CHAPTER TEN THE DETERMINATION OF EXCHANGE RATES

OBJECTIVES
To describe the International Monetary Fund and its role in the determination of exchange rates To discuss the major exchange-rate arrangements that countries use To explain how the European Monetary System wor s and how the euro came into being as the currency of the euro !one To identify the major determinants of exchange rates To show how managers try to forecast exchange-rate mo"ements To explain how exchange-rate mo"ements influence business decisions

CHAPTER OVERVIEW
From a managerial point of "iew# it is critical to understand how exchange-rate mo"ements influence business decisions and operations$ %hapter Ten first describes the International Monetary Fund and the role it plays in exchange-rate determination$ &ext the chapter examines the "arious types of exchange-rate regimes countries may choose# as well as the role central ban s play in the currency "aluation process$ It then presents the theories of purchasing power parity# the Fisher Effect and the International Fisher Effect and discusses their contributions to the explanation of exchange-rate mo"ements$ The chapter concludes with a brief examination of the potential effects of exchange-rate fluctuations on business operations$

CHAPTER OUTLINE
OPENING CASE: El Salvador and !" U#S# Dollar [See Map 10.1] This case describes El Sal"ador's mo"e toward dollari!ation$ In ())*# El Sal"ador pegged its currency# the colon# to the +$S$ dollar$ In ,--(# the go"ernment decided to do away with the colon and adopt the dollar as the country's official currency$ This was done because of the close ties El Sal"ador had to the +$S$ economy$ .t the time of dollari!ation# o"er two-thirds of El Sal"ador's exports went to the +nited States# and /*$,0 of imports to El Sal"ador were from the +nited States In addition# o"er , million Sal"adoreans li"ing in the +nited States wired home nearly 1, billion a year to relati"es$ .fter dollari!ation# the go"ernment and companies in El Sal"ador were able to get access to cheaper interest rates due to the decreased ris of currency de"aluation$ %onsumers were also able to get lower interest rates and easier access to credit$ Ecuador also dollari!ed its economy in ,--- to control hyperinflation$ 2ollari!ation has had some negati"e effects for El Sal"ador$ The currencies of many of its neighbors ha"e de"alued (34(50 against the dollar# gi"ing those countries a competiti"e ad"antage in exporting to (((

the +nited States and other mar ets$ This has forced many companies in El Sal"ador to abandon low-end business and de"elop more ad"antages based on flexibility# 6uality# and design$ T EACHING T IPS: %arefully re"iew the 7ower7oint slides for %hapter Ten and select those you find most useful for enhancing your lecture and class discussion$ For additional "isual summaries of ey chapter points# also re"iew the figures# tables# and maps in the text$ I# INTRODUCTION .n exchange rate represents the number of units of one currency needed to ac6uire one unit of another currency$ Managers must understand how go"ernments set exchange rates and what causes them to change so they can ma e decisions that anticipate and ta e those changes into account$

II# THE INTERNATIONAL MONETAR$ FUND %IMF& In ()**# the major allied go"ernments met in 8retton 9oods# &:# to discuss postwar economic needs$ ;ne of the results was the establishment of the International Monetary Fund (IMF). Its objecti"es are to promote exchange-rate stability# to facilitate the international flow of currencies and hence the balanced growth of international trade# to establish a multilateral system of payments# and to ser"e as the lender of last resort to go"ernments$ Initially# the Bretton Woods Agreement established a system of fixed exchange rates under which each IMF member country set a par value <benchmar = for its currency based on gold and the +$S$ dollar$ 7ar "alues were later done away with when the IMF mo"ed toward greater exchange-rate flexibility$ 9hen a country joins the IMF# it contributes a certain sum of money# called a 6uota# relating to its national income# monetary reser"es# trade balance# and other economic indicators$ The 6uota then becomes part of a pool of money the IMF can draw on to lend to member countries$ It also forms the basis for the "oting power of each country# as well as the allocation of its Special 2rawing >ights$ A# IMF A''(' an)" 9hen a member country experiences economic difficulties# the IMF will negotiate loan criteria designed to help stabili!e its economy$ :owe"er# such stabili!ation measures are often unpopular with a country's citi!ens and firms and# ultimately# its go"ernment officials$ B# S*")(al Dra+(n, R(,! ' %SDR'& The help increase international reser"es# the IMF created Special Dra ing !ights (SD!s)# an international reser"e asset designed to supplement members' existing reser"es of gold and foreign exchange$ The S2> is used as the IMF's unit o" account <the unit in which the IMF eeps its records= and for IMF transactions and operations$ The "alue of the S2> is based on the weighted a"erage of four currencies$ .t the end of ,--* those weights were? the +$S$ dollar /)0# the E+>; /30# the @apanese yen (/0# and the 8ritish pound (,0$ .lthough the S2> was intended to ser"e as a substitute for gold# it has not assumed the role of either gold or the +$S$ dollar as a primary reser"e asset$ Se"eral countries do# howe"er# base the "alue of their currency on the "alue of the S2>$ C# Evol- (on o Floa (n, E.)!an," Ra " ((,

