Tài chính doanh nghiệp - Finance 407: Multinational financial management - Topic 5: Exchange rate systems and the effects of revaluation

Topic #5: Exchange Rate Systems and The Effects of RevaluationL. GattisThe Pennsylvania State UniversityFinance 407: Multinational Financial Management1Review2The spot euro is selling for $1.2231 – 1.2421. The 9-month forward points are 342 / 355. How many euros would you receive for $100 for a 9-month delivery?79.54125.73127.7678.27124.21Learning Objectives3Learning ObjectivesStudents understand and can recallThe advantages and disadvantages of alternative systems for the determination of exchange ratesThe effects of appreciation and depreciation on consumers and business.How exchange rates are determined within fixed rate, floating, and managed float systems.The causes and effects of the major currency crises4DXY “Dollar” Index (98-12)EURUSD (98-12)Currency Crisis5A currency crisis is a rapid and disruptive exchange rate change– usually a devaluation.Often caused by geopolitical or economic shocks the reduce the demand for investment in that countryOften associated by the failure of a fixed exchange rate system in which rates were held unnaturally high or low by governmentsRapid DevaluationsMost often in Emerging and Frontier MarketsShort-run EffectsSpike in the cost of imports (oil, medicine, technology, food)Rapid reduction in foreign investment as firms avoid depreciating currencies and instabilitySharp increase in the cost to repay foreign-denominated loans (emerging market governments and companies often borrow in dollars and euros) Often associated with government layoffs to reduce budget deficits due to increased debt costs and reduced tax revenuesLong-run: inflation (due to import costs) and increase in “cheaper” exports (self correcting mechanism)Poll: Currency Winners and Losers6Who are the most likely winners in an appreciating dollar environment (depreciating foreign currency)?American Exporters to ROW American Outsourcers to ROW?American Tourist in Europe Foreign Tourists in America?7Exchange Rate SystemsThe ERS refers to the set of policies, institutions, practices, regulations, and mechanisms that determine the rate at which one currency is exchanged for another.We shall discuss 4 systemsFree FloatManaged FloatFixed Rate System / Target-Zone ArrangementDollarization / Euroization8IMS Currency SystemsSystemsCharacteristicsFree FloatSupply and Demand (and Speculation) for Currencies – No government interventionManaged FloatMarket determine rate, but government intervenes when (1) excess volatility or (2) undesirable levelTarget-Zone Arrangement / Fixed Rate SystemMember governments agree upon target exchange rates by (1) convergence of interest rates/inflation and (2) trade currencies if necessaryDollarization / EuroizationThe adoption of another nations currency as the official currency89Cost and Benefits of SystemsAdvantagesDisadvantagesFree FloatRequires no effort or resources; Economic Stability (GNP falls, currency declines, exports rise); Less crises.Excess volatility from speculation; loss of central banker macro policy tool (depreciate to spur exports)Managed FloatReduce volatility of free float systemDifficult to know when to intervene and potentially costly and disruptiveFixed Rate / Target ZoneReduced/No Volatility;Reduced exchange rate risk;Encourages financial discipline to maintain ratesPotential for Crisis;Monetary policy is subordinated to currency policy (cannot use to reduce business cycles)Dollar-izationUse of a stable currency value and international tradeLoss of seigniorage revenues from the issuance of currency; loss of monetary policy tool10Officially Dollarized CountriesWikipedia, 9/27/06U.S. dollarBritish Virgin Islands East Timor Ecuador (uses its own coins) El Salvador Marshall Islands Federated States of Micronesia Palau Panama (uses its own coins) Pitcairn Islands (also uses the New Zealand dollar) Turks and Caicos Islands EuroKosovo Monaco (formerly French franc; issues own coins) Andorra (formerly French franc and Spanish peseta) San Marino (formerly Italian lira; issues own coins) Vatican City (formerly Italian lira; issues its own coins) Montenegro New Zealand dollarCook Islands Niue Tokelau Pitcairn Island (also uses U.S. dollar) Australian dollarKiribati (issues own coins) Nauru Tuvalu (prints its own notes) OthersCyprus, Northern (Turkish lira) Liechtenstein (Swiss franc) 11INTERNATIONAL MONETARY SYSTEMS Current system is a hybrid systemMajor currencies are free floating with occasional interventionsUSD, EUR, GBP, JPY, CAD, AUSManaged FloatCNYDollarized and EuroizedTarget-rate zonesECCUFranc ZoneCommon Currency ZoneEuroFixed Rate SystemsEuro