The is the collection of agreements and institutions that govern exchange rates

5.3.1 International Monetary Systems

The international monetary system refers to the operating system of the financial environment, which consists of financial institutions, multinational corporations, and investors. The international monetary system provides the institutional framework for determining the rules and procedures for international payments, determination of exchange rates, and movement of capital.

The major stages of the evolution of the international monetary system can be categorized into the following stages.

3.4 Conclusions and policy implications

This chapter has revisited an old dilemma: Any international monetary system based on a reserve asset that is simultaneously used as national currency, may be characterized by increasing indebtedness of the center country. Whereas this dilemma has been identified long before, this study is the first to evaluate the effects of reserve currency status empirically. The evidence is striking: The accumulation of reserves in developing countries is correlated with a larger current account balance, while this effect is absent in industrial countries. This finding supports the mercantilist explanation for reserve accumulation. The global accumulation of reserves lowers the current account balance of the US, which is the major provider of reserve assets. Any additionally accumulated dollar of reserve assets lowers the US current account by 1 to 2 dollars. Private and official capital flows basically do not affect each other. If the US lost its reserve currency status, its current account balance relative to GDP would improve by 1 to 2 percentage points.32 These numbers are economically significant. Expressed in absolute terms they are outstanding. The existence of the Triffin dilemma is confirmed empirically.

The stylized constellation between the US and emerging markets, with the latter financing the current account deficit of the former by their accumulation of reserves, has its precedent in history (see Meissner, 2010): During the 1920s, France accumulated British sterling, the reserve currency at that time, and contributed to a secular decrease of the British current account.

Our empirical approach has focused on the reserve currency status of the US. Using a historical data set, further research might extend this case study and examine the relationship between reserve currency status and current account balance for the period of sterling dominance before World War II. Special insights might be provided by the changeover from the sterling to the dollar.

While the lower current account balance is an equilibrium outcome, persistent deficits and a deteriorating net external asset position may undermine the confidence in the reserve currency in the long run.33 The theoretical and empirical literature concurs that persistent current account deficits are associated with a higher incidence of currency crises (see Frankel and Saravelos, 2012). As a result, the reserve currency status endogenously increases the vulnerability to financial crises in the long run. In conjunction with a decreasing US share in global economic activity and rising alternative reserve currencies this process might challenge the dollar's role in the long run. It has to be noted, however, that current account deficits in reserve currency countries might be less of concern than in other countries: Investors might react non-linearly to deficits depending on the status of the nation.34

In an early work Kenen (1960) examines the conditions under which the dollar might lose its role as reserve currency. In particular, he assesses the impact of changes in the US ratio of gold to foreign-owned dollar debt for the working of the gold–dollar standard of that time. The theoretical model shows that a lasting deficit of the US balance of payments may erode confidence in the dollar, cause countries to switch to gold and bring about global instability. Once reserve liabilities exceed the gold stock of the reserve currency country, the international monetary system enters a “crisis zone”: Central bank runs, characterized by central banks substituting gold for dollar assets, become self-fulfilling (Officer and Willett, 1969). Under the present system without guaranteed gold conversion, one might argue that reserves are backed by US foreign assets or US GDP. The crisis zone is then characterized by foreign assets falling short of foreign liabilities. According to this definition, the dollar standard has been in a crisis zone since 1985. Alternatively, Farhi et al. (2011) argue that the confidence of the dollar standard is linked to the fiscal capacity of the US.35,36 In an empirical study, which analyzes the determinants of safe haven currencies, Habib and Stracca (2012) find that safe haven status is positively associated with a country's net foreign asset position.

The finding that reserve currency status lowers the current account balance of the dominant center country, however, is not linked to the specific situation of the US being the reserve currency provider. The problem is a more fundamental one: It lies in the fact that a national currency is used as the global reserve currency (see Taylor, 2013). Therefore, shifting to another currency – with the Euro or Renminbi being viable choices – would not solve the underlying problem. While another country might provide a stable reserve currency in the short run, in the long run the Triffin dilemma strikes back: Any reserve currency, that provides the demanded assets in sufficient amounts to the rest of the world, is likely to face a deterioration in its current account and net foreign asset position.

