International Financial Management chapter 5 by PG Apte

International Financial Management P G Apte

P.G.Apte International Financial Management

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5.1 Introduction • The International Monetary System facilitates transfer of funds between parties, conversion of national currencies into one another, acquisition and liquidation of financial assets, and international credit creation • An important constituent of the global financial system


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5.1 Introduction (contd.) The relevant aspects of the system • Exchange rate regimes, current and past

• International liquidity • The International Monetary Fund • The adjustment process i.e. how does the system facilitate the process of coping with payments imbalances between trading nations • Currency blocks and unions such as the EMU P.G.Apte International Financial Management

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5.2 Exchange Rate Regimes • Exchange Rate Regimes – The IMF classifies member countries into eight categories • Currency Union (No separate legal tender) • Currency Board Arrangement • Conventional Fixed Peg Arrangements • Pegged Exchange Rates within Horizontal Bands • Crawling Peg • Crawling bands • Managed float • Independent float P.G.Apte International Financial Management

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5.2 Exchange Rate Regimes: A Historical Perspective

•The Gold Standard – Gold Specie Standard; Gold Bullion Standard Gold Exchange Standard Mint Parity: The exchange rate between any pair of currencies will be determined by their respective exchange rates against gold The gold standard regime imposes very rigid discipline on the policy makers : The money supply in the country must be tied to the amount of gold the monetary authorities have in reserve. When a country loses gold, money supply must contract . Domestic economy governed by external sector .


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5.2 Exchange Rate Regimes: History • The Bretton Woods System

The exchange rate regime that was put in place after WWII can be characterized as Gold Exchange Standard • The US government undertook to convert the US dollar freely into gold at a fixed parity of $35 per ounce • Other member countries of the IMF agreed to fix the parities of their currencies with the dollar with variation within 1% on either side of the central parity being permissible It was an Adjustable Peg system. Central parity could be changed in the face of “fundamental disequilibrium”. P.G.Apte International Financial Management

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5.2 Exchange Rate Regimes: History – In return for undertaking this obligation, the member countries were entitled to borrow from the IMF to carry out their intervention in the currency markets – Whenever the exchange rate tended to move out of the  1% band, the central bank had to sell or buy the foreign currency to bring it back within the band. Devaluation/upvaluation when disequilibrium persisted – Fundamental Disequilibrium


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5.2 Exchange Rate Regimes: History Intervention operations affect the domestic money supply and then the price level, GNP etc. These effects may have an automatic corrective effect – Central bank sells forex, money supply contracts, price level reduces, GNP reduces, imports decline, the pressure on home currency reduces. Central bank can “sterilize” these effects.


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5.2 Exchange Rate Regimes: History – This system could work as long as other countries had confidence in the stability of the US dollar and in the ability of the US treasury to convert dollars into gold on demand at the specified conversion rate – The system came under pressure and ultimately broke down when this confidence was shaken due to various political and some economic factors starting in mid 1960s. – Abandoned in 1973 after some attempts to fix it and revive it. – Major currencies started floating in early 1973.


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5.2 Exchange Rate Regimes Is there an “ideal” regime? • Fixed rates provide a policy anchor & discipline. • Freely floating rates provide monetary policy freedom. • Economists are reconsidering the merits of a floating exchange rate and monetary policy independence which it apparently bestows on a country. Hard pegs have their problems. • It appears therefore that there is no such thing as "the ideal" exchange rate regime for all countries or even for a given country at all times • Crawling pegs, crawling bands, managed float etc. are attempts to get the best of both the worlds


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5.2 Exchange Rate Regimes – One school of thought feels there will be only two types of exchange rate regimes •Truly fixed rate arrangements •Truly market determined, floating rates

–The “impossible trinity” : A country can achieve any two of the following three policy goals but not all three •A stable exchange rate •Monetary policy independence •Financial market integration with rest of the world


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THE IMPOSSIBLE TRINITY Full Capital Controls

