Chapter 5

Understanding International Monetary System

Convertible currencies (hard currencies)

They are exchangeable for any other currency at uniform rates at financial centers, worldwide.

Some examples are; US dollar, euro, British pound sterlin, Turkish lira

Gold Standard

Since ancient times, gold was used to store value, exchange value, and measure value.

As trade increased, it became difficult to carry gold from one place to the other, both because it was heavy and also it was attracting thieves.

The first paper money was used by Egyptians, and later by Kubilay Khan (grandson of Chenghiz Khan).

In the West, Sir Isaac Newton established the price of one ounce of gold as 3 pounds, 17 shillings, 10.5 pence. So gold standar in England has started. Until WW I, (except during Napoleonic Wars), England converted pounds into gold. London was the major center of finance in the world, keeping 90% of world trade and finance.

Gold Standard

In this system, each country sets a number of units of its currency per ounce of gold, and ratios of their gold equivalence established the exchange rate between any two currencies on the gold standard.

Since each currency is backed by gold, the treasuries of the countries were committed to exchange their currencies with gold or visa versa.

Gold Standard

It was simple.It corrected the BOP unbalances. If there would be

too much gold in one country, the prices would go up, imports increase, exports decrease, the unbalance would be corrected. This automatic adjustment was called price-specie-flow mechanism (developed by David Hume, 1758).

Gold standard ended when Britain and other countries sold most of their gold in the First WW, Great Depression, and the Second WW. They were left with no gold to back their currencies.

Gold Standard

There are some advocates of the gold standard even for today, like Steve Forbes (publisher), Robert Bartley (The Wall Street Journal editor), Jaques Rueff (French economist).

Major advantage of the gold standard is the discipline it brings. Under the gold standard, the governments can not print as much money as it wants. Money printing is limited, because money creation had to be backed by gold.

Bretton Woods

After the WW II, in 1944, representatives of the allied states met at Bretton Woods in New Hampshire to plan the new international political and monetary system.

Among the others, there were two major institutions to guard and control this international monetary system: IMF and the World Bank (IBRD).

Bretton Woods

IMF was established to monitor the fixed exchange rate system. In this system, the value of the member-nations’currencies were fixed, with the par value (stated value) based on gold, and the US dollar, which was valued at $35 per ounce of gold. For example;

1 British pound = $2.401 French franc = $0.181 German marc = $0.2732

US government would exchange US dollars for gold, and US dollar was the only currency to be exchanged by gold. The system was also called dollar-based gold exchange standard, and US dollar became the international payment and reserve currency.

Bretton Woods

Because US dollar was the international and reserve currency, other countries needed them.

US had a cumulative deficit of $56 billion between 1958-1971. US was printing dollars and importing goods, and it was financing the Vietnam War.

France’s De Gaulle, realizing that the value of US dollar would go down, started purchasing gold from the US Treasury. The US gold reserves shrank from $24.8 billion to $12.2 billion.

In 1971, August, President Nixon suspended dollar’s convertibility into gold for the stated price.

Triffin Paradox

It is the concept that a national currency that is also a reserve currency will eventually run a deficit, which eventually inspires a lack of confidence in the reserve currency and leads to a financial crisis.

Bretton Woods

IMF tried to make adjustments to protect the fixed currencies, and created SDRs.

The Smithsonian Agreement was a further attempt to restructure the international monetary system, but it was not successful. US dollar’s value was depreciating, continuously.

In 1973, Japan and Europe had allowed their currencies to float.

Fixed exchange rate system established at the Bretton Woods had ended.

The Bretton Woods System

• A new international monetary system was designed in 1944 in Bretton Woods, New Hampshire

• The goal was to build an enduring economic order that would facilitate postwar economic growth

• The Bretton Woods Agreement established two multinational institutions1. The International Monetary Fund (IMF) to maintain

order in the international monetary system2. The World Bank to promote general economic

development

The Bretton Woods System

• Under the Bretton Woods Agreement– the US dollar was the only currency to be

convertible to gold, and other currencies would set their exchange rates relative to the dollar

– devaluations were not to be used for competitive purposes

– a country could not devalue its currency by more than 10% without IMF approval

IMF

• IMF has 184 members contributing funds (in 2006, $308 billion), known as its quota, which is determined based on the country’s share in the world economy.

• For example, the US has 17.08% of the total votes, and is quota is 17.1, UK has 4.95 of the total, China 2.94, and Japan 6.13.

• IMF is addressing economic and exchange rate policies of countries with the largest trade imbalances. Causes of these imbalances include low levels of savings in the US, high levels of savings in China, inflexibility of Chinese currency, continued BOP surpluses in Japan, Germany, and oil-producing countries.

