Lesson 03

UNIT II
LESSON
3
INTERNATIONAL MONETARY SYSTEM
CONTENTS
3.0 3.1 3.2 Aims and Objectives Introduction Gold Standard 3.2.1 Price-Specie-Flow Mechanism 3.2.2 Decline of the Gold Standard 3.3 3.4 3.5 The Inter-war Years, 1914-1944 The Bretton Woods System, 1945-1972 International Monetary Fund 3.5.1 The IMFs Financial Policies and Operations 3.5.2 IMF Supported Programmes and the Poor (Low Income Countries) 3.6 World Bank 3.6.1 A Global Cooperative 3.6.2 Economic Reform Programmes 3.7 Exchange Rate Mechanism 3.7.1 The European Currency Unit (ECU) 3.7.2 The European Monetary Cooperation Fund 3.8 3.9 3.10 3.11 3.12 3.13 Factors Influencing Exchange Rate Let us Sum up Lesson End Activity Keywords Questions for Discussion Suggested Readings
3.0 AIMS AND OBJECTIVES

After studying this lesson, you will be able to: Understand the International Monetary system Analyse the evolution of Gold standard Know about the role of IMF and world bank Understand the exchange rate mechanism Have a view of the factors influencing the exchange rate
46 International Financial Management
3.1 INTRODUCTION
This lesson examines the International Monetary System and helps the student to understand how the choice of system affects currency values. The lesson discusses the first three phases of the IMS The International Gold Standard, The Inter-war Period and the Bretton Woods System, in brief. It then discusses, in detail, the current International Monetary System. Finally, the classification of currency arrangements and the European Monetary System are discussed. The International Monetary System, as we have today, has evolved over the course of centuries and defines the overall financial environment in which multinational corporations operate. The International Monetary System consists of elements such as laws, rules, agreements, institutions, mechanisms and procedures which affect foreign exchange rates, balance of payments adjustments, international trade and capital flows. This system will continue to evolve in the future as the international business and political environment of the world economy continues to change. The International Monetary System plays a crucial role in the financial management of a multinational business and economic and financial policies of each country. Evolution of the International Monetary System can be analysed in four stages as follows: 1. 2. 3. 4. The Gold Standard, 1876-1913 The Inter-war Years, 1914-1944 The Bretton Woods System, 1945-1973 Flexible Exchange Rate Regime since 1973
3.2 GOLD STANDARD

In the early days, gold was used as a storage of wealth and as a medium of exchange. The gold standard, as an International Monetary System, gained acceptance in Western Europe in the 1870s and existed as a historical reality during the period 1875-1914. The majority of countries got off gold in 1914 when World War I broke out. The classical gold standard thus lasted for approximately 40 years. The centre of the international financial system during this period was London reflecting its important position in international business and trade. The fundamental principle of the classical gold standard was that each country should set a par value for its currency in terms of gold and then try to maintain this value. Thus, each country had to establish the rate at which its currency could be converted to the weight of gold. Also, under the gold standard, the exchange rate between any two currencies was determined by their gold content. Thus, the three important features of the gold standard were, First, the government of each country defines its national monetary unit in terms of gold. Second, free import or export of gold and third, two-way convertibility between gold and national currencies at a stable ratio. The above three conditions were met during the period 1875 to 1914. The United States, for example, declared the dollar to be convertible to gold at a rate of $20.67/ounce of gold. The British pound was pegged at 4.2474/ounce of gold. Thus, the dollar-pound exchange rate would be determined as follows:
$20.67/ounce of gold = $4.86656/ 4.2474/ounce of gold
Each countrys government then agreed to buy or sell gold at its own fixed parity rate on demand. This helped to preserve the value of each individual currency in terms of gold and hence, the fixed parities between currencies. Under this system, it was extremely important for a country to back its currency value by maintaining adequate reserves of gold. Consider, by way of example, the US dollar in relation to the British pound and assume that the par value of the pound as defined by the dollar when the gold standard was in effect was $4.86. If the cost of moving gold between the two countries was 2 cents per British pound, the fluctuation limit would then be 2 cents either above or below that par value. That is, the value of the pound sterling could move either up to $4.88 or down to $4.84. The upper limit was known as the gold export point. The pound could not rise above the gold export point because the rate would then be greater than the actual cost of shipping gold. If the value of the gold export point was greater, a US importer would find it more economical simply to buy gold with dollars and ship the gold as a payment to the British creditor instead of paying a higher price unnecessarily to buy pounds. It would be reasonable for the US importer to pay $4.88 for each British pound but no higher than that. By the same token, the pound could not fall below $4.84 the lower limit known as the gold import point. If the pound fell below $4.84, a British importer would be better off converting pounds into gold for payment. The cost of shipping gold would be less than the high cost of buying dollars for payment. In doing so, the importer would export gold and the United States would gain more gold for its reserves. In actual practice, governments always stood ready to buy and sell gold to make certain that the exchange rate would not move outside of the established limits.
47 International Monetary System
3.2.1 Price-Specie-Flow Mechanism

The gold standard functioned to maintain equilibrium through the so-called price-specieflow mechanism (or more appropriately the specie-flow-price mechanism), with specie meaning gold. The mechanism was intended to restore equilibrium automatically. When a countrys currency inflated too fast, the currency lost competitiveness in the world market. The deteriorating trade balance due to imports being greater than exports led to a decline in the confidence of the currency. As the exchange rate approached the gold export point, gold was withdrawn from reserves and shipped abroad to pay for imports. With less gold at home, the country was forced to reduce its money supply, a reduction accompanied by a slowdown in economic activity, high interest rates, recession, reduced national income and increased unemployment. The price-specie-flow mechanism also restored order in case of trade surpluses by working in the opposite manner. As the countrys exports exceeded its imports, the demand for its currency pushed the value toward the gold import point. By gaining gold, the country increased its gold reserves, enabling the country to expand its money supply. The increase in money supply forced interest rates to go lower, while heating up the economy. More employment, increased income and subsequently, increased inflation followed. Inflation increased consumers real income by overvaluing the currency, making it easier to pay for imports. It should be remembered that an inflated country with the exchange rate held constant is an advantageous place to sell products and a poor place to buy. With inflation, prices of domestic products would rise and become too expensive for overseas buyers. At the same time, foreign products would become more competitive and the balance of payments would become worse. Next would come a loss of gold and the need to deflate and the cycle would be repeated.
3.2.2 Decline of the Gold Standard

There are several reasons why the gold standard could not function well over the long run. One problem involved the price-specie-flow mechanism. For this mechanism to function effectively, certain rules of the game that govern the operation of an idealised international gold standard must be adhered to. One rule is that the currencies must be valued in terms of gold. Another rule is that the flow of gold between countries cannot be restricted. The last rule requires the issuance of notes in some fixed relationship to a countrys gold holdings. Such rules, however, require the nations willingness to place balance of payments and foreign exchange considerations above domestic policy goals and this assumption is, at best, unrealistic. Thus, the operation of the gold standard was not as automatic or mechanical as the price-specie-flow mechanism might lead one to believe. Because gold is a scarce commodity, gold volume could not grow fast enough to allow adequate amounts of money to be created (printed) to finance the growth of world trade. The problem was further aggravated by gold being taken out of reserve for art and industrial consumption, not to mention the desire of many people to own gold. The banning of gold hoarding and public exporting of gold bullion by President Franklin Roosevelt was not sufficient to remedy the problem. Another problem of the system was the unrealistic expectation that countries would subordinate their national economies to the dictates of gold as well as to external and monetary conditions. In other words, a country with high inflation and/or trade deficit was required to reduce its money supply and consumption, resulting in recession and unemployment. This was a strict discipline that many nations could not force upon themselves or their population. Instead of having sufficient courage to use unemployment to discourage imports, importing countries simply insisted on intervention through tariffs and devaluations, instead. Nations insisted on their rights to intervene and devalue domestic currencies in order to meet nationwide employment objectives. Because of the rigidity of the system, it was a matter of time before major countries decided to abandon the gold standard, starting with the United Kingdom in 1931 in the midst of a worldwide recession. With a 12 per cent unemployment rate, the United Kingdom chose to abandon the gold standard rather than exacerbate the unemployment problem. Monetary chaos followed in many countries.
3.3 THE INTER-WAR YEARS, 1914-1944

