INTERNATIONAL
FINANCIAL
MANAGEMENT
EUN / RESNICK
Second Edition
2Chapter TwoThe International Monetary System
Chapter Objective:
This chapter serves to introduce the student to the
institutional framework within which:
?International payments are made.
?The movement of capital is accommodated.
?Exchange rates are determined,
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? Evolution of the International Monetary System
? Current Exchange Rate Arrangements
? European Monetary System
? Euro and the European Monetary Union
? The Mexican Peso Crisis
? The Asian Currency Crisis
? Fixed versus Flexible Exchange Rate Regimes
Chapter Two Outline
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Evolution of the
International Monetary System
? Bimetallism,Before 1875
? Classical Gold Standard,1875-1914
? Interwar Period,1915-1944
? Bretton Woods System,1945-1972
? The Flexible Exchange Rate Regime,1973-
Present
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Bimetallism,Before 1875
? A,double standard” in the sense that both gold
and silver were used as money.
? Some countries were on the gold standard,some
on the silver standard,some on both.
? Both gold and silver were used as international
means of payment and the exchange rates among
currencies were determined by either their gold or
silver contents,
? Gresham’s Law implied that it would be the least
valuable metal that would tend to circulate.
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Classical Gold Standard,
1875-1914
? During this period in most major countries:
? Gold alone was assured of unrestricted coinage
? There was two-way convertibility between gold and
national currencies at a stable ratio.
? Gold could be freely exported or imported.
? The exchange rate between two country’s
currencies would be determined by their relative
gold contents.
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For example,if the dollar is pegged to gold at
U.S.$30 = 1 ounce of gold,and the British pound
is pegged to gold at £6 = 1 ounce of gold,it must
be the case that the exchange rate is determined
by the relative gold contents:
Classical Gold Standard,
1875-1914
$30 = £6
$5 = £1
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Classical Gold Standard,
1875-1914
? Highly stable exchange rates under the classical
gold standard provided an environment that was
conducive to international trade and investment.
? Misalignment of exchange rates and international
imbalances of payment were automatically
corrected by the price-specie-flow mechanism.
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Classical Gold Standard,
1875-1914
? There are shortcomings:
? The supply of newly minted gold is so restricted that
the growth of world trade and investment can be
hampered for the lack of sufficient monetary reserves.
? Even if the world returned to a gold standard,any
national government could abandon the standard.
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Interwar Period,1915-1944
? Exchange rates fluctuated as countries widely
used,predatory” depreciations of their currencies
as a means of gaining advantage in the world
export market.
? Attempts were made to restore the gold standard,
but participants lacked the political will to
“follow the rules of the game”.
? The result for international trade and investment
was profoundly detrimental.
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Bretton Woods System,
1945-1972
? Named for a 1944 meeting of 44 nations at
Bretton Woods,New Hampshire.
? The purpose was to design a postwar international
monetary system.
? The goal was exchange rate stability without the
gold standard.
? The result was the creation of the IMF and the
World Bank.
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Bretton Woods System,
1945-1972
? Under the Bretton Woods system,the U.S,dollar
was pegged to gold at $35 per ounce and other
currencies were pegged to the U.S,dollar.
? Each country was responsible for maintaining its
exchange rate within ± 1% of the adopted par
value by buying or selling foreign reserves as
necessary.
? The Bretton Woods system was a dollar-based
gold exchange standard.
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The Flexible Exchange Rate Regime,
1973-Present.
? Flexible exchange rates were declared acceptable
to the IMF members.
? Central banks were allowed to intervene in the
exchange rate markets to iron out unwarranted
volatilities.
? Gold was abandoned as an international reserve
asset.
? Non-oil-exporting countries and less-developed
countries were given greater access to IMF funds.
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Current Exchange Rate Arrangements
? Free Float
? The largest number of countries,about 48,allow market forces to
determine their currency’s value.
? Managed Float
? About 25 countries combine government intervention with market
forces to set exchange rates.
? Pegged to another currency
? Such as the U.S,dollar or euro (through franc or mark).
? No national currency
? Some countries do not bother printing their own,they just use the
U.S,dollar,For example,Ecuador has recently dollarized.
