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Discussion > Students > Others >

Balance of Payments and Exchange Rate Mechanism -INT.FIN -2

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Posted On 19 December 2009 at 23:01 Report Abuse

 

Balance of Payments and Exchange Rate Mechanism
 
Introduction
 
The determination of a country’s exchange rate depends upon the exchange rate system followed by it. The exchange rate of a currency is its value (or price) in terms of another currency. Like all other commodities, the price of a currency also depends on its supply and demand factors. When the exchange rates are truly flexible, the demand and supply arise only from the market forces. In the case of fixed exchange rates, in addition to the supply and demand arising from the market, the Central Bank/regulatory authority ensures an official demand or supply, which keeps the overall forces balanced in order to maintain the exchange rate at an equilibrium level which is considered desirable by the Central Bank.
 
To forecast the level of exchange rate, we need to know the factors that affect the demand for and supply of a currency. Any factor increasing the supply of a currency reduces its price, i.e., causes it to depreciate and vice versa. Similarly, any factor increasing the demand for a currency increases the price of that currency, i.e. causes it to appreciate and vice versa. All these factors are reflected in the Balance of Payments (BoP) account. The BoP account is the summary of the flow of economic transactions between the residents of a country and the rest of the world (ROW) during a given time period. BoP of a country measures the flow of international payments and receipts. As it measures flows and not stocks, it records only the changes in the levels (and not the absolute level) of international assets and liabilities.
 
Principles of BoP Accounting
 
The foremost principle of BoP accounting is the use of the double entry bookkeeping system, i.e., every transaction has two aspects and hence enters the BoP account twice, once as a credit and once as a debit. Since for every credit there is a corresponding debit, the balance of payments account always balances. The logic underlying every transaction being entered twice is that whenever there is a transaction, whether purchase or sale, there would be a corresponding payment – either immediate or deferred, giving rise to two entries. Since there is no compensation involved in the case of transfer payments, they are treated as trade in goodwill to satisfy the principle of double-entry. An outflow on account of transfer payment is regarded as a purchase of goodwill, while an inflow is regarded as a sale.
 
There is a clear rule for determining the side of a BoP account on which a particular transaction should be entered. The rule is that any transaction, which creates demand for the domestic currency in the forex markets, enters the BoP account on the credit side, and any transaction increasing its supply enters the debit side. Another way of understanding the rule is through sources and uses of foreign currency. Any transaction, which is a source of foreign currency, is a credit entry, and any transaction, which is a use, is a debit entry. In accordance with these definitions, credit transactions are recorded with a plus sign, and debit transactions with a minus sign.
 
Let us consider a few examples. As a country exports goods to another country, the demand for the domestic currency goes up as the foreign importer would need to buy the domestic currency to pay for the imports. This would appear as a credit item in the BoP account as it is a source of foreign currency. On the other hand, imports increase the supply of the domestic currency, as foreign currency would need to be bought in exchange for the domestic currency in order to pay for the imports. Since it is a use of the foreign currency, it would appear as a debit item.
 
 
Balance Of Payments
 
The Balance of Payments (BoP) is a systematic record of all economic transactions between the ‘residents’ of a given country and the residents of other countries – the rest of the world – carried out in a specific period of time, usually a year. It represents a classified statement of all receipts on account of goods exported, services rendered and capital received by residents, and payments made by them on account of goods imported, services received from and capital transferred to non-residents or foreigners. Thus, BoP is a much wider term in its coverage as compared to balance of trade. Whereas the balance of trade refers to merchandise imports and exports (visible trade), the BoP refers to all economic transactions – including ‘invisible transactions’ like banking, insurance, transport services, etc. with the rest of the world.

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Balance of payments account is based on the ‘standard double entry system’ of bookkeeping. Thus, every entry is entered twice, once as a credit item and once as a debit item. A transaction, which increases the external purchasing power of a country, is recorded as a credit entry. It represents a source of foreign exchange. Examples of such transactions are,
 
(i)       Export of goods or merchandise exports;
(ii)     Export of services like travel, insurance, etc. or invisibles;
(iii)    A capital inflow into the country, i.e. borrowing abroad;
(iv)    Decrease in foreign exchange reserves and gold reserves of the monetary authority.
 
A transaction, which reduces the external purchasing power of the country, is recorded as a debit entry. It represents the use of foreign exchange reserves. Such transactions are,
(i)         Merchandise imports and invisible imports;
(ii)        A capital outflow or lending abroad;
(iii)      Increase in foreign exchange reserves and gold reserves of the monetary authority.
 
Components of Balance of Payments
 
The BoP statement is usually divided into three major groups of accounts. The construction of the accounts can best be appreciated by examining table 2.1 given below.
 
Table 2.1: India’s Overall Balance of Payments
 
 
 
 
 
Credit
Debit
Net
A.
CURRENT ACCOUNT
 
 
 
 
1.
MERCHANDISE
 
 
 
 
 
a.
Exports (on f.o.b. basis)
 
 
 
 
 
b.
Imports (on c.i.f. basis)
 
 
 
 
2.
INVISIBLES (a + b + c)
 
 
 
 
 
a.
Services
 
 
 
 
 
 
i.     Travel
 
 
 
 
 
 
ii.     Transportation
 
 
 
 
 
 
iii.    Insurance
 
 
 
 
 
 
iv.    G.n.i.e
 
 
 
 
 
 
v.     Miscellaneous
 
 
 
 
 
b.
Transfers
 
 
 
 
 
 
vi.    Official
 
 
 
 
 
 
vii.   Private
 
 
 
 
 
c.
Investment Income
 
 
 
Total Current Account (1 + 2)
 
 
 
B.
CAPITAL ACCOUNT
 
 
 
 
1.
FOREIGN INVESTMENT (a + b)
 
 
 
 
 
a.
In India
 
 
 
 
 
 
i.     Direct
 
 
 
 
 
 
ii.     Portfolio
 
 
 
 
 
b.
Abroad
 
 
 
 
2.
LOANS (a + b + c)
 
 
 
 
 
a.
External Assistance
 
 
 
 
 
 
i.     By India
 
 
 
 
 
 
ii.     To India
 
 
 
 
 
b.
Commercial Borrowings (MT and LT)
 
 
 
 
 
 
i.     By India
 
 
 
 
 
 
ii.     To India
 
 
 
 
 
c.
Short-term
 
 
 
 
 
 
To India
 
 
 
 
3.
BANKING CAPITAL (a + b)
 
 
 
 
 
a.
Commercial Banks
 
 
 
 
 
 
i.     Assets
 
 
 
 
 
 
ii.     Liabilities
 
 
 
 
 
 
iii.    Non-Resident Deposits
 
 
 
 
 
b.
Others
 
 
 
 
4.
RUPEE DEBT SERVICE
 
 
 
 
5.
OTHER CAPITAL
 
 
 
Total Capital Account (1 + 2 + 3 + 4 + 5)
 
 
 
C.
ERRORS AND OMISSIONS
 
 
 
D.
OVERALL BALANCE (A + B + C)
 
 
 
E.
MONETARY MOVEMENTS (i + ii)
 
 
 
 
i.
I.M.F.
 
 
 
 
ii.
Foreign Exchange Reserves
 (Increase – / Decrease +)
 
 
 
 
Current Account
 
The Current Account records the transactions in merchandise and invisibles with the rest of the world. Merchandise covers exports and imports of all movable goods, where the ownership of goods changes from residents to non-residents and vice versa. Therefore Current Account captures the effect of trade link between the economy and rest of the world.
 
The merchandise trade values exports on f.o.b. (Free on Board) basis and are shown as credit items and the imports valued on c.i.f. (Cost Insurance and Freight) basis are the debit items. However, the IMF Balance of Payments manual provides guidelines for compilation of the BoP statistics prescribing the valuation of both exports and imports on f.o.b. basis.
 
The item Invisibles includes travel, transportation, insurance, investment income, and other miscellaneous items. The credit under the Invisibles comprises the value of services rendered by residents to non-residents. The income earned by residents on ownership of financial assets (investment income), use of non-financial assets (property income) and other receipts in cash or kind without a quid pro quo (transfer payments) are all recorded as credits. Similar remittances made by residents to non-residents are recorded as debits.
 
G.n.i.e. implies government not included elsewhere. A credit entry of the G.n.i.e. includes items like: funds received from a foreign government for the maintenance of their embassy, consulates, etc. in India. Under the heading ‘Miscellaneous’, payment to a foreign technical consultant for professional services rendered by him will appear as a debit item.
 
Transfers may be of two types: official and private. A debit entry under the heading Official Transfers constitute items like revenue contributions by the government of India to international institutions or any transfer (even in the form of gifts) of commodities by the government to non-residents. Private transfers include items like cash remittances by non-resident Indians for their family maintenance in India.
 
Capital Account
 
In the case of the Capital Account an increase (decrease) in the country’s foreign financial assets are debits (credits) whereas any increase (decrease) in the country’s foreign financial liabilities are credits (debits).
 
