INTERNATIONAL BUSINESS MANAGEMENT
LESSON 22
THE FOREIGN-EXCHANGE MARKET-STRUCTURE & CASE STUDY
The Foreign-exchange Trading Process
When a company sells goods or services to a foreign customer
and receives foreign currency, it needs to convert the foreign
currency into the domestic currency. When importing, the
company needs to convert domestic to foreign currency to pay
the foreign supplier. This conversion takes place between the
company and its bank, and most of these transactions take
place in the OTC market. Originally, the commercial banks were
the ones that provided foreign-Exchange services for their
customers. Eventually, some of these commercial banks in New
York and other U.S.money centers such as Chicago and San
Francisco began to look at foreign Exchange trading as a major
business activity instead of just a service. They became interme-
diaries for smaller banks by establishing correspondent
relationships with them. They also became major dealers in
foreign exchange.
The left side of Figure 8.4 shows what happens when a U.S.
company needs to sell euros for dollars. This situation could
arise when a customer had to pay in euros or when a German
subsidiary had to send a dividend to the U.S. Company in
euros. The right side of the figure 8.4 shows what happens
when a U.S. company needs to buy euros with dollars. This
situation could arise when a company had to pay euros to a
German supplier. However, there are other markets and
institutions in which foreign exchange is traded. Most of the
foreign-exchange activity takes place in the traditional instru-
ments of spot, outright forward, and FX swaps, and
commercial banks and investment banks or other financial
institutions basically trade these instruments. However,
companies could also deal with an exchange, such as the
Philadelphia Stock Exchange to buy or sell an option contract
and the Chicago Mercantile Exchange to deal in foreign-currency
futures.
The Bank for International Settlements estimates that there are
about 2,000 dealer institutions worldwide that make up the
foreign-exchange market. Of these, about 100 to 200 are
market-making banks, which means that they are willing to
quote bid and offer rates to any one in the currency or currencies
in which they deal. Of this group, only a select few are major
players, and they will be identified and discussed shortly in the
section on commercial and investment banks.
As noted earlier, most of the foreign-exchange trades take place
in the OTC market in which most of the dealers operate. These
dealers operate more in the interbank market with dealers of
other
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190
Figure 8.4 Structure of Foreign-Exchange Markets
Banks than they do with corporate clients. The BIS estimated in
2001 that 59 percent of the foreign-exchange trades took place
among reporting dealers. Fifty-seven percent of the business
between dealers takes place across national borders, whereas 43
percent the dealers’ business with nonfinancial customers takes
place in the domestic market. This number is declining rapidly,
compared with 64 percent in 1998.
When a company needs foreign exchange, it typically goes to its
commercial bank for help. If that bank is a large market maker,
the company can get its foreign exchange fairly easily. However,
if the company is located in a small market and uses a local
bank, where does the bank get its foreign exchange? Figure 8.5
illustrates how foreign-exchange dealers at the banks trade
foreign exchange. A bank, dealing either on its own account or
for a client, can trade foreign exchange with another bank directly
or through a broker. In the broker market, it can use a voice
broker or an electronic brokerage system (EBS). In both the U.S.
and U.K.markets, direct dealing is by far the most widely used
method of trading currency; however, the use of electronic
brokerages is increasing. An increase in electronic brokerage
system shows that dealers are directly trading less actively among
themselves. The share of electronic brokerages in interdealer
trading volume was around 5 percent in 1992, 10 percent in
1995,40 percent in 1998, and 60 percent in 2001.
A foreign-exchange broker is an intermediary who matches the
best bid and offer quotes of interbank traders. There are a
number of brokerage houses around the world, such as the
Martin Brokers Group in London, owned by Trio Holdings,
Exco, Tullett & Tokyo Forex International, and Intercapital
Group. These brokers have traditionally dealt in the market by
voice, linking up interbank traders. According to the BIS survey
in 1998, there were nine brokers in the United States, including
the two major electronic brokerage systems, down from 17 in
1995.
The use of brokers depends on a number of factors, such as
the location of the market and the size and nature of the
foreign-exchange transactions. Voice brokers are especially
important for large foreign-exchange transactions. Brokers have
filled an important role because of their ability to establish
networks with a wide variety of banks, thus allowing banks to
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buy or sell currency from other banks faster than if they had to
try to contact all or different potential banks themselves.