The International Monetary Fund

The International Monetary Fund (IMF) was established in 1946 to “promote international monetary cooperation, exchange stability and orderly exchange arrangements; to foster economic growth and high levels of employment; and to provide temporary financial assistance to countries to help ease balance of payments adjustment.” It carries out these functions through loans, monitoring, and technical assistance.

Since 1962, the IMF has provided emergency assistance to its 188 member countries after they were struck by natural disasters, and, in a great many cases, when affected by complex emergencies. The assistance provided by the IMF is designed to meet the country’s immediate foreign-exchange financing needs, which often arise because earnings from exports fall while the need for imports increases (among other causes). IMF assistance also helps the affected countries avoid serious depletion of their external reserves.

In 1995, the IMF began to provide this type of emergency assistance to countries facing post-conflict scenarios in order to enable them to reestablish macroeconomic stability and to provide a foundation for recovery, namely in the form of long-term sustainable growth. This type of assistance is particularly important when a country must cover costs associated with an “urgent balance of payments need, but is unable to develop and implement a comprehensive economic program because its capacity has been damaged by a conflict, but where sufficient capacity for planning and policy implementation nevertheless exists” (IMF 2005). The IMF maintains that their support must be part of a comprehensive international effort to address the aftermath of a conflict in order to be effective. Its emergency financing is provided to assist the affected country and to gather support from other sources.

It is not uncommon for a country to severely exhaust its monetary reserves in response to an emergency situation. In the event of a natural disaster, funding is directed toward local recovery efforts and any needed economic adjustments. The IMF lends assistance only if a stable governing body is in place that has the capacity for planning and policy implementation and can ensure the safety of IMF resources. After stability has been sufficiently restored, increased financial assistance is offered, which is used to develop the country in its post-emergency status.

When a country requests emergency assistance, it must submit a detailed plan for economic reconstruction that will not create trade restrictions or “intensify exchange.” If the country is already working under an IMF loan, assistance may be in the form of a reorganization of the existing arrangement. It can also request emergency assistance under the Rapid Financing Instrument (RFI).

The Rapid Financing Instrument (RFI) is the vehicle that the IMF uses to meet disaster-impacted countries’ financing needs. The RFI provides funding quickly and with few requirements in instances where it is determined that a disaster or emergency situation has resulted in urgent balance-of-payments needs. Emergencies need not be related to a natural or technological hazard—they can also be the result of rapid increases in the price of certain commodities or because of an economic crisis. Unlike other IMF assistance, there does not need to be a full-fledged financing program in place.

Prior to the creation of the RFI, the IMF used a number of separate programs to address emergency needs, including the Emergency Natural Disaster Assistance (ENDA) program and the Emergency Post-Conflict Assistance (EPCA) program. The 2011 creation of the RFI program combines all emergency needs. RFI financial assistance is provided in the form of outright purchases without the need for a full-fledged program or reviews. However, when a country does request assistance under RFI, they must cooperate with the IMF to make every effort to solve their balance-of-payment problems, and must explain the economic policies it proposes to follow to do so.

The IMF makes the RFI program available to all of its members, though oftentimes very poor countries are more likely to seek assistance under a different program called the Rapid Credit Facility (RCF), which provides similar assistance but has economic-based requirements that many wealthier countries cannot meet. Funds access under the RFI program is limited to 50 percent of a nation’s quota per year and 100 percent of quota on a cumulative basis. Under the RCF program, the access limits are 50 percent of a nation’s quota per year and 125 percent of quota on a cumulative basis. The level of access in each case depends on the country’s balance-of-payments need. Financial assistance provided under the RFI is subject to many of the same financing terms that nations would see in other IMF programs, and the funds borrowed are ideally paid back within 39 to 60 months (IMF 2011).

In certain cases, as decided by the IMF and according to specific criteria, recipients of emergency funding may benefit from the IMF Poverty Reduction and Growth Facility (PRGF). The PRGF is the IMF’s low-interest lending facility for low-income countries. PRGF-supported programs are underpinned by comprehensive country-owned poverty reduction strategies. Under this program, the interest rate on loans is subsidized to 0.5 percent per year, with the interest subsidies financed by grant contributions from bilateral donors. This program has been available for post-conflict emergencies since 2000, but in January 2005, following the South Asia tsunami events, the IMF Executive Board agreed to provide a similar subsidization of emergency assistance for natural disasters upon request.