The gold standard as an International Monetary System worked well until World War I interrupted trade flows and disturbed the stability of exchange rates for currencies of major countries. There was widespread fluctuation in currencies in terms of gold during World War I and in the early 1920s. The role of Great Britain as the worlds major creditor nation also came to an end after World War I. The United States began to assume the role of the leading creditor nation. As countries began to recover from the war and stabilise their economies, they made several attempts to return to the gold standard. The United States returned to gold in 1919 and the United Kingdom in 1925. Countries such as Switzerland, France and Scandinavian countries restored the gold standard by 1928. The key currency involved in the attempt to restore the international gold standard was the pound sterling which returned to gold in 1925 at the old mint parity exchange rate of $4.87/. This was a great mistake since the United Kingdom had experienced considerably more inflation than the United States and because UK had liquidated most of its foreign
investment in financing the war. The result was increased unemployment and economic stagnation in Britain. The pounds overvaluation was not the only major problem of the restored gold standard. Other problems included the failure of the United States to act responsibly, the undervaluation of the French franc and a general decrease in the willingness and ability of nations to rely on the gold standard adjustment mechanism. In 1934, the United States returned to a modified gold standard and the US dollar was devalued from the previous $20.67/ounce of gold to $35.00/ounce of gold. The modified gold standard was known as the Gold Exchange Standard. Under this standard, the US traded gold only with foreign central banks, not with private citizens. From 1934 till the end of World War II, exchange rates were theoretically determined by each currencys value in terms of gold. World War II also resulted in many of the worlds major currencies losing their convertibility. The only major currency that continued to remain convertible was the dollar. Thus the inter-war period was characterised by half-hearted attempts and failure to restore the gold standard, economic and political instabilities, widely fluctuating exchange rates, bank failures and financial crisis. The Great Depression in 1929 and the stock market crash also resulted in the collapse of many banks.
3.4 THE BRETTON WOODS SYSTEM, 1945-1972

The depression of the 1930s, followed by another war, had vastly diminished commercial trade, the international exchange of currencies and cross-border lending and borrowing. What was left was only memories of what the system had once been. Revival of the system was necessary and the reconstruction of the post-war financial system began with the Bretton Woods Agreement that emerged from the International Monetary and Financial Conference of the united and associated nations in July 1944 at Bretton Woods, New Hampshire. There was a general agreement that restoring the gold standard was out of question, that exchange rates should basically be stable, that governments needed access to credits in convertible currencies if they were to stabilise exchange rates and that governments should make major adjustments in exchange rates only after consultation with other countries. On specifics, however, opinion was divided. The British wanted a reduced role for gold, more exchange rate flexibility than had existed with the gold standard, a large pool of lendable resources at the disposal of a proposed international monetary organisation and acceptance of the principle that the burden of correcting payment disequilibria should be shared by both, surplus countries and deficit countries. The Americans favoured a major role for gold, highly stable exchange rates, a small pool of lendable resources and the principle that the burden of adjustment of payment imbalances should fall primarily on deficit countries. The negotiators at Bretton Woods made certain recommendations in 1944: Each nation should be at liberty to use macroeconomic policies for full employment. (This tenet ruled out a return to the gold standard.) Free-floating exchange rates could not work. Their ineffectiveness had been demonstrated during the 1920s and 1930s. But the extremes of both permanently fixed and free-floating rates should be avoided. A monetary system was needed that would recognise that exchange rates were both a national and an international concern.
The agreement established a dollar based International Monetary System and created two new institutions: The International Monetary Fund (IMF) and The International Bank for Reconstruction and Development (World Bank). The basic role of the IMF would be to help countries with balance of payments and exchange rate problems while the World Bank would help countries with post-war reconstruction and general economic development. The basic purpose of this new monetary system was to facilitate the expansion of world trade and to use the US dollar as a standard of value. The Bretton Woods Agreement produced three propositions (i) The stable exchange rates under the gold standard before World War I were desirable but there were certain conditions to make adjustments in exchange rates necessary (ii) Performance of fluctuating exchange rates had been unsatisfactory and (iii) The complex network of government controls during 1931-1945 deterred the expansion of world trade and investment. However, there were certain conditions which required government controls over international trade and payments. The Bretton Woods Agreement placed major emphasis on the stability of exchange rates by adopting the concept of fixed but adjustable rates. The keystones of the system were (i) no provision was made for the United States to change the value of gold at $35 per ounce and (ii) each country was obligated to define its monetary unit in terms of gold or dollars. While other currencies were required to exchange their currencies for gold, US dollars remained convertible into gold at $35 per ounce. Thus, each country established par rates of exchange between its currency and the currencies of all other countries. Each currency was permitted to fluctuate within plus or minus one per cent of par value by buying or selling foreign exchange and gold as needed. However, if a currency became too weak to maintain its par value, it was allowed to devalue up to ten per cent without formal approval by the International Monetary Fund (IMF). Thus, the main points of the post-war system evolving from the Bretton Woods Conference were as follows: 1. A new institution, the International Monetary Fund (IMF), would be established in Washington DC. Its purpose would be to lend foreign exchange to any member whose supply of foreign exchange had become scarce. This lending would not be automatic but would be conditional on the members pursuit of economic policies consistent with the other points of the agreement, a determination that would be made by IMF. The US dollar (and, de facto, the British pound) would be designated as reserve currencies, and other nations would maintain their foreign exchange reserves principally in the form of dollars or pounds. Each Fund member would establish a par value for its currency and maintain the exchange rate for its currency within one per cent of par value. In practice, since the principle reserve currency would be the US dollar, this meant that other countries would peg their currencies to the US dollar, and, once convertibility was restored, would buy and sell US dollars to keep market exchange rates within the 1 per cent band around par value. The United States, meanwhile, separately agreed to buy gold from or sell gold to foreign official monetary authorities at $35 per ounce settlement of international financial transactions. The US dollar was thus pegged to gold and any other currency pegged to the dollar was indirectly pegged to gold at a price determined by its par value. A Fund member could change its par value only with Fund approval and only if the countrys balance of payments was in fundamental disequilibrium. The meaning
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of fundamental disequilibrium was left unspecified but everyone understood that par value changes were not to be used as a matter of course to adjust economic imbalances. 5. After a post-war transition period, currencies were to become convertible. That meant, to anyone who was not a lawyer, that currencies could be freely bought and sold for other foreign currencies. Restrictions were to be removed and, hopefully, eliminated. So, in order to keep market exchange rates within 1 per cent of par value, central banks and exchange authorities would have to build up a stock of dollar reserves with which to intervene in the foreign exchange market. The Fund would get gold and currencies to lend through subscription. That is, countries would have to make a payment (subscription) of gold and currency to the IMF in order to become a member. Subscription quotas were assigned according to a members size and resources. Payment of the quota normally was 25 per cent in gold and 75 per cent in the members own currency. Those with bigger quotas had to pay more but also got more voting rights regarding Fund decisions.
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Breakdown of the Bretton Woods System The Bretton Woods System worked without major changes from 1947 till 1971. During this period, the fixed exchange rates were maintained by official intervention in the foreign exchange markets. International trade expanded in real terms at a faster rate than world output and currencies of many nations, particularly those of developed countries, became convertible. The stability of exchange rates removed a great deal of uncertainty from international trade and business transactions thus helping the countries to grow. Also, the working of the system imposed a degree of discipline on the economic and financial policies of the participating nations. During the 1950s and 1960s, the IMF also expanded and improved its operation to preserve the Bretton Woods System. The system, however, suffered from a number of inherent structural problems. In the first place, there was much imbalance in the roles and responsibilities of the surplus and deficits nations. Countries with persistent deficits in their balance of payments had to undergo tight and stringent economic policy measures if they wanted to take help from the IMF and stop the drain on their reserves. However, countries with surplus positions in their balance of payments were not bound by such immediate compulsions. Although sustained increases in their international resources meant that they might have to put up with some inflationary consequences, these options were much more reasonable than those for the deficit nations. The basic problem here was the rigid approach adopted by the IMF to the balance of payments disequilibria situation. The controversy mainly centres around the conditionality issue, which refers to a set of rules and policies that a member country is required to pursue as a prerequisite to using the IMFs resources. These policies mainly try and ensure that the use of resources by concerned members is appropriate and temporary. The IMF distinguishes between two levels of conditionality low conditionality where a member needs funds only for a short period and high conditionality where the member country wants a large access to the Funds resources. This involves the formulation of a formal financial programme containing specific measures designed to eliminate the countrys balance of payments disequilibrium. Use of IMF resources, under these circumstances, requires IMFs willingness that the stabilisation programme is adequate for the achievement of its objectives and an understanding by the member to implement it.
Smithsonian Agreement From August-December 1971, most of the major currencies were permitted to fluctuate. The US dollar fell in value against a number of major currencies. Several countries imposed some trade and exchange controls causing major concern. It was feared that such protective measures might become sufficiently widespread to limit international commerce. In order to solve these problems, the worlds leading trading countries, called the Group of Ten, produced the Smithsonian Agreement on December 18, 1971. The Agreement established a new set of parity rates. These parity rates were called central rates because they lacked the approval of the IMF. Although the US dollar was not convertible into gold, it was still defined in terms of gold. The other nine currencies were defined in terms of either gold or the dollar. The United States agreed to devalue the dollar from $35 per ounce of gold to $38 in return for promises from other members to upvalue their currencies relative to the dollar by specified amounts. In order to maintain market exchange rates relatively close to the central rates without constant government intervention, currencies were permitted to fluctuate over a wider band than in the past. Although a currency was allowed to fluctuate within a margin of 2.25 per cent from the central rates without government intervention, it could fluctuate by as much as 9 per cent against any currency, except the dollar. Because a currency was permitted to fluctuate up to 2.25 per cent on either side of the central rate, its total fluctuation against the dollar could be as much as 4.5 per cent. Let us assume for purposes of illustration that the Japanese yen upvalued by 4.5 per cent against the dollar and that Italian lira devalued by 4.5 per cent against the dollar. Under these circumstances, these two currencies would exchange by 9 per cent against one another. Proponents of the Smithsonian Agreement argued that a wider band would allow countries to retain (i) discipline that they would expect from the fixed exchange rate system, and (ii) greater freedom and a smoother adjustment process of flexible exchange rates. Although the Agreement was a historical event in international monetary affairs, it failed to reduce speculation. Government control on foreign exchange did not decrease. For all practical purposes, the Agreement came to an end in March 1973 because most of the Group Ten countries allowed their currencies to float according to market forces. Check Your Progress 1 State whether the following statements are True or False: 1. The International monetary system as we have today, has evolved over the course of centuries and defines the overall financial involvement in which multinational corporations operate. The international monetary system consists of elements such as laws, rules, agreements, institutions, mechanisms and procedures, which effect foreign exchange rates, balance of payments adjustments, international trade, and capital flows. The international monetary system doesn't play a crucial role in the financial management of a multinational business and economic and financial policies of each country. The fundamental gold standard was that each country should set a par value for its currency in terms of gold and then try to maintain this value.
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3.5 INTERNATIONAL MONETARY FUND

