CHA Will the Stars Shine on Astra Again? 17 Asta internationals one ofthe oldest and largest conglomerates in Southeast Asia, employingat its peak 125000 peopl. For many yeas the company thrived as Indonesit's dominant automobile miler, producing about 400,000 vehicles a year. Other Astra subsidiaries buld an¢ sll actors operate coal mines, run plantations “Astra’s automobile sal es sh rank pyc. 13% The International Bank for Reconstruction and Development ‘The International Bank for Reconstruction and Development (IBRD) Is the offi- cial name of the World Bank. Established In 1945, the World Bank's initial goal was to help finance reconstruction of the war-torn European economies, With the assistance of the Marshall Plan, the World Bank accomplished this task by the mid- 1950s. The bank then adopted a new mission—to bulld the economies of the world’s developing countries. ‘As {ts mission has expanded over time, the World Bank has created three afflll- ated organizations: , 1. The International Development Association 2. The International Finance Corporation 3. The Multilateral Investment Guarantee Agency ‘Together with the World Bank, these constitute the World Bank Group (see Figure 6.2). The World Bank, which currently has $117 billion in loans outstanding, Is ‘owned by its 182 member countries, In reaching its decisions, the World Bank-uses a weighted voting system that reflects the economic power and contributions of its” members. The United States currently controls the largest bloc of votes (17 per- cent), followed by Japan (8 percent). Germany (5 percent), the United Kingdom (4 percent), France (4 percent), and six countries with 3 percent each: Canada, China, India, Italy, Russia, and Saudi Arabia. From time to time the voting weights are reassessed as economic power shifts or as new members Join the World Bank, To finance Its lending operations, the World Bank borrows money in its own name from international capital markets. Interest earned on existing loans it has made provides it with additional lending power. Néw lending by the World Bank averaged 818 billion per year from 1995 to 1999. ‘According to its charter, the World Bank may lend only for “productive purposes” that will stimulate economic growth within the recipient country. An example of such a loan ts the $100 million provided to Kazakhstan in 1999 to rehabilitate and modernize its national highways. The World Bank cannot finance a trade deficit, but it can finance an infrastructure project, such as a new railroad or harbor facil- ity, that will bolster a country’s economy. It may lend only to national governments oF for projects that are guaranteed by a national government, and its loans may not bbe tied to the purchase of goods or services from any country. Most important, the nf ; : 1 InrentaaTionaL. IvrerwarionaL Mucrivarerat, Deveoruent Fivaice | Iwestuent ‘Assocurion - - -CoRronation Guarantee Acencr ° offers sft loans: promotes private Provides pltical $6 lion in new stor development: risk insurance Toons annually $5.3 bilan infos $00 milion ot ‘and equity annually Insurance in 1999, Organization of the World Bank Group“Napler 6 The International Monetary System and the Balance of Pay World Bank must follow a hard loan polley; that fs, it may make a loan only sf there Is « reasonable expectation that the loan will be repatd. The hard loan policy was severely criticlzed in the 1950s by poorer countries, who complained It hindered their ability to obtain World Bank loans. In response, the World Bank established the International Development Association (IDA) in 1960, The IDA offers soft loans, loans that bear some significant risk of not being repald. IDA loans carry no interest rate, although the IDA collects a small . service charge (currently 0.75 percent) from borrowers. The loans also have long, maturities {normally 35 {0 40 years), and borrowers are often granted a 10-year grace period before they need to begin repaying their loans. The IDA’s lending efforts focus on the least-developed countries. A typical loan ts the $45 million pro- vided Bangladesh in 1999 to repair damage to its bridges and waterways after a devastating flood hit that country the year before. The IDA obtains resources from “the initial subscriptions its members make when joining it, from transferred World Bank profits, and from periodic replenishments contributed by richer countries. From 1995 to 1999, IDA disbursements averaged $6 billion per year. 5 ‘The two other affiliates of the World Bank Group have narrower missions. The International Finance Corporation (IFC), created in 1956, {s charged with pro- moting the development of the private sector in developing countries. Acting like an investment banker, the IFC, tn collaboration with private investors, provides debt and equity capital for promising commercial activities. For example, in 1999 the IFC provided Senegal’s Ciments du Sahel S.A. $4.7 million in equity and $13.5 mil- Yon in loans to help it build a $90-million cement plant to serve the construction industry.in Senegal’s capital city, Dakar, and the regional market. In total the IFC Provided $5,3 billion of financing to supplement $13.3 billion of capital raised from. other sources for private-sector projects in 1999. The other World Bank affiliate, the Multilateral Investment Guarantee Agency (MIGA), was set up in 1988 to overcome private-sector reluctance to invest in develop- ing countries because of perceived political riskiness—a topic covered in Chapter 3. MIGA encourages direct investinent in developing countries by offering private , investors insurance against noncommercial risks. For example, in 1999 MIGA issued Avon Cycles Ltd, an Indian bieycle manufacturer, $710,000 of political risk insurance to protect its investment in a newly privatized bicycle manufacturing plant in Dar-es- Salaam, Tanzania, against war and civil disturbance. Similarly, MIGA issued Turkey's Efes Sinai Yatirim Ve Tircaret $27.6 million in political risk insurance to protect its investment in two Coca-Cola bottling companies it was establishing in the Kyrgyz Republic and Kazakhstan with local joint venture partners. As a result of this insur- ance, Efes was protected against losses due to expropriation, war, o other elvil distur. bances. In 1999 MIGA underwrote about $800 million of political risk insurance. Paralleling the efforts of the World Bank are the regional development banks, such as the African Development Bank, the Asian Development Bank, and the Inter-American Development Bank. These organizations promote the economic development of the poorer countries in their respective regions. The most recently created regional development bank Js the European Bank for Reconstruction and Development. It was established by the Western countries to assist in the recon- struction of Central Europe and Eastern Europe after the regions’ communist regimes collapsed. The regional development banks and the World Bank often work together on development projects. For example, the Asian Development Bank, in conjunction with the World Bank and several other agencies, recently helped fund and insure a hydroelectric power plant near Kathi | mandu, Nepal, which when oper- ational will supply 25 percent of Nepal's electrical power. The International Monetary Fund. “The Bretton Woods attendees believed 7 ea ae etertoration of international trade during the years after World War | was ributable in part to the competitive exchange rate dev: international commerce. nf Sel Wald Wen eee ees ‘To ensure that the post-World War Il monetary systemHistory of the International Monetary System >. 161 would promote international commerce, the Bretton Woods Agreement called for “he creation 7 oe International Monetary Fund (IMF) to oversee the functioning of the International monetary system, Article I of the IMF's Articles of Agreement lays out the organization's objectives: “ 1. To sromote international monetary cooperation 2, To facilitate the expansion and balanced growth of international trade 3, To promote exchange stability, to maintain orderly exchange arrangements among members, and to avold competitive exchange depreciation 4, To assist in the establishment of a multilateral system of payments 5. To give confidence to members by making the general resources of the IMF temporarily available to them’and to correct maladjustments in their balances of payments. z 6. To shorten the duration and lessen the degree of disequilibrium in the Interna- tional balances of payments of members yt Membership in the IMF is available to any country willing to agree to its rules and regulations. As of April 2001, 183 countries were members. To Join. a country must pay a deposit, called a'quota, partly in gold and partly in the country's olvn currency. The quota's size primarily reflects the global importance of the country’s economy, although political considerations may also have some effect. The size of @ quota is important for several reasons: ag 1. A country’s quota determines its voting péiver within the IMF. Currently the United States controls 17 percent of the votes in the IMF. Germany and Japan each control the next largest blocs (6 percent), followed by France (5 percent). the United Kingdom (5 percent). and Saudi Arabla (3 percent). 2. A country’s quota serves As part of its official reserves (we discuss official reserves later in the chapter). 