However, the voice broker market has been rapidly giving way
to electronic brokerage systems.
Historically, most trades took place by telephone. A dealer in
one bank would call a dealer in another bank and execute a
trade. If it did not have access to enough banks to get the
currency needed, it could operate through a broker. The move
from voice to electronic brokerage systems was initiated by
Reuters (its system is called Reuters’ Dealing 3000) and then
followed by other systems such as Icos, an electronic brokerage
company.
Figure 8.5 Foreign-Exchange Transactions
A bank gets access to the automated system by purchasing the
service from Reuters by paying a monthly fee and receiving a
link through telephone lines to the bank’s computers. Then the
bank can use the automated system to trade currency. The
automated system is efficient, because it lists bid and sell
quotes, allowing the bank to trade immediately. For large
transactions, many dealers prefer the familiarity of a trusted
voice broker to find a buyer or seller. Electronic dealers are
efficient but too impersonal for the large transactions. Most
electronic trades average in the $1 million to $2 million range,
although a trade of $1 0 million to $20 million will occasionally
show up. Electronic brokerage systems are used in one third of
all transactions for the dollar, euro, and yen. Many voice brokers
are leaving the spot market and focusing more on derivatives,
such as forwards and options.
A current trend in currency trading is the establishment of
Internet currency trading. During the Internet boom of the
1990s, large banks and corporations started funding Internet
start-ups that were aimed at facilitating Internet exchange
trading. One example is a company called Atriax, which was
formed by Citibank, JPMorgan Chase, and Deutsche Bank.
Then the bottom fell out of the stock market in 2000, many of
these companies found themselves in trouble, including Atriax.
Some companies survived, and Internet trading for foreign
exchange is estimated to be around $14 billion a day. Many
believe that in 10 to 20 years, there will be a variety of platforms
that allow trading in multiple products. And as banks security
issues associated with Internet trading, activity should pick up.
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Commercial and Investment Banks
INTERNATIONAL BUSINESS MANAGEMENT
At one time, only the big money center banks could deal directly
in foreign exchange. Regional banks had to rely on the money
center banks to execute trades on behalf of their clients. The
emergence of electronic trading has changed that, however.
Now even there regional banks can hook up to Reuters and
EBS and deal directly in the interbank market or through
brokers. In spite of this, the greatest volume of foreign-
exchange activity takes place with the big banks.
There is more to servicing customers in the foreign-exchange
market than size alone. Each year, Euromoney magazine
surveys corporations and financial institutions to identify their
customers’ favorite banks and the leading traders in the
interbank market. The criteria for selecting the top foreign-
exchange traders include Ranking of banks by corporations and
other banks in specific locations, such as London, Singapore,
and New York.
Capability to handle major currencies, such as the u.s. dollar and
euro. Capability to handle major cross-trades-for example, those
between the euro and pound or the euro and yen. Capability to
handle specific currencies. Capability to handle derivatives
(forwards, swaps, futures, and options). Capability to engage in
research.
Other factors often mentioned are price, quote speed, credit
rating, liquidity, back office/settlement, strategic advice, trade
recommendations, out-of-hours service/night desk, systems
technology, innovation, risk appraisal, and e-commerce func-
tions. For this reason, large companies may use several banks to
deal in foreign exchange, selecting those that specialize in specific
geographic areas, instruments, or currencies. For example,
AT&T uses Citibank for its broad geographic spread and wide
coverage of different currencies, but it also uses Deutsche Bank
for euros, Swiss Bank Corporation for Swiss francs, NatWest
Bank for British pounds, and Goldman Sachs for derivatives.
Table 6.5 identifies the top banks in the world in terms of
foreign exchange trading. They are the key players in the OTC
market and include both commercial banks (such as Citigroup
and JPMorgan Chase) and investment banks (such as UBS
Warburg-the Table 6.5.
London-based investment banking division of Union Bank of
Switzerland and Swiss Bank Corporation-and Goldman Sachs).
Whether one is looking at overall market share of foreign-
exchange trading, die ranking of best banks in specific locations,
the best banks in the trading of specific currency pairs, or best
dealers, these top 10 banks are usually at or near the top in every
category.
