International Business, 8th Edition

International Business, 8th Edition
Griffin & Pustay Copyright © 2015 Pearson Education, Inc.

Copyright © 2015 Pearson Education, Inc.
Learning Objectives Discuss the role of the international monetary system in promoting international trade and investment Explain the evolution and functioning of the gold standard Summarize the role of the World Bank Group and the International Monetary Fund in the post–World War II international monetary system established at Bretton Woods Explain the evolution of the flexible exchange rate system Describe the function and structure of the balance of payments accounting system Differentiate among the various definitions of a balance of payments surplus and deficit Copyright © 2015 Pearson Education, Inc.

History of the International Monetary System: The Gold Standard
Under the gold standard, countries agree to buy or sell their paper currencies in exchange for gold In 1821 the United Kingdom became the first country to adopt the gold standard The gold standard effectively created a fixed exchange rate system Sterling-based Gold Standard: Most firms accepted either gold or British pounds in settlement of transactions Ancient reliance on gold coins as an international medium of exchange led to the adoption of an international monetary system known as the gold standard. Under the gold standard, countries agree to buy or sell their paper currencies in exchange for gold on the request of any individual or firm and, in contrast to mercantilism’s hoarding of gold, to allow the free export of gold bullion and coins. In 1821 the United Kingdom became the first country to adopt the gold standard. During the nineteenth century, most other important trading countries—including Russia, Austria-Hungary, France, Germany, and the United States—did the same. The gold standard effectively created a fixed exchange rate system. An exchange rate is the price of one currency in terms of a second currency. Under a fixed exchange rate system, the price of a given currency does not change relative to each other currency. The gold standard created a fixed exchange rate system because each country tied, or pegged, the value of its currency to gold. The United Kingdom, for example, pledged to buy or sell an ounce of gold for pounds sterling, thereby establishing the pound’s par value, or official price in terms of gold. The United States agreed to buy or sell an ounce of gold for a par value of $ The two currencies could be freely exchanged for the stated amount of gold, making £4.247 = 1 ounce of gold = $ This implied a fixed exchange rate between the pound and the dollar of £1 = $4.867, or $20.67/£4.247. From 1821 until the end of World War I in 1918, the most important currency in international commerce was the British pound sterling, a reflection of the United Kingdom’s status as Europe’s dominant economic and military power. Most firms accepted either gold or British pounds in settlement of transactions. As a result, the international monetary system during this period is often called a sterling-based gold standard. Because of the international trust in British currency, London became a dominant international financial center in the nineteenth century, a position it still holds. Copyright © 2015 Pearson Education, Inc.

History of the International Monetary System: Collapse of the Gold Standard World War I The Great Depression Competitive Devaluations Beggar-Thy-Neighbor Policies World War II During World War I, the sterling-based gold standard unraveled. With the outbreak of war, normal commercial transactions between the Allies (France, Russia, and the United Kingdom) and the Central Powers (Austria-Hungary, Germany, and the Ottoman Empire) ceased. The economic pressures of war caused country after country to suspend their pledges to buy or sell gold at their currencies’ par values. After the war, conferences at Brussels (1920) and Genoa (1922) yielded general agreements among the major economic powers to return to the prewar gold standard. The resuscitation of the gold standard proved to be short-lived, however, as a result of the economic stresses triggered by the worldwide Great Depression. The harmony of the international monetary system degenerated further as some countries—including the United States, France, the United Kingdom, Belgium, Latvia, the Netherlands, Switzerland, and Italy—engaged in a series of competitive devaluations of their currencies. Most countries also raised the tariffs they imposed on imported goods in the hope of protecting domestic jobs in import-competing industries. As more and more countries adopted these beggar-thy-neighbor policies, international trade contracted, hurting employment in each country’s export industries Copyright © 2015 Pearson Education, Inc.

History of the International Monetary System: Bretton Woods Era
Bretton Woods conferees agreed to: Renew the gold standard on a greatly modified basis The creation of two new international organizations International Bank for Reconstruction and Development-World Bank International Monetary Fund Determined not to repeat the mistakes that had caused World War II, Western diplomats planned to create a postwar economic environment that would promote worldwide peace and prosperity. In 1944, the representatives of 44 countries met at a resort in Bretton Woods, New Hampshire, with that objective in mind. The Bretton Woods conferees agreed to renew the gold standard on a greatly modified basis. They also agreed to the creation of two new international organizations that would assist in rebuilding the world economy and the international monetary system: The International Bank for Reconstruction and Development (aka the IBRD or the World Bank) The International Monetary Fund (aka the IMF) Copyright © 2015 Pearson Education, Inc.

