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THE INSTITUTE OF FINANCE MANAGEMENT

INSTITUTE OF FINANCE MANAGEMENT CHUO CHA USIMAMIZI WA FEDHA

BACC III & BBF III

AFU 08504: INTERNATIONAL FINANCE

LECTURE NOTES
INTERNATIONAL FINANCE AND THE INTERNATIONAL MONETARY SYSTEM

INTRODUCTION TO INTERNATIONAL FINANCE

International Finance: Definition and Importance

International finance deals with financial operations of corporate firms in an environment of

open and integrated financial market. It is financial management for international corporate firm.
International financial management covers many aspects of corporate finance. The financial
operations with which international Finance deals include:

 Investment
 Financing
 Working Capital Management
 Hedging
 Speculation and
 Arbitrage

Why Studying International Finance?

International finance is worth studying because we are now living in a highly globalized and
integrated world economy. The liberalization of international trade and business has
internationalized consumption pattern around the globe. Tanzanians, for instance, routinely
purchase TV sets and motor vehicles from Japan, garments from India and South East Asian
countries, oil from Middle East countries and various types of machines from European
countries. Foreigners, in turn, purchase agricultural products, minerals and other mainly
unprocessed products from Tanzania. Another important area where globalization has a
profound impact is investment. Production of goods and services has become highly globalized.
Japanese cars, for instance, Toyota, sold in the world market might have been assembled in
South Africa. In other words multinational companies are now scattered all over the world in
search for inputs and production locations where costs are lower and profits are higher. A recent
encouraging development concerns the capital markets. Financial markets have also become
highly integrated allowing investors to have their investment portfolios diversified
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internationally. In short, we are currently living in a world where all the three main economic
functions namely consumption, production, and investment are highly internationalized. Thus,
fully understanding of the vital international dimensions of financial management has become
indispensable to the financial manager.

Dimensions Distinguishing International Finance from Domestic FinanceInternational

finance has a wider scope than domestic corporate finance and it is designed to cope with greater
range of complexities than the latter. International finance differs from purely domestic finance
in at least three dimensions. The three dimensions include:

Foreign Exchange and Political Risk

When companies are engaged in international business transactions, they are potentially exposed
to foreign exchange risk that they would no normally encounter in purely domestic transactions.
Exchange rate volatility poses potential risk to companies trading across their borders. Exchange
rate uncertainty may have negative influence on all major economic functions, namely
consumption, production, and investment. Another type of risk that is likely to be faced by firms
carrying out business in an international setting is political risk. Political risk ranges from
unexpected changes in tax rules to complete confiscation of assets by governments of host
countries.

Market Imperfections
International business activities are faced by a number of imperfections, though not at the same
degree as it was that case in few decades ago. Despite the high level of integration of the world
economy, a variety of barriers still hamper free movement of people, goods and services, and
capital across national boundaries. Barriers that are detrimental to global business activities
include legal restrictions, excessive transaction and transportation costs, and discriminatory
taxation. The world markets, including the world financial markets are highly imperfect.
Imperfections in the world financial markets, for instance, tend to restrict the extent to which
investors can diversify their investment portfolios.

Expanded Opportunity Set

Firms engaged in international business are likely to benefit from an expanded opportunity set.
Benefits that may be obtained when firms go international include:

 possibility of raising funds in capital markets where the cost of capital is comparatively
low
 gain from greater economies of scale due to deployment of firm’s assets on a global basis

International Finance and the Role of the Financial Manager

Business firms engage in international operations so that they can reap the benefits of the
internationalization or globalization of trade and investments subjects of to the costs of doing so.
One obvious benefit of international trade is the extension of the markets for the firm’s products
or services beyond the national frontiers. The costs arise from foreign competition, foreign
exchange risk and country risk. Given this background, he financial manager needs to be
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concerned about several issues which we may detect easily by reading financial magazines.
These issues include, inter alia,

 Fluctuations in exchange and interest rates,

 Balance of payments difficulties, and
 The international debt problem

The financial manager would be concerned about these issues simply because they have
ramifications for the firm’s profitability and performance. Exchange and interest rates determine
the firm’s cost of financing and the return on investment. The volatility of exchange and interest
rates implies volatility of profitability and raises the need for managing financial risks. The
balance of payments difficulties affect interest and exchange rates and the economic performance
of countries, since they are often viewed as a constraint on economic policy. The international
debt problem has not only caused some major international banks to incur huge losses or allocate
massive provisions against bad loans, but has also made international business firms in general
think seriously about country risk before taking any about doing business with a particular
country.

The financial manager needs to acquire specific knowledge so that he can execute his tasks
effectively. The financial manger needs to be acquainted with the microeconomic environment in
which the firm operates. This requires the knowledge of:
 Major economic indicators such as growth, inflation, unemployment and the balance of
payments.
 Government policies, including monetary, fiscal and structural policies.

The financial manager must have skills necessary to handle such problems as the management of
foreign exchange risk and analysis of capital budgeting which pertains to direct investment in
projects.

