1914)– Interwar Period (1914 – 1944)– Bretton Woods System (1944 – 1972)– Current “Hybrid” System (1972 - ?)

CURRENT SYSTEM

• Exchange Rate Regimes Fall Along a Spectrum:

• Countries with minimal (or no) Government Involvement (Floating Currencies)

• Countries where Government Manage a Float Regime (Managed Float)

• Countries where Currency is Pegged (or Linked) to Another Currency

FLOATING CURRENCIES

• The market (i.e., market participants) determines exchange rates.

• Exchange rates fluctuate in response to:– Real factors (demand and supply by global

businesses)– Investment/Speculation (institutions involved

on their own behalf

• Governments may occasionally intervene.

FLOATING CURRENCIES

• Present the most difficulties for global firms.

• Currencies potentially very volatile over the short term.– Subject to large percentage changes.

• Global firms need to pay close attention to their foreign currency exposures and utilize appropriate risk management tools.

Example: Dollar against the Euro

Daily Percent Changes in Euro: Jan 1, 2001- Jan 16, 2004

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1 49 97 145 193 241 289 337 385 433 481 529 577 625 673 721

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MANAGED FLOAT

• Governments intervene in foreign exchange markets to manage currency in relation to market forces.

• Buy their currencies when they weaken.– Create demand; act as buyer during sell offs.

• Sell their currencies when they strengthen.– Provide supply to meet demand for currency.

MANAGED FLOAT

• Somewhat difficult for global firms.

• Over the short term, currencies are not likely to be as volatile as purely floating currencies.

• Global companies still need to assess exposure and risk, especially over the intermediate terms.

Example: Singapore dollar

Daily Percent Changes in Sing$: Jan 1, 2001- Jan 16, 2004

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1 59 117 175 233 291 349 407 465 523 581 639 697 755

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PEGGED (Linked) RATES

• Involves the greatest involvement of governments in foreign exchange markets.

• Governments “target” or “link” their currency’s exchange rate in relation to some key “external” currency.– Usually the U.S. dollar.

• Management of the pegged currency done in relation to the “target” currency.

• Used so that currency volatility will not interfere with external trade and investment flows and to build confidence in the currency.

PEGGED (Linked) RATES

• Operationally done through:

• Controlling who participates in the market– Using licenses (e.g., China)

• Controlling the type of exchange transactions allowed.– Only in response to real factors (e.g., China)

• Restricting the daily change in rate– China: + or – 0.03% per day. No more…

• Results in:• Smallest daily risk to global firms, but must be on the

alert for potential changes in the PEG!!!– These can have a substantial impact when they occur.

Background on Chinese Yuan

• In late 1978, the Chinese government began moving the economy from a centrally planned economy to a market-oriented system.

• In 1994, China's central bank linked the yuan (also known as the renminbi, or "people's money“) to the U.S. dollar at about 8.28.

• The yuan is allowed to fluctuate, but only up to about 0.03% per day.

• Trading in yuan is closely supervised and permitted only by approved institutions.

• While China has stated that eventually the yuan will be allowed to float, for now they are committed to a managed rate.– Means selling yuan (buying dollars) when pressures mount for

the yuan to strenghten.

Example: Chinese RMB

Pros and Cons of Yuan Peg

• What do you think are the advantages to China in pegging its currency?

• What do you think are the advantages to foreign companies in China pegging its currency?

• It is argued that the yuan is undervalued. What do you think are the advantages to China and to foreign companies in an overvalued yuan?

Background on Hong Kong Dollar

• The Hong Kong dollar has been a pegged currency for most of its history.– From 1935 to 1972 it was linked to the British pound.

• Colony under British rule at the time.– From 1972 to 1973 it was linked to the U.S. dollar– From November 1973 until October 1983, it was

allowed to float• World moved away from fixed rates in early 1970s.• Worked reasonably well until the 1983 announcement of a

Sino-British agreement on the return of Hong Kong to China (in 1997).

– Set off a round of speculation against the Hong Kong dollar.– HK$ lost a third of its value!

– October 1983, Hong Kong reestablished its currency link to the U.S. dollar (at a rate of KH$7.80)

Example: Hong Kong Dollar

What happened in Sept/October 2003?

• HK$ moved away from its peg:– From 7.8 to 7.705– Represented a strengthening of the Hong Kong dollar.– Why?

• Speculation that China might allow its currency (yuan), to float or to revalue. G7 had released a statement calling for China to do so to take pressure off of other countries.

• Since the HK$ was the only convertible Chinese currency at the time, speculators purchased it.

