International monetary system

The International

Monetary System

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. Liquidityb. Adjustmentc. 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

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.

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 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”) and2. 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 central rate

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

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

Crawling Peg ( The Dirty Float)

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

Crawling Peg ( The Dirty Float)

●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

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