International Financial Management INBU 4200 Fall Semester 2004

International Financial Management: INBU 4200 Fall Semester 2004 Lecture 2 The International Monetary System (Chapter 2)

Web SITES 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 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

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

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 marketoriented 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 1970 s. • 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. G 7 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

Summary • Currency Average % High Low • Euro • Sing$ • HK$ 1. 82 1. 68 0. 49 . 03734. 00224. 00056 Stand Dev -2. 47. 6277 -1. 23. 2787 -0. 27. 0319

CURRENCY CRISES • Another feature of the International Monetary System since the 1970 s 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 DM 2. 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!!!

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/