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					CHAPTER                                             7
                              The International Monetary
                    System and The Balance Of Payments

           After studying this chapter, students should be able to:

           > Discuss the role of the international monetary system in promoting international
             trade and investment.
           > Explain the evolution and functioning of the gold standard.
           > Summarize the role of the World Bank Group and the International Monetary
             Fund in the post-World War II international monetary system established at
             Bretton Woods.
           > Explain the evolution of the flexible exchange rate system.
           > Describe the function and structure of the balance of payments accounting
             system.
           > Differentiate among the various definitions of a balance of payments surplus and
             deficit.


LECTURE OUTLINE

OPENING CASE: Will the Stars Shine on Astra Again?

      PT Astra is one of the oldest and largest conglomerates in Asia, at one point having
      employed 125,000 people. After borrowing in dollars from foreign banks, Astra's
      fortunes plummeted with the collapse of the Indonesian rupiah. A new president
      installed in 1998, Rini Soewandi, did much to turn the company around until her ouster
      in 2000. Now, with deals struck with the Indonesian Bank Restructuring Agency (IBRA)
      and the International Monetary Fund (IMF), Indonesia and Astra may again have reason
      to be optimistic.

      Key Points

         Astra was a domestically oriented firm.

         Even so, it was not impervious to international competitive issues, such as changes
          in the value of the Indonesian rupiah.

         As global competition increases, domestically protected companies face greater and
          greater challenges internally and outside of their country.
124 Chapter 7


CHAPTER SUMMARY

      Chapter Seven explores the international monetary system and the balance of
      payments. The chapter traces the history of the international monetary system
      beginning with the gold standard and ending with the current system of a managed float.
      It then goes on to examine the different accounts and balances in the balance of
      payments.

I.    HISTORY OF THE INTERNATIONAL MONETARY SYSTEM

         The international monetary system establishes the rules by which countries value
          and exchange their currencies. It also provides a mechanism for correcting
          imbalances between a country’s international payments and its receipts.
         The accounting system that governs the international monetary system is the
          balance of payments (BOP). The BOP records international transactions and
          supplies vital information about the health of a national economy and likely changes
          in its fiscal and monetary policies.

                     Teaching Note:
                     Students may find it helpful to use a timeline when discussing the
                     different exchange-rate systems that have taken place over the last
                     century.

      The Gold Standard

         The gold standard, under which countries agreed to buy and sell their paper
          currencies in exchange for gold on the request of any individual or firm, was the
          international monetary system in place in the nineteenth century.
         The gold standard had the effect of creating a fixed exchange-rate system
          because each country tied or pegged the value of its currency to gold. An
          exchange rate is the price of one currency in terms of a second currency. The par
          value of a currency is its official price in terms of gold.
         For nearly a century (from 1821 until 1918), the most important currency in
          international business was the British pound sterling; thus, the international
          monetary system was frequently referred to as the sterling-based gold standard
          during this time. Show Map 7.1 here.

      The Collapse of the Gold Standard

         As countries suffered through the economic chaos of World War I, the sterling-
          based gold standard came unraveled; however, it was readopted in the 1920s.
         In spite of its resuscitation, the gold standard ended in 1931 when Britain, under
          pressure to honor guarantees made under the system, allowed its currency to float
          (the pound’s value was determined by the forces of supply and demand).
         While some countries, primarily those in the British Commonwealth, pegged their
          currencies to the pound after the gold standard was abandoned, others linked their
          currencies to the U.S. dollar or the French franc. In addition, many countries
          engaged in a beggar-thy-neighbor policy, in which nations deliberately devalued
                        The International Monetary System and the Balance of Payments   125


    their currencies in the hope of making their goods cheaper in the world marketplace.
    Figure 7.1 should be discussed here.



The Bretton Woods Era

   In 1944, representatives of 44 countries met to construct a postwar international
    monetary system that would create an environment of worldwide peace and
    prosperity. The representatives agreed to renew the gold standard on a modified
    basis, and they created two new international organizations, the International Bank
    for Reconstruction and Development and the International Monetary Fund, to assist
    the rebuilding of the world economy and monetary system.
   The International Bank for Reconstruction and Development, also known as the
    World Bank, was established in 1945 to finance reconstruction of war-torn
    European economies, and when this was completed, focused on building the
    economies of lesser-developed nations.
   The World Bank has created three affiliated organizations: the International
    Development Association, the International Finance Corporation, and the Multilateral
    Guarantee Agency, which together comprise the World Bank Group. Show Figure
    7.2 here.
   The World Bank lends only for “productive purposes” and follows a hard loan policy
    (it makes loans only if there is a reasonable expectation that they will be repaid).
   The International Development Association (IDA) was established in response to
    criticism from poorer countries that World Bank policies favored countries well along
    the path to economic development. The IDA offers soft loans (those that bear
    significant risk of not being repaid).
   The International Finance Corporation (IFC) is charged with promoting the
    development of the private sector in developing countries, while the Multilateral
    Investment Guarantee Agency (MIGA) encourages direct investment in developing
    countries by offering private investors insurance against non-commercial risk.
   Regional development banks parallel the efforts of the World Bank as they
    promote the economic development of poorer countries within their regions. The
    text provides an example of how the Asian Development Bank and the World Bank
    coordinated their efforts to finance a hydroelectric power plant in Nepal.



    Frog Ranching in Peru
    This section describes the World Bank Group’s attempt to help poor Peruvian
    campesinos (subsistence farmers) improve their livelihood. It financed a new
    Peruvian company, Forests and Frogs, which will raise and export poison-dart frogs.
    Poor peasants are being trained to gather and nurture the amphibians’ eggs.
    Forests and Frogs believes it can double the peasants’ income once the project is
    underway.

   The International Monetary Fund. The International Monetary Fund’s (IMF)
    primary responsibility is to oversee the functioning of the international monetary
    system.
126 Chapter 7


         To join the IMF, countries must pay a deposit, called a quota. Quotas are important
          because they determine a country’s voting power within the organization, serve as
          part of a nation’s official reserves, and determine a country’s borrowing power from
          the IMF.
         A country is allowed to borrow up to 25% of its quota from the IMF. Additional
          borrowings require that countries agree to IMF conditionality.
         A Dollar Based Gold Standard. Under the international monetary system
          established at Bretton Woods, all countries agreed to peg the value of their
          currencies to gold (the dollar was pegged to gold at a value of $35 per ounce).
          Thus, the agreement was a fixed exchange rate system. In addition, the United
          States agreed to redeem the dollar for gold at the request of foreign central banks.
          In this way, the dollar played a key role in the Bretton Woods system.
         The Bretton Woods system provided a generally stable environment for international
          business because under the agreement, each country agreed to maintain the value
          of its currency within ±1 percent of its par value.
         An additional feature of the Bretton Woods agreement was an adjustable peg
          mechanism that allowed a country to alter the value of its currency in extraordinary
          circumstances. The text provides an example of the circumstances that prompted
          Great Britain to readjust the pound’s peg value in 1967.

