ch16

Reinert/Windows on the World Economy

The International Monetary Fund

CHAPTER 16


2

Introduction

1941 is a turning point in the history of global financial arrangements British economist John Maynard Keynes wrote a proposal for an

International Clearing Union (ICU)• Known as the Keynes Plan• Subsequently taken up by the British Treasury

US Treasury official Harry Dexter White wrote a proposal for an International Stabilization Fund (ISF)

• Subsequently embraced wholeheartedly by US Treasury Secretary Henry Morgenthau

• Known as the White Plan Two plans were taken up at the Bretton Woods Conference

in July 1944 White Plan gained prominence, resulting in creation of the

International Monetary Fund (IMF) and the International Bank for Reconstruction and Development (the World Bank)


3

Monetary History

Throughout 20th century, countries struggled with various arrangements for the conduct of international finance

None proved satisfactory In each case, the systems set up by

international economists were overtaken by events Appears international financial system had a

dynamic of its own


4

The Gold Standards

Late 19th and early 20th centuries were characterized by a highly integrated world economy Supported from approximately 1870 to 1914 by an

international financial arrangement known as the gold standard

• Each country defined the value of its currency in terms of gold• Most countries also held gold as official reserves

Since value of each currency was defined in terms of gold, rates of exchange among the currencies were fixed

When World War I began in 1914, the countries involved in that conflict suspended the convertibility of their currencies into gold After the war, unsuccessful attempt to return international

financial system back to gold standard


5

Gold-Exchange Standard

In 1922, there was an attempt to rebuild the pre-World War I gold standard.

New gold standard was different from the pre-war standard due to then current gold shortage Countries that were not important financial centers did not hold gold

reserves but instead held gold-convertible currencies For this reason, the new gold standard was known as the gold-

exchange standard• Goal was to set major rates at their pre-war levels, especially British

pound In 1925, it was set to gold at the overvalued, pre-war rate of US$4.86 per

pound Caused balance of payments problems and market expectations of

devaluation At a system-wide level, each major rate was set to gold

Ignoring the implied rates among the various currencies Politics of the day prevailed over economics


6


Gold-exchange standard consisted of a set of center countries tied to gold and a set of periphery countries holding these center-country currencies as reserves By 1930, nearly all the countries of the world had joined However system’s design contained a significant incentive problem

for the periphery countries• Suppose a periphery country expected that the currency it held as

reserves was going to be devalued against gold Would be in interest of country to sell its reserves before devaluation took

place so as to preserve value of its total reserves Would put even greater pressure on center currency As the British pound was set at an overvalued rate there was a run on the

pound (1931) Forced Britain to cut pound’s tie to gold, leading to many other

countries following suit By 1937, no countries remained on gold-exchange standard


7


Overall standard was not a success Some international economists (e.g. Eichengreen,

1992) have even seen it as a major contributor to Great Depression

Throughout 1930s a system of separate currency areas evolved

Combination of both fixed and floating rates Lack of international financial coordination helped

contribute to the economic crisis of the decade At the worst of times, countries engaged in a game

of competitive devaluation


8

The Bretton Woods System

During World War II, United States and Britain began to plan for the post-war economic system

White and Keynes understood the contribution of previous breakdown in international economic system to war Hoped to avoid same mistake made after World War I But were fighting for relative positions of countries they

represented White largely got his way during 1944 Bretton Woods

Conference• Conference produced a plan that became known as the Bretton

Woods system


9


Essence of the system was an adjustable gold peg US dollar was to be pegged to gold at $35 per ounce Other countries of the world were to peg to the US dollar

or directly to gold• Placed the dollar at the center of the new international financial

system

Currency pegs were to remain fixed except under conditions that were termed “fundamental disequilibrium”

• However, concept was never carefully defined

Countries were to make their currencies convertible to US dollars as soon as possible But process did not happen quickly


