Foreign Exchange Market

Introduction

 Foreign exchange market is crucial for global economy

 Impact on companies like Hyundai and Kia
 Currency fluctuations affect sales, profits, and strategies
 Report aims to explain market workings, predict rate movements, and outline business
implications
 Market facilitates currency conversion for international trade
 Exposure to foreign exchange risk due to unpredictable rate changes
 Market provides some insurance but not complete protection
 Functions and structure include spot exchanges, forward exchanges, and currency swaps
 Factors influencing exchange rates examined
 Currency convertibility restrictions addressed
 Understanding crucial for international business managers

Functions of the Foreign Exchange Market

1. Currency Conversion - The primary function of the foreign exchange market is to facilitate
the conversion of one currency into another. This enables individuals and businesses to
conduct transactions and trade goods and services across borders efficiently.
2. Facilitating International Trade and Investment - By providing a platform for exchanging
currencies, the foreign exchange market enables countries with different currencies to
engage in trade and investment activities. It allows businesses to buy and sell goods and
services internationally, thereby promoting economic growth and development.
3. Price Determination - Exchange rates, which are determined in the foreign exchange
market, play a vital role in determining the prices of goods and services in different
countries. Exchange rates reflect the relative value of currencies and help in comparing the
costs of products and services across borders.
4. Hedging Against Foreign Exchange Risk - The foreign exchange market provides a
mechanism for companies to hedge against foreign exchange risk, which arises from
unpredictable changes in exchange rates. Through various hedging instruments such as
forward contracts and options, businesses can protect themselves from adverse movements
in exchange rates and ensure stability in their cash flows.
5. Speculation and Investment - The foreign exchange market also serves as a platform for
currency speculation and investment. Traders and investors engage in buying and selling
currencies with the aim of profiting from fluctuations in exchange rates. While speculation
carries risks, it also provides opportunities for investors to diversify their portfolios and
potentially earn returns.

What is Spot Exchange Rates?

 Spot exchange rates refer to the immediate exchange of currencies between two parties
at the prevailing market rate. When a transaction occurs on the spot, it means the
exchange is executed promptly.
  The spot exchange rate is the specific rate at which a foreign exchange dealer converts
one currency into another currency on a given day.

What is the role that foreign exchange rates play in insuring against foreign exchange risk?

 Foreign exchange rates play a crucial role in insuring against foreign exchange risk, which refers
to the potential adverse consequences for a firm resulting from unpredicted changes in future
exchange rates. In this context, the foreign exchange market serves as a mechanism for hedging
against such risks.
 Hedging involves taking measures to protect against potential losses arising from fluctuations in
exchange rates. This is achieved through various financial instruments available in the foreign
exchange market, including:

1. Spot Exchange Rates - These represent the immediate exchange of currencies at the
prevailing market rate. By utilizing spot exchange rates, firms can execute currency
transactions promptly to mitigate the impact of adverse exchange rate movements.

2. Forward Exchange Rates - Forward exchange rates allow firms to lock in an exchange
rate for a future date. By entering into forward contracts, companies can hedge against
the risk of unfavorable exchange rate movements that may occur between the time of
contract initiation and settlement.

3. 3. Current Swaps - Currency swaps involve the simultaneous purchase and sale of
foreign exchange for two different value dates. This allows firms to exchange currencies
at predetermined rates, thereby managing exposure to exchange rate fluctuations over
a specified period.

Understanding the Different theories on how currency exchange rates are determined and their
relative merits:
1. Law of One Price

 Identical products in different countries should have the same price when expressed in the same
currency.
 Arbitrage opportunities arise if prices differ, leading to adjustments until prices equalize across
markets.
 Law of one price suggests exchange rates should adjust to maintain price parity for identical
goods

2. Purchasing Power Parity

 PPP theory links exchange rate changes to differences in price levels between two countries.
 In efficient markets with minimal trade barriers, the prices of a basket of goods should be similar
when expressed in a common currency.
  Exchange rates are expected to adjust to equalize the cost of identical baskets of goods across
countries.

