Multinational Business Finance by Eiteman, David K. Stonehill, Arthur I. Moffett

CHAPTER
2
The International
Monetary System
The price of every thing rises and falls from time to time and place to place;
and with every such change the purchasing power of money changes so far
as that thing goes.
—Alfred Marshall.
L EARNI NG OBJECTI V E S
■ Explore how the international monetary system has evolved from the days of the
gold standard to today’s eclectic currency arrangement
■ Detail how the International Monetary Fund categorizes the many different
exchange rate regimes operating across the globe today
■ Examine how the choice of fixed versus flexible exchange rate regimes is made by
a country in the context of its desires for economic and social independence and
openness
■ Explain the dramatic choices the creation of a single currency for Europe—the
euro—required of the European Union’s member states
■ Study the complexity of exchange rate regime choices faced by many emerging
market countries today
■ Describe the detailed strategy being deployed by China in the gradual globalization
of the Chinese renminbi
This chapter begins with a brief history of the international monetary system, from the days
of the classical gold standard to the present time. The first section describes contemporary
currency regimes and their construction and classification, fixed versus flexible exchange rate
principles, and what we would consider the theoretical core of the chapter—the attributes of
the ideal currency and the choices nations must make in establishing their currency regime.
The second section describes the many different exchange rate regimes at work today, fol-
lowing the IMF’s classification system. The third section details the differences between
fixed and flexible exchange rate systems, leading to the fourth section’s description of the
creation and development of the euro for European Union participating countries. The fifth
section then details the difficult currency regime choices faced by many emerging market
countries. The sixth and final section traces the rapid globalization of the Chinese renminbi
now underway. The chapter concludes with the Mini-Case, Iceland—A Small Country in a
48
The International Monetary System CHAPTER 2 49
Global Crisis, which examines the rather classic case of how Iceland was confronted with the
theoretical choices a country must make in defining its currency—described throughout the
chapter—the Impossible Trinity.
History of the International Monetary System

Over the centuries, currencies have been defined in terms of gold, silver, and other items of
value, all within a variety of different agreements between nations to recognize these vary-
ing definitions. A review of the evolution of these systems—or eras as we refer to them in
Exhibit 2.1—provides a useful perspective against which to understand today’s rather eclec-
tic system of fixed rates, floating rates, crawling pegs, and others, and helps us to evaluate
weaknesses in and challenges for all enterprises conducting global business.
The Gold Standard, 1876–1913

Since the days of the pharaohs (about 3000 b.c.), gold has served as a medium of exchange and
a store of value. The Greeks and Romans used gold coins, and they passed on this tradition
through the mercantile era to the nineteenth century. The great increase in trade during the
free-trade period of the late nineteenth century led to a need for a more formalized system for
settling international trade balances. One country after another set a par value for its currency
in terms of gold and then tried to adhere to the so-called “rules of the game.” This later came
to be known as the classical gold standard. The gold standard, as an international monetary
system, gained acceptance in Western Europe in the 1870s. The United States was something
of a latecomer to the system, not officially adopting the gold standard until 1879.
Under the gold standard, the rules of the game were clear and simple: Each country set the
rate at which its currency unit (paper or coin) could be converted to a given weight of gold.
The United States, for example, declared the dollar to be convertible to gold at a rate of $20.67
per ounce (this rate was in effect until the beginning of World War I). The British pound was
EX HIB IT 2. 1 The Evolution of the Global Monetary System
Fixed Floating
Classical Gold Inter-War Exchange Exchange
Standard Years Rates Rates Emerging Era
1870s 1914 1923 1938 1944 1973 1997
1860 1880 1900 1920 1940 1960 1980 2000 2020
World War I World War II
Impact Trade dominated Increased barriers Capital flows Capital flows Selected emerging
on capital flows to trade & begin to dominate trade nations open
Trade capital flows dominate trade capital markets
Impact Increased world Protectionism & Expanded open Industrial Capital flows
on trade with limited nationalism economies economies drive economic
Economies capital flows increasingly development
open; emerging
nations
open slowly
50 CHAPTER 2 The International Monetary System
pegged at £4.2474 per ounce of gold. As long as both currencies were freely convertible into
gold, the dollar/pound exchange rate was
$20.67/Ounce of Gold
= $4.8665/£
£4.2474/Ounce of Gold
Because the government of each country on the gold standard agreed to buy or sell gold
on demand at its own fixed parity rate, the value of each individual currency in terms of gold,
and therefore exchange rates between currencies, was fixed. Maintaining reserves of gold that
were sufficient to back its currency’s value was very important for a country under this system.
The system also had the effect of implicitly limiting the rate at which any individual country
could expand its money supply. Growth in the money supply was limited to the rate at which
official authorities (government treasuries or central banks) could acquire additional gold.
The gold standard worked adequately until the outbreak of World War I interrupted trade
flows and the free movement of gold. This event caused the main trading nations to suspend
operation of the gold standard.
The Interwar Years and World War II, 1914–1944

During World War I and through the early 1920s, currencies were allowed to fluctuate over
fairly wide ranges in terms of gold and in relation to each other. Theoretically, supply and
demand for a country’s exports and imports caused moderate changes in an exchange rate
about a central equilibrium value. This was the same function that gold had performed under
the previous gold standard. Unfortunately, such flexible exchange rates did not work in an
equilibrating manner. On the contrary: international speculators sold the weak currencies
short, causing them to fall further in value than warranted by real economic factors. Selling
short is a speculation technique in which an individual speculator sells an asset, such as a cur-
rency, to another party for delivery at a future date. The speculator, however, does not yet own
the asset and expects the price of the asset to fall before the date by which the speculator must
purchase the asset in the open market for delivery.
The reverse happened with strong currencies. Fluctuations in currency values could not
be offset by the relatively illiquid forward exchange market, except at exorbitant cost. The net
result was that the volume of world trade did not grow in the 1920s in proportion to world
gross domestic product. Instead, it declined to a very low level with the advent of the Great
Depression in the 1930s.
The United States adopted a modified gold standard in 1934 when the U.S. dollar was
devalued to $35 per ounce of gold from the $20.67 per ounce price in effect prior to World
War I. Contrary to previous practice, the U.S. Treasury traded gold only with foreign central
banks, not private citizens. From 1934 to the end of World War II, exchange rates were theo-
retically determined by each currency’s value in terms of gold. During World War II and its
chaotic aftermath, however, many of the main trading currencies lost their convertibility into
other currencies. The dollar was one of the few currencies that continued to be convertible.
Bretton Woods and the International Monetary Fund, 1944

As World War II drew to a close in 1944, the Allied Powers met at Bretton Woods, New Hamp-
shire, to create a new postwar international monetary system. The Bretton Woods Agree-
ment established a U.S. dollar–based international monetary system and provided for two new
institutions: the International Monetary Fund and the World Bank. The International Mon-
etary Fund (IMF) aids countries with balance of payments and exchange rate problems. The
International Bank for Reconstruction and Development (IBRD or the World Bank) helped
fund postwar reconstruction and has since supported general economic development. Global
Finance in Practice 2.1 provides some insight into the debates at Bretton Woods.
GLOBAL FINANCE IN PRACTICE 2.1

Hammering Out an Agreement
at Bretton Woods
The governments of the Allied powers knew that the devastat- was sufficient credit available for countries to defend their cur-
ing impacts of World War II would require swift and decisive rencies in the event of payment imbalances, which they knew
policies. In the summer of 1944 (July 1–22), representatives of to be inevitable in a reconstructing world order.
all 45 allied nations met at Bretton Woods, New Hampshire, The conference divided into three commissions for weeks
for the United Nations Monetary and Financial Conference. of negotiation. One commission, led by U.S. Treasury Secre-
Their purpose was to plan the postwar international monetary tary Morgenthau, was charged with the organization of a fund
system. It was a difficult process, and the final synthesis was of capital to be used for exchange rate stabilization. A second
shaded by pragmatism. commission, chaired by Lord Keynes, was charged with the
The leading policymakers at Bretton Woods were the organization of a second “bank” whose purpose would be for
British and the Americans. The British delegation was led by long-term reconstruction and development. A third commis-
Lord John Maynard Keynes, known as “Britain’s economic sion was to hammer out details such as what role silver would
heavy weight.” The British argued for a postwar system that have in any new system.
would be more flexible than the various gold standards used After weeks of meetings, the participants came to a
before the war. Keynes argued, as he had after World War three-part agreement—the Bretton Woods Agreement. The
I, that attempts to tie currency values to gold would create plan called for: (1) fixed exchange rates, termed an “adjustable
pressures for deflation in many of the war-ravaged economies. peg,” among members; (2) a fund of gold and constituent
The American delegation was led by the director of the currencies available to members for stabilization of their
U.S. Treasury’s monetary research department, Harry D. White, respective currencies, called the International Monetary Fund
and the U.S. Secretary of the Treasury, Henry Morgenthau, Jr. (IMF); and (3) a bank for financing long-term development
The Americans argued for stability (fixed exchange rates) but projects (eventually known as the World Bank). One proposal
not a return to the gold standard itself. In fact, although the U.S. resulting from the meetings, which was not ratified by the
at that time held most of the gold of the Allied powers, the U.S. United States, was the establishment of an international trade
delegates argued that currencies should be fixed in parities, organization to promote free trade.
but that redemption of gold should occur only between official
authorities like central banks.*
*Fixed in parities is an old expression in this field, which means that the
On the more pragmatic side, all parties agreed that a value of currencies should be set or fixed at rates that equalize their value,
postwar system would be stable and sustainable only if there typically purchasing power.
The IMF was the key institution in the new international monetary system, and it has
remained so to the present day. The IMF was established to render temporary assistance
to member countries trying to defend their currencies against cyclical, seasonal, or random
occurrences. It also assists countries having structural trade problems if they promise to take
adequate steps to correct their problems. If persistent deficits occur, however, the IMF can-
not save a country from eventual devaluation. In recent years, the IMF has attempted to help
countries facing financial crises, providing massive loans as well as advice to Russia, Brazil,
Greece, Indonesia, and South Korea, to name but a few.
Under the original provisions of Bretton Woods, all countries fixed the value of their
currencies in terms of gold but they were not required to exchange their currencies for gold.
Only the dollar remained convertible into gold (at $35 per ounce). Therefore, each country
established its exchange rate vis-à-vis the dollar, and then calculated the gold par value of its
currency to create the desired dollar exchange rate. Participating countries agreed to try to
maintain the value of their currencies within 1% (later expanded to 2.25%) of par by buying
or selling foreign exchange or gold as needed. Devaluation was not to be used as a competi-
tive trade policy, but if a currency became too weak to defend, devaluation of up to 10% was
allowed without formal approval by the IMF. Larger devaluations required IMF approval. This
became known as the gold-exchange standard.
An additional innovation introduced by Bretton Woods was the creation of the Special
Drawing Right or SDR. The SDR is an international reserve asset created by the IMF to sup-
plement existing foreign exchange reserves. It serves as a unit of account for the IMF and other
international and regional organizations. It is also the base against which some countries peg
the exchange rate for their currencies. Initially defined in terms of a fixed quantity of gold, the
SDR is currently the weighted average of four major currencies: the U.S. dollar, the euro, the
Japanese yen, and the British pound. The weight assigned to each currency is updated every
five years by the IMF. Individual countries hold SDRs in the form of deposits in the IMF. These
holdings are part of each country’s international monetary reserves, along with its official hold-
ings of gold, its foreign exchange, and its reserve position at the IMF. Member countries may
settle transactions among themselves by transferring SDRs.
Fixed Exchange Rates, 1945–1973

