International Monetary System (IMS)

• The International Monetary System (IMS) is the operating system that regulates the valuation and exchange of money across countries.
• The IMS influences cross-border payments, exchange rates, and the mobility of capital.
• Participants in the IMS include financial institutions (including central banks), multinational corporations, and investors.
• Terms related to the IMS include Monetary Policy, Exchange Rate, Foreign Exchange Market, Gold Standard, Inflation Targeting, and The International Monetary Fund (IMF).

History of the International Monetary System

• The gold standard was in effect from 1876-1913.
• Gold has been used as a medium of exchange since 3000 BC.
• Under the gold standard, each country set the rate at which its currency unit could be converted to a weight of gold creating fixed currency exchange rates.
• Expansionary monetary policy was limited to a government's supply of gold.
• The gold standard lasted until the outbreak of WWI when the free movement of gold was interrupted.
• During the Inter-War Years & WWII (1914-1944), currencies fluctuated in terms of gold and each other.
• Increasing fluctuations in currency values occurred as speculators sold short weak currencies.
• In 1934 the U.S. adopted a modified gold standard.
• During WWII and its aftermath the U.S. dollar was the only major trading currency that continued to be convertible.
• In 1944, as WWII drew to a close, the Allied Powers met at Bretton Woods, New Hampshire, to create a post-war international monetary system.
• The Bretton Woods Agreement established a U.S. dollar-based international monetary system.
• The Bretton Woods Agreement created the International Monetary Fund (IMF) and the World Bank.
• The International Monetary Fund (IMF) is a key institution in the new international monetary system and was created to:
  • Help countries defend their currencies against cyclical, seasonal, or random occurrences.
  • Assist countries having structural trade problems if they take steps to correct these problems.
  • The Special Drawing Right (SDR) is the IMF reserve asset, currently a weighted average of four currencies.
• The International Bank for Reconstruction and Development (World Bank) helped fund post-war reconstruction and has since then supported general economic development.
• The fixed exchange rates era was from 1945-1973.
• The currency arrangement negotiated at Bretton Woods and monitored by the IMF performed well during the post-WWII era of reconstruction and growth in world trade.
• Widely diverging monetary and fiscal policies, differential rates of inflation, and various currency shocks resulted in the fixed exchange rate system's demise.
• The U.S. dollar became the main reserve currency held by central banks.
  • This resulted in a balance of payments deficit which required a heavy capital outflow of dollars to finance deficits and meet the growing demand for dollars from investors and businesses.
• Eventually, the heavy overhang of dollars held by foreigners resulted in a lack of confidence in the ability of the U.S. to meet its commitment to convert dollars to gold.
• This lack of confidence forced President Richard Nixon to suspend official purchases or sales of gold by the U.S. Treasury on August 15, 1971.
• This resulted in subsequent devaluations of the dollar.
• Most currencies were allowed to float to levels determined by market forces as of March 1973.
• The Floating Era was from 1973-1997.
• Since March 1973, exchange rates have become more volatile and less predictable than during the "fixed" period.
• Numerous significant world currency events have occurred over the past 30 years.
• The Emerging Era is from 1997-present.
• Emerging market economies are multiplying in number and growing in complexity.
• This results in a growing number of emerging market currencies.

IMF Classification of Currency Regimes

• Exhibit 2.3 presents the IMF's regime classification methodology in effect since January 2009.
• Category 1: Hard Pegs are countries that have given up their sovereignty over monetary policy, including dollarization or currency boards.
• Category 2: Soft Pegs, AKA fixed exchange rates, include five subcategories of classification.
• Under a crawling peg, the local currency depreciates against another currency (or currency basket) on a regular controlled basis such as:
  • Brazil (1990-2000): during the transition from fixed to floating rate system.
  • China (2005-2008): during the transition from one fixed rate to another.
• Category 3: Floating Arrangements are mostly market driven, and may be free floating or floating with occasional government intervention.
• Category 4: Residual includes currency arrangements that do not fit the previous categorizations.
• Exhibit 2.4 shows how these major regime categories translate in the global market.
• The vertical dashed line, the crawling peg, is the zone some currencies move into and out of depending on their relative currency stability.
• The proportion of IMF member countries with floating regimes has been increasing.
• Soft pegs declined dramatically in 2016.
• Although the contemporary international monetary system is typically referred to as a "floating regime," it is not the case for the majority of the world's nations.

Fixed vs Flexible Exchange Rates

• A nation's choice as to which currency regime to follow reflects national priorities about all facets of the economy, including:

  • inflation,
  • unemployment,
  • interest rate levels,
  • trade balances, and
  • economic growth.

• The choice between fixed and flexible rates may change over time as priorities change.

• Countries would prefer a fixed rate regime for the following reasons:

  • stability in international prices
  • inherent anti-inflationary nature of fixed prices

• Fixed rate regimes have the following problems:

  • Need for central banks to maintain large quantities of hard currencies and gold to defend the fixed rate
  • Fixed rates can be maintained at rates that are inconsistent with economic fundamentals

• Two forces determine the price of a foreign currency in terms of domestic currency (i.e., the exchange rate):

  • demand for a foreign currency and
  • supply of a foreign currency

• For the $/€ example, USA is the home country and the EU is the foreign country.

  • $ is the domestic currency and € is the foreign currency.

• Demand for a foreign currency (euro) is derived from the demand for foreign country's goods, services, and financial assets.