Examp
le:

3. Money Supply and Price Inflation

 Inflation: Occurs when money supply grows faster than goods and services, causing increased
demand and price inflation.
 Government policies, especially regarding monetary growth, are critical.
 Actions like printing more money can influence monetary growth, but excess leads to inflation.
 International businesses should analyze a country's monetary policy to predict currency
movements; controlled monetary growth reduces depreciation.
 Understanding these dynamics helps respond effectively to currency fluctuations.

Examp
le:
4. Interest Rates and Exchange Rates

 The theory explaining how currency exchange rates are determined through interest rates
revolves around the Fisher Effect and the International Fisher Effect.

Fisher Effect

 first formalized by economist Irvin Fisher

 Nominal interest rates are determined by real interest rates and expected inflation.
Mathematically: i = r + l
 Strong relationship between inflation and interest rates.

International Fisher Effect (IFE)

 for any two countries, the spot exchange rate should change in an equal amount but in the
opposite direction to the difference in nominal interest rates between the two counties.

Mathematically:

5. Investor Psychology and Bandwagon Effect

 Short-term exchange rate movements influenced by investor psychology and bandwagon

effects.
 Market traders' expectations about future exchange rates affected by psychological factors,
leading to self-fulfilling prophecies.
 A good example of this mechanism occurred in September 1992 when the famous international
financer George Soros made a huge bet against the British pound.
 Bandwagon effect is where traders moving as a herd in the same direction at the same time.

Identifying the Merits of different approaches towards exchange rate forecasting

1. Fundamental Analysis
 This approach utilizes economic theory and sophisticated econometric models to predict
exchange rate movements. Variables such as relative monetary growth rates, inflation rates,
interest rates, and balance-of-payments positions are considered. The merit of fundamental
analysis lies in its comprehensive consideration of economic fundamentals that can
 potentially influence exchange rates in the long run. However, it may not always accurately
predict short-term exchange rate movements due to the complexity of factors involved and
the influence of psychological factors.
2. Technical Analysis
 Unlike fundamental analysis, technical analysis relies on price and volume data to identify
past trends, which are expected to continue into the future. This approach does not
consider economic fundamentals but instead focuses on market trends and patterns. The
merit of technical analysis lies in its simplicity and accessibility, as it provides a
straightforward method for predicting future exchange rate movements based on historical
data. However, it is often criticized for lacking a theoretical rationale and being akin to
fortune-telling.

Compare and Contrast the differences between transaction, translation, and economic exposure, as
well as the management strategies for each type of exposure, can be compared and contrasted as
follows:
GLOBAL CAPITAL MARKET

Introduction

 The rapid globalization of capital markets facilitates the free flow of money around the world.
 Traditionally, national capital markets have been separated by regulatory barriers.
 Therefore, it was difficult for firms to attract foreign capital.
 Many regulatory barriers fell during the 1980s and 1990s, allowing the global capital market to
emerge.
 Today, firms can list their stock on multiple exchanges, raise funds by issuing equity or debt to
investors from around the world, and attract capital from international investors.

Benefits of The Global Capital Market

 There are market functions that are shared by both domestic and international capital markets.
 However, global capital markets offer some benefits not found in domestic capital markets.

Functions Of A Generic Capital Market

 Capital markets bring together investors and borrowers.

 Investors include corporations with surplus cash, individuals, and non-bank financial institutions
 Borrowers include individuals, companies, and government.
 Markets makers are the financial service companies that connect investors and borrowers,
either directly or indirectly.
  Commercial banks are indirect market makers, and investment banks are direct market makers.
 Capital market loans can be equity (stock) or debt ( cash loans or bonds).

Attractions Of The Global Capital Market

Borrowers benefit from:

 The additional supply of funds global capital markets provide.
 The associated lower cost of capital (the price of borrowing money or the rate of return that
borrowers pay investors).
 The cost of capital is lower in international markets because the pool of investors is much larger
than in the domestic capital market.

 Investors also benefit from the wider range of investment opportunities in global capital
markets that allow them to diversify their portfolios and lower their risks.
 Studies show that fully diversified portfolios are only about 27 percent as risky as individual
stocks.
 International portfolio diversification is even less risky because the movements of stock prices
across countries are not perfectly correlated.
 This low correlation reflects the differences in nations’ macroeconomic policies and economic
policies and how their stock markets respond to different forces, and nations’ restrictions on
cross-border capital flows.
Growth of the Global Capital Market

 Global capital markets are growing at a rapid pace.

