International Financial System Lesson #2 International Monetary System (IMS) Nichosova T. International Financial System

Taras Shevchenko Kyiv University. Economic Department Outline 1.History of Bimetallism 2.Golden Standard ( ) a.General Approach (1880 – 1918) b.The Period between the Wars ( ) 3.Bretton Woods or Fixed ER Regime ( ) a.General Approach ( ) b.The Role of US Dollar c.Collapse of the Fixed Exchange Rate System ( ) 4.Floating Exchange Rate Regime (since 1976) a.IMS under Jamaica Agreement b.Exchange Rate Regimes in Practice 5.European Monetary System Nichosova T. International Financial System 2

Taras Shevchenko Kyiv University. Economic Department Learning Outcomes Statement The student should be able to: 1)identify and interpret the stages of IMS evolution 2)define and interpret key characteristics of IMS 3)explain the reasons that coursed IMS to switch from one standard to another 4)formulate and explain competitive devaluations approach under Golden Standard 5)discuss the role of US dollar in Bretton Woods system 6) explain why the fixed ER system collapsed 7)understand the role of Jamaica agreement 8)discuss why ER became more volatile since )compare and contrast fixed and floating ER regimes 10)understand relative purchasing power parity and interest rate parity relation 11)define major characteristics and drawbacks of the pegged ER policy 12)discuss major characteristics, merits and drawbacks of currency board existence 13)understand major objectives of EMS creation 14)discuss the role of ECU and ERM in introduction of Euro 15)compare and contrast main rules of ERM in 1979 and in Nichosova T. International Financial System 3

Taras Shevchenko Kyiv University. Economic Department History of Bimetallism Money:golden / silver coins Functions:medium of exchange, unit of account, store of value M supply: depends on the amount of gold/silver in the country Sources of M:reserves of gold/silver(government & natural), export ER base:there was no need for exchange rate determination Deficiency:inconvenience during large volume of international trade expanded in the wake of the Industrial Revolution Solution:to arrange for payment in paper currency and for governments to agree to convert the paper currency into gold on demand at a fixed rate (Golden Standard) Nichosova T. International Financial System

Taras Shevchenko Kyiv University. Economic Department Golden Standard. General Approach Money: paper currency converted into gold on demand at a fixed rate Functions:medium of exchange, unit of account, store of value M supply: depends on the amount of gold in the country and convertion ratio Sources of M:reserves of gold (government & natural), export, devaluation of the convertion ratio ER base:depends on the convertion ratios of the local currencies Nichosova T. International Financial System 5 CurrencyOunces of gold / unit Units / ounce of gold Gold par value US dollar0,04820,67 British pound0,2354,25 ER: $20.67/£4.25 or £1 = $4.87

Taras Shevchenko Kyiv University. Economic Department Golden Standard. General Approach Strength: it contained a powerful mechanism for achieving balance-of-trade equilibrium by all countries Nichosova T. International Financial System 6 Deficiency: there was no multinational institution that could stop countries from engaging in competitive devaluations Solution:suspension of convertibility Country ACountry B 1Demand for goodsHighLow 2Contries golden reservesGAGA GBGB 3Balance of tradePositiveNegative 4Countries golden reservesG A +BPG B -BP 5Money supplyIncreaseDecrease 6Price of goodsRiseFall 7Demand for goodsLowHigh

Taras Shevchenko Kyiv University. Economic Department Golden Standard. The Period between the Wars Nichosova T. International Financial System 7 Great Britain Returned to the GS by pegging the pound to gold at the pre-war gold parity level of £4.25 per ounce, despite substantial inflation between 1914 and 1925 Goods are priced out of foreign markets. GB fall into deep depression Foreigners lost confidence in Great Britain's commitment to maintaining its currency's value and begin to convert pounds into gold British government suspended convertibility in 1931

Taras Shevchenko Kyiv University. Economic Department Golden Standard. The Period between the Wars Nichosova T. International Financial System 8 USA Returned to GS in 1934, raising the dollar price of gold from $20.67 per ounce to $35 per ounce Dollar worth less relative to other currencies: - before devaluation £1 = $ after devaluation £1 = $8.24 The price of export increase. The government was trying to create employment in the United States by boosting output

