MODULE 2
INTERNATIONAL MONETARY
SYSTEM
International Monetary Fund (IMF) which defines the overall financial
environment in which multinational corporations and international
investor operates.
Fixed rate regime abandoned in 1973- Adversely affected their competitive position in the market
International investor also face the forex risk in managing their portfolio
European countries have adopted common currency for bilateral trade
Complex system of IMF
Essential for manager to understand the IMF in detail.
The IMF can be defined as the institutional framework
within which International payments are made, movements
of capital are accommodated and exchange rates currencies
are determined.
In simple IMF – gives a broad guidelines regarding
agreement, rules, institution mechanism and policies
regarding exchange rates, international payments and the
flow of capital.
EVALOUTION OF IMF:
Bimetallism: Before 1875
Classical Gold Standard: 1875-1914
Interwar Period: 1915-1944
Bretton Woods System: 1945-1972
The Flexible Exchange Rate Regime: 1973-Present
BIMETALLISM: BEFORE 1875
A “double standard” in the sense that both gold and silver
were used as money.
Some countries were on the gold standard, some on the
silver standard, some on both.
Both gold and silver were used as international means of
payment and the exchange rates among currencies were
determined by either their gold or silver contents.
Gresham’s Law implied that it would be the least valuable
metal that would tend to circulate.
CLASSICAL GOLD STANDARD:
1875-1914
During this period in most major countries:
Gold alone was assured of unrestricted coinage
There was two-way convertibility between gold and national
currencies at a stable ratio.
Gold could be freely exported or imported.
The exchange rate between two country’s currencies would be
determined by their relative gold contents.
CLASSICAL GOLD STANDARD:
1875-1914
For example, if the dollar is pegged to gold at U.S.$30 = 1 ounce
of gold, and the British pound is pegged to gold at £6 = 1 ounce
of gold, it must be the case that the exchange rate is
determined by the relative gold contents:
$30 = £6
$5 = £1
CLASSICAL GOLD STANDARD:
1875-1914
Highly stable exchange rates under the classical gold standard
provided an environment that was conducive to international
trade and investment.
Misalignment of exchange rates and international imbalances of
payment were automatically corrected by the price-specie-flow
mechanism.
CLASSICAL GOLD STANDARD:
1875-1914
There are shortcomings:
Price- specie –flow mechanism
Gold Scarce Commodity
The supply of newly minted gold is so restricted that the growth of world trade
and investment can be hampered for the lack of sufficient monetary reserves.
Even if the world returned to a gold standard, any national government could
abandon the standard.
INTERWAR PERIOD: 1915-1944
World War I ended classical gold standard in August 1914
Many countries suffered hyperinflation(Germany, Austria, Poland and Russia)
Ex: Germany > 1 trillion times of pre war
Countries widely used “Predatory” depreciation of their currency
Post war – Attempted to recover the gold Standard
US emerge as dominant financial power.
US lift restriction on gold export and return to gold standard
Pound sterling return to gold standard in 1925 at the old mint parity
exchange rate of $4.87/Pound
Problems of the resorted gold standard are:
1. Pound’s overvaluation
2. Failure of the US to act reasonably
3. Undervaluation of the French Franc
4. Decrease in the willingness and ability of nations to rely on gold
standard
In 1934 US returned to modified Gold standard
Devalued its currency form 20.67/ ounce to 35.00/ ounce
Gold exchange standard – Foreign Banks not with the individuals
Continued form 1934 to till the end of the World war II
World major currency loosing their convertibility
The only major currency that continued to remain convertible was
the dollar.
Inter war period – half hearted attempts and failure to restore, economic and political
instabilities, widely fluctuation exchange rates, bank failure and financial crisis
BRETTON WOODS SYSTEM:
1945-1972
Named for a 1944 meeting of 44 nations at Bretton Woods, New
Hampshire.
The purpose was to design a postwar international monetary
system.
Signed Articles of agreement of International Monetary Fund(IMF)
Agreement subsequently ratified to launch IMF in 1945
The goal was exchange rate stability without the gold standard.
The result was the creation of the IMF and the World Bank. (IBRD)
BRETTON WOODS SYSTEM:
1945-1972
Under the Bretton Woods system, the U.S. dollar was pegged to
gold at $35 per ounce and other currencies were pegged to the
U.S. dollar.
Each country was responsible for maintaining its exchange rate
within ±1% of the adopted par value by buying or selling foreign
reserves as necessary.
