INBU 4200
INTERNATIONAL
FINANCIAL
MANAGEMENT
Lecture 2:
The International Monetary System:
Foreign Exchange Regimes
What is the International Monetary
System?


It is the overall financial environment in which global
businesses operate.
It is represented by the following 3 sub-sectors:



International Money and Capital Markets
 Banking markets
 Bond markets
 Equity markets
Foreign Exchange Markets
 Currency markets (including foreign exchange regimes)
Derivatives Markets

Forwards, futures, options…
Concept of an Exchange Rate Regime



A exchange rate regime refers to the arrangement
by which the price of country’s currency is
determined within foreign exchange markets.
This arrangement is determined ultimately by
individual governments!
Foreign currency price is:


The foreign exchange rate (“spot rate”).
Expresses the value of a county’s currency as a ratio of
some other country.



Target currency (or common denominator) has historically
(since the 1940s) been the U.S. dollar.
Look in Wall Street Journal under foreign exchange quotes.
See Appendix 1 for a discussion of exchange rate quotes.
Why are Exchange Rate Regimes
Important for Global Firms?


Exchange rate regimes will determine potential
volatility of a country’s exchange rate.
Exchange rate changes are important because they:




Affect the competitive position of global firms
 Especially true for exporting firms
Affect the cost structure of global firms
 Especially true for importing firms and overseas
manufacturers
Affect the profit structure of global firms
 Overseas subsidiaries, exporters, and importers.
In short: affect the “financial performance” of a global firm.
Exchange Rate Regimes Today

Exchange rate regimes fall along a spectrum as
represented by a national government’s involvement
in affecting (i.e., managing) the exchange rate for
their currency.
No
Involvement by
Government
Active
Involvement by
Government
Only market
Forces are
Determining
Exchange rate
Government is
Determining or
Managing the
Exchange rate
Exchange Rate Regimes Today
No
Involvement by
Government
Only market
Forces are
Determining
Exchange rate
Floating
Rate
Regime
Active
Involvement by
Government
Government is
Determining or
Managing the
Exchange rate
Managed
Rate
(“Dirty Float”)
Regime
Pegged
Rate
Regime
Classification of Exchange Rate
Regimes

Floating Currency Regime:

No (or very minimal) government involvement (i.e.,
intervention) in foreign exchange markets.


See Appendix 2 for a discussion of major central bank
intervention.
In the absence of intervention, market forces, i.e.,
demand and supply, determine foreign exchange
rates (prices).

Market forces involve financial institutions (global banks,
investment firms), multinational firms, foreign currency
brokers, speculators (hedge funds), exporters,
importers, etc.
Classification of Exchange Rate
Regimes

Managed Currency (“dirty float”) Regime:

Higher degree of intervention (management) of
government in foreign exchange market.



Either daily (China) or when circumstances warrant
(Singapore).
Purpose of intervention: to offset “undesirable” market forces
and produce “desirable” exchange rate.
Usually done by governments because exchange rate
is seen as important to the national economy (e.g.,
export sector, financial stability, or the price of critical
imports).

Probably why Japan did it up until 2004 and why China does it
today.
Classification of Exchange Rate
Regimes

Pegged Currency Regime




Ultimate management by governments.
Under this regime, governments directly link (i.e., peg)
their currency’s rate to another currency.
Occurs when governments are reluctant to let market
forces determine rate.
Exchange rate seen as essential to country’s
economic development and or trade relationships.


Stable rate is a way of controlling inflation (cost of imports) or
business activity (exports) or foreign direct investment.
Important to Hong Kong today.
Examples of Currencies by Regime



Floating Rate Currencies:
 U.S. dollar (USD, 1973), Canadian dollar (CAD, 1970), Euro
(EUR, 1999), British pound (GPB, 1973), yen (JPY, 1973),
Australian dollar (AUD, 1985), New Zealand dollar (NZD, 1985),
Thai baht (THB, 1997), South Korean Won (KRW, 1997),
Argentina Peso (ARS, 2002), Malaysian ringgit (MYR, 2005).
Managed Rate Currencies:
 Singapore dollar (SGD), Egyptian pound (EGP), Israel shekel
(ILS), Indian rupee (INR), Chinese Yuan (CNY, since July 2005)
Pegged Rate Currencies (to the U.S. dollar or market basket)
 Hong Kong dollar, since 1983 (7.8HKD = 1USD), Saudi Arabia
riyal (3.75SAR = 1USD), Oman rial (0.385OMR = 1USD)

For a further listing, see inside cover of text book.