All transactions of financial nature are entered in the Capital Account of the BoP statement. The transactions under this heading are classified into five heads: (1) Foreign Investment, (2) Loans, (3) Banking Capital, (4) Rupee Debt Service and (5) Other Capital. 
 
Any investment made by foreign residents (individuals, companies, financial institutions or even a foreign government) in the acquisition of physical assets in India is a Foreign Direct Investment. It is depicted by an inflow of foreign capital and is a credit item in the BoP Statement. When a foreign country portfolio investor directly purchases financial assets in the Indian securities market it is termed as Foreign Portfolio Investment.   
 
Loans include concessional loans received by the government or public sector bodies, long-term and medium-term borrowings from the commercial capital market in the form of loans, bond issues, etc. and short-term credits. Disbursements received by Indian resident entities are credit items while repayments and loans made by Indians are debit items.  
 
Banking capital covers the changes in the foreign assets and liabilities of commercial banks whether privately owned or government owned and co-operative banks which are authorized to deal in foreign exchange. An increase in assets (or decrease in liabilities) is a debit item while a decrease in assets (or increase in liabilities) is a credit item.
 

The item ‘Rupee Debt Service’ is defined as the cost of meeting interest payments and regular contractual repayments of principal of a loan along with any administration charges in rupees by India





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Though recording of transactions in the BoP statement is made according to the principle of double entry, certain discrepancies in estimation and timing may result in a situation where debits are not exactly equal to the credits. The item ‘Errors and Omissions’ indicates the value of such discrepancies. A negative value indicates that receipts are overstated or payments are understated, or both, and vice versa. Persistently large errors with the same sign are indicative of serious weaknesses in the recording of transactions or flows.
 
Monetary Movements
 
The monetary movements keep record of (a) India’s transactions with the International Monetary Fund (IMF), and, (b) India’s foreign exchange reserves which basically consist of RBI holdings of gold and foreign currency assets. Drawings (essentially a type of borrowing) from the IMF or drawing down of reserves are credit items, whereas, repayments made to IMF or additions made to existing reserves are debit items.
 
Balance in the BoP Statement
 
The Balance of Payments statement is prepared on the basis of the double entry system. Therefore, the statement as a whole would fully balance without any surplus or deficit. However, analysis of the BoP is not done for the statement as a whole, but only for debit and credit for certain groups of items whose balance has certain significant implications.
 
Trade Balance
 
The trade balance is the difference between merchandises exports and imports. Changes in trade balance indicate changes in the efficiency of the country in producing and exporting goods in which it enjoys comparative advantage. The demand for the products of a country, other things remaining equal, depends on its relative efficiency in producing goods. However, shifts in demand as evident from the trade balances,occur slowly, over time. Japan and West Germany have been exceptions, and have witnessed rapid growth in trade balances after the World War II.
 
Another factor affecting the trade balance of the country is its ‘terms of trade’. Terms of Trade is the ratio of a country’s export prices to import prices. It is constructed by taking an index of prices of exports and an index of prices of imports and dividing the first by the second. An improvement in a country’s terms of trade indicates a faster rise in the prices of its exports than its imports.
 
What is the effect of an improvement in terms of trade on the trade balance? At first instance this may look beneficial: in foreign exchange terms, a given amount of exports will now finance the purchase of a greater amount of imports or a given amount of imports can now be financed with a lower amount of exports. This will improve the trade balance. In the same way when the terms of trade deteriorate for a country, its trade balance will worsen. This is true when the export/import demands are price-inelastic. For instance, when oil prices increased in 1973, the terms of trade for India worsened. The demand for oil being price-inelastic, trade deficit increased substantially. When export/import demand functions are price-elastic, an improvement in terms of trade will result in worsening trade deficit.
 
Current Account Balance
 
In most cases, where transactions in invisibles are not significant, a study of the trade balance explains the current account balance. An important implication of current account balance, viewed from the national income accounting approach, is that it represents the difference between domestic saving and domestic investments in a given year. A deficit on current account means that domestic saving is insufficient to fund domestic investment, resulting in import of savings from abroad. If domestic savings exceed domestic investments a surplus on current account will result and would make our BoP situation more comfortable. The current account balance indicates the country’s stock of net international assets.
 
While reading the balance in both current account and trade account, one has to study the rate of growth in exports and imports. Growth in exports, particularly accompanied by high rates of investment, indicates that economic growth is exported, and is a positive sign. On the other hand, high deficits in the current account, accompanied by high growth rate in imports is undesirable.
 
 
Capital Account Balance
 
The balance in the capital account indicates how the balance in the current account has been financed. If one can distinguish between long and short-term sources, one can comment upon the financing methods adopted by the country. Similarly, distinction has to be made between finances obtained on commercial terms and on soft terms. The larger the former component, the greater the vulnerability of the country to volatility in interest rates.
 
When the BoP is in deficit or surplus, we separate the official reserve account from others. If the balance on current and capital accounts taken together is negative, then it is a case of BoP deficit. This has to be balanced by a matching surplus on the official reserve account i.e. a reduction to foreign exchange and gold reserves. However, this practice is based on the assumption that transactions in the current and capital accounts are autonomous transactions responding to the economic situation, both domestic and external, while official reserve transactions are of a compensating nature.
 
Factors Affecting the Components of BoP Account
 
Exports of Goods and Services
 
Exports of goods and services are affected by the following factors:
·            The prevailing exchange rate of the domestic currency: A lower value of the domestic currency results in the domestic price getting translated into a lower international price. This increases the demand for domestic goods and services and hence their export. This is likely to result in a higher demand for the domestic currency. A higher exchange rate would have an exactly opposite effect.
 
·            Inflation rate: The inflation rate in an economy vis-à-vis other economies affects the international competitiveness of the domestic goods and hence their demand. Higher the inflation, lower the competitiveness and lower the demand for domestic goods. Yet, a lower demand for domestic goods and services need not necessarily mean a lower demand for the domestic currency. If the demand for domestic goods is relatively inelastic, then the fall in demand may not offset the rise in price completely, resulting in an increase in the value of exports. This would end up increasing the demand for the local currency. For example, suppose India exports 100 quintals of wheat to the US at a price of Rs.500 per quintal. Further, assume that due to domestic inflation, the price increases to Rs.530 per quintal and there is a resultant fall in the quantity demanded to 96 quintals. The exports would increase from Rs.50,000 to Rs.52,800 instead of falling.
 
·            World prices of a commodity: If the price of a commodity increases in the world market, the value of exports for that particular product shows a corresponding increase. This would result in an increase in the demand for the domestic currency. A fall in the demand for domestic currency would be experienced in case of a reduction in the international price of a commodity. This impact is different from the previous one. The previous example considered an increase in the domestic prices of all goods produced in an economy simultaneously, while this one considers a change in the international price of a single commodity due to some exogenous reasons.
 
·            Incomes of foreigners: There is a positive correlation between the incomes of the residents of an economy to which the domestic goods are exported, and exports. Hence, other things remaining the same, an increase in the standard of living (and hence, an increase in the incomes of the residents) of such an economy will result in an increase in the exports of the domestic economy. Once again, this would increase the demand for the local currency.
 
·            Trade barriers: Higher the trade barriers erected by other economies against the exports from a country, lower will be the demand for its exports and hence, for its currency.
 
Imports of Goods and Services
 
Imports of goods and services are affected by the same factors that affect their exports. While some factors have the same effect on imports as on exports, some of them have an exactly opposite effect. Let us analyze these factors and their effects.
 
·            Value of the domestic currency: An appreciation of the domestic currency results in making imported goods and services cheaper in terms of the domestic currency, hence increasing their demand. The increased demand for imports results in an increased supply of the domestic currency. A depreciation of the domestic currency has an opposite effect.
 



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·            Level of domestic income: An increase in the level of domestic income increases the demand for all goods and services, including imports. This again results in an increased supply of the domestic currency.
 
·            International prices: The international demand and supply positions determine the international price of a commodity. A higher international price would get translated into a higher domestic price. If the demand for imported goods is inelastic, this would result in a higher domestic currency value of imports, increasing the supply of the domestic currency. In case of the demand being elastic, the effect on the supply of the domestic currency would depend on the effect on the domestic currency value of imports.
 
·            Inflation rate: A domestic inflation rate that is higher than the inflation rate of other economies would result in imported goods and services becoming relatively cheaper than domestically produced goods and services. This would increase the demand for the former, and hence, the supply of the domestic currency.
 
·            Trade barriers: Trade barriers have the same effect on imports as on exports – higher the barriers, lower the imports, and hence, lower the supply of the domestic currency.
 
Importance of BoP Statistics
 
As said earlier, an attempt at forecasting exchange rates can be made if the factors affecting the demand and supply of a currency are known. In the last few sections, the different components of the BoP account and the factors affecting them (and eventually the exchange rate of a currency) were listed. A careful study of these factors and of the underlying economic factors the world over can prove quite helpful for predicting at least the direction of the movement in exchange rates, if not the magnitude.
 
