IFM Lesson 4

8/12/2019 IFM Lesson 4

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INTERNATIONAL MONETARY SYSTEM

IMS has evolved over the course of centuries and

defines the overall financial environment in which

MNCs operate.

IMS plays a crucial role in the financialmanagement of a MNC business and economic

and financial policies of a country.

IMS will continue to evolve in the future as theinternational business and political environment

of the global economy continues to change.


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Specie Commodity Standard

In earlier days trade payments were settledthrough barter arrangement.

On account of inconsistency and inconvenience,traders began using metals like gold and silver to

settle the payments. Subsequently metals took the form of coins that

had the stamp of sovereignty on the basis ofweight and fineness of the metal and that wasthe beginning of the Specie Commodity Standard.

The coins were called full-bodied coins meaningthat their value was equal to the value of themetal contained in it.


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Over a period of time other metals with a lower valuewas mixed with gold coins, as a result value of themetal came to be lower than the face value of the coin.

These coins were known as debased coins.

Full-bodied coins were primarily used for store of

value. To act as a store of value, coins must be reliably saved,

stored, and retrieved and also be usable as a mediumof exchange when it is retrieved.

The value of the money must also remain stable overtime.

The full-bodied coins were driven out of circulation bythe year 1560 by the debased coins.


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The Coinage Act or the Mint Act of 1792 of the USA

established dollar as the monetary unit of the country,declared it as a lawful tender and also fixed its value interms of gold and silver.

The mint ratio between gold and silver was 1:15 in theUnited States and 1:15.5 in France.

The difference in the bimetallic standard between the USand the France led to the export of gold from US to Francefor the purchase of silver.

This led to diminution of gold stock in the US and thecountry was forced to adopt a monometallic silver

standard. Therefore in 1834, the 15:1 ratio of silver to gold was

changed to a 16:1 ratio by reducing the weight of thenation's gold coinage.

Now what is the impact on Dollar???


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This created a new U.S. dollar that was backedby 1.50 g (23.22 grains) of gold.

However, the previous dollar had been

represented by 1.60 g (24.75 grains) of gold. The result of this revaluation, which was the

first ever devaluation of the U.S. dollar, was

that the value in gold of the dollar wasreduced by 6%.


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In 1853, the weight of US silver coin was reduced.This led to placing the nation effectively on thegold standard.

With the enactment of the National Banking Act

in 1863 by the US Government, the dollarbecame the sole currency of the United Statesand remains so today.

The Bland Allison Act of 1878 required thegovernment to purchase between USD 2 millionand USD 4 million worth of silver bullion eachmonth at market prices and to coin it into Silverdollars as a subsidy for the politically influentialsilver producers.


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The discovery of large silver deposits in thewestern regions of the United States in the late19th century created a political controversy.

Due to the large influx of silver, the value of silver

in the nation's coinage dropped considerably. The Eastern banking and commercial interests

advocated a sound money policy and a switch tothe gold standard.

The status of silver was slowly diminishedthrough a series of legislative changes from 1873to 1900, when a gold standard was formallyadopted.


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Gold Standard

From 1876 to 1913, the exchange rates were dictated bythe gold standard.

The gold standard lasted for nearly 40 years and the centreof the international financial system during this period wasLondon, indicating the preeminence position it enjoyed

during the hey days of British rule across the globe. Every country adopting the gold standard had its own

traditional and customary norms.

The fundamental rule of the gold standard was that eachcountry should set a par value for its currency in terms of

gold and enforce its value in commerce and trade. Thus each and every country has to establish the rate, at

which its currency should be converted into the weight ofgold.


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Gold Standard

A true gold standard came in 1900 with thepassage of the Gold Standard Act.

Thus US made gold the sole legal-tendercoinage of the United States, and set the valueof the dollar at $ 20.67 per ounce (66.46 /g)of gold.

This made the dollar convertible to 1.5 g

(23.22 grains), the same convertibility intogold that was possible on the bimetallicstandard.


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Features of Gold Standard

1. Country adopting the gold standard shall fix thevalue of currency in terms of specific weight andfineness of gold and guarantees a two wayconvertibility

2. Export and import of gold shall be allowed sothat it can flow freely among the countriesadopting the gold standard

3. Apex monetary institution shall hold goldreserves in relationship to the currency it hasissued and

4. Government shall allow unrestricted minting ofgold and melting of gold coins at the option ofthe holder


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Since fixed weight of gold formed the basis for aunit of currency and as free flow of gold waspermitted among the countries adopting the goldstandard, the gold standard carried an automaticmechanism for domestic price stability, fixedexchange rates and adjustment in balance ofpayment.

The exchange rate mechanism depended uponthe content of gold in different countries.

Let us say that the pound sterling contained a halfounce of gold and one dollar bill contained onefourth ounce of gold, the exchange rate was fixedat 1 = $ 2.


