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International Monetary System
IN THIS CHAPTER
Specie commodity standard
Gold standard
Decline of the gold standard
Bretton Woods system
Chronology of the Bretton Woods system
Smithsonian arrangement
Exchange rate system
Independent floating
Managed floating
Currency pegging
Crawling peg
Currency band
Snake and the Worm
Currency boards
European monetary system
€ : A single European currency
Prospects of €
Summary
Questions
Project work
Case studies
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International Monetary System
The foreign exchange market allows currencies to be exchanged in order to facilitate
international trade and commerce. MNCs depend on the foreign exchange market to
exchange their home currency for a foreign currency and also to exchange a foreign currency
they receive into their home currency.
2.1
SPECIE COMMODITY STANDARD
In earlier days trade payments were settled through barter arrangement. On account of
inconsistency and inconvenience, traders began using metals like gold and silver to settle
the payments. Subsequently metals took the form of coins that had the stamp of sovereignty
on the basis of weight and fineness of the metal and that was the beginning of the Specie
Commodity Standard. The coins were called full-bodied coins meaning that their value was
equal to the value of the metal contained in it. Over a period of time other metals with a
lower value was mixed with the gold coin, as a result the value of the metal came to be
lower than the face value of the coin. These coins were known as debased coins. Full-bodied
coins were primarily used for store of value. To act as a store of value, coins must be able to
be reliably saved, stored, and retrieved and also be usable as a medium of exchange when
it is retrieved. The value of the money must also remain stable over time. The full-bodied
coins were driven out of circulation by the year 1560 by the debased coins.
The Coinage Act or the Mint Act of 1792, of the United States established dollar as the
monetary unit of the country, declared it to be lawful tender, created a decimal system
for the US currency and also fixed its value in terms of gold and silver. The mint ratio
between gold and silver was 1:15 in the United States and 1:15.5 in France. Thus was the
beginning of the bimetallic standard. In the beginning of 1800, the value of gold rose in
comparison to silver, resulting in the removal from commerce of nearly all the gold coins,
and their subsequent melting. The difference in the bimetallic standard between the US
and the France led to the export of gold from the US to France for the purchase of silver.
This led to diminution of gold stock in the US and the country was forced to adopt a mono
metallic silver standard. Therefore in 1834, the 15:1 ratio of silver to gold was changed to
a 16:1 ratio by reducing the weight of the nation’s gold coinage. This created a new U.S.
dollar that was backed by 1.50 g (23.22 grains) of gold. However, the previous dollar had
been represented by 1.60 g (24.75 grains) of gold. The result of this revaluation, which was
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The essential features of gold standard were:
1. The country adopting the gold standard shall fix the value of currency in terms of
specific weight and fineness of gold and guarantees a two way convertibility
2. Export and import of gold shall be allowed so that it can flow freely among the
countries adopting the gold standard
3. The apex monetary institution shall hold gold reserves in relationship to the currency
it has issued and
4. The government shall allow unrestricted minting of gold and melting of gold coins
at the option of the holder
Since fixed weight of gold had formed the basis for a unit of the currency and since free flow
of gold was permitted among the countries adopting the gold standard, the gold standard
carried an automatic mechanism for domestic price stability, fixed exchange rates and
adjustment in balance of payment. The exchange rate mechanism depended upon the
content of gold in different countries. Let us say that the pound sterling contained a half
ounce of gold and one dollar bill contained one fourth ounce of gold, the exchange rate
was fixed at £1 = $2.
The United States set the value of the dollar at $20.67 per ounce of gold and the British
pound was pegged at £4.2474 per ounce of gold. Thus the dollar to pound ($/£) exchange
rate was determined as follows:
$20.67 per ounce of gold
= $4.8665 per £
£4.2474 per ounce of gold
The rate was known as the mint rate or the mint exchange rate. The actual exchange rate
remained close to mint rate and the free flow of gold between the two countries ensured
not much deviation in the exchange rate. This led to fixed parity between the currencies
and helped to preserve the value of each individual currency in terms of gold.
In the event of occurrence of a transportation cost or transaction cost, the dollar pound
exchange rate would fluctuate above or below the fixed rate. Let us assume hypothetically
that the value of the dollar had depreciated to $5 per £. This will give an opportunity for
the arbitrageurs to move in. The arbitrageurs would buy one ounce of gold in the US for
$20.67 and sell it in Great Britain for £4.24 and then exchange the pound for the dollar in
the forex market for $5 × $4.24 = $21.20, thus making a profit of $21.20 − $20.67 = $0.53 per
ounce. This process would continue till the original parity was established.
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The gold standard maintained a reasonable equilibrium through the principles of
price-specie flow mechanism. This arrangement restored automatic adjustment in the
balance of payments. Say, in the event Great Britain faced a deficit on its trade account
leading to outflow of gold for trade settlement and reducing the money supply with in
the country, the emerging deflation would make the British exports competitive and the
resultant rise in exports would eventually wipe out any deficit on this account. On the
other side, reduced money supply pushes up the interest rate and the credit restrictions
imposed by the apex banks will push up the bank interest rate, resulting in the foreign
investment moving into the economy and off-setting any deficit on the capital account.
2.3
DECLINE OF THE GOLD STANDARD
The gold standard as an international monetary system was accepted by most of the
countries until the First World War broke out in 1914. The warring nations required huge
money supply for financing the activities borne out of war. This was not possible under
the gold standard. The strained relations among the warring nations further impeded the
free flow of gold from one nation to another. The exchange rate parity hither to followed
by the various nations went hay wire.
At the onset of the war, US corporations had large debts payable to European entities, who
began liquidating their debts in gold. With debts looming to Europe, the dollar to British
pound exchange rate reached as high as $6.75, far above the parity of $4.8665. This caused
large outflow of gold. In July 1914, the New York Stock Exchange was closed and the
gold standard was temporarily suspended. In order to defend the exchange value of the
dollar, the US Treasury authorised state and nationally-charted banks to issue emergency
currency under the Aldrich-Vreeland Act, and the newly-created Federal Reserve organised
a fund to clear the debts to foreign creditors. These efforts were largely successful, and the
Aldrich-Vreeland notes were retired starting in November 1914 and the gold standard was
restored when the New York Stock Exchange re-opened in December 1914.
As the United States remained neutral in the war, it remained the only country to maintain
its gold standard, doing so without restriction on import or export of gold from 1915-1917.
US also banned gold export, thereby suspending the gold standard for foreign exchange.
US demanded repayment of war debts from France and France asked compensation from
Germany to meet the war debt. The United States finally joined the war in 1917. Already it
enjoyed a huge trade surplus with the European Nations. Hence the dollar became stronger
and the European currencies became weaker and the United States began to assume the
role of the leading creditor nation. For the reasons mentioned above, the gold standard
was suspended during the First World War.
After the end of the First World War, the nations on the gold standard during the pre-war
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1925, France in 1926 and Switzerland in 1928. All other European countries followed soon
after. The pound sterling returned at the old mint exchange rate of $4.8665 per £. As Great
Britain had liquidated most of its foreign investment in financing the war, the country
experienced a high inflation, economic stagnation and high unemployment. The pound
stood overvalued and completely exposed.
A great depression swept the world in 1929 and lasted for nearly ten years. The depression
originated in the United States, starting with the stock market crash of October 1929, known
as the Black Tuesday, but quickly spread to almost every country in the world. During
the period of great depression, almost every major currency abandoned the gold standard.
