Multinational Financial Management, Study Guide, 6th Edition Solution Manual

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CHAPTER 1: INTRODUCTION1CHAPTER 1INTRODUCTIONChapter 1 emphasizes the internationalization of business and economic activity that has occurred sincethe end of World War II. Although international business activities have existed for centuries, primarily inthe form of exporting and importing, only in the postwar periodhavemultinational firms becomepreeminent. 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 trueMNCis characterized more by attitude than the physicalreality of an integrated, globalsystem of marketing and production activities. It involves looking beyondtheboundaries of the home countryand treating the world as“our oyster.”After stimulating student interest with this vision of the MNC, I then introduce the financial decisionsthatMNCsmust make. I begin by discussing the key concepts and lessons from domestic finance thatapply directly to international corporate finance. The lessons include the emphasis on cash flow ratherthan accounting earnings, the time value of money, the importance of taxes, and the unwillingness ofinvestors to reward companies for activities (like corporate diversification)thatinvestors could replicatefor themselves at no greater cost.The key concepts, which I point out will arise time and again in the course, are arbitrage, marketefficiency, 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 assetpricing model (CAPM) and the arbitrage pricing theory (APT). Although imperfect, the theoreticalframework of domestic corporate finance provides a useful frame of reference, and understanding it isessential before proceeding with the more complex aspects of international financial management. Idevote some time to explaining that total risk matters, even if the CAPM or APT holds. Otherwise,theastute 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 riskmanagement, managing working capital and the internal financial system, financing foreign units, capitalbudgeting, and evaluation and control. I emphasize the additional parameters that MNC financialexecutives must cope with, including multiple currencies, rates of inflation, tax systems, and capitalmarkets, as well as foreign exchange and political risks.

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INSTRUCTORS MANUAL:FOUNDATIONS OF MULTINATIONAL FINANCIAL MANAGEMENT, 6TH ED.2SUGGESTED ANSWERS TO “THE DEBATE OVER OUTSOURCING”1.What are the pros and cons of outsourcing?ANSWER.PROS:OutsourcingenablesAmericans to buy services less expensively abroad,increases U.S.productivity,and enables U.S. companies to cuttheircosts while improving quality, timetomarket, andcapacity to innovate. It also allowstheU.S.touseits comparative advantage in financial, managerial,andtechnical services by specializing in and exporting such services as higher-endcomputer programming,management consulting, engineering, banking, telecommunications,andlegal work.CONS: As with any kind of trade, importingof services through outsourcing resultsin the loss of jobs forAmericans previously employed in providing those services.Outsourcing may alsocauseU.S. companiesthat provide these servicesto go out of business.2.How does outsourcing affect U.S. consumers? U.S. producers?ANSWER.As the answer to part a) points out, outsourcing allows companies to buy services lessexpensively abroad. Competitive pressures force companies to pass these savings along to consumers inthe form of lower-priced goods and services.U.S. producers are able to boost productivity and cut costs while improving quality, timetomarket, andcapacity 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?ANSWER.The longer-term effect of outsourcing on U.S. jobs should be insignificant. Trade has little, ifanything, to do with the quantity of jobs in an economy but rather the nature and distribution of those jobsin various occupations. Outsourcing should lead to higher average productivity of those jobs thatAmericans work at and, hence, to higher wages and benefits.4.Several states are contemplating legislation that would ban the outsourcing of government workto foreign firms. What would be the likely consequences of such legislation?ANSWER.Such legislation would result in less efficient and more expensive government.The end resultwould be higher taxes or, if taxpayers balk, fewer government services.SUGGESTED ANSWERS TO CHAPTER 1 QUESTIONS1.Explain how globalization may affect even a small business in your local area.ANSWER.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, manyfirms find it cheaper to source products from foreign countries. Also, firms are now aware of internationalmarket opportunities and locate theirplants and facilities abroad.As a result, the competition faced byany business is now more global rather than merely local.A small business in any local area now facescompetition frombothlargeMNCsandsimilarly situated businesses that take advantage of theirinternational experience as well as internationally sourced products.

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CHAPTER 1: INTRODUCTION32.Opponentsofglobalizationandoutsourcingarguethat locatingmanufacturingactivitiesabroad causes a loss of U.S.jobs.However, total employment figuresrevealthat rather thanresulting ina net loss of jobs, employment has actually increased.Also, the average wages ofworkershaveincreased. How would you account for this discrepancy between what the criticssay and what statistics reveal?ANSWER.Globalizationis a two-way street.WhilesomeU.S.firmslocate their plants overseas, severalforeign companieshave alsoinvested in the U.S. economy and located their plants here.For example,major foreign automobile manufacturers such as ToyotaandBMW have set up manufacturing plants inthe U.S. andcreated numerous U.S. jobs.Also,over the last 25 years, the U.S. economy has experiencedunprecedented productivity growth due to the increase in trade from globalization.The net impact of thisproductivity growth as measured in output per hour has been such as to increase the inflation-adjustedworker compensation.Thus, while critics of globalization look at only one side of the picture and point tojob losses due to outsourcing, they neglect to take into account the job creation due to foreign investmentin the U.S. andtheincreaseintradedue toglobalization.Criticsalso ignore the fact theincreasedopportunities for trade due to globalization result inhigh-value-added servicesbeing performed in theU.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.ANSWER.Rather than react to globalization, firms benefit by facing globalization and global competitionhead on.Globalization and global competition unleash the forces of creative destruction, whereby newtechnologies and new methods of business force outpoorly performing competitors.To take advantage ofthe 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 resultsofsuch improvementsareclear in terms of the lower prices and expanded choices for consumers.Thus,proactivefirmsstayaheadoftheircompetitionbytakingadvantageofthevariousbenefitsofglobalization and the expanded trade opportunities.4.What are the various reasons for the emergence of multinational firms?ANSWER.The primary reason for the emergence ofMNCsis the international mobility ofseveral factorsof production.MNCsemerge to take advantage of globally available raw materials, markets, specializedskills,and knowledge.Also, firms may become multinational to keep domestic customersthathavemoved abroad or to exploit financial market imperfections.These are elaborated below.SEARCH FOR RAW MATERIALS.Some firms become MNCs to exploit the raw materials thatcan be foundoverseas, such asoil, coal, minerals,and other natural resources.MARKET SEEKING.Some firms become MNCs to exploit foreign markets for their products.Since thesame product may be demanded in different countries,MNCsnot only take advantage of themarketing opportunities,but also gain from the economies of scaleobtained by sellinglarge volumesacross different foreign markets.COST MINIMIZATION.CompaniesalsobecomeMNCsto seek out lower-production-cost sites.Specificskills needed for production may be available at lower costs in some countries,and MNCs may locateplants specializing in specific aspects of production, such as assembly or fabrication, in thosecountries.

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INSTRUCTORS MANUAL:FOUNDATIONS OF MULTINATIONAL FINANCIAL MANAGEMENT, 6TH ED.4KNOWLEDGE SEEKING.Some firms enter foreign markets to gain information and experience that areexpected to prove useful elsewhere.Especially in industries characterized by rapid product innovationand technical breakthroughs, firms obtain technical product and process knowledge, which theyleverage in other countries.KEEPING DOMESTIC CUSTOMERS.Suppliers of goods or services toMNCsoften follow their customersabroad to guarantee them a continuing product flow.In the process, these firms also becomeMNCs.EXPLOITING FINANCIAL MARKET IMPERFECTIONS.Companies may find it advantageous to reduce taxes andcircumvent currency controls when operating in multiple foreign markets. Doing so enables them toobtain 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, areMNCsmore orless risky than purely domestic firms in the same industry? Consider whether a firm thatdecides not to operate abroad is insulated from the effects of economic events that occur outsidethe home country.ANSWER.Individual foreign projects may face more political and economic risks than comparabledomestic projects. YetMNCsare likely to be less risky than purely domestic firmsbecausemuch of therisk faced overseas is diversifiable. Moreover, by operating and producing overseas, theMNChasdiversified its cost and revenue structure relative to what it would be if it were a purely domestic firmproducing and selling in the home market. It is important to note that domestic firms are not insulatedfromeconomicchangesabroad.Forexample,domesticfirmsfaceexchangeriskbecausetheircompetitive positions dependon the cost structuresofbothforeignand domesticcompetitors. 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 anMNC?ANSWER.IBM is selling more than black boxes; it is selling a stream of services associated with itscomputers. In effect, customers are buying the company.Toprovide customers with what they think theyare buying,IBMmust be there on the spot. This enables IBM to service customers’machines as well astailor software and systems to their specifications.7.If capital markets were perfect, i.e., capital could move freely across national borders, wouldMNCsstill exist? Why? Or, why not?ANSWER.Even if capital moved freely across national borders,MNCswould still exist,because MNCsbring a host of firm-specific knowledge and advantages along with capitaltothe countries in which theyoperate.Such advantages may include unique products, processes, technologies, patents, specific rights,or specific knowledgeand skills.These advantages can beusedprofitablyin foreign markets.Moreover,MNCs are better able to apply the knowledge and skills gained in their prior operations in other countriesto each new country that they enter.Thus, from the point of view of a country attracting foreign capital,the capital that is brought in by anMNC brings with it firm-specific advantages that yieldbetter returnsthan the capital that is simply borrowed from a foreign country.

