Finance

WEEK 4&5 Factors That Influence Exchange Rates The equilibrium exchange rate will change over time as supply and demand schedules change. The factors that cause currency supply and demand schedules to change are discussed here by relating each factor’s influence to the demand and supply schedules graphically displayed in Exhibit 4.4. The following equation summarizes the factors that can influence a currency’s spot rate: Relative Inflation Rates Changes in relative inflation rates can affect international trade activity, which influences the demand for and supply of currencies and therefore influences exchange rates. In reality, the actual demand and supply schedules, and therefore the true equilibrium exchange rate, will reflect several factors simultaneously. The point of the preceding example is to demonstrate how to logically work through the mechanics of the effect that higher inflation in a country can have on an exchange rate. Each factor is assessed one at a time to determine its separate influence on exchange rates, holding all other factors constant. Then, all factors can be tied together to fully explain why an exchange rate moves the way it does. Relative Interest Rates Changes in relative interest rates affect investment in foreign securities, which influences the demand for and supply of currencies and therefore influences exchange rates. In the 1999– 2000 period, European interest rates were relatively low compared to U. S. interest rates. This interest rate differential encouraged European investors to invest money in dollar- denominated debt securities. This activity resulted in a large supply of euros in the foreign exchange market and put downward pressure on the euro. In the 2002– 2003 period, U. S. interest rates were lower than European interest rates. Consequently, there was a large U. S. demand for euros to capitalize on the higher interest rates, which placed upward pressure on the euro. Real Interest Rates. Although a relatively high interest rate may attract foreign inflows ( to invest in securities offering high yields), the relatively high interest rate may reflect expectations of relatively high inflation. Because high inflation can place downward pressure on the local currency, some foreign investors may be discouraged from investing in securities denominated in that currency. For this reason, it is helpful to consider the real interest rate, which adjusts the nominal interest rate for inflation: The real interest rate is commonly compared among countries to assess exchange rate movements because it combines nominal interest rates and inflation, both of which influence exchange rates. Other things held constant, there should be a high correlation between the real interest rate differential and the dollar’s value. Relative Income Levels A third factor affecting exchange rates is relative income levels. Because income can affect the amount of imports demanded, it can affect exchange rates. Changing income levels can also affect exchange rates indirectly through effects on interest rates. When this effect is considered, the impact may differ from the theory presented here, as will be explained shortly. Government Controls A fourth factor affecting exchange rates is government controls. The governments of foreign countries can influence the equilibrium exchange rate in many ways, including ( 1) imposing foreign exchange barriers, ( 2) imposing foreign trade barriers, ( 3) intervening ( buying and selling currencies) in the foreign exchange markets, and ( 4) affecting macro variables such as inflation, interest rates, and income levels. Expectations A fifth factor affecting exchange rates is market expectations of future exchange rates. Like other financial markets, foreign exchange markets react to any news that may have a future effect. News of a potential surge in U. S. inflation may cause currency traders to sell dollars, anticipating a future decline in the dollar’s value. This response places immediate downward pressure on the dollar. Many institutional investors ( such as commercial banks and insurance companies) take currency positions based on anticipated interest rate movements in various countries. Interaction of Factors Transactions within the foreign exchange markets facilitate either trade or financial flows. Trade- related foreign exchange transactions are generally less responsive to news. Financial flow transactions are very responsive to news, however, because deci-sions to hold securities denominated in a particular currency are often dependent on anticipated changes in currency values. Sometimes trade- related factors and financial factors interact and simultaneously affect exchange rate movements. Exhibit 4.8 separates payment flows between countries into trade- related and finance- related flows and summarizes the factors that affect these flows. Over a particular period, some factors may place upward pressure on the value of a foreign currency while other factors place downward pressure on the currency’s value. The sensitivity of an exchange rate to these factors is dependent on the volume of international transactions between the two countries. If the two countries engage in a large volume of international trade but a very small volume of international capital flows, the relative inflation rates will likely be more influential. If the two countries engage in a large volume of capital flows, however, interest rate fluctuations may be more influential. Capital flows have become larger over time and can easily overwhelm trade flows. For this reason, the relationship between the factors ( such as inflation and income) that affect trade and exchange rates is not always as strong as one might expect. An understanding of exchange rate equilibrium does not guarantee accurate fore-casts of future exchange rates because that will depend in part on how the factors that affect exchange rates will change in the future. Even if analysts fully realize how factors influence exchange rates, they may not be able to predict how those factors will change. Exchange Rate Systems Exchange rate systems can be classified according to the degree by which exchange rates are controlled by the government. Exchange rate systems normally fall into one of the following categories: • Fixed • Freely floating • Managed float • Pegged Each of these exchange rate systems is discussed in turn. Fixed Exchange Rate System In a fixed exchange rate system, exchange rates are either held constant or allowed to fluctuate only within very narrow boundaries. A fixed exchange rate would be beneficial to a country for the following reasons. First, exporters and importers could en-gage in international trade without concern about exchange rate movements of the currency to which their local currency is linked. Any firms that accept the foreign currency as payment would be insulated from the risk that the currency could depreciate over time. In addition, any firms that need to obtain that foreign currency in the future would be insulated from the risk of the currency appreciating over time. Another benefit is that firms could engage in direct foreign investment, without concern about exchange rate movements of that currency. They would be able to convert their foreign currency earnings into their home currency without concern that the foreign currency their earnings might weaken over time. Thus, the management of an MNC would be much easier. In addition, investors would be able to invest funds in foreign countries, without concern that the foreign currency denominating their investments might weaken over time . A country with a stable exchange rate can attract more funds as investments because the investors would not have to worry about the currency weakening over time. Funds are needed in any country to support economic growth. Countries that attract a large amount of capital flows normally have lower interest rates. This can stimulate their economies. If an exchange rate begins to move too much, governments intervene to maintain it within the boundaries. In some situations, a government will devalue or reduce the value of its currency against other currencies. In other situations, it will revalue or increase the value of its currency against other currencies. A central bank’s actions to devalue a currency in a fixed exchange rate system is referred to as devaluation. The term devaluation is normally used in a different context than depreciation. Devaluation refers to a downward adjustment of the exchange rate by the central bank. Conversely, revalution refers to an upward adjustment of the exchange rate by the central bank. The methods used by governments to alter the value of a currency are discussed later in this chapter. Bretton Woods Agreement. From 1944 to 1971, exchange rates were typically fixed according to a system planned at the Bretton Woods conference ( held in Bretton Woods, New Hampshire, in 1944) by representatives from various countries. Because this arrangement, known as the Bretton Woods Agreement, lasted from 1944 to 1971, that period is sometimes referred to as the Bretton Woods era. Each currency was valued in terms of gold; for example, the U. S. dollar was valued as 1/ 35 ounce of gold. Since all currencies were valued in terms of gold, their values with respect to each other were fixed. Governments intervened in the foreign exchange markets to ensure that exchange rates drifted no more than 1 percent above or below the initially set rates. Smithsonian Agreement. During the Bretton Woods era, the United States often experienced balance- of- trade deficits, an indication that the dollar’s value may have been too strong, since the use of dollars for foreign purchases exceeded the demand by foreign countries for dollar- denominated goods. By 1971, it appeared that some currency values would need to be adjusted to restore a more balanced fl ow of payments between countries. In December 1971, a conference of representatives from various countries concluded with the Smithsonian Agreement, which called for a devaluation of the U. S. dollar by about 8 percent against other currencies. In addition, boundaries for the currency values were expanded to within 2.25 percent above or below the rates initially set by the agreement. Nevertheless, international payments imbalances continued, and as of February 1973, the dollar was again devalued. By March 1973, most governments of the major countries were no longer attempt-ing to maintain their home currency values within the boundaries established by the Smithsonian Agreement. Advantages of Fixed Exchange Rates to MNCs. In a fixed exchange rate environment, MNCs may be able to engage in international trade, direct foreign investment, and international finance without worrying about the future exchange rate. Consequently, the managerial duties of an MNC are less difficult. Disadvantages of Fixed Exchange Rates to MNCs. One disadvantage of a fixed exchange rate system is that there is still risk that the government will alter the value of a specific currency. Although an MNC is not exposed to continual movements in an exchange rate, it does face the possibility that its government will devalue or revalue its currency. A second disadvantage is that from a macro viewpoint, a fixed exchange rate system may make each country and its MNCs more vulnerable to economic conditions in other countries. Freely Floating Exchange Rate System In a freely floating exchange rate system, exchange rate values are determined by mar-ket forces without intervention by governments. Whereas a fixed exchange rate system allows no flexibility for exchange rate movements, a freely floating exchange rate system allows complete flexibility. A freely floating exchange rate adjusts on a continual basis in response to demand and supply conditions for that currency. Advantages of a Freely Floating Exchange Rate System. One advantage of a freely floating exchange rate system is that a country is more insulated from the inflation of other countries. Another advantage of freely floating exchange rates is that a country is more insulated from unemployment problems in other countries. As these examples illustrate, in a freely floating exchange rate system, problems experienced in one country will not necessarily be contagious. The exchange rate adjustments serve as a form of protection against “ exporting” economic