GBE 2.pptx

Global Business Environment CRT 6001 Dr. Ronny Thomas Asst. Professor Rajagiri Business School Global Business Environment  Global Monetary System  The Foreign Exchange Market  The International Monetary System  The Global Capita...

Global Business Environment CRT 6001 Dr. Ronny Thomas Asst. Professor Rajagiri Business School Global Business Environment  Global Monetary System  The Foreign Exchange Market  The International Monetary System  The Global Capital Markets Global Business Environment  Foreign exchange market The foreign exchange market is the market where currencies are bought and sold and in which currency prices are determined. It is a network of banks, brokers and dealers that exchange currencies 24 hours a day. Global Business Environment Exchange Rate Global Business Environment  Exchange Rate The rate at which one currency is exchanged for the other Price of one currency in terms of the other Global Business Environment  Foreign exchange market The foreign exchange market 1. Currency Conversion 2. Insurance against foreign exchange risk - the Global Business Environment Foreign exchange market Global Business Environment Foreign exchange market Global Business Environment  Foreign exchange market The foreign exchange market 1. Currency Conversion 2. Insurance against foreign exchange risk - the Global Business Environment  Insuring against foreign exchange risk The foreign exchange market provides insurance to protect against foreign exchange risk A firm that insures itself against foreign exchange risk is hedging Global Business Environment  How exchange rate market function  Spot Exchange rate  Forward Exchange rate  Currency swaps Global Business Environment  Spot Exchange rate The spot exchange rate is the rate at which a foreign exchange dealer converts one currency into another currency on a particular day Global Business Environment  Spot Exchange rate A spot rate can be quoted in two ways: Direct or Indirect Quote Global Business Environment  How exchange rate market function  Spot Exchange rate  Forward Exchange rate  Currency swaps Global Business Environment  Forward Exchange Rate  If two parties agree to exchange currency and execute the deal at some specific date in the future.  A forward exchange rate is the rate used for these transactions Rates for currency exchange are typically quoted for 30, 90, or 180 days into the future - Global Business Environment  Currency swaps A currency swap is the simultaneous purchase and sale of a given amount of foreign exchange for two different value dates.  Swaps are transacted  between international businesses and their banks  between banks  between governments when it is desirable to move out of one currency into another for a limited period without incurring foreign exchange rate risk Eg: Spot against forward Global Business Environment  Nature Of The Foreign Exchange Market The foreign exchange market is a global network of banks, brokers, and foreign exchange dealers connected by electronic communications systems  the most important trading centers are London, New York, Zurich, Tokyo, and Singapore  the market is always open somewhere in the world—it never sleeps Global Business Environment  Nature Of The Foreign Exchange Market  High-speed computer linkages between trading centers mean there is no significant difference between exchange rates in the differing trading centers  If exchange rates quoted in different markets were not essentially the same, there would be an opportunity for arbitrage  the process of buying a currency low and selling it high Global Business Environment  Nature Of The Foreign Exchange Market Most transactions involve dollars on one side—it is a vehicle currency  85% of all foreign exchange transactions involve the U.S. dollar  other vehicle currencies are the euro, the Japanese yen, and the British pound  China’s renminbi is still only used for about 0.3% of foreign exchange transactions Global Business Environment  How Are Exchange Rates Determined? Exchange rates are determined by the demand and supply of exchange rates. Global Business Environment  How Are Exchange Rates Determined? In a free market, the “price” of any currency (the exchange rate) is determined by supply and demand:  The greater the supply of a currency, the lower its price.  The lower the supply of a currency, the higher its price.  The greater the demand for a currency, the higher its price.  The lower the demand for a currency, the lower its price. Global Business Environment  Demand for foreign currency comes from  Demand for foreign currency comes from people or firms to make payments in foreign currency. 