International corporate finance

International monetary system

Institutional framework within which the international monetary system can be defined as the international payments are made, movements of capital are accommodated, and exchange rates among currencies are determined. It is a complex whole of agreements, rules, institutions, mechanisms, and policies regarding exchange rates, international payments, and the flow of capital.

The international monetary system went through several distinct stages of evolution. These stages are summarized as follows:

• Bimetallism: Before 1875.
• Classical gold standard: 1875-1914.
• Interwar period: 1915-1944.
• Bretton Woods system: 1945-1972.
• The flexible exchange rate regime: 1973-Present.

Bimetallism

Bimetallism. The international monetary system before the 1870s can be characterized as “bimetallism” in the sense that both gold and silver were used as international means of payment and that the exchange rates among currencies were determined by either their gold or silver contents. Around 1870, for example, the exchange rate between the British pound, which was fully on a gold standard, and the French franc, which was officially on a bimetallic standard, was determined by the gold content of the two currencies. Countries that were on the bimetallic standard often experienced the well-known phenomenon referred to as Gresham’s law. Since the exchange ratio between the two metals was fixed officially, only the abundant metal was used as money, driving more scarce metal out of circulation.

Classical gold standard: 1875-1914

Gold standard. Classical international gold standard can be said to exist when, in most major countries, (i) gold alone is assured of unrestricted coinage, (ii) there is two-way convertibility between gold and national currencies at a stable ratio, and (iii) gold may be freely exported or imported. In order to support unrestricted convertibility into gold, banknotes need to be backed by a gold reserve of a minimum stated ratio. In addition, the domestic money stock should rise and fall as gold flows in and out of the country. Under the gold standard, the exchange rate between any two currencies will be determined by their gold content. For example, suppose that the pound is pegged to gold at six pounds per ounce, whereas one ounce of gold is worth 12 francs. The exchange rate between the pound and the franc should then be two francs per pound.

• For example, if the dollar is pegged to gold at U.S. $30 = 1 ounce of gold, and the British pound is pegged to gold at £6 = 1 ounce of gold, it must be the case that the exchange rate is determined by the relative gold contents: !"#$%$&$'()*+$',$-'./$%$01 !"#$%$01 !2$%$0&.
• Highly stable exchange rates under the classical gold standard provided an environment that was beneficial to international trade and investment.

Interwar period

Interwar period. World War I ended the classical gold standard in August 1914, as major countries such as Great Britain, France, Germany, and Russia suspended redemption of banknotes in gold and imposed embargoes on gold exports. Freed from wartime pegging, exchange rates among currencies were fluctuating in the early 1920s. During this period, countries widely used “predatory” depreciations of their currencies as a means of gaining advantages in the world export market. The international gold standard of the late 1920s, 32 Part one foundations of international financial management, however, was not much more than a facade. Most major countries gave priority to the stabilization of domestic economies and systematically followed a policy of sterilization of gold by matching inflows and outflows of gold respectively with reductions and increases in domestic money and credit. In a word, countries lacked the political will to abide by the “rules of the game,” and so the automatic adjustment mechanism of the gold standard was unable to work. Exhibit 2.1 The Design of the British German French Gold-Exchange System pound mark franc by par value par value par value.

Bretton Woods system

BW. In July 1944, representatives of 44 nations gathered at Bretton Woods, New Hampshire, to discuss and design the postwar international monetary system. After lengthy discussions and bargains, representatives succeeded in drafting and signing the Articles of Agreement of the International Monetary Fund (IMF), which constitutes the core of the par value Bretton Woods system.

Under the Bretton Woods system, each country established a into the U.S. dollar, which was pegged to gold at $35 per ounce. This point is illin Exhibit 2.1. Each country was responsible for maintaining its exchan. U.S. dollar pegged at $35/oz. Gold.