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The United States set the value of the dollar at $20.67 per ounce of gold and the British pound

was pegged at 4.2474 per ounce of gold.

Thus the dollar to pound ( $ / ) exchange rate

was determined as follows:

$ 20.67 per ounce of gold

--------------------------------- = $ 4.8665 per

4.2474 per ounce of gold

Todays Rate: GBP 1= USD 1.67


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The rate was known as the mint rate or themint exchange rate.

The actual exchange rate remained close to

mint rate and the free flow of gold betweenthe two countries ensured not much deviation

in the exchange rate.

This led to fixed parity between the currenciesand helped to preserve the value of each

individual currency in terms of gold.


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In the event of occurrence of a transportation cost ortransaction cost, the dollar pound exchange rate wouldfluctuate above or below the fixed rate.

Let us assume hypothetically that the value of thedollar had depreciated to $ 5 per .

This will give an opportunity for the arbitrageurs tomove in.

The arbitrageurs would buy one ounce of gold in theUS for $ 20.67and sell it in Great Britain for 4.24 and

then exchange the pound for the dollar in the forexmarket for $ 5 x $ 4.24 = $ 21.20, thus making a profitof $ 21.20 -$ 20.67 =$ 0.53 per ounce.

This process would continue till the original parity wasestablished.


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Definition of 'Arbitrageur' A type of investor who attempts to profit from

price inefficiencies in the market by makingsimultaneous trades that offset each other and

capturing risk-free profits. An arbitrageur would, for example, seek out price

discrepancies between currencies listed on morethan one exchange, and buy the undervaluedcurrency on one exchange while short selling thesame number of overvalued currency on anotherexchange, thus capturing risk-free profits as theprices on the two exchanges converge.


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The gold standard maintained a reasonable equilibrium

through the principles of price-specie flow mechanism. This arrangement restored automatic adjustment in

the balance of payments.

Eg: in the event Great Britain faced a deficit on its tradeaccount leading to outflow of gold for trade settlementand reducing the money supply with in the country, theemerging deflation would make the British exportscompetitive and the resultant rise in exports wouldeventually wipe out any deficit on this account.

On the other side, reduced money supply pushes upthe interest rate and the credit restrictions imposed bythe apex banks will push up the bank interest rate,resulting in the foreign investment moving into theeconomy and off-setting any deficit on the capital

account.


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Decline of the Gold Standard

The gold standard as an international monetary

system was accepted by most of the countries

until the First World War broke out in 1914.

The warring nations required huge money supply

for financing the activities borne out of war. This was not possible under the gold standard.

The strained relations among the warring nations

further impeded the free flow of gold from onenation to another.

The exchange rate parity hither to followed by

the various nations went hay wire.


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During WW I, US corporations had large debts payable to

European entities and they began liquidating their debts ingold.

USD to GBP exchange rate reached as high as $ 6.75, farabove the parity of $ 4.8665.

This caused large outflow of gold. In July 1914, the New

York Stock Exchange was closed and the gold standard wastemporarily suspended.

In order to defend the exchange value of the dollar, the USTreasury issued emergency currency under the Aldrich-Vreeland Act, and the newly-created Federal Reserve

organized a fund to clear the debts to foreign creditors. These efforts were largely successful, and the Aldrich-

Vreeland notes were retired starting in November 1914 andthe gold standard was restored and the NYSE re-opened inDecember 1914.

How did the US emerge stronger in WWI????


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From 1915-17, US remained neutral in the war

US banned gold export, thereby suspending the goldstandard for foreign exchange.

US demanded repayment of war debts from Franceand France asked compensation from Germany tomeet the war debt.

The United States finally joined the war in 1917.

Now it enjoyed a huge trade surplus with the EuropeanNations.

Hence the USD became stronger and the Europeancurrencies became weaker and the US began toassume the role of the leading creditor nation.

For the above reasons, the gold standard wassuspended during WW I


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After the end of the WW I, the nations on Gold

Standard re-entered.

The US returned to gold in 1919, Great Britain in

1925, France in 1926 and Switzerland in 1928.

All other European countries followed soon after.

The pound sterling returned at the old mint

exchange rate of $ 4.8665 per .

As Great Britain had liquidated most of its foreigninvestment in financing the war and the pound

stood overvalued and completely exposed.


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A great depression swept the world in 1929 and lasted

for nearly ten years. The depression originated in the US, starting with the

stock market crash of Oct 1929, known as the BlackTuesdaybut quickly spread to almost every country inthe world.

During the period of great depression, almost everymajor currency abandoned the gold standard.

The Bank of England abandoned the gold standard in1931 as speculators demanded gold in exchange for

currency. This pattern was repeated throughout Europeand North America.

In the US, the Federal Reserve was forced to raiseinterest rates to protect the gold standard for the USdollar.


