Introduction
This chapter will explain how the international monetary system works and point out its implications for international business
Finally, we will discuss the implications of all this material for international business. We will see how the exchange rate policy adopted by a government can have an important impact on the outlook for business operations in a given country. If government exchange rate policies result in a currency devaluation, for example, exporters based in that country may benefit as their products become more price competitive in foreign markets. Alternatively, importers will suffer from an increase in the price of their products. We will also look at how the policies adopted by the IMF can have an impact on the economic outlook for a country and, accordingly, on the costs and benefits of doing business in that country.
Nature of the Gold Standard
Pegging currencies to gold and guaranteeing convertibility is known as the gold standard.
The Strength of the Gold Standard
The great strength claimed for the gold standard was that it contained a powerful mechanism for achieving balance-of-trade equilibrium by all countries. A country is said to be in balance-of-trade equilibrium when the income its residents earn from exports is equal to the money its residents pay to people in other countries for imports.
Under the gold standard, when Japan has a trade surplus, there will be a net flow of gold from the United States to Japan. These gold flows automatically reduce the US money supply and swell Japan's money supply.
The Bretton Woods System
The Role of the IMF
Discipline
A fixed exchange rate regime imposes discipline in two ways. First, the need to maintain a fixed exchange rate puts a brake on competitive devaluations and brings stability to the world trade environment. Second, a fixed exchange rate regime imposes monetary discipline on countries, thereby curtailing price inflation. For example, consider what would happen under a fixed exchange rate regime if Great Britain rapidly increased its money supply by printing poundsFlexibility
Although monetary discipline was a central objective of the Bretton Woods agreement, it was recognized that a rigid policy of fixed exchange rates would be too inflexible. It would probably break down just as the gold standard had. In some cases, a country's attempts to reduce its money supply growth and correct a persistent balance-of-payments deficit could force the country into recession and create high unemployment. The architects of the Bretton Woods agreement wanted to avoid high unemployment, so they built some limited flexibility into the system. Two major features of the IMF Articles of Agreement fostered this flexibility: IMF lending facilities and adjustable parities.
The IMF stood ready to lend foreign currencies to members to tide them over during short periods of balance-of-payments deficit, when a rapid tightening of monetary or fiscal policy would hurt domestic employment. A pool of gold and currencies contributed by IMF members provided the resources for these lending operations. A persistent balance-of-payments deficit can lead to a depletion of a country's reserves of foreign currency, forcing it to devalue its currency. By providing deficit-laden countries with short-term foreign currency loans, IMF funds would buy time for countries to bring down their inflation rates and reduce their balance-of-payments deficits. The belief was that such loans would reduce pressures for devaluation and allow for a more orderly and less painful adjustment.
The Role of the World Bank
The official name for the World Bank is the International Bank for Reconstruction and Development (IBRD). When the Bretton Woods participants established the World Bank, the need to reconstruct the war-torn economies of Europe was foremost in their minds. The bank's initial mission was to help finance the building of Europe's economy by providing low-interest loans. As it turned out, the World Bank was overshadowed in this role by the Marshall Plan, under which the United States lent money directly to European nations to help them rebuild.
A second scheme is overseen by the International Development Agency (IDA), an arm of the bank created in 1960. Resources to fund IDA loans are raised through subscriptions from wealthy members such as the United States, Japan, and Germany. IDA loans go only to the poorest countries.
The Collapse of the Fixed Exchange Rate System
The increase in inflation and the worsening of the US foreign trade position gave rise to speculation in the foreign exchange market that the dollar would be devalued. In the weeks following the decision to float the deutsche mark, the foreign exchange market became increasingly convinced that the dollar would have to be devalued. However, devaluation of the dollar was no easy matter. Under the Bretton Woods provisions, any other country could change its exchange rates against all currencies simply by fixing its dollar rate at a new level. But as the key currency in the system, the dollar could be devalued only if all countries agreed to simultaneously revalue against the dollar. And many countries did not want this, because it would make their products more expensive relative to US products.
The Bretton Woods system had an Achilles' heel: The system could not work if its key currency, the US dollar, was under speculative attack. The Bretton Woods system could work only as long as the US inflation rate remained low and the United States did not run a balance-of-payments deficit. Once these things occurred, the system soon became strained to the breaking point.
The Floating Exchange Rate Regime
The Jamaica Agreement
The main elements of the Jamaica agreement include the following:
1. Floating rates were declared acceptable. IMF members were permitted to enter the foreign exchange market to even out "unwarranted" speculative fluctuations.
2. Gold was abandoned as a reserve asset. The IMF returned its gold reserves to members at the current market price, placing the proceeds in a trust fund to help poor nations. IMF members were permitted to sell their own gold reserves at the market price.