A movement in the reserves position of a country can also provide some indications as to the possible movement of the exchange rate of its currency. A continuous depletion of reserves may indicate either of the following two circumstances:
 
a.         A repeated overall BoP deficit. As outflow exceeds inflow, there would be an excess supply of the domestic currency in the forex markets, thus putting a downward pressure on its exchange rates with other currencies.
 
b.         There may already be a pressure on the exchange rate due to the above mentioned reason, because of which the official reserves may be used to defend the domestic currency. This would be done by selling the reserves in exchange for the local currency to increase the total demand for the latter, in order to prevent the exchange rate from sliding down.
 
Both the scenarios predict an eventual depreciation of the domestic currency. Similarly, a continuous accretion to the reserves would be an indication of impending appreciation.
 
Limitations of Balance of Payments
 
Though BoP statistics are very helpful in predicting movements in the exchange rates, they are more useful for estimating general trends rather than the specific levels at which the exchange rates would stabilize. Besides, care has to be taken while interpreting BoP data. All the different balances (current account balance, capital account balance, overall balance) should be considered, along with the actual and expected trends in these balances and the expected developments in the international scene. The BoP data for one country can only give an idea as to whether that country’s currency is likely to increase or decline in value. It would not help in predicting the currency’s movement with respect to a particular currency. That movement can be estimated only if the BoP data for both the countries are studied together.
 
EXCHANGE RATE MECHANISM
 
The exchange rate is formally defined as the value of one currency in terms of another. There are different ways in which the exchange rates can be determined. Exchange rates may be fixed, floating, or with limited flexibility. Different systems have different methods of correcting the disequilibria between international payments and receipts, one of the basic functions of these mechanisms.
 
Fixed Exchange Rate System
 
As the name suggests, under a fixed (or pegged) exchange rate system the value of a currency in terms of another is fixed. Governments or the central banks of the respective countries determine these rates. The fixed exchange rates result from countries pegging their currencies to either some common commodity or to some particular currency. There is generally some provision for correction of these fixed rates in case of a fundamental disequilibrium. Examples of this system are the gold standard and the Bretton Woods system. The particular variations of the fixed rate system are
 
·            Currency board system
·            Target zone arrangement
·            Monetary Union.
 
Currency Board System
 
Under a currency board system, a country fixes the rate of its domestic currency in terms of a foreign currency, and its exchange rate in terms of other currencies depends on the exchange rates between the other currencies and the currency to which the domestic currency is pegged. Due to the pegging, the monetary policies and economic variables of the country of the reference currency are reflected in the domestic economy. If the fundamentals of the domestic economy show a wide disparity from that of the reference country’s, there is a pressure on the exchange rate to change accordingly. This may result in a run on the currency, thus forcing the authorities to either change, or altogether abandon the peg. To prevent such an event, the monetary policies are kept in line with that of the reference country by the central monetary authority, called the currency board.It commits to convert its domestic currency on demand into the foreign anchor currency to an unlimited extent, at the fixed exchange rate. The currency board maintains reserves of the anchor currency up to 100% or more of the domestic currency in circulation. These reserves are generally held in the form of low-risk, interest-bearing assets denominated in the anchor currency. An internationally accepted, relatively stable currency is generally selected as the anchor currency.
 
The currency board does not have any discretionary powers over the monetary policy. The interest rates are automatically set by the market mechanism. If demand for the anchor currency rises and people start converting more and more of the domestic currency for the anchor currency, the reserves with the currency board get depleted. As the currency in circulation has to be backed by the anchor currency reserves, the depletion of reserves results in a contraction of the domestic currency’s supply. This, in turn, will result in an increase in the domestic interest rates. A high domestic interest rate increases the demand for the domestic currency as more and more people become interested in investing in the economy. This increases the supply of the anchor currency and eliminates the pressure on the domestic currency. The opposite will happen in case of an increase in the supply of the anchor currency. The interest rates, thus, act as the force, which brings back the forex markets to equilibrium.
 
Unlike a central bank, a currency board does not even have the power to print unlimited amounts of money. Due to the requirement of the domestic currency being backed by reserves of anchor currency, the board can print only as much currency as can be backed by its existing reserves. This prevents the board from lending to either the government, or the domestic banks. As government’s deficits are not automatically monetized, it has to finance its operations by either raising taxes, or by borrowing in the market. The market determined interest rates keep the government borrowing, and hence, spending under check; and thus forces fiscal discipline. At the same time, as neither of the sources of funds (taxes and borrowings) increases the money supply, there is no inflationary pressure on the economy due to government spending.
 
Since the board does not lend to even the domestic banks, it cannot act as the lender of last resort. On one hand, this ensures more prudent policies on the part of banks. On the other hand, it would result in even sound banks going under at the time of a financial panic.
 
The biggest advantage of a currency board system is that it offers stable exchange rates, which act as an incentive for international trade and investment. The discipline enforced on the government and the financial system also helps in improving the macroeconomic fundamentals in the long run.
 

Among the drawbacks, the foremost is the loss of control over interest rates. The equilibrium in the forex markets is established at the point where the domestic interest rates in the economy are in accordance with the underlying economic fundamentals of the domestic and the anchor currency economy and the fixed exchange rate. A high inflation in the domestic markets can result in low or even negative real interest rate. This may cause an asset price bubble as money is borrowed at low interest rates and put in financial and real assets. The excess demand for these assets makes their prices go up to unrealistically high levels. When the interest rates start rising due to any endogenous or exogenous reason, these prices come crashing down due to the high selling pressure and thus cause a financial panic. Another effect of the inability of the board to set interest rates is that an important tool for controlling the level of economic activity becomes inoperative. Interest rates cannot be used to control the inflation level in the economy and hence the level of economic activity. The economy may thus become exposed to phases of painful contraction and inflation. Further, this system, in order to operate efficiently, needs wages to be flexible. In case of the domestic economy facing a higher degree of

inflation than the anchor currency country, or in case of an exogenous shock like a fall in the export prices, a movement in the exchange rates is not possible in this system. Thus, the adjustment has to come via domestic wages. If these prove to be sticky, the domestic currency could become overvalued, and the domestic goods uncompetitive in the international markets.
 



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Target Zone Arrangement
 
A group of countries sometimes get together, and agree to maintain the exchange rates between their currencies within a certain band around fixed central exchange rates. This system is called a target zone arrangement. Convergence of economic policies of the participating countries is a prerequisite for the sustenance of this system. An example of this system is the European Monetary System under which twelve countries came together in 1979, and attempted to maintain the exchange rates of their currencies with other member countries’ currencies within a fixed band around the central exchange rate.
 
Monetary Union
 
Monetary union is the next logical step of target zone arrangement. Under this system, a group of countries agree to use a common currency, instead of their individual currencies. This eliminates the variability of exchange rates and the attendant inefficiencies completely. The economic variables of the member countries have to be quite proximate for the system to be viable. An independent, common Central Bank is set up, which has the sole authority to issue currency and to determine the monetary policy of the group as a whole. The member countries lose the power to use economic variables like interest rates to adjust their economies to the phase of economic cycle being experienced by them. As a result, the region as a whole experiences the same inflation rate. This is the most extreme form of management of exchange rates.
 
Floating Exchange Rate System
 
Under this system, the exchange rates between currencies are variable. These rates are determined by the demand and supply for the currencies in the international market. These, in turn, depend on the flow of money between the countries, which may either result due to international trade in goods or services, or due to purely financial flows. Hence, in case of a deficit or surplus in the balance of payments (difference between the inflation rates, interest rates and economic growth of the countries are some of the factors which result in such imbalances), the exchange rates get automatically adjusted and this leads to a correction in the imbalance.
 
Floating exchange rates can be of two types: Free float and Managed float.
 
Free Float
 
The exchange rate is said to be freely floating when its movements are totally determined by the market. There is no intervention at all either by the government or by the central bank. The current and expected future demand and supply of currencies change on a day-to-day, and even a moment-to-moment basis; as the market receives, analyzes and reacts to economic, political and social news. This, in turn, changes the equilibrium in the currency market and the exchange rate is determined accordingly. As the reactions to events do not follow a set pattern, the resultant movements in the exchange rates turn out to be quite random. Hence, a lot of volatility is observed in the markets following a free float system. This system is also known as the clean float.
 
Managed Float
 
The volatility of exchange rates associated with a clean float increases the economic uncertainty faced by players in the international markets. A sudden appreciation of the domestic currency (a currency appreciates when it becomes dearer vis-à-vis the other currency and vice versa) would make the domestic goods more expensive in the international markets (as the same number of units of domestic currency, representing the good’s cost, would then translate into a higher number of units of the foreign currency). This may result in making the domestic product uncompetitive, and hence reduce the exports. If any industry is totally dependent on exports, it may even get wiped out. A sudden depreciation may lead to increased prices of imported goods, thereby increasing the inflation rate in the economy. These uncertainties increase the risk associated with international trade and investments, and thus reduce the overall efficiency of the world economic system. In order to reduce these inefficiencies, central banks generally intervene in the currency markets to smoothen the fluctuations. Such a system is referred to as a managed float or a dirty float. This management of exchange rates can take three forms:
 
i.            The central bank may occasionally enter the market in order to smoothen the transition from one rate to another, while allowing the market to follow its own trend. The aim may be to avoid fluctuations, which may not be in accordance with the underlying economic fundamentals, and speculative attacks on the currency.
 
ii.          Some events are liable to have only a temporary effect on the markets. In the second variation, intervention may take place to prevent these short- and medium-term effects, while letting the markets find their own equilibrium rates in the long-term, in accordance with the fundamentals.
 
iii.         In the third variation, though officially the exchange rate may be floating, in reality the central bank may intervene regularly in the currency market, thus unofficially keeping it fixed. For example, the rupee-dollar exchange rate was maintained at Rs.31.37 to a dollar for around two years in 1993-94.
 