The IMF's original system was one of fixed exchange ratesA the +$S$ dollar remained constant with respect to the "alue of gold and other currencies operated within narrow bands of "alue relati"e to the dollar$ Following 7resident &ixon's suspension of the dollar's con"ertibility to gold in ()B(# the international monetary system was restructured "ia the Smithsonian Agreement# which permitted a de"aluation of the +$S$ dollar# a re"aluation of other currencies# and a widening of the exchange-rate flexibility bands$ These measures pro"ed insufficient# howe"er# and in ()B3 the #amaica Agreement eliminated the use of par "alues by abandoning gold as a reser"e asset and declaring floating rates to be acceptable$ III# EXCHANGE/RATE ARRANGEMENTS [See Table 10.1 and Map 10.2] The IMF sur"eillance and consultation programs are designed to monitor the economic policies of member nations to be sure they act openly and responsibly with respect to their exchange-rate policies$ Member countries are permitted to select and maintain their exchange-rate regimes# but they must communicate those choices to the IMF$ A# Fro0 P",,"d o Floa (n, C-rr"n)("' The IMF now recogni!es se"eral categories of exchange-rate regimes that begin with pegging <fixing= the rate for one currency to that of another <or to a bas et of currencies= under a "ery narrow range of fluctuations in "alue <e$g$# no separate legal tender# currency boards# con"entional pegs=$ The next category# pegged exchange rates within hori!ontal bands# is characteri!ed by a broader band of fluctuations than the first three$ The last four categories exhibit at least some degree of floating exchange-rate arrangements from crawling pegs to crawling bands to managed floats to independent floats$ B# T!" E-ro The creation of the Euro had its roots in the $uropean Monetary System ($MS)% begun in ()B)$ The EMS was set up as a means of creating exchangerate stability within the European %ommunity$ Members' currencies were lin ed through a parity grid$ .s the fluctuations in exchange rates narrowed# the EMS was replaced with the Exchange >ate Mechanism <E>M=$ In ()))# the $uropean Monetary &nion ($M&) came into being# creating the Euro as the common currency of all EM+ member nations$ The euro is administered by the $uropean 'entral Ban( ($'B). :a"ing a common currency eliminates exchange rate ris among member nations and greatly reduces the cost of cross border transactions$ 2espite these ad"antages# three of the original (C members of the European +nion ha"e opted not to join the euro !one$ &ew applicants to the euro !one# consisting of (- new European +nion members# must meet the following criteria to be accepted to the EM+? .nnual go"ernment deficit must not exceed / percent of D27$ Total outstanding go"ernment debt must not exceed 3- percent of D27$ >ate of inflation must remain within ($C percent of the three best performing E+ countries$ ."erage nominal long-term interest rate must be within , percent of the a"erage rate in the three countries with the lowest inflation rates$