problems to other countries. An additional advantage of a freely floating exchange rate system is that a central bank is not required to constantly maintain exchange rates within specified boundaries. Therefore, it is not forced to implement an intervention policy that may have an unfavorable effect on the economy just to control exchange rates. Further-more, governments can implement policies without concern as to whether the policies will maintain the exchange rates within specified boundaries. Finally, if exchange rates were not allowed to fl oat, investors would invest funds in whatever country had the highest interest rate. This would likely cause governments in countries with low interest rates to restrict investors’ funds from leaving the country. Thus, there would be more restrictions on capital flows, and financial market efficiency would be reduced. Disadvantages of a Freely Floating Exchange Rate System. In the previous example, the United Kingdom is somewhat insulated from the problems experienced in the United States due to the freely floating exchange rate system. Although this is an advantage for the country that is protected ( the United Kingdom), it can be a disadvantage for the country that initially experienced the economic problems. In a similar manner, a freely floating exchange rate system can adversely affect a country that has high unemployment. As these examples illustrate, a country’s economic problems can sometimes be compounded by freely floating exchange rates. Under such a system, MNCs will need to devote substantial resources to measuring and managing exposure to exchange rate fluctuations. Nonetheless, since exchange rate movements can affect economic conditions within a country, most governments want the flexibility to directly or indirectly control their exchange rates when necessary. Managed Float Exchange Rate System The exchange rate system that exists today for some currencies lies somewhere be-tween fixed and freely floating. It resembles the freely floating system in that exchange rates are allowed to fluctuate on a daily basis and there are no official boundaries. It is similar to the fixed rate system in that governments can and sometimes do intervene to prevent their currencies from moving too far in a certain direction. This type of system is known as a managed fl oat or “ dirty” fl oat ( as opposed to a “ clean” fl oat where rates fl oat freely without government intervention). The various forms of intervention used by governments to manage exchange rate movements are discussed later in this chapter. At times, the governments of various countries including Brazil, Russia, South Korea, and Venezuela have imposed bands around their currency to limit its degree of movement. Later, however, they removed the bands when they found that they could not maintain the currency’s value within the bands. Criticism of a Managed Float System. Critics suggest that a man-aged fl oat system allows a government to manipulate exchange rates in a manner that can benefit its own country at the expense of others. For example, a government may attempt to weaken its currency to stimulate a stagnant economy. The increased aggregate demand for products that results from such a policy may reflect a decreased aggregate demand for products in other countries, as the weakened currency attracts foreign demand. Although this criticism is valid, it could apply as well to the fixed exchange rate system, where governments have the power to devalue their currencies. Pegged Exchange Rate System Some countries use a pegged exchange rate arrangement, in which their home currency’s value is pegged to a foreign currency or to some unit of account. While the home currency’s value is fixed in terms of the foreign currency ( or unit of account) to which it is pegged, it moves in line with that currency against other currencies. Some governments peg their currency’s value to that of a stable currency, such as the dollar, because that forces the value of their currency to be stable. First, this forces their currency’s exchange rate with the dollar to be fixed. Second, their currency will move against nondollar currencies by the same degree as the dollar. Since the dollar is more stable than most currencies, it will make their currency more stable than most currencies. Limitations of a Pegged Exchange Rate. While countries with a pegged exchange rate may attract foreign investment because the exchange rate is expected to remain stable, weak economic or political conditions can cause firms and investors to question whether the peg will hold. For example, if the country suddenly experiences a recession, it may experience capital outflows as some firms and investors withdraw funds because they believe there are better investment opportunities in other countries. These transactions result in an exchange of the local currency for dollars and other currencies, which places downward pressure on the local currency’s value. The central bank would need to offset this by intervening in the foreign exchange market ( as explained shortly) but might not be able to maintain the peg. If the peg is broken and the exchange rate is dictated by market forces, the local currency’s value could decline immediately by 20 percent or more. If foreign investors fear that a peg may be broken, they quickly sell their investments in that country and convert the proceeds into their home currency. These transactions place more downward pressure on the local currency of that country. Even the local residents may consider selling their local investments and converting their funds to dollars or some other currency if they fear that the peg may be broken. They can exchange their currency for dollars to invest in the United States before the peg breaks. They may leave their investment in the United States until after the peg breaks, and their local currency’s value is reduced. Then they can sell their investments in the United States and convert the dollar proceeds back to their currency at a more favorable exchange rate. Their initial actions to convert their money into dollars placed more downward pressure on the local currency. For the reasons explained here, countries have difficulty maintaining a pegged exchange rate when they are experiencing major political or economic problems. While a country with a stable exchange rate can attract foreign investment, the investors will move their funds to another country if there are concerns that the peg will break. Thus, a pegged exchange rate system could ultimately create more instability in a country’s economy. Several examples of pegged exchange rate systems follow. Creation of Europe’s Snake Arrangement. One of the best-known pegged exchange rate arrangements was established by several European countries in April 1972. Their goal was to maintain their currencies within established limits of each other. This arrangement became known as the snake. The snake was difficult to maintain, however, and market pressure caused some currencies to move outside their established limits. Consequently, some members withdrew from the snake arrangement, and some currencies were realigned. Creation of the European Monetary System ( EMS). Due to continued problems with the snake arrangement, the European Monetary System ( EMS) was pushed into operation in March 1979. The EMS concept was similar to the snake, but the specific characteristics differed. Under the EMS, exchange rates of member countries were held together within specified limits and were also tied to the European Currency Unit ( ECU), which was a unit of account. Its value was a weighted average of exchange rates of the member countries; each weight was determined by a member’s relative gross national product and activity in intra- European trade. The currencies of these member countries were allowed to fluctuate by no more than 2.25 percent ( 6 percent for some currencies) from the initially established values. The method of linking European currency values with the ECU was known as the exchange rate mechanism ( ERM). The participating governments intervened in the foreign exchange markets to maintain the exchange rates within boundaries established by the ERM. Demise of the European Monetary System. In the fall of 1992, however, the exchange rate mechanism experienced severe problems, as economic conditions and goals began to vary among European countries. The German government was mostly concerned about inflation because its economy was relatively strong. It increased local interest rates to prevent excessive spending and inflation. Other European governments, however, were more concerned about stimulating their economies to lower their high unemployment levels, so they wanted to reduce interest rates. In October 1992, the British and Italian governments suspended their participation in the ERM because they could not achieve their own goals for a stronger economy while their interest rates were so highly influenced by German interest rates. In 1993, the ERM boundaries were widened substantially, allowing more fluctuation in exchange rates between European currencies. The demise of the exchange rate mechanism caused European countries to realize that a pegged system would work in Europe only if it was set permanently. This provided momentum for the single European currency ( the euro), which began in 1999 and is discussed later in this chapter. How Mexico’s Pegged System Led to the Mexican Peso Crisis. In 1994, Mexico’s central bank used a special pegged exchange rate system that linked the peso to the U. S. dollar but allowed the peso’s value to fluctuate against the dollar within a band. The Mexican central bank enforced the link through frequent intervention. In fact, it partially supported its intervention by issuing short-term debt securities denominated in dollars and using the dollars to purchase pesos in the foreign exchange market. Limiting the depreciation of the peso was intended to reduce inflationary pressure that can be caused by a very weak home currency. Mexico experienced a large balance- of- trade deficit in 1994, however, perhaps because the peso was stronger than it should have been and encouraged Mexican firms and consumers to buy an excessive amount of imports. Many speculators based in Mexico recognized that the peso was being maintained at an artificially high level, and they speculated on its potential decline by investing their funds in the United States. They planned to liquidate their U. S. in-vestments if and when the peso’s value weakened so that they could convert the dollars from their U. S. investments into pesos at a favorable exchange rate. Ironically, the fl ow of funds from Mexico to the United States that was motivated by the potential devaluation in the peso put even more downward pressure on the peso because the speculators were converting pesos into dollars to invest in the United States. By December 1994, there was substantial downward pressure on the peso. On December 20, 1994, Mexico’s central bank devalued the peso by about 13 percent. Mexico’s stock prices plummeted, as many foreign investors sold their shares and withdrew their funds from Mexico in anticipation of further devaluation of the peso. On December 22, the central bank allowed the peso to fl oat freely, and it declined by 15 percent. This was the beginning of the so- called Mexican peso crisis. In an at-tempt to discourage foreign investors from withdrawing their investments in Mexico’s debt securities, the central bank increased interest rates, but the higher rates increased the cost of borrowing for Mexican firms and consumers, thereby slowing economic growth. As Mexico’s short- term debt obligations denominated in dollars matured, the Mexican central bank used its weak pesos to obtain dollars and repay the debt. Since the peso had weakened, the effective cost of financing with dollars was very expensive for the central bank. Mexico’s financial problems caused investors to lose confidence in peso- denominated securities, so they liquidated their peso- denominated securities and transferred their funds to other countries. These actions put additional downward pressure on the peso. In the 4 months after December 20, 1994, the value of the peso declined by more than 50 percent. Over time, Mexico’s economy improved, and the paranoia that had led to the withdrawal of funds by foreign investors subsided. The Mexican crisis might not have occurred if the peso had been allowed to fl oat throughout 1994 because the peso would have gravitated toward its natural level. The crisis illustrates that central bank intervention will not necessarily be able to overwhelm market forces; thus, the crisis may serve as an argument for letting a currency fl oat freely. The Break in China’s Pegged Exchange Rate. From 1996 until 2005, China’s yuan was pegged to be worth about $. 