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.
Developing Countries' Concerns,
in three areas where further change is certainly
needed:
-First, the international financial architecture, where
important reforms have been made, but where
the hard work of implementation still lies ahead;
-Second, in international financial regulation, where
there is more work to do to ensure that the right
incentives are in place for financial institutions in
developed and developing markets to manage
their risks more effectively in future; and
-

3.
Developing Countries' Concerns,
Third, in emerging market countries
themselves, where there is a need for
more practical efforts to upgrade
accounting and legal standards, and
systems of financial regulation, and of
course to clean up the balance sheets of
banking systems which, in many cases,
remain very fragile.

4.
The main elements of that quiet
revolution are:
- much more outreach for banking
supervisors, above all to supervisors in
emerging markets;
- increasing acceptance by all supervisors
that core principles of supervision,
rigorously applied in all countries of the
world, are essential;
- increasing acceptance of the need for
external monitoring to ensure compliance
with those core principles;

5.
- a willingness by supervisors to work much
more closely than before with the financial
institutions as the leaders of that
monitoring exercise;
- greater willingness by supervisors to work
more closely with each other across
borders and across traditional sectors of
banking, securities and insurance;

6.
-a willingness by the Fund and the Bank to take on
the rôle of monitoring and to integrate financial
sector surveillance and reconstruction much
more closely into their work; and
-a desire by the international financial community to
consider more carefully the threats to financial
stability, to put in place better incentives for
avoiding such crises, and to bring together the
key government officials, supervisors, central
banks and the financial institutions, through the
new Financial Stability Forum.

7.
Exchange Rate Policy of Developing
Economies.
An exchange rate, as a price of one country's
money in terms of another's, is among the most
important prices in an open economy. It
influences the flow of goods, services, and
capital in a country, and exerts strong pressure
on the balance of payments, inflation and other
macroeconomic variables. Therefore, the choice
and management of an exchange rate regime is
a critical aspect of economic management to
safeguard competitiveness, macro economic
stability, and growth

8.
Exchange Rate Policy of Developing Economies.
The choice of an appropriate exchange rate regime
for developing countries has been at the center
of the debate in international finance for a long
time.
―What are the costs and benefits of various
exchange rate regimes?
―What are the determinants of the choice of an
exchange rate regime and how would country
circumstances affect the choice?
― Does macroeconomic performance differ under
alternative regimes?
―How would an exchange rate adjustment affect
trade flows?

9.
The steady increase in magnitude and variability of
international capital flows has intensified the
debate in the past few years as each of the
major currency crises in the 1990s has in some
way involved a fixed exchange rate and sudden
reversal of capital inflows.
New questions include:
―Are pegged regimes inherently crisis-prone?
― Which regimes would be better suited to deal
with increasingly global and unstable capital
markets?

10.
While today almost every advanced nation has a
flexible exchange rate regime similar to that
advocated by Milton Friedman, most emerging
countries continue to have ‘conventional peg’.
Historical work of Milton Friedman examined the
conditions under which he thought that flexible
rates were the right system for developing
countries, and when he thought that it was
appropriate to have an alternative regime.

11.
The currency crises in Lebanon, Turkey, and
Argentina have once again brought to the fore
the question of the optimal exchange rate regime
in an emerging country.
Almost 70 years ago, Milton Friedman published
“The case for flexible exchange rates”
(Friedman 1953).
In it he argued that a system of ‘pegged but
adjustable’ parities was highly unstable and
made a strong pitch for flexible exchange rates
regimes.

12.
While today almost every advanced nation has a
flexible exchange rate regime similar to the one
advocated by Friedman, most emerging
countries continue to have ‘conventional peg’
(IMF 2019).
What Friedman’s views on currency and monetary
regimes in developing countries were. In a 1973
Congressional testimony, Friedman said:
“[w]hile I have long been in favor of a system
of floating exchange rates for the major
countries, I have never argued that that is
necessarily also the best system for the
developing countries.”

13.
Milton Friedman in India: 1955 and 1963
In 1955, Milton Friedman traveled to India to advise
the Nehru government. He prepared a short
memorandum that covered, among other things,
the exchange rate issue. At the time, foreign
exchange was rationed and allocated in a
discretionary fashion.
Friedman wrote that there were only two ways to
deal with external imbalances: “First, to inflate or
deflate internally in response to a putative
surplus or deficit in the balance of payments;

14.
Milton Friedman in India: 1955 and 1963
second, to permit the exchange rate to fluctuate…
[a method] that has been adopted by Canada
with such conspicuous success” (Friedman
1955).
He added that if a completely free float was ruled
out (for political reasons), an auction system was
a solid second-best solution. This would allow
“purchasers to use it for anything they wish and
in any currency area they wish.”

