International Monetary System: The International Financial System - Reform of International Monetary Affairs - The Bretton Wood System and the International Monetary Fund, Controversy over Regulation of International Finance, Developing Countries' Concerns, Exchange Rate Policy of Developing Economies.

1. Unit 4. International Monetary System
4. International Monetary System:
The International Financial System
- Reform of International Monetary Affairs
- The Bretton Wood System and the International
Monetary Fund, Controversy over Regulation of
International Finance, Developing Countries'
Concerns, Exchange Rate Policy of Developing
Economies.

2. SPECIAL DRAWING RIGHTS
Benefits of Reserve Currency
(i) avoid exchange rate risk: (a) Exchange rates
between two currencies can be volatile, dramatically
changing the prices of the goods. (b) Traders are
reluctant to use the currencies of small countries.
(ii) Other countries hold dollar balances for
transactions purposes ⇒They are lending money to
the US (interest-free loans, much like the commercial
banks paying no interest to checking account
balances). US firms have easier access to the
financial market. US has unlimited financing (Douglas
North, 1993 Nobel lecture)

3. Benefits of Reserve Currency
In particular, President of France, De Gaulle,
complained in 1965 that the US enjoys the
hegemony, using "worthless paper to plunder
other nation's resources and factories." (unlimited
financing)
Vladimir Putin: "US is a parasite on the world
economy." (Reuters, Aug 1, 2011). The Russia-
China currency swap has been ineffective due to
low demand for the Ruble.

4. Costs
US did not coerce any country to hold USD. USD has
been simply more reliable, and trading countries were
willing to hold USD. As the demand for the reserve
currency increases, and USD appreciates. ⇒ US
trade deficit increases.
In a certain sense, SDR allocations were like the credit
limits on a person's credit card or line of credit. SDRs
can be used to make payments to settle debts
between central banks.
In addition, each member country agreed to accept
three times its own SDR quota from other central
banks.

5. An agreement was reached at the IMF annual
meeting in Rio de Janeiro in 1967 to issue
SDRs to be allocated to 104 participants.
The first allocation was made in 1970 (3.4
billion), then 1971 (2.95 billion), 1972 (2.95
billion)

6. value of SDR
Originally, the value of an SDR was set at one US dollar,
both having the same weight in gold in 1970.
However, dollar was devalued a couple of times, and
there was a general move to end the key role of $ in
the international monetary system.
After July 1, 1974, the value of SDR was determined in
terms of "basket" of 16 main currencies. Weights:
USD = 33%, mark = 12.5%, pound = 9%, FF = 7.5%,
yen = 7.5%, CND = 6%, lira = 6%. From April 1980,
only 5 major currencies.
$ = 42%, DM = 19%, yen = 13%, FF = 13%, pound =
13% The value of SDR is calculated daily by IMF.

7. SDR included $, euro, pound and yen. 1 SDR =
$1.50 as of 2013
From October 1, 2016, five currencies are
included: USD, €, Renminbi, yen, £ (GBP).
Renminbi is not "freely convertible" in
international transactions.
Codes: USD, EUR, GBP, CNY, JPY, XDR
SDRs are merely bookkeeping entries. It
becomes a reserve asset because of the
commitment of participating countries to
accept SDRs up to an amount equal to 3 times
their own SDR allocations.

8. creation of SDR
A decision to create SDRs require the approval of a
majority of member countries holding 85% of the
weighted voting power of the Fund.
Once created, SDRs are distributed to participants
in proportion to Fund quotas. As of 2009, the total
allocation reached SDR 204 billion.
Between central banks
Unlike dollar and other currencies, SDRs are not
usable for private international transactions.

9. SDRs represent a net addition to international
reserve that are as useful as gold or dollars,
unlike international borrowing (which does
not change reserves). Since it costs nothing
to create SDRs, the world saves resources
that would otherwise be wasted to mine and
refine gold. For this reasons, SDRs are
sometimes called paper gold. However,
they should be called "e-Gold" (electronic
gold) since no paper notes are issued.

10. Importance
SDR plays a limited role as an international reserve
asset due to its small quantity relative to the daily
transactions volume (about $5 trillion dollars) in
the foreign exchange market. Its main function is
the unit of account of transactions of international
organizations and central banks.
SDR is not tied to any single currency., and hence
there is no need for the US to have large trade
deficits in order to provide more reserves to the
ROW.

11. SDRs can be created as needed to insure
stable growth of international reserves. If
SDRs replace $ as reserve assets in central
banks, the US does not have to be a world
banker. SDR makes the IMF an
international central bank.

