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CHAPTER TEN
THE DETERMINATION OF EXCHANGE RATES
OBJECTIVES
10-1 Describe the International Monetary Fund and its role in determining exchange
rates
10-2 Discuss the major exchange-rate arrangements that countries use
10-3 Identify the major determinants of exchange rates
10-4 Show how managers try to forecast exchange-rate movements
10-5 Examine how exchange-rate movements influence business decisions
CHAPTER OVERVIEW
From a managerial point of view, it is critical to understand how exchange-rate
movements influence business decisions and operations. Chapter Ten first describes the
International Monetary Fund and the role it plays in exchange-rate determination. Next,
the chapter examines the various types of exchange-rate regimes countries may choose,
as well as the role central banks play in the currency valuation 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 movements.
The chapter concludes with a brief examination of the potential effects of exchange-rate
fluctuations on business operations.
CHAPTER OUTLINE
OPENING CASE: Venezuela’s Rapidly Changing Currency
[see Map 9.1]
In 2015 when inflation in the developing countries was 5.7 percent, inflation in
Venezuela was 159.1 percent, the highest in the world by far. The rapid rise in inflation
resulted in the precipitous drop of the Venezuelan bolívar fuerte (known at the VEF).
The key to the Venezuelan economy is oil. Hugo Chavez, the president of Venezuela
from 1999–2013, implemented a program of nationalism, known as chavismo, that led to
huge budget deficits and extensive external borrowing. Under Chavez, the VEF was
locked onto the U.S. dollar at a fixed rate known as a conventional peg, and it was not
allowed to freely float. Under his successor, as the oil prices plunged, Venezuela
experienced severe shortages in everything from pharmaceuticals and medical supplies
to toilet paper to diapers, which led to the creation of a thriving black market. In 2016,
three years after Chavez died, the government allowed the VEF to float against the
dollar but was managed by the government and not freely floating. Unfortunately, this
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also resulted in a black market for the currency. Riots at the end of April 2016 due to
power and water cuts and shortages in food and medical imports led to petitions to
recall President Maduro. The Crisis in Venezuela had raised the question on whether
Dollarization is the Solution. In Latin America, both El Salvador and Ecuador dropped
their currencies in favor of the dollar. After dollarization, Salvadoran companies and the
government gained access
to cheaper interest rates because the move eliminated, or at least reduced, the risk of
devaluation, thereby infusing more confidence in foreign banks to lend to the country.
I. INTRODUCTION
An exchange rate represents the number of units of one currency needed to acquire
one unit of another currency. Managers must understand how governments set
exchange rates and what causes them to change so they can make decisions that
anticipate and take those changes into account.
II. THE INTERNATIONAL MONETARY FUND
In 1944, the major allied governments met in Bretton Woods, NH, to discuss
post-war economic needs. One of the results was the establishment of the
International Monetary Fund (IMF).
A. Origin and Objectives
Twenty-nine countries initially signed the IMF agreement, and there were 187
member countries in July 2011. The IMF has four major objectives:
To ensure stability in the international monetary system
To promote international monetary cooperation and exchange-rate
stability
To facilitate balanced growth of international trade
To provide resources to help countries in balance-of-payments
difficulties or to assist with poverty reduction
1. Bretton Woods and the Principle of Par Value. The Bretton Woods
Agreement established a system of fixed exchange rates under which each
IMF member country set a par value (benchmark) for its currency based on
gold and the U.S. dollar. Par values were later done away with when the
IMF moved toward greater exchange-rate flexibility.
B. The IMF Today
1. The Quota System. When a country joins the IMF, it
contributes a certain sum of money, called a quota, relating to its national
income, monetary reserves, trade balance, and other economic indicators.
The quota then becomes part of a pool of money the IMF can draw on to
lend to member countries. At the end of 2010, the total quota held by the
IMF was SDR 476.8 billion (U.S. $750 billion). It also forms the basis for
the voting power of each country, as well as the allocation of its special
drawing rights.
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2. Special Drawing Rights (SDRs). To help increase
international reserves, the IMF created a special drawing right (SDR), an
international reserve asset designed to supplement members’ existing
reserves of gold and foreign exchange. The SDR is used as the IMF’s unit
of account (the unit in which the IMF keeps its records) and for IMF
transactions and operations. The value of the SDR is based on the weighted
average of four currencies. On January 1, 1981, the IMF began to use a
simplified basket of four currencies for determining valuation, the U.S.
dollar, the euro, the British pound, and the Japanese yen. In 2016, however,
the Chinese renminbi (or yuan) will be added to the basket. The new
weights will be 42 percent for the dollar, 31 percent for the euro, 11 percent
for the renminbi, 8 percent
for the yen, and 8 percent for the pound. The weight of the dollar remained
the same, but the weights of the other three currencies fell to make room
for the renminbi.