Note: “Limited flexibility” is really the same as “managed rate.”
Note: For list of currency designations see:
http://www.xe.com/symbols.htm#list

Simplified Model of Floating Exchange
Rates (i.e., Market Determined Rates)

The market “equilibrium” spot exchange rate at any
point in time can be represented by the point at which
the demand for and supply of a particular foreign
currency produces a market clearing price, or:
Supply (of a certain FX)
Price
(FX
Rate)
Demand (for a certain FX)
Quantity of FX
Simplified Model: Strengthening FX


Any situation that increases the demand (d to d’) for a
given currency will exert upward pressure on that
currency’s exchange rate (price).
Any situation that decreases the supply (s to s’) of a
given currency will exert upward pressure on that
currency’s exchange rate (price).
s
s’
p
p
d
q
d’
d
q
s
Simplified Model: Weakening FX

Any situation that decreases the demand (d to d’) for a
given currency will exert downward pressure on that
currency’s exchange rate (price).

Any situation that increases the supply (s to s’) of a
given currency will exert downward pressure on that
currency’s exchange rate (price).
s
s
p
s’
p
d’ d
q
d
q
Factors That Affect the Equilibrium
Exchange Rate: Floating Rate Regime




Relative rates of (short-term) interest.
 Affects the demand for financial assets (high interest rate
currencies).
 Carry trade strategies affect the supply of currencies (low interest
rate currencies) and the demand for currencies (high interest rate
currencies)
Relative rates of inflation.
 Affects the demand for real (goods) and financial assets; hence
the demand for and supply of currencies
Relative economic growth rates.
 Affects longer term investment flows in real capital assets (FDI)
and financial assets (stocks and bonds).
Relative political and economic risk.
 Markets prefer less riskier assets and less risky countries.
 “Safe haven” phenomenon.
Issues of Floating Currencies

Presents the greatest ongoing risk for global
firms. Why?



What are the implications of long term trend
changes for global companies?


Since it is difficult to predict changes in demand and
supply, it then becomes:
Difficult to predict their long term trends (and changes
in trends), intermediate moves about the trend, and
shorter term movements.
Complicates the long term FDI location decision
(impact on costs and revenues in home currency).
What are the implications of intermediate moves?

Complicates the pricing (invoicing) decision.
Issues of Floating Currencies

Data also show that these currencies are
potentially very volatile over the short term (e.g.,
week to week, day to day basis).


Again, complicates doing business on an ongoing
basis for currency dealers, banks, and any entity
involved in an ongoing pattern of foreign exchange
transactions: exporters, importers.
Conclusion: global firms need to pay close
attention to their floating currency exposures
and utilize appropriate risk management tools.

Examples (charts) which follow will focus on short
term (daily volatility comparisons).
Short Term Daily Volatility of the
British Pound: The last 91 days
Managed Currencies (Dirty Float)

Under this regime, governments manage their
currency to offset (i.e., counteract) market forces.


Exchange rate management may occur on



They do this when market demand factors or supply factors
are seen as creating undesirable exchange rate moves.
a daily basis (e.g., China) or
only when governments feel conditions warrant.
Management involves either



intervention action (buying or selling currencies) or
interest rate adjustments (to make the currency more or
less attractive).
See Appendix 3 for a discussion of these two approaches
to managing a currency
Who Manages and Why?

Today, currency management is likely to be done by
the developing and emerging countries of the world.


Recall, the major countries have stopped managing their
currencies (Japan in 2004).
Why do many developing and emerging
countries still manage their currencies?