The Bretton Woods system was a dollar-based gold exchange
standard.
NEGOTIATION AT BRETTON WOOD
1. Liberty to use macro economic policy
2. Extremities of both fixed and free float should be avoided
3. Monetary system needed – recognize both national and
international concern
4. Dollar based IMS – Establishment of two new institute
5. Role of IMF – BOP, problems of post war
IMPORTANT RESOLUTION
1. Two new institute in Washington D C
2. US $ ( de facto British pound) reserve currency – other nation peg to U S $
3. No provision was made to change the value of US $ to gold
4. Each country obligated to define monetary unit at par with the $
5. Each country was permitted fluctuate ±1
6. Up to 10% in extraordinary circumstances – without approval
7. US made a separate agreement to buy / sell gold at rate $ 35/ounce of gold
8. Fund members can change the fund value only with fund approval - BOP was in
fundamental disequilibrium- not for economic imbalance
9. Post war currency were to be convertible – reserve stock of US $ to intervene in the
market
BREAK DOWN OF BRETTON WOOD
SYSTEM
1. Bretton Wood system worked without major changes- Fixed rate, official
intervention, International trade expanded in a faster rate
2. Imbalance in the roles and responsibilities of surplus and deficit nation
3. Rigid approach adopted by the IMF to the BOP of disequilibria situation
1. Conditionality issue – set of rules and policies for the fund member
2. Conditionality – Short term and long term
3. Formulation of a formal financial programme- eliminate BOP disequilibrium
4. Use of IMF resource – requires IMF’s willingness and understanding by the
member to implement it.
SMITHSONIAN AGREEMENT
G-10 countries met in Smithsonian institution in Washington D C
(Dec 1971) – To save BWS
They entered Smithsonian agreement according to which
1. The price of Gold raise to $38
2. other countries revalued against US$ upto 10%
3. Exchange rate allowed to expand to up to 2.25 in either direction
Smithsonian agreement lasted only for one year
Devaluation of $ not sufficient to stabilize the situation
In Feb 1973 – Heavy selling pressure of Dollar
Prompting central banks around the world to buy the dollar
Gold price raised from $38 to $42
By March 1973 European and Japanese currency were allowed to
float
Since then exchange rates among major countries as the dollar,
mark, yen and pound have been fluctuating against each other
THE FLEXIBLE EXCHANGE RATE
REGIME: 1973-PRESENT.
Followed the dismissal of BWS.
Flexible exchange rates were declared acceptable to the IMF
members.- AS per the Jamaica agreement (January 1976)
1. Central banks were allowed to intervene in the exchange rate
markets to iron out unwarranted volatilities.
2. Gold was abandoned as an international reserve asset.- ½
returned to members remaining sold to use the proceeds to help poor nations
3. Non-oil-exporting countries and less-developed countries were
given greater access to IMF funds.
Exchange rates have become more volatile –since 1973
Behaviour of dollar exchange rate since 1965
1. Decline in dollar between 1970-73 – transition form Bretton wood to flexible exchange rate system.
2. During Regan administration- growing US budget deficit and BOP deficits
3. Large amount inflow of foreign capital – Caused high real interest rates. To attract
foreign capital and finance budget deficit
4. Heavy demand for dollar pushed value of dollar in exchange market –
(Peak Feb 1985) – trade deficit of 160 billion in 1985
5. Downward trend reinforced by government intervention
6. G-5 Countries met at plaza hotel new York – reached to Plaza Accord
Plaza Accord – They agreed that it would be desirable for the dollar to depreciate
against the major currencies to solve the US trade deficit problem and expressed
their willingness to intervene in the exchange market to realize the this objective.
In 1987 dollar rate decline too much and government of major industrial countries
began to worry that it may fall still low
To address volatility and other related issue G7 economic meeting conveyed – Paris 1987
Louvre Accord. Which says
1. G7 countries co-operate to greater exchange rate stability
2. Agree to consult and co-ordinate the macroeconomic policies
Louvre – marked the inception of Manage float system
!985- Reached peak – Plazza Agreement
Technology Boom
Collapse of Breton Wood
System (1970-73)
!987- Louvre Accord
Regan Era
The United States Dollar averaged 97.31 from 1967
until 2015, reaching an all time high of 164.72 in
February of 1985 and a record low of 71.58 in April of
2008.
CURRENT EXCHANGE RATE
ARRANGEMENTS
Free Float
The largest number of countries, about 48, allow market forces to determine their
currency’s value.