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CHAPTER 1: INTRODUCTION58.What are the various ways in which domestic firms enter international markets? What are thebenefits and risks of each strategy of foreign market entry?ANSWER.Three major ways in which domestic firms enter international markets arethroughexporting,licensing, and overseas production.When exporting, the domestic firm operates from its home countryand merely sends its products overseas.In licensing, the domestic firm licenses its product, process,ortechnology to a foreign firm in return for royalties or other forms of payment.In overseas production, thedomestic firm becomes anMNCby setting up a corporation overseas and engaging in manufacturingand/or marketing.The benefits and risks of each strategyaresummarized below.EntryBenefitsRisksExporting•Minimal capital requirements and start-upcosts•Risk is low•Profits are immediate•Learn about present and future supply anddemand, competition,distributionchannels,payment conventions, financial institutions,and financial techniques inhostcountry•Relatively low risk compared to other entrystrategies•Full sales potential of the product is notrealized•Foreign importer is in greater control ofmarketing, and thusthe image,of the firm’sbranded products in the foreign countryLicensing•Minimal investment requirements•Faster market-entry time•Fewer financial and legal risks•Cash flow is relatively low•May be problems in maintaining productquality standards•Foreign licensee may engage in unauthorizedexports of the firm’s products, resulting inloss of future revenues for the licensing firm•Foreign licensee may become a strongcompetitor when licenseagreement endsOverseasProduction•Thefirmcan more easilystayabreast ofmarket developments, adapt its products andproduction schedules to changing local tastesand conditions, fill orders faster,and providemore comprehensive after-sales service•Firmcanexploitlocal skills, includingR&D•Signals a greater commitment to the localmarket, which in turnincreasessales andassurance of supply stability•Tremendous capital and top managementcommitment is required•Financial and operational risks are greaterthanthose forother entry strategies•Companies face greater political risks,including the risk of expropriation of plantsand facilities9.Why do firms from each of the following categories becomeMNCs? Identify the competitiveadvantages that a firm in each category must have to be a successfulMNC.a.Raw-materials seekersb.Market seekersc.Cost minimizersANSWER.FDI is most likely to be economically viable where the possibility of opportunism on the partof unrelated parties or contractual difficulties make it especially costly to coordinate economic activitiesvia arm’s length transactions in the marketplace.Firmsgo overseas to more fully utilize their skills andother tangible and intangible assets.

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INSTRUCTORS MANUAL:FOUNDATIONS OF MULTINATIONAL FINANCIAL MANAGEMENT, 6TH ED.6RAW MATERIALS SEEKERS.The existence of low-cost raw materials overseas is not a sufficient condition forfirms to becomeMNCs; they could just import raw materials rather than set up operations abroad toextract them. Companies that become raw materials MNCs musta)Have intangiblecapabilities in the form of technical skills and face contractual difficulties in the formof an inability to price their know-how or to write, monitor, and enforce use restrictions governingtechnology transfer arrangements; andb)Face problems of opportunism that make it very expensive to enter into long-term purchase contractsto fully utilize their production or distribution capability. For example, an oil refining and distributingfirm 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 tothe refiner.MARKET SEEKERS.These firms usually have intangible capital in the form of organizational skills that areinseparable from the firm itself. A basic skill involves knowledge about how best to service a market,includingnewproductdevelopmentandadaptation,qualitycontrol,advertising,distribution,andafter-sales service. Since it would be difficult, if not impossible, to unbundle these services and sell themapart from the firm, this form of market imperfection often leads to corporate attempts to exert controldirectly via the establishment of foreign affiliates.COST MINIMIZERS.These firms seek to reduce their costs by producing overseas. Yet the existence oflower-cost production sites overseas is not sufficient to justify FDI. Since local firms have an inherentcost advantage over foreign investors,MNCscan succeed abroad only if the production or marketingedge they possess cannot be purchased or duplicated by local competitors. The successful MNC in thiscategory will possess specialized design or marketing skills, a good distribution system, or own a strongbrand name. Excess profits are earned on these intangible assets, not on the low foreign labor or materialscosts. Overseas production just enables them to be cost competitive; it doesn't give them an edge sinceany competitor can replicate its production location.10.What factors help determine whether a firm will export its output, license foreign companiesto manufacture its products, or set up its own production or service facilities abroad? Identifythe competitive advantages that lead companies to prefer one mode of international expansionover another.ANSWER.Here are some factors involved in deciding how to enter a market:i)PRODUCTION ECONOMIES OF SCALE. If these are important, then exporting might be appropriate.ii)TRADE BARRIERS. Companies that might otherwise export to a market may be forced by regulations toproduce abroad, either in a whollyowned operation, a joint venture, or through a licensingarrangement with a local manufacturer.iii)TRANSPORTATION COSTS.These have the same effect as trade barriers. The more expensive it is to shipa product to a market, the more likely it is that local production will take place.iv)SIZE OF THE FOREIGN MARKET.The larger the local market, the more likely local productionwilltakeplace, particularly if significant production economies of scaleexist. Conversely, with smallermarkets, exporting is more likely to take place.