The currency arrangement negotiated at Bretton Woods and monitored by the IMF worked
fairly well during the postwar period of reconstruction and rapid growth in world trade. How-
ever, widely diverging national monetary and fiscal policies, differential rates of inflation, and
various unexpected external shocks eventually resulted in the system’s demise. The U.S. dollar
was the main reserve currency held by central banks and was the key to the web of exchange
rate values. Unfortunately, the U.S. ran persistent and growing deficits in its balance of pay-
ments. A heavy capital outflow of dollars was required to finance these deficits and to meet
the growing demand for dollars from investors and businesses. Eventually, the heavy overhang
of dollars held by foreigners resulted in a lack of confidence in the ability of the U.S. to meet
its commitments in gold.
This lack of confidence came to a head in the first half of 1971. In a little less than seven
months, the United States suffered the loss of nearly one-third of its official gold reserves as
global confidence in the value of the dollar plummeted. Exchange rates between most major
currencies and the U.S. dollar began to float, and thus indirectly, their values relative to gold.
A year and a half later, the U.S. dollar once again came under attack, thereby forcing a second
devaluation in February1973; this time by 10% to $42.22 per ounce of gold. By late February
1973, a fixed-rate system no longer appeared feasible given the speculative flows of curren-
cies. The major foreign exchange markets were actually closed for several weeks in March
1973. When they reopened, most currencies were allowed to float to levels determined by
market forces.
The Floating Era, 1973–1997

Since March 1973, exchange rates have become much more volatile and less predictable than
they were during the “fixed” exchange rate period, when changes occurred infrequently.
Exhibit 2.2 illustrates the wide swings exhibited by the nominal exchange rate index of the
U.S. dollar since 1964. Clearly, volatility has increased for this currency measure since 1973.
Exhibit 2.2 notes some of the most important shocks in recent history: the creation of the
European Monetary System (EMS) in 1979; the run-up and peak of the U.S. dollar in 1985;
the EMS crisis of 1992; the Asian crisis of 1997; the launch of the European euro in 1999; the
rise of the dollar in 2014 and 2015.
The Emerging Era, 1997–Present

The period following the Asian Crisis of 1997 has seen growth in both breadth and depth
of emerging market economies and currencies. We may end up being proven wrong on this
count, but the final section of this chapter argues that the global monetary system has already
begun embracing—for over a decade now—a number of major emerging market currencies,
beginning with the Chinese renminbi. Feel free to disagree.
EX HIB IT 2. 2 The BIS Exchange Rate Index of the Dollar
Index Value
2010 = 100
180
Dollar peaks on
Feb 28, 1985
170
Bretton Woods Euro, €
period ends launched
160
Aug 1971 Jan 1999
Jamaica
150 Agreement
Louvre Asian Crisis Euro
Jan 1976 peaks at
Accords June 1997
140 Feb 1987 $1.60/€
April 2008
130 Dollar
strengthens
US dollar
in 2015
120 devalued
Feb 1973
110
EMS created
March 1979 Dollar reaches
100 EMS Crisis low on index basis
of Sept 1992 Aug 2011
90
64
66
68
70
72
74
76
78
80
82
84
86
88
90
92
94
96
98
00
02
04
06
08
10
12
14
19
19
19
19
19
19
19
19
19
19
19
19
19
19
19
19
19
19
20
20
20
20
20
20
20
20
Source: BIS.org. Nominal exchange rate index (narrow definition) for the U.S. dollar.
IMF Classification of Currency Regimes

The global monetary system—if there is indeed a singular “system”—is an eclectic combina-
tion of exchange rate regimes and arrangements. Although there is no single governing body,
the International Monetary Fund (IMF) has at least played the role of “town crier” since World
War II. We present its current classification system of currency regimes here.
Brief Classification History

The IMF was for many years the central clearinghouse for exchange rate classifications. Mem-
ber states submitted their exchange rate policies to the IMF, and those submissions were the
basis for its categorization of exchange rate regimes. However, that all changed in 1997–1998
with the Asian Financial Crisis. During the Asian Financial Crisis, many countries began fol-
lowing very different exchange rate practices than those they had committed to with the IMF.
Their actual practices—their de facto systems—were not what they had publicly and officially
committed to—their de jure systems.
Beginning in 1998 the IMF changed its practice and stopped collecting regime classifica-
tion submissions from member states. Instead, it confined its regime classifications and reports
to analysis performed in-house. (This included the cessation of publishing its Annual Report
on Exchange Arrangements and Exchange Restrictions, a document on which much of the
world’s financial institutions depended on for decades.) As a global institution, which is in
principle apolitical, the IMF’s analysis today is focused on classifying currencies on the basis
of an ex post analysis of how the currency’s value was based in the recent past. This analysis
focuses on observed behavior, not on official government policy pronouncements.
The IMF’s de facto System

The IMF’s methodology of classifying exchange rate regimes today, in effect since January
2009, is presented in Exhibit 2.3. It is based on actual observed behavior, de facto results, and
not on the official policy statements of the respective governments, de jure classification.1
EX HIBIT 2.3 IMF Exchange Rate Classification
Rate Classification 2009 de facto System Description and Requirements

Hard Pegs Arrangement with no The currency of another country circulates as the sole legal tender
separate legal tender (formal dollarization), as well as members of a monetary or currency
union in which the same legal tender is shared by the members.
Currency board A monetary arrangement based on an explicit legislative
arrangement commitment to exchange domestic currency for a specific foreign
currency at a fixed exchange rate, combined with restrictions on
the issuing authority. Restrictions imply that domestic currency
will be issued only against foreign exchange and that it remains
fully backed by foreign assets.
Soft Pegs Conventional pegged A country formally pegs its currency at a fixed rate to another
arrangement currency or a basket of currencies of major financial or trading
partners. Country authorities stand ready to maintain the fixed
parity through direct or indirect intervention. The exchange rate
may vary ;1% around a central rate, or may vary no more than
2% for a six-month period.
Stabilized arrangement A spot market rate that remains within a margin of 2% for six
months or more and is not floating. Margin stability can be met
by either a single currency or basket of currencies (assuming
statistical measurement). Exchange rate remains stable as a result
of official action.
Intermediate pegs:
Crawling peg Currency is adjusted in small amounts at a fixed rate or in response to
changes in quantitative indicators (e.g., inflation differentials).
Crawl-like arrangement Exchange rate must remain with a narrow margin of 2% relative to
a statistically defined trend for six months or more. Exchange rate
cannot be considered floating. Minimum rate of change is greater
than allowed under a stabilized arrangement.
Pegged exchange rate The value of the currency is maintained within 1% of a fixed
within horizontal bands central rate, or the margin between the maximum and minimum
value of the exchange rate exceeds 2%. This includes countries
that are today members of the Exchange Rate Mechanism II
(ERM II) system.
Floating Floating Exchange rate is largely market determined without an
Arrangements ascertainable or predictable path. Market intervention may be
direct or indirect, and serves to moderate the rate of change (but
not targeting). Rate may exhibit more or less volatility.
Free floating A floating rate is freely floating if intervention occurs only
exceptionally, and confirmation of intervention is limited to at most
three instances in a six-month period, each lasting no more than
three business days.
Residual Other managed This category is residual, and is used when the exchange rate
arrangements does not meet the criteria for any other category. Arrangements
characterized by frequent shifts in policies fall into this category.
Source: “Revised System for the Classification of Exchange Rate Arrangements,” by Karl Habermeier, Anamaria Kokenyne, Romain Veyrune, and Harald
Anderson, IMF Working Paper WP/09/211, International Monetary Fund, November 17, 2009.
1
“Revised System for the Classification of Exchange Rate Arrangements,” by Karl Habermeier, Annamaria
Kokenyne, Romain Veyrune, and Harald Anderson, Monetary and Capital Markets Department, IMF Working
Paper 09/211, November 17, 2009. The system presented is a revision of the IMF’s 1998 revision to a de facto system.
The classification process begins with the determination of whether the exchange rate of the
country’s currency is dominated by markets or by official action. Although the classification
system is a bit challenging, there are four basic categories.
Category 1: Hard Pegs. These countries have given up their own sovereignty over monetary
policy. This category includes countries that have adopted other countries’ currencies (e.g.,
Zimbabwe’s dollarization—its adoption of the U.S. dollar), and countries utilizing a currency
board structure that limits monetary expansion to the accumulation of foreign exchange.
Category 2: Soft Pegs. This general category is colloquially referred to as fixed exchange
rates. The five subcategories of soft peg regimes are differentiated on the basis of what the
currency is fixed to, whether that fix is allowed to change—and if so under what conditions,
what types, magnitudes, and frequencies of intervention are allowed/used, and the degree of
variance about the fixed rate.
Category 3: Floating Arrangements. Currencies that are predominantly market-driven are
further subdivided into free floating with values determined by open market forces without
governmental influence or intervention, and simple floating or floating with intervention, where
government occasionally does intervene in the market in pursuit of some rate goals or objectives.
Category 4: Residual. As one would suspect, this category includes all exchange rate arrange-
ments that do not meet the criteria of the previous three categories. Country systems demon-
strating frequent shifts in policy typically make up the bulk of this category.
Exhibit 2.4 provides a glimpse as to what these major regime categories translate into in
the global market—fixed or floating. The vertical dashed line, the crawling peg, is the zone
some currencies move into and out of depending on their relative currency stability. Although
the classification regimes appear clear and distinct, the distinctions are often more difficult
EX HIB IT 2. 4 Taxonomy of Exchange Rate Regimes
Fixed (pegged) or Floating?
Fixed Floating
(pegged to something) (market driven)
Intermediate or
Crawling Peg
Hard Peg Soft Peg Managed Float Free Floating
Extreme currency Fixed Exchange Rates Market forces of Market forces of