• For example, when Americans demand German goods, they pay in euros and have to exchange their dollars for euros.

• The more Americans have to pay (in dollars) to buy one euro from the foreign exchange market, the less they demand for euro.

• Supply of a foreign currency (euro) is derived from the foreign country's demand for local goods, services and financial assets.

• For example, when German consumers demand for US goods, such as Dell computers, they must convert euros to US $ in order to buy which increases the supply of euros in USA.

• The more (in dollars) Germans get by selling one euro from the foreign exchange market, the more they supply euro.

• To calculate exchange rate changes:

• appreciation or depreciation of foreign currency (euro) against the domestic currency (dollar) = (e₁ - eo)/ eo.*

  • Where:
    • eo = old dollar value of euro
    • e₁ = new dollar value of euro

• In 2007 the yen went from $0.0084161 to $0.0089501:

  • e₀ = yen per dollar in 2006 = 0.0084161
  • e₁ = yen per dollar in 2007 = 0.0089501
  • Appreciation of Yen against dollar = (e₁ - eo)/ eo = 6.34%

• Factors that affect equilibrium exchange rate include:

  • Relative inflation rates
  • Relative interest rates
  • Relative economic growth rates
  • Political and economic risk

• Currency values are forward looking depending on current events and current supply and demand, as well as on expectation-or forecasts-about future exchange rate movements, including holding foreign currency for arbitraging.

• The Asian currency crisis exemplified the role of expectations.

  • Asian currencies, such as Ringgit, Bath, Rupiah, Peso, and Won, were tied to the US dollar resulting in a loss of export competitiveness.
  • The US dollar appreciated in the mid-97 (by 50% against Yen;
  • Exports from the Asian countries declined.
  • Speculators expected that the governments would devalue the currency forcing a round of devaluations.

Fundamentals of Central Bank Intervention

• Central banks may prefer a strong or a weak domestic currency affecting exchange rates.
• Advantages of a strong domestic currency:
  • Cheaper imported goods and services
  • Lower import prices lead to lower production costs and low inflation
  • Low cost of foreign investment
  • Strong currency attracts foreign capital and keeps interest rates (borrowing cost) low.
• Disadvantages of a strong domestic currency:
  • Exports become less competitive
  • Domestic firms face strong competition from low price foreign imports
  • Job loss
  • Reduces foreign investment at home
• Governments prefer overvalued or undervalued currencies, depending on their economic goals.
  • Typically governments are focused on growth, employment, stable prices.
• From 1995 and 2005, China fixed its exchange rate at 8.28 Yuan per US dollar with the Yuan undervalued by 20-30% against the US dollar.
• The USA (and the rest of the world) complained that this gave Yuan an unfair advantage in the world market.
• In 2005, the US Senate voted for the imposition of 27.5% tariff on Chinese imports.
• China resisted Yuan revaluation in order to maintain a stable price level and maintain low export prices so Chinese production and employment would not be affected.
• An undervalued currency attracts foreign investment keeping an upward pressure on the value of yuan.
• In order to maintain a fixed exchange rate, China has to sell Yuan to buy up all these foreign currency inflows which creates inflationary pressure on the economy.
• Mechanisms of government intervention include:
  • Purchases and sales of foreign currencies by the central bank.
  • For example, if the FED wants to raise the value of dollar against euro, it will buy dollars with euros.
  • If the ECB wants to reduce the value of euro, it will sell euros in the foreign exchange market.

Attributes of an ideal currency

• The ideal currency has three attributes, often referred to as the Impossible Trinity:
  • Exchange rate stability
  • Full financial integration
  • Monetary independence
• The forces of economics do not allow the simultaneous achievement of all three.

The Impossible Trinity

• Suppose the central bank is independent and capital is free to move and there is inflationary pressure in the economy so the central bank wants to reduce money supply (i.e., a contractionary monetary policy).
• The can do this by:
  • Selling short-term government bonds in open market which will reduce bond prices and increase interest rates.
  • When interest rate increases, foreign capital flows in causing domestic currency to appreciate.

A Single Currency for Europe: The Euro

• In December 1991, the members of the European Union met at Maastricht, the Netherlands, to finalize a treaty that changed Europe's currency future.
• This treaty set out a timetable and a plan to replace all individual ECU currencies with a single currency called the euro.
• To prepare for the EMU, a convergence criteria was laid out whereby each member country was responsible for managing the following to a specific level:
  • Nominal inflation rates
  • Long-term interest rates
  • Fiscal deficits
  • Government debt
• In addition, a strong central bank, called the European Central Bank (ECB), was established in Frankfurt, Germany in 1998.
• The euro affects markets in three ways:
  • Cheaper transaction costs in the eurozone
  • Currency risks and costs related to uncertainty are reduced
  • All consumers and businesses both inside and outside the eurozone enjoy price transparency and increased price-based competition
• If the euro is to be successful, it must have a solid economic foundation.
• The primary driver of a currency's value is its ability to maintain its purchasing power.
• The single largest threat to maintaining purchasing power is inflation.
  • The job of the EU has been to prevent inflationary forces from undermining the euro.
• All initial euro adopters (except UK and Denmark) had pegged their currency to the ECU for the previous 20 years aided in the initial success of the euro.
• All members of the EU are expected eventually to replace their currencies with the euro, but debate exists as to how far euro-expansion can feasibly extend.
• The UK has always been outside the euro and The Brexit vote in June 2016 did not change that relationship.