The Determination of Exchange Rates
! Describe the International Monetary Fund and its role in the determination of exchange rates.
! Discuss the major exchange-rate arrangements countries use.
! Identify the major determinants of exchange rates in the spot and forward markets.
! Show how managers try to forecast exchange-rate movements using factors such as balance-of-payments statistics.
! Explain how exchange-rate movements influence business decisions.
From a managerial point of view, it is critical to understand how exchange-rate movements influence business decisions and operations. Chapter 10 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.
OPENING CASE: The Chinese Renminbi
This case describes
Teaching Tip: Carefully review the PowerPoint slides for Chapter 10 and select those you find most useful for enhancing your lecture and class discussion. For additional visual summaries of key chapter points, also review the figures, tables and maps in the text.
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 (IMF)
In 1944, the
major allied governments met in
A. IMF Assistance
When a member country experiences economic difficulties, the IMF will negotiate loan criteria designed to help stabilize its economy. However, such stabilization measures are often unpopular with a country’s citizens and firms and, ultimately, its government officials.
B. Special Drawing Rights (SDRs)
The help increase international reserves, the IMF created special drawing rights (SDRs), 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 and for IMF transactions and operations. The value of the SDR is based on the weighted average of four currencies. At the end of 2002 those weights were: the U.S. dollar 45%, the EURO 29%, the Japanese yen 15% and the British pound 11%. Although the SDR was intended to serve as a substitute for gold, it has not assumed the role of either gold or the U.S. dollar as a primary reserve asset.
C. Evolution to Floating Exchange Rates
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. 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 a devaluation of the U.S. dollar, a revaluation of other currencies and a widening of the exchange-rate flexibility bands. 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 declaring floating rates to be acceptable.
III. EXCHANGE-RATE ARRANGEMENTS [See Table 10.1 and Map 10.1]
The IMF surveillance 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. From Pegged to Floating Currencies
The IMF now recognizes several categories of exchange-rate regimes that begin with pegging (fixing) the rate for one currency to that of another (or to a basket of currencies) under a very narrow range of fluctuations in value (e.g., no separate legal tender, currency boards, conventional pegs). The next category, pegged exchange rates within horizontal bands, is characterized 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. 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.
C. The Role of Central Banks
Each country has
a central bank responsible for the policies affecting the value of its
currency. Central banks are primarily concerned with liquidity, in order to
ensure they have the cash and flexibility needed to protect their countries’
currencies. Their reserve assets are kept in three forms: gold,
foreign-exchange reserves and IMF-related assets. The EURO is administered by
the European Central Bank which, although independent of all EU institutions
and governments, works with the governors of
· coordinate its actions with other central banks or go it alone
· aggressively enter the market to change attitudes about its views and policies
· call for reassuring action to calm markets
· intervene to reverse, resist, or support a market trend
· be very visible or very discrete
· operate openly or indirectly through brokers.
for International Settlements (BIS) in
IV. THE DETERMINATION OF 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. Floating Rate Regimes [See Figure 10.2]
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 government intervention. Equilibrium exchange rates are achieved when supply equals demand.
B. Managed Fixed-Rate Regimes
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. A currency that is pegged to another (or to a basket of currencies) is usually changed on a formal basis. In 1999, the G7 group of industrial countries was expanded to the G20 for the purpose of including some developing countries in the discussion of effective exchange-rate policies.
C. Purchasing-Power Parity
The theory of purchasing-power parity states that the prices of tradable goods, when expressed in a common currency, will tend to equalize across countries as a result of exchange-rate changes. Put another way, the theory claims a change in the comparative rates of inflation in two countries necessarily causes a change in their relative exchange rates in order to keep prices fairly similar. (An interesting illustration of this theory is the “Big Mac Index” (see Table 10.2).) While purchasing-power parity may be a reasonably good long-term indicator of exchange-rate movements, it is less accurate in the short run because it is difficult to determine an appropriate basket of commodities for comparison purposes, profit margins vary 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 zero.
D. Interest rates
Although inflation is the most important long-run influence on exchange rates, interest rates are also important. While the Fisher Effect theory links inflation and interest rates, the International Fisher Effect (IFE) theory links 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 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).
Because the real interest rate should be the same in every country, the country with the higher interest rate should have higher inflation. Thus, when inflation rates are the same, investors will likely 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 have the weaker currency. In the short run, however, and during periods of price instability, a country that raises its interest rate is likely to attract capital and see its currency rise in value due to increased demand.
E. Other Factors in Exchange-Rate Determination
A key factor affecting exchange-rate movements is confidence in a country’s economy and administration. Technical factors such as the seasonal demand patterns for a given currency, the release of national economic statistics and events such as 9/11, 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 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. Smart managers develop their own exchange-rate forecasts and then use the fundamental and technical forecasts of outside experts to corroborate their analyses.
