Week 2:The International Monetary System

A Discussion of Foreign Exchange Regimes (i.e., The Arrangement by which a Country’s Exchange Rate is Determined)

What is the International Monetary System? It is the overall financial environment in which global

businesses and global investors operate. It is represented by the following 3 sub-sectors:

International Money and Capital Markets Banking markets (loans and deposits) Bond markets (offshore, or euro-bond markets) Equity markets (cross listing of stock)

Foreign Exchange Markets Currency markets (and foreign exchange regimes)

Derivatives Markets Forwards, futures, options…

This lecture will focus on the foreign exchange market

Concept of an Exchange Rate Regime The exchange rate regime refers to the arrangement

by which the price of country’s currency is determined within foreign exchange markets.

This arrangement is determined by individual governments (essentially how much control if any they wish to exert on the actual exchange rate).

Foreign currency price is: The foreign exchange rate (referred to as the “spot rate”). Expresses the value of a county’s currency as a ratio of

some other country. Since the 1940’s that other currency has been the U.S. dollar. Century before (and under the “Classical Gold Standard) it was

the British pound.

Foreign Exchange Rate Quotations There are two generally accepted ways of

quoting a currency’s foreign exchange rate (i.e., the ratio of one currency to the U.S. dollar). American terms and European Terms quotes

American terms quotes: Expresses the exchange rate as the amount of U.S. dollars per 1 unit of a foreign currency. For Example: $1.65 per 1 British pound Or $1.45 per 1 European euro Or $1.06 per 1 Australian dollar

Foreign Exchange Rate Quotations European terms quote: Expresses the

exchange rate as the amount of foreign currency per 1 U.S. dollar For Example: 76.67 yen per 1 U.S. dollar Or 7.80 Hong Kong dollars per 1 U.S. dollar Or 6.38 Chinese yuan per 1 U.S. dollar

For reporting and trading purposes, most of the world’s major currencies are quoted on the basis of American terms (Pound and Euro); however, the majority of the world’s currencies are quoted on the basis of European terms. http://www.bloomberg.com/markets/currencies/

A Model for Illustrating Exchange Rate Regimes We can think of current exchange rate regimes as

falling along a spectrum as represented by a national government’s involvement in affecting (managing) their country’s exchange rate.

No Involvement by

Government

Very ActiveInvolvement by

Government

Market forcesare

DeterminingExchange rate

Government is Determining orManaging the Exchange rate

Exchange Rate Regimes TodayMinimal (if any)

Involvement by Government

ActiveInvolvement by

Government

Market forcesare

DeterminingExchange rate

Government is Determining orManaging the Exchange rate

Floating Rate

Regime

Managed Rate

(“Dirty Float”)Regime

PeggedRate

Regime

Classification of Exchange Rate Regimes: Floating Rate Regimes Floating Currency Regime:

No (or at best occasional) government involvement (i.e., intervention) in foreign exchange markets.

Market forces, i.e., demand and supply, are the primary determinate of foreign exchange rates (prices). Financial institutions (global banks, investment firms),

multinational firms, speculators (hedge funds), exporters, importers, etc.

Central banks may intervene occasionally to offset what they regard as “inappropriate” or “disorderly” exchange rate levels.

Classification of Exchange Rate Regimes: Managed Rate Regimes Managed Currency (“Dirty Float”) Regime:

High degree of intervention of government in foreign exchange market (perhaps on a daily basis). Purpose: to offset moderate market forces and produce an

“desirable” exchange rate level or path. Usually done because exchange rate is seen as

important to the national economy (e.g., export sector or the price of critical imports or as a means to control inflation).

Currency’s exchange rate will be managed in relation to another currency (or a market basket of currencies) Preferred currencies are the US dollar and Euro.

Classification of Exchange Rate Regimes: Pegged (Fixed) Rate Regimes Pegged Currency Regime

Governments directly link (i.e., peg) their currency’s rate to another currency. Government sets the exchange rate with a certain band (e.g.,

+ or – 1%) of a fixed rate or within a narrow margin, or sometimes use a crawling peg (e.g., + or – 2%) of a trend.

Occurs when governments are reluctant to let market forces determine rate.

Exchange rate seen as essential to country’s economic development and or trade relationships.

Governments are also concerned about the potential negative impacts of a open capital market (i.e., disruptive flows of short term funds – “hot money.”)

Examples of Currencies by Regime Floating Rate Currencies:

Canadian dollar (1970), U.S. dollar (1973), Japanese yen (1973), British pound (1973), Australian dollar (1985), New Zealand dollar (1985), South Korean Won (1997), Thailand baht (1997), Euro (1999), Brazilian real (1999), Chile peso (1999), Argentina Peso (2002).

