Chapter 5
Understanding
International Monetary
System
Convertible currencies (hard
currencies)
They are exchangeable for any other
currency at uniform rates at financial
centers, worldwide.
Some examples are; US dollar, euro, British
pound sterlin, Turkish lira
Gold Standard
Since ancient times, gold was used to store value,
exchange value, and measure value.
As trade increased, it became difficult to carry gold from
one place to the other, both because it was heavy and
also it was attracting thieves.
The first paper money was used by Egyptians, and later by
Kubilay Khan (grandson of Chenghiz Khan).
In the West, Sir Isaac Newton established the price of one
ounce of gold as 3 pounds, 17 shillings, 10.5 pence. So
gold standar in England has started. Until WW I, (except
during Napoleonic Wars), England converted pounds
into gold. London was the major center of finance in the
world, keeping 90% of world trade and finance.
Gold Standard
In this system, each country sets a number
of units of its currency per ounce of gold,
and ratios of their gold equivalence
established the exchange rate between
any two currencies on the gold standard.
Since each currency is backed by gold, the
treasuries of the countries were committed
to exchange their currencies with gold or
visa versa.
Gold Standard
It was simple.
It corrected the BOP unbalances. If there would be
too much gold in one country, the prices would
go up, imports increase, exports decrease, the
unbalance would be corrected. This automatic
adjustment was called price-specie-flow
mechanism (developed by David Hume, 1758).
Gold standard ended when Britain and other
countries sold most of their gold in the First WW,
Great Depression, and the Second WW. They
were left with no gold to back their currencies.
Gold Standard
There are some advocates of the gold standard
even for today, like Steve Forbes (publisher),
Robert Bartley (The Wall Street Journal editor),
Jaques Rueff (French economist).
Major advantage of the gold standard is the
discipline it brings. Under the gold standard, the
governments can not print as much money as it
wants. Money printing is limited, because money
creation had to be backed by gold.
Bretton Woods
After the WW II, in 1944, representatives of
the allied states met at Bretton Woods in
New Hampshire to plan the new
international political and monetary
system.
Among the others, there were two major
institutions to guard and control this
international monetary system: IMF and
the World Bank (IBRD).
Bretton Woods
IMF was established to monitor the fixed exchange rate
system. In this system, the value of the membernations’currencies were fixed, with the par value (stated
value) based on gold, and the US dollar, which was
valued at $35 per ounce of gold. For example;
1 British pound = $2.40
1 French franc = $0.18
1 German marc = $0.2732
US government would exchange US dollars for gold, and
US dollar was the only currency to be exchanged by
gold. The system was also called dollar-based gold
exchange standard, and US dollar became the
international payment and reserve currency.
Bretton Woods
Because US dollar was the international and reserve
currency, other countries needed them.
US had a cumulative deficit of $56 billion between 19581971. US was printing dollars and importing goods, and
it was financing the Vietnam War.
France’s De Gaulle, realizing that the value of US dollar
would go down, started purchasing gold from the US
Treasury. The US gold reserves shrank from $24.8
billion to $12.2 billion.
In 1971, August, President Nixon suspended dollar’s
convertibility into gold for the stated price.
Triffin Paradox
It is the concept that a national currency that
is also a reserve currency will eventually
run a deficit, which eventually inspires a
lack of confidence in the reserve currency
and leads to a financial crisis.
Bretton Woods
IMF tried to make adjustments to protect the fixed
currencies, and created SDRs.
The Smithsonian Agreement was a further attempt
to restructure the international monetary system,
but it was not successful. US dollar’s value was
depreciating, continuously.
In 1973, Japan and Europe had allowed their
currencies to float.
Fixed exchange rate system established at the
Bretton Woods had ended.