Importance of International Finance to the Financial Manager

Studying international finance is important for the financial manager for the following two
principal reasons:

 It helps the financial manager decide how international events will affect the firm, and
which steps can be taken to take advantage of positive developments and protect the firm
from harmful ones.
 It helps the financial manager to anticipate events and to make profitable decisions before
the events occur

Such events include for instance, changes in exchange rates; changes in interest rates; changes in
national income; and changes in political environment.
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Evolution of International Finance and Its Importance

Evolution of International Finance as an Academic Discipline and a Business Activity

International finance has assumed increasing importance at an accelerating rate, both as an
academic discipline as an activity in which business firms get involved. The evolution of
international finance in this context can be traced under two phases:

Phase I: World War II – Early 1970s

This period was characterized by the following:

 a system of fixed exchange rates

 the presence of stringent capital controls and
 segmentation of capital markets

As a reflection of this setting, international finance was taught not as a separate subject in many
institutions of higher learning around the globe, rather as part of international economics,
precisely as the financial counter part of international trade. International finance was treated
only as an ancillary topic, needed because international trade must be financed. Until year 2000
the National Board of Accountants and Auditors (NBAA) treated international finance only as an
examinable topic under the subject “Financial Management”. However, beyond that year
international finance acquired the status of being an examinable subject. As for business firms,
opportunities to engage in international or cross-country financing and investment were very
virtually non-existence. International transactions were dominated by merely exports and
imports. In addition, given a system of fixed exchange rates and the limited size of cross-country
financial transactions, there was limited foreign exchange exposure. Consequently hedging
foreign exchange risk was not a major issue of concern.

Phase I: 1973 – To-date

With the collapse of the Bretton Woods system in 1971, major countries shifted to a system of
flexible or floating exchange rates. A decade later exchange rates were not only flexible but also
very volatile. Other important events characterizing this period include trends toward:

Flexible exchange rate system

Abolition of capital controls by many countries
Integration of Financial Markets

The above developments have given prominence to international finance. As an academic

discipline, the field has become concerned with the very important issues of exchange rate
determination, and the sources and consequences of exchange rate volatility. These issues are of
significant importance to international business operations as the economic and financial
environment makes it possible for firms to expand the scope of their businesses. Conducive
economic and financial environment led to the emergence of international and transnational
firms. The floating exchange rate system has also brought with it the need to hedge foreign
exchange risk. Volatility in exchange rate is relevant not only for business firms with
international operations, but also for firms whose operations are purely domestic. An
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appreciation of the domestic currency will for instance, induce foreign competitors to enter the
domestic market, and hence threatening the market share of purely domestic firms.

Recent Trends in World Economy

The economic and financial environment within which business firms operate at present is the
result of a number of changes and developments in the world economy, all of which emerged
after the World War II. Key trends of the world economy include the following:

International Financial Market Integration

One of the outstanding features of changes particularly during the 1980s was integration. The
boundaries between national financial markets became rapidly blurred, the results of which were
the emergence of a global unified financial market. Financial markets of a particular country are
said to be integrated within the world’s financial markets if:

 There is free capital movement into and out of the country,

 Substitution of domestic assets for foreign assets is possible

Banks in major developed countries have significantly increased their presence in each other’s
countries. In addition, major national markets such as those of the United States, German, Japan
are constantly being tapped by non-residents borrowers on an extensive scale. Further, there has
been a vivid trend towards functional unification across various types of financial institutions
within individual financial markets. For instance, the traditional segmentation between
commercial banking, investment banking, consumer finance, etc. is fast disappearing with the
result that nowadays financial institutions are allowed to provide worldwide a wide range of
financial services beyond what traditionally are supposed to carry out.

Liberalization and Deregulation of Financial Markets

The impetus for globalized financial markets financial markets initially arose from governments
of developed nations that started to liberalize their financial markets with regard to cross border
financial transactions deregulate their foreign exchange and capital markets. Deregulation
involved action on two angles:

 Eliminating the segmentation of the markets for financial services and introducing
measures designed to foster greater competition.
 Permitting foreign financial institutions to enter the national markets and compete on an
equal footing with domestic financial institutions.

The fever of liberalization and deregulation has also swept the developing countries. Most
developing countries began to liberalize their financial markets by allowing foreigners to directly
invest in their financial markets. Tanzania embarked on the liberalization of her entire financial
system from the early 1990s.

Indicators of Internationalization of Finance

There are several factors that indicate an ever increasing internationalization of finance:
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 Increase in international bank lending (including cross border lending and domestic
lending denominated in foreign currency)
 Increase in the value of securities transactions with foreigners, reflecting the belief in the
benefits of international diversification despite the presence of foreign exchange risk.
 Increase in daily turnover (trading volume) in the global foreign exchange market.

THE MULTINATIONAL FIRM

Forms of Business Firms Engaged in International Business

The International Company

It is a firm that is engaged in the traditional international activity of business, namely importing
and exporting. Goods are produced in the domestic country and exported to foreign buyers.
Financial management problems of this basic international trade activity focus on the payment
process between foreign buyer and domestic seller.

