UNIT-I

INTERNATIONAL MONETARY AND FINANCIAL SYSTEM

Introduction (International Financial Management by A.K.Seth, Page No: 11)

The subject matter of international finance can be looked from two perspectives: (a) the
economic perspective and (b) the business perspective. Since business enterprise has to
operate in an economic environment therefore the analysis of business aspects will be
incomplete without the analysis from economic perspective.

In general the students of economics ten to concentrate on macroeconomic issues such as:
balance of payments, the establishment of external and internal equilibrium, the internal
financial adjustment process, the determination of exchange rates. The students of business
mainly concentrate on investments, i.e. from where to barrow and where to invest.

REASONS FOR THE GROWING IMPORTANCE OF INTERNATIONAL FINANCE

(International Financial Management by Dr.Pradip Kumar Sinha, Page No: 3-3)

 Growth of international trade: Because of LPG

 The rewards of international trade:
 The risk of international trade:
 Increased globalization of financial and real-asset markets:
 Increased volatility of exchange rates:
 Increased importance of Multinational Corporations and Transnational Alliances:

Meaning of international financial management

 International financial management may be defined as the management of various

financial operations relating to international business organizations.
 International financial management deals with the financial decisions taken in the area
of international business.
 In simple words international financial management involves two important functions
to perform :( 1) acquisition of funds (2) investment of funds

SCOPE OF INTERNATIONAL FINANCIAL MANAGEMENT/ MAJOR DECISIONS

IN INTERNATIONAL FINANCE (International Financial Management by Dr.Pradip Kumar
Sinha, Page No: 4-4)

 Foreign exchange market

 Exchange rate determination
 Exchange rate risk and its management
 Investment decisions of MNCs
 International working capital decisions
 Financing Decisions of MNC’s (Acquisition of Funds)
 International accounting and taxation
 International debt.

ALIET 1 GLOBAL FINANCIAL MANAGEMENT

  International monetary system
 International political risk

FINANCIAL GOLAS OF MULTI NATIONAL COMPANIES

The finance function has to be performed by financial manager by keeping in view of the
financial objectives of the organization. The objectives of the organization are

 Profit maximization: Business organization is an economic activity its main

objective is to earn profit, profit is the measure of affiance of the business
organization.

Reasons for performing profit maximization

 Profit is the ultimate object of the organization

 Profit is a barometer for measure efficiency of a business organization
 Profit is also the source of finance-(New funds are generated from profit)

Limitations of profit maximization

 No definitions are there for maximization
 Ambiguity in maximum
 Exploitation of customers
 Vague no official definition is there for profit – (Weather short term profit or
long term profit, profit before tax, profit after tax)
 It ignores risk factor
 Profit is linked with risk policy
 Ignores time value of money

 Wealth maximization: Wealth maximization refers to shareholders wealth

maximization and company wealth maximization, the shareholders wealth
maximization is based on the dividend payment ratio, company wealth maximization
is based on market price per share. Company wealth maximization based on market
price per share, market price per share based on firm dividend policy.

Shareholders wealth based on Dividend policy

Company wealth max based on Market price per share

Reasons for wealth maximization
 Satisfy the need of stakeholders
 Safeguard the interest of share holders
 Provide security to money lender
 Earnings per Share Maximization (or) Profit after tax Maximization (EPS &
PAT)

Profit after tax – preference dividend

EPS = -------------------------------------------------
No of equity shares outstanding

ALIET 2 GLOBAL FINANCIAL MANAGEMENT

 Profit available to equity shares
DPS = -----------------------------------------
No of equity shares outstanding
Profit available to share holders = Profit After tax – Reserves.

Limitations

 Market price of shares will not influenced by Earnings per share (EPS)
 EPS/PAT will not increase the economic welfare of the organization
 It does not consider the payment of dividend
 It ignores things and risk of expected benefit

FINANCE FUNCTIONS OF A GLOBAL FINANCE MANAGER (International Financial

Management by P.G.Apte, Page No: 11-11)

Finance functions of a global finance manager are not different from that of a finance
manager of a domestically oriented company. The only difference lies in the recognition of
additional risks and opportunities present in the global economy. Generally speaking there
are two broad finance functions of global finance manager.

