International Monetary System

Prof Mahesh Kumar

Amity Business School
profmaheshkumar@rediffmail.com
Introduction
 Problems of international trade relate to:
1. Liquidity
2. Adjustment
3. Stability
 Liquidity is necessary to finance transactions
that are done on cash basis.
 Adjustment is needed to bridge the gap that
emanates because of imbalance between
demand and supply at existing exchange rates.
 Stability is necessary with intent to limit the
degree of uncertainty in international business
decisions.
Introduction
 International Monetary System addresses itself
to provide mechanisms where all interacting
nations agree to certain modus operandi to find
solutions to common problems.
Evolution of International Monetary System

 IMS has grown over a period of time and has

successfully tackled periods of stresses and
strains.
 It has passed a period of transition from the
system of fixed exchange rates to the system of
floating rates.
Evolution of International Monetary System
Gold Exchange Standard
 Gold Exchange Standard was first major step
towards establishment of IMS in 1850.
 The participants were UK, France, Germany and
USA.
 In this system each currency was linked to a
weight of gold.
 The system was institutionalized at the
Conference of Genes in 1922.
 Since gold was convertible into currencies of the
major developed countries, Central Banks of
different countries either held gold or currency
of these developed countries.
Evolution of International Monetary System
Gold Exchange Standard
 This system failed after the Conference of Genes in
1922 due to
a) Tremendous speculative activity accompanied by
economic crisis in 1929.
b) High inflation in Germany.
c) Protectionism following the crisis of 1929.
d) Competitive devaluations for providing impetus to
exports. (Beggar-Thy-Neighbor Devaluations: A
devaluation that is designed to cheapen a nation’s
currency and thereby increase its exports at other
countries expense and reduce imports . Such
devaluations often lead to trade wars.)
e) Finally the Second World War.
The System of Bretton Woods (1944-71)
 A conference was held at Bretton Woods in the
USA in July 1944 to put in place a new IMS.
 The major objectives of Bretton Woods were:
1. To review the existing rules.
2. To devise a system to encourage international
monetary co-operation.
3. To establish an international institution to
ensure good functioning of the system.
The System of Bretton Woods (1944-71)
 Main characteristics of IMS developed at Bretton
Woods were:
1. Fixed rates in terms of gold (i.e. a system of
gold standard), but only the USD was
convertible into gold as the USA ensured the
convertibility of dollars into gold at international
level.
2. A procedure for mutual international credits.
The System of Bretton Woods (1944-71)
3. Creation of International Monetary Fund (IMF) to
supervise and ensure smooth functioning of the system.
Countries were expected to pursue economic and
monetary policies in a manner so that fluctuations of
currency remained within a permitted margin of + 1
percent. In other words, the central bank of every country
had to intervene to buy or sell foreign exchange
depending on the need.
4. Devaluations or Revaluations of more than 5% had to be
done with the permission of the IMF. This measure was
necessary to avoid chain devaluations like the one which
occurred before the Second World War.
International Monetary Fund (IMF)
 IMF had 44 countries as its members in 1946.
 Currently almost all the countries (181) are
members of IMF. The only exception is Cuba.
 The main functions of IMF are:
1. To help member countries in stabilizing their
currency.
2. To supervise the evolution of exchange rates
and to provide guidance to countries on their
exchange rate policies.
3. To accord temporary financing to tide over BoP
difficulties.
International Monetary Fund (IMF):
Resources
 The capital of the IMF is constituted by the totality of the
subscriptions of the member states known as quotas.
 These quotas are determined as per the economic
importance of each country reflected/measured in terms
of national income, exports etc.
 Since 1970, a new instrument of reserve has been
created, namely SDR (Special Drawing Right).
 The value of SDR represents a weighted average of 5