The Bank of England abandoned the gold standard in 1931 as speculators demanded gold
in exchange for currency, threatening the solvency of the British monetary system. This
pattern repeated throughout Europe and North America. In the United States, the Federal
Reserve was forced to raise interest rates in order to protect the gold standard for the US
dollar, worsening already severe domestic economic pressures.
As the economic crunch became more and more pronounced, several banks shut their shop
and people began to hoard gold coins as distrust for banks led to distrust for paper money
and worsening deflation and gold reserves. The production of gold during 1915-22 was
much lower and this resulted in a scramble for gold. In early 1933, in order to fight the
deflation, the US suspended the gold standard except for foreign exchange, revoked gold
as universal legal tender for debts, and banned private ownership of significant amounts
of gold coin. After the US abandoned the gold standard, other nations followed suit.
In the year 1934, the US returned to a modified gold standard. For foreign exchange
purposes, the set $20.67 per ounce value of the dollar was lifted, allowing the dollar to float
freely in foreign exchange markets with no set value in gold. This was however terminated
after one year. The US finally devalued its dollar from the previous rate of $20.67 per ounce
to $35.00 per ounce, making the dollar more attractive for foreign buyers. The higher price
increased the conversion of gold into dollars, allowing the US to effectively corner the world
gold market. The modified gold standard was known as the Gold Exchange Standard.
From 1934 till the end of World War II, exchange rates were theoretically determined by
each currency’s value in terms of gold.
2.4
BRETTON WOODS SYSTEM
In view of an unstable exchange regime, leading nations made several attempts to foster
an orderly international monetary system. Established in 1944 and named after the New
Hampshire town where the agreements were drawn up, the Bretton Woods system created
an international basis for exchanging one currency for another. It also led to the creation of
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the International Monetary Fund (IMF) and the International Bank for Reconstruction
and Development, now known as the World Bank. The former was designed to monitor
exchange rates and lend reserve currencies to nations with trade deficits, the latter to
provide underdeveloped nations with needed capital—although each institution’s role has
changed over time. Each of the 44 nations who joined the discussions at Bretton Woods
contributed a membership fee, of sorts, to fund these institutions; the amount of each
contribution designated a country’s economic ability and dictated its number of votes.
The Bretton Woods system was history’s first example of a fully negotiated monetary
order intended to govern currency relations among sovereign states. In principle, it was
designed to combine binding legal obligations with multilateral decision making conducted
through an international organisation, the IMF. In practice, the initial scheme, as well as its
subsequent development and ultimate demise, were directly dependent on the preferences
and policies of its most powerful member, the United States.
The conference that gave birth to the system was the culmination of some two and a half
years of planning for postwar monetary reconstruction by the Treasuries of the United
Kingdom and the United States. Although attended by all the 44 allied nations, plus one
neutral government of Argentina, the conference discussion was dominated by two rival
plans developed, respectively, by Harry Dexter White of the U.S. Treasury and by John
Maynard Keynes of Britain. The compromise that ultimately emerged was much closer
to White’s plan than to that of Keynes, reflecting the overwhelming power of the United
States as World War II was drawing to a close.
The participating nations agreed that as far as they were concerned, the interwar period
had conclusively demonstrated the fundamental disadvantages of unrestrained flexibility
of exchange rates. The floating rates of the 1930s were seen as having discouraged
trade and investment and to have encouraged destabilising speculation and competitive
depreciations. Yet in an era of more activist economic policy, governments were at the
same time reluctant to return to permanently fixed rates on the model of the classical
gold standard of the nineteenth century. Policymakers desired to retain the right to
revise currency values on occasion as circumstances warranted. Hence a compromise
was sought between the polar alternatives of either freely floating or irrevocably fixed rates–some
arrangement that might gain the advantages of both without suffering the disadvantages
of either.
What emerged was the ‘pegged rate’ or ‘adjustable peg’ currency regime, also known as the
par value system. Members were obligated to declare a par value (a ‘peg’) for their national
money and to intervene in currency markets to limit exchange rate fluctuations within
maximum margins (a ‘band’) one per cent above or below the parity; but they also retained
the right, whenever necessary and in accordance with agreed procedures, to alter their par
value to correct a ‘fundamental disequilibrium’ in their balance of payments.
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All governments agreed that if exchange rates were not to float freely, states would also
require assurance of an adequate supply of monetary reserves. Negotiators did not
think it necessary to alter in any fundamental way the gold exchange standard that
had been inherited from the interwar years. International liquidity would still consist
primarily of national stocks of gold or currencies convertible, directly or indirectly, into
gold. Negotiators did concur, however, on the desirability of some supplementary source
of liquidity for deficit countries. The big question was whether that source should be akin
to a global central bank able to create new reserves at will or a more limited borrowing
mechanism.
What emerged largely reflected US preferences: a system of subscriptions and quotas
embedded in the IMF, which itself was to be no more than a fixed pool of national currencies
and gold subscribed by each country. Members were assigned quotas, roughly reflecting
each state’s relative economic importance and were obligated to pay into the Fund a
subscription of equal amount. The subscription was to be paid 25% in gold or currency
convertible into gold (effectively the dollar, which was the only currency then still directly
gold convertible for central banks) and 75% in the member’s own money. Each member
was then entitled, when short of reserves, to borrow needed foreign currency in amounts
determined by the size of its quota.
The members also agreed that it was necessary to avoid recurrence of the kind of economic
warfare that had characterised the decade of the 1930s. Nations were in principle forbidden
to engage in discriminatory currency practices or exchange regulation, with only two
practical exceptions. First, convertibility obligations were extended to current international
transactions only. Governments were to refrain from regulating purchase and sale of
currency for trade in goods or services. But they were not obligated to refrain from
regulation of capital account transactions. They were formally encouraged to make use
of capital controls to maintain external balance in the face of potentially destabilising ‘hot
money’ flows. Second, convertibility obligations could be deferred if a member so chose
during a postwar ‘transitional period.’ Members deferring their convertibility obligations
were known as Article XIV countries and members accepting them were known as Article
VIII countries. One of the responsibilities assigned to the IMF was to oversee this legal
code governing currency convertibility.
Finally, negotiators agreed that there was a need for an institutional forum for international
co-operation on monetary matters. Currency troubles in the interwar years, it was felt, had
been greatly exacerbated by the absence of any established procedure or machinery for
inter-governmental consultation. A path breaking decision was to allocate voting rights
among governments in proportion to their quotas. With one-third of all IMF quotas at its
disposal, the US assured itself an effective veto over the decision making process.
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At the centre of the regime was the IMF, which was expected to perform three
important functions: regulatory (administering the rules governing currency values and
convertibility), financial (supplying supplementary liquidity), and consultative (providing a
forum for cooperation among governments). Structurally, the regime combined a respect
for the traditional principle of national sovereignty with a new commitment to collective
responsibility for management of monetary relations. Though multilateral in formal
design, therefore, the Bretton Woods system in practice quickly became synonymous with a
hegemonic monetary regime centred on the dollar, much in the same manner as the classical
gold standard of the nineteenth century had come to be centred on Britain’s pound sterling.
