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International Monetary System 2

International Monetary System 2

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International Monetary System IN THIS CHAPTER 2

Specie commodity standard Gold standard Decline of the gold standard Bre on Woods system Chronology of the Bre on Woods system Smithsonian arrangement system Independent oating Managed oating pegging Crawling peg Currency band Snake and the Worm Currency boards € : A single European currency Prospects of € Summary Questions Project work Case studies

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International Monetary System

The allows to be exchanged in order to facilitate international trade and commerce. MNCs depend on the foreign exchange market to exchange their home currency for a foreign currency and also to exchange a foreign currency they receive into their home currency.

2.1 SPECIE COMMODITY STANDARD

In earlier days trade payments were settled through barter arrangement. On account of inconsistency and inconvenience, traders began using metals like gold and silver to settle the payments. Subsequently metals took the form of coins that had the stamp of sovereignty on the basis of weight and fineness of the metal and that was the beginning of the Specie Commodity Standard. The coins were called full-bodied coins meaning that their value was equal to the value of the metal contained in it. Over a period of time other metals with a lower value was mixed with the gold coin, as a result the value of the metal came to be lower than the face value of the coin. These coins were known as debased coins. Full-bodied coins were primarily used for store of value. To act as a store of value, coins must be able to be reliably saved, stored, and retrieved and also be usable as a medium of exchange when it is retrieved. The value of the money must also remain stable over time. The full-bodied coins were driven out of circulation by the year 1560 by the debased coins.

The Coinage Act or the Mint Act of 1792, of the United States established dollar as the monetary unit of the country, declared it to be lawful tender, created a decimal system for the US currency and also fixed its value in terms of gold and silver. The mint ratio between gold and silver was 1:15 in the United States and 1:15.5 in France. Thus was the beginning of the bimetallic standard. In the beginning of 1800, the value of gold rose in comparison to silver, resulting in the removal from commerce of nearly all the gold coins, and their subsequent melting. The difference in the bimetallic standard between the US and the France led to the export of gold from the US to France for the purchase of silver. This led to diminution of gold stock in the US and the country was forced to adopt a mono metallic silver standard. Therefore in 1834, the 15:1 ratio of silver to gold was changed to a 16:1 ratio by reducing the weight of the nation’s gold coinage. This created a new U.S. dollar that was backed by 1.50 g (23.22 grains) of gold. However, the previous dollar had been represented by 1.60 g (24.75 grains) of gold. The result of this , which was

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The essential features of gold standard were:

1. The country adopting the gold standard shall fix the value of currency in terms of specific weight and fineness of gold and guarantees a two way convertibility 2. Export and import of gold shall be allowed so that it can flow freely among the countries adopting the gold standard 3. The apex monetary institution shall hold gold reserves in relationship to the currency it has issued and 4. The government shall allow unrestricted minting of gold and melting of gold coins at the option of the holder

Since fixed weight of gold had formed the basis for a unit of the currency and since free flow of gold was permitted among the countries adopting the gold standard, the gold standard carried an automatic mechanism for domestic price stability, fixed exchange rates and adjustment in balance of payment. The exchange rate mechanism depended upon the content of gold in different countries. Let us say that the sterling contained a half ounce of gold and one dollar bill contained one fourth ounce of gold, the exchange rate was fixed at £1 = $2.

The United States set the value of the dollar at $20.67 per ounce of gold and the British pound was pegged at £4.2474 per ounce of gold. Thus the dollar to pound ($/£) exchange rate was determined as follows:

$20.67 per ounce of gold = $4.8665 per £ £4.2474 per ounce of gold

The rate was known as the mint rate or the mint exchange rate. The actual exchange rate remained close to mint rate and the free flow of gold between the two countries ensured not much deviation in the exchange rate. This led to fixed parity between the currencies and helped to preserve the value of each individual currency in terms of gold.

In the event of occurrence of a transportation cost or transaction cost, the dollar pound exchange rate would fluctuate above or below the fixed rate. Let us assume hypothetically that the value of the dollar had depreciated to $5 per £. This will give an opportunity for the arbitrageurs to move in. The arbitrageurs would buy one ounce of gold in the US for $20.67 and sell it in Great Britain for £4.24 and then exchange the pound for the dollar in the forex market for $5 $4.24 = $21.20, thus making a profit of $21.20 $20.67 = $0.53 per × − ounce. This process would continue till the original parity was established.

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The gold standard maintained a reasonable equilibrium through the principles of price-specie flow mechanism. This arrangement restored automatic adjustment in the balance of payments. Say, in the event Great Britain faced a deficit on its trade account leading to outflow of gold for trade settlement and reducing the money supply with in the country, the emerging deflation would make the British exports competitive and the resultant rise in exports would eventually wipe out any deficit on this account. On the other side, reduced money supply pushes up the interest rate and the credit restrictions imposed by the apex banks will push up the bank interest rate, resulting in the foreign investment moving into the economy and off-setting any deficit on the capital account.

2.3 DECLINE OF THE GOLD STANDARD

The gold standard as an international monetary system was accepted by most of the countries until the First World War broke out in 1914. The warring nations required huge money supply for financing the activities borne out of war. This was not possible under the gold standard. The strained relations among the warring nations further impeded the free flow of gold from one nation to another. The exchange rate parity hither to followed by the various nations went hay wire.

At the onset of the war, US corporations had large debts payable to European entities, who began liquidating their debts in gold. With debts looming to Europe, the dollar to British pound exchange rate reached as high as $6.75, far above the parity of $4.8665. This caused large outflow of gold. In July 1914, the New York Stock Exchange was closed and the gold standard was temporarily suspended. In order to defend the exchange value of the dollar, the US Treasury authorised state and nationally-charted banks to issue emergency currency under the Aldrich-Vreeland Act, and the newly-created Federal Reserve organised a fund to clear the debts to foreign creditors. These efforts were largely successful, and the Aldrich-Vreeland notes were retired starting in November 1914 and the gold standard was restored when the New York Stock Exchange re-opened in December 1914.

As the United States remained neutral in the war, it remained the only country to maintain its gold standard, doing so without restriction on import or export of gold from 1915-1917. US also banned gold export, thereby suspending the gold standard for foreign exchange. US demanded repayment of war debts from France and France asked compensation from Germany to meet the war debt. The United States finally joined the war in 1917. Already it enjoyed a huge trade surplus with the European Nations. Hence the dollar became stronger and the European currencies became weaker and the United States began to assume the role of the leading creditor nation. For the reasons mentioned above, the gold standard was suspended during the First World War.

After the end of the First World War, the nations on the gold standard during the pre-war years came back to it. The United States returned to gold in 1919, the Great Britain in

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1925, France in 1926 and Switzerland in 1928. All other European countries followed soon after. The returned at the old mint exchange rate of $4.8665 per £. As Great Britain had liquidated most of its foreign investment in financing the war, the country experienced a high inflation, economic stagnation and high unemployment. The pound stood overvalued and completely exposed.