10


Problems became apparent by end of 1940s Growing non-official balance of payments deficits

of United States• Deficits reflected official reserve transactions in

support of expanding global dollar reserves

Although Bretton Woods agreements allowed par values to be defined either in gold or dollar terms• In practice, the dollar became central measure of

value


11

Triffin Dilemma

Belgian monetary economist Robert Triffen described problem of expanding dollar reserves in his 1960 book Gold and the Dollar Crisis Problem became known as the Triffin dilemma

Contradiction between requirements of international liquidity and international confidence “Liquidity” refers to the ability to transform assets into currencies

International liquidity required a continual increase in holdings of dollars as reserve assets As dollar holdings of central banks expanded relative to US official

holdings of gold, however, international confidence would suffer• Triffin argued that US could not back up an ever-expanding supply of

dollars with a relatively constant amount of gold holdings


12

Figure 16.1. The Triffin Dilemma


13

Triffin Dilemma In October 1960 London gold market price rose above $35 to $40 an

ounce Calls for a change in the gold-dollar parity In January 1961, the Kennedy Administration pledged to maintain $35 per

ounce convertibility• U.S. joined with other European countries and set up a gold pool in which their

central banks would buy and sell gold to support the $35 price in London market At 1964 annual IMF meeting in Tokyo, representatives began to talk

publicly about potential reforms in international financial system Attention was given to the creation of reserve assets alternative to US dollar

and gold In 1965, the United States Treasury announced that it was ready to join

in international discussions on potential reforms Johnson Administration was more flexible than the Kennedy Administration


14

Triffin Dilemma

British pound was devalued in November of 1967 President Johnson issued a statement recommitting the United

States to $35 per ounce gold price However, in early months of 1968, the rush began In early 1971, capital began to flow out of dollar assets and

into German mark assets German Bundesbank cut its main interest rate to attempt to curb

purchase of marks Germany and a few other European countries joined Canada’s

floating dollar rate in 1971• Thereafter, capital flowed from dollar assets to yen assets

US President Nixon accepted US Treasury Secretary John Connally’s recommendation to close its “gold window” Effort to force other countries to revalue against US dollar


15

The Non-System

At Smithsonian conference in 1971, several countries revalued their currencies against dollar Gold price was raised to $38 per ounce Canada maintained its floating rate

In June 1972, a large flow out of US dollars into European currencies and Japanese yen occurred Flows stabilized, but new crisis reappeared in January

1973• Swiss franc began to float• In February, there was pressure against German mark and there

were closures of foreign exchange markets in both Europe and Japan

On February 12th, US announced a second devaluation of the dollar against gold to $42


16

The Non-System

During 1974 and 1975, countries went through nearly continuous consultation and disagreement in a process of accommodating their thinking to floating rates

In November 1975, proposed amendment to IMF’s Articles of Agreement restricted allowable exchange rate arrangements to Currencies fixed to anything other than gold Cooperative arrangements for managed values among

countries Floating


17

The Operation of the IMF

IMF is an international financial organization comprised of 183 member countries

Purposes, as stipulated in its Articles of Agreement, are to Promote international monetary cooperation Facilitate the expansion of international trade Promote exchange stability and a multilateral system of

payments Make temporary financial resources available to

members under “adequate safeguards” Reduce the duration and degree of international

payments imbalances


18


Major decision-making body is its Board of Governors Each member appoints a Governor and an Alternate Governor

Day-to-day business rests in the hands of Executive Board Composed of 22 Executive Directors plus Managing Director

• Six of the 22 Executive Directors are appointed by largest IMF quota holders

• Remainder elected by groups of member countries not entitled to appoint Executive Directors

• Managing Director is appointed by Executive Board and is traditionally European (often French)

Chairs Executive Board and conducts IMF’s business

• Currently three Deputy Managing Directors


19

Table 16.1. Administrative Structure of the IMF


20


Most important feature of IMF is its quota system Determine both the amount members can borrow from

the IMF and their relative voting power • Higher a member’s quota, the more it can borrow and the greater

its voting power

Members’ quotas are their subscriptions to the IMF Based on their relative sizes in the world economy Pays one fourth of its quota in widely-accepted reserve

currencies (US dollar, British pound, euro, or yen) or in Special Drawing Rights

Pays remaining three-quarters of quota in its own national currency


21


The IMF engages in four areas of activity Economic surveillance or monitoring Dispensing of policy advice Lending