currencies, that is, the US Dollar (40 percent), German
Deutschmark (21 percent), UK Pound Sterling (11
percent), French Franc (11 percent) and Japanese Yen
(17 percent). These weights reflect the relative strength
of economies of these countries.
International Monetary Fund (IMF):
Resources
 The quotas of different currency are paid to the IMF
in ratio of 25% as SDRs and 75% in national
currency.
 IMF also has recourse to loans from member states
to augment its resources. These loans are drawn in
SDRs.
 Also, under the General Agreement to Borrow (GAB)
signed by the Group of Ten (also known as Paris
Club consist of 10 industrialized countries: Belgium,
Canada, France, Germany, Italy, Japan, the
Netherlands, Sweden, the UK and the USA), the IMF
can borrow in order to have supplementary
resources in convertible currencies.
International Monetary Fund (IMF):
Activities
 Pre requisites of good functioning of IMF
requires:
a) Appropriate adjustment mechanism.
b) An attentive surveillance policies adopted by
member states relating to the exchange rate.
International Monetary Fund (IMF):
Activities
 Member countries have an absolute claim on the
IMF up to the amount of gold subscriptions they
have made. In operational terms, they can draw
this amount (equal to 25% of their quota) from
IMF anytime. This is called reserve tranche (or
gold tranche) and is treated as the reserve of
the country concerned. This amount is to be
reimbursed to IMF within a specified period
varying between 3 months to 5 years.
International Monetary Fund (IMF):
Activities
 Beyond 25%, a country can draw upon its credit tranche:
the additional credit the IMF can grant. The credit tranche
consists of amount of drawings beyond the reserve or gold
tranche that would raise the Fund’s total holding of that
country to 200 percent of the quota (raised to 400 percent
in special cases). Approval from IMF is necessary for a
country to draw on its credit tranche. The approval comes
with restrictions which become increasingly tight as the
credit amount increases. This is in consonance with the
general principles of finance where the lender (IMF) will
like to be assured of security and repayment of sum so
lent along with interest (if charged)
 The temporary credit is used more often to finance
temporary disequilibrium in balance of payments than to
provide temporary liquidity.
International Monetary Fund (IMF):
Activities
 Besides the reserve (or gold) and credit tranche; the IMF
has three permanent credit facilities:
i. The compensatory financing facility (established in 1963
and liberalized in 1975)
ii. The buffer stock financing facility (established in 1969)
iii. The extended facility (established in 1974 & expanded in
1983)
 There are other temporal facilities created in response to
specific needs such as oil price increases, and the Special
Emergency Fund created by General Agreement to Borrow
(GAB)
International Monetary Fund (IMF):
Activities
 Apart from the credits advanced by the IMF, it gives
technical aid as well to its member countries.
 The IMF exercises a firm surveillance on the exchange rate
policy of the member states and adopt specific principles to
guide them.
 In order that the system of exchange rate be effective, the
Fund recommends adoption of an anti-inflationary policy.
 Over the past years, in many countries, the budget deficit
had become very high which resulted in a heavy external
debt. Serious problems of adjustment were a natural
consequence of such a situation. The Fund had to incite the
countries to put in place exchange rate policies compatible
with an overall medium strategy of adjustment.
International Monetary Fund (IMF):
Activities
 The member states have adopted an exchange
rate policy, varying from free floating to pegging
to a single major currency.
 There is no, or very little, government
intervention to maintain an exchange rate in the
case of completely floating currencies.
Ex: the USA, Canada and EMS as a group, are
the examples where currency floats without any
intervention. Among the currencies participating
in the EMS, a system of fixed rate exists,
fluctuation being possible within a permitted
range.
The International Bank for Reconstruction
and Development (The World Bank)

