International Monetary System: The International Financial System - Reform of International Monetary Affairs - The Bretton Wood System and the International Monetary Fund, Controversy over Regulation of International Finance, Developing Countries' Concerns, Exchange Rate Policy of Developing Economies.

1. Unit 4. International Monetary System
4. International Monetary System:
The International Financial System
- Reform of International Monetary Affairs
- The Bretton Wood System and the International
Monetary Fund, Controversy over Regulation of
International Finance, Developing Countries'
Concerns, Exchange Rate Policy of Developing
Economies.

2. International Financial System
The international financial system (IFS)
constitutes the full range of interest‐ and
return‐bearing assets, bank and nonbank
financial institutions, financial markets that
trade and determine the prices of these
assets, and the nonmarket activities (e.g.,
private equity transactions, private
equity/hedge fund joint ventures, leverage
buyouts whether bank financed or not, etc.)
through which the exchange of financial assets
can take place.
The IFS lies at the heart of the global credit
creation and allocation process.

3. To be sure, the IFS depends on the effective
functioning and prudent management of the
IMS and the ready availability of currencies to
support the payment system.
Nevertheless, the IFS extends far beyond IMS’s
common payments and currency pricing role
to encompass the full range of financial
assets, including derivatives, credit classes
and the institutions that engage in the
exchange of these assets as well as their
regulatory and governing bodies.
The IFS encompasses the IMS — but extends
in function and complexity well beyond the
IMS.

4. Government debt links the two systems, as
government debt can function as “near
money” in a zero interest rate environment.
Many financial transactions pass through a
stage of payment in money (i.e., a demand
deposit) — quickly —to a “riskless”
interest‐bearing asset, like government
bonds.
When “riskless” assets become more “risky”
and less liquid, the payment system slows
down and may even be upended.

5. Three features of the international financial
system in the 21 st century:
―the currency system,
―capital flows,
―the responsibilities of authorities in
the major economies.

6. (1) The international monetary system (how
exchange rates, balance of payments and
macroeconomic management are
managed and adjusted globally) is part of
a broader international regime. As such, it
is influenced strongly by the way power is
distributed and exercised in the world, as
well as the presence or absence of a
powerful and reliable leader country.

7. (2) Over time, international monetary
systems exhibit oscillation between two
opposites: for example, (i) general floating
versus general fixity, (ii) stability versus
instability, and (iii) free capital mobility
versus no such mobility. It is hard to say
which situation is normal and which is
abnormal. People often believe that the
prevailing system is normal and
permanent, but it usually isn't. Whether
capital mobility has become irreversible in
the 21st century is an interesting and
open question.

8. (3) "The triangle of impossibility": Consider (i)
exchange rate stability (i.e., fixed exchange
rates), (ii) monetary policy independence,
and (iii) free capital mobility. These three
things are regarded as desirable, but only
two can be realized at any time. Different
international monetary systems emerge
depending on which one we give up. For
example, if we abandon the first, we have a
floating rate system; and if the second is
removed, monetary union like EU will
emerge, and so on.

9. (4) Since the 19th century, there has been a
gradual movement away from commodity
money (typically gold) toward paper money
(managed currency).
The problem with gold is its quantity is too
constraining, which is also a merit if the
central bank is irresponsible. In the 21st
century, maybe we will have e-money which
has completely new characteristics (and
risks).

10. The Currency System
The safest judgment is that the currency
system will continue to evolve along with
the evolution of the international financial
system.
Article IV of the IMF Articles of Agreement
calls upon members to assure orderly
exchange rate arrangements and to
promote a stable system of exchange rates
not a stable exchange rate system.

11. The Currency System
In a rapidly changing international financial system,
the search for comprehensive approaches to
global exchange rate systems is likely to be
unrewarding.
When it comes to exchange rate regimes, there are
no panaceas.
It is easy to demonstrate that there is no single
regime that is best for any national economy
under all economic and financial circumstances;
the disturbances with which regimes must cope
change over time.

12. The Currency System
National authorities have to make choices about
which regime on balance will best serve their
economies; because changes in regimes are not
costless. Eclecticism also is not a realistic option.
Similarly no global currency system promises to
serve best the interests of the global financial
system under all conditions.

13. The economic case for a trade bloc rests on
the observation that ex ante trade barriers
are high; the establishment of the trade
bloc serves on balance to reduce trade
distortions, creating more trade than is
diverted.
Currency blocs, on the other hand, run the
risk of increasing distortions through the
erection of barriers to the free flows of
finance where few exist today, at least
among the major currencies and financial
markets.

14. Capital Flows
Consider a regime with a common global
currency.
Under such a regime, as with national
monetary systems, capital flows would not
be immune from irrational exuberance or
despondence, and crises would continue
to be possible.