C. The Role of the IMF in Global Financial Crises
An important responsibility of the IMF is to monitor and assess vulnerabilities
of the economic and financial policies of member countries in relation to
domestic and global stability. Where necessary, the IMF can provide
precautionary credit lines to countries that are in distress. These loans are
short-term emergency assistance loans, and in order to receive a loan, a country
has to ensure that it will follow sound fiscal and monetary policies as
determined jointly with the IMF staff.
D. Evolution to Floating Exchange Rate
The IMF’s original system was one of fixed exchange rates; the U.S. dollar
remained constant with respect to the value of gold and other currencies
operated within narrow bands of value relative to the dollar.
1. The Smithsonian Agreement. Following President Nixon’s suspension
of the dollar’s convertibility to gold in 1971, the international monetary
system was restructured via the Smithsonian Agreement, which permitted
an 8% devaluation of the U.S. dollar, a revaluation of other currencies, and
a widening of the exchange-rate flexibility bands.
2. The Jamaica Agreement. These measures proved insufficient; however,
and in 1976 the Jamaica Agreement eliminated the use of par values by
abandoning gold as a reserve asset and permitting greater exchange-rate
flexibility.
III. EXCHANGE-RATE ARRANGEMENTS [see Table 10.1]
The IMF surveillance and consultation programs are designed to monitor the
exchange-rate 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. Some countries that use a fixed or pegged
exchange rate use an exchange-rate anchor for their monetary policy, which means
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that they buy or sell foreign exchange at given rates to maintain the value of the
currency. In addition, countries can adopt a monetary policy that uses growth in the
money supply, called the monetary aggregate anchor, a targeted rate of inflation, or
something else that they feel is important.
A. Three Choices: Hard Peg, Soft Peg, or Floating Arrangement
The IMF classifies currencies into one of three broad categories, moving from
the least to the most flexible.
B. Hard Peg
1. Dollarization is the use of the dollar with no domestic legal tender.
2. Some nations use the dollar in addition to creating domestic legal
tender. Currency boards may issue domestic currency anchored to a
foreign currency.
C. Soft Peg
1. There are several types, but a majority of countries have a conventional
peg arrangement in which a country pegs its currency to another
currency or basket of currencies and allows exchange rates to vary plus
or minus 1 percent from that value.
D. Floating Arrangement
1. Floating currencies change according to market forces but may be
subject to market intervention.
2. Free-floating currencies are subject to intervention only in exceptional
circumstances.
E. The Euro, the currency of the European Monetary System
1. The European Monetary System and the European Monetary
Union. The creation of the euro had its roots in the European Monetary
System (EMS), begun in 1979. The EMS was set up as a means of
creating exchange-rate stability within the European Community.
Members’ currencies were linked through a parity grid. As the fluctuations
in exchange rates narrowed, the EMS was replaced with the Exchange
Rate Mechanism (ERM). In 1999, the European Monetary Union (EMU)
came into being, creating the euro as the common currency of all EMU
member nations. The euro is administered by the European Central Bank
(ECB). Having a common currency eliminates exchange rate risk among
member nations and greatly reduces the cost of cross-border transactions.
Despite these advantages, three of the original 15 members of the European
Union have opted not to join the eurozone. New applicants to the eurozone
must meet the following criteria to be accepted to the EMU:
• Annual government deficit must not exceed 3 percent of GDP.
• Total outstanding government debt must not exceed 60 percent of
GDP.
• Rate of inflation must remain within 1.5 percent of the three best
performing EU countries.
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• Average nominal long-term interest rate must be within 2 percent
of the average rate in the three countries with the lowest inflation
rates.
• Exchange rate stability must be maintained, meaning that for at
least two years, the country concerned has kept within the “normal”
fluctuation margins of the European Exchange Rate Mechanism.
As of May 1, 2016, 19 members of the EU were officially in the eurozone,
two had opted out (Denmark and the U.K.), and 7 were still preparing to
join the eurozone.
2. The Euro and the Global Financial Crisis. During the financial crisis
of 2008, the euro fell because investors were pulling money out of stocks
and putting it into safe-haven currencies such as the Japanese yen and the
U.S. dollar. When the stock markets recovered, the dollar fell in value and
the euro rose. However, the weakness in European economies, especially
countries like Greece, Italy, and Spain, forced the ECB to use monetary
stimulus to attempt to boost economic growth. The hardest hit has been
Greece.
