construction of an ad hoc international financial system policy coordination

Construction of an Construction of an Ad Hoc Ad Hoc International Financial International Financial

SystemSystemPolicy Coordination

Economic Summits Fred Thompson 2

Structural Interdependence

• Structural interdependence is the reason that policymakers might consider the joint determination of economic policies.

• Structural interdependence refers to the interconnectedness of nations’ markets for goods and services, financial markets and payments systems.


International Policy Externalities• Structural interdependences can results in international

policy externalities: a benefit or cost for one nation’s economy owing to a policy undertaken in another economy.

• A locomotive effect occurs when an increase in real income in one economy spurs an increase in real income in another.

• A beggar-thy-neighbor effect occurs when a policy action benefits the residents of the home country at the expense of residents in another nation.


International Policy Cooperation and Coordination

• There are two ways that nations may work together to achieve their economic objectives.

• International Policy Cooperation is the adoption of institutions and procedures by which policymakers can inform each other of their objectives and share data.

• International Policy Coordination is the joint determination of economic policies within a group of nations, intended to benefit the whole.


Potential Benefits of Coordination

1. Take account of and minimize policy externalities

2. Achieve a larger number of policy objectives with available instruments

3. Policymakers may present a “united front” in the face of home political pressures that could push them to adopt harmful policies.


Potential Drawbacks to Policy Coordination

1. Must sacrifice or forego some domestic interests

2. Must trust that counterparts are willing to make sacrifices

3. Coordinated policies may have negative consequences such as higher inflation (e.g., Bonn Summit of 1978)

Important Meetings, Events, Important Meetings, Events, and Organizationsand Organizations


Bank for International Settlements: An Overlooked Institution

• Created in 1930 by private U.S. banks and the governments of 10 advanced economies.

• Based in Basle, Switzerland.

• Serves as an international loan trustee, as an agent of central banks, center of economic cooperation (e.g. Basle Agreement).


Economic Summits

• November 1975 French President, Valery Giscard d’Estaing hosts the first economic summit.

• France, US, UK, Germany, Japan (G5).• Italy added to represent the EU (G6).• Agreed to a system of flexible exchange rates.

Countries would intervene when needed to ensure stability.


Jamaica Accords

• January 1976 meeting of IMF member country nations.

• Amended the articles of agreement of the IMF to recognize flexible exchange rate systems.

• Member nations could adopt an arrangement of their own choice.


Summits “Institutionalized”– Summits made an annual event.

• 1976 President Ford hosts the second summit.

• Invites Canada (G7).• Summits now occur ever summer,

rotating from country to country.• British PM, Tony Blair, adds President

Yeltsin (Russia) as a “full member” for the 1998 Birmingham Summit (G8).


Plaza Agreement

– September 1985.

• Meeting of the G5 central bankers and finance ministers.

• Had been meeting quietly for a number of years.

• Discussed the value of the US dollar.• Announced a belief that the dollar was

overvalued and that the nations would intervene on a coordinated basis to drive down the value of the dollar.


Louvre Accord– February 1987

• Meeting of the G7 (less Italy) central bankers and finance ministers.

• Announced that the dollar was now “consistent with economic fundamentals.”

• Would only intervene when required to ensure stability.

• Managed float system emerges.


Groups– The main G’s

• G7 refers to the meetings of the central bankers and finance ministers of the G7 nations.

• G8 refers to the heads of state of the G8 nations meeting at the economic summits.

• G10, G7 plus Belgium, the Netherlands, and Sweden.

The Gold Standard and the The Gold Standard and the Bretton Woods SystemBretton Woods System


The Gold Standard

• Came into effect in the mid-1870s when most of the major economies unilaterally pegged to gold.

• Nations fixed the value of their currency relative to gold via a mint parity rate.

• They also established convertibility, or the ability to exchange the currency for gold.


The Gold Standard

• Pegging the value of each currency to gold, established an exchange rate system by indirectly establishing exchange rates.

• The mint parity rates could be used to determine the exchange rate.