regime peg forms where authorities supply and demand supply and demand
such as Currency maintain a set but set the exchange rate, are allowed to set the
Boards and variable band about but with occasional exchange rate with no
Dollarization some other currency government government
intervention intervention
to distinguish in practice in the market. For example, in January 2014, the Bank of Russia
announced it would no longer conduct intervention activities with regard to the value of the
ruble and that it planned to allow the ruble to trade freely, with no intervention.
A Global Eclectic
Despite the IMF’s attempt to lend rigor to regime classifications, the global monetary system
today is indeed a global eclectic in every sense of the term. As Chapter 5 will describe in detail,
the current global market in currency is dominated by two major currencies, the U.S. dollar and
the European euro, and after that, a multitude of systems, arrangements, currency areas, and zones.
The euro itself is an example of a rigidly fixed system, acting as a single currency for its
member countries. However, the euro is also an independently floating currency against all
other currencies. Other examples of rigidly fixed exchange regimes include Ecuador, Panama,
and Zimbabwe, which use the U.S. dollar as their official currency; the Central African Franc
(CFA) zone, in which countries such as Mali, Niger, Senegal, Cameroon, and Chad among
others use a single common currency (the franc, which is tied to the euro); and the Eastern
Caribbean Currency Union (ECCU), a set of countries that use the Eastern Caribbean dollar.
At the other extreme are countries with independently floating currencies. These include
many of the most developed countries, such as Japan, the United States, the United King-
dom, Canada, Australia, New Zealand, Sweden, and Switzerland. However, this category also
includes a number of unwilling participants—emerging market countries that tried to maintain
fixed rates but were forced by the marketplace to let them float. Among these are Korea, the
Philippines, Brazil, Indonesia, Mexico, and Thailand.
As illustrated by Exhibit 2.5, the proportion of IMF member countries (188 reporting in
2014) with floating regimes (managed floats and free floats) has been holding at about 34%.
Soft pegs continue to dominate, at 43.5% of all member countries in 2014. Although the
EX HIBIT 2.5 IMF Membership Exchange Rate Regime Choices
Percentage of IMF membership by regime choice

100
8% 11.2% 11.1% 8.9% 12.6% 9.9% 9.4%
90 39.9%
42.0% 36.0% 34.7% 34.0% 34.0%
34.7%
80
70
60
50 43.2% 42.9% 43.5%

39.9% 39.7% 39.5%
34.6%
40
30
20
10 12.2% 12.2% 13.2% 13.2% 13.2% 13.1% 13.1%

0
2008 2009 2010 2011 2012 2013 2014
Hard Peg Soft Peg Floating Residual
Source: Data drawn from Annual Report on Exchange Arrangements and Exchange Restrictions 2014, International Monetary Fund, 2014,
Table 3, Exchange Rate Arrangements 2008–2014.
contemporary international monetary system is typically referred to as a “floating regime,” it

is clearly not the case for the majority of the world’s nations.
Fixed versus Flexible Exchange Rates

A nation’s choice as to which currency regime to follow reflects national priorities about all
facets of the economy, including inflation, unemployment, interest rate levels, trade balances,
and economic growth. The choice between fixed and flexible rates may change over time as
priorities change. At the risk of overgeneralizing, the following points partly explain why coun-
tries pursue certain exchange rate regimes. They are based on the premise that, other things
being equal, countries would prefer fixed exchange rates.
■ Fixed rates provide stability in international prices for the conduct of trade. Stable
prices aid in the growth of international trade and lessen risks for all businesses.
■ Fixed exchange rates are inherently anti-inflationary, requiring the country to follow
restrictive monetary and fiscal policies. This restrictiveness, however, can often be a
burden to a country wishing to pursue policies to alleviate internal economic prob-
lems such as high unemployment or slow economic growth.
Fixed exchange rate regimes necessitate that central banks maintain large quantities of
international reserves (hard currencies and gold) for use in the occasional defense of the fixed
rate. As international currency markets have grown rapidly in size and volume, increasing
reserve holdings has become a significant burden to many nations.
Fixed rates, once in place, may be maintained at levels that are inconsistent with economic
fundamentals. As the structure of a nation’s economy changes, and as its trade relationships and
balances evolve, the exchange rate itself should change. Flexible exchange rates allow this to
happen gradually and efficiently, but fixed rates must be changed administratively—usually too
late, with too much publicity, and at too large a one-time cost to the nation’s economic health.
The terminology associated with changes in currency values is also technically specific.
When a government officially declares its own currency to be worth less or more relative to
other currencies, it is termed a devaluation or revaluation, respectively. This obviously applies
to currencies whose value is controlled by government. When a currency’s value is changed
in the open currency market—not directly by government—it is called a depreciation (with a
fall in value) or appreciation (with an increase in value).
The Impossible Trinity

If the ideal currency existed in today’s world, it would possess the following three attributes,
illustrated in Exhibit 2.6, often referred to as the impossible trinity.
1. Exchange rate stability. The value of the currency is fixed in relationship to other
major currencies, so traders and investors could be relatively certain of the foreign
exchange value of each currency in the present and into the near future.
2. Full financial integration. Complete freedom of monetary flows would be allowed,
so traders and investors could easily move funds from one country and currency to
another in response to perceived economic opportunities or risks.
3. Monetary independence. Domestic monetary and interest rate policies would be set
by each individual country to pursue desired national economic policies, especially as
they might relate to limiting inflation, combating recessions, and fostering prosperity
and full employment.
These qualities are termed the impossible trinity (also referred to as the trilemma of inter-
national finance) because the forces of economics do not allow a country to simultaneously
EX HIBIT 2.6 The Impossible Trinity
Exchange Rate Stability:

A Managed or Pegged Exchange Rate
China & major industrial countries

Individual European Union Member States
under Bretton Woods
A B ( give up independent monetary policy )
( give up free flow of capital )
Monetary Independence: Full Financial Integration:

An Independent Monetary Policy C Free Flow of Capital
United States, Japan
( give up a fixed exchange rate )
Nations must choose in which direction to move from the center—toward points A, B, or C. Their choice is a choice of what
to pursue and what to give up—that of the opposite point of the pyramid. Marginal compromise is possible, but only marginal.
achieve all three goals: monetary independence, exchange rate stability, and full financial inte-
gration. For example a country like the United States has knowingly given up having a fixed
exchange rate—moving from the center of the pyramid toward point C—because it wishes to
have an independent monetary policy, and it allows an extremely high level of freedom in the
movement of capital into and out of the country.
China today is a clear example of a nation that has chosen to continue to control and
manage the value of its currency and to conduct an independent monetary policy—moving
from the center of the pyramid toward point A—while continuing to restrict the flow of capital
into and out of the country. To say it has “given up” the free flow of capital probably would be
inaccurate, as China has allowed no real freedom of capital flows in the past century.
The consensus of many experts is that the force of increased capital mobility has been
pushing more and more countries toward full financial integration in an attempt to stimulate
their domestic economies and to feed the capital appetites of their own MNEs. As a result,
their currency regimes are being “cornered” into being either purely floating (like the United
States) or integrated with other countries in monetary unions (like the European Union).
Global Finance in Practice 2.2 drives this debate home.

Who Is Choosing What in the Trinity/Trilemma?
The global financial crisis of 2008–2009 sparked much debate Implied
over the value of currencies—in some cases invoking what Choice #1 Choice #2 Condition #3
some termed currency wars. With most of the non-Chinese United Independent Free movement Currency value
world suffering very slow economic growth, and under heavy States monetary policy of capital floats
pressure to stimulate their economies and alleviate high unem- China Independent Fixed rate of Restricted
ployment rates, more and more arguments and efforts for a monetary policy exchange movement of
weak or undervalued currency arose. Although sounding logi- capital
cal, the impossible trinity makes it very clear that each economy Europe Free movement Fixed rate of Integrated
must choose its own medicine. Here is what many argue are (EU) of capital exchange monetary
policy
the choices of three of the major global economic players:
The choices made by the European Union (EU) are clearly had to give up independent monetary policy, replacing indi-
the more complex. As a combination of different sovereign vidual central banks with the European Central Bank (ECB).
states, the EU has pursued integration of a common currency, The recent fiscal deficits and near-collapses of government
the euro, and free movement of labor and capital. The result, debt issuances in Greece, Portugal, and Ireland have raised
according to the impossible trinity, is that EU member states questions over the efficacy of the arrangement.
A Single Currency for Europe: The Euro

Beginning with the Treaty of Rome in 1957 and continuing with the Single European Act of
1987, the Maastricht Treaty of 1991–1992, and the Treaty of Amsterdam of 1997, a core set of
European countries worked steadily toward integrating their individual countries into one
larger, more efficient, domestic market. However, even after the launch of the 1992 Single
Europe program, a number of barriers to true openness remained, including the use of dif-
ferent currencies. The use of different currencies required both consumers and companies to
treat the individual markets separately. Currency risk of cross-border commerce still persisted.
The creation of a single currency was seen as the way to move beyond these last vestiges of
separated markets.
The original 15 members of the EU were also members of the European Monetary System
(EMS). The EMS formed a system of fixed exchange rates amongst the member currencies,
with deviations managed through bilateral responsibility to maintain rates at {2.5% of an
established central rate. This system of fixed rates, with adjustments along the way, remained
in effect from 1979–1999. Its resiliency was seriously tested with exchange rate crises in 1992
and 1993, but it held and moved onward.
The Maastricht Treaty and Monetary Union

In December 1991, the members of the EU met at Maastricht, the Netherlands, and concluded
a treaty that changed Europe’s currency future. The Maastricht Treaty specified a timetable
and a plan to replace all individual EMS member currencies with a single currency—eventu-
ally named the euro. Other aspects of the treaty were also adopted that would lead to a full
European Economic and Monetary Union (EMU). According to the EU, the EMU is a single-
currency area within the singular EU market, now known informally as the eurozone, in which
people, goods, services, and capital are allowed to move without restrictions.
The integration of separate country monetary systems is not, however, a minor task. To
prepare for the EMU, the Maastricht Treaty called for the integration and coordination of the
member countries’ monetary and fiscal policies. The EMU would be implemented by a process
called convergence.
Before becoming a full member of the EMU, each member country was expected to meet
a set of convergence criteria in order to integrate systems that were at the same relative per-
formance levels: (1) nominal inflation should be no more than 1.5% above the average for the
three members of the EU that had the lowest inflation rates during the previous year; (2) long-
term interest rates should be no more than 2% above the average of the three members with
the lowest interest rates; (3) individual government budget deficits—fiscal deficits—should
be no more than 3% of gross domestic product; and (4) government debt outstanding should
be no more than 60% of gross domestic product. The convergence criteria were so tough that
few, if any, of the members could satisfy them at that time, but 11 countries managed to do so
just prior to 1999 (Greece was added two years later).
The European Central Bank (ECB)

The cornerstone of any monetary system is a strong, disciplined, central bank. The Maastricht
Treaty established this single institution for the EMU, the European Central Bank (ECB),
which was established in 1998. (The EU created the European Monetary Institute (EMI) in
1994 as a transitional step in establishing the European Central Bank.) The ECB’s structure
and functions were modeled after the German Bundesbank, which in turn had been modeled
after the U.S. Federal Reserve System. The ECB is an independent central bank that dominates
the activities of the individual countries’ central banks. The individual central banks continue
to regulate banks resident within their borders, but all financial market intervention and the
issuance of the single currency is the sole responsibility of the ECB. The single most important
mandate of the ECB is its charge to promote price stability within the European Union.
The Launch of the Euro

