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    Unit IIChanging Global

    Financial Environment

    Power Points by:K. Srinivasan

    Department of Management Studies

    Christ University, Bangalore.

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    Fixed Exchange rates among major currencies, such as the U.S Dollar,British Pound, Swiss Franc & Japanese Yen have been fluctuating since thefixed exchange rate regime was abandoned in 1973.Consequently, Corporations nowadays are operating in an environment in

    which exchange rate changes adversely affect their competitive positions inthe marketplace.Due to this, Corporations and many firms have to take careful measure andmanage their exchange risk exposure.

    However, many European Countries have adopted a common currencycalled the EURO, rendering intra-European trade and investment muchless susceptible to exchange risk.Apart from this, the complex international monetary arrangements implythat for skillful financial decision making, it is essential for managers to

    understand the working, details & arrangements of IMS.

    Introduction

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    International Monetary System can be defined as theInstitutional Framework within which international payments aremadeMovements of Capital are accommodated

    Exchange Rates among Currencies are determined

    Overall, it is a complex whole of agreements, rules, institutions,mechanisms and policies regarding international exchange rates,

    international payments and the flow of capital.

    Finally, the IMS has evolved over time and will continue to doso in the future as the fundamental business and political conditions

    underlying the world economy to continue to shift and turns.

    Continued

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    Evolution of the International

    Monetary System

    Bimetallism : Before 1875

    Classical Gold Standard: 1875 1914

    Inter war period: 1915 1944

    Bretton Woods System: 1945 1972

    Flexible Exchange Rates Regime: Since 1973

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    Bimetallism (Before 1875)

    Bimetallism in the sense that both Gold & Silver were usedas international means of payment and the exchange rate amongcountries were determined by either gold or silver contents.

    Exchange Rates Under the Bimetal System: Exchange rates wasdetermined by metal content of the currencies being exchanged.Gold & Silver had a universal price and currencies were exchanged atthe value of metal. This worked well if the currency being exchanged

    was of the same metal but different countries maintained differentmetal systems.

    Bimetallism refers to the use of noble metals Gold & Silver ascurrency. Prior to 1875 this was the predominant monetary system

    in major countries.

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    ContinuedU.K maintained gold & silver coinage until 1816 (Conclusion ofNapoleon War) when the silver coin as dropped and they movedto the gold standard.France maintained the bimetal system from the French revolution

    in 1878.Other Countries such as China, India, Germany & Holland wereon Silver Standard.The United States operated under bimetal form 1792 to 1873

    when it stopped producing the silver dollar.The U.S, Russia & Austria - Hungary had alternative currenciesfrom 1848 - 79, it is mainly due to political turmoil.Till 1870s IMS was not followed systematically by the

    countries.

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    Example:

    If the exchange of British pounds for German Marks was madethough French francs, which made French francs the dominantinternational currency.

    Country Currency

    Germany Silver

    UK Gold

    France Bimetal (Silver & Gold)

    British Pounds

    Gold

    French Francs

    Gold & Silver

    German Marks

    Silver

    Continued

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    Greshams Law: Bad (Abundant) money drives out Good(Scare) money. This law dictated the currency used to trade.

    1. Exchange rate between gold and silver was fixed by FrenchOfficials

    2. Either gold or silver could be used to settle debts.3. More abundant metal would be used to transact and the scare

    metal will fall out of circulation

    During the Gold Rush Era (1850s) gold flooded the

    market & the intrinsic value of gold fell relative to silver. Howeverthe exchange rate in France remained constant at 15.5:1 silver togold francs. Since the price of gold was still set people elected topay debts in the over valued currency (gold) and silver fell out of

    circulation. This effectively put France on the gold standard.