A great depression swept the world in 1929 and lasted for nearly ten years. The depression originated in the United States, starting with the stock market crash of October 1929, known as the Black Tuesday, but quickly spread to almost every country in the world. During the period of great depression, almost every major currency abandoned the gold standard. The Bank of England abandoned the gold standard in 1931 as speculators demanded gold in exchange for currency, threatening the solvency of the British monetary system. This pattern repeated throughout Europe and North America. In the United States, the Federal Reserve was forced to raise interest rates in order to protect the gold standard for the US dollar, worsening already severe domestic economic pressures.

As the economic crunch became more and more pronounced, several banks shut their shop and people began to hoard gold coins as distrust for banks led to distrust for paper money and worsening deflation and gold reserves. The production of gold during 1915-22 was much lower and this resulted in a scramble for gold. In early 1933, in order to fight the deflation, the US suspended the gold standard except for foreign exchange, revoked gold as universal for debts, and banned private ownership of significant amounts of gold coin. After the US abandoned the gold standard, other nations followed suit.

In the year 1934, the US returned to a modified gold standard. For foreign exchange purposes, the set $20.67 per ounce value of the dollar was lifted, allowing the dollar to float freely in foreign exchange markets with no set value in gold. This was however terminated after one year. The US finally devalued its dollar from the previous rate of $20.67 per ounce to $35.00 per ounce, making the dollar more attractive for foreign buyers. The higher price increased the conversion of gold into dollars, allowing the US to effectively corner the world gold market. The modified gold standard was known as the Gold Exchange Standard. From 1934 till the end of World War II, exchange rates were theoretically determined by each currency’s value in terms of gold.

2.4 BRETTON WOODS SYSTEM

In view of an unstable exchange regime, leading nations made several attempts to foster an orderly international monetary system. Established in 1944 and named after the New Hampshire town where the agreements were drawn up, the Bretton Woods system created an international basis for exchanging one currency for another. It also led to the creation of

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the International Monetary Fund (IMF) and the International Bank for Reconstruction and Development, now known as the World Bank. The former was designed to monitor exchange rates and lend reserve currencies to nations with trade deficits, the latter to provide underdeveloped nations with needed capital—although each institution’s role has changed over time. Each of the 44 nations who joined the discussions at Bretton Woods contributed a membership fee, of sorts, to fund these institutions; the amount of each contribution designated a country’s economic ability and dictated its number of votes.

The Bretton Woods system was history’s first example of a fully negotiated monetary order intended to govern currency relations among sovereign states. In principle, it was designed to combine binding legal obligations with multilateral decision making conducted through an international organisation, the IMF. In practice, the initial scheme, as well as its subsequent development and ultimate demise, were directly dependent on the preferences and policies of its most powerful member, the United States.

The conference that gave birth to the system was the culmination of some two and a half years of planning for postwar monetary reconstruction by the Treasuries of the United Kingdom and the United States. Although attended by all the 44 allied nations, plus one neutral government of Argentina, the conference discussion was dominated by two rival plans developed, respectively, by Harry Dexter White of the U.S. Treasury and by John Maynard Keynes of Britain. The compromise that ultimately emerged was much closer to White’s plan than to that of Keynes, reflecting the overwhelming power of the United States as World War II was drawing to a close.

The participating nations agreed that as far as they were concerned, the interwar period had conclusively demonstrated the fundamental disadvantages of unrestrained flexibility of exchange rates. The floating rates of the 1930s were seen as having discouraged trade and investment and to have encouraged destabilising speculation and competitive depreciations. Yet in an era of more activist economic policy, governments were at the same time reluctant to return to permanently fixed rates on the model of the classical gold standard of the nineteenth century. Policymakers desired to retain the right to revise currency values on occasion as circumstances warranted. Hence a compromise was sought between the polar alternatives of either freely floating or irrevocably fixed rates–some arrangement that might gain the advantages of both without suffering the disadvantages of either.

What emerged was the ‘pegged rate’ or ‘adjustable peg’ currency regime, also known as the par value system. Members were obligated to declare a par value (a ‘peg’) for their national money and to intervene in currency markets to limit exchange rate fluctuations within maximum margins (a ‘band’) one per above or below the parity; but they also retained the right, whenever necessary and in accordance with agreed procedures, to alter their par value to correct a ‘fundamental disequilibrium’ in their balance of payments.

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All governments agreed that if exchange rates were not to float freely, states would also require assurance of an adequate supply of monetary reserves. Negotiators did not think it necessary to alter in any fundamental way the gold exchange standard that had been inherited from the interwar years. International liquidity would still consist primarily of national stocks of gold or currencies convertible, directly or indirectly, into gold. Negotiators did concur, however, on the desirability of some supplementary source of liquidity for deficit countries. The big question was whether that source should be akin to a global able to create new reserves at will or a more limited borrowing mechanism.

What emerged largely reflected US preferences: a system of subscriptions and quotas embedded in the IMF, which itself was to be no more than a fixed pool of national currencies and gold subscribed by each country. Members were assigned quotas, roughly reflecting each state’s relative economic importance and were obligated to pay into the Fund a subscription of equal amount. The subscription was to be paid 25% in gold or currency convertible into gold (effectively the dollar, which was the only currency then still directly gold convertible for central banks) and 75% in the member’s own money. Each member was then entitled, when short of reserves, to borrow needed foreign currency in amounts determined by the size of its quota.

The members also agreed that it was necessary to avoid recurrence of the kind of economic warfare that had characterised the decade of the 1930s. Nations were in principle forbidden to engage in discriminatory currency practices or exchange regulation, with only two practical exceptions. First, convertibility obligations were extended to current international transactions only. Governments were to refrain from regulating purchase and sale of currency for trade in goods or services. But they were not obligated to refrain from regulation of capital account transactions. They were formally encouraged to make use of capital controls to maintain external balance in the face of potentially destabilising ‘hot money’ flows. Second, convertibility obligations could be deferred if a member so chose during a postwar ‘transitional period.’ Members deferring their convertibility obligations were known as Article XIV countries and members accepting them were known as Article VIII countries. One of the responsibilities assigned to the IMF was to oversee this legal code governing currency convertibility.

Finally, negotiators agreed that there was a need for an institutional forum for international co-operation on monetary matters. Currency troubles in the interwar years, it was felt, had been greatly exacerbated by the absence of any established procedure or machinery for inter-governmental consultation. A path breaking decision was to allocate voting rights among governments in proportion to their quotas. With one-third of all IMF quotas at its disposal, the US assured itself an effective veto over the decision making process.

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At the centre of the regime was the IMF, which was expected to perform three important functions: regulatory (administering the rules governing currency values and convertibility), financial (supplying supplementary liquidity), and consultative (providing a forum for cooperation among governments). Structurally, the regime combined a respect for the traditional principle of national sovereignty with a new commitment to collective responsibility for management of monetary relations. Though multilateral in formal design, therefore, the Bretton Woods system in practice quickly became synonymous with a hegemonic monetary regime centred on the dollar, much in the same manner as the classical gold standard of the nineteenth century had come to be centred on Britain’s pound sterling.