 In 1990, the stock of cross-border bank loans was just $3,600 billion.
 By 2006, the stock of cross border bank loans was $17,875 billion.
 The international bond market shows a similar pattern with $3,515 billion in outstanding
international bonds in 1997, and $17, 561 billion in 2006.
 International equity offerings were $18 billion in 1997 and $377 billion in 2006.

Two factors are responsible for the growth of capital markets:

1. Information Technology–the growth of international communications technology and advances

in data processing capabilities.
 Financial services companies now engage in 24-hour-day trading –the international capital
market never sleeps.
 However, this also means that shocks that occur in one financial market spread around the
globe very quickly.
2. Deregulation – has facilitated growth in the international capital markets.
 Traditionally, governments have limited the ability of foreign investors to purchase
significant equity positions in domestic companies, and the amount of foreign investment
citizens could make.
 Since the 1980s, these restrictions have been falling in response to the development of the
Eurocurrency market, and also pressure from financial services companies.
  Deregulation began in the United States, then moved on to other countries including Great
Britain, Japan, and France.
 Many countries have also dismantled capital controls making it easier for both inward and
outward investment to occur.
 This trend has spread from the developed world to the emerging nations.
 The global capital market is expected to continue to grow.

WHAT ARE THE RISKS ASSOCIATED WITH GLOBAL CAPITAL MARKET?

1. Deregulation and Reduced Controls

 The deregulations and reduced controls on cross border capital flows have made individual
nations more vulnerable to speculative capital flows, which can lead to destabilizing effects
on national economies.
2. Speculative Flows and Inaccurate Information
 Speculative flows can be driven by inaccurate or misleading information about investment
opportunities.
3. Accounting Principles and Cross
 Border Investments Differences in accounting principles and financial reporting standards
across countries make it challenging to directly compare cross opportunities accurately.

THE EUROCURRENCY MARKET

 A Eurocurrency is any currency bank outside of its country of origin.

 About two thirds of Eurocurrencies are dollars banked outside the United States)
Eurodollars.
 Other important Eurocurrencies are the euro pound, and the euro-euro.

EUROCURRENCY MARKET BENEFITS

1. Regulatory Freedom
 It is attractive to both depositors and borrowers because the government does not regulate
it.
2. Higher Interest Rates for Deposits
 Offering higher deposit rates attracts funds from investors looking for better returns on their
savings.
3. Lower Interest Rates for Borrowings
 Borrowers in the Eurocurrency market can access loans at lower interest rates compared to
domestic markets, making it cost individuals to borrow funds. effective for companies and
4. Competitive Edge for Eurocurrency Banks
 The spread between the Eurocurrency deposit and lending rate is less than the spread
between the domestic deposit and lending rates giving Eurocurrency banks a competitive
edge over domestic banks.

EUROCURRENCY MARKET RISKS

 1. Bank Failure Risks
 Because the Eurocurrency market is unregulated, there is a higher risk of bank failure.
2. Foreign Exchange Risks
 Companies borrowing Eurocurrencies can be exposed to foreign exchange risk.

THE GLOBAL BOND MARKET

 The global market grew rapidly during 1980s and 1990s.

 The most common kind of bond is fixed-rate bond which gives investors fixed cash payoffs.

There are two types of international bonds:

1. Foreign bonds are sold outside the borrower's country and are denominated in the currency of
the country in which they are issued.
2. Eurobonds are underwritten by the syndicate of banks and placed in countries other than the
one in whose currency the bond is denominated.

THE GLOBAL BOND MARKET BENEFITS

1. Lower Cost of Capital

 Companies issue international bonds to lower their cost of capital, taking advantage of
lower interest rates in certain markets.
2. Access to Different Currency Markets
 Global bonds allow issuers to choose the currency denomination that suits their needs,
providing flexibility in funding.
3. Diversification of Investor Base
 Issuers can access a broader investor base globally, contributing to diversified funding
sources.
4. Market Development
 Participation in the global bond market contributes to the development and liquidity of
international capital markets.