12 ( 8.28 yuan per U. S. dollar). During this period, the yuan’s value would change against nondollar currencies on a daily basis to the same degree as the dollar. Because of the peg, the yuan’s value remained at that level even though the United States was experiencing a trade defi cit of more than $ 100 billion per year with China. U. S. politicians argued that the yuan was being held at a superficially low level by the Chinese government, and if it was allowed to fl oat, its value would rise by 10 to 20 percent. The politicians were being pressured by U. S. firms that lost business to Chinese exporters. In 2005, some politicians argued that an explicit tariff ( tax) of about 30 percent should be imposed on all products imported from China. In response to the growing criticism, China revalued its yuan by 2.1 percent in July 2005. It also agreed to allow its yuan to fl oat subject to a .3 percent limit each day from the previous day’s closing value against a set of major currencies. This adjustment by China seemed to reduce the criticism about the yuan being held to a superficially weak level, but it did not have a major impact on the trade imbalance between China and the United States. In May 2007, China widened its band so that the yuan’s value could fl oat subject to a .5 percent limit each day. Even though the yuan is now allowed to fl oat ( within limits), the huge balance-of- trade deficit will not automatically force appreciation of the yuan. Large net capital flows from China to the United States ( purchases of U. S. securities) could offset the trade flows. Currency Boards Used to Peg Currency Values. A currency board is a system for pegging the value of the local currency to some other specified currency. The board must maintain currency reserves for all the currency that it has printed. The large amount of reserves may increase the ability of a country’s central bank to maintain its pegged currency. A currency board can stabilize a currency’s value. This is important because investors generally avoid investing in a country if they expect the local currency will weaken substantially. If a currency board is expected to remain in place for a long period, it may reduce fears that the local currency will weaken and thus may encourage investors to maintain their investments within the country. However, a currency board is worth considering only if the government can convince investors that the ex-change rate will be maintained. A currency board is effective only if investors believe that it will last. If investors expect that market forces will prevent a government from maintaining the local currency’s exchange rate, they will attempt to move their funds to other countries where they expect the local currency to be stronger. When foreign investors withdraw their funds from a country and convert the funds into a different currency, they place downward pressure on the local currency’s exchange rate. If the supply of the currency for sale continues to exceed the demand, the government will be forced to devalue its currency. Exposure of a Pegged Currency to Interest Rate Movements. A country that uses a currency board does not have complete control over its local interest rates because its rates must be aligned with the interest rates of the currency to which it is tied. Even though a country may not have control over its interest rate when it establishes a currency board, its interest rate may be more stable than if it did not have a currency board. Its interest rate will move in tandem with the interest rate of the currency to which it is tied. The interest rate may include a risk premium that could reflect either default risk or the risk that the currency board will be discontinued. Exposure of a Pegged Currency to Exchange Rate Movements. A currency that is pegged to another currency cannot be pegged against all other currencies. If it is pegged to the U. S. dollar, it is forced to move in tandem with the dollar against other currencies. Since a country cannot peg its currency to all currencies, it is exposed to movements of currencies against the currency to which it is pegged. Dollarization Dollarization is the replacement of a foreign currency with U. S. dollars. This process is a step beyond a currency board because it forces the local currency to be replaced by the U. S. dollar. Although dollarization and a currency board both attempt to peg the local currency’s value, the currency board does not replace the local currency with dollars. The decision to use U. S. dollars as the local currency cannot be easily reversed because the country no longer has a local currency. Classification of Exchange Rate Arrangements Exhibit 6.1 identifies the currencies and exchange rate arrangements used by various countries. Many countries allow the value of their currency to fl oat against others but intervene periodically to influence its value. Several small countries peg their currencies to the U. S. dollar. The Mexican peso has a controlled exchange rate that applies to international trade and a floating market rate that applies to tourism. The floating market rate is influenced by central bank intervention. Chile intervenes to maintain its currency within 10 percent of a specified exchange rate with respect to major currencies. Venezuela intervenes to limit exchange rate fluctuations within wide bands. Eastern European countries that have opened their markets have tied their currencies to a single widely traded currency. The arrangement was sometimes temporary, as these countries were searching for the proper exchange rate that would stabilize or enhance their economic conditions. For example, the government of Slovakia devalued its currency ( the koruna) in an attempt to increase foreign demand for its goods and reduce unemployment. Many governments attempt to impose exchange controls to prevent their ex-change rates from fluctuating. When these governments remove the controls, how-ever, the exchange rates abruptly adjust to a new market- determined level. For example, in October 1994, the Russian authorities allowed the Russian ruble to fluctuate, and the ruble depreciated by 27 percent against the U. S. dollar on that day. In April 1996, Venezuela’s government removed controls on the bolivar ( its currency), and the bolivar depreciated by 42 percent on that day. After the 2001 war in Afghanistan, an exchange rate system was needed there. In October 2002, a new currency, called the new afghani, was created to replace the old afghani. The old currency was exchanged for the new money at a ratio of 1,000 to 1. Thus, 30,000 old afghanis were exchanged for 30 new afghanis. The new money was printed with watermarks to deter counterfeits. In 2003, three different currencies were being used in Iraq. The Swiss dinar ( so called because it was designed in Switzerland) was created before the Gulf War but had not been printed since then. It traded at about 8 dinars per dollar and was used by the Kurds in northern Iraq. The Saddam dinar, which was used extensively before 2003, was printed in excess to finance Iraq’s military budget and was easy to counterfeit. Its value relative to the dollar was very volatile over time. The U. S. dollar was frequently used in the black market in Iraq even before the 2003 war. In 2004, the new Iraqi dinar was created and replaced the Swiss dinar and Saddam dinar to become the national currency. Its initial value was set at about $. 0007. The new dinar’s value is allowed to fluctuate in accordance with market forces but has been somewhat stable over time. A Single European Currency In 1991, the Maastricht Treaty called for the establishment of a single European currency. As of January 1, 1999, the euro replaced the national currencies of 11 Euro-pean countries for the purpose of commercial transactions executed through electronic transfers and other forms of payment. By June 1, 2002, when the national currencies were to be withdrawn from the financial system and replaced with the euro, a twelfth country had qualified for the euro. Membership The agreement to adopt the euro was a major historical event. Countries that had previously been at war with each other at various times in the past were now willing to work together toward a common cause. Of the 27 countries that are members of the European Union ( EU), 13 countries participate in the euro: Austria, Belgium, Fin-land, France, Germany, Greece, Ireland, Italy, Luxembourg, the Netherlands, Portugal, Slovenia, and Spain. Together, the participating countries comprise almost 20 percent of the world’s gross domestic product, a proportion similar to that of the United States. Three countries that were members of the EU in 1999 ( the United Kingdom, Denmark, and Sweden) decided not to adopt the euro at that time. The 10 countries in Eastern Europe ( including the Czech Republic and Hungary) that joined the EU in 2004 are eligible to participate in the euro if they meet specific economic goals. Slovenia adopted the euro in 2007. Countries that participate in the EU are supposed to abide by the Stability and Growth pact before they adopt the euro. This pact requires that the country’s budget deficit be less than 3 percent of its gross domestic product. However, there are frequent allegations that some of the existing EU countries that presently participate in the euro have a budget deficit that exceeds their allowable limit. Impact on European Monetary Policy The euro allows for a single money supply throughout much of Europe, rather than a separate money supply for each participating currency. Thus, European monetary policy is consolidated because any effects on the money supply will have an impact on all European countries using the euro as their form of money. The implementation of a common monetary policy may promote more political unity among European countries with similar national defense and foreign policies. European Central Bank. The European Central Bank ( ECB) is based in Frankfurt and is responsible for setting monetary policy for all participating European countries. Its objective is to control inflation in the participating countries and to stabilize ( within reasonable boundaries) the value of the euro with respect to other major currencies. Thus, the ECB’s monetary goals of price stability and currency stability are similar to those of individual countries around the world, but differ in that they are focused on a group of countries instead of a single country. Implications of a European Monetary Policy. Although a single European monetary policy may allow for more consistent economic conditions across countries, it prevents any individual European country from solving local economic problems with its own unique monetary policy. European governments may disagree on the ideal monetary policy to enhance their local economies, but they must agree on a single European monetary policy. Any given policy used in a particular period may enhance conditions in some countries and adversely affect others. Each participating country is still able to apply its own fiscal policy ( tax and government expenditure decisions), however. The use of a common currency may someday create more political harmony among European countries. Government Intervention Each country has a central bank that may intervene in the foreign exchange markets to control its currency’s value. In the United States, for example, the central bank is the Federal Reserve System ( the Fed). Central banks have other duties besides intervening in the foreign exchange market. In particular, they attempt to control the growth of the money supply in their respective countries in a way that will favorably affect economic conditions. Reasons for Government Intervention The degree to which the home currency is controlled, or “ managed,” varies among central banks. Central banks commonly manage exchange rates for