Hybrid Mechanism
 
Crawling Peg
 
A crawling peg system is a hybrid of fixed and flexible exchange rate systems. Under this system, while the value of a currency is fixed in terms of a reference currency, this peg itself keeps changing in accordance with the underlying economic fundamentals, thus letting the market forces play a role in the determination of the exchange rate. There are several bases which could be used to determine the direction of the change in the exchange rate. One could be the actual exchange rate ruling in the market. Though the rate is officially fixed at a certain level, in the market it hovers around the fixed rate, and is allowed to move so if it is not too much in divergence with the official rate. If this market determined exchange rate continuously shows a declining trend over a period, the peg is revised downwards, and vice versa. Another possible base could be the recent figure for the difference between domestic inflation and the inflation rate in the anchor-currency country. The changes could even be based on the balance of trade figures or changes in the external debt of the country. The advantage of a crawling peg is that, though it gives a relatively stable exchange rate (changes in which are fairly predictable), the rate is never too much out of line with the underlying fundamentals of the economy.
 
History of Monetary Systems
 
Various variations and combinations of the above mentioned exchange rate mechanisms have been followed in the past. Each one of them had its own unique method of correcting disequilibrium in the international monetary system. The following monetary systems along with their correction mechanisms are being discussed below:
 
·          The Gold Standard
·          Bretton Woods System
·          Post Bretton Woods System
·          The European Monetary System.
 
The Gold Standard
 
The gold standard was followed in its classical form from 1870 to 1914. While the United Kingdom and the United States were on the gold standard from 1821 and 1834 respectively, most of the countries had joined the system by 1870. The essential feature of this system was that governments gave an unconditional guarantee to convert their paper money or fiat money into gold, at a pre-fixed rate at any point of time, on demand. The continued commitment of the governments to the guarantee, and the readiness of the people to believe it were the reasons the system could sustain for such a long time.
 
The exchange rate between two currencies was determined on the basis of the rates at which the respective currencies could be converted into gold, i.e. the price of gold in the two countries. For example, if in the US the price of one ounce of gold is fixed at $400 and in the UK it is £200, then the exchange rate (called the mint parity) between the $ and the £ would be $2/£ (400/200). The exchange rate would stay at this equilibrium level because of the arbitrage possibility involved. Let us assume that the prevailing exchange rate was $2.5/£. So a person wanting to convert dollars into pounds would have to pay $2.5 for every pound. He could, instead, buy an ounce of gold in the US for $400 (or a fraction thereof for a proportionate price), transport it to the UK, and sell it for £200. Thereby, he would be able to get pounds at the exchange rate of $2/£. As everyone would follow this route for converting dollars into pounds, there would be no demand for pounds in the forex markets. Yet the supply would remain unaffected. This demand-supply imbalance would cause the exchange rate to come down. This would keep happening till the exchange rate reaches the equilibrium level, i.e., $2/£. An exactly opposite process would correct the exchange rate if it falls below the equilibrium level. Thus the exchange rate would be maintained at the equilibrium level. This discussion assumes that there are no transaction costs involved in buying and selling of gold and no transportation costs for shifting it from one country to another. In reality, however, there is a cost involved in all these activities. Thus, the exchange rate would be able to fluctuate between bands on either side of the equilibrium exchange rate, the bands being determined by the size of these costs. The end points of the range fixed by these bands are referred to as thegold points.



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There was an inbuilt mechanism in the gold standard, which helped correct any imbalances in trade that any two countries would face. If France is exporting more to Germany than it is importing from it, Germany would be facing a trade deficit and France a trade surplus. This trade deficit would result in excess supply of DM (Deutsche Mark), which would drive down the DM-FFr (French Franc) exchange rate below the mint-parity level. Since at this rate, the suppliers of DM would prefer to change their holdings into FFr through the ‘sell DM for gold – ship it to France – sell gold for FFr’ route, there would be a transfer of gold from Germany to France. When a government commits itself to convert unlimited amounts of its paper currency into gold on demand, at all points of time it would need to have enough gold with it to make sure that it does not run out of gold in case a lot of people want to go for the conversion simultaneously. In case a country does run out of gold, its credibility would be shattered and the whole system would collapse. To avoid such a situation, a gold reserve equal to a fixed percentage (which may even be up to 100 percent) of the circulating currency is required to be maintained. With gold moving away from Germany, its gold reserves would come down and hence it would be forced to reduce the money supply. On the other hand, the gold reserves in France would go up and its money supply would increase. According to the Quantity Theory of Money, change in the price level is directly proportional to change in the money supply. With an increase in the money supply, the same amount of goods are chased by more money, hence the prices of those goods increase; and vice versa. As the money supply in France increases, the price of the goods produced in France also increases. At the same time, there is a reduction in the money supply in Germany, and the price of German goods decreases. This reduces the competitiveness of French goods vis-à-vis German goods and the former become less attractive to both German as well as French consumers. This results in a reduction in exports from France and an increase in imports from Germany. This process continues till trade balance between the two countries is achieved. This process of correction of imbalance in international receipts and payments is known as the price-specie-flow mechanism.
 
Countries continued to be on the gold standard for a long time due to its inherent advantages. Most of the advantages arose due to discipline enforced by the price stability of gold. The price of gold (its purchasing power) generally moved in line with the price of other goods and services, facing the same inflation rate. Gold being a commodity money (i.e., needing the use of other goods and services to be located, mined, and minted), its cost of production also moved in line with the general inflation rate. This caused the cost of production and the purchasing power of gold to tend towards equality in the long run. The government needed to acquire additional gold before it could issue more money. As the cost of acquiring gold was equal to the value of the additional money that it could issue, the government had no incentive to finance its deficits by digging additional gold and printing more money. This enforced fiscal discipline on the government and protected the economy from inflation resulting from excessive government spending. This ensured price stability in the participating countries. The second advantage of the gold standard lay in the fact that exchange rate movements were quite predictable. In the short run, the exchange rates could move only within the gold points. In the long run, the exchange rates would change only if a country changed the price of its currency in terms of gold. A country experiencing an increase in gold reserves would be likely to lower the price of gold; while those experiencing an exodus of reserves would be likely to increase it. This predictability of exchange rate movements reduced the risk involved in international trade and investments, and thus made the process of allocation of world resources more efficient. The gold standard was abandoned with the advent of the First World War in 1914.
 
Bretton Woods System
 
The Second World War effectively stopped all international economic activity. Global economic growth was severely affected. On one hand, the warring nations suffered huge damages on account of the war, and on the other hand, most of the countries were suffering from hyper-inflation. The continuing war also made any co-operation on the economic front impossible. In this scenario, the need was felt for an economic system which would again make international trade and investments possible. For this, a system of stable exchange rates was required, which would also ensure that the countries do not get any incentive by following inflationary policies. Also required, was some arrangement which would help countries to tide over their short-term balance of payments problems and help them remain within the system without causing undue turmoil in their economies.
 
In 1944, representatives of 44 countries met in Bretton Woods, New Hampshire, USA, and signed an agreement to establish a new monetary system which would address all these needs. This system came to be known as the Bretton Woods System.
 
The main terms of the agreement arrived at were as follows:
 