The Bretton Woods System
• A new international monetary system was designed in
1944 in Bretton Woods, New Hampshire
• The goal was to build an enduring economic order that
would facilitate postwar economic growth
• The Bretton Woods Agreement established two
multinational institutions
1. The International Monetary Fund (IMF) to maintain
order in the international monetary system
2. The World Bank to promote general economic
development
The Bretton Woods System
• Under the Bretton Woods Agreement
– the US dollar was the only currency to be
convertible to gold, and other currencies
would set their exchange rates relative to the
dollar
– devaluations were not to be used for
competitive purposes
– a country could not devalue its currency by
more than 10% without IMF approval
IMF
• IMF has 184 members contributing funds (in 2006, $308
billion), known as its quota, which is determined based
on the country’s share in the world economy.
• For example, the US has 17.08% of the total votes, and
is quota is 17.1, UK has 4.95 of the total, China 2.94,
and Japan 6.13.
• IMF is addressing economic and exchange rate policies
of countries with the largest trade imbalances. Causes of
these imbalances include low levels of savings in the
US, high levels of savings in China, inflexibility of
Chinese currency, continued BOP surpluses in Japan,
Germany, and oil-producing countries.
Major challenges to IMFand the
international monetary system
Jeffrey Sachs lists the following challenges:
• Rise of Asian economies will make the US-centric IMF
approach obsolete. “The US no longer be the conductor
of the global monetary orchestra”.
• As Asia rises, so will the temptation toward protectionism
in US and Europe. The financial crisis will be more global
and more intricate.
• There will be regional currencies. The currencies of
many small countries will be cancelled.
• Ecological shocks, earthquakes, global warming, new
viruses like AIDS, will require new insurances, globally.
Floating exchange rate system
After US “closed the gold window”, that is it is no
longer exchange gold for the paper dollars held
by the foreign banks, there was a shock in the
currency exchange markets.
There were two attempts to have new sets of fixed
currency exchange rates; one in December
1971, and the other in February 1973.
In both cases, speculators, banks, businesses,
and individuals believed that the central banks
had pegged the rates incorrectly, and they were
right.
Floating exchange rates since 1973
• Oil crisis in 1973
• Oil crisis in 1979
• Rapid fall of US dollars against German marks
(1985-1987) and against Japanese yen (19931995)
• Financial crisis in Europe in 1980’s
• South Eas Asian financial crisis in 1996-1998
• Russian crisis in 1998
• Financial crisis in US and Turkey 2001
• Global financial crisis that started in 2008
Fixed currency exchange rates
They are rates that governments agree on and
undertake to maintain.
Floating currency exchange rates are rates that
are allowed to float against other currencies and
are determined by market forces.
Jamaica Agreement established the rules for the
floating system in 1976. It allows for flexible ERs
among the IMF members, while allowing CB
operations in the money markets to smooth out
volatile periods. Gold was demonetized.
Current currency arrangements
IMF recognized three types of currency exchange
arrangements, later they were extended to eight. The
first three were;
1. Free (clean) float – It is closest to perfect competition,
because there is no government intervention and large
amounts of various monies are being traded by
thousands of buyers and sellers.
2. Managed (dirty) float – Governments intervene in the
currency markets as they perceive that national
interests to be served.
3. Fixed peg – A country pegs the value of its currency at
a fixed rate to another currency.
Eight categories of exchange rate
arrangements by IMF
• ER arrangements with no separate legal tender
– is where a country adopts the currency of
another country or a group of countries. Eg. US
dollar in Panama, El Salvadore, and Ecuador.
• Currency board arrangements – describe a
legislated committment to exchange domestic
currency for a specific foreign currency at a fixed
rate. The currency board arrangement committs
the government to hold foreign currency
reserves equal to its domestic currency supply.
Eg. Estonia tied its kroon to euro, in Hong Kong
the Hong Kong dollar is tied to the US dollar.
Continued...
• Other conventional fixed peg arrangements –
describe a peg in which there is a fixed rate
relationship and ER fluctuations are allowed
within a narrow band of less than one percent.
Eg. The Saudi Riyal is pegged to the US dollar
in this way.