(a) Acquisition / Mobilization of funds (b) Investment/ Deployment of funds. These two
broad functions can further be looked in the context of various operational finance
functions in a firm. These operational finance functions can be further categorised in two
types of functions:

I. The Treasury Functions

 Financial Planning and Analysis
 Acquisition of Funds
 Investment of funds
 Cash Management
 Risk Management
II.Accounting and Controller Functions
 External Reporting
 Tax Planning and Management
 Management Information System
 Financial & Management Accounting
 Budget Planning and Control
 Accounts Receivable

ROLE OF INERNATIONAL FINANCIAL MANAGEER

The main tasks of international financial managers may be summarised as follows

 Forecasting the financial environment: Prices, inflation rates, interest rates and
exchange rates.
 Exchange risk management: Measuring the effects of exchange rate changes on
balance sheets, income, cash flows and managing their risks.
 Management of assets: From cash management to international capital budgeting,
both at home and abroad, in terms of domestic and foreign currencies.

ALIET 3 GLOBAL FINANCIAL MANAGEMENT

  Management of liabilities: Barrowing relationships and decisions, in domestic and
foreign currencies and markets, short term and long term.
 Performance evaluation and control: Accounting for outsiders, the tax authorities
and for management, and doing so across countries and currencies without distortion.

DIFFERENCES BETWEEN INTERNATIONAL FINANCE AND DOMESTIC

FINANCE

Basis of difference International Finance Domestic Finance

Objective Maximization of share Maximization of share
holders wealth holders wealth

Exposure to foreign International currencies Domestic currencies

exchange
Environment Macro business environment Micro business Environment
factors factors
Legal and tax environment Follow international Domestic accounting
generally accepted principles and national tax
accounting principles policies
( IGAAP) and follows
international tax policies
Capital management Issue international financial Issue national financial
instruments instruments

INTERNATIONAL MONETARY AND FINANCIAL SYSTEM (IMS/IFS)

(International Financial Management by Cheol S Eun & Bruce G Resnick, Page No: 25-25)

International monetary system defines the overall financial environment in which

multinational corporations operate. The international monetary system consists of elements
such as laws, rules, agreements, institutions, mechanisms, and procedures which affect
foreign exchange rates, balance of payment adjustments, international trade and capital flows.
The international monetary system plays a crucial role in the financial management of
multinational business and economic and financial policies of each country.

Meaning of International Monetary System

 It is a complex whole of agreements, rules, institutions, mechanisms, and policies

regarding exchange rates, international payments, and the flow of capital.
 In simple set of internationally agreed rules, conventions and supporting institutions
that facilitate international trade.
 Overall financial environment in which multinational corporations operate.
 Set of rules, regulations, policies for operating business at international level

Meaning of International Financial system

ALIET 4 GLOBAL FINANCIAL MANAGEMENT

  The financial system is the collection of financial markets, financial institutions, laws
regulators and techniques through which bonds, stocks and other securities are traded,
interest rates are determined and financial services are produced and delivered around
the world.
 In simple global financial system (GFS) is the financial system constituting financial
markets, financial institutions and regulators that act on the international level.

Participants/ Players in International Financial System

Global financial institutions

Financial institutions that have been established by more than one country and followed
international laws, it include

- International Bank for Reconstruction and Development (IBRD) (World Bank)

- International Monetary Fund (IMF)
- Asian Development Bank (ADB)
- European Investment Bank(EIB)
- European Bank for Reconstruction and Development( EBRD)
- CAF-development bank of Latin America
- International Fund for Agricultural Development(IFAD)
- Bank for International Settlements (BIS)
- Central banks
- Private institutions ( private banks, insurance companies etc)
- Regional institutions – NAFTA, CIS (North America free trade agreement,
Commonwealth of independent states).

Global financial markets

- Foreign Exchange market: ( Buying and selling of nations currencies)

- Euro currency market: Euro currency deposits, euro credits, euro notes, euro
commercial papers (ECP)
- International Bond market: Foreign bonds, euro bonds, global bonds, straight
bonds, floating rate notes (FRN), convertible bonds.
- International equity market: Euro equity, mutual funds, American depository
receipts and global depository receipts (ADR’s GDR’s)

EVOLUTION OF INTERNATIONAL FINANCIAL / MONETARY SYSTEM

(IFS)/DEVELOPMENTS IN INTERNATIONAL MONETARY SYSTEM (International
Financial Management by Cheol S Eun & Bruce G Resnick, Page No: 26-38)

The international monetary system went through several distinct stages of evolution. These
stages are summarized as follows.