Monetary Policy

Stable Exchange

Independence

Rate

Floating Rate

Integration


Currency Union

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5.3 The International Monetary Fund (IMF) • The role of IMF – Framework of the Articles of Agreement adopted at Bretton Woods in1944 • Increasing international monetary cooperation • Promoting the growth of trade • Promoting exchange rate stability • Establishing a system of multilateral payments, eliminating exchange restrictions which hamper the growth of world trade and encouraging progress towards convertibility of member currencies • Building a reserve base


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5.3 The International Monetary Fund (IMF) • Funding facilities – Operation of the adjustable peg requires a country to intervene in the foreign exchange markets to support its exchange rate when it threatens to move out of the permissible band – Reserve Tranche & Credit Tranche. Their conditionalities – Other funding facilities such as ESAF, HIPC initiative etc. and their implications for recipient countries. – IMF often criticised for imposing conditions which do more damage than good.


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5.3 The International Monetary Fund (IMF) • International Liquidity and Special Drawing Rights (SDR) – International Liquidity and International Reserves • International liquidity refers to the stock of means of international payments • International Reserves, are assets which a country can use in settlement of payments imbalances that arise in its transactions with other countries International Reserves = Reserve position in IMF + SDRs + Forex assets held by central bank


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5.3 The International Monetary Fund – Special Drawing Rights (SDRs) • SDR is international fiat money created by IMF and allocated to member countries. • Can be used by Central banks to settle payments among themselves. Selected other institutions allowed to hold and use SDRs • In order to make SDRs an attractive asset to hold, the Fund pays interest on holdings in excess of a member's cumulative allocation and it charges interest on any shortfalls • Have not become popular as reserve asset


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5.3 International Liquidity • Demand for Reserves and Composition of Reserves – In the positive tradition, reserve stock is related to the volume of imports, marginal propensity to import, variability of export earnings and so forth – In the optimizing approach, reserve holdings are arrived at by equating the marginal cost of holding reserves to the marginal benefit – The problem of currency composition of reserves has been posed as a problem in portfolio selection along the lines of the Markowitz-Sharpe portfolio choice models –


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5.3 The International Monetary Fund • The Role of IMF in the Post-Bretton Woods World – Under the Bretton Woods system the IMF was responsible for the functioning of the adjustable peg system

– Under the current "non-system" that role has considerably diminished if not eliminated – The Fund is mandated to "exercise firm surveillance over the exchange rate policies of members" – The Fund has played an important role in tackling the debt crisis of developing countries


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5.4 The Problem of Adjustment •Every open economy, from time to time faces the problem of imbalance on its external transactions •The BOP disequilibria may be transitory or permanent in nature •The country must choose between financing the imbalance or undertaking a programme of adjustment. Relevant factors: Exchange Rate Regime; Availability of Financing; Creditworthiness of the Country; Export-Import Demand Elasticities; Saving and Import Propensities; Behaviour of Domestic Costs; State of the Economy

Adjustment more urgent for deficit countries. P.G.Apte International Financial Management

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5.5 The Economic and Monetary Union (EMU): History • Adjustable peg system called Snake was born among the countries belonging to the European Economic Community (EEC) in 1972 • In 1979, the snake became the European Monetary System (EMS) • The feature that distinguished EMS from the snake was the European Currency Unit (ECU), a SDR-like basket of currencies • The ECU was the precursor of the common currency Euro


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5.5 EMU: History • Monetary Union had been envisaged as a part of the move towards creating a single economic zone in Europe • Just when it appeared that Europe will steadily march towards an economic and monetary union as envisaged in the "Maastricht treaty", the system received severe jolts • "Growth and Stability Pact" in 1996 • The single currency "Euro" came into existence on January 1 1999


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5.5 The Economic and Monetary Union • After 2002, their individual currencies will cease to exist • The parities of the eleven member currencies against each other and against the Euro were irrevocably fixed when Euro was born. • At the start 1 Euro = 1 ECU • The EMU and the Euro provide a model for other currency unions


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International Financial Management chapter 5 by PG Apte

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