The Multinational Company

A multinational firm is a company engaged in producing and selling goods or services in more
than one country. It is a firm that does business and has assets in two or more countries. It
ordinarily consists of a parent company floated in the home country and at least five or six
foreign subsidiaries, typically with a high degree of strategic interaction among the units. Thus a
firm doing business across its national borders is considered a multinational enterprise. Basic
reasons for expansion into foreign markets include:
 Competitive pressure in the domestic market;
 The desire to produce more efficiently
 The desire to lower operating costs.
Multinational companies can take several forms. Studies of corporate expansion overseas
indicate that firms became multinational by degree, with foreign direct investment being a late
step in a process that begins with exports. We examine the basic forms briefly.

Exporter
A Multinational company could produce a product domestically and export some of that
production to one or more foreign markets. This is usually the case for firms facing highly
uncertain demand abroad. It is perhaps, the least risky method for overseas expansion. An
exporter reaps the benefits of foreign demand without committing any long-term investment to
that foreign country.

Overseas Production
One of the major drawbacks to exporting is the inability to realize the full sales potential of a
product. Manufacturing abroad offers the multinational company several advantages:
 The company can more easily keep abreast of foreign market development and keep track
of competition.
 The company can easily adapt its products to changing local tastes and provide increased
assurance of supply stability.
 The company can provide more comprehensive after-sales service.
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Licensing Agreement
As an alternative to setting up production facilities abroad, the multinational company may grant
a license to an independent local producer to use the firm’s technology to manufacture the
company's products in return for a license fee or a royalty. In essence then, the multinational
company will be exporting technology, rather than the product, to that foreign country. Among
the principal advantages of licensing agreement include:
 Only minimal investment is required
 Market-entry time is faster, and
 There are fewer financial and legal risks involved.

Joint Venture
As an alternative to licensing, the Multinational Company may establish a joint venture with a
local foreign manufacturer. In fact the current legal, political and economical environments
around the globe are more conducive to the joint venture arrangement than any other modes of
operation. Joint venture with a local firm exposes the multinational firm to the least amount of
political risk.

The Operational Environment of Multinational Companies

The focus of international financial management has been the multinational as the firm crosses
its national borders; it faces an environment that is riskier and more complex than its domestic
surroundings. Sometimes the social and political environment can be hostile. Thus in addition to
the basic risks faced by a purely domestic firm a multinational company faces a number of other
risks. The basic types of risk faced by a multinational firm may be categorized in:
 Political Risks
 Exchange rate Risks

Political Risks
A multinational company faces political risks ranging from mild interference to complete
confiscation of all assets. Mild interference includes for instance, laws that specify a minimum
percentage of nationals who must be employed in various positions, required investment in
environmental and social projects, and restrictions on the convertibility of currencies. Between
mild interference and outright expropriation, there may be also discriminatory practices such as
higher taxes, higher utility charges and the requirement to pay higher wages than a national
company. In essence such practices place the operations of the multinational company at a
competitive disadvantage. Because political risk has a serious influence on the overall risk of an
investment project, it must be realistically assessed. Multinational companies have been using
different methods for assessing political risks. Some firm hire consultants to provide them with a
report of political risk analysis. Others form their own advisory committees consisting of top-
level managers from headquarters and foreign subsidiaries. Once a company decides to invest to
invest in a foreign country, it should take steps to protect itself.

Exchange Rate Risks

This is the natural consequence of international operations in a world that relative currency
values move up and down. There are three types of exchange rate risk exposures with which a
multinational company is concerned:
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Transaction Exposure
Transaction exposure stems from the possibility of incurring future exchange gains or losses on
transactions already entered to and denominated in a foreign currency. It involves the gain or loss
that occurs when settling a specific foreign transaction. The transaction might be the purchase or
sale of a product, the lending or borrowing of funds, or some other transactions involving the
acquisition of assets or assumption of liabilities denominated in a foreign currency. While any
transaction will do, the term “transaction exposure”, is usually employed in connection with
foreign trade i.e., specific imports or exports on open account credit.

Translation Exposure
Translation exposure relates to the accounting treatment of changes in exchange rates. It is the
change in accounting income and balance sheet statement caused by changes in exchange rate.
Firm’s foreign assets and liabilities which are denominated in foreign currency units are exposed
to losses and gains due to changing exchange rates. This is called accounting or translation
exposure. Translation of financial statements of a subsidiary company is usually done for
consolidation purposes. The amount of gain or loss arising from the translation of assets and
liabilities of a foreign subsidiary into the parent company’s currency is called a translation gain
or loss. The amount of loss or gain resulting from this form of exposure and its treatment in the
parent company’s books depends on the accounting rules established by the parent company’s
government.

Economic Exposure
Economic exposure involves changes in expected future cash flows, and hence economic value,
caused by a change in exchange rate. Economic exposure can be separated into two components:
transaction exposure and operating exposure. Operating exposure arises because currency
fluctuations can alter a company's future revenues and costs, i.e. its operating cash flows.
Managing exchange rate risks is an important part of international finance. There are different
methods applied to manage such risks, depending primarily on the type of the exposure

The Transnational Company

As the multinational firm expands its branches, affiliates, subsidiaries, and network of suppliers,
customers, distributors, marketers, and all others that fall the firm’s umbrella of activities, the
once traditional distinction between home country and foreign country becomes less and less
well defined. The firm is then described as a transnational firm. Firms like Unilever, Philips,
Ford, Sony etc. have intricate networks with home offices defined differently for products,
processes, capitalization and even taxation.