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 One area that allows banks to develop niches is that of exotic
INTERNATIONAL BUSINESS MANAGEMENT
currencies. An exotic is a currency from a developing country,
such as the Russian ruble, the Malaysian ringgit, and the
Mexican peso. Exotics are difficult for corporations to work
with because the volume of activity in those currencies is pretty
small, so the costs of dealing with those currencies are relatively
high. It is hard to get a good price, and the bid/ask spread is
usually higher than would be the case for a widely traded
currency like the Japanese yen. In addition, local regulations
governing the use of exotic currencies change daily, realignments
of exchange rates are common, and the volume of activity in
the currencies can be subject to wide swings. Banks such as
Citigroup help their clients with exotics by cutting through the
regulations on buying and selling, dealing with difficult
exchange-rate systems, working with exchange controls on
investments, and getting information on potential changes in
rates. The banks also help their clients manage positions and
move funds.
In addition to the OTC market, there are a number of ex-
changes in which foreign-exchange instruments, mostly options
and futures, are traded. Two of the best-known exchanges are
the Chicago Mercantile Exchange (CME) and the Philadelphia
Stock Exchange (PHLX). The CME offers futures and futures
options contracts (contracts that are options. on futures
contracts rather than options on foreign exchange per se) in the
euro, the Japanese yen, the Mexican peso, the Australian dollar,
the British pound, the Canadian dollar, the Swiss franc, the
Brazilian real, the South African rand, the New Zealand dollar,
the Swedish krona, the Norwegian krone, and the Russian
ruble. The CME hit record trading levels for futures contracts in
2002-with June and July the busiest months in history. When
the economy turned down, investors flocked to the CME to
purchase options in a move to hedge against falling portfolios.
Also, electronic trading increased the ease and availability of
trading.
The Philadelphia Stock Exchange is the only exchange in the
United States that trades foreign-currency options. The PHLX
lists six dollar-based standardized currency option contracts:
Australian dollars, British pounds, Canadian dollars, euros,
Japanese yen, and Swiss Frances. The PHLX has been growing
faster than the CME. Much of the growth has come from
MNEs. Although options cost more than futures, big compa-
nies prefer them to futures (the CME instrument) because of
their greater flexibility and convenience.
Case Study
Foreign Travels, Foreign-Exchange Travails: Excerpts from the
Travel Journal of Lee Radebaugh. One of the more daunting
aspects of overseas travel for the business executive or the
tourist is coping with currency. Recently, I traveled to Latin
America to visit alumni, interview candidates for our MBA
program, and set up a foreign business excursion for graduate
business students. I was in such a hurry to leave that I didn’t
even check the exchange rates in the Wall Street Journal-
something I usually do. Even though the exchange rates in the
Journal are the New York selling rates (my buying rates) for
transactions of $1 million or more –and I didn’t plan on
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192
exchanging $1 million-I could still have gotten a general idea of
what to expect.
The first stop was Chile. I decided to carry a mixture of cash
and traveler’s checks, because on a trip to Brazil a new years
earlier, I was attacked and nearly robbed in Rio de Janeiro.
Traveler’s checks provide security because they can be replaced.
However, in that prior trip, the bank wouldn’t cash traveler’s
checks at the Buenos Aires airport, so this time I came prepared
for all possibilities. In addition, I like to use credit cards, as long
as the local currency is stable. Credit card companies handle large
volumes of currency daily, so they get favorable exchange rates.
When we cleared customs in Chile, the exchange rate was 350
pesos per dollar, I had no idea whether hotel, I asked the
woman at the front desk if she could cash $100, and she said
she was out of pesos but would have some in 30 minutes.
This was no big deal because we needed to unpack and rest
before having lunch. After a nap, we headed down to the front
desk to get some cash. But still the answer was, “sorry, no
pesos.” She did suggest an exchange house two blocks away. So
off we headed. After getting lost, we finally asked directions and
found a casa de cambio (Exchange House) next to the metro
(subway or underground). To our pleasant surprise, the
exchange rate was 450 pesos per dollar, and there was no service
charge. Usually, when you convert currency at the airport, bank,
or hotel, you have to pay a service charge on each transaction.
We walked out of the Case de cambio with 45,000 pesos-10,000
more than if we had converted at the airport.
