International Monetary SystemInternational Monetary

System

PRESENTED BY:Arun Chhikara

Gaurav SharmaGaurav KhuranaPrashant SinghShadab Khan

International Monetary SystemPreface Increased Volatility of currency affects the earnings of MNC’s,

Banks and Cross Border investor’s

There are large and unexpected fluctuations in the value of currency hence a setup called Bretton Woods was formed in 1944 to reduce this riskiness of international business

The main feature of Bretton Woods was the relatively fixed exchange rate of individual currency in the terms of USD $ and convertibility of $ into gold

In 1971 Bretton Woods fell prey to international financial turmoil and was replaced by the present regime of rapidly fluctuating exchange rates which resulted in both problems and opportunities for MNC’s

International Monetary SystemINTERNATIONAL MONETARY SYSTEM

The International Monetary System refers to set of policies, institutions, practices, regulations & mechanism that determine the rate at which one currency would be exchange for another.

There are primarily 5 market mechanisms to establish exchange rate with each having its share of merits & demerits –

•Free float •Managed float•Target zone arrangement•Fixed rate system•Hybrid system

International Monetary System All countries like to have economic stability & prefer a stable

exchange rate, however fixing exchange rate often leads to currency crises if the monetary policy is inconsistent with it

Countries are less vulnerable to economic shocks if they allow their currency to float freely but that may exhibit excessive volatility which hurts trade & economic growth

The trade off between different mechanism depend upon the importance of the underlying benefits & trade offs associated with them

International Monetary SystemFree Float

Free market exchange rates are determined by interaction of currency supply & demand which is in turn influenced by price level changes interest differential & economic growth

The exchange rate fluctuates randomly as market participants arises & react to new information, for example – Government policies or acts of God & nature

This is also called clean float as the exchange rates are free flowing without any manipulation

International Monetary SystemManaged float Intervention by Government’s in the foreign change market in

order to reduce economic uncertainty associated with free/ clean float

This is triggered by the fear that a sudden change in the currency appreciates or inflation of it depreciates

Central banks of countries intervene to smooth as out exchange rate fluctuations & determine the rate that is why it is called Managed/ dirty float

Crawling peg – unofficial pegging

International Monetary SystemTarget zone arrangement

Under this system, countries adjust their national economic policies to maintain there exchange rates within a specific margin

Members of the arrangement adjust their national economic policies to maintain the target range

International Monetary SystemFixed rate Bretton wood was also a fixed rate mechanism, in this type of

regime, Governments are committed to maintain a target exchange rate

Central banks buy/ sell currency actively if the exchange rate is threatened

For this system to work, all member nations must accept the groups joint inflation rate as its own.

These controls are major source of imperfection for MNC’s which provide both risk & opportunities to them

International Monetary SystemThe current hybrid system The currency system is the one where major currencies float on a

managed basis, some currencies are freely floating while other currencies follow various types of pegged exchange rates

Examples – another currency as legal tender – Equador, el Salvador (US dollar) – pegged against a single currency, Malaysia, Maldives, Nepal, Iraq, Jordan

International Monetary SystemBrief history of International monetary system Why Gold – Gold has a certain desirable properties like durability,

ease of storage, easy recognition, standardization

Short term changes in its stock are limited by high production cost, making it expensive to manipulate

It ensures price stability in long run

This is the reason why most currencies fairly recent recently followed gold standard which defined their exchange rates

International Monetary SystemThe Gold standard The gold standard essentially involved a commitment by the

participating countries to fix the price of their currencies in terms of a specific amount of gold

The price was maintained by buying/ selling gold at that price

The value of gold relative to other goods does not change much over long period of time, that helps in maintaining monetary discipline & ensures long run price stability

Concept of fat money – gold standard

International Monetary SystemThe gold standard from 1925 - 1944

The gold standard broke down during World War I, and was briefly re-instated between 1925-31 as gold exchange standard

Under this system, only US & Britain were allowed to hold gold reserves while other could hold both gold, dollars &/ or pound reserves

1931 – Britain departed from Gold standard due to high influx of gold & capital, this led to devaluation of many currencies which in turn led to trade wars, some economists even blame the protectionist regimes of triggering the great depression

International Monetary SystemBretton woods (1946 – 1971 ) To avoid destructive monetary economic policies to be formulated

allied nations agreed to form a new postwar system

The conference held in New hampshire also created institutions, IMF & World Bank to promote international financial stability

World bank had the primary function of lending to nations devastated by the world war

The IMF had agenda to foster global growth and economic stability

International Monetary SystemBretton woods – The fine print USD became the key currency & each Government pledged to

maintain a fixed, or pegged exchange rate vis-à-vis the dollar or gold

1 ounce of gold = $ 35 1 ounce of gold = 140 mark (German) so 4 mark = $ 1 Exchange rates were allowed to fluctuate by 1% above or below

initial base price.

