Chapter 10 The International Monetary System

10-2 Introduction  The institutional arrangements that countries adopt to govern exchange rates are known as the international monetary system  When a country allows the foreign exchange market to determine the relative value of a currency, a floating exchange rate system exists  When a country fixes the value of its currency relative to a reference currency, a pegged exchange rate system exists

10-3 Introduction  When a country tries to hold the value of its currency within some range against an important reference currency (such as U.S. dollar or a ‘basket’ of currencies), dirty float exists. Called dirty float because the central bank of a country will intervene in the forex market to try to maintain the value of its currency.  Fixed exchange rate - the values of a set of currencies are fixed against each other at some mutually agreed-on exchange rate.

10-4 The Gold Standard  The gold standard dates back to ancient times when gold coins were a medium of exchange, unit of account, and store of value  Payment for imports was made in gold or silver  Later, as trade grew, payment was made in paper currency which was linked to gold at a fixed rate

10-5 Mechanics Of The Gold Standard  Pegging currencies to gold and guaranteeing convertibility is known as the gold standard  In the 1880s, most of the world’s trading nations followed the gold standard  Under the gold standard one U.S. dollar was defined as equivalent to grains of "fine” (pure) gold  Since there are 480 grains in an ounce, one ounce of gold cost $20.67 (480/23.22)  The amount of a currency needed to purchase one ounce of gold was called the gold par value  The British pound was valued 113 grains of pure gold, and an ounce of gold cost British pound 4.25 (480/113).  From the gold par values of pounds and dollars, we can calculate the exchange rate for exchanging pounds in dollars, i.e. 1 pound = $4.87 (i.e. $20.67/4.25 pound)

10-6 Strength Of The Gold Standard  The great strength of the gold standard was that it contained a powerful mechanism for achieving balance-of- trade equilibrium (when the income a country’s residents earn from its exports is equal to the money its residents pay for imports) by all countries

10-7 The Period Between The Wars:  The gold standard worked fairly well from the 1870s until the start of World War I in 1914  During the war, many governments financed their war expenditures by printing money, and in doing so, created inflation  People lost confidence in the system and started to demand gold for their currency putting pressure on countries' gold reserves, and forcing them to suspend gold convertibility  By 1939, the gold standard was dead

10-8 The Bretton Woods System  In 1944, representatives from 44 countries met at Bretton Woods, New Hampshire, to design a new international monetary system that would facilitate postwar economic growth Under the new agreement:  a fixed exchange rate system was established  all currencies were fixed to gold, but only the U.S. dollar was directly convertible to gold  devaluations could not to be used for competitive purposes  a country could not devalue its currency by more than 10% without IMF approval

10-9 The Bretton Woods System The Bretton Woods agreement also established two multinational institutions:  the International Monetary Fund (IMF) to maintain order in the international monetary system  the World Bank to promote general economic development

10-10 The Role Of The IMF  The IMF was charged with executing the main goal of the Bretton Woods agreement - avoiding a repetition of the chaos that occurred between the wars through a combination of discipline and flexibility Discipline mean that:  the need to maintain a fixed exchange rate put a brake on competitive devaluations and brought stability to the world trade environment  a fixed exchange rate regime imposed monetary discipline on countries, thereby curtailing price inflation

10-11 The Role Of The IMF Flexibility meant that:  while monetary discipline was a central objective of the agreement, a rigid policy of fixed exchange rates would be too inflexible  the IMF was ready to lend foreign currencies to members to tide them over during short periods of balance-of- payments deficit, when a rapid tightening of monetary or fiscal policy would hurt domestic employment

10-12 The Role Of The World Bank The World Bank is also called the International Bank for Reconstruction and Development (IBRD) There are two ways to borrow from the World Bank: 1. under the IBRD scheme, money is raised through bond sales in the international capital market  borrowers pay what the bank calls a market rate of interest - the bank's cost of funds plus a margin for expenses. 2. through the International Development Agency, an arm of the bank created in 1960  IDA loans go only to the poorest countries

