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7ebyCharlesW.L.HillChapter10TheInternationalMonetarySystemIntroduction

Question:Whatistheinternationalmonetarysystem?Answer:Theinternationalmonetary

systemreferstotheinstitutionalarrangementsthatgovernexchangeratesrecallthattheforeignexchangemarketistheprimaryinstitutionfordeterminingexchangerates

IntroductionAfloatingexchangeratesystemexistsincountrieswheretheforeignexchangemarketdeterminestherelativevalueofacurrencyExamples-theU.S.dollar,theEuropeanUnion’seuro,theJapaneseyen,andtheBritishpoundApeggedexchangeratesystemexistswhenthevalueofacurrencyisfixedtoareferencecountryandthentheexchangeratebetweenthatcurrencyandothercurrenciesisdeterminedbythereferencecurrencyexchangerateManydevelopingcountrieshavepeggedexchangeratesIntroductionAdirtyfloatexistswhenthevalueofacurrencyisdeterminedbymarketforces,butwithcentralbankinterventionifitdepreciatestoorapidlyagainstanimportantreferencecurrencyChinaadoptedthispolicyin2005Withafixedexchangerate

systemcountriesfixtheircurrenciesagainsteachotheratamutuallyagreeduponvaluepriortotheintroductionoftheeuro,someEuropeanUnioncountriesoperatedwithfixedexchangerateswithinthecontextoftheEuropeanMonetarySystem(EMS)Introduction

Question:Whatroledoestheinternationalmonetarysystemplayindeterminingexchangerates?Answer:Toanswerthisquestion,wehavetolookattheevolutionoftheinternationalmonetarysystemTheGoldStandardTheBrettonWoodssystemTheInternationalMonetaryFundTheWorldBankTheGoldStandard

Question:WhatistheGoldStandard?Answer:Theoriginofthegoldstandarddatesbacktoancienttimeswhengoldcoinswereamediumofexchange,unitofaccount,andstoreofvalueTofacilitatetrade,asystemwasdevelopedsothatpaymentcouldbemadeinpapercurrencythatcouldthenbeconvertedtogoldatafixedrateofexchangeMechanicsoftheGoldStandardThegoldstandardreferstothepracticeofpeggingcurrenciestogoldandguaranteeingconvertibilityunderthegoldstandardoneU.S.dollarwasdefinedasequivalentto23.22grainsof"fine(pure)goldTheexchangeratebetweencurrencieswasbasedonthegoldparvalue-theamountofacurrencyneededtopurchaseoneounceofgoldStrengthoftheGoldStandardThekeystrengthofthegoldstandardwasitspowerfulmechanismforsimultaneouslyallowingallcountriestoachievebalance-of-tradeequilibrium-whentheincomeacountry’sresidentsearnfromitsexportsisequaltothemoneyitsresidentspayforimportsmanypeopletodaybelievetheworldshouldreturntothegoldstandard1918-1939Thegoldstandardworkedfairlywellfromthe1870suntilthestartofWorldWarIAfterthewarcountriesstartedregularlydevaluingtheircurrenciestotrytoencourageexportsConfidenceinthesystemfell,andpeoplebegantodemandgoldfortheircurrencyputtingpressureoncountries'goldreserves,andforcingthemtosuspendgoldconvertibilityTheGoldStandardendedin1939TheBrettonWoodsSystemAnewinternationalmonetarysystemwasdesignedin1944inBrettonWoods,NewHampshireThegoalwastobuildanenduringeconomicorderthatwouldfacilitatepostwareconomicgrowthTheBrettonWoodsAgreementestablishedtwomultinationalinstitutionsTheInternationalMonetaryFund(IMF)tomaintainorderintheinternationalmonetarysystemTheWorldBanktopromotegeneraleconomicdevelopmentTheBrettonWoodsSystemUndertheBrettonWoodsAgreementtheUSdollarwastheonlycurrencytobeconvertibletogold,andothercurrencieswouldsettheirexchangeratesrelativetothedollardevaluationswerenottobeusedforcompetitivepurposesacountrycouldnotdevalueitscurrencybymorethan10%withoutIMFapprovalTheRoleoftheIMFTheIMFwasresponsibleforavoidingarepetitionofthechaosthatoccurredbetweenthewarsthroughacombinationof1.Disciplineafixedexchangerateputsabrakeoncompetitivedevaluationsandbringsstabilitytotheworldtradeenvironmentafixedexchangerateregimeimposesmonetarydisciplineoncountries,therebycurtailingpriceinflation

