International Finance

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International Finance
Academy of Economic Studies Faculty of
International Business and Economics

• Lecture III
• The evolution of International Financial System
  (2)

Lect. Cristian PAUN Email cpaun_at_ase.ro URL
http//www.finint.ase.ro
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Why did the BW System breakdown?

• The liquidity problem (the Triffin Dillema)
• Lack of Adjustment Mechanism
• The BW System permitted a realignment of FX rates
  as a last resort in case of fundamental
  disequilibrium of BoP for member states
• The countries were to interested for a frequent
  devaluation and revaluation of their currency
• The fundamental disequilibrium was not defined
• The seigniorage problem
• The US was the major source of international
  liquidity
• To acquire reserves the rest of the world had to
  run surpluses of BoP while US ran deficits
• The rest of the world had to consume less it was
  producing and US consumed more than it was
  producing
• Exporting inflation ? Seigniorage controversy

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Triffin Dilemma

• Belgian monetary economist Robert Triffen
  described problem of expanding dollar reserves in
  his 1960 book Gold and the Dollar Crisis
• Problem became known as the Triffin dilemma
• Contradiction between requirements of
  international liquidity and international
  confidence
• Liquidity refers to the ability to transform
  assets into currencies
• International liquidity required a continual
  increase in holdings of dollars as reserve assets
• As dollar holdings of central banks expanded
  relative to US official holdings of gold,
  however, international confidence would suffer
• Triffin argued that US could not back up an
  ever-expanding supply of dollars with a
  relatively constant amount of gold holdings

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The Triffin Dilemma
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IFS after BW Breakdown

• The Jamaica Conference (1976)concerning the IFSs
  reform to legitimize floating exchange regime
• It was concluded between the European Countries
  and the United States in the purpose of reforming
  the IFS
• Pure floating exchange rate was prohibited for
  the member states of the Bretton Woods Agreement
  with the derogation from 1973
• Pure/flexible/clean floating exchange rate has
  been replaced with dirty/managed floating
  exchange rate for two reasons
• The growth and the development of international
  trade without major fluctuations of the exchange
  rate
• The avoidance of crises in the world economy (
  oil crises)
• The modification of the fourth article of the
  agreement (ratified in 1978 by two thirds of the
  member states
• Each country is free to choose its
  monetary-foreign exchange rate (except for the
  gold exchange standard)
• The International Monetary Fund (IMF) will
  supervise the monetary and exchange rate policy
  of the member states of the system and will work
  out / elaborate / draw out action principles
• IMF, with a majority of 85, can decide to
  reintroduce a system related to the US dollar
  (USA have the power to veto the decision)
• The diminution of the role played by the gold
  exchange standard
• The adoption of Special Drawing Rights as the
  main reserve asset

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IFS after BW Breakdown

• The Principles adopted in 1977 on IFS
• Each member must avoid the interventions in the
  foreign exchange market to prevent the
  disequilibrium of Balance of Payments or to
  obtain an unfair advantage in international
  commercial exchanges
• Each member can interfere in diminishing the
  eventual crises in the Balance of Payments
• In any intervention in the foreign exchange
  market, it must be taken into account the member
  states interests (including the issuing state)
• Plazza Agreement (September 1985)
• Initiated by a group of 5 countries (USA, UK,
  Japan, Germany and France)
• G5 decided to intervene/interfere in decreasing
  the value of the US dollar on the international
  markets (considered until then as being
  overestimated)
• Louvre Agreement (February 1986)
• Initiated by a group of 7 countries (G5 Italy
  and Canada)
• The us dollar was considered to have reached a
  value which reflected the economic realities and
  the interventions in the foreign exchange market
  were suspended
• The countries will interfere without announcement
  and only if necessary, in the favour of their
  currencies

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IFS after BW Breakdown

• Oil price increases of 1973-1974 caused
  substantial balance of payments difficulties for
  many countries of the world
• In June 1974, the IMF established an oil facility
  to assist these countries
• Acted as an intermediary, borrowing funds from
  oil producing countries and lending them to oil
  importing countries
• A second oil facility was established in 1975
• Slightly more strict than the first

• In 1976, IMF began to sound warnings about
  sustainability of developing-country borrowing
  from commercial banking system
• Banking system reacted with hostility to these
  warnings
• Argued Fund had no place interfering with private
  transactions
• The 1980s began with a significant increase in
  real interest rates and a significant decline in
  non-oil commodity prices
• Increased cost of borrowing and reduced export
  revenues

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IFS after BW Breakdown crises in Latin Am.

