financial environment chapter overview development of todays international development of todays...

FINANCIAL ENVIRONMENT FINANCIAL ENVIRONMENT

CHAPTER OVERVIEWCHAPTER OVERVIEW Development of Today’s International Development of Today’s International

Monetary SystemMonetary System Fixed Versus Floating Exchange Rates Fixed Versus Floating Exchange Rates Foreign Exchange and Foreign Exchange RatesForeign Exchange and Foreign Exchange Rates Balance of PaymentsBalance of Payments Economic and Financial Turmoil Around the Economic and Financial Turmoil Around the

WorldWorld

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IntroductionIntroduction

Foreign exchange is the monetary mechanism allowing Foreign exchange is the monetary mechanism allowing the transfer of funds from one nation to another.the transfer of funds from one nation to another.

The existing international monetary system always The existing international monetary system always affects companies as well as individuals whenever they affects companies as well as individuals whenever they buy or sell products and services traded across national buy or sell products and services traded across national borders.borders.

Although international marketers have to operate in a Although international marketers have to operate in a currently existing international monetary system for currently existing international monetary system for international transactions and settlements, they should international transactions and settlements, they should understand how the scope and nature of the system understand how the scope and nature of the system has changed and how it has worked over time.has changed and how it has worked over time.

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IntroductionIntroduction

The 1990s – particularly, the second half of the The 1990s – particularly, the second half of the decade – proved to be one of the most turbulent decade – proved to be one of the most turbulent periods in recent history.periods in recent history.

The adoption of the euro as a common currency in The adoption of the euro as a common currency in the European Union in 1999 is just one example of the European Union in 1999 is just one example of the many changes taking place in today’s the many changes taking place in today’s business world.business world.

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1. Development of Today’s International 1. Development of Today’s International Monetary SystemMonetary System

Post-World War II developments had long-range Post-World War II developments had long-range effects on international financial arrangements.effects on international financial arrangements.

The negotiations to establish the postwar The negotiations to establish the postwar international monetary system took place at the international monetary system took place at the resort of Bretton Woods in New Hampshire in resort of Bretton Woods in New Hampshire in 1944 which established the 1944 which established the International Monetary International Monetary Fund (IMF).Fund (IMF).

President Richard Nixon suspended the President Richard Nixon suspended the convertibility of the dollar to gold on August 15, convertibility of the dollar to gold on August 15, 1971.1971.

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1. Development of Today’s 1. Development of Today’s International Monetary SystemInternational Monetary System

The The IMF IMF oversees the international monetary oversees the international monetary system and its functions are as follows:system and its functions are as follows:– To promote international monetary cooperationTo promote international monetary cooperation– To facilitate the expansion and balanced growth To facilitate the expansion and balanced growth

of international tradeof international trade– To promote exchange stability and to maintain To promote exchange stability and to maintain

orderly exchange arrangementsorderly exchange arrangements– To assist in the establishment of a multilateral To assist in the establishment of a multilateral

system of payments in respect to current system of payments in respect to current transactions between member nations; to transactions between member nations; to eliminate foreign exchange restrictionseliminate foreign exchange restrictions

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1. Development of Today’s International 1. Development of Today’s International Monetary SystemMonetary System

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– To make available the general resources of the To make available the general resources of the fund temporarily available to members under fund temporarily available to members under adequate safeguards; help members to correct adequate safeguards; help members to correct maladjustments in the balance of paymentsmaladjustments in the balance of payments

– To shorten the duration and lessen the degree To shorten the duration and lessen the degree of disequilibrium in the international balance of of disequilibrium in the international balance of payments to memberspayments to members

– The IMF created special drawing rights The IMF created special drawing rights (SDRs)(SDRs) in 1969.in 1969.

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The value of SDRs is determined by a weighted The value of SDRs is determined by a weighted average of a basket of four currencies: the U.S. average of a basket of four currencies: the U.S. dollar, Japanese yen, European Union’s euro, and dollar, Japanese yen, European Union’s euro, and the British pound.the British pound.

After the 1997-98 Asian financial crisis, the IMF has After the 1997-98 Asian financial crisis, the IMF has worked on policies to overcome or even prevent worked on policies to overcome or even prevent future crises.future crises.

Another creation of the Bretton Woods Agreement Another creation of the Bretton Woods Agreement was the was the International Bank for Reconstruction and International Bank for Reconstruction and DevelopmentDevelopment (World Bank), supporting economic (World Bank), supporting economic development and poverty reduction projects. development and poverty reduction projects.

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2. Fixed Versus Floating Exchange Rates2. Fixed Versus Floating Exchange Rates

Two kinds of currency floats encompass free/clean Two kinds of currency floats encompass free/clean float (allows no government intervention) and float (allows no government intervention) and managed float (allows limited government managed float (allows limited government intervention).intervention).

In March 1973, the major currencies began to float In March 1973, the major currencies began to float in the foreign exchange markets.in the foreign exchange markets.

Today, the global economy is dominated by Today, the global economy is dominated by three three major currency blocsmajor currency blocs: The U.S. dollar, the : The U.S. dollar, the Japanese yen, and the EU’s euro. Japanese yen, and the EU’s euro.

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3. Foreign Exchange and Foreign 3. Foreign Exchange and Foreign Exchange RatesExchange Rates

One of the most fundamental determinants of the One of the most fundamental determinants of the exchange rate is exchange rate is Purchasing Power Parity (PPP).Purchasing Power Parity (PPP).