15. At a pragmatic level, responding to potential
problems associated with international
capital flows by the imposition of controls
on those flows is likely over time to prove
to be inefficient (and, therefore, costly),
ineffective, or both, unless the national
financial market itself is tightly controlled or
highly underdeveloped.
Moreover, as countries develop and grow,
controls are relaxed and financial systems
are opened up.

16. Better response to the potential problems
associated with international capital flows
lies in the promotion of sound
macroeconomic policies, flexible markets,
robust financial systems supported by
appropriate regulations and supervision,
transparency about regimes and
institutions, and adherence to agreed
global standards.

17. Responsibilities of Authorities in the Major
Economies
In order to provide support for the appropriate evolution
of the international financial system in the 21 st
century, the authorities in the major economies should
implement sound macroeconomic and structural
policies, demonstrate their respect for market forces,
and endeavor to follow a policy of inclusion when it
comes to establishing the rules and principles that will
guide and govern the financial system. All this may
sound like very little, but it is remarkable how taxing it
is to accomplish these tasks effectively and
successfully.

18. The United Nations Monetary and Financial
Conference, commonly known as Bretton Woods
conference, was held in Bretton Woods, New
Hampshire, USA to regulate the international
monetary and financial order after the conclusion
of World War II.
The aim was to help rebuild the shattered
post-war economy ( WW2 had just finished
in 1945) and to promote international
economic cooperation.

19. The conference resulted in the agreements
to set up the International Bank for
Reconstruction and Development
(IBRD)- popularly known as World Bank
and the International Monetary Fund
(IMF).
The IMF was set up to foster monetary
stability at global level. The IBRD was
created to speed up post-war
reconstruction. The two institutions are
known as the Bretton Woods twins.

20. Origins of Bretton Woods
Political origin lies in 2 key conditions –
Shared experiences of 2 World Wars, with the
sense that failure to deal with economic
problems after the first war had led to the
second <Treaty of Versailles demanding
massive reparation amount from
Germany being the cause of collapse of
German economy and Hitler’s rise to power>
The concentration of power in a small number
of states (US and Western Europe)

21. Members of Bretton Woods Family aka Bretton Woods
Twins
1. International Monetary Fund(IMF) – To maintain
global financial stability through technical assistance,
training, and loans to member states to tide over short
term balance of payment crisis
2. World Bank (WB) Group – Consisting of 5 agencies
which provides vital financial and technical assistance to
developing countries around the world to reduce global
poverty
Remember that WTO has nothing to so with Bretton Woods.
It officially commenced only in 1995 under the Marrakesh
agreement and replace General Agreement on Tariff and
trade (GATT)

22. The Bretton Woods System is a set of unified rules and
policies that provided the framework necessary to
create fixed international currency exchange rates.
Essentially, the agreement called for the newly
created IMF to determine the fixed rate of exchange
for currencies around the world. Every represented
country assumed the responsibility of upholding the
exchange rate, with incredibly narrow margins above
and below. Countries struggling to stay within the
window of the fixed exchange rate could petition the
IMF for a rate adjustment, which all allied countries
would then be responsible for following.
The system was depended on and was used heavily
until the beginning of the 1970s.

23. The Collapse of the Bretton Woods System
Backing currency by the gold standard started to become a
serious problem throughout the late 1960s. By 1971, the
issue was so bad that US President Richard Nixon gave
notification that the ability to convert the dollar to gold was
being suspended “temporarily.” The move was inevitably
the final straw for the system and the agreement that
outlined it.
Still, there were several attempts by representatives,
financial leaders, and governmental bodies to revive the
system and keep the currency exchange rate fixed.
However, by 1973, nearly all major currencies had begun
to float relatively toward one another, and the entire
system eventually collapsed.

24. A brief World War II Timeline
Adolf Hitler demanded that Gdansk be given to
Germany, claiming that Gdansk residents were
predominantly German. Backed by France and
Britain, Poland refused. With this excuse, Germany
invaded Poland on September 1, 1939.
Recall that the representatives of the US and its
Allies worked out three post-war arrangements
(i) ITO (still-born), replaced by GATT and WTO.
(ii) IBRD (which became the World Bank), and
(iii) IMF, immediately after the Normandy invasion
in June 1944.

25. Stable and adjustable exchange rates
For 25 years after WWII, the international monetary
system known as the Bretton Woods system, was
based on stable and adjustable exchange rates.
Exchange rates were not permanently fixed, but
occasional devaluations of individual currencies
were allowed to correct fundamental disequilibria
in the balance of payments (BP). Ever-increasing
attack on the dollar in the 1960s culminated in the
collapse of the Bretton Woods system in 1971,
and it was reluctantly replaced with a regime of
floating exchange rates.