The Gold Standard

GoldAt Center of System

US Dollar20.646

4.856 $/pound

UK Pound4.252


The Gold Standard

• Long-run price stability

• Short-run price instability

• Numerous financial crises

• Suspended in 1914 after the beginning of WWI.

• Return to gold standard in 1925 led to collapse.


The Bretton Woods System1944-1971

• Forty-four nations participated in the conference.• Primary architects were Harry White of the U.S.

and John Maynard Keynes of the U.K.• Ratified in 1944• Though known as the Bretton Woods Conference,

it was officially called the International Monetary and Financial Conference of the United and Associated Nations.


The Bretton Woods ConferenceOrganizations Created

General Agreement on Tariffs and TradeGATT

International Bank for Reconstruction and DevelopmentIRBD

World Bank

International Monetary FundIMF


Bretton Woods System

• System of adjustable pegged exchange rates.

• U.S. dollar was the anchor of the system because it was pegged to gold.

• All other participating nations could peg to gold or to the dollar.

• All chose to beg to the dollar, a dollar-standard exchange rate system was created.


The Dollar-Standard System

Pound2.80 $/pound

Mark4.20 DM/$

11.76 DM/pound

U.S. Dollar$35.00

Gold


The 1960sTrouble for the Dollar

• Glut of dollars due to Vietnam war and programs of the “Great Society.”

• Dollar believed overvalued relative to the currencies of Japan and some Western European economies, e.g., Germany.

• Dollar becomes target of foreign exchange speculators.• U.S. and European countries intervene in the gold

market.• Britain devalues in 1967 and holders of the pound

experience a 15 percent capital loss.


The Dollar and the Mark(from Grabbe, 1999)

• On May 4, 1971, the Bundesbank buys $1 billion on the exchange market to maintain the parity value.

• On the next day they buy $1 billion in the first hour of trading.

• Bundesbank abandons the parity rate and lets the mark float upward relative to the dollar.

• Austria, Belgium, the Netherlands, and Switzerland follow suit.


End of the System

• Faced with a major run on the dollar, President Nixon suspends convertibility of the dollar.

• The system falls into disarray.

• Market is closed on extremely volatile days.


Smithsonian Agreement• In an attempt to restore order to the exchange market,

10 leading nations meet at the Smithsonian institution on December 16 and 17, 1971.

• A new system of exchange parity values determined. Dollar, however, is still not convertible to gold.

• Nixon hails the agreement as the “most significant monetary agreement in the history of the world.”

• System collapses in 15 months and a de facto system of floating rates emerges.

The The Ad HocAd Hoc Exchange Rate Exchange Rate SystemSystem

The Various Types of Arrangements Today


Current Arrangements

20%

4%

21%

6%3%

5%

15%

26% Dollarized

Currency BoardPegged

Pegged w/BandsCrawling Peg

Crawling w/BandsManaged Float

Floating


Dollarization

• Dollarization is the replacement of the domestic currency with the currency of another nation.

• Two possible problems are the loss of seigniorage revenues and the loss of discretionary monetary policy.

• Seigniorage is the revenue created through the manufacturing of money, and can be quite important to developing nations.

• Examples are Panama, El Salvador and Ecuador.


Currency Board

• Establishes and maintains a hard peg between the domestic currency and another currency.

• Issues domestic notes.• Notes issued depend on the value of the exchange

rate and the amount of foreign reserves.• Hence, monetary base is determined by the stock

of foreign reserves.


Currency Board - Continued

• Replaces central bank– Cannot hold domestic debt.– Not a lender of last resort– Does not set reserve requirements

• Theoretically shielded from political pressure.

• E.g.: Argentina, Estonia, and Bulgaria.


Pegged and Pegged with Bands

• Parity value established relative to another currency.

• Central bank must conduct monetary policy to maintain parity.

• “Parity band” allows limited flexibility on either side of the parity rate.

• Band can be very narrow or very wide.• E.g.: Bangladesh, China, and Egypt.