International Bank for Reconstruction and Development
Official name of the World Bank Help finance reconstruction of the war-torn European economies Build the economies of the world’s developing countries Three affiliated organizations: International Development Association International Finance Corporation Multilateral Investment Guarantee Agency The International Bank for Reconstruction and Development is the official 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. It then adopted a new mission—to build the economies of the world’s developing countries. Copyright © 2015 Pearson Education, Inc.

International Bank for Reconstruction and Development
As its mission has expanded over time, the World Bank has created three affiliated organizations. Together with the World Bank, these constitute the World Bank Group. The World Bank may lend only for “productive purposes” that will stimulate economic growth within the recipient country. In addition, the World Bank follows a hard loan policy; that is, it will make a loan only if there is a reasonable expectation that the loan will be repaid. In the 1950s, poorer countries complained that the policy kept them from obtaining World Bank loans. In response, the World Bank established the International Development Association (IDA) in The IDA offers soft loans, which bear some significant risk of not being repaid. The two other affiliates of the World Bank Group have narrower missions. The International Finance Corporation (IFC) was created in It is charged with promoting the development of the private sector in developing countries. The Multilateral Investment Guarantee Agency (MIGA) was set up in 1988 to overcome private-sector reluctance to invest in developing countries by offering private investors insurance against noncommercial risks. Copyright © 2015 Pearson Education, Inc.

International Monetary Fund
Boost international monetary cooperation Facilitate international trade Stabilize exchange arrangements Foster multilateral payment system Build confidence of members Adjust international balance of payments To ensure that the post–World War II monetary system would promote international commerce, the Bretton Woods Agreement created the 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: To promote international monetary cooperation To facilitate the expansion and balanced growth of international trade To promote exchange stability, maintain orderly exchange arrangements among members, and avoid competitive exchange depreciation To assist in the establishment of a multilateral system of payments To give confidence to members by making the general resources of the IMF temporarily available to them and to correct maladjustments in their balance of payments To shorten the duration and lessen the degree of disequilibrium in the international balance of payments of members Copyright © 2015 Pearson Education, Inc.

International Monetary Fund: Quotas and Voting Power
As of 2013, countries were members To join, a country must pay a quota A country’s quota determines Country’s voting power within the IMF Country’s borrowing power from the IMF IMF conditionality IMF Members with Largest Voting Shares (As of 2013) Member Voting Shares USA 16.8 Japan 6.2 Germany 5.8 France 4.3 UK China 3.8 Italy 3.2 Saudi Arabia 2.8 Canada 2.6 Russia 2.4 Membership in the IMF is available to any country willing to agree to its rules and regulations. As of 2013, 188 countries were members. To join, a country must pay a deposit, called a quota, partly in gold and partly in the country’s own 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 a quota is important for several reasons: A country’s quota determines its voting power within the IMF. Currently the United States controls 16.8 percent of the votes in the IMF, Japan 6.2 percent, and Germany 5.8 percent, followed by France and the United Kingdom (4.3 percent), China (3.8 percent), Italy (3.2 percent), Saudi Arabia (2.8 percent), Canada (2.6 percent), and Russia (2.4 percent) A country’s quota serves as part of its official reserves The quota determines the country’s borrowing power from the IMF. Each IMF member has an unconditional right to borrow up to 25 percent of its quota from the IMF. IMF policy allows additional borrowings contingent on the member country’s agreeing to IMF-imposed restrictions—called IMF conditionality—on its economic policies Copyright © 2015 Pearson Education, Inc.

Dollar-Based Gold Standard
U.S. Dollar–Based Gold Standard Fixed Exchange Rate Adjustable Peg System Bretton Woods participants agreed to peg the value of their currencies to gold. For example, the par value of the U.S. dollar was set at $35 per ounce of gold. Only the United States pledged to redeem its currency for gold at the request of a foreign central bank. Thus, the dollar became the keystone of the Bretton Woods system, and a U.S. dollar–based gold standard was established. Because each country established a par value for its currency, the Bretton Woods Agreement resulted in a fixed exchange rate system. Under the agreement, each country pledged to maintain the value of its currency within a range of ± 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 and bring the value back within that range. This arrangement provided an assurance that the value of each currency would remain stable. Under extraordinary circumstances, the Bretton Woods Agreement allowed a country to adjust its currency’s par value. Accordingly, the 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. Copyright © 2015 Pearson Education, Inc.