• Perhaps most important

Technical assistance


22

Tranche

If an IFM member faces balance of payments difficulties Can automatically borrow one fourth of its quota in the

form of a reserve tranche When the IMF lends to a member country, what actually

happens is domestic country purchases international reserves from the IMF using its own domestic currency reserves

• Member country is then obliged to repay IMF by repurchasing its own domestic currency reserves with international reserve assets

• IMF lending is known as a “purchase-repurchase” arrangement


23

Tranche

Credit tranches Originally, each were equal to ¼ of the members’ quotas In the late 1970s, credit tranches were increased to

37.5% of quota First credit tranche is more or less automatic Second through fourth credit tranches require that the

member adopt policies (conditionality) that will solve balance of payments problem at hand

• Effectively limits a member country’s credit to 150 percent of its quota

As IMF evolved, it created a number of special credit facilities that extend potential credit beyond 150% level

Drawings on IMF by its members have to be repaid Five-year limit was established


24

Figure 16.2. IMF Lending


25

Table 16.2. Special Credit Facilities


26

Ideal Role of the Fund

Development of a country requires an inflow of private foreign savings

Inflow would cover a current account deficit often caused by import of capital goods

Occasionally, this private foreign savings disappears Resulting in a balance of payments crisis

• In these instances IMF steps in Member draws on its reserve and credit tranches Repaying credit tranche debts in five years time

Thus, IMF offers short-term credit, stepping in to replace private foreign savings on those rare occasions


27

History of IMF Operations—1950s-1960s

In its initial years, the IMF was nearly irrelevant However, Suez crisis of 1956 forced Britain to draw on its

reserve and first credit tranches Japan drew on its reserve tranche in 1957 Between late 1956 through 1958 IMF was involved in

policies that lead to the convertibility of both British pound and French franc

Concerned about the United States’ ability to defend the dollar and other major industrialized countries’ abilities to maintain their parities IMF introduced the General Arrangements to Borrow (GAB) in

October 1962• Involved the central banks of ten countries setting aside a $6 billion pool

to maintain stability of Bretton Woods system Countries involved became known as Group of Ten or G-10 and comprised

a rich countries club


28

History of IMF Operations—Mid-to-Late 1960s

By 1965, US faced two unappealing options Reduce world supply of dollars to enhance

international confidence by reducing international liquidity

Expand world supply of dollars to enhance international liquidity by reducing international confidence• But where was the world to turn for a reserve asset?

1964 and 1968 annual meetings of IMF resulted in creation of a new reserve asset to supplement both gold and dollar

Known as a special drawing right or SDR


29

History of IMF Operations—Special Drawing Rights, 1970s

Came into being in July 1969 In 1971, when United States broke gold-

dollar link, the SDR was redefined in terms of a basket of five currencies—dollar, pound, mark, yen, and franc

Allocated in proportion to members’ quotas Never played the important role envisaged

for them Perhaps best seen as one of many attempts to

resolve Triffin dilemma


30

History of IMF Operations, 1970s

Oil price increases of 1973-1974 caused substantial balance of payments difficulties for many countries of the world

In June 1974, the IMF established an oil facility to assist these countries Acted as an intermediary, borrowing funds from oil producing

countries and lending them to oil importing countries A second oil facility was established in 1975

Slightly more strict than the first During this time, a bias towards private-sector lending

helped to prevent sufficient increases in IMF quotas Given the limits of the quota system, IMF was becoming more of a

financial intermediary—less of an international cooperative credit arrangement


31

History of IMF Operations, 1970s-1980s

In 1976, IMF began to sound warnings about sustainability of developing-country borrowing from commercial banking system Banking system reacted with hostility to these warnings