The government of a country devastated by disaster often requires technical assistance or policy advice because it has no experience or expertise in this situation. This is especially common in post-conflict situations, where a newly elected or appointed government has been established and officials are rebuilding from the ground up. The IMF offers technical assistance in these cases to aid these countries in building their capacity to implement macroeconomic policy. This can include tax and government expenditure capacity; the reorganization of fiscal, monetary, and exchange institutions; and guidance in the use of aid resources.

Introduction

Formal monetary unions, in which two or more countries agree to give up their national currencies for a single, shared currency, are rare events in the history of international monetary cooperation. The Eurozone, which is analyzed in detail elsewhere in this volume, is the most important modern-day example. There are other types of monetary regimes, ranging in the degree to which countries surrender national monetary sovereignty for exchange rate stability. Examples include dollarization, currency boards, and pegged exchange rate systems.

After a general discussion of the major types and examples of monetary regimes, this chapter considers three important periods of multilateral cooperation, culminating in the Bretton Woods system of fixed exchange rates, which lasted from 1944 to 1971. Under Bretton Woods, the world's industrialized countries and much of the developing world, save for the Soviet bloc, agreed to fix the values of their currencies to gold and to maintain fixed exchange rates within a narrow band of ±1%. The Bretton Woods countries also committed themselves to the free convertibility of all currencies within the system and to open trading markets. The design of the Bretton Woods system, fashioned from an Anglo-American compromise at the end of World War II, was based heavily on the lessons learned from two earlier eras of international monetary cooperation, the classical gold standard of the 1870s to 1913 and the gold-exchange standard of 1925–31, which are also explored in this essay.

Bretton Woods worked remarkably well for the first few decades of its existence, and global finance responded positively to the corollary exchange rate stability and reduced risk in international investment. In the end, however, it was global finance itself – reacting to the fundamental weakening of the US commitment to dollar–gold parity over time – which helped to place the system under stress. By 1971, the inconsistency between an expanding supply of US dollars and a commitment to dollar–gold parity led some countries to demand conversion of their dollars into gold. The weight of that conversion burden on the United States was too great to uphold, and the system of fixed exchange rates relative to the dollar came to an end. Since the end of Bretton Woods, there has been little in the way of international monetary cooperation, apart from a few important one-off agreements such as the Plaza Agreement of 1985 and the Louvre Accords of 1987.

What is remarkable is that, despite the current era of non-cooperation, which has been accompanied by exchange rate volatility and massive current account imbalances, global finance has continued to flourish. The explanation for this trend lies partly in the relaxation of capital controls post-Bretton Woods and technical innovations in global finance, including exchange rate derivatives and other forms of financial hedging.

Abstract

International monetary relations are subject to frequent change, with fixed exchange rates, floating exchange rates, and commodity-backed currency all having their advocates. This chapter considers the merits of various alternative international monetary systems, and also provides an interesting and useful historical background of the international monetary system, beginning with the late 19th century when the gold standard began and continuing to present-day systems. International reserve currencies are discussed in detail, with emphasis on the types of foreign exchange arrangements. Major topics covered include currency boards, “dollarization,” choices of exchange rate systems, optimum currency areas, the European Monetary System, and the emergence of the euro.

