This chapter covers:

5 •Historical and
present uses of gold
•Developments
shaping the world

Understanding the monetary system

•Balance of payments
International •Purchasing power

Monetary System parity theory

•Major foreign
currency markets
•Currency conflict and
SDR
•The euro

International Business
by Ball, McCulloch, Frantz,
Geringer, and Minor
McGraw-Hill/Irwin Copyright © 2006 The McGraw-Hill Companies, Inc. All rights reserved.
 Chapter Objectives
 Understand the historical and present uses and attractiveness
of gold
 Explain the developments shaping the world monetary system
 Explain activities of the International Monetary Fund
 Explain the purposes of the World Bank and its IFC
 Understand balance of payments
 Compare relative strengths and weaknesses of currencies
 Identify the major foreign exchange markets of the world
 Understand changes being caused in the FX markets
 Understand the central reserve asset/national conflict of the
U.S. dollar
 Discuss the euro and its present state of acceptance by EU
countries
5-2
 Convertible Currencies
 Currencies readily
convertible in the
market
 Also called “hard”
currencies
 Most developing
countries are not
convertible

5-3
Understand the historical and present uses and attractiveness
of gold
Gold Standard History
 From about 120 to present price of gold generally up
 Rise in value interrupted around 1980
 Early 2002 gold regained safe haven status
 Most trading and industrial countries adopted the
gold standard
 Each country set a certain number of units of its
currency per ounce of gold
 Comparison of the numbers of units from country to
country known as exchange rate
 Gold standard ended during World War I
5-4
 Explain the developments shaping the world monetary system
Bretton Woods and the Gold Exchange Standard

 In 1944, representative of the major Allied powers

met at Bretton Woods, New Hampshire to plan for
the future.
 General consensus
 Stable exchange rates were desirable.
 Floating or fluctuating exchange rates had proved
unsatisfactory.
 The government controls of trade, exchange, and
production, that had developed through WWII were
wasteful and discriminatory.

5-5
 Bretton Woods and the Gold Exchange
Standard
 To achieve its goals, the Bretton Woods Conference
established
 The International Monetary Fund (IMF)
 The IMF Articles of Agreement entered into force in
December 1945.
 From 1945-1971, IMF agreement was the basis of the
international monetary system.
 The US$ was agreed to be the only central reserve asset.
 An ounce of gold was agreed to be worth US$35

5-6
 Explain activities of the International Monetary Fund

International Monetary Fund

 Abandoned objective of fixed exchange rate 1970s
 Exercises “firm surveillance” over exchange rate
policies of members
 Board of governors regularly examine policies and
performance
 Board reviews economic outlook and exchange rate
developments
 Coordinates with the World Bank to correct
economic problems

5-7
 Explain the purposes of the World Bank
World Bank
 International Bank for Reconstruction and
Development (IBRD)
 Consists of
 International Finance Corporation (IFC)
 International Development Association (IDA)
 Multilateral Investment Guarantee Agency (MIGA)
 International Center for Settlement of Investment
Disputes (ICSID)
 Other Multilateral Development Banks
 African, Asian, European, Inter-American
5-8
 Bank for International Settlements
 Located in Basel, Switzerland
 Functions

 Forum for international monetary cooperation

 Center for research

 Banker for central banks

 Agent with regard to various international

financial arrangements
 Chair of U.S. Federal Reserve represents U.S.

5-9
 Understand balance of payments
Balance of Payments
 A country’s BOP is a very important indicator of
what may happen to the country’s economy.
 If country’s BOP is in deficit
 Inflation is often the cause.
 A company doing business there must adjust its
pricing, inventory, accounting, and other practices to
inflationary conditions.
 The government may take measures to deal with
inflation and the deficit.

5-10
 Balance of Payments
 Actions the government may
take to deal with inflation
and the BOP deficit include
 Market measures

 Deflating the economy

 Devaluing the
currency
 Nonmarket measures

 Currency controls

 Tariffs

 Quotas

5-11
 International Transactions
 Debits involve payments by  Credits involve payments by
domestic residents to foreign residents to
foreign residents domestic residents
 Dividend, interest and
debt repayment services  The BOP is presented as
double-entry accounting
 Merchandise imports
statement
 Transportation services
 Foreign investments
 Gifts to foreign residents
 Total credits and
debits are always
 Imports of gold
equal.