      The End of the Bretton Woods System

         The reliance on the U.S. dollar eventually led to the downfall of the Bretton Woods
          system. Since the supply of gold did not expand in the short term, the dollar became
          the source of additional liquidity to finance expanding international trade. However,
          as foreign dollar holdings began to increase, doubt about the ability of the United
          States to live up to its Bretton Woods obligation began to rise.
         The Tiffin paradox arose because foreign banks needed to increase their holdings
          of dollars to finance expansion of international trade, but the more dollars they
          owned, the less faith they had in the ability of the United States to redeem the
          dollars for gold.
         The IMF attempted to alleviate the situation by creating an additional source of
          international liquidity, the special drawing right (SDR). The SDR, a weighted
          average of the market value of five major currencies, is used by IMF members to
          settle official transactions at the IMF.
         The SDR did not have the desired effect of reducing the glut of dollars held by
          foreigners, and by 1971, it became clear that the United States did not have enough
          gold to meet the demand of those who wanted to exchange dollars for gold. Nixon
          officially ended the system, and currencies began to float against each other.
         The fixed exchange rate system was restored at the Smithsonian Conference (see
          Table 7.1      ) in late 1971. Under the new agreement, the dollar was devalued to
          $38 per ounce of gold, and the par value of strong currencies was revalued upward.
          In addition, the band of fluctuation within which currencies were allowed to fluctuate
          was widened to ± 2.25 percent.

      Performance of the International Monetary System since 1971

         The Smithsonian agreement proved to be short-lived as central banks conceded
          they could not successfully resist free-market forces. Since 1973, many currencies
                         The International Monetary System and the Balance of Payments   127


    have operated under a flexible (or floating) exchange-rate system within which
    currency values are determined primarily by supply and demand. Occasionally, a
    central bank will intervene and affect exchange rates leading to the term “managed
    float” or dirty float. See Table 7.2 for a list of today’s most important central banks.




    Fixed versus Flexible Exchange Rates
    This box discusses how the fixed and flexible exchange rate systems each reach
    equilibrium – the fixed system through the purchase and sale of gold, the flexible
    system through changes in supply and demand (and therefore value) for a country's
    currency.

   Under the Jamaica Agreement, established in 1976, each country was free to adopt
    whatever exchange-rate system best met its requirements. Some countries (i.e., the
    United States) chose a floating exchange rate, while others opted for a fixed
    exchange-rate system by pegging their currencies to another.
   The European Monetary System (EMS) was established by EU members in 1979
    to manage currency relationships among themselves.            Most EMS members
    participate in the exchange-rate mechanism, in which participants maintain fixed
    exchange rates among their currencies (within a ±2.25 percent band) and a floating
    rate against the U.S. dollar and other currencies.
   The EMS members also created a new index currency, the European Currency
    Unit, which is a weighted “basket” of the currencies of the EU members that is used
    for accounting purposes within the EU. Map 7.2 shows the current status of the
    world's exchange rate agreements.
   While the EMS has been helpful in curbing inflation and in promoting intra-EU
    investment, it has also been adjusted 39 times because of differences in the
    monetary policies of EU members.
   The current international monetary system is based on flexible exchange rates,
    although some countries (i.e., the EU) have chosen to maintain fixed exchange-rate
    systems.
   Other Postwar Conferences. The world’s central banks meet periodically to iron
    out policy conflicts among themselves. One such meeting, the Plaza Accord (held
    in 1985), resulted in an agreement to let the dollar’s value fall. Table 7.1 can again
    be used here.
   A second meeting, the Louvre Accord, was called in 1987 to stabilize the dollar.
    Discuss Figure 7.3 here, showing the changing value of the dollar against the
    Japanese yen and German mark          .
   Because a depreciation in a firm’s home currency makes it easier for the firm to
    export, and defends it from the threat of imports, exchange rates are very important
    to firms.
   The International Debt Crisis. The international debt crisis grew out of events that
    occurred shortly after the flexible-exchange rate system of 1973 began, when Arab
    nations quadrupled the price of oil. Banks recycled the petrodollar in the form of
    loans to countries that were damaged by the rise in oil prices. However, many
    countries borrowed more than they could repay.
128 Chapter 7


         Various efforts were made to resolve the crisis. The 1985 Baker Plan stressed the
          importance of debt rescheduling, tight IMF-imposed controls over domestic fiscal
          and monetary policies, and continued lending to debtor countries in hope that
          economic growth would allow them to repay their creditors. The plan had limited
          success.
         The 1989 Brady Plan focused on the need to reduce the debts of the troubled
          countries by writing off parts of debt or providing countries with funds to buy back
          their loan notes at below face value.
         The international monetary system suffered a crisis in July 1997, when investors
          began to distrust the abilities of Thai borrowers to repay their debts. Thailand was
          forced to unpeg its currency from a dollar-denominated basket of currencies,
          resulting in a rapid deterioration in the currency’s value. The crisis quickly spread to
          neighboring countries, setting off a major international currency crisis. Discuss
          Figure 7.4 here.




          Should the IMF Bail Out countries in need?

          Overview: The Asian crisis not only affected Asian countries but also had serious
          global ramifications. Countries as far from Asia as Brazil and Russia were
          significantly affected. Is it better to let Asian countries deal with the causes of their
          economic misfortune on their own, or should the IMF help them get through the
          difficult times?

          Point: Yes, the IMF should help countries in need.
           Huge increases in unemployment justify IMF funds, even if only on humanitarian
             grounds.
           Help to Asia will keep the crisis from spreading to the rest of the world.
           Conditions imposed by the IMF will help those Asian countries accomplish
             necessary economic and political reforms.

          Counterpoint: No, the IMF should not help countries in need.
           IMF intervention distorts market forces. Governments and firms should suffer
            the consequences of their actions.
           IMF funds will be used to subsidize firms in Asian countries, hurting competing
            firms that are not eligible for such aid.
           The mere existence of the possibility of an IMF bailout may encourage
            governments to follow less rigorous economic practices.

          Answers to questions:

          1. If Indonesia had been unwilling to abandon its policies favoring firms linked to the
             Suharto family, should the IMF still have assisted the country?

                That depends on your philosophical stance toward IMF intervention. The
                Suharto family businesses alone would probably not determine whether or not
                the IMF should be involved. However, from a public relations standpoint, the
                               The International Monetary System and the Balance of Payments   129


              refusal of the Indonesian government to comply with such a basic requirement
              would have made the deal with the IMF much more difficult to bring about.

          2. If you were the official U.S. delegate to the IMF's board of governors, how would
             you have responded to Micron's complaint?

              An IMF loan is not a gift or grant. Governments must repay the loans according
              to agreed-upon terms. The Korean government is not being "given" the funds.
              Furthermore, associated with the loan are covenants that will prohibit the very
              Korean practices that have hurt Micron in the past.

          3. Some Koreans believe the IMF has taken unfair advantage of Korea's financial
              problems to force it to make concessions in its trade and FDI regulations. Do you
              agree with this complaint? Why or why not?

              Students should be given latitude to engage in a lively discussion on this point.
              There are legitimate arguments to both points of view. Ultimately, no country is
              forced to accept loans from the IMF, so, if the terms of the loans were too
              disadvantageous, the funds could simply be refused. However, given the crisis
              facing the Korean economy, the Korean government was in a vulnerable position
              and subject to being pressured into less favorable terms than otherwise would
              have been the case.

