The International

Monetary System
Case: Turkeys 18
th
IMF Program
4Large and inefficient state sector heavy subsidies
4Government debt up to 60% of gross domestic
product
4Rampant inflation
4IMF focus
+Reduce inflation
+Stabilize value of currency
+Privatization
+Reduction of subsidies
+Government reforms
4Reasons for failure
Chapter Focus
4Explain how the international
monetary system works
+Review the systems evolution
_The gold standard
_Bretton Woods - 1944
+Reasons for the Bretton Woods
failure
+The present system
_Float versus fixed
4Implications for business
The International Monetary System
4The institutional arrangements that countries
adopt to govern exchange rates
4Dollar, Euro, Yen, and Pound float against each
other
+Floating exchange rate:
_Foreign exchange market determines
the relative value of a currency
4Some countries use other institutional
arrangements to fix their currencys value
In the beginning the Gold Standard
Roots in
mercantile
Trade
From
1200 AD
Inconvenient to ship
gold, changed to
paper - redeemed
for gold
Seeking a
balance of trade
equilibrium
Pegging
currencies
to gold and
guaranteeing
convertibility
International Monetary Evolution (I)
4The gold standard (1870s to 1914)
+Pegging currencies to gold and
guaranteeing convertibility by
central banks
+Trade deficit leads to a loss of gold,
which leads to a smaller base of
money supply
4Global chaos and conflict between
1914 and 1944
Balance of Trade Equilibrium
Trade Surplus
Gold
Increased
money supply =
price inflation
Decreased money
supply = price
decline
As prices decline, exports
increase and trade goes
into equilibrium
exports
remittances
Imports
Payments
Period Between the Wars: 1918-1939
Countries abandoned gold standard at start of WWI
Costs of war led countries to print money resulting in
inflation
- U.S.A. (1919), Great Britain (1925), and France (1928)
returned to gold standard at end of war:
Britain used old rate, thus priced exports out of the
market
U.S.A. did same -- then changed gold to $ ratio
thus devaluing the dollar to increase exports
+ Other countries did same -- no faith in currencies
+ Run on countries gold reserves
1939 - End of gold standard
Bretton Woods
1944:
444 countries meet in New Hampshire
4Fixed exchange rates deemed desirable:
+Agree to peg currencies to US dollar that is
convertible to gold at $35 per ounce
4Promise not to devalue currency for trade
purposes and will defend currencies
4Created:
+ World Bank
+ International Monetary Fund
Bretton Woods
Mt. Washington Hotel from http://www.mtwashington.com/
International Monetary Evolution (II)
4The Bretton Woods system:
+IMF - maintain global monetary order
+World Bank - promote economic development
4All countries fix their currency to gold:
+But no need to maintain convertibility
+Only the US remained convertible at $35/oz
4The system could only work when:
+inflation in the USA was low and
+USA did not have a balance of payments
deficit
The Role of the IMF
Desire to avoid problems following WWI
Discipline:
Fixed rate imposes discipline:
+Need to maintain rate stops competitive devaluations
+Imposes monetary discipline,curtailing inflation
Flexibility by provide financial assistance:
Lending facility:
+Lend foreign currencies to countries having balance-
of-payments problems
Adjustable parities:
+Allow countries to devalue currencies more than 10%
if B of P was in fundamental disequilibrium
Principal Duties of the IMF
4Surveillance of exchange rate policies (No
longer fixed rate exchange)
4Financial assistance (including credits and loans)
4Technical assistance (expertise in
fiscal/monetary policy)
+Note: Persistent borrowings leads to IMF
control of a countrys economic policy
Membership in the IMF
4Open to any country willing to agree to its
rules and regulations
4Must pay a deposit (quota)
4Quota size reflects global importance of a
nations economy
4Quota determines voting powers
Top 10 Contributors to the IMF
182 member countries contribute to the IMF
according to the size of their national economy
(funds remain their property)
http://www.imf.org/external/pubs/ft/exrp/what.htm
in percent of total quotas
Top 12 borrowers from the IMF
Borrower repays loan in 1 to 5 years with interest
No nation has defaulted -- some have extensions
http://www.imf.org/external/pubs/ft/exrp/what.htm
1947 - 2000
NOT the Role of the IMF!
http://www.cartoonstock.com/directory/i/international_monetary_fund_gifts.as
p
The Role of the World Bank
International Bank for Reconstruction
and Development (IBRD)
4Rebuild Europes war-torn economies
+Overshadowed by the Marshall Plan
4Turns to a development role:
+Lending money to Third World nations
_ Agriculture
_ Education
_ Population control
_ Urban development
IBRD raises money in bond
market and lends at market rate
International Development Agency
raises money through subscriptions
and lends to very poor countries
IBRD Largest
Contributors
IMF and the World Bank
inviting the Third World to a meal
Rabei', Al-Riyadh, 8/24/03