As we walked to lunch, I began to figure 8.5 out how much
things would cost. When I get foreign currency, I feel as if I’m
spending Monopoly money-it just doesn’t seem real for some
reason. “Let’s see, if I want to pay $ 10 for lunch, I Should pay
4,500 pesos ($10X450 pesos, the exchange rate I got when I
traded my dollars into pesos). That’s easy. But if lunch costs
7,800 pesos? How much is that? Never mind. It’s more than
$10 and less than $20 (between 4,500 and 9,000 pesos).” I said
to myself that I might have to think about this some more.
After two wonderful days in Santiago, we checked out of the
hotel-an experience in itself. Everyone was very pleasant, but the
system was a little slow. The clerk said, “Do you want to keep
the charges on your American Express?” “Of course,” I said. I
figured American Express could get a pretty good exchange rate
for my room charge for two nights of 102,000 pesos. “That will
be $255,” he said. “Wait,” I said. “What exchange rate are you
using?” “Four hundred pesos,” he replied. “That’s a horrible
rate,” I said. “I got 450 pesos down the street.” “That is not
possible, Senor. Maybe you misunderstood. Perhaps 405, or
maybe 415, but not 450.” “I know what exchange rate I got and
it was 450,” I replied. “That is a very good exchange rate,
Senor.” Yeah, right, I thought. Not only did I not get the
American Express rate, but the room cost me $127.50 per
night! At my conversion rate of 450 pesos from the Casa de
Cambio, I would have spent only $227 for two nights (102,000
pesos/450 pesos), thus saving $28.
MAP. A Trip Through South America’s Exchange Rates
It wasn’t enough to cause an international incident, however, so
I dropped it and thanked him for the lovely stay. I may be back,
SO” didn’t want him to remember an ugly American.
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When I got to the Santiago airport. I decided to exchange
Chilean pesos for Argentine pesos, or “Argentino” for short,
but only dollars were available. This was confusing without any
additional complications, because both Chile and Argentina
used the term peso for their currency even though the values are
very different. I guess this is similar to the U.S.- Canadian
situation-that is, both countries use the term dollar for their
currencies. Then I noticed that the airport bank was selling
dollars for 410 pesos per de if and buying for 430. Because I
had bought at 450 at the Exchange House and sold at 430 at
the airport I made about $0.11 on every 1,000 pesos. It didn’t
amount to much-but if only I could have traded $1 million at
that spread.
When we arrived at the Buenos Aires airport a few hours later, I
cashed some more money at the bank in the airport. This time,
the bank accepted traveler’s checks, and I converted $100 for
93.95 pesos, which was a little surprising because I had read that
the exchange rate was $1 = 1 peso. To my surprise the bank
charged me 5 percent to cash the traveler’s checks and another
1.05 percent service fee-a total of 6.05 pesos.
Because everything was expensive in Buenos Aires, I ran out of
pesos quickly, so I went to the American Express office the next
day, and it converted $100 for 99.8 pesos. Next time, I’ll ask
before using traveler’s checks. It can get confusing. At times, I’ve
sold traveler’s checks at a better rate than I got than if I’d been
selling cash, and other times not. When we left Buenos Aires,
the exchange rate was the same for buying and selling-l: 1. There
was a $0.15 service charge, so it cost almost nothing to change
currency-$l 00 to buy 99.8 pesos at American Express and $100
for selling 99.85 pesos (100 pesos less $0.15).
After a delay at the airport in Buenos Aires, we finally headed
for Sao Paulo, Brazil. The currency market in Brazil has always
been the haven of the black marketer. No one ever has a clue to
the real value, and it varies with personal checks, traveler’s checks,
or cash. Every hotel and shop has its own rate, which requires
astute shopping around.
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The last time I had been in Brazil, the country was in the
INTERNATIONAL BUSINESS MANAGEMENT
process of locking the currency onto the U.S. dollar to eliminate
these price differences and to stabilize its value, but the situation
was still chaotic. Taxi drivers still preferred dollars, no matter
what the exchange rate. Finally, the Brazilian government
succeeded in stabilizing the currency in June 1994, and the
Brazilian real (the name of the currency, pronounced hey ALL)
was fixed to the dollar (or pegged)-the rate was about 1: 1.
When I arrived at the airport. I changed dollars into reais
(pronounced hey-ICE) at R$0.9300 = US $1.00. The bank
demanded no service charge, but it sold dollars (or bought R$)
for R$0.99 = US $1.00. What a change from the historical value!