 Phase I –Bimetallism: Before 1875,

 Phase II- Classical Gold Standard: 1876-1913,
 Phase III- Inter-war years: 1914-1944,
 Phase IV- Bretton Wood System: 1945-1973,

ALIET 5 GLOBAL FINANCIAL MANAGEMENT

  Phase V – Flexible Exchange Rate Regime: Since 1973 (Current Scenario/Present)
 Phase VI- European Monetary System 1995

Phase I –Bimetallism: Before 1875

Prior to the 1870s, many countries had bimetallism, that is, a double standard in that free
coinage was maintained for both gold and silver. In Great Britain, for example, bimetallism
was maintained until 1816 when parliament passed a law maintaining free coinage of gold
only, abolishing the free coinage of silver. In the United States, bimetallism was adopted by
the coinage Act of 1972 and remained a legal standard until 1873, when congress dropped the
silver dollar from the list of coins to be minted. France, on the other hand, introduced and
maintained its bimetallism from the French Revolution to 1878. Some other countries such as
China, India, Germany, and Holland were on the silver standard.

The International monetary system before the 1870s can be characterised as “Bimetallism” in
the sense that both gold and silver were used as international means of payment and that the
exchange rates among currencies were determined by either their gold or silver contents. For
example, the exchange rate between the British pound, which was fully on a gold standard,
and the French franc, which was officially on a bimetallic standard, was determined by the
gold content of the two currencies. On the other hand, the exchange rate between the franc
and German mark, which was on a silver standard, was determined by the silver content of
the currencies.

 In bimetallism period both gold and silver were used as money

 During this phase some countries were used gold standard, some countries silver
standard, some countries used both gold and silver for international payment.

Phase II- Classical Gold Standard: 187-1913 (International Financial Management by

Cheol S Eun & Bruce G Resnick, Page No: 27-28)

Under this gold standard, the exchange rate between any two currencies will be determined
by their gold content. For example, suppose that the pound is pegged to gold at six pounds
per ounce, whereas one ounce of gold is worth 12 franc. The exchange rate between the
pound and the franc should then be two franc per pound. To the extent that the pound and the
franc remain pegged to gold at given prices, the exchange rate between the two currencies
will remain stable. In simple Exchange rate between two countries would be determined by
gold, it refers gold was the base to determine currency exchange rates.

 Fix an official gold price for the national currency in terms of ounce of pure gold.
Example: The British government set the pounds for ounce of pure gold (31.1034768
grams) at 4.24 pounds and the US government set its parity at the rate of $ 20.67 per
ounce of pure gold. Here 1 pound = 4.87$
 Permit the free conversion of gold into domestic money and domestic money into
gold at the parity (Exchange rate) price in unlimited amounts without question.
 Eliminate all restrictions on foreign exchange transactions and allow the import and
export of gold.

Limitations of Gold standard

ALIET 6 GLOBAL FINANCIAL MANAGEMENT

  A gold standard has as a serious weakness which is that revenue hungry governments
are issue more paper currency for store the gold. It was affected on world trade and
investment due to lack of sufficient monetary reserves. The world economy can face
deflationary pressures.
 The government can allow for converting pure gold into money at any time without
restrictions it creates speculation in gold price fixation.

Evaluation of gold standard

Economic growth 
Globalization 
Price stability 
Output stability X
Policy flexibility X
Mutual beneficial ?
Self regulating ?

Phase III- Inter-war years 1914-1944 (International Financial Management by Cheol S

Eun & Bruce G Resnick, Page No: 28-29)
World War I ended the classical gold standard in August 1914, as major countries such as
Great Britain, France, Germany, and Russia suspended redemption (Repayment) of
banknotes in gold and imposed embargoes(Official ban) on gold exports. After the war, many
countries, especially Germany, Austria, Hungary, Poland, and Russia, suffered
hyperinflation. The German experience provides a classic example of hyperinflation: by the
end of 1923, the wholesale price index in Germany was more than 1 trillion times as high as
the prewar level. During this period, countries widely used ‘predatory’ depreciations of their
currencies as a means of gaining advantages in the world export market. As major countries
began to recover from the war and stabilize their economies, they attempted to restore the
gold standard.

