INTERNATIONAL MONETARY SYSTEM

IMS has evolved over the course of centuries and defines the overall financial environment in which MNCs operate. IMS plays a crucial role in the financial management of a MNC business and economic and financial policies of a country. IMS will continue to evolve in the future as the international business and political environment of the global economy continues to change.

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.

Specie Commodity Standard

Over a period of time other metals with a lower value was mixed with gold coins, as a result 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 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.

Specie Commodity Standard

The Coinage Act or the Mint Act of 1792 of the USA established dollar as the monetary unit of the country, declared it as a lawful tender 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. The difference in the bimetallic standard between the US and the France led to the export of gold from 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 monometallic 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. Now what is the impact on Dollar???

Specie Commodity Standard

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 the first ever devaluation of the U.S. dollar, was that the value in gold of the dollar was reduced by 6%.

Specie Commodity Standard

In 1853, the weight of US silver coin was reduced. This led to placing the nation effectively on the gold standard. With the enactment of the National Banking Act in 1863 by the US Government, the dollar became the sole currency of the United States and remains so today. The Bland Allison Act of 1878 required the government to purchase between USD 2 million and USD 4 million worth of silver bullion each month at market prices and to coin it into Silver dollars as a subsidy for the politically influential silver producers.

Specie Commodity Standard

The discovery of large silver deposits in the western regions of the United States in the late 19th century created a political controversy. Due to the large influx of silver, the value of silver in the nation's coinage dropped considerably. The Eastern banking and commercial interests advocated a sound money policy and a switch to the gold standard. The status of silver was slowly diminished through a series of legislative changes from 1873 to 1900, when a gold standard was formally adopted.

Gold Standard
From 1876 to 1913, the exchange rates were dictated by the gold standard. The gold standard lasted for nearly 40 years and the centre of the international financial system during this period was London, indicating the preeminence position it enjoyed during the hey days of British rule across the globe. Every country adopting the gold standard had its own traditional and customary norms. The fundamental rule of the gold standard was that each country should set a par value for its currency in terms of gold and enforce its value in commerce and trade. Thus each and every country has to establish the rate, at which its currency should be converted into the weight of gold.

Gold Standard
A true gold standard came in 1900 with the passage of the Gold Standard Act. Thus US made gold the sole legal-tender coinage of the United States, and set the value of the dollar at $ 20.67 per ounce (66.46 /g) of gold. This made the dollar convertible to 1.5 g (23.22 grains), the same convertibility into gold that was possible on the bimetallic standard.

Features of Gold Standard

1. 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. Apex monetary institution shall hold gold reserves in relationship to the currency it has issued and 4. Government shall allow unrestricted minting of gold and melting of gold coins at the option of the holder

Features of Gold Standard

Since fixed weight of gold formed the basis for a unit of currency and as 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.

Features of Gold Standard

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 Todays Rate: GBP 1= USD 1.67

Features of Gold Standard

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.

Features of Gold Standard

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 $ 20.67and sell it in Great Britain for 4.24 and then exchange the pound for the dollar in the forex market for $ 5 x $ 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.

Features of Gold Standard

Definition of 'Arbitrageur' A type of investor who attempts to profit from price inefficiencies in the market by making simultaneous trades that offset each other and capturing risk-free profits. An arbitrageur would, for example, seek out price discrepancies between currencies listed on more than one exchange, and buy the undervalued currency on one exchange while short selling the same number of overvalued currency on another exchange, thus capturing risk-free profits as the prices on the two exchanges converge.

Features of Gold Standard

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. Eg: 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.

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.

Decline of the Gold Standard

During WW I, US corporations had large debts payable to European entities and they began liquidating their debts in gold. USD to GBP 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 issued emergency currency under the AldrichVreeland Act, and the newly-created Federal Reserve organized a fund to clear the debts to foreign creditors. These efforts were largely successful, and the AldrichVreeland notes were retired starting in November 1914 and the gold standard was restored and the NYSE re-opened in December 1914. How did the US emerge stronger in WWI????

