The International Monetary
System
What is the International Monetary
System?
• The institutional framework within which
▫ International payments are made
▫ Movements of capital are accommodated
▫ Exchange rates among currencies are
determined
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: 1973Present
Bimetallism: Before 1875
• Bimetallism was a “double standard” in the
sense that both gold and silver were used as
money.
• Some countries were on the gold standard, some
on the silver standard, and some on both.
• Both gold and silver were used as an
international means of payment, and the
exchange rates among currencies were
determined by either their gold or silver
contents.
Classical Gold Standard: 1875-1914
• 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.
• In order to support convertibility into gold,
banknotes needed to be backed by a gold reserve
of a minimum stated ratio
• The exchange rate between two country’s
currencies would be determined by their relative
gold contents.
Classical Gold Standard: 1875-1914
• For example, if the dollar is pegged to gold at U.S. $30 =
1 ounce of gold, and the British pound is pegged to gold
at £6 = 1 ounce of gold, it must be the case that the
exchange rate is determined by the relative gold
contents:
$30 = 1 ounce of gold = £6
$30 = £6
$5 = £1
• Highly stable exchange rates under the classical gold
standard provided an environment that was beneficial to
international trade and investment
Collapse of the Gold Standard
• World War I ended the classical gold standard in
August 1914
• Great Britain, France, Germany and Russia
suspended redemption of banknotes in gold and
imposed embargoes on gold exports
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
• Named for a 1944 meeting of 44 nations at
Bretton Woods, New Hampshire.
• The purpose was to design a postwar
international monetary system.
• The goal was exchange rate stability without the
gold standard.
• The result was the creation of the IMF and the
World Bank.
Bretton Woods System: 1945-1972
British
pound
•
•
The U.S. dollar was
pegged to gold at
$35/ounce and other
currencies were
pegged to the U.S.
dollar.
Each country was
responsible for
maintaining its
exchange rate within
+-1% of par value
German
mark
French
franc
Par
Value
U.S. dollar
Pegged at $35/oz.
Gold
Gold-exchange standard:
U.S. dollar the only currency
fully convertible to gold
Collapse of the gold exchange standard
• Professor Robert Triffin warned that the goldexchange system was programmed to collapse in the
long run.
• To satisfy the growing need for reserves, the United
States had to run balance-of-payments deficits
continuously, thereby supplying the dollar to the
rest of the world.
• But if the U.S. did just that, eventually the world will
lose confidence in the dollar— Triffin Paradox
• That indeed happened in the early 1970s.
▫ In August 1971, U.S. President Richard Nixon
announced the "temporary" suspension of the dollar's
convertibility into gold
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 resolve unwarranted
volatilities.
• Gold was abandoned as an international reserve asset.
Current Exchange Rate Arrangements
• No separate legal tender:
•
Currency of another country circulates as the sole legal tender (for example, Ecuador,
El Salvador, and Panama).
• Currency board:
•
An extreme form of the fixed exchange rate regime under which local currency is fully
backed by a foreign currency at a fixed exchange rate leaving little room for
discretionary monetary policy (for example, Hong Kong, Bulgaria, and Brunei).
• Conventional peg:
•
Country formally pegs its currency at a fixed rate to another currency or basket of
currencies (for example, Jordan, Saudi Arabia, and Nepal).
• Stabilized arrangement:
•
Entails a spot market exchange rate that remains within a margin of 2% for 6 months
or more (for example, Vietnam, Nigeria, and Lebanon).
1
3
Current Exchange Rate Arrangements
• Crawling peg:
• The currency is adjusted in small amounts at a fixed rate or in response to
changes in selected indicators (for example, Honduras and Nicaragua).
• Crawl–like arrangement:
• Exchange rate must remain within a narrow margin of 2% relative to a
statistically identified trend for 6 months or more, and the exchange rate
cannot be considered floating (for example, Singapore, Romania, and
Tunisia).
• Pegged exchange rate with horizontal bands:
• Value of the currency is maintained within certain margins of fluctuation of
at least +/− 1% around a fixed central rate, or the margin between the
maximum and minimum value of the exchange rate exceeds 2%.
1
4
Current Exchange Rate Arrangements
3
• Other managed arrangement:
• Residual category used when the exchange rate arrangement does not meet
the criteria for any of the other categories (for example, China, Argentina,
and Kuwait).
• Floating:
• Exchange rate is largely market determined, without an ascertainable or
predictable path for the rate (for example, Brazil, Korea, Turkey, India,
South Africa, and Thailand).
• Free floating:
• Intervention occurs only exceptionally and aims to address disorderly
market conditions; intervention has been limited to at most 3 instances in
the previous 6 months, each lasting no more than 3 business days (for
example, Australia, Canada, Mexico, Japan, U.K., U.S., and euro zone).
