The International Monetary System

.

Zareen Khan Shahid Hayat
Saqib Mehmood Irfan Arshad
Objectives
The types of exchange systems that are
available today
That all nations do not use the same
exchange systems, and that adds
complexity to the foreign exchange
markets
Understand why some currencies
fluctuate more than others as a function
of economic, political, or social stability

Objectives
That currencies appreciate and
depreciate against others
The complexity of world financial
markets and institutions
How Multinational Enterprises finance
global operations via international
capital markets


Mexican Financial Crisis,
1994 - 1995
Initially pegged to United States
dollar, 1988 1992.
Objective: Price Stabilization.
Overvalued peso depreciated
dramatically in order to control inflation.
Depreciated peso inhibited business
purchasing of foreign goods.

Mexican Financial Crisis,
1994 - 1995
Mexican economy stalled, deficits rose,
politics became unstable, politicians
assassinated.
Government issues peso obligations,
pesobonos, to cover obligations.
Nuevo Peso issued in 1994-1995 to create
new valuation schemes.
2000, PRI lost government control to PAN
party, effectively ending 72 years of political
control.

History of the International Monetary
System
Gold Standard Period (1876-1914),
exchange rates determined as ratio of
nations own valuation of gold.
Economic uncertainty and government
obligations changed nations willingness
to pay more or less for gold reserves.
F(x) rates changed accordingly.


History of the International Monetary
System
WWI/WWII created stronger demand for gold
as mechanism for war debt payment.
Currencies devalued against gold to make
debts easier to pay. United States dollar
depreciated from $20.67/troy ounce to
$35.00.
Currencies without gold reserves lost value in
the market. United States dollar became the
ONLY trading currency as other countries
had traded or lost their gold reserves.

History of the International Monetary
System
The Bretton Woods Agreement (1944; Bretton-
Woods, New Hampshire) created a system
where currencies could be pegged to gold, or the
United States dollar. This made it easier for Allied
powers to pay war debts and created mechanism
for controlling Axis powers after the war.
Currency devaluation could approach 10% -
after which participating countries had to help
control the devaluation. This ensured that all
members paid fairly on war obligations. This
created a floating system so true valuations
could be determined.
History of the International Monetary
System
After B-W, floating exchange rates controlled the
system. OPEC crises devalued the United States
dollar, so the Group of Seven (G-7) was created
(1987) to manage dollar valuation through the
Louvre Accords, which tied international
economic policy with valuation. This helped
stabilize western currencies.
1997, the Asian economic crisis forcefully
devalued Asian currencies. 1998, Russia and
Latin America came under pressure. Brazil,
Argentina, Russia all experience GDP shrinkage
and political instability.
History of the International Monetary
System

1999, the Euro is launched and the new
currency starts circulation in 2002.

Gold Standard, 1870-1914
Origins of the Gold Standard
The gold standard had its origin in the use
of gold coins as a medium of exchange,
unit of account, and store of value.
The Resumption Act (1819) marks the first
adoption of a true gold standard.
It simultaneously repealed long-standing
restrictions on the export of gold coins and
bullion from Britain.
The U.S. Gold Standard Act of 1900
institutionalized the dollar-gold link.

Gold Standard, 1870-1914.
External Balance Under the Gold
Standard
Central banks
Their primary responsibility was to preserve the
official parity between their currency and gold.
They adopted policies that pushed the non-
reserve component of the financial account
surplus (or deficit) into line with the total current
plus capital account deficit (or surplus).
A country is in balance of payments equilibrium when
the sum of its current, capital, and non-reserve financial
accounts equals zero.
Many governments took a laissez-faire
attitude toward the current account.
Gold Standard, 1870-1914.
The Gold Standard Rules of the Game: Myth and
Reality
The practices of selling (or buying) domestic assets
in the face of a deficit (or surplus).
The efficiency of the automatic adjustment
processes inherent in the gold standard
increased by these rules.
In practice, there was little incentive for countries
with expanding gold reserves to follow these
rules.
Countries often reversed the rules and sterilized
gold flows.

Gold Standard, 1870-1914
Internal Balance Under the Gold
Standard
The gold standard systems performance in
maintaining internal balance was mixed.
Example: The U.S. unemployment rate
averaged 6.8% between 1890 and 1913, but it
averaged under 5.7% between 1946 and 1992.