Managed (Floating) Rate Currencies: Singapore dollar, 1981, Costa Rica colon (U.S. dollar), Malaysia ringgit

(2005, Market Basket), Vietnam dong (11/08 U.S. dollar). Pegged Rate Currencies – to a fixed rate (against the U.S.

dollar or market basket): Hong Kong dollar, since 1983 (7.8KGD = 1USD), Saudi Arabia riyal

(3.75SAR = 1USD), Oman rial (0.385OMR = 1USD) Pegged Rate Currencies (Crawling Peg) – to a trend (against

the U.S. dollar or market basket): China yuan (7/05 Market Basket), Bolivia boliviano (U.S. dollar)

Note: The IMF notes that 66 out of 192 countries they classify use the U.S. dollar as a “anchor.” Data above as of 2009.

Changing Exchange Rate Regimes: 1970 -2010 (IMF Classifications)% by Number of Countries % by GDP of Countries

Simplified Model of Floating Exchange Rates (Market Determined Rates) The market “equilibrium” exchange rate at any point

in time can be represented by the point at which the demand for and supply of a particular foreign currency produces a market clearing price, or:

Supply (of a certain FX) Price Demand (for a certain FX) Quantity of FX

Simplified Model: Strengthening FX Any situation that increases the demand (d to d’) for a

given currency will exert upward pressure on that currency’s exchange rate (price).

Any situation that decreases the supply (s to s’) of a given currency will exert upward pressure on that currency’s exchange rate (price).

s s’ s

p p

d d’ d

q q

Simplified Model: Weakening FX Any situation that decreases the demand (d to d’) for a

given currency will exert downward pressure on that currency’s exchange rate (price).

Any situation that increases the supply (s to s’) of a given currency will exert downward pressure on that currency’s exchange rate (price).

s s s’

p p

d’ d d

q q

Factors That Affect the Equilibrium Exchange Rate: Changes in Demand Relative (short-term) interest rates.

Affects the demand for financial assets (increase demand for high interest rate currencies).

Relative rates of inflation. Affects the demand for real (goods) and financial assets; hence

the demand for currencies Low inflation results in increase global demand for a country’s goods. Low inflation results in high real returns on financial assets.

Relative economic growth rates. Affects longer term investment flows in real capital assets (FDI)

and financial assets (stocks and bonds). Changes in global and regional risk.

Safe Haven Effects: Foreign exchange markets seek out safe haven countries during periods of uncertainty.

Safe Haven Effect: September 11, 2001

Factors That Affect the Equilibrium Exchange Rate: Government Intervention Foreign exchange intervention policy if a government feels its currency is “too weak” Government will buy their currency in foreign

exchange markets Create demand and push price up.

Foreign exchange intervention policy if government feels its currency is “too strong” Government will sell their currency in foreign

exchange markets Increase supply to bring price down.

Market Intervention by Central Banks Use the model below to explain how intervention by a

central bank can respond to (1) a “weak” currency and (2) a “strong” currency (assume it wants to offset either condition):

Supply (of a certain FX) Price Demand (for a certain FX) Quantity of FX

Factors That Affect the Equilibrium Exchange Rate: Government Interest Rate Adjustments Some governments may also use interest rate

adjustments to influence their currencies. When a currency become “too weak:”

Governments might raise short term interest rates to encourage short term foreign capital inflows. Higher interest rates make investments more attractive and

increase demand for the currency. When a currency becomes “too strong:”

Governments might lower short term interest rates to discourage short term foreign capital inflows. Lower interest rates will make investments less attractive and

reduce the demand for the currency.

Factors That Affect the Equilibrium Exchange Rate: Carry Trade Strategies Carry trade strategy: A foreign exchange trading strategy in which a

trader sells a currency with a relatively low interest rate and uses the funds to purchase a different currency yielding a higher interest rate. This strategy offers profit not only from the interest rate difference (overnight interest rate) but additionally from the currency pair’s fluctuation.

An example of a "yen carry trade": A trader borrows Japanese yen from a Japanese bank, converts the funds into Australian dollars and buys an Australian bond for the equivalent amount. If we assume that the bond pays 4.5% and the Japanese borrowing rate is 1.0%, the trader stands to make a profit of 3.5% as long as the exchange rate between the countries does not change. In this example, the trader is short on yen and long on Australian dollars.

Impact of Carry Trades on Exchange Rates Carry trades can result in a huge amount of capital flows in

and out of currencies. High interest rate currency will experience increase demand. Low interest rate currency will experience increase in supply.

Combined this will result in a strengthening of the high interest rate currency against the low interest rate currency.

However, when traders reverse their positions, the opposite exchange rate effects will occur. When do they reverse: During periods of increasing global

uncertainty about interest rates and exchange rates.