15.
Friedman returned to India in 1965. This time he
was particularly critical of the Bretton Woods’
pegged-but-adjustable regime. A mere
devaluation, he stated, was not a solution in a
country with chronic inflation. In a lecture
delivered in Mumbai he said: “The temptation will
be to change its [the rupee’s] value from its
present level… and then try to hold it at the new
fixed level. That would be another mistake. Even
if the new exchange rates are correct when
established, once you pegged them, there is no
assurance that they will indefinitely remain
correct” (Friedman 1968).

16.
The ten regimes are arranged under the following four
relatively homogeneous groups
(a) Floating regimes (independent floating, lightly
managed float);
(b) Intermediate regimes (managed float, crawling
broad band);
(c) Soft peg reglmes (crawling narrow band, crawling
peg, pegged within bands, fixed peg); and
(d) Hard peg regimes (currency board, currency
union/dollarization).

17.
The floating regimes would be an appropriate choice for medium and
large industrialized countries and some emerging market economies
that have import and export sectors that are relatively small
compared to GDP, but are fully integrated in the global capital
markets and have diversified production and trade, a deep and broad
financial sector, and strong prudential standards. The hard peg
regimes are more appropriate for countries satisfying the optimum
currency area criteria (countries in the European Economic and
Monetary Union), small countries already integrated in a larger
neighboring country (dollarization in Panama), or countries with a
history of monetary disorder, high inflation, and low credibility of
policymakers to maintain stability that need a strong anchor for
monetary stabilization (currency board in Argentina and Bulgaria).

18.
The soft peg regimes would be best for countries with
limited links to international capital markets, less
diversified production and exports, and shallow financial
markets, as well as countries stabilizing from high and
protracted inflation under an exchange rate-based
stabilization program (Turkey). These are largely but not
exclusively non emerging market developing countries .
The intermediate regimes, a middle road between
floating rates and soft pegs, aim to incorporate the
benefits of floating and pegged regimes while avoiding
their shortcomings.

19.
The macroeconomic authorities of developing and transition
countries are faced with a difficult task.
On the one hand, the global economy is unstable with
frequent shocks, crises and volatilities. It is also a place
with fierce competition with multinational corporations of
EU, US, Japan and Korea, the emergence of China as
the factory of the world, dumping and unfair trade
practices by some exporters, etc.
On the other hand, the domestic capability of most
developing and transition countries is still weak. The
market economy is not well developed, and domestic
enterprises lack competitiveness. The government is
often saddled with inefficiency, corruption, lack of
expertise, and political pressure.

20.
The question for the central bank governor and the
finance minister is: how do you manage monetary
policy, and especially the exchange rate, in order to avoid
unnecessary shocks and provide stable environment for
economic development? More specifically, in this age of
accelerated globalization, what is the appropriate
exchange rate system for developing or transition
countries?
The question is difficult enough, but to make the
matter even more complicated, there are many
policy goals but only one exchange rate.

21.
If a country has the multiple exchange rate
system, the IMF will not seriously deal with
you and FDI will probably not come. It is a
good idea to unify the rates as soon as
possible.
China unified their rates in 1994 and Vietnam
did so in 1989. Unification did not give
them any big shock, and they began to
receive large amounts of FDI after that,
partly because of the improved exchange
rate system.

22.
The government is often concerned about
the social consequences of currency
reunification, but people are usually much
better off with a unified rate than without.
The persistence of the multiple exchange
rate practice is mainly a political problem,
not economic. It is a huge and hidden
subsidy and taxation system, from which
some people benefit greatly.

23.
The possible goals for exchange rate
management may include the following:
1. Competitiveness
2. Price stability
3. Current account adjustment
4. Domestic financial stability (protection of
balance sheets of banks and firms)
5. Public debt management
6. Avoiding speculative attacks
7. Minimizing domestic impact of a large
exogenous shock (like a regional conflict or
currency crisis)
8. Promoting FDI, growth, or industrialization

24.
The first two goals--competitiveness and
price stability--are very fundamental and
all countries should mind them. The big
problem is that these two goals often
conflict with each other.
To maintain competitiveness (or regain it
after domestic inflation), the exchange rate
should be flexible and devaluation must be
accepted, if necessary.

25.
On the other hand, to contain domestic
inflation or avoid imported inflation, the
exchange rate should be either stable or
even moderately overvalued (this is called
the use of the exchange rate as a nominal
anchor).
But clearly, these two requirements are not
compatible.
it keeps the exchange rate stable, it will exert a deflationary
pressure on the domestic economy so the inflation-
devaluation spiral can be avoided. But in this case,
competitiveness is lost due to overvaluation, and a
recession is likely.

