Multinational Financial Management, Study Guide, 6th Edition Solution Manual
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CHAPTER 1: INTRODUCTION 1 CHAPTER 1 INTRODUCTION Chapter 1 emphasizes the internationalization of business and economic activity that has occurred since the end of World War II. Although international business activities have existed for centuries, primarily in the form of exporting and importing, only in the postwar period have multinational firms become preeminent. The distinguishing characteristic of the MNC is its emphasis on global, rather than affiliate, performance. Specifically, MNCs ask, “ Where in the world should we build our plants, sell our products, raise capital, and hire personnel? ” Thus the true MNC is characterized more by attitude than the physical reality of an integrated , global system of marketing and production activities. It involves looking beyond the boundaries of the home country and treating the world as “ our oyster. ” After stimulating student interest with this vision of the MNC, I then introduce the financial decisions that MNCs must make. I begin by discussing the key concepts and lessons from domestic finance that apply directly to international corporate finance. The lessons include the empha sis on cash flow rather than accounting earnings, the time value of money, the importance of taxes, and the unwillingness of investors to reward companies for activities (like corporate diversification) that investors could replicate for themselves at no greater cost. The key concepts, which I point out will arise time and again in the course, are arbitrage, market efficiency, and the separation of risk into systematic risk, which must be rewarded, and unsystematic risk, which is not rewarded. The latter concept, of course, is the intuition underlying both the capital asset pricing model (CAPM) and the arbitrage pricing theory (APT). Although imperfect, the theoretical framework of domestic corporate finance provides a useful frame of reference, and understanding it is essential before proceeding with the more complex aspects of international financial management. I devote some time to explaining that total risk matters, even if the CAPM or APT holds. Otherwise , the astute student will see a conflict between the irrelevance of unsystematic risk and hedging activities. I then outline the key decision areas in international financial management: foreign exchange risk management, managing working capital and the internal financial system, financing foreign units, capital budgeting, and evaluation and control. I emphasize the additional parameters that MNC financial executives must cope with, including multiple currencies, rates of inflation, tax systems, and capital markets, as well as foreign exchange and political risks.
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INSTRUCTORS MANUAL: FOUNDATIONS OF MULTINATIONAL FINANCIAL MANAGEMENT , 6TH ED. 2 SUGGESTED ANSWERS TO “THE DEBATE OVER OUTSOURCING” 1. What are the pros and cons of outsourcing? A NSWER . P ROS : Outsourcing enables Americans to buy services less expensively abroad , increases U.S. productivity , and enables U.S. companies to cut their costs while improving quality, time to market, and capacity to innovate . It also allows the U.S. to use its comparative advantage in financial , managerial, and technical services by specializing in and exporting such services as higher - end computer programming, management consulting, engineering, banking, telecommunications, and legal work. C ONS : As with any kind of tr ade, importing of serv ices through outsourcing results in the loss of jobs for Americans previously employed in providing those services. Outsourcing may also cause U.S. companies that provide these services to go out of business . 2. How does outsourcing affect U.S. consumers? U.S. producers ? A NSWER . As the answer to part a) points out, outsourcing allows companies to buy services less expensively abroad. Competitive pressures force companies to pass these savings along to consumers in the form of lower - priced goods and services. U.S. producers are able to boost productivity and cut costs while improving quality, time to market, and capacity to innovate. As such, American companies are better able to compete. This competition, however, forces companies to pass most of their savings from outsourcing through to their customers. 3. Longer term, what is the likely impact of outsourcing on American jobs? A NSWER . The longer - term effect of outsourcing on U.S. jobs should be insignificant. Trade has little, if anything, to do with the quantity of jobs in an economy but rather the nature and distribution of those jobs in various occupations. Outsourcing should lead to higher average productivity of those jobs that Americans work at and, hence, to higher wages and benefits. 4. Several states are contemplating legislation that would ban the outsourcing of government work to foreign firms. What would be the likely consequences of such legislation? A NSWER . Such legislation would result in less efficient and more expensive government. The end result would be higher taxes or, if taxpayers balk, fewer government services. SUGGESTED ANSWERS TO CHAPTER 1 QUESTIONS 1. Explain how globalization may affect even a small business in your local area. A NSWER . Globalization entails opening national borders to enable freer movement of goods and services. Due to the rapid decrease in communication and transportation costs over the last few decades, many firms find it cheaper to source products from foreign countries. Also, firms are now aware of international market opportunities and locate their plants and facilities abroad. As a result, the competition faced by any business is now more gl obal rather than merely local. A small business in any local area now faces competition from both large MNCs and similarly situated businesses that take advantage of their international experience as well as internationally sourced products.
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CHAPTER 1: INTRODUCTION 3 2. Opponents of globalization and outsourcing argue that locating manufacturing activities abroad causes a loss of U.S. jobs. However, total employment figures reveal that rather than resulting in a net loss of jobs, employment has actually increased. Also, the average wages of workers have increased. How would you account for this discrepancy between what the critics say and what statistics reveal? A NSWER . Globalization is a two - way street. While some U.S. firms locate their plants overseas, several foreign companies have also invested in the U.S. economy and located their plants here. For example, major foreign automobile manufacturers such as Toyota and BMW have set up manufacturing plants in the U.S. and created numerous U.S. jobs. Also, over the last 25 years, the U.S. economy has experienced unprecedented productivity growth due to the increas e in trade from globalization. The net impact of this productivity growth as measured in output per hour has been such as to increase the inflation - adjusted worker compensation. Thus, while critics of globalization look at only one side of the picture and point to job losses due to outsourcing, they neglect to take into account the job creation due to foreign investment in the U.S. and the increase in trade due to globalization. Critics also ignore the fact the increased opportunities for trade due to globalization result in high - value - added services being performed in the U.S. and the increase in productivity of the U.S. worker . As a result, worker wages have also gone up. 3. Elaborate on the benefits of a proactive approach to globalization and global competition. A NSWER . Rather than react to globalization, firms benefit by facing globalization and global competition head on. Globalization and global competition unleash the forces of creative destruction, whereby new technologies and new methods of business force out poorly performing competitors. T o take advantage of the full potential of globalization and to counter global competition, many firms adopt new technologies, improve production methods, explore new markets, and introduce new and better products. The result s of such improvements are clear in terms of the lower prices and e xpanded choices for consumers. Thus, proactive firms stay ahead of their competition by taking advantage of the various benefits of globalization and the expanded trade opportunities. 4. What are the various reasons for the emergence of multinational firms? A NSWER . The primary reason for the emergence of MNCs is the international mobility of several factors of production. MNCs emerge to take advantage of globally available raw materials, markets, spe cialized skills , and knowledge. Also, firms may become multinational to keep domestic customers that have moved abroad or to exploit financial market imperfections. These are elaborated below. SEARCH FOR RAW MATERIALS . Some firms become MNCs to exploit the raw materials that can be found overseas, such as oil, coal, minerals , and other natural resources. MARKET SEEKING . Some firms become MNCs to exploit foreign markets for their products. Since the same product may be demanded in different countries, MNCs not only take advantage of the marketing opportunities , but also gain from the economies of scale obtained by selling large volume s across different foreign markets. COST MINIMIZATION . C ompanies also become MNCs to seek out lower - production - cost sites. Specific skills needed for production may be available at lower costs in some countries , and MNCs may locate plants specializing in specific aspects of production, such as assembly or fabrication, in those countries.
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INSTRUCTORS MANUAL: FOUNDATIONS OF MULTINATIONAL FINANCIAL MANAGEMENT , 6TH ED. 4 KNOWLEDGE SEEKING . Some firms enter foreign markets to gain information and experience that are expec ted to prove useful elsewhere. Especially in industries characterized by rapid product innovation and technical breakthroughs, firms obtain technica l product and process knowledge, which they leverage in other countries. KEEPING DOMESTIC CUSTOMERS . Suppliers of goods or services to MNCs often follow their customers abroad to guarantee them a continuing product flow. In the process , these firms also become MNCs . EXPLOITING FINANCIAL MARKET IMPERFECTIONS . Companies may find it advantageous to reduce taxes and circumvent currency controls when operating in multiple foreign markets. Doing so enables them to obtain greater project cash flows and lower costs of funds compared to a purely domestic firm. 5. Given the added political and economic risks that appear to exist overseas, are MNCs more or less risky than purely domestic firms in the same industry? Consider whether a firm that decides not to operate abroad is insulated from the effects of economic events that occur outside the home country. A NSWER . Individual foreign projects may face more political and economic risks than co mparable domestic projects. Yet MNCs are likely to be less risky t han purely domestic firms because much of the risk faced overseas is diversifiable. Moreover, by operating and producing overseas, the MNC has diversified its cost and revenue structure relative to what it would be if it were a purely domestic firm producing and selling in the home market. It is important to note that domestic firms are not insulated from economic changes abroad. For example, domestic firms face exchange risk because their competitive position s depend on the cost structure s of both foreign and domestic competitors. Similarly, changes in the price of oil and other materials abroad immediately lead to changes in domestic prices. 6. How is the nature of IBM ’ s competitive advantages related to its becoming a n MNC ? A NSWER . IBM is selling more than black boxes; it is selling a stream of services associated with its computers. In effect, customers are buying the company. To provide customers with what they think they are buying, IBM must be there on the spot. This enables IBM to service customers ’ machines as well as tailor software and systems to their specifications. 7. If capital markets were perfect, i.e., capital could move freely across national borders, would MNCs still exist? Why? Or, why not? A NSWER . Even if capital moved freely across national borders, MNCs woul d still exist, because MNCs bring a host of firm - specific knowledge and advantages along with capital to the co untries in which they operate. Such advantages may include unique products, processes, technologies, patents, specific rights , or specific knowledge and skills. These advantages can be used profitably in foreign markets. Moreover, MNCs are better able to apply the knowledge and skills gained in their prior operations in other countries to eac h new country that they enter. Thus, from the point of view of a country attracting foreign capital, the capital that is brought in by a n MNC brings with it firm - specific advantages that yield better returns than the capital that is simply borrowed from a foreign country.
