The international monetary system (IMS) exists because most countries have their own currencies. International businesspeople also monitor the balance of payments, the accounting system of the IMS.
This chapter’s learning objectives include the following:Discussingthe role of the international monetary system in promoting international trade and investment. Explainingthe evolution and functioning of the gold standard. Summarizingthe role of the World Bank Group and the International Monetary Fund in the post-World War II international monetary system established at Bretton Woods.
Additional learning objectives include:Explainingthe evolution of the flexible exchange rate system.Describingthe function and structure of the balance of payments accounting system. Differentiatingamong the various definitions of a balance of payments surplus and deficit.
Today’s international monetary system can trace its roots to the ancient allure of gold and silver, both of which served as media of exchange in early trade between tribes and in later trade between city-states. As the modern nation-states of Europe took form in the sixteenth and seventeenth centuries, their coins were traded on the basis of their relative gold and silver content.
The international monetary system establishes the rules by which countries value and exchange their currencies. It also provides a mechanism for correcting imbalances between a country’s international payments and its receipts. Further, the cost of converting foreign money into a firm’s home currency depends on the smooth functioning of the international monetary system.The balance of payments (BOP) accounting system records international transactions and supplies vital information about the health of a national economy and foreshadows likely changes in its fiscal and monetary policies. BOP statistics can be used to detect signs of trouble that could eventually lead to governmental trade restrictions, higher interest rates, accelerated inflation, reduced demand, and general changes in the cost of doing business in any given country.
This section focused on the History of the International Monetary System and discussed the functions of that system. The next section will review the Evolution and Functioning of the Gold Standard.
Ancient reliance on gold coins as a medium of exchange led to the adoption of an international monetary system know as the gold standard. Under the gold standard, countries agree to buy or sell their paper currencies in exchange for gold on the request of any individual or firm and to allow the free export of gold bullion and coins. In 1821, the United Kingdom adopted the gold standard. During the nineteenth century, important trading countries—including Russia, Austria-Hungary, France, Germany, and the United States—did the same.
An exchange rate is the price of one currency in terms of a second currency. Under a fixed exchange rate system, the price of a given currency does not change relative to each other currency. The gold standard created a fixed exchange rate system as each country pegged the value of its currency to gold, thus establishing its par value, or official price in terms of gold. From 1821 until the end of World War I in 1918, the most important currency in international commerce was the British pound sterling, a reflection of the United Kingdom’s status as Europe’s dominant economic and military power. Most firms accepted either gold or British pounds in settlement of transactions. As a result, the international monetary system during this period is often called a sterling-based gold standard. Because of the international trust in British currency, London became a dominant international financial center in the nineteenth century, a position it still holds.
During World War I, the sterling-based gold standard unraveled.The economic pressures of war caused country after country to suspend their pledges to buy or sell gold at their currencies’ par values. Most countries, including the United States, the United Kingdom, and France, readopted the gold standard in the 1920s despite the high levels of inflation, unemployment, and political instability inEurope. However, due to the worldwide Great Depression, the Bank of England was unable to maintain the value of the pound. On September 21, 1931, the pound was allowed to float according to supply and demand and would no longer redeem British paper currency for gold at par value. A “sterling area” emerged as some countries pegged their currencies to the pound. Other countries tied the value of their currencies to the U.S. dollar or the French franc. However, the international monetary system degenerated as countries devalued their currencies to stimulate their exports and raised tariffs to reduce their imports. As more countries adopted these beggar-thy-neighbor policies, international trade contracted. However, trade conflict was soon replaced by military conflict—the outbreak of World War II in 1939.
This section focused on the Evolution and Functioning of the Gold Standard by defining it and reviewing its collapse.The next section will review the Role of the World Bank and the IMF in the Post-WWII International Monetary System.
Many politicians and historians believe the breakdown of the international monetary system and international trade after World War I created economic conditions that helped bring about World War II. Inflation, unemployment, and the costs of rebuilding war-torn economies created political instability that enabled fascist and communist dictators to seize control of their respective governments.