Pegs (E.g., DKK pegged at 7.45 euros, Hong Kong dollar pegged to U.S. Euro Currency (22)NorwayIcelandSwitzerlandLichtensteinGermanyFranceAustriaBelgiumNetherlandsLuxembourgMaltaCyprusEstonia(Latvia,2014)FinlandPortugalIrelandItalyGreeceSpainSan MarinoSlovakiaEuro PeggedDenmarkBulgaria<(Lithuania, 2015)EFTA (4)EU Membership (27)AndoraKosovoMontenegroMonacoSan MarinoVatican CityEuro Zone (18)European Economic Area and the €Free/Managed FloatU.K.SwedenPolandRomaniaHungaryCzechEU: Economic and political union (free movement of people, goods, services, capital)Euro Zone: Monetary union (€uro is sole tender, ECB is monetary and banking authority)EFTA: European free trade association (trade agreement with EU)Euroized (6)Euroized: Use Euro as official currency, but not apart of the euro zone or have representation in the ECB1213Euroized: AndoraKosovoMontenegroMonacoSan MarinoVatican City2014201520??Free Market Exchange Rate Determinants14SupplyAt any moment there is a fixed supply of currency in circulation issued by the Government or Supra-governmental organizations (E.U.)Government printing of money puts inflationary pressure on pricesReducing the buying power of a single currency unit (e.g., USD) – making it less valuable to foreigners (USD will depreciate)DemandCurrencies provide no inherent utilityCurrency is used to facilitate trade for goods and services that provide utilityCurrency is also used to purchase financial assets which allows you to consume more in the future (assuming the return is greater than inflation)Thus, exchange rates reflect current and expected supply of the currency and the demand for the goods, services, and financial assets a currency can buy.Exchange Rate Determinants (and Cases)15Demand for Goods and Services1. Relative Demand for Goods and Services (Dutch Disease)2. Relative Inflation (Zimbabwe’s Hyperinflation)Demand for Financial Asset and Real Investment3. Relative real interest rate4. Relative economic growth (Asian Tigers Bubble and Crisis)Government5. Monetary Policy and Fiscal Policy (Russian Debt Default, Greek Debt Crisis)6. Direct Currency Intervention (China, Peso)1. Demand for Goods (Imports) and Services16foreign goods imports and servicesIncreased demand for foreign currencyAppreciation of foreign currencyDepreciation of domestic currencyHot new BMWDemand for Euro increases€ appreciates $ depreciations↑ $/€↓ €/$Net Exports appreciate currenciesThe Dutch Disease17Refers to potentially devastating affects of a country that suddenly discovers natural resources (and corresponding demand for its currency)Demand for resource (natural gas in the case of the Netherlands in the 1960s) drives up demand for currency and currency appreciatesManufacturing sector becomes uncompetitive due to appreciated currency and declinesWhen the resource is exhausted or prices fall, the economy suffers.This is an argument against “comparative advantage” and “specialization”2. Inflation (and Zimbabwe)18Definition: Inflation is a term for the general increase in price levelsCausesIncreased money supply (printing of money)Excess demand for goods “overheated economy”Scarcity or increased production costsEffects on Exchange RatesIf one country has relatively higher inflation, its currency buys less goods and is less valuableThis reduces demand for the currency and its exchange rate will fall (relative the to low inflation currency)Zimbabwe’s Hyper InflationZimbabwe Inflation reached an annual rate of 66,000% in 2008In one month, the Zim$ devalued from Zim$2M to Zim$7M per USDThat’s Zim$10M to by a coke, Zim$28M to buy a latteThe government prints Zim$200,000 notes (worth about 3 U.S. cents) 3. Real Interest Rates19Increased Demand for Australian Bonds by AmericansIncreased Demand for Aussie DollarsAppreciation of the Aussie DollarDepreciation of the USDFinancial asset demand is more complicated because investors demand the highest real return which depends on the nominal rate and inflation rateReal Rate = (1 + Nominal Rate) / (1 + Inflation) – 1Approximation: Real Rate ≈ Nominal - Inflation ↑ $/A$↓ A$/$4. Economic Growth20High relative economic growth encourages investments in financial assets (stocks, bonds) and real assets (real estate, businesses)The increased demand in these assets, increases the demand for the currency and causes appreciationThe Asian Tigers (Thailand, the Philippines, Malaysia, and Indonesia) experienced tremendous economic growth in the early 1990’s and were touted as a successful “managed economies”However, the economies faltered and currencies collapsed as investors learned of government fraud. Governments and businesses were unable to repay foreign-denominated debts1997 Asian Currency Bubble and