3. Thé quota determines the country’s borrowing power from the IMF. Each IMF member has an unconditional right to borrow up to 28 percent of its quota Hartke IME, IMF policy allows additional borrowings conting. on the mem. Fernountny’s agreeing tc IMF-imposed restrictions—called IMF conditional: Repcon te eeonomie policies. For example, in return for an IMF loan of $21 bil- Te South ovea agreed in December 1997 to undertake major economic © net ne neluding permitting forelgn banks to take over their Korean counter- cae hosing insolvent merchant banks, reducing government favoritism eae ee pager chaebol. and lowering tariffs on many goods. That same year aa ne are ed to lend Indonesia $10 billion after that eountry pledged to sae cee monopolies controlling certain foodstuffs, reform its banking sere eared cut tae barriers directed aginst Imported goods. As noted in irs dace, the IMF also pressured Indonesla's government to guldate qe opening im various companies, which led to, the sale of PT Astra its holdings‘ , gingapore’consortium, Local poitctins and interest groups Internation creat the IMF's condiionallty requirements, arguing that for. tigners, working through the IMF. are taking advantage of ce country's Short ne ee dp entract changes favorable to the foreigners. at mes, the st term problems oie or example, in 1998 Indonesia was wracked by rioting uation can arty unemployment soared os a result ofthe austerly measures after Prices orig IME, and long-time President Suharto was forced to resign his office. ndard. _ The IMF and the World Bank provided the ‘s{-World War Il international monetary system. Institutional framework for the post-Wo ry aystem, paututional (Woods participants also addressed the problem of how the system The Bretton vert ractice. all countries agreed to peg the value of thelr currencies A Dollar-Based Gold Sta1162. > Chapter 6 The international Monetary System and the Balance af Payments ‘When the IMF and the Word Bank heid heir annua conferences in Prague in Sepzember 2000, thousends of demonstrators marched in the xr procescors belive protecting the environment. to gold. For example, the par value of the U.S. dollar was estab- lished at $35 per ounce of gold. However, only the United States pledged to redeem its currency for gold at the request of stone of the Bretton Woods system, Why this central role for the U.S. dollar? During the early postwar years only the U.S, and Canadian dollars were convertible currencies, that 1s, ones that could be freely.exchanged for other currencies with. out legal restrictions. Countries had faith n the U.S. economy , and so were willing to accept U.S. dollars to settle thelr trans. actions. As the British pound sterling had been in the nine- teenth century, the U.S. dollar became the preferred vehicle for settling most international transactions. The effect of the Bretton Woods conference was thus to establish a U.S. dollar- based gold standard. Becauise each country established a par value for its‘cur- rency. the Brettoh Woods Agreement resulted in a fixed exchange rate system. (Figure 6.3 shows the structure of exchange rates at the end of.the Bretton Woods era.) Under. the agreement each country'pledged to maintain the value of its currency within +1 percent of its par value. If the market value of its currency fell outside that range, a country was” obligated to Intervene in the foreign-exchange market to bring the value back within +1 percent of par. value. This stability in exctiange rates benefited international busi- nesses becatis: the Bretton Woods system generally provided an assurance that the value of each currency would remain stable, Note the use of the qualifier generally. Under extraordinary circumstances the Bretton Woods Agreement allowed a country to adjust its cur- Fency's par value. Accordingly, the Bretton Woods system is often described as using an adjustable peg because currencies were pegged to gold but the pegs themselves could be altered under certain conditions. For example, under the system the British pound’s par value was first set at $2.80. (Technically, the par value was pegged to an ounce of gold, which then could be translated into dollars ata rate of $85.00 per ounce. Most businesspeople ignored this technicality and focused on the implicit par value of a currency in terms of the U.S. dollar) Thus the Bank of England was obligated to keep the pound’s value between 82.772 and $2.826 (1 percent of $2.80). Suppose pessimism about the British econoiny caused the pound’s market price to fall to $2.76, The Bank of England would be required to defend the value of the pound by selling some of its gold or U.S-dol. lar holdings to buy pounds. This move would increase the demand for pounds, and the market price would return to within the legal range—from $2.72 to 82.828. This arrangement worked well as long as pessimism about a country’s econ- omy was temporary, but if a country suffered from structural macrocconomlc problems, major difficulties could arise, For example, in the late 1960s, Labour governments striving for social justice dominated British polities, and British unions secured higher wages, better working conditions, and protective work tules. At the same time, however, British productivity decreased relative to that of its major international competitors, and the pound’s value weakened. The Bank of England had to intervene continually in the forelgn-currency market, selling gold and foreign currenctes to support the pound, In so doing, however, the Bank’s'holdings of official reserves, which were needed to back up the coun: y's Bretton Woods pledge, began to dwindle. international currency traders began to fear the Bank ivould run out of reserves, As that fear mounted, inter- @ forelgn central bank. Thuis the U.S. dollar became the key. .Se : pie . vate tert! Manta Sst 9-163 Srenuno. " Foeuce Role of the US. Dollarin the RENCH F Commences ce Bretton Woods System : Note Par values as of December 37 : eget * Frexen 8 360031 . / Franc Source Reproduced from Franklin. Bainsu Fr 5.55/51 Root international Trade and ’ Aer teeta th ite peri 7 sion of South-Western College publahing Contin 19347 ‘ South-Western College Publishing Guuous Geawan Alvighesreseved. Dour jena Can$LOUSL ¥., yom 3.66/81 Oren: A Trauan Cuaaencies tu Par value iste? national banks, currency traders, and other market participants becathe unwill- ing to hold British pounds in theft inventory of foreign currencies, They began dumping pounds on the market as soon as they recelved them A vicious cycle eng Pontne Bank of England continued to drain its official reseres Te support the pound, the fears of the currency-markst participants that the Bank . would ryin qut of reserves were worsened Te Gtuation resembles a run on a bank. Banks. never have enough.cash on. hava iS mor all their liablities. However, as long a5 everyone trusts that their tant wal give them thelr money If they need it- no one worries. If people lose that bank will ve Macaw more of their money than the bank has on, hand: the bank trust and Mirouble. The Bretton Woods system was particularly susceptible to speciilative “runs on he bank” because there Wis little risk in betting against.a canreney in times of doubt. For example, specuaters distrustful of the Bank of England's ability to honor the U.K's Bretton Woods pledge could convert thetr pounds into dollars. Irthey guessed right and the pound were devalued, they could Take a quick financial killing, they guessed ron and the Bank of England rae aay ine pound's par value, the speculators could always reconvert thelr dolles holdings back into pounds wih tle penal : Teaees ted Kingdom faced this type of banc run in Novernbet 1967. The Bank of England could not counter.the flood of poufids dumped on the market by specula- England coulforeed to devalue the pound by 14.9 percent (rom 62, 80 to $2.40 per ; pound), France faced a similar run in 1969 and had to devalue the franc. These Bound). Ffanes {eer ne international business corhmunity’ faith in the, Bretton Woods system. But the system faced Its true Waterloo when the dollar came under atiack in the early 19705- ’Chapter 6 The Internati 1a Monetary System and the Balance of Payments The End of the Bretton Woods System . ‘These runs on the British and French central banks Were a precursor to a run on the most important bank in the Bretton Woods system—the U.S. Federal Reserve Bank. Ironically, the reliance of the Bretton Woods system on the dottar ultimat led to the system's undoing. Because the supply of gold did not expan in the short tun, the only source of the liquidity needed to expand international trade was the U.S. dollar, Under the Bretton Woods system the expansion of international liquid. ity depended on foreigners’ willingness to continually increase their holdings of dol- lars. Forelgners were perfectly happy to hold dollars as long as they trusted the’ Integrity of the U.S. currency, and during the 1950s and 1960s the number of dol- lars held by foreigners rose steadily. 2 — . As foreign dollar holdings increased, however, people began to quéstlon the abil- ity of the United States to live up to tts Bretton Woods obligation. This led to the Triffin paradox, named after the Belgian-born Yale University economist Robert Triffin, who first identified the problem. The paradox arose because foreigners needed to increase their holdings of dollars to finance expansion of international trade, but the more dollars they owned, the less faith they had in the ability of the United States to redeem those dollars for gold. The less faith foreigners had in the United States, the more they wanted to rid themselves of dollars and get gold in return. If they did this, however, internatiorial (zade and the international mone- tary system might collapse because the United States did niot have enough gold to redeem all the doliars held by foreigners. + ‘As a means of injecting more liquidity into the international monetary system While reducing the demands placed on the dollar as a reserve currency, IMF mem. bers agreed in 1967 to create special drawing rights (SDRs). IMF me use SDRs io settle official transactions at the IMF. “paper gold.” As of April 2001, approximately 18.4 1.2 percent of the world’s total reserves, value is currently calculated daily as a wel; major currencies—U.S. dollar, embers can ‘Thus SDRs are sometimes called billion SDRs, representing about were held by IMF members. An SDR's ighted average of the market vale of four euro, Japanese yen, and British pound sterling— ith the weights revised every five years. As of April 2001, the SOR was woh $1.26 in US. dollars, Atiough SDRs did provide new liquidity f the international monetary sys: 6m, they did not reduce the fundamental problem of the glut of dollars tela by foreigners. By mid-1971 the Bretton Woods system was tottering, the victim of matic address on August 15, 1971, regent Richard M. Nixon announced that the United States would ny longer Tileem gold at $35 per ounce. The Bretton Woods system was ended in effect the bank was