Chapter 3 The International Monetary System

The international monetary system provides the essential framework for conducting and settling

cross-border economic transactions. Each nation operates under its own monetary authority—

such as the Federal Reserve in the United States—which is tasked with managing inflation and

fostering economic stability. For international trade to function effectively, a structured system

is required to facilitate payment flows across nations. The international monetary system

integrates global currency, capital, commodity, and real estate markets, governed by a network

of institutions and instruments shaped by intergovernmental agreements. This framework

enables exchange rate determination and supports global economic coordination, aligning

national monetary policies with international economic objectives.

3.1 Key concepts in exchange rate

Exchange Rate: An exchange rate is how much one country’s currency is worth in another

currency. For instance, if 1 U.S. dollar equals 24,000 Vietnamese dong (VND), a Vietnamese

exporter selling goods to the U.S. might receive 24,000 VND for each dollar earned.

Spot Exchange Rate: This rate applies to immediate currency exchanges. For example, if the

company needs to pay a U.S. supplier, they might check the spot rate and find it’s 24,000 VND

per dollar. They would pay their supplier immediately at this rate.

Forward Exchange Rate: Businesses can set exchange rates for future transactions. A

Vietnamese medical devices exporter might lock in a forward rate of 23,800 VND per dollar for a

sale six months in advance, protecting against potential changes in the dollar’s value.
Fixed Exchange Rate: Some currencies are fixed to maintain stability. For example, the

Vietnamese government keeps the dong within a limited range against the U.S. dollar to

support trade and investment stability.

Floating Exchange Rate: This rate changes based on market forces. Although the Vietnamese

dong isn’t fully floating, if it were, businesses would see the rate fluctuate based on supply and

demand, impacting import/export costs. Major floating currencies, like the dollar, impact

Vietnamese firms trading internationally.

Devaluation/Revaluation: If Vietnam’s government reduces the value of the dong, say, from

24,000 to 25,000 VND per dollar, that would be a devaluation. This move could make

Vietnamese exports cheaper for foreigners, boosting business but raising import costs.

Depreciation/Appreciation: If the dong’s value falls in the market without government action

(e.g., 24,000 VND per dollar rises to 25,000), it’s called depreciation. For a Vietnamese coffee

exporter, this means foreign buyers’ money goes further, potentially increasing demand for

Vietnamese coffee.

3.2 Current monetary arrangements

Currency regimes fall into two main groups are floating rates and fixed rates, with variations in

how strictly countries adhere to these approaches. Here’s a breakdown of the key types:

3.2.1 Floating-Rate Regimes

a. Freely Floating: Exchange rates are determined purely by market forces—supply and demand

—without strict government intervention. However, governments may step in to stabilize

sudden fluctuations. For example, if Vietnam allowed the dong to float freely, its value would

change based on global trade, investment, and currency demand.

b. Managed Floating: Governments actively intervene to manage exchange rates by influencing

the currency's supply and demand but without a fixed rate target. For instance, if Vietnam’s

central bank regularly bought or sold the dong to stabilize its value, it would be using a

managed-float system, common in many emerging markets.

3.2.2 Fixed-Exchange-Rate Regimes

a. No Local Currency: Some countries do not issue their own currency and instead use a foreign

currency as legal tender, such as the U.S. dollar in Ecuador. If Vietnam fully adopted the dollar, it

would lose control over its own monetary policy, tying its economy to the U.S. dollar's

performance.

b. Currency Board Arrangement: A country maintains its currency but commits to a fixed

exchange rate, backed by reserves in a foreign currency. For example, if Vietnam committed to

always exchange Vietnam dong for a set amount of dollars, it would need enough dollar

reserves to maintain this stability.

c. Fixed-Peg Arrangement: The currency is pegged to another currency or a basket of currencies

at a set rate, with minimal fluctuation allowed. Vietnam currently pegs the Vietnam dong within

a narrow range against the U.S. dollar, allowing slight adjustments. This helps stabilize the

currency while the central bank intervenes if the rate strays outside the set limits, like how

China manages the yuan.

