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World Financial Infrastructure and Money : Sukumar Nandi
World Financial Infrastructure and Money
Sukumar Nandi
Indian Institute of Management Lucknow
Lucknow 226013, India
mail!! nandi"iiml#ac#in
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$%a&ter 1
Money! 'istory and (olutionMoney! 'istory and (olution
One major event of human civilization is the invention of money as a medium ofexchane! Money in circulation" #oth $a$er and metallic currency" is the interest freelia#ility of the overnment1and aainst this there are claims to virtually nothin ! %hisis #ecause $resent& day money is hardly #acked #y old and other forein asset #y theovernment ! %his is fiat money and it is a leal tender" 'hich the citizens of thecountry are leally #ound to acce$t as a medium of exchane! So money in circulation isnot #acked #y overnment lia#ility and the overnment has virtual mono$oly on the
$rovision of fiat money! Further" the overnment also controls the (uantity of money!)
In the historical context" fiat money is very recent in oriin 'ith a lifes$an ofa fe' decades! Its earlier form 'as commodity money! From history 'e find that useof old as money #ean in the sixth century *! +! in %urkey! ,um$s of old found inthe river #ed 'ere melted and converted into $ieces of uniform sizes and thenstam$ed to ive it leal sanction! %his is the early form of commodity money 'ith facevalue e(ual to its intrinsic value! %he commodities chosen 'ere enerally $reciousmetals 'ith lihter 'eiht for the convenience of carryin to distant $laces ! *utsometimes seashells" cattle 'ere also used as money! %he technical characteristics ofcommodities selected to serve as money are of minor im$ortance! *ut the im$ortant
thin is that there should exist social institutions condoned #y customs and-or la' thatena#le the economic aents to trade efficiently #y follo'in the s$ecific rule that onecommodity traded in every exchane should #e socially sanctioned as an exchaneintermediary! In the money usin economy the rule of the ame is very $recise thatcommodities #uy money and vice versa "#ut commodities do not #uy commodities in anyoranized market . +lo'er"1/0/!
Money in t%e arly )eriod%he emerence of money in the early $eriod can #e kno'n from the follo'in :
2In $rimitive traffic the economic man is a'akin #ut very radually toan understandin of the economic advantae to #e ained #y ex$loitation
of existin o$$ortunities of exchane3 +onsider ho' seldom this is
1Here the central bank's role is not neglected. Actually the central bank works on behalf of the
government of the country. The concept of money as a fiduciary issue and a legal tender is true for all
countries irrespective of the level of development .)The central bank enjoys hardly any autonomy except in a few countries and so it is taken as granted that
the central bank follows the wishes of the government. Technically the currency in circulation are the
liability of the central bank.
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the case" that a commodity o'ned #y some#ody is of less value in usethan another commodity o'ned #y someone else4 5nd for the latter justthe o$$osite relation is the case! *ut ho' much more seldom does itha$$en that these t'o #odies meet4 3! 6ven in the relatively sim$leand so often recurrin case" 'hen an economic unit 5 re(uires a
commodity $ossessed #y *" and * re(uires one $ossessed #y + " 'hile+ 'ants one that is o'ned #y 5 &&&&&even here" under a rule of mere#arter " the exchane of oods in (uestion 'ould as a rule #e of necessityleft undone !2 7 $ae )8)9 +arl Mener .1/)
In the early da'n of history 'hen $eo$le realized the $ro#lem of #arter" theystarted usin $recious metal as medium of exchane! In );
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%he commodity money system delivers a nominal anchor for the $rice level" and this isrealized throuh the $rofit&maximization $rinci$le! %his 'as a$$lica#le in the case ofmint $roducin coins in the middle aes and later! %he mechanism can #e as follo's!Su$$ose there is a 'ay to convert oods into silver and silver into oods at a constantcost" that is" in ounces of silver $er unit of oods! %his can #e considered as .1 the
extraction cost of silver" or .) the 'orld $rice of silver in case of small o$en economy!%he mint converts silver into coins after the $urchase of silver in #ulk from the market" italso decides 'hen to melt the coins to make it into silver #ars! %his is a $rivate sectoractivity" and the rule of the overnment is limited to t'o actions! It s$ecifies ho' muchsilver oes into a coin and it collects a seiniorae tax .Sarent Jelde" 1//=! %he $rofit maximization $rinci$le 'ill dictate the $rivate sector mint toadjust the revenue 'ith the cost " the latter #ein the cost of #uyin silver #ars from themarket alon 'ith the cost of $roduction! %his includes aain the cost of la#our! 5ainthe mint itself can #e enaed in the extraction of silver" 'hich determines the unit $riceof silver! %he revenue of the mint is the value of the coins $roduced and" assumin thateach coin is of the same 'eiht" the revenue de$ends on the num#er of coins and their
denominations! %he mint 'ill find e(uili#rium 'hen the follo'in e(uality holds::
Market Jalue of +oins .or" the Inverse of Crice level K +ost ofSilver L Seiniorae %ax L +ost of Croduction
%he a#ove rule 'ill ensure that the mint 'ill continue mintin coins! When this isviolated" i!e! the market value of coins is less than the com#ined total of the riht handside" mintin of coins 'ill sto$! %his also determines 'hether the mint 'ill $roducene' coins or start meltin the existin coins" and this ultimately de$ends on ho' the$rice level relates to the follo'in $arameters : the cost of silver content" cost of$roduction and seiniorae rate! %he $rice level can not o too lo'" or the mint couldnot make unlimited $rofits #y mintin ne' coins and s$endin them! 5ain" the $ricelevel cannot o too hih" or the mint 'ould make $rofits #y meltin do'n the coins!%hus the a#sence of ar#itrae facility for the mint $laces restriction on the $ricelevel and this remain 'ithin an interval determined #y the mintin $oint and themeltin $oint "as sho'n in the fiure .Fiure 1!