1
5
The Trade–Weighted Value of the U.S. Dollar
since 1964
• The value of the U.S. dollar represents the nominal exchange rate index (2010 = 100)
with weights derived from trade among 27 industrialized countries.
• Source: Bank for International Settlements.
16
Value of the Euro in U.S. Dollars
1.5
1.4
1.3
1.2
1.1
1
0.9
0.8
1999 2000 2001 20022003200420052006200720082009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 2021 2022 2023
China Renminbi’s Exchange Rate
CHINESE RENMINBI TO US $ EXCHANGE RATE
8.5
8
7.5
7
6.5
6
5.5
▫ China maintained a fixed exchange rate between the renminbi (RMB) yuan
and the U.S. dollar for a long time.
▫ Beijing dropped an explicit peg to the US dollar in 2005 and switched to the
current “managed floating exchange rate regime”
▫ The RMB floated between 2005 and 2008 and then again starting in 2010
▫ The RMB has been included in the basket of currencies used by the IMF
(reserve currency) in 2016.
Currency crises: The Mexican Peso 1994
• On December 20, 1994, the Mexican government
announced a plan to devalue the peso against the
dollar by 14 percent.
• This decision changed currency trader’s
expectations about the future value of the peso, and
they rushed for the exits.
• International mutual funds had invested $45 billion
in Mexican securities in the three years prior to the
peso crisis
• In their rush to get out, the peso fell by as much as
40 percent.
Currency crises: The Mexican Peso 1994
• The Mexican Peso crisis is unique in that it
represents the first serious international financial
crisis touched off by cross-border flight of portfolio
capital.
▫ As the world’s financial markets are becoming more
integrated, contagious financial crisis are more likely
to happen
• Two lessons emerge:
▫ It is essential to have a multinational safety net in
place to safeguard the world financial system from
such crises.
▫ An influx of foreign capital can lead to an
overvaluation in the first place.
The Asian Currency Crisis: 1997
• The Asian currency crisis of 1997 turned out to
be far more serious than the Mexican peso crisis
in terms of the extent of the contagion and the
severity of the resultant economic and social
costs.
• Many firms with foreign currency bonds were
forced into bankruptcy.
• The region experienced a deep, widespread
recession.
The Asian Currency Crisis
Origins of the Asian Currency Crisis
• As capital markets were opened, large inflows of private
capital resulted in a credit boom in the Asian countries.
▫ The credit boom was often directed to speculation in real estate
and stock markets
• Fixed or stable exchange rates also encouraged unhedged
financial transactions and excessive risk-taking by both
borrowers and lenders.
• The real exchange rate rose, which led to a slowdown in
export growth.
• Also, Japan’s recession (and yen depreciation) hurt.
• As asset prices declined in part due to government’s effort to
control overheated economy, the quality of bank loans also
declined as the same assets were held as collateral
The Asian Currency Crisis
• If the Asian currencies had been allowed to depreciate in
real terms (not possible due to the fixed exchange rates),
the sudden and catastrophic changes in exchange rates
observed in 1997 might have been avoided
• Eventually something had to give—it was the Thai baht:
▫ The Thai central bank initially injected liquidity to the
domestic financial system and tried to defend the exchange
rate by using its foreign reserves
▫ With its foreign reserves declining rapidly, the central bank
eventually decided to devalue the baht
• The sudden collapse of the baht touched off a panicky
flight of capital from other Asian countries.
• The IMF came to rescue the three hardest-hit Asian
countries: Indonesia, Korea, and Thailand.
Lessons from the Asian Currency Crisis
• Liberalization of financial markets when
combined with a weak, underdeveloped
domestic financial system tends to create an
environment susceptible to currency and
financial crisis
• A fixed but adjustable exchange rate is
problematic in the face of integrated
international financial markets.
▫ A country can attain only two the of three conditions:
1.
2.
3.
A fixed exchange rate.
Free international flows of capital.
Independent monetary policy.
The Argentinean Peso Crisis: 2002
• In 1991 the Argentine government passed a
convertibility law that linked the peso to the U.S.
dollar at parity.
• The initial economic effects were positive:
▫ Argentina’s chronic inflation was reduced.
▫ Foreign investment poured in.
• As the U.S. dollar appreciated on the world
market the Argentine peso became stronger as
well.
The Argentinean Peso Crisis: 2002
• However, the strong peso hurt exports from
Argentina and caused a protracted economic
downturn that led to the abandonment of peso–
dollar parity in January 2002.
▫ The unemployment rate rose above 20 percent.
▫ The inflation rate reached a monthly rate of 20
percent.
The Argentinean Peso Crisis: 2002
• There are at least three factors that are related to the collapse
of the currency board arrangement and the ensuing economic
crisis:
▫ Lack of fiscal discipline.