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The production of gold during 1915-22 was

much lower and this resulted in a scramble for

gold.

In early 1933, in order to fight the deflation,

the US suspended the gold standard except

for foreign exchange, revoked gold as

universal legal tender for debts, and banned

private ownership of significant amounts ofgold coin.

After the US abandoned the gold standard,

other nations followed suit.


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Gold Exchange Standard

In the year 1934, the US returned to a modified gold

standard. For foreign exchange purposes, the set $ 20.67 per

ounce value of the dollar was lifted, allowing the dollarto float freely in foreign exchange markets with no setvalue in gold.

This was however terminated after one year.

The US finally devalued its dollar from the previous rateof $ 20.67 per ounce to $ 35.00 per ounce, making thedollar more attractive for foreign buyers.

The higher price increased the conversion of gold intodollars, allowing the US to effectively corner the worldgold market.

The modified gold standard was known as the GoldExchange Standard.


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Bretton Wood System Established in 1944 and named after the New Hampshire

town where the agreements were drawn up, the BrettonWoods system created an international basis forexchanging one currency for another.

It also led to the creation of the International MonetaryFund (IMF) and the International Bank for Reconstruction

and Development, now known as the World Bank. IMF was designed to monitor exchange rates and lend

reserve currencies to nations with trade deficits, the IBRDto provide underdeveloped nations with needed capital

although each institution's role has changed over time. Each of the 44 nations who joined the discussions at

Bretton Woods contributed a membership fee to fundthese institutions; the amount of each contributiondesignated a country's economic ability and dictated its

number of votes.


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Bretton Wood System The Bretton Woods system was history's first

example of a fully negotiated monetary order

intended to govern currency relations among

sovereign states.

In principle, it was designed to combine legalobligations with multilateral decision conducted

through an international organization the IMF.

In practice, the initial scheme, as well as itssubsequent development and ultimate demise,

were directly dependent on the preferences and

policies of its most powerful member, the US.


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Bretton Wood System Here a compromise was sought between the polar

alternatives of either freely floating or irrevocablyfixed rates.

What emerged was the 'pegged rate' or 'adjustablepeg' currency regime, also known as the par value

system. Countries were obligated to declare a par value (a

'peg') for their national money and to intervene incurrency markets to limit exchange rate fluctuations

within maximum margins (a 'band') one per centabove or below the parity

Countries also retained the right to alter their parvalue to correct a 'fundamental disequilibrium' in

their balance of payments.


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Bretton Wood System What emerged largely reflected US preferences: a system

of subscriptions and quotas embedded in the IMF, whichitself was to be no more than a fixed pool of nationalcurrencies and gold subscribed by each country.

Countries were assigned quotas, roughly reflecting their

relative economic importance. The subscription was to be paid 25 % in gold or currency

convertible into gold (effectively the dollar, which was theonly currency then still directly gold convertible for

central banks) and 75 % in the countrys own money. Each country was then entitled, when short of reserves,

to borrow needed foreign currency in amountsdetermined by the size of its quota


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Bretton Wood System Nations were in principle forbidden to engage in discriminatory

currency practices or exchange regulation, with only twopractical exceptions.

First, convertibility obligations were extended to currentinternational transactions only. Governments were to refrainfrom regulating purchase and sale of currency for trade in

goods or services. They were formally encouraged to make useof capital controls to maintain external balance in the face ofpotentially destabilizing 'hot money' flows.

Second, convertibility obligations could be deferred if amember so chose during a postwar 'transitional period.'

Members deferring their convertibility obligations were knownas Article XIV countries and members accepting them wereknown as Article VIII countries.

One of the responsibilities assigned to the IMF was to overseethis legal code governing currency convertibility.


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Chronology of Bretton Wood System The chronology of the Bretton Woods system can be divided into

two periods: the period of 'dollar shortage," lasting roughly until1958; and the period of 'dollar glut,' covering the remainingdecade and a half

The period of the dollar shortage was the heyday of America'smonetary hegemony.

The term 'dollar shortage,' universally used at the time, wassimply a shorthand expression for the fact that only the US wasthen capable of assuring some degree of global monetary stability;only the US could help other governments avoid a mutuallydestructive scramble for gold by promoting an outflow of dollarsinstead.

Dollar deficits began in 1950, following a round of devaluations ofEuropean currencies and shortfalls in the US balance of payments.

The period upto 1958 was rightly called one of 'beneficialdisequilibrium.'


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Chronology of Bretton Wood System The US balance of payments plunged to a $ 3.5 billion gap

in 1958 and to even larger deficits in 1959 and 1960. In 1958 Europe's currencies returned to convertibility.

Subsequently, the eagerness of European governments toobtain dollar reserves was transformed into what seemed

an equally fervent desire to avoid excess dollaraccumulations.