World Bank and Debt Crisis in Third World
Khaldoun Gharaybeh, Al-Ra'i, 1/25/04.
Collapse of the Fixed Exchange Rate System
Collapsed in 1973:
4Pressure to devalue U.S. dollar led to the collapse:
+President Johnson financed both the Great Society
and the war in Vietnam by printing money:
High inflation
High spending on imports
+President Nixon took dollar off gold standard,
introduced a 10% import tax, wage & price controls
+Countries agreed to revalue their currencies against
the dollar
4Bretton Woods fails when key currency
(the US dollar) is under speculative attack
Now we have a managed-float system
Floating Exchange Rate Regime
Jamaica Agreement - 1967
Floating rates acceptable
Gold abandoned as reserve asset
IMF quotas increased
IMF continues role of helping countries
cope with macroeconomic and exchange
rate problems
Exchange Rates Since 1973
More volatile:
Oil crisis: 1971
Confidence in US $ drops: 1977-78
Oil crisis: 1979
Unexpected rise of US $: 1980-85
Rapid fall of US $: 1985-87, 1993-95, and
2002-?
Partial collapse of the European Monetary
System - UK & Italy back out: 1992
Asian currency crisis: 1997
Some countries use:
Pegged exchange rate
" Value of currency is fixed relative to a
reference currency
Dirty float
" Hold currency value within some range
of a reference currency
Fixed exchange rate
" Set of currencies are fixed against each
other at some mutually agreed upon
exchange rate
All require
some
degree of
government
intervention
Exchange Rates Since 1973
90
100
110
120
130
140
150
160
1
9
7
4
Post-Bretton US Dollar Movements
Index = 100
Fixed versus Floating Exchange Rates
Floating:
4Monetary policy autonomy:
+Restores control to
government
4Trade balance
adjustments:
+Adjust currency to
correct trade
imbalances
Fixed:
4Monetary discipline
4Speculation:
+Limits speculators
4Uncertainty:
+Predictable rate
movements
4Trade balance adjustments:
+Argue no linkage between
exchange rates and
trade
7Linkage between savings
and investment Which system is better?
Evidence is unclear
Exchange Rate Regimes
4Pegged Exchange
+Peg rate of own currency
to a major currency ($)
+Popular among smaller
nations
+Evidence of moderation
of inflation
4Currency Boards
+Country commits to
converting domestic
currency on demand into
another currency at a
fixed exchange rate
+Country holds foreign
currency reserves equal to
100% of domestic currency
issued
IMF Members Exchange Rate
Policies, 2002
22%
22%
8%
22% 4%
22%
Free Float
Managed Float
Adjustable Peg
Fixed Peg
Arrangement
Currency Board
Arrangement
No separate
Tender
Figure 10.2
Target Zones: The European Monetary
System in Retrospect
4An exchange rate system based on target zones
involving a group of countries trying to keep their
currencies within a predetermined zone, of other
currencies in the group.
4Created in 1979:
+ Create stability by reducing volatility and inflation
_Control inflation by imposing monetary discipline
+ Coordinate exchange rates between EU and non-EU
currencies such as the US dollar and Japanese yen.
+Created the European currency unit (Ecu) and the
exchange rate mechanism (ERM) to achieve objectives
Image: www.gettyimages.com
The Ecu and the ERM
4Ecu was a basket of EU
currencies:
+One Ecu = defined % of
national currencies
+Each national currency
given rate versus the Ecu
+Mandatory intervention
into FX market when
currency fluctuates
+Defend against
speculation.
4System performance:
+1992: pound and lira hit
by speculation
+Britain and Italy withdraw
from EMS
4Changed EMS:
+Fluctuation bands
increased to 15%
+Intervention no longer
required
4Performance: good
Systems prior to the introduction of the Euro
The Euro
Image: www.claybennett.com
Crisis Management by the IMF
Role has expanded to meet:
Currency crisis
Banking crisis
Foreign debt crisis
Headquarters in Washington, DC
A World of Financial Crises
Latin America 1982-89: Loan rescheduling & reduction
($30B+, of which $15B for Mexico)
Mexico 1994-5: $18B from IMF; $20B from US
Russia 1996 ($10B); 1998 (domestic default)
Asia 1997: Korea ($55B); Indonesia ($37B); Thailand ($17B)
Common contributing factors:
+Excessive foreign borrowings
+Weak regulatory and financial systems (e.g., corruption)
+High inflation rates
+Widening current account deficit
Incidence of Currency Crises
1975-1997
0
0.1
0.2
0.3
0.4
0.5
0.6
1975 78 81 84 87 90 93 96
Industrial
Emerging Market
Figure 10.3a
Number of Currency Crises per Country
A Typical Problem
Source: www.claybennett.com
Incidence of Banking Crises
1975-1997
0.0
0.1
0.1
0.2
0.2
75 77 79 81 83 85 87 89 91 93 95 97
Developed
Developing
Number of Banking Crises per Country
Mexican Currency Crisis of 1995
4Mexican Peso pegged to the U.S. dollar
4Mexican producer prices rise by 45% without
corresponding exchange rate adjustment
4Investments continued $64B between 1990-94
4Speculators began selling pesos and government
lacked foreign currency reserves to defend it
4IMF stepped in
Mexican Peso Movements
0
20
40
60
80
100
120
140
160
I
n
d
e
x