Taras Shevchenko Kyiv University. Economic Department Golden Standard. The Period between the Wars Nichosova T. International Financial System 9 Each country tried to devaluate their currency to have more competitive position at the world market. In the cycle of competitive devaluations that soon emerged, no country could win Other countries

Taras Shevchenko Kyiv University. Economic Department Golden Standard. The Period between the Wars M supply: depends on the conversion ratio Sources of M: export, printing machine ER base: depends on the conversion ratios of the local currencies Deficiency:with countries devaluing their currencies at will, one could no longer be certain how much gold a currency could buy Solution:to design a new international monetary system with multinational institution that will ensure fixed exchange rates Nichosova T. International Financial System 10

Taras Shevchenko Kyiv University. Economic Department Bretton Woods IMS. General Approach Nichosova T. International Financial System 11 Money:paper currency converted into gold through US dollars Functions:medium of exchange, unit of account (?), store of value (?) M supply: depends on the central bank policy and IMF requirements Sources of M:export, printing machine (IMF approval is needed if devaluation is more than 10%)

Taras Shevchenko Kyiv University. Economic Department Bretton Woods IMS. General Approach Nichosova T. International Financial System 12 Exchange Rate base: each country decided what it wanted its exchange rate to be vis-à-vis the dollar and then calculated the gold par value of the currency based on that selected dollar exchange rate. All 44 countries agreed to try to maintain the value of their currencies within 1 % of the par value by buying or selling currencies (or gold) as needed

Taras Shevchenko Kyiv University. Economic Department Bretton Woods IMS. General Approach Nichosova T. International Financial System 13 Multinational organizations: IMF to maintain order in the international monetary system WB to promote general economic development Deficiency: the system could not work if its key currency, the US dollar, was under speculative attack. The Bretton Woods system could work only as long as the US inflation rate remained low and the United States did not run a balance-of- payments deficit

Taras Shevchenko Kyiv University. Economic Department Bretton Woods IMS. The Role of US Dollar Nichosova T. International Financial System 14 I. US dollar as International Benchmark the only currency that could be converted into gold the currency that served as the reference point for all others II. US dollar as US currency local currency that serves the interests of US

Taras Shevchenko Kyiv University. Economic Department Bretton Woods IMS. The Role of US Dollar Nichosova T. International Financial System 15 Under the Bretton Woods provisions: any other country could change its exchange rates against all currencies simply by fixing its dollar rate at a new level as the key currency in the system, the dollar could be devalued only if all countries agreed to simultaneously revalue against the dollar Many countries did not want this, because it would make their products more expensive relative to US products

Taras Shevchenko Kyiv University. Economic Department Bretton Woods IMS. The Role of US Dollar International Interests US Interests Rise to speculation in the foreign exchange market that the dollar would be devalued Increase in inflation and the worsening of the US foreign trade position: To finance both the Vietnam conflict and President Johnson welfare programs by increase in the money supply: No speculation with US dollar on exchange market Low Inflation Positive Trade Balance: Nichosova T. International Financial System 16 Trade off between national and international interests

Taras Shevchenko Kyiv University. Economic Department Collapse of the Fixed Exchange Rate System Nichosova T. International Financial System 17

Taras Shevchenko Kyiv University. Economic Department Collapse of the Fixed Exchange Rate System 1 March 1971 The US was importing more than it was exporting for the first time since 1945 March – May 1971 Massive purchases of deutsche marks in the foreign exchange market by speculators who guessed that the mark would be revalued against the dollar 4 May 1971 Bundesbank had to buy $1 billion to hold the dollar/deutsche mark exchange rate at its fixed rate Nichosova T. International Financial System 18

Taras Shevchenko Kyiv University. Economic Department Collapse of the Fixed Exchange Rate System 5 May 1971 Bundesbank purchased another $1 billion during the 1 st hour of foreign exchange trading. Bundesbank allowed its currency to float August 71 President Nixon announced that: 1) the dollar was no longer convertible into gold 2) new 10 % tax on imports would remain in effect until US trading partners agreed to revalue their currencies against the dollar Nichosova T. International Financial System 19