• Pegged ERs within horizontal bands - describe
pegged arrangements in which the ER
fluctuations are allowed to be more than 1
percent around a central rate. Eg. Denmark’s
krone is pegged this way to euro.
Continued...
• Crawling pegs – describe arrangement in which
currency is readjusted periodically at a fixed,
preannounced rate or in response to changes in
the indicators. Eg. Bolivia, Costa Rica, and
Tunisia operate this way.
• ERs within crawling pegs – describe fluctuating
margins around a central rate within which the
currency is maintained and adjusted periodically.
Eg. Romania.
Continued...
• Managed floating with no preannounced path for
the ER – describes a monetaru authority that
actively intervenes on the ER market without
specifying or making public its goals and targets.
Eg. Algeria, India, Malaysia, and Singapore.
• Independently floating ERs – is an approach that
relies on the market. There may be
interventions, yet they are conducted to
moderate the rate of change rather than to
establish the currency’s level. Eg. US, Mexico,
Canada, and the UK.
Number of countries in each
approach
Exchange arrangements with no separate tender
Currency board arrangements
Other conventional fixed programs
Pegged exchange within horizontal bands
Crawling pegs
ERs within crawling pegs
Managed floating with no pronounced path
Independently floating
41 countries
7
“
40
“
5
“
6
“
2
“
50
“
36
“
Floating currencies
Floating currencies can move against one
another quickly and in large swings.
Such changes have many causes such as;
• Political events
• Expectations
• Government policies
• Trade imbalances and deficits
• Inflation rate
Financial Forces
Fluctuating currency values
In the post-Bretton Woods monetary system,
floating currencies fluctuate against
eachother. At times, central banks
intervene in the FX markets by buying and
selling large amounts of currency to affect
the supply and demand of a particular
currency.
Fixed versus Floating
Exchange Rates
Question: Which is better – a fixed exchange rate
system or a floating exchange rate system?
• Disappointment with floating rates in recent
years has led to renewed debate about the
merits of a fixed exchange rate system
The Case for Floating
Exchange Rates
•
A floating exchange rate system provides two
attractive features
1. monetary policy autonomy
2. automatic trade balance adjustments
The Case for Floating
Exchange Rates
1. Monetary Policy Autonomy
• The removal of the obligation to maintain
exchange rate parity restores monetary control
to a government
• In contrast, with a fixed system, a country's
ability to expand or contract its money supply
is limited by the need to maintain exchange
rate parity
The Case for Floating
Exchange Rates
2. Trade Balance Adjustments
• The balance of payments adjustment
mechanism works more smoothly under a
floating exchange rate regime
• Under the Bretton Woods system (fixed
system), IMF approval was need to correct a
permanent deficit in a country’s balance of
trade that could not be corrected by domestic
policy alone
The Case for Fixed Exchange Rates
•
A fixed exchange rate system is attractive
because
1. of the monetary discipline it imposes
2. it limits speculation
3. it limits uncertainty
4. of the lack of connection between the trade
balance and exchange rates
The Case for Fixed Exchange Rates
1. Monetary Discipline
• Because a fixed exchange rate system
requires maintaining exchange rate parity, it
also ensures that governments do not expand
their money supplies at inflationary rates
2. Speculation
• A fixed exchange rate regime prevents
destabilizing speculation
The Case for Fixed Exchange Rates
3. Uncertainty
• The uncertainty associated with floating
exchange rates makes business
transactions more risky
4. Trade Balance Adjustments
• Floating rates help adjust trade
imbalances
Who is Right?
•
•
•
There is no real agreement as to which system
is better
History shows that 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
The euro (€)
The euro (€) is the currency of the European Monetary
Union (EMU).
The agreement to move to a common currency, the
Maastricht Treaty, was signed by the EU members in
1991 with the target date of 1999. They tried to
harmonize their economies through disciplining budget
deficits, public debt, and ERs.
