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.
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