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, exchange rates

and

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. 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

1

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.

Gold Standard.

.Classical international

An gold standard can be said to exist when, in most

Classical Gold Standard: 1875-1914

major countries, (i) gold alone is assured of

unrestricted coinage, (ii) there is two-way • For example, if the dollar is pegged to gold at U.S. $30 =

convertibility between gold and national 1 ounce of gold, and the British pound is pegged to gold

currencies at a stable ratio, and (iii) gold at £6 = 1 ounce of gold, it must be the case that the

may be freely exported or imported. In exchange rate is determined by the relative gold

contents:

order to support unrestricted convertibility

into gold, bank- notes need to be backed !"#$%$&$'()*+$',$-'./$%$01

by a gold reserve of a minimum stated !"#$%$01

ratio. In addition, the domestic money

stock should rise and fall as gold flows in !2$%$0&

and out of the country. Under the gold • Highly stable exchange rates under the classical gold

standard provided an environment that was beneficial to

standard, the exchange rate between any international trade and investment

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.

period.

.Interwar 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

EXHIBIT 2.1

respectively with reductions and increases in domestic money

The Design of the British German French

and credit. In a word, countries lacked the political will to abide

Gold-Exchange System pound mark franc

by the “rules of the game,” and so the automatic adjustment

mechanism of the gold standard was unable to work. Par value Par value

Par value

.BW. In July 1944, representatives of 44 nations gathered at U.S. dollar

Bretton Woods, New Hampshire, to discuss and design the

postwar international monetary system. After lengthy discussions Pegged at $35/oz.

and bargains, representatives succeeded in drafting and signing

the Articles of Agreement of the International Monetary Fund Gold

Bretton Woods system.

(IMF), which constitutes the core of the par value

Under the Bretton Woods system, each country established a in

to the U.S. dollar, which was pegged to gold at $35 per ounce. This point is ill

in Exhibit 2.1. Each country was responsible for maintaining its exchan

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.

Exchange rate regime.

.Flexible 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 cur- rency 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 capi- tal 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 indi- rect

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.

arrangement: stabilized arrangement

-Stabilized 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

The Mexican Peso Crisis

fixed rate or in response to changes in selected quantitative indicators, such as past inflation

On December 20, 1994, the Mexican government under new president Ernesto Zedillo

differentials vis-à-vis major trading partners or differentials between the inflation target and

announced its decision to devalue the peso against the dollar by 14 percent. This deci-

expected inflation in major trading partners. Examples are Honduras and Nicaragua.

sion, 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

China’s Renminbi’s exchange rate 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 mar-

China maintained a fixed exchange China Renminbi’s Exchange Rate

ket securities, the peso crisis rapidly spilled over to other Latin American and Asian

rate between the renminbi (RMB) financial markets.

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 US

RATE 7.5

TO As the bailout plan was put together

together a $53 billion package to bail out Mexico. 8

switched to the current “managed YUAN

EXCHANGE 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

▫ China maintained a fixed exchange rate between the renminbi (RMB) yuan

world financial system.

(reserve currency) in 2016. and the U.S. dollar for a long time.

As the world’s financial markets are becoming more integrated, this type of conta-

▫ Beijing dropped an explicit peg to the US dollar in 2005 and switched to the

gious financial crisis is likely to occur more often. Two lessons emerge from the peso

Mexican Peso crisis 1994 current “managed floating exchange rate regime”

On December 20, 1994, the Mexican

▫ The RMB floated between 2005 and 2008 and then again starting in 2010

government under new president Ernesto

▫ The RMB has been included in the basket of currencies used by the IMF

EXHIBIT 2.9 $0.30

Zedillo announced its decision to devalue

(reserve currency) in 2016.

U.S. Dollar versus Mexican

the peso against the dollar by 14 percent.

Peso Exchange Rate $0.25

(November 1, 1994–

This deci- sion, however, touched off a

January 31, 1995)

stampede to sell pesos as well as Mexican $0.20

peso

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 mar- ket 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 politi- cal 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.

t o a n u n p re c e d e n t e d l y d e e p , index

w i d e s p re a d , a n d l o n g - l a s t i n g 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