• Hong Kong monetary authorities (i.e., the equivalent of a central bank) defended the currency through massive intervention.

– Selling HK$ and buying U.S. dollars.

Hong Kong Monetary Authorities

• A monetary authority acts as the central bank for a country.– There is no formal central bank!

• Also used with a “Currency Board” arrangement:– Under a currency board, bank notes (currency) are issued by

approved commercial banks and require the backing of a “second” currency.

• In Hong Kong these 3 banks are the Bank of China, Standard Chartered Bank, and the Hong Kong and Shanghai Bank Corporation (HSBC).

• Bank notes can only be issued to the extent that the issuing bank has “complete” U.S. dollar reserves against the notes.

• In Hong Kong each bank has its own “currency” design (but note size must be consistent).

– Estonia uses a currency board and backs its currency with the European euro.

Hong Kong Notes

Daily Percent Changes in HK$: Jan 1, 2001- Jan 16, 2004

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1 50 99 148 197 246 295 344 393 442 491 540 589 638 687 736Per

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Summary

• Currency Average % High Low Stand Dev

• Euro .03734 1.82 -2.47 .6277• Sing$ .00224 1.68 -1.23 .2787• HK$ .00056 0.49 -0.27 .0319

CURRENCY CRISES

• Another feature of the International Monetary System since the 1970s is the potential for currency crises!

• Attacks on currencies which have the potential to produce large changes in the short term.– Involves hedge fund managers and others.

• Present enormous risk to global firms caught in the middle of these episodes!!!

CURRENCIES CRISES

• Attacks on currencies occur for a variety of reasons, but essentially relate to:

• Established (pegged or managed) rates which deviate from market’s assessment of true value.– Inappropriate domestic monetary and fiscal policies.– Weakness in the country’s external position.– Weakness in the country’s key financial sector.

• Market selling a currency short if it perceives it to be overvalued.

Examples of Currency Crises

• British pound crisis (1992).

• Britain had joined the European Exchange Rate Mechanism in October 1990.– Locked the British pound into the German Mark at a

central rate of about DM2.9

• Markets generally thought the Pound was overvalued at this rate.

• Hedge funds attacked the currency in 1992!

Response of British Government to Speculative Attack

• Wednesday, September 16– Raised interest rates twice from 10% to 12 and then

to 15%– Attempt to make U.K. investments more attractive.

• During the attack the Bank of England spent 7 billion pounds in defense of its currency.

• Buying pounds (selling dollars and marks).

• Thursday, September 17, U.K. left the exchange rate mechanism and let the pound float!

CURRENCY ATTACK: SEPT ‘92

U.S. Companies with Pound Positions Around September

MEXICAN PESO CRISIS

• December 1994, the Mexican government announced that they were going to devalue the peso by 14% against the dollar.– Peso was a pegged currency at that time.

• Announcement resulted in major currency flight from Mexico– Global investors liquidated their stocks and bonds

• Government forced to “float” the currency in early 1995.

Mexican Peso: 1994-95

ASIAN CURRENCY CRISIS

• In July 1997, the Thai government announced that they were devaluing the baht against the dollar.

• Baht had been pegged to the U.S. dollar prior to this announcement at 25 to the dollar.

ASIAN CURRENCY CRISIS

• Reason for Change: Economic boom of the previous years had produced massive inflows of foreign investment into Asian countries.

• Much of the investment went into speculative enterprises:– Real estate, stock market, poor bank loans.

• Export growth began to slow.– Investors became concerned with the balance of

trade turnaround (move to trade deficit).– Felt the currency was “overvalued at 25 to the dollar.

CONTAGION EFFECT IN ASIA

• Investors started pulling their investments out of Thailand.– Government attempted to support the Baht by buying

the currency.– Lose of international reserves resulted in announced

devaluation in July!!!

• The currency crisis spread to other Asian economies (Contagion Effect).

• Concern mounted regarding the “soundness” of these countries as well.

THAI BAHT: 1997

CONTAGION!!!

CONTAGION!!!

ARGENTINA CURRENCY CRISIS

• Through much of the 1990’s, Argentina had “dollarized” its country.

• U.S. dollar and Argentina peso traded at 1:1 and both were used as the country’s legal tender.

• In December 2001, this “currency board” arrangement collapsed as the markets became concerned with mounting inflation in Argentina.

PESO CRISIS: 2001

Web Sites for Foreign Exchange Rates

• University of British Columbia

• http://fx.sauder.ubc.ca/

• Federal Reserve Board

• http://www.federalreserve.gov/releases/