THE GLOBAL BOND MARKET RISKS

1. Currency Risk
 Fluctuations in exchange rates can impact returns for investors holding bonds denominated
in foreign currencies.
2. Interest Rate Risk
 Changes in interest rates can affect bond prices and yields, potentially leading to capital
losses for investors.
3. Political and Economic Risks
  Investing in bonds from different countries exposes investors to political instability,
regulatory changes, economic downturns, and sovereign risk.
4. Liquidity Risk
 Some global bond markets may have lower liquidity than major domestic markets, affecting
the ease of buying or selling bonds at desired prices.

Comparison of Benefits Between Eurocurrency market and Global Bond Market

 Both markets offer lower cost funding opportunities, albeit through different mechanisms
(Eurocurrency via deposit and lending rates, global bonds via international issuance).
 They provide access to diverse funding sources, with the Eurocurrency market focusing on
currency diversity and the global bond market on investor diversity.
 Both contribute to market development, with the Eurocurrency market enhancing
competition among banks and the global bond market expanding international capital
markets.

Contrast of Benefits Between Eurocurrency market and Global Bond Market

 The Eurocurrency market is more focused on interest rate advantages and regulatory freedom,
while the global bond market emphasizes currency diversity and investor base expansion.
 Eurocurrency benefits are primarily bank centric, while global bond market benefits extend to
corporations and governments issuing bonds.
 Eurocurrency benefits are immediate and applicable to short term funding needs, while global
bond market benefits are strategic and can support long structure optimization.

Comparison and Contrast of Risks Between Eurocurrency market and Global Bond Market

 Comparison: Both the Eurocurrency market and the global bond market share a common risk of
Foreign Exchange Risk. Participants in both markets are exposed to fluctuations in exchange
rates, which can affect their financial positions and returns.
 Contrast: Eurocurrency risks are more focused on banking and currency related vulnerabilities,
while global bond market risks are broader, encompassing a wider range of financial and
macroeconomic factors.

The Global Equity Market

 The largest equity markets are in the United States, Britain and Japan.
 Today, many investors invest in foreign equities to diversify their portfolios.
 In the future, this type of trend may result in an internationalization of corporate ownership.
 Companies are also helping to promote this type of shift by listing their stock in the equity
markets of other nations.
 By issuing stock in other countries, firms open the door to raising capital in the foreign market,
and give the firm the option of compensating local managers and employees with stock.
Foreign Exchange Risk and the Cost of Capital

 Adverse exchange rates can increase the cost of foreign currency loans.
 While it may initially seem attractive to borrow foreign currencies, when exchange rate risk is
factored in, that can change.
 Firms can hedge their risk by entering into forward contracts to purchase the necessary currency
and lock in the exchange rate, but this will also raise costs.
 Firms must weigh the benefits of a lower interest rate against the risk of an increase in the real
cost of capital due to adverse exchange rate movements.

Implications for Managers

 Growth in global capital markets has created opportunities for firms to borrow or invest
internationally .
 Firms can often borrow at a lower cost than in the domestic capital market.
 Firms must balance the foreign exchange risk associated with borrowing in foreign currencies
against the cost savings that may exist.
 The growth of capital markets also offers opportunities for firms, institutions, and individuals to
diversify their investments and reduce risk.
 Again, though investors must consider foreign exchange rate risk.

THE INTERNATIONAL MONETARY SYSTEM

 Refers to the institutional arrangements that govern exchange rates.

 It is the globally accepted policies, rules, customs, and practices established by societies
worldwide to trade currency smoothly.

THE HISTORICAL DEVELOPMENT OF THE MODERN GLOBAL MONETARY SYSTEM

 The gold standard had its origin in the use of gold coins as a medium of exchange, unit of
account, and store of value practice that dates to ancient times. When international trade was
limited in volume, payment for goods purchased from another country was typically made in
gold or silver.

MECHANICS OF THE GOLD STANDARD

 Pegging currencies to gold and guaranteeing convertibility is known as the gold standard.
 In the 1880’s, most of the world's major trading nations, including Great Britain, Germany,
Japan, and the United States, had adopted the gold standard. Given a common gold standard,
the value of any currency in units of any other currency (the exchange rate) was easy to
determine.
 Example:
1 US dollar = 23.22 grains of 1 British pound = 113
gold grains of gold
1 ounce = 480 grains of gold 1 ounce = 480 grains of
The gold par value refers
Therefore, 1 ounce of gold to the
gold
amount of currency
needed
cost to(480/23.22)
$20.67 purchase one ounceTherefore,
of gold. 1 ounce of gold
£1 = $4.87 cost £ 4.25 (480/113)
($20.67/£4.25)
STRENGTH OF THE GOLD STANDARD

 The great strength claimed for the gold standard was that it contained a powerful mechanism
for achieving balance-of-trade equilibrium by all countries.
 A country is said to be in balance-of-trade equilibrium – when the income its residents earn
from exports is equal to the money its residents pay to other countries for imports ( the
current account of its balance of payments is in balance).