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CHAPTER 1: INTRODUCTION7v)PRODUCTION COSTS.The real exchange rate, wage rates, and other cost factors will also play a part indetermining whether exporting or local production takes place.vi)INTANGIBLE CAPITAL.If theMNC’sintangible capital is embodied in the form of products, exportingwill generally be preferred. If intangible capital takes the form of specific product or processtechnologies that can be written down and transmitted objectively, foreign expansion will usually takethe licensing route.If intangible capital takes the form of organizational skills that are inseparablefrom the firm itself, then the firm is likely to expand overseas via direct investment.vii)NECESSITY OF A FOREIGN MARKET PRESENCE.By investing in fixed assets abroad, companies candemonstrate to local customers their commitment to the market. This can enhance sales prospects.11.TimeWarnermustdecidewhethertolicenseforeign companies to produce its films and recordsor set up foreign sales affiliates to sell its products. What factors might determine whether itexpands abroad via licensing or investing in its own sales force and distribution network?ANSWER.Some of the factors that Warner should consider in determining whether it expands abroad vialicensing or by investing in its own sales force and distribution network are as follows:a)SALES VOLUME.It needs a certain minimum volume of business to justify its own sales force.b)POTENTIAL PROBLEMS OF OPPORTUNISM.How easy is it to monitor and control independent producersand sellers of its films and records? The easier it is to monitor and control them, the less value there is inhaving its own sales and distribution capability.c)CONFLICTS OF INTEREST.How motivated will independents be in pushingTimeWarner’s productsversus those of other companies?d)COLLATERAL BENEFITS TOWARNER.To the extentTimeWarner gets other benefits from distributing itsfilms(e.g., the sale of toys) that aren’t captured by independents, they will have less incentive to pushTimeWarner’s products thanTimeWarner will have. The more collateral benefits, the more important itis forTimeWarner to control its own sales.e)THE IMPORTANCE OF MARKET INFORMATION.If products must be tailored to the foreign markets,TimeWarner should probably develop its own sales force.TimeWarner will find it difficult to gather thenecessary market intelligence from independent distributors of its products.ADDITIONAL CHAPTER 1 QUESTIONS AND ANSWERS1.a.What are the various categories ofMNCs?ANSWER.Raw materials seekers, market seekers, and cost minimizers.1.b.What is the motivation for international expansion of firms within each category?ANSWER.Raw materials seekers go abroad to exploit the raw materials that can be found thereand can’tbefounddomestically. Marketseekersgooverseasto produce and sell in foreign markets.Cost minimizersinvest in lower-cost production sites overseas to remain cost competitive both at home and abroad. In allcases, the firms involved recognize that the world is larger than the home country and providesopportunities 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.82.a.How does foreign competition limit the prices domestic companies can charge and the wagesand benefits workers can demand?ANSWER. As domestic producers raise their prices, customers begin substituting less-expensive goodsand services supplied by foreign producers. The likelihood of losing sales limits the prices domestic firmscan charge. Foreign competition also limitsthe wages and benefits workers can demand. If workersdemand moremoney, firms have two choices: acquiescetothese demands or fight them. Absent foreigncompetition, the cost of acquiescence is relatively low, particularly if the industry is unionized. Since allfirms will face the same higher costs, they can cover these higher costs byallsimultaneously raising theirprices without fear of being undercut or of being placed at a competitive disadvantage relative to theirpeers. Foreign competition changes the picturebecauseforeign firms’costs will be unaffected by higherdomestic wages and benefits. If domestic firms give in on wages and benefits, foreign firms willunderprice them in the market and take market share away. In this case, higher domestic costs will putdomestic firms at a disadvantage vis-à-vis their foreign competitors. Recognizing this, domestic firmsfacing 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 byforeign competition?ANSWER.The classic political solution is protectionism.By limiting foreign competitioneither throughtariffs or quotas, companies and workers limit the ability of foreign goods to restrain domestic priceincreases. The government can also subsidize domestic firms competing against foreign firms,allowingdomestic firms and unions to perpetuate uneconomic work rules, wages, and productions processes.2.c.Who pays for these political solutions? Explain.ANSWER.Consumers pay for protectionism in the form of higher prices for their goods and services,fewer choices, and lower quality. Taxpayers pay for subsidies in the form of higher taxes or fewer of theother services provided by government.3.a.What factors appear to underlie the Asian currency crisis?ANSWER.Asian countries had run up huge debts, mostly in dollars, and were depending on the stabilityof their currencies to repay these loans. Worse, Asian banks, urged on by the often-corrupt politicalleadership, weremaking loansto money-losing ventures controlled by political cronies. The result wasfinancially 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?ANSWER.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 orpolitical considerations. Countries can stimulate healthier economies by avoiding policies that suppressenterprise, reward cronies, and squander resources on economically dubious, grandiose projects.4.a.What is an efficient market?ANSWER.Anefficient marketis one in which new information is readily incorporated in the prices oftraded securities. In an efficient market,one cannot expect to prosper by finding overvalued orundervalued assets. In addition, all funds require the same risk-adjusted returns. Absent tax considerationsor government intervention, therefore, market efficiency suggests that no financing bargainsareavailable.

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CHAPTER 1: INTRODUCTION94.b.What is the role of a financial executive in an efficient market?ANSWER.In an efficient market, attempts to increasea firm’svalue by purely financial measures oraccounting manipulations are unlikely to succeed unless capital market imperfections or asymmetries intax regulationsexist. The net result has been to focus attention on those areas and circumstances in whichfinancialdecisions and financial managers can have a measurable impact.Key areas are capital budgeting,working capital management, and tax management.Circumstances to be aware of include capital marketimperfections, caused primarily by government regulations, and asymmetries in the tax treatment ofdifferent types and sources of revenues and costs. As such, the role of the financial manager is to searchfor and take advantage of capital market imperfections and tax asymmetries to increase after-tax profitsandlower thecost of capital.Thevalue of good financial management is enhanced in the internationalarena because of the greater likelihood of market imperfections and multiple tax rates. In addition, thegreater complexity of international operations is likely to increase the payoffs from a knowledgeable andsophisticated approach to internationalizing the traditional areas of financial management.5.a.What is the capital asset pricing model?ANSWER.The CAPM quantifies the relevant risk of an investment and establishes the trade-off betweenrisk and return; i.e., the price of risk. It posits a specific relationship between diversification, risk, andrequired asset returns. In effect, the CAPM says that the required return on an asset equals the risk-freereturn plus a risk premium based on the asset’s systematic or nondiversifiable risk. The latter is based onmarket-wide influences that affect all assets to some extent, such as unpredictable changes in the state ofthe economy or in some macroeconomic policy variable, such as the money supply or the governmentdeficit.5.b.What is the basic message of the CAPM?ANSWER.The CAPM’s basic message is that risk is priced in a portfolio context. From this it follows thatonly systematic risk is priced; unsystematic risk, which by definition can be diversified away, is notpriced and hence doesn’t affect the required return on a project.5.c.How might anMNCuse the CAPM?ANSWER.The CAPM can be used to estimate the required return on foreign projects. Itcanalso help acompany raise the right questions about risk when considering the desirability of a foreign project, themost important being which elements of risk are diversifiable and which are not.6.Why might total risk be relevant for a multinational corporation?ANSWER.Higher total risk is relevant for an MNC because it could have a negative impact on the firm’sexpected cash flows The inverse relation between risk and expected cash flows arises because financialdistress, which is more likely to occur for firms with hightotalrisk, can impose costs on customers,suppliers, and employees,and thereby affect their willingness to commit themselves to relationships withthe firm. In summary, total risk is likely toadverselyaffect a firm’s value by leading to lower sales andhigher costs. Consequently, any action taken by a firm that decreases its total risk will improve its salesand cost outlooks, thereby increasing its expected cash flows.

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INSTRUCTORS MANUAL:FOUNDATIONS OF MULTINATIONAL FINANCIAL MANAGEMENT, 6TH ED.107.A memorandum by Labor Secretary Robert Reich to President Clinton suggests that thegovernment penalize U.S.firmsthat invest overseas rather than at home. According to Reich,thiskindofinvestment hurts exports and destroys well-paying jobs. Comment on this argument.ANSWER.The assumption underlying Secretary Reich’s memo is inconsistentwith the empiricalevidence. According to this evidence, U.S.firmsthat invest abroad tend to expand their exports. Thejump in exports stems from the fact that by investing abroad, companies are able to expand their presencein foreign markets as well as protect foreign markets that would otherwise be lost to competitors. Thisenables them to sell more product, most of which is made in theU.S. In addition, the foreign plants tendto 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 wellas the additional exports that such markets generate. Such penalties would also reduce the efficiency ofthe world economy. After all, there is usually asound economic reasonforMNCstoinvest abroad.8.a.AreMNCsriskier than purely domestic firms?ANSWER.AlthoughMNCsare confronted with many added risks when venturing overseas, they can alsotake advantage of international diversification to reduce their overall riskiness. We will also see inChapter 16 that foreign operations enable MNCs to retaliate against foreign competitive intrusions in thedomestic market and to more closely track their foreign competitors, reducing the risk ofbeing blindsidedby new developments overseas.8.b.What data would you need to address this question?ANSWER.You would need to take relatively comparable firms in the same industry, but with differentpercentages 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.ANSWER.Yes. International diversification may actuallyenablefirms to reduce theirtotal risk. Much ofthe general market risk facing a company is related to the cyclical nature of the domestic economy of thehome 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,although the riskiness of operating inany one country may exceed the risk of operating in theU.S.(or other home country), much of that risk iseliminated through diversification. In fact, as shown in Chapter 15, the variability of earnings appears todecline as firms become more internationally oriented.10.In what ways do financial markets grade government economic policies?ANSWER.Traders and their customers receive a continuing flow of news from around the world. Theannouncement of a new policy leads traders to buy or sell currency, stocks,or bonds based on theirevaluation of the effect of that policy on the market. A desirable policy leads them to buy more of theassets favorably affected by the policy, while a policy that is judged to be harmful leads to sell orders ofthose assets that will be hurt by the policy. The result is a continuing global referendum on a nation’seconomic policies, even before they are implemented.