POINT—COUNTERPOINT: Should Africa Develop a Common Currency?
POINT: The success of the euro shows the benefits that a common currency can bring
to close geographical and economic partner countries. Africa, with deep economic and
political problems, stands to benefit greatly from a common currency. Such a move
would hasten economic integration leading to an increase in market size, greater
economies of scale, increased trade, and lower transaction costs. The foundation for a
common currency already exists in three regional monetary unions and five existing
regional economic communities. By combining into one large African economic union,
these groups could form a Central Bank and establish a common monetary policy,
forcing institutions in each African nation to improve and insulating monetary policy
from political pressures.
COUNTERPOINT: There is no way that the countries of Africa will ever establish a
common currency, due to a flawed and inadequate institutional framework. Political
pressures in many African countries are too intense to allow the separation of monetary
policy from political expediency. Countries in the region will be very reluctant, or
completely unwilling, to give up monetary sovereignty. Transportation problems within
Africa also make it much more difficult to transfer goods within the region than it is in
Europe. The establishment of the euro in the EU took years of work despite a very
favorable political climate, strong institutional framework, and very cooperative
relations among member states. None of these factors exist in Africa, making the task
of developing a common currency nearly unimaginable. Further strengthening and
expansion of the existing regional monetary unions is the only viable path toward a
single African currency in the long-term future.
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IV. DETERMINING EXCHANGE RATES
Exchange-rate regimes are either fixed or floating, with fixed rates varying in terms
of just how fixed they are and floating rates varying with respect to just how much
they are allowed to float.
A. Nonintervention: Currency in a Floating-Rate World
Floating-rate 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 government intervention. Equilibrium
exchange rates are achieved when supply equals demand [see Fig 10.1].
A. Intervention: Currency in a Fixed-Rate or Managed Floating-Rate
World
In a managed fixed exchange-rate system, a nation’s central bank intervenes in
the foreign-exchange market in order to influence the currency’s relative price.
To buy foreign currencies, it must have sufficient reserves on hand. When
economic policies and market intervention don’t work, a country may be forced
to either revalue or devalue its currency.
1. The Role of Central Banks
Each country has a central bank responsible for the policies affecting the value
of its currency. The central bank in the United States is the Federal Reserve
System, i.e., the Fed, a system of 12 regional banks. The New York Fed,
representing both the Fed and the U.S. Treasury, is responsible for intervening
in foreign-exchange markets to achieve dollar exchange-rate policy objectives.
The New York Fed also acts as the primary contact with other foreign central
banks. The euro is administered by the European Central Bank, which, although
independent of all EU institutions and governments, works with the governors
of Europe’s various central banks to establish monetary policy and manage the
exchange-rate system.
a. Central Bank Reserve Assets. Central bank reserve assets are kept in
three forms: gold, foreign-exchange reserves, and IMF-related assets.
Central banks are primarily concerned with liquidity, in order to ensure
they have the cash and flexibility needed to protect their countries’
currencies.
b. How Central Banks Intervene in the Market. A central bank can
intervene in currency markets in several ways. The U.S. Fed, for example,
can use foreign currencies to buy dollars when the dollar is weak, or sell
dollars for foreign currency when the dollar is strong. Central banks may
coordinate actions with other central banks, make policy statements to
influence markets, and intervene to reverse, resist, or support a market
trend.
c. Different Attitudes to Intervention. Government policies change over
time, depending on economic conditions and the attitude of the prevailing
administration concerning intervention in the foreign-exchange market.
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d. Challenges with Intervention. In general, the United States
disapproves of foreign currency intervention, based on the belief that it
is very difficult, if not impossible, for intervention to have a lasting
impact on the currency’s value.
B. Black Markets
The less flexible a country’s exchange-rate system, the more likely there will
be a black market, i.e., a foreign-exchange market that lies outside the official
market. Black markets are underground markets where prices are based on
supply and demand; the adoption of floating rates eliminates the need for their
existence.
D. Foreign Exchange Convertibility and Controls
Some countries with fixed exchange rates control access to their currencies.
Fully convertible currencies are those that the government allows both residents
and nonresidents to purchase in unlimited amounts.
1. Hard and Soft Currencies. Hard currencies are currencies that are fully
convertible. Soft (or weak) currencies are not fully convertible and tend
to be the currencies of developing nations. Most countries today have
nonresident, or external, convertibility, meaning that foreigners can convert
their currency into the local currency and can convert back into their
currency as well.