Figure 1# )rice le(el wit%in a domain
Mintin Coint Meltin Coint
....../..............I....................../.......... Crice ,evel
%he system descri#ed a#ove has some uni(ue features! ere the (uantity of money isnot controlled #y the overnment! %he additions or deductions to existin money stock. stock of coins are made #y the mint run in the $rivate sector on the #asis of themovement of $rice level! %he $rice incentive in the market o$erate and this makes thesystem self&reulatory! When coins #ecome too fe'" their value increases and $ricelevel falls! %he mint $oint is reached and more coins are added to the existin stock!%his increases the su$$ly of money" and the $rice level .i!e!" $rice of coins falls ! When
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the num#er #ecomes too lare " the market value reaches the intrinsic metal value andeven #elo'" and it #ecomes im$erative for the mint to melt the coins and reduce thenum#er! Within the interval the $rice level de$ends on ho' the money stock is related to thevolume of transactions and this follo's the famous uantity of Money 6(uation of
Irvin Fisher
C% K M J 3! .1Where C" %"M and J are $rice level" total transactions " money stock and velocity ofcirculation res$ectively! 5s lon as the $rice level remains 'ithin the interval " thestock of money .the num#er of coins does not chane! %he chanes in the volume oftransactions or income 'ill shift the $rice level u$ or do'n 'ithin the interval! Whenthe $ush is severe so that it touches the meltin $oint or the mintin $oint " moneysu$$ly chanes!
One im$ortant im$lication of the a#ove system of $rivate sector mintin of coinsis that run&a'ay inflation of the ty$e seen in the t'entieth century is not $ossi#le in
the commodity money reime! Inflation is the $roduct of the fiat money system!
Mac%ines and $%ange in )roduction )rocess!
5round 1;;< 5B a major shift in mintin technoloy took $lace in >ermany!%'o $rocesses 'ere develo$ed to mechanize the mintin $rocess usin machines tocut into sha$e uniform #lanks and im$ress these 'ith a desin! %he scre'&$resstechnoloy had #een $roved to #e #etter than the alternative" kno'n as the cylinder&$ress technoloyG #ut #ecause of cost consideration" the latter #ecame $o$ular inmany countries! %he in of S$ain heard a#out the cylinder ?$ress technoloy andinstalled the technoloy in his state mint! %he coins $roduced in the mint had #eensmooth and uniform %his ex$eriment then s$read to other states in 6uro$e !
%e laisse .faire &eriment:Aoyal +harter created $rivate mono$olies durin 101@& 88 5B and various
individual firms 'ere allo'ed exclusive riht to issue token coinae " thouh these'ere not made leal tender and the (uantities 'ere limited! %he laissez&faire reime'as ty$ified #y the a#sence of overnment& issued small denomination coins and #ythe issue of tokens #y $rivate $arties and local overnments! In the late sixteenthcentury a#out @
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With the s$read of technoloy" the kins realized the need of issuin coinsof small denominations usin different metal .co$$er and maintainin a fixed exchanerelation #et'een the value of t'o metals! Sometimes" smaller amount of metal 'as
used to make coins of smaller denominations! *ut the advantae of lare scale$roduction $aved the 'ay for de#asement of metallic currency #y the use of inferior(uality metals 'hose face value 'as much hiher that the metal value!