26.
The third goal--current account adjustment--is
popular but controversial. Traditionally,
devaluation is recommended to a country with a
current account (or trade) deficit. However,
whether it really works to reduce the deficit or not
must be carefully studied in the context of each
individual country. Devaluation is a double-edged
sword; as noted above, it may trigger an inflation
spiral. It may also affect the macroeconomy in
other complicated ways to offset the intended
relative-price effect

27.
The fourth and fifth goals--protecting the
balance sheets of the private and public
sectors--are related to the question of
exchange exposure and losses. If the
currency is devalued, the value of foreign
currency-denominated debt will increase in
home currency, which creates enormous
difficulties for both the private and public
sectors. Part of this debt can be hedged,
but not all

28.
The sixth goal--avoiding speculative attacks--can be
achieved by calming the market expectation. How can we
do this? Some economists argue that the exchange rate
should float.
Exchange rate flexibility will remind traders that the currency
can go both up as well as down, which discourages them
from betting on exchange rate stability or one-way
movement. This makes attacks less likely.
But exchange rate volatility itself may become a problem.
Perhaps the best way to avoid attacks is to avoid
overvaluation, and that is attained by frequent reviews
and proper adjustments of the exchange rate levels (i.e.,
fulfilling the competitiveness concern).

29.
The seventh goal--minimizing impact of a large
external crisis--essentially is the question of the
timing and manner of floating. If the currency of
an important neighboring country collapses, your
currency becomes suddenly overvalued,
relatively speaking. The government must decide
whether the home currency should (partly) follow
this depreciation or remain stable.
There is no easy rule of thumb as to whether you
should float earlier, later, or not at all; it depends
on individual cases.

30.
The eighth goal--promoting FDI, growth,
or industrialization--is, in my view, a red
herring. Such long-term real-sector
development goals cannot be pursued by
exchange rate management. The only
thing that the central bank can do for this
purpose is to maintain competitiveness
and price stability (namely, doing well in
the first two goals).

31.
Managed float
After the Mexican (1994) and the Asian
(1997) crises, many economists began to
argue that dollar peg was dangerous. They
contend that exchange rates should be
flexible enough so adjustments are not
delayed until too late. Some even argue
that IMF should not lend to countries with a
dollar peg !

32.
Bipolar view
Some economists--Barry Eichengreen, Stanley
Fischer and others--went even further.
According to them, the reality of the 21st century
with massive financial flows would not allow any
country to adopt a "middle" solution such as
target zones, adjustable peg, baskets, crawling
peg, etc.
They recommend that all countries, including
developing and transition ones, to converge on
either complete fix or 100% free floating.

33.
Currency board
The currency board is an institutional arrangement to
tie money supply closely to the amount of
international reserves, so the monetary authority has
no power to issue money independently (in principle,
at least).
In the most rigid case, monetary base can be issued or
withdrawn only in exchange with foreign assets sold
or bought against the monetary authority (however,
most currency boards are not so rigid; there are
loopholes and lee ways).
With a currency board, monetary policy is not needed
so the central bank is abolished and a simpler
"monetary authority" takes over.

34.
Dollarization
dollarization has two meanings.
Private (or inadvertent) dollarization:
people use dollars because they do not
trust domestic money or foreign money is
more convenient than domestic money.
Official dollarization: the government
declares USD to be the only official money
for the country, and abolishes domestic
money.

35.
Multiple currency basket (proposed for East
Asia)
multiple currency baskets consisting of
dollar, yen and euro are recommended by
some economists to the developing
countries in East Asia.
These baskets are supposed to
automatically smooth the competitiveness
shocks arising from the movements of
major currencies (but they do not
automatically adjust for other shocks

36.
Soft dollar zone (for East Asia)
Ronald McKinnon argues that neither floating
nor the currency basket is practical in East
Asia.
He notes that East Asian currencies actually
returned to the soft dollar peg after the
Asian crisis, the situation which he thinks is
desirable and reasonable.
The dollar is the key currency in the world
economy and monetary stability should be
built around it.

37.
Virtual exchange rate stability
This is also proposed by Prof. McKinnon
(especially for major countries). There should be
a long-term, unchanging nominal exchange rate
target based on tradable PPP (for example,
$1=110 yen).
The two countries (for example, Japan and the US)
have the obligation to keep the rate within the
narrow band around this target forever. When a
large shock hits occasionally (once in a
decade?), the rate can deviate temporarily from
the target.
But after the shock is gone, the rate must return to
the original, unchanged band.

38.
Double target zones
John Williamson (Institute of International
Economics, Washington DC) is the
champion of target zone proposals. He has
many ideas, and the double target zone is
one of them. There should be a "soft" inner
band and a "hard" outer band, so the
central bank will have three zones where
(i) it does not intervene; (ii) it can intervene;
and (iii) it must intervene.

39.
Band-basket-crawl (BBC)
This idea, advanced by Rudiger Dornbusch
and Y. C. Park, is a variation of the target
zone proposal. The central rate should be
defined by a multiple currency basket and
there should be a band around it.
Moreover, there is a built-in inflation sliding
of the central rate. This is what I would call
a currency basket with inflation slide.

40.
"Eclectic" view
Jeffrey Frankel wrote a paper entitled: "No
single currency regime is right for all
countries or at all times." The right choice
depends on circumstances, and each
country should adopt the most suitable
system for itself. The attempt to find a one-
size-fits-all solution is misguided.