GITAM INSTITUTE OF MANAGEMENT

Exchange rate determination: Chinese Yuan

Submitted by PRIYANKA PRADIP (1225111339) RAJESH T (1225111343)

(Section C Group B)

Chapter 10 Case Study

THE DETERMINATION OF EXCHANGE RATES

I. INTRODUCTION An exchange rate represents the number of units of one currency needed to acquire one unit of another currency. Managers must understand how governments set exchange rates and what causes them to change so they can make decisions that anticipate and take those changes into account. THE INTERNATIONAL MONETARY FUND (IMF) In 1944, the major allied governments met in Bretton Woods, NH, to discuss post-war economic needs. One of the results was the establishment of the International Monetary Fund (IMF). Its objectives are to promote exchange-rate stability, to facilitate the international flow of currencies and hence the balanced growth of international trade, to establish a multilateral system of payments and to serve as the lender of last resort to governments. Initially, the Bretton Woods Agreement established a system of fixed exchange rates under which each IMF member country set a par value (benchmark) for its currency based on gold and the U.S. dollar. Par values were later done away with when the IMF moved toward greater exchange-rate flexibility. When a country joins the IMF, it contributes a certain sum of money. A. IMF Assistance When a member country experiences economic difficulties, the IMF will negotiate loan criteria designed to help stabilize its economy. However, such stabilization measures are often unpopular with a countrys citizens and firms and, ultimately, its government officials. B. Special Drawing Rights (SDRs) The help increase international reserves, the IMF created special drawing rights (SDRs), an international reserve asset designed to supplement members existing reserves of gold and foreign exchange. The SDR is used as the IMFs unit of account and for IMF transactions and operations. The value of the SDR is based on the weighted average of four currencies. At the end of 2002 those weights were: the U.S. dollar 45%, the EURO 29%, the Japanese yen 15% and the British pound 11%. Although the SDR was intended to serve as a substitute for gold, it has not assumed the role of either gold or the U.S. dollar as a primary reserve asset. Evolution to Floating Exchange Rates The IMFs original system was one of fixed exchange rates; the U.S. dollar remained constant with respect to the value of gold and other currencies operated within narrow bands of value relative to the dollar. Following President Nixons suspension of the dollars convertibility to gold in 1971, the international monetary system was restructured via the Smithsonian Agreement, which permitted a devaluation of the U.S. dollar, a revaluation of other currencies and a widening of the exchange-rate flexibility bands. These measures proved insufficient, however, and in 1976 the Jamaica Agreement eliminated the use of par values by abandoning gold as a reserve asset and declaring floating rates to be acceptable.

II.

C.

III.

EXCHANGE-RATE ARRANGEMENTS .

The IMF surveillance and consultation programs are designed to monitor the economic policies of member nations to be sure they act openly and responsibly with respect to their exchange-rate policies. Member countries are permitted to select and maintain their exchange-rate regimes, but they must communicate those choices to the IMF. A. From Pegged to Floating Currencies The IMF now recognizes several categories of exchange-rate regimes that begin with pegging (fixing) the rate for one currency to that of another (or to a basket of currencies) under a very narrow range of fluctuations in value (e.g., no separate legal tender, currency boards, conventional pegs). The next category, pegged exchange rates within horizontal bands, is characterized by a broader band of fluctuations than the first three. The last four categories exhibit at least some degree of floating exchange-rate arrangements from crawling pegs to crawling bands to managed floats to independent floats. B. Black Markets The less flexible a countrys exchange-rate system, the more likely there will be a black market, i.e., a foreign exchange market that lies outside the official market. Black markets are underground markets where prices are based on supply and demand; the adoption of floating rates eliminates the need for their existence. C. The Role of Central Banks Each country has a central bank responsible for the policies affecting the value of its currency. Central banks are primarily concerned with liquidity, in order to ensure they have the cash and flexibility needed to protect their countries currencies. Their reserve assets are kept in three forms: gold, foreign-exchange reserves and IMF-related assets. The EURO is administered by the European Central Bank which, although independent of all EU institutions and governments, works with the governors of Europes various central banks to establish monetary policy and manage the exchange-rate system. The central bank in the U.S. is the Federal Reserve System, i.e., the Fed, a system of 12 regional banks. The New York Fed, representing both the Fed and the U.S. Treasury, is responsible for intervening in foreign-exchange markets to achieve dollar exchange-rate policy objectives. Selling U.S. dollars for foreign currency puts downward pressure on the dollars value; buying U.S. dollars for foreign currency puts upward pressure on the dollars value. The New York Fed also acts as the primary contact with other foreign central banks. Depending on market conditions, a central bank may: coordinate its actions with other central banks or go it alone aggressively enter the market to change attitudes about its views and policies call for reassuring action to calm markets intervene to reverse, resist, or support a market trend be very visible or very discrete operate openly or indirectly through brokers. The Bank for International Settlements (BIS) in Basel, Switzerland, acts as the central bankers central bank and serves as a gathering place where central bankers meet to discuss monetary cooperation. Although just 50 central banks are shareholders in the BIS, it regularly deals with some 130 central banks worldwide. IV. THE DETERMINATION OF EXCHANGE RATES Exchange-rate regimes are either fixed or floating, with fixed rates varying in terms of just how .