%he a#ove issue relates to the value of money and lon ao N! W! Senior.1/0/'rote:
P3 3the value of money3 does not de$end $rimarily #y the (uantity of it$ossessed #y a iven community " or in the ra$idity of its circulation" oron the $revalence of exchanes" or on the use of #arter or credit"33exce$tin the cost of its $roduction!27 $! =9
%he need for increased volume of $hysical money 'ith an increase of trade andcommerce alon 'ith an im$rovement in technoloy made it $ossi#le for the overnmentto look for metal or non&metal o#jects 'hich could #e used as token money servin the$ur$oses of money as a medium of exchane! ere the face value of money 'as muchhiher com$ared to the intrinsic value and the cost of $roduction of money 'ill #e muchlo'er! %hus" the cost of $roduction 'as no loner a hindrance to the ex$ansion of moneysu$$ly if the situation 'arranted! %his 'as the #einnin of the emerence of fiatmoney and the states realized the $otential of this mechanism to commandresources from the society 'ithout much effort!
Fiat Money
In modern 'orld" money is the ty$ically $a$er currency 'ith no intrinsic valueof its o'n! Ceo$le hold this currency #ecause money is the only asset that $rovidesexchane services 'hich other assets cannot $rovide! %he emerence of fiat money has#een due to the fact that commodity money is not a cost less affair and 'hen $a$ermoney 'as introduced "it 'as realized that the cost of the $roduction of money had #eenmuch less com$ared to commodity money! %he $roduction and maintenance of moneyre(uires the use of economic resources! So the 'elfare as$ect of the resource usinmoney "'hich is much hiher in case of commodity money " increases 'hen $a$er moneyis used! For this reason society should have an incentive to re$lace hih&cost commoditymoney #y lo' cost $a$er money! *ecause the latter re(uires fe' resources for $roductionand maintenance" its use increases 'elfare! %his 'elfare as$ect of money is sometimesmissed in the academic discussions! Money is not really a veil in the modern 'orld4
%he need for money and its evolution has #een studied from different anles! Inthe search&theoretic literature" trade results from chance encounters ! In such a situation"need for money arises #ecause it minimizes the cost of transactions due to a dou#lecoincidence of 'ants! In the a#sence of the latter" money is used in exchane or nothintakes $lace "and they chane commodities 'hen dou#le coincidence of 'ants aresatisfied . iyotaki and Wriht" 1//@" %hronton" )
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%his cha$ter introduces money in the historical $ers$ective and there is indicationthat money as a commodity is lo#al in nature ! %he exchane of commodities may alsoha$$en #et'een t'o individuals 'ho #y the 'hims of history no' #elon to t'odifferent nations4 %hat induced mankind to make some arranement for facilitatin
international movement of money! %he historical evolution of the lo#al financialarchitecture and its conse(uence on the demand for money in the domestic economy onthe one hand and the $rice of the domestic money in the international field on the other isa com$lex (uestion! %his is discussed in the next cha$ter!
$%a&ter 2
*lternati(e Monetary egimes and World Financial *rc%itecture
"oney! consider is a device which facilitates the working of markets."
7 Sir Qohn icks "1//" $! )!9
2As science joins with technology to reduce man's ignorance and appease
his wants at appalling speed! human institutions lag behind! the victim of
memory! convention and obsolete education in man's life cycle. #e see the
conse$uence of this lag %. At the nerve center of national sovereignties&
international economic arrangements".
7 Ao#ert Mundell" 1/0 9
%he 'orld has seen a num#er of financial systems de$endin on the level of
interation of the 'orld economy and the level of technoloy! Aecent history has
documented the old standard" old exchane standard" dollar standard and the recent
flexi#le exchane rate system! 6ach system evolved de$endin on the need of the time
and the 'ill of the leadin nations of the 'orld 'ho 'ere a#le to carry the P#urdenP of
=
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the 'orld currency! *ut the major characteristics of the financial system determine the
dynamics of the money su$$ly of the countries 'ho are the $artners of trade and the
common 'orld system! We need to kno' a#out the different financial system that
$revailed in the 'orld to understand the evolution of 'orld money! 5 #etter
understandin of the 'orld monetary system 'ould hel$ understand ho' the domestic
money su$$ly in mem#er countries 'as affected #y the chane in the 'orld financial
system! %houh 'e are a'are today that the domestic financial system can not #e fully
insulated from the lo#al $henomenon" the situation in the immediate $ost&'ar $eriod
'as not much different in the >rou$&of&ten countries@!8%he level of economic interation
amon these countries made them inter&de$endent!
Sometimes a distinction is dra'n #et'een a monetary system and a monetary
order and as Crofessor Ao#ert Mundell $ut it :
25 system is an areation of diverse entities united #y reular interaction
accordin to some forms of control! When 'e s$eak of international monetary system 'e
are concerned 'ith the mechanisms overnin the interactions #et'een tradin nations"
and in $articular the money and credit instruments of national communities in forein
exchane" ca$ital" and commodity markets! %he control is exerted throuh $olicies at the
national level interactin 'ith one another in that loose form of su$ervision that 'e call
co&o$eration!