10-13 The Collapse Of The Fixed Exchange Rate System  Bretton Woods worked well until the late 1960s  It collapsed when huge increases in welfare programs and the Vietnam War were financed by increasing the money supply and causing significant inflation  Other countries increased the value of their currencies relative to the dollar in response to speculation the dollar would be devalued  However, because the system relied on an economically well managed U.S., when the U.S. began to print money, run high trade deficits, and experience high inflation, the system was strained to the breaking point

10-14 The Floating Exchange Rate Regime  In 1976, following the collapse of Bretton Woods, IMF members formalized a new exchange rate system at a meeting in Jamaica  The rules that were agreed on then, are still in place today

10-15 The Jamaica Agreement Under the Jamaican agreement:  floating rates were declared acceptable  gold was abandoned as a reserve asset  total annual IMF quotas - the amount member countries contribute to the IMF - were increased to $41 billion

10-16 Exchange Rates Since 1973  Since 1973, exchange rates have become more volatile and less predictable than they were between 1945 and 1973  Volatility has increased because of:  The 1971 oil crisis  The loss of confidence in the dollar that followed the rise of U.S. inflation in 1977 and 1978  The 1979 oil crisis  The unexpected rise in the dollar between 1980 and 1985  The partial collapse of the European Monetary System in 1992  The 1997 Asian currency crisis

10-17 Exchange Rates Since 1973 Figure 10.1: Major Currencies Dollar Index,

10-18 Fixed Versus Floating Exchange Rates  The merit of a fixed exchange rate versus a floating exchange rate system continues to be debated  Many countries today are disappointed with the floating exchange rate system

10-19 The Case For Floating Exchange Rates  The case for floating exchange rates has two main elements: 1. monetary policy autonomy 2. automatic trade balance adjustments

10-20 The Case For Floating Exchange Rates  Supporters of floating exchange rates argue that removing the obligation to maintain exchange rate parity restores monetary control to a government  Under a fixed system, a country's ability to expand or contract its money supply as it sees fit is limited by the need to maintain exchange rate parity  So, under the Bretton Woods system, if a country developed a permanent deficit in its balance of trade that could not be corrected by domestic policy, the IMF would have to agree to a currency devaluation

10-21 The Case For Fixed Exchange Rates  Supporters of fixed exchange rates focus on monetary discipline, uncertainty, and the lack of connection between the trade balance and exchange rates  Having to maintain a fixed exchange rate parity ensures that governments do not expand their money supplies at inflationary rates  They also claim that speculation that is associated with floating exchange rates can cause uncertainty  Advocates of floating exchange rates also argue that floating rates help adjust trade imbalances

10-22 Who Is Right?  There is no real agreement as to which system is better  We know that a fixed exchange rate regime modeled along the lines of the Bretton Woods system will not work  A different kind of fixed exchange rate system might be more enduring and might foster the kind of stability that would facilitate more rapid growth in international trade and investment

10-23 Exchange Rate Regimes In Practice  Various exchange rate regimes are followed today Currently:  14% of IMF members follow a free float policy  26% of IMF members follow a managed float system  28% of IMF members have no legal tender of their own  the remaining countries use less flexible systems such as pegged arrangements, or adjustable pegs

10-24 Exchange Rate Regimes In Practice Figure 10.2: Exchange Rate Policies, IMF Members, 2006

10-25 Pegged Exchange Rates  A country following a pegged exchange rate system, pegs the value of its currency to that of another major currency  Pegged exchange rates are popular among the world’s smaller nations  There is some evidence that adopting a pegged exchange rate regime does moderate inflationary pressures in a country

10-26 Currency Boards  Countries using a currency board commits themselves to converting their domestic currency on demand into another currency at a fixed exchange rate  To make this commitment credible, the currency board holds reserves of foreign currency equal at the fixed exchange rate to at least 100% of the domestic currency issued  The system used in Hong Kong means its currency must be fully backed by US dollar at the specified exchange rate.  Under this arrangement, the currency board can issue additional domestic notes and coins only when foreign exchange reserves are available to back it  This limits the ability of the government to print money and thereby create inflationary pressures