B. Factors to Monitor
When forecasting exchange-rate movements, key variables to monitor include:
· the institutional setting (the extent and nature of government intervention)
· fundamental factors (PPP rates, balance-of-payments levels, the level of foreign-exchange reserves, macroeconomic data, fiscal and monetary policies, etc.)
· confidence factors
· critical events
· technical factors (market trends and expectations).
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 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-rate fluctuations can affect financial decisions in the areas of sourcing funds (both debt and equity), the timing and the level of the remittance of funds and the reporting of financial results. (Translation, transaction and economic exposure will all be considered in Chapter 20.)
Black Market Issues Aren’t Black and White
On a local black market, one can obtain more local currency in exchange for hard currency, but relatively less hard currency for local currency. While it’s always tempting to trade on the black market, governments have differing ethical and legal attitudes toward such transactions. If trading on the black market is illegal, the government’s objections will be emphatic, although the law is often unevenly applied. It is easier to eliminate a black market by letting a country’s currency float freely and thus removing the temptation to circumvent the law than by police enforcement.
LOOKING TO THE FUTURE:
Changing Times Will Bring Greater Exchange-Rate Flexibility
The trend toward greater flexibility in
exchange-rate regimes will surely extend well into the future. The EURO will
continue to strengthen and claim market share from the U.S. dollar as a prime
reserve asset, just as
Teaching Tip: Visit www.prenhall.com/daniels for additional information and links relating to the topics presented in Chapter 10. Be sure to refer your students to the on-line study guide, as well as the Internet exercises for Chapter 10.
CLOSING CASE: Pizza Hut and the Brazilian Real [See Figure 10.3]
1. Do you think it makes sense for Pizza Hut to get out of Brazil, or should it try to weather the storm and stay in? Justify your position.
strategic role that Brazilian operations are likely to play in Pizza Hut’s
worldwide strategy, withdrawing from
2. Where does the Brazilian real fit in the exchange-rate regimes in Table 10.1? What does that imply in terms of how you would predict future values of the real?
the inflationary effects of very weak currencies for many years, maintaining
the relative stability of
3. Discuss whether or not you think the Brazilian government should dollarize its economy and get rid of the real.
Dollarization could be a powerful tool in Brazil’s fight against rampant inflationary pressures; it could also help curtail the speculative pressures on the Brazilian real. Nonetheless, there is a strong argument against doing so. If Brazil were to dollarize its economy, or even simply fix the exchange rate between the U.S. dollar and the real, the Brazilian government would no longer be able set its own monetary policy to manage its economy. Brazil’s money supply would have to be set at the level necessary to maintain the fixed rate between the real and the dollar. Further, full dollarization would not sit well with Brazilian patriotic and nationalistic sentiments. Unlike Argentina, whose currency is fixed at parity with the U.S. dollar, Brazil has resisted pressures to follow suit. Nonetheless, Brazil has expressed some willingness to consider the idea of a single currency for MERCOSUR member countries because of the importance of its trade with Argentina, and its strong links to the economies of Uruguay and Paraguay as well.
4. What are some of the ways instability in the real might be affecting Pizza Hut’s operations in Brazil?
Because of the relatively high price of its product, Pizza Hut’s success in Brazil depends upon a growing, increasingly affluent middle class. However, a prolonged period of economic instability tends to increase the gap between the rich and the poor and reduce the size of the middle class. Further, consumers are less likely to spend money on “luxury” items during times of economic stress, even when they can afford to do so. An overvalued real makes imported products cheaper and thus encourages Pizza Hut to export inputs and supplies to its Brazilian operations. On the other hand, an undervalued real makes local products cheaper and encourages Pizza Hut to source locally. Thus, currency instability makes it very difficult for businesses to plan effectively.
Additional Exercises: Exchange-Rate Determination
Exercise 10.1. A dozen or so years ago, the Canadian and U.S. dollars were close to par. At the end of June 2003, the Canadian dollar was worth about US $0.7374. Ask students to discuss the reasons they believe the Canadian dollar has lost so much ground against its American counterpart. Be sure they raise factors such as the implementation of the North American Free Trade Agreement and the separatist movement in Quebec. Then, note the importance of U.S. trade to the Canadian economy and ask students if they think Canada should consider “Americanizing” (pegging) its dollar to its neighbor’s. Why or why not?
Exercise 10.2. Use the IMF International Financial Statistics to identify countries that use the SDR as a basis for the value of their currencies and those that use the EURO. Then engage the students in a discussion as to why certain countries have chosen to use the SDR while others have chosen the EURO. In what ways are the SDR and the EURO similar? In what ways are they different?
Exercise 10.3. Historically, the International Monetary Fund has prescribed strict monetary policies and reduced government spending for developing countries that sought aid in dealing with currency crises. Ask students to debate the wisdom of the IMF’s approach. Do they believe it was effective? Then ask the students to suggest ways in which the IMF might change its approach in the future. Be sure they consider the implications of their suggestions for international businesses.