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International Financial Management

P G Apte
P.G.Apte International Financial Management

5.1 Introduction
The International Monetary System facilitates
transfer of funds between parties, conversion of
national currencies into one another, acquisition
and liquidation of financial assets, and
international credit creation
An important constituent of the global financial
system

P.G.Apte International Financial Management

5.1 Introduction (contd.)


The relevant aspects of the system
Exchange rate regimes, current and past

International liquidity
The International Monetary Fund
The adjustment process i.e. how does the
system facilitate the process of coping with
payments imbalances between trading nations
Currency blocks and unions such as the EMU

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5.2 Exchange Rate Regimes


Exchange Rate Regimes
The IMF classifies member countries into eight
categories

Currency Union (No separate legal tender)


Currency Board Arrangement
Conventional Fixed Peg Arrangements
Pegged Exchange Rates within Horizontal Bands
Crawling Peg
Crawling bands
Managed float
Independent float

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5.2 Exchange Rate Regimes: A


Historical Perspective

The Gold Standard


Gold Specie Standard; Gold Bullion Standard
Gold Exchange Standard
Mint Parity: The exchange rate between any pair of currencies
will be determined by their respective exchange rates against
gold
The gold standard regime imposes very rigid discipline on the
policy makers :
The money supply in the country must be tied to the amount of
gold the monetary authorities have in reserve. When a country
loses gold, money supply must contract.
Domestic economy governed by external sector .

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5.2 Exchange Rate Regimes: History


The Bretton Woods System
The exchange rate regime that was put in place after WWII can
be characterized as Gold Exchange Standard
The US government undertook to convert the US dollar
freely into gold at a fixed parity of $35 per ounce
Other member countries of the IMF agreed to fix the parities
of their currencies with the dollar with variation within 1%
on either side of the central parity being permissible
It was an Adjustable Peg system. Central parity could be changed
in the face of fundamental disequilibrium.

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5.2 Exchange Rate Regimes: History


In return for undertaking this obligation, the member
countries were entitled to borrow from the IMF to
carry out their intervention in the currency markets
Whenever the exchange rate tended to move out of
the 1% band, the central bank had to sell or buy the
foreign currency to bring it back within the band.
Devaluation/upvaluation when disequilibrium
persisted Fundamental Disequilibrium

P.G.Apte International Financial Management

5.2 Exchange Rate Regimes: History


Intervention operations affect the domestic
money supply and then the price level, GNP etc.
These effects may have an automatic corrective
effect Central bank sells forex, money supply
contracts, price level reduces, GNP reduces,
imports decline, the pressure on home currency
reduces.
Central bank can sterilize these effects.

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5.2 Exchange Rate Regimes: History


This system could work as long as other countries had
confidence in the stability of the US dollar and in the
ability of the US treasury to convert dollars into gold
on demand at the specified conversion rate
The system came under pressure and ultimately broke
down when this confidence was shaken due to various
political and some economic factors starting in mid
1960s.
Abandoned in 1973 after some attempts to fix it and
revive it.
Major currencies started floating in early 1973.

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5.2 Exchange Rate Regimes


Is there an ideal regime?
Fixed rates provide a policy anchor & discipline.
Freely floating rates provide monetary policy freedom.
Economists are reconsidering the merits of a floating
exchange rate and monetary policy independence which it
apparently bestows on a country. Hard pegs have their
problems.
It appears therefore that there is no such thing as "the ideal"
exchange rate regime for all countries or even for a given
country at all times
Crawling pegs, crawling bands, managed float etc. are
attempts to get the best of both the worlds

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5.2 Exchange Rate Regimes


One school of thought feels there will be only two
types of exchange rate regimes
Truly fixed rate arrangements
Truly market determined, floating rates

The impossible trinity : A country can achieve any


two of the following three policy goals but not all
three
A stable exchange rate
Monetary policy independence
Financial market integration with rest of the world