2.5
CHRONOLOGY OF THE BRETTON WOODS SYSTEM
The chronology of the Bretton Woods system can be divided into two periods: the period
of dollar shortage, lasting roughly until 1958; and the period of dollar glut, covering the
remaining decade and a half.
The period of the dollar shortage was the heyday of America’s monetary hegemony. The
term ‘dollar shortage,’ universally used at the time, was simply a shorthand expression
for the fact that only the US was then capable of assuring some degree of global monetary
stability; only the US could help other governments avoid a mutually destructive scramble
for gold by promoting an outflow of dollars instead. Dollar deficits began in 1950, following
a round of devaluations of European currencies. In ensuing years, shortfalls in the US
balance of payments averaged roughly $1.5 billion a year. But for these deficits, other
governments would have been compelled by their reserve shortages to resort to competitive
devaluations or domestic deflation to keep their payments in equilibrium; they would
certainly not have been able to make as much progress as they did towards dismantling
wartime exchange controls and trade barriers. Persistent dollar deficits thus actually
served to avoid destabilising policy conflict. The period up to 1958 was rightly called one
of beneficial disequilibrium.
After 1958, however, America’s persistent deficits began to take on a different colouration.
Following a brief surplus in 1957, owing to special circumstances, the US balance of
payments plunged to a $3.5 billion gap in 1958 and to even larger deficits in 1959 and 1960.
This was the turning point. Instead of talking about a dollar shortage, observers began to
speak of a dollar glut. In 1958 Europe’s currencies returned to convertibility. Subsequently,
the eagerness of European governments to obtain dollar reserves was transformed into
what seemed an equally fervent desire to avoid excess dollar accumulations. Before 1958,
less than 10% of America’s deficits had been financed by calls on the US gold stock and the
balance being financed with dollars. During the next decade, almost two thirds of America’s
cumulative deficit was transferred in the form of gold, mostly to Europe. Bretton Woods
was clearly coming under strain.
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By the mid-1960s, negotiations were begun to establish a substitute source of liquidity
growth in order to reduce systemic reliance on dollar deficits, culminating in agreement to
create the Special Drawing Right (SDR), an entirely new type of international reserve asset.
Governments hoped that with SDRs in place, any future threat of world liquidity shortage
would be successfully averted. On the other hand, they were totally unprepared for the
opposite threat—a reserve surfeit—which is in fact what eventually emerged in the late 1960s.
Earlier in the decade a variety of defensive measures were initiated in an effort to contain
mounting speculative pressures against the dollar. These included a network of reciprocal
short term credit facilities called swaps among the central banks as well as enlarged lending
authority for the IMF. A second source of strain was inherent in the structure of the par
value system: the ambiguity of the key notion of fundamental disequilibrium. How could
governments be expected to change their exchange rates if they cannot even tell when
a fundamental disequilibrium existed? And if they were inhibited from re-pegging the
rates, then how would international payments equilibrium be maintained? In practice,
governments began to go to enormous lengths to avoid the “defeat” of an altered par
value. The resulting rigidity of exchange rates not only aggravated fears of a potential
world liquidity shortage but also created irresistible incentives for speculative currency
shifts.
In the United States, concern was growing about the competitive commercial threat from
Europe and Japan. The cost of subordinating domestic interests to help strengthen foreign
allies was becoming ever more intolerable. Conversely, concern was growing in Europe
and Japan about America’s use of its privilege of liability financing called the ‘exorbitant
privilege’. The Bretton Woods system rested on one simple assumption—that economic
policy in the US would stabilise. During the first half of the 1960s, America’s foreign deficit
actually shrank as a result of a variety of corrective measures adopted at home. After 1965,
however, US behavior became increasingly destabilising, mostly as a result of increased
government spending on social programs at home and an escalating war in Vietnam.
America’s economy began to overheat and inflation began to gain momentum, causing
deficits to widen once again. With governments elsewhere committed to defending their
pegged rates by buying the growing surfeit of dollars, a huge reserve base was created
for global monetary expansion. Inflation everywhere began to accelerate, exposing all the
latent problems of Bretton Woods. The pegged rate system was incapable of coping with
widening payments imbalances, and the confidence problem was worsening as speculators
were encouraged to bet on devaluation of the dollar or revaluations of the currencies of
Europe or Japan. On 15 August 1971, the Richard Nixon administration suspended the
convertibility of the dollar into gold, freeing the greenback to find its own level in currency
markets.
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2.6
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SMITHSONIAN ARRANGEMENT
From August to December 1971, most of the major currencies were allowed to fluctuate.
The US dollar dropped in value against a number of major currencies. Several nations
imposed trade and exchange controls and it was feared that such protective measures might
endanger the institution on international commerce and trade. To mitigate these problems,
the worlds leading trading countries called ‘Group of Ten’ met at the Smithsonian Institute
in Washington DC and formed the Smithsonian arrangement to restore stability of the
system.
The Smithsonian arrangement called for realignment of the par value of major currencies to
conform to their realistic values. The gold parity of the US dollar was changed from $35 to
$38.02 per troy ounce of gold resulting in devaluation of 8.57%. The currencies of surplus
countries were revalued upwards by percentages ranging from 7.4% in respect of the
Canadian dollar to 16.9% in respect of the Japanese yen. The currencies were permitted to
fluctuate over a wider band than in the past. Although a currency was allowed to fluctuate
with in a margin of 2.25% from the central rates without the government intervention, it
could fluctuate by as much as 9% against any currency except the dollar. Since a currency
was permitted to fluctuate up to 2.25% on either side of the central rate, its total fluctuation
against the dollar could be as high as 4.5%.
The purpose of Smithsonian arrangement was to infuse greater flexibility into the par value
system. Unfortunately the arrangement could not be carried for a long term as there was a
tide, as speculation against the weak currencies such as the dollar and the pound against the
strong currency countries such as Germany, France, Japan, Switzerland and Netherlands.
In February 1973, the US government was forced to devalue the dollar by 10% raising the
price of gold to $42.22 per ounce. However, this latent crisis management could not deter
the flow of currency in favour of the European countries and Japan. Finally with a lot
of uncertainty, the exchange markets closed in March 1973 to avert a major crisis in the
international money market. When the markets reopened, all major currencies came on to
float and the Bretton Woods system passed into history.
2.7
EXCHANGE RATE SYSTEM
With the collapse of the Bretton Woods system, six industrialised democracies comprising
the United States, France, Great Britain, Germany, Japan and Italy met at Rambouillet,
France in November 1975 to suggest guidelines for the exchange rate system that could
be acceptable to all the member nations. The Rambouillet declaration envisages closer
international cooperation and constructive dialogue among all countries, transcending
differences in stages of economic development, degrees of resource endowment and
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Table 2.1: Exchange rate arrangements and anchors of monetary policy as of June 30 2004
monetary policy framework
Sl. No
Exchange rate anchor
No. of
Countries
Country List
1
Exchange rate arrangement
where the currency of another
country is the legal tender
9
Ecuador, El Salvador, Kiribati,
Marshall Islands, Micronesia, Fed.
States of Palau, Panama, San
Marino, Timor-Leste
2
Exchange rate arrangements
with no separate legal tender or
they share their own currency
32
Eastern Caribbean Currency
Union(ECCU- 6):
Antigua and Barbuda, Dominica,
Grenada, St. Kitts and Nevis, St.