The International Monetary Fund (IMF) came into official existence on December 27, 1945, when 29 countries signed its Articles of Agreement (its Charter) agreed at a conference held in Bretton Woods, New Hampshire, USA, from July 1-22, 1944. The IMF commenced financial operations on March 1, 1947. Its current membership is 182 countries. Its total quotas are SDR 212 billion (almost US$300 billion), following a 45 per cent quota increase effective from January 22, 1999. Staff: approximately 2,700 from 110 countries. Accounting Unit: Special Drawing Right (SDR). As of August 23, 1999, SDR I equalled US $1.370280. IMF is a cooperative institution that 182 countries have voluntarily joined because they see the advantage of consulting with one another on this forum to maintain a stable system of buying and selling their currencies so that payments in foreign currency can take place between countries smoothly and without delay. Its policies and activities are guided by its charter known as the Articles of Agreement. IMF lends money to members having trouble meeting financial obligations to other members, but only on the condition that they undertake economic reforms to eliminate these difficulties for their own good and that of the entire membership. Contrary to widespread perception, the IMF has no effective authority over the domestic economic policies of its members. What authority the IMF does possess is confined to requiring the member to disclose information on its monetary and fiscal policies and to avoid, as far as possible, putting restrictions on exchange of domestic for foreign currency and on making payments to other members. There are several major accomplishments to the credit of the International Monetary System. For example, it sustained a rapidly increasing volume of trade and investment; displayed flexibility in adapting to changes in international commerce; proved to be efficient (even when there were decreasing percentages of reserves to trade); proved to be hardy (it survived a number of pre-1971 crises, speculative and otherwise, and the down-and-up swings of several business cycles); allowed for a growing degree of international cooperation; established a capacity to accommodate reforms and improvements. To an extent, the fund served as an international central bank to help countries during periods of temporary balance of payments difficulties by protecting their rates of exchange. Because of that, countries did not need to resort to exchange controls and other barriers to restrict world trade. Origins The need for an organisation like the IMF became evident during the great depression that ravaged the world economy in the 1930s. A widespread lack of confidence in paper money led to a spurt in the demand for gold and severe devaluation in the national currencies. The relation between money and the value of goods became confused as did the relation between the value of one national currency and another.
In the 1940s, Harry Dexter (US) and John Maynard Keynes (UK) put forward proposals for a system that would encourage the unrestricted conversion of one currency into another, establish a clear and unequivocal value for each currency and eliminate restrictions and practices such as competitive devaluations. The system required cooperation on a previously unattempted scale by all nations in establishing an innovative monetary system and an international institution to monitor it. After much negotiations in the difficult wartime conditions, the international community accepted the system and an organisation was formed to supervise it. The IMF began operations in Washington DC in May 1946. It then had 39 members. The IMFs membership now is 182. Members and Administration On joining the IMF, each member country contributes a certain sum of money called a quota subscription, as a sort of credit union deposit. Quotas serve various purposes. They form a pool of money that the IMF can draw from to lend to members in times of financial difficulty. They form the basis of determining the Special Drawing Rights (SDR). They determine the voting power of the member. Statutory Purposes The purposes of the International Monetary Fund are: To promote international monetary cooperation through a permanent institution which provides the machinery for consultation and collaboration on international monetary problems. To facilitate the expansion and balanced growth of international trade and to contribute, thereby, to the promotion and maintenance of high levels of employment and real income and to the development of the productive resources of all members as primary objectives of economic policy. To promote exchange stability, to maintain orderly exchange arrangements among members and to avoid competitive exchange depreciation. To assist in the establishment of a multilateral system of payments in respect of current transactions between members and in the elimination of foreign exchange restrictions which hamper the growth of world trade. To give confidence to members by making the general resources of the Fund temporarily available to them under adequate safeguards, thus providing them with opportunity to correct maladjustment in their balance of payments without resorting to measures destructive to national or international prosperity. In accordance with the above, to shorten the duration and lessen the degree of disequilibrium in the international balances of payments of members. Areas of Activity Surveillance is the process by which the IMF appraises its members exchange rate policies within the framework of a comprehensive analysis of the general economic situation and the policy strategy of each member. The IMF fulfils its surveillance responsibilities through annual bilateral Article IV consultations with individual countries; multilateral surveillance twice a year in the context of its World Economic Outlook (WEO) exercise; and precautionary arrangements, enhanced
surveillance and programme monitoring which provide a member with close monitoring from the IMF in the absence of the use of IMF resources. (Precautionary arrangements serve to boost international confidence in a members policies. Programme monitoring may include the setting of benchmarks under a shadow programme but does not constitute a formal IMF endorsement.) Financial assistance includes credits and loans extended by the IMF to member countries with balance of payments problems to support policies of adjustment and reform. As of July 31, 1999 the IMF had credit and loans outstanding to 94 countries for an approved amount of SDR 63.6 billion (about $87 billion). Technical assistance consists of expertise and support provided by the IMF to its members in several broad areas: the design and implementation of fiscal and monetary policy; institution building (such as the development of central banks or treasuries); the handling and accounting of transactions with the IMF; the collection and refinement of statistical data; training officials at the IMF Institute together with other international financial organisations, through the Joint Vienna Institute, the Singapore Regional Training Institute, the Middle East Regional Training Programme and the Joint Africa Institute. The IMF and the World Bank How Do They Differ?
International Monetary Fund Oversees the International Monetary System. Promotes exchange stability and orderly exchange relations among its member countries. Assists all members both industrial and developing countries that find themselves in temporary balance of payments difficulties by providing short to mediumterm credits. Supplements the currency reserves of its members through the allocation of SDRs (special drawing rights); to date SDR 21.4 billion has been issued to member countries in proportion to their quotas. Draws its financial resources principally from the quota subscriptions of its member countries. Has at its disposal fully paid-in quotas now totalling SDR 212 billion (about $300 billion). Has a staff of 2,300 drawn from 182 member countries. World Bank Seeks to promote the economic development of the worlds poorer countries. Assists developing countries through long-term financing of development projects and programmes. Provides to the poorest developing countries whose per capita GNP is less than $865 a year special financial assistance through the International Development Association (IDA). Encourages private enterprises in developing countries through its affiliate, the International Finance Corporation (IFC). Acquires most of its financial resources by borrowing on the international bond market. Has an authorised capital of $184 billion, of which members pay in about 10 per cent. Has a staff of 7,000 drawn from 180 member countries.
3.5.1 The IMFs Financial Policies and Operations