3. Total annual IMF quotas--the amount member countries contribute to the IMF--were increased to $41 billion.
4. After Jamaica, the IMF continued its role of helping countries cope with macroeconomic and exchange rate problems, albeit within the context of a radically different exchange rate regime.
Exchange Rates since 1973
This volatility has been partly due to a number of unexpected shocks to the world monetary system, including:
1. The oil crisis in 1971, when the Organization of Petroleum Exporting Countries quadrupled the price of oil. The harmful effect of this on the US inflation rate and trade position resulted in a further decline in the value of the dollar.
2. The loss of confidence in the dollar that followed the rise of US inflation in 1977 and 1978.
3. The oil crisis of 1979, when OPEC once again increased the price of oil dramatically--this time it was doubled.
4. The unexpected rise in the dollar between 1980 and 1985, despite a deteriorating balance-of-payments picture.
5. The rapid fall of the US dollar against the Japanese yen and German deutsche mark between 1985 and 1987, and against the yen between 1993 and 1995.
6. The partial collapse of the European Monetary System in 1992.
7. The 1997 Asian currency crisis, when the Asian currencies of several countries, including South Korea, Indonesia, Malaysia, and Thailand, lost between 50 percent and 80 percent of their value against the US dollar in a few months.
Fixed Versus Floating Exchange Rates
The Case for Floating Exchange Rates
Monetary Policy Autonomy
It is argued that under a fixed system, a country's ability to expand or contract its money supply as it sees fit is limited by the need to maintain exchange rate parity. Monetary expansion can lead to inflation, which puts downward pressure on a fixed exchange rate .Advocates of a floating exchange rate regime argue that removal of the obligation to maintain exchange rate parity would restore monetary control to a government. If a government faced with unemployment wanted to increase its money supply to stimulate domestic demand and reduce unemployment, it could do so unencumbered by the need to maintain its exchange rate. While monetary expansion might lead to inflation, this would lead to a depreciation in the country's currency. If PPP theory is correct, the resulting currency depreciation on the foreign exchange markets should offset the effects of inflation.
Trade Balance Adjustments
Under the Bretton Woods system, if a country developed a permanent deficit in its balance of trade that could not be corrected by domestic policy, this would require the IMF to agree to a currency devaluation. Critics of this system argue that the adjustment mechanism works much more smoothly under a floating exchange rate regime. They argue that if a country is running a trade deficit, the imbalance between the supply and demand of that country's currency in the foreign exchange markets will lead to depreciation in its exchange rate. In turn, by making its exports cheaper and its imports more expensive, an exchange rate depreciation should correct the trade deficit.
The Case for Fixed Exchange Rates
Monetary Discipline
We have already discussed the nature of monetary discipline inherent in a fixed exchange rate system when we discussed the Bretton Woods system. The need to maintain a fixed exchange rate parity ensures that governments do not expand their money supplies at inflationary rates. While advocates of floating rates argue that each country should be allowed to choose its own inflation rate, advocates of fixed rates argue that governments all too often give in to political pressures and expand the monetary supply far too rapidly, causing unacceptably high price inflation. A fixed exchange rate regime will ensure that this does not occur.
Speculation
Critics of a floating exchange rate regime also argue that speculation can cause fluctuations in exchange rates. They point to the dollar's rapid rise and fall during the 1980s, which they claim had nothing to do with comparative inflation rates and the US trade deficit, but everything to do with speculation. They argue that when foreign exchange dealers see a currency depreciating, they tend to sell the currency in the expectation of future depreciation regardless of the currency's longer-term prospects. As more traders jump on the bandwagon, the expectations of depreciation are realized. Such destabilizing speculation tends to accentuate the fluctuations around the exchange rate's long-run value. It can damage a country's economy by distorting export and import prices. Thus, advocates of a fixed exchange rate regime argue that such a system will limit the destabilizing effects of speculation.
Uncertainty
Speculation also adds to the uncertainty surrounding future currency movements that characterizes floating exchange rate regimes. The unpredictability of exchange rate movements in the post-Bretton Woods era has made business planning difficult, and it makes exporting, importing, and foreign investment risky activities. Given a volatile exchange rate, international businesses do not know how to react to the changes--and often they do not react.
Trade Balance Adjustments
Those in favor of floating exchange rates argue that floating rates help adjust trade imbalances. Critics question the closeness of the link between the exchange rate and the trade balance. They claim trade deficits are determined by the balance between savings and investment in a country, not by the external value of its currency. They argue that depreciation in a currency will lead to inflation. This inflation will wipe out any apparent gains in cost competitiveness that come from currency depreciation. In other words, a depreciating exchange rate will not boost exports and reduce imports, as advocates of floating rates claim; it will simply boost price inflation.