closing its doors. (After Novon's speech most currencies began to'float, their values being deter- cae ay UPPYY and demand in the foreign-exchange market, Thevetaen the U.S. Hou fel relalive to most ofthe world's major currencies, The nue the world, Rowever, were not yet ready to abandon the fixed exchange rate system. At the Emithsontan Conferenee, held in Washington, D.C in December 1971, central Pank representatives from the Group of Ten (sce Table & 1) agreed to restore the fred exchange rate system but with restructured ince of exchange between the Ralor trading currencies. The U.S. dollar was devaleed $38 per ounce but Temained inconvertible into gold, and the "and the par values of strong currencies such as the yen were revalued upward, rf new par values by #2.25 percent t, which replaced authorized by the Bretton Wor ods Agreement, j | |GioUP OF FIVE scROUPOFSéiEN coUPOFTIN’ “'wonbeDr Uniced States “United Staes”——UnkedStaes-, 88, hapan Iapan apa “MMs Germany." Getmany,. Germany” 6 France France’ France wee United Kingdom “United Kingdom United Kingdom’ "ase lay Mealy - 38° Canada Canada, 20 4 Netherlands: 6 ‘Switzerland ‘3 Belgium “8 ‘Sweden + . cumuta Percentage . efWorldGDP $94, ~ 62 7 639 “The Group of Ten has 11 members. : Performance of the International Monetary System Since 1971 Free-market forces disputed the new-set of par values established by’ the Stuthronian conferees. Speculators, believing the dollar and the pound were over valued, sold both and hoarded curreiicles they belleved were undervalued, such as the Swiss franc and the German mark. The Bank of England was tunable té main- fain the pound’s value within the 2.25 pereent band and in June 1972 had to allow.the pound to float downward. Switzerland let the Swiss franc float upward In early 1973. The United States devalued the dollar by 10 percent in February 1973. By March 1973 the central banks (see Table 6.2 for a list of the most important of today’s central banks) conceded they could not successfully: resist free-market forces and so established flexible exchange rate system. Under a flexible (or floating) exchange rate system, supply and deinand for a currency determine its price in the world market, Since 1973, exchange rates aniong many currencies have been established primarily by the interaction of supply and demand. We use the qualifier primarily because central banks sometimes try to affect exchange rates by buying or selling currencies on the foreign-exchange market. Thus the current arrangements are often called a managed float (or, more poetically. a dirty: float) because exchange rates are not determined purely by private-sector market forces. “Bringliig the World into Focus” discussés other differences between fixed and flexible exchange rates. country BANK “| Canada. Bank of Canada “| etopean Union (12 tenders sg the euro) | European Cental Bank psa : Back offapan LUnied Kingdo * pankof Fngland United Scates : Federal Res: ee Bank. istry ofthe tteratonat Monetary Sytem 9°16 ‘Thé Groups of Five, Seven’ andTan Se Gna ees Key Central Bankse 65 > Chapter 6 The Iniernational Monetary Sys Br sig the World inte nl 5 Cone important diference beewee fied and flexible exchange rate systems is the way they reach equilibrium. Under the fixed exchange rate sytem, such as the gold standard (1821 10.1914)" + and the Bretton Woods system (1945 co 1971), each country pledges to maintain the value of ts currency against some Stan dard, such as gold of another currency. If the value of the coun- tny’s currency falls Below par value, the country’s central bank ‘boosts the currency’s price by buying it in che foreign-exchange market, seling ff its gold reserves or stock of convertible curen- cies in the process. che curency/s value rises above pat value, the “central bank sells the curency in che freign-exchange marke, Sang addtional god or foreign curéncyinche process: Long: ‘a4 equiltrium is supposed to.occur rough the deflationary or inflationary impact of changes in the country’s money supply ‘Agreement, each country was and the'Balance of Payments. F © © . S -| EXCHANGE RATES .. : FIXED VERSUS FLEXIBLE inetrie: A country with a BOP surplus did not néed to do ary ‘provided it was willing to accumulate foreign exchange or ‘gold A county suffering a BOP deficit saw a continuing decrease in ies official reserves. t had co cure its BOP problems well before ic ran out of reserves. If fe country did nothing other coves * (and investors}, seing its reserves dwindling, would begin to di trust the country’s ablity to honoris pledge tomaintan its cur- rency’s par value. These foreigners would rush to sell their hold. ings of the currency, thereby worsening the drain on the country’s eserves. Uimatel the government would have to renege on is promise co convert atthe fixed rate and would resort to devalu- ing its currency. This is what happened to the United Kingdom in 1967, Francern 1969'and the United Seatesin 1971. Conversely, under a flexible exchange rate syterd/ the exchange rat is determined by the forces of supply and demand for each currency, Assuming a country’s central bank i willing to live with the outcome of these marker forces, its oficial reservas reed not be depleted because consumers and investors are determining the curiency’s value through their self-interested transactions ree its own requirements. The United States adopted a floating exchange rate. Other countries adopted a fixes dollar, the-French franc, ot some other currency: icular note is the strategy Of parti .d exchange rate by pegging their currencies to the. adopted by European Union (EU) members in the: belief that flexible exchange’rates would hinder thelr ability to create an integrated” « European economy. In 1979 El a “(EMS) {o manage currency rel ‘chose to participate in the EU's exchange rate mechanism (ERM). ERM participants pledged to maintain fixed exchange rates among their currencies withifi & : Tange of +2.25 percent of par value and a floating rate against, the U.S. dollar and. other currencies. The exchange rate mechanism facilitated the credtion of the # single currency, the euro, in 1999, a tople we will cover more thoroughly in ‘Map 6.2 shows the current status of the world’s exchange rate arrangements. U members created the European Monetary System™; lationships among themselves. Most EMS members, EUs. Chapter 9.” ‘The current international monetary system Is an amalgam of fixed and flexibl: exchange rates. For example, as just discussed, most members of the EU have adopted a com | mon cuirrency, while other countries have voluintarily adopted a fixed exchange rate against the U.S. dollar, the French franc, or some other currency. Still-other coun tries, such as Canada, Japan, the United Kingdom, and the United States, have cho i«wos ipo panna tc 8 oc pew Say ~ toe Arenuefjo se stusuadueay sey dumps LOPES EI468 > chorter& Te international Monet Stem ane Batnce of Payments 7 Exchange Rates of the Dollar Versus the Yén andthe Deutsche sierk, 1960-1998 gen to lel thelr currencies font, Aecordingly. under the current international mone. tary system, currencles of one country grouping ust against the currencies of other cotniry groupings. For example, the U.S. dollar and currencies fixed to the U.S. dol. far float againet the euro and currencies fixed to it, The U.S: dollar and the euro if turn fort against numerous independently floating currencies, such as the ‘Canadian dollar, the Australian dollar, the British pound, and the Swiss frdne. Other Post:World War If Conferences. The international monetary system that has grown out of the maica Agreement has not pleased all the world’s central bani all the time. &:.. 1976, the central banks have met numerous Umes to tron out palley conflicts amoing themselves. For example, U.S. complaints that en overval- tied dollar was hurting the competitiveness of U.S, exports and allowing cheap tmports to damage U.S. industrits prompted nance ‘ministers of the Group of Five {Goce Table 6,1) to meet in September 1985 at the Plaza Hotel In New York City. The meeting led to the Plaza Accord. ii which the central banks agreed to let the dollar's _ Tiive fail'on currency markets—and fall did. From its peak In February 1965 the * Gollar plummeted almost 46 percent against the deutsche mark and 41 pereent ‘against the yen by the beginning of 1987, Fearing that continued devaluation of the. dollar would disrupt world trade, nance ministers from the Group of Five met again, “this tinie at the Louvre in Paris in February 1987, The Louvre Aecord signaled the commitment of these five countries to stabilizing the dollar's value. However, the for-« feluivexchange market was ance again thrown Into {urmoll in 1990, thts time by the onset of the Persian Gulf hostilities. The values of key currencies continued to fluctu- fate through the end,of the century. Figure 6.4 shows changes in the dollar's value against the yen and the mark since the collapse of the Bretton Woods system. ‘These. fluctuations in currency values are of great importance to International “tpusinesses, When the value of their domestic currency incfeases in the forelgn- exchange market, firms find tt harder to export thelr goods.,more diffleult to protect their doshestle markets from the thivat of foreign Imports, ang more advantageous to shiff their production from doinestie factories to foreign factories, A decrease tn the domicstlc currency’s value has the opposite effect. Savvy International bust _ inesepeople are mindful of the Impact of these currency fuctations on thelr bust ‘ges opportunities. Recall from the discussion of the Caterpillar-Komatsu rivalry in Ghapter 5 that the strong dollar caused Caterpillar problems during the early” 7980s, and the weak dollar (and strong yen) caused Komatsu problems during the Jake 1980s anid early 1990s. The dollar's rise’since mid-1995-has eased Komatsu _beerns but tse Coterptar ; F ats 3.80 odes rea oe ao ask 290% : zh 240 z. 28 190 ses ; a 1960. . 