1. Importers 2. Tourism 3. Unilateral transfers abroad 4. Purchase of assets in foreign country 5. Speculation Global Business Environment  Demand for foreign exchange Exchange rate Demand for foreign currency Demand for Foreign Currency Global Business Environment  Supply of foreign exchange Supply of foreign exchange comes from 1. Export of G&S 2. Foreign Investments 3. Remittances (Unilateral transfer from abroad) 4. Speculation Global Business Environment  Supply of foreign exchange Exchange rate Supply of foreign currency Supply of Foreign Currency Global Business Environment  Equilibrium exchange rate Exchange rate Supply of foreign currency Demand for foreign currency Foreign Currency Global Business Environment Currency depreciation and appreciation Global Business Environment Three factors impact future exchange rate movements 1. A country’s price inflation 2. A country’s interest rate 3. Market psychology Global Business Environment  Prices and Exchange Rate Understand the link b/w Price and exchange rate using 2 Propositions 1. Law of one price 2. Purchasing Power Parity (PPP) Theory Global Business Environment  Law of one price  The law of one price states that in competitive markets free of transportation costs and barriers to trade, identical products sold in different countries must sell for the same price when their price is expressed in terms of the same currency  Global Business Environment  Purchasing power parity theory (PPP Purchasing power parity theory (PPP) argues that given relatively efficient markets (a market with no impediments to the free flow of goods and services)  the price of a “basket of goods” should be roughly equivalent in each country  predicts that changes in relative prices will result in a change in exchange rates. Global Business Environment Purchasing power parity theory (PPP) Global Business Environment Global Business Environment Global Business Environment Inflation and exchange rate Global Business Environment Inflation and exchange rate Hyper Inflation (1984-’85) Global Business Environment Global Business Environment Three factors impact future exchange rate movements 1. A country’s price inflation 2. A country’s interest rate 3. Market psychology Global Business Environment  Interest rate and Exchange Rates  International Fisher Effect The International Fisher Effect states that 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 two countries Global Business Environment Three factors impact future exchange rate movements 1. A country’s price inflation 2. A country’s interest rate 3. Market psychology Global Business Environment  Investor Psychology Influence Exchange Rates  The bandwagon effect occurs when expectations on the part of traders turn into self-fulfilling prophecies - traders can join the bandwagon and move exchange rates based on group expectations  investor psychology and bandwagon effects greatly influence short term exchange rate movements  government intervention can prevent the bandwagon from starting, but is not always effective Global Business Environment  What Do Exchange Rates Mean For Managers? Managers need to consider three types of foreign exchange risk 1. Transaction exposure - the extent to which the income from individual transactions is affected by fluctuations in foreign exchange values  includes obligations for the purchase or sale of Global Business Environment goods and services at previously agreed prices  What Do Exchange Rates Mean For Managers? 2. Translation exposure - the impact of currency exchange rate changes on the reported financial statements of a company  the risk that a company's equities, assets, liabilities, or income will change in value as a result of exchange rate changes.  occurs when a firm denominates a portion of its equities, assets, liabilities, or income in a foreign currency. Global Business Environment  What Do Exchange Rates Mean For Managers? 3. Economic exposure - the extent to which a firm’s future international earning power is affected by changes in exchange rates  concerned with the long-term effect of changes in exchange rates on future prices, sales, and costs Global Business Environment  Global Monetary System  The Foreign Exchange Market  The International Monetary System  The Global Capital Markets Global Business Environment  International Monetary System The international monetary system refers to the institutional arrangements that countries adopt to govern exchange rates. Global Business Environment  Exchange Rate System  Gold Standard  Fixed exchange rate system  Floating exchange rate system  Managed Float Global Business Environment Gold Standard Global Business Environment  Gold Standard  The gold standard refers to a system in which countries peg currencies to gold and guarantee their convertibility.  The gold par value refers to the amount of a currency needed to purchase one ounce of gold Global Business Environment  Gold Standard Strength: Value of gold never depreciates Not possible to counterfeit Control Inflation & achieve balance of trade Global Business Environment  Gold Standard  The gold standard worked well from the 1870s until 1914 Every country started devaluing the currency  … people lost confidence in the system (due to large demand for gold---adverse effect on gold reserves)  …by 1939, the gold standard was dead Global Business Environment  Bretton Woods System  In 1944, representatives from 44 countries met at Bretton Woods, New Hampshire, to design a new international monetary system that would facilitate postwar economic growth. (United Nations Monetary and Financial Conference) Global Business Environment  Bretton Woods System New agreement  a fixed exchange rate system was established  all currencies were fixed to gold, but only the U.S. dollar was directly convertible to gold.  