5n order " as distinct from a system " re$resents a frame'ork and settin in 'hich
the system o$erates! It is a frame'ork of la's" conventions" reulations" and mores that
esta#lish the settin of the system and the understandin of the environment #y the
$artici$ants in it! 5 monetary order is to a monetary system some'hat like a constitution
is to a $olitical or electoral system! We can think of the monetary system as the modus
o$erandi of the monetary order!2 7 Mundell" 1/=)" $!/)!9!
%he distinction Crofessor Mundell makes #et'een a monetary system and a monetary
order is im$ortant in the sense that the chronoloical order that is follo'ed here 'ill
facilitate the understandin of the 'orkin of the 'orld financial architecture and its
im$act on the domestic monetary $olicies of the mem#er countries!
@.The group of ten were (elgium! )anada! *rance! #est +ermany! taly! ,apan !-etherlands! weden!
/nited 0ingdom and the /nited tates.8
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' 45L +*-*
%he classical old standard emered as a true international standard #y 1ermany etc! acce$ted the dictates of fixed $arities and allo'ed
their money su$$ly to adjust $assively! 6nland" as the leader" had #een #enefited in
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multi$le 'ays! It enjoyed the seiniorae earned on forein &held sterlin #alances!
5lso financial institutions in ,ondon used to have handsome returns for the central
location and easy access to international ca$ital markets!
In an influential study Crofessor Nurkse . 1/88 has arued that in crucial times the
$rinci$al mem#er countries did not #ehave $ro$erly in the sense that they $artially
sterilized their old inflo's " and the results had #een that domestic and forein assets of
these countries moved in o$$osite directions durin this $eriod of old standard! %he
rules of the ame dictated that they should not interfere 'ith the influence of old flo's
on the money su$$ly! Cerha$s they #ecame concerned a#out the $otential inflation and
thus #ecame $ro&active in the control of money su$$ly!
' MI+ 5F $L*++I$*L 45L +*-*
World War I created a massive shock that the financial system could not endure
and the classical old standard ended! %he 'ar reduced the economic strenth of the main
6uro$ean countries in eneral" and 6nland in $articular! %he anchor role 6nland used
to $rovide for the sta#ility of the system ended as the Enited States $ushed 6nland #ack
from the leadershi$ role! 5 reformed system&& old exchane standard..$revailed for a
short $eriod 1/)
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mem#ers" i! e!" France and the Enited States" 'ere reluctant to follo' the rules of the
ame! %hey created deflationary $ressures in the 'orld #y $ersistent sterilization of their
#alance&of&$ayments sur$luses! %he system could not #ear it and ultimately it colla$sed
'ith the >reat Be$ression! *ut #y that time it had transmitted deflation and de$ression
across the 'orld 76ichenreen"1//G Friedman and Sch'artz"1/0@G %emin" 1// 9
' 75- W55+ I--*I5-*L M5-*8 +8+M
With the end of the World War II" the victors assem#led at *retton Woods" Ne'
am$shire" ES5 to #uild u$ the World Monetary System" 'hich came to #e kno'n as
*retton Woods International Monetary System .*WIMS! %he $rinci$al o#jectives 'ere
to remove the ills from the financial system and to create a sta#le 'orld monetary order!
For this several measures 'ere ado$ted! First" the floatin exchane rate system 'as
sto$$ed! Second" the old exchane standard 'as scra$$ed as it 'as thouht to #e
res$onsi#le for the international transmission of deflation in the early 1/@
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$rimarily interested to $revent the deflation of the 1/@
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%e )ar 9alue +ystem
5rticles IJ of IMF defines the numeraire of the international monetary system as
either ES dollar or old of the 'eiht and fineness on Quly 1" 1/88! 5ll the mem#ers of
the Fund 'ere asked to declare a $ar value of their currencies and maintain it 'ithin 1
$er cent marin on #oth sides! If any country faces fundamental dise(uili#rium" she can
exchane the $arity after consultation 'ith other mem#ers! If the chane of $arity is
'ithin 1< $er cent" the decision of the mem#ers 'ill not #e rejected! o'ever" if the
chane is more than 1< $er cent" the country concerned needs to have a$$roval of the
IMF! In case a decision is made for a uniform chane in $ar value of all currencies in
terms of old" it is to #e done #y the a$$roval #y a majority of all votin mem#ers of the
Fund and #y each mem#er se$arately 'ith votin (uota more than 1< $er cent!
%he 5rticle IJ" Section I .a of the 5reement reads as
6x$ression of $ar values! %he $ar value of the currency of each mem#er
country shall #e ex$ressed in term of old as a common denominator or in
terms of the Enited States dollar of the 'eiht and fineness in effect on
Quly 1" 1/88!