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CHAPTER 1: INTRODUCTION 5 8. What are the various ways in which domestic firms enter international markets? What are the benefits and risks of each strategy of foreign market entry? A NSWER . Three major ways in which domestic firms enter international markets are through exporting, licensing , and overseas production. When exporting, the domestic firm operates from its home country and merely sends its products overseas. In licensing, the domestic firm licenses its product, process , or technology to a foreign firm in return for royalt ies or other forms of payment. In overseas production, the domestic firm becomes a n MNC by setting up a corporation overseas and engaging in manufacturing and/or marketing . The benefits and risks of each strategy are summarized below. Entry Benefits Risks Exporting • Minimal c apital requirements and start - up costs • Risk is low • Profits are immediate • L earn about present and future supply and demand, competition, distribution channels, payment conventions, financial institutions , and financial techniques in host country • Relatively low risk compared to other entry strategies • Full sales potential of the product is not realized • Foreign importer is in greater co ntrol of marketing, and thus the image , of the firm’s branded products in the foreign country Licensing • Minimal investment requirements • Faster market - entry time • Fewer financial and legal risks • Cash flow is relatively low • M ay be problems in maintaining product quality standards • Foreign licensee may engage in unauthorized exports of th e firm’s products, resulting in loss of future revenues for the licensing firm • Foreign licensee may become a stro ng competitor when license agreement ends Overseas Production • The firm can more easily stay abreast of market developments, adapt its products and production schedules to changing local tastes and conditions, fill orders faster , and provide more comprehensive after - sales service • Firm can exploit local skills, including R&D • S ignals a greater commitment to the local market, which in turn increases sales and assurance of supply stability • Tremendous capital and top management commitment is required • Financial and operational risks are greater than those for other entry strategies • Companies face greater political risks, including the risk of expropriation of plants and facilities 9. Why do firms from each of the following categories become MNCs ? Identify the competitive advantages that a firm in each category must have to be a successful MNC . a. Raw - materials seekers b. Market seekers c. Cost minimizers A NSWER . FDI is most likely to be economically viable where the possibility of opportunism on the part of unrelated parties or contractual difficulties make it especially costly to coordinate economic activities via arm ’ s length transactions in the marketplace. Firms go overseas to more fully utilize their skills and other tangible and intangible assets.
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INSTRUCTORS MANUAL: FOUNDATIONS OF MULTINATIONAL FINANCIAL MANAGEMENT , 6TH ED. 6 RAW MATERIALS SEEKERS . The existence of low - cost raw materials overseas is not a sufficient condition for firms to become MNCs ; they could just import raw materials rather than set up operations abroad to extract them. Companies that become raw materials MNCs must a) H ave intangibl e capabilities in the form of technical skills and face contractual difficulties in the form of an inability to price their know - how or to write, monitor, and enforce use restrictions governing t echnology transfer arrangements; and b) F ace problems of opportunism that make it very expensive to enter into long - term purchase contracts to fully utilize their production or distribution capability. For example, an oil refining and distributing firm may find it too risky to invest in further refining capacity without controlling its own oil supply. An independent supplier may decide to break a contractual agreement and cut off the flow of oil to the refiner. MARKET SEEKERS . These firms usually have intangible capital in the form of organizational skills that are inseparable from the firm itself. A basic skill involves knowledge about how best to service a market, including new product development and adaptation, quality control, advertising, distribution, and after - sales service. Since it would be difficult, if not impossible, to unbundle these services and sell them apart from the firm, this form of market imperfection often leads to corporate attempts to exert control directly via the establishment of foreign affiliates. COST MINIMIZERS . These firms seek to reduce their costs by producing overseas. Yet the existence of lower - cost production sites overseas is not sufficient to justify FDI. Since local firms have an inherent cost advantage over foreign investors, MNCs can succeed abroad only if the production or marketing edge they possess cannot be purchased or duplicated by local competitors. The successful MNC in this category will possess specialized design or marketing skill s , a good distribution system, or own a strong brand name. Excess profits are earned on these intangible assets, not on the low foreign labor or materials costs. Overseas production just enables them to be cost competitive; it doesn't give them an edge since any competitor can replicate its production location. 10. What factors help determine whether a firm will export its output, license foreign companies to manufacture its products, or set up its own production or service facilities abroad? Identify the competitive advantages that lead companies to prefer one mode of international expansion over another. A NSWER . Here are some factors involved in deciding how to enter a market: i) P RODUCTION ECONOMIES OF SCALE . If these are important, then exporting might be appropriate. ii) T RADE BARRIERS . Companies that might otherwise export to a market may be forced by regulations to produce abroad, either in a wholly owned operation, a joint venture, or through a licensing arrangement with a local manufacturer. iii) T RANSPORTATION COSTS . These have the same effect as trade barriers. The more expensive it is to ship a product to a market, the more likely it is that local production will take place. iv) S IZE OF THE FOREIGN MARKET . The larger the local market, the more likely local production will take place, particularly if significant production economies of scale exist . Conversely, with smaller markets, exporting is more likely to take place.
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CHAPTER 1: INTRODUCTION 7 v) P RODUCTION COSTS . The real exchange rate, wage rates, and other cost factors will also play a part in determining whether exporting or local production takes place. vi) I NTANGIBLE CAPITAL . If the MNC’s intangible capital is embodied in the form of products, exporting will generally be preferred. If intangible capital takes the form of specific product or process technologies that can be written down and transmitted objectively, foreign expansion will usually take the licensing route. I f intangible capital takes the form of organizational skills that are inseparable from the firm itself, then the firm is likely to expand overseas via direct investment. vii) N ECESSITY OF A FOREIGN MARKET PRESENCE . By investing in fixed assets abroad, companies can demonstrate to local customers their commitment to the market. This can enhance sales prospects. 11. Time Warner must decide whether to license foreign companies to produce its films and records or set up foreign sales affiliates to sell its products. What factors might determine whether it expands abroad via licensing or investing in its own sales force and distribution network? A NSWER . Some of the factors that Warner should consider in determining whether it expands abroad via licensing or by investing in its own sales force and distribution network are as follows: a) S ALES VOLUME . It needs a certain minimum volume of business to justify its own sales force. b) P OTENTIAL PROBLEMS OF OPPORTUNISM . How easy is it to monitor and control independent producers and sellers of its films and records? The easier it is to monitor and control them, the less value there is in having its own sales and distribution capability. c) C ONFLICTS OF INTEREST . How motivated will independents be in pushing Time Warner ’ s products versus those of other companies? d) C OLLATERAL BENEFITS TO W ARNER . To the extent Time Warner gets other benefits from distributing its films (e.g., the sale of toys) that aren ’ t captured by independents, they will have less incentive to push Time Warner ’ s products than Time Warner will have. The more collateral benefits, the more important it is for Time Warner to control its own sales. e) T HE IMPORTANCE OF MARKET INFORMATION . If products must be tailored to the foreign markets, Time Warner should probably develop its own sales force. Time Warner will find it difficult to gather the necessary market intelligence from independent distributors of its products. ADDITIONAL CHAPTER 1 QUESTIONS AND ANSWERS 1.a. What are the various categories of MNCs ? A NSWER . Raw materials seekers, market seekers, and cost minimizers. 1. b. What is the motivation for international expansion of firms within each category? A NSWER . R aw materials seekers go abroad to exploit the raw materials that can be found there and can’t be found domestically. Market seekers go overseas to produce and sell in foreign markets. C ost minimizers invest in lower - cost production sites overseas to remain cost competitive both at home and abroad. In all cases, the firms involved recognize that the world is larger than the home country and provides opportunities to gain additional supplies, sell more products , or find lower - cost sources of production.
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INSTRUCTORS MANUAL: FOUNDATIONS OF MULTINATIONAL FINANCIAL MANAGEMENT , 6TH ED. 8 2.a. How does foreign competition limit the prices domestic companies can charge and the wages and benefits workers can demand? A NSWER . As domestic producers raise their prices, customers begin substituting less - expensive goods and services supplied by foreign producers. The likelihood of losing sales limits the prices domestic firms can charge. Foreign competition also limit s the wages and benefits workers can demand. If workers demand more money, firms have two choices: a cquiesce to these demands or fight them. Absent foreign competition, the cost of acquiescence is relatively low, particularly if the industry is unionized. Since all firms will face the same higher costs, they can cover these higher costs by all simultaneously raising their prices without fear of being undercut or of being placed at a competitive disadvantage relative to their peers. Foreign competition changes the picture because foreign firms ’ costs will be unaffected by higher domestic wages and benefits. If domestic firms give in on wages and benefits, foreign firms will underprice them in the market and take market share away. In this case, higher domestic costs will put domestic firms at a disadvantage vis - à - vis their foreign competitors. Recognizing this, domestic firms facing foreign competition are more likely to fight worker demands for higher wages and benefits. 2. b. What political solutions can help companies and unions avoid the limitations imposed by foreign competition? A NSWER . The classic political solution is protectionism. By limiting foreign competition either through tariffs or quotas, companies and workers limit the ability of foreign goods to restrain domestic price increases. The government can also subsidize domestic firms c ompeting against foreign firms, allow ing domestic firms and unions to perpetuate uneconomic work rules, wages, and productions processes. 2. c. Who pays for these political solutions? Explain. A NSWER . Consumers pay for protectionism in the form of higher prices for their goods and service s , fewer choices, and lower quality. Taxpayers pay for subsidies in the form of higher taxes or fewer of the other services provided by government. 3.a. What factors appear to underlie the Asian currency crisis? A NSWER . Asian countries had run up huge debts, mostly in dollars, and were depending on the stability of their currencies to repay these loans. Worse, Asian banks, urged on by the often - corrupt political leadership, were making loans to money - losing ventures controlled by political cronies. The result was financially troubled economies that could not generate the income necessary to repay their dollar loans. 3. b. What lessons can we learn from the Asian currency crisis? A NSWER . Financial crises can be avoided or mitigated if financial markets are open and transparent, thereby leading to investment decisions based on sound economic principles rather than cronyism or political considerations. Countries can stimulate healthier economies by avoiding policies that suppress enterprise, reward cronies, and squander resources on economically dubious, grandiose projects. 4.a. What is an efficient market? A NSWER . An efficient market is one in which new information is readily incorporated in the prices of traded securities. In an efficient market , one cannot expect to prosper by finding overvalued or undervalued assets. In addition, all funds require the same risk - adjusted returns. Absent tax considerations or government intervention, therefore, market efficiency suggests that no financing bargains are available.