three reasons: • To smooth exchange rate movements • To establish implicit exchange rate boundaries • To respond to temporary disturbances Smooth Exchange Rate Movements. If a central bank is concerned that its economy will be affected by abrupt movements in its home currency’s value, it may attempt to smooth the currency movements over time. Its actions may keep business cycles less volatile. The central bank may also encourage international trade by reducing exchange rate uncertainty. Furthermore, smoothing currency movements may reduce fears in the financial markets and speculative activity that could cause a major decline in a currency’s value. Establish Implicit Exchange Rate Boundaries. Some central banks attempt to maintain their home currency rates within some unofficial, or implicit, boundaries. Analysts are commonly quoted as forecasting that a currency will not fall below or rise above a particular benchmark value because the central bank would intervene to prevent that. The Federal Reserve periodically intervenes to re-verse the U. S. dollar’s upward or downward momentum. Respond to Temporary Disturbances. In some cases, a central bank may intervene to insulate a currency’s value from a temporary disturbance. In fact, the stated objective of the Fed’s intervention policy is to counter disorderly market conditions. Several studies have found that government intervention does not have a permanent impact on exchange rate movements. In many cases, intervention is over-whelmed by market forces. In the absence of intervention, however, currency movements would be even more volatile. Direct Intervention To force the dollar to depreciate, the Fed can intervene directly by exchanging dollars that it holds as reserves for other foreign currencies in the foreign exchange market. By “ flooding the market with dollars” in this manner, the Fed puts downward pressure on the dollar. If the Fed desires to strengthen the dollar, it can exchange foreign currencies for dollars in the foreign exchange market, thereby putting upward pressure on the dollar. The effects of direct intervention on the value of the British pound are illustrated in Exhibit 6.2. To strengthen the pound’s value ( or to weaken the dollar), the Fed ex-changes dollars for pounds, which causes an outward shift in the demand for pounds in the foreign exchange market ( as shown in the graph on the left). Conversely, to weaken the pound’s value ( or to strengthen the dollar), the Fed exchanges pounds for dollars, which causes an outward shift in the supply of pounds for sale in the foreign exchange market ( as shown in the graph on the right). During early 2004, Japan’s central bank, the Bank of Japan, intervened on several occasions to lower the value of the yen. In the first 2 months of 2004, the Bank of Japan sold yen in the foreign exchange market in exchange for $ 100 billion. Then, on March 5, 2004, the Bank of Japan sold yen in the foreign exchange market in exchange for $ 20 billion, which put immediate downward pressure on the value of the yen. Direct intervention is usually most effective when there is a coordinated effort among central banks. If all central banks simultaneously attempt to strengthen or weaken the currency in the manner just described, they can exert greater pressure on the currency’s value. Reliance on Reserves. The potential effectiveness of a central bank’s direct intervention is the amount of reserves it can use. For example, the central bank of China has a substantial amount of reserves that it can use to intervene in the foreign exchange market. Thus, it can more effectively use direct intervention than many other countries in Asia. If the central bank has a low level of reserves, it may not be able to exert much pressure on the currency’s value. Market forces would likely over-whelm its actions. As foreign exchange activity has grown, central bank intervention has become less effective. The volume of foreign exchange transactions on a single day now exceeds the combined values of reserves at all central banks. Consequently, the number of direct interventions has declined. In 1989, for example, the Fed intervened on 97 different days. Since then, the Fed has not intervened on more than 20 days in any year. Speculating on Direct Intervention. Some traders in the foreign ex-change market attempt to determine when Federal Reserve intervention is occurring, and the extent of the intervention, in order to capitalize on the anticipated results of the intervention effort. Normally, the Federal Reserve attempts to intervene without being noticed. However, dealers at the major banks that trade with the Fed often pass the information to other market participants. Also, when the Fed deals directly with numerous commercial banks, markets are well aware that the Fed is intervening. To hide its strategy, the Fed may pretend to be interested in selling dollars when it is actually buying dollars, or vice versa. It calls commercial banks and obtains both bid and ask quotes on currencies, so the banks will not know whether the Fed is consider-ing purchases or sales of these currencies. Intervention strategies vary among central banks. Some arrange for one large order when they intervene; others use several smaller orders equivalent to $ 5 million to $ 10 million. Even if traders determine the extent of central bank intervention, they still cannot know with certainty what impact it will have on exchange rates. Indirect Intervention The Fed can also affect the dollar’s value indirectly by infl uencing the factors that determine it. Recall that the change in a currency’s spot rate is infl uenced by the following factors: The central bank can influence all of these variables, which in turn can affect the ex-change rate. Since these variables will likely have a more lasting impact on a spot rate than direct intervention, a central bank may use indirect intervention by influencing these variables. Although the central bank can influence all of these variables, it is likely to focus on interest rates or government controls when using indirect intervention. Government Adjustment of Interest Rates. When countries experience substantial net outflows of funds ( which places severe downward pressure on their currency), they commonly intervene indirectly by raising interest rates to dis-courage excessive outflows of funds and therefore limit any downward pressure on the value of their currency. However, this strategy adversely affects local borrowers ( government agencies, corporations, and consumers) and may weaken the economy. Government Use of Foreign Exchange Controls. Some governments attempt to use foreign exchange controls ( such as restrictions on the ex-change of the currency) as a form of indirect intervention to maintain the exchange rate of their currency. Under severe pressure, however, they tend to let the currency fl oat temporarily toward its market- determined level and set new bands around that level. Intervention as a Policy Tool The government of any country can implement its own fiscal and monetary policies to control its economy. In addition, it may attempt to influence the value of its home currency in order to improve its economy, weakening its currency under some conditions and strengthening it under others. In essence, the exchange rate becomes a tool, like tax laws and the money supply, that the government can use to achieve its desired economic objectives. Influence of a Weak Home Currency on the Economy A weak home currency can stimulate foreign demand for products. A weak dollar, for example, can substantially boost U. S. exports and U. S. jobs. In addition, it may also reduce U. S. imports. Though a weak currency can reduce unemployment at home, it can lead to higher inflation. In the early 1990s, the U. S. dollar was weak, causing U. S. imports from foreign countries to be highly priced. This situation priced firms such as Bayer, Volkswagen, and Volvo out of the U. S. market. Under these conditions, U. S. companies were able to raise their domestic prices because it was difficult for foreign producers to compete. In addition, U. S. firms that are heavy exporters, such as Goodyear Tire & Rubber Co., Northrup Grumman, Merck, DuPont, and Whirlpool, also benefit from a weaker dollar. Influence of a Strong Home Currency on the Economy A strong home currency can encourage consumers and corporations of that country to buy goods from other countries. This situation intensifies foreign competition and forces domestic producers to refrain from increasing prices. Therefore, the country’s overall inflation rate should be lower if its currency is stronger, other things being equal. Though a strong currency is a possible cure for high inflation, it may cause higher unemployment due to the attractive foreign prices that result from a strong home currency. The ideal value of the currency depends on the perspective of the country and the officials who must make these decisions. The strength or weakness of a currency is just one of many factors that influence a country’s economic conditions. By combining this discussion of how exchange rates affect inflation with the discussion in Chapter 4 of how inflation can affect exchange rates, a more complete picture of the dynamics of the exchange rate– inflation relationship can be achieved. A weak dollar places upward pressure on U. S. inflation, which in turn places further downward pressure on the value of the dollar. A strong dollar places downward pressure on inflation and on U. S. economic growth, which in turn places further upward pressure on the dollar’s value. The interaction among exchange rates, government policies, and economic factors is illustrated in Exhibit 6.4. As already mentioned, factors other than the home currency’s strength affect unemployment and/ or inflation. Likewise, factors other than unemployment and the inflation level influence a currency’s strength. The cycles that have been described here will often be interrupted by these other factors and therefore will not continue indefinitely. WEEK 2&3 Exchange Rate Equilibrium Although it is easy to measure the percentage change in the value of a currency, it is more difficult to explain why the value changed or to forecast how it may change in the future. To achieve either of these objectives, the concept of an equilibrium exchange rate must be understood, as well as the factors that affect the equilibrium rate. Before considering why an exchange rate changes, realize that an exchange rate at a given point in time represents the price of a currency. Like any other products sold in markets, the price of a currency is determined by the demand for that currency relative to supply. Thus, for each possible price of a British pound, there is a corresponding demand for pounds and a corresponding supply of pounds for sale. At any point in time, a currency should exhibit the price at which the demand for that currency is equal to supply, and this represents the equilibrium exchange rate. Of course, conditions can change over time, causing the supply or demand for a given currency to ad-just, and thereby causing movement in the currency’s price. This topic is more thoroughly discussed in this section. Demand for a Currency The British pound is used here to explain exchange rate equilibrium. The United Kingdom has not adopted the euro as its currency and continues to use the pound. Exhibit 4.2 shows a hypothetical number of pounds that would be demanded under various possibilities for the exchange rate. At any one point in time, there is only one exchange rate. The exhibit shows the quantity of pounds that would be demanded at various exchange rates at a specific point in time. The demand schedule is down-ward sloping because U. S. corporations will be encouraged to purchase more British goods when the pound is worth less, as it will take fewer dollars to obtain the desired amount of pounds. Supply of a Currency for Sale Up to this point, only the U. S. demand for pounds has been considered, but the British demand for U. S. dollars must also be considered. This can be referred to as a British supply of pounds for sale, since pounds are supplied in the foreign exchange market in exchange for U. S. dollars. A supply schedule of pounds for sale in the foreign exchange market can be developed in a manner similar to the demand schedule for pounds. Exhibit 4.3 