Determined not to repeat the mistakes that had caused World War II, Western diplomats planned to create a postwar economic environment that would promote worldwide peace and prosperity. In 1944, the representatives of 44 countries met at a resort in Bretton Woods, New Hampshire, with that objective in mind. The Bretton Woods conferees agreed to renew the gold standard on a greatly modified basis. They also agreed to the creation of two new international organizations that would assist in rebuilding the world economy and the international monetary system: The International Bank for Reconstruction and Development (aka the IBRD or the World Bank)The International Monetary Fund (aka the IMF)
The International Bank for Reconstruction and Development is the official name of the World Bank. Established in 1945, the World Bank’s initial goal was to help finance reconstruction of the war-torn European economies. With the assistance of the Marshall Plan, the World Bank accomplished this task by the mid-1950s. It then adopted a new mission—to build the economies of the world’s developing countries.
As its mission has expanded over time, the World Bank has created three affiliated organizations. Together with the World Bank, these constitute the World Bank Group.The World Bank may lend only for “productive purposes” that will stimulate economic growth within the recipient country. In addition, the World Bank follows a hard loan policy; that is, it will make a loan only if there is a reasonable expectation that the loan will be repaid. In the 1950s, poorer countries complained that the policy kept them from obtaining World Bank loans. In response, the World Bank established the International Development Association (IDA) in 1960. The IDA offers soft loans, which bear some significant risk of not being repaid. The two other affiliates of the World Bank Group have narrower missions. The International Finance Corporation (IFC) wascreated in 1956. It is charged with promoting the development of the private sector in developing countries. The Multilateral Investment Guarantee Agency (MIGA) was set up in 1988 to overcome private-sector reluctance to invest in developing countries by offering private investors insurance against noncommercial risks.
To ensure that the post–World War II monetary system would promote international commerce, the Bretton Woods Agreement created the International Monetary Fund (IMF) to oversee the functioning of the international monetary system. Article I of the IMF’s Articles of Agreement lays out the organization’s objectives:To promote international monetary cooperationTo facilitate the expansion and balanced growth of international tradeTo promote exchange stability, maintain orderly exchange arrangements among members, and avoid competitive exchange depreciationTo assist in the establishment of a multilateral system of paymentsTo give confidence to members by making the general resources of the IMF temporarily available to them and to correct maladjustments in their balance of paymentsTo shorten the duration and lessen the degree of disequilibrium in the international balance of payments of members
Membership in the IMF is available to any country willing to agree to its rules and regulations. As of 2011, 187 countries were members. To join, a country must pay a deposit, called a quota, partly in gold and partly in the country’s own currency. The quota’s size primarily reflects the global importance of the country’s economy, but political considerations may also have some effect. The size of a quota is important for several reasons:A country’s quota determines its voting power within the IMF.A country’s quota serves as part of its official reserves.The quota determines the country’s borrowing power from the IMF.
Bretton Woods participants agreed to peg the value of their currencies to gold. For example, the par value of the U.S. dollar was set at $35 per ounce of gold. Only the United States pledged to redeem its currency for gold at the request of a foreign central bank. Thus, the dollar became the keystone of the Bretton Woods system, and a U.S. dollar–based gold standard was established.Because each country established a par value for its currency, the Bretton Woods Agreement resulted in a fixed exchange rate system. Under the agreement, each country pledged to maintain the value of its currency within a range of ± 1 percent of its par value. If the market value of its currency fell outside that range, a country was obligated to intervene in the foreign-exchange market and bring the value back within that range. This arrangement provided an assurance that the value of each currency would remain stable.Under extraordinary circumstances, the Bretton Woods Agreement allowed a country to adjust its currency’s par value. Accordingly, the system is often described as using an adjustable peg because currencies were pegged to gold, but the pegs themselves could be altered under certain conditions.