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CHAPTER 1: INTRODUCTION11Politicians who pursue economic policies they perceive tobe beneficial to them (e.g.,improving theirre-election odds), even if these policies harm the national economy, usually don't appreciate the gradesthey receive. But the marketisclear-eyed and hard-nosed and will respond negatively to unsound fiscaland monetary policies. Politicians will not admit that their own policies led to higher interest rates orlower currency values or stock prices; that would be political suicide. It is much easier to blame greedyspeculators 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 exchangerate or the exchange rates for the past 100 days?ANSWER.In an efficient market, which the foreign exchange market certainly appears to be, the currentprice of an asset such as a currency fully reflects all available information, including the complete pricehistory. Thus,knowing today’s price is as informative from a forecasting standpoint as knowing all pastprices. Past prices add nothing to the current price in terms of forecasting ability.12.Why might setting up production facilities abroad lead to expanded sales in the local market?ANSWER.By producing abroad, a company can more easily keep abreast of market developments,adaptingitsproductsandproductionschedulestochanginglocaltastesandconditions,whilesimultaneouslyproviding more comprehensive after-sales service. Establishing local production facilitiesalso demonstrates a greater commitment to the local market and an increased assurance of supplystability. This is particularly important for firms that produce intermediate goods for sale to othercompanies.13a.How might total risk affect a firm’s production costs and its ability to sell? Give someexamples of firms in financial distress that saw their sales drop.ANSWER.Higher total risk can lead to lower sales and higher production costs. The inverse relationbetween risk and expected cash flows arises because financial distress, which is more likely to occur forfirms with hightotalrisk, can impose costs on customers, suppliers, and employees and thereby affecttheir willingness to commit themselves to relationships with the firm. Examples include Chrysler andTexaco, 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 desireto hedge foreign exchange risk?ANSWER.Since total risk is likely to adversely affect firm value, by lowering sales and raising costs, anyaction taken by a firm that decreases its total risk will improve its sales and cost outlook, therebyincreasing its expected cash flows. These effects help justify the range of corporate hedging activitiesdesigned to reduce total risk that MNCs engage in.

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INSTRUCTORS MANUAL:FOUNDATIONS OF MULTINATIONAL FINANCIAL MANAGEMENT, 6TH ED.12SUGGESTED ANSWERS TO APPENDIX 1A QUESTIONS1.In a satirical petition on behalf of French candlemakers,French economistFrederic Bastiatcalled attention to cheap competition from afar: sunlight. A law requiring the shuttering ofwindows during the day, he suggested, would benefit not only candlemakers but“everythingconnected with lighting”and the country as a whole. He explained:“As long as you exclude, asyou do, iron, corn, foreign fabrics, in proportion as their prices approximate to zero, whatinconsistency it would be to admit the light of the sun, the price of which is already at zeroduring the entire day!”1.a.Is there a logical flaw in Bastiat’s satirical argument?ANSWER.No. Bastiat is precisely right. The objective of trade is to gain access to goods and services atlower quality-adjusted prices. The ultimate consequence is to make more efficient use of the world’sresources and thereby increase worldwide production and consumption. Protectionism aims to preventthis end. If protectionism succeeds, world output and consumption are lower than they might otherwise bebecause resources are not being put to their highest-valueuse. 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 therelikely to be consensus among the Japanese carmakers on this point? Might there be anyJapanese automakers that are likely to prefer U.S. trade restrictions? Why? Who are they?ANSWER.It depends. Both tariffs and quotas will lead to higher prices to U.S. consumers of importedJapanese cars. With tariffs, however, most of this price increase will go to the U.S. government in theform of tariffs. Japanese companies (or their dealers), on the other hand, will collect most, if not all, of thehigher prices associated with the scarcity of imported Japanese cars. Once the Japanese producers hit theirquota limit, they have no incentive to compete with each other by cutting price because they cannot sellmore cars than they already are. The net result is that the U.S. market will be extraordinarily profitable toJapanese automakers, which it was.Since quotas tend to be allocated based on current sales, automakers like Toyota and Nissan with largemarket shares would prefer quotas, whereas automakers like Honda and Mitsubishi with smaller marketshares would prefer tariffs. The reason for the latter’s preference for tariffs is that efficient companies caneventuallyovercometheeffectsoftariffsby cutting costs and prices, whereas efficiency counts for nothingwithquotas. Regardless of the type of trade barrier imposed, U.S. automakers will raise their prices in linewith higher import prices. However, U.S. automakers are likely to prefer quotas because quotas enablethem to disguise the reason for higher U.S. car prices. Consumers would be much quicker to figure outthe 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 doesprotectionism persist despite the obvious gains to society from free trade?ANSWER.The U.S. auto industry has received as much protection as it has for two key reasons. First, it isa large and powerful industry. Second, it is concentrated in several politically important states, such asMichigan and Illinois.

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CHAPTER 1: INTRODUCTION132.Review the arguments both pro and con on NAFTA. What is the empirical evidence so far?ANSWER.NAFTA has helped increase international trade between theU.S., Mexico, and Canada. Theresults 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 ofconsumers. 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 hasevery thing to do with the incentives that people have to work, their productivity, and the costs toemployers of hiring workers. What trade does is permit workers to hold jobs in those areas of theeconomy in which the nation has a comparative advantage. At the same time, trade destroys jobs in thosegoods and services in which the nation is at a comparative disadvantage.3.Giventheresourcesavailabletothem,countriesAandBcanproducethefollowingcombinations of steel and corn.Country ACountry BSteel (tons)Corn (bushels)Steel (tons)Corn (bushels)36054030345924636181892727151218366159450180543.a.Do you expect trade to take place between countries A and B? Why?ANSWER.Yes. Given the data presented, if country A has 6 units of resources and it devotes X of theseunits 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 steelproduction, it can produce Y tons of steel plus (54-Y) bushels of corn. The net effect of these productionfunctions is that one bushel of corn is worth 2 tons of steel in country A. In contrast, one bushel of corn isworth only one ton of steel in country B. These relative prices indicate that country A has a comparativeadvantage 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.ANSWER.Given these comparative advantages, A will export steel and B will export corn. The price ofcorn 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 unitto the production of an additional 6 tons of steel. It can trade these 6 tons of steel with B for 6/1.5 = 4bushels of corn, leaving it one bushel of corn better off. Similarly, B can now get 6 tons of steel for the 4bushels of corn it trades to A instead of the 4 tons of steel it could produce on its own with the resources ittook to produce the 4 bushels of corn.

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CHAPTER 2: THE DETERMINATION OF EXCHANGE RATES1CHAPTER 2THE DETERMINATION OF EXCHANGE RATESThis chapter explainswhat an exchange rate is and how it is determined in afreelyfloatingexchange rateregime, that is, in the absence of government intervention. This is done using a simple two-countrymodel. Because of its pervasiveness, we also examine the different forms and consequences of centralbank intervention in the foreign exchange markets. Since an exchange rate can be considered as therelative price of two financial assets, the chapter discusses the asset market model of currencies and therole of expectations in exchange rate determination. A separate section discusses the real changes in anation’s economy that cause exchange rate changes.KEYPOINTS1.Absent government intervention, exchange rates respond to the forces of supply and demand, whichin turndepend 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 moneydemand, the purchasing power of money declines both at home (frominflation) and abroad (fromcurrency 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 onforecasts of future economic and political conditions.5.Toachieve certain economic or political objectives, governments often intervene in the currencymarkets to affect the exchange rate. Although the mechanics of such intervention vary, the generalpurpose of each variant is basically the same: to increase the market demand for one currency byincreasing the market supply of another. Alternatively, the government can control the exchange ratedirectly by setting a price for its currency and then restricting access to the foreign exchange market.6.A critical factorthathelps explain the volatilityof exchange rates is that, withfiat money,there is noanchor to a currency’s value, nothing around which beliefs can coalesce. Since people are unsureabout what to expect, any new piece of information can dramatically alter their beliefs. Thus, if theunderlying domestic economic policies are unstable, exchange rates will be volatile as traders react tonew information.