Lucia, St. Vincent and the
Grenadines
West African Economic and
Monetary Union(WAEMU- 8):
Benin, Burkina Faso, Cte d’Ivoire,
Guinea-Bissau, Mali, Niger,
Senegal, Togo
Central African Economic and
Monetary Community
(CAEMC-6):
Cameroon, Central African
Republic, Chad, Congo, Rep. of
Equatorial Guinea, Gabon
European Area (12)
Austria , Belgium, Finland,
France, Germany, Greece, Ireland,
Italy, Luxembourg, Netherlands,
Portugal, Spain
3
Currency board arrangements
7
Bosnia and Herzegovina, Brunei
Darussalam, Bulgaria,
China-Hong Kong SAR, Djibouti,
Estonia, Lithuania
Continued. . .
International Monetary System
Sl. No
4
Exchange rate anchor
No. of
Countries
Country List
Conventional fixed peg
arrangements
42
Against a single currency (34)
45
Aruba, Bahamas, The Bahrain,
Kingdom of Barbados, Belize,
Bhutan, Cape Verde, China,
Comoros, Eritrea, Guinea, Iraq,
Jordan, Kuwait, Lebanon,
Lesotho, Macedonia, Malaysia,
Maldives, Namibia, Nepal,
Netherlands Antilles, Oman,
Qatar, Saudi Arabia, Seychelles,
Suriname, Swaziland, Syrian Arab
Rep, Turkmenistan, Ukraine,
United Arab Emirates, Venezuela,
Zimbabwe
Against a composite currency (8)
Botswana, Fiji, Latvia, Libyan
Arab Jamahiriya, Malta, Morocco,
Samoa, Vanuatu
5
Pegged exchange rates within
horizontal bands
5
Within a cooperative
arrangement (2)
Denmark, Slovenia
Other band arrangements (3)
Cyprus, Hungary, Tonga
6
Crawling pegs
6
Bolivia, Costa Rica, Honduras,
Nicaragua, Solomon Islands,
Tunisia
7
Exchange rates within crawling
bands
2
Belarus, Romania
8
Managed floating with no
pre-determined path for the
exchange rate
48
Monetary aggregate target:
Bangladesh, Cambodia, Egypt,
Ghana, Guyana, Indonesia, Iran,
Jamaica, Mauritius, Moldova,
Sudan Zambia
Inflation targeting framework:
Czech Rep., Peru, Thailand
Continued. . .
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2.7.1 Independent Floating
In a floating rate regime the exchange rates are determined by the market forces without
intervention by the governments. The major advantage of freely floating exchange regime
is that a country is more insulated from the inflation of other countries.
Let us now examine whether the floating rate regime is superior or the fixed rate regime.
A fixed rate regime does not require hedging of exchange rate risk and hence does not
involve expenditure of resources. However, the exchange rate is not fixed for ever and
does not remain constant for ever. It is realigned time and again to take care of the
changing economic scenario. If the exchange rate is not realigned according to the changes
in the macro economic conditions, there arises a breach between the nominal and the
real exchange rates which hamper the export performance. On the other hand, if and
when realignment is made it involved considerable loss of foreign exchange to the affected
members.
Compared to the fixed regime, in a floating rate regime, the exchange rates tend to change
automatically in line with the changes in the macro economic indicators and there is not
much of a gap in the nominal and the real exchange rates. If a country is hit by inflation,
the home currency depreciates automatically in a floating rate regime. The three major
arguments in favour of floating rate regimes are:
1. The balance of payments on current account disequilibrium will automatically be restored to
equilibrium.
A balance of payments deficit caused by a decrease in the demand for the country’s
exports would lead to a shortage of foreign currency as the amount of foreign currency
available falls–shown by a shift to the left of the supply curve for foreign currency.
This would push up its price from P1 to P2 and hence lead to a depreciation of
the home currency as shown on the next page. The fall in the value of the home
currency causes the price of the country’s exports to decrease and the price of foreign
imports to increase. Consequently the demand for the country’s exports increases
and the demand for foreign imports decreases. The deficit shrinks and the balance of
payments returns to equilibrium.
Thus, in theory, governments need not worry about having to manage their
balance of payments situation. If the exchange rate is allowed to fluctuate freely any
disequilibrium will automatically be restored to equilibrium. The need to resort to
overseas borrowing to finance balance of payments deficits is considerably
minimised. The attention of government can then be focused on achieving other
government objectives such as inflation, unemployment, economic growth and
poverty reduction.
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S2
Price
48
S1
P2
P1
D
Q2
Q1
Quantity
2. Reduces inflationary pressures and international uncompetitiveness.
One argument is that a floating exchange rate will reduce the level of inflation.
Allowing the exchange rate to float freely will ensure that the country’s exports do
not become uncompetitive. This is embodied in the Purchasing Power Parity theory
which is discussed in Chapter 6. A high rate of inflation in the country would tend to
make the country’s exports uncompetitive. Their demand would fall and the foreign
exchange flowing into the country would also fall. The supply curve of available
foreign currency would in turn shift to the left causing its value to increase and the
corresponding value of the currency to depreciate.
3. In the floating rate regime, the home currency is well insulated from the economic shocks
emanating across the globe.
The fact that a country’s economy is well insulated, gives an ample opportunity for the
government to adopt an independent economic policy. For example the Thai Baht was
pegged to the US dollar. During 1980, when the US dollar had depreciated, Thailand
experienced an export boom. But in 1996, when the US dollar had appreciated, the
Thai economy went through turbulence, on account of heavy losses on the trade
account. Analysts claim that had the Thai Baht been on float, it would have remained
insulated by the dollar appreciation.
There are also certain demerits in the floating regime:
1. The Marshall Lerner Condition is not necessarily met
The problem for a developing economy is that the link between the exchange rate
adjustment and the balance of payments improvement is not as straight forward as
the Marshall Lerner Condition suggests. The Marshall Lerner Condition has been
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If the monetary authorities buy and sell currencies in the domestic market to stabilise
the home currency, it is called as direct intervention. On the other hand, if the monetary
authorities stabilise the exchange rate by way of changing the interest rate, it is called as
indirect intervention. When the local government sells foreign currency, its supply increases
and domestic currency appreciates against the foreign currency. On the other hand, if they
purchase foreign currency, its demand increases and the value of the domestic currency will
depreciate against the foreign currency. Such type of intervention by the local governments
and the monetary authorities is permitted by the IMF.
Intervention by the local government and the monetary authorities can move the value of
the home currency up or down through the expectation channel. If intervention is aimed at
preventing long term changes in the exchange rate away from equilibrium, it is referred as
leaning against the wind direction. On the other hand, if the intervention supports the current
trend in the exchange rate already moving towards equilibrium, it is referred as leaning
with the wind expectation. When the monetary authorities support the foreign currency,
speculators step in and buy foreign currency in the expectation that it will appreciate. It
is not that only the local government can intervene in the home currency management.
Sometimes other countries can also intervene to stabilise the home currency. For example,
in 1994, the US government bought large quantities of Mexican pesos to stop the rapid loss
of the peso’s value.
Intervention can be further grouped as stabilising and destabilising intervention. Stabilising
intervention helps in moving the exchange rate towards equilibrium, where as the
destabilising intervention moves the rates away from equilibrium despite the
intervention.