12. interest rate
Once every year, the IMF charges every
country interest on allotment, and credits
every country with interest on the average
SDR holdings during the past year. The
interest rate was 1.5% per year originally,
but raised to 5% in 1975. Now it is
calculated weekly based on a weighted
average of short term interest rates in the
basket currencies (Euro, Yen, Pound
Sterling, USD). 1 SDR is about $1.5 in April
2014.

13. The Role of the US Dollar
The international monetary system evolved in a way
that was not foreseen in the Articles of Agreement
of IMF.
During the 1950s the USD increasingly took over
the function of gold as the major international
reserve asset.
Why hold dollar, not gold?
No one planned this development. The US was the
dominant world power. (US share of output: 50%
in 1950, 40% in 1960, but has been stable at 25%
since the 1980s

14. Well over half of all international money transactions
were financed in terms of dollar
The US also owned about two thirds of the official gold
reserve in the world in 1940.
The dollar became the dominant invoice currency. (The
US profits as the banker.) Most exporters invoiced the
importers in dollars. When the European countries
had reserve surpluses in the 1950s and early 1960s,
they converted the surpluses into dollar reserves
rather than gold because.
(i) interest could be earned on dollar assets, and
(ii) dollar reserves can always be converted into gold at
$35 per ounce whenever it became necessary.

15. All of the non-Communist countries maintained a stable
relationship between their currencies and the dollar
either directly or indirectly through the British pound.
The US dollar was at the center of this system. Since
the Great Britain had halted the gold convertibility of
its currency, US dollar was the only currency directly
convertible into gold for official purposes. Before
WWI, the pound sterling performed a similar function,
but the sterling area had shrunken to a small number
of countries.
As the Bretton Woods system evolved, the reserves of
most countries became a mixture of gold and dollars.
Over time, US dollar became increasingly more
important.

17. dollar as principal reserve asset
The US balance of payments was more important
than those of other countries, because other
countries were holding US dollar as the principal
reserve asset. Moreover, the US was unable to
eliminate ever-increasing trade deficits, which
undermined the Bretton Woods system.
External debts:
US: $18 trillion
EU: $14
UK: $7
Japan: $3

18. Five Ways to Correct BP
Deficits
(1) deflate the
economy
use contractionary Monetary policy
(raise interest rate) or Fiscal policy (cut
federal spending) to reduce aggregate
demand. This is a painful option
because the government will become
less popular. (e.g., Great Britain after
WWI)
A permanent but painful solution.
(2) devalue
As the price of the foreign currency (e)
rises, net exports = X(e) - M(e)
declines, which reduces trade deficit.

19. Five Ways to Correct BP Deficits
(3) impose exchange
control on current
account
An exchange control limits imports. A
temporary stopgap solution.
(4) deplete gold stock
A temporary remedy.
Since the stock of gold is limited, it
will soon run out.

20. Five Ways to Correct BP Deficits
(5) increase
liabilities to
foreign central
banks.
(6)The surplus
country (e.g.,
China) holds
more dollar
assets.
This means the US is unwilling to devalue $, or the
surplus country (e.g., China) is unwilling to let RMB
appreciate. A temporary solution, and eventually
the latter country gives up.
Instead of importing American goods, China buys
dollar assets. As China holds more dollar assets,
their value in RMB declines when RMB appreciates
(Chinese investors lose money: buy high, sell low)
China buys properties in the middle east, and
central Asia (Kazakhstan) (Silkroad Economic Belt,
2013)
China's trade/GDP ratio = 41% in 2015
US = 30%)

21. US Payments Deficit in the 1960s
Persistent US BP deficits in the 60s
In the 1960s the international monetary
system was shaken by a series of
disturbances in the foreign exchange and
gold markets.
Since the US dollar was used as the principal
reserve asset by our trading partners, the
weakness of dollar raised doubts about the
viability of the entire system.

22. Persistent US BP deficits in the 60s
During the period 1958-1971, the US experienced a
persistent deficit in its balance of payments. At
first, economists viewed these annual deficits as
temporary. However, it gradually dawned to policy
makers that the US deficits were not
disappearing. The causes of these chronic deficits
are:
(a) a higher rate of return r* > r, which results in
capital outflows.
(b) military commitments in Europe and Asia.
(c) The Vietnam war also caused inflation in the US.

23. International reserve assets of the US
During the years 1958-1971, the US experienced a
cumulative reserve deficit of $56 billion. International
reserve in other countries mainly consisted of US dollar
and gold, although the currencies of other major countries
were reserve assets but they played a minor role.
US reserve assets included foreign currencies such as Yen,
DM and British pound at first. However, by the end of the
1960s, the US international reserve consisted mainly of
gold.
Some of the fundamentals are wrong (p, w, r, Y, e). The first
best policy is a devaluation of USD. All other policies such
as lowering interest rates are second best.

