International Monetary System: Evolution & Exchange Rates

• The international monetary system is a complex system of agreements, rules, and mechanisms regarding exchange rates, international payments, and capital flow.
• It is the framework within which international payments are made, movements of capital are accommodated, and exchange rates among currencies are determined.

Evolution of the International Monetary System

• The international monetary system has gone through several distinct stages of evolution.
• Before 1875 was the period of Bimetallism.
• From 1875 to 1914 was the classical gold standard era.
• The interwar period spanned from 1915 to 1944.
• The Bretton Woods system was in effect from 1945 to 1972.
• The flexible exchange rate regime has been in place since 1973.
• The U.S. dollar's value represents the nominal exchange rate index (2010 = 100) with weights derived from trade among 27 industrialized countries.
• The Bank for International Settlements is the source for the trade-weighted value of the U.S. dollar.

Bretton Woods System: 1945 to 1972

• The Bretton Woods System derives its name from a July 1944 meeting of 44 nations in Bretton Woods, New Hampshire.
• It aimed to design a postwar international monetary system to provide exchange rate stability independent of the gold standard.
• The result was a dollar-based gold exchange standard, where the U.S. dollar was pegged to gold.
• Other currencies were pegged to the U.S. dollar, and only the U.S. dollar was fully convertible to gold.
• The dominance of the U.S. dollar as the global currency as well as the creation of the IMF and the World Bank came about.

Advantages

• Countries could earn interest on FX holdings.
• Lower transaction costs were realised because there was no transportation of gold.
• Stable exchange rates prevailed

Shortcomings

• Include the Triffin paradox, led to the system's collapse in the early 1970s.
• The reserve currency country has to run a balance of payments deficit to satisfy the growing need for reserves from the rest of the world.
• Confidence in the reserve currency can be affected and lead to a downfall of the system.

Flexible Exchange Rate Regime: 1973 to Present

• The flexible exchange rate regime was ratified in January 1976.
• IMF members met in Jamaica and agreed to a new set of rules, referred to as the Jamaica Agreement.
• Flexible exchange rates were declared acceptable to the IMF members.
• Central banks could intervene in exchange markets to iron out unwarranted volatilities.
• Gold was officially abandoned as an international reserve asset.
• Non-oil-exporting countries and less-developed countries were given greater access to IMF funds.

Current Exchange Rate Arrangements

• Intervention occurs only exceptionally and aims to address disorderly market conditions.
• Intervention has been limited to at most 3 instances in the previous 6 months, each lasting no more than 3 business days e.g. Australia, Canada, Mexico, Japan, U.K., U.S., and euro zone.
• Exchange rates are largely market determined, without an ascertainable or predictable path e.g. Brazil, Korea, Turkey, India, South Africa, and Thailand.
• Another country's currency circulates as the sole legal tender e.g. Ecuador, El Salvador, and Panama.
• Crawling peg is in effect when the currency is adjusted in small amounts at a fixed rate or in response to changes in selected indicators e.g. Honduras and Nicaragua.
• Crawl-like arrangement stipulates that the exchange rate must remain within a narrow margin of 2% relative to a statistically identified trend for 6 months or more with no floating exchange e.g. Singapore, Romania, and Tunisia.
• Pegged exchange rate with horizontal bands is in effect when the currency value is maintained within certain fluctuation margins no less than +/- 1% around a fixed central rate, or the margin between the maximum and minimum exchange rate value exceeds 2%.
• Currency board is an extreme fixed exchange rate regime fully backed by a foreign currency at a fixed exchange rate, limiting discretionary monetary policy e.g. Hong Kong, Bulgaria, and Brunei.
• Conventional peg happens when countries formally peg their currency at a fixed rate to another currency or basket of currencies e.g. Jordan, Saudi Arabia, and Nepal.
• Stabilized arrangement entails a spot market exchange rate which remains within a 2% margin for 6 months or more e.g. Vietnam, Nigeria, and Lebanon.
• Other managed arrangement is used when exchange rate arrangements do not meet criteria for any other category e.g. China, Argentina, and Kuwait.