2.5 CHRONOLOGY OF THE BRETTON WOODS SYSTEM

The chronology of the Bretton Woods system can be divided into two periods: the period of dollar shortage, lasting roughly until 1958; and the period of dollar glut, covering the remaining decade and a half.

The period of the dollar shortage was the heyday of America’s monetary hegemony. The term ‘dollar shortage,’ universally used at the time, was simply a shorthand expression for the fact that only the US was then capable of assuring some degree of global monetary stability; only the US could help other governments avoid a mutually destructive scramble for gold by promoting an outflow of dollars instead. Dollar deficits began in 1950, following a round of of European currencies. In ensuing years, shortfalls in the US balance of payments averaged roughly $1.5 billion a year. But for these deficits, other governments would have been compelled by their reserve shortages to resort to competitive devaluations or domestic deflation to keep their payments in equilibrium; they would certainly not have been able to make as much progress as they did towards dismantling wartime exchange controls and trade barriers. Persistent dollar deficits thus actually served to avoid destabilising policy conflict. The period up to 1958 was rightly called one of beneficial disequilibrium.

After 1958, however, America’s persistent deficits began to take on a different colouration. Following a brief surplus in 1957, owing to special circumstances, the US balance of payments plunged to a $3.5 billion gap in 1958 and to even larger deficits in 1959 and 1960. This was the turning point. Instead of talking about a dollar shortage, observers began to speak of a dollar glut. In 1958 Europe’s currencies returned to convertibility. Subsequently, the eagerness of European governments to obtain dollar reserves was transformed into what seemed an equally fervent desire to avoid excess dollar accumulations. Before 1958, less than 10% of America’s deficits had been financed by calls on the US gold stock and the balance being financed with dollars. During the next decade, almost two thirds of America’s cumulative deficit was transferred in the form of gold, mostly to Europe. Bretton Woods was clearly coming under strain.

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By the mid-1960s, negotiations were begun to establish a substitute source of liquidity growth in order to reduce systemic reliance on dollar deficits, culminating in agreement to create the Special Drawing Right (SDR), an entirely new type of international reserve asset. Governments hoped that with SDRs in place, any future threat of world liquidity shortage would be successfully averted. On the other hand, they were totally unprepared for the opposite threat—a reserve surfeit—which is in fact what eventually emerged in the late 1960s. Earlier in the decade a variety of defensive measures were initiated in an effort to contain mounting speculative pressures against the dollar. These included a network of reciprocal short term credit facilities called swaps among the central banks as well as enlarged lending authority for the IMF. A second source of strain was inherent in the structure of the par value system: the ambiguity of the key notion of fundamental disequilibrium. How could governments be expected to change their exchange rates if they cannot even tell when a fundamental disequilibrium existed? And if they were inhibited from re-pegging the rates, then how would international payments equilibrium be maintained? In practice, governments began to go to enormous lengths to avoid the “defeat” of an altered par value. The resulting rigidity of exchange rates not only aggravated fears of a potential world liquidity shortage but also created irresistible incentives for speculative currency shifts.

In the United States, concern was growing about the competitive commercial threat from Europe and Japan. The cost of subordinating domestic interests to help strengthen foreign allies was becoming ever more intolerable. Conversely, concern was growing in Europe and Japan about America’s use of its privilege of liability financing called the ‘exorbitant privilege’. The Bretton Woods system rested on one simple assumption—that economic policy in the US would stabilise. During the first half of the 1960s, America’s foreign deficit actually shrank as a result of a variety of corrective measures adopted at home. After 1965, however, US behavior became increasingly destabilising, mostly as a result of increased government spending on social programs at home and an escalating war in Vietnam. America’s economy began to overheat and inflation began to gain momentum, causing deficits to widen once again. With governments elsewhere committed to defending their pegged rates by buying the growing surfeit of dollars, a huge reserve base was created for global monetary expansion. Inflation everywhere began to accelerate, exposing all the latent problems of Bretton Woods. The pegged rate system was incapable of coping with widening payments imbalances, and the confidence problem was worsening as speculators were encouraged to bet on of the dollar or revaluations of the currencies of Europe or Japan. On 15 August 1971, the Richard Nixon administration suspended the convertibility of the dollar into gold, freeing the greenback to find its own level in currency markets.

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42 International Financial Management 2.6 SMITHSONIAN ARRANGEMENT

From August to December 1971, most of the major currencies were allowed to fluctuate. The US dollar dropped in value against a number of major currencies. Several nations imposed trade and exchange controls and it was feared that such protective measures might endanger the institution on international commerce and trade. To mitigate these problems, the worlds leading trading countries called ‘Group of Ten’ met at the Smithsonian Institute in Washington DC and formed the Smithsonian arrangement to restore stability of the system.

The Smithsonian arrangement called for realignment of the par value of major currencies to conform to their realistic values. The gold parity of the US dollar was changed from $35 to $38.02 per troy ounce of gold resulting in devaluation of 8.57%. The currencies of surplus countries were revalued upwards by percentages ranging from 7.4% in respect of the Canadian dollar to 16.9% in respect of the Japanese yen. The currencies were permitted to fluctuate over a wider band than in the past. Although a currency was allowed to fluctuate with in a margin of 2.25% from the central rates without the government intervention, it could fluctuate by as much as 9% against any currency except the dollar. Since a currency was permitted to fluctuate up to 2.25% on either side of the central rate, its total fluctuation against the dollar could be as high as 4.5%.

The purpose of Smithsonian arrangement was to infuse greater flexibility into the par value system. Unfortunately the arrangement could not be carried for a long term as there was a tide, as speculation against the weak currencies such as the dollar and the pound against the strong currency countries such as Germany, France, Japan, Switzerland and Netherlands. In February 1973, the US government was forced to devalue the dollar by 10% raising the price of gold to $42.22 per ounce. However, this latent crisis management could not deter the flow of currency in favour of the European countries and Japan. Finally with a lot of uncertainty, the exchange markets closed in March 1973 to avert a major crisis in the international money market. When the markets reopened, all major currencies came on to float and the Bretton Woods system passed into history.

2.7 EXCHANGE RATE SYSTEM

With the collapse of the Bretton Woods system, six industrialised democracies comprising the United States, France, Great Britain, Germany, Japan and Italy met at Rambouillet, France in November 1975 to suggest guidelines for the exchange rate system that could be acceptable to all the member nations. The Rambouillet declaration envisages closer international cooperation and constructive dialogue among all countries, transcending differences in stages of economic development, degrees of resource endowment and

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Table 2.1: Exchange rate arrangements and anchors of as of June 30 2004 monetary policy framework

Sl. No Exchange rate anchor No. of Country List Countries

1 Exchange rate arrangement 9 Ecuador, El Salvador, Kiribati, where the currency of another Marshall Islands, Micronesia, Fed. country is the legal tender States of Palau, Panama, San Marino, Timor-Leste

2 Exchange rate arrangements 32 Eastern Caribbean Currency with no separate legal tender or Union(ECCU- 6): they share their own currency Antigua and Barbuda, Dominica, Grenada, St. Kitts and Nevis, St. Lucia, St. Vincent and the Grenadines West African Economic and Monetary Union(WAEMU- 8): Benin, Burkina Faso, Cte d’Ivoire, Guinea-Bissau, Mali, Niger, Senegal, Togo Central African Economic and Monetary Community (CAEMC-6): Cameroon, Central African Republic, Chad, Congo, Rep. of Equatorial Guinea, Gabon European Area (12) Austria , Belgium, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg, Netherlands, Portugal, Spain

3 arrangements 7 Bosnia and Herzegovina, Brunei Darussalam, Bulgaria, China-Hong Kong SAR, Djibouti, Estonia, Lithuania Continued. . .

