Class Notes 3 INTERNATIONAL MONETARY SYSTEMS Definition: International monetary system refers to the set of policies, institutions, practices,

regulations, and mechanisms that determine the rate at which one currency is exchanged for another.

I. ALTERNATIVE EXCHANGE RATE SYSTEMS FLOATING RATE SYSTEMS Exchange rates are determined by the interaction of currency demand and supply, without direct intervention by government authorities. As exchange rates change continuously, it is difficult to know how much a future foreign currency cash flow will be worth. What influences the supply and demand for foreign currencies?

MANAGED FLOAT SYSTEMS Many countries, such as the U.S. and Japan, with floating currencies have attempted, via central bank intervention, to smooth out exchange rate fluctuations. Such a system of managed exchange rates is called a managed float. Three categories of central bank intervention: 1. Short-term: Smoothing out daily fluctuations 2. Intermediate-term: "Leaning against the wind" 3. Unofficial pegging TARGET ZONE ARRANGEMENT Exchange rates are maintained within a specific margin around agreed-upon, fixed central exchange rates. European Monetary System (EMS) The EMS began operating in March 1979. Its purpose is to foster monetary stability in the European Community (EC). European Currency Unit (ECU)

 A currency unit which is a weighted average of a fixed amounts of currencies in the region. The weights are determined by the relative strengths of each country. The ECU functioned as a unit of account, as a means of settlement, and as a reserve asset for the members of the EMS. Exchange Rate Mechanism (ERM) Each currency has an agreed upon central rate denominated in ECU. The central rate can be adjusted under appropriate circumstances. Bilateral cross-rates are determined from the central rates.

Central banks try to limit exchange rate fluctuations around the central rates. ECU to EURO () On January 1, 1999, the member states of the EU initiated the European Monetary Unification (EMU), the establishment of a single currency for Europe. Euro notes and coins will not begin to circulate until January 1, 2002.

From January 1 until July 1, 2002, euro currency will circulate jointly with national monies and both may be used for cash transactions. After July 1, 2002 the national monies will no longer be a legal tender and only euros may be used. What have we learned from the EMS, regarding the problems that a target-zone system is likely to encounter? Maintenance of a target-zone arrangement requires close coordination of macroeconomic policies. FIXED RATE SYSTEMS Central banks must buy or sell the currency in order to maintain the exchange rate at a determined level (in practice, within a narrow pre-determined range). When will a central bank buy foreign exchange? If fixed exchange rates can be maintained, these systems are attractive because the value of foreign currency cash flow is known. Problems Fixed rates forge a direct link between domestic and foreign inflation rates.

 When exchange rate corrections arrive, they are usually large. When the government cannot sustain the fixed rates, the currency is either devalued or revalued. Devaluation of a currency, in its narrow and semantically correct sense, refers to a drop in the foreign exchange value of a currency that is pegged to gold or to another currency. In other words, the par value is reduced. The opposite of devaluation is revaluation. Fixed versus Flexible exchange rates The key arguments for flexible exchange rates rest on (i) easier external adjustments and (ii) national policy autonomy. As long as the exchange rate is allowed to be determined according to market forces, external balance will be achieved automatically. With flexible exchange rates, government can use its monetary and fiscal policies to pursue whatever economic goals it chooses. Under a fixed rate regime, the government may have to take contractionary (expansionary) monetary and fiscal policies to correct the BOP deficit (surplus) at the existing exchange rate. A possible drawback of a flexible exchange rate regime is that exchange rate uncertainty may hamper international trade and investment, whereas fixed rates provide stability in international prices for the conduct of trade. A good (or ideal) international monetary system should provide (i) liquidity, (ii) adjustment, and (iii) confidence. II. HISTORY OF THE INTERNATIONAL MONETARY SYSTEMS

BRETTON WOODS AGREEMENT Bretton Woods was named after the site at which it took place. The agreement lasted from 1946 until 1971. Under the Bretton Woods System, the U.S. dollar was convertible into gold at $35/ounce. Other currencies were pegged to the US$ or gold. Example: The German DM was set equal to 1/140 th of an ounce of gold, or about $0.25. Under this form of gold exchange standard, only the U.S. dollars were convertible

into gold at the official par value. Other member nations were not required to exchange their currency for gold, but pledged to intervene in the currency markets if their currency moved more than 1% from its official rate. The Bretton Woods conference created two well-known institutions to implement this fixed-rate system. They are the International Monetary Fund (IMF) and the World Bank.