II.   THE BALANCE OF PAYMENTS ACCOUNTING SYSTEM

         The balance of payments (BOP) accounting system is a double-entry bookkeeping
          system designed to measure and record all economic transactions between
          residents of one country and residents of all other countries during a particular time
          period.
         There are several reasons why international business people should pay attention to
          the BOP. First, BOP statistics help identify emerging markets for goods and
          services. Second, they can warn of possible new policies that may alter a country’s
          business climate, thereby affecting the profitability of a firm’s operations in that
          country. Third, they can indicate reductions in a country’s foreign reserves, which
          may mean that a country’s currency will depreciate in the future. Fourth, they can
          signal increased riskiness of lending to particular countries.

          The Major Components of the BOP Accounting System

          The BOP accounting system can be divided into four major accounts: the current
          account; the capital account; the official reserves account; and the errors and
          omissions account.

          Current Account

             The current account records exports and imports of merchandise and services,
              investment income, and gifts. Table 7.3 summarizes the debit and credit entries
              for transactions involving the current account.
130 Chapter 7


               To Germany, a sale of a Mercedes-Benz automobile to a doctor in Marseilles is a
                merchandise export, and the purchase by a German resident of Dom Perignon
                champagne from France is a merchandise import. The difference between a
                country’s exports and imports of goods is called the balance on merchandise
                trade. The United States has a merchandise trade deficit because it has been
                importing more than it exports, while Japan has a merchandise trade surplus
                because it has been exporting more than it imports.
               The sale of a service (i.e., consulting services) to a resident of another country is
                a service export, while the purchase of a service by a resident of another
                country is a service import. The term trade in invisibles is also used to
                describe trade in services. The difference between a country’s export of services
                and its import of services is called the balance on services trade.
               Income (i.e., interest and dividends) German residents earn from their foreign
                investment is viewed as an export of the services of capital by Germany.
                Income earned by foreigners from their investments in Germany is known as an
                import of the services of capital by Germany.
               Unilateral transfers are gifts between residents of one country and another
                country.
               Current account balance measures the net outflow or inflow resulting from
                merchandise trade, service trade, investment income, and unilateral transfers.

          Capital Account

               The capital account records capital transactions -- purchases and sales of
                assets -- between residents of one country and those of other countries. Capital
                account transactions can be divided into foreign direct investment (FDI) and
                portfolio investment. The former is any investment made for the purpose of
                controlling the organization in which the investment is made, while the latter is
                any investment made for purposes other than control. Both types of investment
                are discussed in Chapter One. Discuss Table 7.4 here.
               Short-term portfolio investments are financial instruments with maturities of
                one year or less. Long-term portfolio investments are stocks, bonds, and
                other financial instruments issued by private and public organizations that have
                maturities greater than one year and that are held for purposes other than
                control.
               Current account transactions affect the short-term components of the capital
                account because the first entry in the double-entry BOP accounting system
                involves the purchase or sale of something, and the second entry typically
                records the payment or receipt of payment for the thing bought or sold. (See
                Building Global Skills at the end of the chapter for an example of the process.)

               Capital inflows are credits in the BOP accounting system and occur either when
                foreign ownership of assets in a county increases or when ownership of foreign
                assets by a country’s residents declines. The text provides examples of both
                situations.
               Capital outflows are debits in the BOP accounting system and occur either when
                ownership of foreign assets by a country’s residents increases or when foreign
                ownership of assets in a country declines. The text provides examples of both
                        The International Monetary System and the Balance of Payments   131


        situations. Table 7.5 summarizes the impact of various capital account
        transactions on the BOP.

    Official Reserves Account

       The official reserves account records holdings of the official reserves held by a
        national government including gold, convertible currencies (currencies that are
        freely exchangeable in world currency markets), SDRs, and reserve positions at
        the IMF.

    Errors and Omissions

       The errors and omissions account is used to make the BOP balance in
        accordance with the following equation: Current Account + Capital Account +
        Errors and Omissions + Official Reserves = 0.
       A large portion of the errors and omissions account is probably due to
        underreporting of capital account transactions. It is becoming more and more
        difficult to keep track of legal capital transactions as they become increasingly
        sophisticated and grow in volume. Other errors and omissions are deliberate
        actions and are frequently illegal. Flight capital, for example, is money sent
        abroad by foreign residents seeking a safe haven for their assets, hidden from
        the sticky fingers of their home governments.


        Ben Franklin, World Traveler
        This Bringing the World into Focus box examines the process of determining
        how much U.S. currency is held by foreigners. The box notes that current
        estimates are that 49% of U.S. currency in circulation is held by foreigners.
        These foreign holdings act as interest-free loans to the United States.

       Other errors and omissions are related to the current account, particularly
        merchandise exports and trade in services.

The U.S. Balance of Payments in 2002

   U.S. merchandise exports were $682.6 billion in 2002 (see Figure 7.5a for detailed
    breakdown    ). Automobiles and auto parts were the largest component of U.S.
    merchandise exports. Table 7.6 and Figure 7.6 give a more detailed breakdown of
    imports and exports by industry. Discuss the tables here.
   U.S. merchandise imports totaled $1,166.9 billion in 2002. The leading import was
    automobiles and auto parts. Show Figure 7.5b here.
   U.S. exports of services were $289.3 billion in 2002, with travel and tourism being
    the largest portion.
   The U.S. tends to import more goods from its major trading partners than it exports
    to them; however, it tends to export more services to them that it imports from them.
   The capital account (use Table 7.6 here   ) shows that in 2002, U.S. FDI outflows
    were $123.5 billion, while FDI inflows were $30.1 billion. New U.S. long-term
132 Chapter 7


           international portfolio investments were $25.8 billion in 2002, while new foreign long-
           term portfolio investments in the United States were $343.6 billion. The capital
           account balance was $484.8 billion in 2002, as foreigners bought more U.S. assets
           than U.S. residents bought foreign assets.
          The official reserves account transactions were $3.7 billion, and the errors and
           omissions account was $28.5 billion.

       Defining Balance of Payments Surpluses and Deficits

          When people talk about a balance of payments surplus or deficit, they are talking
           about a subset of BOP accounts. For example, a merchandise trade surplus occurs
           when a country exports more than it imports.          Other balances that are often
           mentioned include the balance on services, the balance on goods and services, the
           current account balance, and the basic balance (the sum of the current account and
           net long-term capital investment).
          The official settlements balance reflects changes in a country’s official reserves; it
           essentially records the net impact of the central bank’s interventions in the foreign
           exchange market in support of the local currency.
          Which BOP concept to use depends on the issue confronting the international
           business person or policy maker. There is no single measure of a country’s global
           economic performance. The balance on goods and services reflects the combined
           international competitiveness of a country’s manufacturing and service sectors. The
           current account balance shows the combined performance of the manufacturing and
           service sectors and also reflects the generosity of the country’s residents, as well as
           income generated by past investments. The basic balance combines current
           account transactions with long-term capital investments. The official settlements
           balance is a record of supply and demand for a country’s currency.
          Figure 7.7        shows the U.S. Balance of Payments for the past decade using
           figures for various sub-accounts.


CHAPTER REVIEW

1. What is the function of the international monetary system?

   The international monetary system establishes the rules by which countries value and
   exchange their currencies. In addition, the system provides a mechanism to correct
   imbalances that may exist between a country’s international payments and its receipts.