• In 1982, IMF calculated that US banking system
  outstanding loans to Latin America represented
  approximately 100 of total bank capital
• In August 1982 Mexico announced it would stop
  servicing its foreign currency debt
• At the end of the month, Mexican government
  nationalized its banking system
• 1982 also found debt crises beginning in
  Argentina and Brazil
• Argentina Overvalued exchange rate, used as a
  nominal anchor to curb inflationary
  expenditures
• Brazil Rates of devaluation did not keep up
  with rates of inflation, causing an overvalued
  real exchange rate

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IFS after BW Breakdown

• International commercial banks began to withdraw
  credit from many of the developing countries of
  the world
• Debt crisis became global
• Involved capital account payments of debtor
  countries exceeding capital account receipts
• By second half of 1980s, some debt was trading at
  discounts in secondary markets
• In 1989, US Treasury Secretary Nicholas Brady
  proposed a plan in which IMF and World Bank
  lending could be used by developing countries to
  buy back discounted debt
• Amounted to partial and long-needed debt
  forgiveness, were approved by the IMF and became
  known as the Brady Plan
• Also allowed for extending time periods of debt
  and provided for new lending

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History of IMF Operations, 1990s

• Starting in the 1990s, private, non-bank capital
  began to flow to developing countries in the form
  of both direct and portfolio investment
• Number of highly-indebted countries began to show
  increasing unpaid IMF obligations
• In November 1992, a Third Amendment to the
  Articles of Agreement allowed for suspension of
  voting rights in the face of large, unpaid
  obligations
• Mexico underwent a second crisis in late 1994 and
  early 1995

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History of IMF Operations, 1990s

• In 1997-1998, crises struck a number of Asian
  countriesmost notably Thailand, Indonesia, South
  Korea, and Malaysia and also Russia
• Resulted in sharp depreciations of the currencies
• In the cases of Thailand, Indonesia, and South
  Korea, IMF played substantial and controversial
  roles in addressing crises
• Loan packages were designed with accompanying
  conditionality agreements
• Supplementary Reserve Facility was introduced to
  provide large volumes of high-interest,
  short-term loans to selected Asian countries
• In October and November 1998, IMF put together a
  package to support Brazilian currency, the real
• Attempt to prevent Asian and Russian crises from
  spreading to Latin America
• Still, Brazil was forced to devalue the real in
  January 1999

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History of IMF Operations, 1990s

• Recent years have witnessed important changes at
  the IMF
• In 1997 General Agreement to Borrow was
  supplemented by the New Arrangement to Borrow
• Involves 25 IMF members agreeing to lend up to
  US46 billion to IMF in instances where quotas
  prove to be insufficient
• In 1999, a new lending facility was added
• Poverty Reduction and Growth Facility was created
  to replace the 1987 Enhanced Structural
  Adjustment Facility
• Represents beginning of an attempt to integrate
  poverty reduction consideration into
  macroeconomic policy formation of IMF
• In 1999, quotas were increased by 45 to a total
  of US283 billion

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Reforming the IMF System

• The present system permits countries to adopt
  whatever exchange-rate policy they wish providing
  that they do not peg their currencies to the
  value of gold.
• In practice there exists a wide range of
  exchange-rate polices from completely free
  floating to various pegging arrangements (next
  slides).
• The present international monetary system has
  been called a 'non-system' as there are no clear
  sets of exchange-rate arrangements among the
  major international currencies (the dollar, yen,
  deutschmark and sterling)
• The large and dramatic currency swings in the
  1970s, 1980s and 1990s between the major
  currencies, particularly between the dollar and
  other currencies, have led to a variety of
  proposals to reform the system.
• All the proposals are based upon the view that
  it is desirable to limit the exchange-rate swings
  between the major currencies
• Three of the best-known proposals to bring some
  stability to the international monetary system
  have been made by John Williamson, Ronald
  McKinnon and James Tobin and are worthy of some
  consideration.