POST BRETTON WOODS (Exhibit 3.1) After the 1973-74 Oil Crisis (270-310 /$) US: High inflation, stagnant economy. Growing government budget deficit. Current account deficit. High inflation rate, but fell quickly. Current account surplus starts to increase due to weak yen.

Japan:

1977-78 (260-210 /$) US: Fed switched its policy to stabilizing money supply than interest rates. Growing government deficit leads to higher interest rates.

1978-83 (around 220-250 /$) Reaganomics: Lower inflation and high interest rates. Capital inflow due to high interest rates and strong dollar.

Japan: More current account surplus due to the strong dollar (cheap yen). 1985-87 (250 to 120 /$) US: Stagnant economy and the sinking dollar. Slow growth relative to other economies. Government deficit.

Japan: Period of a bubble High yen, high stock market, high interest rates 1988-90 (120-150 /$), 1990-94 (130-100 /$), 1995 (100-80 /$) Japan: Burst of the bubble, stagnant economy, even higher yen. 1996: Back to around 100, and $ up to 120 in January 1997 and 146 in June 1998.

III. THE INTERNATIONAL MONETARY FUND The IMF is the key institution in the current international monetary system. The IMF was created to administer a code of fair exchange practices and provide compensatory financial assistance to member countries with BOP difficulties. Membership and quotas To carry out its task, the IMF was originally funded by each member subscribing to a quota based on expected post-World War II trade patterns. Relative size of quotas is important as a determinant of voting power. The industrialized countries have always maintained voting control because they supply most of the quotas. In addition to its quota resources, the IMF has access under certain circumstances to funds that it borrows in the worlds capital markets. Special Drawing Rights The SDR is an international reserve asset created by the IMF to supplement existing foreign exchange reserves. Defined initially in terms of a fixed quantity of gold, the SDR has been redefined several times. It is currently the weighted value of currencies of the five IMF members having the largest exports of goods and services. Individual countries hold SDRs in the form of deposits in the IMF. These holdings are part of each countrys international monetary reserves.

IV.

THE CASE OF HONG KONG A fixed exchange rate system against the US dollar, at US$1=HK$7.80, established in 1983.

CURRENCY BOARD SYSTEM Definition: A currency board is a system aimed at establishing a fixed exchange rate between the domestic currency and an external currency. A currency board fixes its exchange rate by making a commitment to exchange domestic currency for foreign currency at a pre-specified rate. Local currency in circulation, therefore, needs to be at least 100% backed by foreign reserves. Local notes are issued only when there is a demand for foreign exchange to be converted into the local currency. CB reserves are invested in low-risk assets mainly denominated in the reserve currency, earning interest. Under a traditional currency board system, interest rates bear the burden of adjusting to market forces. The monetary base is completely flexible. A capital outflow (which pushes down the value of a floating domestic currency) causes a contraction in the money supply and pushes up interest rates. Higher interest rates, in turn, induce capital inflow, reversing the original outflow, and stabilizing the exchange rate. The possibilities of arbitrage imply that interest rates would not persistently deviate much from those applicable to the reserve currency.

Currency Attack: In the case of a currency attack, the monetary base will have to shrink under the currency board system and may easily lead a liquidity crunch (of local currency) and banking crisis. This happened in Argentina in 1995. But Argentina was able to hold onto the peg to the US$.

THE HONG KONG CURRENCY BOARD HK dollar is fully backed by the US dollar. [Reserve US$ held by the Hong Kong Monetary Authority] [ Promised exchange rate HK$7.80/US$] = [Level of monetary base in HK$] With a currency board system, HKMA never runs out of foreign currency, even if everyone who held HK$ wanted to convert to US$, i.e., a currency attack. Thus, it is easy to avoid currency devaluation. In fact, HK Government has far more US dollar asset than the HK$ monetary base converted to US$. The US$ asset is technically managed by the Exchange Fund. When the note-issuing banks (NIBs) need to issue HK$ notes, they submit US dollars to the Exchange Fund (EF) in return for non-interest-bearing Certificates of Indebtedness (CIs) at the fixed rate of HK$7.80:US$1.

Today, we have more developed and deep monetary systems, so that currency in circulation no longer means money supply, and it is the interbank balance, not the total money supply, that determines interest rates. Modern currency boards require the interbank clearing balance to be backed by foreign exchange reserves in addition to the stock of currency in circulation. Capital outflow (downward pressure on HK$) B i capital inflow (HK$ strengthens) Capital inflow (upward pressure on HK$) B i capital outflow (HK$ weakens)

Before 1988: HongkongBank had all the control! The HongkongBank (HKB) assumed the role of clearing house for all commercial banks. Interbank payments were settled at the end of each working day at the HKB. The settlement system was characterized by a three-tiered structure: (i) Management Bank of the Clearing House of the Hong Kong Association of Banks, HKB; (ii) 10 Settlement Banks; and (iii) 159 Subsettlement Banks. Each bank kept a non-interest bearing clearing account with a respective bank one level up the hierarchy. Negative balances were penalized. The HKB had the unique ability to influence the interbank market and, in turn, interest rates.