The Articles of Agreement

In 2010, the Fund had 31 Articles of Agreement. They set out the IMF's obligations to its member countries and conversely members’ duties to the Fund. Article I describes the Fund's main goals as promoting exchange stability and “international monetary cooperation; facilitating the expansion and balanced growth of international trade; assisting in the establishment of a multilateral system of payments; and making resources available (with adequate safeguards) to members experiencing balance of payments difficulties.” Article II concerns membership, while Article III determines quotas. Section 1 of the important Article IV sets out members’ responsibilities: “each member undertakes to collaborate with the Fund and other members to assure orderly exchange arrangements and to promote a stable system of exchange rates.” Section 3 notes that “The Fund shall oversee the international monetary system to ensure its effective operation and shall oversee the compliance of each member with its obligations under Section 1 of this article.” Section 3 gives the rationale for the Fund's surveillance in its Article IV assessments of individual countries’ economies and policies, for its biannual World Economic Outlook (WEO) and Global Financial Stability Reports (GFSRs), and for its vigorous research activities. Article VIII lays out members’ general obligations to the Fund, while Article XXVI and the Fund's Bylaws specify the sanctions that the Fund can impose on members found not to have met their obligations. Article XV gives the IMF authority to allocate Special Drawing Rights (SDRs) to participating countries in order to supplement existing reserve assets. The subsequent ten articles set out the conditions governing SDRs.

Abstract

The chapter on “Global Aspects of Central Bank Policies”, the final part of this book, relates our findings to various aspects of global central banking: First, based on our theoretical and empirical results, we provide suggestions for a reform of the international monetary system in order to reduce instabilities linked to central banks' reserve policies. Second, we show how financial integration and global liquidity spillovers have increased the importance of central bank cooperation. This section provides some examples of how central banks have coordinated their actions in the past. Finally, by illustrating the interbank payment system of the European Union (Target) we show that Target balances arise from net cross-border capital flows. These balances are a form of official financing and may be considered as a substitute for reserves. They have contributed to balance-of-payments imbalances.

Introduction

The use of money goes back to the earliest kind of exchange and can be traced to settled societies 4000 years ago. But, none of these early uses of money meant there were monetary economies, far less international monetary arrangements; monetary economies are much more recent and date to parts of medieval Europe. International monetary relations developed sometime after that, perhaps in the late medieval and early modern period – 1400–1700. But, there was no international monetary system (some set of rules more or less formally agreed upon by participants for effecting international payments) until sometime after that again. It was really only after the emergence of the nation state and national monies, together with the great growth of international trade and capital flows in the nineteenth century that we can begin to talk about an international monetary system. It is therefore common and sensible, when discussing the international monetary system, to think in terms of the years after the 1860s.

Such a system will have a set of exchange rate arrangements and perhaps some other institutions that together facilitate the smooth working of the international payment arrangements. A good system will allow ready adjustment for balance-of-payments disequilibria. Different sorts of arrangements of the kinds implied have emerged at different times. Sometimes, these have been consciously designed but more often they have simply appeared as the outcome of the forces at work. Thus for example, it is obviously a short step from the use of commodity-based money to the acceptance of more formal rules and to a metallic standard and then to an international version.

Commodity money meant, in effect, fixed exchange rates in international transactions. For if one country defines its currency in terms of a unit of some metal and another does the same with its currency, then there is a fixed rate of one currency in terms of the other. (There could be small variations that reflected shipping and insurance and other transaction costs.) The attraction of fixed rates was that they reduced or even removed nominal exchange rate uncertainty. However, in the course of the development of the international monetary system, it became clear that not only was it on occasions impossible for some countries to adhere to a fixed rate, but also that different regimes had different kinds of attractions as policy options were freed or constrained. For example, if there is free capital mobility and country A pegs its rate to another country's, then it must have similar nominal interest rates to that country, and therefore sacrifice any independent monetary policy. For if its interest rate deviated from the other country, investors could borrow in the ‘low’ country and lend in the ‘high’ without fear of loss through movements in the exchange rate. If on the other hand capital movement were prohibited, then country A could have its pegged rate and its own interest rate policy. Or, if A did wish to maintain free capital movement, it could do so if it allowed its exchange rate to float. These different possibilities have become known as a ‘macroeconomic policy trilemma’ (Obstfeld and Taylor, 2004). Policy makers do not have complete policy freedom. They can have only two of the three out of the ‘inconsistent trinity’: (i) free capital movements, (ii) fixed exchange rates, and (iii) independent monetary policy.

This is a useful organizing framework that helps guide us through the changing regimes in history and helps in understanding why one regime gives way to another. Deep down it may be for political reasons, for example, when domestic objectives take precedence over international ones for the electorate.