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INSTRUCTORS MANUAL:FOUNDATIONS OF MULTINATIONAL FINANCIAL MANAGEMENT, 6TH ED.2SUGGESTED ANSWERS TO “ASIAN CURRENCIES SINK IN 1997”1.What were the origins of the Asian currency crisis?ANSWER. The case suggests several causes of the Asian currency crisis. First was the loss of exportcompetitiveness. A number of Asian countries had tied their currencies to the dollar, so the dramaticappreciation of the dollar against the yen, Deutsche mark,and other currencies made their exports lessprice competitive. Their competitiveness problem was exacerbated by the fact that during this period, theChinese yuan depreciated by about 25% against the dollar. A second contributing factor to Asia’sfinancial 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 governmentguarantees. 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 anyprofits, while sticking the government with any losses.Without market discipline or risk-based banklending, the result was overinvestment–financed by vast quantities of debt–and inflated prices of assetsin short supply, such as land. The Asian financial crisis then was touched off when local investors begandumping their own currencies for dollars and foreign lenders refused to renew their loans to Asiancompanies and banks.2.What role did expectations play in the Asian currency crisis?ANSWER. Expectations were critical in causing the financial bubble and then popping it. Specifically, theAsian financial bubble persisted as long as people believedthe governmentcouldhonor its implicitguarantee. However, this guaranteebroughtwith it the seeds of its own demise as inevitable glut of realestate and excess production capacityleadto large amounts of nonperforming loans and widespread loandefaults. When realitystruckand investors realizedthat the governmentdidn’thave the resources to bailout everyone, asset values plummetedand the bubble burst. Thedecline in asset values triggeredfurtherloan defaults, causing a loss of the confidence on which economic activity depended. Investors alsoworriedthat the governmentwouldtry to inflate its way out of its difficulty. The resultwasa self-reinforcing downward spiral and capital flight. As foreign investors refusedto renew loans and begin tosell off shares of overvalued local companies, capital flight acceleratedand the local currencyfell,increasing the cost of servicing foreign debts. Local firms and banks scrambledto buy foreign exchangebefore the currency fellfurther, putting even more downward pressure on the exchange rate. This storyexplainedwhy stock prices and currency values declined together and why Asian financial institutionswere especially hard hit. Moreover, this processwaslikely to be contagious, as investors searchedforother countries with similar characteristics. When such a country is found, everyone rushes for the exitsimultaneously and another bubble is burst, another currency is sunk. In the case of the Asian currencycrisis, investors alsorealized that their loss of export competitivenessgave the Asian central banks amutual incentive to devalue their currenciesto try to regain their export competitiveness. According toone theory, recognizing these altered incentives, speculators attacked the East Asian currencies almostsimultaneously and forced a round of devaluations.

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CHAPTER 2: THE DETERMINATION OF EXCHANGE RATES33.How did the appreciation of the U.S. dollar and depreciation of the yuan affect the timing andmagnitude of the Asian currency crisis?ANSWER. Sooner or later, the moral hazard associated with implicit government guarantees of recklessinvestmentswouldresult in a crisis. What dollar appreciation and yuan depreciation did was to speed upthe crisis. Specifically, the loss of export competitiveness slowed down Asian growth and causedutilization rates–and profits–on huge investments in production capacity to plunge. It also gave theAsian central banks a mutual incentive to devalue their currencies to try to regain their exportcompetitiveness.4.What is moral hazard and how did it help cause the Asian currency crisis?ANSWER.As explained above,moral hazard is the tendency to incur risks that one is protected against.Theoriginofthemoralhazardfaced by Asian countrieswasthe implicit or explicit government guaranteesthat most Asian banks and finance companies operated with. When combined with poor regulation, theseguarantees distorted investment decisions, encouraging financial institutions to fund risky projects in theexpectation 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 vastquantities of debt–and inflated prices of assets in short supply, such as land. The Asian financial crisisthen was touched off when local investors began dumping their own currencies for dollars and foreignlenders 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 marksinstead of their local currencies to finance their operations? What risks were they exposingthemselves to?ANSWER.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 carriedlower interest rates than did their domestic currencies. The risk they were exposing themselves–a riskthat manifested itself–was that their local currencies would devalue against the borrowed foreigncurrencies, making these foreign currency loans more expensive to pay backin terms of their localcurrencies.This risk was also borne by the banks that made these foreign currency loans, since a companythat goes bankrupt because it cannot repay its loans will eventually pass its loan losses onto 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?ANSWER.China and Japan intervened in the foreign exchange market to weaken their currencies againstthe 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 yenand yuan and increasing the demand for dollars, both countries managed to hold down the value of theircurrencies against the dollar.China and Japan then used the dollars they acquired through their foreignexchange intervention to buy U.S. Treasury bonds.

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INSTRUCTORS MANUAL:FOUNDATIONS OF MULTINATIONAL FINANCIAL MANAGEMENT, 6TH ED.42.Why did the U.S. dollar and U.S. Treasury bonds fall in response to the G7 statement?ANSWER.TheG7endorsed“flexibility”inexchangerates,acodewordwidelyregardedasanencouragement for China and Japan to stop managing their currencies. If China and Japanaccepted thisadvice, they wouldcease theirpurchases of dollars. Such an action would reduce the value of the dollar.At the same time, the reduced purchases of dollars wouldcauseChina and Japantomake fewer purchasesof 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 bondsfell on the G7announcement based on the expectation thatChina and Japan might accept the G7 advice.3.What is the link between currency intervention and China and Japan buying U.S. Treasurybonds?ANSWER.As noted above, China and Japan acquired the dollars they used to buy U.S. Treasury bondsthrough their foreign exchange market intervention.The more these countries intervened in the foreignexchange market, the more dollars they would have to buy Treasury bonds. Conversely, ceasing suchintervention would mean these countries would no longer have the dollars to buyTreasury bonds.4.What risks do China and Japan face from their currency intervention?ANSWER.Tointervene in the foreign exchange market, China and Japan have to expand their domesticmoney supplies.The danger is that therisingmoney supplieswillcauseinflation.Another risk is thatother countries will engage in competitive devaluations to boost their export competitiveness vis-à-vis theChinese and Japanese. Finally, China and Japan face the very real danger that theircheap currency policywill 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 isindeed pursing a weak currently policy?ANSWER. China believes that it needs to export to keep people employed and provide jobs, as stateenterprises become obsolete and close down. The government worries thata large body ofunemployedpeople would lead to unrest.Evidencethataweakyuanpolicy isbeingpursuedshows up inthe peg to thedollarbeingmaintained despite the weakening of the dollar. The existence of the peg is evident from thefixed exchange rate and the large quantity of dollars the government is buying up to support the dollaragainst 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?ANSWER.China hopes that flourishing export businesses will be able to absorb newly unemployed peoplefrom state enterprises that are being shut down. In addition, a perceived potential deflation can be avertedby maintaining a weak yuan (which raises the price of foreign goods)and expanding the yuan moneysupply in pursuit of this policy.

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CHAPTER 2: THE DETERMINATION OF EXCHANGE RATES53.Other things being equal, what would a 27.5% tariff cost American consumers annually on$200 billion in imports from China?ANSWER. Other things being equal, American consumers would pay an additional $55 billion on suchimports (0.275*$200 billion).4.Currently,importsfromChinaaccountforabout10% of total U.S. imports. A 25% appreciationof the yuan would be the equivalent of what percent dollar depreciation? How significant wouldsuch a depreciation likely be in terms of stemming America’s appetite for foreign goods?ANSWER.All else being equal, if the yuan appreciates by 25%, the dollar cost of Chinese goods wouldrise by the same percent.With Chinese imports accounting for about 10% of totalU.S.imports, a 25%yuan appreciation would increase the dollar cost ofU.S.imports by about 2.5%overall.This figurerepresents an approximate 2.5% dollar depreciation.(1-1/1.025 =-2.439% to be exact).5.What policy toolis China using to maintain the yuan at an artificially low level? Are there anypotentialproblemswith using this policy tool? What might China do to counter these problems?ANSWER.Chinais keeping the yuan pegged to thedollarby issuing more yuan to buy up dollars. Theproblem with maintaining the weak value is a rising money supply. A rapidly expanding money supplyresults in inflation. In China’s case, this inflationary pressure ismost noticeable in asset prices.To copewith this problem, the Chinese government could sterilize its foreign exchange intervention, but that islikely to result in continuing pressure on the yuan to appreciate. Alternatively, as suggested in the answerto part 6, China could free its currency and allow capital outflows, which would absorb much of thepressure,to appreciate.6.Does an undervalued yuan impose any cost on the Chinese economy? If so, what are they?ANSWER.An undervalued yuan raises the cost of foreign goods and services to Chinese consumers andcompanies, reducing their purchasing power overseas.Another potential cost of pursuing a cheapcurrency policy is the possibility of stirring up protectionist measures in its trading partners.7.Suppose the Chinese government ceasedits foreign exchange market intervention andtheyuanclimbed to five to the dollar. What would be the percentage gain to the dollar investor?ANSWER.In this scenario, the value of the yuan would rise from $0.1307(1/7.65) to $0.20 (1/5). Theresulting gain in dollar value is (0.20–0.1307)/0.1307or53%.8.Currently the yuan is not a convertible currency, meaning Chinese individualscannot exchangetheir yuan for dollars to invest abroad. Moreover, companies operating in China must convertall their foreign exchange earnings into yuan.What would happen to the pressure on the yuanto revalue ifChina relaxedthese currency controls andrestraints on capital outflows?ANSWER.Relaxing currency controls and constraints on capital outflows would result in increased capitaloutflows and an increase in the demand for foreign currency. Other things being equal, this increaseddemand for foreign exchange would reduce the pressure on the yuan to revalue and could even result in adepreciation 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.6SUGGESTED ANSWERS TO CHAPTER 2 QUESTIONS1.Describe how these three typical transactions should affect present and future exchange rates.1.a.Seagramimports a year's supply of French champagne. Payment ineuros is due immediately.ANSWER.Theeuroshould appreciate relative to the dollar since demand foreuros is rising.1.b.MCI sells a new stock issue to Alcatel, the French telecommunications company. Payment indollars is due immediately.ANSWER. The spot value of the dollar should increase as Alcatel demands dollars to pay for the newstock issue. The future value of the dollar should decline as dividend payments are sent to Alcatel andother Alcatel equipment and parts are imported. However, the value of the dollar in the future couldincrease 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 forthe purchase amount from the U.S. Export-Import Bank. The loan is to be paid back over thenext seven years with a two-year grace period.ANSWER.The spot price of the dollar should be unaffected. The future price of the dollar should increaseas KAL repays the loan.2.The maintenance of money's value is said to depend on the monetary authorities. What mightthe monetary authorities do to a currency that would cause its value to drop?ANSWER.The value of any good or asset is driven by its scarcity.The monetary authorities could makemoney less scarce by issuing more of it. This would lower its scarcity value. Even though its nominalvalue 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 thatexchange 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.ANSWER.The value of the dollar should rise as more rapidly;rising GDP in the United States leads to arelative increase in demand for dollars.3.b.Inflation is higher in the U.S. than in Japan.ANSWER.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.ANSWER.According to PPP, the exchange rate should remain the same.3.d.Real interest rates are higher in the United States than in Japan.ANSWER.The value of the dollar should rise as the higher real rates attract capital from Japan that mustfirst be converted into dollars.