1970 1980 1990 1998 oa‘aioy of the International Monetary System 9-169) Bringingthe Worldintol = FOCUS , SHOULD BRETTON WOODS BE RESTORED? tieracional policy makers have debated the’ value of recon: smuténg the Breton Woods system. Proponencs bere excage xe oft ntemsrona basse een arancages Exchange rates are nat subject to wice cal, weekly 1 and monthly fluctuations. The riskiness of international cade ansictons is. thus reduced, and firms have greater assurance of sabi inthe values of foreign curencies, Also, Fact exchange ‘mes a an important anc-inflaionary tool beeause the loss of afi teserves forces a country to counteract inflationary ten dence in its econcmy, Bretcon Woods proponents also ate di essed because the wild swings in the values of key currencies that occur inflexible exchange rate systems can dstupe sound iemavonalivestmene decision making. «Advocates of fexble exchange races look a che athe side of she cain: If balance of payments (80P) equilibrium can be |: teacheg through changes in exchange rates, then domeitic pel- igy makers are free to focus on domestic economic concerns ‘without worrying about the BOP consequences oftheir act.2n. Flexible exchange rates also reduce the need for international coordination of domestic economic policies and allow each country to follow its own economic destiny. For example, if Mexico’ monerary authorities choose more inflaionary. growsh-orienced economic policies than thote adopted by irs major trading pariners, changes in’ exchange rates will bring about BOP equilibrium. Flexible exchange rates can absorb the impace of damaging exceral economic events, such as occurred duting che «wo oil embargoes in the 1970s, Proponents of flexi- ble exchange races ao suggest that fixed exchange rate systems are not invulnerable co disurderly changes in currency values and, Gite the depreciation of the pound in 196), the French frane in 1968, and the US. dollar in'197%, Simitaly. they poins out the chaos and hardships created by che 1997-1999 collapse of che fixed exchange race systems used by Thailand, Indone ‘other Southeas Asian countries, {Currency fluctuations also affect international Investment opportunities, For ‘gample, the appreciation of the mark against the dollar a ler 1985 made it more “iMeatt for Bayerische Moloren Werke to sustain its sales of BMWs tn the United Sales. The company’s solution was to bulld an autoniobile asseinbly plant near ‘“Sartanburg, South Carolina. a move designed to lower the company’s production ‘ests and raise its visibility in the North American mazket. The mark's fall against ,bedglar since 1995 has eroded some of the cost advantages to BMW of its South ‘tartha plant, As “Bringing the World into Focus” suggests, the problems eaused ty these exchange rate fluctuations have motivated some experts to call for a Mstoration of the Bretton Woods system. ‘The International Debt Crisis. ‘The flexible exchange rate system instituted in 1973 was immediately put to a severe test. In response to the [sraclt vietory in the ‘kab-isrdeli War of 1973, Arab lations imposed an embargo on oll shipments to tnntrtes such as the United States and the Netherlands, which had supported the bratll cacce. ae a result, the Organization of Petroleum Exp ting Countries [OPECy stucceeded in quadrupling world oll prices from $3 a barrel October 1973 8812 a barrel by March 1974. This rapt increase in oll prices cat:ved Inflaitonary Fessures in oll importing countries. For example, In the United States inflation efrom 6.1 percent in 1973 to 11-1 percent in 1974. In 1974 alone $60 billion in tealth was transferred from oil-importing countries to oll-exposting count . The fev litermational monetary arvangements absorbed soire of the shock caused by tidupheaval in the olf market, as exchange rates acy sted to account for changes lathe value of each country’s oll exports or inipos! eorrenctes of the oll fxporters strengthened, while those of the all Importers eae ted3 Chapier 6 The iitemsitonl Monetary System andthe Balance of Payments, ‘This enormous transfer of wealt\ rated certain cconomie-con . The iigher oll prices fntted 88 a tax on the ¢conomies of te oll-mporting countries. Some ‘economists feared that worldwide depression would develop’ as'consumer demand fellin the richer countries, Other économtots worried that because trade fri gil was denominated in dollars, International liquidity, would dry up as dollars piled up in ‘Arab bank accounts, Neither of these fears was realized. Many of the.oll-exporting | countries vent on spending sprees, using their new Wealth to tmprove thelr infra Strugtures or t6 invest In hew facilities (such as petroleum reflferles)ito produce wealth for futuré generation ‘The unspent petrodollars were deposited in banks tr International money cente: : uch as London and New York City. The interpational - banking’corhnfunity then recycled these petrodollars through its international lending activities to help revive the economies damaged by rising ofl prices. . Unfortunately, the international banks were too aggressive in recycling these * dollars. Many countries borrowed more than they could repay. Mexico, for example, orroived $90 billion, while Brazil took on 867 billion in new loans. The financial positions of these borrowers became precarious after the of shock of 1978-1979, which was triggered by the toppling from power of the Shah of Iran. The price of oll ‘skyrocketed from $13 a barrel in 1978 to over $30.a barrel In 1980, triggering another round of worldwide inflation. Interest rates on these loans rose, a8 most carried a floatirig interest rate, further burdening the heavily indebted nations; Thie_ international debt crisis formally began when Mexico declared in August 1982 that it could not service its external debts: Mexico requested a rescheduling of Its debts, a moratorium on repayment of principal, and a loan from the IMF to help it through {ts debt crisis. Mexico was soon Joined by Brazil and Argéntina. In total more than 40 countries in Asia, Africa, and Latin America sought relief from thelr external debts. Negotiations among the debtor countries, creditor countries, -private banks, and international organtzationis continued through the rest of the 1980s. Various approaches were used to resolve the crisis, The 1985 Baker Plan (named after then U.S. Treasury Secretary James Baker) stressed the importance Jof debt rescheduling, tight IMF-imposed controls over domestfe monetary and fiscal policies, and continued lending to debtor countries in hopes that economic growth ‘would allow them to repay thelr creditors. In Mexico's case the IMF agreed to pro: vide a loan package only if private foreign banks holding Mexican debt agreed to reschedule thelr loaris and provide Mexico with additional financing. However, the debtor nations made little progress in repaying thelr loans. Debtors and creditors alike agreed that a new approach was needed. The 1989 Brady Plan (named after. the Bush administration's treasury secretary, Nicholas Brady) focused on the need to reduce the debts of the troubled countries by writing off parts of the debts or by providing the countries with finds to buy back their loan notes at below face value. The international’ debt crigis"receded during the 1990s as-the debt-servicing * requirements of debtor countries were made more manageable via a combination of: IMF loans, debt rescheduling, and changes in governmental economic-polictes (see the discussion of economle‘reforms in Mexico, Argentina, and Brazil in Chapter 2). ‘The inipact of the crisis cannot be overstated. Many experts consider the 1980s the “lost decade” for economic development tn Latin America. ‘The most recent crisis facing te international monetary system erupted in July 1997, when Thailand, which had pegged its currency to a dollar-dominated basket, of currencies, was forced to unpeg its currency, the baht, after investors began to distrust the abilities of Thal borrowers to repay their foreign loans and of the Thi .. government to maintain'the baht's value. Not wanting to hold a currency Ikely to be, devalued, forfign and damestic investors converted their bahts to dollars ahd other currencies. The Thal central bank spent much ofits official reserves desperately try" ing to ‘maintain the pegged value of the-baht. After Thailand was forced to abandon the peg on July 2, the baht promptly fell 20 percent in value. As invéstots realized _fliat other countries in |the region shared Thailand's averdependence.on forelgh ‘short-term capifal, thelr currencies also came untler attack and their stock marketsDecune nm Cunpeney VaLue Eau Mai (change Jay 1, 299750 10 TSE” any eee +‘ Geehango July 1, 1997-Fab. 18, 1998) ee a) |~48.1 Singapore "Hone" | passed aginst ne US $ were devastated, Indonesia was hit the worst by the’so-clled Aslan contagion, as our earlier discussion of PT Astra International indicated and as.Figure 6.5 shows. Afersfiocks of the crisis spread to Latin America and Russia, and the Russian gov- emment effectively defaulted on its foreign debts. All told, the IMF and the Quad ‘ountries'pledged over $100 billion in loans to help restore these countries tg.eco- ‘nomic health. The closing case of Chapter 7 ar the “Point-Counterpolnt™ tpt fol- “pws that chapter discuss this erisis in more detaif ‘These crises did not come as a surprise to the analysts who’had been monitoring {he affected countries’ balance of payments accounts for danger signs./The BOP ‘accounting system provided clear warning ‘of the detertorating performance of the countries In crisis and the increasing riskiness of their overextended external debt positions. A careful reading of BOP statistics could have protected international bankers from bad investments and risky loans. Because the BOP accounting sys* (em provides'such valuable economic intelligence information, the next section dis- fusses tin detall + Re iS ee The Bi eel Peyment Aeauning Sen mat Grae ‘The Asian Cont Source Gerard Bases. “US. Los to G7 Backing on Asa Criss? Financial Times February 20,1998, 9.4. Reprinced wich permission. Y | THE: BALANCE OF PAYMENTS ACCOUNTING SYSTEM ¢. Fach year countries purchase trillions of dollars of goods, services, and assets from. ‘tach other. The BOP.accouriting system.ts a doyble-entry bookkeep gystem designed to measure and recotd ‘all economic transactions between resident of one ‘Suntry and residents ofall other couritries during a particular time period. It helps pal rs understand the performance