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 Exchange rate stability must be maintained# meaning that for at least two years# the country concerned has ept within the EnormalF fluctuation margins of the European Exchange >ate Mechanism$ POINT1COUNTERPOINT: S!o-ld A2r()a D"v"lo* a Co00on C-rr"n)34 POINT: The success of the euro shows the benefits that a common currency can bring to close geographical and economic partner countries$ .frica# with deep economic and political problems# stands to benefit greatly from a common currency$ Such a mo"e would hasten economic integration leading to an increase in mar et si!e# greater economies of scale# increased trade# and lower transaction costs$ The foundation for a common currency already exists in three regional monetary unions and fi"e existing regional economic communities$ 8y combining into one large .frican economic union# these groups could form a %entral 8an and establish a common monetary policy# forcing institutions in each .frican nation to impro"e and insulating monetary policy from political pressures$ COUNTERPOINT: There is no way that the countries of .frica will e"er establish a common currency# due to a flawed and inade6uate institutional framewor $ 7olitical pressures in many .frican countries are too intense to allow the separation of monetary policy from political expediency$ %ountries in the region will be "ery reluctant# or completely unwilling# to gi"e up monetary so"ereignty$ Transportation problems within .frica also ma e it much more difficult to transfer goods within the region than it is in Europe$ The establishment of the euro in the E+ too years of wor despite a "ery fa"orable political climate# strong institutional framewor # and "ery cooperati"e relations among member states$ &one of these factors exist in .frica# ma ing the tas of de"eloping a common currency nearly unimaginable$ Further strengthening and expansion of the existing regional monetary unions is the only "iable path toward a single .frican currency in the long-term future$

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Bla)5 Mar5" ' The less flexible a country's exchange-rate system# the more li ely there will be a )lac( mar(et# i$e$# a foreign exchange mar et that lies outside the official mar et$ Black markets are underground mar ets where prices are based on supply and demandA the adoption of floating rates eliminates the need for their existence$ T!" Rol" o2 C"n ral Ban5' Each country has a central ban responsible for the policies affecting the "alue of its currency$ %entral ban s are primarily concerned with li6uidity# in order to ensure they ha"e the cash and flexibility needed to protect their countries' currencies$ Their reser"e assets are ept in three forms? gold# foreign-exchange reser"es# and IMF-related assets$ The E+>; is administered by the European %entral 8an which# although independent of all E+ institutions and go"ernments# wor s with the go"ernors of Europe's "arious central ban s to ((*

establish monetary policy and manage the exchange-rate system$ The central ban in the +nited States is the Federal >eser"e System# i$e$# the Fed# a system of (, regional ban s$ The &ew Gor Fed# representing both the Fed and the +$S$ Treasury# is responsible for inter"ening in foreign-exchange mar ets to achie"e dollar exchange-rate policy objecti"es$ Selling +$S$ dollars for foreign currency puts downward pressure on the dollar's "alueA buying +$S$ dollars for foreign currency puts upward pressure on the dollar's "alue$ The &ew Gor Fed also acts as the primary contact with other foreign central ban s$ 2epending on mar et conditions# a central ban may? coordinate its actions with other central ban s or go it alone aggressi"ely enter the mar et to change attitudes about its "iews and policies call for reassuring action to calm mar ets inter"ene to re"erse# resist# or support a mar et trend be "ery "isible or "ery discrete operate openly or indirectly through bro ers$ The Ban( "or International Settlements (BIS) in 8asel# Swit!erland# acts as the central ban ers' central ban and ser"es as a gathering place where central ban ers meet to discuss monetary cooperation$ .lthough just CC central ban s are shareholders in the 8IS# it regularly deals with some (*- central ban s worldwide$ IV# THE DETERMINATION OF EXCHANGE RATES Exchange-rate regimes are either fixed or floating# with fixed rates "arying in terms of just how fixed they are and floating rates "arying with respect to just how much they are allowed to float$ A# Floa (n, Ra " R",(0"' Floating rates regimes are those whose currencies respond to the conditions of supply and demand$ Technically# an independent floating currency is one that floats freely# unhampered by any form of go"ernment inter"ention$ $*uili)rium exchange rates are achie"ed when supply e6uals demand <see Figure (-$(=$ A# Mana,"d F(."d/Ra " R",(0"' In a managed fixed exchange-rate system# a nation's central ban inter"enes in the foreign exchange mar et in order to influence the currency's relati"e price$ To buy foreign currencies# it must ha"e sufficient reser"es on hand$ 9hen economic policies and mar et inter"ention don't wor # a country may be forced to either re"alue or de"alue its currency$ . currency that is pegged to another <or to a bas et of currencies= is usually changed on a formal basis$ In ()))# the DB group <now the D5= of industrial countries was expanded to the D,- for the purpose of including some de"eloping countries in the discussion of effecti"e exchange-rate policies$ C# P-r)!a'(n,/Po+"r Par( 3 The theory of purchasing+po er parity (,,,) states that the prices of tradable goods# when expressed in a common currency# will tend to e6uali!e across countries as a result of exchange-rate changes$ 7ut another way# the theory claims a change in the comparati"e rates of inflation in two countries necessarily causes a change in their relati"e exchange rates in order to eep prices fairly similar$ <.n interesting illustration of this theory is the H8ig Mac IndexF <see ((C

