world financial infrastructure and money

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World Financial Infrastructure and Money : Sukumar Nandi

World Financial Infrastructure and Money

Sukumar Nandi

Indian Institute of Management Lucknow

Lucknow 226013, India

mail!! nandi"iiml#ac#in

1
mailto:[email protected]:[email protected]


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$%a&ter 1

Money! 'istory and (olutionMoney! 'istory and (olution

One major event of human civilization is the invention of money as a medium ofexchane! Money in circulation" #oth $a$er and metallic currency" is the interest freelia#ility of the overnment1and aainst this there are claims to virtually nothin ! %hisis #ecause $resent& day money is hardly #acked #y old and other forein asset #y theovernment ! %his is fiat money and it is a leal tender" 'hich the citizens of thecountry are leally #ound to acce$t as a medium of exchane! So money in circulation isnot #acked #y overnment lia#ility and the overnment has virtual mono$oly on the

$rovision of fiat money! Further" the overnment also controls the (uantity of money!)

In the historical context" fiat money is very recent in oriin 'ith a lifes$an ofa fe' decades! Its earlier form 'as commodity money! From history 'e find that useof old as money #ean in the sixth century *! +! in %urkey! ,um$s of old found inthe river #ed 'ere melted and converted into $ieces of uniform sizes and thenstam$ed to ive it leal sanction! %his is the early form of commodity money 'ith facevalue e(ual to its intrinsic value! %he commodities chosen 'ere enerally $reciousmetals 'ith lihter 'eiht for the convenience of carryin to distant $laces ! *utsometimes seashells" cattle 'ere also used as money! %he technical characteristics ofcommodities selected to serve as money are of minor im$ortance! *ut the im$ortant

thin is that there should exist social institutions condoned #y customs and-or la' thatena#le the economic aents to trade efficiently #y follo'in the s$ecific rule that onecommodity traded in every exchane should #e socially sanctioned as an exchaneintermediary! In the money usin economy the rule of the ame is very $recise thatcommodities #uy money and vice versa "#ut commodities do not #uy commodities in anyoranized market . +lo'er"1/0/!

Money in t%e arly )eriod%he emerence of money in the early $eriod can #e kno'n from the follo'in :

2In $rimitive traffic the economic man is a'akin #ut very radually toan understandin of the economic advantae to #e ained #y ex$loitation

of existin o$$ortunities of exchane3 +onsider ho' seldom this is

1Here the central bank's role is not neglected. Actually the central bank works on behalf of the

government of the country. The concept of money as a fiduciary issue and a legal tender is true for all

countries irrespective of the level of development .)The central bank enjoys hardly any autonomy except in a few countries and so it is taken as granted that

the central bank follows the wishes of the government. Technically the currency in circulation are the

liability of the central bank.

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the case" that a commodity o'ned #y some#ody is of less value in usethan another commodity o'ned #y someone else4 5nd for the latter justthe o$$osite relation is the case! *ut ho' much more seldom does itha$$en that these t'o #odies meet4 3! 6ven in the relatively sim$leand so often recurrin case" 'hen an economic unit 5 re(uires a

commodity $ossessed #y *" and * re(uires one $ossessed #y + " 'hile+ 'ants one that is o'ned #y 5 &&&&&even here" under a rule of mere#arter " the exchane of oods in (uestion 'ould as a rule #e of necessityleft undone !2 7 $ae )8)9 +arl Mener .1/)

In the early da'n of history 'hen $eo$le realized the $ro#lem of #arter" theystarted usin $recious metal as medium of exchane! In );


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%he commodity money system delivers a nominal anchor for the $rice level" and this isrealized throuh the $rofit&maximization $rinci$le! %his 'as a$$lica#le in the case ofmint $roducin coins in the middle aes and later! %he mechanism can #e as follo's!Su$$ose there is a 'ay to convert oods into silver and silver into oods at a constantcost" that is" in ounces of silver $er unit of oods! %his can #e considered as .1 the

extraction cost of silver" or .) the 'orld $rice of silver in case of small o$en economy!%he mint converts silver into coins after the $urchase of silver in #ulk from the market" italso decides 'hen to melt the coins to make it into silver #ars! %his is a $rivate sectoractivity" and the rule of the overnment is limited to t'o actions! It s$ecifies ho' muchsilver oes into a coin and it collects a seiniorae tax .Sarent Jelde" 1//=! %he $rofit maximization $rinci$le 'ill dictate the $rivate sector mint toadjust the revenue 'ith the cost " the latter #ein the cost of #uyin silver #ars from themarket alon 'ith the cost of $roduction! %his includes aain the cost of la#our! 5ainthe mint itself can #e enaed in the extraction of silver" 'hich determines the unit $riceof silver! %he revenue of the mint is the value of the coins $roduced and" assumin thateach coin is of the same 'eiht" the revenue de$ends on the num#er of coins and their

denominations! %he mint 'ill find e(uili#rium 'hen the follo'in e(uality holds::

Market Jalue of +oins .or" the Inverse of Crice level K +ost ofSilver L Seiniorae %ax L +ost of Croduction

%he a#ove rule 'ill ensure that the mint 'ill continue mintin coins! When this isviolated" i!e! the market value of coins is less than the com#ined total of the riht handside" mintin of coins 'ill sto$! %his also determines 'hether the mint 'ill $roducene' coins or start meltin the existin coins" and this ultimately de$ends on ho' the$rice level relates to the follo'in $arameters : the cost of silver content" cost of$roduction and seiniorae rate! %he $rice level can not o too lo'" or the mint couldnot make unlimited $rofits #y mintin ne' coins and s$endin them! 5ain" the $ricelevel cannot o too hih" or the mint 'ould make $rofits #y meltin do'n the coins!%hus the a#sence of ar#itrae facility for the mint $laces restriction on the $ricelevel and this remain 'ithin an interval determined #y the mintin $oint and themeltin $oint "as sho'n in the fiure .Fiure 1!

Figure 1# )rice le(el wit%in a domain

Mintin Coint Meltin Coint

....../..............I....................../.......... Crice ,evel

%he system descri#ed a#ove has some uni(ue features! ere the (uantity of money isnot controlled #y the overnment! %he additions or deductions to existin money stock. stock of coins are made #y the mint run in the $rivate sector on the #asis of themovement of $rice level! %he $rice incentive in the market o$erate and this makes thesystem self&reulatory! When coins #ecome too fe'" their value increases and $ricelevel falls! %he mint $oint is reached and more coins are added to the existin stock!%his increases the su$$ly of money" and the $rice level .i!e!" $rice of coins falls ! When

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the num#er #ecomes too lare " the market value reaches the intrinsic metal value andeven #elo'" and it #ecomes im$erative for the mint to melt the coins and reduce thenum#er! Within the interval the $rice level de$ends on ho' the money stock is related to thevolume of transactions and this follo's the famous uantity of Money 6(uation of

Irvin Fisher

C% K M J 3! .1Where C" %"M and J are $rice level" total transactions " money stock and velocity ofcirculation res$ectively! 5s lon as the $rice level remains 'ithin the interval " thestock of money .the num#er of coins does not chane! %he chanes in the volume oftransactions or income 'ill shift the $rice level u$ or do'n 'ithin the interval! Whenthe $ush is severe so that it touches the meltin $oint or the mintin $oint " moneysu$$ly chanes!

One im$ortant im$lication of the a#ove system of $rivate sector mintin of coinsis that run&a'ay inflation of the ty$e seen in the t'entieth century is not $ossi#le in

the commodity money reime! Inflation is the $roduct of the fiat money system!

Mac%ines and $%ange in )roduction )rocess!

5round 1;;< 5B a major shift in mintin technoloy took $lace in >ermany!%'o $rocesses 'ere develo$ed to mechanize the mintin $rocess usin machines tocut into sha$e uniform #lanks and im$ress these 'ith a desin! %he scre'&$resstechnoloy had #een $roved to #e #etter than the alternative" kno'n as the cylinder&$ress technoloyG #ut #ecause of cost consideration" the latter #ecame $o$ular inmany countries! %he in of S$ain heard a#out the cylinder ?$ress technoloy andinstalled the technoloy in his state mint! %he coins $roduced in the mint had #eensmooth and uniform %his ex$eriment then s$read to other states in 6uro$e !

%e laisse .faire &eriment:Aoyal +harter created $rivate mono$olies durin 101@& 88 5B and various

individual firms 'ere allo'ed exclusive riht to issue token coinae " thouh these'ere not made leal tender and the (uantities 'ere limited! %he laissez&faire reime'as ty$ified #y the a#sence of overnment& issued small denomination coins and #ythe issue of tokens #y $rivate $arties and local overnments! In the late sixteenthcentury a#out @


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With the s$read of technoloy" the kins realized the need of issuin coinsof small denominations usin different metal .co$$er and maintainin a fixed exchanerelation #et'een the value of t'o metals! Sometimes" smaller amount of metal 'as

used to make coins of smaller denominations! *ut the advantae of lare scale$roduction $aved the 'ay for de#asement of metallic currency #y the use of inferior(uality metals 'hose face value 'as much hiher that the metal value!

