International Finance

INBU 4200 INTERNATIONAL FINANCIAL MANAGEMENT Lecture 2, Appendix 2 History of the International Monetary System (With Focus on Exchange Rate Regimes). And The Euro-Zone (and the European Euro). Recall from Lecture 2 the Definition of an Exchange Rate Regime Defined: The arrangement by which the price of a countrys currency is determined on foreign exchange markets. These arrangements range from:

Floating Rate Managed Rate (Dirty Float) Pegged Rate The particular arrangement is determining by individual governments. History of Exchange Rate Regimes Over the past 200+ years, the world has gone though major changes its global exchange rate environment. Starting with the gold standard in the 19th century to todays mixed system there are 3 distinct periods: Gold Standard: 1816 - 1914 Bretton Woods: 1945 1973

Rates tied into gold contents. Stable rates pegged to the U.S. dollar Mixed System: 1973 the present But moving towards more flexibility (market determination) of rates. Gold Standard: 1816 1914 During the 1800s, the industrial revolution brought about a vast increase in the production of goods and as a result widened the basis of world trade. At that time, trading countries believed that a necessary condition to facilitate world trade was a stable exchange rate system. Stable exchange rates were seen as necessary for

encouraging and settling commercial transactions across borders (both by companies and by governments). So, by the second half of the 19th century, most major countries had adopted the gold standard exchange rate regime. The Industrial Revolution and the British Empire The Industrial Revolution which began in the 1760s was centered in Northwest England. The Industrial Revolution transformed Britain from an agricultural economy to one based on the application of power-driven machinery to manufacturing. As a result of Britains advantage in production, the amount of British products available for export increased. This was especially cotton textiles

The Dominance of the British Pound During the Classical Britains search for overseas markets for their Gold Period manufactured goods (and for raw materials) was the incentive for overseas colonization in the 1800s. During this period, Britain focused on markets in Asia and Africa. Trading posts were established in these colonies. Because of the dominance of the British Empire, the British pound became the worlds major trading currency. As one example, by 1914, 47% of the worlds holdings of international reserves was in the form of British pounds. Basics of the Gold

Standard The gold standard exchange rate regime required that each countrys national money be defined in terms of a specific weight of gold. As one example, during this period: The U.S. dollar was defined as worth 0.0483% of an ounce of pure gold. And, the British pound was worth .23506% Thus, the U.S. dollar British pound parity rate (ie.., the exchange rate) was about $4.8666 per pound sterling, or (.23506/.0483 = $4.8666) This was the gold standard exchange rate between these two currencies.

Examples of Some Countries Joining the Gold Standard Country U.K. Australia Canada Germany France U.S. Japan Russia Mexico Date 1816 1852 1854 1871 1878 1879 1897 1897 1905

WWI (1914 1919) World War I (August 1914) marks the beginning of the end of the Gold Standard and the decline of the British pound. During the war, countries suspended the convertibility of their currencies into gold. During World War I and into the 1920s, governments let their currencies float. It was a time when speculators sold weak currencies and bought strong currencies. After the war, many countries suffered hyperinflation and economic recessions. As one policy solution, many countries turned to competitive devaluations in an attempt to stimulate their export sectors and gain advantages in world export markets. In reality, however, one countrys competitive devaluation was followed by another country currency devaluation (as an offset). Interwar Period: 1919 After WW I, various attempts were made to restore the classical 1939 gold standard.

1919: United States returned to a gold standard. 1925: Great Britain joined, followed by France and Switzerland. These attempts proved unsuccessful. Why: During this time, most countries were more concerned with their national economies than exchange rate stability. As a result, countries abandoned their attempts to return to an interwar gold standard. Especially during the Great Depression (1929 1930s) Britain and Japan dropped it in 1931, the U.S. in 1933.

Countries also erected high tariff walls to protect their domestic economy. During the depression years, world trade slowed and eventually declined to very low levels. Bretton Woods: July 1944 As World War II was coming to an end, all 44 allied countries met in Bretton Woods, New Hampshire (at the Mount Washington Hotel), to consider a new international monetary system. During this period: The U.S. economy emerged as the worlds strongest. The Bretton Woods International

Monetary System was agreed upon at these meetings. U.S. dollar becomes the key currency within this new arrangement Bretton Woods At Bretton Woods, it was agreed that fixed Agreements exchange rates were necessary for restarting world trade and global investment. As noted, the U.S. dollar became the cornerstone of this new international monetary system. Key points of Bretton Woods were: U.S. dollar is pegged to gold at $35 per ounce, and the Dollar is the only currency which is convertible into gold.