·            Two new institutions were to be established, namely, the International Monetary Fund (IMF) and the International Bank for Reconstruction and Development (IBRD, also called the World Bank). IMF was supposed to be more important and powerful than the World Bank. It was decided that the member countries would meet under the aegis of this institution and together take a decision on any important thing which might affect the world trade or the world monetary system. Hence, co-operation and mutual consultation was built into the system in order to avoid the universally harming policies being followed by most of the countries before the Second World War. The second most important function of these institutions was to provide funds to member-countries to help them tide over temporary balance-of-payments deficit. These institutions and their functions are explained in detail later.
·            A system (which came to be known as the adjustable peg system) was established which fixed the exchange rates, with the provision of changing them if the necessity arose. Under the new system, all the members of the newly set up IMF were to fix the par value of their currency either in terms of gold, or in terms of the US dollar. The par value of the US dollar, in turn, was fixed at $35 per ounce. All these values were fixed with the approval of the IMF, and reflected the changed economic and financial scenario in each of the countries and their new positions in international trade. Further, the member countries agreed to maintain the exchange rates for their currency within a band of one percent on either side of the fixed par value. The extreme points of these bands were to be referred to as the upper and the lower support point, due to the requirement that the countries do not allow the exchange rate to go beyond these points. The monetary authorities were to stand ready to buy or sell their currencies in exchange for the US dollar at these points, and thereby support the exchange rates. For this purpose, a country which would freely buy and sell gold at the aforementioned par value for the settlement of international transactions was deemed to be maintaining its exchange rate within the 1 percent band. Thus US, which was the only country fulfilling this condition, did not need to intervene in the forex markets.
·            Currencies were required to be convertible for trade-related and other current-account transactions, though governments were given the power to regulate capital flows. This was done in the belief that capital flows destabilize economies. For the purpose of such conversion, gold reserves needed to be maintained by the US, and dollar reserves by other countries. As selling the local currency would result in an increase in the dollar reserves and buying it would result in a reduction in the reserves, the countries facing a downward pressure (which would inevitably be the ones facing a balance-of-payments deficit, as explained later) were under more pressure than countries facing an upward pressure on its currency (the ones enjoying a balance-of-payments surplus). The additional pressure existed because the deficit country could eventually run out of reserves, and hence needed to follow more prudent economic, monetary and fiscal policies; while the surplus countries would only face an accretion of reserves. This imbalance in the responsibilities imposed on the two sets of countries eventually led to the downfall of the system.
·            Since there was a possibility of such exchange rates being determined as may not be compatible with a country’s BoP position, the countries were allowed to revise the exchange rate up to 10% of the initially determined rate, within one year of the rates being determined. After that period, a member country could change the original par values up to five percent (on either side) without referring the matter to IMF, that too only if its financial and economic condition made it essential. A bigger change could be brought about only with the consent of IMF’s executive board, which would allow it only in case of a “fundamental disequilibrium” in its balance-of-payments. Continuous reduction in reserves was supposed to serve as an indication of a fundamental disequilibrium.
·            All the member countries were required to subscribe to IMF’s capital. The subscripttion was to be in the form of gold (one-fourth of the subscripttion) and its own currency (the balance). Each country’s quota in IMF’s capital was to be decided in accordance with its position in the world economy. This capital was needed to enable IMF to help the countries in need of reserves for defending their currency.
 
The Institutions
 
As mentioned earlier, two institutions were set up as a part of the Bretton Woods system. These institutions and their activities have to be studied in detail in order to understand the system in totality. A few more institutions came up as a part of this system. The following institutions are discussed below:
 
·            The International Monetary Fund (IMF)
·            The International Bank for Reconstruction and Development (IBRD, also called the World Bank)
·            The International Finance Corporation (IFC)
·            The International Development Association (IDA)



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International Monetary Fund
 
The International Monetary Fund was established to ensure proper working of the international monetary system. One of the important functions of IMF was to provide reserve credit to member countries facing temporary balance-of-payments problems. For this purpose, a currency pool was maintained. Each member country was required to contribute to this pool according to its quota, which was fixed on the basis of each country’s importance in world trade. These contributions were to be partly in an international reserve currency and partly in the country’s domestic currency. Initially, the first part of the payments was made in gold. Later it was replaced by SDRs (Special Drawing Rights, explained later). A country’s quota would also determine its access to the pool and its voting powers at IMF. A country could draw from IMF in tranches for maintaining its currency’s parity. A tranche represents 25% of a country’s quota. A drawing of the first tranche is automatically approved by IMF. A further 100% of its quota can be borrowed in four steps. With each step, stricter conditions are imposed on the borrowing country, in order to ensure that structural corrections are carried out. In order to draw from IMF, a member country has to buy reserve assets and other currencies by paying its own currency to IMF. At the time of repayment of the loan, the borrowing country reverses the deal.
 
IMF’s management is vested in its executive board. Out of its 22 directors, six are appointed by governments holding the largest quotas. The rest of the directors are elected by the remaining countries. The managing director, who is also the chairman of the executive board, is appointed by the executive board for five years. The board of governors, which is the highest governing body of IMF, meets once a year to take major policy decisions. Its members are generally the finance ministers or the central bank governors of the member countries. All the member countries are represented on this board.
 
IMF lends to its member countries under various schemes. These schemes are listed below:
·            Standby arrangement: This scheme was introduced in 1952. Under this scheme, countries can borrow at the first indication of its possible need. This would help the country in time as it would not have to wait for IMF’s approval for the loan when the need actually arose.
 
·            Compensating financing facility: This scheme was introduced in 1963 for providing financial assistance to countries facing temporary shortfall in reserves.
 
·            Buffer stock financing facility: Introduced in 1969, this scheme provides for countries receiving financial assistance from IMF in order to purchase approved primary products. This help is extended to prevent countries from suffering due to price shocks.
 
·            Extended facility: This scheme was introduced in 1974. It allows countries to borrow on a medium-term basis for overcoming balance-of-payments problems caused by structural imbalance.
 
·            Oil facility:It was introduced in 1974 and was terminated in 1976. Under this scheme, help was extended to countries most affected by the oil price rise.
 
·            Trust Fund: As gold was demonetized in 1976, IMF set up this fund with the proceeds from the sale of gold held by it. This fund was used for providing special development loans on concessional terms to those 25 member-countries which had the lowest per capita income. It was discontinued in 1981.
 
·            Supplementary financing facility: Under this scheme, established in 1977, financial assistance is provided to countries facing serious BoP problems and having high external debt.
 
In 1993, other facilities were extended to the member countries for assistance in exchange rate stabilization.
 
World Bank
 
The World Bank or the International Bank for Reconstruction and Development (IBRD), as its name suggests, was established to help countries in reconstructing their economies in the post World War II period and to help the developing countries increase their economic growth rate.
 
The World Bank generally makes medium- and long-term loans for infrastructure projects. Lately, it has started lending to countries having BoP problems, if they are willing to adopt growth-oriented economic policies. It requires a government guarantee for making these loans. For these activities, it raises funds through subscripttions from member countries and by issuing bonds which are generally meant for private subscripttion.
 
 
 
 
 
International Finance Corporation (IFC)
 
IFC was incorporated in 1956 to help the development of private enterprise in different countries. It thus supplements the activities of the World Bank. IFC helps the private sector in a number of ways. It finances their projects through loans and subscripttion to equity. It provides technical assistance to private enterprises. It also tries to bring private capital and private management together by creating conditions conducive to the flow of private capital. It does not insist upon government guarantee and generally takes up more risks than its counterparts.
 
International Development Association (IDA)
 
While the above-mentioned agencies were set up to finance profitable projects, IDA endeavors to finance those projects in developing countries, which may not be financially profitable, but indirectly may have a positive effect on the concerned economy. IDA was set up in 1960. The membership of World Bank is a prerequisite for membership of IDA. Hence, it is usually referred to as the soft loan window of the World Bank. It provides highly concessional loans (including long-term interest-free loans) to such projects. IDA also insists on a government guarantee.
 
The Failure
 
Though, under this system, the member countries had the option of pegging their currencies to either gold or to the dollar, the only reserve asset mentioned in the agreement establishing the system was gold. However, as the gold stocks did not increase substantially in the years following the agreement, this provision acted as an impediment to the growth of international trade. Increase in such trade required a simultaneous increase in the official reserves held by various countries, in order to facilitate the payment for these trades. To get around this problem, countries started holding dollar reserves. They generally held the reserves in the form of interest bearing securities issued by the US government. This was encouraged by the US because of the seigniorage gains involved. While the cost of printing money was almost nil, the benefits were immense as the US could pay for its increased imports just by printing additional money, without suffering a reduction in its reserves. Seigniorage gain refers to this benefit accruing from the ability to finance unlimited imports. Since other governments were ready to hold dollar reserves and not convert them into gold, the US started following a system of fractional reserves. The total number of dollars issued by the Federal Reserve (the American central bank) was far in excess of the value of the gold held by it. As it would not have been possible for the Fed to convert all the dollars into gold, the system ran on the confidence of other countries on its ability to do so, and their non-insistence for an immediate conversion. This created a paradox in the system known as the Triffin paradox or the Triffin dilemma after a Yale University professor, Robert Triffin, who first spoke about it in 1960. According to him, it was necessary for the US to run BoP deficit in order to supply the world with the additional dollar reserves needed for increased international trade. Yet, as its deficit increased and the volume of dollar reserves held by other countries grew without a simultaneous increase in US’s gold reserves, its ability to honor its commitment (of converting dollars into gold) would decrease. Such a situation would result in decreased confidence in the system, and since the system was running on the member countries’ confidence, it would result in the system breaking down.
 
Another problem with the system was that it had become too rigid, despite the aim of the members being otherwise. As the system provided for realignment of exchange rates in case of a fundamental disequilibrium, predicting exchange rate movements became very easy. This put currencies at the mercy of private speculators. If a country started facing regular BoP deficits, people would start expecting a devaluation of its currency. Attempting to profit from such a scenario, private speculators would start selling the currency for gold or some other currency which was expected to remain strong, in the hope of buying it later at a reduced price. As these capital outflows built up, the reserves of the country would go down, eventually forcing it to devalue its currency. Thus, the expectations prove self-fulfilling. These outflows could only be stopped by a firm commitment by the concerned government at the very beginning, of not devaluing its currency. After making such a commitment, though, the country would find it very difficult to go for devaluation as such an act would make it lose its credibility, and the possibility of controlling the markets next time would be very bleak. The country would also not have any other choice but to devalue, as the other adjustment mechanisms were generally not acceptable to them (which implied a contraction of the economy, thus resulting in increased unemployment); leaving them in a catch-22 situation. A country whose currency faces an upward pressure would also face a similar problem, as the inflation resulting from an attempt to stop its currency from appreciating may not be acceptable; and the only other option left would be to revalue the currency.
 