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CHAPTER 1: INTRODUCTION 9 4. b. What is the role of a financial executive in an efficient market? A NSWER . In an efficient market, attempts to increase a firm’s value by purely financial measures or accounting manipulations are unlikely to succeed unless capital market imperfections or asymmetries in tax regulations exist . The net result has been to focus attention on those areas and circumstances in which financial decisions and financial managers can have a measurable impact. K ey areas are capital budgeting, working capital management, and tax management. C ircumstances to be aware of include capital market imperfections, caused primarily by government regulations, and asymmetries in the tax treatment of different types and sources of revenues and costs. As such, the role of the financial manager is to search for and take advantage of capital market imperfections and tax asymmetries to increase after - tax profits and lower the cost of capital. The value of good financial management is enhanced in the international arena because of the greater likelihood of market imperfections and multiple tax rates. In addition, the greater complexity of international operations is likely to increase the payoffs from a knowledgeable and sophisticated approach to internationalizing the traditional areas of financial management. 5.a. What is the capital asset pricing model? A NSWER . The CAPM quantifies the relevant risk of an investment and establishes the trade - off between risk and return; i.e., the price of risk. It posits a specific relationship between diversification, risk, and required asset returns. In effect, the CAPM says that the required return on an asset equals the risk - free return plus a risk premium based on the asset ’ s systematic or nondiversifiable risk. The latter is based on market - wide influences that affect all assets to some extent, such as unpredictable changes in the state of the economy or in some macroeconomic policy variable, such as the money supply or the government deficit. 5. b. What is the basic message of the CAPM? A NSWER . The CAPM ’ s basic message is that risk is priced in a portfolio context. From this it follows that only systematic risk is priced; unsystematic risk, which by definition can be diversified away, is not priced and hence doesn ’ t affect the required return on a project. 5. c. How might a n MNC use the CAPM? A NSWER . The CAPM can be used to estimate the required return on foreign projects. It can also help a company raise the right questions about risk when considering the desirability of a foreign project, the most important being which elements of risk are diversifiable and which are not. 6. Why might total risk be relevant for a multinational corporation? A NSWER . Higher total risk is relevant for an MNC because it could have a negative impact on the firm’s expected cash flows The inverse relation between risk and expected cash flows arises because financial distress, which is more likely to occur for firms with high total risk, can impose costs on customers, suppliers, and employees , and thereby affect their willingness to commit themselves to relationships with the firm. In summary, total risk is likely to adversely affect a firm ’ s value by leading to lower sales and higher costs. Consequently, any action taken by a firm that decreases its total risk will improve its sales and cost outlooks, thereby increasing its expected cash flows .
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INSTRUCTORS MANUAL: FOUNDATIONS OF MULTINATIONAL FINANCIAL MANAGEMENT , 6TH ED. 10 7. A memorandum by Labor Secretary Robert Reich to President Clinton suggests that the government penalize U.S. firms that invest overseas rather than at home. According to Reich, this kind of investment hurts exports and destroys well - paying jobs. Comment on this argument. A NSWER . The assumption underlying Secretary Reich ’ s memo is inconsistent with the empirical evidence. According to this evidence, U.S. firms that invest abroad tend to expand their exports. The jump in exports stems from the fact that by investing abroad, companies are able to expand their presence in foreign markets as well as protect foreign markets that would otherwise be lost to competitors. This enables them to sell more product, most of which is made in the U.S . In addition, the foreign plants tend to use components and capital equipment that are mostly made in and exported from U.S. plants. Penalizing U.S. companies that invest abroad would most likely lead to the loss of foreign markets as well as the additional exports that such markets generate. Such penalties would also reduce the efficiency of the world economy. After all, there is usually a sound economic reason for MNCs to invest abroad. 8.a. Are MNCs riskier than purely domestic firms? A NSWER . Although MNCs are confronted with many added risks when venturing overseas, they can also take advantage of international diversification to reduce their overall riskiness. We will also see in Chapter 16 that foreign operations enable MNCs to retaliate against foreign competitive intrusions in the domestic market and to more closely track their foreign competitors, reducing the risk of being blind sided by new developments overseas. 8. b. What data would you need to address this question? A NSWER . You would need to take relatively comparable firms in the same industry, but with different percentages of earnings from abroad, and compare the variability of their earnings. 9. Is there any reason to believe that MNCs may be less risky than purely domestic firms? Explain. A NSWER . Yes. International diversification may actually ena b le firms to reduce the ir total risk. Much of the general market risk facing a company is related to the cyclical nature of the domestic economy of the home country. Operating in a number of nations whose economic cycles are not perfectly in phase may, therefore, reduce the overall variability of the firm ’ s earnings. Thus, al though the riskiness of operating in any one country may exceed the risk of operating in the U.S. (or other home country), much of that risk is eliminated through diversification. In fact, as shown in Chapter 15, the variability of earnings appears to decline as firms become more internationally oriented. 10. In what ways do financial markets grade government economic policies? A NSWER . Traders and their customers receive a continuing flow of news from around the world. The announcement of a new policy leads traders to buy or sell currency, stocks , or bonds based on their evaluation of the effect of that policy on the market. A desirable policy leads them to buy more of the assets favorably affected by the policy, while a policy that is judged to be harmful leads to sell orders of those assets that will be hurt by the policy. The result is a continuing global referendum on a nation ’ s economic policies, even before they are implemented.
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CHAPTER 1: INTRODUCTION 11 Politicians who pursue economic policies they perceive to be beneficial to them (e.g., improving their re - election odds), even if these policies harm the national economy, usually don't appreciate the grades they receive. But the market is clear - eyed and hard - nosed and will respond negatively to unsound fiscal and monetary policies. Politicians will not admit that their own policies led to higher interest rates or lower currency values or stock prices; that would be political suicide. It is much easier to blame greedy speculators rather than their policies for the market ’ s response. 11 . In seeking to predict tomorrow ’ s exchange rate, are you better off knowing today ’ s exchange rate or the exchange rates for the past 100 days? A NSWER . In an efficient market, which the foreign exchange market certainly appears to be, the current price of an asset such as a currency fully reflects all available information, including the complete price history. Thus , knowing today ’ s price is as informative from a forecasting standpoint as knowing all past prices. Past prices add nothing to the current price in terms of forecasting ability. 1 2. Why might setting up production facilities abroad lead to expanded sales in the local market? A NSWER . By producing abroad, a company can more easily keep abreast of market developments, adapting its products and production schedules to changing local tastes and conditions , while simultaneously providing more comprehensive after - sales service. Establishing local production facilities also demonstrates a greater commitment to the local market and an increased assurance of supply stability. This is particularly important for firms that produce intermediate goods for sale to other companies. 1 3a. How might total risk affect a firm ’ s production costs and its ability to sell? Give some examples of firms in financial distress that saw their sales drop. A NSWER . Higher total risk can lead to lower sales and higher production costs. The inverse relation between risk and expected cash flows arises because financial distress, which is more likely to occur for firms with high total risk, can impose costs on customers, suppliers, and employees and thereby affect their willingness to commit themselves to relationships with the firm. Examples include Chrysler and Texaco, which saw their sales fall and costs of doing business rise when they were in financial distress. 13. b. What is the relation between the effects of total risk on a firm's sales and costs and its desire to hedge foreign exchange risk? A NSWER . Since total risk is likely to adversely affect firm value, by lowering sales and raising costs, any action taken by a firm that decreases its total risk will improve its sales and cost outlook, thereby increasing its expected cash flows. These effects help justify the range of corporate hedging activities designed to reduce total risk that MNCs engage in.