On January 4, 1999, 11 member states of the EU initiated the EMU. They established a single
currency, the euro, which replaced the individual currencies of the participating member states.
The 11 countries were Austria, Belgium, Finland, France, Germany, Ireland, Italy, Luxembourg,
the Netherlands, Portugal, and Spain. Greece did not qualify for EMU participation at the time,
but joined the euro group later, in 2001. On December 31, 1998, the final fixed rates between
the 11 participating currencies and the euro were put into place. On January 4, 1999, the euro
was officially launched.
The United Kingdom, Sweden, and Denmark chose to maintain their individual curren-
cies. The United Kingdom has been skeptical of increasing EU infringement on its sovereignty,
and has opted not to participate. Sweden, which has failed to see significant benefits from EU
membership (although it is one of the newest members), has also been skeptical of EMU par-
ticipation. Denmark, like the United Kingdom, Sweden, and Norway has so far opted not to
participate. (Denmark is, however, a member of ERM II, the Exchange Rate Mechanism II,
which effectively allows Denmark to keep its own currency and monetary sovereignty, but
fixes the value of its currency, the krone, to the euro.)
The official currency symbol of the euro, EUR, was registered with the International
Standards Organization. The official symbol of the euro is €. According to the EU, the € symbol
was inspired by the Greek letter epsilon (e), simultaneously referring to Greece’s ancient role
as the source of European civilization and recalling the first letter of the word Europe.
The euro would generate a number of benefits for the participating states: (1) Countries
within the eurozone enjoy cheaper transaction costs; (2) Currency risks and costs related to
exchange rate uncertainty are reduced; and (3) All consumers and businesses both inside and
outside the eurozone enjoy price transparency and increased price-based competition. The
primary “cost” of adopting the euro, the loss of monetary independence, would be a continuing
challenge for the members for years to come.
On January 4, 1999, the euro began trading on world currency markets. Its introduction
was a smooth one. The euro’s value slid steadily following its introduction, however, primarily
as a result of the robustness of the U.S. economy and U.S. dollar, and sluggish economic sectors
in the EMU countries. Beginning in 2002, the euro appreciated versus the dollar. Since that
time, as illustrated in Exhibit 2.7, it had remained in a range of roughly $1.20 to $1.50 per euro.
It has, however, demonstrated significant volatility.
The use of the euro has continued to expand since its introduction. As of January 2012, the
euro was the official currency for 17 of the 27 member countries in the European Union, as well
as five other countries (Montenegro, Andorra, Monaco, San Marino, and the Vatican) that may
eventually join the EU. The 17 countries that currently use the euro—the so-called eurozone—
are Austria, Belgium, Cyprus, Estonia, Finland, France, Germany, Greece, Ireland, Italy, Luxem-
bourg, Malta, the Netherlands, Portugal, Slovakia, Slovenia, and Spain. Although all members of
EX HIB IT 2. 7 The U.S. Dollar–European Euro Spot Exchange Rate
U.S. dollars (USD) to = 1 euro (EUR)

1.60
1.50
1.40
1.30
1.20
1.10
1.00
0.90
0.80
99
99
00
01
01
02
03
03
04
05
05
06
07
07
08
09
09
10
11
11
12
13
13
14
15
n-
p-
y-
n-
p-
y-
n-
p-
y-
n-
p-
y-
n-
p-
y-
n-
p-
y-
n-
p-
y-
n-
p-
y-
n-
Ma
Ma
Ma
Ma
Ma
Ma
Ma
Ma
Ja
Se
Ja
Se
Ja
Se
Ja
Se
Ja
Se
Ja
Se
Ja
Se
Ja
Se
Ja
the EU are expected eventually to replace their currencies with the euro, recent years have seen
growing debates and continual postponements by new members in moving toward full euro
adoption. The continuing issues with European sovereign debt, as discussed in Global Finance
in Practice 2.3, also continue to pose serious challenges to further euro expansion.

The Euro and the Greek/EU Debt Crisis
The European Monetary Union is a complex organism com- Bank (ECB)—to conduct monetary policy on behalf of all EU
pared to the customary country structure of fiscal and mon- members.
etary policy institutions and policies described in a typical But fiscal and monetary policies are still somewhat inter-
Economics 101 course. The members of the EU do not have twined. Government deficits that are funded by issuing debt to
the ability to conduct independent monetary policy. When the the international financial markets still impact monetary policy.
EU moved to a single currency with the adoption of the euro, Proliferating sovereign debt—debt issued by Greece, Portugal,
its member states agreed to use a single currency (exchange and Ireland, for example—may be euro-denominated, but it is the
rate stability), allow the free movement of capital in and out debt obligation of each individual government. However, if one or
of their economies (financial integration), but give up indi- more of these governments flood the market with debt, this may
vidual control of their own money supply (monetary indepen- result in increased cost and decreased availability of capital to
dence). Once again, a choice was made among the three other member states. In the end, if monetary independence is not
competing dimensions of the impossible trinity; in this case, preserved, then one or both of the other elements of the impos-
to form a single monetary policy body—the European Central sible trinity may fail—capital mobility or exchange rate stability.
Emerging Markets and Regime Choices

The 1997–2005 period specifically saw increasing pressures on emerging market countries to
choose among more extreme types of exchange rate regimes. The increased capital mobility
pressures noted in the previous section have driven a number of countries to choose between
a free-floating exchange rate (as in Turkey in 2002) or, at the opposite extreme, a fixed-rate
regime—such as a currency board (as in Argentina throughout the 1990s and detailed in the
following section) or even dollarization (as in Ecuador in 2000). These systems deserve a bit
more time and depth in our discussions.
Currency Boards
A currency board exists when a country’s central bank commits to back its monetary base—its
money supply—entirely with foreign reserves at all times. This commitment means that a unit
of domestic currency cannot be introduced into the economy without an additional unit of
foreign exchange reserves being obtained first. Eight countries, including Hong Kong, utilize
currency boards as a means of fixing their exchange rates.
Argentina. In 1991, Argentina moved from its previous managed exchange rate of the
Argentine peso to a currency board structure. The currency board structure pegged the
Argentine peso’s value to the U.S. dollar on a one-to-one basis. The Argentine govern-
ment preserved the fixed rate of exchange by requiring that every peso issued through the
Argentine banking system be backed by either gold or U.S. dollars held on account in banks
in Argentina. This 100% reserve system made the monetary policy of Argentina depen-
dent on the country’s ability to obtain U.S. dollars through trade or investment. Only after
Argentina had earned these dollars through trade could its money supply be expanded. This
requirement eliminated the possibility of the nation’s money supply growing too rapidly
and causing inflation.
Argentina’s system also allowed all Argentines and foreigners to hold dollar-denominated
accounts in Argentine banks. These accounts were in actuality eurodollar accounts, dollar-
denominated deposits in non-U.S. banks. These accounts provided savers with the ability to
choose whether or not to hold pesos.
From the very beginning there was substantial doubt in the market that the Argentine
government could maintain the fixed exchange rate. Argentine banks regularly paid slightly
higher interest rates on peso-denominated accounts than on dollar-denominated accounts. This
interest differential represented the market’s assessment of the risk inherent in the Argentine
financial system. Depositors were rewarded for accepting risk—for keeping their money in
peso-denominated accounts. In January 2002, after months of economic and political turmoil
and nearly three years of economic recession, the Argentine currency board was ended. The
peso was first devalued from Peso1.00/$ to Peso1.40/$, then it was floated completely. It fell
in value dramatically within days. The Argentine decade-long experiment with a rigidly fixed
exchange rate was over.
Dollarization
Several countries have suffered currency devaluation for many years, primarily as a result of
inflation, and have taken steps toward dollarization. Dollarization is the use of the U.S. dol-
lar as the official currency of the country. Panama has used the dollar as its official currency
since 1907. Ecuador, after suffering a severe banking and inflationary crisis in 1998 and 1999,
adopted the U.S. dollar as its official currency in January 2000. One of the primary attributes
of dollarization was summarized well by BusinessWeek in a December 11, 2000, article entitled
“The Dollar Club”:
One attraction of dollarization is that sound monetary and exchange-rate policies no longer
depend on the intelligence and discipline of domestic policymakers. Their monetary policy
becomes essentially the one followed by the U.S., and the exchange rate is fixed forever.
The arguments for dollarization follow logically from the previous discussion of the impossi-
ble trinity. A country that dollarizes removes any currency volatility (against the dollar) and would
theoretically eliminate the possibility of future currency crises. Additional benefits are expecta-
tions of greater economic integration with other dollar-based markets, both product and financial.
This last point has led many to argue in favor of regional dollarization, in which several countries
that are highly economically integrated may benefit significantly from dollarizing together.
Three major arguments exist against dollarization. The first is the loss of sovereignty over
monetary policy. This is, however, the point of dollarization. Second, the country loses the
power of seigniorage, the ability to profit from its ability to print its own money. Third, the
central bank of the country, because it no longer has the ability to create money within its
economic and financial system, can no longer serve the role of lender of last resort. This role
carries with it the ability to provide liquidity to save financial institutions that may be on the
brink of failure during times of financial crisis.
Ecuador. Ecuador officially completed the replacement of the Ecuadorian sucre with the U.S.
dollar as legal tender in September 2000. This step made Ecuador the largest national adopter
of the U.S. dollar, and in many ways it made Ecuador a test case of dollarization for other
emerging market countries to watch closely. This was the last stage of a massive depreciation
of the sucre in a brief two-year period.
During 1999, Ecuador suffered a rising rate of inflation and a falling level of economic
output. In March 1999, the Ecuadorian banking sector was hit with a series of devastating
“bank runs,” financial panics in which all depositors attempted to withdraw all of their funds
simultaneously. Although there were severe problems in the Ecuadorian banking system, the
truth was that even the healthiest financial institution would fail under the strain of this finan-
cial drain. Ecuador’s president immediately froze all deposits (this was termed a bank holiday
in the United States in the 1930s when banks closed their doors). The value of the Ecuadorian
sucre plummeted in early March, inducing the country to default on more than $13 billion in
foreign debt in 1999 alone. Ecuador’s president moved quickly to propose dollarization to save
the Ecuadorian economy.
By January 2000, when the next president took office (after a rather complicated military coup
and subsequent withdrawal), the sucre had fallen in value to Sucre 25,000/$. The new president
continued the dollarization initiative. Although unsupported by the U.S. government and the
IMF, Ecuador completed its replacement of its own currency with the dollar over the next nine
months. The results of dollarization in Ecuador are still unknown. Today, many years later, Ecuador
continues to struggle to find both economic and political balance with its new currency regime.
Currency Regime Choices for Emerging Markets