%he a#ove issue relates to the value of money and lon ao N! W! Senior.1/0/'rote:

P3 3the value of money3 does not de$end $rimarily #y the (uantity of it$ossessed #y a iven community " or in the ra$idity of its circulation" oron the $revalence of exchanes" or on the use of #arter or credit"33exce$tin the cost of its $roduction!27 $! =9

%he need for increased volume of $hysical money 'ith an increase of trade andcommerce alon 'ith an im$rovement in technoloy made it $ossi#le for the overnmentto look for metal or non&metal o#jects 'hich could #e used as token money servin the$ur$oses of money as a medium of exchane! ere the face value of money 'as muchhiher com$ared to the intrinsic value and the cost of $roduction of money 'ill #e muchlo'er! %hus" the cost of $roduction 'as no loner a hindrance to the ex$ansion of moneysu$$ly if the situation 'arranted! %his 'as the #einnin of the emerence of fiatmoney and the states realized the $otential of this mechanism to commandresources from the society 'ithout much effort!

Fiat Money

In modern 'orld" money is the ty$ically $a$er currency 'ith no intrinsic valueof its o'n! Ceo$le hold this currency #ecause money is the only asset that $rovidesexchane services 'hich other assets cannot $rovide! %he emerence of fiat money has#een due to the fact that commodity money is not a cost less affair and 'hen $a$ermoney 'as introduced "it 'as realized that the cost of the $roduction of money had #eenmuch less com$ared to commodity money! %he $roduction and maintenance of moneyre(uires the use of economic resources! So the 'elfare as$ect of the resource usinmoney "'hich is much hiher in case of commodity money " increases 'hen $a$er moneyis used! For this reason society should have an incentive to re$lace hih&cost commoditymoney #y lo' cost $a$er money! *ecause the latter re(uires fe' resources for $roductionand maintenance" its use increases 'elfare! %his 'elfare as$ect of money is sometimesmissed in the academic discussions! Money is not really a veil in the modern 'orld4

%he need for money and its evolution has #een studied from different anles! Inthe search&theoretic literature" trade results from chance encounters ! In such a situation"need for money arises #ecause it minimizes the cost of transactions due to a dou#lecoincidence of 'ants! In the a#sence of the latter" money is used in exchane or nothintakes $lace "and they chane commodities 'hen dou#le coincidence of 'ants aresatisfied . iyotaki and Wriht" 1//@" %hronton" )


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%his cha$ter introduces money in the historical $ers$ective and there is indicationthat money as a commodity is lo#al in nature ! %he exchane of commodities may alsoha$$en #et'een t'o individuals 'ho #y the 'hims of history no' #elon to t'odifferent nations4 %hat induced mankind to make some arranement for facilitatin

international movement of money! %he historical evolution of the lo#al financialarchitecture and its conse(uence on the demand for money in the domestic economy onthe one hand and the $rice of the domestic money in the international field on the other isa com$lex (uestion! %his is discussed in the next cha$ter!

$%a&ter 2

*lternati(e Monetary egimes and World Financial *rc%itecture

"oney! consider is a device which facilitates the working of markets."

7 Sir Qohn icks "1//" $! )!9

2As science joins with technology to reduce man's ignorance and appease

his wants at appalling speed! human institutions lag behind! the victim of

memory! convention and obsolete education in man's life cycle. #e see the

conse$uence of this lag %. At the nerve center of national sovereignties&

international economic arrangements".

7 Ao#ert Mundell" 1/0 9

%he 'orld has seen a num#er of financial systems de$endin on the level of

interation of the 'orld economy and the level of technoloy! Aecent history has

documented the old standard" old exchane standard" dollar standard and the recent

flexi#le exchane rate system! 6ach system evolved de$endin on the need of the time

and the 'ill of the leadin nations of the 'orld 'ho 'ere a#le to carry the P#urdenP of

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the 'orld currency! *ut the major characteristics of the financial system determine the

dynamics of the money su$$ly of the countries 'ho are the $artners of trade and the

common 'orld system! We need to kno' a#out the different financial system that

$revailed in the 'orld to understand the evolution of 'orld money! 5 #etter

understandin of the 'orld monetary system 'ould hel$ understand ho' the domestic

money su$$ly in mem#er countries 'as affected #y the chane in the 'orld financial

system! %houh 'e are a'are today that the domestic financial system can not #e fully

insulated from the lo#al $henomenon" the situation in the immediate $ost&'ar $eriod

'as not much different in the >rou$&of&ten countries@!8%he level of economic interation

amon these countries made them inter&de$endent!

Sometimes a distinction is dra'n #et'een a monetary system and a monetary

order and as Crofessor Ao#ert Mundell $ut it :

25 system is an areation of diverse entities united #y reular interaction

accordin to some forms of control! When 'e s$eak of international monetary system 'e

are concerned 'ith the mechanisms overnin the interactions #et'een tradin nations"

and in $articular the money and credit instruments of national communities in forein

exchane" ca$ital" and commodity markets! %he control is exerted throuh $olicies at the

national level interactin 'ith one another in that loose form of su$ervision that 'e call

co&o$eration!

5n order " as distinct from a system " re$resents a frame'ork and settin in 'hich

the system o$erates! It is a frame'ork of la's" conventions" reulations" and mores that

esta#lish the settin of the system and the understandin of the environment #y the

$artici$ants in it! 5 monetary order is to a monetary system some'hat like a constitution

is to a $olitical or electoral system! We can think of the monetary system as the modus

o$erandi of the monetary order!2 7 Mundell" 1/=)" $!/)!9!

%he distinction Crofessor Mundell makes #et'een a monetary system and a monetary

order is im$ortant in the sense that the chronoloical order that is follo'ed here 'ill

facilitate the understandin of the 'orkin of the 'orld financial architecture and its

im$act on the domestic monetary $olicies of the mem#er countries!

@.The group of ten were (elgium! )anada! *rance! #est +ermany! taly! ,apan !-etherlands! weden!

/nited 0ingdom and the /nited tates.8


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' 45L +*-*

%he classical old standard emered as a true international standard #y 1ermany etc! acce$ted the dictates of fixed $arities and allo'ed

their money su$$ly to adjust $assively! 6nland" as the leader" had #een #enefited in

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multi$le 'ays! It enjoyed the seiniorae earned on forein &held sterlin #alances!

5lso financial institutions in ,ondon used to have handsome returns for the central

location and easy access to international ca$ital markets!

In an influential study Crofessor Nurkse . 1/88 has arued that in crucial times the

$rinci$al mem#er countries did not #ehave $ro$erly in the sense that they $artially

sterilized their old inflo's " and the results had #een that domestic and forein assets of

these countries moved in o$$osite directions durin this $eriod of old standard! %he

rules of the ame dictated that they should not interfere 'ith the influence of old flo's

on the money su$$ly! Cerha$s they #ecame concerned a#out the $otential inflation and

thus #ecame $ro&active in the control of money su$$ly!

' MI+ 5F $L*++I$*L 45L +*-*

World War I created a massive shock that the financial system could not endure

and the classical old standard ended! %he 'ar reduced the economic strenth of the main

6uro$ean countries in eneral" and 6nland in $articular! %he anchor role 6nland used

to $rovide for the sta#ility of the system ended as the Enited States $ushed 6nland #ack

from the leadershi$ role! 5 reformed system&& old exchane standard..$revailed for a

short $eriod 1/)


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mem#ers" i! e!" France and the Enited States" 'ere reluctant to follo' the rules of the

ame! %hey created deflationary $ressures in the 'orld #y $ersistent sterilization of their

#alance&of&$ayments sur$luses! %he system could not #ear it and ultimately it colla$sed

'ith the >reat Be$ression! *ut #y that time it had transmitted deflation and de$ression

across the 'orld 76ichenreen"1//G Friedman and Sch'artz"1/0@G %emin" 1// 9

' 75- W55+ I--*I5-*L M5-*8 +8+M

With the end of the World War II" the victors assem#led at *retton Woods" Ne'

am$shire" ES5 to #uild u$ the World Monetary System" 'hich came to #e kno'n as

*retton Woods International Monetary System .*WIMS! %he $rinci$al o#jectives 'ere

to remove the ills from the financial system and to create a sta#le 'orld monetary order!

For this several measures 'ere ado$ted! First" the floatin exchane rate system 'as

sto$$ed! Second" the old exchane standard 'as scra$$ed as it 'as thouht to #e

res$onsi#le for the international transmission of deflation in the early 1/@


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$rimarily interested to $revent the deflation of the 1/@


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%e )ar 9alue +ystem

5rticles IJ of IMF defines the numeraire of the international monetary system as

either ES dollar or old of the 'eiht and fineness on Quly 1" 1/88! 5ll the mem#ers of

the Fund 'ere asked to declare a $ar value of their currencies and maintain it 'ithin 1

$er cent marin on #oth sides! If any country faces fundamental dise(uili#rium" she can

exchane the $arity after consultation 'ith other mem#ers! If the chane of $arity is

'ithin 1< $er cent" the decision of the mem#ers 'ill not #e rejected! o'ever" if the

chane is more than 1< $er cent" the country concerned needs to have a$$roval of the

IMF! In case a decision is made for a uniform chane in $ar value of all currencies in

terms of old" it is to #e done #y the a$$roval #y a majority of all votin mem#ers of the

Fund and #y each mem#er se$arately 'ith votin (uota more than 1< $er cent!

%he 5rticle IJ" Section I .a of the 5reement reads as

6x$ression of $ar values! %he $ar value of the currency of each mem#er

country shall #e ex$ressed in term of old as a common denominator or in

terms of the Enited States dollar of the 'eiht and fineness in effect on

Quly 1" 1/88!