of each country’s economy in interna~ ‘Mona? markets, It also signals fundamental changes tp the competitiveness of eoun- ‘ties and assists polley makers in designing appropriate publlc policies to respond tothese changes. * “International businesspeople need to pay close attention to countries’ BOP sta- ° Listes for several reasons, including the fpliowing: 1. BOP statistics help identify emerging markets'for goods and services: 2. BOP statistics ran warn of possible new polictes that may alter a country’s business climate, thereby affecting the profitability of a firm's operations In that-coyntry. For example, sharp rises In a country’s imports may signal an , (overheated economy and portend a tightening of the domestic monéy supply. ‘1n this case attentive businesspeople will shrink th:tr ‘nventortes tn antielpa- “, Uae ofa reduction in customer demand. .Chapter 6 The Inernatons! Monetary System and the Delance of 'sjments which may mean that the country’s currency will depreciate In t1 fuiture, as occurred in Thailand in 1997, Exporters to such a country may fir that domestic producers will become nore price.competitive, 4, Aswas true in the international debt crisis, BOP statistics can s{gnel increas’ § 8, BOP statistics can indicate reductions in.a country's foreign-exchan, . § { riskiness of lending to particular countries. . Four important aspects.of the BOP accounting system need to'be highlighted: 1; The BOP’ace-“unting system recorde-Infernational transactions made dur some time od, for example, a year. : . | 12. It records only economic transactions, those that Involve something of mon. | tary value, . : ‘ \ ‘3. It records transactions Weyveen residents of one country and: residents of all other countries. Residents can be individuals, businesses. government agen, | cles, or nonprofit organizations, but defining residency 1s'sometimes tricky Persons temporarily located in a country—tourists, students, and military < / diplomatic personnel—are still considered residents of their home country f-._ BOP purposes. Businesses are considered residents of the country In which | they are incorporated. Firms often conduct international business by locatin: either a branch or a subsidiary In a foreign country. A branch, which by de tlon 1s an unincorporated operation and thus not legally distinct from Its pa: | - ent corporation, is a resident of the parent's home country. A subsidiar. which by definitior’ Is a separately incorporated operation, Is a resident of the country in which it is Incorporated. fir most cases the subsidiary 1s incorpy rated in the host country to take advantage of legally being a resident of Ux ‘country in which it {s operating. : = j 4. The BOP accountig system is a double-entry system, Each transaction p1 duces a credit entry and a debit entry of equal Size, In most international busi ness dealings the first entry in a BOP transaction involves the purchase or si of something—a good. a service, or an asset, The second entry records the pay ment or receipt of payment for the thing bought or sold. Figuring out which the BOP debit entry and which fs the BOP credit entry is not a skill that people are born with. Many experts compare a BOP accounting statement to ‘statement of sources and uses of funds. Debit entries reflect uses of fun: credit entries measure sources of funds. Under this franfework, buying thi creates debits, and selling things produces credit: The Major Components of the Balance of Payments ‘Accounting System The BOP accounting system can be divided conceptually into ‘The first two accounts—the current account, ‘and the capital nee chases of goods, services, and assets by the private and public sectors, The Teserves account reflects the impact of central bank intervention in the fo exchange market. The last account—evors.and omissions--captures mi made in recording BOP transactions, San Current Account. ‘The current. _ mong resents eater etene ASOUNE Yecords four types of tain f. Exports and imports of goods (or jncichandise) > ee 2. Exports and iriporis of services” a 8. Investment ticome —- - 4 citsF “Tho Balance of Payments Accounting Sytem >.173 DEBIT CREDIT Goods By Sell Services Bly Sell Djvidendsandinceresc Pay =e {investment income) Gis * Give Receive For example,.to Germany the sale of a Mercedes-Benz automobile to a doctor in Marseflles 1s a merchandise export, and the purchase by.a German resident of Dom Perignon champagne from France \s a merchandise import. (The British use the ter n trade in visibles to refer to merchandise trade.) The difference between & country's exports and imports of goods 1s called the balance on merchandise trade. For example, the United States, which fias been importing more goods than it has been exporting, has a merchandise trade deficit: Japan, which has. been. exporting more goods than'it has been importing, has « merchandise trade surplus. ‘The services account records sales and purchases of such services as trans~ portation. tourism, medical care, telecommunteations, advertising, fnancial se fees, and education. The sale of a service to a resident of another country Is a serv" fee export, and the purchase by a resident of a service from another country Is a service import. (The British use the term trade In Invisibles to denote trade Jn sentees,) For example, for Germany a German student spending a year studying at the Sorbonne in Paris {s an Import of services. and the telephone call home that an _ feolign tourist makes during the Onjoberfest In Munich represents a service export. The difference between a country’s exports of services and its Imports of services Is called the balance om services trade. ‘The third type of transaction recorded in the current accgunt is investment incane! Income German residents earn from thelr foreign investments ts viewed a8 seenport of the segrices of capital by Germany. This income takes the form of an erro tcrest and dividends earned by German residents on thelr tnvestments 1% forelgh stocks, bonds. and deposit accounts or profits that are repatriated back to Geneeay from incorporated subsidiaries in other countries that-are owned by Fay eos. Of eourse, foreigners also make tnvestments in Germany. fncome Cainea by foreigners from thelr investments in Germany {s viewed 95 97 import of. the services of capital by Germany. This income Includes Interest and dividends fala by flems In Germany on stocks, bonds. and depos accounts owned by foreign ald by fiimye well as profits that are repatriated by foreign-owned sncorporated cessctdlsgies In Germany back to thelr corporate parents, 3 He rn type of transaction in the current account Is unllaterat transfers, of fits between residents of one country and another Unilateral transfers include Crivate and public gis. For example, Pakistanl bom residents of Kuwait who send en of their earnings back home to thelr relatives o°¢ engaging In private unJateral aan een contrast, governmental ald from the United Kingdom used for a flood tater project in Bangladesh 1s a public uniateral transfer. In both cases, the fealptents need not provide any compensation (othe donors. cipents nee account balanes measures the net bai © resend from mer- chantise trade, service trade, investment income, and « allateral transfers. It ts tlosely scrutinized by'government officials and policy makers because It broadly cose he country’s current competitiveness In International markets. Capltal Account. The second major account tn the BOP accounting system 1s the capital aceount, which records capital trancactions—purchases and sales of the eapiittveen residents of one country and those of olher countries. Capital (cuminarized in Table 6.4) can be divided Into two categories: 1 (FD) and portfolio investment, | account transactions foreign direct investment rr BOP Entrles, Current ‘Account‘174 > Chapter 6 The Intemational Monetary System and the Balance of Payments i warurity. ‘MOTIVATION ‘TYPICAL INVESTMENTS ~ Forforo ‘One year or Investment income or ‘Checking account balances: |. (horeterm) «less facilitation of| Time deposks : _ ot : incerational commerce Csrameril paper : _ . . + Bank loans ut Portfolio” More than > tivestment income = Goverment bill, notes, (long-term), ~ one year and bonds : . ‘Corporate stocks and bonds Foreign dtect " Indeterminate Active control of organization Foreign subsidiaries: investment _» (owm atleast 10 percent Foreign factories . isiscrins oct) Uncernasionaljoine ventures] «FDI Is any Investment made for purpose of controlling the organization tn which the investment ts made, typically through ownership of significant blocks of commion stock with voting privileges. Under U.S. BOP accounting standards : toe . control Is defined as ownership of at least 10 percent of a company’s voting stock. +. A portfolio investment fs any investment made, for purposes other than control. “ Portfolio investments ’are divided into two subcategories: short-term frivestments and long-term investments. Short-term portfolio investments are financial, “ instruments with maturities of one year or less. Included in this category aré . éommerctal paper; checking accounts, time deposits. and certificates of deposit held by residents of a country In foreign banks or by foreigners in domestic banks; trade receivables and deposits from International commercial customers; and banks’ short-term international lending activ- tUes, such as commercial loans. Long-term portfolio investments are €tocks, bonds, and other Ananclal instruments Issued by private and public organizations that have maturities greater than one year and that are held for purposes other than control. For example, when IBM invests, excess cash balances overnight in a Paris, bank to earn a higher Interest rate than it could earn in New York, it is making a short-term portfolio investment. When the California Public Employers Retirement System Pension Fund buys stock in British Ainways, it'ls, making a Iéng-term portfolio Investment. When ‘British Alrways purchaSes 23 percent of the common stock of. USAr, It Is making an FDI Current account transactions invarfably affect the short-term component of the capital account. Why? As néted earlier in the chapter. the first entry in the double-entry BOP . ‘accounting system records the purchase or sale of sdmething—a good, a service, ar an asset. The second entry typleally records the paymtient or receipt of payment for the thing bought or sold. In most cases this sec. > Renault’s purchase of Samsung totes in 2000 improvedits access toForees auromobie make Ths ecigudnecriwemene gnd entry reflects a change In someone's checking account balance, which in the recordedin the French balance of |-BOP accounting system 1s a short-term capital account transaction, (‘Building paymentsasadebicra checapical Global Skills" at the end of this chapter walks you through this linkage between the scoune. current account aga the capital account in more detail.) :\.” Capital inflowd are credits in the BOP accounting systern. They can occur in iw iz Foreign ownership of assets in a country increases. An example of a capital {nflow into the United States Is the purchase of Lycos, 9 U.S. Web portal com- pany, by. Terra Networks SA, a Spanish dot-com company. for $8.6 billion in + late 2000.4 A capital inflow also occurs if a forelgn firm deposits a check ini a USS. bank. In this case, the asset being purchased ts a claim on a U.S. bank, * which of course fs all that a checking account balance represents. 