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INSTRUCTORS MANUAL: FOUNDATIONS OF MULTINATIONAL FINANCIAL MANAGEMENT , 6TH ED. 12 SUGGESTED ANSWERS TO APPENDIX 1A QUESTIONS 1. In a satirical petition on behalf of French candlemakers, French economist Frederic Bastiat called attention to cheap competition from afar: sunlight. A law requiring the shuttering of windows during the day, he suggested, would benefit not only candlemakers but “ everything connected with lighting ” and the country as a whole. He explained: “ As long as you exclude, as you do, iron, corn, foreign fabrics, in proportion as their prices approximate to zero, what inconsistency it would be to admit the light of the sun, the price of which is already at zero during the entire day! ” 1. a. Is there a logical flaw in Bastiat ’ s satirical argument? A NSWER . No. Bastiat is precisely right. The objective of trade is to gain access to goods and services at lower quality - adjusted prices. The ultimate consequence is to make more efficient use of the world ’ s resources and thereby increase worldwide production and consumption. Protectionism aims to prevent this end. If protectionism succeeds, world output and consumption are lower than they might otherwise be because resources are not being put to their highest - value use. In the example cited by Bastiat, protectionism will lead to a squandering of resources by replicating what the sun can do less expensively. 1. b. Do Japanese automakers prefer a tariff or a quota on their U.S. auto exports? Why? Is there likely to be consensus among the Japanese carmakers on this point? Might there be any Japanese automakers that are likely to prefer U.S. trade restrictions? Why? Who are they? A NSWER . It depends. Both tariffs and quotas will lead to higher prices to U.S. consumers of imported Japanese cars. With tariffs, however, most of this price increase will go to the U.S. government in the form of tariffs. Japanese companies (or their dealers), on the other hand, will collect most, if not all, of the higher prices associated with the scarcity of imported Japanese cars. Once the Japanese producers hit their quota limit, they have no incentive to compete with each other by cutting price because they cannot sell more cars than they already are. The net result is that the U.S. market will be extraordinarily profitable to Japanese automakers, which it was. Since quotas tend to be allocated based on current sales, automakers like Toyota and Nissan with large market shares would prefer quotas, whereas automakers like Honda and Mitsubishi with smaller market shares would prefer tariffs. The reason for the latter ’ s preference for tariffs is that efficient companies can eventually overcome the effects of tariffs by cutting costs and prices, whereas efficiency counts for nothing with quotas. Regardless of the type of trade barrier imposed, U.S. automakers will raise their prices in line with higher import prices. However, U.S. automakers are likely to prefer quotas because quotas enable them to disguise the reason for higher U.S. car prices. Consumers would be much quicker to figure out the cause - effect relationship between higher tariffs and higher prices on U.S. and Japanese cars. 1. c. What characteristics of the U.S. auto industry have helped it gain protection? Why does protectionism persist despite the obvious gains to society from free trade? A NSWER . The U.S. auto industry has received as much protection as it has for two key reasons. First, it is a large and powerful industry. Second, it is concentrated in several politically important states, such as Michigan and Illinois.
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CHAPTER 1: INTRODUCTION 13 2. Review the arguments both pro and con on NAFTA. What is the empirical evidence so far? A NSWER . NAFTA has helped increase international trade between the U.S. , Mexico, and Canada. The results thus far indicate that NAFTA has created some jobs in both countries and cost some jobs. Indeed, the purpose of free trade is not to create jobs but to increase the purchasing power and choice of consumers. With respect to jobs, the effect of free trade is to create higher - paying jobs that replace lower - paying jobs. The number of jobs in an economy is independent of the presence or absence of trade. It has every thing to do with the incentives that people have to work, their productivity, and the costs to employers of hiring workers. What trade does is permit workers to hold jobs in those areas of the economy in which the nation has a comparative advantage. At the same time, trade destroys jobs in those goods and services in which the nation is at a comparative disadvantage. 3. Given the resources available to them, countries A and B can produce the following combinations of steel and corn. Country A Country B Steel (tons) Corn (bushels) Steel (tons) Corn (bushels) 36 0 54 0 30 3 45 9 24 6 36 18 18 9 27 27 15 12 18 36 6 15 9 45 0 18 0 54 3. a. Do you expect trade to take place between countries A and B? Why? A NSWER . Yes. Given the data presented, if country A has 6 units of resources and it devotes X of these units to steel production, where X is an integer, it can produce a total of 6X tons of steel and 3(6 - X) bushels of corn Similarly, with 54 units of resources, country B of which it devotes Y units to steel production, it can produce Y tons of steel plus (54 - Y) bushels of corn. The net effect of these production functions is that one bushel of corn is worth 2 tons of steel in country A. In contrast, one bushel of corn is worth only one ton of steel in country B. These relative prices indicate that country A has a comparative advantage in the production of steel, whereas B has a comparative advantage in the production of corn. 3. b. Which country will export steel? Which will export corn? Explain. A NSWER . Given these comparative advantages, A will export steel and B will export corn. The price of corn will settle somewhere between one and two tons of steel. Suppose it settles at 1.5 tons of steel. Then, instead of producing, say, 30 tons of steel and 3 bushels of corn, it can devote an additional resource unit to the production of an additional 6 tons of steel. It can trade these 6 tons of steel with B for 6/1.5 = 4 bushels of corn, leaving it one bushel of corn better off. Similarly, B can now get 6 tons of steel for the 4 bushels of corn it trades to A instead of the 4 tons of steel it could produce on its own with the resources it took to produce the 4 bushels of corn.
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CHAPTER 2: THE DETERMINATION OF EXCHANGE RATES 1 CHAPTER 2 THE DETERMINATION OF EXCHANGE RATES T his chapter explain s what an exchange rate is and how it is determined in a freely floating exchange rate regime, that is, in the absence of government intervention. This is done using a simple two - country model. Because of its pervasiveness, we also examine the different forms and consequences of central bank intervention in the foreign exchange markets. Since an exchange rate can be considered as the relative price of two financial assets, the chapter discusses the asset market model of currencies and the role of expectations in exchange rate determination. A separate section discusses the real changes in a nation ’ s economy that cause exchange rate changes. K EY P OINTS 1. Absent government intervention, exchange rates respond to the forces of su pply and demand, which in turn depend on relative inflation rates, interest rates, and GNP growth rates. 2. Monetary policy is crucial. If the central bank expands the money supply at a faster rate than money demand, the purchasing power of money declines both at home ( from inflation) and abroad ( from currency depreciation). 3. The healthier the economy is, the stronger the currency is likely to be. 4. Exchange rates are affected by expectations of future exchange rate changes, which depend on forecasts of future economic and political conditions. 5. To achieve certain economic or political objectives, governments often intervene in the currency markets to affect the exchange rate. Although the mechanics of such intervention vary, the general purpose of each variant is basically the same: to increase the market demand for one currency by increasing the market supply of another. Alternatively, the government can control the exchange rate directly by setting a price for its currency and then restricting access to the foreign exchange market. 6. A critical factor that helps explain the volatility of exchange rates is that, with fiat money , there is no anchor to a currency ’ s value, nothing around which beliefs can coalesce. Since people are unsure about what to expect, any new piece of information can dramatically alter their beliefs. Thus, if the underlying domestic economic policies are unstable, exchange rates will be volatile as traders react to new information.
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INSTRUCTORS MANUAL: FOUNDATIONS OF MULTINATIONAL FINANCIAL MANAGEMENT , 6TH ED. 2 SUGGESTED ANSWERS TO “A SIAN CURRENCIES SINK IN 1997 ” 1. What were the origins of the Asian currency crisis? A NSWER . The case suggests several causes of the Asian currency crisis. First was the loss of export competitiveness. A number of Asian countries had tied their currencies to the dollar, so the dramatic appreciation of the dollar against the yen, Deutsche mark , and other currencies made their exports less price competitive. Their competitiveness problem was exacerbated by the fact that during this period, the Chinese yuan depreciated by about 25% against the dollar. A second contributing factor to Asia’s financial problems was moral hazard – the tendency to incur risks that one is protected against. Specifically, most Asian banks and finance companies operated with implicit or explicit government guarantees. When combined with poor regulation, these guarantees distorted investment decisions, encouraging financial institutions to fund risky projects in the expectation that the banks would enjoy any profits, while sticking the government with any losses. Without market discipline or risk - based bank lending, the result was overinvestment – financed by vast quantities of debt – and inflated prices of assets in short supply, such as land. The Asian financial crisis then was touched off when local investors began dumping their own currencies for dollars and foreign lenders refused to renew their loans to Asian companies and banks. 2. What role did expectations play in the Asian currency crisis? A NSWER . Expectations were critical in causing the financial bubble and then popping it. Specifically, the Asian financial bubble persisted as long as people believe d the government could honor its implicit guarantee. However, this guarantee brought with it the seeds of its own demise as inevitable glut of real estate and excess production capacity lead to large amounts of nonperforming loans and widespread loan defaults. When reality struck and investors realize d that the government didn’t have the resources to bail out everyone, asset values plummet ed and the bubble burst. The decline in asset values triggered further loan defaults, causing a loss of the confidence on which economic activity depend ed. Investors also worried that the government would try to inflate its way out of its difficulty. The result was a self - reinforcing downward spiral and capital flight. As foreign investors refuse d to renew loans and begin to sell off shares of overvalued local companies, capital flight accelerate d and the local currency fell , increasing the cost of servicing foreign debts. Local firms and banks scramble d to buy foreign exchange before the currency f ell further, putting even more downward pressure on the ex change rate. This story explained why stock prices and currency values declined together and why Asian financial institutions were especially hard hit. Moreover, this process was likely to be contagious, as investors search ed for other countries with similar characteristics. When such a country is found, everyone rushes for the exit simultaneously and another bubble is burst, another currency is sunk. In the case of the Asian currency crisis, investors also realized that their loss of export competitiveness gave the Asian central banks a mutual incentive to devalue their currencies to try to regain their export competitiveness . According to one theory, recognizing these altered incentives, speculators attacked the East Asian currencies almost simultaneously and forced a round of devaluations .