THE INTERNATIONAL MONETARY SYSTEM

International Monetary System: Definition

The international monetary system refers primarily to the set of policies, institutions, practices,
regulations, and mechanisms that determine the rate at which one for establishing exchanged for
another. This section considers five market mechanisms fixed-rate system, and the current hybrid
system.
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The History of the International Monetary System

Over the ages currencies have been defined in terms of gold and other items of value, and the
international monetary system has been subject to a variety of international agreements. A
review of these systems provides a useful perspective against which to understand today’s
system and to evaluate weaknesses and proposed changes in the present system.

The Gold Standard 1876 – 1913

Since the days of pharaohs (about 3000B.C), gold has served as a medium of exchange and a
store of value. The Greeks and Romans used gold coins and passed on this tradition through the
mercantile era to the nineteenth century. The great increase in trade during the free-trade period
of the late nineteenth century led to a need for a more formalized system for settling international
trade balances. One country after another set a par value for its currency in terms of gold and
then tried to adhere to the so-called rules of the game. This later came to be known as the
classical gold standard. The gold standard as an international monetary system gained acceptance
in Western Europe in the 1870s. The United States was something of a late corner to the system,
not officially adopting the standard until 1879.
Under the gold standard, the “rules of the game” were clear and simple. Each country set the rate
at which its currency unit (paper of coin) could be converted to a weight of gold.

The United States, for example, declared the dollar to be convertible to gold at a rate of $20.67
per ounce (a rate in effect until the beginning of World War I). The British pound was pegged at
£4.2474 per ounce of gold. As long as both currencies were freely convertible into gold, the
dollar/pound exchange rate was:

$20.67/ounce of gold = $4.8665/£

£4.2474/ounce of gold

Because the government of each country on the gold standard agreed to buy or sell gold on
demand with anyone at its own fixed parity rate, the value of each individual currency in terms
of gold, and therefore exchange rates between currencies, was fixed. Maintaining adequate
reserved of gold to back its currency’s value was very important for a country under this system.
The system also had the effect of implicitly limiting the rate at which any individual country
could expand its money supply. Any growth in the amount of money was limited to the rate at
which official authorities could acquire additional gold. The gold standard worked adequately
until the outbreak of World War I interrupted trade flows and the free movement of gold. This
event caused the main trading nations to suspend operation of the gold standard.

The Interwar Years and World War II: 1914 – 1944

During World War I and the early 1920s, currencies were allowed to fluctuate over fairly wide
ranges in terms of gold and in relation to each other. Theoretically, supply and demand for a
country’s exports and imports caused moderate changes in an exchange rate about a central
equilibrium value. This was the same function that gold had performed under the previous gold
standard. Unfortunately, such flexible exchange rates did not work in an equilibrating manner.
On the contrary: international speculators sold the weak currencies short, causing them to fall
further in value than warranted by real economic factors. Selling short is a speculation technique
in which an individual speculator sells an asset such as a currency to another party for delivery at
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a future date. The speculator sells an asset such as a currency to another party for delivery at a
future date. The speculator, however, does not yet own the asset, and expects the price of the
asset to fall by the date when the asset must be purchased in the open market by the speculator
for delivery.

The reverse happened with strong currencies. Fluctuations in currency values could not be offset
by the relatively illiquid forward exchange market except at exorbitant cost. The net result was
that the volume of world trade did not grow in the 1920s in proportion to world gross domestic
product but instead declined to a very low level with the advent of the Great Depression in the
1930s.

The United States adopted modified gold standards in 1934 when the U.S. dollar was devalued to
$35 per ounce of gold from the $20.67 per ounce price in effect prior to World War I. Contrary
to previous practice; the U.S Treasury traded gold only with foreign central banks, not private
citizens. From 1934 to the end of World War II, exchange rates were theoretically determined by
each currency’s value in terms of gold. During World War II and its chaotic aftermath, however,
many of the main trading currencies lost their convertibility into other currencies. The dollar was
the only major trading currency that continued to be convertible.

Bretton Woods and the International Monetary Fund: 1944

As World War II drew to a close in 1944, the Allied Powers met at Bretton Woods, New
Hampshire, in order to create a new post-war international monetary system. The Bretton Woods
Agreement established a U.S. dollar-based international monetary system and provided for two
new institutions: the International Monetary Fund and the World Bank. The International
Monetary Fund (IMF) aids countries with balance of payments and exchange rate problems. The
International Bank for Reconstruction and Development (World Bank) helped fund postwar
reconstruction and since then has supported general economic development. The IMF was the
key institution in the new international monetary system, and it has remained so to the present.
The IMF was established to render temporary assistance to member countries trying to defend
their currencies against cyclical, seasonal, or random occurrences. It also assists countries having
structural trade problems if they promise to take adequate steps to correct their problems. If
persistent deficits occur, however, the IMF cannot save a country from eventual devaluation. In
recent years, it has attempted to help countries facing financial crises. It has provided massive
loans as well as advice to Russia and other former Russian republics, Brazil, Indonesia, and
South Korea, to name but a few.