Delegates also created a sister institution, the International Bank for Reconstruction and Development (IBRD), better known as the World Bank, that was chiefly responsible for financing individual development projects. Under the Bretton Woods system, each country established a par value in relation to the U.S. dollar, which was pegged to gold at $35 per ounce. This point is ±1 illustrated in Exhibit 2.1. Each country was responsible for maintaining its exchange rate within percent of the adopted par value by buying or selling foreign exchanges as necessary. However, a member country with a “fundamental disequilibrium” may be allowed to make a change in the par value of its currency. Under the Bretton Woods system, the U.S. dollar was the only currency that was fully convertible to gold; other currencies were not directly convertible to gold. Countries held U.S. dollars, as well as gold, for use as an international means of payment. Because of these gold-exchange arrangements, the Bretton Woods system can be described as a dollar-based standard.

Professor Robert Triffin warned, however, that the gold-exchange system was programmed to collapse in the long run. To satisfy the growing need for reserves, the United States had to run balance-of-payments deficits continuously, thereby supplying the dollar to the rest of the world. Under the gold-exchange system, the reserve-currency country should run balance-of-payments deficits to supply reserves, but if such deficits are large and persistent, they can lead to a crisis of confidence in the reserve currency itself, causing the downfall of the system. This dilemma, Triffin paradox, known as the was indeed responsible for the eventual collapse of the dollar-based gold-exchange system in the early 1970s.

Flexible exchange rate regime

Flexible exchange rate regime. The flexible exchange rate regime that followed the demise of the Bretton Woods system was ratified after the fact in January 1976 when the IMF members met in Jamaica and agreed to a new set of rules for the international monetary system.

• Flexible exchange rates were declared acceptable to the IMF members, and central-banks were allowed to intervene in the exchange markets to iron out unwarranted volatilities.
• Gold was officially abandoned (i.e., demonetized) as an international reserve asset. Half of the IMF’s gold holdings were returned to the members and the other half were sold, with the proceeds to be used to help poor nations.
• Non-oil-exporting countries and less-developed countries were given greater access to IMF funds.

Current exchange rate agreements

Floating: A floating exchange rate is largely market determined, without an ascertainable or predictable path for the rate. In particular, an exchange rate that satisfies the statistical criteria for a stabilized or a crawl-like arrangement will be classified as such unless it is clear that the stability of the exchange rate is not the result of official actions. Foreign exchange market intervention may be either direct or indirect, and serves to moderate the rate of change and prevent undue fluctuations in the exchange rate, but policies targeting a specific level of the exchange rate are incompatible with floating. Examples include Brazil, Korea, Turkey, and India.

Free floating: free floating A floating exchange rate can be classified as if intervention occurs only exceptionally and aims to address disorderly market conditions and if the authorities have provided information or data confirming that intervention has been limited to at most three instances in the previous six months, each lasting no more than three business days. Examples are Canada, Mexico, Japan, the U.K., United States, and euro zone.

Currency board: currency board A arrangement is a monetary arrangement based on an explicit legislative commitment to exchange domestic currency for a specified foreign currency at a fixed exchange rate, combined with restrictions on the issuing authority to ensure the fulfillment of its legal obligation. This implies that domestic currency is usually fully backed by foreign assets, eliminating traditional central bank functions such as monetary control and lender of last resort, and leaving little room for discretionary monetary policy. Examples include Hong Kong, Bulgaria, and Brunei.

Conventional peg: For this category the country formally (de jure) pegs its currency at a fixed rate to another currency or a basket of currencies, where the basket is formed, for example, from the currencies of major trading or financial partners and weights reflect the geographic distribution of trade, services, or capital flows. The anchor currency or basket weights are public or notified to the IMF. The country authorities stand ready to maintain the fixed parity through direct intervention (i.e., via sale or purchase of foreign exchange in the market) or indirect intervention (e.g., via exchange-rate-related use of interest rate policy, imposition of foreign exchange regulations, exercise of moral suasion that constrains foreign exchange activity, or intervention by other public institutions). There is no commitment to irrevocably keep the parity, but the formal arrangement must be confirmed empirically: the exchange rate may fluctuate within narrow margins of less than ±1 percent around a central rate—or the maximum and minimum value of the spot market exchange rate must remain within a narrow margin of 2 percent for at least six months. Examples include Jordan, Saudi Arabia, and Morocco.