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CHAPTER 2: THE DETERMINATION OF EXCHANGE RATES 3 3. How did the appreciation of the U.S. dollar and depreciation of the yuan affect the timing and magnitude of the Asian currency crisis? A NSWER . Sooner or later, the moral hazard associated with implicit government guarantees of reckless investments would result in a crisis. What dollar appreciation and yuan depreciation did was to speed up the crisis. Specifically, the loss of export competitiveness slowed down Asian growth and caused utilization rates – and profits – on huge investments in production capacity to plunge. It also gave the Asian central banks a mutual incentive to devalue their currencies to try to regain their export competitiveness. 4. What is moral hazard and how did it help cause the Asian currency crisis? A NSWER . As explained above, moral hazard is the tendency to incur risks that one is protected against. The origin of the moral hazard faced by Asian countries was the implicit or explicit government guarantees that most Asian banks and finance companies operated with. When combined with poor regulation, these guarantees distorted investment decisions, encouraging financial institutions to fund risky projects in the expectation that the banks would enjoy any profits, while sticking the government with any losses. Without market discipline or risk - based bank lending, the result was overinvestment – financed by vast quantities of debt – and inflated prices of assets in short supply, such as land. The Asian financial crisis then was touched off when local investors began dumping their own currencies for dollars and foreign lenders refused to renew their loans to Asian companies and banks. 5. Why did so many East Asian companies and banks borrow dollars, yen, and Deutsche marks instead of their local currencies to finance their operations? What risks were they exposing themselves to? A NSWER . East Asian banks and companies financed themselves with dollars, yen, and Deutsche marks – some $275 billion worth, much of it short term – because dollar and other foreign currency loans carried lower interest rates than did their domestic currencies. The risk they were exposing themselves – a risk that manifested itself – was that their local currencies would devalue against the borrowed foreign currencies, making these foreign currency loans more expensive to pay back in terms of their local currencies . This risk was also borne by the banks that made these foreign currency loans, since a company that goes bankrupt because it cannot repay its loans will eve ntually pass its loan losses on to its lenders. SUGGESTED ANSWERS TO “THE U.S. DOLLAR SELLS OFF” 1. How did China and Japan manage to weaken their currencies against the dollar? A NSWER . China and Japan intervened in the foreign exchange market to weaken their currencies against the dollar. Specifically, the Chinese and Japanese central banks issued additional yuan and yen, respectively, and used this money to buy an equivalent amount of dollars. By expanding the supply of yen and yuan and increasing the demand for dollars, both countries managed to hold down the value of their currencies against the dollar. China and Japan then used the dollars they acquired through their foreign exchange intervention to buy U.S. Treasury bonds.
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INSTRUCTORS MANUAL: FOUNDATIONS OF MULTINATIONAL FINANCIAL MANAGEMENT , 6TH ED. 4 2. Why did the U.S. dollar and U.S. Treasury bonds fall in response to the G7 statement? A NSWER . The G7 endorsed “flexibi lity” in exchange rates, a code word widely regarded as an encouragement for China and Japan to stop managing their currencies. If China and Japan accepted this advice, they would cease their purchases of dollars. Such an action would reduce the value of the dollar. At the same time, the reduced purchases of dollars would cause China and Japan to make fewer purchases of U.S. Treasury bonds, thereby reducing the demand for Treasury bonds. A reduced demand for U.S. Treasury bonds would lead to a drop in value. Both the dollar and U.S. Treasury bonds fell on the G7 announcement based on the expectation that China and Japan might accept the G7 advice. 3. What is the link between currency intervention and China and Japan buying U.S. Treasury bonds? A NSWER . As noted above, China and Japan acquired the dollars they used to buy U.S. Treasury bonds through their foreign exchange market intervention. The more these countries intervened in the foreign exchange market, the more dollars they would have to buy Treasury bonds. Conversely, c easing such intervention would mean these countries would no longer have the dollars to buy Treasury bonds. 4. What risks do China and Japan face from their currency intervention? A NSWER . To intervene in the foreign exchange market, China and Japan have to expand their domestic money supplies. The danger is that the rising money supplies will cause inflation. Another risk is that other countries will engage in competitive devaluations to boost their export competitiveness vis - à - vis the Chinese and Japanese. Finally, China and Japan face the very real danger that their cheap currency policy will stir up protectionist measures in its trading partners. SUGGESTED ANSWERS TO “A YEN FOR YUAN” 1. Why is China trying to hold down the value of the yuan? What evidence suggests that China is indeed pursing a weak currently policy? A NSWER . China believes that it needs to export to keep people employed and provide jobs, as state enterprises become obsolete and close down. The government worries that a large body of unemployed people would lead to unrest. Evidence that a weak yuan policy is being pursued shows up in the peg to the dollar being maintained despite the weakening of the dollar . The existence of the peg is evident from the fixed exchange rate and the large quantity of dollars the government is buying up to support the dollar against the yuan (as seen in the jump in China’s foreign exchange reserves in recent years). 2. What benefits does China expect to realize from a weak currency policy? A NSWER . China hopes that flourishing export businesses will be able to absorb newly unemployed people from state enterprises that are being shut down. In addition, a perceived potential deflation can be averted by maintaining a weak yuan (which raises the price of foreign goods) and expanding the yuan money supply in pursuit of this policy .
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CHAPTER 2: THE DETERMINATION OF EXCHANGE RATES 5 3. Other things being equal, what would a 27.5% tariff cost American consumers annually on $200 billion in imports from China? A NSWER . Other things being equal, American consumers would pay an additional $55 billion on such imports (0.275 * $200 billion). 4. Currently, imports from China account for about 10% of total U.S. imports. A 25% appreciation of the yuan would be the equivalent of what percent dollar depreciation? How significant would such a depreciation likely be in terms of stemming America’s appetite for foreign goods? A NSWER . All else being equal, if the yuan appreciates by 25%, the dollar cost of Chinese goods would rise by the same percent. With Chinese imports accounting for about 10% of total U.S. imports, a 25% yuan appreciation would increase the dollar cost of U.S. imports by about 2.5% overall . This figure represents an approximate 2.5% dollar depreciation. (1 - 1/1.025 = - 2.439% to be exact). 5 . What policy tool is China using to maintain the yuan at an artificially low level? Are there any potential problems with using this policy tool? What might China do to counter these problems? A NSWER . China is keeping the yuan pegged to the d ollar by issuing more yuan to buy up dollars . The problem with maintaining the weak value is a rising money supply . A rapidly expanding money supply results in inflation . In China’s case, this inflationary pressure is most noticeable in asset prices. To cope with this problem, the Chinese government could sterilize its foreign exchange intervention, but that is likely to result in continuing pressure on the yuan to appreciate. Alternatively, as suggested in the answer to part 6, China could free its currency and allow capital outflows, which would absorb much of the pressure , to appreciate. 6. Does an undervalued yuan impose any cost on the Chinese economy? If so, what are they? A NSWER . An undervalued yuan raises the cost of foreign goods and services to Chinese consumers and companies, reducing their purchasing power overseas. Another potential cost of pursuing a cheap currency policy is the possibility of stirring up protectionist measures in its trading partners. 7. Suppose the Chinese government cease d its foreign exchange market intervention and the yuan climbed to five to the dollar. What would be the percentage gain to the dollar investor? A NSWER . In this scenario, the value of the yuan would rise from $0. 1307 (1/ 7.65 ) to $0.20 (1/5). The resulting gain in dollar value is (0.20 – 0. 1307 )/0. 1307 or 53 % . 8. Currently the yuan is not a convertible currency, meaning Chinese individuals can not exchange their yuan for dollars to invest abroad. Moreover, companies operating in China must convert all their foreign exchange earnings into yuan. What would happen to the pressure on the yuan to revalue if China relax ed these currency controls and restraints on capital outflows ? A NSWER . Relaxing currency controls and constraints on capital outflows would result in increased capital outflows and an increase in the demand for foreign currency. Other things being equal, this increased demand for foreign exchange would reduce the pressure on the yuan to revalue and could even result in a deprec i ation of the yuan if the demand for foreign assets (for diversification and investment purpose, say) were sufficiently great.
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INSTRUCTORS MANUAL: FOUNDATIONS OF MULTINATIONAL FINANCIAL MANAGEMENT , 6TH ED. 6 SUGGESTED ANSWERS TO CHAPTER 2 QUESTIONS 1. Describe how these three typical transactions should affect present and future exchange rates. 1. a. Seagram imports a year's supply of French champagne. Payment in euro s is due immediately. A NSWER . The euro should appreciate relative to the dollar since demand for euro s is rising. 1. b. MCI sells a new stock issue to Alcatel, the French telecommunications company. Payment in dollars is due immediately. A NSWER . The spot value of the dollar should increase as Alcatel demands dollars to pay for the new stock issue. The future value of the dollar should decline as dividend payments are sent to Alcatel and other Alcatel equipment and parts are imported. However, the value of the dollar in the future could increase if expanded MCI output substitutes for telecom imports. 1. c. Korean Airlines buys five Boeing 747s. As part of the deal, Boeing arranges a loan to KAL for the purchase amount from the U.S. Export - Import Bank. The loan is to be paid back over the next seven years with a two - year grace period. A NSWER . The spot price of the dollar should be unaffected. The future price of the dollar should increase as KAL repays the loan. 2. The maintenance of money's value is said to depend on the monetary authorities. What might the monetary authorities do to a currency that would cause its value to drop? A NSWER . The value of any good or asset is driven by its scarcity. T he monetary authorities could make money less scarce by issuing more of it. This would lower its scarcity value. Even though its nominal value will always be the same, the added supply will reduce the purchasing power per unit of money. 3. For each of the following six scenarios, say whether the value of the dollar will appreciate, depreciate, or remain the same relative to the Japanese yen. Explain each answer. Assume that exchange rates are free to vary and that other factors are held constant. 3. a. The growth rate of national income is higher in the United States than in Japan. A NSWER . The value of the dollar should rise as more rapidly ; rising G D P in the United States leads to a relative increase in demand for dollars. 3. b. Inflation is higher in the U.S. than in Japan. A NSWER . The value of the dollar should fall in line with purchasing power parity. 3. c. Prices in Japan and the United States are rising at the same rate. A NSWER . According to PPP, the exchange rate should remain the same. 3. d. Real interest rates are higher in the United States than in Japan. A NSWER . The value of the dollar should rise as the higher real rates attract capital from Japan that must first be converted into dollars.