shows the quantity of pounds for sale ( supplied to the foreign exchange market in exchange for dollars) corresponding to each possible exchange rate at a given point in time. Notice from the supply schedule in Exhibit 4.3 that there is a positive relationship between the value of the British pound and the quantity of British pounds for sale ( supplied), which can be explained as follows. When the pound is valued high, British consumers and firms are more likely to purchase U. S. goods. Thus, they supply a greater number of pounds to the market, to be exchanged for dollars. Conversely, when the pound is valued low, the supply of pounds for sale is smaller, reflecting less British desire to obtain U. S. goods. Equilibrium The demand and supply schedules for British pounds are combined in Exhibit 4.4. At an exchange rate of $ 1.50, the quantity of pounds demanded would exceed the sup-ply of pounds for sale. Consequently, the banks that provide foreign exchange services would experience a shortage of pounds at that exchange rate. At an exchange rate of $ 1.60, the quantity of pounds demanded would be less than the supply of pounds for sale. Therefore, banks providing foreign exchange services would experience a surplus of pounds at that exchange rate. According to Exhibit 4.4, the equilibrium exchange rate is $ 1.55 because this rate equates the quantity of pounds demanded with the sup-ply of pounds for sale. Impact of Liquidity. For all currencies, the equilibrium exchange rate is reached through transactions in the foreign exchange market, but for some currencies, the adjustment process is more volatile than for others. The liquidity of a currency affects the sensitivity of the exchange rate to specific transactions. If the currency’s spot market is liquid, its exchange rate will not be highly sensitive to a single large purchase or sale of the currency. Therefore, the change in the equilibrium exchange rate will be relatively small. With many willing buyers and sellers of the currency, transactions can be easily accommodated. Conversely, if the currency’s spot market is illiquid, its exchange rate may be highly sensitive to a single large purchase or sale transaction. There are not sufficient buyers or sellers to accommodate a large transaction, which means that the price of the currency must change to rebalance the supply and demand for the currency. Consequently, illiquid currencies tend to exhibit more volatile exchange rate movements, as the equilibrium prices of their currencies adjust to even minor changes in supply and demand conditions. Balance of Payments The balance of payments is a summary of transactions between domestic and foreign residents for a specific country over a specified period of time. It represents an accounting of a country’s international transactions for a period, usually a quarter or a year. It accounts for transactions by businesses, individuals, and the government. A balance- of- payments statement can be broken down into various components. Those that receive the most attention are the current account and the capital account. The current account represents a summary of the fl ow of funds between one specified country and all other countries due to purchases of goods or services, or the provision of income on financial assets. The capital account represents a summary of the fl ow of funds resulting from the sale of assets between one specified country and all other countries over a specified period of time. Thus, it compares the new foreign investments made by a country with the foreign investments within a country over a particular time period. Transactions that reflect inflows of funds generate positive numbers ( credits) for the country’s balance, while transactions that reflect outflows of funds generate negative numbers ( debits) for the country’s balance. Current Account The main components of the current account are payments for ( 1) merchandise ( goods) and services, ( 2) factor income, and ( 3) transfers. Payments for Merchandise and Services. Merchandise ex-ports and imports represent tangible products, such as computers and clothing, that are transported between countries. Service exports and imports represent tourism and other services, such as legal, insurance, and consulting services, provided for customers based in other countries. Service exports by the United States result in an inflow of funds to the United States, while service imports by the United States result in an outflow of funds. The difference between total exports and imports is referred to as the balance of trade. A deficit in the balance of trade means that the value of merchandise and services exported by the United States is less than the value of merchandise and services imported by the United States. Before 1993, the balance of trade focused on only merchandise exports and imports. In 1993, it was redefined to include service ex-ports and imports as well. The value of U. S. service exports usually exceeds the value of U. S. service imports. However, the value of U. S. merchandise exports is typically much smaller than the value of U. S. merchandise imports. Overall, the United States normally has a negative balance of trade. Factor Income Payments. A second component of the current account is factor income, which represents income ( interest and dividend payments) received by investors on foreign investments in financial assets ( securities). Thus, factor income received by U. S. investors reflects an inflow of funds into the United States. Factor in-come paid by the United States reflects an outflow of funds from the United States. Transfer Payments. A third component of the current account is transfer payments, which represent aid, grants, and gifts from one country to another. Examples of Payment Entries. Exhibit 2.1 shows several examples of transactions that would be reflected in the current account. Notice in the exhibit that every transaction that generates a U. S. cash inflow ( exports and income receipts by the United States) represents a credit to the current account, while every transaction that generates a U. S. cash outflow ( imports and income payments by the United States) represents a debit to the current account. Therefore, a large current account deficit indicates that the United States is sending more cash abroad to buy goods and services or to pay income than it is receiving for those same reasons. Actual Current Account Balance. The U. S. current account balance in the year 2006 is summarized in Exhibit 2.2. Notice that the exports of merchandise were valued at $ 1,019 billion, while imports of merchandise by the United States were valued at $ 1,836 billion. Total U. S. exports of merchandise and services and income receipts amounted to $ 2,056 billion, while total U. S. imports amounted to $ 2,793 billion. The bottom of the exhibit shows that net transfers ( which include grants and gifts provided to other countries) were $ 54 billion. The negative number for net transfers represents a cash outflow from the United States. Exhibit 2.2 shows that the current account balance ( line 10) can be derived as the difference between total U. S. exports and income receipts ( line 4) and the total U. S. imports and income payments ( line 8), with an adjustment for net transfer payments ( line 9). This is logical, since the total U. S. exports and income receipts represent U. S. cash inflows while the total U. S. imports and income payments and the net transfers represent U. S. cash outflows. The negative current account balance means that the United States spent more on trade, income, and transfer payments than it received. Capital and Financial Accounts The capital account category has been changed to separate it from the financial account, which is described next. The capital account includes the value of financial assets transferred across country borders by people who move to a different country. It also includes the value of nonproduced nonfinancial assets that are transferred across country borders, such as patents and trademarks. The sale of patent rights by a U. S. firm to a Canadian firm reflects a credit to the U.S. balance- of- payments account, while a U. S. purchase of patent rights from a Canadian firm reflects a debit to the U. S. balance- of- payments account. The capital account items are relatively minor compared to the financial account items. The key components of the financial account are payments for ( 1) direct foreign investment, ( 2) portfolio investment, and ( 3) other capital investment. Direct Foreign Investment. Direct foreign investment represents the investment in fixed assets in foreign countries that can be used to conduct business operations. Examples of direct foreign investment include a firm’s acquisition of a foreign company, its construction of a new manufacturing plant, or its expansion of an existing plant in a foreign country. In 2006, the United States increased its direct foreign investment abroad by $ 248 billion, while non- U. S. countries increased their direct foreign investment in the United States by $ 185 billion. Portfolio Investment. Portfolio investment represents transactions involving long- term financial assets ( such as stocks and bonds) between countries that do not affect the transfer of control. Thus, a purchase of Heineken ( Netherlands) stock by a U. S. investor is classified as portfolio investment because it represents a purchase of foreign financial assets without changing control of the company. If a U. S. firm purchased all of Heineken’s stock in an acquisition, this transaction would result in a transfer of control and therefore would be classified as direct foreign investment in-stead of portfolio investment. In 2006, the U. S. net purchases of foreign stocks were $ 129 billion, while its net purchases of foreign bonds were $ 149 billion. Non- U. S. net purchases of U. S. stocks were $ 114 billion in 2006, while non- U. S. net purchases of U. S. bonds were $ 507 billion. Other Capital Investment. A third component of the financial account consists of other capital investment, which represents transactions involving short-term financial assets ( such as money market securities) between countries. In general, direct foreign investment measures the expansion of firms’ foreign operations, whereas portfolio investment and other capital investment measure the net fl ow of funds due to financial asset transactions between individual or institutional investors. Errors and Omissions and Reserves. If a country has a negative current account balance, it should have a positive capital and financial account balance. This implies that while it sends more money out of the country than it receives from other countries for trade and factor income, it receives more money from other countries than it spends for capital and financial account components, such as investments. In fact, the negative balance on the current account should be offset by a positive balance on the capital and financial account. However, there is not normally a perfect offsetting effect because measurement errors can occur when attempting to measure the value of funds transferred into or out of a country. For this reason, the balance- of- payments account includes a category of errors and omissions. International Trade Flows Canada, France, Germany, and other European countries rely more heavily on trade than the United States does. Canada’s trade volume of exports and imports per year is valued at more than 50 percent of its annual gross domestic product ( GDP). The trade volume of European countries is typically between 30 and 40 percent of their respective GDPs. The trade volume of the United States and Japan is typically between 10 and 20 percent of their respective GDPs. Nevertheless, for all countries, the volume of trade has grown over time. As of 2006, exports represented about 18 percent of U. S. GDP. Distribution of U. S. Exports and Imports The dollar value of U. S. exports to various countries during 2006 is shown in Exhibit 2.3. The amounts of U. S. exports are rounded to the nearest billion. For ex-ample, exports to Canada were valued at $ 230 billion. The proportion of total U. S. exports to various countries is shown at the top of Exhibit 2.4. About 23 percent of all U. S. exports are to Canada, while 13 percent of U. S. exports are to Mexico. The proportion of total