Fixed versus Flexible Exchange Rate Regimes

• Arguments in favor of flexible exchange rates include easier external adjustments and national policy autonomy.
• Arguments against flexible exchange rates include that exchange rate uncertainty may hamper international trade and investment.
• No safeguards to prevent crises is another argument against flexible exchange rates.
• A "good" or ideal international monetary system should provide sufficient liquidity to support the growth of and international trade and investment.
• A mechanism for adjustment that restores the balance of payments disequilibrium should be provided.
• A safeguard to prevent crises of confidence in the system is important.

New currencies

• Focus includes the Euro and European Monetary Union.
• Focus includes Cryptocurrencies.
• Focus includes the Rise of Chinese RMB.

Exchange Rate Crisis

• Examples include the Mexican Peso Crisis.
• Examples include the Asian Currency Crisis.
• Examples include the Argentine Peso Crisis.

European Monetary System (EMS)

• It was formally launched in 1979 to accomplish several goals.
• EMS sought to establish a "zone of monetary stability" in Europe.
• The body was designed to coordinate exchange rate policies vis-à-vis the non-EMS currencies.
• It was geared towards paving the way for the eventual European monetary union.
• Main instruments of the EMS were the European Currency Unit (ECU), precursor of the euro, and the Exchange Rate Mechanism (ERM).
• The institution went through a series of realignments and paved the way for the European Monetary Union (EMU).

Euro and the European Monetary Union (EMU)

• On January 1, 1999, 11 of 15 EU countries adopted a common currency, the euro.
• EMU was created.
• Each national currency of the euro-11 countries was irrevocably fixed to the euro at a conversation rate as of January 1, 1999.
• Euro notes and coins were introduced to circulation on January 1, 2002.
• National bills and coins were being gradually withdrawn.
• Sovereign countries voluntarily have given up their monetary independence to foster economic integration.
• The European Central Bank (ECB), headquartered in Frankfurt is where monetary policy for the eurozone happens.
• A primary objective is to maintain price stability.
• Independence is legally guaranteed.
• Eurosystem is made up of the ECB and central banks of the Eurozone.
• This body is designed to define and implement common monetary policy of the Union as well as conduct foreign exchange operations.
• The agency also holds and manage official foreign reserves of euro member states.

Benefits and Costs of Monetary Union

Key benefits

• Reduced transaction costs
• Elimination of exchange rate uncertainty
• Enhanced efficiency and competitiveness of the European economy
• Development of continental capital markets with depth and liquidity comparable to those of the U.S.
• Political cooperation and peace in Europe.

Key costs

• Loss of national monetary and exchange rate policy independence.
• This situation makes it hard to deal with asymmetric shocks.

Prospects of the Euro

• The relevant criterion for an optimum currency area or a common currency zone is the degree of factor mobility within the zone.
• Intra-euro-zone trade accounts for about 60% of foreign trade of the euro-zone countries.
• Relative prominence of asymmetric shocks has decreased compared with the importance of common shocks in recent years.
• The Euro is emerging as the second global currency, challenging the dollar's sole dominance.

Cryptocurrencies

• Fiat currencies are put into circulation by governments.
• These currencies have no intrinsic values backed by claims on underlying real assets like gold.
• A digital currency designed to function as a "medium of exchange" through decentralized networks, is called a Cryptocurrency
• These are made up of computers that keep public records of transaction data using mostly cryptographic technology, without the need for governments or central banks.
• Central Bank Digital Currency (CBDC) is essentially a digital version of fiat currency issued by central banks.
• The majority of central banks are actively researching the potential for CBDCs, but they have not yet been formally adopted anywhere.
• Bitcoin was introduced as open-source software in January 2009 and is the first and most important cryptocurrency .
• Ethereum and Litecoin etc followed Bitcoin in subsequent years
• Due to extreme volatility of its price, Bitcoin was found to be unsuitable to serve monetary functions like; unit of accounting, medium of exchange, or storage of value.
• Since this shortcoming became public, Bitcoin has been used as a highly speculative asset class.
• El Salvador selected Bitcoin as legal tender in September 2021, while the Central African Republic followed in April 2022 despite extreme volatility.