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CHAPTER 2: THE DETERMINATION OF EXCHANGE RATES 7 3. e. The United States imposes new restrictions on the ability of foreigners to buy American companies and real estate. A NSWER . The value of the dollar should fall as foreigners find it less attractive to own U.S. assets. 3. f. U.S. wages rise relative to Japanese wages, and American productivity falls behind Japanese productivity. A NSWER . Higher U.S. wages and declining relative productivity weaken the American economy and make it less attractive for investment purposes. Assuming that a weak economy leads to a weak currency, the dollar will fall. From a somewhat different perspective, when a nation ’ s productivity growth lags behind that of its major tradi ng partners, the other country’s currency will depreciate . The lagging country regains its balance, but only by accepting a lower real price for its goods. In effect, the cheaper currency is the market ’ s way of cutting wages in the lagging country. 4. The Fed adopts an easier monetary policy. How is this likely to affect the value of the dollar and U.S. interest rates? A NSWER . If the Fed switches to an easier monetary policy, the value of the dollar will drop as fears of inflation rise. Short - term U.S. interest rates will initially fall but will then rise as investors seek to protect themselves from higher anticipated inflation. Long - term rates will probably rise immediately because of fears of future inflation. Over time, however, if the growth in the money supply stimulated the economy to grow more rapidly than it otherwise would, the value of the dollar could rise, and so could real interest rates. This is an unlikely scenario, however, as indicated by the experiences of Latin American nations. 5. Comment on the following news from the Wall Street Journal (April 3, 2007, p. C12): “The dollar was little changed against the euro and yen, but weakened versus the currencies of Australia and the United Kingdom as investors mulled possible further rate increases in those countries.” A NSWER . The increase in Australia and U.K. interest rates made assets in the two coun tri es more attractive to investors. In the process of shifting funds from the U.S. to Australia and the U.K , investors sold dollars to buy the AUS$ and p ounds they needed to invest in these assets. An alternative – and consistent – explanation is that the rise in interest rates reflected a tightening of monetary polic ies in Australia and U.K. , leading investors to anticipate less inflation in the future for the two economies , which would increase their desire to hold AUS$ and p ound and thereby boost its value. 6 . On November 28, 1990, Federal Reserve Chairman Alan Greenspan told the House Banking Committee that despite possible benefits to the U.S. trade balance, “ a weaker dollar also is a cause for concern. ” This statement departed from what appeared to be an attitude of benign neglect by U.S. monetary officials toward the dollar ’ s depreciation. He also rejected the notion that the Fed should aggressively ease monetary policy, as some Treasury officials had been urging. At the same time, Mr. Greenspan didn ’ t mention foreign exchange market intervention to support the dollar ’ s value.
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INSTRUCTORS MANUAL: FOUNDATIONS OF MULTINATIONAL FINANCIAL MANAGEMENT , 6TH ED. 8 6. a. What was the likely reaction of the foreign exchange market to Mr. Greenspan ’ s statements ? Explain. A NSWER . The dollar rose when Chairman Greenspan indicated that he was concerned about the dollar's slide and would not aggressively ease monetary policy. Investors responded to his statement by lowering their expectations about future U.S. inflation, making dollars a more desirable asset. 6. b. Can Mr. Greenspan support the value of the U.S. dollar without intervening in the foreign exchange market? If so, how? A NSWER . Yes. By tightening U.S. monetary policy, he can lower investor expectations about future U.S. inflation and raise real U.S. interest rates (at least temporarily). Both these effects of tighter monetary policy will boost the dollar ’ value. 7 . Many Asian governments have attempted to promote their export competitiveness by holding down the values of their currencies through foreign exchange market intervention. 7. a. What is the likely impact of this policy on Asian foreign exchange reserves? O n Asian inflation? O n Asian export competitiveness? O n Asian living standards? A NSWER . To hold down the value of their currencies, Asian central banks must buy up foreign exchange in the market. The result is increased foreign reserves and an expanded domestic money supply, which has the potential to increase inflation. At the sam e time, the lower exchange rates boost Asian export competitiveness, but at the expense of a lower living standards for their populations (who find foreign goods and services more expensive). 7 . b. Some Asian countries have attempted to sterilize their foreign exchange market intervention by selling bonds. What are the likely consequences of sterilization on interest rates? O n exchange rates in the longer term? O n export competitiveness? A NSWER . To sterilize the expanded domestic money supply resulting from the purchase of foreign exchange, the Asian central bank must sell government securities to the market. These sales would drive down the price of government bonds and drive up domestic interest rates. Higher interest rates, in turn, would attract more foreign capital, which would boost the value of the domestic currency. Thus, in the long run, sterilized intervention will not a ffect exchange rates and export competitiveness. 8 . Hong Kong has a currency board that fixes the exchange rate between the U.S. and HK dollars. 8. a. What is the likely consequence of a large capital inflow for the rate of inflation in Hong Kong? For the competitiveness of Hong Kong business? Explain. A NSWER . As capital flows in, the currency board must exchange the foreign currency for an equivalent amount of HK dollars. The rise in the supply of HK dollars will lead to a higher rate of inflation. Combined with the fixed exchange rate, the rise in the inflation rate will result in an increase in the real exchange rate, making Hong Kong business less competitive.
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CHAPTER 2: THE DETERMINATION OF EXCHANGE RATES 9 8. b. Given a large capital inflow, what would happen to the value of the HK dollar if it were allowed to float freely? What would be the effect on the competitiveness of Hong Kong business? Explain. A NSWER . Given a freely floating HK dollar, all else being equal, a large capital inflow would cause the HK dollar to appreciate. As with a currency board, the resulting appreciation in the real value of the HK dollar would make Hong Kong business less competitive. 8. c. Given a large capital inflow, will Hong Kong business be more or less competitive under a currency board or with a freely floating currency? Explain. A NSWER . In both instances, the HK dollar will rise in real terms. However, the ways in which the real exchange rate change occurs will differ. With a currency board, the real exchange rate change will be brought about by the higher inflation that Hong Kong will experience, whereas with a free float it will be brought about by a rise in the nominal exchange rate. Indeed, the appreciation of a freely floating HK dollar will actually cause Hong Kong inflation to fall by reducing the cost of imports. The lower inflation rate will offset some of the loss of competitiveness brought about by the appreciating HK dollar. All else being equal, therefore, a large capital inflow would seem to harm Hong Kong business more under a currency board than with a freely floating currency. Because of this deflationary impact, however, the rise in the nominal exchange will likely be larger than it otherwise might be to balance the supply and demand for HK dollars. In general, the net effect is likely to be the same since it depends only on the demand for HK dollars , and the demand is not affected by the different ways in which that demand is satisfied. 9. In 1994, an influx of drug money to Colombia coincided with a sharp increase in its export earnings from coffee and oil. 9. a. What was the likely impact of these factors on the real value of the Colombian peso and the competitiveness of Colombia's legal exports? Explain. A NSWER . The sharp increase in earnings from drug dealing, coffee, and oil led – as expected – to an appreciation in the real value of the Columbian peso during 1994 (30% against the dollar) by boosting the demand for pesos in the foreign exchange market (as dollar earnings were converted into pesos). This real appreciation reduces the competitiveness of Columbia ’ s legal exports. 9. b. In 1996, Colombia ’ s president, facing charges of involvement in his country ’ s drug cartel, sought to boost his domestic popularity by pursing more expansionist monetary pol icies. Standing in the way was Colombia ’ s independent central bank – Banco de la Republica. In response, the president and his supporter s discussed the possibility of returning central bank control to the executive branch. Describe the likely economic consequences of ending Banco de al Republica ’ s independence. A NSWER . A sharp and continuing increase in the m oney supply would lead to hyper inflation and lower popularity for the president.
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INSTRUCTORS MANUAL: FOUNDATIONS OF MULTINATIONAL FINANCIAL MANAGEMENT , 6TH ED. 10 ADDITIONAL CHAPTER 2 QUESTIONS AND ANSWERS 1. Suppose prices start rising in the U.S. relative to prices in Japan. What would we expect to see happen to the dollar:yen exchange rate? Explain. A NSWER . As U.S. prices start rising relative to Japanese prices, both American and Japanese consumers will start substituting Japanese for U.S. goods, leading to increases in both the supply of U.S. dollars and the demand for Japanese yen. The result will be a depreciation of the dollar. 2. If a foreigner purchases a U.S. government security , what happens to the supply of and demand for dollars? A NSWER . In order to purchase a U.S. government security, the foreigner must first acquire dollars. This increases the demand for dollars, but has no affect on the supply of dollars. 3. In 1987, the British government cut taxes significantly, raising the after - tax return on investments in Great Britain. What would be the likely consequence of this tax cut on the equilibrium value of the British pound? A NSWER . The cut in British tax rates should raise after - tax returns, making investment in the U.K. more attractive to both British and foreign investors. In response, investors should demand more pounds to acquire the now - more - lucrative British assets, driving up the value of the pound. This is, in fact, what happened. 4. Some economists have argued that a lower government deficit could cause the dollar to drop by reducing high real interest rates in the U.S . What does the asset view of exchange rates predict will happen if the U.S. lowers its budget deficit? What is the evidence from countries such as Mexico and Brazil? A NSWER . The impact of a reduction in the budget deficit on the value of the dollar depends on how that deficit reduction is accomplished. The key according to the asset - market model is whether the mechanism used leads to a healthier or weaker economy. If the government reduces the deficit by raising taxes, economic incentives to work and invest will diminish, thereby hurting economic growth and the dollar. By contrast, deficit reduction brought about by a cut in government spending would signal a sensible economic policy and the dollar would rise. Another factor is also relevant. Lower deficits owing to a reduction in spending would convince foreigners that the chances for future inflation in the U.S. had decreased. This would make dollar investments look even better, further strengthening the dollar. As mentioned in the text, if high government deficits increased a currency ’ s value, Mexico and Brazil should have two of the strongest currencies in the world today. 5. What is there about fiat money that makes its exchange rate especially volatile? A NSWER . With fiat money , there is no anchor to a currency ’s value, nothing around which beliefs can coalesce. In this situation, where people are unsure of what to expect, any new piece of information can dramatically alter their beliefs about currency values. As people change their views of what the future holds, they change the price at which they are willing to hold the existing stock of currency.