Major challenges to IMFand the international monetary system

Jeffrey Sachs lists the following challenges:• Rise of Asian economies will make the US-centric IMF

approach obsolete. “The US no longer be the conductor of the global monetary orchestra”.

• As Asia rises, so will the temptation toward protectionism in US and Europe. The financial crisis will be more global and more intricate.

• There will be regional currencies. The currencies of many small countries will be cancelled.

• Ecological shocks, earthquakes, global warming, new viruses like AIDS, will require new insurances, globally.

Floating exchange rate system

After US “closed the gold window”, that is it is no longer exchange gold for the paper dollars held by the foreign banks, there was a shock in the currency exchange markets.

There were two attempts to have new sets of fixed currency exchange rates; one in December 1971, and the other in February 1973.

In both cases, speculators, banks, businesses, and individuals believed that the central banks had pegged the rates incorrectly, and they were right.

Floating exchange rates since 1973

• Oil crisis in 1973• Oil crisis in 1979• Rapid fall of US dollars against German marks

(1985-1987) and against Japanese yen (1993-1995)

• Financial crisis in Europe in 1980’s• South Eas Asian financial crisis in 1996-1998• Russian crisis in 1998• Financial crisis in US and Turkey 2001• Global financial crisis that started in 2008

Fixed currency exchange rates

They are rates that governments agree on and undertake to maintain.

Floating currency exchange rates are rates that are allowed to float against other currencies and are determined by market forces.

Jamaica Agreement established the rules for the floating system in 1976. It allows for flexible ERs among the IMF members, while allowing CB operations in the money markets to smooth out volatile periods. Gold was demonetized.

Current currency arrangements

IMF recognized three types of currency exchange arrangements, later they were extended to eight. The first three were;

1. Free (clean) float – It is closest to perfect competition, because there is no government intervention and large amounts of various monies are being traded by thousands of buyers and sellers.

2. Managed (dirty) float – Governments intervene in the currency markets as they perceive that national interests to be served.

3. Fixed peg – A country pegs the value of its currency at a fixed rate to another currency.

Eight categories of exchange rate arrangements by IMF

• ER arrangements with no separate legal tender – is where a country adopts the currency of another country or a group of countries. Eg. US dollar in Panama, El Salvadore, and Ecuador.

• Currency board arrangements – describe a legislated committment to exchange domestic currency for a specific foreign currency at a fixed rate. The currency board arrangement committs the government to hold foreign currency reserves equal to its domestic currency supply. Eg. Estonia tied its kroon to euro, in Hong Kong the Hong Kong dollar is tied to the US dollar.

Continued...

• Other conventional fixed peg arrangements – describe a peg in which there is a fixed rate relationship and ER fluctuations are allowed within a narrow band of less than one percent. Eg. The Saudi Riyal is pegged to the US dollar in this way.

• Pegged ERs within horizontal bands - describe pegged arrangements in which the ER fluctuations are allowed to be more than 1 percent around a central rate. Eg. Denmark’s krone is pegged this way to euro.

Continued...

• Crawling pegs – describe arrangement in which currency is readjusted periodically at a fixed, preannounced rate or in response to changes in the indicators. Eg. Bolivia, Costa Rica, and Tunisia operate this way.

• ERs within crawling pegs – describe fluctuating margins around a central rate within which the currency is maintained and adjusted periodically. Eg. Romania.

Continued...

• Managed floating with no preannounced path for the ER – describes a monetaru authority that actively intervenes on the ER market without specifying or making public its goals and targets. Eg. Algeria, India, Malaysia, and Singapore.

• Independently floating ERs – is an approach that relies on the market. There may be interventions, yet they are conducted to moderate the rate of change rather than to establish the currency’s level. Eg. US, Mexico, Canada, and the UK.

Number of countries in each approach

Exchange arrangements with no separate tender 41 countries

Currency board arrangements 7 “

Other conventional fixed programs 40 “

Pegged exchange within horizontal bands 5 “

Crawling pegs 6 “

ERs within crawling pegs 2 “

Managed floating with no pronounced path 50 “

Independently floating 36 “

Floating currencies

Floating currencies can move against one another quickly and in large swings.

Such changes have many causes such as;• Political events• Expectations• Government policies• Trade imbalances and deficits• Inflation rate

Financial ForcesFluctuating currency values

In the post-Bretton Woods monetary system, floating currencies fluctuate against eachother. At times, central banks intervene in the FX markets by buying and selling large amounts of currency to affect the supply and demand of a particular currency.

Fixed versus Floating Exchange Rates

Question: Which is better – a fixed exchange rate system or a floating exchange rate system?