%he im$ortance of old as the numeraire 'as o#scured mostly 'hen most of the countries

excludin the ES5 had chosen to define their $ar values in terms of ES dollar! Qohn

Williamson suested that the neutral old numeraire had #een chosen to ive the Enited

States the symmetrical o$tion to chane its exchane rate of dollar alon 'ith other

countries! >old 'as chosen as a conveniently neutral numeraire for definin $ar values of

the exchane rates of the currencies" #ut old 'as not $erceived as the fundamental asset

'hich 'ould act as a #rake on the issue of currencies and hel$ in the determination of the

common $rice level of the commodities in the mem#er countries the 'ay it had #een in

the nineteenth century . Williamson" 1/== ! 6ven no sinle currency" nor even ES

dollar" had #een reconized as the 2key2 currency linkin the $rinci$al currencies in the

'orld in 1/8;!

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Multilateral )ayments Mec%anism

5rticle JIII of the IMF states that mem#ers are su$$osed to make their currencies

current account converti#le thouh they can kee$ ca$ital control as stated in 5rticle

JI.@! %he mem#ers are to avoid discriminatory currency and multi$le currency

arranements! 5ain 5rticle RIJ allo's the countries to kee$ their currencies not

converti#le for a $eriod of three years and" durin this $eriod" exchane control can #e

maintained! In fact" it had taken a lon time for the develo$in countries to make their

currencies converti#le in current account transactions!

+ountries 'ould adjust their exchane rates de$endin on the domestic e(uili#rium

for 'hich the current account #alance is one im$ortant $arameter! ere Crofessor

Mundell raised one interestin issue 'hen he stated the follo'in:

Only .N&1 inde$endent #alance of $ayments instruments are needed in an N&

country 'orld #ecause e(uili#rium in the #alance of .N&1 countries im$lies

e(uili#rium in the #alance of Nth country! %he redundancy $ro#lem is the

$ro#lem of decidin ho' to utilize the extra deree of freedom . Mundell" 1/0"

$!1/;: !

*ecause of the demonetization of old in all $rivate transactions" as 'ell as its virtual

demonetization in official transactions too" the redundancy $ro#lem as stated #y Mundell

had arisen in a very stron form after 1/8;! 5ll currencies o$eratin in the system 'ere

$otentially inde$endent national fiat monies! %he amount of these fiat monies 'ere not

related to their #ase of monetary old" neither the exchane rates of these monies 'ere

tied to the traditional old $arity! 5s old failed to act as the Nth currency" ES dollar

slo'ly took its $lace! %his created the conditions for the Fixed&Aate Bollar Standard!

esources of IMF

1;


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%he size of the total fund of IMF" contri#uted #y the mem#ersP (uota in the form

of ); $er cent in old and =; $er cent in national currencies" 'as initially ES !

#illion" and the amount could #e increased every five years if the majority of the

mem#ers 'anted! Ender the scheme of White Clan" mem#ers could o#tain resources from

IMF to hel$ finance short and medium term $ayments" dise(uili#rium in external

transactions! IMF esta#lished a num#er of conditions on the use of its resources #y the

countries sufferin from #alance of $ayments deficits! It sets the re(uirements and

conditions for the re$urchase" i!e! the re$ayment of loan! 5ll these are to facilitate the

manaement of currencies 'hich are of reater demand for the $ayments of international

o#liations! %he conditions im$osed on the mem#er country seekin loans from IMF are

derived from a monetarist model of Crofessor Colok" and in many cases this has #een

resisted #y the countries!

%e )owers of IMF

%he articles in the areement delineated the $o'ers of the t'o institutions created

for the creation and sustaina#ility of the system! %he International Monetary Fund has

the $o'ers to a$$rove the chanes made in the $arity #y the mem#ers to a$$rove or

other'ise on the use of multi$le exchane rates or other discriminatory $ractices! %he

fund has considera#le $o'er to influence the international monetary system and it

exercises its $o'er in consultation 'ith national and international monetary authorities!

%e +tructure of 5rganisation

IMF is overned #y a *oard of >overnors 'ho are a$$ointed on the votin

strenth of the mem#ers! %he *oard makes the $olicy decision reardin the actions of

the mem#ers! 5lso a num#er of 6xecutive Birectors and one Manain Birector are

selected #y the mem#ers! %he $o'er of the mem#ers is reflected in the votin rihts"

'hich are $ro$ortional to the mem#ersP (uota .of contri#ution

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Ender the areement the ES5 had to maintain a fixed $rice of old at ES@; $er

ounce" and 'hen the mem#ers are maintainin fixed $arity" the old $rice used to #e an

anchor of the system" 'hich converted the old standard into a dollar standard!

%he architects of the *retton Woods 5reement 'ere not very much s$ecific

a#out the system of the functionin of the system! %he evolution of the system 'as

$artly #ased on su#se(uent inter$retations of the economists 'ho 'ere enaed in

research! Several im$ortant features 'ere mentioned .%e' 1/G Williamson" 1/;!

One such feature is that all currencies 'ere treated as e(ual in the articles of areement"

'hich im$lies that each country 'as re(uired to maintain its $ar value #y intervenin in

the currency of other countries! %his $osition dictated #y theory 'ould not have #een

meaninful" as other countries can fix their $arities in terms of ES dollar as the Enited

States 'as the only country that $eed her currency in terms of old!

'istorical +tages of t%e 7retton Woods *greement! 1:;6.1:60

%he $eriod of transition from the 'ar to $eace in the $ost World War II 'as very

lon and $ainful and the functionin of the *retton Woods system had not #een on the

desired lines! %he system started functionin normally #y 1/;; and till 1/; full

converti#ility of the currencies of the major industrial countries could not #e achieved!

Ender the 5rticle RIJ of the *retton Woods 5reement" the countries could continue to

use exchane controls for an indefinite $eriod of transition after the esta#lishment of the

IMF in March" 1/8=! %he countries used exchane control to $reserve their forein

exchane and also every country had neotiated a series of #ilateral $ayments areements

'ith each of its tradin $artners! %he countries in 'ar ravaed 6uro$e 'ere in des$erate

need for the im$orts of ra' materials and ca$ital oods and thus the allocation of scarce

forein exchane had come under the control of the overnment!

6ven #efore the start of the World War&II" $olitical uncertainty in 6uro$e induced

massive ca$ital fliht from 6uro$e to the Enited States! In 1/@8" 5merican

administration resorted to the devaluation of dollar and the $rice of old 'as raised from

1=


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)

esta#lished in 1/8 to coordinate the fundin of the Marshall Clan" and the latter

facilitated hue inflo' of ca$ital to the economies of 6uro$e for reconstruction and

develo$ment! In fact" hue amount of forein ca$ital " mainly from the Enited States" 'as

invested in the countries of 6uro$e to lead the economies to'ards reconstruction and

develo$ment!

%he $eriod 1/80&1/0< sa' some events 'hich 'ere #oth dynamic and havin

sinificant effect on the international financial system!

In 1/8/" >reat *ritain devalued $ound sterlin #y @

countries reduced their $arities 'ith ES dollar #y more or less similar manitude! %his

s$ate of devaluation hel$ed the 6uro$ean countries to adjust their external sector

efficiently and" as a result" they could eliminate their lare trade deficit! *ut lare scale

chanes in the $arity conditions #y a num#er of countries created the im$ression that

monetary authorities could $er$etuate their dise(uili#rium situation for some time and

that 'ould create condition for s$eculation! In any case" there 'ere $erce$ti#le

resistance from the monetary authorities to chane their $arity and slo'ly the *retton

Woods system had #een reduced to a fixed exchane rate reime even thouh it 'as an

adjusta#le $e system in the initial thinkin stae! It is interestin from academic

stand$oint that the authorities $referred the s$ill over of domestic dise(uili#rium into the

external sector in their adverse #alance of $ayments rather than correctin their exchane

rates!

6ven #efore the *ritish devaluation of $ound" France devalued French franc in

Qanuary 1/8" and this created a multi$le exchane rate system" 'hich created $ro#lem in

1


19/129


the form of #roken cross rates #et'een $ound and dollar! %he system 'as rectified 'ith

the devaluation of $ound! In 1/;


20/129


Further" 'hile the intention of the *retton Woods 5reement had #een the

adjusta#le $e system in the exchane rate mechanism" the system that evolved over time

could #e called a fixed rate system! %he reason that monetary authorities #ecame too

much conservative reardin the adjustment of the $arities 'as $erha$s they 'ere

un'illin to take the risks of chanin the $arities as that miht lead to the $ossi#ility of

s$eculative ca$ital flo's and follo' u$ #ehaviour #y others! %hus the resultin system

took the sha$e of a fixed exchane rate dollar old standard! %his evolution created

some $ro#lems in the international financial systems 'hich 'ere not uncommon in the

inter&'ar $eriod also and these can #e $laced into t'o cateories: li(uidity and

confidence!