Stabilising intervention causes gain of foreign exchange, while the
destabilising intervention causes loss of foreign exchange. Officially, the Indian rupee has
a market determined exchange rate. However, the Reserve Bank of India trades actively
in the USD/INR currency market to impact the effective exchange rate. Thus, the currency
regime in place for the Indian rupee with respect to the US dollar is a de facto controlled
exchange rate. However, it has to be noted that the RBI intervention in currency markets
is solely to deliver low volatility in the exchange rates, and not to take a view on the rate
or direction of the Indian rupee in relation to other currencies.
Under a managed floating exchange system the central bank holds foreign currency, which
is called foreign exchange reserves. It must be mentioned here that the managed floating
system will be successful only if the government’s implicit range is near the equilibrium,
and it should exist without the central bank interfering. If the central bank makes a habit
of interfering, it runs the risk of losing all its foreign currency reserves. If the government
loses all its foreign currency reserves, it cannot take part in the foreign currency market.
This would result in the country having to revert to a floating exchange system.
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India’s balance of payments problems began in earnest in 1985. Even as exports
continued to grow through the second half of the 1980s, interest payments and imports
rose faster so that India ran consistent current account deficits. The Gulf War led
to much higher imports due to the rise in oil prices. The trade deficit in 1990 was
US $9.44 billion and the current account deficit was US $9.7 billion. Also, foreign
currency assets fell to US $1.2 billion. However, as is the case with the Indo-Pakistan
war of 1965 and the drought during the same period, India’s financial woes cannot be
attributed exclusively to events outside of the control of the government. Since the Gulf
War had international economic effects, there was no reason for India to be harmed
more than other countries. Instead, it further destabilised an already unstable economic
situation brought on by inflation and debt. In July of 1991 the Indian government
devalued the rupee by between 18 and 19 percent. The government also changed its
trade policy from its highly restrictive form to a system of freely tradable EXIM scrips
which allowed exporters to import 30% of the value of their exports. In March 1992
the government decided to establish a dual exchange rate regime and abolish the EXIM
scrip system. Under this regime, the government allowed importers to pay for some
imports with foreign exchange valued at free-market rates and other imports could be
purchased with foreign exchange purchased at a government-mandated rate. In March
1993, the government then unified the exchange rate and allowed, for the first time, the
rupee to float. From 1993 onward, India has followed a managed floating exchange rate
system. Under the current managed floating system, the exchange rate is determined
ostensibly by market forces, but the Reserve Bank of India plays a significant role in
determining the exchange rate by selecting a target rate and buying and selling foreign
currency in order to meet the target.
2.7.3
Currency Pegging
Some countries use a pegged exchange rate management in which the home currency value
is pegged to a foreign currency or to some unit of account. While the home currency’s value
is fixed in terms of the foreign currency to which it is pegged, it moves inline with that
currency against other currencies. A fixed exchange rate is usually used to stabilise the
value of a currency, with respect to the currency or the other valuable it is pegged to.
Pegging a currency to another currency facilitates trade and investments between the two
countries, and is especially useful for small economies where external trade forms a large
part of their GDP. Pegging is also used as a means to control inflation. However, as the
reference value rises and falls, so does the currency pegged to it. In addition, a fixed
exchange rate prevents a government from using domestic monetary policy in order to
achieve macroeconomic stability.
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53
With the Mint Act of 1792, the dollar was pegged to silver and gold at 371.25 grains
(1 grain = 64.79891 milligrams) of silver and 24.75 grains of gold (15:1 ratio). In 1900, the
bimetallic standard was abandoned and the dollar was defined as 23.22 grains (1.505 g)
of gold, equivalent to setting the price of 1 troy ounce of gold at $20.67. In 1934, the gold
standard was changed to 13.71 grains (0.888 g), equivalent to setting the price of 1 troy
ounce of gold at $35.
In 1898, the Indian rupee was tied to gold standard through the British Pound. Prior to this,
the Indian rupee was a silver coin, which made the rupee to be pegged at a value of 1 shilling
4 pence (i.e., 15 rupees = 1 pound). In 1920, the rupee was increased in value to 2 shilling
(10 rupees = 1 pound). However, in 1927, the peg was reduced to 1 shilling and 6 pence
(13.33 rupees = 1 pound). This peg was maintained until 1966, when the rupee was
devalued and pegged to the U.S. dollar at a rate of 7.50 rupees = 1 dollar and the rupee
became equal to 11.4 British pence. This peg lasted until the U.S. dollar was devalued in
1971.
Some countries like Malaysia and Thailand had pegged their currency’s value to the dollar.
Pegging to a single currency is not advisable if the country’s trade is diversified. In such a
case pegging to a basket of currencies is advised. But if the basket is very large, pegging to
multi currencies is not advisable, as it will prove to be a costly affair. One another method
of pegging is through the SDRs. Pegging to SDR is not much as SDRs are themselves
pegged to a basket of multi currencies. Furthermore, pegging to SDRs in not an attractive
proposition in views of its declining value.
2.7.4
Crawling Peg
Under this system a country pegs its currency to the currency of another country but allows
the parity value to change gradually over time to catch up with the challenges imposed by
the market. Hence crawling band can be defined as hybrid of fixed rate system and a flexible rate
system. Crawling pegs are different from fixed rates on account of their flexibility in terms
of the exchange rate movement. They also differ from the floating rate system because
there is a limit with regard to their maxima movement.
The basic behind the crawling peg system is that there exists an exchange rate that
equilibrates the international supply and demand for a particular currency. However,
the possibility that the economic uncertainties may generate fluctuations in the supply
and demand over short periods suggests that the movement of exchange rate should
be restrained. To accomplish this, countries would continue to hold the forex market
rate within a predetermined range during any business day by sale and purchase of
international reserves. However, the parity would be allowed to change from day to
day by a small margin. The actual formula for changing the peg will have to be determined
International Monetary System
2.7.6
55
Snake and the Worm
Following the collapse of the Bretton Woods system on August 15, 1971, the EEC countries
agreed to maintain stable exchange rates by preventing exchange fluctuations of more than
2.25%. This arrangement was called European snake in the tunnel because the community
currencies floated as a group against outside currencies such as the dollar. Commonly
called as the snake, it was one of the best known pegged exchange rate arrangements by the
European countries. The snake was difficult to maintain and the market pressure caused
some currencies to move outside their established limits. By 1978, the snake turned into a
worm with only German mark, Belgian franc, Dutch guilder and the Danish kroner as part
of the arrangement. Finally the worm was realigned with the launching of a new effort by
the European Union to achieve monetary cooperation. By March 1979, the EC established
European Monetary System, and created the European Currency Unit (ECU).
2.7.7
Currency Boards
In a currency board arrangement the country does not have a central bank, rather it has
a currency board that links the domestic currency to the foreign exchange holding. In
other words, a currency board is a system for pegging the value of the local currency to
a currency of another nation and buys and sells the foreign currency reserves in order to
maintain the parity value. For a currency board to be successful, at marinating the value of
the local currency to some other specified currency, it must have credibility in its promise
to maintain the exchange rate. If there is a downward pressure on the local currency, the
central bank must intervene to defend the currency value. If the speculators are of the view
that the currency board cannot support the specified exchange rate, they may take positions
that will generate profits if the currency board ceases its support of the local currency. As
the currency board has only limited functions and powers as compared to the central bank,
it cannot frame a discretionary monetary policy like the other central banks.