Though the IMF remains, primarily, a supervisory institution for coordinating efforts to achieve greater cooperation in the formulation of economic policies, nevertheless, its financial function is a significant activity as is evident from the role it played in the Mexican financial meltdown and the Asian financial crises. The IMF makes its financial resources available to member countries through a variety of financial facilities.
The main source of finance remains the pool of funds from the quota subscriptions. Besides this, IMF has had, since 1962, a line of credit, now worth $24 billion, with a number of governments and banks throughout the world also known as the General Arrangements to Borrow. Financial Assistance The IMF lends money only to member countries with balance of payments problems. A member country with a payments problem can immediately withdraw from the IMF the 25 per cent of its quota. A member in greater difficulty may request for more money from the IMF and can borrow up to three times its quota provided the member country undertakes to initiate a series of reforms and uses the borrowed money effectively. The frequently used mechanisms by the IMF to lend money are: 1. 2. 3. Standby Arrangements Extended Arrangements Structural Adjustment Mechanism (with low interest rates)
Regular IMF Facilities Standby Arrangements (SBA) are designed to provide short-term balance of payments assistance for deficits of a temporary or cyclical nature; such arrangements are typically for 12 to 18 months. Drawings are phased on a quarterly basis, with their release made conditional on meeting performance criteria and the completion of periodic programme reviews. Repurchases are made 3 to 5 years after each purchase. Extended Fund Facility (EFF) is designed to support medium-term programmes that generally run for three years. The EFF aims at overcoming balance of payments difficulties stemming from macroeconomic and structural problems. Performance criteria are applied, similar to those in standby arrangements and repurchases are made in 4 to 10 years. Concessional IMF Facility Enhanced Structural Adjustment Facility (ESAF) was established in 1987 and enlarged and extended in 1994. Designed for low-income member countries with protracted balance of payments problems, ESAF drawings are loans and not purchases of other members currencies. They are made in support of three years programmes and carry an annual interest rate of 0.5 per cent, with a 5 year grace period and a 10 year maturity. Quarterly benchmarks and semi-annual performance criteria apply; 80 low income countries are currently eligible to use the ESAF. Other Facilities Systemic Transformation Facility (STF) was in effect from April 1993 to April 1995. The STF was designed to extend financial assistance to transition economies experiencing severe disruption in their trade and payments arrangements. Repurchases are made over 4 to 10 years. Compensatory and Contingency Financing Facility (CCFF) provides compensatory financing for members experiencing temporary export shortfalls or excesses in cereal import costs, as well as financial assistance for external contingencies in Fund arrangements. Repurchases are made over 3 to 5 years.
Supplemental Reserve Facility (SRF) provides financial assistance for exceptional balance of payments difficulties due to a large short-term financing need resulting from a sudden and disruptive loss of market confidence. Repurchases are expected to be made within 1 to 1 years, but can be extended, with IMF Board approval, to 2 to 2 years. Contingent Credit Lines (CCL) is aimed at preventing the spread of a crisis. Whereas the SRF is for use by members already in the throes of a crisis, the CCL is intended solely for members that are concerned with potential vulnerability. This facility will enable countries that are basically sound and well managed to put in place precautionary financing should a crisis occur. Short-term financing if the need arises will be provided under the CCL to help members overcome the exceptional balance of payments financing needs that can arise from a sudden and disruptive loss of market confidence, largely generated by circumstances beyond the members control. Repurchase terms are the same as under the SRF. Charges If a member borrows money from the IMF, it pays various charges to cover the IMFs operational expenses and to recompensate the member whose currency it is borrowing. Service charges and commitment fees of 1 per cent of the amount borrowed. Interest charges of 4 per cent (except for Structural Adjustment Mechanism). Earning on quota by the member: 4 per cent. SDRs As time passed, it became evident that the Funds resources for providing short-term accommodation to countries in monetary difficulties were not sufficient. To resolve the situation, the Fund, after much debate and long deliberations, created new drawing rights in 1969. Special Drawing Rights (SDRs), sometimes called paper gold, are special account entries on the IMF books designed to provide additional liquidity to support growing world commerce. Although SDRs are a form of money not convertible to gold, their gold value is guaranteed, which helps to ensure their acceptability. Initially, SDRs worth $9.5 billion were created. Participant nations may use SDRs as a source of currency in a spot transaction, as a loan for clearing a financial obligation, as a security for a loan, as a swap against currency, or in a forward exchange operation. A nation with a balance of payments need may use its SDRs to obtain usable currency from another nation designated by the fund. A participant also may use SDRs to make payments to the Fund, such as repurchases. The Fund itself may transfer SDRs to a participant for various purposes including the transfer of SDRs instead of currency to a member using the Funds resources. By providing a mechanism for international monetary cooperation, working towards reducing restrictions to trade and capital flows and helping members with their shortterm balance of payments difficulties, the IMF makes a significant and unique contribution to human welfare and improved living standards throughout the world. Services Besides supervising the International Monetary System and providing financial support to member countries, the IMF assists its members by: Providing technical assistance in certain areas of its competence. Running an educational institute in Washington and offering training courses abroad.
Issuing wide variety of publications containing valuable information and statistics that are useful not only to the member countries but also to banks, research institutes, university and the media.
3.5.2 IMF Supported Programmes and the Poor (Low Income Countries)
In 1987, the IMF established the Enhanced Structural Adjustment Facility (ESAF) to provide resources to low income countries for longer periods on concessional terms. Like its predecessor, the Structural Adjustment Facility (SAF), the ESAF was created in response to a need to better address the macroeconomic and structural problems of low income countries. SAF/ESAF: A Concessional Facility to Assist Poorer Countries The IMFs executive board established the Enhanced Structural Adjustment Facility (ESAF) in 1987 to better address the macroeconomic and structural problems faced by low income countries. It offers loans with lower interest rates and for longer terms than the typical IMF market-related arrangements. The principal objectives are To promote balance of payments viability; and Foster sustainable long-term growth. Although the objectives and features of the ESAF are similar to those of its predecessor, the Structural Adjustment Facility (SAF) set up in 1986, the ESAF was expected to be more ambitious with regard to macroeconomic policy and structural reform measures. The IMF no longer makes disbursements under the SAF. ESAF loans are disbursed semi-annually (as against quarterly for regular IMF standby arrangements) initially upon approval of an annual arrangement and subsequently on the observance of performance criteria and after completion of a mid-term review. ESAF loans are repaid in 10 equal semi-annual installments beginning 5 years and ending 10 years after the date of each disbursement. The interest on ESAF loans is 0.5 per cent a year. By contrast, charges for standby arrangements are linked to the IMFs SDR market determined interest rate and repayments are made within 3 to 5 years of each drawing. A three-year access under the ESAF is up to 190 per cent of a members quota. The access limits of standby arrangements are 100 per cent of quota annually and 300 per cent cumulatively. An eligible member seeking to use ESAF resources develops, with the assistance of the IMF and the World Bank, a Policy Framework Paper (PEP) for a three-year adjustment programme. The PEP, updated annually, sets out the authorities macroeconomic and structural policy objectives and the measures that they intend to adopt during the three years. The PEP also lays out the associated external financing needs of the programme, a process that is meant to catalyse and help coordinate financial and technical assistance from donors in support of the adjustment programme. Check Your Progress 2 State whether the following statements are True or False: 1. 2. The Contingent Credit Lines (CCL) is aimed at preventing the spread of a crisis. The world bank group is a multinational financial institution established at the end of world war II to help provide long term capital for the reconstruction and development of member countries.
Contd....
3. 4.
Extend Fund Facility is designed to support medium term programmes that generally run for three and a half years. In the nineties the IMF established the Enhanced Structural Facility (ESAF) to provide resources to low income countries for longer periods on concessional terms.
3.6 WORLD BANK