2. Why is the gold standard a type of fixed exchange-rate system?

   The gold standard is a type of fixed exchange-rate system because under the system, each
   country pegged the value of its currency to gold. Currencies are then exchanged using the
   stated amount of gold. The text provides an example of the process using the U.S. dollar
   and the British pound.
                               The International Monetary System and the Balance of Payments   133




3. What were the key accomplishments of the Bretton Woods conference?

   The key accomplishments of the Bretton Woods conference included an agreement to
   renew the gold standard on a modified basis and an agreement to create two international
   organizations – the International Bank for Reconstruction and Development and the
   International Monetary Fund – to assist in the rebuilding of the world economy and the
   international monetary system.

4. Why was the IFC established by the World Bank?

   The International Finance Corporation was created in 1956 to promote the development of
   the private sector in developing countries. To that end, the IFC (in collaboration with private
   investors) serves as an investment banker as it provides debt and equity capital for
   commercial activities that show promise.

5. Why are quotas important to IMF members?

   Quotas (the deposits countries pay to join the organization) are important to IMF members
   for several reasons. First, a country’s quota determines its voting power within the IMF.
   Second, a country’s quota serves as part of its official reserves. Third, quotas determine a
   country’s borrowing power from the IMF.

6. Why did the Bretton Woods system collapse in 1971?

   A key part of the Bretton Woods system was the agreement by the United States to
   exchange its currency for gold. During the 1950s and 1960s, foreigners happily held onto
   dollars. However, as their holdings increased, they began to question the ability of the
   United States to redeem their dollars for gold. After an attempt by the IMF to increase
   liquidity in the system using special drawing rights, the Bretton Woods system collapsed in
   1971 amid fears that the United States did not have enough gold on hand to meet the
   demands of those who wanted to exchange their dollars for gold.
134 Chapter 7


7. Describe the differences between a fixed exchange-rate system and a flexible exchange-
   rate system.

   Under a fixed exchange-rate system, the price of a given currency does not change relative
   to other currencies. Under a flexible exchange-rate system, currencies fluctuate according
   to supply and demand.

8. List the four major accounts of the BOP accounting system and their components.

   The four major accounts of the BOP accounting system are the current account, the capital
   account, the official reserves account, and the errors and omissions account. The capital
   account summarizes merchandise exports and imports, service exports and imports,
   investment income, and gifts for a given country. The capital account provides a record of a
   country’s capital transactions including purchases and sales of assets. The official reserves
   account provides a summary of a country’s official reserves including gold, convertible
   currencies, SDRs, and reserve positions at the IMF. Finally, the errors and reserves
   account provides a mechanism for ensuring that the BOP balances.

9. What factors cause measurement errors in the BOP accounts?

   Various factors contribute to measurement errors in the BOP accounts. It is believed that a
   large portion of the account is a result of the underreporting of capital account transactions.
   A portion of this underreporting is due in part to the growing volume of legal short-term
   money flowing between countries. Another portion of the account is due to the illegal
   activities of drug smuggling, money laundering, and the evasion of government imposed
   currency and investment controls. Errors in the current account also affect the errors
   and omissions account. The main problems reducing the accuracy of current account
   transactions typically involve merchandise exports and trade in services.

10. Identify the different types of balance of payments surpluses and deficits.

   The merchandise trade balance, which summarizes a country’s trade position in goods, is
   the most commonly referred to balance. Other balances include the balance on services,
   which records a country’s trade in services, the balance on goods and services which
   combines the balance on services and the merchandise trade balance, the current account
   balance which summarizes the activities in the current account (see Review Question 8),
   the basic balance which sums the current account balance and net long-term capital, and
   the official settlements balance which reflects changes in a country’s official reserves.


QUESTIONS FOR DISCUSSION

1. What parallels exist between the role of the British pound in the nineteenth-century
   international monetary system and that of the U.S. dollar since 1945?

   In the nineteenth century, the British pound was the most important currency in international
   business. The pound gained this status because the United Kingdom emerged at the end
   of the Napoleonic Wars as the dominant economic and military power in Europe. The
   British pound (or gold) was accepted by most companies in the settlement of transactions.
   However, after World War I, when the Great Depression affected economies worldwide,
                               The International Monetary System and the Balance of Payments   135


   Britain was unable to meet its pledges under the gold standard, and the monetary system
   ended shortly thereafter. The U.S. dollar, like the British pound, emerged as the dominant
   currency at the conclusion of World War II, when the United States held the position of a
   military and economic superpower. Individuals and companies were happy to settle their
   transactions with dollars, much as they were with the pound in earlier times. Under the new
   international monetary system established at Bretton Woods, the U.S. pledged to exchange
   its currency for gold at the rate of $35 per ounce. However, when the country found itself
   unable to meet its pledge, it ended the system in 1971.

2. Did the key role that the dollar played in the Bretton Woods system benefit or hurt the
   United States?

   It can be argued that the key role the dollar played in the Bretton Woods system benefited
   the United States because it helped the country to gain the status of a force to be reckoned
   with. Moreover, the system gave the United States veto power on important decisions, and
   a portion of each country’s deposits with the IMF were kept in the United States. On the
   other hand, it could be argued that the large depreciation in the value of the dollar that
   began at the conclusion of the system and continued into the 1980s helped to create an
   unstable domestic environment (although U.S. exporters benefited from the decline in the
   dollar’s value.

3. Under what conditions might a country devalue its currency today?

   A country might devalue its currency in an effort to help the international competitiveness of
   its exporters. A devalued dollar, for example, has the effect of making U.S. exports cheaper
   in foreign markets and foreign imports more expensive to U.S. consumers. U.S.
   automakers enjoyed a less competitive domestic environment, for example, in the early
   1990s when the U.S. dollar was very weak compared to the Japanese yen. This created a
   situation in which Japanese auto exports were not price competitive with domestically
   produced vehicles and eventually allowed U.S. producers to recapture a share of the U.S.
   market.

4. Are there any circumstances under which a country might want to increase its currency’s
   value?

   Countries may try to increase the value of their currencies in certain circumstances. For
   example, major trading partners met at the Louvre Accord in an effort to halt the decline of
   the dollar, which had plummeted almost 46% against the Deutsche mark and 41% against
   the yen in just two years. Countries were worried that any further devaluation in the dollar
   would disrupt world trade. However, for the most part, countries will be reluctant to revalue
   their currencies because a stronger currency makes exports less competitive, and imports
   less expensive. The combination of these effects creates a trade deficit.

5. Can international businesses operate more easily in a fixed exchange rate system or in a
   flexible exchange-rate system?

   Under a fixed exchange rate system, countries peg the value of their currencies to gold.
   Under a flexible exchange-rate system, supply and demand determine the value of a
   country’s currency. Many people would argue that because of the stability and predictability
   of exchange rates under a fixed system, such a system would be preferred by international
136 Chapter 7


   businesses. However, others would argue that a flexible exchange rate system would be
   preferable to international businesses because their competitiveness would not be affected
   by inflation, as it would be offset by a depreciation in exchange rates.

6. What connections exist between the current account and the capital account?

   The current account and the capital account have an inverse relationship as a result of the
   BOP double entry accounting system. Thus, if the current account is running a deficit, the
   capital account must run a surplus to offset the deficit and bring the BOP into balance. In
   the 1990s, the United States has experienced a current account deficit and a capital
   account surplus, while Japan has experienced just the opposite situation.