Currency Basket Peg

• Currency is pegged to a “basket” currencies.• Parity value is the weighted average of a

basket of currencies in various quantities. Each currency has an implicit weight assigned to it.

• Provides some degree of flexibility against individual currencies.

• E.g.: Poland and Chile.


Crawling Peg

• Parity value is changed on a periodic basis.• Crawl is typically designed to compensate for

differences between the economic performance of the pegging country and the country being pegged to.

• Bands may be established around the crawling parity rate. Bands may be symmetric or asymmetric.

• E.g: Chile, Hungary, and Poland.


Managed Float

• Currency value is determined in the interbank market.

• Monetary authority may intervene periodically to maintain stability.

• Sometimes referred to as a “dirty float.”


Floating

• Value of domestic currency is determined in the foreign exchange market.

• Forces of supply and demand are the sole determinants of currency value movements.

Alternative Exchange Rate Alternative Exchange Rate SystemsSystems


Monetary Unions

• An extreme type of coordination is for a nation to give up its own currency and adopt a currency common to it and a coalition of other nations.

• That is, form a monetary union.• For a monetary union to succeed, the

coalition must represent an optimal currency area.


Optimal Currency Area

• The theory of optimal currency areas is a means of determining the size of a geographic area within which residents’ welfare is greater if their governments fix exchange rates or adopt a common currency.

• An optimal currency area is on in which labor is sufficiently mobile to permit speedy adjustments to payments imbalances and regional unemployment so that exchange rates can be fixed or a common currency adopted.


Exchange Rate Target Zones

• A target zone is a “intermediate” approach to exchange rate management that limits exchange rate volatility while still permitting some variation in countries currency values.

• Specifically, a target zone is a range of permitted exchange rate variation between upper and lower exchange rate bands that a central bank defends by purchasing or selling foreign exchange reserves.

International DebtInternational Debt

Debt Relief for the Poorest Nations?


Debtor / Creditor Status

• Net Debtor Nation– A nation whose total claims abroad are less

than the total foreign claims on the nation.

• Net Creditor Nation– A nation whose stock of foreign financial assets

is greater than the stock of foreign-held domestic financial assets.


The US and Net Debtor Status

• It is neither necessarily good nor bad to be a net debtor.

• The US is the world’s largest net debtor, primarily because of record FDI inflows.

• The US has been a net debtor in the past, and it spurred an industrial revolution.


Debt Relief

• Debt relief for the poorest nations is one of the most pressing international economic policy issues today.

• Beginning in the early 1980s, the stock of international debt became so large that many developing nations could no longer make all of their debt service payments.


Debt Relief / Institutions

• Paris Club– Forum for multilateral negotiations between

debtor and creditor nations.

• London Club– Forum for negotiations on private debt owed to

commercial banks.

• Millennium Fund– Private sector donations for debt relief


Debt Relief

• Despite the efforts undertaken in these organizations, during the 1990s, the debt stock of the poorest nations doubled in 5 years.

• At the start of 2000, less than half of the debt obligations were being fulfilled, with $US60 billion in arrears.


Debt Relief

• In 1996, the leaders of the G7 nations agreed upon the HIPC (Heavily Indebted Poor Countries) Initiative, intended as a means to qualify nations (originally 26) and deliver debt relief.

• The HIPC initiative failed to deliver relief after 3 years, as only seven nations qualified and none saw any debt relief.


Debt Relief

• In 1999, public pressure lead to the Cologne Debt Initiative (CDI). The CDI was intended to deliver faster and deeper relief.

• Expanded list of countries.


Problems

• 15 percent of debt stock owned by nations not part of the CDI negotiations.

• 50 percent of the debt stock not being serviced as is. Hence, forgiveness of stock may not help that much.

• Public financing issues.


Current Status

• For current information on HIPC, visit the web sites of the International Monetary Fund and the World Bank.


Balance of Payments Accounting

• Balance of Payments Accounting I

• Balance of Payments Accounting II

construction of an ad hoc international financial system policy coordination

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