The World Bank group is a multinational financial institution established at the end of World War II (1944) to help provide long-term capital for the reconstruction and development of member countries. The group is important to multinational corporations because it provides much of the planning and financing for economic development projects involving billions of dollars for which private businesses can act as contractors and suppliers of goods and engineering related services. The purposes for the setting up of the Bank are: To assist in the reconstruction and development of territories of members by facilitating the investment of capital for productive purposes, including the restoration of economies destroyed or disrupted by war, the reconversion of productive facilities to peacetime needs and encouragement of the development of productive facilities and resources in less developed countries. To promote private foreign investment by means of guarantees or participation in loans and other investments made by private investors; and when private capital is not available on reasonable terms, to supplement private investment by providing, on suitable conditions, finance for productive purposes out of its own capital, funds raised by it and its other resources. To promote the long-range balanced growth of international trade and the maintenance of equilibrium in balance of payments by encouraging international investment for the development of the productive resources of members, thereby assisting in raising productivity, the standard of living and condition of labour in their territories. To arrange the loans made or guaranteed by it in relation to international loans through other channels so that the more useful and urgent projects, large and small alike, can be dealt with first. To conduct its operations with due regard to the effect of international investment on business conditions in the territories of members and, in the immediate post-war years, to assist in bringing about a smooth transition from a wartime to a peacetime economy. The World Bank is the International Bank for Reconstruction and Development (IBRD) and the International Development Association (IDA). The IBRD has two affiliates, the International Finance Corporation (IFC) and the Multilateral Investment Guarantee Agency (MIGA). The Bank, the IFC and the MIGA are sometimes referred to as the World Bank Group. International Bank for Reconstruction and Development The IBRD was set up in 1945 along with the IMF to aid in rebuilding the world economy. It was owned by the governments of 151 countries and its capital is subscribed by those governments; it provides funds to borrowers by borrowing funds in the world capital markets, from the proceeds of loan repayments as well as retained earnings. At its
funding, the banks major objective was to serve as an international financing facility to function in reconstruction and development. With Marshall Plan providing the impetus for European reconstruction, the Bank was able to turn its efforts towards the developing countries. Generally, the IBRD lends money to a government for the purpose of developing that countrys economic infrastructure such as roads and power generating facilities. Funds are directed towards developing countries at more advanced stages of economic and social growth. Also, funds are lent only to members of the IMF, usually when private capital is unavailable at reasonable terms. Loans generally have a grace period of five years and are repayable over a period of fifteen or fewer years. The projects receiving IBRD assistance usually require importing heavy industrial equipment and this provides an export market for many US goods. Generally, bank loans are made to cover only import needs in foreign convertible currencies and must be repaid in those currencies at long-term rates. The government assisted in formulating and implementing an effective and comprehensive strategy for the development of new industrial free zones and the expansion of existing ones; reducing unemployment, increasing foreign-exchange earnings and strengthening backward linkages with the domestic economy; alleviating scarcity in term financing; and improving the capacity of institutions involved in financing, regulating and promoting free zones. The World Bank lays special operational emphasis on environmental and womens issues. Given that the Banks primary mission is to support the quality of life of people in developing member countries, it is easy to see why environmental and womens issues are receiving increasing attention. On the environmental side, it is the Banks concern that its development funds are used by the recipient countries in an environmentally responsible way. Internal concerns, as well as pressure by external groups, are responsible for significant research and projects relating to the environment. The womens issues category, specifically known as Women In Development (WID), is part of a larger emphasis on human resources. The importance of improving human capital and improving the welfare of families is perceived as a key aspect of development. The WID initiative was established in 1988 and it is oriented to increasing womens productivity and income. Bank lending for womens issues is most pronounced in education, population, health and nutrition and agriculture. International Development Association The IDA was formed in 1960 as a part of the World Bank Group to provide financial support to LDCs on a more liberal basis than could be offered by the IBRD. The IDA has 137 member countries, although all members of the IBRD are free to join the IDA. IDAs funds come from subscriptions from its developed members and from the earnings of the IBRD. Credit terms usually are extended to 40 to 50 years with no interest. Repayment begins after a ten-year grace period and can be paid in the local currency, as long as it is convertible. Loans are made only to the poorest countries in the world, those with an annual per capita gross national product of $480 or less. More than 40 countries are eligible for IDA financing. An example of an IDA project is a $8.3 million loan to Tanzania approved in 1989 to implement the first stage in the longer-term process of rehabilitating the countrys agricultural research system. Co-financing is expected from several countries as well as other multilateral lending institutions.
Although the IDAs resources are separate from the IBRD, it has no separate staff. Loans are made for similar projects as those carried out by IBRD, but at easier and more favourable credit terms. As mentioned earlier, World Bank/IDA assistance, historically, has been for developing infrastructure. The present emphasis seems to be on helping the masses of poor people in the developing countries become more productive and take an active part in the development process. Greater emphasis is being placed on improving urban living conditions and increasing productivity of small industries. International Finance Corporation The IFC was established in 1956. There are 133 countries that are members of the IFC and it is legally and financially separate from the IBRD, although IBRD provides some administrative and other services to the IFC. The IFCs main responsibilities are (i) To provide risk capital in the form of equity and long-term loans for productive private enterprises in association with private investors and management (ii) To encourage the development of local capital markets by carrying out standby and underwriting arrangements and (iii) To stimulate the international flow of capital by providing financial and technical assistance to privately controlled finance companies. Loans are made to private firms in the developing member countries and are usually for a period of seven to twelve years. The key feature of the IFC is that its loans are all made to private enterprises and its investments are made in conjunction with private business. In addition to funds contributed by IFC, funds are also contributed to the same projects by local and foreign investors. IFC investments are for the establishment of new enterprises as well as for the expansion and modernisation of existing ones. They cover a wide range of projects such as steel, textile production, mining, manufacturing, machinery production, food processing, tourism and local development finance companies. Some projects are locally owned, whereas others are joint ventures between investors in developing and developed countries. In a few cases, joint ventures are formed between investors of two or more developing countries. The IFC has also been instrumental in helping to develop emerging capital markets. Multilateral Investment Guarantee Agency (MIGA) The MIGA was established in 1988 to encourage equity investment and other direct investment flows to developing countries by offering investors a variety of different services. It offers guarantees against noncommercial risks; advises developing member governments on the design and implementation of policies, programmes and procedures related to foreign investments; and sponsors a dialogue between the international business community and host governments on investment issues.
3.6.1 A Global Cooperative