History of the International Monetary System: The End of the Bretton Woods System Speculative “Runs on the Bank” Triffin Paradox Special Drawing Rights (SDRs) Nixon’s 1971 Speech Smithsonian Conference The Bretton Woods system was particularly susceptible to “runs on the bank” because there was little risk in converting a suspect currency into dollars. In November 1967, the United Kingdom faced this type of bank run. The Bank of England could not counter the flood of pounds dumped on the market by speculators, so it was forced to devalue the pound by 14.3 percent. In 1969, France faced a similar run, and had to devalue the franc. 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—in the early 1970s. During the 1950s and 1960s, foreigners were willing to hold U.S. dollars since they trusted the integrity of the currency. The expansion of international liquidity depended on foreigners’ willingness to continually increase their holdings of dollars. As foreign dollar holdings increased, investors began to question the ability of the United States to live up to its Bretton Woods obligation. This led to the Triffin Paradox: Foreigners needed to increase their holdings of dollars to finance international trade, but the more dollars they owned, the less faith they had that the United States could redeem dollars for gold. The less faith they had, the more they wanted to rid themselves of dollars and get gold in return. If they did this, however, the international monetary system might collapse because the United States did not have enough gold to redeem the dollars 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 members agreed in 1967 to create special drawing rights (SDRs). IMF members could use SDRs to settle official transactions at the IMF. Unfortunately, SDRs did not reduce the glut of dollars held by foreigners. By mid-1971, the Bretton Woods system was tottering. During the first seven months of 1971, the United States sold one-third of its gold reserves to maintain the dollar’s value. However, the United States did not have sufficient gold to meet the demands of those who still wanted to exchange dollars for gold. On August 15, 1971, President Nixon announced that the United States would no longer redeem gold at $35 per ounce. Consequently, the Bretton Woods system ended. At the Smithsonian Conference, held in Washington, D.C., in December 1971, central bank representatives from the Group of Ten agreed to restore the fixed exchange rate system but with restructured rates of exchange between the major trading currencies. Copyright © 2015 Pearson Education, Inc.

History of the International Monetary System: Performance of the IMF Since 1971 Flexible (or Floating) Exchange Rate System Managed Float (or, a Dirty Float) Jamaica Agreement Flexible exchange rate system legitimized Pegged exchange rate Crawling pegs European Monetary System (EMS) By March 1973 the central banks conceded they could not successfully resist free-market forces and so established a flexible exchange rate system. Under a flexible (or floating) exchange rate system, supply and demand for a currency determine its price in the world market. Since 1973, exchange rates among 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. The new flexible exchange rate system was legitimized by an international conference held in Jamaica in January According to the resulting Jamaica Agreement, each country was free to adopt whatever exchange rate system best met its own requirements. Other countries adopted a fixed exchange rate by pegging their currencies to the dollar, the French franc, or some other currency. Still others used crawling pegs, allowing the peg to change gradually over time. In 1979, EU members created the European Monetary System (EMS) to manage currency relationships among themselves. Most EMS members chose to participate in the EU’s exchange rate mechanism (ERM). They pledged to maintain fixed exchange rates among their currencies within a narrow range of ± 2.25 percent of par value and a floating rate against the U.S. dollar and other currencies. Copyright © 2015 Pearson Education, Inc.

Other Post–World War II Conferences
The Plaza Accord The Louvre Accord The United States complained that an overvalued dollar was making its exports noncompetitive and allowing cheap imports to damage U.S. industries. In 1985, finance ministers from the Group of Five enacted the Plaza Accord, in which the central banks agreed to let the dollar’s value fall on currency markets. Fearing that continued devaluation of the dollar would disrupt world trade, the group of five enacted the Louvre Accord in This accord signaled the commitment of these five countries to stabilizing the dollar’s value. Copyright © 2015 Pearson Education, Inc.

International Debt Crisis
Soaring Oil Prices (1973 – 1974) and (1978 – 1979) In 1973, the Organization of Petroleum Exporting Countries (OPEC) imposed an oil embargo. World oil prices quadrupled from $3 a barrel in October 1973 to $12 a barrel by March This rapid increase in oil prices increased inflation in oil-importing countries. In response, exchange rates adjusted to account for changes in the value of each country’s oil exports or imports. The currencies of the oil exporters strengthened, while those of the oil importers weakened. Many oil-exporting countries used their new wealth to improve their infrastructures or invest in new facilities. Unspent petrodollars were deposited in international banks. The banking community then recycled these petrodollars through its international lending activities to help revive the economies damaged by rising oil prices. Many countries borrowed more than they could repay. The financial positions of these borrowers became precarious after the oil shock of when the price of oil skyrocketed from $13 to over $30 a barrel. This triggered another round of worldwide inflation. Interest rates on these loans rose, as most carried a floating interest rate, further burdening the heavily indebted nations. Copyright © 2015 Pearson Education, Inc.