The first time I went to Brazil in 1964, the dollar was worth
1,200 cruzeiros, the name of the currency then. Since that time,
the Brazilian currency has changed names seven times: cruzeiro
(1942-1967), new cruzeiro (1967-1970), cruzeiro (1970-1986),
cruzado (1986-1989), new cruzado (1989-1990), cruzeiro (again!)
(1990-1993), cruzeiro real (1993-1994), and real (since 1994).
Every change knocked three zeros off the currency. So 1,200
cruzeiros became 1.2 new cruzeiros, and so on. At an exchange
rate of 1: 1, it was obviously easier to figure out how much
everything cost in dollars. But everything was more expensive
compared to U.S. costs. When the Brazilian government fixed
the rate at 1: 1, it made the real a little too strong, so the dollar
lost much of its purchasing power there.
It can be confusing to travel overseas-whether on a business trip
or for pleasure-and the more countries you go to in a single trip,
the more confusing it gets. And the worst part is that every time
you travel, you need to get used to new exchange rates. For
example, by early 2003, the Chilean peso was trading for713.78
per U.S. dollar, the Argentine peso for 3.33 per dollar, and the
Brazilian real for 3.44 per dollar-quite a change from my last trip
to South America.
Ethical Dilemma
The need for Check and Balances
There are plenty of opportunities for a trader to make money
illegally. One of the most publicized events in the derivatives
markets in recent years involved 28-year-old Nicholas lesson and
233-year old Barings PLC. Lesson, a trader for Barings PLC,
went to Singapore in the early 1990s to help resolve some
problems Barings was having. With in a year, he was promoted
to chief trader. The problem was that he was responsible for
trading securities and booking the settlements. This meant that
there were no checks and balances on his trading actions, thus
opening the door to possible fraud. When two different
people ate assigned to trade securities and book settlements, the
person booking the settlements can confirm independently
whether or not the trades were accurate and legitimate. In 1994,
leeson brought stock index futures on the assumption that the
Tokyo stock, market would rise. Unfortunately, the market fell,
and lesson had to come up with cash to cover the margin call on
the future contract. A margin is a deposit made as security for a
financial transaction that is otherwise financed on credit. When
the price of an instrument changes and the margin rises, the
exchange “calls” the increased margin from the other party in
this case leeson. However, leeson soon ran out of cash from
Barings, so he had to come up with more cash. One approach
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 he used was to write options contracts and use the premium he
INTERNATIONAL BUSINESS MANAGEMENT
collected on the contracts to cover his margin call. Unfortunately,
he was using brings’ funds to cover his transactions. As the
Tokyo stock market continued to plunge, leeson fell farther and
farther behind and eventually fled the country, later to be caught
and returned to Singapore for trial. Barings estimated that
leeson generated losses in excess of $1 billion, which put
Barings into bankruptcy. Eventually, the Dutch bank ING
purchased Barings. Lesson’s activities in the derivatives markets
were illegal and a violation of solid internal controls.
Finally, leeson went to prison on Singapore (where he was
treated for colon cancer as well). On July 3,1999, leeson was
released from prison, and he returned to his native Britain.
Since the collapse of Barings, measures have been put into place
in banks to prohibit such consequences, yet negative outcomes
of rogue trading continue to happen. In February 2002, Allied
Irish Banks discovered that an employee, John Rusnak at its
U.S. subsidiary, All first banks, lost $750 million, but the profit
was not investigated by the bank because it was making a great
deal of money off his trades. But because of the U.S. market at
that time, Rusnak’s leveraged gains quickly turned to huge
losses. A/B suspect Rusnak was involved with fictitious trades
and collusion inside or outside of allfirst bank.
Looking to the Future
Exchange Markets in the New Millennium
Significant strides have been made and will continue to be made
in the development of foreignexchange markets. The speed at
which transactions are processed and information is transmitted
globally will certainly lead to greater efficiencies and more
opportunities for foreign-exchange trading. The impact on
companies is that costs of trading foreign exchange should
come down, and companies should have faster access to more
currencies.
In addition, exchange restrictions that hamper the free flow of
goods and services should diminish as governments gain
greater control over their economies and as they liberalize
currency markets. Capital controls still impact foreign invest-
ment, but they will continue to become less of a factor for trade
in goods and services.
The introduction of the euro has allowed cross-border
transactions in Europe to progress more smoothly. As the euro
solidifies its position in Europe, it will reduce exchange-rate
volatility and should lead to the euro taking some of the
pressure off the dollar so that it is no longer the only major
vehicle currency in the world.