TheRoleoftheIMF2.Flexibility

ArigidpolicyoffixedexchangerateswouldbetooinflexibleSo,theIMFwasreadytolendforeigncurrenciestomemberstotidethemoverduringshortperiodsofbalance-of-paymentsdeficitsAcountrycoulddevalueitscurrencybymorethan10percentwithIMFapprovalTheRoleoftheWorldBankTheWorldBanklendsmoneyintwowaysundertheIBRDscheme,moneyisraisedthroughbondsalesintheinternationalcapitalmarketandborrowerspaywhatthebankcallsamarketrateofinterest-thebank'scostoffundsplusamarginforexpenses.undertheInternationalDevelopmentAgencyscheme,loansgoonlytothepoorestcountriesTheofficialnameoftheWorldBankistheInternationalBankforReconstructionandDevelopment(IBRD)TheCollapseoftheFixedSystem

Question:WhatcausedthecollapseoftheBrettonWoodssystem?Answer:ThecollapseoftheBrettonWoodssystemcanbetracedtoU.S.macroeconomicpolicydecisions(1965to1968)Duringthistime,theU.S.financedhugeincreasesinwelfareprogramsandtheVietnamWarbyincreasingitsmoneysupplywhichthencausedsignificantinflationSpeculationthatthedollarwouldhavetobedevaluedrelativetomostothercurrenciesforcedothercountriestoincreasethevalueoftheircurrenciesrelativetothedollarTheCollapseoftheFixedSystemTheBrettonWoodssystemreliedonaneconomicallywellmanagedU.S.So,whentheU.S.begantoprintmoney,runhightradedeficits,andexperiencehighinflation,thesystemwasstrainedtothebreakingpointTheBrettonWoodsAgreementcollapsedin1973TheFloatingExchangeRateRegime