The Foreign Exchange Market

An Empirical Analysis of the Impact of Foreign Exchange Regimes on Exchange Rates

Where is this International Financial Center?

Relationship of Exchange Rate Volatility to Exchange Rate Regime Question: Given the spectrum of exchange

rate regimes which can confront both global firms and global investors, an important question is whether there is a difference in exchange rate volatility from one regime to another. An additional question: what happens to volatility

when regimes change?

Measured Volatility (Standard Deviations of % Changes) Against the U.S. Dollar Using monthly data from January 1990 –

August 2011 Floating Currencies:

British Pound: 2.31% Japanese Yen: 2.30% Australian Dollar: 3.22% Euro: 2.59%

Managed Currencies: Singapore Dollar: 1.20%

Pegged Currencies (“Crawling Peg): Chinese Yuan: 0.42% (since July 2005)

Pegged Currencies (Fixed Rate): Hong Kong Dollar: 0.12% (peg at 7.8 since Oct 1983)

Volatility of 3 Exchange Rate Regimes (Monthly Data, Jan 1990 – Aug 2011)

Measured Volatility (Standard Deviations of % Changes) Against the U.S. Dollar Using weekly data from August 2008 – August

2011 Floating Currencies:

British Pound: 1.55% Japanese Yen: 1.26% Australian Dollar: 2.17% Euro: 1.55%

Managed Currencies: Singapore Dollar: 0.73%

Pegged Currencies (“Crawling Peg): Chinese Yuan: 0.16%

Pegged Currencies (Fixed Rate): Hong Kong Dollar: 0.07%

Measured Volatility (Standard Deviations of % Changes) Against the U.S. Dollar Using daily data from August 2008 – August

2011 Floating Currencies:

British Pound: 0.77% Japanese Yen: 0.80% Australian Dollar: 1.30% Euro: 0.82%

Managed Currencies: Singapore Dollar: 0.41%

Pegged Currencies (“Crawling Peg): Chinese Yuan: 0.11%

Pegged Currencies (Fixed Rate): Hong Kong Dollar: 0.04%

Intermediate and Long Term Trend Changes by RegimeGBP: Floating Rate Currency SGD: Managed Currency

Intermediate and Long Term Trend ChangesCNY Crawling Peg Currency (since July 2005)

HKD: Pegged Currency (since Oct 1983 at 7.8)

Issues of Floating Currencies Floating currencies present the greatest ongoing risk for

global firms and global investors. Data showed that these currencies are very volatile over the

short term (e.g., Monthly, weekly and daily basis). Complicates doing business or investing on an ongoing basis

for: Exporters, importers, global asset managers, global commercial banks,

overseas sales and manufacturing subsidiaries. What will be the costs and returns associated with different markets

and different investments?

Thus, global firms and global investors need to pay close attention to their floating currency exposures and utilize appropriate risk management tools. Issue: How easy is it to forecast a floating rate currency’s price?

Managed Currencies (Dirty Float) Under this regime, governments manage their

currency to offset (i.e., counteract) market forces. They do this when market demand factors or supply factors

are seen as creating undesirable exchange rate moves. They do this as a monetary policy target to achieve inflation

target (e.g., Singapore). As a result, over the short term, these currencies are not as

volatile as floating currencies. Exchange rate management may occur on

A regular basis or when governments feel conditions warrant.

Management involves either intervention action (buying or selling currencies) or interest rate adjustments (to affect demand/capital flows).

Pegged Currency Regimes Under a pegged currency regime, governments link their national

currency to a key international currency (usually the U.S. dollar or the euro or some “market basket” of currencies).

Why do governments peg their currencies? A peg is seen as a necessary condition to promote confidence in the

currency and in the country and promoting economic growth. May encourage foreign direct investment or long term capital inflows. Or by pegging the currency at an undervalued currency this may support the

country’s export sector.

Pegs can either be at a fixed rate (e.g., Hong Kong dollar) or in relation to a trend (i.e., a crawling peg).

As long as the peg is maintained, the exchange rate risk is negligible (recall there is some potential daily variation).

Peg is maintained through market intervention (buying and selling)

Hong Kong Dollar: Pegged to a Fixed Rate (7.8HKD = 1 USD)

Daily Volatility of the Hong Kong Dollar Over the Last 6 Months

Saudi Arabia Riyal

Issues with Pegged Currencies As long as the peg is maintained, this regime presents

the smallest risk to global firms; however there is the potential for enormous risk, when: Governments either (1) abandon the peg for another foreign

currency regime or (2) adjust to a new peg. These changes occur either by

An orderly change adopted by the government (China from a fixed peg to a crawling peg on July 21, 2005 with more changes which followed and to be discussed in a later slide).