Table (-$,=$= 9hile purchasing-power parity may be a reasonably good longterm indicator of exchange-rate mo"ements# it is less accurate in the short-run because it is difficult to determine an appropriate bas et of commodities for comparison purposes# profit margins "ary according to the strength of competition# different tax rates will influence prices differently# and the theory falsely assumes no barriers to trade exist and transportation costs are !ero$ D# In "r"' ra "' .lthough inflation is the most important long-run influence on exchange rates# interest rates are also important$ 9hile the Fisher $""ect theory lin s inflation and interest rates# the International Fisher $""ect (IF$) theory lin s interest rates and exchange rates$ The Fisher Effect theory states a country's nominal interest rate r <the actual monetary interest rate earned on an in"estment= is determined by the real interest rate R <the nominal rate less inflation= and the inflation rate i as follows? <( I r= J <( I R=<( I i=$ 8ecause the real interest rate should be the same in e"ery country# the country with the higher interest rate should ha"e higher inflation$ Thus# when inflation rates are the same# in"estors will li ely place their money in countries with higher interest rates in order to get a higher real return$ The International Fisher Effect implies the currency of the country with the lower interest rate will strengthen in the future# i$e$# the interest-rate differential is an unbiased predictor of future changes in the spot exchange rate$ The country with the higher interest rate <and higher inflation= should ha"e the wea er currency$ In the short-run# howe"er# and during periods of price instability# a country that raises its interest rate is li ely to attract capital and see its currency rise in "alue due to increased demand$ E# O !"r Fa) or' (n E.)!an,"/Ra " D" "r0(na (on . ey factor affecting exchange-rate mo"ements is confidence in a country's economy and administration$ Technical factors such as the seasonal demand patterns for a gi"en currency# the release of national economic statistics and e"ents such as )K((# corporate scandals and budget deficits also exert their influence$ V# FORECASTING EXCHANGE/RATE MOVEMENTS Managers must be able to formulate at least a general idea of the timing# magnitude# and direction of exchange-rate mo"ements$ A# F-nda0"n al and T")!n()al For")a' (n, 9hile "undamental "orecasting uses trends regarding fundamental economic "ariables to predict future exchange rates# technical "orecasting uses past trends in exchange-rate mo"ements to spot future trends$ Smart managers de"elop their own exchange-rate forecasts and then use the fundamental and technical forecasts of outside experts to corroborate their analyses$ B# Fa) or' o Mon( or 9hen forecasting exchange-rate mo"ements# ey "ariables to monitor include? the institutional setting <the extent and nature of go"ernment inter"ention=

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fundamental analysis <PPP rates# balance-of-payments le"els# the le"el of foreign-exchange reser"es# macroeconomic data# fiscal and monetary policies# etc$= confidence factors critical e"ents technical analysis <mar et trends and expectations=$

VI# BUSINESS IMPLICATIONS OF EXCHANGE/RATE CHANGES Exchange-rate fluctuations can affect all areas of a company's operations$ A# Mar5" (n, D")('(on' Exchange-rate changes can affect demand for a firm's products# both at home and abroad$ For instance# the strengthening of a country's currency could create price competiti"eness problems for exportersA on the other hand# importers would fa"or that situation$ B# Prod-) (on D")('(on' Firms may choose to locate production operations in a country whose currency is wea because initial in"estment there is relati"ely inexpensi"eA it could also be a good base for exporting the firm's output$ Exchange-rate differentials contribute to this situation across industriali!ed nations# as well from industriali!ed to de"eloping nations$ C# F(nan)(al D")('(on' Exchange-rate fluctuations can affect financial decisions in the areas of sourcing funds <both debt and e6uity=# the timing and the le"el of the remittance of funds# and the reporting of financial results$ <-ranslation% transaction and economic exposure will all be considered in %hapter ,-$= LOO6ING TO THE FUTURE: C!an,(n, T(0"' W(ll Br(n, Gr"a "r E.)!an,"/Ra " Fl".(7(l( 3 The trend toward greater flexibility in exchange-rate regimes will surely extend well into the future$ The E+>; will continue to strengthen and claim mar et share from the +$S$ dollar as a prime reser"e asset# just as Europe's transition economies will progress in their mo"es toward floating exchange-rate regimes$ >egional trading relationships will also encourage Latin .merican go"ernments to mo"e still closer toward dollari!ation# or at least some form of regional monetary union$ Li ewise# the +$S$ dollar should continue to be the benchmar currency in .sia# because so many countries there <including %hina= rely on the +$S$ mar et as an export destination$ The wild card in .sia is the %hinese yuan$ %hina finally allowed the yuan to rise in ,--C# but only by a "ery small amount$ Further changes will li ely ha"e to be made in order to a"oid a major trade war with Europe and the +nited States$ .lthough one of the most widely traded currencies in the world# the @apanese yen remains specific to the @apanese economy$ The inability of the @apanese economy to reform and open up will eep the yen from wielding the same ind of influence as the dollar and the euro$

