International Finance Management

History ofInternational Financial

Management

Presented By:

Ashish Rai

MBA 6th Semester

120251017

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Course Overview

InternationalFinancial

Management

ForeignExchangeMarkets

SourcingCapital in

Global Markets

ManagingFOREX

Exposure

ForeignInvestmentDecisions

Synthesis

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It refers to financial institutions and financial markets/facilitators of international trade, financial instruments (to minimise risk exposure), rules regulations, principles and procedures of international trade.

International Financial System

International Monetary System It is defined as a set of procedures, mechanisms, processes,

institutions to establish that rate at which exchange rate is determined in respect to other currency.

The whole story of monetary and financial system revolves around 'Exchange Rate' i.e. the rate at which currency is exchanged among different countries for settlement of payments arising from trading of goods and services.

What is special about international finance? Foreign exchange risk E.g., an unexpected devaluation adversely affects your

export market…

Political risk E.g., an unexpected overturn of the government that

jeopardizes existing negotiated contracts…

Market imperfections E.g., trade barriers and tax incentives may affect location of

production…

Expanded opportunity sets E.g., raise funds in global markets, gains from economies of

scale…8

What is money? Barter economy• Search frictions• Indivisibilities• Transferability Commodity money• Beaver pelts• Dried corn• Metals Fiat money• Faith in government…

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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

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Evolution of the International Monetary System

Bimetallism: Before 1875 Classical Gold Standard: 1875-1914 Interwar Period: 1915-1944 Bretton Woods System: 1945-1972 The Flexible Exchange Rate Regime: 1973 - Present

Bimetallism: Before 1875A “double standard” in the sense that both gold and silver were

used as money.

Both gold and silver were used as international means of payment and the exchange rates among currencies were determined by either their gold or silver contents.

Bimetallism: Before 1875Gresham’s Law

Phenomenon experienced by the countries that were on the bimetallic standard.

Since exchange rate between two currency was fixed officially, only the abundant metal was used as money, driving more scarce metal out of circulation.

Gresham’s Law: “Bad” (abundant) money drives out “Good” (scarce) money

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Classical Gold Standard: 1875-1914

Great Britain introduced full-fledged gold standard in 1821, France (effectively) in the 1850s, Germany in 1875, the US in 1879, Russia and Japan in 1897.

During this period in most major countries:• Gold alone was assured of unrestricted coinage• There was two-way convertibility between gold and national

currencies at a stable ratio.• Gold could be freely exported or imported.

The exchange rate between two country’s currencies would be determined by their relative gold contents.

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Classical Gold Standard: 1875-1914

Highly stable exchange rates under the classical gold standard provided an environment that was favorable to international trade and investment.

Misalignment of exchange rates and international imbalances of payment were automatically corrected by the price-specie-flow mechanism.

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Price-Specie-Flow Mechanism Suppose Great Britain exported more to France than France

imported from Great Britain.• Net export of goods from Great Britain to France will be

accompanied by a net flow of gold from France to Great Britain.• This flow of gold will lead to a lower price level in France and, at

the same time, a higher price level in Britain.

The resultant change in relative price levels will slow exports from Great Britain and encourage exports from France.

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Classical Gold Standard: 1875-1914 There are shortcomings:• The supply of newly minted gold is so restricted that the growth of

world trade and investment can be hampered for the lack of sufficient monetary reserves.

• Even if the world returned to a gold standard, any national government could abandon the standard.

• 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 exchange rate between pair of two currencies was determined by respective exchange rates against 'Gold' which was called 'Mint Parity'.

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Three rules of Mint Parity

The authorities must fix some once-for-all conversion rate of paper money issued by them into gold.

There must be free flow of Gold between countries on Gold Standard.

The money supply should be tied with the amount of Gold reserves kept by authorities. The gold standard was very rigid and during 'great depression' (1929-32) it vanished completely.

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The Gold Exchange Standard (1925-1931)

In 1925, US and England could hold gold reserve and other nations could hold both gold and dollars/sterling as reserves.

The countries started devaluing their currencies in order to increase exports and de-motivate imports.

This was termed as "beggar-thy-neighbour " policy.

Interwar Period: 1915-1944 Exchange rates fluctuated as countries widely used

“predatory” depreciations of their currencies as a means of gaining advantage in the world export market.

Attempts were made to restore the gold standard, but participants lacked the political will to “follow the rules of the game”.

The result for international trade and investment was profoundly detrimental.

Bretton Woods System: 1945-1972

Allied nations held a conference in New Hampshire, the outcome of which gave birth to two new institutions namely the International Monetary Fund (IMF) and the World Bank, (WB) and the system was known as Bretton Woods System which prevailed during (1946-1971).

Bretton Woods, the place in New Hampshire, where more than 40 nations met to hold a conference.

The purpose was to design a postwar international monetary system.

The goal was exchange rate stability without the gold standard.


Under the Bretton Woods system, the U.S. dollar was pegged to gold at $35 per ounce and other currencies were pegged to the U.S. dollar.

Each country was responsible for maintaining its exchange rate within ±1% of the adopted par value by buying or selling foreign reserves as necessary.

The Bretton Woods system was a dollar-based gold exchange standard.


In Bretton Woods modified form of Gold Exchange Standard was set up with the following characteristics

• One US dollar conversion rate was fixed by the USA as one dollar = 35 ounce of Gold

• Other members agreed to fix the parities of their currencies vis-à-vis dollar with respect to permissible central parity with one per cent (± 1%) fluctuation on either side.


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Guess what happened to inflation?

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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 . 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

The Flexible Exchange Rate Regime: 1973-Present.

Flexible exchange rates were declared acceptable to the IMF members.• Central banks were allowed to intervene in the

exchange rate markets to iron out unwarranted volatilities.

Gold was abandoned as an international reserve asset.

Non-oil-exporting countries and less-developed countries were given greater access to IMF funds.

The Monetary System Jamaica Agreement (1976)• Central banks were allowed to intervene in the foreign exchange markets to

iron out unwarranted volatilities.• Gold was officially abandoned as an international reserve asset. Half of the

IMF’s gold holdings were returned to the members and the other half were sold, with proceeds used to help poor nations.

• Non-oil exporting countries and less-developed countries were given greater access to IMF funds.

Plaza Accord (1985)• G-5 countries (France, Japan, Germany, the U.K., and the U.S.) agreed that it

would be desirable for the U.S. dollar to depreciate. Louvre Accord (1987)• G-7 countries (Canada and Italy were added) would cooperate to achieve

greater exchange rate stability.• G-7 countries agreed to more closely consult and coordinate their

macroeconomic policies.

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The Monetary System

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80

90

100

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Mar

ch 7

3 =1

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Broad Real US dollar IndexSource: www.federalreserve.gov

Jamaica 1978

Plaza 1985

Louvre 1987

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Current Exchange Rate Arrangements Free Float

• The largest number of countries, about 48, allow market forces to determine their currency’s value.

Managed Float • About 25 countries combine government intervention with

market forces to set exchange rates. Pegged to another currency

• Such as the U.S. dollar or euro. No national currency

• Some countries do not bother printing their own, they just use the U.S. dollar. For example, Ecuador, Panama, and El Salvador have dollarized.

Note: As of July 31, 2005.20

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

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. 13.331949 – Pound was devalued 30.5% so was Rupee

but 36.5% in dollar terms1967 – 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

Thank You

International Finance Management

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