Madura: International Financial Management Chapter 6

Chapter
6 Chapter Objectives

Government Influence • To describe the exchange rate systems

On Exchange Rates used by various governments;
• To explain how governments can use direct
and indirect intervention to influence
exchange rates; and
• To explain how government intervention in
the foreign exchange market can affect
economic conditions.

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Fixed
Exchange Rate Systems Exchange Rate System
• Exchange rate systems can be classified • In a fixed exchange rate system, exchange
according to the degree to which the rates rates are either held constant or allowed to
are controlled by the government. fluctuate only within very narrow bands.

• Exchange rate systems normally fall into • A central bank may devalue or revalue its
one of the following categories: currency against other currencies
¤ A central bank’s actions to devalue a currency
¤ fixed
in a fixed exchange rate system are referred to
¤ freely floating
as devaluation.
¤ managed float ¤ Revaluation refers to an upward adjustment of
¤ pegged the exchange rate by the central bank
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Fixed Fixed
Exchange Rate System Exchange Rate System
• The Bretton Woods era (1944-1971) fixed • Pros:
each currency’s value in terms of gold. ¤ Easier trade, direct foreign investment, and
foreign investment
• The 1971 Smithsonian Agreement (1971-
1973) which followed merely adjusted the • Cons:
exchange rates and expanded the ¤ Governments may revalue their currencies.
fluctuation boundaries. The system was ¤ Institutional Investors will invest funds in
whatever country has the highest interest rate.
still fixed.
¤ Each country may become more vulnerable to
the economic conditions in other countries.

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Freely Floating Freely Floating

Exchange Rate System Exchange Rate System
• In a freely floating exchange rate system, • Pros:
exchange rates are determined solely by ¤ Each country may become more insulated
market forces. against the economic problems in other
countries.
• Allows for complete flexibility. ¤ Governments are free to implement policies
irrespective of their effect on the exchange
rate.

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Freely Floating Managed Float

Exchange Rate System Exchange Rate System
• Cons: • In a managed (or “dirty”) float exchange
¤ MNCs may need to devote substantial rate system, exchange rates are allowed to
resources to managing their exposure to move freely on a daily basis and no official
exchange rate fluctuations. boundaries exist. However, governments
¤ The country that initially experienced may intervene to prevent the rates from
economic problems (such as high inflation, moving too much in a certain direction.
increasing unemployment rate) may have • Cons: A government may manipulate its
its problems compounded. exchange rates such that its own country
benefits at the expense of others.
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Managed Float Pegged

Exchange Rate System Exchange Rate System
• Some countries use a pegged exchange rate, in
which their home currency’s value is pegged to one
foreign currency or to an index of currencies.
¤ Hong Kong has tied the value of its currency, the
Hong Kong dollar, to the U.S. dollar (HK$7.80±0.05 =
$1.00) since 1983
• Although the home currency’s value is fixed in terms
of the foreign currency to which it is pegged, it
moves in line with that currency against other
currencies.

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Pegged Pegged
Exchange Rate System Exchange Rate System

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Pegged Pegged
Exchange Rate System Exchange Rate System
• A government may peg its currency’s value to that • Although countries with a pegged exchange
of a stable currency, such as the U.S. dollar, rate may attract foreign investment because the
because doing so stabilizes the value of its own exchange rate is expected to remain stable,
currency in two ways. weak economic or political conditions can
¤ First, this practice forces the pegged currency’s
cause firms and investors to question whether
exchange rate with the dollar to be fixed.
the peg will hold.
¤ Second, that currency will move against non-dollar
currencies to the same extent as the dollar does. • If the peg is broken and if the exchange rate is
dictated by market forces, then the local
currency’s value could immediately decline
substantially.