26. loss of national sovereignty
• By signing the agreement, nations were
submitting their exchange rates to
international disciplines.
• This amounted to a significant surrender of
national sovereignty to an international
organization.
• Territorial waters = 12 nautical miles. US
navy ships patrolled near Spratly
archipelago on international waters (outside
12 nm).

27. Advantages over the gold exchange standard
Deflationary policy: Under the gold exchange
standard, a country has to resort to the classical
medicine of deflating the domestic economy when
faced with chronic BP deficits.
Before World War II, European nations often used
this policy, in particular the Great Britain. Even
though few currencies were convertible into gold,
policy makers thought that currencies should be
backed by gold and willingly adopted deflationary
policies after WWI.

28. Advantages over the gold exchange standard
Deflationary policy is not the only option when faced
with BP deficits. Devaluation is accepted in
Bretton Woods.
The adjustable peg was viewed as a vast
improvement over the gold exchange standard
with fixed parity.
Currencies were convertible into gold, but unlike the gold
exchange standard, countries had the ability to change par
values of their currencies . For this reason, Keynes
described the Bretton Woods system as "the exact
opposite of the gold standard." The world economy tripled
in size during the two decades, but gold supply did not
change much.

29. Unanticipated Problems
Structural problems: (i) Over time the world
economy grew and needed more liquidity or
reserve assets. ⇒ Marshall Plan Aid.
Gate of Honor, Versaille Palace
"Wir wollen Kohle, Wir wollen Brot" (We want
coal, We want bread). (former) President Herbert
Hoover (1947): The whole economy of Europe is
interlinked with German economy through the
exchange of raw materials and manufactured
goods.)
(

30. Unanticipated Problems
(ii) Given the fixed quantity of gold (192,000 tons or
6.2 billion ounces, annual production of gold = 80
million ounces = $100 billion), other countries had
to hold US dollar and gold as reserve. Keynes
had proposed that a world reserve currency be
created and managed by a central bank. (Today
IMF manages SDR.)
(iii) As the world economy grew, the increased world
demand for dollar as reserve assets meant that
US had to incur increasing trade deficits.

31. Unanticipated Problems
The dollar was the numéraire of the system, i.e., it was
the standard to which every other currency was
pegged. Accordingly, the U.S. did not have the power
to set the exchange rate between the dollar and any
other currency.
Changing the value of dollar in terms of gold has no real
effect, because the parities of other currencies were
pegged to the dollar. This is the n-th currency
problem. This problem would not have existed if most
of other currencies were pegged to gold. However,
none of these currencies were pegged to gold
because they were not convertible into gold. (limited
supply of gold)

32. Invasion of Normandy (June 6, 1944)
International Monetary Fund and World Bank
meeting was held in July 1944 in Bretton Woods,
New Hampshire, one month after the invasion of
Normandy.
This meeting to establish United Nations was held in
San Francisco and the charter was signed in June
1945 (after Germany's surrender).
UN came into existence in October 1945. The
Articles of Agreement of the IMF was signed in
December 1945. The next year, the By-laws were
adopted at a meeting in Savanna, Georgia (March
8-18, 1946).

33. Contents of the Articles of Agreement
• IMF was established to provide member
countries with the necessary funds to cover
short term balance of payments problems.
The Fund in turn received resources from
members who were allotted quotas.
• Initial quota: $8 billion (worth about $80
billion today)
(Total Quota = 238 billion SDR as of 2010,
doubled, reaching 476 billion SDR in 2011).

34. Par value and 1% band
Upon entering the Fund, a country submitted
a par value of its currency expressed in
terms of gold or in terms of the US dollar
using the weight of gold in effect on July 1,
1944 ($35 per troy oz).
All exchange transactions between member
countries were to be effected at a rate that
fluctuated within 1% band (which
approximates gold import/export points)
around the par values of the respective
currencies.

35. Article IV : Changing par value
Article IV: A member could change the par value of its
currency only to correct a fundamental disequilibrium in
its balance of payments, and only after consulting with the
Fund.
(However, speculators correctly anticipate such weak
currencies, making it more difficult for the monetary
authorities to defend them.)
In case the Fund objects a change, but the member devalues
its currency, then that member is ineligible to use Fund's
resources.
The Fund cannot formally propose a change of the par value
of a currency.
No objection to a change if the cumulative change is less
than 10% of the par value.