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Sl. No Exchange rate anchor No. of Country List Countries

4 Conventional fixed peg 42 Against a single currency (34) arrangements Aruba, Bahamas, The Bahrain, Kingdom of Barbados, Belize, Bhutan, Cape Verde, China, Comoros, Eritrea, Guinea, Iraq, Jordan, Kuwait, Lebanon, Lesotho, Macedonia, Malaysia, Maldives, Namibia, Nepal, Netherlands Antilles, Oman, Qatar, Saudi Arabia, Seychelles, Suriname, Swaziland, Syrian Arab Rep, Turkmenistan, Ukraine, United Arab Emirates, Venezuela, Zimbabwe Against a composite currency (8) Botswana, Fiji, Latvia, Libyan Arab Jamahiriya, , Morocco, Samoa, Vanuatu 5 Pegged exchange rates within 5 Within a cooperative horizontal bands arrangement (2) Denmark, Slovenia Other band arrangements (3) , Hungary, Tonga 6 Crawling pegs 6 Bolivia, Costa Rica, Honduras, Nicaragua, Solomon Islands, Tunisia 7 Exchange rates within crawling 2 Belarus, Romania bands 8 Managed floating with no 48 Monetary aggregate target: pre-determined path for the exchange rate Bangladesh, Cambodia, Egypt, Ghana, Guyana, Indonesia, Iran, Jamaica, Mauritius, Moldova, Sudan Zambia Inflation targeting framework: Czech Rep., Peru, Thailand Continued. . .

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International Monetary System 47 2.7.1 Independent Floating

In a floating rate regime the exchange rates are determined by the market forces without intervention by the governments. The major advantage of freely floating exchange regime is that a country is more insulated from the inflation of other countries.

Let us now examine whether the floating rate regime is superior or the fixed rate regime. A fixed rate regime does not require hedging of exchange rate risk and hence does not involve expenditure of resources. However, the exchange rate is not fixed for ever and does not remain constant for ever. It is realigned time and again to take care of the changing economic scenario. If the exchange rate is not realigned according to the changes in the macro economic conditions, there arises a breach between the nominal and the real exchange rates which hamper the export performance. On the other hand, if and when realignment is made it involved considerable loss of foreign exchange to the affected members.

Compared to the fixed regime, in a floating rate regime, the exchange rates tend to change automatically in line with the changes in the macro economic indicators and there is not much of a gap in the nominal and the real exchange rates. If a country is hit by inflation, the home currency depreciates automatically in a floating rate regime. The three major arguments in favour of floating rate regimes are:

1. The balance of payments on current account disequilibrium will automatically be restored to equilibrium. A balance of payments deficit caused by a decrease in the demand for the country’s exports would lead to a shortage of foreign currency as the amount of foreign currency available falls–shown by a shift to the left of the supply curve for foreign currency. This would push up its price from P1 to P2 and hence lead to a depreciation of the home currency as shown on the next page. The fall in the value of the home currency causes the price of the country’s exports to decrease and the price of foreign imports to increase. Consequently the demand for the country’s exports increases and the demand for foreign imports decreases. The deficit shrinks and the balance of payments returns to equilibrium. Thus, in theory, governments need not worry about having to manage their balance of payments situation. If the exchange rate is allowed to fluctuate freely any disequilibrium will automatically be restored to equilibrium. The need to resort to overseas borrowing to finance balance of payments deficits is considerably minimised. The attention of government can then be focused on achieving other government objectives such as inflation, unemployment, economic growth and poverty reduction.

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S S 2 1 Price

P 2 P 1

D

Q Q 2 1 Quantity

2. Reduces inflationary pressures and international uncompetitiveness. One argument is that a floating exchange rate will reduce the level of inflation. Allowing the exchange rate to float freely will ensure that the country’s exports do not become uncompetitive. This is embodied in the Purchasing Power Parity theory which is discussed in Chapter 6. A high rate of inflation in the country would tend to make the country’s exports uncompetitive. Their demand would fall and the foreign exchange flowing into the country would also fall. The supply curve of available foreign currency would in turn shift to the left causing its value to increase and the corresponding value of the currency to depreciate.

3. In the floating rate regime, the home currency is well insulated from the economic shocks emanating across the globe. The fact that a country’s economy is well insulated, gives an ample opportunity for the government to adopt an independent economic policy. For example the Thai Baht was pegged to the US dollar. During 1980, when the US dollar had depreciated, Thailand experienced an export boom. But in 1996, when the US dollar had appreciated, the Thai economy went through turbulence, on account of heavy losses on the trade account. Analysts claim that had the Thai Baht been on float, it would have remained insulated by the dollar appreciation.

There are also certain demerits in the floating regime:

1. The Marshall Lerner Condition is not necessarily met The problem for a developing economy is that the link between the exchange rate adjustment and the balance of payments improvement is not as straight forward as the Marshall Lerner Condition suggests. The Marshall Lerner Condition has been

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If the monetary authorities buy and sell currencies in the domestic market to stabilise the home currency, it is called as direct intervention. On the other hand, if the monetary authorities stabilise the exchange rate by way of changing the interest rate, it is called as indirect intervention. When the local government sells foreign currency, its supply increases and domestic currency appreciates against the foreign currency. On the other hand, if they purchase foreign currency, its demand increases and the value of the domestic currency will depreciate against the foreign currency. Such type of intervention by the local governments and the monetary authorities is permitted by the IMF.

Intervention by the local government and the monetary authorities can move the value of the home currency up or down through the expectation channel. If intervention is aimed at preventing long term changes in the exchange rate away from equilibrium, it is referred as leaning against the wind direction. On the other hand, if the intervention supports the current trend in the exchange rate already moving towards equilibrium, it is referred as leaning with the wind expectation. When the monetary authorities support the foreign currency, speculators step in and buy foreign currency in the expectation that it will appreciate. It is not that only the local government can intervene in the home currency management. Sometimes other countries can also intervene to stabilise the home currency. For example, in 1994, the US government bought large quantities of Mexican pesos to stop the rapid loss of the peso’s value.