    Continued

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    Classical Gold Standard(1875 1914)

    The first full-fledged Gold Standard was introduced in 1821 at Englandwhen notes issued by the Bank of England for gold standard.France, unofficially on the gold standard since 1850, officially adoptedthe gold standard in 1878.Germany converted in 1875 after receiving a large endowment fromFrance.The united states adopted the gold standard in 1879Finally, Russia and Japan followed the gold standard in the year 1897

    Historically speaking, the international gold standard existed as ahistorical reality during the period 1875 - 1914. Due to World War Imany countries got off from gold standard in 1914. The CGS as an IMSlasted for about 40 years. During the period, London became the centrefor International Financial System, reflecting Britains advanced economy& top position in International trade.

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    International Gold Standard can prevailed in most of the countriesby followed reasons; they are

    Gold alone is assured of unrestricted coinage.There is two-way convertibility between gold & national

    currencies at a stable ratioGold may be freely exported or imported

    In Gold standard, the exchange rates between two currencies will bedetermined by the respective currencies gold content.

    Auto correction under the gold standard:Buying pressure will increase on the poundBuying pressure will decrease on the francExcess demand for pound will cause the price of pound to

    increase relative to the franc & the miss pricing will be corrected.

    Classical Gold Standard

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    Trade imbalance under the Gold standard: The goldstandard also has a build in auto correction for tradeimbalances.

    Germany France

    Goods1000 pounds of gold

    Goods750 pounds of gold

    Flow of Goods

    250 pounds of gold

    Flow of Gold /Currency

    Continued

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    1. The supply of newely minted gold is so restricted that thegrowth of world trade and investment can be seriously affected

    because of insufficient monetary reserves.2. The supply of gold is limited and countries are required tomaintain a pegged ratio, which means a countrys money supplyis limited and regulated by the trade imbalance self correction.

    The restriction of a countries money supply can seriously impaireconomic growth.3. The gold standard works well if all countries adhere to the rules

    however, nothing binds countries to follow the gold standard.Therefore, it can be abandoned at any time as it was in WW I

    Disadvantages of the Gold

    Standard

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    Inter War Period (1915 1944)

    After World War I ended the classical gold standard was abandon inAugust 1914, there was no global cooperation between the majorcountries and restricted gold exports.Great Britain, France, Germany & Russia were suffered hugehyperinflationIn 1923, the Wholesale Price Index in Germany was more than 1 trilliontimes as high as the prewar level.Due to fluctuation in exchange rate, many countries predatorydepreciated their currency value to gain advantage in world export market

    & trying to rebuild their economy by attempting to restore the goldstandard.

    Ex: Predatory depreciation is a country can increase its money,supply which will cause the price of its currency to decrease. Goodsmanufactured in this country then become less expensive on theworld market, which attracts foreign investment.

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    Continued

    Finally, many countries returned to the gold standardfrom 1919 & 1928.The U.S, which replaced Great Britain as the dominant

    financial power, spearheaded efforts to restore the goldstandard.In 1919, the U.S was able to lift restrictions on goldexports with mild inflation.In Great Britain, Winston Churchill played a key rolein restoring the gold standard in 1925.

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    Besides Great Britain, the countries like Switzerland,France & Scandinavian countries restored the goldstandard by 1928.The International gold standard was not much

    popularized after World War I, because most of thecountries gave priority to stabilization of gold by matchinginflows with outflows of gold by reduction & increases indomestic money and credit.

    Federal Reserve Bank & Bank of England also followedthe policy of keeping gold outside the domestic market.Due to this policy, countries not having gold Standard &political support has been ruled out and gold standard was

    unable to work properly.

    Continued

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    Images of Post War Germany

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    The Great Depression

    The restored gold standard was destroyed in the wake ofGreat Depression & accompanying financial crisis.In 1929 after the stock market crash banks in Austria,

    England ,and The United States experienced large declines inportfolio values, touching off runs on the banks.Britain experienced a massive outflow of gold reserves &chronic BOP , which made to lose confidence in pound,

    which ended its use from international level.Despite coordinated international efforts to rescue to pound,British gold reserves continued to fall and impossible tomaintain gold standard in Britain.

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    Continued.

    In September 1931, British government suspended goldand pound to float.

    Canada, Sweden, Austria, Japan and the US got off goldbetween 1931 1933.