THE PERIOD BETWEEN THE WARS: 1918-1939

 Great Britain returned to the gold standard by pegging the pound to gold at the prewar gold
parity level of £4.25 per ounce, despite substantial inflation between 1914 and 1925. This priced
British goods out of foreign markets, which pushed the country into a deep depression. When
foreign holders of pounds lost confidence in Great Britain's commitment to maintaining its
currency's value, they began converting their holdings of pounds into gold. The British
government saw that it could not satisfy the demand for gold without seriously depleting its
gold reserves, so it suspended convertibility in 1931.
 The United States followed suit and left the gold standard in 1933 but returned to it in 1934,
raising the dollar price of gold from $20.67 per ounce to $35 per ounce. Since more dollars were
needed to buy an ounce of gold than before, the implication was that the dollar was worth less.
This effectively amounted to a devaluation of the dollar relative to other currencies.

THE BRETTON WOODS SYSTEM

 In 1944, at the height of World War II representatives from 44 countries met at Bretton Woods,
New Hampshire, to design a new international monetary system.
 The agreement reached at Bretton Woods established two multinational institutions:
o International Monetary Fund (IMF) – the task of the IMF would be to maintain order in
the international monetary system
o World Bank – would be to promote general economic development.
  The Bretton Woods agreement also called for a system of fixed exchange rates that would be
policed by the IMF.
 Under the agreement, all countries were to fix the value of their currency in terms of gold but
were not required to exchange their currencies for gold. Fixed exchange rates pegged to the US
Dollar.
 US Dollar pegged to gold at $35 per ounce.
 All participating countries agreed to try to maintain the value of their currencies within 1
percent of the par value by buying or selling currencies (or gold) as needed.

THE ROLE OF THE IMF

 The IMF Articles of Agreement were heavily influenced by the worldwide financial collapse,
competitive devaluations, trade wars, high unemployment hyperinflation in Germany and
elsewhere, and general economic disintegration that occurred between the two world wars. The
aim of the Bretton Woods agreement, of which the IMF was the main custodian, was to try to
avoid a repetition of that chaos through a combination of discipline and flexibility.

Discipline

A fixed exchange rate regime imposes discipline in two ways:

 The need to maintain a fixed exchange rate puts a brake on competitive devaluations and brings
stability to the world trade environment.
 A fixed exchange rate regime imposes monetary discipline on countries, thereby curtailing price
inflation.

Flexibility

Two major features of the IMF articles of agreement fostered this flexibility:

1. IMF Lending Facilities – the IMF stood ready to offer short-term foreign currency loans to
member countries facing balance-of-payments deficits, aiming to prevent rapid economic
tightening that could harm domestic employment.
2. Adjustable parities - the adjustable parities system permitted countries to devalue their
currency by more than 10% if the IMF determined that the country's balance of payments was in
a state of "fundamental disequilibrium.”

THE ROLE OF THE WORLD BANK

 The official name of the World Bank is the International Bank for Reconstruction and
Development (IBRD).
 The bank’s initial mission was to help finance the building of Europe’s economy by providing
low-interest loans.
  By the 1950s, it had shifted its focus to development and public-sector projects.
 During the 1960s, the bank also began to lend heavily in support of agriculture, education,
population control, and urban development.

The bank lends under two schemes:

1. IBRD Scheme
 Under the IBRD scheme, money is raised through bond sales in the international capital market.
Borrowers pay what the bank calls a market rate of interest—the bank’s cost of funds plus a
margin for expenses.
 Under the IBRD (International Bank for Reconstruction and Development) scheme, the bank
offers low-interest loans to risky customers whose credit rating is often poor, such as the
governments of underdeveloped nations.
2. International Development Association (IDA)
 Resources to fund IDA loans are raised through subscriptions from wealthy members such as the
United States, Japan, and Germany.
 IDA loans go only to the poorest countries. Borrowers have 50 years to repay at an interest rate
of 1 percent a year. The world’s poorest nations receive grants and no-interest loans.