The fixed exchange rates were maintained by official intervention by central banks in the form of sale & purchase of dollars with the IMF providing the foreign exchange

International Monetary SystemBretton woods (continued) Technical aspects of the system had practical implications on the

participating countries

Stability of exchange rates removed a great deal of uncertainty from international trade & investment transactions

It also imposed a great deal of discipline on the participating nations economic policies

International Monetary SystemFall of Bretton woods

The Bretton wood system was fixed rate, only in name, out of 21 major industrialized countries Only the US & Japan held to their par value during 1946-71. Out of 21, 12 devalued their currencies more than 30% against the dollar

The death blow for the system came from President Nixon, who was alarmed at high inflation rate & he devalued the dollar to deal with the emerging trade deficit

International Monetary SystemPost Bretton woods

Smithsonian agreement of 1971 – US devalued to 38 $ / Oz of gold & other countries were revalued on agreed amounts vis-à-vis the dollar

By 1973 – The world officially turned to floating exchange rates

International Monetary SystemRole of International Monetary FundThe IMF works to foster global growth and economic stability. It provides policy advice and financing to members in economic difficulties and also works with developing nations to help them achieve macroeconomic stability and reduce poverty.

Its main works are –

•policy advice to governments and central banks based on analysis of economic trends and cross-country experiences

•research, statistics, forecasts, and analysis based on tracking of global, regional, and individual economies and markets

•loans to help countries overcome economic difficulties

•concessional loans to help fight poverty in developing countries

International Monetary SystemIt is having 188 member countries till date

Special Drawing Right (SDR)

The IMF supplemented its foreign exchange by creating a new reserve asset, (named SDR).

It serves as the IMF’s unit of account

It is a weighted average of the currencies of five nations (US, Germany, France, Japan & Great Britain)

The weights, which are based on the relative importance of each country in international trade are updated periodically

International Monetary SystemRole of World bank

The world bank is an internationally supported bank that provides financial and technical assistance to developing countries for development programs (e.g. bridges, roads, schools)with the stated goal of reducing poverty.

Role of Bank of International Settlements•Acts as the “Central Bank“ for Industrial Countries’ Central Bank

•Helps in managing FOREIGN EXCHANGE RESERVES

•BIS also holds deposits of Central Banks

International Monetary SystemFloating Rate system - 1973 Proponents of the new system said that this system would reduce

economic volatility & facilitate free trade, floating exchange rates would offset the differences in inflation rate

High inflation countries would have their currencies depreciate, allowing their firms to stay competitive without having to act wages & unemployment

International Monetary SystemAssessment of Floating Rate system

Currency volatility has increased – The experience till date from the system has been disappointing. The dollars ups & down has little to do with inflation & a lot to do with expectations of future government policies & economic conditions

The instability reflects the non monetary shocks to the world economy, such as changing oil prices & competitiveness amongst countries

International Monetary SystemJamaica Agreement 1976

Floating rates declared acceptable

Gold abandoned as reserve asset; I. IMF returned gold reserves to members at current pricesII. Proceeds placed in trust fund to help poor nationsIII. IMF quotas – member country contributions – increased;

membership now 182 countriesIV. Less-develop, non-oil exporting countries given more

access to IMFIMF continued its role of helping countries cope with

macroeconomic and exchange rate problems

International Monetary SystemMajor events after 1973OPEC and the Oil Crisis (1973-74)

1. OPEC raised oil prices four fold 2. Exchange rate turmoil resulted 3. Caused OPEC nations to earn large surplus B-O-P. Surpluses recycled to debtor nations which set up debt crisis of 1980’s.

Dollar Crisis (1977-78)

1. U.S. B-O-P difficulties2. Result of inconsistent monetary policy in U.S.3. Dollar value falls as confidence shrinks.

International Monetary SystemThe Rising Dollar (1980-85)

1. U.S. inflation subsides as the Fed raises interest rates2. Rising rates attracts global capital to U.S.3. Result: Dollar value rises.

The Sinking Dollar:(1985-87)

1. Dollar revaluated slowly downward;2. Plaza Agreement (1985) G-5 agree to depress US $ further.3. Louvre Agreement (1987) G-7 agree to support the falling US $

Recent History (1988-2005)

I. 1988 US$ stabilizedII. Post-1991 Confidence resulted in stronger dollarIII. 1993-1995 Dollar value falls.

International Monetary SystemFinancial Crisis 2007-12Global Financial crisis: Worst Financial Crisis since the Great

Depression (1930)EVENTS• Subprime lending• Growth of the housing bubble• Easy credit conditions• Weak and fraudulent underwriting practices• Deregulation• Increased debt burden or over-leveraging• Incorrect pricing of risk• Boom and collapse of the shadow banking system• EURO Zone crisis• Commodities boom•Currency volatility

International Monetary System

Thank You