    France abandoned the gold standard in 1936 because offlight from franc and paper standard came into force at

    International Markets.In sum, interwar period was characterized by economicnationalism, halfhearted attempts, failure of gold reserves,flight, bank failure & nothing was materialized.

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    Bretton Woods System

    (1945 1972)In 1944, 44 major countries met at Bretton Woods NewHampshire to discuss international monetary policy

    The agreement was subsequently approved in 1945 by majority of

    the countries to launch a chief responsible institutions for financialindividual development projects; they are

    The International Monetary Fund (IMF)

    The International Bank of Reconstruction Development(IBRD) popularly known as World Bank

    In designing Bretton Woods System, representatives were mainlyconcerned with how to prevent the economic nationalism with

    destructive policy and how to address the interwar years

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    British Delegates led by John Maynard Keynes proposed an internationalclearing union that would create an international reserve asset calledBancorPeople Bank of China governor considered SDR because of recent turmoil.

    Countries would accept payments in bancor to settle internationaltransaction, without limit.Apart from this, countries are allowed to acquire bancor by using overdraftfacilities with clearing union.On the other hand, American delegates headed by Harry Dexter White

    proposed a currency group to member countries would make contributionand borrow to short-term Balance of Payment deficits.Finally, both the delegates desired exchange rate stability without restoringan international gold standard. So the American proposal was largely

    incorporated into the Article of Agreement of the IMF.

    British & American Solution

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    Continued.Under the Bretton Wood System:

    Each country established a par rate in relation to the US dollar. The US dollar was then pegged to gold at $35 per ounce

    Each country was responsible for maintaining their par exchangerate with the dollar with in +1% or - 1%.

    Bretton Woods System had provisions for reevaluating par ifdeviations persist.

    The US dollar was the only currency directly exchangeable forgold. Therefore, most international transactions occurred in USdollars and gold.

    Due to this, Bretton Wood System can be described as Dollar-

    Based Gold Exchange Standard.

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    Continued.

    Example:

    British

    Pound

    French

    Franc

    U.S. Dollar

    Gold

    Pegged at $35/oz.

    Par

    Value

    German

    Mark

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    Advantages of Bretton

    WoodsCountries can use both gold and foreign exchanges asmeans of payment.

    Countries can earn interest on foreign exchange reserves

    where gold dose not earn interest.Transactions costs associated with the transportation of

    gold was eliminated.

    Foreign exchange rates where very stableAmple supply of International Monetary Reserves coupledwith stable exchange rates provide an conduciveenvironment growth of international trade & investment

    throughout 1950 to 1960.

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    Collapse of Bretton Wood

    SystemProf. Robert Tiffins :Gold - Exchange System was programmed to collapse in the long-run.To avoid this, the U. S had to run balance of payment deficit (Trade

    deficit) continuously for expansion of international trade and globalexpansion.In case of perennial BOP deficit in U. S, the trade deficit persistence wouldeventually impact the public confidence in dollar because total dollar valuewill exceed total gold value.

    Due to short-run BOP deficit in U. S, can lead to crisis of confidence incurrency reserves and cause downfall of the system.Finally, the confusion in currency reserves, short-run and long-run BOPdeficit, known as the Triffin Paradox, was responsible for the collapse of

    the dollar based gold exchange system in the early 1970.

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    Continued.Downfall of Bretton Woods:

    The U. S began to experience trade deficit with the rest of theworld in 1950s, and the problem persisted into the 1960.Eventually the excess pressure on the dollar causes the BrettonWood System to collapse.The US adopts an expansionary monetary policy, which causesinflation to a hike.Foreign countries (Japan & Germany) had to make significant

    move in Forex markets to maintain their par ratios .In 1963, President John Kennedy imposes the InterestEqualization Tax (IET) on U.S purchases of foreign securities inorder to stem the outflow of dollars. The IET designed to increase

    the cost of foreign borrowing in the U.S Bond markets.