Taras Shevchenko Kyiv University. Economic Department Collapse of the Fixed Exchange Rate System December 1971 An agreement was reached to devalue the dollar by about 8 % against foreign currencies. The import tax was then removed December – February 1971 US balance-of-payments position continued to deteriorate and M supply continued to expand at an inflationary rate Foreign exchange dealers anticipated the 2nd wave of dollar devaluation and bought European currencies European Central Banks spent $3.6 billion by 1 st of March to try to prevent their currencies from appreciating against the dollar Nichosova T. International Financial System 20

Taras Shevchenko Kyiv University. Economic Department Collapse of the Fixed Exchange Rate System March 1, 1972 Foreign Exchange market closed 19 March 1972 When the foreign exchange market reopened the currency of Japan and most European countries were floating against the dollar Nichosova T. International Financial System 21

Taras Shevchenko Kyiv University. Economic Department Floating Exchange Rate Regime. Jamaica Agreement The main elements of Jamaica Agreement: Floating rates were declared acceptable. IMF members were permitted to enter the foreign exchange market to even out "unwarranted" speculative fluctuations Gold was abandoned as a reserve asset. The IMF returned its gold reserves to members at the current market price, placing the proceeds in a trust fund to help poor nations. IMF members were permitted to sell their own gold reserves at the market price Nichosova T. International Financial System 22

Taras Shevchenko Kyiv University. Economic Department Floating Exchange Rate Regime. Jamaica Agreement The main elements of Jamaica Agreement (cont.): Total annual IMF quotas--the amount member countries contribute to the IMF--were increased to $41 billion. (Since then they have been increased to $195 billion while the membership of the IMF has been expanded to include 186 countries.) Non-oil-exporting, less developed countries were given greater access to IMF funds After Jamaica, the IMF continued its role of helping countries cope with macroeconomic and exchange rate problems, albeit within the context of a radically different exchange rate regime Nichosova T. International Financial System 23

Taras Shevchenko Kyiv University. Economic Department Exchange Rates since 1973 Since March 1973, exchange rates have become much more volatile and less predictable than they were between 1945 and This volatility has been partly due to a number of unexpected shocks to the world monetary system, including: The oil crisis in 1971, when the Organization of Petroleum Exporting Countries (OPEC) quadrupled the price of oil. The harmful effect of this on the US inflation rate and trade position resulted in a further decline in the value of the dollar. The loss of confidence in the dollar that followed the rise of US inflation in 1977 and 1978 …(cont.) Nichosova T. International Financial System 24

Taras Shevchenko Kyiv University. Economic Department Exchange Rates since 1973 The oil crisis of 1979, when OPEC once again increased the price of oil dramatically--this time it was doubled. The unexpected rise in the dollar between 1980 and 1985, despite a deteriorating balance-of-payments picture. The rapid fall of the US dollar against the Japanese yen and German deutsche mark between 1985 and 1987, and against the yen between 1993 and The partial collapse of the European Monetary System in The 1997 Asian currency crisis, when the Asian currencies of several countries, lost between 50 to 80 % of their value against the US dollar in a few months Nichosova T. International Financial System 25

Taras Shevchenko Kyiv University. Economic Department Exchange Rates since Nichosova T. International Financial System 26 Source: JP Morgan, Effective Exchange Rate Index, (1990=100.) Long-Term Exchange Rate Trends A C B

Taras Shevchenko Kyiv University. Economic Department Exchange Rates since US dollar case Nichosova T. International Financial System 27 A Rising period The factors that stimulated the growth where stronger, than those that hold it: 1.Hold factor: US running large and growing trade deficit. In 1985 US posted a record-high trade deficit of over $160 billion 2.Growth factors: (i) strong economic growth in the US along with relatively slow economic growth in the developed countries of Europe; (ii) high real interest rates; (iii) political turmoil in other parts of the world.