U. S. imports from various countries is shown at the bot-tom of Exhibit 2.4. Canada, China, Mexico, and Japan are the key exporters to the United States: Together, they are responsible for more than half of the value of all U. S. imports. U. S. Balance- of- Trade Trend Recent trends for U. S. exports, U. S. imports, and the U. S. balance of trade are shown in Exhibit 2.5. Notice that the value of U. S. exports and U. S. imports has grown substantially over time. Since 1976, the value of U. S. imports has exceeded the value of U. S. exports, causing a balance- of- trade deficit. Much of the trade defi cit is due to a trade imbalance with just two countries, China and Japan. In 2006, U. S. exports to China were about $ 55 billion, but imports from China were about $ 255 billion, which resulted in a balance- of- trade deficit of $ 200 billion with China. Any country’s balance of trade can change substantially over time. Shortly after World War II, the United States experienced a large balance- of- trade surplus because Europe relied on U. S. exports as it was rebuilt. During the last decade, the United States has experienced balance- of- trade deficits because of strong U. S. demand for imported products that are produced at a lower cost than similar products can be produced in the United States. Should the United States Be Concerned about a Huge Balance- of- Trade Deficit' If firms, individuals, or government agencies from the United States purchased all their products from U. S. firms, their payments would have resulted in revenue to U. S. firms, which would also contribute to earnings for the shareholders. In addition, if the purchases were directed at U. S. firms, these firms would need to produce more products and could hire more employees. Thus, the U. S. unemployment rate might be lower if U. S. purchases were focused on products produced within the United States. In reality, the United States sends more than $ 200 billion in payments for products per year to other countries than what it receives when selling products to other countries. Thus, international trade has created jobs in foreign countries, which re-place some jobs in the United States. However, there are some benefits of international trade for the United States. First, international trade has created some jobs in the United States, especially in industries where U. S. firms have a technology advantage. International trade has caused a shift of production to countries that can produce products more efficiently. In addition, it ensures more competition among the firms that produce products, which forces the firms to keep their prices low. International Trade Issues Given the importance of international trade and the potential impact that a government can have on trade, governments continually seek trade policies that are fair to all countries. Much progress has been made as a result of several events that have either reduced or eliminated trade restrictions. Events That Increased International Trade The following events reduced trade restrictions and increased international trade. Removal of the Berlin Wall. In 1989, the Berlin Wall separating East Germany from West Germany was torn down. This was symbolic of new relations between East Germany and West Germany and was followed by the reunification of the two countries. It encouraged free enterprise in all Eastern European countries and the privatization of businesses that were owned by the government. It also led to major reductions in trade barriers in Eastern Europe. Many MNCs began to export products there, while others capitalized on the cheap labor costs by importing supplies from there. Single European Act. In the late 1980s, industrialized countries in Europe agreed to make regulations more uniform and to remove many taxes on goods traded between these countries. This agreement, supported by the Single European Act of 1987, was followed by a series of negotiations among the countries to achieve uniform policies by 1992. The act allows firms in a given European country greater access to supplies from firms in other European countries. Many firms, including European subsidiaries of U. S.- based MNCs, have capitalized on the agreement by attempting to penetrate markets in border countries. By producing more of the same product and distributing it across European countries, firms are now better able to achieve economies of scale. Best Foods ( now part of Unilever) was one of many MNCs that increased efficiency by streamlining manufacturing operations as a result of the reduction in barriers. NAFTA. As a result of the North American Free Trade Agreement ( NAFTA) of 1993, trade barriers between the United States and Mexico were eliminated. Some U. S. firms attempted to capitalize on this by exporting goods that had previously been restricted by barriers to Mexico. Other firms established subsidiaries in Mexico to produce their goods at a lower cost than was possible in the United States and then sell the goods in the United States. The removal of trade barriers essentially al-lowed U. S. firms to penetrate product and labor markets that previously had not been accessible. The removal of trade barriers between the United States and Mexico allows Mexican firms to export some products to the United States that were previously restricted. Thus, U. S. firms that produce these goods are now subject to competition from Mexican exporters. Given the low cost of labor in Mexico, some U. S. firms have lost some of their market share. The effects are most pronounced in the labor-intensive industries. Within a month after the NAFTA accord, the momentum for free trade continued with a GATT ( General Agreement on Tariffs and Trade) accord. This accord was the conclusion of trade negotiations from the so- called Uruguay Round that had be-gun 7 years earlier. It called for the reduction or elimination of trade restrictions on specified imported goods over a 10- year period across 117 countries. The accord has generated more international business for firms that had previously been unable to penetrate foreign markets because of trade restrictions. Inception of the Euro. In 1999, several European countries adopted the euro as their currency for business transactions between these countries. The euro was phased in as a currency for other transactions during 2001 and completely replaced the currencies of the participating countries on January 1, 2002. Consequently, only the euro is used for transactions in these countries, so firms ( including European subsidiaries of U. S.- based MNCs) no longer face the costs and risks associated with converting one currency to another. The single currency system in most of Europe encouraged more trade among European countries. Expansion of the European Union. In 2004, Cyprus, the Czech Republic, Estonia, Hungary, Latvia, Lithuania, Malta, Poland, Slovakia, and Slovenia were admitted to the EU, followed by Bulgaria and Romania in 2007. Slovenia ad-opted the euro as its currency in 2007. The other new members continued to use their own currencies, but may be able to adopt the euro as their currency in the future if they meet specified guidelines regarding budget deficits and other financial conditions. Nevertheless, their admission into the EU is relevant because restrictions on their trade with Western Europe are reduced. Since wages in these countries are substantially lower than in Western European countries, many MNCs have established manufacturing plants there to produce products and export them to Western Europe. Other Trade Agreements. In June 2003, the United States and Chile signed a free trade agreement to remove tariffs on products traded between the two countries. In 2006, the Central American Trade Agreement ( CAFTA) was implemented, allowing for lower tariffs and regulations between the United States, the Dominican Republic, and four Central American countries. In addition, there is an initiative for Caribbean nations to create a single market in which there is the free fl ow of trade, capital, and workers across countries. The United States has also established trade agreements with many other countries. Trade Friction International trade policies partially determine which firms get most of the market share within an industry. These policies affect each country’s unemployment level, income level, and economic growth. Even though trade treaties have reduced tariffs and quotas over time, most countries still impose some type of trade restrictions on particular products in order to protect their local fi rms. An easy way to start an argument among students ( or professors) is to ask what they think the policy on international trade should be. People whose job prospects are highly influenced by international trade tend to have very strong opinions about international trade policy. On the surface, most people agree that free trade can be beneficial because it encourages more intense competition among firms, which enables consumers to obtain products where the quality is highest and the prices are low. Free trade should cause a shift in production to those countries where it can be done most efficiently. Each country’s government wants to increase its exports because more ex-ports result in a higher level of production and income and may create jobs. However, a job created in one country may be lost in another, which causes countries to battle for a greater share of the world’s exports. People disagree on the type of strategies a government should be allowed to use to increase its respective country’s share of the global market. They may agree that a tariff or quota on imported goods prevents free trade and gives local firms an unfair advantage in their own market. Yet, they disagree on whether governments should be allowed to use other more subtle trade restrictions against foreign firms or provide incentives that give local firms an unfair advantage in the battle for global market share. Consider the following situations that commonly occur: 1. The firms based in one country are not subject to environmental restrictions and, therefore, can produce at a lower cost than firms in other countries. 2. The firms based in one country are not subject to child labor laws and are able to produce products at a lower cost than firms in other countries by relying mostly on children to produce the products. 3. The firms based in one country are allowed by their government to offer bribes to large customers when pursuing business deals in a particular industry. They have a competitive advantage over firms in other countries that are not allowed to offer bribes. 4. The firms in one country receive subsidies from the government, as long as they export the products. The exporting of products that were produced with the help of government subsidies is commonly referred to as dumping. These firms may be able to sell their products at a lower price than any of their competitors in other countries. 