Even the facade of the restored gold standard was destroyed in the wake of the Great
depression and the accompanying financial crises. Following the stock market crash and the
onset of the Great depression in 1929, many banks, especially in Austria, Germany, and the
United States, suffered sharp declines in their portfolio values, touching off runs on the
banks. Against this backdrop, Britain experienced a massive outflow of gold, which resulted
from chronic balance of payment deficits and lack of confidence in the pound sterling. In
September 1931 the British government suspended gold payments and let the pound float. As
a Great Britain got of gold, countries such as Canada, Sweden, Austria, and Japan followed
suit by the end of 1931. The United States got of gold in April 1933 after experiencing a
spate of bank failures and out flows of gold. Lastly France abandoned the gold standard in
1936. Paper standards came into begin when the gold standard was abandoned. During this
period that the U.S. dollar emerged as the dominant world currency, gradually replacing the
British pound for the role. In brief during 1914-1918 gold standards majorly influenced by
First World War, john Maynard, Keynes argued that the countries need tight and strong
monetary policies to restore the real value of gold relative to the currencies.

Limitations of interwar period

ALIET 7 GLOBAL FINANCIAL MANAGEMENT

  Economic nationalism/Economic Patriotism: (Country interventionism over the
market mechanisms, with policies such as domestic control of the economy, labor,
and capital formation, including if this requires the imposition of tariffs and other
restrictions on the movement of labor, goods and capital.
 Half-hearted attempts
 Economic and political instabilities
 Bank failures
 Panicky flights of capital across borders. (Capital flights: is a large-scale exodus
of financial assets and capital from a nation due to events such as political or
economic instability, currency devaluation or the imposition of capital controls)
 Effects on international trade and investment
 No coherent international monetary system prevailed during this period

Evaluation of Interwar Period

Economic growth X
Globalization X
Price stability X
Output stability X
Policy flexibility X
Mutual beneficial X
Self regulating X

Phase IV- The Bretton Woods System (1945-1973) (International Financial Management
by Cheol S Eun & Bruce G Resnick, Page No: 29-32)

In July 1944, representatives of 44 nations gathered at Bretton Woods, New Hampshire, (US)
to discuss and design the post-war international monetary system. After lengthy discussion
and bargains, representatives succeeded in drafting and signing the Articles of Agreement of
the International Monetary Fund (IMF), which constitutes the core of the Bretton Woods
system. The agreement was subsequently ratified by the majority of countries to launch the
IMF in 1945. The IMF embodied an explicit set of rules about the conduct of international
monetary policies and was responsible for enforcing these rules. Delegates also created a
sister institution, the International Bank for Reconstruction and Development (IBRD), better
known as word bank, that was chiefly responsible for financing individual development
projects.

Objectives of Bretton woods system

 To review the functions of existing international monetary system.

 To develop new monetary system and encourage international monetary cooperation.
 To establish international financial institutions
 Encourage sound macroeconomic policies to generate growth and employment in all
economies.
 Encourage flow of goods and investment between countries.

Features of Bretton woods system

ALIET 8 GLOBAL FINANCIAL MANAGEMENT

  Bretton woods system can be described as a dollar based gold exchange standard.
 The result of Bretton woods system two bodies were created IMF and IBRD (world
bank)
 Under Bretton woods system the US dollar was pegged to Gold at $ 35 per ounce and
other currencies were pegged to the US dollar.
 Each country was responsible for maintaining its exchange rate with + 1% of the
adopted par value by buying or selling foreign reserves as necessary.

Evaluation of dollar based gold exchange system

 System economizes on gold because countries can use not only gold but also foreign
exchanges as an international means of payment.
 Individual countries can earn interest on their foreign exchange holdings, whereas
gold holdings yield no returns.
 In addition countries can save transactions costs associated with transporting gold
across countries under the gold exchange system.
 Professor Robert Triffin warned, however, that the dollar based gold exchange system
was programmed to collapse in the long run. To satisfy the growing needs for
reserves, the United States had to run balance of payments deficits contentiously. It
would eventually impair the public confidence on the dollar, if such deficits are large
and persistent, they can lead to a crisis. This dilemma, known as ‘Triffin paradox’ was
indeed responsible for the eventual collapse of the dollar-based gold exchanged
system in the early 1970s.

Evaluation of Bretton wood system

Economic growth 
Globalization 
Price stability ?
Output stability ?
Policy flexibility X
Mutual beneficial ?
Self regulating X

Phase V – Flexible Exchange Rate Regime: Current Scenario (International Financial

Management by Cheol S Eun & Bruce G Resnick, Page No: 32-35)

The flexible exchange rate regime that followed the demise of the Bretton Woods system was
ratified after the fact in January 1976 when the IMF members met in Jamaica and agreed to a
new set of rules for the international monetary system. The key elements of Jamaica
agreement include.

