978-0134200057 Chapter 10 Lecture Notes

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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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