Decline of the Gold Standard

From 1915-17, US remained neutral in the war US 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. Now it enjoyed a huge trade surplus with the European Nations. Hence the USD became stronger and the European currencies became weaker and the US began to assume the role of the leading creditor nation. For the above reasons, the gold standard was suspended during WW I

Decline of the Gold Standard

After the end of the WW I, the nations on Gold Standard re-entered. The US returned to gold in 1919, Great Britain in 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 and the pound stood overvalued and completely exposed.

Decline of the Gold Standard

A great depression swept the world in 1929 and lasted for nearly ten years. The depression originated in the US, starting with the stock market crash of Oct 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. This pattern was repeated throughout Europe and North America. In the US, the Federal Reserve was forced to raise interest rates to protect the gold standard for the US dollar.

Decline of the Gold Standard

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.

Gold Exchange Standard

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.

Bretton Wood 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 the International Monetary Fund (IMF) and the International Bank for Reconstruction and Development, now known as the World Bank. IMF was designed to monitor exchange rates and lend reserve currencies to nations with trade deficits, the IBRD 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 to fund these institutions; the amount of each contribution designated a country's economic ability and dictated its number of votes.

Bretton Wood System

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 legal obligations with multilateral decision conducted through an international organization 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 US.

Bretton Wood System

Here a compromise was sought between the polar alternatives of either freely floating or irrevocably fixed rates. What emerged was the 'pegged rate' or 'adjustable peg' currency regime, also known as the par value system. Countries 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 Countries also retained the right to alter their par value to correct a 'fundamental disequilibrium' in their balance of payments.

Bretton Wood System

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. Countries were assigned quotas, roughly reflecting their relative economic importance. 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 countrys own money. Each country was then entitled, when short of reserves, to borrow needed foreign currency in amounts determined by the size of its quota

Bretton Wood System

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. They were formally encouraged to make use of capital controls to maintain external balance in the face of potentially destabilizing '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.

Chronology of Bretton Wood 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 and shortfalls in the US balance of payments. The period upto 1958 was rightly called one of 'beneficial disequilibrium.'

Chronology of Bretton Wood System

The US balance of payments plunged to a $ 3.5 billion gap in 1958 and to even larger deficits in 1959 and 1960. 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.

Chronology of Bretton Wood System

By Mid 60s, negotiations began to create the Special Drawing Rights (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 averted. On the other hand, they were totally unprepared for the opposite threat - a reserve surfeit - which is in fact 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.

Chronology of Bretton Wood System

By Mid 60s, negotiations began to create the Special Drawing Rights (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 averted. On the other hand, they were totally unprepared for the opposite threat - a reserve surfeit - which is in fact 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.

Chronology of Bretton Wood System

A second source of strain was inherent in the structure of the par value system: How could governments be expected to change their exchange rates if they can not 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? The Bretton Woods system rested on one simple assumption - that economic policy in the US would stabilize. 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 became increasingly destabilized, 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.

Chronology of Bretton Wood System

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.

Smithsonian Arrangement
From Aug to Dec 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.

Smithsonian Arrangement
Smithsonian arrangement called for realignment of the par value of major currencies to conform to their realistic values. Gold parity of the US dollar was changed from $ 35 to $ 38.02 per troy ounce of gold resulting in devaluation of 8.57%. 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. Currencies were permitted to fluctuate over a wider band than in the past.

Smithsonian Arrangement
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 rat,, its total fluctuation against the dollar could be as high as 4.5%. Purpose of Smithsonian arrangement was to infuse greater flexibility into the par value system.

Case Study 4 :Greece Economy

In the beginning of 2009, the Greece economy collapsed and the country was bailed out to the tune of over $100 billion. Unions and the socialists are upset that the Greek government has to cut their pay and benefits to just keep them employed. Greece already has a VAT of 21 % which has been increased to 23% after the collapse. Imagine 23% being added to the cost of everything you buy. Greece has announced a 20% pay cut to public employees and a hiring freeze for the next 3-5 years.

Case Study 4 :Greece Economy

Today Greece roughly has a debt of 150 % of GDP.

Q
i) Analyse the real issue of the collapse of the Greece economy. ii) What is happening in Europe can and may very well happen in India. Discuss iii) A bloated broke government that cant pay for its own survival is a recipe for new taxes and one other thing, a disaster. Comment in Detail.