fixed they are and floating rates varying with respect to just how much they are allowed to float. A. Floating Rate Regimes Floating rates regimes are those whose currencies respond to the conditions of supply and demand. Technically, an independent floating currency is one that floats freely, unhampered by any form of government intervention. Equilibrium exchange rates are achieved when supply equals demand. A. Managed Fixed-Rate Regimes In a managed fixed exchange-rate system, a nations central bank intervenes in the foreign exchange market in order to influence the currencys relative price. To buy foreign currencies, it must have sufficient reserves on hand. When economic policies and market intervention dont work, a country may be forced to either revalue or devalue its currency. A currency that is pegged to another (or to a basket of currencies) is usually changed on a formal basis. In 1999, the G7 group of industrial countries was expanded to the G20 for the purpose of including some developing countries in the discussion of effective exchange-rate policies. B. Purchasing-Power Parity The theory of purchasing-power parity states that the prices of tradable goods, when expressed in a common currency, will tend to equalize across countries as a result of exchange-rate changes. Put another way, the theory claims a change in the comparative rates of inflation in two countries necessarily causes a change in their relative exchange rates in order to keep prices fairly similar. (An interesting illustration of this theory is the Big Mac Index While purchasing-power parity may be a reasonably good long-term indicator of exchange-rate movements, it is less accurate in the short run because it is difficult to determine an appropriate basket of commodities for comparison purposes, profit margins vary according to the strength of competition, different tax rates will influence prices differently and the theory falsely assumes no barriers to trade exist and transportation costs are zero. D. Interest rates Although inflation is the most important long-run influence on exchange rates, interest rates are also important. While the Fisher Effect theory links inflation and interest rates, the International Fisher Effect (IFE) theory links interest rates and exchange rates. The Fisher Effect theory states a countrys nominal interest rate r (the actual monetary interest rate earned on an investment) is determined by the real interest rate R (the nominal rate less inflation) and the inflation rate i as follows: (1 + r) = (1 + R)(1 + i). Because the real interest rate should be the same in every country, the country with the higher interest rate should have higher inflation. Thus, when inflation rates are the same, investors will likely place their money in countries with higher interest rates in order to get a higher real return. The International Fisher Effect implies the currency of the country with the lower interest rate will strengthen in the future, i.e., the interest-rate differential is an unbiased predictor of future changes in the spot exchange rate. The country with the higher interest rate (and higher inflation) should have the weaker currency. In the short run, however, and during periods of price instability, a country that raises its interest rate is likely to attract capital and see its currency rise in value due to increased demand. E. Other Factors in Exchange-Rate Determination A key factor affecting exchange-rate movements is confidence in a countrys economy .

and administration. Technical factors such as the seasonal demand patterns for a given currency, the release of national economic statistics and events such as 9/11, corporate scandals and budget deficits also exert their influence. V. FORECASTING EXCHANGE-RATE MOVEMENTS Managers must be able to formulate at least a general idea of the timing, magnitude and direction of exchange-rate movements. A. Fundamental and Technical Forecasting While fundamental forecasting uses trends regarding fundamental economic variables to predict future exchange rates, technical forecasting uses past trends in exchange-rate movements to spot future trends. Smart managers develop their own exchange-rate forecasts and then use the fundamental and technical forecasts of outside experts to corroborate their analyses. B. Factors to Monitor When forecasting exchange-rate movements, key variables to monitor include: the institutional setting (the extent and nature of government intervention) Fundamental factors (PPP rates, balance-of-payments levels, the level of foreign-exchange reserves, macroeconomic data, fiscal and monetary policies, etc.) confidence factors critical events Technical factors (market trends and expectations). BUSINESS IMPLICATIONS OF EXCHANGE-RATE CHANGES Exchange-rate fluctuations can affect all areas of a companys operations. A. Marketing Decisions Exchange-rate changes can affect demand for a firms products both at home and abroad. For instance, the strengthening of a countrys currency could create price competitiveness problems for exporters; on the other hand, importers would favor that situation. B. Production Decisions Firms may choose to locate production operations in a country whose currency is weak because initial investment there is relatively inexpensive; it could also be a good base for exporting the firms output. Exchange-rate differentials contribute to this situation across industrialized nations, as well from industrialized to developing nations. C. Financial Decisions Exchange-rate fluctuations can affect financial decisions in the areas of sourcing funds (both debt and equity), the timing and the level of the remittance of funds and the reporting of financial results.