%e Li=uidity )rolem

%o'ards the end of sixties the Enited States started ex$eriencin deficit in its

#alance of $ayments and this 'as mainly due to hue ca$ital outflo' in the ca$ital

account transactions! Since the ES5 is a reserve currency country" it did not have to

adjust its domestic $olicies to the chanes in the #alance of $ayments! %he dollar

outflo's had #een sterilized #y the federal reserve as a matter of routine! %he outflo's of

dollar meant that other countries" $articularly 6uro$ean countries" had #een holdin

dollar reserve! %his created different $erce$tion in some main 6uro$ean countries and

there 'as resentment aainst the do&nothin attitude of the ES federal reserve on the

deficit #alance of $ayment situation! In 1/0; France #ean to convert outstandin dollar

lia#ilities into old throuh the old 'indo'! %hat created some $ressure on the $rice of

old!

Mean'hile ES monetary authorities res$onded to the emerin 'orld situation

#y initiatin measures to im$rove the #alance of trade" chanin the fiscal&monetary

$olicies" im$osin cur# on the ex$ort of ca$ital and takin measures to $revent the

conversion of outstandin dollars into old! *ut these $olicies could not chane the

situation much and the li(uidity $ro#lem continued!

%he li(uidity $ro#lem in the international scene 'as due to the maladjustment of

the demand and su$$ly of old" as the short&fall of the latter #ean to #e felt in the early

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1/0


22/129


need to create a su$$lementary reserve 'hich 'ould #olster international trade and

commerce!! %he results had #een the First 5mendment of the IMF 5rticles of 5reement

in 1/0= and this em$o'ered the IMF to create a S$ecial Bra'in 5ccount to su$$lement

its (uota system that o$erates under its >eneral 5ccount! Ender the ne' scheme a

reserve asset 'as to #e created #y the IMF and that 'ould #e called S$ecial Bra'in

Aihts .SBA " and this 'ill not #e #acked #y the de$osits of the mem#ers" #ut the value

of SBA as a reserve asset 'ill rest on it #ein rearded as an acce$ta#le means of

exchane #et'een the IMF and the central #anks of the mem#er countries!

%he value of SBA 'as initially set e(uivalent to 1 or set at 1-@; th of an ounce of

old! Ender the scheme each mem#er 'as allocated a s$ecified annual amount of SBA

in $ro$ortion to their (uota 'ith the IMF" and the country could dra' u$on its SBA

allocation if it ex$eriences a #alance of $ayments difficulties! %he mem#er is re(uired to

consult the IMF in the case of dra'in the (uota" #ut in dra'in the SBA allocation the

mem#er need not consult 'ith IMF! Further there is no conditionality attached 'ith SBA

dra'in and it is not su#ject to re$ayment! %he last thin im$lies that SBA has increased

the amount of international reserve!

%he cumulative total holdins of SBA allocated to a country is kno'n as the Pnet

cumulative allocationP of the country and over a ;&year $eriod the mem#er has to

maintain its SBA #alance at an averae of @< $er cent of its net cumulative allocation!

%his $ercentae 'as reduced to 1; in 1/=/! %he first allocation of SBA durin the

$eriod 1/=< && =) 'as to the amount of ES /!; #illion! In Quly 1/=0" the value of SBA

'as chaned from 1 to a 'eihted #asket of 10 currencies! ,ater in Qanuary 1/1" the

value of SBA 'as redefined and $eed to a #asket of ; currencies and these currencies

are Cound sterlin" French franc" Qa$anese yen" ES dollar and >erman mark!

5 country u$on dra'in the SBA can exchane the same 'ith other forein

currency and can increase its reserve! 5ll mem#ers of the IMF are #ound to acce$t the

SBA in exchane for their currencies u$ to three times their net cumulative allocation!

%he country that dra's its SBA allocation is to $ay rate of interest to the Fund and the

country that exchanes the allocated SBA 'ith its currency ets the rate of interest! %hus

the SBA is an indirect loan mechanism throuh the international li(uidity increases!

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Market )rice of 4old and $onfidence Issues!

>old had #een the anchor of the system and it 'as su$$osed to ive sta#ility to it!

*ut the $ein of the official $rice of old at @; $er ounce #y the ES %reasury attracted

attention of the s$eculators" 'ho $ushed the free market $rice of old in ,ondon market

to 8< $er ounce from the ES %reasury #uyin $rice of @;!)

#ackin to the ES dollar 'ith a ); $er cent old reserve re(uirement aainst federal

reserve notes! So" ES monetary authority a$$rehended that the s$eculation in the old

market miht s$ill over to the official demand for the conversion of dollar into old! 5s a

remedial measure" ES %reasury su$$lied old to the *ank of 6nland to restore sta#ility

and re(uested the monetary authorities of >rou$ of %en countries not to #uy old at

$rices hiher than @;!)< $er ounce! In Novem#er 1/01" the ,ondon >old Cool 'as

formed #y the Enited States and seven other countries" and it could sta#ilize the $rice of

old! %he central #anks of the seven countries su$$lied 8< $er cent of the old stock in

this $ool!

%he sixties 'itnessed t'o $henomena not conducive to the sta#ility of the

financial system! First" there had #een a ro'in scarcity of the old as the $roduction of

the yello' metal leveled off #y 1/0;&00! 5lso the demand for old increased mainly

from the $rivate sector! Second" there had #een a $erce$ti#le increase in the E!S!

inflation rate as the money su$$ly increased $artly due to Jietnam 'ar! Some economists

think that the ES5 follo'ed an inflationary $olicy at home that time #ecause of

domestic com$ulsion!

%he t'o $henomena cited a#ove created a crisis of confidence reardin ES

dollar and durin 1/0=&0" the ,ondon >old Cool #ecame a net seller of old" losin old

of a#out @ #illion e(uivalent at the $eed $rice! %here 'as a$$rehension a#out the

devaluation of dollar" thouh the scarcity of old in the 'orld 'as one reason .>il#ert"

1/0" Qohnson" 1/0! %he resultin situation had its conse(uences! In March 1/0 the

,ondon >old Cool 'as a#olished and it 'as re$laced #y a t'o&tier arranement! %he

monetary authorities of old $ool sto$$ed #uyin and sellin sold in the market" #ut

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instead they started transaction of old only amon themselves at fixed $rice @; $er

ounce! 5lon 'ith that the Enited States removed the ); $er cent old reserve

re(uirement aainst Federal Aeserve currency! %hus" the link #et'een old $roduction

and other market resources of old and official reserves 'as severed! %he result of these

ne' arranements 'as that old had #een demonetized at the marin! %he system

evolved into a de facto dollar standard" thouh old converti#ility remained!

*y 1/0 the system also reduced to a de facto fixed exchane rate system! %he

major industrial countries areed not to convert their hue dollar reserve into old!

Mean'hile 6uro$ean countries and Qa$an #ecame economic $o'er houses and they

#ecame increasinly reluctant to a#sor# more dollar lia#ilities! %hese countries also 'ere

not ready to readjust their exchane rate u$'ards as they ex$ected the Enited States to

make the readjustment! Faced 'ith these contradictory $ulls and $ressures the

International Monetary Fund found itself hel$less as its resources 'ere not enouh to

$revent devaluation #y major industrial countries #y $rovidin them ade(uate assistance

for adjustment .Bominuez" 1//@!

%he esta#lishment of the t'o&tier system after the closure of the ,ondon >old

Cool could not maintain the sta#ility of the old&dollar $arity for lon and the Enited

States 'as forced to close the old 'indo' in 5uust 1/=1! With this the *retton Woods

System colla$sed" #ut the institutions created as a result of the areement &&& IMF and

I*AB &&& survived! IMF still had an im$ortant role as a clearin house for different

vie's on monetary $olicies" as a centre of information" as the $rimary source of

adjustment of the countries outside the >rou$ of %en and as a monitor of the 'orld

financial system! Carticularly" the develo$in countries need the uidance and hel$ of the

IMF to standardize their financial system!

4res%am@s law in International Le(el

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In the 1/0


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currencies vis&T&vis ES dollar! %his had the im$lication that the .n&1 countries had to

follo' a definite set of fiscal and monetary $olicies 'hich 'ere consistent 'ith the fixed

$arities! *ut the countries could chane their $arities #ecause of the adjusta#le $e! In

the $rocess dise(uili#rium in the domestic economy miht ha$$en #ut this continency

'as not s$elled out in the sense that there had #een no constraints $laced on the mem#er

countries reardin the extent to 'hich the domestic monetary and fiscal $olicy could

deviate from the $attern set #y the Enited States .>iovannini" 1//@G Mundell" 1/0!

%he crisis of li(uidity in the 'orld financial system had not #een $ro$erly

addressed! %he countries 'ere to kee$ reserves aainst their currencies either in the form

of old" or in some $rinci$al currencies such as dollar! *ut in reality ES dollar had #een

the main currency 'hich 'as used as the reserve currency #ecause of the old

converti#ility! %here had #een the old converti#ility clause and a crisis of confidence

too and these $revented the Enited States to su$$ly the monetary reserve demanded #y

the .n&1 countries! In addition to it" the ES5 follo'ed an inflationary $olicy in the late

sixties" #ut 'as un'illin to devalue the dollar! %his reinforced the confidence $ro#lem

reardin ES dollar! So 'hen some countries tried to li(uidate their dollar lia#ilities and

transform that into old" the Enited States ot $anicky and closed the old 'indo' in

1/=1" sinalin the colla$se of the system!

