International banking lesson 01

7 International Monetary System LESSON 1 INTERNATIONAL MONETARY SYSTEM CONTENTS 1.0 Aims and Objectives 1.1 Introduction 1.2 International Monetary System 1.3 System of Bretton Woods

5 International Monetary System

UNIT I

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International Banking

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International Banking

7 International Monetary System

LESSON

1

INTERNATIONAL MONETARY SYSTEM

CONTENTS

1.0 Aims and Objectives

1.1 Introduction

1.2 International Monetary System

1.3 System of Bretton Woods (1944-71)

1.3.1 Main Characteristics of Bretton Woods System

1.4 International Monetary System Since 1971

1.5 International Monetary Fund

1.6 International Bank for Reconstruction and Development

1.7 Late Bretton Woods System

1.8 Structural Changes Underpinning the Decline of International

Monetary Management

1.8.1 Return to Convertibility

1.8.2 Growth of International Currency Markets

1.8.3 Decline of U.S Monetary Influence

1.9 "Floating" Bretton Woods (1968-72)

1.10 The "Nixon Shock"

1.11 The Gold Standard

1.11.1 Gold Specie Standard

1.11.2 Gold Bullion Standard

1.12 Let us Sum up

1.13 Lesson End Activity

1.14 Keywords

1.15 Questions for Discussion

1.16 Suggested Readings

1.0 AIMS AND OBJECTIVES

After studying this lesson, you should be able to understand:

z The international monetary system and new forms of monetary interdependence

z Growth of international currency market and gold standards

1.1 INTRODUCTION

International monetary system addresses itself to provide mechanisms to solve the

problems of liquidity and foreign exchange transactions Since these cannot be solved

by any nation in isolation, it is desirable that all interacting nations agree to a certain

modus operandi to find solutions to common problems Adequate finances are to be

arranged (particularly for less developed/developing countries) so that international

transactions take place smoothly In the context of international trade, the problems

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International Banking that crop up relate to: (i) liquidity, (ii) adjustment, and (iii) stability Liquidity is

necessary to finance the 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 Similarly, stability is necessary with intent to limit the degree of uncertainty in international business decisions

1.2 INTERNATIONAL MONETARY SYSTEM

Gold Exchange Standard was the first major step towards the establishment of an international monetary system This system was put into effect in 1850 The participants were the UK, France, Germany and the 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 the currency of these developed countries

1.3 SYSTEM OF BRETTON WOODS (1944-71)

The Bretton Woods system of monetary management established the rules for commercial and financial relations among the world's major industrial states The Bretton Woods system was the first example of a fully negotiated monetary order intended to govern monetary relations among independent nation-states Preparing to rebuild the international economic system as World War II was still raging, 730 delegates from all 44 Allied nations gathered at the Mount Washington Hotel in Bretton Woods, New Hampshire for the United Nations Monetary and Financial Conference The delegates deliberated upon and signed the Bretton Woods Agreements during the first three weeks of July 1944 In the year 1946, the International Bank for Reconstruction and Development (IBRD) and the International Monetary Fund (IMF) were established

1.3.1 Main Characteristics of Bretton Woods System

z Fixed rates in terms of gold (i.e a system of gold standard), but only the US dollar was convertible into gold as the USA ensured convertibility of dollars into gold at international level

z A procedure for mutual international credits

z Creation of International Monetary Fund (IMF) to supervise and ensure smooth functioning of the system Countries were expected to pursue the economic and monetary policies in a manner so that fluctuations of currency remained within a permitted margin of + or - 1 per cent That is, the central bank at every country had to intervene to buy or sell foreign exchange, depending on the need

z Devaluations or reevaluations of more than 5 per cent had to be done with the permission of the IMF This measure was necessary to avoid chain & valuations like the ones which occurred before the Second World War

Check Your Progress 1

1 What do you understand by international gold exchange standard?

……… ………

2 What is Bretton Woods System?

……… ………

9 International Monetary System

1.4 INTERNATIONAL MONETARY SYSTEM

SINCE 1971

On 15 August 1971, President Nixon of the USA suspended the system of

convertibility of gold and dollar For some time, the system of fixed-rates with an

adjustment margin of + or –2.5 per cent was tried but did not work Finally, the fixed

rate system was abandoned and the floating rate system came into effect In December