Formula for PPP:Formula for PPP: (1 + (1 + InflInflBritainBritain))RRtt = R = R00 * _____________ * _____________ (1 (1 + Infl+ InflU.S.U.S.)) WhereWhere R R = = the exchange rate quoted in a the exchange rate quoted in a currencycurrencyInflInfl = = Inflation rateInflation ratett = = time periodtime period

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The Economist The Economist publishes apublishes a PPP PPP study (study (Big Mac Big Mac IndexIndex) every year ) every year based on based on McDonald’s Big McDonald’s Big Mac hamburger Mac hamburger (see Exhibit 3-2).(see Exhibit 3-2).

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Factors influencing Foreign Exchange RatesFactors influencing Foreign Exchange Rates (see Exhibit 3-3):(see Exhibit 3-3):

– Macroeconomic FactorsMacroeconomic Factors: Relative inflation, balance of : Relative inflation, balance of payments, foreign exchange reserves, economic payments, foreign exchange reserves, economic growth, government spending, money supply growth, growth, government spending, money supply growth, and interest rate policy.and interest rate policy.

– Political FactorsPolitical Factors: Exchange rate control, election year : Exchange rate control, election year or leadership change.or leadership change.

– Random FactorsRandom Factors: Unexpected and/or unpredicted : Unexpected and/or unpredicted events, fear of uncertainty, etc.events, fear of uncertainty, etc.

Many countries attempt to maintain a lower value Many countries attempt to maintain a lower value for their currency in order to encourage exports.for their currency in order to encourage exports.

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3. Foreign Exchange and Foreign Exchange Rates3. Foreign Exchange and Foreign Exchange Rates

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Spot versus forward exchange ratesSpot versus forward exchange rates Hard currencies are the world’s strongest and Hard currencies are the world’s strongest and

represent the world’s leading economies.represent the world’s leading economies. To avoid the risk of currency fluctuations, To avoid the risk of currency fluctuations,

companies use hedging.companies use hedging. Target exchange rateTarget exchange rate Exchange rate pass throughExchange rate pass through

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3. Foreign Exchange and Foreign Exchange 3. Foreign Exchange and Foreign Exchange RatesRates

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4. Balance of Payments4. Balance of Payments

The balance of payment (BOP)The balance of payment (BOP) of a nation of a nation summarizes all the transactions that take place summarizes all the transactions that take place between its residents and and the residents of between its residents and and the residents of other countries over a specified time period, other countries over a specified time period, usually a month, quarter, or year. usually a month, quarter, or year.

The BOP transactions contain three categories The BOP transactions contain three categories (see Exhibit 3-5):(see Exhibit 3-5):– Current accountCurrent account– Capital accountCapital account– Official reservesOfficial reserves

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The BOP in capital account, the mirror image of The BOP in capital account, the mirror image of the BOP in the current account, summarizes the BOP in the current account, summarizes financial transactions and is divided into short -and financial transactions and is divided into short -and long-term capital accounts.long-term capital accounts.

Direct investments are controlled by residents of Direct investments are controlled by residents of other nations.other nations.

Portfolio investment includes long-term Portfolio investment includes long-term investments that do not give the investors effective investments that do not give the investors effective control over the investment.control over the investment.

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4. Balance of Payments4. Balance of Payments There are three balances to identify on the BOP statement There are three balances to identify on the BOP statement

of a country: of a country: – Balance of merchandise trade accountBalance of merchandise trade account– The current account (including merchandise trade, trade The current account (including merchandise trade, trade

in services, and unilateral transfers)in services, and unilateral transfers)– The basic balance (the current account and the long-The basic balance (the current account and the long-

term capital)term capital) The internal market adjustment refers to movement of The internal market adjustment refers to movement of

prices and income in a country.prices and income in a country. The external market adjustment concerns exchange rates The external market adjustment concerns exchange rates

or a nation’s currency and its value with respect to the or a nation’s currency and its value with respect to the currencies of other nations.currencies of other nations.

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5. 5. Economic and Financial Turmoil Economic and Financial Turmoil Around the WorldAround the World

The Asian financial crisisThe Asian financial crisis in the latter half of the in the latter half of the 1990s escalated into the biggest threat to global 1990s escalated into the biggest threat to global prosperity.prosperity.

China’s devaluation of its currency (yuan) China’s devaluation of its currency (yuan) triggered the Asian financial crisis in 1994. triggered the Asian financial crisis in 1994.

Because of this financial crisis, Thailand lost Because of this financial crisis, Thailand lost almost almost 60 percent60 percent of its baht’s purchasing power of its baht’s purchasing power in dollar terms in 1997.in dollar terms in 1997.

The Malaysian ringgit lost some The Malaysian ringgit lost some 40 percent40 percent of its of its value during the same period.value during the same period.

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The Korean won depreciated The Korean won depreciated 50 percent50 percent against againstthe U.S. dollar.the U.S. dollar.

The acceleration in Asia economic growth since The acceleration in Asia economic growth since 2000 can be largely credited to the Japanese 2000 can be largely credited to the Japanese economic recovery and China’s surging import economic recovery and China’s surging import demand.demand.

The South American Financial CrisisThe South American Financial Crisis took place in took place in 2001 when Argentina defaulted and lost nearly 40 2001 when Argentina defaulted and lost nearly 40 percent of its currency value.percent of its currency value.

The Argentina crisis also hurt Brazil.The Argentina crisis also hurt Brazil.

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Responses to the regional financial crises.Responses to the regional financial crises.– Consumer response to the recession (see Exhibit 3-7)Consumer response to the recession (see Exhibit 3-7)– Corporate response to the recessionCorporate response to the recession

Pull-outPull-out Emphasize a product’s valueEmphasize a product’s value Change the product mixChange the product mix Repackage the goodsRepackage the goods Maintain stricter inventoryMaintain stricter inventory Look outside the region for expansion opportunitiesLook outside the region for expansion opportunities Increase advertising in the regionIncrease advertising in the region Increase local procurementIncrease local procurement

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