Chapter 10
The International Monetary and
Financial Environment
International Business
Strategy, Management & the New Realities
by
Cavusgil, Knight and Riesenberger
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Currencies and Exchange Rates
• There are some 175 currencies in use
worldwide.
• Currency regimes are simplifying – many
countries in Europe use the euro; several
countries have adopted the dollar.
• Exchange rate: the price of one currency
expressed in terms of another.
• Exchange rate fluctuations impact company
profitability in various ways
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Currency Risk
Currency risk arises from changes in the price of one
currency relative to another, complicating international
transactions. Issues:
● Currency exposure
● Asset valuation
● Foreign taxation
● Inflationary and transfer pricing
For example,
 If a supplier’s currency appreciates, you pay a larger
amount of your currency for your purchase.
 If a foreign buyer’s currency depreciates, you receive
a smaller payment amount in your currency
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The Four Risks of International Business
Convertible and Nonconvertible Currencies
• Convertible currency can be readily exchanged for
other currencies.
• Hard currencies are the most convertible
currencies; e.g., U.S. dollar, Japanese yen,
Canadian dollar, British pound, and the European
euro. Most transactions use these currencies and
nations prefer to hold them as reserves because of
their strength and stability.
• A nonconvertible currency is not acceptable for
international transactions
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Capital Flight
• Capital flight: The (often rapid) sale of holdings in
a nation’s currency or conversion into a foreign
currency. Governments impose restrictions on
currency convertibility to prevent capital flight and
preserve their supply of hard currencies. Capital
flight diminishes a country’s ability to service debt/
pay for imports.
• In 1979-1983, some $90 billion left Mexico when
foreign lenders lost confidence in the Mexican
economy and investors withdrew their investments
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Foreign Exchange Markets
Foreign exchange: all forms of internationally-traded
monies including currency, bank deposits, checks, and
electronic transfers.
Foreign exchange market: the global marketplace for
buying and selling national currencies
Exchange rates fluctuate constantly. E.g., yen-dollar
exchange rate:
• 1985 - 240 yen to the U.S. dollar.
• 1988 - 125 yen to the dollar (nearly 50% appreciation).
Result: Decrease in Japanese exports to U.S.; Increase in
U.S. exports to Japan
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How Exchange Rates are Determined
In a free market, the “price” of any currency (rate of
exchange) is determined by supply and demand:
• The greater the supply of a currency, the lower its
price
• The lower the supply of a currency, the higher its
price
• The greater the demand for a currency, the higher
its price
• The lower the demand for a currency, the lower its
price
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Appreciation and Depreciation: Example
• Euro appreciation: If the euro-dollar exchange
rate goes from one euro = $1.25 to one euro =
$1.50, the euro becomes expensive to
Americans
• Euro depreciation: If the euro-dollar exchange
rate goes from one euro = $1.25 to one euro =
$1.00, the euro then becomes cheaper to
Americas
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Factors That Influence
the Supply and Demand of a Currency
1. Economic growth
2. Interest rates and inflation
3. Market psychology
4. Government action
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1. Economic Growth
The increase in value of the goods and services
produced by an economy.
• Typically measured as the annual increase in
real GDP.
• Innovation and entrepreneurship drive business
activity and demand.
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2. Interest Rates and Inflation
Inflation: a rise in the prices of goods and services.
• Reduces the purchasing power of the affected
currency
• Interest rates and inflation are positively related. I.e.,
high inflation = high interest rates, because
investors expect a return that exceeds inflation rate.
• Where inflation or interest rates are rising, the value
of the currency generally falls
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3. Market Psychology
• Herding: the tendency of investors to mimic each
others’ actions
• Momentum trading: investors buy stocks whose
prices have been rising and sell stocks whose prices
have been falling- usually done via computers set to
do massive buying/selling when asset prices reach
certain levels.
• For example, in early 2000s, Argentina experienced
a massive flight of capital investment when the
government announced it would default on its
international bank loans.
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4. Government Action
• Governments intervene to influence the value of
their own currencies. E.g., the Chinese
government regularly intervenes to keep the
renminbi undervalued, ensuring that Chinese
exports remain strong.
• Intervention is conducted via the nation’s
Central Bank, by buying and selling currency in
the foreign exchange market
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Valuation of Currency Affects
Trade Surplus or Deficit
• Trade surplus: country’s exports exceed its
imports; may result when currency is
undervalued.
• Trade deficit: nation's imports exceed its
exports, causing net outflow of foreign exchange.
• Balance of trade: difference between the value
of a nation’s exports and its imports.
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The Bretton Woods Agreement
• Signed by 44 countries in 1944
• Pegged value of the dollar to an established value of
gold, at $35 per ounce.
• U.S. government agreed to buy and sell gold to
maintain the fixed rate.
• All other signatories pegged their currencies to the
U.S. dollar, and agreed to maintain this value via
central bank intervention.
• System kept exchange rates stable for 25 years.
• Broke down in early 1970s
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The Bretton Woods Legacy
• Instituted the concept of ‘international
monetary cooperation’ among central banks.
• Established the concept of fixing exchange
rates to minimize currency risk.
• Created the International Monetary Fund
(IMF) and the World Bank, agencies that
aim to stabilize currencies and reduce global
poverty.
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The Exchange Rate System Today
• Most advanced economies (e.g., Europe, Japan,
U.S.) use the floating exchange rate system.
The value of a currency ‘floats’ according to
market forces, with little government
intervention.
• Many developing economies and emerging
markets use the fixed exchange rate system.
The value of a currency is set at a specified rate
to the value of another currency, or basket of
currencies. E.g., China, African countries.
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Monetary and Financial Systems
• International monetary system: the institutional
framework, rules, and procedures by which national
currencies are exchanged for one another.
• Global financial system: the collection of financial
institutions that facilitate and regulate the flows of
investment and capital funds worldwide, incorporating
the national and international banking systems, the
international bond market, national stock markets, and
the market of bank deposits denominated in foreign
currencies. Has become huge since the 1990s. E.g.,
15% of U.S. equity funds are invested abroad
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Globalization of Finance
Advantages:
• Reduces cost of capital for firms
• More financing alternatives for firms
• More investment opportunities for people
• More financing options for emerging markets and
developing economies
Facilitating trends:
• Monetary and financial deregulation worldwide
• New technologies and the Internet
• Growing role of single-currency systems, e.g., euro
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Risks in the Globalization of Finance
• Contagion: tendency of a financial or
monetary crisis in one country to spread
rapidly to others due to worldwide financial
integration. E.g., SE Asia crisis in late 1990s
• Capital flows are much more volatile than
FDI-type investments
• Financial instability is worsened due to
underdeveloped regulatory frameworks, and
insufficient monitoring of banking and
financial sectors.
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