In the early 50s, the US was running a BoP surplus, and hence there was a shortage of dollars in the international markets. By the late 50s, however, the US BoP situation had reversed and there was an excess supply of dollars. So much so, that there was a considerable reduction in US’s gold holdings and the general




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belief became that the dollar had become overvalued and a correction in its value was due. This situation occurred due to two reasons. One was the devaluation of other currencies vis-à-vis the dollar in the previous decade, which made American goods less competitive in the international markets, and the other was the high inflation rate prevailing in the American economy. In 1960, the value of gold flared up in the London market where most of the private gold trading took place. This happened due to the speculation that the dollar was going to be devalued by increasing the price of gold. To prevent the markets from going too far off from the official price of $35 per ounce, the US arrived at a gold pool arrangement with 7 other countries, under which they sold gold in London. This helped in controlling the gold prices in the short run. At around the same time, US inflation started coming down and its BoP situation started improving. By the early 60s, US was enjoying a current account surplus. This was being balanced by capital flows out of US, mostly on account of US companies investing in Europe. In an attempt to reduce unemployment in US, monetary tightening was not introduced despite the overall BoP figure remaining negative. Believing that the increasing trend in the current account balance would continue and the BoP deficit was a short-term phenomenon, the government looked at short-term arrangements for tiding over the BoP difficulties. It tried to persuade foreign governments not to convert their dollar holdings into gold, opened credit lines with foreign central banks, and drew small amounts from IMF. It also entered into the General Arrangements to Borrow (GAB), an agreement with 9 other major countries to form the Group of Ten (G-10). The members of this group agreed to lend their currencies to IMF in case any one of them needed to draw a huge sum from it.
 
Despite all these steps, the BoP position did not turn positive as capital outflows continued. The main reason was the continuing high inflation rate in the US economy. With the US needing a lot of money to finance its commitments (to provide money for the reconstruction of the various war ravaged economies) under the Marshall Plan and its own expenses due to the Vietnam war, the money supply increased drastically, thus pushing the inflation to high levels. The US government then started imposing various restrictions on capital flows. An ‘interest equalization tax’ was introduced on purchase of foreign securities by US citizens and its citizens were prohibited from holding gold either within the country or outside. In 1965, American banks and companies were told to voluntarily restrict loans to foreigners, and foreign direct investments respectively. In 1968, these controls were made compulsory. By then, however, the current account had also weakened. The pressure on the dollar started building up.
 
As the pressure on the dollar increased, a new reserve asset was created by IMF in 1967. Named SDRs (Special Drawing Rights), this international currency was allocated to the IMF member countries in proportion to their quotas. The biggest benefit of SDRs was that there would be a provision for international money to be created without any country needing to run a BoP deficit or to mine gold. Its value lay not in any backing by a currency or a real asset (like gold), but in the readiness of the IMF member countries to accept it as a new form of international money. Any member country, when facing payment imbalances arising out of BoP deficits, could draw on these SDRs, as long as it maintained an average balance of 30% of its total allocations. It could then sell these SDRs to a surplus country in exchange for that country’s currency, and use it for settlement of international payments. Every member country was obliged to accept up to 3 times its total allocations as a settlement of international payments. It is an interest bearing source of finance, i.e. countries holding their SDRs receive interest, and the ones drawing on them pay interest. This interest rate is determined on the basis of the average money market interest rates prevailing in France, Germany, Japan, the UK and the US. Only the member countries of IMF and specific official institutions are eligible to hold SDRs. SDR is also the unit of account for all IMF transactions.
 
Despite the introduction of SDRs, the crisis continued to deepen. By this time, US’s gold holdings had reduced considerably (both as an absolute figure and as a proportion of its foreign liabilities). By 1979, its reserve position turned negative as the BoP deficit increased drastically. In the first three months of 1971, huge pressure built up against the dollar, especially with respect to the mark. A number of countries had to buy a lot of dollars to defend their exchange rates. Germany, not intending to increase its money supply to unmanageable proportions, once again floated its currency. In April 1971, the US suffered a trade deficit for the first time, but it could not follow contractionary policies as it was simultaneously suffering from high unemployment. The only option left to it was to devalue. Even that it could not do on its own, as increasing the price of gold in terms of the dollar would not have had the desired effect due to other currencies being pegged to the dollar directly (rather than through gold prices). Also, an unexpected devaluation of the dollar would have penalized those countries, which were trying to help the US by holding on to dollars instead of converting them into gold. Most of the countries held on to dollars in the first half of 1971. In the beginning of August, France needed gold to repurchase francs from the IMF, which it had sold earlier in harder times. It fulfilled this need by converting its dollar holdings into gold. As gold reserves of the US fell and rumors spread about Britain also trying to follow the same route as France, panic spread in the international markets about US’s ability to honor its commitment to convert all dollar holdings into gold. This caused a run on its gold reserves as all countries rushed to get their dollar holdings converted when they could. This precipitated the matters so much that the US decided to stop converting dollars into gold and let its currency float on August 15, 1971. To improve its BoP position, it simultaneously imposed an additional 10% tariff on imports. Hence, the two most important pillars of the system were gone – fixing of prices of currencies in terms of gold and their convertibility into gold. As a reaction to this development, many of the countries let their currencies float.
 
The intention of the US behind these steps was not to shift from a pegged-exchange rate system to a floating rate system, but to seek a realignment of exchange rates. Therefore, it called for a meeting of the 10 largest IMF member countries, which was held in December 1971, at the Smithsonian Institute in Washington, and considered the issue of realignment. As a part of the agreement arrived at in that meeting, which came to be known as the Smithsonian agreement, many of the countries revalued their currencies in terms of the dollar, while the dollar was devalued by raising the price of gold from $35 to $38 per ounce. The other part of the system, i.e., the facility of conversion of dollars into gold, however, was not re-established. The band around the parity rates was increased from one percent to 2.25 percent on each side, thus providing the central banks more flexibility in the management of exchange rate and monetary policy. It was also agreed to liberalize trade policies and to introduce more flexibility to exchange rates.
 
When the demand curve for exports is relatively inelastic, a devaluation of a country’s currency does not immediately lead to an improvement in its current-account balance. In the initial period, the reduction in the price of the exports is much more than the increase in the volumes and hence there is a net reduction in exports. In the long run, however, the volumes pick up and the net exports start rising. The current-account curve, thus, traces a J-shape. It first becomes worse than its position before the devaluation, and then improves. This is called the J-curve effect. The US’s BoP behaved in a similar manner after the Smithsonian agreement. It was misinterpreted to mean that the devaluation of the dollar was smaller than it should have been. In mid-1972, the UK floated the pound as a response to BoP problems. This again fuelled speculation against the dollar, with dollar being abandoned in favor of mark and yen. In February 1973, the dollar came under extreme selling pressure due to these factors and the high inflation rate, which continued to reign in the US. It was contemplating devaluing the dollar once again, but was pre-empted by Switzerland, which floated its currency. The dollar was, nevertheless, devalued by raising the price of gold to $41.22 per ounce. In mid-March, 14 major industrial countries followed Switzerland by abandoning the system and floating their currencies. With this, the system came to an end.
 
Post Bretton Woods System (The Current System)
 
As the Bretton Woods system was abandoned, most countries shifted to floating exchange rates. The IMF finally recognized this fact and the articles were amended in its agreement. The amendment was decided upon in Jamaica in 1976 and became effective on April 1, 1978. This was the second amendment to IMF’s articles. Under the new articles, countries were given much more flexibility in choosing the exchange rate system they wanted to follow and in managing the resultant exchange rates. They could either float or peg their currencies. The peg could be with a currency, with a basket of currencies or with SDRs. The only restriction put was that the pegging should not be done with gold. Neither was the member countries allowed to fix an official price for gold. This was done to reduce the role of gold and to make SDRs more popular as a reserve asset. For the same reason, the value of an SDR was redefined in terms of a basket of currency (to make it more stable and hence preferable as a reserve asset), rather than in dollar terms. Also, the members were no longer required to deposit a part of their quota in gold, and IMF sold off its existing gold reserves. In order to make SDRs more attractive as a reserve asset, they were made interest bearing. It was also allowed to be used for different types of international transactions. The member countries were also left free to decide upon the degree of intervention required in the forex markets, and could hence make it compatible with their economic policies. Secondly, IMF was given increased responsibility for supervising the monetary system. As a part of these increased responsibilities, IMF was required to identify those countries, which were causing such changes in the exchange rates through their domestic economic policies, which proved disruptive to international trade and investment. It could then suggest alternate economic policies to these countries. IMF was also responsible for identifying any country, which was trying to defend an exchange rate which was inconsistent with the underlying economic fundamentals. This was to be done by a constant monitoring of the reserves position of various countries. Lastly, the new articles made it easier for countries facing short-term imbalances in their BoP accounts to access IMF’s assistance.
 