5-12
 BOP Accounts
 Current Account  Official Reserves
 Goods or merchandise Account
 Gold imports and
 Services
exports
 Unilateral transfers
 Increases or
 Capital Account
decreases in foreign
 Direct investments exchange held by
 Portfolio investments government
 Decreases or
 Short-term capital
increases in
flows
liabilities to foreign
5-13
central banks
 Balance of Payment Deficit
 Temporary BOP deficit
 Can be corrected by the
country’s monetary
policies or fiscal policies.
 May be corrected by
short-term IMF loans and
advice.
 Fundamental BOP deficit too
severe to be repaired by
monetary or fiscal policies
 IMF permits countries’
currencies to be devalued
5-14
 Gold Exchange Standard
 Gold and dollars go abroad
 From 1958 through 1971, United States cumulative
deficit was $56 billion.
 Deficit was financed partly by use of the U.S. gold
reserves.
 Deficit partly financed by incurring liabilities to foreign
central banks.
 The gold standard ends
 By 1971, many more dollars were in the hands of
foreign central banks than the gold held by the U.S.
Treasury could cover.
5-15
 Currency Exchange Rates
 Two attempts made to set fixed currency exchange
rates
 December 1971 and February 1973
 Speculators felt banks had pegged rates incorrectly

 March 1973 floating currency exchange rates

developed
 Clean float depends on competition with no
government intervention
 Dirty float governments intervene and manage
currency market to smooth irregularities
5-16
 Group of Seven (G7)
 Plaza Accord
 Result of concern over U.S.
trade deficit
 Group of Five included

 Britain, France, Germany,

Japan, U.S.
 Met in 1985 to set the US$ at
the “right” exchange rate
 Canada and Italy added to
become G7
 Meet yearly to coordinate
economic policy
5-17
 Currency Areas
 Most currencies of developing countries are pegged (fixed)
 In value to one of the major currencies.

 To a currency basket such as the special drawing rights.

 To some specially chosen currency mix or basket.

 In Europe during the mid-1970 a currency grouping called the

“snake” was created led by German deutsche mark
 The snake was so called because of how it appeared on a
graph showing the member currencies floating against
nonmember currencies.
 System’s inflexibility led to ultimate demise.

5-18
 Experience with Floating
 Fears that banking and money systems would not be
able to handle amounts and directions of currency
flows were unfounded
 January 1999 new major currency, the euro, joined
the world market
 Floating exchange rates create big uncertainties for
international business managers
 Asian financial crisis in 1997 reduced Asian reliance
on U.S. economy
 Forecasting float direction includes measuring
inflation with purchasing power parity (PPP)
5-19
 Big MacCurrencies

5-20
Money Markets, Foreign Exchange
 London is the world’s largest
foreign exchange market.
 It has 30 percent share of
foreign exchange
turnover.
 New York is the second
largest foreign exchange
market.
 Asia, Tokyo, Hong Kong, and
Singapore are fighting for
foreign exchange supremacy

5-21
 Money Markets, Foreign Exchange
 Asian currencies are no longer  Most traded currency US$
thought of as exotic since their  Busiest currency trades
markets have emerged.
 The more liquid currencies
 US$ - euro first, then
include the  US$ - yen
 Singapore dollar
 US$ - British sterling
 Thai baht
 US$ - Swiss franc
 Indonesian rupiah

 Malaysian ringgit
 Hong Kong dollar
 Singapore fourth largest
currency trading center
5-22
 Euro – yen
 Virtually all Asian trade is
through the US$
 Rates not quoted in US$ are
called cross rates
 Special Drawing Rights (SDRs)
 SDRs in the future
 May be a step toward a truly international currency.
 The US$ has been the closest thing to such a currency
since gold in the pre-WWI gold standard system.
 The objective was to make the SDR the principal
reserve asset in the international monetary system.
 Value based on a basked of four currencies
 US dollar, euro, Japanese yen, British pound
 Percentage of each changes periodically
 Calculated daily by the IMF