There is no doubt that for many emerging markets the choice of a currency regime may lie
somewhere between the extremes of a hard peg (a currency board or dollarization) or free-
floating. However, many experts have argued for years that the global financial marketplace
will drive more and more emerging market nations toward one of these extremes. As shown
in Exhibit 2.8, there is a distinct lack of middle ground between rigidly fixed and free-floating
extremes. But is the so-called bi-polar choice inevitable?
EX HIBIT 2.8 Regime Choices for Emerging Markets
Emerging Market
Country
High capital mobility is forcing
emerging market nations to
choose between two extremes
Free-Floating Regime Currency Board or Dollarization

Currency value is free to float up and Currency board fixes the value of local
down with international market forces currency to another currency or basket;
dollarization replaces the currency
Independent monetary policy and free
with the U.S. dollar
movement of capital allowed, but at
the loss of stability Independent monetary policy is lost;
political influence on monetary policy
Increased volatility may be more than
is eliminated
what a small country with a small
financial market can withstand Seignorage, the benefits accruing to
a government from the ability to print
its own money, is lost
There is general consensus that three common features of emerging market countries
make any specific currency regime choice difficult: (1) weak fiscal, financial, and monetary
institutions; (2) tendencies for commerce to allow currency substitution and the denomina-
tion of liabilities in dollars; and (3) the emerging market’s vulnerability to sudden stoppages
of outside capital flows. Calvo and Mishkin may have said it best:2
Indeed, we believe that the choice of exchange rate regime is likely to be one second order
importance to the development of good fiscal, financial and monetary institutions in produc-
ing macroeconomic success in emerging market countries. Rather than treating the exchange
rate regime as a primary choice, we would encourage a greater focus on institutional reforms
like improved bank and financial sector regulation, fiscal restraint, building consensus for
a sustainable and predictable monetary policy and increasing openness to trade.
In anecdotal support of this argument, a poll of the general population in Mexico in 1999
indicated that 9 out of 10 people would prefer dollarization to a floating-rate peso. Clearly,
many in the emerging markets have little faith in their leadership and institutions to implement
an effective exchange rate policy.
Globalizing the Chinese Renminbi

Logically, it would be reasonable to expect China to make the RMB fully convertible
before embarking on the ultimate goal of internationalizing the currency. But China
appears to have put “the horse before the cart” by creating an offshore market to promote
2
“The Mirage of Exchange Rate Regimes for Emerging Market Countries,” Guillermo A. Calvo and Frederic S.
Mishkin, The Journal of Economic Perspectives, Vol. 17, No. 4, Autumn 2003, pp. 99–118.
the currency’s use in international trade and investments first. And this offshore trade has
taken the lead over the onshore market.
—“RMB to Be a Globally Traded Currency by 2015,”
John McCormick, RBS, in the May 3, 2013, China Briefing.
The Chinese renminbi (RMB) or yuan (CNY) is going global.3 Although trading in the RMB
is closely controlled by the People’s Republic of China (PRC)—with all trading inside China
between the RMB and foreign currencies (primarily the U.S. dollar) being conducted only
according to Chinese regulations—its reach is spreading. The RMB’s value, as illustrated in
Exhibit 2.9, has been carefully controlled but allowed to gradually revalue against the dollar.
It is now quickly moving toward what most think is an inevitable role as a true international
currency.
Two-Market Currency Development

The RMB continues to develop along a segmented onshore/offshore two-market structure
regulated by the PRC, as seen in Exhibit 2.10. The onshore market (carrying the official ISO
code for the Chinese RMB, CNY) is a two-tier market, with retail exchange and an interbank
wholesale exchange. The currency has, since mid-2005, been a managed float regime. Internally,
EX HIB IT 2. 9 The Revaluation of the Chinese Yuan (1994–2015)
Chinese yuan (CNY) to = 1.00 U.S. dollar (USD)

9.0
Value fixed at RMB 8.28 = USD 1.0 People’s Bank of China announces
it is abandoning its peg to the
8.5 U.S. dollar on July 21, 2005
Continuation of a “managed floating
exchange rate regime” translating into
8.0 a gradual revaluation of the RMB
against the dollar
7.5
7.0
6.5
6.0
5.5
5.0
15
Oc 4
4
5
Ja 6
Oc 7
7
8
Ja 9
Oc 0
0
1
Ja 2
Oc 3
3
4
Ja 5
Oc 6
6
7
Ja 8
Oc 9
9
0
Ja 1
Oc 2
2
3
n-
9
t-9
l-9
r-9
9
t-9
l-9
r-9
0
t-0
l-0
r-0
0
t-0
l-0
r-0
0
t-0
l-0
r-0
0
t-0
l-1
r-1
1
t-1
l-1
r-1
n-
n-
n-
n-
n-
n-
n-
Ja
Ju
Ju
Ju
Ju
Ju
Ju
Ju
Ap
Ap
Ap
Ap
Ap
Ap
Ap
Ja
3
The People’s Republic of China officially recognizes the terms renminbi (RMB) and yuan (CNY) as names of its
official currency. Yuan is used in reference to the unit of account, while the physical currency is termed the renminbi.
EX HIBIT 2.10 Structure of the Chinese Renminbi Market
China Onshore Market (CNY)
Restricted exchange of currency

in and out of the onshore market
Exchange of RMB in and out of the onshore market continues to be heavily

Hong Kong-based banks have preferred
Backflow controlled and restricted. But RMB-denominated trade has risen
access to RMB for trade financing (import
to onshore to more than 16% of all foreign trade settlement.
and exports).
Hong Kong Offshore

Market (CNH)
Corporate bond issues in RMB growing, the Panda Bond or Dim Sum Market
RMB Qualified Foreign Institutional Investors gaining greater access to onshore financial deposits
Expansion of offshore market to Singapore, Macau, and Taiwan, with trading hubs in London,
Sydney, and Seoul
the currency is traded through the China Foreign Exchange Trade System (CFETS), in which
the People’s Bank of China sets a daily central parity rate against the dollar (fixing). Actual
trading is allowed to range within {1% of the parity rate on a daily basis. This internal market
continues to be gradually deregulated, with banks now being allowed to exchange negotiable
certificates of deposit amongst themselves, with fewer and fewer interest rate restrictions. Nine
different currencies are traded daily in the market against the RMB and themselves.
The offshore market for the RMB has grown out of a Hong Kong base (accounts labeled
CNH, an unofficial symbol). This offshore market has enjoyed preferred access to the onshore
market by government regulators, both in acquiring funds and re-injecting funds (termed
back-flow). Growth in this market has been fueled by the issuance of RMB-denominated debt,
so-called Panda Bonds, by McDonald’s Corporation, Caterpillar, and the World Bank, among
others. Hong Kong-based institutional investors are now allowed access to onshore financial
deposits (interest bearing), allowing a stronger use of these offshore deposits. The PRC also
continues to promote the expansion of the offshore market to other major regional and global
financial centers like Singapore and London.
Theoretical Principles and Practical Concerns

As the world’s largest commercial trader and second-largest economy, it is inevitable that
the currency of China become an international currency. But there is a variety of degrees of
internationalization.
First and foremost, an international currency must become readily accessible for trade (this
is technically described as Current Account use, to be described in detail in the next chapter).
As noted in Exhibit 2.11, it is estimated that more than 16% of all Chinese trade is now denomi-
nated in RMB, which although small, is a radical increase from just 1% a mere four years ago.
EX HIB IT 2.1 1 Exchange Rate Regime Tradeoffs
Policy Rules
Bretton Woods
Pre-WWII
Gold Standard
European
Monetary
System 1979–1999
Non-Cooperation Cooperation
Between Between
Countries Countries
The Future?
U.S. Dollar,
1981–1985
Discretionary Policy
A Chinese exporter was typically paid in U.S. dollars, and was not allowed to keep those dollar
proceeds in any bank account. Exporters were required to exchange all foreign currencies for
RMB at the official exchange rate set by the PRC, and to turn them over to the Chinese gov-
ernment (resulting in a gross accumulation of foreign currency reserves). Now, importers and
exporters are encouraged to use the RMB for trade denomination and settlement purposes.
A second degree of internationalization occurs with the use of the currency for interna-
tional investment—capital account/market activity. This is an area of substantial concern and
caution for the PRC at this time. The Chinese marketplace is the focus of many of the world’s
businesses, and if they were allowed free and open access to the market and its currency there
is fear that the value of the RMB could be driven up, decreasing Chinese export competitive-
ness. Simultaneously, as major capital markets like the dollar and euro head into stages of rising
interest rates, there is a concern that large quantities of Chinese savings could flow out of the
country in search of higher returns—capital flight.
A third degree of internationalization occurs when a currency takes on a role as a reserve
currency (also termed an anchor currency), a currency to be held in the foreign exchange
reserves of the world’s central banks. The continued dilemma of fiscal deficits in the United
States and the European Union has led to growing unease over the ability of the dollar and
euro to maintain their value over time. Could, or should, the RMB serve as a reserve currency?
Forecasts of the RMB’s share of global reserves vary between 15% and 50% by the year 2020.
The Triffin Dilemma. One theoretical concern about becoming a reserve currency is the Triffin
Dilemma (or sometimes called the Triffin Paradox).4 The Triffin Dilemma is the potential con-
flict in objectives that may arise between domestic monetary and currency policy objectives
4
The theory is the namesake of its originator, Belgian-American economist Robert Triffin (1911–1963), who was an
outspoken critic of the Bretton Woods Agreement, as well as a strong advocate and collaborated in the development
of the European Monetary System (EMS).
and external or international policy objectives when a country’s currency is used as a reserve
currency. Domestic monetary and economic policies may on occasion require both contraction
and the creation of a current account surplus (balance on trade surplus).
If a currency rises to the status of a global reserve currency, in which it is considered one
of the two or three key stores of value on earth (possibly finding its way into the IMF’s Spe-
cial Drawing Right [SDR] definition), other countries will require the country to run current
account deficits, essentially dumping growing quantities of the currency on global markets.
This means that the country needs to become internationally indebted as part of its role as
a reserve currency country. In short, when the world adopts a currency as a reserve currency,
demands are placed on the use and availability of that currency, which many countries would
prefer not to deal with. In fact, both Japan and Switzerland both worked for decades to pre-
vent their currencies from gaining wider international use, partially because of these complex
issues. The Chinese RMB, however, may eventually find that it has no choice—the global
market may choose.
Exchange Rate Regimes: What Lies Ahead?