Under the original provisions of the Bretton Woods Agreement, all countries fixed the value of
their currencies in terms of gold but were not required to exchange their currencies for gold.
Only the dollar remained convertible into gold (at$35 per ounce). Therefore, each country
established its exchange rate vis-à-vis the dollar, and then calculated the gold par value of its
currency to create the desired dollar exchange rate. Participating countries agreed to try to
maintain the value of their currencies within 1% (later expanded to 2.25%) of par by buying or
selling foreign exchange or gold as needed. Devaluation was not to be used as a competitive
trade policy, but if a currency became too weak to defend, a devaluation of up to 10% was
allowed without formal approval by the IMF. Larger devaluations required IMF approval.
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The Special Drawing Right (SDR) is an international reserve asset created by the IMF to
supplement existing foreign exchange reserves. It serves as a unit of account for the IMF and
other international and regional organizations, and is also the base against which some countries
hold SDRs in the form of deposits in the IMF. Members may settle transactions among
themselves by transferring SDRs.

The main features of the system were:

 A system of fixed exchange rates on the adjustable peg system was established. Exchange
rates were fixed against gold but since there was a fixed dollar price of gold ($35 per
ounce) the fixed rates were expressed relative to the dollar. Between 1949 and 1967
sterling was pegged at $2.80 to £. Governments were obliged to intervene in foreign
exchange markets to keep the actual rate within 1% of the pegged rate.

 Governments were permitted by IMF rules to alter the pegged rate-in effect to devalue or
revalue the currency but only if the country was experiencing a balance of payments
deficit/surplus of a ‘fundamental’ nature.

 The dollar became the principal international reserve asset. Only the USA undertook to
convert their currency into gold if required. In the 1950s the USA held the largest gold
stocks in the world. This the dollar became ‘as good as gold’ and countries were willing
to use the dollar as their principal reserve.

The collapse of the Bretton Woods System

In 1971 the Bretton Woods System collapsed: the USA suspended the convertibility of dollars
into gold and most countries moved to some system of floating exchange rates. What caused the
demise of the system? The system relied on periodic revaluations/devaluations to ensure that
exchange rates did not move too far out of line with underlying competitiveness. However
countries were reluctant to alter their pegged exchange rates.

Surplus countries were under no pressure to revalue since the accumulation of foreign exchange
reserves posed no real economic problems. Deficit countries regarded devaluation as an indicator
of the failure of economic policy. The UK resisted devaluation until 1967 – long after it had
become clearly necessary.

The system became vulnerable to speculation since speculation was a ‘one way bet’ a deficit
country might devalue or not – it would never revalue. Thus pressures grew on deficit countries
especially as capital flows increased with the development of the Eurocurrency markets. Once
markets decided that a currency was overvalued, capital would flow out and it was almost
impossible to maintain the pegged rate.

The system had an inherent flaw. The system had adopted the dollar as the principal reserve
currency. As world trade expanded more dollars would be needed to provide sufficient
internationally liquid assets to finance that trade. A steady supply of dollars to the world required
that the USA ran a balance of payments deficit and financed by exporting dollars. But eventually
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the world held more dollars that the value of the USA’s holding of gold: the ability to convert
dollars into gold was called in doubt. Thus confidence in the dollar declined.

The system eventually collapsed. Countries moved to a system of floating exchange rates and the
USA abandoned the convertibility of dollars into gold.

IMF’S EXCHANGE RATE REGIME CLASSIFICATIONS

Today, the international monetary system is composed of national currencies, artificial
currencies (such as the SDR), and one entirely new currency (euro) that replaced the 11 national
European Union currencies on January 1, 1999. All of these currencies are linked to one another
via a “smorgasbord” of currency regimes. The IMF classified all exchange rate regimes into
eight specific categories. The eight categories span the spectrum of exchange rate regimes from
rigidly fixed to independently floating.

 Exchange arrangements with no separate legal tender. The currency of another country
circulates as the sole legal tender or the member belongs to a monetary or currency union
in which the same legal tender is shares by the members of the union
 Currency board arrangements. A monetary regime based on an implicit legislative
commitment to exchange rate, combined with restrictions on the issuing authority to
ensure the fulfilment of its legal obligation.
 Other conventional fixed peg arrangements. The country pegs its currency (formally or
de facto) at a fixed rate to a major currency or a basket of currencies (a composite), where
the exchange rate fluctuates within a narrow margin or at most 1% around a central rate.