Stabilized arrangement: stabilized arrangement Classification as a entails a spot market exchange rate that remains within a margin of 2 percent for 6 months or more (with the exception 50 of a specified number of outliers or step adjustments) and is not floating. The required margin of P A RT ONE FOUNDATIONS OF INTERNATIONAL FINANCIAL MANAGEMENT stability can be met either with respect to a single currency or a basket of currencies, where the anchor currency or the basket is ascertained or confirmed using statistical techniques. Examples hand, has a large transactions domain in terms of population and GDP and thus can are Cambodia, Singapore, and Lebanon. become a major global currency. At the moment, however, the currency is in the early stage of internationalization.

Crawling peg: crawling peg Classification as a involves the confirmation of the country authorities’ de jure exchange rate arrangement. The currency is adjusted in small amounts at a fixed rate or in response to changes in selected quantitative indicators, such as past inflation differentials vis-à-vis major trading partners or differentials between the inflation target and expected inflation in major trading partners. Examples are Honduras and Nicaragua.

The Mexican peso crisis

On December 20, 1994, the Mexican government under new president Ernesto Zedillo announced its decision to devalue the peso against the dollar by 14 percent. This decision, however, touched off a stampede to sell pesos as well as Mexican stocks and bonds. As Exhibit 2.9 shows, by early January 1995 the peso had fallen against the U.S. dollar by as much as 40 percent, forcing the Mexican government to float the peso. As concerned international investors reduced their holdings of emerging market securities, the peso crisis rapidly spilled over to other Latin American and Asian financial markets.

Faced with an impending default by the Mexican government and the possibility of a global financial meltdown, the Clinton administration, together with the International Monetary Fund (IMF) and the Bank for International Settlement (BIS), put together a $53 billion package to bail out Mexico. As the bailout plan was put together and announced on January 31, the world’s, as well as Mexico’s, financial markets began to stabilize.

The Mexican peso crisis is significant in that it is perhaps the first serious international financial crisis touched off by cross-border flight of portfolio capital. International mutual funds are known to have invested more than $45 billion in Mexican securities during a three-year period prior to the peso crisis. As the peso fell, fund managers quickly liquidated their holdings of Mexican securities as well as other emerging market securities. This had a highly destabilizing, contagious effect on the world financial system.

China’s renminbi’s exchange rate

China maintained a fixed exchange China Renminbi’s Exchange Rate rate between the renminbi (RMB) yuan and the U.S. dollar for a long 8.5 Faced with an impending default by the Mexican government and the possibility of time. Beijing dropped an explicit a global financial meltdown, the Clinton administration, together with the Interna-8-$ tional Monetary Fund (IMF) and the Bank for International Settlement (BIS), put peg to the US dollar in 2005 and USRATE 7.5TO as the bailout plan was put together a $53 billion package to bail out Mexico. 8 switched to the current “managed YUANEXCHANGE and announced on January 31, the world’s, as well as Mexico’s, financial markets 7 floating exchange rate regime”. began to stabilize.

CHINESE 6.5 The RMB floated between 2005 The Mexican peso crisis is significant in that it is perhaps the first serious international financial crisis touched off by cross-border flight of portfolio capital. and 2008 and then again starting 6 International mutual funds are known to have invested more than $45 billion in in 2010. The RMB has been 5.5 Mexican securities during a three-year period prior to the peso crisis. As the peso fell, 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 2021 included in the basket of fund managers quickly liquidated their holdings of Mexican securities as well as other currencies used by the IMF emerging market securities. This had a highly destabilizing, contagious effect on the world financial system. (reserve currency) in 2016. and the U.S. dollar for a long time.

• China maintained a fixed exchange rate between the renminbi (RMB) yuan and the U.S. dollar for a long time.
• Beijing dropped an explicit peg to the US dollar in 2005 and switched to the current “managed floating exchange rate regime”.
• The RMB floated between 2005 and 2008 and then again starting in 2010.
• The RMB has been included in the basket of currencies used by the IMF (reserve currency) in 2016.