%he im$ortance of old as the numeraire 'as o#scured mostly 'hen most of the countries
excludin the ES5 had chosen to define their $ar values in terms of ES dollar! Qohn
Williamson suested that the neutral old numeraire had #een chosen to ive the Enited
States the symmetrical o$tion to chane its exchane rate of dollar alon 'ith other
countries! >old 'as chosen as a conveniently neutral numeraire for definin $ar values of
the exchane rates of the currencies" #ut old 'as not $erceived as the fundamental asset
'hich 'ould act as a #rake on the issue of currencies and hel$ in the determination of the
common $rice level of the commodities in the mem#er countries the 'ay it had #een in
the nineteenth century . Williamson" 1/== ! 6ven no sinle currency" nor even ES
dollar" had #een reconized as the 2key2 currency linkin the $rinci$al currencies in the
'orld in 1/8;!
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Multilateral )ayments Mec%anism
5rticle JIII of the IMF states that mem#ers are su$$osed to make their currencies
current account converti#le thouh they can kee$ ca$ital control as stated in 5rticle
JI.@! %he mem#ers are to avoid discriminatory currency and multi$le currency
arranements! 5ain 5rticle RIJ allo's the countries to kee$ their currencies not
converti#le for a $eriod of three years and" durin this $eriod" exchane control can #e
maintained! In fact" it had taken a lon time for the develo$in countries to make their
currencies converti#le in current account transactions!
+ountries 'ould adjust their exchane rates de$endin on the domestic e(uili#rium
for 'hich the current account #alance is one im$ortant $arameter! ere Crofessor
Mundell raised one interestin issue 'hen he stated the follo'in:
Only .N&1 inde$endent #alance of $ayments instruments are needed in an N&
country 'orld #ecause e(uili#rium in the #alance of .N&1 countries im$lies
e(uili#rium in the #alance of Nth country! %he redundancy $ro#lem is the
$ro#lem of decidin ho' to utilize the extra deree of freedom . Mundell" 1/0"
$!1/;: !
*ecause of the demonetization of old in all $rivate transactions" as 'ell as its virtual
demonetization in official transactions too" the redundancy $ro#lem as stated #y Mundell
had arisen in a very stron form after 1/8;! 5ll currencies o$eratin in the system 'ere
$otentially inde$endent national fiat monies! %he amount of these fiat monies 'ere not
related to their #ase of monetary old" neither the exchane rates of these monies 'ere
tied to the traditional old $arity! 5s old failed to act as the Nth currency" ES dollar
slo'ly took its $lace! %his created the conditions for the Fixed&Aate Bollar Standard!
esources of IMF
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%he size of the total fund of IMF" contri#uted #y the mem#ersP (uota in the form
of ); $er cent in old and =; $er cent in national currencies" 'as initially ES !
#illion" and the amount could #e increased every five years if the majority of the
mem#ers 'anted! Ender the scheme of White Clan" mem#ers could o#tain resources from
IMF to hel$ finance short and medium term $ayments" dise(uili#rium in external
transactions! IMF esta#lished a num#er of conditions on the use of its resources #y the
countries sufferin from #alance of $ayments deficits! It sets the re(uirements and
conditions for the re$urchase" i!e! the re$ayment of loan! 5ll these are to facilitate the
manaement of currencies 'hich are of reater demand for the $ayments of international
o#liations! %he conditions im$osed on the mem#er country seekin loans from IMF are
derived from a monetarist model of Crofessor Colok" and in many cases this has #een
resisted #y the countries!
%e )owers of IMF
%he articles in the areement delineated the $o'ers of the t'o institutions created
for the creation and sustaina#ility of the system! %he International Monetary Fund has
the $o'ers to a$$rove the chanes made in the $arity #y the mem#ers to a$$rove or
other'ise on the use of multi$le exchane rates or other discriminatory $ractices! %he
fund has considera#le $o'er to influence the international monetary system and it
exercises its $o'er in consultation 'ith national and international monetary authorities!
%e +tructure of 5rganisation
IMF is overned #y a *oard of >overnors 'ho are a$$ointed on the votin
strenth of the mem#ers! %he *oard makes the $olicy decision reardin the actions of
the mem#ers! 5lso a num#er of 6xecutive Birectors and one Manain Birector are
selected #y the mem#ers! %he $o'er of the mem#ers is reflected in the votin rihts"
'hich are $ro$ortional to the mem#ersP (uota .of contri#ution
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Ender the areement the ES5 had to maintain a fixed $rice of old at ES@; $er
ounce" and 'hen the mem#ers are maintainin fixed $arity" the old $rice used to #e an
anchor of the system" 'hich converted the old standard into a dollar standard!
%he architects of the *retton Woods 5reement 'ere not very much s$ecific
a#out the system of the functionin of the system! %he evolution of the system 'as
$artly #ased on su#se(uent inter$retations of the economists 'ho 'ere enaed in
research! Several im$ortant features 'ere mentioned .%e' 1/G Williamson" 1/;!