Before 1958, less than 10 % of America's deficits had beenfinanced by calls on the US gold stock and the balance

being financed with dollars. During the next decade, almost two thirds of America's

cumulative deficit was transferred in the form of gold,mostly to Europe. Bretton Woods was clearly coming under

strain.


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Chronology of Bretton Wood System By Mid 60s, negotiations began to create the Special Drawing

Rights (SDR), an entirely new type of international reserve asset. Governments hoped that with SDRs in place, any future threat of

world liquidity shortage would be averted. On the other hand,

they were totally unprepared for the opposite threat - a reserve

surfeit - which is in fact eventually emerged in the late 1960s. Earlier in the decade a variety of defensive measures were

initiated in an effort to contain mounting speculative pressures

against the dollar.

These included a network of reciprocal short term credit facilitiescalledswaps among the central banks as well as enlarged lending

authority for the IMF.


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Chronology of Bretton Wood System By Mid 60s, negotiations began to create the Special Drawing

Rights (SDR), an entirely new type of international reserveasset.

Governments hoped that with SDRs in place, any future threat

of world liquidity shortage would be averted. On the other

hand, they were totally unprepared for the opposite threat - areserve surfeit - which is in fact eventually emerged in the late

1960s.

Earlier in the decade a variety of defensive measures were

initiated in an effort to contain mounting speculative pressuresagainst the dollar.

These included a network of reciprocal short term credit

facilities calledswaps among the central banks as well as

enlarged lending authority for the IMF.


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Chronology of Bretton Wood System A second source of strain was inherent in the structure of the par

value system: How could governments be expected to changetheir exchange rates if they can not even tell when a fundamental

disequilibrium existed?

And if they were inhibited from re-pegging the rates, then how

would international payments equilibrium be maintained? The Bretton Woods system rested on one simple assumption - that

economic policy in the US would stabilize.

During the first half of the 1960s, America's foreign deficit actually

shrank as a result of a variety of corrective measures adopted athome. After 1965, however, US became increasingly destabilized,

as a result of increased government spending on social programs

at home and an escalating war in Vietnam. America's economy

began to overheat and inflation began to gain momentum, causing

deficits to widen once again.


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Chronology of Bretton Wood System Inflation everywhere began to accelerate, exposing all

the latent problems of Bretton Woods.

The pegged rate system was incapable of coping with

widening payments imbalances, and the confidence

problem was worsening as speculators were encouragedto bet on devaluation of the dollar or revaluations of the

currencies of Europe or Japan.

On 15 August 1971, the Richard Nixon administration

suspended the convertibility of the dollar into gold,freeing the greenback to find its own level in currency

markets.


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Smithsonian Arrangement

From Aug to Dec 1971, most of the major currencies

were allowed to fluctuate.

The US dollar dropped in value against a number of

major currencies.

Several nations imposed trade and exchange controlsand it was feared that such protective measures might

endanger the institution on international commerce and

trade.

To mitigate these problems, the worlds leading tradingcountries called Group of Ten met at the Smithsonian

Institute in Washington DC and formed the Smithsonian

arrangement to restore stability of the system.


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Smithsonian arrangement called for realignment of the

par value of major currencies to conform to theirrealistic values.

Gold parity of the US dollar was changed from $ 35 to $

38.02 per troy ounce of gold resulting in devaluation of8.57%.

Currencies of surplus countries were revalued upwards

by percentages ranging from 7.4% in respect of the

Canadian dollar to 16.9% in respect of the Japanese yen. Currencies were permitted to fluctuate over a wider

band than in the past.


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Although a currency was allowed to fluctuate with in a

margin of 2.25% from the central rates without thegovernment intervention, it could fluctuate by as much

as 9% against any currency except the dollar.

Since a currency was permitted to fluctuate up to 2.25%on either side of the central rat,, its total fluctuation

against the dollar could be as high as 4.5%.

Purpose of Smithsonian arrangement was to infuse

greater flexibility into the par value system.


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Case Study 4 :Greece Economy

In the beginning of 2009, the Greece economy collapsed

and the country was bailed out to the tune of over $100billion.

Unions and the socialists are upset that the Greek

government has to cut their pay and benefits to justkeep them employed.

Greece already has a VAT of 21 % which has been

increased to 23% after the collapse.

Imagine 23% being added to the cost of everything youbuy.

Greece has announced a 20% pay cut to public

employees and a hiring freeze for the next 3-5 years.


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Case Study 4 :Greece Economy

Today Greece roughly has a debt of 150 % of GDP.

Q

i) Analyse the real issue of the collapse of the Greece

economy.

ii) What is happening in Europe can and may very well

happen in India. Discuss

iii) A bloated broke government that cant pay for its

own survival is a recipe for new taxes and one otherthing, a disaster. Comment in Detail.

IFM Lesson 4

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