Finally, technological developments may not cause the foreign-
exchange broker to disappear entirely, but they will certainly
cause foreign-exchange trades to be executed more quickly and
cheaply. The growth of Internet trades in currency will take away
some of the market share of dealers and allow more entrants
into the foreign-exchange market. Internet trades will also
increase currency price transparency and increase the ease of
trading, thus allowing more investors into the market.
H SBC Holdings plc, one of the world’s largest banks, is faced
with a difficult decision regarding its Argentine subsidiary.
Argentina’s economy collapsed at the end of 2001, leaving both
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194
local and foreign companies suffering from a shortage of cash, a
devaluing peso, and a burden of growing debt. HSBC lost $1.1
billion in 2001 because of Argentina’s problems, and its
outlook for 2002 was not much better. If things don’t improve
soon in Argentina, HSBC may be forced to close its operations
in the country.
London-based HSBC derives its name from its founding
member, the Hong Kong and Shanghai Banking Corporation
Limited, which was established in 1865 to permit trade between
China and Europe. Until the early twentieth century, Hongkong
and Shanghai Banking Corporation set up offices and branches
mainly in China and southeast Asia-but also in India, Japan,
Europe, and North America. As HSBC’s Web site states, “In
many of its branches, the bank was the pioneer of modern
banking practice. From the outset, trade finance was a strong
feature of the bank’s business, with bullion, exchange, and
merchant banking also playing an important part.”
After World War II, Hongkong and Shanghai Banking corpora-
tion expanded and diversified its business with acquisitions “,c
alliances. Through the 1980s, it expanded into Canada, Austra-
lia, and the United States, and in the 1990s, it moved into Brazil
and Argentina. In 1991, its member companies came together
to form HSBC Holdings plc. HSBC pursues a balance of
opportunities in developed economies and emerging markets
and now has over 7,000 offices in 81 countries. It has stock
market listings in London, Hong Kong, New York, and Paris.
HSBC’s entry into Argentina began in 1997, when the bank
acquired Roberts SA de Inversions, changing its name to HSBC
Argentina Holdings SA Along with the banking arm, HSBC
bought into a general insurance agency with the purchase of
Roberts. In 1994, HBSC united with New York Life to form a
life and retirement insurance company, so the acquisition of
Roberts was a strategic fit in both banking and insurance. HSBC
Argentina has also acquired companies in pension fund
management and medical care, thus creating a diversified
portfolio in Argentina. HSBC is the eighth largest bank in
Argentina and employs over 5,900 people in 183 offices. The
banking arm of HSBC Argentina maintains commercial services
with about 80 percent of the nation’s top 200 companies and
MNEs. The outlook for HSBC in Argentina looked good. In
1998, its first full year of operations, the bank had a pretax loss
of $13 million but earned a profit of $67 minion in 1999 and
expected profits to continue growing at 100 percent.
To understand the decline of HSBC in Argentina, it is necessary
to take a look at Argentina’s economic history. Argentina’s
economy flourished in the beginning of the twentieth century,
growing at an annual rate of 5 percent for three years. It
attracted a flood of British and Spanish capital and was rated as
one of the world’s 10 richest countries-even ahead of France
and Germany. However, it has been downhill since then. When
Juan Peron ruled the country from 1946 to 1955, he instituted
protectionist measures and printed money to finance generous
benefits for workers. State intervention in all sectors led to poor
productivity and structural weakness in the economy. Inflation
plagued the country; there were two bouts of hyperinflation in
the 1980s and two banking collapses. As a result, Argentines
lost trust in the peso and invested in U.S. dollars or shipped
their capital abroad.
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In 1989, Carlos Menem took control of the country and set out
to implement free-market reforms and to restructure monetary
and economic policies. He privatized many state-run companies,
tightened fiscal management, and opened up the country’s
borders to trade. Probably the most important policy he
established was the Convertibility Law, which pegged the
Argentine peso 1: 1 with the U.S. dollar and restricted the
money supply to its hard dollar currency reserves. This mon-
etary arrangement was called a currency board and was
established to impose discipline on the central bank. The new
currency board accomplished what it set out to do: It halted
inflation and attracted investment. Investors felt that there was
little risk anymore in investing in the peso, since it was pegged
to the dollar. The sentiment that “the peso is as good as the
dollar” was strong throughout the country. Because there was a
stable money supply, this reduced inflation to nearly 0 percent
through-the rest of the 1990s and kept the exchange rate at a
constant value. Real GDP grew by 6.1 percent from 1991 to
1997 compared to 0.2 percent from 1975 to 1990.