 Flexible exchange rates were declared acceptable to the IMF members, and central
banks were allowed to intervene in the exchange markets to iron out unwarranted
volatilities.

ALIET 9 GLOBAL FINANCIAL MANAGEMENT

  Gold was officially demonetized as an international reserve asset. Half of the IMF’s
gold holdings were returned to the members and the other half was sold, with the
proceeds to be used to help poor nations.
 Non oil exporting countries and less developed countries were given great access to
IMF funds. The IMF continued to provide assistance to countries facing balance of
payments and exchange rate difficulties.

Exchange rate regime: It is the way an authority manages its currency in relation to other
currencies and the foreign exchange market. The collapse of bretton wood system and oil
crisis of 1970 floating exchange rate system was adopted by leading industrialized countries.

The International Monetary Fund (IMF) classifies member countries into seven
categories according to the exchange rate regime they have adopted. The exchange rate
arrangements under these categories are briefly described below. The information sourced
from IMF’s publication titled “Annual Report on Exchange Arrangements and Exchange
Restrictions 2006”.

 Exchange arrangements with no Separate Legal Tender: Under this regime a

country either adopts the currency of another country as its legal or a group of
countries share a common currency.
Example: Ecuador and Panama which have adopted US dollar as their legal tender.
The most prominent example was European Union (the twelve member countries of
which all have Euro as their Currency)
 Currency Board Arrangements: A regime under which there is a legislative
commitment to exchange the domestic currency against a specified foreign currency at
a fixed exchange rate coupled with restrictions on the monetary authority to ensure
that this commitment will be honoured. The first currency board was setup in
Mauritius in the 19th century for the purpose of fixing the exchange rates in
international business. In its classification for 2006 IMF classified some countries as
having a currency board system.
Example: In its classification for 2006 IMF classified seven countries Bosnia,
Herzegovina, Brunei, Bulgaria, Djibouti, Estonia, Hong Kong and Lithuania.

History of currency board

Country Currency pegged Establishment year

Argentina US dollar 1991-2001
Bermuda US dollar 1915
Bosnia German Mark/Euro 1997/2002
Brunei Singapore Dollar 1967
Bulgaria German Mark/Euro 1997/2002
Cayman island US dollar 1972
Djibouti US dollar 1949
Eastern Caribbean US dollar 1983
Estonia German Mark/Euro 1992/2002
Falkland island British Pound 1899
Forue island Danish Krone 1940
Gibraltar British Pound 1927

ALIET 10 GLOBAL FINANCIAL MANAGEMENT

 Hong Kong US dollar 1983
Lithuania US dollar/ Euro 1994/2002

Policies supporting currency board arrangement

- Fiscal policy
- Liberal trade and investment regime
- Flexible labour market
- Strong banking system
- Preparation for EU membership

How to avoid overheating of the economy under CBA (a case of Estonia)

- Flexibility
- Reminding conservative financial decisions (Plan what you want to do with
your money)
- Reducing cost and price pressure of the government
- More reserves in the financial system
- Close cooperation with supervisions
- High liquidity
 Conventional fixed peg arrangements/Fixed exchange rate: This is identical to
Bretton Woods system where a country pegs its currency to another or to a basket of
currencies with a band of variation not exceeding + 1% around the central parity. The
peg is adjustable at the discretion of the domestic authorities.
Example: 49 IMF member countries had this regime as of 2006. Of these 44 countries
had pegged their currencies to a single currency and the rest to a basket.

Merits
 Provide stability in international trade
 Reduce risk for commercial transactions
 Exporter would know how much he is going to receive
Demerits
 This system is speculation

 Pegged exchange rates with horizontal bands: Here there is a peg but a variation is
permitted within wider bands. It can be interpreted as a sort of compromise between a
fixed and a floating exchange rate.
Example: Six countries had such wider band regimes in 2006.
 Crawling Peg: This is another variant of a limited flexibility regime. The currency is
pegged to another currency or a basket but the peg is periodically adjusted. The
adjustments may be pre-announced and according to a well specified criterion or
discretionary in response to changes in selected qualitative indicators such as inflation
rate differentials.
Example: Five countries were under such a regime in 2006.

ALIET 11 GLOBAL FINANCIAL MANAGEMENT

  Managed floating with no preannounced path for the exchange rate/Dirty Float:
Exchange rates fluctuated from day to day but central banks attempt to influence their
countries exchange rates through buying and selling currencies against home currency
without any commitment to maintain the rate at any particular level or keep it on any
pre-announced trajectory.
Example: 53 countries including India were classified as belonging to this group in
2006.
 Independent floating (Limited Intervention): The exchange rate is market
determined with central bank intervention only to moderate the speed of change and
to prevent excessive fluctuations but not attempting to maintain it at, or drive it
towards, any particular level.
Example: In 2006, 26 countries characterised themselves as independent floaters.
(USA, UK, Japan Australia etc

As of July 2005, a large number of countries (36), including Australia, Canada, Japan, United
Kingdom, and the United States, allow their currencies to float independently against other
currencies; the exchange rates of these countries are essentially determined by market forces.
Fifty (50) countries, including China, India, Russia and Singapore adopt some forms of
‘managed floating’ system that combines market forces and government intervention in
setting the exchange rates. In contrast, 41 countries do not have their own national currencies.
Example: 14 Central and western African countries jointly use the CFA-franc, seven
countries including Bulgaria, Hong Kong, and Estonia, on other hand maintain national
currencies but they are permanently fixed to such hard currencies as the U.S. dollar or euro.
The remaining countries adopt a mixture of fixed and floating exchange rate regimes.

Phase VI- European Monetary System 1995 (International Financial Management by

Cheol S Eun & Bruce G Resnick, Page No: 35-38)

According to the Smithsonian agreement, which was signed in December 1971, the band of
exchange rate movements was expanded from the original plus or minus 1 percent to plus or
minus 2.25 percent. Members of European Economic Community (EEC), however, decided
on a narrower band of + 1.25 percent for their currencies. this scaled –down, European
version of the fixed exchange rate system that arose concurrently with the decline of the
Bretton Woods system was called the ‘snake’. The name ‘snake’ was derived from the way
the EEC currencies moved closely together within the wider band allowed for other
currencies like the dollar. The ‘snake’ arrangement was replaced by the European Monetary
System (EMS) in 1979. The EMS, which was originally proposed by German Chancellor
Helmut Schmidt, was formally launched in March 1979.

Objectives of EMS

- To establish a zone of monetary stability in Europe

- To coordinate exchange rate policies based on non EMS currencies
- To pave (Easy) the way for the eventual European monetary union

Features of EMS

ALIET 12 GLOBAL FINANCIAL MANAGEMENT

 - Euro is the single currency of the European monetary union (EMU) which was
adopted by 11 member states on 1 January 1999.
- These original member states were Belgium, Germany, Spain, France, Ireland,
Italy, Luxemburg, Finland, Austring, Portugal, and Netherlands.

Phases to achieve above objectives

First phase in EMU 1999

- In the first phase there were no notes/Coins

- Payment could be made through cheques and electronic device
- The exchange rate between Euro and member countries currency was fixed

Second phase in 2002

- In a January 2002 Euro bank notes and Coins were issued

- By the end of February 2002 Euro completely replaced the members
currency , now there is one currency throughout the EMU and that is Euro
- Euro bank notes issued by European central Bank(ECB) and National central
banks with full understanding between them
- Out of the total size of the issue 8% are allocated to the ECB and the
remaining 92% are allocated to the nations central banks

Evaluation of EMU

- Inflation must be less than 1.5 on average

- The government budget deficit must be less than 3% of GDP
- Total government debt must be less than 60% of GDP

SOUTH EAST ASIA CRISIS AND CURRENT TRENDS

Reference:https://corporatefinanceinstitute.com/resources/knowledge/finance/asian-
financial-crisis/

Concept of South East Asia Crisis

The Asian Financial Crisis is a crisis caused by the collapse of the currency exchange rate
and hot money bubble. It started in Thailand in July 1997 and swept over East and Southeast
Asia. The financial crisis heavily damaged currency values, stock markets, and other asset
prices in many East and Southeast Asian countries.

ALIET 13 GLOBAL FINANCIAL MANAGEMENT

On July 2, 1997, the Thai government ran out of foreign currency. No longer able to support
its exchange rate, the government was forced to float the Thai baht, which was pegged to the
U.S. dollar before. The currency exchange rate of the baht thus collapsed immediately.