▫ Labor market inflexibility.
▫ Contagion from the financial crises in Brazil and Russia.
• Competing claims on economic resources by different groups
were accommodated by increasing public sector indebtedness
• The government borrowed heavily in dollars, when the
economy entered into recession, the government eventually
defaulted on its internal and external debt: the largest
sovereign default in history
• 2018: back to the crisis
The Argentinean Peso Crisis: 2018
• For years, governments printed money to finance
wide budget deficits, causing consumer prices and
inflation rate to spike
• Economists had long argued that Argentina’s peso
currency was overvalued
• the peso plunged against the dollar in April, due to
investor concerns about the government’s ability to
control inflation and interest rate hikes by the U.S.
Federal Reserve, which strengthened the dollar
worldwide
• The depreciation made Argentina’s dollar debts
more expensive for the government, prompting it to
turn to the International Monetary Fund (IMF) for a
$50 billion loan.
The Argentinean Peso Crisis: 2018
The Turkish Lira Crisis in 2018
• It looks like a classic emerging-market
meltdown:
• a rapidly growing economy funded by shortterm, dollar-denominated liabilities
• In 2017 43% of total foreign direct investment
flowed into Turkey's real estate sector
• Turkish banks were heavily dependent on FX
wholesale funding
The Turkish Lira Crisis in 2018
Russian Ruble
160
140
120
100
80
60
40
20
0
Currency Crisis Explanations
• In theory, a currency’s value mirrors the fundamental
strength of its underlying economy, relative to other
economies, in the long run.
• In the short run, currency trader expectations play a
much more important role.
• In today’s environment, traders and lenders, using the
most modern communications, act on fight-or-flight
instincts. For example, if they expect others are about to
sell Brazilian reals for U.S. dollars, they want to “get to
the exits first.”
• Thus, fears of depreciation become self-fulfilling
prophecies.
Fixed versus Flexible Exchange Rate
Regimes
• Suppose the exchange rate is $1.40/€ today.
• In the next slide, we see that demand for the
euro far exceeds supply at this exchange rate (or
the supply of U.S. dollars exceeds demand).
• The United States experiences trade deficits.
• Under a flexible exchange rate regime, the dollar
will simply depreciate to $1.60/€, the price at
which supply equals demand and the trade
deficit disappears.
Dollar price per €
(exchange rate)
Fixed versus Flexible Exchange Rate
Regimes
$1.60
$1.40
Supply (S)
Dollar depreciates (flexible
regime)
Demand (D)
Trade deficit
QS
QD = QS
QD
Q of €
Fixed versus Flexible Exchange Rate
Regimes
• Instead, suppose the exchange rate is “fixed” at
$1.40/€, and thus the imbalance between supply
and demand cannot be eliminated by a price
change.
• The government would have to shift the demand
curve from D to D*.
▫ In this example, this shift corresponds to
contractionary monetary and fiscal policies.
Dollar price per €
(exchange rate)
Fixed versus Flexible Exchange Rate
Regimes
Supply (S)
Contractionary
policies
(fixed regime)
$1.40
Demand (D)
Demand (D*)
QD* = QS
Q of €
Balance of Payments Accounts
• The balance of payments accounts are those that
record all transactions between the residents of a
country and residents of all foreign nations.
• They are composed of the following:
▫ The Current Account
▫ The Capital Account
▫ The Official Reserves Account
▫ Statistical Discrepancy
The Current Account
• Includes all imports and exports of goods and
services.
• If the debits exceed the credits, then a country is
running a trade deficit.
• If the credits exceed the debits, then a country is
running a trade surplus.
Balance of Payments Example
• Suppose that Maplewood Bicycle in Maplewood,
Missouri, USA imports $100,000 worth of
bicycle frames from Mercian Bicycles in Darby,
England.
• There will exist a $100,000 credit recorded by
Mercian that offsets a $100,000 debit at
Maplewood’s bank account.
• This will lead to a rise in the supply of dollars
and the demand for British pounds.
341
The Capital Account
• The capital account measures the difference
between sales of assets to foreigners and
purchases of foreign assets.
• Sales of assets results in capital inflow; purchase
of assets results in capital outflow
• The capital account is composed of Foreign
Direct Investment (FDI), portfolio investments,
and other investments.
The Official Reserves Account
• Official reserves assets include gold, foreign
currencies, and reserve positions in the IMF.
The Balance of Payments Identity
BCA + BKA + BRA = 0
where
BCA = balance on current account
BKA = balance on capital account
BRA = balance on the reserves account
Under a pure flexible exchange rate regime,
BCA + BKA = 0
Required reading
• Eun C.S. and Resnik B.G. (2021) “International
Financial Management”, Mc Graw Hill, Ch. 2
and Ch. 3 (read only)