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    In 1965, the Federal Reserve introduces the US Voluntary ForeignCredit Restraint Program (FCRP) which regulated the amount inU.S firm could lend to U.S multinational companies engaged in FDI.Finally, due to IET & FCRP lent a strong impetus to the rapid

    growth of the Eurodollar market, which is transnational, unregulatedfund market.In 1970, the U.S $ was overvalued, especially relative to the Markand the Yen. As a result Germany and Japanese central banks had to

    make massive interventions in the foreign exchange market tomaintain their par values.Finally 1971, President Richard Nixon suspends the convertibilityof the U. S dollars into gold and impose 10 % import surcharge,

    which breaks to Bretton Woods System.

    Continued.

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    In December 1971, 10 major countries popularlyknown as G - 10 met at the Smithsonian Institution in

    Washington, D.C to discuss and attempt to save theBretton Wood SystemPrice of gold increased to $38 per ounceEach country reevaluated its currency against U.S $ upto

    10 %Band for exchange rate were allowed to move wasexpanded from 1 % to 2.25% in either direction.

    Smithsonian Agreement

    (1971)

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    The Smithsonian agreement lasted for a year before it wasreplaced. It is due to the following reasons; they areDevaluation in U.S $ was not sufficient to stabilize thesituation.In February 1973, the selling pressure in U.S $ was heavy,which prompting central banks around the world to buy DollarsThe price of gold was further raised from $ 38 to $ 42 perounce.By March 1973, European & Japanese currencies were allowedto float, so it lead to complete fall in Bretton Woods System.Finally, the exchange rates among major currencies like Dollar,

    Mark, Pound &Yen have been fluctuating against each other.

    Continued.

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    Flexible Exchange Rates

    Regime: Since 1973In 1976, the IMF members met in Jamaica & agreed to a newset of rules for IMS. The key elements of Jamaican Agreementinclude;

    IMF member countries and Central banks were declared and allowedto maintain floating exchange rate policiesGold was officially abandoned as the international asset. Half of theIMFs gold holding were returned to the members and other halfwere sold, to help the poor nations

    Non - oil exporting countries and less - developing countries weregiven greater access to IMF loans

    Apart from this, IMF extended assistance & loans to themember countries. The loans & assistance were provided to those

    countries follow the IMFs macroeconomic policy prescriptions.

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    Plaza Accord

    In 1980, President Reagan encouraged deficit spending andBOP deficits, which induced U.S to borrow mass amounts ofmoney from outside countries.

    Due to this, the U.S currency was experienced a majorappreciation throughout the first half of 1980.The U.S attracted large scale inflows of foreign capital withhigh interest rates, which increased demand for dollars.

    The heavy demand for dollars by foreign investors pushed thevalue of dollar in the exchange market and caused the dollar tostrengthen against other currencies.The value of U.S Dollar reached its peak in February 1985 and

    then begin to persistent downfall drift and stabilized in 1988

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    The reversal in the exchange rate trend partially reflectedthe effect of high U.S trade deficit, about $160 billion in1985The downward trend was also reinforced by concertedgovernment interventions.In February 1985, the G5 countries (France, Germany,

    Japan, UK and US) met at the Plaza Hotel in New Yorkand reached a solution called Plaza AccordIn Plaza Accord they agreed that the dollar needed to

    depreciate relative to other currencies in an effort to

    resolve the US trade deficit.

    What would happen if

    Interest Rates Reversed?

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    US Dollar to ForeignCurrencies 1980s

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    Louvre Accord

    The government of major industrial countries began to worrythat the dollar may fall too farTo address the problem of exchange rate volatility and other

    related issues, the G-7 economics (France, Japan, Germany,U.K, U.S, Italy and Canada) summit meeting was convened inParis in 1987. The meeting produced the Louvre Accord,according to which;

    G-7 countries would cooperate to achieve stability inexchange ratesG-7 countries agreed to more closely consult and

    coordinate their macroeconomic policies

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    Louvre Accord marked the inception of the managed floatingrate system under which G-7 countries would jointly involve incorrecting the exchange rate of their currencies.