24. Increasing liabilities to foreign central
banks
During this period (from 1958 to 1971), the
US not only witnessed a gradual depletion
of its international reserve assets but also a
dramatic increase in liabilities to foreign
central banks.
Gold Coverage of a currency
= Gold held by the Fed/Liabilities to Foreign
Central Banks

25. Gold coverage in 1963 Gold coverage in 1971
(a few months after Nixon’s
declaration of dollar’s
gold inconvertibility)

26. By 1963, the US gold reserve at FRB New
York (Manhattan) barely covered liabilities
to foreign central banks, and by 1970 the
gold coverage had fallen to 55%, by 1971
22%. Thus, from 1963, had the foreign
central banks tried to convert their dollar
reserves into gold, the US would have been
forced to abandon dollar's gold
convertibility.

27. Collapse of the Bretton Woods
Temporary measures
To lesson the outflow of private capital, the
US imposed an interest equalization tax
in 1963. This was effective to curb
temporarily the outflow of portfolio
investment. However, because r* > r, it was
more than offset by a big jump in US bank
loans to foreign borrowers and a further
growth in US direct investment.

28. (a) Voluntary Foreign Credit Restraint program was adopted
in 1965 (Canada and developing countries were
exempted). This was replaced by Mandatory Investment
Controls in 1968, lifted in 1975.
(b)Federal Reserve System entered into a series of
currency swap agreements with central banks of
Western Europe, Canada, and Japan. Under these
bilateral agreements, a foreign central bank provided
standby credit (in foreign currency) to the Federal Reserve
System in return for an equal amount of standby credit (in
dollar).
None of these measures reduced US basic deficit but
lessened the gold drain and dampened the speculative
capital outflows. President Nixon once raised the value of
dollar, to penalize the speculators. (It did not work).

29. Collapse of Bretton Woods
President Richard Nixon
The crisis of 1971 was caused by a gradual loss of
confidence in dollar. In 1970, funds began to
move at an enormous rate from the US dollar to
financial centers in Europe and Japan.
In May 1971, West Germany left the Bretton woods
system. Switzerland redeemed $50 million for
gold. In early August 1971, France sent a
battleship to New York harbor and took delivery of
$191 million in gold (Huffington Post).

30. Collapse of Bretton Woods
Then on August 11, the British ambassador
requested to redeem $3 billion for gold (1/3 of US
gold reserve, Tyler Durden) President Nixon
announced on August 15, 1971:
(i) a 90-day freeze on wages and prices
(ii)10% import surcharge on dutiable imports
(iii) suspension of dollar's convertibility into gold.

31. "Dollars for Oil" replaces "Dollars for
gold”
After the Yom Kippur war (October 6-25,
1973), in July 1974, Kissinger sent his
deputy William Simon to the Middle East.
Kissinger and Saudi royal family agreed:
(i) All of oil sales will be prices in USD
(Saudi's will not accept other currencies),
and invest surplus oil revenues in US
securities,
(ii) in return, US will protect Saudi's oil fields
and guarantee protection from Israel.

32. SMITHSONIAN AGREEMENT
International monetary negotiations were
undertaken within the framework of the Group of
Ten. Details were worked out by the Group of Ten
in a meeting at the Smithsonian Institution in
Washington DC in December 1971. The
agreement was then formalized by the IMF.
It was a temporary regime. The agreement
allowed member countries to vary their exchange
rates within margins of 2 ¼% on either side of the
central rates after currency realignment.

33. Currency realignment: Yen appreciated 17%, Mark
13.5 %, pound 9%, FF 9%. Par value of other
minor currencies were also changed. In return for
the revaluation of other currencies, the U.S.
agreed to raise the price of gold from $35 to $38
an ounce. This was equivalent to a dollar
devaluation of 8.57%.
This devaluation of dollar has no significance
because the dollar remains inconvertible. 10%
import surcharge was suppressed.
The collapse of the Bretton Woods system did not
generate a chaos as did the collapse of the
international gold standard in the 1930s.

34. The Smithsonian Agreement was a useless attempt
to perpetuate the adjustable peg system with a
new currency alignment.
Par Value Modification Act, 1973 (amended) With
the second devaluation of the dollar in March
1973 by 11% (the price of gold rose from $38.00
to $42.22 per ounce), the Smithsonian agreement
fell apart and other currencies were left to float
against the dollar. Bank of Japan absorbed a few
billion dollars in one week, but eventually quit.