In spite of these positive developments, the currency board also
had its drawbacks. It reduced the Argentine government’s ability
to respond to external shocks by allowing its exchange-rate and
monetary policy to be determined de facto by the United States.
Interest rates were in reality set by the U.S. Federal Reserve; plus
there was a risk-margin for investing in Argentina. This
arrangement was put to the test in 1995, when the Mexican
peso devalued. Investors got nervous about Latin America in
general and pulled investments out of Argentina. Its economy
shrank by 4 percent, and many banks collapsed. The govern-
ment responded by tightening bank regulation and capital
requirements, and some of the larger banks took over weaker
ones. Argentina increased exports and investment, and the
country returned to 5.5 percent growth.
Unfortunately, the government wasn’t so lucky with its results
at the end of the 1990s. Commodity prices, which Argentina
relied heavily on, declined; the U.S. dollar strengthened against
other currencies; Argentina’s main trading partner, Brazil,
devalued its currency; and emerging economies’ cost of capital
increased. Argentina soon fell into a recession, with GDP falling
to 3.4 percent in 1999 and unemployment increasing into the
double digits. Argentina, because of its hard link to the dollar,
was unable to compete internationally, especially in Brazil,
because of its high prices. One way to correct this problem
would be to devalue the currency to bring the value closer to its
fundamental value. Argentina couldn’t devalue unless it
canceled the currency board, a move it didn’t want to take
because of the currency board’s popularity and past success. The
only way for Argentina to become more competitive was for
prices to fall. As deflation set in, the government (and some
private companies) found it difficult to pal’ its debt because it
was not collecting as much revenue. Banks had been lending
dollars at 25 percent interest rates even though the risk was
supposed to be low.
Argentina was acquiring a burgeoning public debt. When the
recession hit, tax revenue fell and spending increased to pay for
such things as higher unemployment. Tax evasion is extremely
high in Argentina, but the government did little to tackle the
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problem. The budget went from a surplus of 1.2 percent of
INTERNATIONAL BUSINESS MANAGEMENT
GDP in 1993 to a deficit of 2.4 percent in 2000. Increased
interest rate payments also added to the increasing budget
deficit. FromJ991 to 2000, the amount of interest rate pay-
ments increased from $2.5 billion to $9.5 billion annually. This
drained the economy more as most of this money went to
overseas investors. This currency “mismatching,” meaning
most of the debt is taken out in one currency but assets are held
in another, was large in Argentina and would later prove
disastrous.
Politicians found little they could do to help the struggling
economy., They fiddled with tariffs and finally the currency
board. They pegged the peso half to the dollar and half to the
euro for exporters. The idea of devaluation scared investors and
caused interest rates to rise even more. Unable to pay its interest
payments and unwilling to declare a debt default, the govern-
ment turned to the banks. The Menem government had
strengthened the banking system, particularly the central bank,
but his successor, Fernando de la Rua, sent a crushing blow to
the sector. He strong-armed the banks into buying government
bonds. This triggered a bank run, and Argentines withdrew
over $15 billion between July and November 2001. In a
desperate attempt to save the industry, Mr. de 1a Rua imposed a
ceiling of $1,000 a month on the bank withdrawals on Decem-
ber 1. Within days, the country defaulted on $155 million in
public debt, the largest such default in world history. As rioters
and looters took to the streets, Mr. de la Rua resigned.
Argentina struggled to find a president who was fit for the job.
It went through a total of five presidents in four months,
ending finally with Eduardo Duhalde. The government
abandoned the currency board in January 2002 and let the peso
float against the dollar peso began falling quickly, so the
government spent around $100 million a day-to a total of $1.2
billion-to prop up the value. More money was leaking out of
the banking system too (around $50 million a day), because the
courts had overturned the freeze on withdrawals.
In March 2002, Mr. Duhalde imposed new restrictions on the
foreign exchange market. Individuals could buy no more than
$1,000 a day and companies no more than $10,000 a day. Banks
and business had restrictions on the number of dollars they
could hold and on how much money could be shipped abroad.