)ost 7retton Woods ra! Managed Floating c%ange ate

%he $eriod #et'een 1/=1 and 1/=@ had #een one of the shock and adjustment for

the major countries of the 'orld and in March 1/=@ the 'orld turned to a eneralized

floatin exchane rate! In the ne' system the monetary authorities started extensive

intervention to influence #oth the levels of volatility and the exchane rates of their

currencies! *y 1/


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the 'orld financial system" $articularly on the via#ility of the international #ankin

system! Some #anks in Qa$an could mo#ilize enouh ca$ital and #ecame very lare in

terms of the asset size! %he countervailin $o'er emered and the *asle +ommittee

introduced ca$ital ade(uacy norms for all #anks o$eratin in the international market!

%he ca$ital ade(uacy ratio .+5A initially $ro$osed as $er cent of the risk&'eihted

assets acted as a constraint on the ex$ansion of credit $ortfolio of the #anks! %he latter

had an im$ortant im$act on the money su$$ly of the mem#er countries!

%e +econd *mendment of IMF *rticle

%he Second 5mendment of the IMF 5rticles came into effect on 5$ril 1/= and it

formally ave the IMF mem#ers a lare deree of discretion in the selection of their

exchane rate arranements! IMF had #een ured to ado$t a $olicy of 2 firm surveillance2

over the exchane rate $olicies of the mem#ers!

%he Second 5mendment 5rticle IJ defined the res$onsi#ility of the mem#ers!

6ach mem#er 'as o#lied to notify the IMF of its exchane rate arranement! %he

mem#ers 'ere free to select the exchane rate arranement they 'ould think riht for

their interest" #ut they 'ere to su$$ly information to the Fund! 5lso a mem#er 'as to

avoid mani$ulatin exchane rates in order to $revent effective #alance of $ayments

adjustments or to ain an unfair com$etitive advantae over other mem#er 'hich miht

hurt the interest of the latter! In a 'ay the Second 5mendment reduced the $o'er of the

IMF drastically!

*&&reciation of A+ dollar

Burin the $eriod 1/< & 1/;" ES dollar ex$erienced su#stantial a$$reciation

aainst major currencies! %he nominal effective exchane rate a$$reciated #y ;< $er cent

and the same thin ha$$ened 'ith the real rate! %his 'as the results of the diverent

macroeconomic $olicies $ursued #y the Enited States" Qa$an and 6uro$ean countries! %he

ES authorities follo'ed a relaxed fiscal $olicy #ut a tiht monetary $olicy" 'ith the

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#udet deficit skyrocketin from ESB 10 #illion in 1/=/ to ESB )ermany" Qa$an" Enited States"

Enited indom&& met at Claza otel in Se$tem#er 1/; and after the deli#erations of

their res$ective vie' $oints" they issued a +ommuni(ue 'hich is kno'n a Claza 5ccord!

5ccordin to the 5ccord" the exchane rate of ES dollar did not accurately reflect the

chanes in the economic fundamentals like the measures Qa$an 'as to take to stimulate

domestic demand" or the ES commitment to reduce #udet deficits! %here 'as also

areement for the de$reciation of dollar and the countries areed to coo$erate on this

issue! %he dollar started to decline and the extent of the decline of dollar caused concern

amon the mem#ers!

In Fe#ruary 1/=" the >&= countries .+anada and 5ustralia toether 'ith >&;

rou$ met in Caris to consider the situation of declinin ES dollar and reached an

areement kno'n as ,ouvre 5ccord! In this" the >&= countries areed that further decline

of dollar 'as not desira#le and the then exchane rates 'ere true reflections of the

economic fundamentals! Im$licit had #een the areement that the ES dollar should #e

ke$t 'ithin a ; $er cent taret #and aainst the deutschmark and the yen! *ut the accord

could not com$letely $revent the decline of dollar!

In Octo#er 1/=" there had #een a colla$se in the stock markets around the 'orld and

as a conse(uence the dollar came under $ressure as the crash in the stock market induced

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the fear of 'orld recession! %he overnments of some industrialized countries started the

loosenin of their monetary $olicies and reducin the interest rates! In Qanuary 1/" the

trade deficits of the Enited States sho'ed the sin of im$rovements" and ES dollar

started the recovery $hase!

International $a&ital Flows

%he flexi#le exchane rate system in the 'orld had #een associated 'ith an

increasin strenth of the international money manaers 'ho 'ere a#le to make lare

scale ca$ital movement from one country to another 'ithin a very short time! %he trans&

#order ca$ital flo's had #een effected to make $rofit either from the $ossi#le fluctuations

of the exchane rates due to the $otential chanes in the short&term interest rates or the

$otential chanes in the $rices of the stocks in 'ell&interated stock exchanes of

different countries! %he first reason had #een man&made on some occasions leadin to a

$re&$lanned attack on a currency and this has led to a desta#ilization of the currency"

'hen the concerned central #ank failed to take care of its total lia#ility denominated in

the form of total currency in circulation 'ith the #anks and the $u#lic! %his ty$e of

situation had #een very common in the 1//erman reunification

and the reluctance of other mem#er states to $ursue $olicies" 'hich could have checked

inflation! %he Mexican crisis had resulted as a com#ination of several factors after

Mexico ex$erienced hue ca$ital inflo' till 1//8 'hen the crisis occurred! %he forces

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'ere as follo's: First" interest rates increased in the Enited States makin investment in

Mexico less attractive! Second" a re#ellion in the state of +hia$as increased dou#ts

amon the investors a#out the $olitical sta#ility! 5lon 'ith that 'hen one $residential

candidate of a $olitical $arty 'as assassinated" ca$ital inflo' to Mexico reduced

drastically and Mexico had to use its de$leted reserve to save the currency!

%he Aussian crisis in the aftermath of 1// 'as a culmination of external shock

like a decline in the $rices of ra' materials to an asymmetric ex$ectations of the

creditors! %he decline of tax recei$ts of the overnment due to the fall in the $rice of oil

led to an im#alance in the #udet of the Aussian overnment! %he $arliament #locked the

reform $ro$osal of the overnment and the currency #ecame 'eak due to ca$ital fliht!

In this situation Aussia souht hel$ from the IMF and after some controversy ot a loan

of 11!8 #illion! %his created an u$'ard ex$ectation in the financial market and investors

started #uyin short&term rou#le de#t to earn very hih interest rates! Interestinly no

one understood that rou#le miht de$reciate further #ecause of hih interest rates" and

this $recisely did ha$$en! In 5uust 1// Aussia allo'ed the rou#le to float and

sus$ended the redem$tion of rou#le denominated de#t! %he de$reciation of rou#le

initiated a PrunP on the #ank" as de$ositors 'anted to 'ithdra' rou#les to #uy dollars!

%he #anks 'ere the holders of lare de#ts 'hich 'ere PfrozenP and so they could not $ay

their de$ositors! %he country had to suffer for the irrational decision of the investors first

to $ut money 'ith 'ron ex$ectations and then 'ithdra' ca$ital leadin to the colla$se!

,ookin at the evolution of the international monetary system one finds several

im$ortant conclusions! First" the maintenance of the fixed exchane rate system in the

#einnin and the flexi#le exchane rate system since the early 1/=


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Enited States to allo' other countries adjust their exchane rates vis&T&vis ES dollar

solved the n&th country $ro#lem in the initial years till 1/0

ex$erienced deficit in the #alance of $ayments and other countries accumulated dollar

reserves and they su#stituted old reserves #y dollars! %he Enited States tried to solve

this $ro#lem #y a realinment of the exchane rates #y Smithsonian 5reement in 1/=1!

*ut this arranement fell a$art in 1/=@ 'hen the ES5 devalued the dollar unilaterally!

%his induced other overnments to float their currencies!

%he second lesson of the evolution of the international financial system is the

market #ehaviour in the $eed exchane rate system! When the latter is firmly in order"

investors are tem$ted to take advantae of the interest rate differences 'ithout coverin

their forein exchane ex$osure! *ut the moment market sus$ects the dura#ility of the

$eed rate system" the investors rush for cover! %he resultin conversion of currencies

and the lare amount of ca$ital flo's can $roduce the antici$ated exchane rate chane"

'hich the investors a$$rehended! %his has ha$$ened time and aainG this ha$$ened in

6uro$e in 1//)&/@" Mexico in 1//;" 5sia in 1//=&/ and in Aussia in 1// .>oldstein"

1//G 5dams et al" 1//! %he re$eated crises has reo$ened the de#ate a#out 'hether

restrictions should #e im$osed on the international ca$ital flo's" 'hat should #e the

a$$ro$riate exchane rate arranement for the ne' market economies and 'hether IMF

needs restructurin! Some economists are in favour of introducin some sort of a tax on

the international ca$ital flo's as suested #y %o#in! %his 'ill make the transfer a #it

costly #ut o$inion differs on this issue! o'ever" 'e 'ill have a close look at this issue

later in this cha$ter! 5ain the enormity of the crisis as seen in 5sia in 1//=&/ has

induced thinkin alon the line 'hether the IMF in its $resent form can take care this sort

of $ro#lem in future!

c%ange ate *rrangements

In recent times different countries have arraned different ty$es of exchane rate

arranements and #roadly these can #e $ut in the follo'in cateories:

&&&&+urrency $eed to another stron currency or SBA

&&&&+urrency $eed to a currency com$osite

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&&&& flexi#le exchane rates of a sinle currency

&&&& flexi#le exchane rate under coo$erative arranement

&&&& More flexi#le or manaed floatin exchane rate

&&&& Inde$endent floatin exchane rate

+ountries like 5nola" ,i#eria" Ira(" Oman" Canama" Syria and *eliz have $ein

arranements 'ith ES dollar! 5ain countries like *enin" +ameroon" +ono" Mali and

Seneal have a fixed $e system 'ith French franc! %he countries like ,y#ia and

Myanmar have $eed their currency 'ith SBA" 'hile some countries have $ein

arranement 'ith s$ecific currency&&&e!!" *hutan 'ith Indian ru$ee" *runei 'ith

Sina$ore dollar" 6stonia 'ith >erman mark and San Marino 'ith Italian ,ira!