All other countries peg their currencies to the U.S. dollar. Their par values are set in relation to the U.S. dollar Countries agree to support their exchange rates within + or 1% of these established par values. This is done through the buying or selling of foreign exchange when market forces needed to be offset. Examples of Bretton Woods Par Values Foreign currencies were linked (pegged) to the U.S. Dollar which in turn was linked (pegged) to gold: BRITISH POUND Par Value $2.80/ GERMAN MARK Par Value DM4.2/$ ITALIAN LIRA

Par Value Lit625/$ U.S. DOLLAR GOLD $35 an ounce JAPANESE YEN Par Value 360/$ Key Bretton Woods Agreements During the Bretton Woods period, countries agreed not to devalue their currencies for trade gaining purposes.

Competitive devaluations were prohibited. However, currency devaluations were allowed in response to fundamental and chronic balance of payments disequilibrium. U.S. dollar, however, was the one currency which was not permitted to change its value. The Bretton Woods meetings also create: International Monetary Fund (IMF). World Bank. International Monetary Fund (IMF) The IMF is created to watch over the international monetary system and to ensure the maintenance of fixed-exchange rates. IMF agrees to lend a country hard currency when

needed to defend their par values. Stated goal of the IMF at the time is to promote international monetary cooperation and facilitate the growth of international trade. Recall that stable exchange rates are seen as critical to this IMF goal. World Bank The World Bank is also part of the 1944 Bretton Woods Agreement Initial goal of World Bank was to rebuild Europe and Asias war-torn economies through U.S. financial aid. World Bank manages Marshall aid funds to Europe and Asia. In later years, the World Bank turns to development issues. Today the World Bank lends money to developing countries for:

Agriculture Education Population issues (e.g., water supplies) Urban development Assessment of Bretton Woods: During its first two decades, the Bretton Woods International 1944- 1960s Monetary System appears to be successful. Exchange rates are relatively stable and world trade grows. Some countries, however, do devalue their currencies. This causes the U.S. dollar to effectively appreciate. 2.9 D o lla r/P o u n d 2.8 2.7 2.6 2.5 2.4 2.3 2.2

2.1 Example of the Stable Yen During Bretton Woods: 362 to 363 358 Range 362 Y e n /D o lla r 361 360 359 358 357 356 355 The Seeds of Bretton Woods In the 1960s, Bretton Woods begins to unravel. Demise

President Lyndon Johnson tries to finance both his Great Society programs at home and the American war in Vietnam. This produces a large US Federal budget deficit, which, coupled with easy monetary policy, results in: High inflation in the United States and An increase in U.S. spending for cheaper imports As a result, the United States balance of payments moves from a surplus into a deficit. Dollar is seen by the market as overvalued. Foreigners become concerned about holding overvalued U.S. dollars at a rate of $35 an ounce. Markets are suggesting it should take more than $35 to buy 1 oz of gold.

U.S. Balance of Payments: By the mid-1960, the U.S. balance of payment is showing marked deterioration. 1965 And 1971, the U.S. merchandise trade balance actually moves into deficit. But, U.S. dollar is still pegged at $35 per ounce. And now is starting to be seen by markets as overvalued. The Last Years of Bretton Woods: By 1970, financial markets are unwilling to hold the overvalued 1970 -1973 U.S. dollar. Dollars are sold on foreign exchange markets.

Central banks engage in massive intervention in an attempt to hold their Bretton Woods par values. This puts downward pressure on the exchange rate for dollars. And upward pressure on the exchange rate for foreign currencies. They buy U.S. dollars as they are sold in markets. As a result, foreign holdings of dollars increase dramatically and eventually exceed U.S. gold holdings. By 1971, gold coverage for U.S. dollars had dropped to 22%. Then, in August 1971, President Nixon suspends dollar convertibility into gold. In response, more dollars are sold on foreign exchange markets and

the dollar trades lower in response (and foreign currencies appreciate). U.S. government expresses an interested in forging a new fixed exchange rate system, but one without gold. Smithsonian Agreements, In December 1971, ten major counties meet in 1971 Washington, D.C. Meeting results in the Smithsonian Agreements, whereby: Key countries agree to revalue their currencies (e.g., yen 17%, mark 13.5%, pound and franc 9%) In return, the U.S. agrees to raise the dollar price of gold from $35 to $38 an ounce.