2.. Ownership of foreign assets by a country's residents declines. When K-Mart and a US. partner sold K-Mart’s Canadian operations to Zelle’s (a division of Ganada's Hudsoh's Bay Compeny) for $168 million in the late 19903, the United States experienced a capital inflow. Similarly, when IBM pays @ Japanese disk drive supplier with a check drawn on IBM's account at a Tokyo bank, IBM's Japanese checking account balance declines and the United + States experiences a capltal inflow because IBM Is partially liquidating its own- ership of foreign assets. : . Capital outflows are debits in the BOP accounting system. They also can occur in two ways: 2 es < "1. Ounership of foretgn assets by a country's residents increases, Ford's £1,6 bil Won purchase,of the British firm Jaguar Motor Company represented a capital + - outflow from the United States. A U.S. capital outflow also éccurs when Delta | Air Lines depostts a check from a London businessperson into an account it holds in an English Bank. . - a Forelgri ownership of assets in a country declines. A German ritutual fund that «sells 190.000 stiares of GM common stock from Its portfollo to a U.S. resident 2° Gauses'a capital outflow from the United States. A U.S. capital outflow also ~-oGurs if Japan Air Lines writes a check drawn on its account at an Hawallam ‘bank te pay its fuel supplier at Honolulu Alrport: In both cases foreigners are liquidating a portion of thelr U.S-assets. : ” Table 6.5 summarizes he Impact of various capital account transactions on the BOP accounting system.” : : : Deer (ourAiow) ‘caeoir @nFLOW) Farka Resting paymene oma lreenes Waking pyrene sane (hore zim) Buying a short-term foreign asset Seling a domestic short-cerrwasset to'a foregner 5 uy back shorccerm domestic, ° Seling a shorccern foreign asec strom its foreign owner acquired previously ponfiio -. Biyingalong-ermforign asset” Selinga domestic long tem ase roa (long-term) (not for purposes of control) foreigner (not for purposes of : : : centl) Buying backalongermdomesic Slings lingterm. ignasee ' ~ ‘asset from its foreign owner (not acquired previously (not for ferpurposesofconcel) pupores of conte) orn dine Bijingatorignavetto puns Saga donesic seta imesment °-ofcontol fore for purposes ofcontol Buying back roms fortign owner, * Sling 2 fear ase previously oye * ‘adomestic asset previously acquired acquired for purposes of contrat ; for purposes of control : BOP Entries, Capital ‘Account76.2 Chopter G The Jnteranienal Monetary System and the Belance of Payments ‘The third major account In the BOP accounting : system, the official reserves account, records the level of official reserves held by national. government. These reserves are used {0 intervene,in the forelgn- txchange-market and in transactions with other central banks. Official reserves comprise four types of assets: ‘ 1, Gold . ct 2, Convertible currencles 8. SDRs 4, Reserve positions at the IM" Oficial gold holdings are measured using a par value established by a country’s treasury of finance ministry. Convertible currencies are currencies that are freely exchangeable in world currency markets. The'convertible currencies most com- ‘monly used as official reserves are the U.S, dollar, the euro and associated curren- cles, and the yen. The last two types of reserves—SDRs and reserve positions (quo- tas minus IMF borrowings) at the IMF—wére discussed éarller in this chapter, ~ : * Errots and Omissions.’ The last account in the BOP accounting system fs the errors and ‘omissions. account, One truism of the BOP. accounting system {s. that. ; the BOP must balance; In theory the following equality should be ‘obseryed:* y Curent Account + Capital Account + Official Reserves Account = 0 Official Reserves Account. However, this equality 1s never achieved in practice because of measurement errors: The errors and omissions account {s used to make the BOP balance in accordance with the following equation: Current Account +.Capital Account + Official Reserves Account + Errors and Omissions = 0 ae ‘The errors and omissions account can be quité large. In 1999, for example, the U.S. errors.and omissions account totaled $11.6 billion. In 1998 It was $69.7 bil- ion. Experts suspect that a large portion of the errors and omissions account bal- ance,is due to underreporting of eapital account transactions. Such Innovations as instantaneous, round-the-clock forelign-exchange trading, sophisticated monetary. swaps and hedges, and international monéy market funds have made tt difficult for government statisticians to keep up with the growing volume of legal short-term guioney flowing between countries in search of the highest interest rate. is ‘Sometimes, errors and omissions are dite to deliberate actions by individuals who are engaged in illegal aétivities such as drug smugeling, money laundering, or eva‘ iGion. of currency and investment controls imposed by their home governments. ‘Politically stable countries. such as the United States, are often the destination-of fitght capital, money sent abroad by foreign residents seeking a safe haven for thelr assets, hidden from the’ sticky fingers of their home governments. Given the often filegal nature of fight capital. persons sending It to the United States often try to avoid any official recognition of their transactions, making it difficult for government BOP statisticians to record such transactions. Residents of other countries who dis- trust the stability of their own currency may also choose to use a stronger currency, such as the dollar or the yen, to transact their business or keep thelr savings, a8 "Venturing Abroad” suggests In 1969 alone some $22 bilion of U.S. currency lowed . overseas, as concerns about the Y2K problem, exchange rate Muct frlancial nstabiityinerensed the desie of foreigners to held US. eureney? + Some errors may érop up Inthe curfent account as well. Statistics for merchan- dise imports are generally thought to be reasonably accurate because most coun- trfes' customs services scrutinize imports to ensure that all appropriate taxes are collected. This scrutiny genérates paper trails that facilitate the collection of accu- rate statistics. However, few couintries tax exports, so customs services have less inceritive to. assess the accuracy of statistics concerning merchandise exports.Whois the most wellknown American outside the borders ofthe United States? George W. Bush?.... Madonna?.:; Gwyneth Paltrow? A good argument can be made for Ben Franklin, whose face adorns the US, $109 bill Economists and aecouneants at the US. Federal Reserve Bank (FRB) have been trying for years to est- ‘mate how much US. currency is held by foreigners. Their best {guess is that ofthe $515 billon in US, currency in circulation 1999, $251 bilion, or 49 percén. is held by foreigners. Most ofthis foreign-held currency is in $100 Bills US. consumers prefer co ut- lize smaller denomination ils. “ Tracking down the toral numberof dls held overseas rather ‘complex, and is based on a mixture of sophisticated economic mmedeling, consumer surveys and educated guesswork, A 1995 FRB survey of US. households could accounc for only 3 percent of tie $100 bits prince by, the US. governmane. ye che numberof such bil in ciculation has increased by $143 bilion since 1990. FRB _ safes alo know thatthe Los Angeles and New York City Branches ‘ofthe FB dsribuce enormous numbers of $100 bits relative co the ‘ther branches, From 1980 to 1996 these ewo branches sccounced {or Re percent of the new 5100 bilsnlaced in eircuation, Experts | Delieve that most of this currency flows to citizens of countries where economic andor polis unrest high Rusa, ther formes ‘Soviet Republics, che Middle East. ard Latin America appeat to be partcuatyimponanc destinations for US S100 "Another contibuting facto he creasing “olaiation of Latin Ameria, On Nev Yar Day 2001 El Salvador made the US " imporcanc benefic. <9 the US. Treasury. and ulkimacely to the US. ‘The Balance of Payments Accounting Systems > UIE "BEN FRANKLIN, * “WORLD TRAVELER 7 . dollar legal tender there. El Salvador’s Central Reserve Bank pur- chased $450 milion worth of US.’cirency to implement this, change. Ecuador adopted a similar policy in mid-2000, and Guiacemala has taken steps to dollrize its economy a8 welt These foreign holdings of US. paper currency provide an Caxpayer because they effectively serve,as an incesesc-free loan, Normally, to fund the US. debt, the US. Treasury must float loans in the form of bonds, notes, and bils. Currency holdings subsci: ‘ute for such loans and reduce che amount the creasury must bor- row If 30-year treasury bonds bear an interest race of 65 percent, then the US taxpayer saves $163 billion (65 peicent times $25T bill) in incerese payments annually a8 a result of foreign hold- ings of US. currency. This is ne of the benefits American citizens receive as 4 result ofthe country’s economic and politcal scabily, ‘Other councties in particular, Germany—also benef from large holdings oftheir paper currencies by residents of other countries ‘Many experts believe that many foreigners will also hold euros once that currency becomes available in 2002, Sources “Dalora Sie of World Reserves Grows? Wall Seat Journal, September 10,1997, 9.A2: Survey Curent Business July 2000p. 51: Resa CCounes Cos of Change as US Set to Isue New $100 Bil” Financa! Times, Jnvary 16,1536, . 