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CHAPTER 2: THE DETERMINATION OF EXCHANGE RATES73.e.The United States imposes new restrictions on the ability of foreigners to buy Americancompanies and real estate.ANSWER.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 Japaneseproductivity.ANSWER.Higher U.S. wages and declining relative productivity weaken the American economy andmake 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 lagsbehind that of its major trading partners, the other country’s currencywilldepreciate. The lagging countryregains its balance, but only by accepting a lower real price for its goods. In effect, the cheaper currencyis 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 andU.S. interest rates?ANSWER.If the Fed switches to an easier monetary policy, the value of the dollar will drop as fears ofinflation rise. Short-term U.S. interest rates will initially fall but will then rise as investors seek to protectthemselves from higher anticipated inflation. Long-term rates will probably rise immediately because offears of future inflation. Over time, however, if the growth in the money supply stimulated the economyto grow more rapidly than it otherwise would, the value of the dollar could rise, and so could real interestrates. This is an unlikely scenario, however, as indicated by the experiences of Latin American nations.5.Commentonthefollowingnewsfrom theWall Street Journal(April 3, 2007, p. C12): “The dollarwas little changed against the euro and yen, but weakened versus the currencies of Australiaand the United Kingdom as investors mulled possible further rate increases in those countries.”ANSWER.The increase inAustralia and U.K.interest rates made assetsin the two countriesmoreattractive to investors. In the process of shifting funds from theU.S.toAustralia andtheU.K, investorssold dollars to buy theAUS$ andpoundsthey needed to invest intheseassets. An alternative–andconsistent–explanation is that the rise in interest rates reflected a tightening of monetary policies inAustralia and U.K., leading investors to anticipate less inflation in the futurefor the two economies,which would increase their desire to holdAUS$ andpoundand thereby boost its value.6.On November 28, 1990, Federal Reserve Chairman Alan Greenspan told the House BankingCommittee that despite possible benefits to the U.S. trade balance,“a weaker dollar also is acause for concern.”This statement departed from what appeared to be an attitude of benignneglect by U.S. monetary officials toward the dollar’s depreciation. He also rejected the notionthat the Fed should aggressively ease monetary policy, as some Treasury officials had beenurging. At the same time, Mr. Greenspan didn’t mention foreign exchange market interventionto support the dollar’s value.

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INSTRUCTORS MANUAL:FOUNDATIONS OF MULTINATIONAL FINANCIAL MANAGEMENT, 6TH ED.86.a.What was the likely reaction of the foreign exchange market to Mr. Greenspan’s statements?Explain.ANSWER.The dollar rose when Chairman Greenspan indicated that he was concerned about the dollar'sslide and would not aggressively ease monetary policy. Investors responded to his statement by loweringtheir 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 foreignexchange market? If so, how?ANSWER.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 monetarypolicy will boost the dollar’value.7.Many Asian governments have attempted to promote their export competitiveness by holdingdown 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?On Asianinflation?On Asian export competitiveness?On Asian living standards?ANSWER.Tohold down the value of their currencies, Asian central banks must buy up foreign exchangein the market. The result is increased foreign reserves and an expanded domestic money supply, whichhas the potential to increase inflation. At the same time, the lower exchange rates boostAsian exportcompetitiveness, but at the expense of a lower living standards for their populations (who find foreigngoods and services more expensive).7.b.Some Asian countries have attempted to sterilize their foreign exchange market interventionby selling bonds. What are the likely consequences of sterilization on interest rates?Onexchange rates in the longer term?On export competitiveness?ANSWER.Tosterilize the expanded domestic money supply resulting from the purchase of foreignexchange, the Asian central bank must sell government securities to the market. These sales would drivedown 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 thelong run, sterilized intervention will notaffect 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 HongKong? For the competitiveness of Hong Kong business? Explain.ANSWER.As capital flows in, the currency board must exchange the foreign currency for an equivalentamount ofHKdollars. 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 realexchange rate, making Hong Kong business less competitive.

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CHAPTER 2: THE DETERMINATION OF EXCHANGE RATES98.b.Given a large capital inflow, what would happen to the value of theHKdollar if it wereallowed tofloatfreely? What would be the effect on the competitiveness of Hong Kongbusiness? Explain.ANSWER.Given a freelyfloatingHKdollar, all else being equal, a large capital inflow would cause theHK dollar to appreciate. As with a currency board, the resulting appreciation in the real value of the HKdollar would make Hong Kong business less competitive.8.c.Given a large capital inflow, will Hong Kong business be more or less competitive under acurrency board or with a freelyfloating currency? Explain.ANSWER.In both instances, the HK dollar will rise in real terms. However, the ways in which the realexchange rate change occurs will differ. With a currency board, the real exchange rate change will bebrought about by the higher inflation that Hong Kong will experience, whereas with a free float it will bebrought about by a rise in the nominal exchange rate. Indeed, the appreciation of a freelyfloating HKdollar will actually cause Hong Kong inflation to fall by reducing the cost of imports. The lower inflationrate will offset some of the loss of competitiveness brought about by the appreciating HK dollar. All elsebeing equal, therefore, a large capital inflow would seem to harm Hong Kong business more under acurrency board than with a freelyfloating currency. Because of this deflationary impact, however, the risein the nominal exchange will likely be larger than it otherwise might be to balance the supply and demandfor HK dollars. In general, the net effect is likely to be the same since it depends only on the demand forHK 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 exportearnings from coffee and oil.9.a.What was the likely impact of these factors on the real value of the Colombian peso and thecompetitiveness of Colombia's legal exports? Explain.ANSWER.The sharp increase in earnings from drug dealing, coffee, and oil led–as expected–to anappreciation in the real value of the Columbian peso during 1994 (30% against the dollar) by boosting thedemand for pesos in the foreign exchange market (as dollar earnings were converted into pesos). This realappreciation 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 pursingmore expansionist monetary policies.Standing in the way was Colombia’s independent central bank–Banco de la Republica. Inresponse, the president and his supportersdiscussed the possibility of returning central bankcontrol to the executive branch. Describe the likely economic consequences of ending Bancode al Republica’s independence.ANSWER.A sharp and continuing increase in the money supply would lead to hyperinflation and lowerpopularity for the president.