Managed Float
About 25 countries combine government intervention with market forces to set exchange
rates.
Pegged to another currency
Such as the U.S. dollar or euro (through franc or mark).
No national currency
Some countries do not bother printing their own, they just use the U.S. dollar. For
example, Ecuador has recently dollarized.
File:Currency Exchange [Link]
Free float regime
Managed float regime
Different types of currency peg
Usage of foreign currency
EUROPEAN MONETARY SYSTEM
Eleven European countries maintain exchange rates among
their currencies within narrow bands, and jointly float
against outside currencies.
Objectives:
To establish a zone of monetary stability in Europe.
To coordinate exchange rate policies vis-à-vis non-
European currencies.
To pave the way for the European Monetary Union.
WHAT IS THE EU?
The European Union is a system of international institutions, the first of which
originated in 1957, which now represents 25 European countries through the:
European Parliament: elected by citizens of member countries
Council of the European Union: appointed by governments
of the member countries
European Commission: executive body
Court of Justice: interprets EU law
European Central Bank, which conducts monetary policy, through a system of
member country banks called the European System of Central Banks
20-28
WHAT IS THE EMS?
The European Monetary System was originally a system of fixed
exchange rates implemented in 1979 through an exchange rate
mechanism (ERM).
The EMS has since developed into an economic and monetary union
(EMU), a more extensive system of coordinated economic and monetary
policies.
The EMS has replaced the exchange rate mechanism for most members
with a common currency under the economic and monetary union.
MEMBERSHIP OF THE
ECONOMIC AND MONETARY UNION
To be part of the economic and monetary union, EMS members must
1. first adhere to the ERM: exchange rates were fixed in specified bands
around a target exchange rate,
2. next follow restrained fiscal and monetary policies as determined by
Council of the European Union and the European Central Bank,
3. finally replace the national currency with the euro, whose circulation
is determined by the European System of Central Banks.
WHAT IS THE EURO?
The euro is the single currency of the European Monetary
Union which was adopted by 11 Member States on 1 January
1999.
These member states are: Belgium, Germany, Spain, France,
Ireland, Italy, Luxemburg, Finland, Austria, Portugal and the
Netherlands.
EURO CONVERSION RATES
1 Euro is Equal to:
40.3399 BEF Belgian franc
1.95583 DEM German mark
166.386 ESP Spanish peseta
6.55957 FRF French franc
.787564 IEP Irish punt
1936.27 ITL Italian lira
40.3399 LUF Luxembourg franc
2.20371 NLG Dutch gilder
13.7603 ATS Austrian schilling
200.482 PTE Portuguese escudo
5.94573 FIM Finnish markka
WHAT IS THE OFFICIAL SIGN OF THE
EURO?
⚫ The sign for the new single currency looks like an
“E” with two clearly marked, horizontal parallel
lines across it.
It was inspired by the Greek letter epsilon, in reference to the cradle of
European civilization and to the first letter of the word 'Europe'.
Balance
of
Payment
CHAPTER OBJECTIVES
This chapter will:
A. Explain the key components of the balance of payment
B. Explain how international trade flows are influenced by economic
factors and other factors
C. Explain how international capital flows are influenced by country
characteristics
INTRODUCTION
The balance of payments is a measurement of all transactions
between domestic and foreign residents over a specified period of
time.
Each transaction is recorded as both a credit and a debit, i.e. double-
entry bookkeeping.
The transactions are presented in three groups – a current account, a
capital account, and a financial account and Official reserve account
CONTD….
Balance of Payment : is a statistical record of a country’s
transaction with rest of the world.
1. Provides demand and supply of a country’s currency
2. Country’s balance of payment data may signal its
potential as a business partner for the rest of the world
3. BOP is used to evaluate the performance of the country
in International economic condition
BALANCE OF PAYMENTS – ACCOUNTING
Summary of transactions between domestic and foreign residents for
a specific country over a specified period of time presented in the
form of double –entry booking keeping.
Example of international transaction – Imports and exports of goods
and services, cross boarder investments in business, bank accounts,
bonds, stocks and real estate.
Generally,
Receipt from foreigner – Credit + sign
Payments to foreigners – Debit – sign
DEBIT ENTRIES AND CREDIT ENTERIES
Credit entries – Sale of goods and services, goodwill,
financial claim and real estate
Debit Entries- Purchase
Credit entries give rise to demand for the country’s
currency whereas debit entries give rise to supply of
country’s currency
BALANCE OF PAYMENT ACCOUNTS
BOP records all types of transaction.
