FINS3616

International Business Finance

Week 2 Exchange Rate Systems
1. Exchange Rate Systems
2. The Role of Central Banks
3. History of Exchange Rate Systems

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1. Given great demand of cross-border trade and

investment, how do we exchange currencies?

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The International Monetary Fund

IMF member state

Christine Lagarde, managing director (July 2011-now)

IMF member states not accepting some obligations

The IMF is an international organization of 187 member countries, based

in Washington, DC, which was created at a UN conference in Bretton
Wood, the U.S., 1944.
The main goal of IMF is to ensure the stability of the international
monetary and financial system, to help resolve crises, and to promote
growth and reduce poverty.
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Two major exchange rate systems

Pegged exchange rate systems

Governments maintain currency values at official exchange
rates
In July 2015, 1USD=7.75HKD

Fixed to the U.S. dollar, the Euro, and a composite currency

(SDR)
Devaluation (revaluation) is used when the currency falls
(rises)
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Special drawing rights (SDR)

Supplementary foreign exchange reserve assets defined

and maintained by the International Monetary Fund (IMF).
Their value is based on a basket of key international
currencies reviewed by IMF every five years
2016-2020
The internationalization of RMB
In Nov. 2014, RBA and PBC signed an
agreement to established official RMB
clearing arrangements in Australia
China seeks confirmation of
arrival on world stage

RMBs

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Two major exchange rate systems

Floating exchange rate systems

Currency values fluctuate according to market supply and
demand.
In July 2015, 1USD=1.37AUD

Depreciation (appreciation) is used when the currency falls

(rises).
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Exchange rate systems around the World

Pegged exchange rate systems

Conventional fixed rate like Saudi Arabia and UAE
Target zones and crawling pegs like Denmark and China
Currency board like Hong Kong

Floating exchange rate systems

Independently floating like Canada, Japan, and Australia
Managed floating like Argentina and Brazil

No separate legal tender

Adopt the currency of another country. For example,
Ecuador and Panama use the US dollar, Kiribati uses the
Australian dollar, and Kosovo uses the Euro

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Conventional fixed rate

In July 2015, 1USD=3.75 SAR (Saudi Riyal)

In July 2015, 1USD=3.67 AED (UAE Dirham)

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Target zones and crawling pegs

In July 2015, 1EUR=7.46 DKK (Danish Kroner)

In July 2015, 1USD=6.20 CNY (Chinese Yuan)

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Currency board
In July 2015, 1USD=7.75HKD

HKMA

1 USD
Certificates of
indebtedness

HSBC (Hong Kong)

SCB (Hong Kong)

7.75 HKD

The
Market

BOC (Hong Kong)

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Independent floating
In July 2015, 1USD=1.30CAD (Canadian dollar)

In July 2015, 1USD=124.3JPY (Japanese yen)

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Managed floating
In July 2015, 1USD=8.80ARS (Argentine Peso)

In July 2015, 1USD=3.37BRL (Brazilian Real)

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No separate legal tender

Population: 15.74 million
Language: Spanish
Currency: the U.S. dollar
Major industries: mining and
petroleum refining
Population: 3.84 million
Language: Spanish
Currency: the U.S. dollar
Major industries: tourism and
Canal
Population: 102,351
Language: English
Currency: the Australian dollar
Major industries: fishing
Population: 1.82 million
Language: Albanian
Currency: the Euro
Major industries: mining
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Trend and distribution in exchange rate systems

Trend:

Distribution in 2010:

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What drives exchange rate in a floating system?

Exchange

rate variations are determined by market

demand and supply of a currency.
Large demand=>
Large supply =>

Determinants

Differences in money supply growth

Differences in real interest rate
Political and financial risks

Measure

of currency risk
Volatility
Historical data that indicates past currency volatility
Are pegged currencies risk free?
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2. Exchange rate variations in a floating system

--the role of central banks

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Reserve Bank of Australia

Glenn Stevens
Governor of the Reserve Bank of Australia
from 2006 to now

RBAs duty is to contribute to the stability of the currency,

full employment, and the economic prosperity and welfare of
the Australian people.
It does this by setting the cash rate to meet an agreed
medium-term inflation target, working to maintain a strong
financial system and efficient payments system, and issuing
the nation's banknotes.
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Our mission, as set forth by the

Congress, is a critical one: to
preserve price stability, to foster
maximum sustainable growth in
output and employment, and to
promote a stable and efficient
financial system that serves all
Americans well and fairly

Ben Bernanke
Chairman of the Federal Reserve of the U.S.
from 2006 to 2014

Zhou, Xiaochuan
Governor of the People's Bank of China
from 2002 to now

Functions
of
the
PBC
are
formulating
and
implementing
monetary policy; issuing RMB and
administering
its
circulation;
regulating inter-bank lending market
and
inter-bank
bond
market;
administering foreign exchange and
regulating
inter-bank
foreign
exchange market; regulating gold
market
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Inside the RBA:

RBA

Government bonds

The
secondary
market

Loans
(cash rate, 2.0%)

Westpac
Deposits
(deposit rate, 2.0%)

Households

Loans
(lending rate, 5.4%)

Corporations

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The balance sheet of the RBA

Assets

Liabilities

Official international reserves

Deposits of domestic financial institutions

Domestic credit

Currency in circulation

Government bonds
Loans to domestic financial institutions
Other

Other

Official international reserves: foreign currency reserves (86%); gold

reserves (14%)
Domestic credit: the purchase or sales of government bonds by the central
banks are used to influence the money supply; loans to domestic financial
institutions are especially important in times of panic and financial crisis
Deposits of domestic financial institution: countries require their
commercial banks to hold a certain percentage of the deposits the banks
accept from the public
Currency in circulation: the coins and bills are used by the public
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In-class questions
The current exchange rate is A$1.0/US$.
(1) Reserve Bank of Australia buys A$5 billion Australian
government bonds from the Australian government. What
is the outcome on the Australian dollar? What about the
impact on inflation in Australia?