1971, the Smithsonian Agreement was signed at Washington; its major features were:

z devaluation of the dollar and revaluation of other currencies; gold passed from

$ 35 per ounce to $ 38;

z new fluctuation margins: changing from ± 1 per cent to ± 2.25 per cent;

z non-convertibility of the dollar

In 1973, another devaluation of the dollar took place Petrol shock added to the

international monetary crisis Exchange rates became volatile

In 1976, Jamaica Agreements were signed focusing on the:

z Legalization of the floating exchange rate;

z 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, the IMP sold one-third of its gold

reserves In 1977 and 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 the American BOP situation

deteriorated

1.5 INTERNATIONAL MONETARY FUND

IMF was established on December 27, 1945, when the 29 participating countries at the

conference of Bretton Woods signed its Articles of Agreement, the IMF was to be the

keeper of the rules and the main instrument of public international management The

Fund commenced its financial operations on March 1, 1947 IMF approval was

necessary for any change in exchange rates in excess of 10% It advised countries on

policies affecting the monetary system

1.6 INTERNATIONAL BANK FOR

RECONSTRUCTION AND DEVELOPMENT

The International Bank for Reconstruction and Development (IBRD) — now the most

important agency of the World Bank Group The IBRD had an authorized

capitalization of $10 billion and was expected to make loans of its own funds to

underwrite private loans and to issue securities to raise new funds to make possible a

speedy postwar recovery The IBRD was to be a specialized agency of the United

Nations charged with making loans for economic development purposes In 1956, the

World Bank created the International Finance Corporation and in 1960 it created the

International Development Association (IDA) Both have been controversial Critics

of the IDA argue that it was designed to head off a broader based system headed by

the United Nations, and that the IDA lends without consideration for the effectiveness

of the program Critics also point out that the pressure to keep developing economies

"open" has led to their having difficulties obtaining funds through ordinary channels,

and a continual cycle of asset buy up by foreign investors and capital flight by locals

Defenders of the IDA pointed to its ability to make large loans for agricultural

programs which aided the "Green Revolution" of the 1960s, and its functioning to

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International Banking stabilize and occasionally subsidize Third World governments, particularly in Latin

America

Check Your Progress 2

Match the following:

1 Gold Exchange Standard December 27, 1945

2 IMF 1946

3 International Bank for Reconstruction and Development 1960

4 International Development Association 1850

1.7 LATE BRETTON WOODS SYSTEM

After the end of World War II, the U.S held $26 billion in gold reserves, of an estimated total of $40 billion (approx 65%) As world trade increased rapidly through the 1950s, the size of the gold base increased by only a few percent In 1958, the U.S

balance of payments swung negative The first U.S response to the crisis was in the late 1950s when the Eisenhower administration placed import quotas on oil and other restrictions on trade outflows More drastic measures were proposed, but not acted on

However, with a mounting recession that began in 1959, this response alone was not sustainable In 1960, with Kennedy's election, a decade-long effort to maintain the Bretton Woods System at the $35/ounce price was begun The design of the Bretton Woods System was that nations could only enforce gold convertibility on the anchor currency—the United States’ dollar Gold convertibility enforcement was not required, but instead, allowed Nations could forgo converting dollars to gold, and instead hold dollars Rather than full convertibility, it provided a fixed price for sales between central banks However, there was still an open gold market, 80% of which was traded through London, which issued a morning "gold fix," which was the price

of gold on the open market For the Bretton Woods system to remain workable, it would either have to alter the peg of the dollar to gold, or it would have to maintain the free market price for gold near the $35 per ounce official price The greater the gap between free market gold prices and central bank gold prices, the greater the temptation to deal with internal economic issues by buying gold at the Bretton Woods price and selling it on the open market

However, keeping the dollar was still more desirable than holding gold because of the dollar's ability to earn interest In 1960 Robert Triffin noticed that holding dollars was more valuable than gold was because constant U.S balance of payments deficits helped to keep the system liquid and fuel economic growth What would later come to

be known as Triffin's Dilemma was predicted when Triffin noted that if the U.S failed

to keep running deficits the system would lose its liquidity, not be able to keep up with the world's economic growth, and, thus, bring the system to a halt But incurring such payment deficits also meant that, over time, the deficits would erode confidence

in the dollar as the reserve currency created instability

The first effort was the creation of the "London Gold Pool." The theory behind the pool was that spikes in the free market price of gold, set by the "morning gold fix" in London, could be controlled by having a pool of gold to sell on the open market that would then be recovered when the price of gold dropped Gold's price spiked in response to events such as the Cuban Missile Crisis, and other smaller events, to as high as $40/ounce The Kennedy administration drafted a radical change of the tax system in order to spur more productive capacity, and thus encourage exports This culminated with his tax cut program of 1963, designed to maintain the $35 peg