5. The firms in one country receive tax breaks if they are in specific industries. This practice is not necessarily a subsidy, but it still is a form of government financial support. In all of these situations, firms in one country may have an advantage over firms in other countries. Every government uses some strategies that may give its local firms an advantage in the fight for global market share. Thus, the playing field in the battle for global market share is probably not even across all countries. Yet, there is no formula that will ensure a fair battle for market share. Regardless of the progression of international trade treaties, governments will always be able to find strategies that can give their local firms an edge in exporting. Suppose, as an extreme example, that a new international treaty outlawed all of the strategies described above. One country’s government could still try to give its local firms a trade advantage by attempting to maintain a relatively weak currency. This strategy can increase foreign demand for products produced locally because products denominated in a weak currency can be purchased at a low price. Using the Exchange Rate as a Policy. At any given point in time, a group of exporters may claim that they are being mistreated and lobby their government to adjust the currency so that their exports will not be so expensive for foreign purchasers. In 2004, European exporters claimed that they were at a disadvantage be-cause the euro was too strong. Meanwhile, U. S. exporters still claimed that they could not compete with China because the Chinese currency ( yuan) was maintained at an artificially weak level. In July 2005, China revalued the yuan by 2.1 percent against the dollar in response to criticism. It also implemented a new system in which the yuan could fl oat within narrow boundaries based on a set of major currencies. In May 2007, China widened the band so that the yuan could deviate by as much as .5 percent within a day. This had a very limited effect on the relative pricing of Chinese versus U. S. products and, therefore, on the balance of trade between the two countries. Outsourcing. One of the most recent issues related to trade is the outsourcing of services. For example, technology support of computer systems used in the United States may be outsourced to India, Bulgaria, China, or other countries where labor costs are low. Outsourcing affects the balance of trade because it means that a service is purchased in another country. This form of international trade allows MNCs to conduct operations at a lower cost. However, it shifts jobs to other countries and is criticized by the people who lose their jobs due to the outsourcing. Many people have opinions about outsourcing, which are often inconsistent with their own behavior. Using Trade and Foreign Ownership Policies for Security Reasons. Some U. S. politicians have argued that international trade and foreign ownership should be restricted when U. S. security is threatened. While the general opinion has much support, there is disagreement regarding the specific business transactions in which U. S. businesses deserve protection from foreign competition. Consider the following questions: 1. Should the United States purchase military planes only from a U. S. producer of planes, even when Brazil could produce the same planes for half the price' The tradeoff involves a larger budget deficit for increased security. Is the United States truly safer with planes produced in the United States' Are technology secrets safer when the production is in the United States by a U. S. firm' 2. If you think military planes should be produced only by a U. S. firm, should there be any restrictions on foreign ownership of the firm' Foreign investors own a pro-portion of most large publicly traded companies in the United States. 3. Should foreign ownership restrictions be imposed only on investors based in some countries' Or is there a concern that owners based in any foreign country should be banned from doing business transactions when U. S. security is threatened' What is the threat' Is it that the owners could sell technology secrets to enemies' If so, isn’t such a threat also possible for U. S. owners' If some foreign owners are acceptable, what countries would be acceptable' 4. What products should be viewed as a threat to U. S. security' For example, even if military planes were required to be produced by U. S. firms, what about all the components that are used within the production of the planes' Some of the components used in U. S. military plane production are produced in China and imported by the plane manufacturers. To realize the degree of disagreement about these issues, try to get a consensus answer on any of these questions from your fellow students in a single classroom. If students without hidden agendas cannot agree on the answer, consider the level of dis-agreement among owners or employees of U. S. and foreign firms that have much to gain ( or lose) from the international trade and investment policy that is implemented. It is difficult to distinguish between a trade or investment restriction that is enhancing national security versus one that is unfairly protecting a U. S. firm from foreign competition. The same dilemma regarding international trade and investment policies to protect national security in the United States also applies to all other countries. Using Trade Policies for Political Reasons. International trade policy issues have become even more contentious over time as people have come to expect that trade policies will be used to punish countries for various actions. People expect countries to restrict imports from countries that fail to enforce environmental laws or child labor laws, initiate war against another country, or are unwilling to participate in a war against an unlawful dictator of another country. Every international trade convention now attracts a large number of protesters, all of whom have their own agendas. International trade may not even be the focus of each protest, but it is often thought to be the potential solution to the problem ( at least in the mind of that protester). Although all of the protesters are clearly dissatisfied with existing trade policies, there is no consensus as to what trade policies should be. These different views are similar to the disagreements that occur between government representatives when they try to negotiate international trade policy. The managers of each MNC cannot be responsible for resolving these international trade policy conflicts. However, they should at least recognize how a particular international trade policy affects their competitive position in the industry and how changes in policy could affect their position in the future. Factors Affecting International Trade Flows Because international trade can significantly affect a country’s economy, it is important to identify and monitor the factors that influence it. The most influential factors are: • Inflation • National income • Government policies • Exchange rates Impact of Inflation If a country’s inflation rate increases relative to the countries with which it trades, its current account will be expected to decrease, other things being equal. Consumers and corporations in that country will most likely purchase more goods overseas ( due to high local inflation), while the country’s exports to other countries will decline. Impact of National Income If a country’s income level ( national income) increases by a higher percentage than those of other countries, its current account is expected to decrease, other things being equal. As the real income level ( adjusted for inflation) rises, so does consumption of goods. A percentage of that increase in consumption will most likely reflect an increased demand for foreign goods. Impact of Government Policies A country’s government can have a major effect on its balance of trade due to its policies on subsidizing exporters, restrictions on imports, or lack of enforcement on piracy. Subsidies for Exporters. Some governments offer subsidies to their domestic firms, so that those fIrms can produce products at a lower cost than their global competitors. Thus, the demand for the exports produced by those firms is higher as a result of subsidies. Some subsidies are more obvious than others. It could be argued that every government provides subsidies in some form. A country’s government can prevent or discourage imports from other countries. By imposing such restrictions, the government disrupts trade flows. Among the most commonly used trade restrictions are tariffs and quotas. Restrictions on Imports. If a country’s government imposes a tax on imported goods ( often referred to as a tariff), the prices of foreign goods to consumers are effectively increased. Tariffs imposed by the U. S. government are on average lower than those imposed by other governments. Some industries, however, are more highly protected by tariffs than others. American apparel products and farm products have historically received more protection against foreign competition through high tariffs on related imports. In addition to tariffs, a government can reduce its country’s imports by enforcing a quota, or a maximum limit that can be imported. Quotas have been commonly applied to a variety of goods imported by the United States and other countries. Lack of Restrictions on Piracy. In some cases, a government can affect international trade flows by its lack of restrictions on piracy. As a result of piracy, China’s demand for imports is lower. Piracy is one reason why the United States has a large balance- of- trade deficit with China. However, even if pi-racy were eliminated, the U. S. trade deficit with China would still be large. Impact of Exchange Rates Each country’s currency is valued in terms of other currencies through the use of exchange rates, so that currencies can be exchanged to facilitate international transactions. The values of most currencies can fluctuate over time because of market and government forces ( as discussed in detail in Chapter 4). If a country’s currency begins to rise in value against other currencies, its current account balance should decrease, other things being equal. As the currency strengthens, goods exported by that country will become more expensive to the importing countries. As a consequence, the demand for such goods will decrease. Using the tennis racket example above, consider the possible effects if currencies of several countries depreciate simultaneously against the dollar ( the dollar strengthens). The U. S. balance of trade can decline substantially. Just as a strong dollar is expected to cause a more pronounced U. S. balance-of- trade deficit as explained above, a weak dollar is expected to reduce the U. S. balance- of- trade deficit. The dollar’s weakness lowers the price paid for U. S. goods by foreign customers and can lead to an increase in the demand for U. S. products. A weak dollar also tends to increase the dollar price paid for foreign goods and thus reduces the U. S. demand for foreign goods. Interaction of Factors Because the factors that affect the balance of trade interact, their simultaneous influence on the balance of trade is complex. For example, as a high U. S. inflation rate reduces the current account, it places downward pressure on the value of the dollar ( as discussed in detail in Chapter 4). Since a weaker dollar can improve the current account, it may partially offset the impact of inflation on the current account. Correcting a Balance- of- Trade Deficit A balance- of- trade deficit is not necessarily a problem, as it may enable a country’s consumers to benefit from imported products that are less expensive than locally produced products. However, the purchase of imported products implies less reliance on domestic production in favor of foreign production. Thus, it may be argued that a large balance- of- trade deficit causes a transfer of jobs to some foreign countries. Consequently, a country’s government may attempt to correct a balance- of- trade deficit. By reconsidering some of the factors that affect the balance of trade, it is possible to develop some common methods for correcting a deficit. Any policy that will increase foreign demand for the country’s goods and services will improve its balance- of- trade position. Foreign demand may increase if export prices become more attractive. This can occur when the country’s inflation is low or when its currency’s value is reduced, thereby making the prices cheaper from a foreign perspective. A floating exchange rate could possibly correct any international trade imbalances in the following way. A deficit in a country’s balance of trade suggests that the country is spending more funds on foreign products than it is receiving from exports to foreign countries. Because it is selling its currency ( to buy foreign goods) in greater volume than the foreign demand for its currency, the value of its currency should de-crease. This decrease in value should encourage more foreign demand for its goods in the future. While this theory seems rational, it does not always work as just described. It is possible that, instead, a country’s currency will remain stable or appreciate even when the country has a balance- of- trade deficit. Why a Weak Home Currency Is Not a Perfect Solution Even if a country’s home currency weakens, its balance- of- trade deficit will not necessarily be corrected for the following reasons. Counterpricing by Competitors. When a country’s currency weakens, its prices become more attractive to foreign customers, and many foreign companies lower their prices to remain competitive with the country’s fi rms. Impact of Other Weak Currencies. The currency does not necessarily weaken against all currencies