Chapter 5 The International Monetary System and Exchange Rate Arrangements

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 5-2 Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa

Definition The IMS is the framework of rules, regulations and conventions that govern the financial relations among countries 5-3 Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa

Components of the IMS A public component consisting of a series of agreements A private component represented by the banking and finance industry 5-4 Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa

Classification according to reserve assets Pure commodity standards (e.g. the gold standard) Pure fiat standards Mixed standards (e.g. the Bretton Woods system) 5-5 Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa

Classification according to flexibility of exchange rates Several systems may arise by restricting, or otherwise, the exchange rate 5-6 Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa

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 5-7 Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa

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 5-8 Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa

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 5-9 Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa

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 5-10 Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa

Crawling peg The par value of the exchange rate is revised periodically according to its recent behaviour or economic indicators such as inflation 5-11 Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa

Dual exchange rates A commercial (fixed) rate is used for imports and exports A financial (flexible) rate is used for trading in financial assets 5-12 Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa

Managed floating The exchange rate is flexible, but the central bank intervenes to limit the frequency and amplitude of exchange rate fluctuations 5-13 Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa

Target zones Major countries establish a set of mutually consistent targets for real effective exchange rates 5-14 Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa

The classical gold standard This system operated between approximately 1870 and 1914 It is remembered with nostalgia because the world economy prospered during that period 5-15 Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa

Pillars of the gold standard The monetary authorities fix the price of gold in terms of their currencies, which produces a fixed exchange rate The market exchange rate can move above or below the fixed rate by certain limits: the gold points 5-16 Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa

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 5-17 Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa

The inter-war 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, signalling the creation of the gold exchange standard 5-18 Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa

The collapse of the gold exchange standard In 1931 Britain abolished the convertibility of the pound, bringing to an end the era of the gold exchange standard This was followed by the decade of the Great Depression ( ) 5-19 Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa

Failure of the inter-war experiment: reasons The golden age was a myth The world economy experienced significant changes 5-20 Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa

The Bretton Woods system Forty-four countries signed the BW agreement in 1944 The creation of the system was accompanied by the creation of international institutions (the IMF and IBRD or the World Bank) 5-21 Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa

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 5-22 Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa

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) 5-23 Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa

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 5-24 Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa

The present system In 1971, the Smithsonian Agreement was signed, but it failed to salvage the BW system In 1973, floating became widespread 5-25 Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa

The US dollar’s effective exchange rate under the present system 5-26 Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa

Current exchange rate arrangements The Jamaica Accord gave countries the freedom of choosing the arrangements they deemed appropriate for their economies Not all countries opted for floating 5-27 Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa

Arrangements with no separate legal tender Under this arrangement, the currency of another country circulates as the sole legal tender Alternatively, the country belongs to a monetary or currency union in which the same legal tender is shared by members of the union 5-28 Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa

Currency boards A currency board is an arrangement that is based on an explicit legislative commitment to exchange the domestic currency for a specified foreign currency at a fixed exchange rate, combined with restrictions on the issuing authority to ensure the fulfillment of its legal obligation 5-29 Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa

Other fixed peg arrangements Pegging to a single currency Pegging to a basket of currencies 5-30 Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa

Pegged exchange rates with horizontal bands Under this arrangement the exchange rate is allowed to fluctuate within a band that is wider than ±1 per cent 5-31 Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa

Crawling peg Under a crawling peg, the exchange rate is adjusted periodically at a fixed, pre-announced small rate or in response to changes in some quantitative indicators (for example, inflation) 5-32 Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa

Crawling bands This arrangement requires the exchange rate to be maintained within a certain band around a central rate that is adjusted periodically at a fixed, pre- announced rate or in response to changes in some indicators 5-33 Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa

Managed floating without a preannounced path Under this arrangement, the exchange rate is determined by market forces but the monetary authority intervenes actively in the foreign exchange market without specifying a path for the exchange rate 5-34 Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa

Independent floating Under independent floating the exchange rate is determined by market forces. Any intervention in the foreign exchange market aims at curbing exchange rate volatility 5-35 Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa

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) 5-36 Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa

Realignments The first realignment involving all currencies took place in March 1983 The period January 1987-September 1992 was tranquil 5-37 Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa

Speculative attacks In September 1992, speculative attacks forced the pound and the lira out of the ERM 5-38 Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa

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 5-39 Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa

The EUR/USD exchange rate 5-40 Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa

Arguments for the euro Currency stability reduces inflation Reduction in transaction and hedging costs Efficiency gains Transparency gains Benefits to trade and capital markets 5-41 Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa

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 5-42 Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa

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 (cont.) 5-43 Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa

The AUD exchange rate arrangements (cont.) Until December 1983, the AUD was pegged to a basket In December 1983, the AUD was floated 5-44 Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa

The USD/AUD exchange rate 5-45 Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa

Arguments for flexible exchange rates The BOP adjustment mechanism is smoother and less painful Large and persistent BOP deficits do not arise Liquidity problems do not arise or are less acute (cont.) 5-46 Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa

Arguments for flexible exchange rates (cont.) Flexible rates are conducive to free trade Flexible rates are conducive to policy independence 5-47 Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa

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 5-48 Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa

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 (cont.) 5-49 Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa

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 (cont.) 5-50 Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa

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 5-51 Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa

A global currency? Convenience Loss of exchange rate policy A small open economy has more to gain from the convenience 5-52 Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa

The Tobin tax Proposed by James Tobin in 1972, it is a uniform international tax payable on all spot FX transactions Although the idea sounds appealing, there are serious implementation problems 5-53 Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa