1

Evolution of the Foreign Exchange Market

1.1 INTRODUCTION
The movement of money and capital between countries arising out of financial transactions and
cross-border trade is the origin of foreign exchange business. All claims of foreign currency pay-
able abroad, whether consisting of monies held in foreign currency with banks abroad, or bills or
cheques in foreign currency and payable abroad, are termed foreign exchange.
In line with the growth of international trade and the progressive liberalisation of capital
movements by countries, the volume of foreign exchange business grew tremendously during the
Sixties and the early Seventies of the previous century. The gradual move by several countries
from fixed or pegged rates to partial or full float also helped to increase volumes.
The evolution of the present monetary system and growth of the global foreign exchange
market have a chequered history. In this chapter we will touch upon the milestones and introduce
the historical aspects as briefly as possible.

1.2 THE GOLD STANDARD

1.2.1 Background
The development of the foreign exchange market in its present form can be traced back to
around the mid-1850s. Around that time, bimetallism (using gold and silver) gradually gave
way to a monetary system using gold alone.
The history of the foreign exchange market was a story that virtually ran parallel to the
history of the US currency. The US Dollar was established in April 1792 under the Mint Act of
the US. Its supremacy in international finance can be traced to the post-Great Depression days
and the introduction of the fixed exchange rate system. It was at that time that the US Dollar
was set to be made freely convertible to gold at the fixed rate of $35 to a troy ounce. The main
characteristic of the Gold Standard was that it was based on the system of fixed exchange rates,
exchange rates parities being set against gold as the reference value. Two main types operated
under the Gold Standard, viz., Gold Specie Standard and the Gold Bullion Standard.

1.2.2 The Gold Specie Standard

For the Gold Specie Standard to work efficiently, four main conditions had to be operating.
They were as follows:
2 Fundamentals of International Banking

1. The central bank of the country concerned had to back the currency, promising to buy or
sell the metal in unrestricted amount at the price fixed;
2. Extending this reasoning, a person who possessed gold could approach the State mint and
have the right to have coin struck from gold, whatever the amount;
3. By the same reasoning, he could also melt the gold as and when he wished to do so;
4. Gold could be freely imported and exported.
Under the arrangement described above, the face value of gold and the value of the coins
struck were thus always the same. Obviously, the supply of gold determined the liquidity and
consequently its value.

1.2.3 Gold Bullion Standard

Under the Gold Bullion Standard the metal was not the medium of exchange. Rather, the
medium of exchange (coin or paper currency) was backed by gold as the reserve asset. A country
thus could have more money in circulation than the actual quantity of gold that it held in the
State mint or with the central bank. Depending on the credibility of the currency in circulation,
the monetary authorities could print more paper currency than the amount of gold held as
physical asset or currency equivalent.

1.3 THE FIRST WORLD WAR AND AFTER

During this period, the demand for finance to meet the war efforts forced the monetary authorities
of countries to print more money than could be supported by the gold available in the respective
treasuries. Many countries printed more paper currencies than the relative growth of production
of goods and services, i.e. of its Gross Domestic Product (GDP), resulting in
increased inflation and resultant decline in value of the currency reflected by one or more
devaluations forced on the country(ies) concerned. International parities in prices received a
serious set-back, resulting eventually in massive devaluations, corrections, and further devaluations.

1.3.1 Introduction of Exchange Control

Inflation, devaluation and parity correction put tremendous pressure on the international monetary
systems and the economy of several countries. To counter the resultant adverse effects and the
shock waves, from 1931 onwards, several countries introduced exchange control in one form or
another. The primary objective was to regulate and control the outflow through setting out of
priorities in spending of available foreign exchange in order to preserve the stock of foreign
exchange within the country.
When the Second World War broke out, those countries that had not till then introduced
exchange control, were forced to do so.

1.3.2 US Dollar as World’s Reserve Currency

The strength of the US economy rose further after the end of the Second World War as the US
single-handedly began to restructure the war-shattered world economy, especially in Europe and
parts of Asia. The US helped the world with finance, technology, goods and services – most of
 Evolution of the Foreign Exchange Market 3

which came in the shape of the US Dollar. This is one reason why the US currency virtually
became the most common currency throughout the world.
With the US becoming the only net creditor country in the world (the UK, which had
wielded unquestioned power, had by then become a net debtor country), the dollar emerged as
the only international reserve currency worldwide.