%he countries 'ho have a $ein arranement 'ith a currency com$osite are:

*anladesh" *urundi" +y$rus" Fiji" Iceland" Qordan" Malta" Slovak Ae$u#lic" %ona and

Januatu!

%he countries like *ahrain" atar" Saudi 5ra#ia and E56 have currency 'hich are

(uite flexi#le thouh not of the elite rou$! On the other hand the countries like 5ustria"

*elium" Benmark" Finland" France" >ermany" Ireland" Italy" ,uxem#our" Netherlands"

Cortual and S$ain have flexi#le and elite currencies 'hich are also sta#le throuh

coo$erative arranements! %hese countries #elon to the elite O6+Brou$!

Some countries have currencies 'hose exchane rates are descri#ed as manaed

floatin! %heir list is (uite lon and the $rinci$al countries in this rou$ are&&& 5leria"

*razil" +hile" +hina" +osta Aica" 6y$t" >eoria" unary" Indonesia" Israel" Iran"

Malaysia" Cakistan" Aussia" Sina$ore" Sri ,anka" %hailand" Jenezuela and Jietnam! %his

$osition 'as as on Qune 1//=!

Some countries have o$ted for an inde$endent floatin exchane rate reime and this

list is very lon! Some of these countries are: India" 5l#ania" 5ustralia" +anada" >hana"

Qamaica" enya" ,e#anon" Mexico" Ceru" S'eden" S'itzerland" Enited States and

Uam#ia!

%he a#ove sho's that the exchane rate arranements of the different mem#ers of the

IMF are of various nature and this has made the system much more com$lex! 6ach

country follo's a course reardin its currencyPs exchane rate accordin to the strenth

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of the economic fundamentals! In fact the Second 5mendment of IMF 5rticles in 1/=

has em$o'ered the mem#ers to choose their o'n exchane rate reime and su$$ly

information to the Fund accordinly!

%e oin a )ro&osal on $a&ital Mo(ement

Crofessor Qames %o#in arues that in a 'orld of flexi#le exchane rates the

dynamics of the short term ca$ital flo's has a desta#ilizin effects on the sta#ility of the

exchane rates and in fact it can disru$t the 'hole $rocess . %o#in" 1/=:

National economies and national overnments are not ca$a#le of adjustin to

massive movements of funds across the forein exchanes" 'ithout the real

hardshi$ and 'ithout sinificant sacrifice of the o#jectives of national economic

$olicy 'ith res$ect to em$loyment" out$ut" and inflation .$!1;8!!

%o#in arues that in the hihly interated 'orld of today it is difficult for the

national economies to $ursue inde$endent monetary $olicies! If domestic interest rate

rises" this can induce a shar$ a$$reciation of the currency in real sense! 5ain" a fall in

the interest rate 'ill lead to a real de$reciation! %his sort of effect 'ill have adverse

im$act on the economic $arameters of the economy and %o#in suests that a tax can #e

im$osed on all forein exchane transactions so that the desta#ilizin effects are

reduced ! %he $ro$osed tax 'ill reduce the incentive for the s$eculators to instiate hue

ca$ital flo' in and flo' out of the economy in res$onse to a small interest rate chane!

%o#in suests that this ty$e of tax should #e im$osed on all ty$es of forein exchane

transactions 'ithout exce$tion and then only it 'ill #e effective! %houh it may have a

neative effect on the international trade" %o#in thinks that the trade&off is 'orth'hile as

it 'ill have a sta#ilizin effects on the exchane rate and throuh that on em$loyment and

income!

Many economists #elieve that %o#inPs tax is a #it harsh measure as a flat tax on all

forein exchane movements can reduce the de$th and #readth of the markets and the

conse(uent reduction in li(uidity can increase the volatility of the market" and it is an

o$$osite and un'elcome situation than 'hat is desired! 5lso 'ith todayPs innovative

financial markets" it is hihly $ro#a#le that the tax 'ill #e circumvented as financial

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innovation 'ill induce a re$lication of instruments that 'ould remain unaffected #y the

tax!

%e 4.< +tudy for World Monetary eform

%he 5sian crisis in 1//= induced the >&= countries 7 the = countries are&&& the

ES5" +anada" Enited indom" France" >ermany" Italy and Qa$an 9 for a fresh study for

revam$in the 'orld monetary system and the finance ministers of the seven countries

#ouht out a Ae$ort entitled " trengthening the nternational *inancial Architecture"

'hich 'as acce$ted in a summit in +olone in Qune 1///! %he Ae$ort identifies five

main areas 'hich are to looked into for strenthenin the 'orld monetary system . >&="

1///!%he areas are:

&& trans$arency and #est $ractices

&& stron financial reulation in industrial countries

&& stron macroeconomic $olicies and financial system in emerin countries

&& im$rovin crisis and manaement 'ith $rivate sector involvement

&& $romotin social $olicies to $rotect the $oor

Aeardin the transparencythe Ae$ort em$hasizes that trans$arency is needed to

ensure that information a#out existin conditions" decisions and actions of the authority

should #e made accessi#le" and easily understood #y the economic aents! When the

latter et sufficient market information" they can efficiently allocate the resources to

minimize the risks! %rans$arency also $romotes healthy market ex$ectations of the aents

that hel$ maintain sta#ility in the system!

Monetary authorities should $u#lish information a#out their reserve $osition" the

leverae $osition and external inde#tedness! %he countries are to #e encouraed to a$$ly

uniform standards and sound $ractices to foster the develo$ment of sound financial

system! International institutions should disclose their evaluations of the res$ective

countriesP financial system!

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+tronger Financial egulation

%he Ae$ort em$hasizes that inade(uate and inefficient evaluation of the credit

$ro$osals are also res$onsi#le for the creation of #ad asset! 6xcessive risk takin alon

'ith hih deree of leverae can make the financial system fraile and s$read neative

ex$ectations! %he Ae$ort identifies three areas 'hich are to #e addressed #y the

industrial countries and these are:

&&im$rovin risk measurement and its manaement

&&assessin the im$lications of the activity of the highly leveraged institutions!

and"

&&evaluation of the im$lications of the activities of the Offshore Financial +entres

%he three areas are inter&connected as it is the offshore reions 'here the $ro#a#ility is

very hih that hihly leveraed financial institutions are enaed in hih risk #usiness!

%he resultant loss" 'hen it ha$$ens" erodes the #ottom line of the $arent institutions!

+trong Macroeconomic )olicy

%he Ae$ort devotes considera#le s$ace to discuss the s$ectrum of

macroeconomic and financial $olicies the emerin countries should ado$t in the current

lo#al scenario! One im$ortant area is the exchane rate reime 'hich should #e

su$$orted #y consistent macroeconomic and fiscal $olicies #y the res$ective

overnments! %he financial system should also 'ork in an efficient manner #y

maintainin a $ro$er leverae $osition!

%he Ae$ort also asks the >&= rou$ for its firm commitment to 'ork toether 'ith

the im$ortant financial institutions of the 'orld to im$rove the standard of su$ervision of

#ankin and financial system! It also re(uests the overnments of the emerin countries

to narro' do'n the zone of the overnment uarantee for $rivate sector loan so that the

$ro#lem of moral ha1ards can #e minimized!

%he >&= countries also caution the emerin countries 7 there are 11 in the rou$

and they are&&&& 5rentina" 5ustralia" *razil" +hina" India" Mexico" Aussia" Saudi 5ra#ia"

orea" South 5frica and %urkey 9 to $roceed for ca$ital account li#eralization 'ith $ro$er

se(uencin of $olicies and creation of necessary infrastructure! %he International

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Monetary Fund .IMF and other similar institutions are asked to monitor closely the

transorder ca$ital flo's to minimize the $otential desta#ilizin effects of the latter! It is

reconized that the international ca$ital market has an im$ortant role for the

im$rovement of $roductivity in the emerin countries!%he re$ort also asks the emerin

countries to ado$t #est $ractices reardin de#t manaement 'ith reater reliance on lon

term de#t" if $ossi#le" denominated in domestic currency and removal of #iases that

encourae short term !

$risis )re(ention and $risis Management

Aeardin crisis $revention the >&= re$ort envisaes a frame'ork for $reventin

crisis 'ithout introducin moral hazards! %he main element in this frame'ork is the

involvement of $rivate creditors in all the as$ects of de#t manaement strateies! %he

Ae$ort reconizes that the official financial assistance in certain situations can $lay an

im$ortant role in the $revention of crisis" and even 'hen crisis occurs" in limitin the

risk of contaion! 5lso the Ae$ort ures the emerin countries to develo$ a mechanism

for a more consistent and systematic dialoue 'ith the main creditors for the

restructurin of loan and thus s$readin the lia#ility over a larer time horizon so that the

risk of contaion remains limited!