EXCHANGE RATE

 Is a rate at which one currency will be exchanged for another currency and affects trade and
the movement of money between countries.
• Free-floating
• Fixed

THE COLLAPSE OF THE FIXED EXCHANGE RATE SYSTEM

 The system of fixed exchange rate established at Bretton Woods worked well until the late
1960s, when it began to show signs of strain. The system finally collapsed in 1973, when it was
replaced by a manage-float system.
 To understand why the fixed exchange rate system collapsed, one must appreciate the special
role of the U.S. dollars. As the only currency that could be converted into gold, and as the
currency that served as the reference point of all others, the dollar occupied a central place in
the system.
 Any pressure on the dollar to devalue could wreak havoc with the system and that is what
occurred.

THE FLOATING EXCHANGE RATE REGIME

  The floating exchange rate regime that followed the collapse of the fixed exchange rate system
was formalized in January 1976 when IMF members met in Jamaica and agreed to the rules for
the international monetary that are in place today.

THE JAMAICA AGREEMENT

 The Jamaica meeting revised the IMF's Articles of Agreement to reflect the new reality of
floating exchange rates. The main elements of the Jamaica agreement include the following:
• Floating rates were declared acceptable. IMF members were permitted to enter the
foreign exchange market to even out "unwarranted" speculative fluctuations.
• Gold was abandoned as a reserve asset. The IMF returned its gold reserves to members
at the current market price, placing the proceeds in a trust fund to help poor nations.
IMF members were permitted to sell their own gold reserves at the market price.
• Total annual IMF quotas the amount member countries contribute to the IMF-were
increased to $41 billion. (Since then they have been increased to $311 billion while the
membership of the IMF has been expanded to include 184 countries.) Non-oil-exporting.
less developed countries were given greater access to IMF funds.

FIXED VERSUS FLOATING EXCHANGE RATES

The breakdown of the Bretton Woods system has not

stopped the debate about the relative merits of fixed
versus floating exchange rate regimes.
Disappointment with the system of floating rates in
recent years has led to renewed debate about the
merits of fixed exchange rates.

EXCHANGED RATE REGIMES IN PRACTICE

 Governments around the world pursue a number of different exchange rate policies. These
range from a pure "free float" where the exchange rate is determined by market forces to a
pegged system that has some aspects of the pre-1973 Bretton Woods system of fixed exchange
rates.
PEGGED EXCHANGE RATES

 Under a pegged exchange rate regime, a country will peg the value of its currency to that of a
major currency.
 Pegged exchange rate are popular among many of the world’s smallest nation. As with a full
fixed exchange rate regime, the great virtue claimed for a pegged exchange rate is that it
imposes monetary discipline on a country and leads to low inflation.
 For a pegged exchange rate to impose monetary discipline on a country, the country whose
currency is chosen for the peg must also pursue sound monetary policy.

What is a Currency Board?

 Countries using a currency board commit to converting their domestic currency on demand into
another currency at a fixed exchange rate.
 The currency board holds reserves of foreign currency equal at the fixed exchange rate to at
least 100% of the domestic currency issued.
 The currency board can issue additional domestic notes and coins only when foreign exchange
reserves are available to back it. This limits the ability of the government to print money and
thereby create inflationary pressures.

What is the role of the IMF

 The IMF’s original function was to provide a pool of money from which the members could
borrow, over the short term, to adjust their balance-of-payments position and maintain their
exchange rate.
 Today, the IMF focuses on lending money to countries in financial crisis
 There are three main types of financial crises:
• Currency Crisis
• Banking Crisis
• Foreign Debt Crisis
CURRENCY CRISIS

 A currency crisis occurs when a speculative attack on the currency results in a sharp
depreciation, or forces authorities to expend large volumes of international currency reserves
and sharply increase interest rates in order to defend prevailing exchange rates.
 Brazil 2002, Thailand 1997, Philippines 1982

BANKING CRISIS

 A banking crisis refers to a situation in which a loss of confidence in the banking system leads to
a run on the banks, as individuals and companies withdraw their deposits

FOREIGN DEBT CRISIS

 A foreign debt crisis is a situation in which a country cannot service its foreign debt obligations,
whether private sector or government debt
 The two crises that have been of particular significance in terms of IMF involvement since the
early 1990’s– the 1995 Mexican currency crisis and the 1997 Asian financial crisis.
 These crises were the result of excessive foreign borrowings, a weak or poorly regulated
banking system, and high inflation rates. These factors came together to trigger simultaneous
debt and currency crises.