The Interwar Years, 1918-1939
With the eruption of WWI in 1914, the
gold standard was suspended.
The interwar years were marked by severe
economic instability.
The reparation payments led to episodes
of hyperinflation in Europe.
The German Hyperinflation
Germanys price index rose from a level of
262 in January 1919 to a level of
126,160,000,000,000 in December 1923 (a
factor of 481.5 billion).

The Interwar Years, 1918-1939
The Fleeting Return to Gold
1919
U.S. returned to gold
1922
A group of countries (Britain, France, Italy, and
Japan) agreed on a program calling for a
general return to the gold standard and
cooperation among central banks in attaining
external and internal objectives.

The Interwar Years, 1918-1939
1925
Britain returned to the gold standard
1929
The Great Depression was followed by bank
failures throughout the world.
1931
Britain was forced off gold when foreign holders
of pounds lost confidence in Britains
commitment to maintain its currencys value.

The Interwar Years, 1918-1939
International Economic Disintegration
Many countries suffered during the Great
Depression.
Major economic harm was done by restrictions on
international trade and payments.
These beggar-thy-neighbor policies provoked
foreign retaliation and led to the disintegration of
the world economy.
All countries situations could have been bettered
through international cooperation
Bretton Woods agreement

The Bretton Woods System and IMF
Convertibility
Convertible currency
A currency that may be freely exchanged for
foreign currencies.
Example: The U.S. and Canadian dollars became
convertible in 1945. A Canadian resident who acquired
U.S. dollars could use them to make purchases in the U.S.
or could sell them to the Bank of Canada.
The IMF articles called for convertibility on
current account transactions only.

Internal and External Balance
Under the Bretton Woods System
The Changing Meaning of External
Balance
The Dollar shortage period (first decade
of the Bretton Woods system)
The main external problem was to acquire
enough dollars to finance necessary purchases
from the U.S.
Marshall Plan (1948)
A program of dollar grants from the U.S. to
European countries.
It helped limit the severity of dollar shortage.

Internal and External Balance
Under the Bretton Woods System
Speculative Capital Flows and Crises
Current account deficits and surpluses took
on added significance under the new
conditions of increased private capital
mobility.
Countries with a large current account deficit
might be suspected of being in fundamental
disequilibriumunder the IMF Articles of
Agreement.
Countries with large current account surpluses
might be viewed by the market as candidates
for revaluation.

The External Balance
Problem of the United States
The U.S. was responsible to hold the dollar price of
gold at $35 an ounce and guarantee that foreign
central banks could convert their dollar holdings into
gold at that price.
Foreign central banks were willing to hold on to
the dollars they accumulated, since these paid
interest and represented an international money
par excellence.
The Confidence problem
The foreign holdings of dollars increased until they
exceeded U.S. gold reserves and the U.S. could
not redeem them.

The External Balance
Problem of the United States
Special Drawing Right (SDR)
An artificial reserve asset
SDRs are used in transactions between
central banks but had little impact on the
functioning of the international monetary
system.

Worldwide Inflation and
the Transition to Floating Rates
The acceleration of American inflation in the
late 1960s was a worldwide phenomenon.
It had also speeded up in European
economies.
When the reserve currency country speeds
up its monetary growth, one effect is an
automatic increase in monetary growth rates
and inflation abroad.
U.S. macroeconomic policies in the late
1960s helped cause the breakdown of the
Bretton Woods system by early 1973.

Exchange Rate Regimes
Foreign Exchange and Exchange Rates
Spot versus forward exchange rates
Fixed exchange rates
Floating exchange rates
Free (no government intervention)
Managed (some government intervention)
To avoid the risk of currency fluctuations,
companies use hedging.
Target exchange rate
Exchange rate pass through

Foreign Exchange and Exchange Rates
Factors influencing Foreign Exchange Rates
Macroeconomic Factors: Relative inflation,
balance of payments, foreign exchange
reserves, economic growth, government
spending, money supply growth, and interest
rate policy.
Political Factors: Exchange rate control, election
year or leadership change.
Random Factors: Unexpected and/or
unpredicted events, fear of uncertainty, etc.
Many countries attempt to maintain a lower value
for their currency in order to encourage exports.