Peg coming under successful market attack (e.g., British pound in 1992; Argentina, February 11, 2002; Mexico from a crawling peg to a float on December 22, 1994; Some Asian currencies in 1997).

These changes can have substantial impacts on global firms and global investors. Especially if the firm or investor did not take advanced steps to

protect itself. Thus, global firms and global investors must be on the alert for

exchange rate regime changes.

China Policy Decision: From a Fixed Peg to a Crawling Peg to a Fixed Peg to a Crawling Peg

Currency Regime Changes Due to “Currency Attacks” Another situation that changes currency

regimes occurs when a peg comes under attack by the market. Attacks occur because the market is convinced

that the peg is unrealistic and unsustainable (ie., the government doesn’t have the political will or resources in the form of hard currency to defend the peg.

British Pound: Driven Out of the Exchange Rate Mechanism in 1992Background In 1990, the U.K. joined Europe’s

exchange rate mechanism (ERM). Under this arrangement the U.K. agreed to

peg the pound to the German mark at a rate of 1:2.95 (+- 3%).

During the next two years, the German economy surged and the U.K. economy fell into recession.

By 1992, Germany had raised interest rates and the U.K. was forced to follow.

In September 1992, George Soros decided to bet against the pound (he felt it was overvalued) and his hedge fund started selling pounds short.

The U.K. responded by buying pounds and selling U.S. dollars and by raising interest rates twice in one day (to 12 and then 15%)

On September 17, the U.K. government announced they were leaving the ERM

GBP-D

Mexican Peso Crawling Peg (with a Floor of 3.0512): Abandoned Dec 1994

Philippine Peso During the Asian Currency Crisis, 1997

Implications of the 1997 Asian Currency Crisis for Regional Economic Growth: Average GDP Growth

Impact of Asian Currency Crisis for Global Investors

Argentina: Abandoning a Fixed Peg: Moving to a Floating Regime, Jan 2002

Percent Change in ARS-USD Daily Data, Jan 1, 2000 – Dec 31, 2001

Percent Change in ARS-USD Daily Data, Jan 1, 2003– Jan 1, 2005

Response of Currencies to Dropping a Peg Regime

Abandoning a Pegged Rate and the Currency Weakens: RISKS for Global Firms and Investors As noted, changes in exchange rate regimes pose

potential risks for global firms. Using the Argentina example, discuss the following:

What do you think happened to foreign multinationals located in and selling in Argentina after the peso weakened? For Example: McDonalds’ U.S. dollar profits in Argentina?

What do you think happened to foreign multinationals exporting to Argentina after the peso weakened? For example: Boeing ability to export airplanes to Argentina?

What do you think happened to the portfolios of investors holding Argentina stocks and bonds?

Abandoning a Pegged Rate and the Currency Weakens: OPPORTUNITIES for Global Firms However, changes in exchange rate regimes also

offer potential opportunities for global firms. Again, using the Argentina example:

What do you think happened to foreign multinationals importing from Argentina after the peso weakened? For Example: Wal-Mart’s U.S. dollar cost associated with

importing goods from Argentina? What do you think happened to foreign multinationals

considering expanding FDI into Argentina after the peso weakened? For Example: The new U.S. dollar cost to Ford Motor

Company considering setting up a production facility in Argentina?

Potential Costs to Holding a Peg If market forces push a pegged currency above

its peg (i.e., the currency becomes “too strong” or “overvalued”) this happens because: The market is buying the currency, then

Government management involves either selling the pegged currency on foreign exchange markets (thus, buying hard currency) or reducing domestic interest rates.

Issues: If the government sells its currency this created to potential for expansion of its domestic money supply and hence inflationary pressures.

On the other hand, lowering domestic interest rates can also stimulate domestic investment and economic activity which may lead to inflationary pressures.

Potential Costs to Holding a Peg If market forces push a pegged currency below its

peg (i.e., the currency becomes “too weak” or “undervalued”) this happens because: The market is selling the currency, then Government management involves either buying the

pegged currency on foreign exchange markets (thus, selling hard currency or raising domestic interest rates. Issues: Does the government want to give up its hard

currency (does it have potentially better uses for this (e.g., buying oil or paying off international debts)

On the other hand, raising domestic interest rates can dampen economic activity and lead to rising unemployment.

Note: These last two slides summarize one reason (i.e., the costs) why major central banks have probably gotten out of the currency management business.

Appendix 1: Monitoring FX Intervention

Most major central banks provide timely information regarding their intervention activities in foreign exchange markets.

As on example see: http://www.ny.frb.org/markets/foreignex.html

This site provides a quarterly report on both the U.S. dollar and intervention activities on behalf of the dollar.

Go to archives, July 30, 1998 to view intervention activity.