2024 Lecture 3
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Title Slide
University of Ljubljana
SEB, School of Economics and Business
International Business Environment 2024-2025
Lecture 3: Global Financial Environment
Professor: Mojmir Mrak
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Outline of Lecture
Exchange Rates
Foreign Exchange Market
The Balance of Payments
The International Monetary System and Changes in Global Economic Governance
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Multinational Business Finance
Textbook: Multinational Business Finance 14th Edition
Authors: Eiteman, Stonehill, Moffett
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Definition of Exchange Rates
Price of one country’s currency in terms of another currency.
Considered the most important relative price in the economy.
Types of Exchange Rate:
Nominal bilateral exchange rate
Real bilateral exchange rate
Effective exchange rate
Real effective exchange rate
Classifications of Exchange Rate Regimes:
De-jure (official classification)
De-facto (actual implementation)
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IMF Classification of Currency Regimes
Effective since January 2009:
Category 1: Hard Pegs (e.g., dollarization)
Category 2: Soft Pegs (fixed exchange rates with five subcategories)
Category 3: Floating Arrangements (market-driven with government intervention)
Category 4: Residual (doesn’t fit other categories)
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IMF Exchange Rate Classifications
Hard Pegs
Soft Pegs: Conventional pegged arrangements, stabilized arrangements, and intermediate pegs.
Floating Arrangements: Free floating, residual categories.
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Exchange Rate Definitions
Floating Arrangements: Market determined, can be free floating.
Residual: For exchange rates that don’t meet the criteria for other categories.
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Taxonomy of Exchange Rate Regimes
Fixed vs Floating:
Fixed (pegged) arrangements
Floating arrangements (market driven)
Intermediate or Crawling Peg: Combines aspects of both regimes.
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Fixed Versus Flexible Exchange Rates
Choice reflects national priorities (inflation, unemployment, interest rates, trade balances, economic growth).
Can change over time as priorities shift.
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Advantages of Fixed Rates
Stability in international prices.
Anti-inflationary nature.
Challenges of maintaining sufficient reserves and consistency with economic fundamentals.
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Determinants of Exchange Rate Regime Choice
Size of country, openness, economy diversification, trade concentration, inflation rates, policy maker credibility.
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Attributes of the “Ideal” Currency
Three attributes: Exchange rate stability, full financial integration, monetary independence.
Impossible to achieve all simultaneously (Impossible Trinity).
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The Impossible Trinity Explained
Illustration of the trade-offs among exchange rate stability, monetary independence, and full financial integration.
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Euro: The European Single Currency
Maastricht treaty in early 1990s aimed to create a single currency in Europe—Euro.
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Preparation for EMU
Convergence criteria established for member countries regarding inflation, interest rates, fiscal deficits, and government debt.
Establishment of the European Central Bank (ECB).
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Effects of the Euro
Reduced transaction costs.
Decreased currency risks.
Improved price transparency and competition.
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Monetary Unification and Value Stability
Purchasing power maintenance as a goal.
Inflation control essential for euro stability.
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Currency Boards
Commitment to back domestic currency supply with foreign reserves.
Example: Argentina's transition to a currency board in 1991, later ended in 2001.
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Dollarization
Use of U.S. dollar as official currency (e.g., Panama, Ecuador).
Reduced dependence on domestic monetary policies.
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Currency Regime Difficulties for Emerging Markets
Common features leading to hard peg or free-floating regimes due to weak institutions and capital vulnerability.
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Regime Choices for Emerging Markets
Free-floating regime vs Currency board or dollarization: comparison of risks and benefits.
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Foreign Exchange Market Overview
Introduced again as part of the multinational business finance discussion.
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Functions of the Foreign Exchange Market
Transfer purchasing power, provide credit, minimize exchange rate risk.
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Structure of the Foreign Exchange Market
Rapidly changing due to electronic platforms and increasing liquidity.
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Global Currency Trading Timings
Overview of major overlapping trading periods.
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Market Participants
Categories: banks, individuals, speculators, central banks, brokers.
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FX Market Transactions
Types: Spot, Forward, Swap transactions.
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Size of the Foreign Exchange Market
April 2022 BIS survey: daily turnover of $7.5 trillion driven by electronic trading.
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Currency Trading Instruments
Breakdown of turnover by instruments and trends over time.
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Foreign Exchange Rates and Quotations
Definition of foreign exchange rate and importance of quotations.
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Quotations Format
Currency symbols and ISO codes usage.
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Bid, Ask, and Midpoint Quotes
Explanation of trading quotes using examples.
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The Balance of Payments (BOP)
Importance of BOP data for governance and MNEs; indicates economic competitiveness.
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BOP Accounting Fundamentals
Credits (inflows) vs Debits (outflows).
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BOP Balancing
BOP must balance; disequilibrium suggests miscalculations.
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BOP Accounts
Major accounts: current account, capital account, financial account, official reserves, net errors and omissions.
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The Current Account
Launches including goods, services, and income categories.
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Current Account Components
Definitions and significance of merchandise trade.
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Slovenia’s BOP Current Account
Data table detailing current account performance from 2020-2022.
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Capital and Financial Accounts
Measures international transactions of financial assets, includes capital account components.
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Direct Investment
Differentiates from portfolio investment and discusses concerns of foreign control.
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Portfolio Investment
Focuses on investments not meeting the threshold of direct control.
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Slovenia’s Financial Account
Overview of data presented in the segment.
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Net Errors & Omissions
Ensures BOP balances and denotes significance of reserves.
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Causes of BOP Deficits
Categories: short-term vs long-term problems, with examples.
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BOP Disequilibrium Mechanisms
Financing and adjustment strategies outlined.
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International Monetary System Concept
Conditions for stability, effective adjustment mechanisms, and liquidity access.
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Models for International Monetary Systems
Summary of four models based on historical practices.
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Evolution of Global Monetary System
Timeline and description from classical to the emerging system.
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Gold Standard Era
Overview of the gold standard's influence on currencies pre-WWI.
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Inter-War and WWII Years
Currencies fluctuated; US dollar's unique status.
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Bretton Woods System
Establishment of IMF and world monetary regulations post-WWII.
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IMF Role Context
Support structural adjustments and promote stability post-Bretton Woods.
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Fixed Exchange Rates Period
Success of Bretton Woods, challenges leading to its end.
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Collapse of Bretton Woods
Transition to floating rates due to over-reliance on the US dollar.
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Floating Era Insights
Increased volatility post-1973 and significant currency events.
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Emerging Era Characteristics
Growth in emerging market currencies and complexities.
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Global Economic Governance
Evolution of economic governance following WWII.
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Shift to Deal-Based Governance
Changing geopolitical dynamics and the emergence of a multipolar world.
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Key Features of Deal-Based System
Characterization of new governance structures and their impacts.