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THE IMPOSSIBLE TRINITY


Full Capital Controls

Monetary Policy

Stable Exchange

Independence

Rate

Floating Rate

Integration

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Currency Union

12

5.3 The International Monetary Fund


(IMF)
The role of IMF
Framework of the Articles of Agreement adopted at
Bretton Woods in1944
Increasing international monetary cooperation
Promoting the growth of trade
Promoting exchange rate stability
Establishing a system of multilateral payments,
eliminating exchange restrictions which hamper the
growth of world trade and encouraging progress
towards convertibility of member currencies
Building a reserve base

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5.3 The International Monetary Fund


(IMF)
Funding facilities
Operation of the adjustable peg requires a country to
intervene in the foreign exchange markets to support its
exchange rate when it threatens to move out of the
permissible band
Reserve Tranche & Credit Tranche. Their
conditionalities
Other funding facilities such as ESAF, HIPC initiative
etc. and their implications for recipient countries.
IMF often criticised for imposing conditions which do
more damage than good.

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5.3 The International Monetary Fund


(IMF)
International Liquidity and Special Drawing
Rights (SDR)
International Liquidity and International Reserves
International liquidity refers to the stock of means of
international payments
International Reserves, are assets which a country
can use in settlement of payments imbalances that
arise in its transactions with other countries
International Reserves = Reserve position in IMF + SDRs
+ Forex assets held by central bank

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5.3 The International Monetary Fund


Special Drawing Rights (SDRs)
SDR is international fiat money created by IMF and
allocated to member countries.
Can be used by Central banks to settle payments
among themselves. Selected other institutions
allowed to hold and use SDRs
In order to make SDRs an attractive asset to hold,
the Fund pays interest on holdings in excess of a
member's cumulative allocation and it charges
interest on any shortfalls
Have not become popular as reserve asset

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5.3 International Liquidity


Demand for Reserves and Composition of Reserves
In the positive tradition, reserve stock is related to the
volume of imports, marginal propensity to import, variability
of export earnings and so forth
In the optimizing approach, reserve holdings are arrived at
by equating the marginal cost of holding reserves to the
marginal benefit
The problem of currency composition of reserves has been
posed as a problem in portfolio selection along the lines of
the Markowitz-Sharpe portfolio choice models

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5.3 The International Monetary Fund


The Role of IMF in the Post-Bretton Woods World
Under the Bretton Woods system the IMF was
responsible for the functioning of the adjustable peg
system
Under the current "non-system" that role has
considerably diminished if not eliminated
The Fund is mandated to "exercise firm surveillance
over the exchange rate policies of members"
The Fund has played an important role in tackling the
debt crisis of developing countries

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5.4 The Problem of Adjustment


Every open economy, from time to time faces the problem of
imbalance on its external transactions
The BOP disequilibria may be transitory or permanent in
nature
The country must choose between financing the imbalance or
undertaking a programme of adjustment. Relevant factors:
Exchange Rate Regime; Availability of Financing;
Creditworthiness of the Country; Export-Import Demand
Elasticities; Saving and Import Propensities; Behaviour of
Domestic Costs; State of the Economy

Adjustment more urgent for deficit countries.


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5.5 The Economic and Monetary


Union (EMU): History
Adjustable peg system called Snake was born
among the countries belonging to the European
Economic Community (EEC) in 1972
In 1979, the snake became the European Monetary
System (EMS)
The feature that distinguished EMS from the snake
was the European Currency Unit (ECU), a SDRlike basket of currencies
The ECU was the precursor of the common
currency Euro

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5.5 EMU: History


Monetary Union had been envisaged as a part of the
move towards creating a single economic zone in Europe
Just when it appeared that Europe will steadily march
towards an economic and monetary union as envisaged
in the "Maastricht treaty", the system received severe
jolts
"Growth and Stability Pact" in 1996
The single currency "Euro" came into existence on
January 1 1999

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5.5 The Economic and Monetary


Union
After 2002, their individual currencies will cease
to exist
The parities of the eleven member currencies
against each other and against the Euro were
irrevocably fixed when Euro was born.
At the start 1 Euro = 1 ECU
The EMU and the Euro provide a model for other
currency unions

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