%he Ae$ort advises the de#tor countries to esta#lish sound and efficient

#ankru$tcy $rocedures and stron judiciary to $romote trans$arency and e(uity in the

insolvency reime! %he Ae$ort $uts em$hasis on #oth the commitment of countries to

meet their o#liations and market disci$line!

Formation of a -ew 4rou&! 4.20

On the initiative of >&= a ne' rou$ has #een created in the 'orld scene and it is

called >&)&= is of the vie' that they $ro$ose to esta#lish a ne'

mechanism for informal dialoue in a frame'ork of *retton Woods institutional system "

and to #roaden the dialoue on key economic and financial issues amon major emerin

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economies for the $romotion of 'orld ro'th and sta#ility! Some sort of a collective

management of the world financial systemhas #een the motivatin force #ehind the

formation of >&)


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sta#ility of this system . 6ichenreen" 1///G *linder"1///" >oldstein"1/// ! %here has

#een a #road consensus a#out 'hat the emerin countries should do reardin external

financial transactions and these are: ado$tion of a floatin exchane rate reime" less

reliance on forein currency #orro'in and extreme cautious a$$roach reardin ca$ital

account li#eralization! 5lon 'ith these elements there has #een an em$hasis on the role

of market in the ne' scheme of thins!

%here are still certain ray areas 'hich are to #e looked into! %he sta#ility of the

'orld system de$ends on the interde$endence #et'een the macroeconomic $olicies of

the lo#al financial $o'ers" $articularly the Enited States" 6uro$ean Enion and Qa$an!

*ut the $resent arranement may not #e considered as sufficient! 5s for exam$le" the lo'

interest rate $olicy as 'ell as 'eak yen $olicy $ursued #y *ank of Qa$an since the middle

of 1//; had #een necessary to fiht the domestic recession! *ut this $olicy led to a hue

Qa$anese investment in the ES5 at a chea$ cost and also hue Qa$anese loan to South

5sia! In early 1/// there had #een a shar$ reversal of the yen decline vis&T&vis ES dollar

and the >&= $assively acce$ted that thouh it 'as not ood for the recovery of Qa$an! %he

market took the sinal that yen 'as oin to a$$reciate further 'hich 'as consistent 'ith

the 5merican attem$t to reduce the deficit in current account in its trade 'ith Qa$an!

%here is $erha$s another issue 'hich should #e addressed $ro$erly and it is the

li(uidity of IMF" 'hich o#tains its resources throuh (uota su#scri$tions from mem#ers!

In return" IMF creates international li(uidity! %his is su$$lemented 'ith the creation of

the S$ecial Bra'in Aihts.SBA! *ut in the $resent scenario of market&led 'orld

financial system 'hat is feared is that IMF may create too much li(uidity in the system

'hich it may not endure! *ein the international lender of last resort IMF should not

create any moral hazard $ro#lem so far as the manaement of the current account of

individual mem#er is concerned! *ut the market $erce$tion should #e clear that IMF has

the means to $revent a crisis situation of a $articular mem#er from deeneratin into a

systemic insta#ility!

%his cha$ter ex$lains in detail the evolution of the 'orldPs financial system" and

the descri$tion of the ne' financial architecture 'ill not #e com$lete 'ithout a

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discussion of the ne' ex$eriment of the t'entieth century" i!e!" the formation of

6uro$ean Enion and the ne' currency 6uro! We 'ill discuss this in the next section!

uro&ean Anion and uro

%he sinle currency of 6uro$ean Enion 6uro 'as launched on Qanuary 1" 1///

and it is a com$osite currency consistin of 1) currencies 'hose 'eihts are

$ro$ortionate to the im$ortance of the economy! %he currencies 'ith their res$ective

'eihts are discussed in detail in +ha$ter 8! ere 'e discuss the systemic im$act of the

6uro on the lo#al financial system!

5t the time of launch" 6uro 1 K Es 1!1= and that 'as the theoretical value! *ut

durin the last t'o years 6uro has lost heavily aainst ES dollar and in Becem#er )

leacy currencies 'ill #e 'ithdra'n and in Quly" )reece. from Qanuary1" )


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similarity" same ty$e of external shocks 'ould create different ty$e of effects and the

countries 'ould re(uire different exchane rate $olicies!

Second" the economies of the countries under 6E should #e $ro$erly interated

such that they face the same $hase of #usiness cycles at the same time! %his 'ill facilitate

ado$tin same interest rate $olicy and one monetary $olicy! %his condition is touh #ut

very im$ortant" #ecause if interest rates deviates from one another" diverse ca$ital

movements 'ill create $ro#lems for the sinle monetary $olicy! %he latter is crucial for

the credi#ility of 6uro #ein the sinle currency in 6E! It 'ill #e a difficult $ro$osition

for the 6uro$ean +entral *ank .6+* to fiht inflation in one country 'ith hih interest

rate and tackle recession in another country 'ith lo'er rate of interest!

%hird" the mem#er states should have a common economy in the sense that the

movement of ca$ital" la#our as 'ell as commodities should face no restrictions across the

$olitical #orders! %his im$lies a sinle market condition and the industries in the

concerned countries should #e ready to face this com$etition!

%he three conditions as outlined a#ove are necessary for the esta#lishment of the

o$timum currency areas! %he fact is that 6E mem#er states are yet to achieve this stae!

*ut the Maastricht %reaty tried to ensure that the eleven countries 'ere similar #y

im$osin four convergence criteria related to the exchane rate" inflation rate" interest

rates and the $u#lic deficit . #udet deficit in relation to the ross domestic $roduct!

First" the exchane rate of the country must remain 'ithin the normal fluctuation margin

of the 6xchane Aate Mechanism 7 6AM9 for ) years! Second" the rate of inflation should

#e no more than 1!; $er cent a#ove the averae rate of the three #est $erformin mem#er

states! %hird" the lon term interest rate should #e in line 'ith the #est countries in term

of $erformances! Fourth" the #udet deficit should #e no more than @ $er cent of the

ross domestic $roduct of the country!

On the surface the success of the converence criteria in the case of 11 countries

sho's the success of the common currency! *ut round reality may remain different!

When all ca$ital market instruments are converted to common currency" the interest rates

'ill convere" #ut that 'ill not ensure the similarity of the o#jective situations of the

ca$ital markets of the mem#er states! Failure of this im$lies that ca$ital 'ill not move to

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the ca$ital $oor reions as ex$ected initially! 5ll these sho' the difficulties in the 'ay of

the mem#er states under 6E formin the o$timum currency areas!

%he literature ex$lains the o$timum currency areas as an ideal state and it defines

'hether a rou$ of countries can enter into a monetary union 'ithout much neative

externality! In a sense every country 'ith its o'n currency is a monetary union" #ut that

does not uarantee that the country $resents an o$timum currency areas! *i countries

like the Enited States" Aussia" +hina and India are not o$timum currency areas" as

different states either in the Enited States or in India do not exhi#it the similarity of the

economic structures as descri#ed under the o$timum currency areas!

*ut the monetary unions do function and this they do 'ith relative success

#ecause of the functionin of some adjustment mechanism like flexi#ility of factor $rices

and mo#ility of la#our and ca$ital across the reions! Flexi#le 'aes and interest rates

'ill clear the markets and that takes care of the unem$loyment and under em$loyment of

factors of $roduction! Free and unrestricted mo#ility of ca$ital and la#our is very

im$ortant in this adjustment mechanism 'ithout 'hich sectoral unem$loyment 'ill

$revail!

What is the real situation in 6uro$ean EnionV Bifferent studies suest that the

cultural and linuistic differences amon the countries in 6uro$e form a sinificant

#arrier to la#our mo#ility! It has to try hard to achieve the ty$e of la#our mo#ility as seen

in the Enited States! *ut socioloists raise a more fundamental issue and that is 'hether

the social friction that may result duo to la#our mo#ility in the face of cultural differences

are desira#le from the sta#ility as$ect of the society! %his is an a$$rehension and for this

economics has no ans'er!

%he success of the 6uro 'ill de$end larely on the role of the 6uro$ean +entral

*ank . 6+*" 'hich is located in Frankfurt and 'hich is controlled #y a set of

inde$endent central #ankers 'ho are not vulnera#le to the $olitical o$inion! %he 6+*

'ill see rouh days ahead as it tries to im$ose strict monetary and fiscal disci$line on the

'eaker countries for the sta#ility of 6uro and its success 'ill de$end to 'hat extent it can

'ithstand the $otential $olitical $ressure! %he formation of 6uro$ean Enion and its

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im$act is discussed in this cha$ter from the $ers$ective of the theory of o$timum

currency areas! %he structure of the currency 6uro and its recent chanes are ex$lained in

+ha$ter 8!

$%a&ter 3#

International Mo(ement of Money! %e Institutions

"n a world of banks and insurance companies! money markets

and stock exchanges! money is $uite different thing from what it

was before these institutions came into being".

7 icks" 1/0=: $! 1; 9

Money as a commodity is lo#al #y nature and its movement is facilitated #y

'ell&esta#lished institutions like money market" ca$ital market and the market for forein

currencies! %he latter is $art of money market #ut for the convenience of analysis 'e

discuss it se$arately! In todayPs 'orld of interated treasury o$erations of #anks and

other financial institutions the $ersons involved in the movement of money across the

$olitical #oundaries are the same 'orkin simultaneously in the three markets as

mentioned! %he money market and the ca$ital market have #een descri#ed earlier" and let

us take the forein exchane market!