July 1988: Accounting Arrangements The Accounting Arrangements agreed between the EF and the HKB required HKB to maintain a Balance with the EF, equivalent to that of its net clearing balance (NCB) the net amount of funds that all other banks place with it. The Balance is non-interest bearing and represents a level of interbank liquidity. NCB > Balance HKB pays penalty interest to the EF. NCB < Balance There is an opportunity cost to HKB. The Accounting Agreements transferred control over interbank liquidity from the HKB to the EF. Note: A small open economy with a fixed exchange rate cannot have an independent monetary policy. HKs money supply is determined by its balance of payments. The EF can influence interbank liquidity and interest rates, but not the money supply.

March 1990: Exchange Fund Bills The EF began issuing short-term EF Bills in March 1990 and EF Notes in May 1993, as instruments for banks to manage their liquidity. Banks enter into swap or repurchase agreements with the EF to obtain HK$ liquidity when needed. The Bills and Notes do not exist as physical securities but only as book entries. All transactions are paperless.

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June 1992: Liquidity Adjustment Facility (LAF) The LAF, HKs version of a discount window, operated daily after the close of the HK$ interbank market. Overnight liquidity assistance could be obtained through entering overnight repo (repurchase agreements) of eligible securities. If banks had surplus funds in their settlement accounts (which do not earn any interest), they had the incentive to lend the funds to the HKMA through the LAF at the LAF Bid Rate (which stood at 4% just before it was abolished in September 1998). Other banks that found themselves with a negative balance, could borrow at the LAF Offer Rate (7% until September 1998). The LAF Bid and Offer Rates were the benchmark interest rates, and were kept close to the US Federal Funds Rate. In theory, HKs overnight HIBOR should stay within the LAF Bid and Offer Rates.

April 1993: The Establishment of the HKMA The HKMA was formally established on April 1, 1993, merging the Office of the Exchange Fund (responsible for the management of foreign exchange reserves), the Monetary Affairs Branch of the Government and the Office of the Commissioner of Banking.

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December 1996: Implementation of the RTGS System The Real Time Gross Settlement (RTGS) system was put in place in December 1996. Interbank clearing switched from HKB to the Hongkong Interbank Clearing Limited (HKIC) under the HKMA. Each of the 175 licensed commercial banks now keeps a clearing account with the HKIC. Transactions are settled gross and real-time. These (noninterest bearing) clearing accounts constitute the aggregate balance of settlement accounts. Under the RTGS system, each transaction between two licensed banks needs to be adequately funded prior to settlement. No negative settlement balance is allowed at any time for any bank. Intraday liquidity can be obtained through conducting intraday repos of eligible securities with the HKMA. These intraday loans, by definition, must be repaid by the end of the working day.

September 1998: Seven-Point Measures Following a period of frequent speculative attacks on the HK$, the HKMA unveiled major changes to the monetary system on September 5, 1998. The aim was to strengthen the currency board arrangement and restore confidence in the linked exchange rate.

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 Seven Technical Measures 1. Convertibility: The HKMA has extended the convertibility undertaking by the currency board from only currency in circulation (at HK$7.80:US$1) to include commercial banks clearing balances (at HK$7.75:US$1). However, the HKMA does not guarantee conversion for banks for funds from US$ to HK$ at a fixed rate. It, thus, remains the banks responsibility to ensure that there are sufficient HK$ in the clearing accounts upon settlement. 2. Bid Rate of the LAF is removed. Banks will, therefore, no longer deposit funds with the HKMA overnight and will seek to lend out all their funds during the day in the interbank market. 3. The LAF is renamed the Discount Window (DW). The LAF Offer Rate is renamed the Base Rate (BR) based on which discount rates for use in overnight repos are calculated. The BR will be announced each morning before the market opens. Initially, the BR will be the average of the overnight and 1-month HIBOR of the previous day. Eventually, a methodology will be developed so as to make BR determination transparent and automatic.