While countries were free to determine their exchange rate policies, under Article IV of the Agreement, they were required to ensure that the economic and financial policies followed by them were such as to foster ‘orderly economic growth and reasonable price stability’. They also had to follow principles of exchange rate management, adopted by IMF in April, 1977. According to these principles:
 
·            A member country neither should manipulate the exchange rates in such a way as to prevent a correction in the BoP position, nor should it use the exchange rates to gain competitive advantage in the international markets.
·            A member country was required to prevent short-term movements in the exchange rates which could prove disruptive to international transactions, by intervening in the exchange markets.



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·            While intervening in the forex markets, a member country was required to keep other countries’ interest in mind, especially the country whose currency it choses to intervene in.
 
These principles attempted to bring some stability in the forex markets and to prevent another bout of competitive devaluations.
 
Given the freedom, different countries chose different exchange rate mechanisms. While some of them kept their currencies floating, some of them pegged their currencies either to a single currency or to a basket of currencies. A peg was maintained by intervention in the foreign exchange markets and by regulating forex transactions. Table 5.1 shows the status of currencies as on March 31, 1995.
 
Floating of currencies was expected to make the exchange rate movements more smooth. Instead a lot of volatility has since been experienced. To remove a part of this volatility, sometimes a group of nations come together to form closer economic ties by co-operating with each other in the management of their exchange rates. One such group is the European Monetary Union (EMU).
 
The European Monetary Union
 
The basis of the European Monetary Union was the American desire to see a united Western Europe after the World War II. This desire started taking shape when the Europeans created the European Coal and Steel Community, with a view to freeing trade in these two sectors. The pricing policies and commercial practices of the member nations of this community were regulated by a supranational agency. In 1957, the Treaty of Rome was signed by Belgium, France, Germany, Italy, Luxembourg and the Netherlands to form the European Economic Community (EEC), whereby they agreed to make Europe a common market. While they agreed to lift restrictions on movements of all factors of production and to harmonize domestic policies (economic, social and other policies which were likely to have an effect on the said integration), the ultimate aim was economic integration. The European countries desired to make their firms more competitive than their American counterparts by exposing them to internal competition and giving them a chance to enjoy economies of scale by enlarging the market for all of them.
 
The EEC achieved the status of a customs union by 1968. In the same year, it adopted a Common Agricultural Policy (CAP), under which uniform prices were set for farm products in the member countries, and levies were imposed on imports from non-member countries to protect the regional industry from lower external prices. An important roadblock in the European unification was the power given under the treaty to all the member countries, by which they could veto any decision taken by other members. This hindrance was removed when the members approved the Single European Act in 1986, making it possible for a lot of proposals to be passed by weighted majority voting. This paved the way for the unification of the markets for capital and labor, which converted the EEC into a common market on January 1, 1993. Meanwhile, a number of countries joined EEC. Denmark, Ireland and the United Kingdom joined in 1973. By 1995, Austria, Finland, Greece, Portugal, Spain and Sweden had also joined, thus bringing the membership to 15.
 
The structure of the EEC consists of the European Commission, a Council of Ministers and a European Parliament. The Commission’s members are appointed by the member countries’ governments and its decisions are subject to the approval of the Council, where, by convention, either the Finance Ministers or the heads of the central bank represent their respective countries. The members of the Parliament are directly elected by the voters of the member countries. In December 1991, the Treaty of Rome was revised drastically and the group was converted into the European Community by extending its realm to the areas of foreign and defense policies. The members also agreed to convert it into a monetary union by 1999.
 
As the Bretton Woods system was breaking down in 1973, six out of the nine members of the EEC jointly floated their currencies against the dollar. While Britain and Italy did not participate in the joint float, France joined and dropped out repeatedly. The currencies of the participating countries were allowed to fluctuate in a narrow band with respect to each other (1.125% on either side of the parity exchange rate), and the permissible joint float against other currencies was also limited (to 2.5% on either side of the parity, by the Smithsonian agreement). This gave the currency movements the look of a ‘snake’, with the narrow internal band forming the girth and the movements against other currencies giving the upward and downward wriggle. The external band restricting the movement of these European currencies on either side, gave the impression of a ‘tunnel’ thus giving rise to the term ‘snake in the tunnel’. The idea of creating a monetarily stable zone started taking shape in 1978, which resulted in the creation of the European Monetary System in 1979. The system was quite similar to the Bretton Woods system, with the exception that instead of the currencies being pegged to the currency of one of the participating nations, a new currency was created for the purpose. It was named the European Currency Unit (ECU) and was defined as a weighted average of the various European currencies. Each member had to fix the value of its currency in terms of the ECU. This had the effect of pegging these currencies with each other. Since each currency could vary against the ECU and against other currencies within a certain band on either side of the parity rate (2.25% for others and 6% for pound sterling, Spanish peseta and Portuguese escudo), a certain grid was formed which gave the limits within which these currencies could vary against each other. Whenever the exchange rate between two of the member currencies went beyond the permissible limit, both the countries had to intervene in the forex markets. This co-operation between the countries was expected to make the system more effective. Another important feature of this system was that the members could borrow unlimited amounts of other countries’ currencies from the European Monetary Cooperation Fund in order to defend their exchange rates. This was expected to ward off any speculative activities against a member currency. Though the countries involved were also expected to simultaneously adjust their monetary policies, this burden was put more on the erring country. It was easier to fix the blame, as at the time of the fluctuation in the exchange rate of two members, the erring country’s exchange rate would also be breaching its limits with respect to the ECU and other member currencies. When these parity rates became indefensible, they could be realigned by mutual agreement. The system was, thus, much more flexible than the Bretton Woods system.
 
The ECU also served as the unit of account for the EMS countries. It served another important purpose in that loans among EMS countries (including private loans) could be denominated in the ECU. The ECU’s value being the weighted average of a basket of currencies, it was more stable than the individual currencies. This made it more suitable for international transactions.
 
A number of realignments took place in the first few years of the system. However, the 1980s saw the system becoming more rigid. The German central bank, the Bundesbank, was committed to a low inflation rate, and hence to a tighter monetary policy. Some other countries (specially France and Italy, who had meanwhile joined the EMS) tried to control their domestic inflation by not realigning their currency’s exchange rate with the DM and instead following the same monetary policy as the Bundesbank. The UK, which joined the EMS in 1990, also followed the same policy. This resulted in a high unemployment rate in such countries. This cost was acceptable to these countries, till the situation changed drastically with the effects of the 1990 German unification slowly becoming visible. As the erstwhile West Germany bore the expenses of the unification, its budget deficit started rising, increasing the German prices and wages. To keep inflation under control, the Bundesbank had to increase the interest rates to an even higher level. If the DM was allowed to appreciate at that time, the Bundesbank would not have had to increase the interest rates too much, as German prices would have reduced in response to the higher DM. But as some other member countries of the EMS refused to let the DM appreciate, they had to increase their domestic interest rates in response. This happened at a time when many of the European countries were experiencing very high unemployment rates, and Britain was going through a recession.
 
The situation became worse with the decision of the EC countries to go ahead with monetary union. In 1989, the report of a committee chaired by the president of the European Commission, Jacques Delor, was published. It recommended that the members of the EC abolish all capital controls and follow one common monetary policy. This monetary policy was proposed to be formulated by a European Central Bank (ECB), and followed by the central banks of all the member countries, which would become a part of the European System of Central Banks (ESCB). It also recommended the irrevocable locking of the EC exchange rates and the introduction of a common currency for the member nations. In the same year, the first stage of the process of economic integration began, and most of the recommendations of the Delor Committee report were accepted. However, it was decided that to make the integration long-lasting, member countries were to achieve a high degree of economic convergence before being allowed to merge their economies with the rest of the group.
 

In December 1991, as a follow up to the Delor’s report, the Treaty of Rome was revised extensively to provide for the monetary union. As these revisions were adopted in the Dutch town of Maastricht, they collectively came to be known as the Maastricht Treaty. The treaty laid down the timetable for the monetary union. According to the timetable, the union was to be completed by 1999, and the qualifying countries had to fulfill criteria regarding inflation rates, exchange rates, interest rates and budget deficits. As the markets believed these criteria to be too hard for some countries to achieve, speculative pressure against the currencies of these countries started building up. By September 1992, the pressure reached its peak. The first country to bear the brunt of the speculative attacks was Italy. Even as its government announced a set of fiscal reforms to be able to meet the convergence criteria, pressures against the lira continued. Finally, Germany and Italy entered into a deal under which Italy devalued the lira and Germany reduced its interest rates. The UK was also facing a similar attack on its currency, and had to withdraw from the EMS soon after the Italian devaluation. Despite having already devalued its currency, Italy followed Britain and pulled its currency out of the EMS. Immediately afterwards, French voters approved the Maastricht treaty. Yet, this approval could not stop an attack against the French franc. Even Bundesbank and the Banque de France (the French central bank) together could not postpone the inevitable for long. In July 1993, there was another attack on the franc as it became clear that the French and German interest rates would not converge. The French unemployment rates being very high and continuing to rise, it could be foreseen that a further possibility of interest rates rising there did not exist. At the same time, the German government could not be expected to reduce the interest rates as inflation was still not




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Posted On 19 December 2009 at 23:20

 

·            While intervening in the forex markets, a member country was required to keep other countries’ interest in mind, especially the country whose currency it choses to intervene in.
 