5-23
 Uses of SDR
 The SDR’s value remains more stable than that of
any single currency.
 Holders of SDRs include
 The International Monetary Fund (IMF)
 Most of the 181 members of the IMF
 16 official institutions
 These institutions typically regional development or
banking institutions prescribed by the IMF.
 Not likely to become principal reserve asset

5-24
 European Monetary System
 European countries prefer
fixed exchange rates
 EMS created in 1979
 Replaced the snake with
a more flexible system
 European Currency Unit
(ECU) established as
bookkeeping currency
 more popular than the
SDR
 Euro has replaced ECU and
12 national currencies
 Euro is supervised by the
European Central Bank
5-25
 Transition to the Euro
 Began on January 1, 1999
Figure 5.6
 Coins and notes of 12
countries replaced
 Circulated side by side
until January 1, 2002
 Exchanged old for new at
commercial banks
 Twelve countries now called
the “eurozone”
 All under European Central
Bank

5-26
 Fast Facts on the IMF

 Current Membership: 184 countries

 Staff: approximately 2,690 from 141 countries

 Total Quotas: $316 billion (as of 12/31/03)

 Loans Outstanding: $107 billion to 87 countries, of which $10

billion to 60 on concessional terms (as of 12/31/03)

 Technical Assistance provided: 356 person years during

FY2003

 Surveillance Consultations concluded: 136 countries during

FY2003, of which 96 voluntarily published their staff reports
IMF Loans
Canada’s BOP Data
 Country GDP - per capita
 Afghanistan purchasing power parity - $700 (2003 est.)
 Albania purchasing power parity - $4,500 (2003 est.)
 Algeria purchasing power parity - $5,900 (2003 est.)
 American Samoa purchasing power parity - $8,000 (2000 est.)
Andorra purchasing power parity - $19,000 (2000 est.)
 Angola purchasing power parity - $1,900 (2003 est.)
 Anguilla purchasing power parity - $8,600 (2001 est.)
 Antigua and Barbuda purchasing power parity - $11,000 (2002
est.)
 Argentina purchasing power parity - $11,200 (2003 est.)
Armenia purchasing power parity - $3,900 (2003 est.)
 Aruba purchasing power parity - $28,000 (2002 est.)
 Australia purchasing power parity - $28,900 (2003 est.)
 Austria purchasing power parity - $30,000 (2003 est.)
 Warning Signs of Foreign Currency
Exchange Fraud
 Stay Away From
Opportunities That Sound
Too Good to Be True
 Avoid Any Company that
Predicts or Guarantees Large
Profits
 Stay Away From Companies
That Promise Little or No
Financial Risk
 Don't Trade on Margin
Unless You Understand
What It Means
Source: www.cftc.gov
 Question Firms That Claim To
Trade in the "Interbank
Market"
 Be Wary of Sending or
Transferring Cash on the
Internet, By Mail or
Otherwise
 Currency Scams Often Target
Members of Ethnic Minorities
 Be Sure You Get the
Company's Performance
Track Record
 Don't Deal With Anyone Who
Won't Give You Their
Background
 Two Types of SDRs
 General allocations of SDRs  Special one-time allocation
 Have to be based on a
long-term global need to
supplement existing
reserve assets. General
allocations are considered
every five years, although
decisions to allocate
SDRs have been made
only twice.
Source: www.imf.org
of SDRs
 Approved by the IMF's
Board of Governors in
September 1997. Its intent is
to enable all members of the
IMF to participate in the
SDR system on an equitable
basis and correct for the fact
that countries that joined the
Fund subsequent to 1981
have never received an SDR
allocation.
 Euro Coins
 Euro coins have one common
side and one national side. They
can be used anywhere within the
euro area, regardless of the
country of issue.
 There are coins in
denominations of €2, €1, 50 cent,
20 cent, 10 cent, 5 cent, 2 cent and
1 cent. There are 100 cent to €1.
 Euro coins are also available for
Monaco, San Marino and Vatican
City (example).

Source: www.euro.gov.uk