 Pegged exchange rates within horizontal bands. The value of the currency is maintained
within margins of fluctuation around a formal or de factor fixed peg that are wider than
1% around a central rate
 Crawling pegs. The currency is adjusted periodically in small amounts at a fixed,
preannounced rate or in response to changes in selective quantitative indicators
 Exchange rates within crawling pegs. The currency is maintained within certain
fluctuation margins around a central rate that is adjusted periodically at a fixed
preannounced rate of in response to changes in selective quantitative indicators.
 Managed floating with no preannounced path for the exchange rate. The monetary
authority influences the movements of the exchange rate through active intervention in
the foreign exchange market without specifying or recommitting to a preannounced path
for the exchange rate.
 Independent floating. The exchange rate is market-determined, with any foreign
exchange intervention aimed at moderating the rate of change and preventing undue
fluctuations in the exchange rate, rather than establishing a level for it.

The most prominent example of a rigidly fixed system is the euro area, in which the euro is the
single currency for its member countries. However, the euro itself is an independently floating
currency against all other currencies. Other examples of rigidly fixed exchange regimes include
Ecuador and Panama, which use the U.S dollar as their official currency, the Central African
Franc (CFA) zone, in which countries such as Mali, Niger, Senegal, Cameroon, and Chad among
others use a single common currency (the frank, tied to the euro) and the Eastern Caribbean
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Currency Union (ECCU), whose

members use a single common currency (the Eastern Caribbean dollar). At the other extreme are
countries with independently floating currencies. These include many of the most developed
countries, such as Japan, the United Kingdom, Canada, Australia, New Zealand, Sweden, the
United States, and Switzerland.

MANAGED FLOATING SYSTEM

Managed float fall into three distinct categories of central bank intervention. The approaches,
which vary in their reliance on market forces, are follows:

Smoothing out daily fluctuations

Governments following this route attempt only to preserve an orderly pattern of exchange rate
changes. They occasionally enter the market on the buy or sell side to ease the transition from
one rate to another, rather than resist fundamental market forces, tending to bring about longer-
term currency appreciation or depreciation. One variant of this approach is the “crawling peg”
system used in some countries, such as Poland, Russia, and Brazil.

“Leaning against the wind”

This approach is an intermediate policy designed to moderate or prevent abrupt short- and
medium-term fluctuations brought about by random events whose effects are expected to be only
temporary. The rationale for this policy – which is primarily aimed at delaying, rather than
resisting, fundamental exchange rate adjustments is that government intervention can reduce for
exports and importers the uncertainty caused by disruptive exchange rates changes.

Unofficial pegging
The strategy evokes memories of a fixed-rate system. It involves resisting fundamental upward
or downward exchange rate movements for reasons clearly unrelated to exchange market forces.

Target Zone Arrangement

Many economists and policymakers have argued that the industrialized countries could minimize
exchange rate volatility and enhance economic stability if the United States, German, and Japan
linked their currencies in a target-zone system. Under a target-zone arrangement, countries adjust
their national economic policies to maintain their exchange rates within a specific margin around
agree-upon, fixed central exchange rates. Such a system existed for the major European
currencies participating in the European Monetary System and was the precursor to the euro,
which is discussed later in this chapter.

FIXED-RATE SYSTEM
Under a fixed system, such as the Bretton Woods system, governments are committed to
maintaining target exchange rates. Each central bank actively buys or sells its currency in the
foreign exchange market whenever its exchange rate threatens to deviate from its stated par value
by more than an agreed-on-percentage. The resulting coordination of monetary policy ensures
that all member nations have the same inflation rate. Put another way, for a fixed-rate system to
work, each member must accept the group’s joint inflation rate as its own.
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ATTRIBUTES OF THE IDEAL CURRENCY

If the ideal currency existed in today’s world, it would possess three attributes, often referred to
as the “impossible trinity”

Exchange rate stability

The value of the currency would be fixed in relationship to other major currencies, so traders and
investors could be relatively certain of the foreign exchange value of each currency in the present
and into the near future.

Full financial integration

Complete freedom of monetary flows would be allowed so traders and investors could willingly
and easily move funds, from one country and currency to another in response to perceived
economic opportunities or risks.

Monetary independence
Domestic monetary and interest rate policies would be set by each individual country to pursue
desired national economic policies, especially as they might relate to limiting inflation,
combating recessions, and fostering prosperity and full employment.

These qualities are termed “the impossible trinity” because a country must give up one of the
three goals described by the sides of the triangle, monetary independence, exchange rate stability
or full financial integration. The forces of economics do not allow the simultaneous achievement
of all three. For example, a country with a pure float exchange rate regime can have monetary
independence and a high degree of financial integration with the outside capital markets, but the
result must be a loss of exchange rate stability (the case of the Unites States).

CURRENCY BOARDS
A currency board exists when a country’s central bank commits to back its monetary base is
money supply – entirely with foreign reserves at all times. This commitment means that a unit of
domestic currency cannot be introduced into the economy without an additional unit of foreign
exchange reserves being obtained first. Eight countries, including the Hong Kong territory,
utilize currency boards as a means of fixing their exchange rates. A currency board is an
arrangement that might be used by a developing country. The aim of having a currency board is
to demonstrate to the international community that the country is committed t an anti-inflationary
policy. Typically, a currency board is set up with the backing of a national law.