2.8
EUROPEAN MONETARY SYSTEM
The Economic and Monetary Union (EMU) is an important chain in the west European
economic cooperation that began in the late 1950s. Even though the European Common
Market (ECM) became a success over the years, the monetary cooperation between the
member countries was not successful. Under the Jenkins European commission, most
nations of the European Economic Community (EEC) linked their currencies to prevent
large fluctuations relative to one another. As a result, the spot spread between the parties
of any two member currencies of ‘Snake’ was restricted to +/ − 1.25% that was equivalent
to one half of the fluctuation band prescribed under the Smithsonian arrangement (tunnel).
There was provision for intervention in preventing the snake from leaving the tunnel.
The main objective of the arrangement was to narrow the fluctuation margin among the
International Monetary System
57
Eleven of the fifteen European Union member states initially qualified to join the EMU
in 1998. Those states were Austria, Belgium, Finland, France, Germany, Ireland, Italy,
Luxembourg, the Netherlands, Portugal, and Spain. As part of the EMU, these eleven
countries now make up the world’s second-largest economy, after the United States. By
using the flexible definitions Belgium and Italy meet the deficit related criteria. Two
countries, Greece and Sweden, failed to meet the convergence requirements in time to join
the EMU in the first round. Sweden failed to satisfy two of the conditions: laws governing
Sweden’s central bank were not compatible with the Maastricht Treaty and the currency
exchange rates in Sweden were not sufficiently stable for the previous two years. Greece
failed to meet all the requirements. These countries would be reevaluated every two
years to determine if they meet the requirements for joining the EMU. The two remaining
members of the European Union, the United Kingdom and Denmark, chose not to join the
EMU immediately. Both of these countries made provisions in the Maastricht Treaty that
preserved their right not to join the EMU. To ensure stable currency exchange rates among
all the EU member states, the currencies of those states that did not qualify to join the EMU
or that chose not to participate in the EMU initially were linked to the single European
currency of the EMU, the euro, by a new currency exchange rate mechanism, known as
ERM 2.
ECU was a composite monetary unit made up of a basket of specified amounts of the
currencies of the eleven EU member countries. Each specified amount was determined
on the basis of the nations GDP and the foreign trade. One ECU was equivalent to the
sum of the fixed amount of such currencies. The ECU is a unit of account for the European
communities. It is used for the EC budget, in the accounts and transactions of the European
Investment Bank, the European Development Fund, and the financial operations of the
European Coal and Steel Community. The ECU also plays a significant role in the common
agricultural policy of the EC, in particular for denominating agricultural prices. The ECU
plays a central role in the exchange rate mechanism of the EMS. It is used as a numeraire
for expressing central rates, as the unit of denomination of credit extended through the
European Monetary Cooperation Fund (EMCF) in connection with the EMS intervention
mechanism and as a reference unit for operation of the EMS divergence indicator. The
tables show the composition of the ECU basket at different times during the existence of
the ECU.
The EMS was a limited-flexible exchange rate system that defined bands in which the
bilateral exchange rates of the member countries could fluctuate. The bands of fluctuation
were characterised by a set of adjustable bilateral central parities and margins that defined
the bandwidth of permissible fluctuations. This set of parities was called a parity grid as
it defined parities for all combinations of the ECU constituent currencies. The borders of
the fluctuation bands were described by the upper intervention point and lower intervention
point. Typically, the bandwidths were 2.25% to each side, with a wider margin for the
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Table 2.2: ECU basket from 13-3-1979 to 16-9-1984
13-Mar-1979 through 16-Sep-1984
ISO
Currency
BEF
DEM
DKK
FRF
GBP
IEP
ITL
LUF
NLG
Belgian Francs
German Marks
Danish Krones
French Francs
British Pounds
Irish Punts
Italian Lira
Luxembourg Francs
Dutch Guilders
*
Value
Weight (%)
3.80
0.828
0.217
1.15
0.0885
0.00759
109
(*)
0.286
9.64
32.98
3.06
19.83
13.34
1.15
9.49
(*)
10.51
The Belgian and Luxembourg francs were in a currency
union. Thus, the ECU basket values are combined and
shown only for Belgium. Weights are evaluated at central
parities on March 13, 1979.
Table 2.3: ECU basket from 17-9-1984 to 21-9-1989
17-Sep-1984 through 21-Sep-1989
ISO
Currency
BEF
DEM
DKK
FRF
GBP
GRD
IEP
ITL
LUF
NLG
Belgian Francs
German Marks
Danish Krones
French Francs
British Pounds
Greek Drachmas
Irish Punts
Italian Lira
Luxembourg Francs
Dutch Guilders
*
Value
Weight (%)
3.85
0.719
0.219
1.31
0.0878
1.15
0.00871
140
(*)
0.256
8.57
32.08
2.69
19.06
14.98
1.31
1.20
9.98
(*)
10.13
Weights are evaluated at central parities on September 17,
1984.
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The other aspect of the exchange rate mechanism related to the rules governing the
divergence indicator. A divergence limit was set at 75% of 2.25% that is about 1.6875%.
In case of a particular member currency, this depended on its weight in the ECU basket
of currencies. As per Table 2.4, the Belgian Francs had a weight of 8.183%. Hence, its
divergence limit can be calculated as:
Divergence limit = (100 − 8.183) × 1.6875% = 1.5494%
Thus, the moment the Belgian Francs fluctuated to 1.5494%, it was subject to intervention
under the provisions of the divergence indicator. In the event the intervention failed, the
central rates were realigned. From 1979 to 1999 there were a number of realignments. The
EMS was severely disrupted by the aggressive storm that hit the European currency markets
in September and October 1992, following the difficulties over ratifying the Maastricht
Treaty in Denmark and France. The British pound and the Italian lira left the exchange
rate mechanism in September 1992, and in November of the same year the Spanish peseta
and the Portuguese escudo were devalued by 6% against the other currencies. In January
1993, the Irish pound was devalued by 10%; in May the peseta and the escudo were again
devalued. Finally, in August 1993, the fluctuation band was widened to 15%. However,
Germany and the Netherlands stuck to the original fluctuation band of ±2.25%.
Exchange rate stability is the main objective of EMU. But this objective could not be achieved
over the years owing to the incongruent and dissimilar economic performance in different
member countries. It was observed that disparity in macroeconomic performance could be
avoided through convergence of economic policies among the member countries. In 1989,
the committee for the study of Economic and Monetary Union put forth a three stage plan
popularly called as the Delors plan.
On the basis of the Delors Report, the European Council decided that the first stage of
realisation of economic and monetary union should begin on 1 July 1990. On this date,
in principle, all restrictions on the movement of capital between the member states were
abolished. The members allocated 10% of their foreign exchange reserve to create the
European Reserve Fund (ERF) that could help intervention in the forex market. The
establishment of the European Monetary Institute (EMI) on 1 January 1994 marked the
start of the second stage of EMU and with this the Committee of Governors ceased to
exist. The EMI’s transitory existence also mirrored the state of monetary integration within
the community. The EMI had no responsibility for the conduct of monetary policy in the
European Union and this remained the preserve of the national authorities nor had it any
competence for carrying out foreign exchange intervention.
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61
The two main tasks of the EMI were:
1. To strengthen the central bank cooperation and monetary policy co-ordination
2. To make the preparations required for the establishment of the European System
of Central Banks (ESCB), for the conduct of the single monetary policy and for the
creation of a single currency in the third stage.