These principles attempted to bring some stability in the forex markets and to prevent another bout of competitive devaluations.
 
Given the freedom, different countries chose different exchange rate mechanisms. While some of them kept their currencies floating, some of them pegged their currencies either to a single currency or to a basket of currencies. A peg was maintained by intervention in the foreign exchange markets and by regulating forex transactions. Table 5.1 shows the status of currencies as on March 31, 1995.
 
Floating of currencies was expected to make the exchange rate movements more smooth. Instead a lot of volatility has since been experienced. To remove a part of this volatility, sometimes a group of nations come together to form closer economic ties by co-operating with each other in the management of their exchange rates. One such group is the European Monetary Union (EMU).
 
The European Monetary Union
 
The basis of the European Monetary Union was the American desire to see a united Western Europe after the World War II. This desire started taking shape when the Europeans created the European Coal and Steel Community, with a view to freeing trade in these two sectors. The pricing policies and commercial practices of the member nations of this community were regulated by a supranational agency. In 1957, the Treaty of Rome was signed by Belgium, France, Germany, Italy, Luxembourg and the Netherlands to form the European Economic Community (EEC), whereby they agreed to make Europe a common market. While they agreed to lift restrictions on movements of all factors of production and to harmonize domestic policies (economic, social and other policies which were likely to have an effect on the said integration), the ultimate aim was economic integration. The European countries desired to make their firms more competitive than their American counterparts by exposing them to internal competition and giving them a chance to enjoy economies of scale by enlarging the market for all of them.
 
The EEC achieved the status of a customs union by 1968. In the same year, it adopted a Common Agricultural Policy (CAP), under which uniform prices were set for farm products in the member countries, and levies were imposed on imports from non-member countries to protect the regional industry from lower external prices. An important roadblock in the European unification was the power given under the treaty to all the member countries, by which they could veto any decision taken by other members. This hindrance was removed when the members approved the Single European Act in 1986, making it possible for a lot of proposals to be passed by weighted majority voting. This paved the way for the unification of the markets for capital and labor, which converted the EEC into a common market on January 1, 1993. Meanwhile, a number of countries joined EEC. Denmark, Ireland and the United Kingdom joined in 1973. By 1995, Austria, Finland, Greece, Portugal, Spain and Sweden had also joined, thus bringing the membership to 15.
 
The structure of the EEC consists of the European Commission, a Council of Ministers and a European Parliament. The Commission’s members are appointed by the member countries’ governments and its decisions are subject to the approval of the Council, where, by convention, either the Finance Ministers or the heads of the central bank represent their respective countries. The members of the Parliament are directly elected by the voters of the member countries. In December 1991, the Treaty of Rome was revised drastically and the group was converted into the European Community by extending its realm to the areas of foreign and defense policies. The members also agreed to convert it into a monetary union by 1999.
 
As the Bretton Woods system was breaking down in 1973, six out of the nine members of the EEC jointly floated their currencies against the dollar. While Britain and Italy did not participate in the joint float, France joined and dropped out repeatedly. The currencies of the participating countries were allowed to fluctuate in a narrow band with respect to each other (1.125% on either side of the parity exchange rate), and the permissible joint float against other currencies was also limited (to 2.5% on either side of the parity, by the Smithsonian agreement). This gave the currency movements the look of a ‘snake’, with the narrow internal band forming the girth and the movements against other currencies giving the upward and downward wriggle. The external band restricting the movement of these European currencies on either side, gave the impression of a ‘tunnel’ thus giving rise to the term ‘snake in the tunnel’. The idea of creating a monetarily stable zone started taking shape in 1978, which resulted in the creation of the European Monetary System in 1979. The system was quite similar to the Bretton Woods system, with the exception that instead of the currencies being pegged to the currency of one of the participating nations, a new currency was created for the purpose. It was named the European Currency Unit (ECU) and was defined as a weighted average of the various European currencies. Each member had to fix the value of its currency in terms of the ECU. This had the effect of pegging these currencies with each other. Since each currency could vary against the ECU and against other currencies within a certain band on either side of the parity rate (2.25% for others and 6% for pound sterling, Spanish peseta and Portuguese escudo), a certain grid was formed which gave the limits within which these currencies could vary against each other. Whenever the exchange rate between two of the member currencies went beyond the permissible limit, both the countries had to intervene in the forex markets. This co-operation between the countries was expected to make the system more effective. Another important feature of this system was that the members could borrow unlimited amounts of other countries’ currencies from the European Monetary Cooperation Fund in order to defend their exchange rates. This was expected to ward off any speculative activities against a member currency. Though the countries involved were also expected to simultaneously adjust their monetary policies, this burden was put more on the erring country. It was easier to fix the blame, as at the time of the fluctuation in the exchange rate of two members, the erring country’s exchange rate would also be breaching its limits with respect to the ECU and other member currencies. When these parity rates became indefensible, they could be realigned by mutual agreement. The system was, thus, much more flexible than the Bretton Woods system.
 
The ECU also served as the unit of account for the EMS countries. It served another important purpose in that loans among EMS countries (including private loans) could be denominated in the ECU. The ECU’s value being the weighted average of a basket of currencies, it was more stable than the individual currencies. This made it more suitable for international transactions.
 
A number of realignments took place in the first few years of the system. However, the 1980s saw the system becoming more rigid. The German central bank, the Bundesbank, was committed to a low inflation rate, and hence to a tighter monetary policy. Some other countries (specially France and Italy, who had meanwhile joined the EMS) tried to control their domestic inflation by not realigning their currency’s exchange rate with the DM and instead following the same monetary policy as the Bundesbank. The UK, which joined the EMS in 1990, also followed the same policy. This resulted in a high unemployment rate in such countries. This cost was acceptable to these countries, till the situation changed drastically with the effects of the 1990 German unification slowly becoming visible. As the erstwhile West Germany bore the expenses of the unification, its budget deficit started rising, increasing the German prices and wages. To keep inflation under control, the Bundesbank had to increase the interest rates to an even higher level. If the DM was allowed to appreciate at that time, the Bundesbank would not have had to increase the interest rates too much, as German prices would have reduced in response to the higher DM. But as some other member countries of the EMS refused to let the DM appreciate, they had to increase their domestic interest rates in response. This happened at a time when many of the European countries were experiencing very high unemployment rates, and Britain was going through a recession.
 
The situation became worse with the decision of the EC countries to go ahead with monetary union. In 1989, the report of a committee chaired by the president of the European Commission, Jacques Delor, was published. It recommended that the members of the EC abolish all capital controls and follow one common monetary policy. This monetary policy was proposed to be formulated by a European Central Bank (ECB), and followed by the central banks of all the member countries, which would become a part of the European System of Central Banks (ESCB). It also recommended the irrevocable locking of the EC exchange rates and the introduction of a common currency for the member nations. In the same year, the first stage of the process of economic integration began, and most of the recommendations of the Delor Committee report were accepted. However, it was decided that to make the integration long-lasting, member countries were to achieve a high degree of economic convergence before being allowed to merge their economies with the rest of the group.
 

In December 1991, as a follow up to the Delor’s report, the Treaty of Rome was revised extensively to provide for the monetary union. As these revisions were adopted in the Dutch town of Maastricht, they collectively came to be known as the Maastricht Treaty. The treaty laid down the timetable for the monetary union. According to the timetable, the union was to be completed by 1999, and the qualifying countries had to fulfill criteria regarding inflation rates, exchange rates, interest rates and budget deficits. As the markets believed these criteria to be too hard for some countries to achieve, speculative pressure against the currencies of these countries started building up. By September 1992, the pressure reached its peak. The first country to bear the brunt of the speculative attacks was Italy. Even as its government announced a set of fiscal reforms to be able to meet the convergence criteria, pressures against the lira continued. Finally, Germany and Italy entered into a deal under which Italy devalued the lira and Germany reduced its interest rates. The UK was also facing a similar attack on its currency, and had to withdraw from the EMS soon after the Italian devaluation. Despite having already devalued its currency, Italy followed Britain and pulled its currency out of the EMS. Immediately afterwards, French voters approved the Maastricht treaty. Yet, this approval could not stop an attack against the French franc. Even Bundesbank and the Banque de France (the French central bank) together could not postpone the inevitable for long. In July 1993, there was another attack on the franc as it became clear that the French and German interest rates would not converge. The French unemployment rates being very high and continuing to rise, it could be foreseen that a further possibility of interest rates rising there did not exist. At the same time, the German government could not be expected to reduce the interest rates as inflation was still not



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