BUILDING GLOBAL SKILLS

Essence of the exercise
This exercise is designed to allow students to better understand the BOP concept by actually
accounting for various “transactions.” The exercise provides three examples of how the BOP
double entry system works, and then asks students to record another set of transactions.

Answers to the follow-up questions.

How will the following transactions be recorded in the U.S. BOP accounts?

1. An American entrepreneur seeking to sell souvenirs at the 2004 summer Olympics in
   Athens, Greece, pays Olympic Airlines, a Greek airline, $1400 for a New York—Athens
   round-trip ticket.

   The credit entry in this transaction affects the short-term portfolio account in the amount of
   $1400. The debit entry in this transaction is a service import of $1400.

2. The American entrepreneur instead pays United Airlines (an American airline) $1400 for a
   New York – Athens round-trip ticket.

   This transaction will not affect the U.S. BOP because the airline is an American carrier
   being used by an American national.

3. Ford Motor Company (U.S.) pays $2.5 billion for all the common stock of the Jaguar Motor
   Co. (U.K.).

   Ford is buying a long-term asset (the Jaguar Motor Co.) for purposes of control, and the
   U.K. is buying a short-term asset called “an increase of claims on foreigners or a decrease
   of foreign claims on the U.K." The U.S. BOP will reflect a debit of $2.5 billion in the foreign
   direct investment account, and a credit of $2.5 billion in the short-term portfolio account.
                               The International Monetary System and the Balance of Payments   137


4. The U.S. government gives Rwanda $500 million worth of food to feed starving refugees.

   The U.S. BOP would reflect a debit in the unilateral transfer account for the amount of $500
   million since the money is a gift, and the short-term portfolio account would show a credit for
   $500 million.

Other Applications
   Students can take this exercise to the next level by determining how each of the
   transactions listed above affects the current account, the capital account, and the overall
   balance of payments for each country in question.


CLOSING CASE

Recent U.S. BOP Performance: Is the Sky Falling?

       The closing case provides two divergent views as to how the U.S. BOP should be
       interpreted. One perspective looks at the last decade’s BOP favorably, while the other
       perspective does not.

       Key Points:

          Over the last decade, the U.S. BOP has reflected a large annual deficit in the current
           account, a large annual surplus in the capital account, and relatively small changes
           in the official reserves account.

          This BOP can be interpreted in two ways. First, that U.S. firms are uncompetitive in
           foreign markets, and foreigners are taking over the country by buying up valuable
           U.S. assets. Second, that the United States is attracting foreign investment through
           foreign country current account surpluses.

          Both views are consistent with the data.

          Those who favor the first argument believe that the United States must reduce its
           BOP deficit by following policies to make U.S. firms more competitive in foreign
           markets and by following policies to keep imported goods out.

          People who believe the second argument is true feel that the country should strive to
           do anything possible to become more attractive to foreign investors.

          It is important for companies to understand BOP statistics because they are the key
           to the type of international trade policy the United States will pursue.
138 Chapter 7


      Case Questions

      1. What is more important to the U.S. economy – exports or foreign capital inflows?

          The answer to this question depends on whether one takes the view that the last
          decade’s BOP indicates that the United States is becoming uncompetitive in foreign
          markets, or the view that the BOP indicates that the United States is in a good
          position relative to foreign rivals. Those who support the former viewpoint would
          probably argue that exports are more important to the U.S. economy, while those
          who feel that the United States is attracting investment because its prospects are
          very attractive are likely to believe that foreign capital inflows are more important.

      2. What is the connection between the U.S. current account deficit and capital account
         surplus?

          The connection between the current account deficit and the capital account surplus
          is that one cannot exist without the other; the accounts have an inverse relationship.
          In a sense then, the means by which the United States is able to run a deficit in its
          current account (by importing more than it exports) is to finance the deficit with its
          capital account.

      3. Which of the following groups is likely to endorse the “sky is falling” view of the U.S.
         BOP?
          Import-threatened firms such as textile producers
          Textile workers
          A cash-starved California biotechnology company
          Merrill Lynch
          Boeing Aircraft, one of the country’s largest exporters
          Consumers

          Import-threatened firms such as textile producers, and textile workers are likely to
          endorse the “sky is falling” perspective of the United States. A cash-starved biotech
          firm is likely to view foreign investment favorably, as is Merrill Lynch. Consumers
          probably do not endorse the “sky is falling” perspective unless they happen to be
          employed by a firm that is threatened by imported goods. Finally, export-oriented
          Boeing Aircraft is not likely to endorse a “sky is falling” perspective.

      Additional Case Application
             Instructors may wish to raise the issue of whether the BOP should be considered
             an accurate measure of economic performance for the United States or other
             service-oriented economies. The class can be divided into two groups. One
             group can be assigned responsibility for analyzing the position of the United
             States when service trade is not included in the overall BOP. The second group
             can analyze the economic well being of the United States when trade in services
             is incorporated into its economic measures. The two groups can then present
             their findings to the rest of the class.
                               The International Monetary System and the Balance of Payments   139




            Chapter 7: International Monetary System


Suggestions on incorporating the Multimedia exploration into the lesson plan

The key objectives of Chapter 7 are:

      Understanding the role of the international monetary system in promoting international
       trade and investment.
      Exploring the evolution and functioning of the gold standard.
      Summarizing the role of the World Bank Group and the International Monetary Fund in
       the post-World War II international monetary system established at Bretton Woods.
      Explaining the evolution of the flexible exchange rate system.
      Describing the function and structure of the balance of payments accounting system.
      Differentiating among the various definitions of a balance of payments surplus and
       deficit.


The following are some suggestions on how best to utilize the CultureQuest materials to
achieve these objectives.

                                            1.                 Global Business Video: Argentina
                                                 and Ecuador: Understanding the Currency
                                                 Crisis that explores the different policy
                                                 approaches undertaken by the two countries.

       Show the Video as you review the section entitled, Bringing the World into Focus:
       Fixed Versus Flexible Exchange Rates.

                                            2.                 Review the questions in class and
                                                 use the following suggested responses to
                                                 initiate class discussion.



Responses to end of the chapter CultureQuest questions (for video related sections
only)

The complete video narration for the video titled, CultureQuest: Global Business Video, is noted
at the end of this chapter guide. Please reference it for a full review of the responses to the
following questions from the textbook. Below, we’ve noted suggested answers for your quick
reference
140 Chapter 7


Textbook Question: This chapter has reviewed how the international monetary system
functions. Answer the following questions based on the materials in the chapter and the
accompanying video your instructor may choose to show you.

(Please refer to narration below and Chapter 7 in text)


1. What factors contributed to the Argentine financial crisis?

There a several key factors that led to the financial crisis:

1. High levels of national and provincial government spending beginning in the early 1990s
when the economy was stronger.

2. Pegging the currency to the US Dollar in 1991. The strong rules governing the currency
board under which the Argentine government maintained its fixed peso-dollar exchange rate
eventually subjected the country to fluctuations in the U.S. currency, as well as fluctuations in
US fiscal policy. The government of Argentina could no longer control its own monetary policy,
and subsequently it had no control over the price of its exports.