Contemporary Exchange Rate Systems
The Fixed Rate System has governments
buying and selling currency reserves when
exchange rates differ from stated par values.
Pure fixed systems are rare. Current
examples: Cuba, North Korea, Malaysia.
The Crawling Peg System has governments
managing exchange rates within a
percentage range from par. A peg can be
made to other currencies (like a dollar) or to
market baskets of currencies.

Contemporary Exchange Rate Systems
The Target Zone Arrangement, is a managed
multilateral float system arranged by nations (like
the G7) who have common interests and goals.
The European Monetary System is an example
of this. This is managed by the European Central
Bank.
The Managed Float System, known as the dirty
float, is managed by governments to preserve
orderly exchange and eliminate excess volatility.
Central banks manage currency valuations by
buying and selling currencies, and altering
balances of payments, exchange reserves, and
black market rates.
Contemporary Exchange Rate Systems

Independent Float Systems, allow
clean floating and full flexibility.

Contemporary Exchange Rate Systems
The United States uses independent
floating
Canada uses managed floats
the EU uses target zones
Panama uses the crawling peg
Cuba uses the fixed system.

Advantages and Disadvantages of
Various Exchange Rate Regimes
Country Circumstances Main Advantages


Main
Disadvantages

Floating
System

Appropriate for medium
and large industrialized
countries and some
emerging market
economies that are
relatively closed to
international trade but
fully integrated in the
global capital markets,
and have diversified
production and trade, a
deep and broad financial
sector, and strong
prudential standards.

More easily deflect
or absorb adverse
shocks. Not prone
to currency crisis.
High international
reserves not
required.

High short-term
volatility (excessive
fluctations may be
dampened in the
case of lightly
managed float). Large
medium-term swings
only weakly related to
economic
fundamentals. High
possibility of
misalignment.
Discretion in
monetary policy may
create inflationary
bias.

Advantages and Disadvantages of
Various Exchange Rate Regimes
Country
Circumstances
Main Advantages


Main
Disadvantages

Intermediate
System


Appropriate for
emerging market
economies and some
other developing
countries with relatively
stronger financial sector
and track record for
disciplined
macroeconomic policy.


Limited flexibility
permits partial
absorption of
adverse shocks.
Can maintain
stability and
competitiveness if
the regime is
credible. Low
vulnerability to
currency crisis if
edges of the band
are soft.

Lack of transparency
because criterion for
intervention is not
disclosed in
managed float, and
broad band regimes
are not immediately
identifiable. This may
lead to uncertainty
and lack of credibility.
High international
reserves are
required.
Advantages and Disadvantages of
Various Exchange Rate Regimes
Country
Circumstances
Main Advantages


Main Disadvantages


Soft Peg
System


Appropriate for
developing countries
with limited links to
global financial
markets, less
diversified production
and export structure,
shallow financial
markets, and lacking
monetary discipline
and credibility.
Countries stabilizing
from very high level of
inflation

Can maintain stability
and competitiveness
if the peg is credible.
Lower interest rates
Provides a clear and
easily monitorable
nominal anchor
Allows high inflation
countries to reduce
inflation by
moderating
inflationary
expectations.
Prone to currency
crisis if the country is
open to international
capital markets.
Encourages foreign
debt. High
international reserves
are required. Little
shock absorptive
capacity. Shocks are
largely absorbed by
changes in the real
sector.
Advantages and Disadvantages of
Various Exchange Rate Regimes
Country
Circumstances
Main Advantages


Main Disadvantages


Hard Peg
System


Appropriate for
countries with a history
of monetary disorder,
high inflation, and low
credibility of
policymakers that
need a strong anchor
for monetary
stabilization.


Provides maximum
credibility for the
economic policy
regime. Can facilitate
disinflation. Not
prone to currency
crisis. Low
transaction costs, low
and stable interest
rates. Lack of
monetary discretion
eliminates
inflationary bias.

Central bank loses its
role as lender of last
resort. Higher
probability of liquidity
crisis. Low seigniorage
under currency board,
no seigniorage in the
case of dollarization.
No shock absorptive
capacity. Shocks have
to be fully absorbed by
changes in economic
activity. Exit from
dollarization is very
difficult.
Determination of Foreign Exchange
Rates
The determination of exchange rates should
address two questions:
How base rates between currencies are
determined.
How exchange rates change over time.
The gold standard did this, and each
exchange system does that for countries that
uses respective systems. How well they do
this predicts exchange volatility and future
policy on f(x).

