Intro to Accounting for Foreign Currency:

1
Intro to Accounting for Foreign Currency

• Overview
• Floating vs Fixed Rates
• Economic Effects of a Floating Rate System

2
The Concept of Foreign Exchange

• Foreign exchange involves the exchange of one
  currency for another.
• Direct and indirect rates of exchange are quoted
  for this purpose

3
International Foreign Exchange- History1800s and
early 1900s

• In 1800s, pound sterling was the reserve currency
  of the world.
• Most currencies were linked to sterling and/or
  gold.
• Exchange rates were thus fixed!

4
International Foreign Exchange- HistoryThe
Depression Years (1930-1940)

• Depression years saw many currency devaluations
  as countries tried to compete in weak global
  markets.
• Rather than face severe economic decline, UK
  abandoned the gold standard. As a result,
  Sterling lost its seat as the worlds reserve
  currency.

5
The Beginning of the End for Fixed Rates of
Currency Exchange

• In the 1930s, many countries followed UKs
  example.
• Starved for gold reserves, and facing severe
  deflation, they abandoned the gold standard and
  let their currencies devalue and/or float.

6
The Depression Years in the USA (1930-1940)-
Confiscation!

• In the US, in 1933, with half of all banks
  closed, and unemployment at 25
• To stop hoarding and devalue US , American
  citizens were required to sell their gold at a
  price of 28 per ounce.
• Thereafter, American citizens were not allowed to
  own gold, except in the form of jewelry.

7
The Depression Years in the USA (1930-1940)- Then
Devaluation!

• The confiscated gold was then used to back the
  issuance of much more currency (convertible at
  35/oz) - in the hope of reviving the economy,
  and mitigating deflation.
• It didnt work- the country stayed in depression
  for ten painful years.
• The depression finally ended with the advent of
  WWII.

8
International Foreign Exchange- History1944-1967

• During WWII, the USA produced arms and sold them
  to the Allies in exchange for physical gold and
  promissory notes.
• By the end of WWII, much of the gold in the world
  was now stored in American vaults.
• This imbalance created a need for some other
  monetary basis. As a result, the Bretton Woods
  agreement emerged.

9
Under Bretton Woods

• The US was tied to gold. Other currencies were
  linked, at a fixed rate of exchange, to the
  dollar.
• The dollar thus became the new reserve currency
  of the world.
• Moreover, the world returned to fixed rates of
  currency exchange, now orchestrated by the US
  Federal Reserve.

10
Under Bretton Woods

• For more than 20 years, the system worked well
  and responsively.
• There was also rapid expansion of the world
  economy, including the development of many new
  products and markets, and rising standards of
  living in many industrialized countries.

11
International Foreign Exchange- HistoryThe
Inflation Years 1967-1980

• In the mid 1960s, trouble began as world
  economies became overextended and equity markets
  peaked.
• In the mid 1960s, The USA became involved in
  Vietnam. By 1967, the war was in full swing.
• The war was contentious and divisive. For this
  reason, it could not be paid for with tax
  increases.
• As a result, much more paper was needed to
  finance the war than gold reserves would allow.

12
The inflationary years

• The US thus printed paper in much larger
  quantities than its gold reserves could justify.
• When markets became aware of the increased
  amounts of currency, a few countries began to
  come to the gold window to exchange US for
  gold.
• Soon, massive amounts of gold began to leave the
  country.

13
International Foreign Exchange- HistoryThe
Inflation Years (1967-1980)

• In 1974, to stop the gold drain, President Nixon,
  without warning, quickly abandoned the gold
  standard and closed the gold window. The Bretton
  Woods agreement collapsed.
• In its place the Floating Rate system we have
  today developed.

14
International Foreign Exchange- HistoryThe
Concept of a Floating Rate

• From 1974 on, the US , and thus most other
  currencies, were no longer backed by gold. Paper
  money, although formally a form of credit, is now
  really backed by nothing except faith, i.e.,
  the collective willingness of society to accept
  it in trade for real goods and services.
• Advantages of floating rate currencies
• No reserve of gold is needed to back currency.
• Countries have greater freedom to create money
  and stimulate demand.
• Floating rates in currency markets assure that
  disparate inflation rates will not disrupt
  capital flows and trade.

15
International Foreign Exchange- HistoryThe
Concept of Floating Rate

• Disadvantages of a floating rate system-
• No restraint on governments propensity to
  devalue currency- usually to finance govt
  spending or to avoid politically unpalatable
  economic pain.
• Can induce greater asset price volatility,
  especially when coupled with a fractional
  reserve money-creating mechanism (i.e., the
  creation of credit).
• Foreign exchange rate volatility and risk are now
  directly borne by market agents, i.e., companies,
  investors, etc.

16
Traditionally

• Fiat currency, including paper, while
  theoretically a valid form of money, has always
  become worthless over time (example China,
  Rome).
• The ancient Chinese Empire, for example, was
  forced to abandon fiat currency because they
  found it was inflationary. In other words, such
  money could not hold its value.
• The US is no exception! The US has lost 98 of
  its value over the last 100 years!

17
The Behavioral Impact of Floating rates of
exchange

• Floating rates create new forms of investment
  risk that investors seek to avoid.
• They can also motivate governments to spend far
  more than they take in, without immediate
  political or economic consequence.
• The long-term results, however, can be painful
  (e.g., Japan 1990-2006)

18
Causes of Exchange Rate Movements

• Only well understood reason Inflation
• Other possibilities
• Trade imbalances
• Demand and supply of investment cash flows
• Fiscal deficits
• Economic growth
• Interest rates
• Political turmoil and stability
• and so on.

19
Euro Versus US Dollar
20
Japanese Yen Versus US Dollar
21
British Pound Versus US Dollar
22
Mexican Peso Versus US Dollar
23

• Floating rates also greatly increase the
  complexity of measuring changes in real economic
  wealth.

24
The Problem of Making Sound Economic Judgements
in a World of Floating Rates

• One way is to value things in terms of something
  traditionally monetary and real, e.g., gold.
• Example
• You buy a house for 200,000.
• It appreciates to 380,000 over 5 years, or 90
• /oz of Gold increases from 265 to 590 (125)
• House in gold oz Before 755 oz, After644 oz
• Conclusion House depreciated 15 in terms of
  gold.

25
Gold Versus US Dollar
26
Light Crude Oil Versus US Dollar
27
The Problem With Floating Rates

• Another example
• You get a 25 raise over 5 years.
• Gold appreciates 125
• Gasoline increases from 1.25 to 2.50 (100).
• Houses and many other real goods and services
  increase 100 or more in the same 5 years.
• Conclusion You may have actually taken a
  significant pay cut while feeling your income,
  and wealth, was increasing!

28
An example of the measurement problems inherent
in a floating rate system

• Has the national debt really grown? What if
• Total government debt has grown nominally by
  about 1/3 (6 trillion in 2002 to 8 trillion (?)
  in 2006) in 4 years?
• The value of the dollar, in terms of gold has
  decreased by more than 50 over the same time
  frame.
• In terms of gold, the national debt has thus
  shrunk considerably.

29
The Problem with Currency Devaluation
(revaluation) from an Accounting Standpoint

• One of the assumptions behind all financial
  reports is that the monetary unit is the same.
• If currency changes value over time, the monetary
  units () represented on financial statements are
  not the same.
• As such, they cannot be added or interpreted
  meaningfully.