The arrangement just discussed worked well, as long a pessimism about a country’s economy was temporary. However, macroeconomic problems in a country could cause major difficulties. Banks never have enough cash on hand to honor all their liabilities. As long as people trust that their bank will give them their money if they need it, all goes well. If they lose trust and withdraw more of their money than the bank has on hand, the bank could be in trouble. The Bretton Woods system was particularly susceptible to “runs on the bank” because there was little risk in converting a suspect currency into dollars. In November 1967, the United Kingdom faced this type of bank run. The Bank of England could not counter the flood of pounds dumped on the market by speculators, so it was forced to devalue the pound by 14.3 percent. In 1969, France faced a similar run, and had to devalue the franc. These runs on the British and French central banks were a precursor to a run on the most important bank in the Bretton Woods system—the U.S. Federal Reserve Bank—in the early 1970s.
During the 1950s and 1960s, foreigners were willing to hold U.S. dollars since they trusted the integrity of the currency. The expansion of international liquidity depended on foreigners’ willingness to continually increase their holdings of dollars. As foreign dollar holdings increased, investors began to question the ability of the United States to live up to its Bretton Woods obligation. This led to the Triffin Paradox: Foreigners needed to increase their holdings of dollars to finance international trade, but the more dollars they owned, the less faith they had that the United States could redeem dollars for gold. The less faith they had, the more they wanted to rid themselves of dollars and get gold in return. If they did this, however, the international monetary system might collapse because the United States did not have enough gold to redeem the dollars held by foreigners.
As a means of injecting more liquidity into the international monetary system while reducing the demands placed on the dollar as a reserve currency, IMF members agreed in 1967 to create special drawing rights (SDRs). IMF members could use SDRs to settle official transactions at the IMF. Unfortunately, SDRs did not reduce the glut of dollars held by foreigners. By mid-1971, the Bretton Woods system was tottering. During the first seven months of 1971, the United States sold one-third of its gold reserves to maintain the dollar’s value. However, the United States did not have sufficient gold to meet the demands of those who still wanted to exchange dollars for gold. On August 15, 1971, President Nixon announced that the United States would no longer redeem gold at $35 per ounce. Consequently, the Bretton Woods system ended.
This section focused on the Role of the World Bank and the IMF in the Post-WWII International Monetary System. The discussion was supported by an examination of the Bretton Woods era, the International Bank for Reconstruction and Development (the official name for the World Bank), the World Bank Group, and the International Monetary Fund and IMF membership. It also included a review of the dollar-based gold standard, challenges to the Bretton Woods system, the Triffin Paradox, and the end of the Bretton Woods system. This concludes our discussion of the Role of the World Bank and the IMF in the Post-WWII International Monetary System. The next section will review the Performance of the IMF since 1971.
After Nixon’s 1971 speech, most currencies began to float, their values determined by supply and demand in the foreign-exchange market. As a result, the value of the U.S. dollar fell relative to most of the world’s major currencies. The nations of the world, however, were not yet ready to abandon the fixed exchange rate system. At the Smithsonian Conference in December 1971, representatives from the Group of Ten agreed to restore the fixed exchange rate system but with restructured rates of exchange between major trading currencies. Currencies were allowed to fluctuate around their new par values by ± 2.25 percent, which replaced the narrower ± 1.00 percent range authorized by the Bretton Woods Agreement.
By March 1973, the central banks conceded they could not successfully resist free-market forces and so established a flexible exchange rate system. Under a flexible (or floating) exchange rate system, supply and demand for a currency determine its price in the world market. Since then, exchange rates among many currencies have been established primarily by the interaction of supply and demand. In an effort to affect exchange rates, however, central banks sometimes buy or sell currencies on the foreign-exchange market. Thus, the current arrangements are often called a managed float (or a dirty float) because exchange rates are not determined purely by private-sector market forces.