• Disappointment with floating rates in recent years has led to renewed debate about the merits of a fixed exchange rate system

The Case for Floating Exchange Rates

• A floating exchange rate system provides two attractive features

1. monetary policy autonomy

2. automatic trade balance adjustments

The Case for Floating Exchange Rates

1. Monetary Policy Autonomy• The removal of the obligation to maintain

exchange rate parity restores monetary control to a government

• In contrast, with a fixed system, a country's ability to expand or contract its money supply is limited by the need to maintain exchange rate parity

The Case for Floating Exchange Rates

2. Trade Balance Adjustments• The balance of payments adjustment

mechanism works more smoothly under a floating exchange rate regime

• Under the Bretton Woods system (fixed system), IMF approval was need to correct a permanent deficit in a country’s balance of trade that could not be corrected by domestic policy alone

The Case for Fixed Exchange Rates

• A fixed exchange rate system is attractive because

1. of the monetary discipline it imposes

2. it limits speculation

3. it limits uncertainty

4. of the lack of connection between the trade balance and exchange rates

The Case for Fixed Exchange Rates

1. Monetary Discipline• Because a fixed exchange rate system

requires maintaining exchange rate parity, it also ensures that governments do not expand their money supplies at inflationary rates

2. Speculation• A fixed exchange rate regime prevents

destabilizing speculation

The Case for Fixed Exchange Rates

3. Uncertainty

• The uncertainty associated with floating exchange rates makes business transactions more risky

4. Trade Balance Adjustments

• Floating rates help adjust trade imbalances

Who is Right?

• There is no real agreement as to which system is better

• History shows that 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

The euro (€)

The euro (€) is the currency of the European Monetary Union (EMU).

The agreement to move to a common currency, the Maastricht Treaty, was signed by the EU members in 1991 with the target date of 1999. They tried to harmonize their economies through disciplining budget deficits, public debt, and ERs.

The monetary control was handed to an EU institution; European Central Bank (ECB). The euro started circulating (2002) in Austria, Belgium, Finland, France, Germany, Ireland, Italy, Luxembourg, the Netherlands, Portugal, and Spain. Greece joined later. UK, Sweden, and Denmark did not join the euro zone.

Benefits of euro

• It reduces transaction costs for conducting business within the zone

• Eliminates ER fluctuation risks

• Businesses focus on Europe rather than domestic national markets.

Balance of Payments (BOP)

BOP is a record of country’s transactions with the rest of the world. BOP data is important because;

• It shows the demand for a country’s currency.

If X > I, demand will be high.

If I > X, demand will be low.• It helps managers to predic what sort of changes

in the economic environment might develop in the economy.

BOP major accounts1. Current account

a. Goods or merchandise account net trade account balance

b. Services accountc. Unilateral transfers

net current account balance2. Capital account

a. Direct investmentsb. Portfolio investmentsc. Short-term capital flows

net capital account balance3. Official reserves account

a. Gold imports and exportsb. Foreign exchange held by the governmentc. Liabilities to foreign CBs

net official account balance4. Discrepencies

Current account

Net changes in imports and exports of goods and services.

a. Goods or merchandise account – Shows the imports and exports of tangibles.

b. Services account – Shows the imports and exports of intangibles

c. Unilateral transfers – shows the transfers with no reciprocity (gifts, aid, migrant workers’ earnings). To satisfy the need for double-entry accounting, entry made that treats the aid or gift as purchase of goodwill.

Capital account

Net changes in a nation’s international financial assets and liabilities; credit entry occurs when residents sell stocks, bonds, or other financial assets to non-residents. Money flows to resident, while resident’s LT international liabilities (debit entry) increase.

a. Direct investment – located in one country and controlled by the residents of another country.

b. Portfolio investment – LT investments without control.c. Short-term capital flows – such as currency exchange

rate and interest rate hedging in the forward, futures, option, and swap markets, volatility and transaction privacy makes this entry the most unreliable measure.

Official reserve account

Net international transactions of the CB.

a. Gold imports and exports – if it is done by the government.

b. Foreign exchange held by the CB – Foreign currency portfolio held by the government.

c. Liabilities to foreign CB – CB borrowing and/or lending.

Net descrepencies

Net difference between the debits and credits.

The difference show the BOP surplus or BOP deficit.

Deficits and surpluses in BOP accounts

Take the example of the US.US has a huge deficit in the current account (1.5

trillion in 2009) meaning that US is importing much more than it is exporting. Yet US is exporting more services than it is importing.

Moreover, US has a surplus in the capital account meaning foreigners are buying US bonds, stocks, property in the New York City (Arab investment in US agriculture and Japanese investment in real estate, eg).

Temporary and Fundemental BOP Deficits

• Temporary BOP deficit is the one that can be corrected by country’s monetary and fiscal policies.