Two weeks later, the Philippian peso and Indonesian rupiah underwent major devaluations as
well. The crisis spread internationally, and Asian stock markets plunged to their multi-year
lows in August. The capital market of South Korea maintained relatively stable until October.
However, the Korean won dropped to its new low on October 28 th, and the stock market
experienced its biggest one-day drop to that date on November 8th.

Causes of the Asian Financial Crisis

 The causes of the Asian Financial Crisis are complicated and disputable. A major
cause is considered to be the collapse of the hot money bubble. During the late 1980s
and early 1990s, many Southeast Asian countries, including Thailand, Singapore,
Malaysia, Indonesia, and South Korea, achieved massive economic growth of an 8%
to 12% increase in their gross domestic product (GDP). The achievement was known
as the “Asian economic miracle.” However, a significant risk was embedded in the
achievement.
 The economic developments in the countries mentioned above were mainly boosted
by export growth and foreign investment. Therefore, high interest rates and fixed
currency exchange rates (pegged to the U.S. dollar) were implemented to attract hot
money. Also, the exchange rate was pegged at a rate favorable to exporters. However,
both the capital market and corporates were left exposed to foreign exchange risk due
to the fixed currency exchange rate policy.

ALIET 14 GLOBAL FINANCIAL MANAGEMENT

  In the mid-1990s, following the recovery of the U.S. from a recession, the Federal
Reserve raised the interest rate against inflation. The higher interest rate attracted hot
money to flow into the U.S. market, leading to an appreciation of the U.S. dollar.
 The currencies pegged to the U.S. dollar also appreciated, and thus hurt export
growth. With a shock in both export and foreign investment, asset prices, which were
leveraged by large amounts of credits, began to collapse. The panicked foreign
investors began to withdraw.
 The massive capital outflow caused a depreciation pressure on the currencies of the
Asian countries. The Thai government first ran out of foreign currency to support its
exchange rate, forcing it to float the baht. The value of the baht thus collapsed
immediately afterward. The same also happened to the rest of the Asian countries
soon after.

Effects of the Asian Financial Crisis

 The countries that were most severely affected by the Asian Financial Crisis included
Indonesia, Thailand, Malaysia, South Korea, and the Philippines. They saw their
currency exchange rates, stock markets, and prices of other assets all plunge. The
GDPs of the affected countries even fell by double digits.
 From 1996 to 1997, the nominal GDP per capita dropped by 43.2% in Indonesia,
21.2% in Thailand, 19% in Malaysia, 18.5% in South Korea, and 12.5% in the
Philippines. Hong Kong, Mainland China, Singapore, and Japan were also affected,
but less significantly.
 Besides its economic impact, the Asian Financial Crisis also resulted in political
repercussions. The Prime Minister General of Thailand, Yongchaiyudh, and the
President of Indonesia, Suharto, resigned. An anti-Western sentiment was triggered,
especially against George Soros, who was blamed for triggering the crisis with large
amounts of currency speculation by some individuals.
 The impact of the Asian Financial Crisis was not limited to Asia. International
investors became less willing to invest in and lend to developing countries, not only in
Asia in other areas of the world. Oil prices also fell due to the crisis. As a result, some
major mergers and acquisitions in the oil industry took place to achieve economies of
scale

IMF’s Role in the Asian Financial Crisis

 The International Monetary Fund (IMF) is an international organization that promotes

global monetary cooperation and international trades, reduces poverty, and supports
financial stability. The IMF generated several bailout packages for the most affected
countries during the financial crisis. It provided packages of around $20 billion to
Thailand, $40 billion to Indonesia, and $59 billion to South Korea to support them, so
they did not default.
 The bailout packages are structural-adjustment packages. The countries that received
the packages were asked to reduce their government spending, allow insolvent
financial institutions to fail, and raise interest rates aggressively. The purpose of the

ALIET 15 GLOBAL FINANCIAL MANAGEMENT

 adjustments was to support the currency values and confidence over the countries’
solvency.

Lessons Learned from the Asian Financial Crisis

 One lesson that many countries learned from the financial crisis was to build up their
foreign exchange reserves to hedge against external shocks. Many Asian countries
weakened their currencies and adjusted economic structures to create a current
account surplus. The surplus can boost their foreign exchange reserves.
 The Asian Financial Crisis also raised concerns about the role that a government
should play in the market. Supporters of neoliberalism promote free-market
capitalism. They considered the crisis as a result of government intervention and
crony capitalism.
 The conditions that IMF set within their structural-adjustment packages also aimed to
weaken the relationship between the government and capital market in the affected
countries, and thus to promote the neoliberal model.

