Chapter 5 The International Monetary System and Exchange Rate Arrangements

Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 2 Objectives To classify international monetary systems. To outline the history of exchange rate arrangements. To outline the pros and cons of fixed and flexible exchange rates. To examine the Australian exchange rate arrangements.

Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 3 Definition The IMS refers to the framework of rules, regulations and conventions that govern the financial relations among countries.

Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 4 Components of the IMS Public component consisting of a series of agreements Private component represented by the banking and finance industry

Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 5 Classification According to Reverse Assets Pure commodity standards (e.g. the gold standard) Pure fiat standards Mixed standards (e.g. the Bretton Woods system)

Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 6 Classification According to Flexibility of Exchange Rates Several systems may arise by restricting, or otherwise, the exchange rate.

Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 7 Fixed Exchange Rates The exchange rate is fixed by the central bank and is not allowed to move. The FX market is likely to be out of equilibrium.

Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 8 Perfectly Flexible Exchange Rates The exchange rate moves continuously, propelled by market forces, to maintain equilibrium in the FX market. Under this system, currencies appreciate and depreciate.

Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 9 Fixed but Adjustable Exchange Rates Countries alter the fixed values of their exchange rates. Devaluation and revaluation are implemented to ‘correct’ some economic fundamentals such as the BOP.

Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 10 Fixed Exchange Rates and Flexible Within a Band Exchange rates are flexible within upper and lower limits defined by a band around the par value. Central bank intervention is required to keep the exchange rate within the band.

Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 11 Crawling Peg The par value of the exchange rate is revised periodically according to its recent behaviour or economic indicators such as inflation.

Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 12 Dual Exchange Rates A commercial (fixed) rate is used for imports and exports. A financial (flexible) rate is used for trading in financial assets.

Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 13 Managed Floating The exchange rate is flexible, but the central bank intervenes to limit the frequency and amplitude of exchange rate fluctuations.

Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 14 Target Zones Major countries establish a set of mutually consistent targets for real effective exchange rates.

Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 15 The Classical Gold Standard This system operated between approximately 1870 and It is remembered with nostalgia because the world economy prospered during that period.

Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 16 Pillars of the Gold Standard The monetary authorities fix the price of gold in terms of their currencies, which gives a fixed exchange rate. The market exchange rate can move above or below the fixed rate by certain limits: the gold points.

Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 17 The Collapse of the Gold Standard The gold standard collapsed in 1914 as the warring countries suspended the convertibility of their currencies and prohibited the export of gold.

Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 18 The Interwar Period Between the end of World War I and 1926 a system of flexible exchange rates was adopted. In 1925, Britain re-established the convertibility of the pound into gold.

Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 19 The Collapse of the Gold Exchange Standard In 1931, Britain abolished the convertibility of the pound. This was followed by the decade of the Great Depression ( ).

Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 20 Failure of the Interwar Experiment: Reasons The golden age was a myth. The world economy experienced significant changes.

Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 21 The Bretton Woods System Forty-four countries signed the BW agreement in The creation of the system was accompanied by the creation of international institutions (the IMF and IBRD).

Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 22 The BW Exchange Rate System Fixed but adjustable exchange rates. The US dollar was pegged to gold, whereas other currencies were pegged to the dollar. Exchange rates could move within a 1% band.

Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 23 Problems of the BW System The adjustment mechanism lacked flexibility and stability. Speculation could be destabilising. There were defects in the liquidity creation mechanism (Triffin Paradox).

Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 24 The Collapse of the BW System In 1971, the United States suspended the convertibility of the dollar into gold. As a result, the system collapsed.

Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 25 The Present System In 1971, the Smithsonian Agreement was signed, but it failed to salvage the BW system. In 1973, floating became widespread.

Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 26 The 1980s and 1990s Plaza Accord (1985) Louvre Accord (1987) The EMS crisis (1992)

Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 27 The US Dollar’s Effective Exchange Rate

Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 28 Current Exchange Rate Arrangements Arrangements without separate legal tender Currency boards Other conventional fixed pegs

Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 29 Current Exchange Rate Arrangements (cont.) Pegged exchange rates with horizontal bands Crawling peg Crawling bands Managed floating without predetermined path

Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 30 The EMS The system started functioning in March 1979 when the Snake ceased to exist. It is a system of fixed but adjustable exchange rates as governed by the exchange rate mechanism (ERM).

Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 31 Realignments The first realignment involving all currencies took place in March The period January 1987-September 1992 was tranquil.

Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 32 Speculative Attacks In September 1992, speculative attacks forced the pound and the lira out of the ERM.

Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 33 The EMU and the Euro The EMU was established by the 1991 Maastricht Treaty. In January 1999, the euro was introduced. In January 2002, the euro replaced national currencies.

Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 34 The EUR/USD Exchange Rate

Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 35 Arguments for the Euro Currency stability reduces inflation Reduction in transaction and hedging costs Efficiency gains Transparency gains Benefits to trade and capital markets

Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 36 Arguments Against the Euro For the system to work well, countries should be similar. Individual countries have to give up national interest and exchange rate policies.

Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 37 Financial Crises Since the mid-1990s, financial crises have hit Asia, Latin America and Russia. The crises have led to bank failures, corporate bankruptcies, unemployment, fiscal burdens and depletion of reserves.

Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 38 Causes of the Asian Crisis ( ) Availability of substantial short-term funds at low interest rates Fixed exchange rates gave borrowers a false sense of security Weakness of exports by the mid-1990s Financial fragility

Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 39 The AUD Exchange Rate Arrangements Until December 1971, the AUD was pegged to the pound. Until September 1974, the AUD was pegged to the US dollar.

Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 40 The AUD Exchange Rate Arrangements (cont.) Until December 1983, the AUD was pegged to a basket. In December 1983, the AUD was floated.

Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 41 The USD/AUD Exchange Rate

Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 42 Arguments for Flexible Exchange Rates The BOP adjustment mechanism is smoother and less painful. Large and persistent BOP deficits will not arise. Liquidity problems do not arise or are less acute.

Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 43 Arguments for Flexible Exchange Rates (cont.) Flexible rates are conducive to free trade. Flexible rates are conducive to policy independence.

Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 44 Arguments Against Flexible Exchange Rates They cause uncertainty and inhibit international trade and investment. They cause destabilising speculation. They are not suitable for small countries. They are unstable.

Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 45 New International Financial Architecture Linking IMF loans to crisis prevention efforts Imposition of holding-period taxes on short- term capital flows in countries characterised by financial fragility

Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 46 New International Financial Architecture (cont.) Making the private sector partly responsible for the consequences of sovereign bond issues Discouraging fixed but adjustable exchange rates in favour of either managed floating or currency boards

Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 47 New International Financial Architecture (cont.) Directing the IMF to lend less freely and to distinguish between country crises and systemic crises Removing overlap from the responsibilities of the IMF and the World Bank

Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 48 A Global Currency? Convenience Loss of exchange rate policy A small open economy has more to gain from the convenience