In December 1996, the EMI presented its report to the European Council, which formed
the basis for the new exchange rate mechanism (ERM II), which was adopted in June 1997.
It was also decided that the current ERM bilateral central rates of the currencies of the
participating member states would be used in determining the irrevocable conversion rates
for the euro. 1st June 1998 marked the establishment of the European Central Bank (ECB).
The ECB and the national central banks of the participating member states constituted the
Euro system to formulates and define the single monetary policy in Stage Three of EMU.
With the establishment of the ECB on 1 June 1998, the EMI had completed its tasks. In
accordance with Article 123 of the Treaty establishing the European Community, the EMI
went into liquidation on the establishment of the ECB.
On 1st January 1999, the third and final stage of EMU commenced with the irrevocable fixing
of the exchange rates of the currencies of the 11 member states initially participating in the
Monetary Union and with the conduct of a single monetary policy under the responsibility
of the ECB. The number of participating member states increased to 12 on 1st January 2001,
when Greece entered the third stage of EMU. Slovenia became the 13th member of the euro
area on 1st January 2007, followed one year later by Cyprus and Malta and by Slovakia
on 1st January 2009. On the day each of the country joined the euro area, its central bank
automatically became part of the Euro system.
The period between 1993 and 1999 saw a distinct return to normal. In 1996, all the
participating currencies including the lira, now reincorporated in the ERM, and the
Austrian and Finnish currencies which entered in 1995 and 1996 had moved back within
the original margin of fluctuation of ±2.25%. The primary goal of the EMS, namely to
create a zone of internal and external monetary stability, based upon the Exchange Rate
Mechanism, was achieved. The participating countries were spared the instability that
characterised the international monetary system during the 1980s. The 1992-93 crisis was
finally overcome and after nearly twenty years of effort, stability prevailed. The monetary
discipline led to economic convergence with reduction of inflation rates and alignment of
interest rates.
The private use of the ECU, as opposed to its ‘official’ use between EMS central banks grew
considerably. The ECU was increasingly used in international bond issues by community
institutions, member state governments and companies. It became a major international
financial instrument, overtaking most of its component currencies. There was also a
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63
there were no notes or coins, but all commercial transactions could be executed through
electronic transfers and other forms of payment. The currency of the member countries
also existed side by side. The exchange ratio between euro and other non-member currency
was to be determined by the market forces. Initially one euro was equal to USD 1.1665. The
participating countries comprise almost 20% of the global gross domestic product, which
is similar to the level of production in the United States. The exchange ratio between the
euro and the member country currency is given in Table 2.5.
In January 2002, euro bank coins and notes were issued and by the end of February 2002,
euro completely replaced the members’ currency. The new currency became the legal
tender. Following table shows the date on which the members’ currency was replaced by
euro.
Table 2.6: Date on which the member currencies was replaced by euro
Country
Currency Name
Converted by
Germany
German Mark
Dec. 31, 2001
The Netherlands
Dutch Guilder
Jan. 28, 2002
Ireland
Irish Punt
Feb. 9, 2002
France
French Franc
Feb. 17, 2002
Austria
Austrian Schilling
Feb. 28, 2002
Belgium
Belgian Franc
Feb. 28, 2002
Finland
Finnish Markka
Feb. 28, 2002
Greece
Greek Drachma
Feb. 28, 2002
Italy
Italian Lira
Feb. 28, 2002
Luxembourg
Luxembourg Franc
Feb. 28, 2002
Portugal
Portuguese Escudo
Feb. 28, 2002
Spain
Spanish Peseta
Feb. 28, 2002
Slovenia
Slovenian Tolar
Jan. 14, 2007
Cyprus
Cypriot Pound
Jan. 31, 2008
Malta
Maltese Lira
Jan. 31, 2008
Slovak Republic
Slovak Koruna
Jan. 16, 2009
Now there is a single currency thought out the EMU and that is undoubtedly the euro.
Euro bank notes are being issued by both the ECB and the National central banks with total
transparency and cooperation between one another. Out of the total issue, 8% are allocated
to the ECB and the balance 92% to the National central banks. The euro coins are minted
by the National authorities.
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2.10
PROSPECTS OF €
Despite the difficulties involved in making any quantitative assessment of the effects of
the euro, it is possible to make a few general qualitative observations. First, the technical
changeover to the new currency was highly successful. This complex task, involving
several changes at central banks, stock exchanges, authorities and thousands of private
institutions, was carried out without any major glitch. This clearly reflects the commitment
and professionalism of all member nations involved in this gigantic exercise. Second,
banks and other market participants swiftly adapted to the new environment. Before the
introduction of the euro, there were concerns about how rapidly and smoothly the national
money markets would integrate. An integrated euro area money market is a precondition
for the common monetary policy, so as to eliminate interest rate differentials across the
member nations. Third, the target system - an integral part of the technical infrastructure
has contributed to the rapid integration of the money market and links all the Real Time
Gross Settlement (RTGS) payments in the EU. Fourth, the successful execution of the single
monetary policy has dispelled any criticism that the EUs organisational setup would be
complex and inefficient. Fifth, the successful changeover to the euro and the decisive
implementation of monetary policy seem to have contributed to a clear strengthening of
the Euro system’s credibility. Sixth, the euro has established itself as one of the most
important currencies in the forex market. EUR/USD trading is the most active and liquid
segment of the forex market at the global level and provides a wide range of instruments
and substantial hedging possibilities.
One very important structural effect is that euro is expected to lead to improved
competition and increased price transparency in the markets for goods and services.
These micro-economic effects will have a great impact on the financial services. In most
European countries, the financial markets have traditionally been rather shallow, with
few participants and a narrow set of financial instruments on offer. A high degree of
segmentation and a lack of cross-border competition have implied relatively low trading
volumes, high costs and a reluctance to introduce innovative financial instruments. The
segmentation was not a function of exchange rate borders alone. Tradition has also played a
role: heterogeneous practices, national regulations and differing tax regimes have been and
still are obstacles to full integration. The introduction of the euro and the disappearance of
forex risk have triggered increasing cross-border competition and have provided incentives
for the harmonisation of market practices. The cross-border integration of bond markets
in the euro area is progressing at a slower pace, as is also true of equities and derivatives
markets. Euro area market participants increasingly perceive similar instruments traded
in the different national markets to be close substitutes. This holds true, in particular, for
bonds issued by the euro area governments, where a considerable degree of cross-border
substitutability has already been achieved.
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transactions, including transactions carried out outside the euro area. With regard to the
invoicing of international trade, estimates suggest that in the early 1990s about one half of
global exports were invoiced in US dollars; one third in euro area currencies and only 5%
in Japanese yen.
In a medium-term perspective, international trade flows both between the euro area and
foreign countries, as well as euro-denominated trade between non-euro areas residents are
likely to increase. Nevertheless, at the global level it is likely to take time for the euro
to attain sufficient importance to rival the US dollar as a trading currency. The value of
US dollar-denominated international trade is nearly four times higher than that of US
exports. As this ratio indicates, the use of the US dollar as an international currency on the
goods and financial markets is not so much related to trade shares as to the convenience of
using one standard currency.
