QUESTIONS. 1. Explain how inflation and nationalism make it impossible for a single global currency to exist.

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1 QUESTIONS 1. Explain how inflation and nationalism make it impossible for a single global currency to exist. A global currency is practically impossible because of national sovereignty and inflation. Because of national pride, no nation wants to give up its identity and sovereignty, and this includes its national currency. Furthermore, nations do not have an identical inflation rate. As a result, the effect of inflation on the value of various currencies is uneven. It is thus not possible for any single currency to be used on a worldwide basis while maintaining constant value in all countries. 2. Why do companies involved in international trade have to hedge their foreignexchange exposure? The rationale for hedging lies in the exchange-rate fluctuation which can move significantly and erratically even within a short time. Since it is common for a customer to take some time in accepting the quoted price, placing an order, and making payment, financial loss due to exchange-rate movement can easily occur. Without a hedge, the high degree of volatility in the foreign exchange market may erode or even wipe out the amount of anticipated profit. 3. Distinguish between the spot market and the forward market. The spot market is a cash market where foreign exchange is available for immediate delivery. The forward market, on the other hand, provides companies with an opportunity to buy or sell currencies at some specified time in the future at a specified rate. 4. Should an exporter use the spot rate or forward rate for quotation? An exporter should not use the spot rate for quotation since foreign currency as payment is not received until a later date. Because there is no immediate conversion, the forward rate is the more appropriate one. The expectation in terms of interest rate inflation has already been factored into the forward rate agreed upon. 5. Is devaluation good for exports and imports? Why is the impact of devaluation usually not immediate? Devaluation is supposed to expand exports and reduce imports. When the U.S. dollar is devalued, American products become relatively inexpensive. As a result, foreigners can import more U.S. goods without having to spend more of their money. The devalued dollar however is bad for U.S. importers who will have to spend more U.S. dollars just to maintain their import level. There is a substantial time lag between the change in currency value and its impact on the physical flow of trade. The lag occurs because suppliers and buyers need time to adjust their habits and decisions before they start getting used to the new exchange rate. 6. Explain how these exchange-rate systems function: (1) gold standard, (b) par value, (c) crawling peg, (d) wide band, and (e) floating. In the case of the gold standard, each country is required to link its currency value to gold by legally defining a par value based on a specified quantity of gold for its standard monetary unit. Thus, exchange rates have fixed par values as determined by the gold content of the national monetary links. 1

2 The par value system requires a fixed exchange ratio or par value. The agreement fixes the world s paper currencies in relation to the U.S. dollar which is fully convertible into gold. As the other international currency in addition to gold, the dollar provides added reserves for stability as well as liquidity for gold and currencies. The crawling peg, a semi-fixed system, adjusts the exchange rate slowly by small amounts at any point in time on a continuous basis to correct for any overvaluation and undervaluation. The continuous but small adjustment mechanism was designed to discourage speculation by setting an upper limit that speculators could gain from devaluation in one year. The purpose of the wide band is to compensate for the rigidity of the fixed-rate systems (which allow only small margins of fluctuation on either side of parity) by allowing the currency value to fluctuate, say, 5 percent on each side of the par. The more flexible movement warns speculators of the more adverse consequence when their guess about the direction of the exchange rate proves to be wrong. In the case of floating, a currency is allowed to seek its own value based on the demand, supply, and market conditions. There is no movement limit. 7. How does a clean float differ from a dirty float? In the absence of government intervention, the float is said to be clean. The float becomes dirty when there is a central-bank intervention to influence exchange rates. 8. How can an MNC hedge or cover its foreign-exchange exposure? An MNC can hedge its foreign exchange exposure in a number of ways. One method involves the interbank market which offers spot and forward transactions. These contracts specify the purchase and sale of currencies at a certain price, either for immediate or future delivery. If the company wants a standardized contract, it may choose to buy (sell) either a futures contract or an options contract. The standardization feature provides market liquidity, making it easy to enter and exit the market at anytime. 9. How does the forward market differ from the futures and options markets? The forward market offers a contract size tailored to individual needs. It is usually limited to very large customers who deal in foreign trade. The futures (and options) market offers standardized contracts in terms of currency amount and contract months. It is open to anyone who needs hedge facilities or has risk capital with which to speculate. 10. How does inflation affect a country s currency value? Is it a good idea to borrow or obtain financing in a country with high inflation? A country s inflation reduces the country s currency value. A country with high inflation tends to have a weak currency which is usually accompanied by high interest rates. The higher interest cost does not necessarily make it an undesirable place to take out loans. As a matter of fact, inflation discourages lending but encourages borrowing, because a loan when due can be repaid with less expensive money. 11. What are leading and lagging, and how should they be employed with regard to payment and collection? 2

