The International Monetary System Chapter 10 The International Monetary System

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 The world’s four major currencies – dollar, euro, yen, and pound – are all free to float against each other. Pegged exchange rates, dirty floats and fixed exchange rates all require some degree of government intervention.

Introduction When a country tried to hold the value of its currency within some range of a reference currency, dirty float exists Countries that adopt a fixed exchange rate system fix their currencies against each other Prior to the introduction of the euro, some European Union countries operated with fixed exchange rates within the context of the European Monetary System (EMS)

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

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 23.22 grains of "fine (pure) gold The amount of a currency needed to purchase one ounce of gold was called the gold par value

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

The Period Between The Wars: 1918-1939 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 Post WWI, war heavy expenditures affected the value of dollars against gold. US raised dollars to gold from $20.67 to $35 per ounce. Other countries followed suit and devalued their currencies.

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 A key problem with the gold standard was that there was no multinational institution that could stop countries from engaging in competitive devaluations.

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

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 The International Monetary Fund (IMF) Articles of Agreement were heavily influenced by the worldwide financial collapse, competitive devaluations, trade wars, high unemployment, hyperinflation in Germany and elsewhere, and general economic disintegration that occurred between the two world wars. The aim of the IMF was to try to avoid a repetition of that chaos through a combination of discipline and flexibility.

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

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

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 The system of fixed exchange rates established at Bretton Woods worked well until the late 1960’s. The US dollar was the only currency that could be converted into gold The US dollar served as the reference point for all other currencies Any pressure to devalue the dollar would cause problems through out the world Factors that led to the collapse of the fixed exchange system include: President Johnson financed both the Great Society and Vietnam by printing money High inflation and high spending on imports On August 8, 1971, President Nixon announces dollar no longer convertible into gold Countries agreed to revalue their currencies against the dollar On March 19, 1972, Japan and most of Europe floated their currencies In 1973, Bretton Woods fails because the key currency (dollar) is under speculative attack

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

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

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

Figure 10.1: Major Currencies Dollar Index, 1973-2006 Exchange Rates Since 1973 Figure 10.1: Major Currencies Dollar Index, 1973-2006

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 Country Focus: The U.S. Dollar, Oil Prices, and Recycling Petrodollars Summary This feature e closing case explores what oil producing nations are likely to do with the dollars they have earned. Recently, oil prices have surged as a result of higher than expected demand, tight supplies, and perceived geopolitical risks. Since oil is priced in dollars, oil producers have seen their dollar reserves increase. Discussion of the feature can begin with the following questions. 1. What will happen to the value of the U.S. dollar if oil producers decide to invest most of their earnings from oil sales in domestic infrastructure projects? Discussion Points: If oil producers decide to invest their earnings in domestic infrastructure projects, it would be expected that the countries involved would see a boost in economic growth, and an increase in imports. This would put downward pressure on the dollar as the petrodollars are sold, or are invested in the local community, however the expected increase in imports that should result from greater economic growth would increase the demand for dollars. 2. What factors determine the relative attractiveness of dollar, euro, and yen denominated assets to oil producers flush with petrodollars? What might lead them to direct more funds towards non-dollar denominated assets? Discussion Point s: The relative attractiveness of an investment whether it is denominated in dollars, euro, or yen depends on expected returns and the degree of risk associated with the investment. When considering different currencies, it would be important to consider expected shifts in the exchange rate. So, for example, if the dollar was expected to depreciate relative to the euro or yen, non-dollar denominated assets might be more attractive all else being equal.

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

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

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

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

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

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

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

Currency Boards Countries using a currency board commit 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

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

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

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

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

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

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

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 Country Focus: Turkey’s and the IMF Summary This feature explores Turkey’s 18th IMF program. In May 2001, the IMF agreed to lend $8 billion to Turkey to help stabilize its economy and halt a sharp slide in the value of its currency. While initially the Turkish government resisted IMF mandates on economic policy, in 2003, the government passed an austerity budget. By 2005, significant progress had been made and today, the country appears to be on track for recovery, with lower inflation rates, an increase in privatization, and a budget surplus. The following questions can be helpful in directing the discussion: Suggested Discussion Questions 1. What led to Turkey’s financial crisis? What goals did the IMF establish as part of the loan agreement? Discussion Points: Several factors led to Turkey’s financial crisis including a large and inefficient state sector and a subsidized agricultural sector, both of which were financed through debt. The IMF pushed for accelerated privatization of inefficient sectors, and a reduction in agricultural subsidies. In addition, the IMF called for pension reform and tax increases. 2. What are the challenges for a government to deal with a financial crisis like the one that Turkey experienced? Discussion Points: Students will probably suggest that one of the biggest challenges for governments facing a financial crisis is the domino effect it seems to have throughout the economy. In the case of Turkey, IMF assistance to stabilize the situation meant that the country had to follow what initially seemed to be unattractive policies. 3. Was the IMF successful in Turkey? Discussion Points: After several rocky attempts, most students will probably agree that the IMF’s programs in Turkey are finally beginning to show results. Inflation is down, economic growth is up, and the privatization program has continued to move along. In addition, government spending seems to be under control.

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