Monetary Policy → regulate the amount of growth or contraction of a nation’s monetary stock.

Fiscal Policy → regulate government revenues and government payments through taxes and expenditures.

Temporary and Fundemental BOP Deficits

• Fundamental BOP deficit is too severe to be repaired by any monetary and fiscal policies the country can apply; there are economic, political and social limits as to how much a country can deflate its economy which causes unemployment, or devalue which causes higher prices for imports.

Currency Areas

Current developments made the growth of currency areas, trading blocks and currency blocks likely. The most important development was the circulation of euro in the EU.

Money Markets and Foreign Exchange

Money markets are places where moneys can be bought, sold or borrowed. Since some currencies started floating freely in 1973, the daily volume of foreign exchange trading grew rapidly.

After the 2001 crises the growth slowed down.

Growth slowed down

Because:•The onset of EMU stopped the trade between EU member countries, because 17 of them adopted euro.

•Central banks ceased targeting unrealistic exchange rates. In the early 1990’s traders made billions speculating on the exchange rates.

•Expectations were better about the rates because of the electronic media and information system.

Financial Forces

Historically, US dollar was used as the main central reserve asset after 1945.

What makes a currency an international reserve asset?•It should be a vehicle currency (transaction currency), so that the country can use the currency for international trade and investments, •it should be an intervention currency, so that the central bank can use it to intervene in local and international capital markets, and foreign currency exchange markets, •it should be a safe heaven, so that it should not lose its value.

Foreign Exchange

Reciprocal currency - In the FX, generally US dollar is used as the base currency, a currency that is quoted as dollars per unit of currency instead of in units of currency per dollar; also known as direct quote.

Spot rate – The exchange rates between two currencies for delivery within two business days.

Forward rate – The exchange rate between two currencies for delivery in the future, usually 30, 60, 90, or 180 days.

Foreign Exchange

Forward currency market – Trading market for currency contracts deliverable 30, 60, 90, or 180 days in the future.

Bid price – Highest priced buy order that is currently in the market.

Ask price – Lowest priced sell order that is currently in the market.

The difference between the two prices, the bid-ask spread, provides a margin for the bank or agency.

Foreign Exchange

The foreign exchange markets are large, liquid and quite competitive with 24-hour trading through international banks.

They are unregulated.

«They are Wild West of global capitalism»

They operate with no government or other type of regulatory oversight.

Causes of exchange rate movements

• Supply and demand forecasts of for the two currencies

• Relative inflation in the two countries• Relative productivity and unit labor cost changes• Political developments; such as expected election

results• Expected government fiscal and monetary

policies, and currency exchange market actions• BOP accounts• Psychological aspects

Law of one price

It argues that similar products will have similar prices in efficient markets. If price differences exist, the process of arbitrage (buying and selling to make a profit with no risk) will quickly close any gaps and markets will be back at equilibrium.

Fisher Effect

It is the relationship between real and nominal interest rates: The real interest rate will be the nominal interest rate minus the expected rate of inflation.

rr = (rn) – I

Thus an increase in the expected inflation rate will lead to an increase in the interest rate.

International Fisher Effect

It states that the interest rate differentials for any two currencies will reflect the expected change in their exchange rates.

For example, if the nominal interest rate in US is 5%, and in EU it is 3%, we expect that the value of US dolar to decrease by 2% against euro, or the value of euro to strengthen against dollar by 2% in that year.

Purchasing Power ParityIt shows the number of units of a currency required to buy the same basket of goods and services in the foreign market that one dollar would buy in the US or other home market. It argues that the cost of goods in the US should be equal the cost of these goods time the exchange rate between the two currencies.

£P ($/£) = $P

Similarly, the ratio of the exchange rates of the two countries will be equal to the prices of the two basket of goods in the two countries. It is also called the Big Mac index, assumning that the price of Big Mac should be equal in the two countries if the exchange rate differences are neutralized.

Exchange Rate Forecasting

There are three main approaches to exchange rate forecasting:

1.Efficient market approach

2.Fundamental approach

3.Technical analysis

1) Efficient Market Approach

It assumes that current market prices fully reflect all available relevant information. It suggests that forward exchange rates are the best predictors of the future spot rates.

It also assumes random walk hypothesis. Random walk hypothesis assumes that the unpredictability of factors suggests that the best predictor of tomorrow’s prices is today’s prices.

2) Fundamental approach

It is the exchange rate prediction based on econometric models that attempt to capture the variables and their correct relationships.

This approach gives importance to surveying firms and advising firms.

3) Technical Analysis

It is an approach that analyzes data for trends and then projects these trends into future.

The past experience show that fpreign exchange traders use this method more than the others.