Intervention can be further grouped as stabilising and destabilising intervention. Stabilising intervention helps in moving the exchange rate towards equilibrium, where as the destabilising intervention moves the rates away from equilibrium despite the intervention. Stabilising intervention causes gain of foreign exchange, while the destabilising intervention causes loss of foreign exchange. Officially, the Indian rupee has a market determined exchange rate. However, the Reserve Bank of India trades actively in the USD/INR currency market to impact the effective exchange rate. Thus, the currency regime in place for the Indian rupee with respect to the US dollar is a de facto controlled exchange rate. However, it has to be noted that the RBI intervention in currency markets is solely to deliver low volatility in the exchange rates, and not to take a view on the rate or direction of the Indian rupee in relation to other currencies.

Under a managed floating exchange system the central bank holds foreign currency, which is called foreign exchange reserves. It must be mentioned here that the managed floating system will be successful only if the government’s implicit range is near the equilibrium, and it should exist without the central bank interfering. If the central bank makes a habit of interfering, it runs the risk of losing all its foreign currency reserves. If the government loses all its foreign currency reserves, it cannot take part in the foreign currency market. This would result in the country having to revert to a floating exchange system.

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India’s balance of payments problems began in earnest in 1985. Even as exports continued to grow through the second half of the 1980s, interest payments and imports rose faster so that India ran consistent current account deficits. The Gulf War led to much higher imports due to the rise in oil prices. The trade deficit in 1990 was US $9.44 billion and the current account deficit was US $9.7 billion. Also, foreign currency assets fell to US $1.2 billion. However, as is the case with the Indo-Pakistan war of 1965 and the drought during the same period, India’s financial woes cannot be attributed exclusively to events outside of the control of the government. Since the Gulf War had international economic effects, there was no reason for India to be harmed more than other countries. Instead, it further destabilised an already unstable economic situation brought on by inflation and debt. In July of 1991 the Indian government devalued the rupee by between 18 and 19 percent. The government also changed its trade policy from its highly restrictive form to a system of freely tradable EXIM scrips which allowed exporters to import 30% of the value of their exports. In March 1992 the government decided to establish a regime and abolish the EXIM scrip system. Under this regime, the government allowed importers to pay for some imports with foreign exchange valued at free-market rates and other imports could be purchased with foreign exchange purchased at a government-mandated rate. In March 1993, the government then unified the exchange rate and allowed, for the first time, the rupee to float. From 1993 onward, India has followed a managed floating exchange rate system. Under the current managed floating system, the exchange rate is determined ostensibly by market forces, but the Reserve Bank of India plays a significant role in determining the exchange rate by selecting a target rate and buying and selling foreign currency in order to meet the target.

2.7.3 Currency Pegging

Some countries use a pegged exchange rate management in which the home currency value is pegged to a foreign currency or to some unit of account. While the home currency’s value is fixed in terms of the foreign currency to which it is pegged, it moves inline with that currency against other currencies. A fixed exchange rate is usually used to stabilise the value of a currency, with respect to the currency or the other valuable it is pegged to. Pegging a currency to another currency facilitates trade and investments between the two countries, and is especially useful for small economies where external trade forms a large part of their GDP. Pegging is also used as a means to control inflation. However, as the reference value rises and falls, so does the currency pegged to it. In addition, a fixed exchange rate prevents a government from using domestic monetary policy in order to achieve macroeconomic stability.

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With the Mint Act of 1792, the dollar was pegged to silver and gold at 371.25 grains (1 grain = 64.79891 milligrams) of silver and 24.75 grains of gold (15:1 ratio). In 1900, the bimetallic standard was abandoned and the dollar was defined as 23.22 grains (1.505 g) of gold, equivalent to setting the price of 1 troy ounce of gold at $20.67. In 1934, the gold standard was changed to 13.71 grains (0.888 g), equivalent to setting the price of 1 troy ounce of gold at $35.

In 1898, the Indian rupee was tied to gold standard through the British Pound. Prior to this, the Indian rupee was a silver coin, which made the rupee to be pegged at a value of 1 4 pence (i.e., 15 rupees = 1 pound). In 1920, the rupee was increased in value to 2 shilling (10 rupees = 1 pound). However, in 1927, the peg was reduced to 1 shilling and 6 pence (13.33 rupees = 1 pound). This peg was maintained until 1966, when the rupee was devalued and pegged to the U.S. dollar at a rate of 7.50 rupees = 1 dollar and the rupee became equal to 11.4 British pence. This peg lasted until the U.S. dollar was devalued in 1971.

Some countries like Malaysia and Thailand had pegged their currency’s value to the dollar. Pegging to a single currency is not advisable if the country’s trade is diversified. In such a case pegging to a basket of currencies is advised. But if the basket is very large, pegging to multi currencies is not advisable, as it will prove to be a costly affair. One another method of pegging is through the SDRs. Pegging to SDR is not much as SDRs are themselves pegged to a basket of multi currencies. Furthermore, pegging to SDRs in not an attractive proposition in views of its declining value.

2.7.4 Crawling Peg

Under this system a country pegs its currency to the currency of another country but allows the parity value to change gradually over time to catch up with the challenges imposed by the market. Hence crawling band can be defined as hybrid of fixed rate system and a flexible rate system. Crawling pegs are different from fixed rates on account of their flexibility in terms of the exchange rate movement. They also differ from the floating rate system because there is a limit with regard to their maxima movement.

The basic behind the crawling peg system is that there exists an exchange rate that equilibrates the international supply and demand for a particular currency. However, the possibility that the economic uncertainties may generate fluctuations in the supply and demand over short periods suggests that the movement of exchange rate should be restrained. To accomplish this, countries would continue to hold the forex market rate within a predetermined range during any business day by sale and purchase of international reserves. However, the parity would be allowed to change from day to day by a small margin. The actual formula for changing the peg will have to be determined

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International Monetary System 55 2.7.6 Snake and the Worm

Following the collapse of the Bretton Woods system on August 15, 1971, the EEC countries agreed to maintain stable exchange rates by preventing exchange fluctuations of more than 2.25%. This arrangement was called European because the community currencies floated as a group against outside currencies such as the dollar. Commonly called as the snake, it was one of the best known pegged exchange rate arrangements by the European countries. The snake was difficult to maintain and the market pressure caused some currencies to move outside their established limits. By 1978, the snake turned into a worm with only German mark, , and the Danish kroner as part of the arrangement. Finally the worm was realigned with the launching of a new effort by the European Union to achieve monetary cooperation. By March 1979, the EC established European Monetary System, and created the (ECU).

2.7.7 Currency Boards

In a currency board arrangement the country does not have a central bank, rather it has a currency board that links the domestic currency to the foreign exchange holding. In other words, a currency board is a system for pegging the value of the local currency to a currency of another nation and buys and sells the foreign currency reserves in order to maintain the parity value. For a currency board to be successful, at marinating the value of the local currency to some other specified currency, it must have credibility in its promise to maintain the exchange rate. If there is a downward pressure on the local currency, the central bank must intervene to defend the currency value. If the speculators are of the view that the currency board cannot support the specified exchange rate, they may take positions that will generate profits if the currency board ceases its support of the local currency. As the currency board has only limited functions and powers as compared to the central bank, it cannot frame a discretionary monetary policy like the other central banks.