Exchange Rate Regimes in Practice
Pegged Exchange Rates and Currency Boards
Under a pegged exchange rate regime a country will peg the value of its currency to that of a major currency so that, for example, as the US dollar rises in value, its own currency rises too. Pegged exchange rates are popular among many of the world's smaller nations. As with a full fixed exchange rate regime, the great virtue claimed for a pegged exchange rate regime is that it imposes monetary discipline on a country and leads to low inflation. There is some evidence that adopting a pegged exchange rate regime does moderate inflationary pressures in a country.
Under this arrangement, the currency board can issue additional domestic notes and coins only when there are foreign exchange reserves to back it. This limits the ability of the government to print money and, thereby, create inflationary pressures. Under a strict currency board system, interest rates adjust automatically. If local inflation rates remain higher than the inflation rate in the country to which the currency is pegged, the currencies of countries with currency boards can become uncompetitive and overvalued. Also, under a currency board system, government lacks the ability to set interest rates.
Target Zones: The European Monetary System
The Ecu and the ERM
The ecu was a basket of the EU currencies that served as the unit of account for the EMS. One ecu comprised a defined percentage of national currencies. The share of each country's currency in the ecu depended on the country's relative economic weight within the EC.
Intervention in the foreign exchange markets was compulsory whenever one currency hit its outer margin of fluctuation relative to another. The central banks of the countries issuing both currencies were supposed to intervene to keep their currencies within the 2.25 percent band. The central bank of the country with the stronger currency was supposed to buy the weaker currency, and vice versa. It tended to be left to the country with the weaker currency to take action.
To defend its currency against speculative pressure, each member could borrow almost unlimited amounts of foreign currency from other members for up to three months. A second line of defense included loans that could be extended for up to nine months, but the total amount available was limited to a pool of credit--originally about 14 billion ecus--and the size of the member's quota in the pool.
Performance of the System
Underlying the ERM were all the standard beliefs about the virtues of fixed rate regimes that we have discussed. EU members believed the system imposed monetary discipline, removed uncertainty, limited speculation, and promoted trade and investment within the EU. For most of the EMS's existence, it achieved these objectives. When the ERM was established, wide variations in national interest rates and inflation rates made its prospects seem shaky. However, there had long been concern within the EU about the vulnerability of a fixed system to speculative pressures. Dealers in the foreign exchange market, believing a realignment of the pound and the lira within the ERM was imminent, started to sell pounds and lira and to purchase German deutsche marks. This led to a fall in the value of the pound and the lira against the mark on the foreign exchange markets. Although the central banks of Great Britain and Italy tried to defend their currencies by raising interest rates and buying back pounds and lira, they were unable to keep the values of their currencies within their respective ERM bands
Recent Activities and the Future of the IMF
Financial Crises in the Post-Bretton Woods Era
A number of broad types of financial crisis have occurred over the last quarter of a century, many of which have required IMF involvement. A currency crisis occurs when a speculative attack on the exchange value of a currency results in a sharp depreciation in the value of the currency or forces authorities to expend large volumes of international currency reserves and sharply increase interest rates to defend the prevailing exchange rate. A banking crisis refers to a loss of confidence in the banking system that leads to a run on banks, as individuals and companies withdraw their deposits. A foreign debt crisis is a situation in which a country cannot service its foreign debt obligations, whether private sector or government debt. These crises tend to have common underlying macroeconomic causes: high relative price inflation rates, a widening current account deficit, excessive expansion of domestic borrowing, and asset price inflation.
Third World Debt Crisis
Much of the recycled money ended up in the form of loans to the governments of various Latin American and African nations. The loans were made on the basis of optimistic assessments about these nations' growth prospects, which did not materialize. Instead, Third World economic growth was choked off in the early 1980s by a combination of factors, including high inflation, rising short-term interest rates, and recession conditions in many industrialized nations.
The consequence was a Third World debt crisis of huge proportions. At one point it was calculated that commercial banks had over $1 trillion of bad debts on their books, debts that the debtor nations had no hope of paying off. Then Argentina and several dozen other countries of lesser credit standings followed suit. The international monetary system faced a crisis of enormous dimensions.
However, the IMF's solution to the debt crisis contained a major weakness: It depended on the rapid resumption of growth in the debtor nations. If this occurred, their capacity to repay debt would grow faster than their debt itself, and the crisis would be resolved. The Brady Plan, as it became known, stated that debt reduction, as distinguished from debt rescheduling, was a necessary part of the solution and the IMF and World Bank would assume roles in financing it. The essence of the plan was that the IMF, the World Bank, and the Japanese government would each contribute $10 billion toward debt reduction. To gain access to these funds, a debtor nation would once again have to submit to imposed conditions for macroeconomic policy management and debt repayment.