The new flexible exchange rate system was legitimized in 1976 by theJamaica Agreement, and each country was free to adopt whatever exchange rate system best met its own requirements. The United States adopted a floating exchange rate. Other countries adopted a fixed exchange rate by pegging their currencies to the dollar, the French franc, or some other currency. Still others utilized crawling pegs, allowing the peg to change gradually over time.In 1979, EU members created the European Monetary System (EMS) to manage currency relationships among themselves. Most EMS members chose to participate in the EU’s exchange rate mechanism (ERM). They pledged to maintain fixed exchange rates among their currencies within a narrow range of ± 2.25 percent of par value and a floating rate against the U.S. dollar and other currencies. The U.S. complained that an overvalued dollar was making its exports noncompetitive and allowing cheap imports to damage U.S. industries. In 1985, finance ministers from the Group of Five enacted the Plaza Accord, in which the central banks agreed to let the dollar’s value fall on currency markets. Fearing that continued devaluation of the dollar would disrupt world trade, the group of five enacted the Louvre Accord in 1987. This accord signaled the commitment of these five countries to stabilizing the dollar’s value.
In 1973, the Organization of Petroleum Exporting Countries (OPEC) imposed an oil embargo. World oil prices quadrupled from $3 a barrel in October 1973 to $12 a barrel by March 1974. This rapid increase in oil prices increased inflation in oil-importing countries. In response, exchange rates adjusted to account for changes in the value of each country’s oil exports or imports. The currencies of the oil exporters strengthened, while those of the oil importers weakened.Many oil-exporting countries used their new wealth to improve their infrastructures or invest in new facilities. Unspent petrodollars were deposited in international banks. The banking community then recycled these petrodollars through its international lending activities to help revive the economies damaged by rising oil prices.Many countries borrowed more than they could repay. The financial positions of these borrowers became precarious after the oil shock of 1978-1979 when the price of oil skyrocketed from $13 to over $30 a barrel. This triggered another round of worldwide inflation. Interest rates on these loans rose, as most carried a floating interest rate, further burdening the heavily indebted nations.
In 1982, the international debt crisis began when Mexico requested a rescheduling of its debts, a moratorium on repayment of principal, and a loan from the IMF to help it through its debt crisis. In total, more than 40 countries in Asia, Africa, and Latin America sought relief from their external debts.Various approaches were used to resolve the crisis. In 1985, the Baker Plan stressed several points: the importance of debt rescheduling, tight IMF-imposed controls over domestic monetary and fiscal policies, and continued lending to debtor countries so that economic growth would allow them to repay their creditors. In spite of these initiatives, the debtor nations made little progress in repaying their loans. Debtors and creditors alike agreed that a new approach was needed. In 1989, the Brady Plan focused on the need to reduce the debts of the troubled countries by writing off parts of the debts or by providing the countries with funds to buy back their loan notes at below face value.In the 1990s, the debt-servicing requirements of debtor countries were made more manageable via a combination of IMF loans, debt rescheduling, and changes in governmental economic policies. As a result, the international debt crisis receded during this time.
In July 1997, Thailand had to un-peg its currency, the baht, from a dollar-denominated basket of currencies. Investors had begun to distrust the abilities of Thailand to service its debt and maintain the baht’s value. As investors converted their baht to dollars and other currencies, the Thai central bank spent much of its official reserves trying to maintain the pegged value of the baht. In spite of the bank’s efforts, the value of the baht fell 20 percent. As investors realized that other countries in the region were also overly dependent on short-term foreign capital, their currencies also came under attack, and their stock markets were devastated. All told, the IMF and developed countries pledged over $100 billion in loans to help restore these countries to economic health.The latest financial crisis to plague the international capital market began with the so-called subprime meltdown, which resulted from the bursting of the U.S. housing bubble. The problems created by this collapse affected financial markets throughout the world.
This section focused on the Performance of the IMF Since 1971. The discussion started with an overview of the flexible exchange rate and a review of the IMF conferences. It then explained the start of the international debt crisis, reviewed the Baker Plan and the Brady Plan, and outlined the Asian currency crisis and the sub-prime meltdown. This concludes our discussion of the overall Performance of the IM Since 1971. The next section will review The Balance of Payments Accounting System.