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Reforming the IMF System
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Reforming the IMF System

• IFS is at the moment a combination of foreign
  exchange regimes
• 12 countries have adopted EURO which floats
  freely on the international markets in the same
  way as the US dollar, Canadian dollar, sterling,
  yen.
• The currencies of the developing countries have
  adopted the following kinds of foreign exchange
  regimes
• 27 countries pegged to the US dollar
• 12 countries pegged to EURO
• 5 countries pegged to other currencies
• 6 countries related to SDR
• 34 countries related to other currency
• 5 countries limited float
• 5 countries crawling peg
• 22 countries exchange rate bands
• 27 countries independent float

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The Williamson Target Zone Proposal

• In a number of papers John Williamson in
  conjunction with other authors (1985, 1987, 1988)
  has proposed that the exchange rate between the
  major international currencies should be managed
  within a target zone system.
• For each of the major currencies Williamson has
  suggested a method to calculate the currency's
  'Fundamental Equilibrium Effective Exchange Rate'
  (FEEER).
• Broadly speaking, the FEEER is a real exchange
  rate that is consistent with a sustainable
  current account position.
• The calculated FEEER would be periodically
  adjusted as the economic fundamentals change, for
  example relative inflation rates, and should not
  therefore be confused with a fixed central rate.
• A country's exchange rate would then be allowed
  to fluctuate within a system of 'soft edged
  bands' of 10 per cent either side of the FEEER.
• The idea of soft bands is that the authorities
  will not necessarily be committed to buy or sell
  the currency if it reaches the upper or lower
  limit of its band.
• The band will prevent the speculative shocks.

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A. The Williamson Target Zone Proposal

• In a number of papers John Williamson in
  conjunction with other authors (1985, 1987, 1988)
  has proposed that the exchange rate between the
  major international currencies should be managed
  within a target zone system.
• For each of the major currencies Williamson has
  suggested a method to calculate the currency's
  'Fundamental Equilibrium Effective Exchange Rate'
  (FEEER).
• Broadly speaking, the FEEER is a real exchange
  rate that is consistent with a sustainable
  current account position.
• The calculated FEEER would be periodically
  adjusted as the economic fundamentals change, for
  example relative inflation rates, and should not
  therefore be confused with a fixed central rate.

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B. The McKinnon Global Monetary Target Proposal

• Ronald McKinnon (1982, 1984 and 1988) has argued
  that much exchange-rate volatility is due to the
  process of currency substitution.
• He argues that in a world in which there are few
  capital controls, multinational corporations and
  international investors like to hold a portfolio
  of various national currencies.
• He argues that demand to hold a portfolio of
  national currencies is quite stable but the
  composition of the total portfolio can be highly
  volatile.
• This means that rigid control of the supply of
  the individual national currencies in the
  portfolio is inappropriate.
• He suggests that the Friedman rule for smooth
  monetary growth should be shifted from a national
  to a carefully defined international level
• McKinnon argues that these disruptive real
  exchange-rate changes can be avoided by adjusting
  money supply in two different countries (ex US
  and Germany).

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The McKinnon Global Monetary Target Proposal

• This policy, while leading to changes in national
  money stocks, would leave the global money supply
  and exchange rates unchanged and leave the two
  economies unaffected by the process of currency
  substitution
• Another suggestion was to adjust the volume of
  bonds at international level (the main cause of
  currency substitution at the level of investors)
  
• Say there is a decrease in the demand for US
  bonds and an increase in the demand for German
  bonds. The appropriate response of the US
  authorities to this would be to sell German bonds
  and purchase the excess supply of US bonds, this
  would leave interest rates and exchange rates
  unchanged.