One such feature is that all currencies 'ere treated as e(ual in the articles of areement"
'hich im$lies that each country 'as re(uired to maintain its $ar value #y intervenin in
the currency of other countries! %his $osition dictated #y theory 'ould not have #een
meaninful" as other countries can fix their $arities in terms of ES dollar as the Enited
States 'as the only country that $eed her currency in terms of old!
'istorical +tages of t%e 7retton Woods *greement! 1:;6.1:60
%he $eriod of transition from the 'ar to $eace in the $ost World War II 'as very
lon and $ainful and the functionin of the *retton Woods system had not #een on the
desired lines! %he system started functionin normally #y 1/;; and till 1/; full
converti#ility of the currencies of the major industrial countries could not #e achieved!
Ender the 5rticle RIJ of the *retton Woods 5reement" the countries could continue to
use exchane controls for an indefinite $eriod of transition after the esta#lishment of the
IMF in March" 1/8=! %he countries used exchane control to $reserve their forein
exchane and also every country had neotiated a series of #ilateral $ayments areements
'ith each of its tradin $artners! %he countries in 'ar ravaed 6uro$e 'ere in des$erate
need for the im$orts of ra' materials and ca$ital oods and thus the allocation of scarce
forein exchane had come under the control of the overnment!
6ven #efore the start of the World War&II" $olitical uncertainty in 6uro$e induced
massive ca$ital fliht from 6uro$e to the Enited States! In 1/@8" 5merican
administration resorted to the devaluation of dollar and the $rice of old 'as raised from
1=
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)
esta#lished in 1/8 to coordinate the fundin of the Marshall Clan" and the latter
facilitated hue inflo' of ca$ital to the economies of 6uro$e for reconstruction and
develo$ment! In fact" hue amount of forein ca$ital " mainly from the Enited States" 'as
invested in the countries of 6uro$e to lead the economies to'ards reconstruction and
develo$ment!
%he $eriod 1/80&1/0< sa' some events 'hich 'ere #oth dynamic and havin
sinificant effect on the international financial system!
In 1/8/" >reat *ritain devalued $ound sterlin #y @
countries reduced their $arities 'ith ES dollar #y more or less similar manitude! %his
s$ate of devaluation hel$ed the 6uro$ean countries to adjust their external sector
efficiently and" as a result" they could eliminate their lare trade deficit! *ut lare scale
chanes in the $arity conditions #y a num#er of countries created the im$ression that
monetary authorities could $er$etuate their dise(uili#rium situation for some time and
that 'ould create condition for s$eculation! In any case" there 'ere $erce$ti#le
resistance from the monetary authorities to chane their $arity and slo'ly the *retton
Woods system had #een reduced to a fixed exchane rate reime even thouh it 'as an
adjusta#le $e system in the initial thinkin stae! It is interestin from academic
stand$oint that the authorities $referred the s$ill over of domestic dise(uili#rium into the
external sector in their adverse #alance of $ayments rather than correctin their exchane
rates!
6ven #efore the *ritish devaluation of $ound" France devalued French franc in
Qanuary 1/8" and this created a multi$le exchane rate system" 'hich created $ro#lem in
1
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the form of #roken cross rates #et'een $ound and dollar! %he system 'as rectified 'ith
the devaluation of $ound! In 1/;
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Further" 'hile the intention of the *retton Woods 5reement had #een the
adjusta#le $e system in the exchane rate mechanism" the system that evolved over time
could #e called a fixed rate system! %he reason that monetary authorities #ecame too
much conservative reardin the adjustment of the $arities 'as $erha$s they 'ere
un'illin to take the risks of chanin the $arities as that miht lead to the $ossi#ility of
s$eculative ca$ital flo's and follo' u$ #ehaviour #y others! %hus the resultin system
took the sha$e of a fixed exchane rate dollar old standard! %his evolution created
some $ro#lems in the international financial systems 'hich 'ere not uncommon in the
inter&'ar $eriod also and these can #e $laced into t'o cateories: li(uidity and
confidence!
%e Li=uidity )rolem
%o'ards the end of sixties the Enited States started ex$eriencin deficit in its
#alance of $ayments and this 'as mainly due to hue ca$ital outflo' in the ca$ital
account transactions! Since the ES5 is a reserve currency country" it did not have to
adjust its domestic $olicies to the chanes in the #alance of $ayments! %he dollar
outflo's had #een sterilized #y the federal reserve as a matter of routine! %he outflo's of
dollar meant that other countries" $articularly 6uro$ean countries" had #een holdin
dollar reserve! %his created different $erce$tion in some main 6uro$ean countries and
there 'as resentment aainst the do¬hin attitude of the ES federal reserve on the
deficit #alance of $ayment situation! In 1/0; France #ean to convert outstandin dollar
lia#ilities into old throuh the old 'indo'! %hat created some $ressure on the $rice of
old!