What was the Mexican Currency Crisis of 1995?

 The Mexican currency crisis of 1995 was a result of

o high Mexican debts
o a pegged exchange rate that did not allow for a natural adjustment of prices
 To keep Mexico from defaulting on its debt, the IMF together with the U.S government and the
Bank for International Settlements created a $50 billion aid package
o IMF required tight monetary policies and further cuts in public spending

What was the Asian Currency Crisis?

 The financial crisis that erupted across Southeast Asia during the fall of 1997 emerged as the
biggest challenge to date for the IMF.
 Holding the crisis in check required IMF loans to help the shattered economies of Indonesia,
Thailand, and South Korea to stabilize their currencies.
 In addition, although they did not request IMF loans, the economies of Japan, Malaysia,
Singapore, and the Philippines were also hurt by the crisis.
 The 1997 Asian financial crisis was caused by events that took place in the previous decade
including:
o An investment boom-The wealth created by export-led growth helped fuel an
investment boom in commercial and residential property, industrial assets, and
infrastructure.
o Excess capacity- investments were based on projections of future demand conditions.
 o The Debt Bomb- investment were supported by dollar based debts
o Expanding imports- caused current account to deficits
 By mid-1997, several key Thai financial institutions were on the verge of default speculation
against baht
 Thailand abandoned the baht peg and allowed the currency to float
 The IMF provided a $17 billion bailout loan package required higher taxes, public spending cuts,
privatization of state-owned businesses, and higher interest rates.
 Speculation caused other Asian currencies including the Malaysian Ringgit, the Indonesian
Rupaih and the Singapore Dollar to fall
 These devaluations were mainly driven by
o excess investment and high borrowings, much of it in dollar denominated debt
o A deteriorating balance of payments position
 In October 31, 1997 the IMF provided a $37 billion rescue deal for Indonesia in conjunction with
the world bank and the Asian Development Bank.
o In return they agreed to reduce public spending, closure of troubled banks, a balanced
budget, and an end to crony capitalism
 In December 3, 1997 the IMF lend a $55 billion to South Korea
o The agreement with the IMF called for the South Korea to open their economy and
banking system to foreign investors and South Korea pledged restraint the chaebol

How Has The IMF Done?

 By 2006, the IMF was committing loans to 59 countries that were struggling with economic and
currency crises.
 All IMF loan packages require tight macroeconomic policies, including cuts in public spending,
higher interest rates and tight monetary policy.
 However, critics worry
o The “one-size-fits-all” approach to macroeconomic policy is inappropriate for many
countries
o The IMF is exacerbating moral hazard – when people behave recklessly because they
know they will be saved if things go wrong
o The IMF has become too powerful for an institution without any real mechanism for
accountability
 As with many debates about international economics, it is not clear which side has the winning
hand about the appropriateness of IMF policies.
 However, in recent years, the IMF has started to change its policies and be more flexible
o urged countries to adopt fiscal stimulus and monetary easing policies in response to the
2008-2009 global financial crisis

IMPLICATIONS FOR MANAGERS

 The implications for international businesses fall into three main areas: currency management,
business strategy, and corporate government relations.
 Managers need to understand how the international monetary system affects.
o Currency management – the current system is a mixed system in which a combination
of government intervention and speculative activity can influence the foreign exchange
market.
 Speculative buying and selling of currencies can create very volatile movements
in exchange rates.
o Business strategy – exchange rate movements are difficult to predict, and yet their
movement can have a major impact on the company’s competitive position.
 To cope with this effect, managers need strategic flexibility
o Corporate-government relations – businesses can influence government policy towards
the international monetary system
 Companies should promote a system that facilitates the growth of international
trade and investment.