Currency exchanges could only operate three to four hours each
day-versus the typical seven hours. However, the courts kept
overturning policies set by the government and had police arrest
bank managers who didn’t follow their rulings. Still unable to
prevent the increasing flow of money out of the system,
Duhalde closed all banks for a week. In the meantime, he
proposed to forcibly convert billions of dollars in bank
deposits into low-interest bonds. The senate refused the
president’s bone proposal, thus sending him back to the
drawing board.
As Argentina tries to repair its economy, it is waiting for help
from the international Monetary Fund (IMF). However, the
IMF continues to turn down Argentina’s requests for help until
it implements some sweeping changes in its exchange-rate
policy, fiscal policy, and banking system. In an attempt to find
someone to blame, Duhalde started criticizing foreign-owned
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 banks, such as HSBC, for not infusing more cash into the Argentina or cease operations in the country. It injected $211
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system from their headquarters. The central bank has been million into its Argentine operations to keep them stable, but
printing pesos to keep banks solvent, but this has led to if the situation continues to worsen in the country, HSBC may
increased inflation. The national and provincial government are have no choice but to exit.
also using bond notes, quasi-currency, to pay many of their
Questions
debts. This note is being swapped in everyday transactions and
has surprisingly held its value against the peso. Officials promise 1. What are the major factors that caused the peso to fall in
Argentines that once a deal is signed with the IMF, they will value against the dollar?
gather up this quasi-rency and swap it for pesos at face value. 2. What should President Duhalde do to stabilize Argentina’s
Progress is slow with the IMF. Many of the measures required currency?
by the IMF are extremely unpopular with the provincial 3. What are HSBC’s options in Argentina, and what do you
governors and the courts. As a result, Duhalde has had to think they should do?
abandon some of his required cost cutting in order to please Tourists and business travelers hope for favorable exchange
the country. One of the last measures Duhalde has imple- rates when traveling abroad. By early 2003, the dollar had risen
mented is that of pacification, which turned bank’s dollar assets bringing the exchange to 713.78 Chilean pesos, 3.33 Argentine
and liabilities into devalued peso. This again has put a severe pesos, and 3.44 Brazilian reals per dollar. But the dollar began
strain on the banking system. People do not trust the banks to drop again in mid-2003.
anymore. They blame the banks for the bank freezes even
though the government ordered them. Two foreign banks have
left the country, and others are threatening to do the same.
Argentina’s economy, though still deeply damaged, is starting to
stabilize. The peso was trading around 27 cents in the latter half
of 2002, inflation declined and the central bank’s reserves
increased a little partly due to the fact that the nation’s banks
aren’t paying their debts). Some economists believe that
Argentina should go with full “dollarization” of its currency,
not at 1: 1 but more like 4: 1. This would be even more binding
than its previous policy, but it would bring confidence back to
the economy. Others argue for a system of “managed floating
plus” that would give the government flexibility to alter its
monetary policy but still stay within certain targets and reduce its
currency mismatching. The world is waiting to see what the IMF
will do to support the country and what Argentina’s next move
will be.
HSBC’s reaction to the crisis was similar to that of other banks
in the country. It was forced to rethink loans and to decide if
the political and economic instability of the country was worth
the risk of continued operations. HSBC quickly cut its profit
estimate for 2001 by 10 percent. Then when its annual report
came out, the bank declared a $1.12 billion charge for provisions
associated with Argentina and losses from foreign currency
redenomination. A total of $520 million of this charge stems
from the loss in value of the peso. In Latin America, HSBC lost
$977 million in 2001, compared to a profit of $324 million in
2000. Overall, HSBC Holdings doubled its bad-debt charges to
$Z.4 billion, and pretax profits fell by 14 percent in 2001.
Because of the pesification instituted by the Argentine govern-
ment, loan repayments to HSBC were deeply discounted. In
June 2002, HSBC refused a loan payment by Perez Company,
an energy holding company, because the payment was in pesos.
The original loan was for $101 million and Perez’s offered
payment of 104.57 pesos only equaled about $28 million at
market rates. HSBC argued that debt was not covered by
pesification. HSBC worked quickly to renegotiate all contractual
agreements, but it hoped that the IMF would soon provide
assistance to the battered country. Because the IMF was stalling,
HSBC questioned whether it should continue to fight losses in

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