at the same time. Prearranged International Transactions. Many international trade transactions are prearranged and cannot be immediately adjusted. Thus, exporters and importers are committed to continue the international transactions that they agreed to complete. Over time, non- U. S. firms may begin to take advantage of the weaker dollar by purchasing U. S. imports, if they believe that the weakness will continue. The lag time between the dollar’s weakness and the non- U. S. firms’ increased demand for U. S. products has sometimes been estimated to be 18 months or even longer. The U. S. balance of trade may actually deteriorate in the short run as a result of dollar depreciation, since U. S. importers would need more dollars to pay for the imports they contracted to purchase. The U. S. balance of trade only improves when U. S. and non- U. S. importers respond to the change in purchasing power that is caused by the weaker dollar. This pattern is called the J- curve effect, and it is illustrated in Exhibit 2.6. The further decline in the trade balance before a reversal creates a trend that can look like the letter J. Intracompany Trade. A fourth reason why a weak currency will not always improve a country’s balance of trade is that importers and exporters that are under the same ownership have unique relationships. Many firms purchase products that are produced by their subsidiaries in what is referred to as intracompany trade. This type of trade makes up more than 50 percent of all international trade. The trade be-tween the two parties will normally continue regardless of exchange rate movements. Thus, the impact of exchange rate movements on intracompany trade patterns is limited. International Capital Flows One of the most important types of capital flows is direct foreign investment. Firms commonly attempt to engage in direct foreign investment so that they can reach additional consumers or can rely on low- cost labor. In 2006, the total amount of direct foreign investment ( by firms or government agencies all over the world) into all countries was about $ 1.2 trillion. Exhibit 2.7 shows a distribution of the regions where the DFI was targeted during 2006. Notice that Europe attracted almost half of the total DFI in 2006. Western European countries attracted most of the DFI, but Eastern European countries such as Poland, Hungary, Slovenia, Croatia, and the Czech Republic also attracted a significant amount of DFI. This is not surprising since these countries are not as developed as those in Western Europe and have more potential for growth. They also have relatively low wages. The United States attracted about $ 177 billion in DFI in 2006, or 14 percent of the total DFI. Distribution of DFI by U. S. Firms Many U. S.- based MNCs have recently increased their DFI in foreign countries. For example, ExxonMobil, IBM, and Hewlett- Packard have at least 50 percent of their as-sets in foreign countries. The United Kingdom and Canada are the biggest targets. Europe as a whole receives more than 50 percent of all DFI by U. S. fi rms. Another 30 percent of DFI is focused on Latin America and Canada, while about 16 percent is concentrated in the Asia and Pacific region. The DFI by U. S. firms in Latin American and Asian countries has increased substantially as these countries have opened their markets to U. S. fi rms. Distribution of DFI in the United States Just as U. S. firms have used DFI to enter markets outside the United States, non- U. S. firms have penetrated the U. S. market. Much of the DFI in the United States comes from the United Kingdom, Japan, the Netherlands, Germany, and Canada. Seagram, Food Lion, and some other foreign- owned MNCs generate more than half of their revenue from the United States. Many well- known firms that operate in the United States are owned by foreign companies, including Shell Oil ( Netherlands), Citgo Petroleum ( Venezuela), Canon ( Japan), and Fireman’s Fund ( Germany). Many other firms operating in the United States are partially owned by foreign companies, including MCI Communications ( United Kingdom) and Northwest Airlines ( Nether-lands). While U. S.- based MNCs consider expanding in other countries, they must also compete with foreign firms in the United States. Factors Affecting DFI Capital flows resulting from DFI change whenever conditions in a country change the desire of firms to conduct business operations there. Some of the more common factors that could affect a country’s appeal for DFI are identified here. Changes in Restrictions. During the 1990s, many countries lowered their restrictions on DFI, thereby opening the way to more DFI in those countries. Many U. S.- based MNCs, including Bausch & Lomb, Colgate- Palmolive, and General Electric, have been penetrating less developed countries such as Argentina, Chile, Mexico, India, China, and Hungary. New opportunities in these countries have arisen from the removal of government barriers. Privatization. Several national governments have recently engaged in privatization, or the selling of some of their operations to corporations and other investors. Privatization is popular in Brazil and Mexico, in Eastern European countries such as Poland and Hungary, and in such Caribbean territories as the Virgin Islands. It al-lows for greater international business as foreign firms can acquire operations sold by national governments. Privatization was used in Chile to prevent a few investors from controlling all the shares and in France to prevent a possible reversion to a more nationalized economy. In the United Kingdom, privatization was promoted to spread stock ownership across investors, which allowed more people to have a direct stake in the success of British industry. The primary reason that the market value of a firm may increase in response to privatization is the anticipated improvement in managerial efficiency. Managers in a privately owned firm can focus on the goal of maximizing shareholder wealth, whereas in a state- owned business, the state must consider the economic and social ramifications of any business decision. Also, managers of a privately owned enterprise are more motivated to ensure profitability because their careers may depend on it. For these reasons, privatized firms will search for local and global opportunities that could enhance their value. The trend toward privatization will undoubtedly create a more competitive global marketplace. Potential Economic Growth. Countries that have greater potential for economic growth are more likely to attract DFI because firms recognize that they may be able to capitalize on that growth by establishing more business there. Tax Rates. Countries that impose relatively low tax rates on corporate earnings are more likely to attract DFI. When assessing the feasibility of DFI, firms estimate the after- tax cash flows that they expect to earn. Exchange Rates. Firms typically prefer to pursue DFI in countries where the local currency is expected to strengthen against their own. Under these conditions, they can invest funds to establish their operations in a country while that country’s currency is relatively cheap ( weak). Then, earnings from the new operations can periodically be converted back to the firm’s currency at a more favorable exchange rate. Factors Affecting International Portfolio Investment The desire by individual or institutional investors to direct international portfolio in-vestment to a specific country is influenced by the following factors. Tax Rates on Interest or Dividends. Investors normally prefer to invest in a country where the taxes on interest or dividend income from investments are relatively low. Investors assess their potential after- tax earnings from investments in foreign securities. Interest Rates. Portfolio investment can also be affected by interest rates. Money tends to fl ow to countries with high interest rates, as long as the local currencies are not expected to weaken. Exchange Rates. When investors invest in a security in a foreign country, their return is affected by ( 1) the change in the value of the security and ( 2) the change in the value of the currency in which the security is denominated. If a country’s home currency is expected to strengthen, foreign investors may be willing to in-vest in the country’s securities to benefit from the currency movement. Conversely, if a country’s home currency is expected to weaken, foreign investors may decide to purchase securities in other countries. In a period such as 2006, U. S. investors that in-vested in foreign securities benefited from the change in exchange rates. Since the foreign currencies strengthened against the dollar over time, the foreign securities were ultimately converted to more dollars when they were sold at the end of the year. Impact of International Capital Flows The United States relies heavily on foreign capital in many ways. First, there is foreign investment in the United States to build manufacturing plants, offices, and other buildings. Second, foreign investors purchase U. S. debt securities issued by U. S. firms and therefore serve as creditors to these fi rms. Third, foreign investors purchase Treasury debt securities and therefore serve as creditors to the U. S. government. Foreign investors are especially attracted to the U. S. financial markets when the interest rate in their home country is substantially lower than that in the United States. For example, Japan’s annual interest rate has been close to 1 percent for several years because the supply of funds in its credit market has been very large. At the same time, Japan’s economy has been stagnant, so the demand for funds to support business growth has been limited. Given the low interest rates in Japan, many Japanese investors invested their funds in the United States to earn a higher interest rate. The impact of international capital flows on the U. S. economy is shown in Exhibit 2.8. At a given point in time, the long- term interest rate in the United States is determined by the interaction between the supply of funds available in U. S. credit markets and the amount of funds demanded there. The supply curve S1 in the left graph reflects the supply of funds from domestic sources. If the United States relied solely on domestic sources for its supply, its equilibrium interest rate would be i1 and the level of business investment in the United States ( shown in the right graph) would be BI1. But since the supply curve also includes the supply of funds from foreign sources ( as shown in S2), the equilibrium interest rate is i2. Because of the large amount of international capital flows that are provided to the U. S. credit markets, interest rates in the United States are lower than what they would be otherwise. This allows for a lower cost of borrowing and therefore a lower cost of using capital. Con-sequently, the equilibrium level of business investment is BI2. Because of the lower interest rate, there are more business opportunities that deserve to be funded. Consider the long- term rate shown here as the cost of borrowing by the most creditworthy fi rms. Other firms would have to pay a premium above that rate. With-out the international capital flows, there would be less funding available in the United States across all risk levels, and the cost of funding would be higher regardless of the firm’s risk level. This would reduce the amount of feasible business opportunities in the United States. Does the United States Rely Too Much on Foreign Funds' If Japan and China stopped investing in U. S. debt securities, the U. S. interest rates would possibly rise, and investors from other countries would be attracted to the relatively high U. S. interest rate. Thus, the United States would still be able to obtain funding for its debt, but its interest rates ( cost of borrowing) may be higher. In general, access to international funding has allowed more growth in the U. S. economy over time, but it also makes the United States more reliant on foreign investors for funding. The United States should be able to rely on substantial foreign funding in the future as long as the U. S. government and firms are still perceived to be creditworthy. If that trust is ever weakened, the U. S. government and firms would only be able to obtain foreign funding if they paid a higher interest rate to compensate for the risk ( a risk premium).