The monetary control was handed to an EU institution;
European Central Bank (ECB). The euro started
circulating (2002) in Austria, Belgium, Finland, France,
Germany, Ireland, Italy, Luxembourg, the Netherlands,
Portugal, and Spain. Greece joined later. UK, Sweden,
and Denmark did not join the euro zone.
Benefits of euro
• It reduces transaction costs for conducting
business within the zone
• Eliminates ER fluctuation risks
• Businesses focus on Europe rather than
domestic national markets.
Balance of Payments (BOP)
BOP is a record of country’s transactions with the
rest of the world. BOP data is important
because;
• It shows the demand for a country’s currency.
If
X > I, demand will be high.
If
I > X, demand will be low.
• It helps managers to predic what sort of changes
in the economic environment might develop in
the economy.
BOP major accounts
1.
2.
3.
4.
Current account
a. Goods or merchandise account
net trade account balance
b. Services account
c. Unilateral transfers
net current account balance
Capital account
a. Direct investments
b. Portfolio investments
c. Short-term capital flows
net capital account balance
Official reserves account
a. Gold imports and exports
b. Foreign exchange held by the government
c. Liabilities to foreign CBs
net official account balance
Discrepencies
Current account
Net changes in imports and exports of goods and
services.
a. Goods or merchandise account – Shows the
imports and exports of tangibles.
b. Services account – Shows the imports and
exports of intangibles
c. Unilateral transfers – shows the transfers with
no reciprocity (gifts, aid, migrant workers’
earnings). To satisfy the need for double-entry
accounting, entry made that treats the aid or gift
as purchase of goodwill.
Capital account
Net changes in a nation’s international financial assets and
liabilities; credit entry occurs when residents sell
stocks, bonds, or other financial assets to nonresidents. Money flows to resident, while resident’s LT
international liabilities (debit entry) increase.
a. Direct investment – located in one country and
controlled by the residents of another country.
b. Portfolio investment – LT investments without control.
c. Short-term capital flows – such as currency exchange
rate and interest rate hedging in the forward, futures,
option, and swap markets, volatility and transaction
privacy makes this entry the most unreliable measure.
Official reserve account
Net international transactions of the CB.
a. Gold imports and exports – if it is done
by the government.
b. Foreign exchange held by the CB –
Foreign currency portfolio held by the
government.
c. Liabilities to foreign CB – CB borrowing
and/or lending.
Net descrepencies
Net difference between the debits and
credits.
The difference show the BOP surplus or
BOP deficit.
Deficits and surpluses in BOP
accounts
Take the example of the US.
US has a huge deficit in the current account (1.5
trillion in 2009) meaning that US is importing
much more than it is exporting. Yet US is
exporting more services than it is importing.
Moreover, US has a surplus in the capital account
meaning foreigners are buying US bonds,
stocks, property in the New York City (Arab
investment in US agriculture and Japanese
investment in real estate, eg).
Temporary and Fundemental BOP
Deficits
• Temporary BOP deficit is the one that can be
corrected by country’s monetary and fiscal
policies.
Monetary Policy → regulate the amount of growth
or contraction of a nation’s monetary stock.
Fiscal Policy → regulate government revenues
and government payments through taxes and
expenditures.
Temporary and Fundemental BOP
Deficits
• Fundamental BOP deficit is too severe to
be repaired by any monetary and fiscal
policies the country can apply; there are
economic, political and social limits as to
how much a country can deflate its
economy which causes unemployment, or
devalue which causes higher prices for
imports.
Currency Areas
Current developments made the
growth of currency areas, trading
blocks and currency blocks likely.
The most important development
was the circulation of euro in the
EU.
Money Markets and Foreign
Exchange
Money markets are places where moneys
can be bought, sold or borrowed. Since
some currencies started floating freely in
1973, the daily volume of foreign exchange
trading grew rapidly.
After the 2001 crises the growth slowed
down.
Growth slowed down
Because:
• The onset of EMU stopped the trade between EU
member countries, because 17 of them adopted euro.