Forein exchane is enerally referred to as the instruments " communications or

orders that results in a chane of o'nershi$ of demand #ank #alances a#road! %hus

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forein exchane is defined as any order" communication or any instrument that

necessitates the recei$t or $ayment of funds in a currency other than the currency of the

market 'here the settlement for the order or communication is made! %he instruments are

enerally 'ire transfers" checks" airmail $ayment orders and #ills of exchane! So any

instrument that can #e sent to another country and effect a transfer in the o'nershi$ of

demand #alances in #anks is a $iece of forein exchane! We can thus include 'ithin this

definition forein cash" forein stocks and #onds" credit card vouchers" travelerPs checks

etc!!

%e Market for Foreign $urrencies

%he market for forein currencies or forein exchane market .F6M is the

market for tradin in diverse currencies 'hich are all soverein money uaranteed #y the

res$ective overnments and issued #y the central #anks 'ith ade(uate reserves as the

#ackin of the res$ective lia#ilities! 6ach transaction involves the exchane of one

currency" say ES dollar" #y the currency of another country" say Indian ru$ee" and in most

of the cases it is #y chanin o'nershi$ of de$osit #alances in #ankin system! It is

al'ays money aainst money! 5t the smallest level it can #e as artless as the tout

chanin ES dollar aainst ru$ee in the market $lace at Mum#ai or the $orter chanin

the dollar for ru$ee at the Calam air$ort! 5t the other extreme it may #e so$histicated

electronic hook&u$ ta#les 'ith com$uter and tele$hones" fax machines and telex in the

forein exchane dealin rooms of the #anks in major financial centres like Mum#ai"

,ondon" Ne' ork etc! transactin in millions of currencies of different denominations

'ithin a short time! %he essential $rocess is the same " only modern technoloy has

facilitated the transfer of hue volume 'ithin a very short time! %he 'orld has #ecome a

very short $lace in the dealin room! It is not a market 'here t'o $arties meet each other

face to face" #ut it is an electronically o$erated market and this sort of market functions

)8&hours a day around the lo#e and handles over /; $er cent of total #usiness!

%he $layers in the market are individuals" traders" financial institutions"

commercial #anks" #rokers and central #anks! %he traders in the market o$eratin from

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the dealin rooms are dedicated to orderin the movement of money in and out of the

account their #anks maintain in other #anks and corres$ondent institutions around the

'orld! %he F6M is closely linked 'ith #oth the ca$ital market and the money market

since in the recent lo#alization of finance" many investors and other $artici$atin aents

are to o throuh financial intermediation across the $olitical #orders and from one

currency to another to reach their counter&$arty! %he modern arranement of interated

treasury manaement is the loical outcome of the close interation of the three markets!

%he nature of the movement of the exchane rates of different currencies are a

su#ject matter hotly $ursued #y #oth the academicians and the traders 'ho man the

terminals in the dealin rooms! %he theoretical ex$lanations are com$lex and sometimes

tricky . Nandi"1//0 and one non&mathematical 'ay of understandin the market is

$rovided in the %echnical 5nalysis literature! %he latter is not $ursued in this #ook as it is

too s$ecialized a su#ject and the reader is advised to see any #ook on the su#ject for

further discussion!

%e FM and ime Bones

%he lo#al F6M o$erations is a )8&hour cycle! On any 'eek day this market

o$ens in 5uckland" Wellinton and Sydney" then %okyo o$ens" follo'ed #y on on

and Sina$ore an hour later! When it is mid&day in the far east" *ahrain and other Middle

east markets o$en and a fe' hours later the 6uro$ean markets o$en! It is then mid&

afternoon in the Far 6ast as centre as Uurich" *asle" >eneva" Frankfurt" Munich and

,ondon o$en in the early trade hours! 5fter lunch in these markets" the eastern markets

close" #ut Ne' ork o$ens! %he market then s$reads to'ards the 'estern side of the

Enited States in $laces as +hicao" ,os 5neles! When the evenin sets in 5merica" Ne'

Uealand and 5ustralian #anks o$en the next day and thus the )8&hour cycle #ecomes

com$lete!

%he res$ective countryPs rules and reulations #ein uni(ue that 'ay uide the

o$eration in each market! In some exchane rate is fixed" in others it is flexi#le and

relatively free 'hile in some $laces it is a manaed float ty$e! *ut the $layers are of a

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common mould any'here in the 'orld and the $roduct is the forein exchane! In s$ite

of the fact that forein exchane reimes vary across the countries" the $layers in the

market determine the exchane rate and make the market! %his they do #y chanin the

s$reads #et'een the #id -ask rates and sometimes throuh the hel$ of the #rokers and

also #y creatin $ositions in the ex$ectations of influencin the future rates of the

currencies!

Foreign c%ange Market! Microstructural ynamics

%he forein exchane market is characterized #y the AeutersP B)


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%he #rokers in the F6M o$erate in the interank markets and in some countries

#et'een the customers and the #anks! %he #rokers do not set the rates in the markets" #ut

their #ids and offers are $assed on to the commercial #anks and these reflect the demand&

su$$ly factors in the markets! %hese facilitate the determination of final rates #y the

#anks! %he existence of #rokers #roadens the markets and makes it more efficient!

*rokers enerally do not take a $osition in the markets and they 'ork as liaison! When

the trade occurs #et'een the customer and the #ank" #rokers do not a$$ear in #et'een"

#anks often take their services 'hen market is volatile ! Of course the #rokers have their

o'n customer #ase and they take commissions from #oth sides of transactions! *anks

often use #rokers in forein exchane transactions to maintain anonymity until the

closin of the deals and-or 'hen they 'ant to reduce the $a$er 'ork of their o'n! %he

im$ortance of #rokers is related to the nature and oranization of the markets" and if there

is a drastic chane in the oranization of the markets . as are seen no'&a&days 'ith the

arrival of ne' technoloy and ne' ty$es of money" $osition of the #rokers 'ill chane

also!

$ommercial 7anks

%he commercial #anks are the larest $layers in the forein exchane market and

they conduct their o$erations throuh their dealin rooms! %he latter are connected 'ith

the lo#al markets #y all modern adets of telecommunications! %he traders in these

dealin rooms determine the areate demand and su$$ly of any currency and throuh

these they determine the $rice! %he dealin rooms have electronic tradin arranements

'ith the hel$ of on&line com$uters" the latter link $artici$atin #anks on a one&on&one

#asis so that traders car reconize on their monitor 'ho the counter&$arty is" the amount

of #id or offer" the rates etc! %he deal "if areed u$on" can #e closed 'ith the stroke of a

sinle key of the com$uter! %he relia#ility of the deal is uaranteed as every transaction is

electronically stored and thus documented! %he market information and the dealin

facility are $rovided #y com$anies like Aeuter! 5lso other $roviders like *loom#er

and niht Aider are in the same cateory of #usiness!

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5ll over the 'orld the dealin rooms are #usy 'ith the trade of five $rinci$al

currencies & ES dollar" >erman mark" S'iss franc" *ritish $ound and Qa$anese yen! No'

another currency has joined the leaue and that is 6uro! 5 second layer of currency is

com$osed of French franc" Italian lira" *elian franc" +anadian dollar and Butch

uilders! Other currencies are traded in lo' volumes " and one reason for this is that

traders do not create $ositions in third layer currencies !

+ommercial #anks maintain demand accounts at major #anks in all the countries

'hose currencies are traded! ,eadin #anks may maintain several corres$ondents at main

financial centers of the same country to handle #usiness of the customers! In the major

dealin room of the #ank several traders may #e involved in trade o$erations of one

major currency" and the +hief Bealer remains res$onsi#le for the #ankPs lo#al $osition

in the currency" as he must #e continuously monitorin the net $osition of that currency!

%he chief dealer must #e alert a#out the likely movement of the currency in near future"

'hich may #e a day" one 'eek or one month! *anks enaed in international o$erations

do essentially international #ankin and it is taken u$ in +ha$ter ;!

urocurrency Markets

6urocurrency markets are s$ecialized money and ca$ital markets" controlled and

administered mainly #y commercial #anks in offshore financial centers . OF+ ! %he

assets and customers are enerally outside the countries of the centers! 6uro&currencies

are currencies handled #y the #anks outside the countries of their oriin! %hese are mostly

hard currencies like ES dollar" yen" >erman mark" S'iss francs and French francs! 6uro&

#anks in offshore centers maintain accounts in different currencies in #anks in Ne' ork"

,ondon and such main financial centers and they transfer money accordin to the needs

of the customers from these accounts!

%he history of the eurocurrency markets is very interestin! In the 1/;


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#anks! %he modern 6urocurrency markets develo$ed from these first roots and today the

$otential of this market has attracted many financial centers in this #usiness like >eneva"

,uxem#our" 5msterdam" *russels" %oronto etc! 5t $resent more than ;< countries have

#ankin reulations that $ermit the o$enin of time de$osits accounts in forein

currencies on the #ooks of their financial institutions on #ehalf of their non&resident

foreiners! %he currencies circulatin in this #usiness are currencies 'hich are ca$ital

account converti#le" thouh major currencies are only a fe' in num#er! %he countries of

oriin of these currencies have #ankin reulations allo'in their

world financial infrastructure and money

Documents