The crises discussed in the previous section did not surprise to the analysts who had been monitoring the balance of payments (or BOP) accounts of these countries for danger signs. The BOP accounting system provided clear warning of the deteriorating performance of the countries in crisis; therefore, a careful reading of BOP statistics could have protected international bankers from bad investments and risky loans. Because the BOP accounting system provides such valuable economic intelligence information, this section discusses it in detail.
The BOP accounting system is a double-entry bookkeeping system designed to measure and record all economic transactions between residents of one country and residents of all other countries during a particular time period. International businesspeople need to pay close attention to BOP statistics for a number of reasons:BOP statistics help identify emerging markets for goods and services. BOP statistics can warn of possible new policies that may alter a country’s business climate, thereby affecting the profitability of a firm’s operations in that country. BOP statistics can indicate reductions in a country’s foreign-exchange reserves, which could signal that the country’s currency will depreciate in the future. BOP statistics can signal increased riskiness of lending to particular countries.
Four important aspects of the BOP accounting system need to be highlighted: The BOP accounting system records international transactions made during some period of time, for example, a year. It records only economic transactions, those that involve something of monetary value. It records transactions between residents of one country and residents of all other countries. Residents can be individuals, businesses, government agencies, or nonprofit organizations. The BOP accounting system is a double-entry system. Each transaction produces a credit entry and a debit entry of equal size. Debit entries reflect uses of funds; credit entries indicate sources of funds.
The BOP accounting system can be divided conceptually into four major accounts. The first two accounts—the current accountand the financial account—record purchases of goods, services, and assets by the private and public sectors. The official reserves account reflects the impact of central bank intervention in the foreign-exchange market. The errors and omissions account captures mistakes made in recording BOP transactions.
A country’s current account balance is scrutinized by policy makers and government officials because it broadly reflects the country’s competitiveness in international markets. The current account records four types of transactions among residents of different countries:Exports and imports of goods: The balance on merchandise trade is the difference between a country’s merchandise exports and merchandise imports.Exports and imports of services: The difference between a country’s exports of services and its imports of servicesis called the balance on services trade. Investment income: Income that a country’s residents earn from foreign investments is viewed as an export of the services of capital. Income earned by foreigners from their investments in a country is viewed as an import of the services of capital bythat country. Gifts (or unilateral transfers): Private gifts between residents of one country and residents in another country are called unilateral transfers. Governmental aid is a public unilateral transfer. In either case, recipients don’t need to provide any compensation to the donors.
The capital account records financial transactions—purchases and sales of assets—between residents of one country and those of other countries. Account transactions can be divided into two categories: foreign direct investment and foreign portfolio investment.Foreign Direct Investment (FDI) is any investment made for the purpose of controlling the organization in which the investment is made. A typical means of obtaining this goal is through ownership of significant blocks of common stock with voting privileges.Foreign portfolio investment (FPI) is any investment made for purposes other than control. Short-term foreign portfolio investments are financial instruments with maturities of one year or less: (e.g., commercial paper, checking accounts, time deposits, and trade receivables). Long-term foreign portfolio investments include stocks, bonds, and other financial instruments that have maturities greater than one year.
Current account transactions invariably affect the short-term component of the financial account. The first entry in the double-entry BOP accounting system records the purchase or sale of something—a good, a service, or an asset. The second entry typically records the payment or receipt of payment for the thing bought or sold.Capital inflows are credits in the BOP accounting system. They can occur in two ways:Foreign ownership of assets in a country increases. Ownership of foreign assets by a country’s residents declines. Capital outflows are debits in the BOP accounting system. They also can occur in two ways:Ownership of foreign assets by a country’s residents increases. Foreign ownership of assets in a country declines.
The official reserves account is the third major component in the BOP accounting system. It records the level of official reserves held by a national government. These reserves are used to intervene in the foreign-exchange market and to complete transactions with other central banks. Official reserves include four types of assets:GoldConvertible currenciesSpecial Drawing Rights (SDRs)Reserve positions at the IMFOfficial gold holdings are measured using a par value established by a country’s treasury or finance ministry. Convertible currencies are freely exchangeable in world currency markets. The convertible currencies most commonly used as official reserves are the U.S. dollar, the euro, and the yen. The last two types of reserves—SDRs and reserve positions at the IMF—were discussed earlier in this chapter.