CLOSING CASE: T!" C!(n"'" $-an1To R"val-" or No o R"val-"8 T!a I' !" 9-"' (on [See Figure 10.2] ((B

This case loo s at the contro"ersial issue of re"aluing the %hinese Guan$ For many years# the %hinese currency has been pegged to the +$S$ dollar$ %ritics argue that this policy has resulted in an unfair ad"antage for %hinese manufacturers exporting product to the +$S$# and has contributed to ballooning +$S$ trade deficits$ 7ressure to re"alue# including threats of trade sanctions against %hina# has led the %hinese go"ernment to adopt a slightly more flexible policy which pegs the Guan to a bas et of currencies rather than the dollar alone$ Some in the +$S$ continue to argue that this is not sufficient# and continue to exert pressure toward a policy of further re"aluation$ %hinese leaders feel that increasing the "alue of the yuan relati"e to the dollar would contribute to economic and political instability in %hina$ 9-"' (on' 1. Evaluate the four choices that hina faces in determining !hat to do !ith its currency value. "hich choice !ould you choose# and !hy$ The first option# maintaining a fixed rate# is not a "iable option in the long term$ .ny currency regime based on fixed rates has pro"en to be untenable in the long-term$ There are too many pressures exerted on a currency due to differences in inflation# economic growth# and supply and demand for the currency to maintain fixed rates for long$ The fourth option# to mo"e to a freely floating regime# is far too ris y and would ne"er be seriously considered by the %hinese go"ernment$ 8oth of the remaining options# widening the trading band against the dollar or pegging the yuan to a bas et of currencies# would help to relie"e some of the pressure in trade relations between %hina and its trading partners$ The plan to peg the yuan to a bas et of currencies# howe"er# ma es the most sense$ This plan would pro"ide more flexibility and balance with all of %hina's trading partners# not just the +nited States$ In fact# %hina adopted this plan in @uly of ,--C# pegging the yuan to a bas et of currencies including the @apanese yen# euro# +$S$ dollar# South Morean wan# 8ritish pound# Thai baht# and >ussian ruble$ &n 'uly %(# %))*# hina revalued the yuan. +o! much !as the yuan revalued against the dollar and the euro$ ,ou can get the historical rate before and after the revaluation from http-..!!!.oanda.com.convert.fxhistory. "hich of the four options listed above !as chosen# and do you think it !ill be successful$ 8efore the re"aluation# the yuan was trading at 5$,53C$ .fter the re"aluation# the yuan traded at 5$(,((# a decrease of $(3C* yuanKdollar or just under , percent$ %hina chose to adopt the plan to peg the yuan to a bas et of currencies$ This action resulted in a "ery minor change in the "alue of the yuan$ ;"er time# the change could become more significant but is li ely to be mostly symbolic$ 2ue to the huge pressures to maintain economic and employment growth in %hina# it is unli ely that the %hinese go"ernment will e"er adopt a policy that could result in a significant decrease in exports to the +nited States# Europe# and other countries$ The success of the plan# then# depends on whether it is judged from the %hinese perspecti"e or from that of its trading partners$ The plan is li ely to be successful from the %hinese "iewpoint# because it will relie"e some political pressure from other countries while not ha"ing any significant impact on export competiti"eness$ ((5