The World Bank is comparable to a global cooperative which is owned by member countries. The size of a countrys shareholding is determined by the size of the countrys economy relative to the world economy. Together, the largest industrial countries (the Group of seven or G-7) have about 45 per cent of the shares in the World Bank and they carry great weight in international economic affairs, generally. So it is true that the rich countries have a good deal of influence over the Banks policies and practices. The United States has the largest shareholding about 17 per cent which gives it the power to veto any changes in the Banks capital base and Articles of Agreement (85 per cent of the shares are needed to effect such changes). However, virtually all
other matters, including the approval of loans, are decided by a majority of the votes cast by all members of the Bank. The Banks board of executive directors, which is resident at the Banks headquarters in Washington DC, represents all the members. Policies and practices are regularly and frequently debated and decided upon by the board, so every members voice is heard. In fact, developing countries, together, have about half the votes in the Bank. And the Banks cooperative spirit is reflected in the fact that voting is rare because consensus is the preferred way of making decisions. Only developing countries can borrow from the Bank. But all members, including the richer nations, gain from economic growth in developing countries. A world increasingly divided between rich and poor is in no ones interest. Everybody benefits from increased trade and investment, higher incomes, fewer social tensions, better health and education and environmental protection. The Banks member countries particularly the industrial countries also benefit from procurement opportunities derived from World Bank financed projects. What Does the World Bank Do? The World Bank is the worlds largest source of development assistance, providing nearly $30 billion in loans, annually, to its client countries. The Bank uses its financial resources, its highly trained staff and its extensive knowledge base to individually help each developing country onto a path of stable, sustainable and equitable growth. The main focus is on helping the poorest people and the poorest countries but for all its clients, the Bank emphasises the need for investing in people, particularly through basic health and education; protecting the environment; supporting and encouraging private business development; strengthening the ability of the governments to deliver quality services efficiently and transparently; promoting reforms to create a stable macroeconomic environment conducive to investment and long-term planning; focusing on social development, inclusion, governance and institution building as key elements of poverty reduction. The Bank is also helping countries to strengthen and sustain the fundamental conditions that help to attract and retain private investment. With Bank support both lending and advice governments are reforming their overall economies and strengthening banking systems. They are investing in human resources, infrastructure and environmental protection which enhance the attractiveness and productivity of private investment. Through World Bank guarantees, MIGAs political risk insurance and in partnership with IFCs equity investments, investors are minimising their risks and finding the comfort to invest in developing countries and countries undergoing transition to market-based economies. Where Does the World Bank Get its Money? The World Bank raises money for its development programmes by tapping the worlds capital markets and in the case of the IDA, through contributions from wealthier member governments. IBRD, which accounts for about three-fourths of the Banks annual lending, raises almost all its money in financial markets. One of the worlds most prudent and conservatively managed financial institutions, the IBRD sells AAA-rated bonds and other debt securities to pension funds, insurance companies, corporations, other banks and individuals around the globe. IBRD charges interest from its borrowers at rates which reflect its cost of borrowing. Loans must be repaid in 15 to 20 years; there is a three to five years grace period before repayment of principal begins. IDA helps to promote growth and reduce poverty in the same ways as does the IBRD but using interest free loans (which are known as IDA credits), technical assistance and policy advice. IDA credits account for about one-fourth of all Bank lendings. Borrowers pay a fee of less than 1 per cent of the loan to cover administrative costs. Repayment is required in 35 to
40 years with a 10 years grace period. Nearly 40 countries contribute to IDAs funding, which is replenished every three years. IDAs funding is managed in the same prudent, conservative and cautious way as is the IBRDs. Like the IBRD, there has never been default on an IDA credit. Who Runs the World Bank? The World Bank is owned by more than 180 member countries whose views and interests are represented by a board of governors and a Washington based board of directors. Member countries are shareholders who carry ultimate decision making power in the World Bank. Each member nation appoints a governor and an alternate governor to carry out these responsibilities. The governors, who are usually officials such as ministers of finance or planning, meet at the Banks annual meetings each fall. They decide on key Bank policy issues, admit or suspend country members, decide on changes in the authorised capital stock, determine the distribution of the IBRDs net income and endorse financial statements and budgets.
3.6.2 Economic Reform Programmes

World Bank programmes are designed to help the poor and the record is good. The Bank has lent almost $400 billion since it started more than 50 years ago. During this time, developing countries, with the help of the international community, including the Bank, have doubled their incomes, halved infant mortality rates and increased life expectancy. The absolute number of poor people is still rising, largely because of rapid population growth. But as a percentage of the worlds population, the number of poor is falling. Economic progress has been faster than during any similar period in history. Economic reform programmes are part of that progress. The economic shocks of the 1970s and early 1980s high interest rates, low commodity prices and sluggish growth in the world economy hit many developing countries hard. Countries needed to make reforms in the way they ran their economies to encourage long-term and sustainable development: not spending more than a country can afford; ensuring the policy that benefits the whole country rather than only the elite; investing where scarce resources have impact for example, in basic education and health instead of excessive military spending; and in encouraging a productive private sector. Far from being the victims of reforms, the poor suffer most when countries dont reform. What benefits the poor the most is rapid and broad based growth. This comes from having sound macroeconomic policies and a strategy that favours investment in basic human capital primary health care and universal primary education. Reform is not unique to developing countries. The long struggle to reduce the United States budget deficit, a struggle mirrored in many other industrial countries, is also a form of economic reform or structural adjustment. Such changes can be painful. In the short-term unemployment may rise. Workers in loss making state enterprises may lose their jobs. Civil servants may be made redundant as a consequence of cuts in government spending. Groups of poor people are also particularly vulnerable, for instance, poor pregnant women and nursing mothers, young children and poor elderly people. So, not surprisingly, Bank support for these developing countries carrying out structural reforms generally includes social safety nets and other measures to ease the problems that poor people may experience. The Bank helps governments in financing unemployment compensation, job creation schemes and retraining programmes. In addition, it helps governments target health and nutrition spending on the most needy people and also finances investments that are specifically designed to attack deep-seated poverty.
But poor people can also benefit quickly from adjustments: farmers get higher prices for their crops and currency devaluation helps workers in export industries. And in the long run, these adjustments lead to higher incomes, strengthen civil institutions and create a climate more favourable to private enterprise all of which benefit the poor. For example, in the past few decades, East Asia has achieved some of the most remarkable poverty declines in history 27 per cent from 1975-85 and 35 per cent from 1985-95 along with substantial improvements in the education and health of the poor.
3.7 EXCHANGE RATE MECHANISM