Crisis5. Monetary and Fiscal Policy21Fiscal Policy: Spending, taxes, and deficitsDeficit SpendingIn the short run it increases interest rates as more debt is issued (leading to a currency appreciation)In the long run it may increase risk and uncertainty in the currency as inflation and/or default becomes more probableMonetary Policy: Money Supply and Interest RatesThe increase in money supply may cause economic strength in the short run (causing an appreciation), but is largely inflationary in the long run (causing a depreciation)Increasing real interest rates tends to appreciate a currency (increasing nominal rates to match increases in inflation should have no effect since real rates are unchanged)Russian Debt Default and Greek Crisis221998 Russia Debt Default and Currency CrisisRussia issued domestic debt to cover deficit spendingSignificant drop in oil prices reduced exports and foreign currency inflows, widening budget deficit and debt serviceAsian economic crisis contagion led to outflows of capital needed to service debtRussians defaulted on bonds, currency devalued, and FDI fell sharplyOne of the causes of the failure of LTCM which bet against the defaultGreek Debt Crisis and the PIGSGreek deficits have led to speculation that they may default on bonds and loansSince Greece is part of the eurozone, their problems led to a substantial drop in the value of the euro in 2010The E.U. has committed to bail out Greece to sure up the euroMany fear that the other weak eurozone members, affectionately know as the PIGS (Portugal, Italy, Greece, Spain, and sometime Ireland – PIIGS) will also require bail outs 6. Direct Currency Intervention23Buy or Sell Foreign or Domestic currency reserves (or bonds)Restrict inward or outward foreign investment or convertibilityMandate official exchange ratesThe Peso Problem“Beware of calm water”24On December 20, 1994, Mexico, under attack from speculators selling the peso, allowed the peso to devalue by 12.7%. Two days later, the government was forced to abandon its fixed rate system and allowed the peso to float. The peso devalued 50% within 3 months.The government had previously defended the exchange rate by standing ready to buy pesos (selling foreign reserves) at the governments target rate. This system works if the government accumulated enough foreign reserves to buy pesos when under attack.To accumulate foreign reserves the government also offered increasingly higher real exchange rates to attract peso-denominated bond buyers. However, higher interest rates would reduce Mexico’s domestic investment, production, and employment. Higher interest rates also increased interest payments and the budget deficit.Investors knew that the government’s plan to defend the peso was unsustainable. Investors continued to sell the peso, expecting it to depreciate when the government was no longer able to defend itThe government caved-in, allowing the peso to float and depreciate and a crisis ensuedThe “peso problem” refers to a market which has been stabile (or even provided above average returns) that has the potential to crash. So, seemingly easy money strategies may simply be peso problems in disguise. Short and Long Run Currency Determinants25Medium to Long-Run Determinants (Economic)Inflation, trade balances, budget deficits, real interest rates, growth, competitivenessShort run Determinants (days-weeks)portfolio flows, interest rates, speculation, policy newse.g. The U.S. make a surprise announcement that they are raising rates on T-Bills -- dollar will likely appreciate against major currencies as foreign portfolios acquire T-Bills.e.g., The ECB announces an expanded rescue package for Spain -- Euro gains against major currenciesPolls26Dollar AppreciatesDollar DepreciatesGovernment announces that U.S. CPI unexpectedly rose in AugustGermany reaffirms its commitment to back Italian and Greek government bailouts.The Fed announces that they are raising the Fed Funds target rate from 0.25% to .75% to maintain the current level of inflation.Textbook27Shapiro and Sarin’s Foundation of Multinational Finance 6th Ed. Chapter 3 covers alternative exchange rate systems and the history of the international monetary system includingThe E.U. and the euroEmerging market currency crisesiClicker: Class Evaluation28How would you rate today’s class? Highest LowestAssignment29Suppose the yen appreciates 5% against the U.S. dollar while inflation in Japan is 2% and inflation in the U.S. is 0%. How much more expensive are Japanese goods to Americans?If the initial price of the Japanese good is P and the rate is $/Yen rate is X. The cost is PX. The new cost is P*1.02*X*1.05=1.071PX; Change is (1071-1)/1=7.1% (more expensive)