SOUTH EAST ASIA CRISIS/ASIAN CURRENCY CRISIS 1997

The financial crisis started in July 1997in Thailand

Thailand (Reasons)

 Floating the pegged currency(external borrowers)

 Real estate driven
 Excessive foreign exposure
 Collapse of Thai baht (currency name)

Major affected countries

 Thailand
 Indonesia
 South Korea
 Hong Kong
 Malaysia
 Philippines

Less affected Countries

 China
 India
 Taiwan
 Singapore
 Vietnam

Measures

ALIET 16 GLOBAL FINANCIAL MANAGEMENT

  IMF Role: It was given $40 billion to stabilize their currencies of south Korea,
Thailand and Indonesia
 Structural adjustment packages(plans)
 Cut back on government spending to reduce deficits
 Allow insolvent banks and financial institutions to fail and aggressively raise interest
rates
 High exports

Countries currency exchange rated per U.S $ during Asian currency crisis

 Thai baht 24.5 to 41

 Indonesia rupiah 2,380 to 14,150
 Philippine peso 26.3 to 42
 Malaysia ringgit 2.5 to 4.1
 South Korean won 850 to 1290

NOTE
 Capital flights: Capital flight is a large-scale exodus of financial assets and capital
from a nation due to events such as political or economic instability,
currency devaluation or the imposition of capital controls.
 Economic nationalism: Economic nationalism, also called economic
patriotism and economic populism, is an ideology that favors state
interventionism over other market mechanisms, with policies such as domestic control
of the economy, labor, and capital formation, including if this requires the imposition
of tariffs and other restrictions on the movement of labor, goods and capital.
 Hyperinflation: Hyperinflation is a term to describe rapid, excessive, and out-of-
control general price increases in an economy.
 India's current quota in the IMF is SDR (Special Drawing Rights) 5,821.5 million,
making it the 13th largest quota holding country at IMF and giving it shareholdings of
2.44%.
 Inconvertibility of rupee: Those were the days of restriction on foreign exchange.
No one could keep foreign exchange without the knowledge and due permission of
RBI. The exchange control consisted of restrictions on the purchase and sale of
foreign exchange by general public and payments to and from non-residents. There
were also restrictions on the import and export of Indian currency, foreign currency
and bullion. In those times, the exchange rates used to be different than what they are
today. Today we have a market determined exchange rate system, but during those
times, RBI used to dictate its Official Exchange Rate on which Indian currency could
be converted into foreign currency and vice versa. All transactions in foreign
exchange were governed by this official rate of exchange. This means that Rupee was
inconvertible at the market rate. An importer who wanted to import from abroad was
supposed to buy dollars at the RBI dictated rates. Similarly, an exporter who just got
dollars was supposed to sell them to RBI appointed Authorize agents at RBI decided
rate. This was the inconvertibility of Rupee.

ALIET 17 GLOBAL FINANCIAL MANAGEMENT

  Full convertibility of rupee: Before knowing about “full convertibility of rupee”,
one should know first “what is convertibility of currency?” Currency convertibility
means “the freedom to convert one currency into other internationally accepted
currencies. Full convertibility of rupees means unified market determined exchange
rate regime, converting rupees in to foreign currencies on both sides i.e. from “current
account” and from “capital account” side.
 Convertibility of rupee: Convertibility can also be identified as the removal of
quantitative restrictions on trade and payments on current account.
 Current account & Capital account convertibility: Current account convertibility
relates to the removal of restrictions on payments relating to the international
exchange of goods, services and factor incomes (in simple exports and imports) ,
while capital account convertibility refers to a similar liberalization of a country’s
capital transactions such as loans and investment, both short term and long term.
 Demonetization of gold: If authorities release monetary gold (Reserve asset) from
their holdings for non-monetary purposes. Example: for sale to private holders or
users.
 Monetary gold: Monetary gold is gold owned by the authorities (or by others who are
subject to the effective control of the authorities) and held as a reserve asset.
 Hot money: In economics, hot money is the flow of funds from one country to
another in order to earn a short-term profit on interest rate differences and/or
anticipated exchange rate shifts.

ALIET 18 GLOBAL FINANCIAL MANAGEMENT