36. Article VI: allows members to control capital
movements.
Article VII: The Fund may declare a currency to be
scarce. If so, member countries are authorized to
impose exchange control over the scarce
currency.
Remark: A problem that appeared during the interwar period was that
unlike deficit countries, surplus countries were not under any pressure
to adjust their BP. A deficit country was compelled to take some kind of
action to restore equilibrium, but a surplus country can accumulate
reserves indefinitely. (This is still true even today. IMF monitors
currency practices of deficit countries that receive loans.)
Britain adopted deflationary policy in the 1920s, but the surplus countries
(US + France) did not participate in the adjustment process.

37. Article VIII forbids restrictions on current account
balances. Members are obligated to maintain the
convertibility of foreign held current account
balances (to facilitate trade).
Exceptions: Article VII + XIV
Article XIV allows a member country to retain
exchange control restrictions in effect when that
country entered the Fund. Once a member
country abolishes its exchange control over the
current payments and accepted the obligations of
Article VIII, then it cannot reimpose exchange
control without the approval of the Fund.

38. Remark: Most major countries in Europe accepted
the obligations of Article VIII by 1961. Japan came
under this article in 1964.
The remaining Article XIV countries are obligated to
consult annually with the Fund on exchange
controls, but the Fund has no power to abolish the
exchange control unilaterally. No scarce currency
declaration has been made.
Most nations outside the Communist bloc became
members of the IMF.

39. Borrowing under Bretton Woods
During the Bretton Woods era (1948-73),
world trade volume increased six-fold while
GWP tripled (from $7 trillion in 1950 to $21
trillion) . ⇒ Transctions demand for foreign
currencies increased 6 times but the gold
supply did not increase much. Per capita
US GDP doubled ($2,700 in 1950 to $5,400
in 1973 at the end of the Bretton Woods.)

40. • But the total international reserve increased
only by 3% during the same period. So
there developed an acute shortage of
international reserve assets. The US had
acquired the bulk of the world's gold. In
1946, the US held $26 billion worth of gold
(740 million ounces, world total = 6 billion
oz). Today, Treasury owns 260 million
ounces of gold (mostly in Fort Knox,
Denver, and West Point and a little bit at
FRB NY).

41. If the U.S. had exported Treasury bills, it
would have provided additional reserves for
the US. However, nations became
increasingly reluctant to hold $. Gradually,
the US stock of gold was depleted.
The Fund was the source of financing for a
member country experiencing a temporary
disequilibrium in its balance of payments.
These resources come from gold and
currency subscriptions of its members.

42. Reserve/Gold tranche / Credit tranche
Upon entering the Fund, each country was
allotted a quota in accordance with its
relative economic size.
Reserve (gold) tranche: 25% of quota was
paid to the Fund in gold (1944 US dollar).
Today, this must be paid in SDR or major
currencies ($, £, € and yen).
Credit tranche: 75% of quota was paid in the
currency's own currency.

43. Quota
In 1946, the Fund started with aggregate quotas of
$8 billion, 20% of world reserves. (Today, this
amount is worth roughly $100 billion) The quota
was raised in 1971. The largest quota was US:
$6.7 billion (21.9%): U.K. $2.8 billion (9.2%),
Germany, France 5%, Japan 4%. The quota was
increased several times.
In 1990 the quota was increased to $135 billion, still
equal to about 20% of world reserves.
In 2011, quota increased to SDR 477 billion
(about $677 billion). There have been no
increases thereafter.

44. Quota
The quota determines the voting power of a
member's executive director. (250 votes + 1 vote
for SDR100,000)
e.g., US = 17.75% ($65 billion), total = $366 billion
(as of 2009)
Total: 2.5 million votes (and growing).
US holding of gold: currently, about 8,000 tons
($160 billion at $40 per oz), or about 5% of the
world's total gold stock. (the world has about
190,000 tons in 2019, World Gold Council)
Jewelry: 90,000 tons, Investors: 40,000 tons,
governments: 33,000 tons

45. Borrowing
The size of a country's quota determines the
borrowing limit of that country.
(i) Basic Facility: gold tranche + 4 credit tranche =
125%
(ii) Extended Facility: 140%
(iii) Standby Agreements: Short term borrowing
member countries negotiate to receive the Fund's
guarantee. usually borrowing is for 3-5 years.
.

46. Borrowing
(iv) General Agreements to Borrow (GAB): was negotiated
in 1962 by the Group of Ten: France, Italy, Germany,
Belgium, Netherlands, Sweden, Japan, UK, US, Canada.
Switzerland joined in 1964. The fund could borrow up to
$5.9 billion from the Group of Ten to provide more short
term assistance.
(v) Currency Swap Arrangements : made in 1962. bilateral
arrangements between central banks. Purpose: to avoid
exchange control. At maturity, both parties re-exchange
the original amounts.
The total quota is small, not sufficient to deal with the
European crisis.
In 2008, Japan lent $100 billion to the IMF. US also extended
$100 billion line of credit.