2. Controlling Convertibility. Governments sometimes place restrictions
on currencies such as licenses that are required of importers and exporters
that fix exchange rates at an official price. Some countries employ
multiple exchange rates, where different exchange rates are set for
different types of transactions, and others use advance import deposits,
which require a deposit with the central bank for as long as one year
interest-free. Governments may also limit the amount of exchange through
quality controls, which limit the amount of foreign currency that can be
used in a specific transaction.
E. Exchange Rates and Purchasing Power Parity
1. Purchasing Power Parity (PPP). The PPP exchange rate is the rate at
which the currency of one country would have to be converted into that of
another country to buy the same amount of goods and services in each
country
2. The “Big Mac Index”. An illustration of the PPP theory is the “Big Mac
index” of currencies used by The Economist each year. Since 1986, the
British periodical The Economist has used the price of a Big Mac to
estimate the exchange rate between the dollar and another currency (see
Table 10.2 for a sample of countries).
F. Exchange Rates and Interest Rates
Although inflation is the most important long-run influence on exchange rates,
interest rates are also important.
1. The Fisher Effect. The Fisher Effect is the theory that the nominal interest
rate in a country (r, the actual monetary interest rate earned on an
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investment) is determined by the real interest rate (R, the nominal rate less
inflation) and the inflation rate (i) as follows:
(1 + r) = (1 + R)(1 + i) or r = (1 + R)(1 + i) - 1
2. The International Fisher Effect. The International Fisher Effect
implies the currency of the country with the lower interest rate will
strengthen in the future.
G. Other Factors in Exchange-Rate Determination
1. Confidence: Flight to Risk Versus Flight to Safety. Various other factors
can affect currency values. One not to be dismissed lightly is confidence:
In times of turmoil, people prefer to hold currencies that are considered
safe. On the other hand, sometimes the appetite for risk (which implies
greater returns) is more important than safety.
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 movements.
A. Fundamental and Technical Forecasting
While fundamental forecasting uses trends regarding fundamental economic
variables to predict future exchange rates, technical forecasting uses past
trends in exchange-rate movements to spot future trends.
1. Dealing with Biases. Smart managers develop their own exchange-rate
forecasts and then use the fundamental and technical forecasts of outside
experts to corroborate their analyses.
2. Timing, Direction, and Magnitude. Forecasting includes predicting the
timing, direction, and magnitude of exchange-rate movements. For
countries whose currencies are not freely floating, the timing is often a
political decision, and not so easy to predict. Predicting the direction is
easier than predicting the magnitude. The problem with attempting to
predict the value of a freely floating currency is that you never really know
what will happen to its value.
B. Fundamental Factors to Monitor
When forecasting exchange-rate movements, key variables to monitor include:
Institutional Setting
Fundamental Analyses
Confidence Factors
Circumstances
Technical Analyses
VI. BUSINESS IMPLICATIONS OF EXCHANGE-RATE CHANGES
Exchange-rate fluctuations can affect all areas of a company’s operations.
A. Marketing Decisions
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
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price competitiveness problems for exporters; on the other hand, importers
would favor that situation.
B. Production Decisions
Firms may choose to locate production operations in a country whose currency
is weak because initial investment there is relatively inexpensive; it could also
be a good base for exporting the firm’s output. Exchange-rate differentials
contribute to this situation across industrialized nations, as well from
industrialized to developing nations.
C. Financial Decisions
Exchange rates can influence the sourcing of financial resources, the
cross-border remittance of funds, and the reporting of financial results.
LOOKING TO THE FUTURE:
Changes in the Relative Strength of Global Currencies
Although the U.S. dollar is the main reserve asset used by central banks, the Chinese
RMB is gaining steam. However, the three key determinants of the reserve status of a
currency are size, stability, and liquidity. The RMB suffers in all three areas: size
(although the Chinese economy is formidable), stability, and liquidity. The financial
institutions in China are still very weak, even though they are improving. Although the
RMB became part of the SDR basket in 2016 and thus eligible to be a reserve asset, it
has been struggling. In addition, the RMB is not a freely floating currency.
The euro is a strong currency and represents the second-largest amount of allocated
reserves behind the dollar. The major challenge of the euro is that its member countries
are fragmented with numerous internal problems, such as Greek debt. In addition,
Britain, one of the strongest countries in the EU, never adopted the Euro, and in 2016 it
voted to leave the EU.
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