Devaluations- not to be used for competitive purposes  a country could not devalue its currency by more than 10% without IMF approval Global Business Environment  Bretton Woods System The Bretton Woods agreement established two multinational institutions 1. The International Monetary Fund (IMF) 2. The World Bank Global Business Environment  Bretton Woods System The Bretton Woods agreement established two multinational institutions 1. The International Monetary Fund (IMF) to maintain order in the international monetary system through a combination of discipline and flexibility 2. The World Bank to promote general economic development  also called the International Bank for Reconstruction and Development (IBRD) Global Business Environment The International Monetary Fund (IMF)  Stopped competitive devaluations and brought stability to the world trade environment  Monetary discipline on countries, limiting price inflation  in cases of fundamental disequilibrium, devaluations were permitted  Support during short periods of balance-of- payments deficit, when a rapid tightening of monetary or fiscal policy would hurt domestic employment Global Business Environment  Headquartered: Washington, D.C., United States Dr. Gita Gopinath Chief Economist: Pierre-Olivier First Deputy Managing Director , IMF Gourinchas Membership: 189 countries Global Business Environment  The World Bank Headquarters: Washington, D.C., United States President: Ajay Banga Global Business Environment  The World Bank Countries can borrow from the World Bank in two ways: 1. Under the IBRD scheme, money is raised through bond sales in the international capital market 2. Through the International Development Association, an arm of the bank created in 1960 Global Business Environment  Bretton Woods System Bretton Woods worked well until the late 1960s Global Business Environment Vietnam war and inflation in US economy Global Business Environment  Bretton Woods System  Bretton Woods worked well until the late 1960s  It collapsed when huge increases in welfare programs and the Vietnam War were financed by increasing the money supply and causing significant inflation.  However, because the system relied on an economically well managed U.S., when the U.S. began to print money, run high trade deficits, and experience high inflation, the system was strained to the breaking point  the U.S. dollar came under speculative attack Global Business Environment  Jamaica Agreement 1976  A new exchange rate system was established in 1976 at a meeting in Jamaica Global Business Environment  Jamaica Agreement 1976  Under the Jamaican agreement  floating rates were declared acceptable  gold was abandoned as a reserve asset  total annual IMF quotas - the amount member countries contribute to the IMF - were increased to $41 billion – today they are about $300 billion Global Business Environment  Exchange Rates Since 1973  Volatile and less predictable than they were between 1945 and 1973 because of:  the 1971 and 1979 oil crises  the loss of confidence in the dollar after U.S. inflation in 1977-78  the rise in the dollar between 1980 and 1985  the 1997 Asian currency crisis  the decline in the dollar from 2001 to 2009 Global Business Environment Exchange Rates Since 1973 Global Business Environment  Which Is Better – Fixed Rates Or Floating Rates? But, a fixed exchange rate system 1. Provides monetary discipline  ensures that governments do not expand their money supplies at inflationary rates 2. Minimizes speculation  causes uncertainty 3. Reduces uncertainty  promotes growth of international trade and investment Global Business Environment Which Is Better – Fixed Rates Or Floating Rates? Floating exchange rates provide 1. Monetary policy autonomy 2. Automatic trade balance adjustments Global Business Environment  Which Is Better – Fixed Rates Or Floating Rates?  There is no real agreement as to which system is better  We know that a Bretton Woods-style fixed exchange rate regime will not work  But a different kind of fixed exchange rate system might be more enduring Global Business Environment  What Type of Exchange Rate System Is In Practice Today?  