Question:WhatfollowedthecollapseoftheBrettonWoodsexchangeratesystem?Answer:FollowingthecollapseoftheBrettonWoodsagreement,afloatingexchangerateregimewasformalizedin1976inJamaicaTherulesfortheinternationalmonetarysystemthatwereagreeduponatthemeetingarestillinplacetodayTheJamaicaAgreementAttheJamaicameeting,theIMF'sArticlesofAgreementwererevisedtoreflectthenewrealityoffloatingexchangeratesUndertheJamaicanagreementfloatingratesweredeclaredacceptablegoldwasabandonedasareserveassettotalannualIMFquotas-theamountmembercountriescontributetotheIMF-wereincreasedto$41billion(today,thisnumberis$300billion)ExchangeRatesSince1973Since1973,exchangerateshavebecomemorevolatileandlesspredictablebecauseoftheoilcrisisin1971thelossofconfidenceinthedollarafterU.S.inflationjumpedbetween1977and1978theoilcrisisof1979theriseinthedollarbetween1980and1985thepartialcollapseoftheEuropeanMonetarySystemin1992the1997Asiancurrencycrisisthedeclineinthedollarinthemidtolate2000sFixedvs.FloatingExchangeRatesQuestion:Whichisbetter–afixedexchangeratesystemorafloatingexchangeratesystem?Answer:DisappointmentwithfloatingratesinrecentyearshasledtoreneweddebateaboutthemeritsofafixedexchangeratesystemTheCaseforFloatingRatesAfloatingexchangeratesystemprovidestwoattractivefeaturesmonetarypolicyautonomyautomatictradebalanceadjustmentsTheCaseforFloatingRates1.MonetaryPolicyAutonomyTheremovaloftheobligationtomaintainexchangerateparityrestoresmonetarycontroltoagovernmentwithafixedsystem,acountry'sabilitytoexpandorcontractitsmoneysupplyislimitedbytheneedtomaintainexchangerateparityTheCaseforFloatingRates2.TradeBalanceAdjustmentsThebalanceofpaymentsadjustmentmechanismworksmoresmoothlyunderafloatingexchangerateregimeundertheBrettonWoodssystem(fixedsystem),IMFapprovalwasneededtocorrectapermanentdeficitinacountry’sbalanceoftradethatcouldnotbecorrectedbydomesticpolicyaloneTheCaseforFixedRatesAfixedexchangeratesystemisattractivebecauseofthemonetarydisciplineitimposesitlimitsspeculationitlimitsuncertaintyofthelackofconnectionbetweenthetradebalanceandexchangeratesTheCaseforFixedRates1.MonetaryDisciplineBecauseafixedexchangeratesystemrequiresmaintainingexchangerateparity,italsoensuresthatgovernmentsdonotexpandtheirmoneysuppliesatinflationaryrates2.SpeculationAfixedexchangerateregimepreventsdestabilizingspeculationTheCaseforFixedRates3.UncertaintyTheuncertaintyassociatedwithfloatingexchangeratesmakesbusinesstransactionsmorerisky4.TradeBalanceAdjustmentsFloatingrateshelpadjusttradeimbalancesWhoisRight?ThereisnorealagreementastowhichsystemisbetterHistoryshowsthatfixedexchangerateregimemodeledalongthelinesoftheBrettonWoodssystemwillnotworkAdifferentkindoffixedexchangeratesystemmightbemoreenduringandmightfosterthekindofstabilitythatwouldfacilitatemorerapidgrowthininternationaltradeandinvestmentExchangeRateRegimesinPracticeCurrently,thereareseveraldifferentexchangerateregimesinpracticeIn200614%ofIMFmembersallowtheircurrenciestofloatfreely26%ofIMFmembersfollowamanagedfloatsystem28%ofIMFmembershavenolegaltenderoftheirowntheremainingcountriesuselessflexiblesystemssuchaspeggedarrangements,oradjustablepegsExchangeRateRegimesinPracticeFigure10.2:ExchangeRatePolicies,IMFMembers,2008PeggedExchangeRatesUnderapeggedexchangerateregimecountriespegthevalueoftheircurrencytothatofothermajorcurrenciespopularamongtheworld’ssmallernationsThereissomeevidencethatadoptingapeggedexchangerateregimemoderatesinflationarypressuresinacountryCurrencyBoardsAcountrywithacurrencyboardcommitstoconvertingitsdomesticcurrencyondemandintoanothercurrencyatafixedexchangerateThecurrencyboardholdsreservesofforeigncurrencyequalatthefixedexchangeratetoatleast100%ofthedomesticcurrencyissuedadditionaldomesticnotesandcoinscanbeintroducedonlyifthereareforeignexchangereservestobackitCrisisManagementbytheIMF

Question:WhathasbeentheroleoftheIMFintheinternationalmonetarysystemssincethecollapseofBrettonWoods?Answer:TheIMFhasredefineditsmission,andnowfocusesonlendingmoneytocountriesexperiencingfinancialcrisesinexchangeforenactingcertainmacroeconomicpoliciesMembershipintheIMFhasgrownto186countriesin2010,54ofwhichhassometypeofIMFprograminplaceFinancialCrisesPost-BrettonWoodsThreetypesoffinancialcrisesthathaverequiredinvolvementbytheIMFare1.A

currencycrisis-occurswhenaspeculativeattackontheexchangevalueofacurrencyresultsinasharpdepreciationinthevalueofthecurrency,orforcesauthoritiestoexpendlargevolumesofinternationalcurrencyreservesandsharplyincreaseinterestratesinordertodefendprevailingexchangeratesFinancialCrisesPost-BrettonWoods2.Abankingcrisis-referstoasituationinwhichalossofconfidenceinthebankingsystemleadstoarunonthebanks,asindividualsandcompanieswithdrawtheirdeposits3.Aforeigndebtcrisis-asituationinwhichacountrycannotserviceitsforeigndebtobligations,whetherprivatesectororgovernmentdebtTwocrisesthatareparticularlysignificantarethe1995Mexicancurrencycrisisthe1997AsiancurrencycrisisTheMexicanCurrencyCrisisof1995