2.8 EUROPEAN MONETARY SYSTEM

The Economic and Monetary Union (EMU) is an important chain in the west European economic cooperation that began in the late 1950s. Even though the European Common Market (ECM) became a success over the years, the monetary cooperation between the member countries was not successful. Under the Jenkins , most nations of the European Economic Community (EEC) linked their currencies to prevent large fluctuations relative to one another. As a result, the spot spread between the parties of any two member currencies of ‘Snake’ was restricted to +/ 1.25% that was equivalent − to one half of the fluctuation band prescribed under the Smithsonian arrangement (tunnel). There was provision for intervention in preventing the snake from leaving the tunnel. The main objective of the arrangement was to narrow the fluctuation margin among the

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Eleven of the fifteen European Union member states initially qualified to join the EMU in 1998. Those states were Austria, Belgium, Finland, France, Germany, Ireland, Italy, Luxembourg, the Netherlands, Portugal, and Spain. As part of the EMU, these eleven countries now make up the world’s second-largest economy, after the United States. By using the flexible definitions Belgium and Italy meet the deficit related criteria. Two countries, Greece and Sweden, failed to meet the convergence requirements in time to join the EMU in the first round. Sweden failed to satisfy two of the conditions: laws governing Sweden’s central bank were not compatible with the Maastricht Treaty and the currency exchange rates in Sweden were not sufficiently stable for the previous two years. Greece failed to meet all the requirements. These countries would be reevaluated every two years to determine if they meet the requirements for joining the EMU. The two remaining members of the European Union, the United Kingdom and Denmark, chose not to join the EMU immediately. Both of these countries made provisions in the Maastricht Treaty that preserved their right not to join the EMU. To ensure stable currency exchange rates among all the EU member states, the currencies of those states that did not qualify to join the EMU or that chose not to participate in the EMU initially were linked to the single European currency of the EMU, the , by a new currency exchange rate mechanism, known as ERM 2.

ECU was a composite monetary unit made up of a basket of specified amounts of the currencies of the eleven EU member countries. Each specified amount was determined on the basis of the nations GDP and the foreign trade. One ECU was equivalent to the sum of the fixed amount of such currencies. The ECU is a unit of account for the European communities. It is used for the EC budget, in the accounts and transactions of the European Investment Bank, the European Development Fund, and the financial operations of the European Coal and Steel Community. The ECU also plays a significant role in the common agricultural policy of the EC, in particular for denominating agricultural prices. The ECU plays a central role in the exchange rate mechanism of the EMS. It is used as a numeraire for expressing central rates, as the unit of denomination of credit extended through the European Monetary Cooperation Fund (EMCF) in connection with the EMS intervention mechanism and as a reference unit for operation of the EMS divergence indicator. The tables show the composition of the ECU basket at different times during the existence of the ECU.

The EMS was a limited-flexible exchange rate system that defined bands in which the bilateral exchange rates of the member countries could fluctuate. The bands of fluctuation were characterised by a set of adjustable bilateral central parities and margins that defined the bandwidth of permissible fluctuations. This set of parities was called a parity grid as it defined parities for all combinations of the ECU constituent currencies. The borders of the fluctuation bands were described by the upper intervention point and lower intervention point. Typically, the bandwidths were 2.25% to each side, with a wider margin for the

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Table 2.2: ECU basket from 13-3-1979 to 16-9-1984

13-Mar-1979 through 16-Sep-1984

ISO Currency Value Weight (%)

BEF Belgian Francs 3.80 9.64 DEM German Marks 0.828 32.98 DKK Danish Krones 0.217 3.06 FRF French Francs 1.15 19.83 GBP British Pounds 0.0885 13.34 IEP Irish Punts 0.00759 1.15 ITL Italian 109 9.49 LUF Luxembourg Francs (*) (*) NLG Dutch Guilders 0.286 10.51

* The Belgian and Luxembourg francs were in a currency union. Thus, the ECU basket values are combined and shown only for Belgium. Weights are evaluated at central parities on March 13, 1979.

Table 2.3: ECU basket from 17-9-1984 to 21-9-1989

17-Sep-1984 through 21-Sep-1989

ISO Currency Value Weight (%)

BEF Belgian Francs 3.85 8.57 DEM German Marks 0.719 32.08 DKK Danish Krones 0.219 2.69 FRF French Francs 1.31 19.06 GBP British Pounds 0.0878 14.98 GRD Greek Drachmas 1.15 1.31 IEP Irish Punts 0.00871 1.20 ITL 140 9.98 LUF Luxembourg Francs (*) (*) NLG Dutch Guilders 0.256 10.13

* Weights are evaluated at central parities on September 17, 1984.

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The other aspect of the exchange rate mechanism related to the rules governing the divergence indicator. A divergence limit was set at 75% of 2.25% that is about 1.6875%. In case of a particular member currency, this depended on its weight in the ECU basket of currencies. As per Table 2.4, the Belgian Francs had a weight of 8.183%. Hence, its divergence limit can be calculated as:

Divergence limit = (100 8.183) 1.6875% = 1.5494% − ×

Thus, the moment the Belgian Francs fluctuated to 1.5494%, it was subject to intervention under the provisions of the divergence indicator. In the event the intervention failed, the central rates were realigned. From 1979 to 1999 there were a number of realignments. The EMS was severely disrupted by the aggressive storm that hit the European currency markets in September and October 1992, following the difficulties over ratifying the Maastricht Treaty in Denmark and France. The British pound and the Italian lira left the exchange rate mechanism in September 1992, and in November of the same year the and the were devalued by 6% against the other currencies. In January 1993, the was devalued by 10%; in May the peseta and the escudo were again devalued. Finally, in August 1993, the fluctuation band was widened to 15%. However, Germany and the Netherlands stuck to the original fluctuation band of 2.25%. ± Exchange rate stability is the main objective of EMU. But this objective could not be achieved over the years owing to the incongruent and dissimilar economic performance in different member countries. It was observed that disparity in macroeconomic performance could be avoided through convergence of economic policies among the member countries. In 1989, the committee for the study of Economic and Monetary Union put forth a three stage plan popularly called as the Delors plan.

On the basis of the Delors Report, the European Council decided that the first stage of realisation of economic and monetary union should begin on 1 July 1990. On this date, in principle, all restrictions on the movement of capital between the member states were abolished. The members allocated 10% of their foreign exchange reserve to create the European Reserve Fund (ERF) that could help intervention in the forex market. The establishment of the European Monetary Institute (EMI) on 1 January 1994 marked the start of the second stage of EMU and with this the Committee of Governors ceased to exist. The EMI’s transitory existence also mirrored the state of monetary integration within the community. The EMI had no responsibility for the conduct of monetary policy in the European Union and this remained the preserve of the national authorities nor had it any competence for carrying out foreign exchange intervention.

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The two main tasks of the EMI were:

1. To strengthen the central bank cooperation and monetary policy co-ordination

2. To make the preparations required for the establishment of the European System of Central Banks (ESCB), for the conduct of the single monetary policy and for the creation of a single currency in the third stage.