There are many accounts of the evolution of monetary regimes and the determining factors in the transition from one to another. A monetary regime can be thought of as a set of monetary arrangements and the public's reaction to them. In order to be sustainable, the arrangements should be internally consistent – monetary policy, fiscal policy, and the exchange rate regime should be in agreement. And in addition, they must be credible to the public. Changes in the underlying conditions can produce the need for change in regimes, and these undoubtedly account for the transitions from one to another that have been witnessed over the last century and more. Across most of history, commodity money was used and the later and more refined versions of this were bimetallic systems using both gold and silver. By the end of the nineteenth century, most countries had adopted gold, a watered-down version of which lasted till the 1970s.

In the period from the second half of the nineteenth century to date, the international monetary system has had a number of different exchange rate regimes. And in addition, there have been numerous deviations from the more commonly prevailing regimes. There were broadly five different regimes across the period. In the two decades before 1880, there was some competition between the bimetallic (gold and silver) standard and the gold standard. From about 1880 to the outbreak of World War I (WWI), the classical gold standard was supreme. That broke down inevitably on the outbreak of war, and was followed after the war by a variety of attempts to cope in a world of turmoil. That coping lasted until the end of World War II (WWII). So, within the interwar period, there was: free floating (1919–25/27), a restored but different gold standard – the gold exchange standard (1925–31/33), and managed floating (1931/33–39). The unsatisfactory state of some of these arrangements led to the design of a new system for the postwar years.

The ambition was to draw consciously on the strengths of the gold standard but at the same time attempt to introduce some improvements in terms of flexibility. The Bretton Woods ‘system’ that was designed is usually said to have come into being in 1946, at least in its first form where there was less than full convertibility of currencies. But, the new arrangements with convertibility broke down in 1971. Since the early 1970s, the ‘system’ has been one essentially of floating exchange rates. And within that there were attempts to escape what was seen as excessive volatility. Monetary unions, currency boards, dollarization, and other measures have been adopted in these attempts.

Plan of Attack

This book can be thought of in terms of four main sections. To aid our understanding of the relationships among prices, exchange rates, and interest rates, we will consider existing theories, as well as the current state of research that illuminates their validity. For those students who choose to proceed professionally in the field of international finance, the study of this text should provide both a good reference and a springboard to more advanced work—and ultimately employment. Chapters 1 through 3Chapter 1Chapter 2Chapter 3 identify the key institutions and the historical types international monetary system as well as discussing the current system. In Chapters 4 through 7Chapter 4Chapter 5Chapter 6Chapter 7 the international monetary system is expanded by allowing payments to be due in a future time period. This results in a need for hedging instruments and expands the interaction between financial variables in different countries.

Chapters 8 through 11Chapter 8Chapter 9Chapter 10Chapter 11 are devoted to applied topics of interest to the international financial manager. Issues range from the “nuts and bolts” of financing imports and exports to the evaluation of risk in international lending to sovereign governments. The topics covered in these chapters are of practical interest to corporate treasurers and international bankers.

Chapters 12 through 15Chapter 12Chapter 13Chapter 14Chapter 15 cover the determinants of balance of payments and exchange rates. Government and industry devote many resources to trying to forecast the balance of payments and exchange rates. The discussion in these chapters includes the most important recent developments. Although there is some disagreement among economists regarding the relative significance of competing theories, as far as possible in an intermediate-level presentation, the theories are evaluated in light of research evidence. Altogether, these chapters present a detailed summary of the current state of knowledge regarding the determinants of the balance of payments and exchange rates.

At the beginning of this introduction we asked: Why study international money and finance? We hope that the brief preview provided here will have motivated you to answer this question. International finance is not a dull “ivory tower” subject to be tolerated, or avoided if possible. Instead, it is a subject that involves dynamic real-world events. Since the material covered in this book is emphasized daily in the newspapers and other media, you will soon find that the pages in International Money and Finance seem to come to life. To this end, a daily reading of The Wall Street Journal or the London Financial Times makes an excellent supplement for the text material. As you progress through the book, international financial news will become more and more meaningful and useful. For the many users of this text who do not go on to a career in international finance, the major lasting benefit of the lessons contained here will be the ability to understand the international financial news intelligently and effectively.