3 Leading and lagging have to do with the speed with which collection and payment are made. When foreign currencies are rising against the U.S. dollar, a U.S. firm should make immediate payments to foreign creditors (i.e., leading). Furthermore, it probably should hasten collection of debts (in dollars) from abroad. On the other hand, if the dollar is rising in value, it should delay making payments to foreign creditors (i.e., lagging). DISCUSSION ASSIGNMENTS AND MINICASES 1. Should the world abolish all local currencies except the U.S. dollar, which would function as a global currency? It is not practical to abolish all local currencies except the U.S. dollar. It is virtually impossible for the U.S. dollar to function as the global currency. Just like the American public s resistance to embrace other currencies (and the metric system), other nations also resist replacing their national currencies with the U.S. dollar. In addition to the problem of national pride, inflation presents another insurmountable obstacle to the creation of a world currency. Nations do not have an identical inflation rate, resulting in an uneven effect on the purchasing power of local citizens. It is thus extremely unlikely for any single currency to be used on a worldwide basis while maintaining constant value in all countries. 2. Should the world adopt a basket of the five or ten leading currencies (e.g., U.S. dollar, Japanese yen, Swiss franc, etc.) as a global currency for international trade? The assignment is similar to the previous one. The main difference of the two assignments is that, instead of having one national currency to be used as a global currency, there is a new currency designed specifically for this purpose based on a basket of several leading currencies. This may solve some of the problems mentioned above by increasing flexibility. Still those problems are not completely eliminated. There is also a problem of agreeing on the currencies to be used for this purpose. In addition, by trying to construct something intended for everyone, a compromise will have to be reached, resulting in something that does not fit the need of all countries exactly. As commented by Sir Kit McMahon, Chairman and Group Chief Executive of Midland Bank, we will never have one dominant currency or country; we will have an oligopolistic situation forever." He felt that there would be two major currency blocs (led by Japan and the United States) around which countries would cluster. Furthermore, baskets of commodities and SDRs may develop into useful reference points, but nothing more. Commenting on whether the EU might develop into a currency bloc having its own external reserve currency and central bank, Sir Kit believed that it would not because no country would yield sovereignty to the required degree and because the markets would not allow it. "I don't think a finance minister will be able to convince the markets for many decades that his national currency cannot be dislodged from the general currency." 3. Should European firms insist on the euro for all buying as well as selling transactions? It is neither sound nor practical for European firms to insist on the euro for all buying and selling transactions. To do so would make it convenient for European companies--at the expense of their customers/suppliers. To use the euro for invoicing purpose means shifting the foreign 3

4 exchange risk to their customers/suppliers, something which they are not likely to appreciate. This in turn will eliminate many foreign firms from wanting to do business with their European counterparts. 4. Japan has aggressively pursued the lower yen value. Is this strategy good for Japan? The action has two sides that must be addressed. Whether the lower yen value is good for Japan depends on the nation's particular objective. If Japan elects to pursue the goal of full employment, the lower yen rate is preferred because this rate makes it easier for foreign firms to buy from Japan. The other side of the balance, however, is also important. If Japan's goal is to maximize consumer welfare, this strategy is harmful. The devalued yen makes imported goods more expensive, resulting in Japanese consumers having to pay more just to maintain the same level of purchase and consumption. 5. Should the United States abandon the float in favor of the gold standard or some other type of fixed or semifixed system? It is probably not a good idea for the United States to abandon the float in favor of the gold standard or other similar systems. The gold standard is simply too simplistic. Other problems include the inability to: (1) link money supply to gold volume, (2) keep gold price stable, and (3) keep rates of inflation uniform among the industrial countries. As concluded by the Group of 10, "a return to a generalized system of fixed parities is unrealistic at the present time." The floating system has proven itself through several periods of raging inflation, deep recession, and massive money movements from oil-consuming countries to oil producers. Many observers continue to find fault with it; yet other systems have just as much, if not more, of the same flaws. At present, there does not appear to be a superior alternative that can be used. 6. Both fixed and floating rates claim to promote exchange-rate stability while controlling inflation. Is it possible for these two divergent systems to achieve the same goals? It is not logical for both fixed and floating rates to be able to promote exchange-rate stability while controlling inflation because the two systems are so divergent. Fixed rates might have been able to partially accomplish these goals at one time when conditions were favorable. But fixed rates are no longer effective because such conditions as high levels of employment and low and fairly uniform rates of inflation no longer exist today. 7. How should an MNC reduce its foreign-exchange risks? There are several financial strategies which can be used to minimize exchange risks. An MNC can hedge its foreign exchange exposure in a number of ways. One method involves the interbank market which offers spot and forward transactions. These contracts specify the purchase and sale of currencies at a certain price, either for immediate or future delivery. If the company wants a standardized contract, it may choose to buy (sell) either a futures contract or an options contract. The standardization feature provides market liquidity, making it easy to enter and exit the market at anytime. For an MNC with a network of subsidiaries, subsidiaries with strong currencies should delay or lag the remittances of dividends, royalties, and fees to other subsidiaries. Those in weak currency countries should try to lead, or promptly pay their liabilities and reduce their asset exposure. 4