In principle, the BOP accounting system must balance. However, this equilibrium is elusive in practice because of measurement errors. Therefore, the errors and omissions account is used to make the BOP balance. Several sets of circumstances can account for errors and omissions:When trying to keep up with the volume of legal short-term money flowing between countries, government statisticians face challenges such as round-the-clock foreign-exchange trading; sophisticated monetary swaps and hedges; and international money market funds. Politically stable countries are often the destination of flight capital, money sent abroad by foreign residents seeking a safe haven for their assets. Sometimes, flight capital was obtained illegally; therefore, persons investing it often try to avoid any official recognition of their transactions. The flight capital concept also applies to residents of other countries who distrust the stability of their own currency and choose to transact business and keep their savings in a stronger currency.Some errors may crop up in the current account as well. Statistics for merchandise imports are reasonably accurate because most customs agents scrutinize imports to ensure that all taxes are collected. However, customs agents have less incentive to assess merchandise exports. Statistics for trade in services may also contain inaccuracies.
This section focused on The Balance of Payments Accounting System. The discussion started by reviewing the importance of BOP statistics and some important aspects of the BOP system. This was followed by a review of the major accounts in the BOP system—current, capital, official reserves, and errors and omissions. This concludes our discussion of The BOP Accounting System. The next section will focus on Defining Balance of Payments Surpluses and Deficits.
Every month the federal government reports on the performance of U.S. firms in international markets, when it releases monthly BOP statistics. In most months during the past decade, newscasters have reported on the evening news that the U.S. BOP is in deficit. What do the newscasters mean? We just said that the BOP always balances (equals zero), so how can there be a BOP deficit? In reality, when knowledgeable people talk about a BOP surplus or deficit, they are referring only to a subset of the BOP accounts. Most newscasters are in fact reporting on the balance on trade in goods and services. When a country exports more goods and services than it imports, there is a trade surplus. When it imports more goods and services than it exports, there is a trade deficit.
Because the balance on trade in goods and services is readily available to the news media and relatively easy to understand, it receives the most public attention. In fact, the balance reflects the combined international competitiveness of a country’s manufacturing and service sectors. However, other balances also exist.
The balance on merchandise trade reflects the competitiveness of a country’s manufacturing sector. The balance on services reflects the service sector’s global competitiveness. Although the balance on merchandise trade often receives more publicity, the balance on services is growing in importance because of the expansion of the service sector in many national economies. The current account balance shows the combined performance of the manufacturing and service sectors. It also reflects the generosity of the country’s residents (unilateral transfers) as well as income generated by past investments. The official settlements balance reflects the net quantity of the country’s currency that is demanded and supplied by all market participants, other than the country’s central bank.Which of these BOP balances is the balance of payments? There is no single measure of a country’s global economic performance. Rather, each balance presents a different perspective on the nation’s position in the international economy. Knowing which BOP concept to use (and when to use it) depends on the issue that confronts the international businessperson or government policy maker.
In order to define the Balance of Payments Surpluses and Deficits, this section examined the balance on trade in goods and services. Then, it reviewed some additional measures of global economic performance.The presentation will close with a review of this chapter’s learning objectives.
This concludes the PowerPoint presentation on Chapter 7, “The International Monetary System and the Balance of Payments.” During this presentation, we have accomplished the following learning objectives: Discussed the role of the international monetary system in promoting international trade and investment. Explained the evolution and functioning of the gold standard. Summarized the role of the World Bank Group and the International Monetary Fund in the post-World War II international monetary system established at Bretton Woods.Explained the evolution of the flexible exchange rate system.Described the function and structure of the balance of payments accounting system. Differentiated among the various definitions of a balance of payments surplus and deficit. For more information about these topics, refer to Chapter 7 in International Business.