Given the international importance of the euro, it is not surprising that the development
of the euro exchange rate has attracted a great deal of attention. The prospect of achieving
more stable conditions in the forex market globally, markedly deeper and more efficient
financial markets in Europe and increased cross-border competition are likely to effect
the international financial system as a whole. The structural implications of the euro are,
of course, particularly important for the neighbouring countries, whose economies and
financial markets are generally closely linked to those of the euro area.
The implementation of the single monetary policy has been successful, which has
contributed to a further strengthening of the Euro system’s credibility. The use of a single
currency is clearly promoting the integration of financial markets in the euro area and a
re-shaping of the European banking sector. The euro has established itself as one of the
world’s leading currencies for investment and trade. Given the international importance of
the euro, the long-term success of Economic and Monetary Union is of global importance.
At present there are excellent prospects for achieving sustainable non-inflationary growth
in the euro area. The expected acceleration of growth does not seem to pose a threat
to price stability for the time being. Although rising oil prices may lead to a gradual
picking-up of the inflation rate over the coming years, price pressures generally remain
subdued in the euro area. In this context, it is important to underline that the Euro system’s
firm commitment to internal price stability should in the long run also be reflected in the
external value of the currency.
International Monetary System
67
Table 2.7: EUR/USD exchange rate-historical data
Date
Exchange Rate
2010-06-14
2010-05-31
2010-04-30
2010-03-31
2010-02-26
2010-01-29
2009-12-31
2009-12-14
1.2249
1.2307
1.3315
1.3479
1.3570
1.3966
1.4406
1.4647
Nevertheless, the euro area economy is still suffering from structural weaknesses. In
particular, the improved cyclical conditions are not sufficient to solve the problem of
unacceptably high unemployment in the euro area. In order to tackle this problem,
structural reforms are imperative. It would be beneficial to take advantage of the improved
cyclical situation in the euro area for the implementation of structural reforms aiming at
enhancing the efficiency of the labour markets in the euro area.
The experience of the euro has generally been not very exciting. From being equal to
US $1.1665 in the beginning, it gradually slipped against the US dollar reaching to a low
of US $0.88 at the end of 2001. The reasons for the decline were attributed to large current
account deficit in the EMU than in the US and falling rate of industrial production in the
EMU as compared to the US. The euro is now hovering around a exchange rate of US $1.22.
Since January 1999
Min = 0.8252 (26 Oct 2000); Max = 1.599 (15 Jul 2008)
Jan 2010
Jan 2009
Jan 2008
Jan 2007
Jan 2006
Jan 2005
Jan 2004
Jan 2003
Jan 2002
Jan 2001
Jan 2000
Jan 1999
Exchange rate
EUR/USD Exchange rates: Since Jan 1999 (Frankfurt)
1.59990
1.44424
1.28948
1.13472
0.97996
0.82520
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Last 365 days
Exchange rate
EUR/USD Exchange rates: Last 365 days (Frankfurt)
1.5120
1.4484
1.3849
1.3213
1.2578
1.1942
01 Jun
01 Jul
03 Aug 01 Sep 01 Oct 02 Nov 01 Dec 04 Jan 01 Feb 01 Mar
Min = 1.1942 (8 Jun 2010); Max = 1.512 (3 Dec 2009)
01 Apr 03 May 01 Jun
Last 30 days
Exchange rate
EUR/USD Exchange rates: Last 30 days (Frankfurt)
1.2397
1.2386
1.2275
1.2164
1.2053
1.1942
14
17
18
19
20
21
24
25
26
27
28
31
01
02
03
Min = 1.1942 (8 Jun 2010); Max = 1.2497 (21 May 2010)
04
07
08
09
10
11
14
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2.12
QUESTIONS
1. What is a gold standard? How does it differ from the gold bullion standard?
2. Gold standard provided price stability besides automaticity in exchange rates and
BOP adjustments, explain.
3. What were the reasons for the decline of the gold standard?
4. What were the reasons for the breakdown of the Bretton Woods System? Explain.
5. Enumerate the difference between dollar shortage and dollar glut.
6. Smithsonian arrangement was to infuse greater flexibility into the par value system,
explain.
7. Do you agree that floating rate regime is a better option than the fixed exchange rate
regime? Explain.
8. What were the reasons for India devaluing its currency in the year 1966?
9. What are the three major arguments in favour of floating rate regimes? Explain.
10. The problem for a developing economy is that the link between the exchange rate
adjustment and the balance of payments improvement is not as straight forward as
the Marshall Lerner Condition suggests; why it is so?
11. How does a clean float differ from a dirty float?
12. What are the differences between direct intervention and indirect intervention?
13. Under the current system of managed floating has the exchange rate movements been
excessive? Explain.
14. How does a crawling peg function?
15. What are the factors to be considered before implementing the currency band system?
16. What do you understand by ‘Snake in the tunnel’?
17. Can the currency boards perform the role of a central bank, If not why?
18. Explain briefly the following:
(a) European Monetary System (EMS)
(b) Exchange Rate Mechanism (ERM)
(c) European Currency Unit (ECU)
International Monetary System
19. Write short note on the Maastricht Treaty.
20. Explain the three stages of Delors Plan.
21. Define a parity grid and a divergence indicator.
22. What are the main tasks of the EMI?
23. How can a central bank use direct intervention to change the value of a currency?
24. If euro is worth $1.10 what is the value of a dollar in euros?
25. Write a note on the prospects of the euro.
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International Monetary System
2.14
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CASE STUDIES
Case Study 2.14.1
Devaluation of the Indian Rupee
Independent India devalued its currency on two occasions once in 1966 and the second
time in 1991. Both were preceded by large fiscal and current account deficits and by
dwindling international confidence in India’s economy. Inflation caused by expansionary
monetary and fiscal policy depressed exports and it led to continuous trade deficits. In
each case, there was a large adverse shock to the Indian economy. Further the policy of the
Indian government was to follow the Soviet model of foreign trade by viewing exports as
a necessary evil whose sole purpose was to earn foreign currency with which to purchase
goods from abroad that could not be produced at home. As a result, there were inadequate
incentives to export and the Indian economy missed out on the gains from comparative
advantage. 1991 represented a fundamental paradigm shift in Indian economic policy and
the government moved toward a freer trade stance.
Questions
1. What was wrong in the Government of India’s policies? Could these two major
financial crisis been averted by the Government of India. Please Explain.
2. Given the fact that the household saving rate in India is quite high, should the blame
for India’s balance of payments problems rest with the government for its inability
to control its own spending.
3. By borrowing from the Reserve Bank of India and, therefore, just printing money,
the Government could finance its extravagant spending through an inflation tax. Do
you concur that engaging in inflationary economic policy in conjunction with a fixed
exchange rate regime is a destructive policy.
4. Do you agree had India followed floating rate system instead, the rupee would have
been automatically devalued by the market and India would not have faced such
financial crises. Enumerate your views.
International Monetary System
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2.50 to under 3.80 to the dollar. In 1998, the output of the real economy declined plunging
the country into its first recession for many years.
Questions
1. Was there a deliberate attempt by the US to destabilise the ASEAN economies or was
it an failure of ASEAN countries?
2. To fight the recession, the Malaysian Government moved the ringgit from a free float
to a fixed rate and imposed capital controls. Was this a right move, comment?
3. Explain how the Asian crisis would have affected the returns to a US based MNC
from investing in the Asian Stock Markets as a means of international diversification.
4. What lessons can be learnt from the crisis?