All exchange rate regimes must deal with the tradeoff between rules and discretion, as well
as between cooperation and independence. Exhibit 2.11 illustrates the tradeoffs between
exchange rate regimes based on rules, discretion, cooperation, and independence.
1. Vertically, different exchange rate arrangements may dictate whether a country’s
government has strict intervention requirements (rules) or if it may choose whether,
when, and to what degree to intervene in the foreign exchange markets (discretion).
2. Horizontally, the tradeoff for countries participating in a specific system is between
consulting and acting in unison with other countries (cooperation) or operating as a
member of the system, but acting on their own (independence).
Regime structures like the gold standard required no cooperative policies among coun-
tries, only the assurance that all would abide by the “rules of the game.” Under the gold stan-
dard, this assurance translated into the willingness of governments to buy or sell gold at parity
rates on demand. The Bretton Woods Agreement, the system in place between 1944 and 1973,
required more in the way of cooperation, in that gold was no longer the “rule,” and countries
were required to cooperate to a higher degree to maintain the dollar-based system. Exchange
rate systems, like the European Monetary System’s (EMS) fixed exchange rate band system
used from 1979 to 1999, were hybrids of these cooperative and rule regimes.
The present international monetary system is characterized by no rules, with varying
degrees of cooperation. Although there is no present solution to the continuing debate over
what form a new international monetary system should take, many believe that it will succeed
only if it combines cooperation among nations with individual discretion to pursue domestic
social, economic, and financial goals.
SUMMARY POINTS
■ Under the gold standard (1876–1913), the “rules of the ■ The Bretton Woods Agreement (1944) established a U.S.
game” were that each country set the rate at which its dollar-based international monetary system. Under the
currency unit could be converted to a weight of gold. original provisions of the Bretton Woods Agreement, all
■ During the inter-war years (1914–1944), currencies were countries fixed the value of their currencies in terms of
allowed to fluctuate over fairly wide ranges in terms of gold but were not required to exchange their currencies
gold and each other. Supply and demand forces deter- for gold. Only the dollar remained convertible into gold
mined exchange rate values. (at $35 per ounce).
■ A variety of economic forces led to the suspension of ■ The members of the European Union are also mem-
the convertibility of the dollar into gold in August 1971. bers of the European Monetary System (EMS). This
Exchange rates of most of the leading trading countries group has tried to form an island of fixed exchange rates
were then allowed to float in relation to the dollar and among themselves in a sea of major floating currencies.
thus indirectly in relation to gold. Members of the EMS rely heavily on trade with each
■ If the ideal currency existed in today’s world, it would other, so the day-to-day benefits of fixed exchange rates
possess three attributes: a fixed value, convertibility, and between them are perceived to be great.
independent monetary policy. However, in both theory ■ The euro affects markets in three ways: (1) Coun-
and practice, it is impossible for all three attributes to tries within the eurozone enjoy cheaper transaction
be simultaneously maintained. costs; (2) Currency risks and costs related to exchange
■ Emerging market countries must often choose between rate uncertainty are reduced; and (3) All consumers
two extreme exchange rate regimes: a free-floating and businesses both inside and outside the eurozone
regime or an extremely fixed regime, such as a currency enjoy price transparency and increased price-based
board or dollarization. competition.
MINI - CA S E
Iceland—A Small Country in a Global Crisis5

There was the short story, and the longer more complex invested heavily in everything from real estate to Land
story. Iceland had seen both. And what was the moral of the Rovers (or Game Overs as they became known).
story? Was the moral that it’s better to be a big fish in a little Then September of 2008 happened. The global financial
pond, or was it once burned twice shy, or something else? crisis, largely originating in the United States and its real
Iceland was a country of only 300,000 people. It was rel- estate-securitized-mortgage-debt-credit-default-swap cri-
atively geographically isolated, but its culture and economy sis brought much of the international financial system and
were heavily intertwined with that of Europe, specifically major industrial economies to a halt. Investments failed—
northern Europe and Scandinavia. A former property of in the U.S., in Europe, in Iceland. Loans to finance those
Denmark, it considered itself both independent and yet bad investments fell delinquent. The Icelandic economy
Danish. Iceland’s economy was historically driven by fish- and its currency—the krona—collapsed. As illustrated in
ing and natural resource development. Although not flashy Exhibit A, the Krona fell more than 40% against the euro
by any sense of the word, they had proven to be solid and in roughly 30 days, more than 50% in 90 days. Companies
lasting industries, and in recent years, increasingly profit- failed, banks failed, unemployment grew, and inflation
able. At least that was until Iceland discovered “banking.” boomed. A long, slow, and painful recovery began.
The Icelandic Crisis: The Short Story The Icelandic Crisis: The Longer Story
Iceland’s economy had grown very rapidly in the 2000 to The longer story of Iceland’s crisis has its roots in mid-
2008 period. Growth was so strong and so rapid that infla- 1990s, when Iceland—like many other major industrial
tion—an ill of the past in most of the economic world— economies—embraced privatization and deregulation.
was a growing problem. As a small, industrialized and open The financial sector, once completely owned and operated
economy, capital was allowed to flow into and out of Ice- by government, was privatized and largely deregulated
land with economic change. As inflationary pressures rose, by 2003. Home mortgages were deregulated in 2003; new
the Central Bank of Iceland had tightened monetary policy, mortgages required only a 10% down payment. Invest-
interest rates rose. Higher interest rates attracted capital ment—foreign direct investment (FDI)—flowed into
from outside Iceland, primarily European capital, and the Iceland rapidly. A large part of the new investment was
banking system was flooded with capital. The banks in turn in aluminum production, an energy-intensive process that
5
Copyright © 2015 Thunderbird School of Global Management at Arizona State University. All rights reserved. This case was prepared
by Professor Michael H. Moffett for the purpose of classroom discussion only, and not to indicate either effective or ineffective
management.
EX HIBIT A The Icelandic Short Story—Fall of the Krona
Icelandic krona (ISK) = Euro 1.00 (EUR)

190
ISK 172.16 ISK 187.70
180
170
160
150
140
ISK 121.28
130
120
08
08
8
08
08
08
08
08
08
08
08
08
08
08
00
00
00
00
00
00
00
00
00
20
20
20
20
20
20
20
20
20
20
20
20
20
/2
/2
/2
/2
/2
/2
/2
/2
/2
1/
8/
5/
0/
7/
4/
1/
4/
1/
8/
2/
9/
6/
15
22
29
12
19
26
/3
/7
/5
8/
8/
9/
/1
/1
/2
/3
/1
/2
/2
/1
/1
/2
10
11
12
8/
8/
8/
9/
9/
9/
10
10
10
10
11
11
11
12
12
12
Date ISK = EUR 1.00 Percent Chg
Sept 3, 2008 121.28
Oct 6, 2008 172.16 –42.0%
Dec 2, 2008 187.70 –54.8%
could utilize much of Iceland’s natural (natural after mas- economic powers was roughly 6%, Iceland’s overheat-
sive damn construction) hydroelectric power. But FDI of ing economy had only 3% unemployment. But rapid eco-
all kinds also flowed into the country, including household nomic growth in a small economy, as happens frequently
and business capital. in economic history, stoked inflation. And the Icelandic
The new Icelandic financial sector was dominated government and central bank then applied the standard
by three banks—Glitnir, Kaupthing, and Landsbanki prescription: slow money supply growth to try to control
Islands. Their opportunities for growth and profitability inflationary forces. The result—as expected—was higher
seemed unlimited, both domestically and internationally. interest rates.
Iceland’s membership in the European Economic Area A financial crash in Iceland snowballed yesterday, setting
(EEA) provided the Icelandic banks a financial passport off a series of tremors as far afield as Brazil and South
to expand their reach throughout the greater European Africa. At one point the Icelandic krona was down 4.7
marketplace. per cent at a 15-month low of IKr69.07 to the dollar, hav-
As capital flowed into Iceland rapidly in 2003–2006, ing fallen a further 4.5 per cent on Tuesday, its biggest
the krona rose, increasing the purchasing power of Ice- one-day slide in almost five years. The krona’s collapse
landers but raising concerns with investors and govern- meant carry trade investors who borrowed in euros to
ment. Gross domestic product (GDP) had grown at 8% gain exposure to Reykjavik’s 10 per cent interest rate, saw
in 2004, 6% in 2005, and was still above 4% by 2006. one-and-a-half years’ worth of carry trade profit wiped
While the average unemployment rate of the major out in less than two days.
The collapse, which was sparked by Fitch downgrad- Now those same interest rates, which had been driven
ing its outlook on Iceland, citing fears over an “unsus- up by both markets and policy, prevented any form of
tainable” current account deficit and drawing parallels renewal—mortgage loans were either impossible to get
with the imbalances evident before the 1997 Asian crisis, or impossible to afford, business loans were too expensive
led to a generalised sell-off in Icelandic assets . . . given the new limited business outlook. The international
—“Iceland’s Collapse Has Global Impact,” interbank market, which had largely frozen-up during the
Financial Times, Feb 23, 2006, p. 42. midst of the crisis in September and October 2008, now
treated the Icelandic financial sector like a leper. As illus-
Lessons Not Learned trated by Exhibit C, interest rates had a long way to fall to
reach earth (the Central Bank of Iceland’s overnight rate
Brennt barn forðast eldinn (A burnt child keeps away
rose to well over 20%).
from fire)
—Icelandic proverb Aftermath: The Policy Response
The mini-shock suffered by Iceland in 2006 was short lived, There is a common precept observed by governments and
and investors and markets quickly shook off its effects. central banks when they fall victim to financial crises: save
Bank lending returned, and within two years the Icelandic the banks. Regardless of whether the banks and bankers
economy was in more trouble than ever. were considered the cause of the crisis, or complicit (one
In 2007 and 2008 Iceland’s interest rates continued to Icelandic central banker termed them the usual suspects),
rise—both market rates (like bank overnight rates) and it is common belief that all economies need a function-
central bank policy rates. Global credit agencies rated the ing banking system in order to have any hope for business
major Icelandic banks AAA. Capital flowed into Icelandic rebirth and employment recovery. This was the same rule
banks, and the banks in turn funneled that capital into all used in the U.S. in the 1930s and across South Asia in 1997
possible investments (and loans) domestically and interna- and 1998.
tionally. Iceland’s banks created Icesave, an Internet bank- But the Icelandic people did not prescribe to the usual
ing system to reach out to depositors in Great Britain and medicinal. Their preference: let the banks fail. Taking to
the Netherlands. It worked. Iceland’s bank balance sheets the streets in what was called the pots and pans revolu-
grew from 100% of GDP in 2003 to just under 1,000% of tion, the people wanted no part of the banks, the bankers,
GDP by 2008. the bank regulators, or even the Prime Minister. The logic
Iceland’s banks were now more international than Ice- was some combination of “allow free markets to work”
landic. (By the end of 2007 their total deposits were 45% and “I want some revenge.” (This is actually quite similar
in British pounds, 22% Icelandic krona, 16% euro, 3% to what many analysts have debated over what happened
dollar, and 14% other.) Icelandic real estate and equity in the U.S. at the same time when the U.S. government let
prices boomed. Increased consumer and business spend- Lehman go.)
ing resulted in the growth in merchandise and service In contrast to the bank bailouts in the United States
imports, while the rising krona depressed exports. The in 2008 following the onset of the financial crisis under-
merchandise, service, and income balances in the current taken under the mantra of “too big to fail,” Iceland’s banks
account all went into deficit. Behaving like an emerging were considered “too big to save.” Each of the three major
market country that had just discovered oil, Icelanders banks, which had all been effectively nationalized by the
dropped their fish hooks, abandoned their boats, and second week of October in 2008, was closed. As illustrated
became bankers. Everyone wanted a piece of the pie, in Exhibit D, although Iceland’s bank assets and exter-
and the pie appeared to be growing at an infinite rate. nal liabilities were large, and had grown rapidly, Iceland
Everyone could become rich. was not alone. Each failed bank was reorganized by the
Then it all stopped, suddenly, without notice. Whether government into a good bank and a bad bank in terms
it was caused by the failure of Lehman Brothers in the of assets, but not combined into singular good banks and
U.S., or was a victim of the same forces, it is hard to say. bad banks.
But beginning in September 2008 the krona started falling The governing authorities surviving in office in the
and capital started fleeing. Interest rates were increased fall of 2008 undertook a thee-point emergency plan: (1)
even further to try and entice (or ‘bribe’) money to stay in stabilize the exchange rate; (2) regain fiscal sustainability;
Iceland and in krona. None of it worked. As illustrated by and (3) rebuild the financial sector. The primary tool was
Exhibit B, the krona’s fall was large, dramatic, and some- capital controls. Iceland shut down the borders and the
what permanent. In retrospect, the 2006 crisis had been Internet lines for moving capital into or out of the coun-
only a small rain shower; 2008 proved a tsunami. try. The most immediate problem was the exchange rate.
72
1/
1/ 2
60
80
100
120
140
160
180
200
4/ 4/ 000
2
0
5
10
15
20
25
5/ 200
4/ 0 7/ 000
9/ 200 10 200
4/ 0 /2 0
1/ 000
1/ 200
4/ 0 2
4/ 001
2
EX HIBIT B
EX HIBIT C
5/ 200
4/ 1 7/ 001
9/ 200 10 200
4/ 1 /2 1
1/ 001
1/ 200
4/ 1 2
4/ 002
5/ 200 2
4/ 2 7/ 002
9/ 200 10 200
4/ 2 /2 2
1/ 002
2
1/ 200
4/ 2
4/ 003
5/ 200 2
CHAPTER 2
4/ 3 7/ 003
9/ 200 10 200
4/ 3 /2 3
Icelandic krona (ISK) = Euro 1.00 (EUR)
completed
1/ 003
2
1/ 200
4/ 3
& deregulation
4/ 004
2
Bank privatization
5/ 200
Percent per annum (Icelandic krona, ISK)