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INSTRUCTORS MANUAL:FOUNDATIONS OF MULTINATIONAL FINANCIAL MANAGEMENT, 6TH ED.10ADDITIONAL CHAPTER 2 QUESTIONS AND ANSWERS1.Suppose prices start rising in theU.S.relative to prices in Japan. What would we expect to seehappen to the dollar:yen exchange rate? Explain.ANSWER.As U.S. prices start rising relative to Japanese prices, both American and Japanese consumerswill start substituting Japanese for U.S. goods, leading to increases in both the supply of U.S. dollars andthe 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 demandfordollars?ANSWER.In order to purchase a U.S. government security, the foreigner must first acquire dollars. Thisincreases the demand for dollars, but has no affect on the supply of dollars.3.In1987,theBritishgovernmentcuttaxessignificantly,raisingtheafter-taxreturnoninvestments in Great Britain. What would be the likely consequence of this tax cut on theequilibrium value of the British pound?ANSWER.The cut in British tax rates should raise after-tax returns, making investment inthe U.K.moreattractive to both British and foreign investors. In response, investors should demand more pounds toacquire the now-more-lucrative British assets, driving up the value of the pound. This is, in fact, whathappened.4.Some economists have argued that a lower government deficit could cause the dollar to drop byreducing high real interest rates in theU.S. What does the asset view of exchange rates predictwill happen if theU.S.lowers its budget deficit? What is the evidence from countries such asMexico and Brazil?ANSWER.The impact of a reduction in the budget deficit on the value of the dollar depends on how thatdeficit reduction is accomplished. The key according to the asset-market model is whether the mechanismused 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 sensibleeconomic policy and the dollar would rise. Another factor is also relevant. Lower deficits owing to areduction in spending would convince foreigners that the chances for future inflation in the U.S. haddecreased. This would make dollar investments look even better, further strengthening the dollar. Asmentioned in the text, if high government deficits increased a currency’s value, Mexico and Brazil shouldhave two of the strongest currencies in the world today.5.What is there aboutfiat money that makes its exchange rate especially volatile?ANSWER.Withfiat money,there is no anchor to a currency’svalue, nothing around which beliefs cancoalesce. In this situation, where people are unsureofwhat to expect, any new piece of information candramatically alter their beliefs about currency values. As people change their views of what the futureholds, 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 RATES116.Comment on the following headlines inThe Wall Street Journal:6.a.“Sterling Drops Sharply Despite Good Health of British Economy: Oil Price Slump IsBlamed” (January 17, 1985)ANSWER.The value of the pound is very sensitive to the price of oil because England has large North Seaoil reserves and is a major oil exporter. Hence, British wealth is positively related to the price of oil. Anyevent that reduces a nation’s wealth will also tend to drive down the value of its currency. The health ofthe British economy was already factored into the value of the pound. The new information about theprice of oil drove down the pound’s value because it indicated that British wealth would be lower thanwas previously expected.6.b.“Dollar Surges as Coup in Soviet Union Revives Unit’s Appeal as a Safe Haven” (August 20,1991)ANSWER.With the reduction in world tension occasioned by the decline in Communism’s appeal in theSoviet Union, investors had less need for the U.S. dollar as a safe haven. The Soviet coup brought backthe threat of Soviet militarism and led investors to desire once again to hold an increased share of theirwealth 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)ANSWER.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. Asinvestors 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)ANSWER.There are two possible reasons for the fall in the dollar. One possibility is that the Fed’s cut inthe discount rate reduced real interest rates in theU.S., reducing the attractiveness of dollar-denominatedfinancial assets relative to assets denominated in foreign currencies. As investors shifted to non-U.S.assets, they had to first sell dollars, depressingthe dollar’svalue. The second possibility is that the Fed’slowering of the discount rate was a harbinger of a looser U.S. monetary policy, fueling fears of higherinflation 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”(September28, 1992)ANSWER.A Canadian recession combined with the perceived political risk associated with Canada’sconstitutional crisis significantly reduces Canada’s appeal to investors, leading to expected capitaloutflows and a depressed Canadian dollar. However, to the extent that this bad news has already beenfactored into the Canadian dollar's value–and in an efficient market it should have been–the headline iswrong; the Canadian dollar should not fall further. Otherwise, speculators can earn risk-free profits bybetting against the Canadian dollar.

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INSTRUCTORS MANUAL:FOUNDATIONS OF MULTINATIONAL FINANCIAL MANAGEMENT, 6TH ED.126.f.“Dollar Soars on U.S. and Iraqi Tension, Hints of Possible Lower German Rates” (Dec.12,1992)ANSWER.The combination of the desire to hold more dollars because of political fears brought about bynew problems with Iraq and the reduced appeal of investing in Germany because of the possibility oflower interest rates there, led to a large increase in capital flows to theU.S. These capital inflows boostedthe value of the dollar.6.g.“Inflation, Slow Growth Seen Spurring Latin America to Devaluate Currencies” (January 22,1990)ANSWER.The Latin American countries have been maintaining their currencies at an artificially highlevel. Inflation and slow growth increase the overvaluation of Latin American currencies, putting greaterpressure on their governments to devalue their currencies.7.Suppose a new Russian government makes threatening moves against Western Europe. How isthis threat likely to affect the dollar's value? Why?ANSWER.As investors in Western Europe become more nervous about their prospects,they will try toshift out of Western European assets and into U.S. dollars and dollar-denominated assets. Since they can’tall sell off their Western European assets simultaneously, the result will be a drop in the real value ofWestern 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 spendingthrough2002and thereby end the persistent U.S. budget deficits. How do you think the dollarresponded to this news?ANSWER.This news should be favorable for the dollar because it indicated that theU.S.was going tofollow a sounder economy policy, which would lead to lower inflation and higher economic growth in thefuture. The improved economic climate would make the U.S. investment environment more desirable andlead 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 interventionis how those who manage our economic affairs think they know what is the‘right’price for adollar in terms of francs, pounds, yen, or Deutsche marks. And if they do know, why do theykeep changing their minds?”ANSWER.Here’s one possible answer. Once President Nixon decided to abandon the gold standard, thedollar became just a piece of paper backed by nothing more substantial than“the full faith and trust of theUnited 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 tomanage 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 whatthe dollar would be worth tomorrow in world markets. But governments wouldn’t then be able tomanipulate exchange rates or money supplies to achieve other objectives. So the odds are that the powersthatbe will keep tinkering with the dollar on the foreign exchange market while they search for thedollar’s“right”price. But that still leaves unresolved a key question: How will they know when they’vefound the“right”price for the dollar?

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CHAPTER 2: THE DETERMINATION OF EXCHANGE RATES1310.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 inflationarypressures in Japan. Many currency traders had expected the Japanese central bank to raise itsrate by more than 0.75%. What was the likely consequence of this interest rate rise on theyen:dollar exchange rate?ANSWER.The key to this answer is to focus on the operative term“widely anticipated”and recognize thatthe foreign exchange market already factors any anticipated interest rate change into currency values.Thus, when the Bank of Japan hiked the interest rate byonly0.75%, the yen became a less desirableinvestment 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 butwhat happens relative to what wasexpectedto happen.11.In the late 1980s, the Bank of Japan bought billions of dollars in the foreign exchange marketto prop up the dollar’s value against the yen. What were the likely consequences of this foreignexchange market intervention for the Japanese economy?ANSWER.Without domestic sterilization, the increased purchase of dollars for yen led to a jump in theJapanese money supply. Initially, this increased supply of yen lowered Japanese interest rates and helpedfuel what many observers have argued was a speculative rise in the Japanese stock and real estatemarkets. Over time, however, the higher money supply led to a rise in Japanese inflation. When the Bankof Japan responded in early 1990 to higher inflation by clamping down on the money supply, realJapanese interest rates rose and Japanese stock and real estate prices plunged.12.Countrieswithhighinflationneedtokeepdevaluingtheircurrenciestomaintaincompetitiveness. But countries that try to maintain their competitiveness by devaluing theircurrencies only end up with even higher inflation. Discuss.ANSWER.Devaluation improves competitiveness to the extent that it does not cause higher inflation. Ifthe devaluation causes domestic wages and prices to rise, any gain in competitiveness is immediatelyeroded. To address the competitive consequences of devaluation, therefore, two possible cases must bedistinguished: Prior to devaluation,(a) the exchange rate is overvalued and (b) the exchange rate is inequilibrium. Consider, for example, a country with high inflation that tries to fix its nominal exchangerate. 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 willrise somewhat. That is, devaluation will reduce the local currency’s real exchange rate. But if thecurrency 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 competewith them in the domestic market, and (b) indirectly, by forcing the central bank to expand the moneysupply to sustain the devaluation. Here, the real exchange rate stays the same and there is no improvementin competitiveness.