Taras Shevchenko Kyiv University. Economic Department Exchange Rates since US dollar case Nichosova T. International Financial System 28 B Declining period The factors that stimulated decline in growth where: 1.Government intervention. According to Plaza Accord (Sept. 1985) the finance ministers and central bank governors of G5 announced that it would be desirable for most major currencies to appreciate vis-à-vis the US dollar and pledged to intervene in the foreign exchange markets, selling dollars, to encourage this objective. 2.Market forces. The dollar begun to weaken in the summer of 1985, and this announcement further accelerated the decline. The dollar continued to decline until early The governments of the Group of Five even began to worry that the dollar might decline too far.

Taras Shevchenko Kyiv University. Economic Department Exchange Rates since US dollar case Nichosova T. International Financial System 29 C Stable period The main factor was intergovernmental agreement (G5) known as Louvre Accord. According to the accord ER had been realigned sufficiently and pledged to support the stability of ER around their current levels by intervening in the foreign exchange markets. Except for a brief speculative flurry around the time of the Persian Gulf War in 1991, the dollar has been relatively stable since then against most major currencies with the notable exception of the Japanese yen

Taras Shevchenko Kyiv University. Economic Department Exchange Rates since Nichosova T. International Financial System 30 Market forces produce a volatile dollar exchange rate Governments respond by intervening in the market-buying and selling currency-in attempting to limit the market's volatility and to correct what they see as overvaluation ($ in 1985) or potential undervaluation ($ in 1987) of the currency The frequency of government intervention in the foreign exchange markets explains why that system is often referred to as a managed-float system or a dirty float system.

Taras Shevchenko Kyiv University. Economic Department Fixed Versus Floating Exchange Rates Nichosova T. International Financial System 31 Fixed ER Merits 1) monetary discipline 2) limit of the destabilizing effects of speculation 3) fixed exchange rate, by eliminating uncertainty, promotes the growth of international trade and investment (?) Floating ER Merits 1) government has monetary control 2) trade balance adjustment. If a country is running a trade deficit, the imbalance between the S and D of that country's currency will lead to depreciation in its ER that should correct trade deficit

Taras Shevchenko Kyiv University. Economic Department Fixed Versus Floating Exchange Rates Nichosova T. International Financial System 32 Fixed ER Drawbacks 1) countries are limited in their ability to use monetary policy to expand or contract their economies 2) if a country developed a permanent deficit in its balance of trade that would require the IMF to agree to a currency devaluation Floating ER Drawbacks 1) lack of monetary discipline. Governments all too often expand the M supply far too rapidly, causing unacceptably high price inflation 2) speculation can cause fluctuations in exchange rates 3) Uncertainty dampens the growth of international trade and investment (?)

Taras Shevchenko Kyiv University. Economic Department Exchange Rate Regimes in Practice Nichosova T. International Financial System 33 Source: IMF data Exchange Rate Policies Adopted by Member States of the IMF in 1987

Taras Shevchenko Kyiv University. Economic Department Pegged Exchange Rates Nichosova T. International Financial System 34 Major characteristics of the pegged ER policy: the country pegs the value of its currency to that of a major currency it is imposes monetary discipline on a country and leads to low inflation pegged exchange rates are popular among many of the world's smaller nations to impose monetary discipline on a country, the country whose currency is chosen for the peg must also pursue sound monetary policy (see relative Purchasing Power Parity formula)

Taras Shevchenko Kyiv University. Economic Department Pegged Exchange Rates Nichosova T. International Financial System 35 Relative PPP: where S1 – spot ER at the start of the period (the foreign price of the one unit of the domestic currency) S2 – spot ER at the end of the period IFC – inflation rate, over the period, in the foreign country IDC – inflation rate, over the period, in domestic country

Taras Shevchenko Kyiv University. Economic Department Pegged Exchange Rates Nichosova T. International Financial System 36 Source: IMF data

Taras Shevchenko Kyiv University. Economic Department The Drawback of Pegged ER Regime is that it can be very difficult for a smaller country to maintain a peg against another currency if: – capital is flowing out of the country – foreign exchange traders are speculating against the currency In 1997 Asian countries (incl. Thailand and Malaysia) abandon pegs against the US dollar and let their currencies float freely after combination of adverse capital flows and currency speculation. This situation was coursed by excessive private-sector debt and expanding current account trade deficits in early 1990s. Pegged Exchange Rates Nichosova T. International Financial System 37