TheMexicancurrencycrisisof1995wasaresultofhighMexicandebts,andapeggedexchangeratethatdidnotallowforanaturaladjustmentofpricesinordertokeepMexicofromdefaultingonitsdebt,a$50billionaidpackagewascreatedbytheIMFBy1997,MexicowaswellonthewaytorecoveryTheAsianCrisis

Question:Whatwerethecausesofthe1997Asianfinancialcrisis?Answer:Thecausesofthecrisiscanbetracedtothepreviousdecadewhentheregionwasexperiencingunprecedentedgrowth

1.TheInvestmentBoomfueledbyexport-ledgrowthlargeinvestmentswereoftenbasedonprojectionsaboutfuturedemandconditionsthatwereunrealisticTheAsianCrisis2.ExcessCapacityinvestmentsmadeonthebasisofunrealisticprojectionsaboutfuturedemandconditionscreatedsignificantexcesscapacity3.TheDebtBombinvestmentswereoftensupportedbydollar-baseddebtswheninflationandincreasingimportsputpressureonthecurrencies,theresultingdevaluationsledtodefaultondollardenominateddebts4.ExpandingImports

bythemid1990s,importswereexpandingacrosstheregioncausingbalanceofpaymentsdeficitsThebalanceofpaymentsdeficitsmadeitdifficultforcountriestomaintaintheircurrenciesagainsttheU.S.dollarTheAsianCrisisBymid-1997,itbecameclearthatseveralkeyThaifinancialinstitutionswereonthevergeofdefaultForeignexchangedealersandhedgefundsstartedtospeculateagainsttheThaibaht,sellingitshortAfterstrugglingtodefendthepeg,theThaigovernmentabandoneditsdefenseandannouncedthatthebahtwouldfloatfreelyagainstthedollarTheAsianCrisisThailandturnedtotheIMFforhelpSpeculationcontinuedtoaffectotherAsiancountriesincludingMalaysia,Indonesia,Singaporewhichallsawtheircurrenciesdropthesedevaluationsweremainlyaresultofexcessinvestment,highborrowings,muchofitindollardenominateddebt,andadeterioratingbalanceofpaymentspositionSouthKoreawasthefinalcountryintheregiontofallEvaluatingtheIMF’sPoliciesQuestion:HowsuccessfulistheIMFatgettingcountriesbackontrack?Answer:In2009,54countrieswereworkingIMFprogramsAllIMFloanpackagescomewithconditionsattached,generallyacombinationoftightmacroeconomicpolicyandtightmonetarypolicyManyexpertshavecriticizedthesepolicyprescriptionsforthreereasonsEvaluatingtheIMF’sPolicies1.InappropriatePoliciesTheIMFhasbeencriticizedforhavinga“one-size-fits-all”approachtomacroeconomicpolicythatisinappropriateformanycountries2.MoralHazardTheIMFhasalsobeencriticizedforexacerbatingmoralhazard(whenpeoplebehaverecklesslybecausetheyknowtheywillbesavedifthingsgowrong)

EvaluatingtheIMF’sPolicies3.LackofAccountabilityThefinalcriticismoftheIMFisthatithasbecometoopowerfulforaninstitutionthatlacksanyrealmechanismforaccountabilityQuestion:Whoisright?Answer:Aswithmanydebatesaboutinternationaleconomics,itisnotclearwhoisrightImplicationsforManagersQuestion:Whataretheimplicationsoftheinternationalmonetarysystemformanagers?

Answer:TheinternationalmonetarysystemaffectsinternationalmanagersinthreewaysCurrencymanagementBusinessstrategyCorporate-governmentrelationsCurrencyManagement1.Curr