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INSTRUCTORS MANUAL:FOUNDATIONS OF MULTINATIONAL FINANCIAL MANAGEMENT, 6TH ED.1413.The Russian government is trying to figure out how to stabilize the value of its currency. Whatadvice would you offer to it?ANSWER.The value of the ruble depends on the available supply of rubles relative to the demand forrubles.Tostabilize the ruble’s value, the Russian government must restore the public’s confidence thatthe ruble can be held and exchanged for something of value. That is, the Russian government mustdemonstrate its willingness to maintain the ruble’s value. Confidence in money can be wononlybycontrolling 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 goevenone step further by creating a currency board, thereby fixing the value of the ruble to the dollar and noteven establishing a central bank with discretionary money-creation authority.14.“Unsterilized interventions are just open market operations conducted through the foreignexchange market rather than through the U.S. government securities market.”Comment onthis statement.ANSWER.This statement accurately depicts the monetary consequences of unsterilized interventions. Inordinary open market operations, the central bank buys (sells) government bonds to expand (contract) thedomestic money supply. Unsterilized interventions entail buying (selling) foreign exchange, whichcausesan 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 toslow the growth in the supply of rubles. However, the moves weren’t popular with thecountry’s giant state-run industrial enterprises, which are still dependent on official subsidiesand cheap credit. In July 1992, the Russian Parliament appointed Viktor Gerashchenko headof the central bank. One of his first acts was to say that he didn't think the time was right tomake the ruble convertible. Then he said that he would continue to extend credits to bankruptand inefficient state enterprises.15.a.HowindependentistheRussiancentralbanklikely to be? What political pressures is it facing?ANSWER.The Russian central bank is unlikely to be very independent since the Russian Parliament canfire its head at will. Mr. Gerashchenko will face pressure to keep funding the bankrupt state-run industrialenterprises with newlycreated money. If credit is cut off, these enterprises will go under. Their managersand workers will continue putting pressure on Parliament and the central bank to ensure their continuedfunding.15.b.What is the likely effect of Mr. Gerashchenko's statements on inflationary expectations inRussia?ANSWER.In effect, Mr. Gerashchenko has abdicated his control over monetary policy. The amount ofmoney to be created will depend on the losses of state enterprises, not the amount necessary fornoninflationary growth. Rational individuals will, therefore, take his statement to imply higher inflation,possibly hyperinflation.

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CHAPTER 2: THE DETERMINATION OF EXCHANGE RATES1515.c.How do you think the ruble:dollar exchange rate was affected by these statements?ANSWER.The expectation of higher future inflation, combined with the central bank’s unwillingness topermit ruble convertibility, should cause the ruble to fall in value, which it did. A stable, convertiblecurrency is the cornerstone of maintaining a currency’s value and Mr. Gerashchenko’s statementsindicated that this was not going to happen anytime soon.15.d.In 1995, the Russian Central Bank signed an agreement with the International MonetaryFund not to issue cheap credits to state enterprises. How should the ruble react if the centralbank sticks to its agreement with the IMF?ANSWER.This agreement is a positive development for the ruble because it implies that the RussianCentral Bank will continue to expand the supply of rubles, which is the indirect consequence ofsubsidizing state enterprises through bank credits. A lower rate of growth in the ruble money supplymeans less Russian inflation and a stronger ruble.16.In January 1991, President Mikhail Gorbachev banned all 50-ruble and 100-ruble bills, whilepermitting Sovietcitizens to change only 1,000 rubles in these large bills into smallerdenominations. In addition, savings-bank accounts were frozen for six months. The object ofthese 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 atabout 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 andleast expensive version at its disposal.”16.a.Were these measures likely to achieve President Gorbachev's objectives?ANSWER.These measures might drive some black marketeers out of business, but they cannot reduceinflation. Although the confiscation of large bills and freezing savings accounts will reduce the moneysupply, the demonstrated willingness of the government to expropriate wealth held in the form of rubleswill 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 capitalthan 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 byGorbachev’s policies.16.b.How do you think the ruble’s exchange rate responded to President Gorbachev’s initiative?Explain.ANSWER.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.1617.On October 29, 1995, the Mexican government announced a new economic planthatcalled forthe government to boost the economy by cutting taxes and spending. The plan also included anagreement among business, labor, and government representatives to limit wage and priceincreases. How do you think the peso responded to this announcement? What about theMexican stock market? Explain.ANSWER.This plan is positive news for the Mexican economy. If lived up to, the plan implies strongereconomic growth and less inflation. Bothofthese factors should boost the Mexican stock market and thevalue of the peso, which happened.18.Under the Convertibility Act, Argentina’s central bank is allowed to count dollar-denominatedbonds issued by the Argentine government as part of its“foreign”reserve assets. Whatpotential problem do you see with this rule?ANSWER.The centralbank’s ability to count dollar-denominated bonds issued by the Argentinegovernment as part of its“foreign”reserve assets is a loophole big enough to drive a truck through. UnderMr. Cavallo’s watchful eye, the central bank has not abused that loophole, with the so-called Bonexbonds varying between 3% and 9% of the monetary base cover. However, the central bank could alter itscourse overnight and expand the Bonex share of the reserves. In addition, although the Argentinegovernment has always paid its Bonex obligations, it could refuse to honor Bonex obligations held by thecentral bank.19.After the Mexican devaluation, investors questioning Argentina’s ability to maintain currencyconvertibilitybeganpullingtheirmoneyoutofArgentina.Inresponse,theArgentinegovernment 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?For Argentine peso interest rates?For economic growth?ANSWER.Since Argentina maintains a currency board, it cannot sterilize the effects of currency inflowsor 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 economicgrowth. However, as investors became convinced that Argentina was not going to devalue the peso, thehigh real interest rates began attracting capital back into Argentina, lowering real interest rates back towhere they had been before. This process of arbitrage is to be expected, as Argentina’s interest ratescannot diverge much from U.S. rates as long as the Argentine peso is perceived to be tied to the dollar. Atthe same time, the greater confidence in the value of the peso boosted business confidence and businessbegan investing again in Argentina. The result was that economic growth picked up again after the initialfright and capital flight.19.b.Why was the Argentine government so reluctant to devalue the peso?ANSWER.Argentina saw what happened in Mexico a month before, where peso devaluation led to higherinflation (because of the higher price of foreign goods and services), which led in turn to furtherdevaluation and inflation. Interest rates jumped to account for the high inflation rate and loss of faith inthe government’s ability to maintain the peso’s value. In other words, devaluation of the Mexican pesohad not solved anything but rather had revived the specter of an ongoing inflation-devaluation cycle–aspecter that most Mexicans hoped had disappeared during the 1980s.

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CHAPTER 2: THE DETERMINATION OF EXCHANGE RATES1719.cAs U.S. interest rates rise, what is likely to happen to Argentine rates? Why?ANSWER.Since the Argentine peso is tied to the U.S. dollar at a 1:1 rate, interest rates between the twocountries cannot diverge by more than a small amount. Divergence in interest rates will come only if thereis a fear of peso devaluation. Otherwise, the two currencies are virtually identical and so must bearvirtually identical interest rates.20.One recommended approach to strengthen the dollar against the yen is for the U.S. Treasuryto 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?ANSWER.Such a move would strengthen the dollar by providing ahighly visible signal that the U.S.government is interested in a strong dollar. A weakening dollar would increase the U.S. government’scost 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 theBank of Mexico, Mexico’s central bank, autonomy vis-à-vis the central government. As aninvestor, how would you view such a proposal? What other changes might help to amplify thesignals sent by this proposal?ANSWER.Investors, who value price stability, would view such a bill as strongly positive. Such a lawwould enable the Bank of Mexico to avoid financing government deficits by printing pesos and therebyimprove 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’sability to run budget deficits were constrained, since these deficits are the driving force underlying thepeso printing. Absent such constraints,investors would be concerned that future deficits could lead thegovernment to renege on its commitment to central bank independence. Unfortunately, the Bank ofMexicobadly damaged its credibility when, during 1994,it appeared to collaborate with an administrationfacing tough electionsby pouring more pesos into the banking system. The monetary expansion keptinterest rates low,which kept the economy growingbut led to the traumatic devaluation of December1994.22.The People’s Bank of China, China's central bank, is run by bureaucrats whose primeobjective seems to be funding loss-making state-owned firms. What is your prediction aboutthe inflation outlook for China and the value of its currency, the yuan? Explain.ANSWER.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. Thedilemma for Chinese policymakers is that tightening credit to the cash-starved state sector, while coolinginflation 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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