20, “Where's ere Buck? Dollars Make the World: Go ‘Around, Fed Says" Houston Chronicle October 13,195, p.2C:"ESahador Sehtching ca US, Dolla’ Houston Croncle December 30,2000 6. 1C. Statistics for trade in services also may contain inaccuracies. Many service trade ‘statistics are generated by surveys. For exaniple. U.S. tourism exports are meas. : ured by surveying forelgn tourists on how many days they spent in the United States and how many dollars they spent per day. If tourlsts underestimate thelr daily spending, then U.S. service exports are underestimated. To help you gain a better understanding of the BOP accounts: we next review the international trans- . actions of the United States in 1999. The U.S. Balance of Payments in 1999 ‘The first component of the current account Is merchandise (goods) exports and Imports. As shown in Table 6.6, U.S. merchandise exports totaled $684.3 billion in 1999. Figure 6.6(a)-presents a more detalled picture of the leading US. exports. Automobiles and auto parts were the largest component of U.S. merchandise exports, genefating $75.8 billion In sales. Of U.S. automobile exports 60 pereent Were to Canada-a reflection of the integrated nature of North American automobile Production that resulted from the 1963 Auto Pact between the United States and Carita: (Canada—meaning primarily GM, Ford, and Chrysler plants, that ace located in Canada—exported $65.9 billion In automobiles nd auto parts to the |of dottars) 1 5 Chapter 6 The Internation! Moneta Syslemand he Bante of Prony Po a ta ‘ é Perr US: BOP, 1999 (Ir billions | ~ a ne 2 t ]) Unilateral Transfers(ne) 7 Current Account | oar Coren Ace Pee hy ct ; caimpons wh ie . Balance on Merchandise Tide .'S ‘ 1s Epon” ond Investment income ; Received Paid . . Balance on Investment Incarne (- means outward gifes greaver.than inward) Balance on Current Account Capital Account Portfolio shor-ferm (Net Oixfow) “laa -| + Portfolio, Long-Term eek . "] New Foreign Investmene in US. 4306 New US Investment Abroad = 6 VBE.” Foreign Direct lnvestment + ; oy es . Le New FDI in US. i 42755 7 New US. FDI Abroad 1809 ve “fe Balance on Capital Account 32 Official Reserves Account 2487 Errorsand Omissions” : pede TEs ‘Net Balance a we = ~ : i. ‘ S United States.) Thé six industited shown In Figure'6.6\a) accounted for 49 percent of U.S. merchandise exports In 1999. “From Table 6.6; you can see that U.S. pillion in 1999. From Figure 6.6(b) you can see mobiles and auto parts, at $179.4 billion; or 17 percent : decounted for $466.5 billion, or 45 percent of total U-S- thre second component of the current account is trade tn services. U.S. exports of cepaees totaled $271.9 billion in 1999, with travel and tourism being the arge*t portion (894.7 billion). U.S. service Imports equaled $191.3, with ‘travel and touirigm again being the largest portion ($80.8 billion). The ‘United States had.a pos - itive balance on services trade of $80.6 billion (see Table 6.6). - "Figure 6.7 shows exports and imports for the major trading partners of the * ‘United States and includes trade in both goods and services, From this, figure you'” ‘can see that the United States tends to import more foods fram its major. trading partiers than it exports to them: you can also see that the United States tends to Export More services-to its trading partners than it imports from the. é ‘The third componegt of the cureht account Is investment income {see Table 6.6), In'1999 U.S. residents recélvetl, $276.2 billlon from foreign. Anvestments,2 merchandise imports totaled $1.029.9 ‘that the leading impart was auto- it of imports. Six industries merchandise impofts.; . +. + The Balance of Payments Accounting System >” 172 S.Ledng US, mectandinimpins,1999 arc Leading US. Merchandise Exports and Imports, 1999 i ae : m0 al Exports Imports By Senices. 3 200 ——E# —— Trade Between the United States and Its Major Trading Partners, 1999. Nore! Data on services exports at ienports are noe avalable for Taiwan, CChina,and South Korea.> Asacondiion fo jsning the Word Tade Orgaisaron China {reed co reduce es tade bares apna foreign goods Here Fonds ‘Agriculture Commissones hands a ceremonial rst grape (03 Bejing shopper ata medigevers berading the nial shipment of US. Gieros ui US agrestural expors reached alos $50 Bilfon in 199° paid out 6204.7 billion to foreigners for a net. Negative balance.on investment income of 818.5 billion. The United States hnd a net defiett of | ‘848 billion in the fourth component of the cur- rent account, unilateral transfers, Summing up the four components yielded a 1999 current account defictt of $331.5 billion, ‘The capital account Is the second major BOP account (see Table 6.6). In 1999 new U.S. FDI abroad (outflows) totaled $150.9 bil- lion, while new FDI in the United’ States (inflows) totaled $275.5 billion. New U.S. long- term international portfolio investments were. $128.6 billion in 1999, while new foreign long-term-portfolio investments In the United States were $343.6 billion. There was also a net outflow of shoft-term portfollo investment from the United States, totaling $28.4 billion. ‘The capital account balance.was $311.2 bil- Hon in 1999, as foreigners bought more U.S. assets than U.S. residents bought foreign assets. . . U.S. official reserves account transactions were $8.7 billion. If the BOP statisti- cal data net were perfect. the current account balance plus the capital account bal- ance plus the offietal reserves account balance should equal zero. Any discrepancy: is put into thé errors and omissions account. In 1999 there was a discrepancy of $11.6 billion. Therefore, for the U.S. BOP in 1999 the following equatfon.applies: Carrent Capital Changes in Errors and Account ~ “+ Account +. Officlal Reserves + Omissions = 0 (-$331.5 billion) (+8311.4 billion) _(+68.7 billion) “~~ (4811.6 billion) Defining Balance af Payments Surpluses and Deficits : Every month the federal government reports the performance of U.S: firms in inter- national markets when it releases the monthly BOP statistics, In most months dur- Ing the pas’ decade, newssasters have solemnly reported oh the eventng news that the U.S. BOP Is In deficit. ' What do the néwscasters mean? We jist'sald that the BOP always balances {equals zero). so how can there be a BOP deficit? In reality when knowledgeable people (or even newscasters) talk about a BOP surplus or deftett, they are referring only toa subset of the BOP accounts. Most newscasters aré in fact reporting on the balance on trade In goods and services. When a country exports more goods and services than it Imports, it hes a trade. surplus. When it Imports more goods and services than It exports, Ithas a trade deficit. - Because the balance on trade in goods and services {s readily understandable end quickly avallable to the news media, It recelves the most public attention. However, other balances also exist, stich as the balance on services, the. balance on meichant~ dise trade, agd the current eccount balance. Ancther closely watched BOP belance Is the official settlements balance. The official settlements balance reflects changes i a country’s official reserves: essentially, tt récords the net impact of the central bank's Interventions tn the forelgn-exchange market in support of the local currency. Which of these BOP balances #5 the balance of payments? That is really W trick question. There:Is no single measure of a country’s global economic performence, Rather, as in the parable of the blind men touching thé elephant, each balance pre- “sents 0 different perspective-on the nation’s position In-the tnterizational economy.e 80 ‘tions of ° -80 Goods and services_— balan 100 = 150 Merchahdise trade balance 200 os, + Current account balance 250 50 Je67 1969 1971 1973 1978 1977 1979 1981 1983 1985 1987 1969 1991 1999 1995 1997 1999 cee ‘The US. BOP According to Various Reporting Measures Which BOP concept to use depends on the isstie confronting ‘the International bust- * nessperson or government policy maker. The balance on merchandise trade reflects the competitiveness of a country’s manufacturing sector. The balance on services reflects the service sector's global competitiveness. Although the balance on mer~ Chandise trade often recelves more publicity, the balance on services 1s growing th importance because of the expansion of the service sector in many national economies. The competitiveness of palance on goods and services reflects the combined International a country’s manufacturing and service sectors. The current secont balance shows the combined performance of the manufacturing and service sectors and also reflects the generosity of the country's residents (untlateral transfers) seiwell as income generated by past investments. The official settlements balance oe ects the net quantity demanded and supplied ofthe country’s currency by all mar- fet participants, other than the country’s central bank. Figure 6.8 shows the U-S. balance of payments for the past decade according to these various measures. CHAPTER Summary. ~ In their norinal commercial accvities international businesses often deal with curtencies other than those oftheir home countries. For incernasional commerce to thrive, some system for exchanging and ‘aluing differen currencies, preferably at low cost, must exit The REVIEW international monecary system accomplishes this by establishing che rules for valuing and exchanging differen currencies. “The economic growthlof the nineceenth century i attributable in parc co the success ofthe gold standard in providing a stable, reliable international monetary system based on fixed exchange rates.V82_> Chapter6 The International Mon However the gold standard broke down during Wold Warland could * mot be satisfactorily revived in the years between the two world was. The Bretton Woods Agreement of 1944 structured the post: ‘Wotld Wari international monetary system. In addition to creating the International Bank for Reconstruction and Development (the World Bank) and the IMA, the agreement relnuituted a fixed ‘extharige rate system, with the US. dolla playing a key role In inter= ‘ational transactions, However, asthe number of dollars held by for- ‘igners increased, the marketplace began to distrust the ablity of the United states to redeem its currency at $35:per ounce of gold as required by the agreement. After fending off waves of speculation ‘against the dollar, the United States abandoned the Bretton Woods ‘Agreement in August 1971 ‘Since then, the international monetary system has lied on acom- bination of fied and flexible exchange rate sjstems, Some countries have allowed their currencies to lot; others, such as the EU mem- bers, have attempted to maintain fixed exchange rates among their Currencies The system has proven responsive to majr shocks to the ‘world economy, such asthe shift of wealth from oitconsuming to oi producing countries afer the 1973-1974 ol embargo, the 1980s inter- national debt crisis, and the 1997-1998 Asan currency crs ‘The BOP accounting system which is used t6 record international transactions is important to incernational businesspeople. The BOP system provides economic.inteligence data about the international. competitiveness of a country’s industries, ikely changes in is fiscal and monerary polices, andi ability to repay is international debts ‘The BOP accounting sytern comprises four accounts. The current account reflects exports and imports of goods, exports and impores of services, investment income, and gifts. The capital account records capital transactions among countries and includes FDI and portflio investments, Portfolio investments in turn can be divided into long- term and short-term investments. The official reserves account is a record of changes in a country’s official reserves, which include cen- tral bank holdings of gold, convertible currencies, SDRs, and reserves at the IME The errors and omissions account captures satstical di Ctepancies that often result from transactions that participants wane to hide from government official ‘There are numerous ways to measure a balance of payments sur- plus or deficit. Each presents a different perspective on a country’s global economic performance. The balance’ on merchandise trade ry Syetem and the Balance of Payments 3 measures the difference verween a country’ exports and imports of ‘goods. The balance on services is growing in importance because of the rapid expansion ofthe service sector in many economies. The balance on goods and services measures a country’s trade in goods and services, The current account balance reflects both trade in goods and trade In services, as well as net Investment income and gilts. The official settlements balance shows changes In a country} official reserves, Review Questions 1. What is the function of the international monetary system? * 2. Why isthe gold standard a type of fixed exchange rate system? 3. What were the key accomplishments of the Bretton Woods conference? 4, Why was the IFC established by the World Bank? '5, Why are quotas important to IMF members? 6. Why did the Bretton Woods system collapse in 19712 7. Describe the differences between a fixed exchange rate system and a flexible exchange rate system. - List the four major accounts of the BOP accounting system and their components. 9. What factors cause measurement errors in the BOP accounts? 10, Differentiate among the different types of balance of payments surpluses and deficis. Questions for Discussion 1. What parallels exist betiveen the role of the British pound in the nineceenth-century incernational monetary system and that of the US. dollar since 1945? 2. Did the key role that the dollar played in the Bretton Woods 5ys- tem benefit or hurt the Uniced States? 3. Under what conditions might a country devalue its currency today? 4. ‘Are there any circumstances under which a country mighe want to increase its currency’s value? 5. Can international businesses operate more easily in a fixed ‘exchange rate system or in a flexible exchange rate system? 6. What connections exist between the current account and the capital accoune? BUILDING GLOBAL SKILLS «This exercise explains how US. governmental statisticians account for international transactions. You may want to refer to Tables 63 and 6$ and to the definitions of capital inflows and capital outflows ‘on page 175. Example 1 Suppose Wal-Mart imports $1 milion worth of VCRs from the Sony Corporation of Japan, The debit entry isa merchandise import of $1 «milion. The import ofthe Japanese goods means the United States “will observe an outflow (ora use) ef foreign exchange. Here is the tough part, What is the offsecing credit entry? The answer is a capital inflow affecting the short-term portfolio account. Recall that a capital inflow occurs because of ether an increase infor eign-owned US, assets or a decrease in US-owned foreign assets. F ‘Wal-Marc pays Sony with a $1-million check that Sony deposits ints US. bank, foreign ownership of assets in the United States increases, wich isa short-term capital inflow f Wal-Mare pays Sony in yen by ‘drawing down a Wal-Mare checking agcount balance at a Tokyo bank, a decrease of US-owned assets in foreign counties occurs, Which i also short-term capita inflow ither way, a short-term cap-talinflow occurs because the VCRS are being exchanged fora change ina checking accourtt balance. ‘What if Wal-Mart pays Sony with a $1-millon check, but Sony _ wants yen? Sony will take the check to its US. bank and ask the bank to.convert the $1-milln check to yen. The US. bank can accommo- date Sony in one of two ways: 41, Give Sony yen thatthe US. bank already owns-—this represents decrease in US-owned foreign asses. 12. Pass along the check to a Japanese bank that keeps che $1 mil- lion but gives Sony the equivalent in yen—this represents an increas in US. assets owned by foreigners (the lapanese bank). In either case, a capical inflow occurs, Thus Wal-Mart’s purchase ‘of the VCRs from Sony encers the US. BOP accounts a follows: ee DesiT cReoIr Merchandise importsaccount $1 milion Short-term portfolio account $1 milign “The merchandise import account is debited to reflect a use of funds. ‘The payment itslfis credited because effectively a foreigner has pur- chased a US. asset (either an increase in foreign claims on the United States or a decrease in US. claims on foreigners). Note the linkage becween the current account and the capital account. Example 2 ‘A Kosovarrestauranc oviner in Los Angeles who escaped her home- land during the Serbian-Kosovo civil war in 1999 smugges $1000 in cash back to her relatives in Serbia, The US. BOP accounts should record this transaction as flows. : beer CREDIT Unilaceral fansfer account $1000 < Shore-cerm portfolio account $1,000 ‘The wansacton invohes a unilateral tasfer because the $1000 isa gift Because the gifts beng given by 2 US. resident, itis debit The Capital account is crediced because foreigners have increased their chaims on the United Stats. (A counery/s currency reflects claim on its goods services, and assets) Had the restauranc owners sent 2 $4000 stereo system instead of cash, the credit entry would have been 2 merchandise export Nove the use of the qualifier should in the previous paragraph. Us. governmental statisticians were omniscient, Doing Business with the W: “The Wie ste ofthe World Bank provides a variety of information about the baits mision its polices, and how and where itis send ing ics moneys. Because the bank lends billions of dollars a yea its the transaction» ‘Working with the Web: Bullding Global Internet Skills > 133 ‘would be recorded as just explained. However ifthe restaurant owner wished to hide her transaction from the government its unlikely US. statisticians would ever learn of it. When you consider the widespread usage ofthe dolar in couneries sutfering poical turmoil ics nr sur- prising thatthe errors and omisions account as large as ici, Example 3 Mitsubishi buys 51 percent of Rockefeller Center for $846 milion from a Rockefeller family trust. This transaction will be recorded in the US. BOP accounts as follows: i oe ee eds 5 = DesiT CREDIT Foreign direct investment account $846 milion Shore-tetm portfolio account. $846 millon. In ths transaction two asses are being exchanged. apan is buying a long-term asset—Rockefelee Center—for purposes of control. and the United States is buying a short-term asset called an “increase of cchims on foreigners or a decrease of foreign claims on the Uniced States” The US. BOP is credited witha long-term FDI capical inflow of '846 milion because foreign ownership oF US. assets (for purposes of control) has increased. However the actual payment of che $846 mil lions debited asa short-term capica outflow. Either Japanese-owned ‘checking account balances in the United States declined by $846 mi Fon or US-owined checking account balances in Japan rose by SB46 milion ‘Unlike Examples 1 and 2, this transaction does not involve a cur rent account entry and a capital account entry. Both the debit entry and the credit encry affect the capital account. However, a balance in someone's checking accounc is affected by this transaction, as was ‘the casein Example 1. + Do the folowing exercises on your own. How will che following ‘ransactions be recorded in the US. BOP accounts? 1. A Swiss entrepreneur seeking o sel souvenir atthe 2002 wincer Olympics in Sale Lake City, Utah, pays Dek, @ US. atin, $1,400, fora ZurichSale Lake City round-trip ticket. 2. The Swiss entrepreneir instead pays Swissair (a Swiss airline) 11.400 for a Zurich Sale Lake City round-eipcicket. . 5. Ford Motor Company (US) pays $25 billion for the Jaguar Motor Co (UK). ‘4. The US. government gives Rwanda $500 milion worth of food feed scarving refugees. : y TH THE WEB INTERNET SKILLS Web Se is a weasure rove of rarkeing lsd for a wide vey of Companies that sel goods nd sence needed by the bank’ ens. Rsgnment: YOU ae currency employed by WaterPure a com pany tha manufactures water eaten machinery and hydrelec- tric generating cechnology. Most of cs sales are to large, publicly