11 International Monetary System

Check Your Progress 3

Describe, in brief, the following:

1 Triffin’s dilemma

………

………

2 London Gold Pool

………

………

1.8 STRUCTURAL CHANGES UNDERPINNING THE

DECLINE OF INTERNATIONAL MONETARY

MANAGEMENT

1.8.1 Return to Convertibility

In the 1960s and 70s, important structural changes eventually led to the breakdown of

international monetary management One change was the development of a high level

of monetary interdependence The stage was set for monetary interdependence by the

return to convertibility of the Western European currencies at the end of 1958 and of

the Japanese yen in 1964 Convertibility facilitated the vast expansion of international

financial transactions, which deepened monetary interdependence

1.8.2 Growth of International Currency Markets

Another aspect of the internationalization of banking has been the emergence of

international banking consortia Since 1964 various banks had formed international

syndicates, and by 1971 over three quarters of the world's largest banks had become

shareholders in such syndicates Multinational banks can and do make huge

international transfers of capital not only for investment purposes but also for hedging

and speculating against exchange rate fluctuations

These new forms of monetary interdependence made possible huge capital flows

During the Bretton Woods era countries were reluctant to alter exchange rates

formally even in cases of structural disequilibria Because such changes had a direct

impact on certain domestic economic groups, they came to be seen as political risks

for leaders As a result official exchange rates often became unrealistic in market

terms, providing a virtually risk-free temptation for speculators They could move

from a weak to a strong currency hoping to reap profits when a revaluation occurred

If, however, monetary authorities managed to avoid revaluation, they could return to

other currencies with no loss The combination of risk-free speculation with the

availability of huge sums was highly destabilizing

1.8.3 Decline of U.S Monetary Influence

A second structural change that undermined monetary management was the decline of

U.S hegemony The U.S was no longer the dominant economic power it had been for

more than two decades By the mid-1960s, the E.E.C and Japan had become

international economic powers in their own right With total reserves exceeding those

of the U.S., with higher levels of growth and trade, and with per capita income

approaching that of the U.S., Europe and Japan were narrowing the gap between

themselves and the United States The shift toward a more pluralistic distribution of

economic power led to increasing dissatisfaction with the privileged role of the U.S

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International Banking dollar as the international currency As in effect the world's central banker, the U.S.,

through its deficit, determined the level of international liquidity In an increasingly interdependent world, U.S policy greatly influenced economic conditions in Europe and Japan In addition, as long as other countries were willing to hold dollars, the U.S could carry out massive foreign expenditures for political purposes—military activities and foreign aid—without the threat of balance-of-payments constraints Dissatisfaction with the political implications of the dollar system was increased by

détente between the U.S and the Soviet Union The Soviet threat had been an

important force in cementing the Western capitalist monetary system The U.S political and security umbrella helped make American economic domination palatable for Europe and Japan, which had been economically exhausted by the war As gross domestic production grew in European countries, trade grew When common security tensions lessened, this loosened the transatlantic dependence on defense concerns, and allowed latent economic tensions to surface

1.9 "FLOATING" BRETTON WOODS (1968-72)

By 1968, the attempt to defend the dollar at a fixed peg of $35/ounce, the policy of the Eisenhower, Kennedy and Johnson administrations, had become increasingly untenable Gold outflows from the U.S accelerated, and despite gaining assurances from Germany and other nations to hold gold, the profligate fiscal spending of the Johnson administration had transformed the "dollar shortage" of the 1940s and 1950s into a dollar glut by the 1960s In 1967, the IMF agreed in Rio de Janeiro to replace the tranche division set up in 1946 Special Drawing Rights were set as equal to one U.S dollar, but were not usable for transactions other than between banks and the IMF Nations were required to accept holding Special Drawing Rights (SDRs) equal

to three times their allotment, and interest would be charged, or credited, to each nation based on their SDR holding The original interest rate was 1.5%