VI.

ETHICAL DILEMMA: Black Market Issues Arent Black and White On a local black market, one can obtain more local currency in exchange for hard currency, but relatively less hard currency for local currency. While its always tempting to trade on the black market, governments have differing ethical and legal attitudes toward such transactions. If trading on the black market is illegal, the governments objections will be emphatic, although the law is often unevenly applied. It is easier to eliminate a black market by letting a countrys currency float freely and thus removing the temptation to circumvent the law than by police enforcement. .

LOOKING TO THE FUTURE: Changing Times Will Bring Greater Exchange-Rate Flexibility The trend toward greater flexibility in exchange-rate regimes will surely extend well into the future. The EURO will continue to strengthen and claim market share from the U.S. dollar as a prime reserve asset, just as Europes transition economies will progress in their moves toward floating exchange-rate regimes. Regional trading relationships will also encourage South American governments to move still closer toward dollarization, or at least some form of regional monetary union. Likewise, the U.S. dollar should continue to be the benchmark currency in Asia, because so many countries there (including China) rely on the U.S. market as an export destination. Although one of the most widely traded currencies in the world, the Japanese yen remains specific to the Japanese economy. CLOSING CASE: Pizza Hut and the Brazilian Real 1. Do you think it makes sense for Pizza Hut to get out of Brazil, or should it try to weather the storm and stay in? Justify your position. Given the strategic role that Brazilian operations are likely to play in Pizza Huts worldwide strategy, withdrawing from Brazil could have serious long-term consequences. Nonetheless, while the worst problems associated with Brazils rampant inflation and currency revaluation appear to be under control, Pizza Hut must carefully consider the nature of the pizza business in Brazil. Largely made up of small entrepreneurs, pizzarias typically charge one set price for all the pizza a customer can eat; toppings are different, and dessert pizzas are popular. Pizza Hut must determine the extent to which it is willing to modify its image and operations in order to fit local tastes in Brazil (and elsewhere). Problems related to corporate expansion and management strategy must also be resolved. Though the Brazilian economy is still shaky, its ability to weather the Mexican currency crisis in 1994 and the speed with which it recovered from its own currency crisis in 1999 are reassuring. The size of the potential market, Brazils proven taste for pizza and its affinity for American products all bode well for Pizza Huts eventual success there as its gains expertise in effectively managing in the Brazilian context. Where does the Brazilian real fit in the exchange-rate regimes? What does that imply in terms of how you would predict future values of the real? Having suffered the inflationary effects of very weak currencies for many years, maintaining the relative stability of Brazils currency value is critical to controlling inflation and thus protecting the Brazilian economy. In the early years of the Real Plan, the real was allowed to move within a 7% band again the U.S. dollar (a pegged exchange rate with horizontal bands). Each year, the real moved 7% against the dollar, and a new 7% band was established (an exchange rate with a crawling band). In January, 1999, keeping the real within its band was costing the Brazilian government billions of U.S. dollars per day; therefore, the government decided to let it float. Since that time, the government has intervened to stabilize the real at its new, lower rate. The Brazilian government has clearly demonstrated its willingness to intervene in the foreign exchange market when necessary to support the real. Discuss whether or not you think the Brazilian government should dollarize its economy and get rid of the real ? Dollarization could be a powerful tool in Brazils fight against rampant inflationary pressures; it could also help curtail the speculative pressures on the Brazilian real. Nonetheless, there is a strong argument against doing so. If Brazil were to dollarize its economy, or even simply fix the .

2.

3.

exchange rate between the U.S. dollar and the real, the Brazilian government would no longer be able set its own monetary policy to manage its economy. Brazils money supply would have to be set at the level necessary to maintain the fixed rate between the real and the dollar. Further, full dollarization would not sit well with Brazilian patriotic and nationalistic sentiments. Unlike Argentina, whose currency is fixed at parity with the U.S. dollar, Brazil has resisted pressures to follow suit. Nonetheless, Brazil has expressed some willingness to consider the idea of a single currency for MERCOSUR member countries because of the importance of its trade with Argentina, and its strong links to the economies of Uruguay and Paraguay as well. 4. What are some of the ways instability in the real might be affecting Pizza Huts operations in Brazil? Because of the relatively high price of its product, Pizza Huts success in Brazil depends upon a growing, increasingly affluent middle class. However, a prolonged period of economic instability tends to increase the gap between the rich and the poor and reduce the size of the middle class. Further, consumers are less likely to spend money on luxury items during times of economic stress, even when they can afford to do so. An overvalued real makes imported products cheaper and thus encourages Pizza Hut to export inputs and supplies to its Brazilian operations. On the other hand, an undervalued real makes local products cheaper and encourages Pizza Hut to source locally. Thus, currency instability makes it very difficult for businesses to plan effectively.