It refers to the procedure by which the EMS member countries collectively manage their exchange rates. The ERM is based on a parity grid mechanism that places an upper and lower limit on the possible exchange rates between each pair of member currencies. In a parity grid mechanism each country is obliged to intervene whenever its exchange rate reaches the upper or lower limit against any other currency. The parity grid system, in the ERM, is in the form of a matrix showing for each pair of currencies the par value in addition to the highest and lowest permitted exchange rates. Thus there are specified bilateral exchange rates among all member countries which, in fact, constitutes a grid. Each currency is then allowed to fluctuate 2 per cent above and below the par rates. Each currency has hence got three exchange rates: the par value, an upper limit and a lower limit. If an exchange rate is at either limit, indicators of divergence are encountered that mandate bilateral actions for the maintenance of the central rates by both the countries. The ERM has, thus, got three features (1) A bilateral responsibility for the maintenance of exchange rates (2) Availability of additional support mechanism that helps in maintaining the parities; (3) If the currencies irretrievably diverge from parity a last resort or safety valve of agreed upon realignments. Consider an example. If the Spanish peseta was at its lower support point vis-a-vis the German mark, the Spanish authorities were required to buy Spanish peseta and the German authorities were also supposed to sell marks. The fact that the Germans were also required to sell marks made the ERM fundamentally different from the Bretton Woods System. In the Bretton Woods System only one country had to undergo painful measures while the other country was not required to cooperate.
3.7.1 The European Currency Unit (ECU)

The ECU is a basket currency based on a weighted average of the currencies of member countries of the European Union. The weights are based on each countrys relative size of GNP and on each members share of intra-European Union trade. The ECUs value varies over time as the members currencies float jointly with respect to the US dollar and other non-member currencies. The ECU serves as the accounting unit of the EMS and helps in the working of the exchange rate mechanism. In fact, the ECU since Jan 1, 1999 has evolved into the common currency of the European union and is called the Euro. Two kinds of mechanism were energised in the EMS. One mechanism was based on the parity grid while the other was in terms of a divergence indicator defined with reference to the ECU. In the divergence indicator mechanism, each countrys central rate against the ECU is determined and the permissible margins of variations around this are specified. When the rate moves outside these margins, the onus of adjustment is on the country concerned. For example, if the German mark appreciates against all other currencies, it would also
appreciate against the ECU since the ECU is a basket of all the member countries. When the mark moves beyond the upper limit, Germany will have to intervene and take appropriate action or explain to other EMS members why it should not. Only as a last resort were par values realigned, although this happened on several occasions.
3.7.2 The European Monetary Cooperation Fund

Like the IMF, the EMS has its own institutional set up for monetary cooperation. Member countries extend credit to each other for the purpose of carrying out exchange market intervention through the European Monetary Cooperation Fund (EMCF). The EMCF gives various short-term and medium-term credit facilities depending upon the deficit countrys needs. Very short-term financing is granted for 45 days, short-term monetary support for three months renewable up to two times, medium-term financial assistance for a period of two to five years. Credit facilities are granted directly by one member country to another and are accounted for in ECU terms through the EMCF. Check Your Progress 3 State whether the following statements are True or False: 1. The fundamental principle of the classical gold standard was that each country should set a par value for its currency in terms of gold and then try to maintain its value. The price specie-flow mechanism also restored order in case of trade surpluses by working in opposite manner. The EMS created a currency bloc known as the ECU (European Currency Unit) to provide a substitute as well as a complement to the US Dollar. The gold standard worked well until World War I interrupted trade flows and disturbed the stability of exchange rate for currencies. The float becomes dirty when there is a central bank intervention to influence exchange rates.
2. 3. 4. 5.
3.8 FACTORS INFLUENCING EXCHANGE RATE

The demand and supply for foreign currency remain the key factors influencing the exchange rates between the two countries. Though the medium of exchange may be third countrys currency, say US dollar or British Pound. If the demand for foreign country increases, then the exchange rate will depreciate. For example to demonstrate the factors behind how the exchange rates are determined under a flexible exchange rate system. Assume, for simplicity, that there are only two nations, the US and the UK, with dollars ($) being the domestic currency and the pound sterling () as the foreign currency. The exchange rate (R) between the dollar and the pound is equal to the number of dollars needed to purchase one pound. That is R = $ /. For example, if R = $/=2, this means that two dollars are required to purchase one pound. Figure 1 shows the determination of the equilibrium exchange rate between US and UK under a flexible exchange rate system. The vertical axis measures the dollar price of pounds or the exchange rate, R = $/ and the horizontal axis measures the quantity of pounds. The equilibrium exchange rate is determined by the intersection of the market demand and supply curves for pounds at point E, i.e., at R = 2. At this point, the quantity
of pounds demanded and the quantity of pounds supplied are equal to 40 million per day. At an exchange rate lower than R = 2 or at an exchange rate higher than R = 2, the quantity of pounds demanded will not match with the quantity of pounds supplied and the tendency for the exchange rate will be to move towards R = 2. The US demand for pounds is negatively inclined, indicating that the lower the exchange rate (R), the greater is the quantity of pounds demanded by the US. The reason is that the lower is the exchange rate (i.e., the fewer the number of dollars required to purchase one pound), the cheaper it is for the US to import from and to invest in the UK and thus, the greater is the quantity of pounds demanded by US residents. On the other hand, the US supply of pounds is usually positively inclined (as in the figure), indicating that the higher the exchange rate (R), the greater is the quantity of pounds earned by or supplied to the US. The reason is that at higher exchange rates, UK residents receive more dollars for each of their pounds. As a result, they find US goods and investments cheaper and more attractive and spend more in the US, thus supplying more pounds to the US. If the US demand curve for pounds shifted upwards (for example, as a result of increased US tastes for British goods) and intersected the US supply curve for pounds at point G, the equilibrium exchange rate would be R=3 and the equilibrium quantity of pounds would be 60 million per day. The dollar would then be said to have depreciated since it now requires three (instead of the previous two) dollars to purchase one pound. Depreciation thus refers to an increase in the domestic price of the foreign currency. On the other hand, if the US demand curve for pounds shifted down so as to intersect the US supply curve for pounds at point H (figure 3.1), the equilibrium exchange rate would fall to R = 1, and the dollar would be said to have appreciated (because fewer dollars are now required to purchase one pound). Appreciation thus refers to a decline in the domestic price of the foreign currency. An appreciation of the domestic currency means a depreciation of the foreign currency and vice versa. Shifts in the US supply curve for pounds would similarly affect the equilibrium exchange rate and equilibrium quantity of pounds.
R = $/ S 4 A B 3 E 2 G F
1 H 0 10 20 30 40 50 60 70 D Million /day
Quantity of Pounds
Figure 3.1: The exchange rate under a flexible exchange rate system
The above discussion only deals with two currencies. However, in reality, there are a number of exchange rates, one between any pair of currencies. That is, besides the exchange rate between the US dollar and the British pound, there is an exchange rate between the US dollar and the Indian rupee, between the US dollar and the French
franc, between the British pound and the French franc, between the British pound and the Indian rupee and so on. Since a currency can depreciate with respect to some currencies and appreciate against others, an effective exchange rate is calculated. This is a weighted average of the exchange rates between the domestic currency and the nations most import trade parties, with weights being assigned according to the relative importance of the nations trade with each of these trade partners. The foreign exchange rate is simply a pricethe price of one national currency as expressed by the value of another. This exchange price, once established, allows currencies to be exchanged one for another. Much like the price of any other product, the price of a currency is determined by the demand and supply of that currency. When the currency is in demand, its price increases. But if a currencys supply increases without any corresponding increase in demand, its value declines. The purchasing-power-parity hypothesis, when combined with the quantity theory, attempts to predict exchange rates based on money supplies and production: A nation with slower money supply growth and faster expansion in real capacity to produce should have a currency rising in relative value, whereas a nation with fast money growth and a stagnant real economy should have a depreciating currency. With excess imports comes excess supply of money because a large volume of money must be generated to pay for all the imports. With excess money in circulation, the business community as well as the general population begin having doubts about its value, making the currency appear overvalued. In contrast, excess exports result in too much demand for the exporting nations currency since foreign buyers require large amounts to pay for goods. The currency then becomes expensive because of its scarcity and its real value increases. The demand of a currency is determined by several factors. Some of these include: i. ii. iii. Domestic and foreign prices of goods and services. Trading opportunities within a country. International capital movement as affected by the countrys stability, inflation, money supply and interest as well as by speculators perceptions and anticipations of such conditions. The countrys export and import performance.
iv.
3.9 LET US SUM UP