10-27 Crisis Management By The IMF  Since many of the original reasons for the IMF no longer exist, the organization has redefined its mission  The IMF now focuses on lending money to countries experiencing financial crises  However, critics claim that IMF policies in these countries have actually made the situation worse

10-28 Financial Crises In The Post-Bretton Woods Era  A currency crisis occurs when a speculative attack on the exchange value of a currency results in a sharp depreciation in the value of the currency, or forces authorities to expend large volumes of international currency reserves and sharply increase interest rates in order to defend prevailing exchange rates  A banking crisis refers to a situation in which a loss of confidence in the banking system leads to a run on the banks, as individuals and companies withdraw their deposits  A foreign debt crisis is a situation in which a country cannot service its foreign debt obligations, whether private sector or government debt  These crises tend to have common underlying macroeconomic causes: high relative price inflation rates, a widening current account deficit, excessive expansion of domestic borrowing, and asset price inflation.

10-29 Mexican Currency Crisis Of 1995 The Mexican currency crisis of 1995 was a result of:  high Mexican debts  a pegged exchange rate that did not allow for a natural adjustment of prices  To keep Mexico from defaulting on its debt, a $50 billion aid package was created

10-30 The Asian Crisis The 1997 Southeast Asian financial crisis was caused by a series of events that took place in the previous decade:  huge increases in exports that helped fuel a boom in commercial and residential property, industrial assets, and infrastructure  investments that were made on the basis of projections about future demand conditions that were unrealistic and created significant excess capacity Investments made on the basis of unrealistic projections about future demand conditions created significant excess capacity  investments were often supported by dollar-based debts

10-31 The Asian Crisis  when inflation and increasing imports put pressure on the currencies, the resulting devaluations led to default on dollar denominated debts  by the mid 1990s, imports were expanding across the region  by mid-1997, it became clear that several key Thai financial institutions were on the verge of default  foreign exchange dealers and hedge funds started to speculate against the Baht, selling it short  after struggling to defend the peg, the Thai government abandoned its defense and announced that the Baht would float freely against the dollar

10-32 The Asian Crisis  With its foreign exchange rates depleted, Thailand lacked the foreign currency needed to finance its international trade and service debt commitments, and was in desperate need of the capital the IMF could provide  Following the devaluation of the Baht, speculation caused other Asian currencies including the Malaysian Ringgit, the Indonesian Rupaih and the Singapore Dollar to fall  These devaluations were mainly driven by similar factors to those that led to the earlier devaluation of the Baht-- excess investment, high borrowings, much of it in dollar denominated debt, and a deteriorating balance of payments position

10-33 Evaluating The IMF’s Policy Prescriptions  By 2006, the IMF was committing loans to some 59 countries in economic and currency crisis  All IMF loan packages require a combination of tight macroeconomic policy and tight monetary policy However, critics worry:  the “one-size-fits-all” approach to macroeconomic policy is inappropriate for many countries  the IMF is exacerbating moral hazard (when people behave recklessly because they know they will be saved if things go wrong)  The IMF has become too powerful for an institution without any real mechanism for accountability  As with many debates about international economics, it is not clear who is right

10-34 Implications For Managers For managers, understanding the international monetary system is important for:  currency management  business strategy  corporate-government relations

10-35 Currency Management  Managers must recognize that the current international monetary system is a managed float system in which government intervention can help drive the foreign exchange market  Under the present system, speculative buying and selling of currencies can create volatile movements in exchange rates

10-36 Business Strategy  Managers need to recognize that while exchange rate movements are difficult to predict, their movement can have a major impact on the competitive position of businesses  To contend with this situation, managers need strategic flexibility

10-37 Corporate-Government Relations  Managers need to recognize that businesses can influence government policy towards the international monetary system  So, companies should promote an international monetary system that facilitates international growth and development