A currency board is a financial institution operating either in the absence of a central bank or in
parallel with the central bank. With a currency board arrangement, the country fixes is exchange
rate against a ‘reserve currency’ and maintains 100% backing of its national money supply with
financial assets in the reserve currency. The country cannot issue more ‘base money’
(essentially, notes and coins) unless they are fully backed by an equivalent amount of the reserve
currency. For example, a developing country might set up a currency board and fix is exchange
rate against the US dollar. For every bank note issued by the currency board, the board must
have the equivalent value of financial assets in US dollars.
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The only way for the currency board to issue more notes and coins is for the private sector to buy
them with US dollar assets (interest-bearing financial instruments denominated in US dollars). If
the private sector needs US dollars to finance a balance of payments deficit, it must buy the
dollars from the currency board in exchange for domestic notes and coins, which are therefore
withdrawn from circulation.

CURRENCY BLOCS
A currency bloc can exist either as a formal arrangement or unofficially. Countries within the
block try to fix their exchange rate against a major trading currency. For example, countries
might belong to a US dollar currency bloc, and try to fix their exchange rate against the dollar.
The reason for trying to link currencies in this way is to stabilize international trade. Countries
belonging to a dollar currency bloc, for example, would be countries whose international trade is
carried on mainly with the US or in US dollars. The EMS is an example of a formal currency
bloc. Until the national currencies of the member states were replaced by the euro, they were all
linked to the ECU.

DOLLARIZATION
Several countries have suffered currency devaluation for many years, primarily as a result of
inflation and have taken steps toward dollarization. Dollarization is the use of the U.S. dollar as
the official currency of the country. Panama has used the dollar as its official currency since
1907. The arguments for dollarization follow logically from the previous discussion of the
impossible trinity. A country that dollarizes removes any currency volatility (against the dollar)
and would theoretically eliminate the possibility of future currency crises. Additional benefits are
expectations of greater economic integration with the United States and other dollar-based
markets, both product and financial. This last point has led many to argue in favor of regional
dollarization, in which several countries that are high economically integrated may benefit
significantly from dollarizing together.

Three major arguments exist against dollarization. The first is the loss of sovereignty over
monetary policy. This is, however, the point of dollarization. Second, the country loses the
power of seignorage, the ability to profit from its ability to print its own money. Third, the
central bank of the country, because it no longer has the ability to create money within its
economic and financial system, can no longer serve the role of lender of last resort.

THE BIRTH OF THE EUROPEAN CURRENCY: THE EURO

The original 15 members of the European Union (EU) are also members of the European
Monetary System (EMS). This group has tried to form an island of fixed exchange rates among
themselves in a sea of major floating currencies. Members of the EMS rely heavily on trade with
each other, so they perceive that the day-to-day benefits of fixed exchange rates between them
are great. Nevertheless, the EMS has undergone a number of major changes since its inception in
1979, including major crises and reorganizations in 1992 and 1993, and conversion of 11
members to the euro on January 1, 1999 (Greece joined in 2001).

The Maastricht Treaty

In December 1991, the members of the EU met at Maastricht, the Netherlands, and concluded a
treaty that changed Europe’s currency future.
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Timetable
The Maastricht Treaty specified a timetable and a plan to replace all individual ECU currencies
with a single currency called the euro. Other steps were adopted that would lead to a full
European Economic and Monetary Union (EMU).

Convergence Criteria
To prepare for the EMU, the Maastricht Treaty called for the integration and coordination of the
member countries’ monetary and fiscal policies. The EMU would be implemented by a process
called convergence. Before becoming a full member of the EMU, each member country was
originally expected to meet the following convergence criteria: The convergence criteria were so
tough that few, if any, of the members could satisfy them at that time, but 11 countries managed
to do so just prior to 1999. Greece adopted the euro on January 1, 2001.

Strong Central Bank

A strong central bank, called the European Central Bank (ECB), has been established in
Frankfurt, Germany, in accordance with the Treaty. The bank is modeled after the U.S. Federal
Reserve System. This independent central bank dominates the countries’ central banks, which
continue to regulate banks resident within their borders; all financial market intervention and the
issuance of euros remain the sole responsibility of the ECB. The single most important mandate
of the ECB is to promote price stability within the European Union.

THE EUROPEAN MONETARY SYSTEM AND MONETARY UNION

With the collapse of the Bretton Woods System, several European countries started to move
towards a system in which there as increasing stability between their national currencies, even
though there might still be volatility in their exchange rates with currencies of non-member
states. This objective was eventually incorporated into the European Monetary System (EMS) of
the European Union. The EMS was established in 1979. As part of this system, there was an
Exchange Rate Mechanism for achieving stability in the exchange rate of member currencies, by
restricting exchange rate movements within certain limits or ‘bands’.

A long-term aim was that of achieving a single European currency as part of a wider economic
and monetary union. The first stage was to establish the ECU. This was the central currency of
the EMS and was a composite currency whose value was determined by a weighted basket of
European currencies. Use of the ECU was largely restricted to official transactions.