4/ 4 7/ 004
9/ 200 10 200
4/ 4 /2 4
1/ 200 1/ 004
4/ 4 2
4/ 005
5/ 200
4/ 5 2
7/ 005
9/ 200 10 200
4/ 5 /2 5
1/ 200 1/ 005
4/ 5 2
4/ 006
5/ 200
4/ 6 2
7/ 006
9/ 200 10 200
4/ 6 /2 6
2006 Crisis
1/ 200 1/ 006
2
2006 Crisis
4/ 6
4/ 007
5/ 200
4/ 7 2
7/ 007
Icelandic Central Bank Interest Rates

9/ 200 10 200
4/ 7 /2 7
1/ 200 1/ 007
4/ 7 2
4/ 008
The International Monetary System
2
5/ 200
4/ 8 7/ 008
9/ 200 10 200
4/ 8 /2 8
1/ 200 1/ 008
4/ 8 2
4/ 009
2
5/ 200
4/ 9
2008 Crisis
9/ 200 7/ 009
4/ 9 10 200
1/ 200 /2 9
2008 Crisis
1/ 009
4/ 9 2
4/ 010
2
5/ 201
4/ 0
9/ 201 7/ 010
The Icelandic Krona—European Euro Spot Exchange Rate
4/ 0 10 201
1/ 201 /2 0
1/ 010
4/ 0 2
5/ 201 4/ 011
4/ 1 2
9/ 201 7/ 011
4/ 1 10 201
1/ 201 /2 1
1/ 011
2
4/ 1
5/ 201 4/ 012
2
Overnight CBI rate

4/ 2
9/ 201 7/ 012
4/ 2 10 201
/2 2
CBI current account rate

1/ 201
4/ 2 1/ 012
2
Collateralized lending rate

5/ 201 4/ 013
4/ 3 2
9/ 201 7/ 013
4/ 3 10 201
1/ 201 /2 3
4/ 3 1/ 013
5/ 201 2
4/ 014
4/ 4 2
9/ 201 7/ 014
4/ 4 10 201
20 /2 4
14 01
4
CBI = Central Bank of Iceland
EX HIB IT D Icelandic Banks Compared to Others in Potential Crisis
1000%
900%
800%
700%
600%
500%
400%
300%
200%
100%
0%
Iceland Ireland Hong Kong SAR Singapore Switzerland
Bank Assets to GDP - 2001 Bank Assets to GDP - 2007

Bank External Debt Liabilities to GDP - 2001 Bank External Debt Liabilities to GDP - 2007
Source: IMF and Iceland Central Bank.
The falling krona had decimated purchasing power, and magnified in revisions in November and December 2008
the rising prices of imported goods were adding even more and again in March of 2009.
inflationary pressure. Payments linked to current account transactions and
Given the substantial macroeconomic risks, capital inward FDI were released after a short period of time.
controls were an unfortunate but indispensable ingredi- Thus, transactions involving actual imports and exports
ent in the policy mix that was adopted to stabilise the of goods and services are allowed and so are interest pay-
króna when the interbank foreign-exchange market was ments, if exchanged within a specified time limit. Most
restarted in early December 2008. capital transactions are controlled both for residents and
—Capital Control Liberalisation, Central Bank of non-residents; that is, their ability to shift between ISK
Iceland, August 5, 2009, p. 2. and FX is restricted. Króna-denominated bonds and
other like instruments cannot be converted to foreign
The bank failures (without bailout) raised serious
currency upon maturity. The proceeds must be rein-
and contentious discussions between Iceland and other
vested in other ISK instruments. Furthermore, the Rules
authorities in the United Kingdom, the EU, the Nether-
require residents to repatriate all foreign currency that
lands, and elsewhere. Because so many of the deposits in
they acquire.
Iceland banks were from foreign depositors, home-country
authorities wanted assurance that their citizens’ financial —Capital Control Liberalisation, Central Bank of
assets would be protected. In Iceland, although the gov- Iceland, August 5, 2009, p. 2–3.
ernment guaranteed domestic residents that their money It also turned out that the crisis itself was not such a
was insured (up to a limit), foreign depositors were not. big surprise. The Central Bank of Iceland had approached
Foreign residents holding accounts with Icelandic financial the European Central Bank (ECB), the Bank of Eng-
institutions were prohibited from pulling the money out of land, and the U.S. Federal Reserve in the spring of 2008
Iceland and out of the krona. (months before the crisis erupted), hoping to arrange
Capital controls were introduced in October—upon foreign exchange swap agreements in case its foreign
the recommendation of the IMF—and then altered and exchange reserves proved inadequate. The answer was no,
basically summarized as “talk to the IMF (International regulations allow banks to borrow too much, where they
Monetary Fund).” In the end the IMF did indeed help, shouldn’t, and invest too much where they shouldn’t? Bank
providing a Stand-By Arrangement to provide favorable loan books and bank capital needs to be regulated? Small
access to foreign capital markets and additional credit countries cannot conduct independent monetary policy?
and credibility for the Icelandic government’s recovery Small fish should not swim in big ponds? Or . . .
program. The paper concludes that, to prevent future crises of simi-
The krona’s value was indeed stabilized, as seen previ- lar proportions, it is impossible for a small country to
ously in Exhibit B, but has stayed weaker, which has helped have a large international banking sector, its own cur-
return the merchandise trade account to surplus in subse- rency and an independent monetary policy.
quent years. Inflation took a bit longer to get under control,
—“Iceland’s Economic and Financial Crisis:
but was successfully cut to near 2% by the end of 2010.
Causes, Consequences and Implications,” by
Iceland remains a heavily indebted Lilliputian country
Rob Spruk, European Enterprise Institute,
(according to the Financial Times), in both public debt and
23 February 2010.
private debt as a percentage of GDP.
20-20 Hindsight Mini-Case Questions

Interestingly, in the years since the crisis, there has been a 1. Do you think a country the size of Iceland—a Lillipu-
reversal (or as one writer described it, 20-20-20-20 hind- tian—is more or less sensitive to the potential impacts
sight) in the assessment of Iceland’s response to the crisis. of global capital movements?
In the first few years it was believed that Iceland’s recovery 2. Many countries have used interest rate increases to
would be shorter and stronger than other European coun- protect their currencies for many years. What are the
tries falling into crisis in 2009 and 2010, like Ireland, Estonia, pros and cons of using this strategy?
and others. But then, after a few more years of experience, 3. How does the Iceland story fit with our understanding
revised hindsight concluded that Iceland’s recovery has of the Impossible Trinity? In your opinion, which of
been slower, weaker, and less successful than that of others, the three elements of the Trinity should Iceland have
partly a result of allowing the banks to fail, partly a result of taken steps to control more?
the country’s “addiction” to capital controls. 4. In the case of Iceland, the country was able to sustain
And the lessons? What are the lessons to be taken from a large current account deficit for several years, and
the Icelandic saga? Deregulation of the financial system at the same time have ever-rising interest rates and
is risky? Banks and bankers are not to be trusted? Cross- a stronger and stronger currency. Then one day, it all
border banking is risky? Inadequate cross-border banking changed. How does that happen?
QUESTIONS 6. De facto and de jure. What do the terms de facto