Combined, this was equivalent to a effective dollar devaluation of 8.57%. However, this dollar devaluation had no significance because the dollar remained inconvertible. But currencies were also allowed to fluctuate + or 2.25%. The Dollar Collapses, 1973 13 months after the Smithsonian Agreements, the dollar comes under renewed attack. February 1973, markets sell off dollars again. Central banks again intervene and buy dollars. On February, 12th, 1973 the dollar is devalued further to $42.

But the price of gold on the London gold markets is $70 per ounce. Japan and Italy finally let their currencies float on February 13th. France and Germany continue to manage their currencies in relation to the dollar. In response to mounting speculative currency flows, foreign exchange markets are closed on March 1, 1973, and reopen on March 19, 1973. The Collapse of Bretton Woods On March, 19 , 1973, when foreign exchange th markets reopen, major countries float their

currencies: On March 19, 1973, the list floating their currencies includes Japan, Canada, and Western Europe. The Bretton Woods fixed exchange rate system effectively ends on this date. And by June 1973, the dollar floats down an average of 10% against the major currencies of the world. 1975 Jamaican Agreement In January 1975, IMF member countries meet for the first time since the end of Bretton Woods in Jamaica and agree to the following:

To officially accept flexible exchange rate regimes and, Agree, that central banks should intervene (e.g., buy and sell their currencies) in foreign exchange markets to deal with unwarranted currency volatility. These meetings are referred to as the Jamaican Agreement. Early Post Bretton Woods During the years immediately after the collapse of Years Bretton Woods, the dollar fluctuates, but no discernable trend is observed at first. Consensus view is that during these early years the new system works fairly well. And, by the end of 1973, the dollar actually recovers in response a strengthening U.S. balance of payments position brought about by the weak dollar.

One potential problem, however, is the formation and success of OPEC in 1973. First OPEC imposes an oil embargo, followed by: Oil prices increases from under $5 a barrel to around $30 by 1980. Renewed U.S. Dollar Crisis, During the 1977-78 period, expansionary 1977-1978 domestic monetary policy of the Carter administration leads to increasing rates of inflation and a deterioration of the U.S. balance of payments. Thus, the dollar comes under attack again. From early 1977 to October 1978, the dollar loses 20% of its value.

In response to the foreign exchange market instability, in March 1979, 9 members of the European Union establish the European Monetary System, with the goal of promoting exchange rate stability within this group. Mid 1970s to Mid 1980s From the mid 1970s until 1980, the U.S. dollar continues to weaken against most currencies. This results from high inflation in the U.S. and continuing deterioration of the U.S. balance of payments. In April 1981, the U.S. Government announces that they will no longer intervene in foreign exchange markets to support the dollar. Thus, U.S. central bank intervention on behalf of the dollar comes to an end!

However, from 1980 to February 1985, the dollar unexpectedly strengthens. Why? Relatively high U.S. interest rates attracted foreign capital inflows and more than offset the trade deficit outflow. 1985 Plaza Accord In September 1985, 5 countries (U.S. , U.K., France, Germany and Japan) meet at the Plaza Hotel in New York. They sign the Plaza Accord, whereby: Countries agree on coordinated intervention in foreign exchange markets to deal with the strong U.S. dollar and the U.S. trade deficit.

They agree to sell U.S. dollars on foreign exchange markets (i.e., increase supply) and thus drive down its exchange rate. G7 felt a weak dollar was needed to offset U.S. trade deficit. In response to central bank intervention, the U.S. dollar weakens. Over the next ten years, the dollar continues to weaken as markets respond to a continuing worsening of the U.S. trade deficit. Roller Coaster Decade of the 1980s Strong StrongDollar Dollar Period: Period: 1980

1980--1985 1985 WEAK DOLLAR 1987 Louvre Accord In February 1987, G7 meet in Paris, France (Louvre Accord): The dollar continues to be weak until the mid-1990s. Trade Weighted Exchange Rate U.S. Dollar Index Countries agree to engage in greater cooperate to achieve reasonable exchange rate stability, and To consult and also coordinate their macroeconomic policies. 140 130 120