1.4 THE BRETTON WOODS CONFERENCE

In 1943, the USA and Great Britain took initiatives to create a free, stable and multilateral
monetary system which, these countries hoped, would be able to neutralise the after-effects of the
two World Wars. The Bretton Woods Conference in July 1944 was the first step in this direction.
At the Conference, it was also decided to set up the International Monetary Fund (IMF).
The objectives of the IMF were mainly to establish an international monetary system based on
stable exchange rates, to eliminate the regime of exchange controls, and to bring about the
convertibility1 of all currencies. Through these laudable objectives, a much-needed monetary
regime was sought to be brought about by the member countries. The IMF was entrusted with
the task of nudging the world towards them, and also to monitor the new system.

1.4.1 The Bretton Woods System – Fixed Parity

In order to achieve a stable exchange rate within a fixed range of permissible parity fluctuations,
each member of the IMF fixed a parity for its currency relative to the gold or the US Dollar. The
concept was very similar to the Gold Standard of yore.
It was agreed that to avoid unjustified devaluations no member would change its parity
without the approval of the IMF. The IMF was not supposed to withhold approval if the change
did not exceed 10 per cent. A credit fund, called the Ordinary Drawing Rights (ODR), was
simultaneously created to help countries with balance of payment difficulties. The arrangement
was to prevent them from taking recourse to sudden exchange rate changes, or imposing
restrictions on payments or trade to tide over their difficulties.

1.5 THE 1950s AND THE 1960s

1.5.1 Creation of OECD
In 1950 the European Payments Union (EPU) was founded as part of the external trade policy
of the European Economic Cooperation. In 1961 it was renamed as the Organisation for
Economic Cooperation and Development – the OECD.
The system introduced at the Bretton Woods Conference passed through turbulent times
during the next 25 years, but survived. A wave of devaluations occurred in September 1950. The
French Franc was devalued by 14.90 per cent in 1958.

1
Convertibility means freedom to convert home currency into foreign currency and vice versa. In a ‘full convertibility’ regime
no restriction whatsoever is imposed. In a ‘partial convertibility regime’ restrictions are imposed in a selective manner.
4 Fundamentals of International Banking

1.5.2 The Bretton Woods System under Strain

Since the early 1960s, however, the system came under great pressure. The very act – conversion
of dollar into gold at fixed price – that was supposed to maintain stability in the foreign exchange
market became its Achilles heel. The USA faced a massive balance of payments problem of
around US$ 11 billion during 1958–60. That started a run on gold. The difference in the GDP
growth rates of the member countries also put pressure on the par values. The Deutsche Mark
(DM) and the Dutch Guilder were revalued in March 1961 consequent to large balance of
payment surpluses. After three years of dogged defence, the British Pound had to be devalued in
1967, which again triggered a run on gold. This forced the central banks to abandon the gold
pool that they had created earlier.
The French Franc was devalued once again, now by 11.1 per cent, mainly as a result of
social unrest that triggered a serious depletion of France’s currency reserves. On the other hand,
massive inflow of capital into the German economy forced its central bank to allow its currency
to initially float and later, on 27 October 1969, to be revalued by 9.3 per cent. The exchange rate
parity and the fixed band systems conceived under the Bretton Woods system thus came under
severestrain.
[The rationale behind such massive flow of funds across international borders, and the
asymmetry that prompts such movements, have been explained in Chapter 15. It would help the
reader to better understand these developments if he makes a simultaneous reference to ‘Why
exchange rates fluctuate’ and the ‘Factors affecting exchange rates’,2 while perusing this chapter.]

1.6 END OF GOLD CONVERTIBILITY OF THE USD

1.6.1 USA abandons Gold-Dollar Convertibility
The early 1970s saw the loss of confidence in the US Dollar caused by chronic balance of
payments problem faced by the USA. Severe dollar crisis was sparked off by sharply declining
interest rates and the spike in the balance of trade deficit caused by the Vietnam War. Capital
moved from low interest regime in the US to high interest rate regions in Europe. Switzerland
and Austria revalued their currencies; Germany and Holland allowed theirs to float.
August 1971 again witnessed massive flight of capital from the USA, which grew in a few
days to several billion, finally forcing the country to abandon dollar-gold convertibility. As a
result, most other countries also let their currencies float, thus officially ending the official parities
and exchange rates regime prescribed under the Bretton Woods System.

1.6.2 Demise of the Bretton Woods System

At the Monetary Conference held on 17 and 18 December 1971, the USA, within the framework
of The Smithsonian Agreement, undertook to raise the official price of gold from US$ 0.35 to
US$ 0.38 per ounce. The US$ thus stood devalued by 7.9 per cent. Japan and the European
countries revalued their currencies by up to 7.66 per cent. However, since the