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European Monetary System
? Eleven European countries maintain exchange
rates among their currencies within narrow bands,
and jointly float against outside currencies.
? Objectives:
? To establish a zone of monetary stability in Europe.
? To coordinate exchange rate policies vis-à-vis non-
European currencies.
? To pave the way for the European Monetary Union.
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The Euro
? What is the euro?
? When will the new European currency become a
reality?
? What value do various national currencies have in
euro?
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What Is the Euro?
? The euro is the single currency of the European
Monetary Union which was adopted by 11
Member States on 1 January 1999,
? These member states are,Belgium,Germany,
Spain,France,Ireland,Italy,Luxemburg,
Finland,Austria,Portugal and the Netherlands.
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EURO CONVERSION RATES
1 Euro is Equal to:
40.3399 BEF Belgian franc
1.95583 DEM German mark
166.386 ESP Spanish peseta
6.55957 FRF French franc
.787564 IEP Irish punt
1936.27 ITL Italian lira
40.3399 LUF Luxembourg franc
2.20371 NLG Dutch gilder
13.7603 ATS Austrian schilling
200.482 PTE Portuguese escudo
5.94573 FIM Finnish markka
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What is the subdivision of the euro?
? During the transitional period up to 31 December
2001,the national currencies of the member states
(Lira,Deutsche Mark,Peseta,Franc.,, ) will be
"non-decimal" subdivisions of the euro,
? The euro itself is divided into 100 cents,
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What is the official sign of the euro?
It was inspired by the Greek letter epsilon,in reference to the
cradle of European civilization and to the first letter of the
word 'Europe',
? The sign for the new single currency looks like an
“E” with two clearly marked,horizontal parallel
lines across it,
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What are the different denominations
of the euro notes and coins?
? There will be 7 euro notes and 8 euro coins,
? The notes will be,500,200,100,50,20,10,and
5 euro,
? The coins will be,2 euro,1 euro,50 euro cent,20
euro cent,10,euro cent,5 euro cent,2 euro cent,
and 1 euro cent,
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How will the euro affect contracts
denominated in national currency?
? All insurance and other legal contracts will continue in
force with the substitution of amounts denominated in
national currencies with their equivalents in euro,
? Euro values will be calculated according to the fixed
conversion rates with the national currency unit adopted
on 1 January 1999.
? Generally,the conversion to the euro will take place on 1
January 2002,unless both parties to the contract agree to
do so beforehand,
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The Mexican Peso Crisis
? On 20 December,1994,the Mexican government
announced a plan to devalue the peso against the
dollar by 14 percent.
? This decision changed currency trader’s
expectations about the future value of the peso.
? They stampeded for the exits,
? In their rush to get out the peso fell by as much as
40 percent.
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The Mexican Peso Crisis
? The Mexican Peso crisis is unique in that it
represents the first serious international financial
crisis touched off by cross-border flight of
portfolio capital.
? Two lessons emerge:
? It is essential to have a multinational safety net in place
to safeguard the world financial system from such
crises.
? An influx of foreign capital can lead to an overvaluation
in the first place.
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The Asian Currency Crisis
? The Asian currency crisis turned out to be far
more serious than the Mexican peso crisis in
terms of the extent of the contagion and the
severity of the resultant economic and social
costs.
? Many firms with foreign currency bonds were
forced into bankruptcy.
? The region experienced a deep,widespread
recession.
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Currency Crisis Explanations
? In theory,a currency’s value mirrors the fundamental
strength of its underlying economy,relative to other
economies,In the long run.
? In the short run,currency trader’s expectations play a
much more important role.
? In today’s environment,traders and lenders,using the
most modern communications,act by fight-or-flight
instincts,For example,if they expect others are about to
sell Brazilian reals for U.S,dollars,they want to,get to
the exits first”,
? Thus,fears of depreciation become self-fulfilling
prophecies.
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Fixed versus Flexible
Exchange Rate Regimes
? Arguments in favor of flexible exchange rates:
? Easier external adjustments.
? National policy autonomy.
? Arguments against flexible exchange rates:
? Exchange rate uncertainty may hamper international
trade.
? No safeguards to prevent crises.
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End Chapter Two