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/ssume that you are a hinese exporter. "ould you prefer a hinese export tariff on selected garment and textile exports as a !ay to relieve pressure against the yuan or a revaluation of the currency$ "hy$ If I were a textile exporter# I would prefer a re"aluation of the currency to a selecti"e tariff that would target only textile producers$ This is because a broad de"aluation would li ely result in only minor strengthening of the yuan while a targeted export tariff would result in a much greater loss of competiti"eness$ If I were any other type of %hinese exporter# I would prefer the textile export tariff$ It would ha"e "ery little impact on my business but would reduce political pressure from foreign go"ernments and lower the li elihood of future re"aluations$ 1o you think the 'uly %))* revaluation !ill hurt you as a hinese exporter$ "hy or !hy not$ Since the impact of the re"aluation was a strengthening of less two percent# the re"aluation will not hurt me much$ I will li ely still ha"e a significant ad"antage in pricing o"er many foreign competitors

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WEB CONNECTION T"a)!(n, T(*: Nisit .prenhall.com.daniels for additional information and lin s relating to the topics presented in %hapter Ten$ 8e sure to refer your students to the online study guide# as well as the Internet exercises for %hapter Ten$ $

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OOOOOOOOOOOOOOOOOOOOOOOOO CHAPTER TERMINOLOG$: International Monetary Fund# p$/*/ 8retton 9oods .greement# p$/*/ par "alue# p$/*/ Special 2rawing >ight <S2>=# p$/** unit of account# p$/** Smithsonian .greement# p$/*C @amaica .greement# p$/*C pegging# p$/*C pegged exchange rate# p$ /*3 European Monetary System <EMS=# p$/*B European Monetary +nion <EM+=# p$/*B European %entral 8an <E%8=# p$/*5 blac mar et# p$/C( +$%$ 8an for International Settlements <8IS=# p$ /C/ E6uilibrium Exchange >ate# p$ /C* purchasing-power parity <777=# p$ /CC Fisher Effect# p$ /C5 International Fisher Effect <IFE=# p$ /C5 fundamental forecasting# p$ /C) technical forecasting# p$ /C) OOOOOOOOOOOOOOOOOOOOOOOOO

ADDITIONAL EXERCISES: E.)!an,"/Ra " D" "r0(na (on $xercise /0./. In the early ())-s# the %anadian and +$S$ dollars were close to par$ .t the end of @une ,--/# the %anadian dollar was worth about +S 1-$B/B*$ 8y March ,--3# the %anadian dollar was worth about +S 1$53/C$ .s students to discuss the reasons they belie"e the %anadian dollar lost so much ground against its .merican counterpart between ())- and ,--/$ 8e sure they raise factors such as the implementation of the &orth .merican Free Trade .greement and the separatist mo"ement in Puebec$ &ow# as them why the %anadian dollar strengthened against the +$S$ dollar from ,--/ to ,--3$ Finally# note the importance of +$S$ trade to the %anadian economy and as students if they thin %anada should consider H.mericani!ingF <pegging= its dollar to its neighbor's$ 9hy or why notQ $xercise /0.1. +se the 23F 2nternational Financial 4tatistics to identify countries that use the 41R as a basis for the "alue of their currencies and those that use the E+>;$ Then engage the students in a discussion as to why certain countries ha"e chosen to use the 41R while others ha"e chosen the E+>;$ In what ways are the S2> and the E+>; similarQ In what ways are they differentQ $xercise /0.2. :istorically# the International Monetary Fund has prescribed strict monetary policies and reduced go"ernment spending for de"eloping countries that sought aid in dealing with currency crises$ .s students to debate the wisdom of the IMF's approach$ 2o they belie"e it was effecti"eQ Then as the students to suggest ways in which the IMF might change its approach in the future$ 8e sure they consider the implications of their suggestions for international businesses$ $xercise /0.3. :a"e students loo up 8ig Mac prices in Table (-$,$ 9hich is the most expensi"e country in which to buy a 8ig MacQ 9hich is the least expensi"eQ 9hat factors other than currency o"er"aluation or under"aluation might contribute to

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these differencesQ 8ased on the theory of purchasing power parity# what is li ely to happen to these currencies against the dollar in the next few yearsQ

(,(