Mean'hile ES monetary authorities res$onded to the emerin 'orld situation
#y initiatin measures to im$rove the #alance of trade" chanin the fiscal&monetary
$olicies" im$osin cur# on the ex$ort of ca$ital and takin measures to $revent the
conversion of outstandin dollars into old! *ut these $olicies could not chane the
situation much and the li(uidity $ro#lem continued!
%he li(uidity $ro#lem in the international scene 'as due to the maladjustment of
the demand and su$$ly of old" as the short&fall of the latter #ean to #e felt in the early
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need to create a su$$lementary reserve 'hich 'ould #olster international trade and
commerce!! %he results had #een the First 5mendment of the IMF 5rticles of 5reement
in 1/0= and this em$o'ered the IMF to create a S$ecial Bra'in 5ccount to su$$lement
its (uota system that o$erates under its >eneral 5ccount! Ender the ne' scheme a
reserve asset 'as to #e created #y the IMF and that 'ould #e called S$ecial Bra'in
Aihts .SBA " and this 'ill not #e #acked #y the de$osits of the mem#ers" #ut the value
of SBA as a reserve asset 'ill rest on it #ein rearded as an acce$ta#le means of
exchane #et'een the IMF and the central #anks of the mem#er countries!
%he value of SBA 'as initially set e(uivalent to 1 or set at 1-@; th of an ounce of
old! Ender the scheme each mem#er 'as allocated a s$ecified annual amount of SBA
in $ro$ortion to their (uota 'ith the IMF" and the country could dra' u$on its SBA
allocation if it ex$eriences a #alance of $ayments difficulties! %he mem#er is re(uired to
consult the IMF in the case of dra'in the (uota" #ut in dra'in the SBA allocation the
mem#er need not consult 'ith IMF! Further there is no conditionality attached 'ith SBA
dra'in and it is not su#ject to re$ayment! %he last thin im$lies that SBA has increased
the amount of international reserve!
%he cumulative total holdins of SBA allocated to a country is kno'n as the Pnet
cumulative allocationP of the country and over a ;&year $eriod the mem#er has to
maintain its SBA #alance at an averae of @< $er cent of its net cumulative allocation!
%his $ercentae 'as reduced to 1; in 1/=/! %he first allocation of SBA durin the
$eriod 1/=< && =) 'as to the amount of ES /!; #illion! In Quly 1/=0" the value of SBA
'as chaned from 1 to a 'eihted #asket of 10 currencies! ,ater in Qanuary 1/1" the
value of SBA 'as redefined and $eed to a #asket of ; currencies and these currencies
are Cound sterlin" French franc" Qa$anese yen" ES dollar and >erman mark!
5 country u$on dra'in the SBA can exchane the same 'ith other forein
currency and can increase its reserve! 5ll mem#ers of the IMF are #ound to acce$t the
SBA in exchane for their currencies u$ to three times their net cumulative allocation!
%he country that dra's its SBA allocation is to $ay rate of interest to the Fund and the
country that exchanes the allocated SBA 'ith its currency ets the rate of interest! %hus
the SBA is an indirect loan mechanism throuh the international li(uidity increases!
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Market )rice of 4old and $onfidence Issues!
>old had #een the anchor of the system and it 'as su$$osed to ive sta#ility to it!
*ut the $ein of the official $rice of old at @; $er ounce #y the ES %reasury attracted
attention of the s$eculators" 'ho $ushed the free market $rice of old in ,ondon market
to 8< $er ounce from the ES %reasury #uyin $rice of @;!)
#ackin to the ES dollar 'ith a ); $er cent old reserve re(uirement aainst federal
reserve notes! So" ES monetary authority a$$rehended that the s$eculation in the old
market miht s$ill over to the official demand for the conversion of dollar into old! 5s a
remedial measure" ES %reasury su$$lied old to the *ank of 6nland to restore sta#ility
and re(uested the monetary authorities of >rou$ of %en countries not to #uy old at
$rices hiher than @;!)< $er ounce! In Novem#er 1/01" the ,ondon >old Cool 'as
formed #y the Enited States and seven other countries" and it could sta#ilize the $rice of
old! %he central #anks of the seven countries su$$lied 8< $er cent of the old stock in
this $ool!
%he sixties 'itnessed t'o $henomena not conducive to the sta#ility of the
financial system! First" there had #een a ro'in scarcity of the old as the $roduction of
the yello' metal leveled off #y 1/0;&00! 5lso the demand for old increased mainly
from the $rivate sector! Second" there had #een a $erce$ti#le increase in the E!S!
inflation rate as the money su$$ly increased $artly due to Jietnam 'ar! Some economists
think that the ES5 follo'ed an inflationary $olicy at home that time #ecause of
domestic com$ulsion!