• Argued Fund had no place interfering with private transactions

The 1980s began with a significant increase in real interest rates and a significant decline in non-oil commodity prices Increased cost of borrowing and reduced export

revenues


32

History of IMF Operations—1980s

In 1982, IMF calculated that US banking system outstanding loans to Latin America represented approximately 100% of total bank capital In August 1982 Mexico announced it would stop servicing

its foreign currency debt At the end of the month, Mexican government

nationalized its banking system 1982 also found debt crises beginning in Argentina

and Brazil Argentina: Overvalued exchange rate, used as a

“nominal anchor” to curb inflationary expenditures Brazil: Rates of devaluation did not keep up with rates of

inflation, causing an overvalued real exchange rate


33


International commercial banks began to withdraw credit from many of the developing countries of the world Debt crisis became global Within a few years of outbreak phenomenon of net capital outflows

appeared• Involved capital account payments of debtor countries exceeding capital

account receipts By second half of 1980s, some debt was trading at

discounts in secondary markets In 1989, US Treasury Secretary Nicholas Brady proposed a plan in

which IMF and World Bank lending could be used by developing countries to buy back discounted debt

• Amounted to partial and long-needed debt forgiveness, were approved by the IMF and became known as the Brady Plan

• Also allowed for extending time periods of debt and provided for new lending


34


Starting in the 1990s, private, non-bank capital began to flow to developing countries in the form of both direct and portfolio investment

Number of highly-indebted countries began to show increasing unpaid IMF obligations

In November 1992, a Third Amendment to the Articles of Agreement allowed for suspension of voting rights in the face of large, unpaid obligations

Mexico underwent a second crisis in late 1994 and early 1995 IMF was unable to respond effectively—US Treasury

assembled a loan package


35


In 1997-1998, crises struck a number of Asian countries—most notably Thailand, Indonesia, South Korea, and Malaysia and also Russia Resulted in sharp depreciations of the currencies In the cases of Thailand, Indonesia, and South Korea, IMF played

substantial and controversial roles in addressing crises• Loan packages were designed with accompanying conditionality

agreements• Supplementary Reserve Facility was introduced to provide large

volumes of high-interest, short-term loans to selected Asian countries• In October and November 1998, IMF put together a package to support

Brazilian currency, the real Attempt to prevent Asian and Russian crises from spreading to Latin

America Still, Brazil was forced to devalue the real in January 1999


36


Recent years have witnessed important changes at the IMF In 1997 General Agreement to Borrow was

supplemented by the New Arrangement to Borrow• Involves 25 IMF members agreeing to lend up to US$46 billion to

IMF in instances where quotas prove to be insufficient

In 1999, a new lending facility was added• Poverty Reduction and Growth Facility was created to replace

the 1987 Enhanced Structural Adjustment Facility Represents beginning of an attempt to integrate poverty reduction

consideration into macroeconomic policy formation of IMF

In 1999, quotas were increased by 45% to a total of US$283 billion


37

An Assessment

When IMF opened for business in 1947, its quotas were approximately 13% of world imports Quotas failed to address the needs of the post-war European

economy Since 1947, IMF quotas as a percent of world imports have

fallen to approximately 4% A number of observers have questioned whether IMF has

succeeded in addressing global liquidity John Maynard Keynes envisioned a global central bank with

an international currency This central bank would be responsible for regulating expansion of

international liquidity• In light of concerns over liquidity, some observers have called for a

return to the global central bank idea


38

An Assessment

Keynes’s original Bretton Woods proposal also included adjustment requirements being distributed among deficit and surplus countries However adjustment is solely the responsibility of deficit countries Deficit countries are required to adjust no matter what the source of the

deficit Dell (1983) argues that requisite adjustments are too severe and violate

purposes of IMF Reform of existing IMF framework could involve

Reconstituting it more along the lines of a world central bank• Reaffirming role of the SDR as a reserve asset• Giving IMF independent responsibility for regulating world liquidity through

expanded quotas and SDR management Redesigning adjustment mechanisms to spread responsibility over deficit

and surplus countries Changes are radical and would require a complete redrafting of the

IMF’s Articles of Agreement

ch16

Documents