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The McKinnon Global Monetary Target Proposal

• There are numerous problems with the McKinnon
  proposal.
• Many economists disputed his suggestion that
  currency substitution is a the major force in
  exchange-rate movements.
• Also by fixing the nominal exchange rate at some
  PPP level the proposal does not allow for the
  possibility of real exchange-rate changes which
  some economists believe have been a major force
  behind large exchange-rate swings
• If Japanese tradeables productivity growth is
  higher than US tradeables growth, then over time
  there needs to be a real appreciation of the yen
  against the dollar. If not, the yen will become
  undervalued in relation to the dollar and this
  could lead to serious trade frictions.

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C. The Tobin Foreign Exchange Tax Proposal

• James Tobin (1978) has argued that many of the
  disruptive exchange-rate movements witnessed
  under floating have been caused by destabilizing
  short-term capital flows.
• He argues that the highly integrated world
  capital markets leave very little room for
  national authorities to pursue independent
  monetary polices.
• National economies and national governments are
  not capable of adjusting to massive movements of
  funds across the foreign exchanges, without real
  hardship and without significant sacrifice of the
  objectives of national economic policy with
  respect to employment, output, and inflation.
• Specifically, the mobility of financial capital
  limits viable differences among national interest
  rates and this severely restricts the ability of
  central banks and governments to pursue monetary
  and fiscal policies appropriate to their national
  economies, (Tobin p. 154)
• To reduce these effects, Tobin has suggested that
  a tax be imposed on all foreign exchange
  transactions, 'to throw some sand in the wheels
  of our excessively efficient international money
  markets' (p. 154).
• The tax would reduce the incentives for
  speculators to suddenly flood money into and out
  of a currency in response to small interest-rate
  changes.

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C. The Tobin Foreign Exchange Tax Proposal

• He argues that a small tax of say 1 per cent
  would especially hit short-term capital movements
  but not greatly interfere with longer-term
  movements.
• This would restore some autonomy to domestic
  monetary authorities.
• Tobin's proposal differs significantly from those
  of Williamson and McKinnon in that it is
  motivated by the belief that the exchange-rate
  regime is not the major problem of the IFS
  crisis.
• He displays considerable skepticism over the
  rationality of foreign exchange market
  speculation
• Critics
• Clearly not all short-term capital movements are
  undesirable and the tax would prevent some
  stabilizing movements (ex short term financing
  exports / imports activity)
• The tax will influence the international trade
• that the tax would easily be circumvented as
  financial innovation would lead to a replication
  of speculative positions through synthetic
  instruments that were unaffected by the tax
• in a bid to avoid the tax there could a greater
  use of barter trade which is notoriously
  inefficient.

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Suggested readings

• McKinnon, R. I. (1981) 'The Exchange Rate and
  Macroeconomic Policy Changing Postwar
  Perceptions', Journal of Economic Literature,
  vol. 19, pp. 531-57.
• McKinnon, R. I. (1982) 'Currency Substitution and
  Instability in the World Dollar
• Standard', American Economic Review, vol. 72, pp.
  320-33.
• McKinnon, R.I. (1984) An International Standard
  for Monetary Stabilization. Institute for
  International Economics, Policy Analyses No. 8
  (Cambridge, Mass. MIT Press).
• McKinnon, R.I. (1988) 'Monetary and Exchange Rate
  Policies for International Financial Stability a
  Proposal', Journal of Economic Perspectives,
  vol. 2, pp. 83-103.
• Miller M. and Williamson, J. (1987) 'The
  International Monetary System an Analysis of
  Alternative Regimes', European Economic Review,
  vol. 32, pp. 103148.
• Tobin J, (1978), A proposal for International
  Monetary Reform, Eastern Economic Journal, vol.
  4, pp. 153-9, Reprinted in J. Tobin (1982)
  Essays in Economics (Cambridge, Mass. MIT
  Press).