Categorized into
1. The Current Account
2. The Capital Account and Financial Account
3. The official Reserve account
CURRENT ACCOUNT
summary of flow of funds due to the import and export of goods or
services or the provision of income on financial assets.
The current account balance which is defined as export minus
imports plus unilateral transfer.
The current account deficit implies that country has consumed more
than it produced. Borrowing
Country can pay current account deficit
Surplus acquires IOU from foreigners Drawing Accumulated
foreign wealth
CURRENT ACCOUNT
Payments for merchandise
Services
Factor income payments
Unilateral Transfer payments
MERCHANDISE TRADE
Export and import of tangible goods
Ex: wheat oil clothes etc
US has deficit on trade balance since the early 1980’s
Trade balance represents net merchandise export.
US counterpart Japan, Germany and China have generally
realized trade surplus.
Resulted in decline in US$ observed since 2001
SERVICES
It includes payment and receipt for legal, consulting and
engineering services, royalties for payment and intellectual
properties, Insurance premiums, shipping fees and tourist
expenditure.
These trade in services can also be called as invisible trade
US has performed better in services than merchandise.
FACTOR INCOME
It consists largely of payments and receipts of interest,
dividends, and other income on foreign investments that
were previously made.
Receipt should be recorded on credit side where as
payments should be recorded on debit side.
UNILATERAL TRANSFER
Unilateral transfers are unrequited payments.
It includes foreign aid, reparations, official and private
grants and gifts.
Unilateral transfers have only one directional flows, without
offsetting flows.
For the purpose of preserving the double entry system of
book keeping, unilateral transfer are regarded as act of
buying goodwill from the recipient.
INTERNATIONAL TRADE
FLOWS
Different countries rely on trade to different extents.
The trade volume of European countries is typically
between 30 – 40% of their respective GDP, while the trade
volume of U.S. and Japan is typically between 10 – 20% of
their respective GDP (India @ 40%).
Nevertheless, the volume of trade has grown over time
for most countries.
INTERNATIONAL TRADE FLOWS
Recent Changes in North American Trade
In 1998, a 1989 free trade pact between U.S. and Canada was
fully phased in.
Passed in 1993, the North American Free Trade Agreement
(NAFTA) removes numerous trade restrictions among Canada,
Mexico, and the U.S.
In 2001, trade negotiations were initiated for a free trade area
of the Americas. 34 countries are involved.
INTERNATIONAL TRADE
FLOWS
Recent Changes in European Trade
The Single European Act of 1987 was implemented to remove
explicit and implicit trade barriers among European countries.
Consumers in Eastern Europe now have more freedom to
purchase imported goods.
The single currency system implemented in 1999 eliminated
the need to convert currencies among participating countries.
INTERNATIONAL TRADE
FLOWS
Trade Agreements Around the World
In 1993, a General Agreement on Tariffs and Trade (GATT) accord
calling for lower tariffs was made among 117 countries.
Other trade agreements include:
Association of Southeast Asian Nations
European Community
Central American Common Market
North American Free Trade Agreement
SAARC
SAFTA
INTERNATIONAL TRADE FLOWS
Friction Surrounding Trade Agreements
Trade agreements are sometimes broken when one
country is harmed by another country’s actions.
Dumping refers to the exporting of products by one
country to other countries at prices below cost.
Another situation that can break a trade agreement is
copyright piracy.
FACTORS AFFECTING
INTERNATIONAL TRADE FLOWS
Inflation
A relative increase in a country’s inflation rate will
decrease its current account, as imports increase and
exports decrease.
National Income
A relative increase in a country’s income level will decrease
its current account, as imports increase.
FACTORS AFFECTING
INTERNATIONAL TRADE FLOWS
Government Restrictions
A government may reduce its country’s imports by
imposing tariffs on imported goods, or by enforcing a
quota. Note that other countries may retaliate by
imposing their own trade restrictions.
Sometimes though, trade restrictions may be imposed on
certain products for health and safety reasons.
FACTORS AFFECTING
INTERNATIONAL TRADE FLOWS
Exchange Rates
If a country’s currency begins to rise in value, its current
account balance will decrease as imports increase and
exports decrease.
Note that the factors are interactive, such that their
simultaneous influence on the balance of trade is a complex
one.