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In-class questions
The current exchange rate is A$1.0/US$.
(2) Reserve Bank of Australia buys US$5 billion US
government bonds from the U.S. government (RBA does
not use their foreign currency reserves). What is the
outcome on the Australian dollar? What about the impact
on inflation in Australia?

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In-class questions
The current exchange rate is A$1.0/US$.
(3) Reserve Bank of Australia buys US$5 billion US
government bonds from the U.S. government (RBA does
not use their foreign currency reserves) and sells A$5
billion Australian government bonds to the ANZ bank. What
is the outcome on the Australian dollar? What about the
impact on inflation in Australia?

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Foreign exchange rate intervention

Central

banks affect exchange rates directly

By supplying domestic currency, central banks weaken
the value of domestic currency.
By demanding domestic currency, central banks
strengthen the value of domestic currency.

Two

methods of foreign exchange rate intervention

Non-sterilized interventions (currency value and inflation)
Sterilized interventions (currency value)

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3. The history of exchange rate systems

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A brief history
1875

1914

1944

A double standard: both gold and silver were used as money,

accepted as means of payment.
The gold standard: European countries and the U.S. pegged their
currency to gold. For example, $20.7 per ounce and 4.2 per ounce
WWI : 1914-1918, John M. Keynes called it the barberian relique.
The Great Depression: 1929-1935, the longest, deepest, and most
widespread depression of the 20th century
WWII: 1939-1945, the deadliest conflict in human history
Bretton Woods system: $35 per ounce and other currencies are
pegged to the U.S. dollar
Vietnam War: 1955-1975, Americans paid a lot
1971: U.S. president Nixon surrendered to market forces and took
the U.S. off the gold standard

1976

Jamaica agreement: floating exchange rates were declared

acceptable.

1999

Euro zone: the Euro was introduced into Europe.

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Currency crises

Mexican peso crisis in 1995

Asian financial crisis in 1997

Russian ruble crisis in 1998

Brazilian real crisis in 1998

Turkish lira crisis in 2001

Argentinian peso crisis in 2002

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Asian financial crisis in 1997

Asian currency values: $1.0/unit in Jan. 1996

Thai baht

Indonesian
rupiah

Korean
won

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Asian financial crisis in 1997

George Soross Quantum Fund:

1.
2.
3.

Borrowed a lot of Thai baht from Thai banks

Sold the Thai baht to the Thai government for the
U.S. dollar and spread negative sentiment
After the Thai government devaluated the Thai
baht, he bought the baht at a lower value and
repaid his loans.

Fundamental reasons:
A pegged exchange rate system that overvalued the local
currency
A large amount of foreign currency debt

Consequences:
Currency crises have a negative short-term impact on the
local economy
A shift to floating systems has a positive long-term impact on
the local economy
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Should IMF lend money to those crisis countries?

Proponents:
IMF loans helped countries overcome financial crises

Critics:
Borrowing conditions such as fiscal constraints and
capital market liberalizations increased economic and
financial risks
IMF loans usually lasted for decades
IMF loans were spent to support an overvalued exchange
rate
IMF loans benefited developed countries but not crisis
countries

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The road to monetary integration in Europe

The desire for currency stability in Europe is very

strong
Western European countries trading partners are
their neighboring countries
Need for a common market for agricultural products
Political reason to achieve the integrated union
among European countries

The

approach to achieve currency stability in Europe

1944-1973: the Bretton Wood system
1979-1999: the European Monetary System
1999 to now: the Euro

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The European Monetary System (1979-1999)

Conditions:
A grid of bilateral exchange rates is 2.25% on each side
Central banks should intervene when the grid is reached
If the grid can not be sustained, a new grid will be
established

Outcomes:
Daily variations were reduced but large devaluations
still occurred
The EMS was designed to be a symmetric system but
Germany played a central role and other countries
pegged their currencies to the German mark.
Inflation and interested differential were controlled but it
hurt a weak countrys economy in the long run.
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The Euro (1999 to now)

The

Maastricht Treaty:
In 1991, the European heads of state met in Maastricht in the
Netherlands to map out the road to economic and monetary
union with a single currency to be reached by 1999.

Criteria:
Inflation within 1.5% of 3 best performing countries
Interest rate on government bonds within 2% of 3 bestperforming countries
Budget deficit to GDP <3%
Government debt to GDP< 60%
No devaluation over the past 2 years
Phases:
Restrictions of movement on capital removed, and European
Monetary Institute was created in Jan. 1994
European Central Bank replaced European Monetary Institute
in Jan. 1999
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Euro Zone (2013)

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Should the European Union adopt the Euro?

Pros: enhanced price transparency, lower transaction costs,

and no exchange rate uncertainty that promote trade and
economic growth.
Cons: loss of independent monetary policy. It is bad if country is
in a bad stage. For example, Greece in a great recession from
2010.
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