In December 1996, the EMI presented its report to the European Council, which formed the basis for the new exchange rate mechanism (ERM II), which was adopted in June 1997. It was also decided that the current ERM bilateral central rates of the currencies of the participating member states would be used in determining the irrevocable conversion rates for the euro. 1st June 1998 marked the establishment of the (ECB). The ECB and the national central banks of the participating member states constituted the Euro system to formulates and define the single monetary policy in Stage Three of EMU. With the establishment of the ECB on 1 June 1998, the EMI had completed its tasks. In accordance with Article 123 of the Treaty establishing the European Community, the EMI went into liquidation on the establishment of the ECB.

On 1st January 1999, the third and final stage of EMU commenced with the irrevocable fixing of the exchange rates of the currencies of the 11 member states initially participating in the Monetary Union and with the conduct of a single monetary policy under the responsibility of the ECB. The number of participating member states increased to 12 on 1st January 2001, when Greece entered the third stage of EMU. Slovenia became the 13th member of the euro area on 1st January 2007, followed one year later by Cyprus and Malta and by Slovakia on 1st January 2009. On the day each of the country joined the euro area, its central bank automatically became part of the Euro system.

The period between 1993 and 1999 saw a distinct return to normal. In 1996, all the participating currencies including the lira, now reincorporated in the ERM, and the Austrian and Finnish currencies which entered in 1995 and 1996 had moved back within the original margin of fluctuation of 2.25%. The primary goal of the EMS, namely to ± create a zone of internal and external monetary stability, based upon the Exchange Rate Mechanism, was achieved. The participating countries were spared the instability that characterised the international monetary system during the 1980s. The 1992-93 crisis was finally overcome and after nearly twenty years of effort, stability prevailed. The monetary discipline led to economic convergence with reduction of inflation rates and alignment of interest rates.

The private use of the ECU, as opposed to its ‘official’ use between EMS central banks grew considerably. The ECU was increasingly used in international bond issues by community institutions, member state governments and companies. It became a major international financial instrument, overtaking most of its component currencies. There was also a

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there were no notes or coins, but all commercial transactions could be executed through electronic transfers and other forms of payment. The currency of the member countries also existed side by side. The exchange ratio between euro and other non-member currency was to be determined by the market forces. Initially one euro was equal to USD 1.1665. The participating countries comprise almost 20% of the global gross domestic product, which is similar to the level of production in the United States. The exchange ratio between the euro and the member country currency is given in Table 2.5.

In January 2002, euro bank coins and notes were issued and by the end of February 2002, euro completely replaced the members’ currency. The new currency became the legal tender. Following table shows the date on which the members’ currency was replaced by euro. Table 2.6: Date on which the member currencies was replaced by euro

Country Currency Name Converted by

Germany German Mark Dec. 31, 2001 The Netherlands Dutch Guilder Jan. 28, 2002 Ireland Irish Punt Feb. 9, 2002 France Feb. 17, 2002 Austria Feb. 28, 2002 Belgium Belgian Franc Feb. 28, 2002 Finland Feb. 28, 2002 Greece Feb. 28, 2002 Italy Italian Lira Feb. 28, 2002 Luxembourg Feb. 28, 2002 Portugal Portuguese Escudo Feb. 28, 2002 Spain Spanish Peseta Feb. 28, 2002 Slovenia Jan. 14, 2007 Cyprus Cypriot Pound Jan. 31, 2008 Malta Jan. 31, 2008 Slovak Republic Jan. 16, 2009

Now there is a single currency thought out the EMU and that is undoubtedly the euro. Euro bank notes are being issued by both the ECB and the National central banks with total transparency and cooperation between one another. Out of the total issue, 8% are allocated to the ECB and the balance 92% to the National central banks. The are minted by the National authorities.

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64 International Financial Management 2.10 PROSPECTS OF €

Despite the difficulties involved in making any quantitative assessment of the effects of the euro, it is possible to make a few general qualitative observations. First, the technical changeover to the new currency was highly successful. This complex task, involving several changes at central banks, stock exchanges, authorities and thousands of private institutions, was carried out without any major glitch. This clearly reflects the commitment and professionalism of all member nations involved in this gigantic exercise. Second, banks and other market participants swiftly adapted to the new environment. Before the introduction of the euro, there were concerns about how rapidly and smoothly the national money markets would integrate. An integrated euro area money market is a precondition for the common monetary policy, so as to eliminate interest rate differentials across the member nations. Third, the target system - an integral part of the technical infrastructure has contributed to the rapid integration of the money market and links all the Real Time Gross Settlement (RTGS) payments in the EU. Fourth, the successful execution of the single monetary policy has dispelled any criticism that the EUs organisational setup would be complex and inefficient. Fifth, the successful changeover to the euro and the decisive implementation of monetary policy seem to have contributed to a clear strengthening of the Euro system’s credibility. Sixth, the euro has established itself as one of the most important currencies in the forex market. EUR/USD trading is the most active and liquid segment of the forex market at the global level and provides a wide range of instruments and substantial hedging possibilities.

One very important structural effect is that euro is expected to lead to improved competition and increased price transparency in the markets for goods and services. These micro-economic effects will have a great impact on the financial services. In most European countries, the financial markets have traditionally been rather shallow, with few participants and a narrow set of financial instruments on offer. A high degree of segmentation and a lack of cross-border competition have implied relatively low trading volumes, high costs and a reluctance to introduce innovative financial instruments. The segmentation was not a function of exchange rate borders alone. Tradition has also played a role: heterogeneous practices, national regulations and differing tax regimes have been and still are obstacles to full integration. The introduction of the euro and the disappearance of forex risk have triggered increasing cross-border competition and have provided incentives for the harmonisation of market practices. The cross-border integration of bond markets in the euro area is progressing at a slower pace, as is also true of equities and derivatives markets. Euro area market participants increasingly perceive similar instruments traded in the different national markets to be close substitutes. This holds true, in particular, for bonds issued by the euro area governments, where a considerable degree of cross-border substitutability has already been achieved.

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transactions, including transactions carried out outside the euro area. With regard to the invoicing of international trade, estimates suggest that in the early 1990s about one half of global exports were invoiced in US dollars; one third in euro area currencies and only 5% in Japanese yen.

In a medium-term perspective, international trade flows both between the euro area and foreign countries, as well as euro-denominated trade between non-euro areas residents are likely to increase. Nevertheless, at the global level it is likely to take time for the euro to attain sufficient importance to rival the US dollar as a trading currency. The value of US dollar-denominated international trade is nearly four times higher than that of US exports. As this ratio indicates, the use of the US dollar as an international currency on the goods and financial markets is not so much related to trade shares as to the convenience of using one standard currency.

Given the international importance of the euro, it is not surprising that the development of the euro exchange rate has attracted a great deal of attention. The prospect of achieving more stable conditions in the forex market globally, markedly deeper and more efficient financial markets in Europe and increased cross-border competition are likely to effect the international financial system as a whole. The structural implications of the euro are, of course, particularly important for the neighbouring countries, whose economies and financial markets are generally closely linked to those of the euro area.