The intent of the SDR system was to prevent nations from buying pegged gold and selling it at the higher free market price, and give nations a reason to hold dollars by crediting interest, at the same time setting a clear limit to the amount of dollars which could be held The essential conflict was that the American role as military defender

of the capitalist world's economic system was recognized, but not given a specific monetary value In effect, other nations "purchased" American defense policy by taking a loss in holding dollars They were only willing to do this as long as they supported U.S military policy, because of the Vietnam War and other unpopular actions, the pro-U.S consensus began to evaporate The SDR agreement, in effect, monetized the value of this relationship, but did not create a market for it

The use of SDRs as "paper gold" seemed to offer a way to balance the system, turning the IMF, rather than the U.S., into the world's central banker The US tightened controls over foreign investment and currency, including mandatory investment controls in 1968 In 1970, U.S President Richard Nixon lifted import quotas on oil in

an attempt to reduce energy costs; instead, however, this exacerbated dollar flight, and created pressure from petro-dollars now linked to gas-euros resulting the 1963 energy transition from coal to gas with the creation of the Dutch Gasunie Still, the U.S continued to draw down reserves In 1971 it had a reserve deficit of $56 Billion dollars; as well, it had depleted most of its non-gold reserves and had only 22% gold coverage of foreign reserves In short, the dollar was tremendously overvalued with respect to gold

13 International Monetary System

Check Your Progress 4

1 What do you understand by Special Drawing Rights (SDRs)?

………

………

2 What was the intent behind the creation of SDRs?

………

………

1.10 THE "NIXON SHOCK"

By the early 1970s, as the Vietnam War accelerated inflation, the United States as a

whole began running a trade deficit (for the first time in the twentieth century) The

crucial turning point was 1970, which saw U.S gold coverage deteriorate from 55%

to 22% This, in the view of neoclassical economists, represented the point where

holders of the dollar had lost faith in the ability of the U.S to cut budget and trade

deficits In 1971 more and more dollars were being printed in Washington, then being

pumped overseas, to pay for government expenditure on the military and social

programs In the first six months of 1971, assets for $22 billion fled the U.S In

response, on August 15, 1971, Nixon unilaterally imposed 90-day wage and price

controls, a 10% import surcharge, and most importantly "closed the gold window,"

making the dollar inconvertible to gold directly, except on the open market

Unusually, this decision was made without consulting members of the international

monetary system or even his own State Department, and was soon dubbed the "Nixon

Shock"

The surcharge was dropped in December 1971 as part of a general revaluation of

major currencies, which were henceforth allowed 2.25% devaluations from the agreed

exchange rate But even the more flexible official rates could not be defended against

the speculators By March 1976, all the major currencies were floating—in other

words, exchange rates were no longer the principal method used by governments to

administer monetary policy

1.11 THE GOLD STANDARD

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 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 foreign exchange rate system It was at 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 are Gold Specie

Standard and the Gold Bullion Standard

1.11.1 Gold Specie Standard

For the Gold specie standard to work efficiently, four main conditions had to be

operating They are as follows:

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;

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International Banking 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

1.11.2 Gold Bullion Standard

Under this the metal was not the medium of exchange Rather, the medium of exchange (coin or 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 to 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

1.12 LET US SUM UP

Over the period, the international monetary system has undergone a significant evolution The Bretton Woods system put into effect in 1944 has had to be abandoned Subsequently, the monetary role of gold has, been reduced, which is no longer used as

a means of settlement with the IMF The far reaching changes that took place in East Europe at the end of 1980s have 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 has had important repercussions on the international financial scene

1.13 LESSON END ACTIVITY

Go through the recent developments in the international currency market and position

of Dollar in terms of other currencies

1.14 KEYWORDS

ADB: Asian Development Bank

Balance of Trade: The difference between the value of exports and import of

merchandise

Blocked Currency: A currency that is not convertible/transferable across the broader

due to exchange control

IBRD: International Bank of Reconstruction and Development

IMF: International Monetary Fund

1.15 QUESTIONS FOR DISCUSSION

1 Recapitulate the historic developments which led to floating exchange rate system

2 What do you know about gold standard? Why did it fail?

3 How did the US / position of the balance of payments influence the whole International monetary system under the Bretton Woods system?

4 How does exchange rate stability affect international trade?

5 Is a floating rate system more inflationary than a fixed rate system?