Financial Crisis International Debt Crisis The Baker Plan The Brady Plan Asian Currency Crisis Subprime Meltdown In 1982, the international debt crisis formally began when Mexico requested a rescheduling of its debts, a moratorium on repayment of principal, and a loan from the IMF to help it through its debt crisis. In total, more than 40 countries in Asia, Africa, and Latin America sought relief from their external debts. Various approaches were used to resolve the crisis. In 1985, the Baker Plan stressed several points: the importance of debt rescheduling, tight IMF-imposed controls over domestic monetary and fiscal policies, and continued lending to debtor countries so that economic growth would allow them to repay their creditors. In spite of these initiatives, the debtor nations made little progress in repaying their loans. Debtors and creditors alike agreed that a new approach was needed. In 1989, the Brady Plan 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 funds to buy back their loan notes at below face value. In the 1990s, the debt-servicing requirements of debtor countries were made more manageable via a combination of IMF loans, debt rescheduling, and changes in governmental economic policies. As a result, the international debt crisis receded during this time. The Asian currency crisis 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 Thai borrowers to repay their foreign loans and of the Thai government to maintain the baht’s value. As investors realized that other countries in the region were also overly dependent on short-term foreign capital, their currencies also came under attack, and their stock markets were devastated. All told, the IMF and developed countries pledged over $100 billion in loans to help restore these countries to economic health. The latest financial crisis to plague the international capital market began with the so-called subprime meltdown, which resulted from the bursting of the U.S. housing bubble. The problems created by this collapse affected financial markets throughout the world. Copyright © 2015 Pearson Education, Inc.

BOP Accounting System Double-entry Bookkeeping System Measures and records transactions between residents of one country and residents of all other countries Importance of BOP statistics: Help identify emerging markets for goods and services Can warn of possible new policies that may alter a country’s business climate Can indicate reductions in a country’s foreign- exchange reserves Can signal increased riskiness of lending to particular countries The BOP accounting system is a double-entry bookkeeping system designed to measure and record all economic transactions between residents of one country and residents of all other countries during a particular time period. International businesspeople need to pay close attention to BOP statistics for a number of reasons: BOP statistics help identify emerging markets for goods and services. BOP statistics can warn of possible new policies that may alter a country’s business climate, thereby affecting the profitability of a firm’s operations in that country. BOP statistics can indicate reductions in a country’s foreign-exchange reserves, which could signal that the country’s currency will depreciate in the future. BOP statistics can signal increased riskiness of lending to particular countries. Copyright © 2015 Pearson Education, Inc.

BOP Accounting System: Major Components of the BOP System
Current Account Capital Account Official Reserves Errors and Omissions The BOP accounting system can be divided conceptually into four major accounts. The first two accounts—the current account and the financial account—record purchases of goods, services, and assets by the private and public sectors. The official reserves account reflects the impact of central bank intervention in the foreign-exchange market. The errors and omissions account captures mistakes made in recording BOP transactions. Copyright © 2015 Pearson Education, Inc.

Current Account Exports and imports of goods (or merchandise) Exports and imports of services Investment income Gifts (or unilateral transfers) The current account records four types of transactions among residents of different countries: Exports and imports of goods: The balance on merchandise trade is the difference between a country’s merchandise exports and merchandise imports. Exports and imports of services: The difference between a country’s exports of services and its imports of services is called the balance on services trade. Investment income: Income that a country’s residents earn from foreign investments is viewed as an export of the services of capital. Income earned by foreigners from their investments in a country is viewed as an import of the services of capital by that country. Gifts (or unilateral transfers): Private gifts between residents of one country and residents in another country are called unilateral transfers. Governmental aid is a public unilateral transfer. In either case, recipients don’t need to provide any compensation to the donors. Copyright © 2015 Pearson Education, Inc.