What is the potential issue of a weak currency for them?
Concern of the Government is that the price of imported
goods will rise; may cause (or intensify) domestic inflation.
What is the potential issue of a strong currency?
Concern of Government is that its exports will become too
costly overseas and they may lose overseas market share.
In addition, the slow down in exports may reduce domestic
economic growth and result in higher unemployment and a
recession.
Managed Currencies

Over the long term, managed currencies are
somewhat risky for global firms, but not as risky as
floating currencies.


Reason: since these currency moves are being “managed”
their trend moves are likely to be more gradual than for
currencies under floating rate regimes.
However, these currencies are still subject to trend
moves and trend changes (similar to floating rate
currencies).


So, global companies need to assess currency exposures
and risk, over the intermediate term and long term.
Trend changes will affect their FDI positions and longer
term export and import situations
Managed Currencies

Over the short term, these currencies are not likely
to be as volatile as floating currencies.


Reason: Government management is aimed at countering
short term volatility (more so than trends or trend changes).
 Thus daily and weekly changes are not potentially as
great as with floating rate currencies.
 Thus, there is some risk here, but not potentially as
great as with a floating rate regime.
Potential risk for global companies:


If governments are managing their currencies within ranges
which markets feel are inappropriate, these currencies may
come under attack.
Successful attacks can quickly alter a currency’s exchange
rate.
 Example: British pound was managed in the ERM until a
speculative attack drove it out in 1992.
Observed Short Term Volatility of the
Chinese Yuan: The last 91 days

Note: Trading band changed from 0.3% to 0.6% on May 18, 2007
Pegged Currency Regimes: Ultimate
Currency Management

Under a pegged currency regime, governments link their
national currency to a key international currency (usually
the U.S. dollar or some combination of currencies).

A peg is seen as a necessary condition to promote confidence in the
currency and in the country and promoting economic growth.
 May encourage foreign direct investment and long term capital
inflows. Hong Kong’s rational behind its initial (1983) peg.
 Or by pegging the currency at an undervalued currency this may
support the country’s export sector. China’s rational for its early peg.

However, there are potential costs to governments in holding
a peg.
Global companies must recognize that at some point
governments may decide that the cost of the peg is too much
and then abandon this regime.

Observed Short Term Volatility of the
Hong Kong Dollar: The last 91 days
Comparison of Volatility

British Pound, Chinese Yuan, Hong Kong Dollar
Potential Costs to Holding a Peg

If market forces push a pegged currency above
its peg (i.e., the currency becomes “too strong”
or “overvalued”) this happens because:

The market is buying the currency, then



Government management involves either selling the
pegged currency on foreign exchange markets (thus,
buying hard currency) or reducing domestic interest
rates.
Issues: If the government sells its currency this created
to potential for expansion of its domestic money supply
and hence inflationary pressures.
On the other hand, lowering domestic interest rates can
also stimulate domestic investment and economic
activity which may lead to inflationary pressures.
Potential Costs to Holding a Peg

If market forces push a pegged currency below its
peg (i.e., the currency becomes “too weak” or
“undervalued”) this happens because:



The market is selling the currency, then
Government management involves either buying the
pegged currency on foreign exchange markets (thus,
selling hard currency or raising domestic interest rates.
 Issues: Does the government want to give up its hard
currency (does it have potentially better uses for this
(e.g., buying oil or paying off international debts)
 On the other hand, raising domestic interest rates can
dampen economic activity and lead to rising
unemployment.
Note: The last two slides summarize one reason (i.e., the
costs) why major central banks have probably gotten out of
the currency management business.
Pegged Currencies

As long as the peg is maintained, this regime presents
the smallest risk to global firms; however there is the
potential for enormous risk, where:


Governments either (1) abandon the peg for another foreign
currency regime or (2) adjust to a new peg.
These changes occur either by



An orderly change adopted by the government (e.g., China).
Peg coming under successful market attack (e.g., Argentina).
These changes can have substantial impacts on the
financial situation (as well as the competitive position)
of a global firm when they do occur.

Especially if the firm did not take advanced steps to protect
itself.