Taras Shevchenko Kyiv University. Economic Department Currency Board A country that introduces a currency board commits itself to converting its domestic currency on demand into another currency at a fixed exchange rate. To make this commitment credible, the currency board holds reserves of foreign currency equal at the fixed exchange rate to at least 100 % of the domestic currency issued Nichosova T. International Financial System 38

Taras Shevchenko Kyiv University. Economic Department Currency Board It means that country currency must be fully backed by the chosen currency at the specified exchange rate. This is still not a true fixed exchange rate regime, because, e.g. the US dollar, and by extension the Hong Kong dollar, floats against other currencies, but it has some features of a fixed exchange rate regime Nichosova T. International Financial System 39

Taras Shevchenko Kyiv University. Economic Department Currency Board Nichosova T. International Financial System 40 Major characteristics of ER regime under Currency Board: 1)the currency board can issue additional domestic notes and coins only when there are foreign exchange reserves to back it 2)the ability of the government to print money and, thereby, create inflationary pressures is limited 3)Interest rates adjust automatically (Interest Rate Parity Relation)

Taras Shevchenko Kyiv University. Economic Department Currency Board Nichosova T. International Financial System 41 Interest Rate Parity Relation where F – forward rate S – spot rate r FC – interest rate of the foreign currency r DC – interest rate of the domestic currency the exchange rates are indirect quotes as the number of units of foreign currency FC for one unit of domestic currency DC

Taras Shevchenko Kyiv University. Economic Department Currency Board Merits – Hong Kong's success in avoiding the currency collapse that affected its Asian neighbors suggests that other developing countries may adopt a similar system. – Argentina introduced a currency board in 1991, and Bulgaria, Estonia, and Lithuania have all gone down this road in recent years Nichosova T. International Financial System 42

Taras Shevchenko Kyiv University. Economic Department Currency Board Drawbacks – if local inflation rates remain higher than the inflation rate in the country to which the currency is pegged, the currencies of countries with currency boards can become uncompetitive and overvalued – government lacks the ability to set interest rates. Interest rates in Hong Kong, for example, are effectively set by the US Federal Reserve Nichosova T. International Financial System 43

Taras Shevchenko Kyiv University. Economic Department Target Zones: The European Monetary System Major characteristics: an exchange rate system based on target zones involves a group of countries trying to keep their currencies within a predetermined range, or zone, of other currencies in the group Nichosova T. International Financial System 44

Taras Shevchenko Kyiv University. Economic Department Target Zones: The European Monetary System The exchange rate mechanism (ERM) that was a central part of the European Monetary System (EMS) of the European Union between 1979 and 1999 is the most famous example of this kind of system To establish a common currency, the EU needed to achieve convergence between the inflation rates and interest rates of its member states. The European Monetary System (EMS) was a mechanism for attaining this goal Nichosova T. International Financial System 45

Taras Shevchenko Kyiv University. Economic Department Target Zones: The European Monetary System The EMS created in March 1979 was entrusted with 3+1 main objectives: 1)to create a zone of monetary stability in Europe by reducing exchange rate volatility and converging national interest rates; 2)to control inflation through the imposition of monetary discipline; Nichosova T. International Financial System 46

Taras Shevchenko Kyiv University. Economic Department Target Zones: The European Monetary System The EMS created in March 1979 was entrusted with 3+1 main objectives: 3)to coordinate exchange rate policies versus non-EU currencies such as the US dollar and the yen; 4)in 1991, the objective of introduction of a common currency in 1999 was added to this list. Two instruments were used to achieve these objectives: – the European currency unit (ECU) – the exchange rate mechanism (ERM) Nichosova T. International Financial System 47

Taras Shevchenko Kyiv University. Economic Department Target Zones: The European Monetary System Nichosova T. International Financial System 48 ECU The ECU was a basket of the EU currencies that served as the unit of account for the EMS One ECU comprised a defined percentage of national currencies The share of each country's currency in the ecu depended on the country's relative economic weight within the EU