    Since the Louvre Accord, exchange rates became relatively morestable for a while.During the period 1996 - 2001, the U.S Dollar generallyappreciated, reflecting a robust performance of the U.S

    economy fueled by technology boomDuring this period, foreigners invested heavily in the U.S toparticipate in the booming U.S economy and stock market.This helped the dollar to appreciate.

    Continued.

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    Exchange Agreements with no Separate Legal Tender: Countrieshave no domestic currency but use foreign currency to trade. Ex:Ecuador, Panama using $ & France, Germany & Italy using common

    currency as Euro.Currency Board Agreements: Countries peg their currency tothat of another country. Ex: Hong Kong fixed to $Other Conventional fixed Pegged Arrangements: The currency

    is peg its currency with basket of currency & allowed tofluctuate with in - 1%. Ex: China, Malaysia, India & S. ArabiaPegged Exchange Rates with Horizontal Bands: The exchangerate was fixed with bands greater than 1% Ex: Egypt & Denmark

    Current Exchange Rate

    System

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    Crawling Peg: Currency is adjusted periodically in smallpreannounce increments. Ex: Bolivia & Costa RicaExchange Rate with Crawling Bands: The currency is pegged

    to a crawling peg currency but allowed to fluctuate with thebands and that should be responded. Ex: Israel, Romania &Venezuela.Managed Floating with no Preannounce Path for Exchange

    Rates: Floating exchange rate with government interventionin the Forex markets. Ex: Algeria, Singapore & ThailandIndependent Floating: The exchange rate is fully determinedby market forces. Ex: U.K, U.S, Australia, Japan, Korea &

    Canada

    Continued.

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    In December 2001

    Forty One countries including Australia, Canada, Japan, the U.K& the U.S to allow their currencies to float independently againstother currencies

    Forty Two countries including India, Russia & Singapore adopttowards Managed Floating that combines market forces &Government intervention.Forty countries do not have their own national currencies. Ex:F

    ourteen Central & Western African countries joined withFr

    anc(i.e.) which is fixed to Euro through French Franc.Eight countries including Hong Kong & Estonia maintain towardsHard currencies like Dollar & Euro

    Re

    maining countr

    ie

    s adopt both the E

    xchange

    Rate

    Syste

    m

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    European Monetary System

    According to Smithsonian Agreement (1971) the band ofexchange rate movements was expanded from +1 or -1 % to 1to 2.25% in either direction.

    However, the members of European Economic Community(EEC) decided to narrow down the exchange rate band to +1.125 or -1.125 % for the currenciesThe scaled down, European version of the fixed exchange rate

    system that arose concurrently with the decline of the BrettonWoods system was called as Snake, because the EECcurrencies moved closely together within the wider bandallowed for other currencies like the dollar.

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    Finally, the snake arrangement was replaced by the EuropeanMonetary System (EMS) in 1979, which was originallyproposed by German Chancellor Helmut Schmidt with the

    following objectives; they areTo establish a Zone of Monetary Stability in EuropeTo coordinate exchange rate policies with the non EMScurrencies.

    To pave the way for the eventual European monetary union.Due to political pressure, the EMS represented a Franco-German initiative to speed up to the movement towardsEuropean economic & political unification

    Continued.

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    Finally, the EEC member countries, except the U.K andGreece joined the EMS and their main instruments of theEMS are;

    European Currency Units:ECU is a basket of currency constructed on the averageweight of European Union countries. Where, the

    weights are based on GNP and Share in intra-EU trade.Exchange Rate Mechanism:ERM refers to the procedure by which EMS membercountries collectively manage their exchange rates

    Continued.

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    During December 1991, the turbulence period inEMS, which motivated the European Union countriesto met in Netherland and signed the Maastricht Treaty

    European Union will permanently fix exchange ratesamong the member countries from January 1999 andsubsequently introduced a common currency by

    replacing individual national currencies.The European Central Bank to be located inFrankfurt, Germany will be solely responsible forcommon currency and conducting monetary policy.

