The International Monetary System Exchange Rate Regimes

							International Financial Management
              P G Apte
      Exchange Rate Regimes: A
        Historical Perspective
• The Gold Standard
   Gold Specie Standard; Gold Bullion Standard
   Gold Exchange Standard
   • Mint Parity: The exchange rate between any
   pair of currencies will be determined by their
   respective exchange rates against gold
   • The gold standard regime imposes very rigid
   discipline on the policy makers :
   • The money supply in the country must be tied
   to the amount of gold the monetary authorities
   have in reserve.
   When a country loses (gains) gold, money
   supply must contract (expand).
   • Domestic economy governed by external
   sector.
  Exchange Rate Regimes: History
• The Bretton Woods System
 The exchange rate regime that was put in place
 after WWII can be characterized as Gold
 Exchange Standard
     •The US government undertook to convert
     the US dollar freely into gold at a fixed
     parity of $35 per ounce
     •Other member countries of the IMF agreed
     to fix the parities of their currencies with
     the dollar with variation within 1% on either
     side of the central parity being permissible
     It was an Adjustable Peg system. Central
     parity could be changed in the face of
     “fundamental disequilibrium”.
Exchange Rate Regimes: History
– In return for undertaking this obligation, the
  member countries were entitled to borrow
  from the IMF to carry out their intervention
  in the currency markets. Beyond a country’s
  reserve position borrowings are conditional
  on the country adopting certain policy
  changes recommended by IMF.
– Whenever the exchange rate tended to
  move out of the  1% band, the central bank
  had to sell or buy the foreign currency to
  bring it back within the band.
  Devaluation/Upvaluation when
  disequilibrium persisted – Fundamental
  Disequilibrium
Exchange Rate Regimes: History
 Intervention operations affect the
 domestic money supply and then the
 price level, GNP etc.
 These effects may have an automatic
 corrective effect – Central bank sells
 forex, money supply contracts, price level
 reduces, GNP reduces, imports decline,
 the pressure on home currency reduces.
 Central bank can “sterilize” these effects.
Exchange Rate Regimes: History
 – This system could work as long as
   other countries had confidence in the
   stability of the US dollar
 – The system came under pressure and
   ultimately broke down when this
   confidence was shaken starting mid
   1960’s. August 15, 1971, US gave up the
   commitment to convert dollars into gold
   at fixed rate.
 – Abandoned in 1973 after some attempts
   to fix it and revive it.
 – Major currencies started floating in
   early 1973.
        SUBSEQUENT EVOLUTION

    Major Exchange Rate Agreements
– 1971 Smithsonian Agreement
– 1972 European Joint Float Agreement
– 1976 Jamaica Agreement
– 1979 European Monetary System (EMS)
  created
– 1985 Plaza Accord
– 1987 Louvre Accord
– 1991 Treaty of Maastricht
  History of the International Monetary
                  System
• 1971 Exchange rate turmoil
     dollar falls off the gold standard
   – most currencies begin to float on world markets

• 1971 Smithsonian Agreement (Group of Ten)

  – dollar devalued to $38/oz of gold
  – other currencies revalued against the dollar
  – 4.5% band adopted

• 1972 European Joint Float Agreement

  – “The snake” adopted by EEC
Smithsonian Agreement

1971 Smithsonian negotiations led to official renunciation of
gold/dollar convertibility and unilateral devaluation of the US
dollar by nine per cent.

Modified version of fixed exchange rates with managed,
adjustable parities.

Notion of irrevocably locking exchange rates together without
any margin of fluctuation was abandoned in favour of
mechanism to reduce margin of fluctuation around the central
parities . Intra-EEC exchanges confined to a narrower band of
fluctuation than was permitted in respect of EEC currencies
against the dollar (the ‘snake in the tunnel’).
The Basle Agreement : Snake in the Tunnel

The Basle Agreement, March 1972 reduced intra-EEC
exchange rate fluctuations to 2.25 per cent the “snake in the
tunnel” . “Tunnel” set at 4.5 % “snake” confined to a margin
of 2.25%.

European currencies used as means of central bank
intervention while dollar deployed to prevent the snake from
leaving the tunnel.

The six original members of the currency bloc joined by
Ireland, the UK, Denmark and Norway
History of the International Monetary System

  • 1976      Jamaica Agreement
    Floating rates declared “acceptable”


   1979 European Monetary System
   (EMS)
     European Exchange Rate Mechanism
    (ERM) established to maintain currencies
     within a 2.25% band around central rates
    – European currency unit (ECU) created
History of the International Monetary
                System
 • 1985 Plaza Accord (Group of Ten)

   –The Group of Ten form an agreement to
    cooperate in controlling volatility and
    bringing down the value of the dollar

  1987 Louvre Accord
    The Group of Five agree to maintain
   current levels – not to allow the US dollar
   to slide down any further
The Plaza Accord 1985

In 1985 inflation was low and growth was rapid. The US was
experiencing a large and growing trade deficit, caused in part
by the rising dollar. Japan and Germany were facing large and
growing surpluses. This imbalance threatened to upset the
foreign exchange market.