Most global currencies combine elements of fixed and floating regimes, allowing for minor

adjustments to support economic goals. While major currencies (like the dollar and euro) often

float, many developing countries opt for a pegged or managed approach to maintain stability in

international trade.

3.3 Foreign exchange rate quotations

3.3.1 Cross rate
Cross rates are exchange rates between two non-U.S. currencies, calculated using their rates

against a common currency like the U.S. dollar. This helps people determine the value of one

currency in terms of another when neither is the dollar.

For example, suppose a Vietnamese company plans to buy goods from Germany, and the

exchange rates are as follows:

Spot rate for euro: €0.84 = $1

Spot rate for Japanese yen: ¥110 = $1

To find the cross rate of euros to yen, we calculate:

This means 1 euro is worth approximately 130.95 yen. Alternatively, the cross rate from yen to

euro would be the reciprocal: €0.0076 per yen.

3.3.2 Direct and Indirect Exchange Rate Quotations

Exchange rates can be expressed in two ways: direct and indirect quotations. These depend on

the "home" currency perspective.

a. Direct Quotation: Shows the home currency price of one unit of foreign currency. For

instance, if Vietnam is the home country, a rate like "VND 24,000 per 1 USD" is a direct

quotation for Vietnam. This means 1 U.S. dollar costs 24,000 Vietnamese dong.

b. Indirect Quotation: Shows the foreign currency price of one unit of the home currency. For

example, if a Vietnamese company looks at the rate "0.0000417 USD per 1 VND," this is an

indirect quotation for Vietnam, reflecting the cost of 1 dong in terms of U.S. dollars.

These terms change depending on which currency is considered "home." For instance, if the

home currency were the U.S. dollar instead, the quotations would be reversed.

3.4 Trading in foreign exchange

Businesses, tourists, and governments buy and sell currencies in the foreign exchange market

for transactions like importing and exporting. For example, the company medical devices

exporter selling to the U.S. may receive payment in U.S. dollars, which they then exchange for

Vietnamese dong to cover domestic costs. This process, like buying stocks, happens through a

global network of banks and brokers in financial hubs like New York, using computers and

phones.

a. Spot Rate: The exchange rate for immediate delivery of a currency, typically within two days.

For instance, if a Vietnamese medical devices company buys components from US, it will use

the spot rate to pay in dollar.

b. Forward Rate: A fixed exchange rate for currency delivery at a future date (e.g., 30, 90, or 180

days). Suppose the company exporter needs to pay a US supplier in 90 days. To avoid exchange

rate fluctuations, they could enter a forward contract to lock in the current rate, securing

payment stability.

If the forward rate for a currency is lower than the spot rate, it’s said to be selling at a discount;

if higher, it’s selling at a premium. For example, if the forward rate for the dollar is cheaper than

the spot rate, the dollar is trading at a discount, and Vietnamese importers could benefit by

paying less in the future. This process, called hedging, helps businesses protect against currency

volatility.

3.5 The relation between inflation rate, interest rate and exchange rate

When comparing inflation rates between countries, two key effects arise for multinational

businesses:

a. Production Costs: Higher inflation abroad can lead to increased production costs, impacting

profits for firms producing in or sourcing from those countries. For example, if inflation in the

U.S. rises faster than in Vietnam, it could increase the cost for a Vietnamese medical devices

firm importing components from the U.S.

b. Interest and Exchange Rates: Inflation differences affect interest and exchange rates,

impacting financing and investment decisions. Currencies in high-inflation countries tend to

depreciate over time. For instance, if inflation in Vietnam is higher than in US, the Vietnamese

dong may depreciate against the US dollar. As a result, a Vietnamese importer might face higher

costs when paying in dollar.

Because countries with high inflation often have higher interest rates, companies might

consider borrowing in countries with lower rates. However, if a Vietnamese firm borrows in a

low-inflation country like US, the dollar might appreciate over time, increasing the cost of

repaying the loan. Conversely, borrowing in a high-inflation country like Brazil might be

beneficial, as currency depreciation could lower the real cost of repayment.