    MaastrichtTreaty

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    European Monetary Union

    Advantages of a Common Currency:Reduced in transaction costs and elimination of Forex riskCreate a continental capital market with increased liquidity

    Disadvantages of a Common Currency:

    Loss of Independent Monetary & Exchange Rate Policy: Membercountries can no longer stimulate their economies by depreciatingtheir currency. This severely limits the action a country can take intimes of recession.

    Risk of Asymmetric News: The success of any common currencywill depend on how well member countries deal with economicshocks that effect only one country. Therefore, in times of recessionthe limitations of a common currency will not serve the benefit. So,

    there is a risk of recession for common currency.

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    On 20th Dec. 1994, the Mexican government under new President ErnestoZedillo announced its decision to devaluate the peso against $ by 14 %Due to this, there was a sudden stampede to sell pesos as well as Mexicanstocks & Bonds

    In early January 1995 the peso fell against the U.S$ by 40 %. So, theMexican government forced to float the peso.The international investors reduced their holdings of emerging marketsecurities, the peso crisis rapidly spillover to other Latin America & Asianfinancial markets.

    At the verge of global meltdown, the Mexican Govt. was supported byClinton administration contributed ($20 Billion) with IMF & BIS ($17.8& $10 Billion), put together $ 53 billion package to bail out Mexico.Finally, 31st January, the world & Mexico Financial market beganstabilized.

    The Mexican Peso Crisis

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    ContinuedMexico was on a crawling peg to the dollar, which allowed the upperband or increase daily at a pre announced amountNAFTA problem was breaking down trade barriers and US companieswere moving into Mexico

    Increased Exports & Demand for Mexican products cause prices inMexico to increase.Their pegged ratio system did not allow exchange rates to adjustquickly enough. So, the real exchange rate had to stabilize & should be

    hiked, which would cause foreign investors to realize large lossesApart from this, the presidential candidate was assassinated, which leadto the mass sale of Pesos.Due to world financial markets are becoming more integrated, this typeof contagious financial crisis is likely to occur more often.

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    Lessons Emerged in Mexican

    Peso CrisisFirst, it is essential to have a multinational safety net inplace to safeguard the world financial system from the

    peso-type crisis, where No single currency orinstitution can handle a potentially global crisis alone.

    Second, the Mexico excessively depends on foreign

    portfolio capital to finance its economic development.Due to this, there was a high domestic inflation andovervalued the peso, which hurt Mexicos tradebalances.

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    Fixed Vs. Floating Rates

    Correction of Trade Deficits:Currently the United State is supporting a large trade deficit especiallywith respect to China. This means there is an excess supply of dollarson the world market.

    Floating Rate System:under the floating rate system the excess supply of dollars on themarket cause a depreciation in the value of the dollar. As the value ofthe dollar declines foreign imports to the US become more expensiveand US exports become less expensive thereby reducing the tradeimbalance.

    Fixed Rate System:Under the fixed rate system China would be required to maintain itspar ratio to the USD. In this case, China would have to buy up theexcess supply of dollars on the FX market or depreciate their owncurrency by increasing the supply of Yuan on the global market. Theforced maintenance of the FX ratio would cause prices to correct and

    the trade imbalance to resolve.

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    Currency Board Agreement

    One way to avoid the Peso/Asian currency crisis is to implement aCurrency Board Agreement. This is a strictly fixed exchange rates inwhich a countries currency is fully backed by the US dollar.The idea is that both prices & exchange rates are stable. Therefore, therewould be no advantage to operating in Argentina as opposed to the US.

    Argentina:Maintained a currency board agreement though 2002Due to dot com boom the USD strengthened relative to other currenciesThis means that the Argentinean Peso also strengthened relative to other

    currencies. This reduced demand for Argentinean exportsArgentina abandon the currency board agreement leading to soaringinflation and unemployment around 20%Having borrowed heavily against the dollar, eventually Argentinas

    government defaulted on its internal and external debt

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