and de jure mean in reference to the International
These questions are available in MyFinanceLab. Monetary Fund’s use of the terms?
1. The Rules of the Game. Under the gold standard, all 7. Exchange Rates. Why do many developing countries
national governments promised to follow the “rules of fix their currencies, while emerging economies adopt
the game.” What did this mean? a crawling peg?
2. Defending a Fixed Exchange Rate. What did it mean
8. Global Eclectic. What does it mean to say the
under the gold standard to “defend a fixed exchange rate,”
international monetary system today is a global
and what did this imply about a country’s money supply?
eclectic?
3. Bretton Woods. What was the foundation of the Bret-
9. The Impossible Trinity. With reference to the impos-
ton Woods international monetary system, and why
sible trinity, what are the possible policy mixes that a
did it eventually fail?
nation could have?
4. Technical Float. What specifically does a floating rate
10. Eurozone Central Banks. How does the European
of exchange mean? What is the role of government?
Central Bank operate and what is its relationship with
5. Fixed Exchange Rate. Why do many emerging market the central banks of the various jurisdictions of the
economies prefer to adopt a fixed exchange rate? Eurozone?
11. Currency Boards. What is the difference between cen- the exchange rate between the pound and the rand?
tral banks and currency boards? How would the exchange rate change if the oil price
jumps to GBP50 per barrel (assume no change in the
12. Argentine Currency Board. How did the Argentine
price in South Africa)?
currency board function from 1991 to January 2002
and why did it collapse? 5. Toyota Exports to the United Kingdom. Toyota manu-
13. SDRs. What are the advantages and disadvantages of factures in Japan most of the vehicles it sells in the
Special Drawing Rights (SDRs)? United Kingdom. The base platform for the Toyota
Tundra truck line is ¥1,650,000. The spot rate of the
14. Currency Strength. Is a strong currency good or bad Japanese yen against the British pound has recently
for the domestic economy? moved from ¥197/£ to ¥190/£. How does this change
15. Fixed Exchange Rates in Emerging Market Econo- the price of the Tundra to Toyota’s British subsidiary
mies. What are the methods available to an emerg- in British pounds?
ing market economy if it elects to adopt a pegged 6. Online shopping. Tamara lives in Egypt and has placed
exchange rate system? What is the ideal system if it a bundle of items in her Amazon.co.uk account basket.
needs to manage inflation and economic growth? She has the choice to pay in Egyptian pounds (EGP
16. The Yuan as a Reserve Currency. What is a reserve 1844) or in GBP (151.17). What is the exchange rate
currency? Do you believe that the Chinese yuan will between both currencies? In which currency should
reach reserve currency status? she pay?
17. Triffin Dilemma. What is the Triffin Dilemma? How 7. Israeli Shekel Changes Value. One British Pound
does it apply to the development of the Chinese yuan (GBP) traded against Israeli Shekels (ILS) 5.82 in
as a true global currency? 2013, but the exchange rate rose to 6.78 in late 2014.
What is the percentage change of the ILS? Has the
18. China and the Impossible Trinity. What choices do you
shekel depreciated or appreciated?
believe that China will make in terms of the Impos-
sible Trinity as it continues to develop global trading 8. Hong Kong Dollar and the Chinese Yuan. The Hong
and use of the Chinese yuan? Kong dollar has long been pegged to the U.S. dollar
at HK$7.80/$. When the Chinese yuan was revalued
in July 2005 against the U.S. dollar from Yuan8.28/$
to Yuan8.11/$, how did the value of the Hong Kong
PROBLEMS dollar change against the yuan?
These problems are available in MyFinanceLab. 9. Chinese Yuan Revaluation. Many experts believe
1. Albert’s Trip to Canada. Albert visits Toronto and that the Chinese currency should not only be reval-
buys 1.74 Canadian dollars (CAD) for one British ued against the U.S. dollar as it was in July 2005, but
pound (GBP). When he returns home to the U.K., he also be revalued by 20% or 30%. What would be the
converts CAD1 into GBP0.59. Is the new exchange new exchange rate value if the yuan were revalued an
rate favorable or unfavorable? additional 20% or 30% from its initial post-revalua-
tion rate of Yuan8.11/$?
2. Lottery winner. Aisha lives in Melbourne, Australia.
She wins €150 in an online lottery on Thursday and 10. TEXPAK (Pakistan) in the United Kingdom. TEX-
wishes to convert the amount into Australian dollars PAK is a Pakistani-based textile firm that is facing
(AUD). If the exchange rate is 0.5988 euros per AUD, increasing competition from other manufacturers in
how many AUDs does she get, and what is the value emerging markets selling in Europe. All garments are
date of the AUD payment? produced in Pakistan, with costs and pricing initially
stated in Pakistani rupees (PKR), but converted to
3. Gilded Question. In 1923, one ounce of gold costs 380
British pounds (GBP) for distribution and sale in the
French francs (FRF). If at the same time one ounce of
United Kingdom. In 2014, one suit was priced at PKR
gold could be purchased in Britain for GBP4.50, what
11,000 with a British pound price set at GBP95. In
was the exchange rate between the French franc and
2015, the GBP appreciated in value versus the PKR,
the British pound?
averaging PKR120/GBP. In order to preserve the GBP
4. Brent oil. In 2015 one barrel of Brent oil traded for price and product profit margin in rupees, what should
GBP42.5 and South Africa rands (ZAR) 790. What is the new rupee price be set at?
11. Vietnamese Coffee Coyote. Many people were sur- Barcelona, ships an order to a buyer in Jordan. The
prised when Vietnam became the second largest cof- purchase price is €425,000. Jordan imposes a 13%
fee producing country in the world in recent years, import duty on all products purchased from the Euro-
second only to Brazil. The Vietnamese dong, VND pean Union. The Jordanian importer then re-exports
or d, is managed against the U.S. dollar but is not the product to a Saudi Arabian importer, but only
widely traded. If you were a traveling coffee buyer after imposing its own resale fee of 28%. Given the
for the wholesale market (a “coyote” by industry ter- following spot exchange rates on April 11, 2010, what
minology), which of the following currency rates and is the total cost to the Saudi Arabian importer in Saudi
exchange commission fees would be in your best inter- Arabian riyal, and what is the U.S. dollar equivalent
est if traveling to Vietnam on a buying trip? of that price?
Currency
Exchange Rate Commission
INTERNET EXERCISES
Vietnamese bank rate d19,800 2.50%
Saigon Airport d19,500 2.00% 1. International Monetary Fund’s Special Drawing
exchange bureau rate Rights. Use the IMF’s Web site to find the current
Hotel exchange d19,400 1.50% weights and valuation of the SDR.
bureau rate
International www.imf.org/external/np/tre/sdr/
Monetary Fund sdrbasket.htm
12. Chunnel Choices. The Channel Tunnel or “Chun-
nel” passes underneath the English Channel between 2. Malaysian Currency Controls. The institution of cur-
Great Britain and France, a land-link between the rency controls by the Malaysian government in the
Continent and the British Isles. One side is therefore aftermath of the Asian currency crisis is a classic
an economy of British pounds, the other euros. If you response by government to unstable currency con-
were to check the Chunnel’s rail ticket Internet rates ditions. Use the following Web site to increase your
you would find that they would be denominated in knowledge of how currency controls work.
U.S. dollars (USD). For example, a first class round
International www.imf.org/external/pubs/ft/
trip fare for a single adult from London to Paris via the Monetary Fund bl/rr08.htm
Chunnel through RailEurope may cost USD170.00.
This currency neutrality, however, means that custom- 3. Personal Transfers. As anyone who has traveled inter-
ers on both ends of the Chunnel pay differing rates nationally learns, the exchange rates available to pri-
in their home currencies from day to day. What is the vate retail customers are not always as attractive as
British pound and euro denominated prices for the those accessed by companies. The OzForex Web site
USD170.00 round trip fare in local currency if pur- possesses a section on “customer rates” that illustrates
chased on the following dates at the accompanying the difference. Use the site to calculate what the per-
spot rates drawn from the Financial Times? centage difference between Australian dollar/U.S.
dollar spot exchange rates are for retail customers
British Pound versus interbank rates.
Date of Spot Spot Rate Euro Spot
Rate (£/$) Rate (€/$) OzForex www.ozforex.com.au/exchange-rate
Monday 0.5702 0.8304 4. Exchange Rate History. Use the Pacific Exchange
Tuesday 0.5712 0.8293 Rate database and plot capability to track value
Wednesday 0.5756 0.8340 changes of the British pound, the U.S. dollar, and the
Japanese yen against each other over the past 15 years.
13. Barcelona Exports. Oriol D’ez Miguel S.R.L., a Pacific Exchange Rate fx.sauder.ubc.ca
manufacturer of heavy-duty machine tools near Service

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History of the International Monetary System

The Gold Standard, 1876–1913

EX HIB IT 2. 1 The Evolution of the Global Monetary System

1870s 1914 1923 1938 1944 1973 1997

1860 1880 1900 1920 1940 1960 1980 2000 2020

World War I World War II

The Interwar Years and World War II, 1914–1944

Bretton Woods and the International Monetary Fund, 1944

GLOBAL FINANCE IN PRACTICE 2.1

Fixed Exchange Rates, 1945–1973

The Floating Era, 1973–1997

The Emerging Era, 1997–Present

EX HIB IT 2. 2 The BIS Exchange Rate Index of the Dollar

IMF Classification of Currency Regimes

Brief Classification History

The IMF’s de facto System

EX HIBIT 2.3 IMF Exchange Rate Classification

Rate Classification 2009 de facto System Description and Requirements

EX HIB IT 2. 4 Taxonomy of Exchange Rate Regimes

Fixed (pegged) or Floating?

Hard Peg Soft Peg Managed Float Free Floating

Extreme currency Fixed Exchange Rates Market forces of Market forces of

EX HIBIT 2.5 IMF Membership Exchange Rate Regime Choices

Percentage of IMF membership by regime choice

50 43.2% 42.9% 43.5%

10 12.2% 12.2% 13.2% 13.2% 13.2% 13.1% 13.1%

contemporary international monetary system is typically referred to as a “floating regime,” it

Fixed versus Flexible Exchange Rates

The Impossible Trinity

EX HIBIT 2.6 The Impossible Trinity

Exchange Rate Stability:

China & major industrial countries

Monetary Independence: Full Financial Integration:

GLOBAL FINANCE IN PRACTICE 2.2

A Single Currency for Europe: The Euro

The Maastricht Treaty and Monetary Union

The European Central Bank (ECB)

The Launch of the Euro

EX HIB IT 2. 7 The U.S. Dollar–European Euro Spot Exchange Rate

U.S. dollars (USD) to = 1 euro (EUR)

GLOBAL FINANCE IN PRACTICE 2.3

Emerging Markets and Regime Choices

Currency Regime Choices for Emerging Markets

EX HIBIT 2.8 Regime Choices for Emerging Markets

Free-Floating Regime Currency Board or Dollarization

Globalizing the Chinese Renminbi

Two-Market Currency Development

EX HIB IT 2. 9 The Revaluation of the Chinese Yuan (1994–2015)

Chinese yuan (CNY) to = 1.00 U.S. dollar (USD)

EX HIBIT 2.10 Structure of the Chinese Renminbi Market

China Onshore Market (CNY)

Restricted exchange of currency

Exchange of RMB in and out of the onshore market continues to be heavily

Hong Kong Offshore

Theoretical Principles and Practical Concerns

EX HIB IT 2.1 1 Exchange Rate Regime Tradeoffs

Exchange Rate Regimes: What Lies Ahead?

Iceland—A Small Country in a Global Crisis5

EX HIBIT A The Icelandic Short Story—Fall of the Krona