Excess Capacity
As the volume of investments ballooned during the 1990s, often at the bequest of national governments, the quality of many of these investments declined significantly. The investments often were made on the basis of unrealistic projections about future demand conditions. The result was significant excess capacity. For example, Korean chaebol's investments in semi-conductor factories surged when a temporary global shortage of dynamic random access memory chips led to sharp price increases for this product. However, supply shortages had disappeared by 1996 and excess capacity was beginning to make itself felt, just as the South Koreans started to bring new DRAM factories on stream.
The Debt Bomb
Expanding Imports
The investments in infrastructure, industrial capacity, and commercial real estate were sucking in foreign goods at unprecedented rates. To build infrastructure, factories, and office buildings, Southeast Asian countries were purchasing capital equipment and materials from America, Europe, and Japan. Many Southeast Asian states saw the current accounts of their balance of payments shift strongly into the red.
Evaluating the IMF's Policy Prescriptions
One criticism is that the IMF's "one-size-fits-all" approach to macroeconomic policy is inappropriate for many countries. This point was made in the opening case when we looked at how the IMF's policies toward Zaire may have made things worse rather than better. In the recent Asian crisis, critics argue that the tight macroeconomic policies imposed by the IMF are not well suited to countries that are suffering not from excessive government spending and inflation, but from a private-sector debt crisis with deflationary undertones. The IMF rejects this criticism. According to the IMF, the critical task is to rebuild confidence in the won. Once this has been achieved, the won will recover from its oversold levels. This will reduce the size of South Korea's dollar-denominated debt burden when expressed in won, making it easier for companies to service their dollar-denominated debt. The IMF also argues that by requiring South Korea to remove restrictions on foreign direct investment, foreign capital will flow into the country to take advantage of cheap assets
A second criticism of the IMF is that its rescue efforts are exacerbating a problem known to economists as moral hazard. Moral hazard arises when people behave recklessly because they know they will be saved if things go wrong.This argument ignores two critical points. First, if some Japanese or Western banks with heavy exposure to the troubled Asian economies were forced to write off their loans due to widespread debt default, the impact would be difficult to contain. The failure of large Japanese banks, for example, could trigger a meltdown in the
The final criticism of the IMF is that it has become too powerful for an institution that lacks any real mechanism for accountability.
Implications for Business
Currency Management
The current system is a mixed system in which a combination of government intervention and speculative activity can drive the foreign exchange market. Companies engaged in significant foreign exchange activities need to be aware of this and to adjust their foreign exchange transactions accordingly.
Business Strategy
The volatility of the present global exchange rate regime presents a conundrum for international businesses. Exchange rate movements are difficult to predict, and yet their movement can have a major impact on a business's competitive position. Faced with uncertainty about the future value of currencies, firms can utilize the forward exchange market. However, the forward exchange market is far from perfect as a predictor of future exchange rates. It is also difficult if not impossible to get adequate insurance coverage for exchange rate changes that might occur several years in the future. The forward market tends to offer coverage for exchange rate changes a few months--not years--ahead. Given this, it makes sense to pursue strategies that will increase the company's strategic flexibility in the face of unpredictable exchange rate movements.
Another way of building strategic flexibility involves contracting out manufacturing. This allows a company to shift suppliers from country to country in response to changes in relative costs brought about by exchange rate movements. However, this kind of strategy works only for low-value-added manufacturing (e.g., textiles), in which the individual manufacturers have few if any firm-specific skills that contribute to the value of the product. It is inappropriate for high-value-added manufacturing, in which firm-specific technology and skills add significant value to the product (e.g., the heavy equipment industry) and in which switching costs are correspondingly high. For high-value-added manufacturing, switching suppliers will lead to a reduction in the value that is added, which may offset any cost gains arising from exchange rate fluctuations.
The roles of the IMF and the World Bank in the present international monetary system also have implications for business strategy. Increasingly, the IMF has been acting as the macroeconomic policeman of the world economy, insisting that countries seeking significant borrowings adopt IMF-mandated macroeconomic policies. These policies typically include anti-inflationary monetary policies and reductions in government spending. In the short run, such policies usually result in a sharp contraction of demand. International businesses selling or producing in such countries need to be aware of this and plan accordingly. In the long run, the kind of policies imposed by the IMF can promote economic growth and an expansion of demand, which create opportunities for international business.
Corporate - Government Relations
As major players in the international trade and investment environment, businesses can influence government policy toward the international monetary system. For example, intense government lobbying by US exporters helped convince the US government that intervention in the foreign exchange market was necessary.
With this in mind, business can and should use its influence to promote an international monetary system that facilitates the growth of international trade and investment. Whether a fixed or floating regime is optimal is a subject for debate. However, exchange rate volatility such as the world experienced during the 1980s and 1990s creates an environment less conducive to international trade and investment than one with more stable exchange rates. when those movements are unrelated to long-run economic fundamentals.
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