Changes in the International Monetary System have been driven largely by the rapid growth of private international capital flows, which first overwhelmed the Bretton Woods fixed exchange rate system, and, since the 1980s, have had especially strong effects on the emerging market countries. Increasingly the discretion of national policy makers is constrained by international capital markets, which magnify the rewards for good policies and the penalties for bad policies. But markets may, on occasion, overreact by responding late and excessively to change in underlying conditions. The International Monetary System has had to adapt to the increasing role of private capital flows. That process was evident in the shift towards flexible exchange rates among the major currencies three decades ago, and it continues today, as we absorb and react to the lessons of the emerging market crises of the last decade. The gold standard worked well until World War I interrupted trade flows and disturbed the stability of exchange rate for currencies. The inter-war years from 1914-1944 were characterised by political instabilities and financial crisis.
The Bretton Woods System, which played a major emphasis on the stability of exchange rates, worked from 1945-1972. However it came under mounting pressure as the postwar growth of international trade was complemented by an even more dramatic expansion of cross-border capital flows. These starkly revealed the difficulty of fixed exchange rate, an open capital account, and a monetary policy dedicated to domestic economic goals. With the leading countries unwilling to subordinate domestic policies to maintenance of the exchange rate, the fixed exchange rate regime among the major economies gave way. Today, the flexible (floating) exchange rate is prevalent, wherein the market force, based on demand and supply, determines a currencys value. Both fixed and floating exchange rates have their own advantages and disadvantage. The main objective of the EMS was to coordinate the exchange rate policies vis--vis the non EMS currencies and to form a zone of monetary stability in Europe. It has three components the ERM, the ECU and the EMCF.
3.10 LESSON END ACTIVITY

In recent years, we have witnessed a number of financial crises and the plethora of recent to prospective difficulties in financial systems worldwide indicates troubling degree of instability. What lessons can we learn from the international financial crises and how they might be prevented, managed and resolved. In the real world the three words prevention, management and resolution are often inextricably linked. The procedures followed in managing crises can easily have implications for the willingness of creditors to write off debts as well as the likelihood of crises occurring in the future. In the context of the recent financial crises, present your analysis of crisis prevention, crisis management and crisis resolution.
3.11 KEYWORDS
Foreign exchange rate: It is simply a pricethe price of one national currency as expressed by the value of another. Demand of a currency: It is determined by domestic and foreign prices of goods and services. A Nations currency in Equilibrium: A nations currency is in equilibrium when its rate creates no net change in the countrys reserve of international means of payment More flexible exchange rate systems: Countries such as the Japan and United States are in a more flexible exchange rate system in which currency values are allowed to float in relation to each other. Pegged exchange rate systems: In this system, currency values are fixed in relation to another currency such as the US dollar, Euro or to a currency basket such as the special drawing right (SDR). The limited flexibility exchange rate system: It attempts to combine the best of the fixed (pegged) period and floating rate (more flexible) systems. Exchange Rate Mechanism: It refers to the procedure by which the EMS member countries collectively manage their exchange rates. European Currency Unit (ECU): The ECU is a basket currency based on a weighted average of the currencies of member countries of the European Union.
3.12 QUESTIONS FOR DISCUSSION

1. 2. 3. 4. 5. 6. 7. 8. 9. Explain how these exchange-rate systems function (a) gold standard (b) par value (c) crawling peg (d) wide band and (e) floating. What are the EMS and ECU? How does a clean float differ from a dirty float? Both fixed and floating rates claim to promote exchange rate stability while controlling inflation. Is it possible for these two divergent systems to achieve the same goals? Should the world adopt a basket of the five or ten leading currencies (e.g., US dollar, Japanese yen, Swiss franc, etc.) as a global currency for international trade? Is a floating-rate system more inflationary than a fixed-rate system? Explain. Briefly explain the changes in the present International Monetary System that you consider likely to occur in the near future. Why? Under the current system of managed floating, have the exchange rate movements been excessive? Explain. What lessons can economists draw from the breakdown of the Bretton Woods System?
10. What do you think were the major reasons for the currency crisis of September 1992? 11. Describe the exchange rate arrangements that are permitted by the International Monetary Fund.
12. How are exchange rates determined in the following three systems: freely fluctuating, manage-fixed exchange rate and automatic-fixed exchange rate?
Check Your Progress: Model Answers

CYP 1 1. 2. 3. 4. 1. 2. 3. 4. 1. 2. 3. 4. 5. True True False True True True False True True True True True True
CYP 2
CYP 3
3.13 SUGGESTED READINGS

Madhu Vij, International Financial Management, Excel Books, New Delhi, IInd Edition, 2003. V. Sharan, International Financial Management, 4th Edition, Prentice Hall of India. Alan. C. Shapiro, International Financial Management, PHI. Levi, International Finance, McGraw Hill International Series. Adrian Buckly, Multinational Finance, PHI.

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UNIT II

3.0 AIMS AND OBJECTIVES

46 International Financial Management

3.2 GOLD STANDARD

$20.67/ounce of gold = $4.86656/ 4.2474/ounce of gold

47 International Monetary System

3.2.1 Price-Specie-Flow Mechanism

48 International Financial Management

3.2.2 Decline of the Gold Standard

3.3 THE INTER-WAR YEARS, 1914-1944

49 International Monetary System

3.4 THE BRETTON WOODS SYSTEM, 1945-1972

50 International Financial Management

51 International Monetary System

52 International Financial Management

3.5 INTERNATIONAL MONETARY FUND

53 International Monetary System

54 International Financial Management

55 International Monetary System

3.5.1 The IMFs Financial Policies and Operations

56 International Financial Management

57 International Monetary System

58 International Financial Management

59 International Monetary System

3.6 WORLD BANK

60 International Financial Management

61 International Monetary System

3.6.1 A Global Cooperative

62 International Financial Management

63 International Monetary System

3.6.2 Economic Reform Programmes

64 International Financial Management

3.7 EXCHANGE RATE MECHANISM

3.7.1 The European Currency Unit (ECU)

65 International Monetary System

3.7.2 The European Monetary Cooperation Fund

3.8 FACTORS INFLUENCING EXCHANGE RATE

66 International Financial Management

67 International Monetary System

3.9 LET US SUM UP

68 International Financial Management

3.10 LESSON END ACTIVITY

3.12 QUESTIONS FOR DISCUSSION

69 International Monetary System

Check Your Progress: Model Answers

70 International Financial Management

3.13 SUGGESTED READINGS

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