3.6 Interest rate Parity

Market forces dictate whether a currency is at a forward premium (when its future value is

expected to be higher) or discount (when its future value is expected to be lower). This

relationship is explained by interest rate parity, which states that investors should earn similar

returns on investments across different countries after considering risk and currency

fluctuations.

a. Investment Returns: When investing abroad, returns depend on:

- The nominal interest rate of the investment.

- Changes in the exchange rate.

- If a foreign currency appreciates, your overall returns increase; if it depreciates, your returns

decrease.
b. Interest Rate Parity Equation:

- Here, Rh is the domestic interest rate, and Rf is the foreign interest rate.

Suppose a Vietnamese investor wants to invest in 90-day U.S. Treasury bonds offering a 4%

annual return. Here’s how the investor might proceed:

1. Convert VND to USD: The investor exchanges 1,000,000 VND for approximately $43.33 (using

a spot rate of 23,000 VND per dollar).

2. Invest in U.S. Bonds: The investor purchases U.S. Treasury bonds, which will yield a 1% return

over 90 days (equivalent to $43.33 × 1.01 = $43.76).

3. Forward Rate Agreement: The investor locks in a future exchange rate (for example, 23,200

VND per dollar) to convert their investment back to VND in 90 days. This means after 90 days,

they can convert $43.76 back into VND, yielding approximately 1,016,832 VND.

By locking in the forward exchange rate, the Vietnamese investor eliminates exchange rate risk

and ensures a return. If the local interest rate in Vietnam were lower than in the U.S., the

Vietnamese dong would likely be at a forward discount, reflecting this disparity. Interest rate

parity illustrates the expected returns and risks in currency investments, guiding investors in

their financial strategies.

3.7 Purchasing power parity

While we have explored exchange rates and the relationship between spot and forward rates, it

is essential to understand what determines the spot exchange rates in various countries.

Although many unpredictable factors influence exchange rates daily, over the long term, market

forces align prices for identical goods across countries when adjusted for exchange rates. This

principle is known as purchasing power parity (PPP).

PPP suggests that identical goods should cost the same in different countries when exchange

rates are considered. If a product is priced differently, arbitrage opportunities will exist, leading

to price adjustments. Example: If a Vietnamese brand of athletic shoes is priced at 1,500,000

VND in Vietnam and at 75,000 VND in Thailand, PPP indicates that the exchange rate should be

20 VND per Thai Baht. Vietnamese consumers could either buy the shoes in Thailand for 75,000

Baht or exchange 75,000 Baht for 1,500,000 VND to purchase the same shoes domestically.

How PPP Restores Price Equality?

If the shoes cost only 1,200,000 VND in Vietnam, traders could buy them in Vietnam, sell them

in Thailand for 60,000 Baht, and exchange the Baht back to VND for a profit. This trading activity

would:

- Increase demand for shoes in Vietnam, raising the local price.

- Increase supply in Thailand, leading to a decrease in the price there.

- Increase demand for VND in the foreign exchange market, thus affecting the exchange rate.

Limitations of PPP:
- Assumptions: PPP assumes there are no transportation costs, transaction fees, or import

restrictions that might hinder international trade.

- Real-World Applications: In practice, products differ in quality or branding, which can lead to

price discrepancies that PPP may not account for.

Despite its limitations, the concepts of PPP and interest rate parity are vital for companies and

investors engaged in international business. Understanding these relationships helps them

anticipate changes in interest rates, inflation, and exchange rates, enabling effective risk

management strategies.

3.8 Investing oversea

Investing in foreign markets involves additional risk factors that investors must consider:

a. Country Risk

- Definition: Country risk refers to the potential risks associated with investing in a specific

country, influenced by its economic, political, and social environment. Some countries offer a

more stable investment climate than others.

- Examples: In Vietnam, investors may face country risk from potential changes in government

regulations, local labor laws, or tax policies. For instance, if the Vietnamese government decides

to change tax rates suddenly or imposes new regulations on foreign investments, this could

affect profitability. Additionally, there may be risks of property expropriation without adequate

compensation.
b. Exchange Rate Risk

- Definition: This risk arises when investments are denominated in a foreign currency. Changes

in exchange rates can impact the returns received by investors when converting funds back to

their home currency.