The 80% appreciation in value of the US dollar against the
currencies of its major trading partners was seen as the source
of the problems.

A US dollar with a lower valuation would help stabilize the
global economy- creating a balance between the exporting and
importing capabilities of all countries.
The Plaza Accord 1985 …
Devaluing the dollar made US exports cheaper for its
trading partners, which caused other countries to buy more
American-made goods and services.

The US persuaded the leaders to coordinate a multilateral
intervention, designed to allow for a controlled decline of the
dollar and the appreciation of the main anti-dollar
currencies.

Each country agreed to make changes in it's economic
policies and to intervene in currency markets as necessary to
bring down the value of the dollar.
The Louvre Accord 1987

Agreement between the then G6 (France, West Germany,
Japan, Canada, the United States and the United Kingdom)
on February 22, 1987 in Paris, France. Italy had been an
invited member, but declined to finalize the agreement.

The goal of the Louvre Accord was to stabilize the
international currency markets and halt the continued decline
of the US Dollar caused by the Plaza Accord (of which a
primary aim was depreciation of the US dollar in relation to
the Japanese yen and German Deutsche Mark).
The Louvre Accord …

The Louvre Accord aimed to improve the stability of
foreign exchange by the mutual agreement of the G7
Minister of Finance.

Since the Plaza accord, the dollar rate had continued to
slide, reaching an exchange rate of ¥150 per US$1 in 1987.
The ministers of the G7 nations gathered at the Louvre in
Paris to "put the brakes" on this decline. It was assumed
that a lower dollar valuation might stall economic growth
world-wide. The monetary authorities of the G7 ministers
agreed to cooperate to stabilize exchange rates.
  History of the international monetary system

• 1991 Treaty of Maastricht
  –European community members agree to pursue a
   broad agenda of economic, financial and monetary
   reforms
  –A single European currency is proposed as the
   ultimate goal of monetary union

• 1999 Introduction of the Euro
  –Emu-zone currencies are pegged to the euro
  –European bonds convert to the euro

• 2002 The Euro begins public circulation
      Mexican peso crisis
1.2

                          Mexican stock market
1.0                      value (in local currency)
                          (Dec 31, 1993 = 1.00)
0.8


0.6

       Mexican peso
0.4   (in U.S.dollars)

0.2



        1994                               1995
       The Asian contagion
      (December 31, 1996 = 1.00)
1.2



1.0



0.8

                                 Thai bhat
0.6
                                    Korean
                                     won
0.4
                    Indonesian
                      rupiah
0.2



0.0
       1996        1997                      1998
    The International Monetary
              System
The Relevant Aspects of the System
• Exchange rate regimes, current and past
• International liquidity
• The International Monetary Fund (IMF)
• The adjustment process i.e. how does the
  system facilitate the process of coping
  with payments imbalances between
  trading nations
• Currency blocks and unions such as the
  EMU
              Exchange Rate Regimes
• The IMF classifies member countries into eight
  categories of exchange rate arrangements
     • Currency Union (No separate legal tender) as in the
       Euro area
     • Currency Board Arrangement
     • Conventional Fixed/Adjustable Peg Arrangements
     • Pegged Exchange Rates within Horizontal Bands
     • Crawling Peg
     • Crawling Bands (BBC- Basket, Band, Crawl)
     • Managed Float
     • Independent/Free Float
        EXCHAGE RATE REGIMES
• Adjustable Peg Regimes
A fixed parity (“peg”) against a major currency is
publicly announced with a commitment to defend it
within narrow margins but with an option to adjust the
parity in case of a large change in fundamentals which
renders the old parity unsustainable.

• The “BBC” Regime (Band, Basket, Crawl
Regime)
The peg is against a basket of currencies rather than a
single currency; fluctuations within a wider band (say
10%) around the peg permitted; the peg is allowed to
shift or “crawl” according to a pre-announced formula
          EXCHANGE RATE REGIMES
• Currency Board Arrangement
The home currency is backed (usually 50% or more) by a
foreign reserve currency and the currency board is legally
obligated to convert home currency into the foreign currency
on demand at a fixed rate of exchange.

• Currency Union
•Hardest of hard pegs. A country abolishes its own currency
and replaces it with the national currency of another country –
obviously a major convertible currency

• Free Float
The currency is allowed to fluctuate without any attempt to
direct or control its movements. Theoretical.
          EXCHANGE RATE REGIMES
• Managed Floating
Authorities use various policies to counter some movements in
exchange rates e.g. excessive fluctuations. They would not use
large scale interventions in the forex markets to alter the
trends in exchange rate nor try to eliminate all short term
volatility.