 Created at the time of creation of IMF.

 Initially its principal role was to facilitate the
reconstruction of countries affected by the
Second World War and to aid these countries
develop their economies.
 IBRD has two other associated institutions:
1. International Finance Corporation (IFC) est. in
1956.
2. International Development Association (IDA)
est. in 1960.
The Role of the IBRD
 It provides long term debt financing for periods
up to 15-20 years.
 Financing is done for
1. The development of infrastructure such roads,
rail, telecommunication.
2. The development of energy resources,
electricity, gas and petrol.
3. The regional development programs, irrigation
projects, agriculture development, education
and the projects to promote investments in
small and medium enterprises.
The Resources of the IBRD
 Every member country subscribes to the fixed capital of
the Bank. Member’s share is payable in two parts:
a) The first corresponds to a deposit of 10 percent- 1
percent payable in gold or US dollars and 9 percent in
national currency.
b) The second corresponds to a deferred deposit of 90
percent. This represents a commitment to respond to the
eventual needs of the Bank.
 The bank can also issue bonds on principal financial
markets. Bonds are issued either in US dollars or in
currency of some other countries. Duration of these bonds
varies from 6 to 35 years.
Affiliated Institutions: IFC ( International
Finance Corporation
 Role to engage private sector in developing
countries.
 It lends without government guarantees and
may participate in the capital creation of certain
institutions.
 Loan period may vary from 5 to 15 years.
 Interest rates conform to that of the market.
Affiliated Institutions: IDA (International
Development Association)
 Lends to the poorest countries, with conditions
that do not weight heavily on the balance of
payments.
 Loans mostly are for a period of 50 years.
 Rate of interest is very low or nil.
 Loans are refused in the currency of the
borrowing country.
 Credits of the IDA are accorded only to the
government.
The IMS since 1971
 Difficulties for the system of Bretton Woods started from
1958 when 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. Anticipating a devaluation of the US dollars,
speculator bought gold while other governments
demanded conversion of US dollars into gold.
 To solve the problem, a ‘gold pool’ was established with
the co-operation of the UK , France, Germany, Italy,
Belgium, the Netherlands & Switzerland. The gold pool
was used to sell gold to maintain its price at $35 per
ounce. In return, the USA was expected to improve its
external trade.
The IMS since 1971
 Since the US could not reduce its trade deficits, some of
the European countries started demanding again for
conversion of their dollar holdings into gold. Finally the
‘gold pool’ arrangement broke down. Eventually a series
of devaluations & speculations led to the breaking down of
the fixed rate system of Bretton Woods.
 On 15th August 1971, President Nixon of USA suspended
the system of convertibility of gold and dollar.
 For sometime, the system of fixed rates with an
adjustment margin of + 2.5% was tried but did not work.
Finally the fixed rate system was abandoned and floating
rate system came into effect.
The IMS since 1971
 In December 1971, the Smithsonian Agreement
was signed at Washington; its major features
were:
1. Devaluation of the dollar and revaluation of other
currencies; gold passed from $35 per ounce to
$38.
2. New fluctuations margins: changing from +1% to
+2.5%.
3. Non convertibility of dollar.
 In 1973, another devaluation of the dollar took
place. Petrol shock added to the international
monetary crisis. Exchange rates became volatile.
The IMS since 1971
 In 1976, Jamaica Agreements were signed
focusing on the:
1. Legalization of the floating exchange rate.
2. Demonetization of gold as the currency of
reserves.
 Thus, the part of quota which was hitherto
required to be deposited in gold could be
deposited in foreign exchange. At the same
time, IMF sold one third of its gold reserves.
The IMS since 1971
 In 1977 & 1978, in the wake of inflation in the USA, the
dollar further depreciated. The Federal Reserve practiced
a strict monetary policy. Between 1980 and 1985, the
dollar appreciated but at the same time American BoP
situation deterioted.
 The changes that took place in East Europe at the end of
1980s led to the creation of several new currencies.
Besides, adoption of the system of market economy by a
large majority of countries the world over had important
repercussions on the international financial scene.
 Now the member of G-7 (Canada, France, Germany, Italy,
Japan, the UK and the USA) meet from time to time to co-
ordinate the policies so that the exchange rate stability
can be maintained. Their meeting has an effect of
avoiding protectionist tendencies on the part of any one
or more of them.
Different Exchange Rate Regimes
The IMF classifies exchange rate regimes in
four categories:
1. Regime of fixed exchange rates
2. Regime of free floating exchange rates.
3. Regime of managed floating rates.
4. Regime of limited flexibility.
Regime of Fixed Exchange Rates
 In this system, a currency is pegged to a foreign currency
with fixed parity.
 The rates are maintained constant or they may fluctuate
within a narrow range.
 When a currency tends crossing over the limits,
governments intervene to keep it within the band.
 A country pegs its currency to the currency of the country
in which the major foreign transactions are carried out.
 Some countries peg their currencies to SDR.
 The currencies to which many other currencies are
pegged are:
1. USD (24 currencies)
2. French Franc (14 currencies)
3. SDR (4 currencies)
Advantages and Disadvantages of the
Fixed Rate System
 It provides stability to international trade.
Commercial transactions take place without any
worry about exchange rate risk.
 The disadvantage of the system is speculation
e.g. A speculator anticipating devaluation of the
pound sterling will buy USD at forward so as to
sell them when devaluation of pound takes place
on future date.
Regime of Floating Exchange Rates
 In the regime of floating exchange rates, adjustment
takes place on the market as a function of free play of
demand and supply.
 Sometimes central banks do intervene to avoid high
volatility of exchange rates.
 Different variants of this regime are:
• Regime of freely floating rates.
• Regime of managed flexibility.
• Regime of flexibility, adjusted according to a series of
indicators.
• Regime of limited flexibility according to certain
agreement (e.g. European Union Exchange Mechanism)
Advantages and Disadvantages of the
Floating Rate System
Advantages:
 Possibility of speculation is reduced because the central
bank is not responsible to ensure as to what future rate
should be. A speculator is exposed to greater risk, and
therefore, will indulge in it less often.
 Central Bank of the country is not required to maintain
large reserves to defend the currency.
Disadvantage:
 Since one is not in a position to anticipate with any
degree of accuracy as to what is going to happen in
future, a trader is continuously exposed to foreign
exchange risk. As a result, one has to take recourse to
different techniques of exchange rate risk management.