• Central banks ceased targeting unrealistic exchange
rates. In the early 1990’s traders made billions
speculating on the exchange rates.
• Expectations were better about the rates because of the
electronic media and information system.
Financial Forces
Historically, US dollar was used as the main central reserve
asset after 1945.
What makes a currency an international reserve asset?
• It should be a vehicle currency (transaction currency), so
that the country can use the currency for international
trade and investments,
• it should be an intervention currency, so that the central
bank can use it to intervene in local and international
capital markets, and foreign currency exchange markets,
• it should be a safe heaven, so that it should not lose its
value.
Foreign Exchange
Reciprocal currency - In the FX, generally US
dollar is used as the base currency, a currency
that is quoted as dollars per unit of currency
instead of in units of currency per dollar; also
known as direct quote.
Spot rate – The exchange rates between two
currencies for delivery within two business days.
Forward rate – The exchange rate between two
currencies for delivery in the future, usually 30, 60,
90, or 180 days.
Foreign Exchange
Forward currency market – Trading market for
currency contracts deliverable 30, 60, 90, or 180
days in the future.
Bid price – Highest priced buy order that is
currently in the market.
Ask price – Lowest priced sell order that is
currently in the market.
The difference between the two prices, the bid-ask
spread, provides a margin for the bank or agency.
Foreign Exchange
The foreign exchange markets are large,
liquid and quite competitive with 24-hour
trading through international banks.
They are unregulated.
«They are Wild West of global capitalism»
They operate with no government or other
type of regulatory oversight.
Causes of exchange rate
movements
• Supply and demand forecasts of for the two
currencies
• Relative inflation in the two countries
• Relative productivity and unit labor cost changes
• Political developments; such as expected
election results
• Expected government fiscal and monetary
policies, and currency exchange market actions
• BOP accounts
• Psychological aspects
Law of one price
It argues that similar products will have
similar prices in efficient markets. If
price differences exist, the process of
arbitrage (buying and selling to make a
profit with no risk) will quickly close any
gaps and markets will be back at
equilibrium.
Fisher Effect
It is the relationship between real and nominal
interest rates: The real interest rate will be the
nominal interest rate minus the expected rate of
inflation.
rr = (rn) – I
Thus an increase in the expected inflation rate will
lead to an increase in the interest rate.
International Fisher Effect
It states that the interest rate differentials for
any two currencies will reflect the expected
change in their exchange rates.
For example, if the nominal interest rate in
US is 5%, and in EU it is 3%, we expect that
the value of US dolar to decrease by 2%
against euro, or the value of euro to
strengthen against dollar by 2% in that year.
Purchasing Power Parity
It shows the number of units of a currency required to buy
the same basket of goods and services in the foreign
market that one dollar would buy in the US or other home
market. It argues that the cost of goods in the US should be
equal the cost of these goods time the exchange rate
between the two currencies.
£P ($/£) = $P
Similarly, the ratio of the exchange rates of the two
countries will be equal to the prices of the two basket of
goods in the two countries. It is also called the Big Mac
index, assumning that the price of Big Mac should be equal
in the two countries if the exchange rate differences are
neutralized.
Exchange Rate Forecasting
There are three main approaches to
exchange rate forecasting:
1.Efficient market approach
2.Fundamental approach
3.Technical analysis
1) Efficient Market Approach
It assumes that current market prices fully
reflect all available relevant information. It
suggests that forward exchange rates are
the best predictors of the future spot rates.
It also assumes random walk hypothesis.
Random walk hypothesis assumes that the
unpredictability of factors suggests that the
best predictor of tomorrow’s prices is today’s
prices.
2) Fundamental approach
It is the exchange rate prediction based on
econometric models that attempt to capture
the variables and their correct relationships.
This approach gives importance to
surveying firms and advising firms.
3) Technical Analysis
It is an approach that analyzes data for
trends and then projects these trends into
future.
The past experience show that fpreign
exchange traders use this method more
than the others.