110 100 90 80 Years (monthly average; May 1973 = 100) Mid 1990s to Early 2000s From 1996 through 2001 the dollar strengthens. Strong U.S. economic performance attracts capital inflows. Beginning in 2002, however, the dollar weakens again. U.S. deficits become a concern again. Trade Weighted Exchange Rate U.S . Do llar In d ex

Strong economic performance offsets trade deficit concerns. 110 105 100 95 90 85 80 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 Years (monthly average; May 1973 = 100) Where are we Today in Terms of Exchange Rate Regimes? Mixed International Monetary System consisting of: Floating exchange rate regimes: Managed (dirty float) rate regimes:

Market forces determine the relative value of a currency. Governments managing their currencys value with regard to a reference currency. Market moves these currencies, but governments are managing the process and intervening when necessary. Pegged exchange rate regimes: Government fixes (links) the value of its currency relative to a reference currency. Fewer of these regimes than in the past. Post Bretton Woods Summary Since March 1973, the major currencies of the world

operate under a floating exchange rate system. A growing number of other currencies have also moved to a floating rate system. Thus: more and more, market forces are driving currency values. The Post Bretton Woods period has resulted exchange rates become much more volatile and less predictable then they were during previous fixed exchange rate eras. This currency volatility complicates the management of global companies. The Euro-Zone: A Currency As of January 1, 2007, 13 countries within the 25 Union member European Union have adopted a single currency, the euro, as their legal tender.

In essence, the national currencies of these 13 countries has been replaced by the euro. As one example The Euro Time Line: Pre Euro 1979: European Monetary System is created. Recall this period was one of increasing exchange rate instability. The EMS was designed to promote exchange rate stability within the European Community. European currencies were tied (pegged) to one another.

But essentially they were all linked to the German mark. Series of crises followed within the EMS, but it survives 1991: Maastricht Treaty signed. Calls for the adoption of a single currency in Europe by 1999. But countries needed to meet specified economic and financial criteria before they could adopt the single currency. And some countries elect not to join the euro curreny zone (U.K. ops out). The Euro Time Line: Introducing the Euro January 1, 1999. The European Monetary Union (EMU) is created. Eleven countries irrevocably lock their national currencies to the euro.

For Example: 1,936.27 Italian lira = 1 euro; 1.95583 German marks = 1 euro, etc. These locked rates were based on the exchange rates between these national currencies on January 1, 1999. The euro starts trading on foreign exchange markets. January 1, 2002. euro notes and coins are introduced into circulation and over a short period of time all national money is withdrawn. Greece joins the Euro zone on January 1, 2002, and Slovenia joins on January 1, 2007, bringing the current number of countries in the euro zone to 13. The U.K., Denmark, and Sweden remain out. Countries in the EuroZone Today Whose in the Euro-zone (12):

Austria, Belgium, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg, Netherlands, Portugal, Spain. Whose out of Euro Zone (But in the EU): The U.K., Denmark, Sweden and the 10 countries that joined the European Union on May 1, 2004. Cyprus, Czech Republic, Estonia, Hungary, Latvia, Lithuania, Malta, Poland, Slovakia, Slovenia Bulgaria and Romania hope to join the EU by 2007. The European Central As part of the European Monetary Union, the Bank European Central Bank (ECB) was created. Headquartered in Frankfurt, Germany

Primary objective of the ECB is to maintain price stability within the euro-zone. It is modeled after the German Bundesbank. Thus, the ECB is highly independent and low inflation becomes its main objective. See: Price stability is defined in the ECB charter at less than 2% This inflation targeting goal is achieved through ECB interest rate policies. But many (even in Europe) see the ECB as operating within too narrow a mandate.

Especially true with high rates of unemployment in key euro zone countries. The Euro-Zone and Exchange Rate Risk In essence, the single currency of the eurozone has removed exchange rate issues for transactions within the euro-zone itself. However, the euro itself is still a floating currency against the other currencies of the world. Thus, exchange rate issues exist for foreign companies (e.g., American firms and U.K. firms) doing business in the euro-zone and euro-zone countries doing business outside of the singe currency area. This is important to remember. The Euro Exchange Rate: Jan

Exchange-rate on first trading day: $1.18 (American Terms) 1,Note: 1999 Source:

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