The negative effects of one-to-one parity with the U.S. dollar became apparent in 1995 when
the Mexican peso devalued, and again in 1999, when Brazil’s currency devalued as a result of
the Asian meltdown. Suddenly, Argentina’s exports, priced virtually in dollars, were overpriced
and no longer competitive. Argentina, like its neighbors, relies heavily on the export of its
goods for revenue. With Argentine products no longer competitive, revenue from exports
plummeted and unemployment soared.

2. In what ways have Argentina and Ecuador pursued different policies towards
   their currencies? Which has been more successful? Explain.

Argentina chose to peg its currency to the US Dollar in 1991. The negative effects of one-to-
one parity with the U.S. dollar became apparent in 1995 when the Mexican peso devalued, and
again in 1999, when Brazil’s currency devalued as a result of the Asian meltdown. Suddenly,
Argentina’s exports, priced virtually in dollars, were overpriced and no longer competitive.
Argentina, like its neighbors, relies heavily on the export of its goods for revenue. With
Argentine products no longer competitive, revenue from exports plummeted and unemployment
soared.

In March 2000, in what many predict could be one of the key moves to help the economy in the
long run, the dollar was implemented as Ecuador’s currency, replacing the sucre. Many
considered the move to full dollarization a structural reform to end the unstable dual-currency
system that had resulted from an earlier move to semi-dollarization.

Most observers agree that while it’s still too early to assess the full impact of dollarization, the
results so far have been positive. Inflation and unemployment rates are both improving,
although the transition process has proven a little difficult for the large number of people living
below the poverty line. Unemployment now fluctuates between 10 and 15 percent, and half the
population is estimated to be underemployed.
                                 The International Monetary System and the Balance of Payments   141


Inflation has been tamed, and the civil unrest that led to the January 2000 coup seems to have
died down. In 2001, Ecuador was the fastest-growing economy in Latin America, with GDP
expanding by 5 percent.

Despite the stabilizing effects first felt after dollarization, a number of concerns persist. Some
pundits have suggested that the impressive results are just a flash in the pan and that
sustainable growth will be much harder to achieve. They point to the economic meltdown in
Argentina as a prime example of what can go wrong in a dollarized system. Analysts say that
for dollarization to work long-term in Ecuador, the government needs to strengthen public
finances, but various plans to do so (including increasing the value-added tax and privatizing
the electricity companies) have been slow in progressing.

There is also a certain amount of unease over the effects of dollarization on the country’s many
poor people. The higher cost of basic necessities is causing problems in rural indigenous
communities, where people live an agrarian life and still buy and sell their produce in sucres.


3. What are the currency risks for an American company operating in Argentina and how
might they best manage these risks?

After months of discussion between the Argentine government and the IMF, the peso was
devalued against the U.S. dollar, falling to nearly 3 pesos per dollar in mid-2003.

Some economists have argued in favor of a system of managed floating to give the government
flexibility within a set of targets. Others believe that dollarizing the Argentine Peso at a discount
would bring back stability. For a country that prized itself on its cultural similarities to Europe,
facing large spending cuts in return for continued financial assistance from the IMF is a bitter
pill to swallow. However, with an unemployment level of 25 percent and a poverty level of 60
percent by mid-2003, Argentina may have little choice.

In May 2003, Nestor Kirchner became the default president, after the two-time former president
Carlos Menem, fearing defeat, withdrew from the race. Kirchner vowed to put Argentineans
first while taking a hard line with extremely unpopular foreign creditors. Kirchner faces some
tough economic issues, including finishing a new accord with the International Monetary Fund,
reforming a weakened banking system and renegotiating a large part of Argentina's $144 billion
foreign debt. Many are concerned that the lack of popular mandate may make it difficult for him
to garner critical political and public support.

Additional Exercises for Understanding the Currency Crisis

   1. Student Activity and Discussion:
   Have each student select a global company with operations in Ecuador and/or Argentina.

       1. Research how the company has performed in the country and how it has managed
          the currency crisis. Use the company’s website as well as business news websites.
       2. Determine whether the company should remain operating in the country and how it
          should manage its currency risk. If the company has already exited the Argentine or
          Ecuadorian market due to economic crisis, explain if you agree or disagree with the
          company’s decision to exit.
142 Chapter 7



   2. Team Activity and Discussion:

   Group students into teams of up to 4. Assign them one emerging market country. Have
   them:

       1. Research the country’s recent (past twenty years) economy.
       2. What has been the country’s approach to currency, exchange rates, fiscal and
          monetary policy? What factors have impacted the country’s economy?
       3. Has the country’s ideology changed dramatically as a result of policy successes or
          failures?
       4. What is the outlook for the country for the next 2-3 years in terms of the stability of
          its currency and strength of its economy?




Additional test questions on this information can be found in the Test Item File.




Video Narration:              Global Business Video

Argentina and Ecuador: Understanding the Currency Crisis

While fiscal policy is never far from the mind of your average Argentine, who remembers the
tough times and hyperinflation of the 1980s, the events of 2001 and 2002 have brought fiscal
policy back to the forefront of public concern. Though the early 1990s may have been
characterized by financial optimism, Argentina has been in a recession since Brazil’s 1998
monetary crisis sent shockwaves across the regional and global markets.

In early 2002, Argentina defaulted on its US$132 billion in debt. Outraged over the limits
imposed on bank withdrawals, and fed up with four years of recession, Argentines took to the
streets, calling for general strikes. The popularity of President Fernando de la Rua, who took
office in December 1999, plummeted until he was forced to step down.

Travel north to Ecuador, and you’ll encounter a very different financial perspective. In March
2000, Ecuador underwent dollarization, the process of making the US Dollar its currency. This
policy move is credited with bringing the country’s current stability and growth.

In this segment, we’ll cover the factors surrounding the economic situations in both countries:
the different foreign exchange paths and policies the countries took to address the economic
challenges, and what they mean for global businesses operating in each country.

Crisis in Argentina

First we’ll look at Argentina. To completely understand the crisis that rocked this nation, we
need to look at Argentina’s economic history and culture. The land of gauchos, the tango, and
Eva Perón, Argentina is considered by many to be the most Europeanized of all the countries in
Latin American. The clean, orderly, café-lined streets of Buenos Aires and the mannerisms of
                                 The International Monetary System and the Balance of Payments   143


the people are indicative of a country that takes great pride in its modernity as well as its
Spanish and Italian heritage.

With a population of almost 38 million in 2002, Argentina is the third-largest country in Latin
America. After its independence from Spain in 1816, more than 4 million Europeans immigrated
to Argentina. Others poured in from the Middle East, notably from Syria, Lebanon, and
Armenia. Koreans, Peruvians, Bolivians, and Paraguayans are also prominent. Italian and
German are second languages for many Argentines, though the country’s distinctive Spanish is
the principle tongue. Today, only 15 percent of Argentina’s population is mestizo. Unlike other
Latin American countries, Argentina has virtually no indigenous people or customs.

These immigrants came to Argentina in search of opportunity. As their successful offspring can
attest, many found it. Despite the economic tumult of the late ’90s, Argentina boasts Latin
America’s largest middle class and the highest per capita GDP in Latin America. However,
since 1997, the country has been in a steep recession that has sent many middle-class
Argentines back into the ranks of the poor.