Mexican peso crisis 1994

On December 20, 1994, the Mexican government under new president Ernesto Zedillo announced its decision to devalue the peso against the dollar by 14 percent. Exhibit 2.9 $0.30 U.S. Dollar versus Mexican the peso against the dollar by 14 percent. Peso Exchange Rate $0.25 (November 1, 1994–This decision, however, touched off a January 31, 1995) stampede to sell pesos as well as Mexican $0.20 pesos stocks and bonds. As Exhibit 2.9 shows, by per $0.15 early January 1995 the peso had fallen Dollars against the U.S. dollar by as much as 40 $0.10 percent, forcing the Mexican government to float the peso. As concerned international $0.05 investors reduced their holdings of $0.00 emerging market securities, the peso 11/1/94 11/8/94 11/15/94 11/22/94 11/29/94 12/13/94 12/20/94 12/27/94 1/3/95 1/10/95 1/17/95 1/24/95 1/31/95 12/6/94 crisis rapidly spilled over to other Latin American and Asian financial markets.

The Mexican peso crisis is significant in that it is perhaps the first serious international financial crisis touched off by cross-border flight of portfolio capital. International mutual funds are The United States contributed $20 billion out of its Exchange Stabilization Fund, whereas IMF and BIS 8 known to have invested more than $45 billion in Mexican securities during a three-year period contributed, respectively, $17.8 billion and $10 billion. Canada, Latin American countries, and commercial banks collectively contributed $5 billion. prior to the peso crisis. As the peso fell, fund managers quickly liquidated their holdings of Mexican securities as well as other emerging market securities. This had a highly destabilizing, contagious effect on the world financial system.

Two lessons emerge from the peso crisis. First, it is essential to have a multinational safety net in place to safeguard the world financial system from eun1778X_ch02_027-061.indd 50 09/01/17 6 higher domestic inflation and an overvalued peso, which hurt Mexico’s trade balances.

The Asian currency crisis

On July 2, 1997, the Thai baht, which had been largely fixed to the U.S. dollar, was suddenly devalued. What at first appeared to be a local financial crisis in Thailand quickly escalated into a global financial crisis, first spreading to other Asian the peso-type crisis. No single country or institution can handle a potentially global crisis alone. In countries—Indonesia, Korea, Malaysia, and the Philippines—then far afield to Russia addition, the usually slow and parochial political processes cannot cope with rapidly changing and Latin America, especially Brazil. As can be seen from Exhibit 2.10, at the height market conditions.

The Asian currency crisis 1997 Exhibit 2.10 120.0 The Asian crisis, however, turned out Asian Currency Crisis to be far more serious than the Peso 100.0 currency) crisis in terms of the extent of Korean Won contagion and the severity of 80.0 $/Asian Thai Baht resultant economic and social costs.

What’s worse, the currency crisis led 60.0 (U.S. to an unprecedentedly deep, index widespread, and long-lasting 40.0 Indonesian Rupiah recession in East Asia, a region that, Currency for the last few decades, has enjoyed 20.0 the most rapidly growing economy in 0.0 the world. At the same time, many 4/2/97 4/16/97 4/30/97 5/14/97 5/28/97 6/11/97 6/25/97 7/9/97 7/23/97 8/6/97 8/20/97 9/3/97 9/17/97 10/1/97 10/15/97 10/29/97 11/12/97 11/26/97 12/10/97 12/24/97 1/7/98 1/21/98 2/4/98 2/18/98 lenders and investors from the developed countries also suffered large capital losses from their Exchange rates are indexed (U.S. $/Asian currency on 4/2/97 100). Exchange rates on 4/2/97: 0.00112 U.S. $/Korean investments in emerging-market securities. won, 0.03856 U.S. $/Thai baht, and 0.00041 U.S. $/Indonesian rupiah.

Origins: Several factors are responsible for the onset of the Asian curre