5 Finally, for invoicing purpose, the invoice should use the seller's currency when the buyer is in a soft currency but the seller in a hard currency. But the buyer's currency should be used for invoicing when the buyer is in a hard currency but the seller is in a soft currency. When both the buyer and the seller are in soft currencies, they should consider a third currency as an alternative. 8. Honda was the first of the Japanese automakers to manufacture its cars in Ohio for the U.S. market. The success of its assembly plant in Marysville (Ohio) led to a plan to add a second Ohio plant. Honda also began exporting its cars from the American plant to Japan. Mazda and Mitsubishi followed suit. Other Japanese companies that export or plan to export products or components made in the United States to Japan include Hitachi, Yamaha, Fujitsu, and Sony. Politically and financially, what are the benefits of (a) manufacturing cars in the United States for U.S. consumption and (b) exporting cars to Japan? The purpose of this assignment is to emphasize the political and financial aspects of international business. There are several benefits for manufacturing Japanese cars in the United States for U.S. consumption. First, this method enables Japanese companies to overcome quotas and other protectionist measures and sentiment. Second, it minimizes the foreign exchange risks. When the yen is strong, as was the case in 1987, early 1988, 1992, and early 1995, the cost advantage of manufacturing in Japan declined. The prices of Japanese cars imported from Japan must be drastically increased to offset the eroding profits, thus making these cars less affordable to American consumers. By manufacturing these cars in the United States, the prices can be significantly divorced from the value of the yen. Furthermore, it allows Japanese firms to take advantage of local sourcing. Exporting Japanese cars from the United States to Japan also makes some sense. Once again, it is a gesture of goodwill, and it should lower the protectionist sentiment in the United States. In addition, the strategy allows Japanese firms to benefit from, instead of being hurt by, the strong yen. Japanese car buyers can benefit from the favorable exchange rate which makes the imported cars affordable. 9. International travelers often wonder why it is necessary to have so many different currencies. Obviously, it would be preferable to have just one worldwide currency that could be used anywhere on Earth. After all, the 50 states of the United States use the U.S. dollar, and most members of the European Union use the euro. If the euro can replace the mark, franc, and others, it should also be theoretically possible to have a single world currency. If not, at the least, the big three currencies (the U.S. dollar, euro, and yen) should fix the exchange rates among themselves, preferably at the rates of $1, 1 euro, and 100 yen. These currencies could form a common monetary policy that serves as the anchor for the world price level. Nobel Prize economist Robert Mundell has been advocating a new world currency that merges the dollar, euro, and yen. All currencies will then be converted into this international money. The supply of this currency will be supervised by an international board, and monetary gains from its issue will be split along the IMF quotas. As suggested 5

6 by Mundell, the name of the world currency should be the dey (dollar, euro, yen) or perhaps the intor. Is it practical to create and introduce the world currency as envisioned? Assess the likelihood of success of this universal currency. As the minicase states, Robert Mundell has organized conferences that brought economists and experts together to discuss the creation of a world currency. (See "World Money at the Palazzo Mundell," The Asian Wall Street Journal, 2 July 2003.) Technology and globalization have increasingly blurred the distinctions between national and international uses of money. Credit cards and electronic banking have replaced traditional money to some extent. As such, it can be argued that VISA and MasterCard are a form of international money that is accepted worldwide. In spite of the significant advantages of having a world currency, it is exceedingly difficult to persuade countries to abolish their national currency. After all, a national currency is a symbol of national sovereignty, not to mention an emotional sentiment attached to it. (Because of national pride, most countries do not want to abandon their national but unprofitable airlines.) It is unlikely that globalization can replace nationalism any time soon. As a matter of fact, globalization protests seem to be gathering strength. (See "Despite Trend toward Fewer Currencies, a Single World Currency Seems Unlikely in Near Future," IMF Survey, 11 December 2000,