International Monetary System

The International

Monetary System

Part I

Introduction

The international monetary system refers to

the institutional arrangements that countries

adopt to govern exchange rates

Introduction

International monetary systems are sets of internationally agreed rules, conventions and supporting institutions that facilitate international trade, cross border investment and generally the reallocation of capital between nation states

Introduction

It addresses to solve the problems relating to

international trade:

a. Liquidity

b. Adjustment

c. Stability

The problem of Liquidity

The problem of liquidity existed even in the

domestic transactions through barter

system Barter system was replaced by precious

metals as a medium of exchange and store

of value Gold standard system of international

payments came into existence

The Gold Standard

The first modern international monetary system was the gold standard

Put in effect in 1850Participants – UK,

France, Germany & USA

USAJapan

Gold

Trade

Gold Standard- I ( 1876-1913)

● In this system, each currency was linked to a weight of gold

● Under gold standard, each country had to establish the rate at which its currency could be converted to a weight of gold

E.g. $ 20.67/ ounce ; Pound 4.247/ once

Gold Standard- I ( 1876-1913)

● Most of the countries used to declare par value of their currency in terms of gold

● The problem was every country needed to maintain adequate reserves of gold in order to back its currency

The Gold Standard

● After World War I, the exchange rates were

allowed to fluctuate

● Since gold was convertible into currencies

of the major developed countries, central

banks of different countries either held gold

or currencies of these developed countries

The System of Bretton Woods ( 1944-71)

In July, 1944, 44 countries met in Bretton

Woods, New Hampshire, USA – a new

International Monetary System was created

John Maynard Keynes of Britain and Harry

Dexter White of USA were the key movers

The Bretton Woods Agreement

Creation of International Monetary Fund (IMF)

to promote consultations and collaboration

on international monetary problems and

countries with deficit balance of payments Establish a par value of currency with

approval of IMF Maintain exchange rate for its currency

within one percent of declared par value

The Bretton Woods Agreement

Each member to pay a quota into IMF pool –

one quarter in gold and the rest in their own

currency The pool to be used for lending Dollar was to be convertible to gold till

international instrument was introduced International Bank for Reconstruction and

Development (IBRD) was created to

rehabilitate war-torn countries and help

developing countries

The System of Bretton Woods ( 1944-71)

So in effect this was a gold – dollar exchange

standard ( $35/ounce)- known as fixed

exchange rate system or adjustable peg Devaluation could not be resorted arbitrarily When BOP problem became structural i.e.

repetitive, devaluation upto ten percent was

permitted by IMF Thus each currency was tied to dollar directly

or indirectly

Collapse of the Fixed Exchange System

The system of fixed exchange rates established at Bretton Woods worked well until the late 1960’s Any pressure to devalue the dollar would cause problems throughout the world The trade balance of the USA became highly negative and a very large amount of US dollars was held outside the USA ; it was more than the total gold holdings of the USA

Collapse of the Fixed Exchange System

During end of sixties, European governments wanted gold in return for the dollar reserves they held On 15th Aug. 1971, President Nixon suspended the system of convertibility of gold and dollar and decided for floating exchange rate system

The end of the Bretton Woods System (1972–81)

The system dissolved between 1968 and

1973

By March 1973, the major currencies began

to float against each other

The end of the Bretton Woods System (1972–81)

IMF members have been free to choose any

form of exchange arrangement they wish

(except pegging their currency to gold): Allowing the currency to float freely Pegging it to another currency or a basket

of currencies Adopting the currency of another country,

participating in a currency bloc, or Forming part of a monetary union

Exchange Systems after 1973

• Exchange Rate systems are classified on the basis of the flexibility that the monetary authorities show towards fluctuations in the exchange rates and are divided into two categories:

1. Systems with a fixed exchange rate ( “fixed peg” or “hard peg”) and

2. Systems with a flexible exchange rate ( “Floating” systems)

Exchange Systems after 1973

• But as usual, between these two extreme positions there exists also an intermediate range of different systems with limited flexibility, usually referred to as “soft pegs”

A fixed peg regime

A fixed peg regime exists when the exchange rate of the home currency is fixed to an anchor currency

This is the case with economies having currency boards or with no separate national currency of their own

Countries do not have a separate national currency, either when they have formally dollarized, or when the country is a member of a currency union, for example Euro

Floating Exchange Rate System

● The collapse of Bretton Woods and Smithsonian Agreements coupled with oil crisis of 1970, the floating exchange rate system was adopted by leading industrialised countries

● Officially approved in April 1978

● Under the system, the exchange rate would be determined by market forces without the intervention of government