Capital Account Foreign Direct Investment (FDI) Foreign Portfolio Investment (FPI) Short-Term Foreign Portfolio Investments Long-Term Foreign Portfolio Investments The capital account records financial transactions—purchases and sales of assets— between residents of one country and those of other countries. Account transactions can be divided into two categories: foreign direct investment and foreign portfolio investment. Foreign Direct Investment (FDI) is any investment made for the purpose of controlling the organization in which the investment is made. A typical means of obtaining this goal is through ownership of significant blocks of common stock with voting privileges. Foreign portfolio investment (FPI) is any investment made for purposes other than control. FPIs are divided into two subcategories: short-term investments and long-term investments. Short-term foreign portfolio investments are financial instruments with maturities of one year or less: (e.g., commercial paper, checking accounts, time deposits, and trade receivables). Long-term foreign portfolio investments include stocks, bonds, and other financial instruments that have maturities greater than one year. Copyright © 2015 Pearson Education, Inc.

Capital Account Current account transactions invariably affect the short-term component of the financial account. The first entry in the double-entry BOP accounting system records the purchase or sale of something—a good, a service, or an asset. The second entry typically records the payment or receipt of payment for the thing bought or sold. Capital inflows are credits in the BOP accounting system. They can occur in two ways: Foreign ownership of assets in a country increases. Ownership of foreign assets by a country’s residents declines. Capital outflows are debits in the BOP accounting system. They also can occur in two ways: Ownership of foreign assets by a country’s residents increases. Foreign ownership of assets in a country declines. Table 7.5 summarizes the impact of various capital account transactions on the BOP accounting system. Copyright © 2015 Pearson Education, Inc.

Official Reserves Account
Records the level of official reserves held by a national government Official reserves comprise 4 types of assets: Gold Convertible currencies Special Drawing Rights (SDRs) Reserve positions at the IMF The official reserves account is the third major component in the BOP accounting system. It records the level of official reserves held by a national government. These reserves are used to intervene in the foreign-exchange market and to complete transactions with other central banks. Official reserves include four types of assets: Gold Convertible currencies Special Drawing Rights (SDRs) Reserve positions at the IMF Official gold holdings are measured using a par value established by a country’s treasury or finance ministry. Convertible currencies are freely exchangeable in world currency markets. The convertible currencies most commonly used as official reserves are the U.S. dollar, the euro, and the yen. The last two types of reserves—SDRs and reserve positions at the IMF—were discussed earlier in this chapter. Copyright © 2015 Pearson Education, Inc.

Errors and Omissions BOP accounting system must balance Current Account + Capital Account + Official Reserves Account + Errors and Omissions = 0 Circumstances accounting for errors and omissions: Underreporting of capital account transactions Deliberate actions by individuals Errors in the current account In principle, the BOP accounting system must balance. However, this equilibrium is elusive in practice because of measurement errors. Therefore, the errors and omissions account is used to make the BOP balance. Several sets of circumstances can account for errors and omissions: The errors and omissions account can be quite large. Experts suspect that a large portion of the errors and omissions account balance is the result of the underreporting of capital account transactions. Sometimes, errors and omissions are due to deliberate actions by individuals who are engaged in illegal activities such as drug smuggling, money laundering, or evasion of currency and investment controls imposed by their home governments. Some errors may crop up in the current account as well. Statistics for merchandise imports are reasonably accurate because most customs agents scrutinize imports to ensure that all taxes are collected. However, customs agents have less incentive to assess merchandise exports. Statistics for trade in services may also contain inaccuracies. Copyright © 2015 Pearson Education, Inc.

BOP Accounting System: Defining BOP Surpluses and Deficits
Trade Surplus Trade Deficit Official Settlements Balance When a country exports more goods and services than it imports, it has a trade surplus. When it imports more goods and services than it exports, it has a trade deficit. The official settlements balance reflects changes in a country’s official reserves; essentially, it records the net impact of the central bank’s interventions in the foreign-exchange market in support of the local currency. 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. The balance on goods and services reflects the combined international competitiveness of a country’s manufacturing and service sectors. The current account balance shows the combined performance of the manufacturing and service sectors and also reflects the generosity of the country’s residents (unilateral transfers) as well as income generated by past investments. The official settlements balance reflects the net quantity demanded and supplied of the country’s currency by all market participants, other than the country’s central bank. Copyright © 2015 Pearson Education, Inc.

Review Questions What is the function of the international monetary system? Why is the gold standard a type of fixed exchange rate system? What was the initial goal of the World Bank? Why was the IFC established by the World Bank? Why are quotas important to IMF members? Copyright © 2015 Pearson Education, Inc.

Review Questions (Cont.)
Why did the Bretton Woods system collapse in 1971? 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. What factors cause measurement errors in the BOP accounts? Identify the different types of balance of payments surpluses and deficits. Copyright © 2015 Pearson Education, Inc.

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