The European Monetary Union

Many politicians and commentators pointed to the turmoil in the EMS as increasing the need for
the European Community to move toward monetary union. This view prevailed and was
formalized in the Maastricht Treaty. Under this treaty, the EC nations would establish a single
central bank with the sole power to issue a single European currency called the euro as of
January 1, 1999. On that date, conversion rates would lock in for member currencies, and the
euro would become a currency, although euro coins and bills would not be available until 2002.
Francs, marks guilders, schillings, and other currencies would be phased out, to be replaced on
January 1, 2002, by the euro.
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Economic and Monetary Union (EMU)

The objective of EMU was to establish a single currency and a single monetary authority within
all countries in the EU. The EMS and the ERM can be thought of as steps towards EMU, but it
was not until the Maastricht Treaty of 1991 that all the members of the EU signed up to the
principle of monetary union (though the UK and Denmark insisted on opt-outs to postpone their
final consent).

The Maastricht Treaty envisaged a three-stage progress towards monetary union:

 Stage 1 involved closer monetary co-operation between member states within the existing
framework.
 Stage 2 began on 1 January 1994 and set up the European Monetary Institute, as a
prototype European Central Bank (ECB), though responsibility remained in national
hands.
 Stage 3 began on 1 January 1999 involving the irrevocable locking of exchange rates
between participating countries. The ECB carries out the common monetary policy and
manages the single currency.

From 1 January 1999, the euro was established to replace the ECU. A single monetary policy
was defined and applied for the member countries.

THE EUROPEAN CENTRAL BANK (ECB)

The ECB began operations in May 1998 as the single body with the power to issue currency,
draft monetary policy, and set interest rates in the euro-zone. The Maastricht Treaty envisaged
the ECB as an independent body free from day-to-day political interference, with a principal
duty of price stability. The ECB is the central bank for the euro currency area and is based in
Frankfurt. It is the sole issuer of the euro. Its main objective, as defined by the Maastricht Treaty,
is price stability. It therefore has the power to set short-term interest rates. The man focus of its
activities has been on interest rate policy rather than exchange rate policy. Like the Monetary
Policy Committee of the Bank of England, the ECB pursues a policy of controlling interest rates
as a means of achieving influence over the long-term rate of inflation.

INTERNATIONAL FINANCIAL INSTITUTIONS

The international financial institutions that are central to the operation of international trade and
finance were, with one exception, created in the immediate post-war period. The most important
of these are:
 The International Monetary Fund (IMF)
 The International Bank for Reconstruction and Development (IBRD) – more popularly
known as the World Bank.
 World Trade Organization (WTO) – covered in an earlier chapter
 The Bank for International Settlements

THE INTERNATIONAL MONETARY FUND [IMF]

The IMF was founded in 1944 at an international conference at Bretton Woods in the USA but
did not really begin to fully function until the 1950s. The so called Bretton Woods System that
the IMF was to supervise was to have two main characteristics: stable exchange rates and a
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multilateral system of international payments and credit. In particular the IMF became
responsible for:

 Promoting international financial cooperation and establishing a system of stable

exchange rates and freely convertible currencies.
 Providing a source of credit for members with balance of payments deficits while
corrective policies were adopted.
 Managing the growth of international liquidity partly by creating (1970) an international
financial asset called Special Drawing Rights (SDR).

Most countries became members of the IMF. Membership required that the country subscribed a
quota to the IMF, paid partly in its own currency (75%) and partly in gold or foreign currencies
(25%). The quota is determined by a formula based on size of GNP and trade and (until 1976)
that it maintained a pegged exchange rate. In turn a member could borrow from the IMF when
facing a balance of payments deficit.

THE WORLD BANK [IBRD]

The World Bank was the second institution created at the Bretton Woods meeting in 1944. Its
membership and decision making processes are similar to those of the IMF. The original purpose
of the IBRD was to help finance the reconstruction of economies damaged by the war. However,
it son shifted the focus of its lending to countries of the developing world. The bank now
comprises three principal constituent elements: The IBRD proper whose function is to lend long-
term funds for capital projects in developing economies at a commercial rate of interests. The
main source of these funds is borrowing by the IBRD itself.

THE INTERNATIONAL DEVELOPMENT ASSOCIATION (IDA)

This was which was established in 1960 to provide ‘soft’ loans to the poorest of the developing
countries. The IDA: Is mainly financed by 20 donor countries providing funds every three years;
funding therefore depends on the generosity or otherwise of these countries. It provides loans on
concessionary terms, normally interest free loans repayable over 50 years.

THE BANK FOR INTERNATIONAL SETTLEMENT [BIS]

The Bank for International Settlement (BIS) was established at Basle in Switzerland in 1930. Its
initial task was organizing payment of German reparations dating the post- First World War
settlement. It now acts as a clearing house and banker for central banks. It receives deposits from
those central banks who are members of BIS. The principal functions of BIS are:
 To encourage cooperation between central banks on matters associated with international
payments.
 To provide facilities for financial cooperation between central banks such as providing
temporary credit for member banks
BIS loans are underwritten by member central banks but are essentially short term, temporary
finance. BIS has not acquired the function of international lender of the last resort and therefore
cannot really be regarded as the international equivalent of a central bank.