CORRECTING
A BALANCE OF TRADE DEFICIT
By reconsidering the factors that affect the balance of
trade, some common correction methods can be
developed.
For example, a floating exchange rate system may correct a
trade imbalance automatically since the trade imbalance
will affect the demand and supply of the currencies
involved.
CORRECTING
A BALANCE OF TRADE DEFICIT
However, a weak home currency may not necessarily improve a
trade deficit.
Foreign companies may lower their prices to maintain their
competitiveness.
Some other currencies may weaken too.
Many trade transactions are prearranged and cannot be
adjusted immediately. This is known as the J-curve effect.
The impact of exchange rate movements on intracompany
trade is limited.
2. CAPITAL AND FINANCIAL ACCOUNTS
Capital accounts includes the value of financial assets transferred
across the boarders by people who move to a different country. It
also includes the value of financial assets transferred across the
country boarders, such as patents and trademarks.
Capital account items are relatively minor compared to the
financial accounts.
Current account balance must be equal to the capital account
balance but with the opposite sign. (Absence of government reserve)
KEY COMPONENT OF FINANCIAL
ACCOUNTS
Direct foreign investment
Portfolio investment
Other capital investment
Errors and omissions
59
DIRECT FOREIGN INVESTMENT
DFI/FDI represents the investment in fixed assets in foreign
countries that can be used to conduct business operations.
For Ex: Acquisition of new company, Manufacturing plant,
Expansion etc.
Generally takes place when the firm tend to take advantage
of various market imperfections.
Higher ROI compared to domestic market (coc, PR, FER)
PORTFOLIO INVESTMENT
Portfolio investment represents transaction involving long-
term financial assets between countries that do not effect
the transfer of control.
In other words it represents sale and purchase of foreign
financial assets such as stocks and bonds that do not involve
a transfer of management control.
Portfolio investment is a desire for safety and liquidity in
investment either in domestic or international.
International portfolio boom – desire for diversify risk
globally
OTHER CAPITAL INVESTMENT
It represents transaction involving short financial assets
(Such as money market instruments) between the
countries.
In general FDI measures the expansion of firm’s foreign
operations, whereas portfolio investment and other capital
investment measures the net flow of funds due to the
financial asset transactions between the individual and or
institutional investors.
ERRORS OMISSIONS AND RESERVES
If a country has negative current account balance, it should have a
positive capital and financial account balance.
In simple, if a country sends more money out of country than it
receives fr0m other countries for trade and factor income .
If it receives more money from other countries than it spends than it
spends for capital and financial account component.(Investment)
Negative balance of current account should offset with positive
balance of capital account.
No perfect matching – hence in BOP errors and omissions
CONTD……
Recording of receipt and payments, bound to imperfect – different method
Cross boarder transaction BOP always presents a “balancing” debit
and credit as statistical discrepancy
When we compute BOP of current account, capital account and the
statistical discrepancy, we obtain the so called Overall balance or
official settlement balance.
Overall balance is significant – indicates gap – official reserve
transaction.
It also indicates the pressure that a currency faces for depreciation or
appreciation
THE OFFICIAL RESERVE ACCOUNT
Official reserves are the government owned assets. It
represents only purchase and sales made by the central
bank
If country’s BOP deficit, the central bank either run down its
official reserve assets such as gold, FOREX and SDR or
borrow fresh from foreign bank
If surplus – acquire additional reserve assets form foreigners
or retire some of its foreign debts.
DEBIT AND CREDIT ENTRIES
PARTICULARS DEBIT (OUTFLOW) CREDIT (INFLOW)
CURRENT ACCOUNT
Goods BUY Sell
Services BUY Sell
Factor Income Pay Receive
Unilateral transfer Give Receive
CAPITAL ACCOUNT
Receiving a payment from foreigner Making payment to foreigner
Portfolio (short term) Buying a short term asset Selling a short term asset
Buying back ST domestic asset from its foreign owner Selling ST asset acquired previously
Buying a long-term foreign asset Selling a LT asset to foreigner
Portfolio (Long term)
Buying back LT domestic asset from its foreigner owner selling LT asset acquired previously
Buying a foreign asset for the purpose of control selling a LT foreign asset acquired
FDI Buying back from its foreign owner a domestic asset Selling a foreign asset acquired for
previously acquired for purpose of control purpose of control
EXHIBIT 2.4
2015
DISTRIBUTION
OF U.S. EXPORTS
AND IMPORTS