The implementation of the single monetary policy has been successful, which has contributed to a further strengthening of the Euro system’s credibility. The use of a single currency is clearly promoting the integration of financial markets in the euro area and a re-shaping of the European banking sector. The euro has established itself as one of the world’s leading currencies for investment and trade. Given the international importance of the euro, the long-term success of Economic and Monetary Union is of global importance. At present there are excellent prospects for achieving sustainable non-inflationary growth in the euro area. The expected acceleration of growth does not seem to pose a threat to price stability for the time being. Although rising oil prices may lead to a gradual picking-up of the inflation rate over the coming years, price pressures generally remain subdued in the euro area. In this context, it is important to underline that the Euro system’s firm commitment to internal price stability should in the long run also be reflected in the external value of the currency.

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Table 2.7: EUR/USD exchange rate-historical data

Date Exchange Rate

2010-06-14 1.2249 2010-05-31 1.2307 2010-04-30 1.3315 2010-03-31 1.3479 2010-02-26 1.3570 2010-01-29 1.3966 2009-12-31 1.4406 2009-12-14 1.4647

Nevertheless, the euro area economy is still suffering from structural weaknesses. In particular, the improved cyclical conditions are not sufficient to solve the problem of unacceptably high unemployment in the euro area. In order to tackle this problem, structural reforms are imperative. It would be beneficial to take advantage of the improved cyclical situation in the euro area for the implementation of structural reforms aiming at enhancing the efficiency of the labour markets in the euro area.

The experience of the euro has generally been not very exciting. From being equal to US $1.1665 in the beginning, it gradually slipped against the US dollar reaching to a low of US $0.88 at the end of 2001. The reasons for the decline were attributed to large current account deficit in the EMU than in the US and falling rate of industrial production in the EMU as compared to the US. The euro is now hovering around a exchange rate of US $1.22.

Since January 1999

EUR/USD Exchange rates: Since Jan 1999 (Frankfurt) 1.59990 1.44424 1.28948 1.13472 0.97996

Exchange rate 0.82520 Jan 1999 Jan 2000 Jan 2001 Jan 2002 Jan 2003 Jan 2004 Jan 2005 Jan 2006 Jan 2007 Jan 2008 Jan 2009 Jan 2010

Min = 0.8252 (26 Oct 2000); Max = 1.599 (15 Jul 2008)

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Last 365 days

EUR/USD Exchange rates: Last 365 days (Frankfurt) 1.5120 1.4484 1.3849 1.3213 1.2578

Exchange rate 1.1942 01 Jun 01 Jul 03 Aug 01 Sep 01 Oct 02 Nov 01 Dec 04 Jan 01 Feb 01 Mar 01 Apr 03 May 01 Jun Min = 1.1942 (8 Jun 2010); Max = 1.512 (3 Dec 2009)

Last 30 days

EUR/USD Exchange rates: Last 30 days (Frankfurt) 1.2397 1.2386 1.2275 1.2164 1.2053

Exchange rate 1.1942 14 17 18 19 20 21 24 25 26 27 28 31 01 02 03 04 07 08 09 10 11 14 Min = 1.1942 (8 Jun 2010); Max = 1.2497 (21 May 2010)

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70 International Financial Management 2.12 QUESTIONS

1. What is a gold standard? How does it differ from the gold bullion standard?

2. Gold standard provided price stability besides automaticity in exchange rates and BOP adjustments, explain.

3. What were the reasons for the decline of the gold standard?

4. What were the reasons for the breakdown of the Bretton Woods System? Explain.

5. Enumerate the difference between dollar shortage and dollar glut.

6. Smithsonian arrangement was to infuse greater flexibility into the par value system, explain.

7. Do you agree that floating rate regime is a better option than the fixed ? Explain.

8. What were the reasons for India devaluing its currency in the year 1966?

9. What are the three major arguments in favour of floating rate regimes? Explain.

10. The problem for a developing economy is that the link between the exchange rate adjustment and the balance of payments improvement is not as straight forward as the Marshall Lerner Condition suggests; why it is so?

11. How does a clean float differ from a dirty float?

12. What are the differences between direct intervention and indirect intervention?

13. Under the current system of managed floating has the exchange rate movements been excessive? Explain.

14. How does a crawling peg function?

15. What are the factors to be considered before implementing the currency band system?

16. What do you understand by ‘Snake in the tunnel’?

17. Can the currency boards perform the role of a central bank, If not why?

18. Explain briefly the following:

(a) European Monetary System (EMS) (b) Exchange Rate Mechanism (ERM) (c) European Currency Unit (ECU)

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19. Write short note on the Maastricht Treaty.

20. Explain the three stages of Delors Plan.

21. Define a parity grid and a divergence indicator.

22. What are the main tasks of the EMI?

23. How can a central bank use direct intervention to change the value of a currency?

24. If euro is worth $1.10 what is the value of a dollar in ?

25. Write a note on the prospects of the euro.

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International Monetary System 73 2.14 CASE STUDIES Case Study 2.14.1

Devaluation of the Indian Rupee

Independent India devalued its currency on two occasions once in 1966 and the second time in 1991. Both were preceded by large fiscal and current account deficits and by dwindling international confidence in India’s economy. Inflation caused by expansionary monetary and fiscal policy depressed exports and it led to continuous trade deficits. In each case, there was a large adverse shock to the Indian economy. Further the policy of the Indian government was to follow the Soviet model of foreign trade by viewing exports as a necessary evil whose sole purpose was to earn foreign currency with which to purchase goods from abroad that could not be produced at home. As a result, there were inadequate incentives to export and the Indian economy missed out on the gains from comparative advantage. 1991 represented a fundamental paradigm shift in Indian economic policy and the government moved toward a freer trade stance.

Questions

1. What was wrong in the Government of India’s policies? Could these two major financial crisis been averted by the Government of India. Please Explain.

2. Given the fact that the household saving rate in India is quite high, should the blame for India’s balance of payments problems rest with the government for its inability to control its own spending.

3. By borrowing from the Reserve Bank of India and, therefore, just printing money, the Government could finance its extravagant spending through an inflation tax. Do you concur that engaging in inflationary economic policy in conjunction with a fixed exchange rate regime is a destructive policy.

4. Do you agree had India followed floating rate system instead, the rupee would have been automatically devalued by the market and India would not have faced such financial crises. Enumerate your views.

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2.50 to under 3.80 to the dollar. In 1998, the output of the real economy declined plunging the country into its first recession for many years.

Questions

1. Was there a deliberate attempt by the US to destabilise the ASEAN economies or was it an failure of ASEAN countries?

2. To fight the recession, the Malaysian Government moved the ringgit from a free float to a fixed rate and imposed capital controls. Was this a right move, comment?

3. Explain how the Asian crisis would have affected the returns to a US based MNC from investing in the Asian Stock Markets as a means of international diversification.

4. What lessons can be learnt from the crisis?

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