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4. Banks are given greater access to day-end liquidity through repos at the DW using EF paper, which is fully backed by the foreign exchange reserves. The restriction that discourages repeated borrowing through penal interest rates is removed, which effectively makes EF paper fully transferable with clearing balances. 5. New EF paper will only be issued upon foreign capital inflow, so as to make the backing more credible. (As at the end of August, foreign exchange reserves, including unsettled contracts, still represented 3.6 times the enlarged monetary base.) 6. The first half of each licensed banks EF paper holdings will be discounted at BR, and the next half will be discounted at BR+5% or overnight HIBOR, whichever is higher. 7. With regard to existing eligible papers for LAF discounting, AAArated paper and Specified Instruments will follow the discount rate schedule outlined in Measure 6, while other eligible papers will be discounted at a 25bp premium. The repeated borrowing penalty continues to apply to instruments other than EF paper. No new issues of paper other than EF paper will be eligible at the DW.

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 Three Points to Note 1. A licensed bank, if perceived to be abusing the DW in an attempt to facilitate manipulation that may destabilize the currency or money markets, can be denied access to the DW. 2. The HKMA is responsible for managing the fiscal reserves and will remain active in the foreign exchange and money markets in response to the need to provide funding for the budget deficit. 3. The HKMA remains alert to extreme conditions in the interbank market and reserves the right to lend and borrow in the market to dampen these conditions. What are the major effects of the Seven-Point Measures?

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SPECULATIVE ATTACKS ON THE HK DOLLAR An Example: Assume a current exchange rate of HK$7.75:US$1. A customer of Bank A sells HK$7.75 billion by instructing the bank to debit his HK$ account by HK$7.75 billion and credit his US$ account by US$1 billion. Any bank, facing this particular customer instruction, would not maintain such a large currency mismatch between its assets and liabilities and hence would seek to square its position by selling HK$ in the foreign exchange market in exchange for US$. If the sale of HK$ is so large that there are not enough buyers to absorb them all, the HKMA will become the residual buyer. The institution that Bank A sells HK$ in the foreign exchange market will have to deliver the sum of HK$ in two days time. What would happen to the interest rates? Why?

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The Mexican Crisis: January 1995 (Exhibit 3.2) Despite a balanced budget inflation of 27% (versus 150% in 1987), Mexico had two problems: 1. Foreign currency reserves fell from $30 billion in early 1994 to only $5 billion by November 1994 as the government pegged the peso at artificially high levels. 2. Commercial banks and the government had rolled over $23 billion of short-term peso debt into similar short-term tesebonos whose principal was indexed to the dollar. These obligations rose with the value of the dollar. December 1994 - January 1995: Peso fell 50% against the dollar, doubling the peso value of Mexicos tesebono obligations. Mexicos peso crisis was severe but relatively short-lived. During the Mexican peso crisis in January 1995, the HK$ came under a speculative attack and depreciated from HK$7.7375:US$1 at the beginning of the year to HK$7.7725:US$1 on January 12.

The Asian Financial Crisis: October 1997 (Exhibit 3.3) Thailand fell first, with problems that resembled Mexicos. Like Thailand, Indonesia and Korea suffered from fixed exchange rates, large current account deficits, large amounts of short-term foreign currency debt used to support speculative property ventures, and declining competitiveness.

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 Hong Kong: Selling pressure on HK$ intensified on October 21, following the devaluation of the NT dollar. The HKMA absorbed a substantial amount of HK$ on October 21, to be settled on October 23 (Black Thursday). On Thursday morning, the aggregate balance totaled HK$2 billion but as much as HK$6 billion was due to be settled on that day. This was the amount that banks sold to the currency board on behalf of their customers on Tuesday. In the face of this acute shortage of HK$ liquidity and in fear of being penalized for repeatedly using the LAF, banks bid aggressively in the interbank market for HK$ funds during the morning of October 23. Overnight HIBOR shot up to nearly 300% just before noon. In the end, HK$ were bought back from the HKMA, some for early settlement. The demand for HK$ drove the exchange rate as high as HK$7.50:US$1 in the afternoon. The HK$ that were bought were due for settlement until the following Monday (October 27) so banks ended up having to borrow HK$ at very high interbank rates to cover their positions over the weekend.

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Exhibit 3.1 Nominal Value of the US$ under Floating Rates, 1961-1995

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Exhibit 3.2 Mexican Peso Crisis

1.2

1.0 0.8 0.6 0.4 0.2

Mexican stock market value, in peso (December 31, 1993 = 1.00)

1994
Exhibit 3.3 Asian Contagion (December 31, 1996 = 1.00)
1.2

1995

1.0

0.8

Thai bhat
0.6

Korean won
0.4

Indonesian rupiah
0.2

0.0

1996

1997

1998

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