PPP and IRP
Purchasing Power Parity (PPP) and
Interest Rate Parity (IRP) are
approaches to F(x) that tie exchange
rates to baskets of goods, or baskets of
borrowed money.

PPP
Absolute PPP states that the exchange
rate is determined by the relative prices of
similar baskets of goods and/or services.
Relative PPP considers inflation and
the change of F(x) rate over time.

IRP
Interest Rate Parity provides an
understanding of the way in which interest
rates are linked between countries through
capital flows. IRP suggests that the
differences in interest rates for securities of
similar beta should be similar, but opposite,
the forward rate discount for a currency.
The Forward Rate is the rate at which a bank
will exchange currencies at some future date.
The Balance of Payments
The balance of payments is an
accounting statement that summarizes
all the economic transactions between
residents of a home country and those
of all other countries.
An Account Deficit means more
money is going out of a country to
purchase goods than is coming in.
An Account Surplus, is just the
opposite of an account deficit.

Balance of Payments
The balance of payment (BOP): summary of
all transactions between a country & its
residents and other countries (& their
residents) over a specified time period (a
month, quarter, or year).
The BOP transactions contain three
categories
Current account
Capital account
Official reserves

Balance of Payments Categories
Current account = Balance of trade + Net factor income (fees,
interest, dividends etc.) + net unilateral transfers from abroad

Financial account (IMF)/Capital account (economics) = Increase in
foreign ownership of domestic assets - Increase in domestic
ownership of foreign assets (= FDI) + Portfolio investment +
Other investment

Official reserves = Stock of reserve assets at a countrys monetary
authority (official gold reserves + foreign exchange reserves +
(IMF) SDRs + any foreign property held by such central banks)

Net errors and omissions: any necessary corrections in the above
three accounts
Interpretation of Deficit and Surplus
This is a difficult issue. Ever wonder why
economics is called a dismal science? An
account deficit theoretically means that
foreign goods are more competitive and that
perhaps national industries arent making
competitive products, which could then signal
recession, depression, or closure of
economies or business firms .
A surplus, could theoretically mean there is
excess demand, that could trigger inflation
and eventual economic slowdown.

Interpretation: Does it matter?
Another group of people believe the
interpretations of deficit and surplus are
only good for politicians. They believe
that with globalization, the older
interpretations of deficit and surplus are
becoming meaningless.

International Foreign Exchange Market
International financial markets play a
crucial role in global business. Business
firms face many opportunities and
threats from monetary systems and
financial/capital markets.

International Foreign Exchange Market:
Terms
Foreign Exchange Market/Transaction
Direct Quotes/Indirect Quotes
Bids and Offers
Spot and Forward
Swaps and Barters
Arbitrage, Black, and Parallel Markets

International Foreign Exchange Market
International financial markets
International Foreign Exchange Market
International Money Markets are the markets in
which foreign monies are financed or invested.
International firms use international markets to
finance global operations at lower costs than are
available domestically.
Firms assume the risk of currency devaluation
(which can lower the cost of borrowing) or
currency appreciation (which raises the cost).
Available to businesses are the currency
markets, like the Eurocurrency market,
international bond markets, international stock
and equity markets, and international loan or
commercial paper markets.

International Foreign Exchange Market
Factors used in sovereign rating by Standard &
Poors
The Asian Financial Crisis
Crises can occur in international
financial markets. These impact
business operations dramatically
because they impact the availability and
cost of financial instruments, while
introducing political risk, and making it
more difficult to plan, organize, lead,
and control business operations
globally.

Asian Crisis Perspectives: Financial
This point of view suggests that the
crisis came from financial sector
weakness and market failure.
Specifically, the maintenance of pegged
exchange rates became too expensive
and forced rising deficits in Asian
countries.
Loan defaults increased and
governments were left with no recourse
but to float their currencies, causing
massive devaluation.

Asian Crisis Perspectives: Political
This perspective asserts that the causes
of the crisis extended deeper than
financial.
Market and financial sector failures
were symptoms of corruption, cronyism,
irresponsible governance, weak
institutions, poor regulatory
environments and institutions, and bad
political systems.
Asian Crisis Perspectives: Managerial
This perspective maintains that micro-
management was at the heart of the
problem.
Companies pursued risky
diversification. When faced with the
reality of performance, the banks and
networks couldnt provide returns.
As a result, the financial markets
collapsed.