2
Refer to Chapter 15, Sections 15.3 and 15.4 respectively.
 Evolution of the Foreign Exchange Market 5

fundamentals were all wrong, the Smithsonian Agreement did nothing to restore the dollar’s
convertibility into gold.
Capital started moving once again from early next year. In June 1972 the British Pound
came under heavy pressure and was forced to be ‘floated’. Some of the European countries tried
their best to stem the inflow of capital. Nothing worked. Italy and Switzerland came under
pressure in January 1972. On 13 February 1973 the USA finally devalued its currency (once
again) by raising the official price of gold from US$ 0.38 to US$ 42.22 per ounce. Immediately
thereafter, Switzerland and Japan revalued their currencies. But that did nothing to stop the
inflow of capital. Finally, in March 1973 Japan and the European hard-currency countries threw
up their collective hands, and suspended their obligations (of limiting rate fluctuations within
the IMF prescribed limits) to the IMF to ‘manage’ the exchange rates.
The Bretton Woods System with its fixed exchange rates and fluctuation bands was
effectively abandoned and finally buried.

1.7 FLOATING RATE SYSTEM

The alternate to the fixed rate system was, obviously, the floating rate system. Although
considered a temporary measure, rise in international prices of oil and recession (among others)
ensured the continuity of the floating rate system. A revision of Article IV of the IMF statute in
January 1976 legalised the foregoing. This allowed each member country to decide whether it
could adopt a fixed or a flexible exchange rate system.
It was expected that after an initial period of fluctuations the exchange rates would reach
a state of equilibrium relative to one another. However, owing to the continual changes in global
economic and political factors, exchange rates continued to remain volatile. (They continue to
defy all predictions even to this day.)
During 1978 and 1979 the US Dollar had become extremely soft and had to be saved with
the help of a rescue plan mounted by the Federal Reserve Board of the USA, by borrowing
currencies worldwide to support its exchange rate in the foreign exchange markets against the
different currencies. Towards the end of 1979 and from the beginning of 1981 the US regained
much of its losses against the major currencies. However, during the early 1980s the Japanese Yen
and the German DM began to give tough competition to the dollar as a currency of choice in
global finance.

1.7.1 Exchange Rates: Managed Floats

Rate volatility affects factors of growth, and has direct bearing on a country’s economy. Most
countries, therefore, were not prepared to leave the exchange rate fluctuations entirely to the
market forces, and so imposed ‘controlled floating’ or ‘managed float’ in one form or another.
These arrangements – some overt and some covert – had many labels. A few countries went to
the extent of ‘pegging’ their currencies to another principal currency, for better or worse – in
some instances with disastrous consequences. (An example of this effect is the South-East Asian
currency melt down in general, and the slide of the Indonesian currency in particular.)
Whether ‘flexible’, ‘market determined’ or ‘managed’, ‘free floats’ introduced considerable
benefits including autonomy in money supply policies. Artificial exchange rates, including those
induced by inflation, became less of a threat. The floating rate also helped to avoid undue and
unnecessary pressure on external trade balance, balance of payment situation and, therefore, on
6 Fundamentals of International Banking

the general economy of a country. Sudden and uncontrollable shocks to a country’s economy
that often brought quite a few economies to their knees could thus be avoided. It was also
possible to easily calculate the ‘real’ exchange rates by adjusting the ‘nominal’ exchange rates for
the inflation differentials as determined by factoring in consumer prices, wholesale prices and
other relevant factors.

1.8 THE CONTINUING SAGA OF THE US DOLLAR

The US Dollar helped by its Federal Reserve Bank reached its post-1971 peak levels in early 1985
against the DEM and the Japanese Yen. Against the Pound Sterling it approached the one-to-one
parity level. On 6 March 1985 the US$ had reached £1 = $1.055. The market was agog with
widespread anticipation about the anticipated historic event – the possibility of the US$ reach-
ing the ultimate parity of 1 GBP being equal to 1 US$. The world speculated, bookies took huge
bets, and those in the foreign exchange dealing rooms of international banks watched the rate
movement with their fingers crossed. But, as it always happens with the markets, no one could
correctly predict the future movements, and none should have tried.
Under the impact of the strong dollar for almost 50 months beginning from January 1981,
the US global trade position deteriorated as never before. Its exports initially remained static,
and later declined. By 1986 Germany was overtaking the US for the first time as the world’s
largest exporting nation. The US emerged as a net debtor country for the first time since 1913. It
was the largest indebted country in the world, well behind the then largest indebted Third World
countries Brazil and Mexico.3
From September 1985 started the new phase when the G-7 countries agreed to pull down
the US$ to the desired level. The then record lowest closing rate for the dollar against DM at
1.443 and Yen at 120.45 was reached on 19 February 1991 and 4 January 1988, respectively.