Boosting Exports

Through the early ‘90s, Argentina was the sweetheart of Latin American economies. The
economic situation looked good in the early 1990s, largely due to the reforms of the
government of President Carlos Menem, who managed to pull his country through the extreme
economic hardships and hyperinflation of the ‘80s. State enterprises were privatized, and
Argentina modernized, rebuilding its social and transportation infrastructure, its water and
sewer systems, and cooperating with formerly state-owned corporations in the fields of
electricity, oil, gas, and telecommunications. Foreign direct investment in Argentina flourished.

 Argentina pegged its currency to the dollar in 1991, curbing hyperinflation and creating an
economic boon. Presidente Menem was credited with implementing free-market reforms,
opening the borders to more trade and restructuring monetary and economic policies. Better
trade policies capitalized on Argentina’s natural resources, which include an agriculturally based
export sector focusing on wheat, meat, corn, oilseed, manufactured goods, and oil. As the
economy flourished, national and provincial government spending skyrocketed. Many believe
that government spending contributed to the economic crisis.

Unfortunately, the strong rules governing the currency board under which the Argentine
government maintained its fixed peso-dollar exchange rate eventually subjected the country to
fluctuations in the U.S. currency, as well as fluctuations in US fiscal policy. The government of
Argentina could no longer control its own monetary policy, and subsequently it had no control
over the price of its exports.

The negative effects of one-to-one parity with the U.S. dollar became apparent in 1995 when
the Mexican peso devalued, and again in 1999, when Brazil’s currency devalued as a result of
the Asian meltdown. Suddenly, Argentina’s exports, priced virtually in dollars, were overpriced
and no longer competitive. Argentina, like its neighbors, relies heavily on the export of its
goods for revenue. With Argentine products no longer competitive, revenue from exports
plummeted and unemployment soared.
144 Chapter 7


The policies and practices of the then-President Fernando de la Rua, which included strong-
arming the banks into buying government bonds, triggered a widespread bank-run, and
Argentines withdrew over $15 billion between July and November 2001. The country’s default
on public debt in December 2001 combined with unpopular policies led to De La Rua’s
resignation. Over the next four months, the country went through five presidents, culminating in
Eduardo Duhalde’s election.

Duhalde imposed new restrictions on the foreign exchange markets that were unsuccessful.
Further, the IMF frowned on the way provinces were being allowed to issue their own parallel
currencies to make government payrolls. After months of discussion, during which the central
bank promised, yet failed, to take control of the economy, the IMF and Argentine officials began
to negotiate a bailout package. Eventually, the peso was devalued against the U.S. dollar,
falling to nearly 3 pesos per dollar in mid-2003.

Some economists have argued in favor of a system of managed floating to give the government
flexibility within a set of targets. Others believe that dollarizing the Argentine Peso at a discount
would bring back stability. For a country that prized itself on its cultural similarities to Europe,
facing large spending cuts in return for continued financial assistance from the IMF is a bitter
pill to swallow. However, with an unemployment level of 25 percent and a poverty level of 60
percent by mid-2003, Argentina may have little choice.

In May 2003, Nestor Kirchner became the default president, after the two-time former president
Carlos Menem, fearing defeat, withdrew from the race. Kirchner vowed to put Argentineans
first while taking a hard line with extremely unpopular foreign creditors. Kirchner faces some
tough economic issues, including finishing a new accord with the International Monetary Fund,
reforming a weakened banking system and renegotiating a large part of Argentina's $144 billion
foreign debt. Many are concerned that the lack of popular mandate may make it difficult for him
to garner critical political and public support.

Ecuador

Although small in size, Ecuador is a picture of diversity. The Andes run through the country
north to south, bringing a spectacular variety of climatic conditions. Ecuador’s people and
culture are equally diverse, with nearly as many Indians as mestizos and nearly as many blacks
as whites. The largest cities are sophisticated, while dozens of rural communities struggle for
survival without the basic necessities. Presiding over all of this is a fragile government run by
the sixth president since 1996, searching for solutions to the country’s economic problems —
large and small.

With a population of around 13 million, Ecuador is the eighth most populous country in Latin
America. It has just a million more inhabitants than Guatemala and 2 million fewer than Chile.
Sixty percent of Ecuadorians live in urban areas, all of which are located in the coastal lowlands
and the central highlands. Some 2.7 million live in Ecuador’s commercial center, the steamy
southern port city of Guayaquil, and 1.8 million live in the capital city, Quito, high in the Andes.

Most of Ecuador’s rural dwellers are indigenous people. It’s difficult to break down the
population into ethnic groups, partly because the last official census was in 1990. Some
estimates put the mestizo population at 55 percent and the indigenous at 25 percent, while
others place the two groups equally at 40 percent each. About 15 percent of Ecuadorians are
                                 The International Monetary System and the Balance of Payments     145


white, and around 5 percent are black, although some figures put the black population at about
10 percent of the total. There are also a small number of people of Asian descent.

Ecuador has never been a wealthy country, and the political instability of recent years has
exacerbated the massive inequality that has characterized the society since colonial times.
Most of the wealth is in the hands of a white elite, who live sophisticated lives in the large cities,
eating in fancy restaurants and flying off to Miami for shopping trips. Indeed, Quito looks much
like any other modern industrialized city, complete with cinemas, fast-food restaurants, Internet
cafés, and shopping malls.

But while the rich enjoy an enviable lifestyle, the vast majority of the country’s large indigenous
population lives in extreme poverty. Eight out of ten rural households live below the poverty line,
and four out of 10 are unable to meet basic nutritional requirements. Running water and
sewage systems reach a paltry 40 percent of households, and only half of Ecuador’s teenagers
go to school. Although official unemployment figures show a small drop in the jobless rate in
recent years, more than half the population is underemployed.

The disparity in wealth distribution and the lack of viable jobs have caused more people,
particularly children, to join the “informal economy.” Hundreds of itinerant peddlers pepper the
streets of the country’s cities, selling chewing gum, candy, cigarettes, and flowers, hoping to
scrape together enough money for something to eat.

Various international aid programs attempt to alleviate the poverty blighting so many
Ecuadorians, but a lot depends on the country’s government. Corruption is endemic in the
political system, which is run largely by the white elite, so progress is forecast to be slow.

Like many Latin American nations, Ecuador is struggling economically despite abundant natural
resources. Its economy has traditionally been agrarian, and banana exports drove its economy
through the second half of the last century. Petroleum took over as the country’s biggest export
in the 1970s, and by the early 1980s, oil accounted for more than half of Ecuador’s export
earnings.

The fall in oil prices in the 1980s hit Ecuador hard, compounding the damage caused by floods
in 1982 and 1983 and the severe disruption in the country’s agricultural production and exports,
particularly bananas and coffee. The devastating earthquake of 1987 wiped out much of
Ecuador’s only oil pipeline, pushing the economy into full-scale meltdown.

While the country still relies on oil and is the world’s biggest exporter of bananas, other major
exports, like shrimp, have dropped in recent years and inflation is on the rampage. In 1999,
Ecuador’s inflation was the worst in Latin America, at 60 percent.

Dollarization

In March 2000, in what many predict could be one of the key moves to help the economy in the
long run, the dollar was implemented as Ecuador’s currency, replacing the sucre. Many
considered the move to full dollarization a structural reform to end the unstable dual-currency
system that had resulted from an earlier move to semi-dollarization.