Rise of the Chinese Renminbi

• While China has become one of the top trading powers and the world's second largest economy, its currency, the renminbi or RMB, has not achieved similar international prominence.
• The limited openness of China's capital markets is cited as a factor.
• The IMF included RMB as a constituent currency of the SDR beginning in 2016.
• China has been gradually lowering barriers to international capital flows and promoting greater usage of RMB in international transactions.
• China's currency has the potential to become a global currency.
• Full convertibility of its currency as well as open capital markets with depth and liquidity are needed.
• A Rule of law and protections for property rights will need to become commonplace.

Currency Crises

• Three major currency crises revealed the fragility of the international monetary system (IMS).
• The Mexican peso crisis occurred from 1994 to 1995.
• The Asian currency crisis happened from 1997 to 1998.
• The Argentine peso crisis occurred in 2002.

Mexican Peso Crisis

• On December 20, 1994, the Mexican government announced a plan to devalue the peso against the dollar by 14%.
• This decision caused pesos, as well as Mexican stocks and bonds, to be sold rapidly.
• By early January 1995, the peso had fallen against the U.S. dollar by as much as 40%.
• This event forced the Mexican government to float the peso.
• The peso crisis rapidly spilled over to other Latin American and Asian financial markets.
• It is unique because it represents the first serious international financial crisis touched off by cross-border flight of portfolio capital.
• It is essential to have a multinational safety net in place to safeguard the world financial system from similar crises.
• Mexico depended excessively on foreign portfolio capital to finance economic development, and a higher priority should have been placed on saving domestically.

Causes Behind Asian Currency Crisis

• On July 2, 1997, the Thai baht, fixed largely to the U.S. dollar, was suddenly devalued.
• This touched off a panicky flight of capital from other Asian countries.
• It quickly escalated into a global financial crisis more serious than the EMS and Mexican peso crises.
• It led to an unprecedented deep, widespread, and long-lasting recession in East Asia.

Origins of the Asian Currency Crisis

• Factors responsible for the onset of the crisis are varied.
• One factor is the weak domestic financial system with poor risk management and supervision.
• Another is the free international capital flows that resulted in a credit boom and speculation in real estate and stock markets.
• Fixed or stable exchange rates encouraged unhedged financial transactions and excessive risk-taking by both borrowers and lenders.
• Booming economy with a fixed exchange rate appreciating an appreciation of the real exchange rate which led to a slowdown in export growth.
• Japan's long-lasting recession and yen depreciation hurt neighboring countries.
• Liberalization of financial markets, when combined with a weak, underdeveloped domestic system, tends to create an environment susceptible to crises.
• Incompatible trinity suggests it is very difficult, if not impossible, to have all these conditions: a fixed exchange rate, free international flows of capital, and independent monetary policy.

The Argentine Peso Crisis

• In February 1991, the Argentine government passed the Convertibility Law, linking the peso to the U.S. dollar at parity (1:1).
• Initial economic effects were positive including an economic boom.
• In the second half of the 1990s, the U.S. dollar became increasingly stronger, which caused the peso to appreciate against most currencies.
• A strong peso hurt Argentina's exports and caused a protracted economic downturn.
• The country abandoned peso-dollar parity in January 2002, causing economic and political distress.
• Three factors are related to the collapse of the currency board and the ensuing economic crisis.
• Factors include: Lack of fiscal discipline, a Labor market inflexibility issue, and contagion from financial crises in Brazil and Russia.