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CHAPTER 2: THE DETERMINATION OF EXCHANGE RATES 11 6. Comment on the following headlines in The Wall Street Journal : 6. a. “ Sterling Drops Sharply Despite Good Health of British Economy: Oil Price Slump Is Blamed ” (January 17, 1985) A NSWER . The value of the pound is very sensitive to the price of oil because England has large North Sea oil reserves and is a major oil exporter. Hence, British wealth is positively related to the price of oil. Any event that reduces a nation ’ s wealth will also tend to drive down the value of its currency. The health of the British economy was already factored into the value of the pound. The new information about the price of oil drove down the pound ’ s value because it indicated that British wealth would be lower than was previously expected. 6. b. “ Dollar Surges as Coup in Soviet Union Revives Unit ’ s Appeal as a Safe Haven ” (August 20, 1991) A NSWER . With the reduction in world tension occasioned by the decline in Communism ’ s appeal in the Soviet Union, investors had less need for the U.S. dollar as a safe haven. The Soviet coup brought back the threat of Soviet militarism and led investors to desire once again to hold an increased share of their wealth in dollars. This increased demand for dollars led to the dollar ’ s surge in value. 6. c. “ Dollar Plummets on Soviet Coup Failure ” (August 22, 1991) A NSWER . As the threat of Soviet militarism once again faded with the failure of the Soviet coup, investors refused to continue paying the safe - haven premium they had previously been willing to pay. As investors shifted their demand from dollars to other currencies, the dollar reversed its previous run - up. 6. d. “ Dollar Falls Across the Board as Fed Cuts Discount Rate to 6 .5% From 7% ” (December 19, 1990) A NSWER . There are two possible reasons for the fall in the dollar. One possibility is that the Fed ’ s cut in the discount rate reduced real interest rates in the U.S. , reducing the attractiveness of dollar - denominated financial assets relative to assets denominated in foreign currencies. As investors shifted to non - U.S. assets, they had to first sell dollars, depressing the dollar’s value. The second possibility is that the Fed ’ s lowering of the discount rate was a harbinger of a looser U.S. monetary policy, fueling fears of higher inflation in the future. In response to higher expected U.S. inflation, the dollar fell immediately. 6. e. “ Canadian Dollar Likely to Fall Further On Recession and Constitutional Crisis ” (September 28, 1992) A NSWER . A Canadian recession combined with the perceived political risk associated with Canada ’ s constitutional crisis significantly reduces Canada ’ s appeal to investors, leading to expected capital outflows and a depressed Canadian dollar. However, to the extent that this bad news has already been factored into the Canadian dollar's value – and in an efficient market it should have been – the headline is wrong; the Canadian dollar should not fall further. Otherwise, speculators can earn risk - free profits by betting against the Canadian dollar.
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INSTRUCTORS MANUAL: FOUNDATIONS OF MULTINATIONAL FINANCIAL MANAGEMENT , 6TH ED. 12 6. f. “ Dollar Soars on U.S. and Iraqi Tension, Hints of Possible Lower German Rates ” (Dec. 12, 1992) A NSWER . The combination of the desire to hold more dollars because of political fears brought about by new problems with Iraq and the reduced appeal of investing in Germany because of the possibility of lower interest rates there, led to a large increase in capital flows to the U.S . These capital inflows boosted the value of the dollar. 6. g. “ Inflation, Slow Growth Seen Spurring Latin America to Devaluate Currencies ” (January 22, 1990) A NSWER . The Latin American countries have been maintaining their currencies at an artificially high level. Inflation and slow growth increase the overvaluation of Latin American currencies, putting greater pressure on their governments to devalue their currencies. 7. Suppose a new Russian government makes threatening moves against Western Europe. How is this threat likely to affect the dollar's value? Why? A NSWER . As investors in Western Europe become more nervous about their prospects , they will try to shift out of Western European assets and into U.S. dollars and dollar - denominated assets. Since they can ’ t all sell off their Western European assets simultaneously, the result will be a drop in the real value of Western European currencies relative to the real value of the dollar. Once the dollar has risen sufficiently, investors will again be willing to hold the existing (now devalued) stock of Western European assets, including currencies. 8. On May 11, 1995, the House Budget Committee approved a plan to slash federal spending through 2002 and thereby end the persistent U.S. budget deficits. How do you think the dollar responded to this news? A NSWER . This news should be favorable for the dollar because it indicated that the U.S. was going to follow a sounder economy policy, which would lead to lower inflation and higher economic growth in the future. The improved economic climate would make the U.S. investment environment more desirable and lead to capital inflows, which would drive up the dollar. As predicted, the dollar rose on the news. 9. Comment on the following statement: “ One of the puzzling aspects of central bank intervention is how those who manage our economic affairs think they know what is the ‘ right ’ price for a dollar in terms of francs, pounds, yen, or Deutsche marks. And if they do know, why do they keep changing their minds? ” A NSWER . Here ’ s one possible answer. Once President Nixon decided to abandon the gold standard, the dollar became just a piece of paper backed by nothing more substantial than “ the full faith and trust of the United States government. ” Of course, we could again peg the dollar and other currencies to gold, which – as we will see in Chapter 3 – would make them relatively stable. Each country would then be forced to manage its economic affairs by the straitjacket imposed by a metal whose supply doesn ’ t vary much. Many people would view that situation as desirable, since they would then have a good idea today what the dollar would be worth tomorrow in world markets. But governments wouldn ’ t then be able to manipulate exchange rates or money supplies to achieve other objectives. So the odds are that the powers that be will keep tinkering with the dollar on the foreign exchange market while they search for the dollar ’ s “ right ” price. But that still leaves unresolved a key question: How will they know when they ’ ve found the “ right ” price for the dollar?
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CHAPTER 2: THE DETERMINATION OF EXCHANGE RATES 13 10. In a widely anticipated move, on August 30, 1990, the Bank of Japan raised the discount rate (the rate it charges on loans to financial institutions) from 5.25% to 6% to reduce inflationary pressures in Japan. Many currency traders had expected the Japanese central bank to raise its rate by more than 0.75%. What was the likely consequence of this interest rate rise on the yen:dollar exchange rate? A NSWER . The key to this answer is to focus on the operative term “ widely anticipated ” and recognize that the foreign exchange market already factors any anticipated interest rate change into currency values. Thus, when the Bank of Japan hiked the interest rate by only 0.75%, the yen became a less desirable investment vehicle than it was before the announcement and investors sold off their yen assets. Consequently, the yen fell on August 30, 1990. In general, what moves markets is not what happens but what happens relative to what was expected to happen. 11. In the late 1980s, the Bank of Japan bought billions of dollars in the foreign exchange market to prop up the dollar ’ s value against the yen. What were the likely consequences of this foreign exchange market intervention for the Japanese economy? A NSWER . Without domestic sterilization, the increased purchase of dollars for yen led to a jump in the Japanese money supply. Initially, this increased supply of yen lowered Japanese interest rates and helped fuel what many observers have argued was a speculative rise in the Japanese stock and real estate markets. Over time, however, the higher money supply led to a rise in Japanese inflation. When the Bank of Japan responded in early 1990 to higher inflation by clamping down on the money supply, real Japanese interest rates rose and Japanese stock and real estate prices plunged. 12. Countries with high inflation need to keep devaluing their currencies to maintain competitiveness. But countries that try to maintain their competitiveness by devaluing their currencies only end up with even higher inflation. Discuss. A NSWER . Devaluation improves competitiveness to the extent that it does not cause higher inflation. If the devaluation causes domestic wages and prices to rise, any gain in competitiveness is immediately eroded. To address the competitive consequences of devaluation, therefore, two possible cases must be distinguished: Prior to devaluation , (a) the exchange rate is overvalued and (b) the exchange rate is in equilibrium. Consider, for example, a country with high inflation that tries to fix its nominal exchange rate. The currency will become overvalued and hurt local industry ’ s competitiveness. In this case, devaluation will reduce the currency overvaluation and improve competitiveness, even though prices will rise somewhat. That is, devaluation will reduce the local currency ’ s real exchange rate. But if the currency was in equilibrium to start with, then devaluation will occur only if monetary policy is eased. Easing will cause prices to rise (a) directly, by raising the price of imports and the goods that compete with them in the domestic market, and (b) indirectly, by forcing the central bank to expand the money supply to sustain the devaluation. Here, the real exchange rate stays the same and there is no improvement in competitiveness.