When President Jamil Mahuad first broached the idea of dollarization in 1999, it was extremely
unpopular. Indeed, opposition to the idea helped motivate the indigenous people who triggered
146 Chapter 7


the January 2000 coup, that cost Mahuad his term in office. They realized that, as the country’s
poorest people, they had the most to lose from the dollarization process. The price of seed,
fertilizer, and insecticide would be sure to rise, while their incomes would not.

Despite the resistance to Mahuad’s plans to change the currency, his successor, President
Gustavo Noboa, followed through on them, and, although it’s still too early to assess the full
impact of dollarization, the results so far have been positive. Inflation and unemployment rates
are both improving, although the transition process has proven a little difficult for the large
number of people living below the poverty line. Unemployment now fluctuates between 10 and
15 percent, and half the population is estimated to be underemployed.

Inflation has been tamed, and the civil unrest that led to the January 2000 coup seems to have
died down. In 2001, Ecuador was the fastest-growing economy in Latin America, with GDP
expanding by 5 percent.

Despite the stabilizing effects first felt after dollarization, a number of concerns persist. Some
pundits have suggested that the impressive results are just a flash in the pan and that
sustainable growth will be much harder to achieve. They point to the economic meltdown in
Argentina as a prime example of what can go wrong in a dollarized system. Analysts say that
for dollarization to work long-term in Ecuador, the government needs to strengthen public
finances, but various plans to do so (including increasing the value-added tax and privatizing
the electricity companies) have been slow in progressing.

There is also a certain amount of unease over the effects of dollarization on the country’s many
poor people. The higher cost of basic necessities is causing problems in rural indigenous
communities, where people live an agrarian life and still buy and sell their produce in sucres.
Development activists say they would like to see more government money spent on antipoverty
programs in the wake of dollarization.
Ecuador’s main trading partner is the United States, followed by other Latin American countries,
Japan, and many European countries.

Global businesses operating in these countries will find that the economies remain fragile.
Argentina, once considered a model country for regional economic success, is being forced to
reinvent its financial policies. Ecuador, currently in a state of steady progress, must hope to
elude the problems of Argentina’s economic crisis. The long-term effectiveness of
dollarization, and the future of these two countries, remains to be seen.

In this segment, you’ve learned that:

   1. Argentina’s economic crisis was the result of two core problems – an overvalued
      currency and overspending by the government.
   2. Ecuador dollarized its currency in 2000 and has been experiencing improving economic
      and social results bringing much needed stability and growth.
                                 The International Monetary System and the Balance of Payments     147




            Chapter 7:
Test Questions


1. Which statement best describes dollarization.

   a.   Adopting the US Dollar as a country’s national currency.
   b.   Pegging a country’s currency to the US Dollar
   c.   Pegging a country’s currency to gold.
   d.   Fixing a country’s currency to a U.S. Dollar-based gold standard.

   A. Dollarization is the process of making the US Dollar its currency.

2. Compare and contrast the two different approaches of Argentina and Ecuador to their
   currency crisis.

Argentina chose to peg its currency to the US Dollar in 1991. The negative effects of one-to-
one parity with the U.S. dollar became apparent in 1995 when the Mexican peso devalued, and
again in 1999, when Brazil’s currency devalued as a result of the Asian meltdown. Suddenly,
Argentina’s exports, priced virtually in dollars, were overpriced and no longer competitive.
Argentina, like its neighbors, relies heavily on the export of its goods for revenue. With
Argentine products no longer competitive, revenue from exports plummeted and unemployment
soared.

In March 2000, in what many predict could be one of the key moves to help the economy in the
long run, the dollar was implemented as Ecuador’s currency, replacing the sucre. Many
considered the move to full dollarization a structural reform to end the unstable dual-currency
system that had resulted from an earlier move to semi-dollarization.

Most observers agree that while it’s still too early to assess the full impact of dollarization, the
results so far have been positive. Inflation and unemployment rates are both improving,
although the transition process has proven a little difficult for the large number of people living
below the poverty line. Unemployment now fluctuates between 10 and 15 percent, and half the
population is estimated to be underemployed.

Inflation has been tamed, and the civil unrest that led to the January 2000 coup seems to have
died down. In 2001, Ecuador was the fastest-growing economy in Latin America, with GDP
expanding by 5 percent.

3. True or False.

Dollarization is the best way for countries to fix their currency problems.

False. Despite the stabilizing effects first felt after dollarization, a number of concerns persist.
Some pundits have suggested that the impressive results are just a flash in the pan and that
sustainable growth will be much harder to achieve. They point to the economic meltdown in
Argentina as a prime example of what can go wrong in a dollarized system. Analysts say that
for dollarization to work long-term in Ecuador, the government needs to strengthen public
148 Chapter 7


finances, but various plans to do so (including increasing the value-added tax and privatizing
the electricity companies) have been slow in progressing.

There is also a certain amount of unease over the effects of dollarization on the country’s many
poor people. The higher cost of basic necessities is causing problems in rural indigenous
communities, where people live an agrarian life and still buy and sell their produce in sucres.


4. Immigrant groups from which of the following regions came to Argentina in the past century?

   a.   Europeans
   b.   Middle Easterners
   c.   Neighboring Latin Americans
   d.   All of the above.

D. All of the above. After its independence from Spain in 1816, more than 4 million Europeans
immigrated to Argentina. Others poured in from the Middle East, notably from Syria, Lebanon,
and Armenia. Koreans, Peruvians, Bolivians, and Paraguayans are also prominent. Italian and
German are second languages for many Argentines, though the country’s distinctive Spanish is
the principle tongue. Today, only 15 percent of Argentina’s population is mestizo. Unlike other
Latin American countries, Argentina has virtually no indigenous people or customs. These
immigrants came to Argentina in search of opportunity.




Resources for additional information


http://www.intracen.org/index.htm – The International Trade Centre (ITC) is the technical
cooperation agency of the United Nations Conference on Trade and Development (UNCTAD)
and the World Trade Organization (WTO) for operational, enterprise-oriented aspects of trade
development.
http://www.aworldconnected.org/index.php – A project of the Institute for Humane Studies at
George Mason University, a non-profit educational organization that promotes innovative
thinking about globalization

http://www.worldbank.org/search.htm -- search by country to see impact of fiscal and monetary
policy on both countries

www.imf.org – search by country to see impact of fiscal and monetary policy on both countries

http://www.cato.org/current/argentina/index.html – review of Argentine crisis

http://www.coha.org – research and information organization focusing on regional issues

http://www.countrybriefings.com/?showPage&PAGE=atmaGlobal.tml&RID=4196 – current
economic information on major economies around the world

www.time.com – search by country to see impact of fiscal and monetary policy on both
countries
                               The International Monetary System and the Balance of Payments   149


www.economist.com – search by country to see impact of fiscal and monetary policy on both
countries
www.worldinformation.com – overview per continent/region; current events; trade, etc.

www.nationsonline.org – general information on countries/regions/continents; history, business
and finance information

www.latinamericalinks.com – information on Latin America (i.e., business, sociology, etc.)

www.nationbynation.com – information on geography, history and people of each country

www.culture-quest.com – business and cultural information on countries and regions around
the world

				
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