=

1
0
0
1994 1995
The Russian
Ruble Crisis
4Persistent decline in value of ruble:
+ High inflation
_Artificial low prices from the Communist era
_Shortage of goods
+ Growing public-sector debt
4Refusal to raise taxes to pay for government services
4Financial markets loss of confidence in Russias ability to
meet national and international payments:
+Loss of international reserves
+Unable to roll over treasury bills reaching maturity
4Financial markets unable to determine whos in charge
Russian Government Actions
Exacerbating the Situation
4De facto devaluation of the ruble
4Unilateral restructuring of ruble-
denominated public debt
490-day moratorium on foreign credits
repayment
4Increased interest rates to defend ruble
4Duma (Parliament) rejects measures
designed to alleviate problems
4Refuses to pass required tax legislation
Photograph - http://creative.gettyimages.com
Decline of the Russian Ruble
-6000
-5000
-4000
-3000
-2000
-1000
0
1992 1993 1994 1995

Rubles/USdollar
Banknote from http://aes.iupui.edu/rwise/countries/russia_regular.html
Russian Ruble Crisis
QuickTime and a Cinepak decompressor are needed to see t his picture.
The Asian Crisis
1997:
LInvestment boom
LExcess capacity
LDebt
LExpanding imports
Impact of the Asian Financial Crisis
on U.S. Imports
0 10 20 30 40 50 60
Apparel
Toys
TV & VCR
Motor Vehicles
Appliances
1998
1997
1996
Image: John Pritchett, http://www.pritchettcartoons.com/flu.htm
Devalued Asian Currencies
0
20
40
60
80
100
120
I
n
d
e
x

=

1
0
0
Thailand
Indonesia
S. Korea
1997 1998
Banknotes from http://aes.iupui.edu/rwise/countries
South Korean Crisis
QuickTime and a Cinepak decompressor are needed to see t his picture.
http://www.cia.gov/cia/publications/factbook/geos/ks.html
http://www.kcshop.com/imagegallery/SouthKorea.htm
Problems in Asian Market Economies
4Cronyism
4Too much money, dependence on speculative
capital inflows
4Lack of transparency in the financial sector
4Currencies tied to (then) strengthening US$
4Increasing current account deficits
4Weakness in the Japanese economy
QuickTime and a
TIFF (Uncompressed) decompressor
are needed to see this picture.
QuickTime and a
TIFF (Uncompressed) decompressor
are needed to see this picture.
Chinese characters: www.totalpackage.com.au/ winter98.htm
The IMFs Tools
Short-term loans with strings attached:

4 Slash government spending
4 Enhance tax revenues
4 Raise interest rates to slow monetary
growth and inflation

These are harsh prescriptions!
Evaluating the IMFs Policy Prescriptions
Inappropriate policies?
4 One size fits all
4 Moral hazard (provides global insurance):
+People behave recklessly when they know they will
be saved if things go wrong
+Foreign lending banks could fail
+Foreign lending banks have paid price for rash
lending
4 Lack of Accountability:
+ IMF has grown too powerful?
+ Monitoring many countries
+ Unelected, understaffed body
Unclear as to the
appropriateness
of IMF actions
Impact on the Countries
4Currency devaluation
4Declining investment
4Rising prices
4Rising unemployment
4Rising poverty
Rising resentment?
http://www.aseed.net/callsandnews/dutchmeeting-wbb.html
http://www.cartoonwork.com/imf.htm
Implications for Business
4Currency management
4Business strategy
+Forward exchange market (months not
years ahead)
+Strategic flexibility
4Corporate-government relations
Implications for Business?!
http://www.envirocitizen.org/news/Upload/stooges.gif
The Future?
Copyright 2005 Christo Komarnitski, Bulgaria, All rights reserved
Qualifications?
Copyright 2005 Mike Keefe, The Denver Post All rights reserved