Thus, Global firms must be on the alert for changes
See Appendix 4 for a discussion of China’s move away from a
peg to a managed exchange rate regime.
Argentina Peso: Pegged Currency, 1996
to December 2001
Argentina: Abandoning the Peg –
Moving to a Floating Regime: Jan 2002
Abandoning a Pegged Rate and the Currency
Weakens: RISKS for Global Firms


As noted, changes in exchange rate regimes pose
potential risks for global firms.
Using the Argentina example, discuss the following:

What do you think happened to foreign multinationals
located in and selling in Argentina after the peso
weakened?


For Example: McDonalds’ U.S. dollar profits in Argentina?
What do you think happened to foreign multinationals
exporting to Argentina after the peso weakened?

For example: Boeing ability to export airplanes to Argentina?
Abandoning a Pegged Rate and the Currency
Weakens: OPPORTUNITIES for Global
Firms


However, changes in exchange rate regimes also
offer potential opportunities for global firms.
Again, using the Argentina example:

What do you think happened to foreign multinationals
importing from Argentina after the peso weakened?


For Example: Wal-Mart’s U.S. dollar cost associated with
importing goods from Argentina?
What do you think happened to foreign multinationals
considering expanding FDI into Argentina after the peso
weakened?

For Example: The new U.S. dollar cost to Ford Motor
Company considering setting up a production facility in
Argentina?
Which Currency Regimes are Prone
to Currency Crises?
Web Sites for Foreign Exchange Rates

Intra-day quotes (and charts)


Historical Data (and charts)



University of British Columbia
http://fx.sauder.ubc.ca/
More Historical Data



http://www.fxstreet.com/
Federal Reserve Board
http://www.federalreserve.gov/releases/
Daily commentary and analysis

http://www.cnb.com/business/international/fxfiles/fxarchive/f
xarchive.asp
Appendix 1: Quoting
Currencies
Currencies can be quoted in foreign exchange
markets in one of two ways: American terms
and European terms.
The following slides provide examples of both.
Foreign Exchange Rate Quotations

There are two generally accepted ways of
quoting a currency’s foreign exchange rate.

American terms and European Terms quotes

American terms quote: The amount of U.S.
dollars per 1 unit of a foreign currency.



For Example: $1.90 per 1 British pound
Or $1.30 per 1 European euro
Or $0.78 per 1 Australian dollar
Foreign Exchange Rate Quotations

European terms quote: The amount of a foreign
currency per 1 U.S. dollar




For Example: 115 yen per 1 U.S. dollar
Or 7.8 Hong Kong dollars per 1 U.S. dollar
Or 1.54 Singapore dollars per 1 U.S. dollar
Most of the world’s major currencies are
quoted on the basis of American terms, but
the majority of the world’s currencies are
quoted on the basis of European terms.
Appendix 2: Intervention in
Foreign Exchange Markets
While the world’s major central banks have essentially
gotten out of the business of foreign exchange
intervention, some developing and emerging country
central banks still do. In addition, there is nothing
preventing the world’s major central banks from
intervening if they so desire.
Monitoring FX Intervention


Most major central banks provide timely
information regarding their intervention
activities in foreign exchange markets.
As on example see:



http://www.ny.frb.org/markets/foreignex.html
This site provides a quarterly report on both
the U.S. dollar and intervention activities on
behalf of the dollar.
Go to archives, July 30, 1998 to view
intervention activity.
Intervention by Major Central Banks



Historically, central banks of the major countries of the world did
use intervention even with their floating rate regimes.
However, they have done this in the past usually only under
“extreme” market forces circumstances.
 Intervention occurred if a situation produced exchange rate
volatility which was seen as potentially too disruptive to financial
market stability.
 For example, U.S. intervened immediately after the attempted
assassination of President Reagan on March 30, 1981.
 But, interestingly enough, did NOT around the 9/11/2001 terrorist
attack.
At the present time, it appears that the major countries have
gotten out of currency intervention.
 U.S. has been out of the intervention market for a long time (only
two interventions in the 1990s; last intervention in 1998) as has
the U.K.
 Japan recently moved away (March 2004).
Why Have the Major Central Banks
Stopped Intervening?


There are a couple of reasons why this is so:
(1) The record on central bank intervention with
regard to the major central banks of the world is
mixed at best.