Various exchange rate regimes are followed today  21% of IMF members follow a free float policy  23% of IMF members follow a managed float system  5% of IMF members have no legal tender of their own  remaining countries use less flexible systems such as pegged arrangements, or adjustable pegs Global Business Environment  Exchange rate system A pegged exchange rate system exists when a country fixes the value of its currency relative to a reference currency Global Business Environment  Pegged Rate System  A country following a pegged exchange rate system pegs the value of its currency to that of another major currency  popular among the world’s smaller nations  imposes monetary discipline and leads to low inflation  adopting a pegged exchange rate regime can moderate inflationary pressures in a country Global Business Environment  Exchange rate system Fixed exchange rate system: A fixed exchange rate system exists when countries fix their currencies against each other at some mutually agreed on exchange rate.  European Monetary System (EMS) prior to 1999 Global Business Environment  Exchange rate system A floating exchange rate system exists when a country allows the foreign exchange market to determine the relative value of a currency. The rate of exchange is determined by forces of demand and supply of foreign exchange market. Global Business Environment  Exchange rate system A managed or dirty float is a floating exchange rate system in which the government or the country’s central bank may occasionally intervene in order to direct the country’s currency value into a certain direction. A dirty float/managed float exchange rate regime is the environment in which exchange rates fluctuate from day to day. Global Business Environment Currency Board Global Business Environment  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 there are foreign exchange reserves to back them Global Business Environment  Role Of The IMF Today Today, the IMF focuses on lending money to countries in financial crisis There are three main types of financial crises: 1. Currency crisis 2. Banking crisis 3. Foreign debt crisis Global Business Environment  Currency crisis  A currency crisis  occurs when a speculative attack on the exchange value of a currency results in a sharp depreciation in the value of the currency. or  forces authorities to expend large volumes of international currency reserves and sharply increase interest rates in order to defend prevailing exchange rates Global Business Environment Currency crisis: Brazil Global Business Environment Currency Crisis Global Business Environment The Mexican Currency Crisis Of 1995  The Mexican currency crisis of 1995 was a result of  high Mexican debts  a pegged exchange rate that did not allow for a natural adjustment of prices  To keep Mexico from defaulting on its debt, the IMF created a $50 billion aid package  required tight monetary policy and cuts in public spending Global Business Environment  Asian Currency Crisis  The 1997 Southeast Asian financial crisis was caused by events that took place in the previous decade including 1. An investment boom - fueled by huge increases in exports 2. Excess capacity - investments were based on projections of future demand conditions 3. High debt - investments were supported by dollar-based debts 4. Expanding imports – caused current account deficits Global Business Environment  Asian Currency Crisis  By mid-1997, several key Thai financial institutions were on the verge of default  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 Global Business Environment  Asian Currency Crisis Speculation caused other Asian currencies including the Malaysian Ringgit, the Indonesian Rupaih and the Singapore Dollar to fall  These devaluations were mainly driven by  excess investment and high borrowings, much of it in dollar denominated debt  a deteriorating balance of payments position Global Business Environment  Asian Currency Crisis  The IMF provided a $37 billion aid package for Indonesia  required public spending cuts, closure of troubled banks, a balanced budget, and an end to crony capitalism  The IMF provided a $55 billion aid package to South Korea  required a more open banking system and economy, and restraint by chaebol Global Business Environment  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 Global Business Environment  Foreign debt crisis Foreign debt crisis is a situation in which a country cannot service its foreign debt obligations, whether private sector or government debt Global Business Environment  IMF performance an overview  By 2010, the IMF was committing loans to 68 countries in economic and currency crisis  All IMF loan packages require tight macroeconomic and monetary policy Global Business Environment  IMF: Major Criticism  the “one-size-fits-all” approach to macroeconomic policy is inappropriate for many countries  the IMF is exacerbating moral hazard  the IMF has become too powerful for an institution without any real mechanism for accountability Global Business Environment What Does The Monetary System Mean For Managers Managers need to understand how the international monetary system affects: 1. Currency management - the current system is a managed float - government intervention can influence exchange rates  speculation can also create volatile movements in exchange rates 2. Business strategy 3. Corporate-government relations Global Business Environment