Floating Exchange Rate System

● No country in the world has adopted freely floating exchange rate system

● Floating exchange rate regimes consist of independent floating and managed floating systems

Independent Floating systems

In Independent Floating systems the exchange rate is market determined and monetary policy usually functions without exchange rate considerations

Foreign exchange interventions are rare and meant to prevent undue fluctuations

But no attempt is undertaken to achieve/maintain a particular rate

Managed Floating systems

Managed Floating systems usually let the market take its own course but the monetary authorities intervene in the market to “manage” the exchange rate, if needed, to prevent high volatilities and to stimulate growth, without committing to a particular exchange rate level

The monetary authorities do not specify their opinion on “suitable” exchange rate level

The IMF calls this practice a “Managed Floating With No Predetermined Path for the Exchange Rate”

Intermediate Regimes ( Soft Pegs)

• Intermediate exchange rate regimes consist of an array of differing systems allowing a varying degree of flexibility, such as conventional fixed exchange rate pegs, crawling pegs and exchange rate bands

Conventional fixed exchange rate pegs

In a Conventional Fixed Peg arrangement a currency is pegged at a fixed rate to a major currency or a basket of currencies, allowing the exchange rate to fluctuate within a narrow margin of ±1 percent around a formal (or de facto) central rate

The monetary authority intervenes in the market, if the fluctuation is outside these limits

(post-crisis Malaysia, fixing Ringgit against US dollar for a rate of RM 3,8 per $1)

Crawling Peg ( The Dirty Float)

● In this system an attempt is made to combine the advantages of fixed exchange rate with flexibility of floating exchange rate

● It fixes the exchange rate at a given level which is responsive to changes in market conditions i.e. it is allowed to crawl


In a Crawling Peg arrangement the currency is adjusted periodically “in small amounts at a fixed rate or in response to changes in selective quantitative indicators (past inflation differentials vis-à-vis major trading partners…)

A Crawling Band allows a periodic adjustment of the exchange rate band itself


● The upper and lower limits are decided for exchange rate depending demand and supply of foreign exchange

● As the exchange rate crosses these limits, fiscal and monetary policies come into play to push the exchange rate within the target zone

● But in this case, these limits are sustained for some time and if it is felt that economic indicators are being disturbed, the monetary authorities let the exchange rate depreciate or appreciate as the case may be

Trends in Global Exchange Rate Regimes

Exchange Rate Regimes IMF Members, 2006

Exchange Rates Since 1973

• Since 1973, exchange rates have become more volatile and less predictable than they were between 1945 and 1973, due to:

Oil crisis -1971 Loss of confidence in the dollar - 1977-78 Oil crisis – 1979, OPEC increases price of oil Unexpected rise in the dollar - 1980-85 Rapid fall of the dollar - 1985-87 and 1993-95 Partial collapse of European Monetary System – 1992 Asian currency crisis - 1997

Exchange Rates Since 1973

● The merits of each continue to be debated

● There is no agreement as to which system

is better

● Many countries today are disappointed

with the floating exchange rate system

Implications For Managers

For managers, understanding the international monetary system is important for:

Currency management Business strategy Corporate-government relations

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

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 e.g. dispersing

production to different locations

Corporate-Government Relations

Managers need to recognize that

businesses can influence government

policy towards the international monetary

system

Companies should promote an

international monetary system that

facilitates international growth and

development

Evolution of Indian Exchange Rate system

• 1931 – Rupee pegged to Pound Sterling – parity Rs. 1= shilling 1 and 6 pence

• 1944 – IMF asked nations to peg currency to dollar or gold – chose gold – parity again with sterling –

BP 1 = Rs. 13.33

• 1949 – Pound was devalued 30.5% so was

Rupee but 36.5% in dollar terms


• 1967 – Pound again devalued by 14.3% but India did not – it delinked rupee

from pound and linked it to dollar

• 1971 – Smithsonian Agreement – the international currencies were realigned– India returned to sterling

peg – parity BP = Rs. 18.9677

The fluctuation of (+)/(-) 2.25% was allowed


• Sept. 1975 – the sterling peg was replaced by a basket peg - The fluctuation band widened to

(+)/(-) 5%

• July 1991 – the rupee was devalued twice by 18-20%

• 1991-92 Budget - partial convertibility on current account


• 1992-93 Budget – the rupee was made fully convertible on current account and a liberalized exchange rate management system ( LERMS) was introduced

• Presently, FEDAI announces indicative rates on every business day . RBI has discretion to enter the market to stabilise the exchange rate

GOOD LUCK TO YOU

International Monetary System

Education

Transcript of International Monetary System