1.8.1 Market Intervention

Intervention in the foreign exchange market takes place when the central bank of a country, or
central banks of several countries acting in consort, creates a demand-supply imbalance. They
pump in or withdraw money (a particular currency) from the market in an attempt to push the
exchange rate in a desired direction or correct a perceived imbalance.
During the last week of July 1992, the dollar was rescued with the help of intervention by
15 international banks led by the US Fed (Federal Reserve Bank). During 1978, the direction of
the US Dollar’s exchange rate could be reversed for only less than a fortnight. In November
1979, the duration of influence of intervention lasted about a month or so. The frailty and the
futility of intervention were proved again during late July and early August 1992. The very next
day of intervention, the bearish tone in the dollar re-emerged, although the dollar was not
pushed down too aggressively this time because of the fear of intervention.

3
For an explanation as to how the balance of payment position puts pressure on exchange rates refer to Chapter 15,
Section 15.4.
 Evolution of the Foreign Exchange Market 7

1.8.2 Futility of ‘Intervention’

Intervention has remained confined to ironing out distortions only in the near term. Though
used by the central banks from time to time, ‘intervention’ remains a short-term remedy to a
long-term problem. Ultimately the fate of the currency has to be left to the fundamentals of the
economy and the market perception about the durability of the fundamentals’ recovery or their
downslide. In a nutshell, these factors could be said to be the keys to the future directions of the
exchange rates in the longer term.

1.9 SPECIAL DRAWING RIGHTS (SDR)

The Special Drawing Rights (SDR) were created by the IMF in 1969 to avoid a possibility of
international liquidity crisis among member countries. SDRs are not credits but currency reserves
in addition to the then existing gold and US$ reserves. The quantum of SDRs allocated was
determined by decision of the IMF, the allocation being the same as for the Ordinary Drawing
Rights (ODRs). Originally the value of an SDR was fixed in gold, but later changed to a basket
of currencies – initially sixteen in number, but later (in September 1980) reduced to only five.
The SDR gave its bearer the option to purchase foreign exchange from the central bank of
another (member) country. If a country was faced with a balance of payment crisis, it could
exchange its SDRs for another foreign currency as determined by the IMF and use them to bail
itself out of the crisis.

1.10 EUROMARKET AND EUROMONEY

1.10.1 The Euromarket
The Euromarket is an international financial market where funds are traded in currencies outside
the borders of the respective countries concerned, and free from any sort of interference by the
latter. The market was initially created by countries which hesitated to invest their funds with
banks in the US. Towards the late Fifties, low interest rates on dollar deposits in the US also
prompted the funds to seek greener pastures at higher interest rate havens like the banks in
Europe. The sequence of events reached their climax with OPEC countries parking their huge
income from the sale of oil with banks in Europe.
Since most of these transactions were initially routed through the banks in Europe, the
market that served the investors’ needs was termed as the Euromarket.

1.10.2 The Euromoney

This is the term used for funds that are deployed as short-term borrowing and lending, with
maturities of up to one year. This market helps participants to even out their liquidity, park
excess but short-term funds for interest arbitrage and to manage their foreign exchange
positions.4 The most active players in this market are the international commercial banks,
countries’ central banks, and a few very large multinational companies.

4
These terms have been explained in Chapter 15, Sections 15.11 and 15.12.
8 Fundamentals of International Banking

1.10.3 The European Monetary System

The EC: The European Monetary System (EMS) was established on 13 March 1979 in an effort
to expand the European Community (EC) into a uniform economic and monetary zone, and in
order to bring the currencies of the community on a common platform of economic stability.
The EMS allowed the exchange rates to fluctuate freely within a pre-determined margin.
The relationship between the ten (initially Portugal and Greece did not participate) EC
currencies was separately determined. The ECU’s value was made up of the weighted total of the
bilateral exchange rates of the currencies of the EC. The range within which the parity value
could move was decided in advance. The EC member countries were required to avoid volatility,
and control causes giving rise to steep fluctuations. Because the fluctuations were restricted to
within a given band or range, the exchange rate movements appeared like a snake moving within
a tunnel – equidistant from the median or parity rate but restricted to a pre-determined
percentage band. Thus the origin of the term ‘snake in the tunnel’.
The European Currency Unit (ECU) played an important role in the EMS. It was used as
the reference for the central rates, as the unit of account for inter-member transactions, and to
maintain stability within the European economic zone.
The Euro: The ECU was the precursor to the Euro as we know it today. As of 1 January 1999 the
ECU was replaced by the Euro ( ) at the rate of one Euro to one ECU. With effect from
1 January 2002 the participating nations made total transition from their respective national
currencies to the Euro ( ) and adopted it as their common official currency and the only legal
tender. From that date, the likes of DM, French Franc, Italian Lira, etc., ceased to exist as legal
tender.5
The Euro community has been expanded since its inception, but charting out a not too
easy course of late.

5
A limited transition period was, however, allowed for these currencies to be surrendered in favour of the Euro.