- Example: If a Vietnamese company invests in a bond issued in the U.S. that pays interest in

dollars, fluctuations in the VND/USD exchange rate will affect the actual returns. If the

Vietnamese Dong depreciates against the dollar, the amount of VND received upon conversion

will be less when funds are repatriated. Conversely, if the Dong appreciates, the effective return

will be greater.

Returns on foreign investments depend not only on the performance of the foreign asset but

also on fluctuations in exchange rates. Investors should carefully evaluate both country and

exchange rate risks when making international investments to better understand their potential

impact on overall returns.

3.9 Risk management techniques

To effectively manage country risk and exchange rate risk associated with overseas investments,

investors can employ several risk management techniques:

a. Country Risk Management Techniques

- Diversification: Spread investments across multiple countries or regions to reduce exposure to

any single country's economic or political instability. For instance, a Vietnamese investor could
consider investing in several Southeast Asian countries rather than concentrating investments

solely in Vietnam.

- Political Risk Insurance: Obtain insurance from entities such as Multilateral Investment

Guarantee Agency (MIGA) or private insurers that protect against losses due to expropriation,

political violence, or breach of contract.

- Thorough Due Diligence: Conduct comprehensive research on the economic, political, and

regulatory environment of the target country before investing. This includes analyzing historical

data and current trends related to the country's stability, government policies, and investment

climate.

- Engagement with Local Experts: Work with local financial advisors, legal experts, and industry

professionals who have in-depth knowledge of the country’s business landscape and can

provide insights into potential risks.

- Monitoring and Adjusting Strategies: Continuously monitor the political and economic

developments in the country of investment. Be prepared to adjust investment strategies based

on emerging risks or changes in the political environment.

b. Exchange Rate Risk Management Techniques

- Hedging: Use financial instruments such as forward contracts, options, and swaps to lock in

exchange rates. For example, a Vietnamese company planning to invest in U.S. dollars could

enter into a forward contract to fix the exchange rate for a future date, thus eliminating

uncertainty.
- Currency Diversification: Hold assets in multiple currencies to mitigate the impact of adverse

movements in any single currency. This strategy can help balance potential losses from one

currency with gains in another.

- Natural Hedging: Structure operations to generate revenues in the same currency as expenses.

For instance, if Vietnamese company exports goods to the U.S. and incurs costs in dollars, it can

offset currency risk by matching its revenue and expenses in the same currency.

- Regular Assessment of Currency Exposure: Monitor currency exposures regularly to

understand their impact on overall investment returns. Investors can reassess their currency

positions based on market trends and adjust their strategies accordingly.

- Using Currency ETFs: Invest in currency exchange-traded funds (ETFs) to gain exposure to

foreign currencies while managing risks. Currency ETFs can help mitigate exchange rate

fluctuations by providing a hedge against currency movements.

By implementing these risk management techniques, investors can better protect themselves

against country and exchange rate risks associated with international investments. A proactive

approach to risk management not only safeguards investments but also enhances the potential

for stable returns over time.

3.10 Federal reverse bank

The Federal Reserve Bank plays a critical role in influencing both exchange rates and interest

rates through its monetary policy framework. As the central bank of the United States, the

Federal Reserve's primary objectives include promoting maximum employment, stable prices,
and moderate long-term interest rates. It utilizes various tools to achieve these goals, notably

open market operations, the federal funds rate, and the discount rate.

When the Federal Reserve adjusts the federal funds rate, which is the interest rate at which

banks lend reserves to one another overnight, it indirectly influences other interest rates

throughout the economy, including those for loans, mortgages, and savings. A decrease in the

federal funds rate typically lowers borrowing costs, stimulating economic activity, while an

increase can cool down an overheating economy.

Moreover, changes in U.S. interest rates have significant implications for exchange rates. Higher

interest rates attract foreign capital seeking higher returns, leading to an appreciation of the

U.S. dollar as demand for the currency increases. Conversely, lower interest rates may result in

capital outflows and a depreciation of the dollar. Additionally, the Federal Reserve's forward

guidance and communication strategies can impact market expectations about future interest

rates, further influencing both domestic and international capital flows.