• Other Mixed Regimes
Crawling pegs, crawling bands, discretionary crawling etc.
De-facto regimes may be quite different from de-jure regimes
as intimated to IMF.

IS THERE AN OPTIMAL REGIME?
   Exchange Rate Regimes
Is there an “ideal” regime?
• Fixed rates provide a policy anchor &
discipline.
• Freely floating rates provide monetary policy
freedom.
• Economists are reconsidering the merits of a
floating exchange rate and monetary policy
independence which it apparently bestows on a
country. But hard pegs have their problems too.
• It appears therefore that there is no such thing
as "the ideal" exchange rate regime for all
countries or even for a given country at all times
• Crawling pegs, crawling bands, managed float
etc. are attempts to get the best of both the
worlds
    Exchange Rate Regimes
– One school of thought feels that only two types
of exchange rate regimes will survive in long
run:
 • Truly fixed rate arrangements, legally
 irrevocable
 • Truly market determined, floating rates
–The “Impossible Trinity” : A country can
achieve any two of the following three policy
goals but not all three
 • A stable exchange rate
 • Monetary policy independence
 • Financial market integration with rest of the
 world
      THE IMPOSSIBLE TRINITY
                  Full Capital Controls




Monetary Policy                           Stable Exchange
Independence                              Rate




 Floating Rate       Integration           Currency Union
The International Monetary Fund (IMF)
• The Role of IMF

  – Framework of the Articles of Agreement
    adopted at Bretton Woods in1944

     • Increasing international monetary
       cooperation
     • Promoting the growth of trade
     • Promoting exchange rate stability
     • Establishing a system of multilateral
       payments, eliminating exchange restrictions
       which hamper the growth of world trade and
       encouraging progress towards
       convertibility of member currencies
     • Building a reserve base
                 The IMF
• Funding Facilities
  – Operation of the adjustable peg requires a
    country to intervene in the foreign exchange
    markets to support its exchange rate when it
    threatens to move out of the permissible band
  – Reserve Tranche & Credit Tranche. Their
    conditionalities
  – Other funding facilities such as ESAF
    (Enhanced Structural Adjustment Facility)
    HIPC (Highly Indebted Poor Countries)
    initiative etc. and their implications for
    recipient countries.
  – IMF often criticized for imposing conditions
    which do more damage than good.
                 The IMF
• International Liquidity and Special
  Drawing Rights (SDR)
   – International Liquidity and International
     Reserves
      • International liquidity refers to the
        stock of means of international
        payments
      • International Reserves, are assets
        which a country can use in settlement
        of payments imbalances that arise in
        its transactions with other countries
International Reserves = Reserve position in
  IMF + SDRs + Forex assets held by central
  bank
               The IMF
– Special Drawing Rights (SDRs)
  • SDR is international fiat money created by
    IMF and allocated to member countries.
  • Can be used by Central banks to settle
    payments among themselves. Selected
    other institutions allowed to hold and use
    SDRs
  • In order to make SDRs an attractive asset to
    hold, the Fund pays interest on holdings in
    excess of a member's cumulative allocation
    and it charges interest on any shortfalls
  • Have not become popular as reserve asset
           SDR VALUATION Friday, July 31, 2009

Currency      Currency Amount          Exchange Rate         U.S.
                                                             Dollar
                                                           Equivalent

  Euro         0.4100                   1.41320             0.579412
Japanese Yen 18.4000                   95.67000            0.192328
Pound Sterling 0.0903                   1.65660             0.149591
U.S. dollar    0.6320                   1.00000             0.632000
                                                           _________
                                                            1.553331
                  US$ 1.00 = SDR 0.643778

                  SDR 1 = US$ 1.55333

(Note: EUR,GBP rates stated as $ per EUR and $ per GBP. JPY rate stated
 as JPY per $ )
                   The IMF
• The Role of IMF in the Post-Bretton Woods
  World
  – Under the Bretton Woods system the IMF was
    responsible for the functioning of the
    adjustable peg system
  – Under the current "non-system" that role has
    considerably diminished if not eliminated
  – The Fund is mandated to "exercise firm
    surveillance over the exchange rate policies of
    members"
  – The Fund has played an important role in
    tackling the debt crisis of developing countries
    (not a unanimous view)
         The Problem of Adjustment
• Every open economy, from time to time faces
the problem of imbalance on its external
transactions
• The BOP disequilibria may be transitory or
permanent in nature
• The country must choose between financing
the imbalance or undertaking a programme of
adjustment. Relevant factors:
• Exchange Rate Regime; Availability of Financing
Creditworthiness of the Country; Export-Import
Demand Elasticities; Saving and Import Propensities;
Behaviour of Domestic Costs; State of the Economy

Adjustment more urgent for deficit countries.