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Currency Boards Used to Peg Currency Boards Used to Peg

Currency Values Currency Values
• A currency board is a system for pegging • A currency board is effective only if
the value of the local currency to some investors believe that it will last. If
other specified currency. investors expect that market forces will
• The board must maintain currency prevent a government from maintaining
reserves for all the currency that it has the local currency’s exchange rate, then
printed. they will attempt to move their funds to
countries in which the local currency is
• This large amount of reserves may expected to be stronger.
increase the ability of a country’s central
bank to maintain its pegged currency.
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Exposure of a Pegged Currency to Exposure of a Pegged Currency to

Interest Rate Movements Exchange Rate Movements
• A country that uses a currency board does • A currency that is pegged to another
not have complete control over its local currency will have to move in tandem with
interest rates, as the rates must be aligned that currency against all other currencies.
with the interest rates of the currency to • So, the value of a pegged currency does
which the local currency is tied. not necessarily reflect the demand and
• The interest rate may include a risk supply conditions in the foreign exchange
premium reflecting either default risk or market, and may result in uneven trade or
the risk that the currency board will be capital flows.
discontinued.
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Exposure of a Pegged Currency to

Exchange Rate Movements Dollarization

When the Argentinean peso was pegged to the • Dollarization refers to the replacement of a
dollar (during the period 1991–2002), the dollar often local currency with U.S. dollars.
strengthened against the Brazilian real and some other
currencies in South America; therefore, the Argentinean • Dollarization goes beyond a currency
peso also strengthened against those currencies. Many board, as the country no longer has a
exporting firms in Argentina were adversely affected by the local currency.
strong Argentinean peso because it made their products
too expensive for importers. Since then, Argentina’s • For example, Ecuador implemented
currency board has been eliminated, and the Argentinean dollarization in 2000.
peso is no longer forced to move in tandem with the dollar
against other currencies.

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Government Intervention Government Intervention

• Each country has a government agency • Central banks manage exchange rates
(called the central bank) that may ¤ to smooth exchange rate movements,
intervene in the foreign exchange market ¤ to establish implicit exchange rate
to control the value of the country’s boundaries, and/or
currency. ¤ to respond to temporary disturbances.
• In the United States, the Federal • Often, intervention is overwhelmed by
Reserve System (Fed) is the market forces. However, currency
central bank. movements may be even more volatile in
the absence of intervention.
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Government Intervention Government Intervention

• Direct intervention refers to the exchange Fed exchanges $ for £ Fed exchanges £ for $
of currencies that the central bank holds to strengthen the £ to weaken the £
as reserves for other currencies in the Value Value S1
S1
foreign exchange market. of £ of £ S2
• Direct intervention is usually most V2 V1
effective when there is a coordinated V1 V2
D2
effort among central banks. D1 D1
Quantity of £ Quantity of £

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Government Intervention Government Intervention

• Central banks of other countries commonly hold • When a central bank intervenes in the
reserves in U.S. dollars that they can use in their
foreign exchange market without
direct intervention process if they want to strengthen
their currency’s value by exchanging dollars for their adjusting for the change in money supply,
currency in the foreign exchange market. it is said to engaged in nonsterilized
• They also hold reserves in their own currency that intervention.
they can exchange for dollars or another currency in
case they want to weaken their currency’s value in the • In a sterilized intervention, Treasury
foreign exchange market. securities are purchased or sold at the
• Direct intervention is more likely to be effective when same time to maintain the money supply.
it is coordinated by several central banks.

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Nonsterilized Intervention Sterilized Intervention

Federal Reserve Federal Reserve T- securities
To $ C$ To $ C$ Financial
Strengthen Strengthen $ institutions
the C$: Banks participating the C$: Banks participating that invest
in the foreign in the foreign in Treasury
exchange market exchange market securities

$
Federal Reserve Federal Reserve
To Weaken $ C$ To Weaken $ C$ Financial
T- securities
the C$: the C$: institutions
Banks participating Banks participating that invest
in the foreign in the foreign in Treasury
exchange market exchange market securities
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Government Intervention Government Intervention

• Some speculators attempt to determine • Central banks can also engage in indirect
when the central bank is intervening, and intervention by influencing the factors that
the extent of the intervention, in order to determine the value of a currency.
capitalize on the anticipated results of the ¤ Government Control of Interest Rates
intervention effort. ¤ Government Use of Foreign Exchange
Controls
¤ Intervention Warnings

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Intervention as a Policy Tool Intervention as a Policy Tool

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