Taras Shevchenko Kyiv University. Economic Department Target Zones: The European Monetary System Nichosova T. International Financial System 49 ECU Until 1992, each national currency in the EU was given a central rate vis-à-vis the ECU. From these central rates flowed a series of bilateral rates. In September 1989, one ECU was equal to – DM – Fr – £ Before 1992, the rule was that a currency must not depart by more than 2.25% from its bilateral central rate with another ERM participating currency

Taras Shevchenko Kyiv University. Economic Department Target Zones: The European Monetary System ERM. General Rules intervention in the foreign exchange markets was compulsory to keep currencies within the 2.25 % band the central bank of the country with the stronger currency was supposed to buy the weaker currency, and vice versa. It tended to be left to the country with the weaker currency to take action Nichosova T. International Financial System 50

Taras Shevchenko Kyiv University. Economic Department Target Zones: The European Monetary System ERM. Defensive instruments each member could borrow almost unlimited amounts of foreign currency from other members for up to 3 months 2 nd line of defense included loans that could be extended for up to 9 months, but the total amount available was limited to a pool of credit – originally about 14 billion ECUs – and the size of the member's quota in the pool additional funds were available for maturities from 2 to 5 years from a 2 nd pool of about 11 billion ECUs(originally) as a condition of using these funds, the borrowing member had to commit itself to correcting the economic policies causing its currency to deviate Nichosova T. International Financial System 51

Taras Shevchenko Kyiv University. Economic Department Target Zones: The European Monetary System Nichosova T. International Financial System 52 YearAv. annual rate of inflation Max-Min 19934%5% %1.7%

Taras Shevchenko Kyiv University. Economic Department Literature 1.Peter Isard. Globalization and the International Financial System. What's Wrong and What Can Be Done - IMF Institute, Washington DC – Bruno Solnik, Dannis McLeavy. International Investments. 5 th Edition. – The Addison-Wesley series in finance – 2004 – 760 p. 3.Baltina А.М. Financial systems of foreign countries: study guide / А.М. Baltina, V.А. Volohina, N.V. Popova. – М.: Finances and statistics, – 304 p. 4.Borynets S.Y. International finances: Textbook. – 2-nd edition, readjusted and complemented – К.: Znannya, – 494 p. 5.The argument goes back to 18th century philosopher David Hume. See D. Hume, "On the Balance of Trade," reprinted in The Gold Standard in Theory and in History, ed. B. Eichengreen. (London: Methuen, 1985). 6.R. Solomon, The International Monetary System, (New York: Harper & Row, 1982). 7.For an extended discussion of the dollar exchange rate in the 1980s, see B. D. Pauls, "US Exchange Rate Policy: Bretton Woods to the Present," Federal Reserve Bulletin, November 1990, pp A. R. Ghosh and A. M. Gulde, "Does the Exchange Rate Regime Matter for Inflation and Growth?" Economic Issues, no. 2, (1997). 9."The ABC of Currency Boards," The Economist, November 1, 1997, p N. Colchester and D. Buchan, Europower (New York: Random House, 1990), and D. Swann, The Economics of the Common Market (London: Penguin Books, 1990). 11.M. Wolf, "Emu May Not Be Dead After All." Financial Times, August 1, 1994, p P. Norman, "A test for the ERM and a Warning for the Emu," Financial Times, March 7, 1995, p Nichosova T. International Financial System

Taras Shevchenko Kyiv University. Economic Department Homework Nichosova T. International Financial System 54 Form: Report on the chosen topic in frame of International Financial Crises Topics: 1. The World Debt Crises (OPEC oil price hikes in 1973 and 1979) 2. Mexican Currency Crisis of Russian Ruble Crisis The Asian Crisis 1998 Structure of the review: 1.General overview 2.The reasons that caused crisis 3.Attempts to avoid crisis 4. Implications of the crises 5.Lessons learned 6.Literature Size:10 slides is max Duration: 30 min In class: be ready to discuss the role of the IMF in International financial crises