See next two slides for intervention record since 1985.
(2) Intervention can be costly (see earlier lectures
slides on this subject).
(3) Not intervening is consistent with the philosophy
of many central bankers today that the markets
should function without government interference or
government manipulations and if they do, the prices
of currencies will be set efficiently and correctly.
Currency Intervention: A Mixed Record

Date
Players
Goal
Result

Sept 1985
U.S., U.K.
Weaken $
Japan, France
Germany
Success:
$ falls 18%
within year

Feb 1987
G7
Stabilize $
Failure:
$ falls 10%
within year.

Sept 1992
UK
Maintain £
in ERM
Failure:
₤ out of ERM
within days.
Currency Intervention: A Mixed
Record

Date
Players
Goal
Result

July 1995
Japan, U.S.
Halt rising ¥
Success:
¥ drops 26%
within a year.

June 1998
Japan, U.S.
Strengthen ¥
Success:
¥ rises 17%
within a year.
Appendix 3: How Do
Governments Manage their
Currencies?
Governments (or central banks) using a managed exchange
rate regime can support their currencies through two possible
policies: (1) direct intervention and (2) interest rate
adjustments. The slides that follow discuss these.
Note that when major central banks of the world were
intervening in foreign exchange markets in support of their
currencies, they selected from the same two policies.
Managed Currencies: Direct
Intervention Policy

Intervention policy when a currency becomes
“too weak”

Government will buy their currency in foreign
exchange markets


Create demand and push price up.
Intervention policy when a currency becomes
“too strong”

Government will sell their currency in foreign
exchange markets

Increase supply to bring price down.
Managed Currencies: Interest Rate
Adjustments


Some countries also use interest rate adjustments to
manage their currencies.
When a currency become “too weak:”

Governments can raise short term interest rates to attract
short term foreign capital inflows.


Higher interest rates make investments more attractive.
When a currency becomes “too strong:”

Governments can lower short term interest rates to
discourage short term foreign capital inflows.

Lower interest rates will make investments less attactive.
Empirical Findings on the Use of
Intervention by Emerging/Developing
Countries


Conclusion from studies: Many emerging/developing
countries still intervene in foreign exchange markets
to influence currency values.
A survey of emerging/developing countries showed
that:


One third intervene regularly (more than 50% of trading
days).
Most emerging/developing market central banks felt that
intervention was more effective in influencing the foreign
exchange rate over short periods of time:
 2 to three days to one week.
Appendix 4: China’s Old and
New Exchange Rate Regime
On July 21, 2005, China surprised the world by
announcing that they were moving away from a peg to
the U.S. dollar. The following slides trace the peg
period, the new exchange rate regime (which is a
managed float), and the move of the yuan since the
introduction of the new currency regime.
Appendix 4: China’s Old and
New Exchange Rate Regime
On July 21, 2005, China surprised the world by
announcing that they were moving away from a peg to
the U.S. dollar. The following slides trace the peg
period, the new exchange rate regime (which is a
managed float), and the move of the yuan since the
introduction of the new currency regime.
China’s Currency Regime: 1978 -2005


In late 1978, the Chinese government began
moving its economy from a centrally planned
system to a market-based system.
 As part of this process, in 1994, China's central
bank pegged (i.e., linked) the Chinese currency,
the yuan (also known as the renmimbi, or
"people's money“) to the U.S. dollar.
In 1994, the peg was set at 8.28 yuan to 1 U.S.
dollar.
China Moves to a Managed Float

July 21, 2005, the Chinese government
announced it was changing to a managed float
regime with an immediate adjustment of the rate to
8.11 yuan to the dollar.


This represented an immediate strengthening of the
yuan, by 2.0% against the U.S. dollar.
China’s currency regime is now a managed float against
a market basket of currencies (including the U.S. dollar,
Euro and Japanese yen – although we don’t know all the
currencies and their weights).


Chinese Government now manages the yuan within a daily
trading range of 0.03% against this basket.
The 0.03% range is established each trading day based on
the previous close.

Thus, the yuan is now allowed to gradually “move” in relation
to market forces.
Chinese Yuan Has Appreciated Since
Moving to a Managed Float