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INSTRUCTORS MANUAL: FOUNDATIONS OF MULTINATIONAL FINANCIAL MANAGEMENT , 6TH ED. 14 13. The Russian government is trying to figure out how to stabilize the value of its currency. What advice would you offer to it? A NSWER . The value of the ruble depends on the available supply of rubles relative to the demand for rubles. To stabilize the ruble ’ s value, the Russian government must restore the public ’ s confidence that the ruble can be held and exchanged for something of value. That is, the Russian government must demonstrate its willingness to maintain the ruble ’ s value. Confidence in money can be won only by controlling its supply and convincing the public that a stable currency is the only goal of monetary policy. The West Germans achieved this feat in the postwar era by giving the Bundesbank a currency - stabilization mandate and a high degree of political independence. Russia could do the same and go even one step further by creating a currency board, thereby fixing the value of the ruble to the dollar and not even establishing a central bank with discretionary money - creation authority. 14. “ Unsterilized interventions are just open market operations conducted through the foreign exchange market rather than through the U.S. government securities market. ” Comment on this statement. A NSWER . This statement accurately depicts the monetary consequences of unsterilized interventions. In ordinary open market operations, the central bank buys (sells) government bonds to expand (contract) the domestic money supply. Unsterilized interventions entail buying (se lling) foreign exchange, which causes an increase (decrease) in the supply of domestic currency that is not offset by open market operations. 15. As 1992 began, the Russian government and the central bank tightened credit in an attempt to slow the growth in the supply of rubles. However, the moves weren ’ t popular with the country ’ s giant state - run industrial enterprises, which are still dependent on official subsidies and cheap credit. In July 1992, the Russian Parliament appointed Viktor Gerashchenko head of the central bank. One of his first acts was to say that he didn't think the time was right to make the ruble convertible. Then he said that he would continue to extend credits to bankrupt and inefficient state enterprises. 15. a. How independent is the Russian central bank likely to be? What political pressures is it facing? A NSWER . The Russian central bank is unlikely to be very independent since the Russian Parliament can fire its head at will. Mr. Gerashchenko will face pressure to keep funding the bankrupt state - run industrial enterprises with newly created money. If credit is cut off, these enterprises will go under. Their managers and workers will continue putting pressure on Parliament and the central bank to ensure their continued funding. 15. b. What is the likely effect of Mr. Gerashchenko's statements on inflationary expectations in Russia? A NSWER . In effect, Mr. Gerashchenko has abdicated his control over monetary policy. The amount of money to be created will depend on the losses of state enterprises, not the amount necessary for noninflationary growth. Rational individuals will, therefore, take his statement to imply higher inflation, possibly hyperinflation.
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CHAPTER 2: THE DETERMINATION OF EXCHANGE RATES 15 15. c. How do you think the ruble:dollar exchange rate was affected by these statements? A NSWER . The expectation of higher future inflation, combined with the central bank ’ s unwillingness to permit ruble convertibility, should cause the ruble to fall in value, which it did. A stable, convertible currency is the cornerstone of maintaining a currency ’ s value and Mr. Gerashchenko ’ s statements indicated that this was not going to happen anytime soon. 15. d. In 1995, the Russian Central Bank signed an agreement with the International Monetary Fund not to issue cheap credits to state enterprises. How should the ruble react if the central bank sticks to its agreement with the IMF? A NSWER . This agreement is a positive development for the ruble because it implies that the Russian Central Bank will continue to expand the supply of rubles, which is the indirect consequence of subsidizing state enterprises through bank credits. A lower rate of growth in the ruble money supply means less Russian inflation and a stronger ruble. 16. In January 1991, President Mikhail Gorbachev banned all 50 - ruble and 100 - ruble bills, while permitting Soviet citizens to change only 1,000 rubles in these large bills into smaller denominations. In addition, savings - bank accounts were frozen for six months. The object of these measures was to strip the country's powerful black marketeers of their operating capital, driving as many as possible out of business, and to reduce inflation, which has been running at about 80% a year. The official Russian news agency Tass reported that the government had “ clearly decided that the confiscation version of monetary reform was the most efficient and least expensive version at its disposal. ” 16. a. Were these measures likely to achieve President Gorbachev's objectives? A NSWER . These measures might drive some black marketeers out of business, but they cannot reduce inflation. Although the confiscation of large bills and freezing savings accounts will reduce the money supply, the demonstrated willingness of the government to expropriate wealth held in the form of rubles will reduce the demand for money further. The result will be more inflation, not less. At the same time, these measures are likely to be much less effective at stripping black marketeers of their operating capital than Gorbachev thinks. Black marketeers are precisely the people who hold their wealth in gold, dollars, or other hard currencies. It is the ordinary citizens who will be (and were) most heavily penalized by Gorbachev ’ s policies. 16. b. How do you think the ruble ’ s exchange rate responded to President Gorbachev ’ s initiative? Explain. A NSWER . The ruble fell in value as people tried to convert their risky rubles into something, like dollars, more likely to hold its value.
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INSTRUCTORS MANUAL: FOUNDATIONS OF MULTINATIONAL FINANCIAL MANAGEMENT , 6TH ED. 16 17. On October 29, 1995, the Mexican governmen t announced a new economic plan that called for the government to boost the economy by cutting taxes and spending. The plan also included an agreement among business, labor, and government representatives to limit wage and price increases. How do you think the peso responded to this announcement? What about the Mexican stock market? Explain. A NSWER . This plan is positive news for the Mexican economy. If lived up to, the plan implies stronger economic growth and less inflation. Both of these factors should boost the Mexican stock market and the value of the peso, which happened. 18. Under the Convertibility Act, Argentina ’ s central bank is allowed to count dollar - denominated bonds issued by the Argentine government as part of its “ foreign ” reserve assets. What potential problem do you see with this rule? A NSWER . The central bank ’ s ability to count dollar - denominated bonds issued by the Argentine government as part of its “ foreign ” reserve assets is a loophole big enough to drive a truck through. Under Mr. Cavallo ’ s watchful eye, the central bank has not abused that loophole, with the so - called Bonex bonds varying between 3% and 9% of the monetary base cover. However, the central bank could alter its course overnight and expand the Bonex share of the reserves. In addition, although the Argentine government has always paid its Bonex obligations, it could refuse to honor Bonex obligations held by the central bank. 19. After the Mexican devaluation, investors questioning Argentina ’ s ability to maintain currency convertibility began pulling their money out of Argentina. In response, the Argentine government took extraordinary steps to maintain its exchange rate at $1 per peso. 19. a. What were the likely consequences of this capital flight for Argentina ’ s peso money supply? F or Argentine peso interest rates? F or economic growth? A NSWER . Since Argentina maintains a currency board, it cannot sterilize the effects of currency inflows or outflows. An outflow of capital, therefore, must lead to a decline in the quantity of pesos in circulation. The immediate impact was a jump in interest rates. In turn, high real rates led to a slowdown in economic growth. However, as investors became convinced that Argentina was not going to devalue the peso, the high real interest rates began attracting capital back into Argentina, lowering real interest rates back to where they had been before. This process of arbitrage is to be expected, as Argentina ’ s interest rates cannot diverge much from U.S. rates as long as the Argentine peso is perceived to be tied to the dollar. At the same time, the greater confidence in the value of the peso boosted business confidence and business began investing again in Argentina. The result was that economic growth picked up again after the initial fright and capital flight. 19. b. Why was the Argentine government so reluctant to devalue the peso? A NSWER . Argentina saw what happened in Mexico a month before, where peso devaluation led to higher inflation (because of the higher price of foreign goods and services), which led in turn to further devaluation and inflation. Interest rates jumped to account for the high inflation rate and loss of faith in the government ’ s ability to maintain the peso ’ s value. In other words, devaluation of the Mexican peso had not solved anything but rather had revived the specter of an ongoing inflation - devaluation cycle – a specter that most Mexicans hoped had disappeared during the 1980s.
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CHAPTER 2: THE DETERMINATION OF EXCHANGE RATES 17 19 .c As U.S. interest rates rise, what is likely to happen to Argentine rates? Why? A NSWER . Since the Argentine peso is tied to the U.S. dollar at a 1:1 rate, interest rates between the two countries cannot diverge by more than a small amount. Divergence in interest rates will come only if there is a fear of peso devaluation. Otherwise, the two currencies are virtually identical and so must bear virtually identical interest rates. 20. One recommended approach to strengthen the dollar against the yen is for the U.S. Treasury to issue about $70 billion a year (the Japanese share of the U.S. trade deficit) in yen - denominated bonds. How might this move help the dollar? A NSWER . Such a move would stre ngthen the dollar by providing a highly visible signal that the U.S. government is interested in a strong dollar. A weakening dollar would increase the U.S. government ’ s cost of servicing its debt, thereby giving it a strong disincentive to talk down the dollar against the yen, which it has done on a fairly regular basis. 21. In 1993, President Carlos Salinas de Gortari proposed a bill that would formally grant the Bank of Mexico, Mexico ’ s central bank, autonomy vis - à - vis the central government. As an investor, how would you view such a proposal? What other changes might help to amplify the signals sent by this proposal? A NSWER . Investors, who value price stability, would view such a bill as strongly positive. Such a law would enable the Bank of Mexico to avoid financing government deficits by printing pesos and thereby improve financial discipline. The relentless printing of pesos is what has led to the ongoing inflation - devaluation cycle in Mexico. Investors would be even happier, however, if the Mexican government ’ s ability to run budget deficits were constrained, since these deficits are the driving force underlying the peso printing. Absent such constraints , investors would be concerned that future deficits could lead the government to renege on its commitment to central bank independence. Unfortunately, the Bank of Mexico badly damaged its credibility when, during 1994 , it appeared to collaborate with an admini stration facing tough elections by pouring more pesos into the banking system. The monetary expansion kept interest rates low, which kept the economy growing but led to the traumatic devaluation of December 1994. 22. The People ’ s Bank of China, China's central bank, is run by bureaucrats whose prime objective seems to be funding loss - making state - owned firms. What is your prediction about the inflation outlook for China and the value of its currency, the yuan? Explain. A NSWER . Subsidizing money - losing state firms exacerbates the Chinese government ’ s budget deficit. These deficits, in turn, lead to inflation since they are being financed by printing additional yuan. The dilemma for Chinese policymakers is that tightening credit to the cash - starved state sector, while cooling inflation pressures, will also lead to a shutdown of many state firms and throw millions out of work, which could result in social chaos.
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