%he t'o $henomena cited a#ove created a crisis of confidence reardin ES
dollar and durin 1/0=&0" the ,ondon >old Cool #ecame a net seller of old" losin old
of a#out @ #illion e(uivalent at the $eed $rice! %here 'as a$$rehension a#out the
devaluation of dollar" thouh the scarcity of old in the 'orld 'as one reason .>il#ert"
1/0" Qohnson" 1/0! %he resultin situation had its conse(uences! In March 1/0 the
,ondon >old Cool 'as a#olished and it 'as re$laced #y a t'o&tier arranement! %he
monetary authorities of old $ool sto$$ed #uyin and sellin sold in the market" #ut
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instead they started transaction of old only amon themselves at fixed $rice @; $er
ounce! 5lon 'ith that the Enited States removed the ); $er cent old reserve
re(uirement aainst Federal Aeserve currency! %hus" the link #et'een old $roduction
and other market resources of old and official reserves 'as severed! %he result of these
ne' arranements 'as that old had #een demonetized at the marin! %he system
evolved into a de facto dollar standard" thouh old converti#ility remained!
*y 1/0 the system also reduced to a de facto fixed exchane rate system! %he
major industrial countries areed not to convert their hue dollar reserve into old!
Mean'hile 6uro$ean countries and Qa$an #ecame economic $o'er houses and they
#ecame increasinly reluctant to a#sor# more dollar lia#ilities! %hese countries also 'ere
not ready to readjust their exchane rate u$'ards as they ex$ected the Enited States to
make the readjustment! Faced 'ith these contradictory $ulls and $ressures the
International Monetary Fund found itself hel$less as its resources 'ere not enouh to
$revent devaluation #y major industrial countries #y $rovidin them ade(uate assistance
for adjustment .Bominuez" 1//@!
%he esta#lishment of the t'o&tier system after the closure of the ,ondon >old
Cool could not maintain the sta#ility of the old&dollar $arity for lon and the Enited
States 'as forced to close the old 'indo' in 5uust 1/=1! With this the *retton Woods
System colla$sed" #ut the institutions created as a result of the areement &&& IMF and
I*AB &&& survived! IMF still had an im$ortant role as a clearin house for different
vie's on monetary $olicies" as a centre of information" as the $rimary source of
adjustment of the countries outside the >rou$ of %en and as a monitor of the 'orld
financial system! Carticularly" the develo$in countries need the uidance and hel$ of the
IMF to standardize their financial system!
4res%am@s law in International Le(el
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In the 1/0
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currencies vis&T&vis ES dollar! %his had the im$lication that the .n&1 countries had to
follo' a definite set of fiscal and monetary $olicies 'hich 'ere consistent 'ith the fixed
$arities! *ut the countries could chane their $arities #ecause of the adjusta#le $e! In
the $rocess dise(uili#rium in the domestic economy miht ha$$en #ut this continency
'as not s$elled out in the sense that there had #een no constraints $laced on the mem#er
countries reardin the extent to 'hich the domestic monetary and fiscal $olicy could
deviate from the $attern set #y the Enited States .>iovannini" 1//@G Mundell" 1/0!
%he crisis of li(uidity in the 'orld financial system had not #een $ro$erly
addressed! %he countries 'ere to kee$ reserves aainst their currencies either in the form
of old" or in some $rinci$al currencies such as dollar! *ut in reality ES dollar had #een
the main currency 'hich 'as used as the reserve currency #ecause of the old
converti#ility! %here had #een the old converti#ility clause and a crisis of confidence
too and these $revented the Enited States to su$$ly the monetary reserve demanded #y
the .n&1 countries! In addition to it" the ES5 follo'ed an inflationary $olicy in the late
sixties" #ut 'as un'illin to devalue the dollar! %his reinforced the confidence $ro#lem
reardin ES dollar! So 'hen some countries tried to li(uidate their dollar lia#ilities and
transform that into old" the Enited States ot $anicky and closed the old 'indo' in
1/=1" sinalin the colla$se of the system!
)ost 7retton Woods ra! Managed Floating c%ange ate
%he $eriod #et'een 1/=1 and 1/=@ had #een one of the shock and adjustment for
the major countries of the 'orld and in March 1/=@ the 'orld turned to a eneralized
floatin exchane rate! In the ne' system the monetary authorities started extensive
intervention to influence #oth the levels of volatility and the exchane rates of their
currencies! *y 1/
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the 'orld financial system" $articularly on the via#ility of the international #ankin
system! Some #anks in Qa$an could mo#ilize enouh ca$ital and #ecame very lare in
terms of the asset size! %he countervailin $o'er emered and the *asle +ommittee
introduced ca$ital ade(uacy norms for all #anks o$eratin in the international market!
%he ca$ital ade(uacy ratio .+5A initially $ro$osed as $er cent of the risk&'eihted
assets acted as a constraint on the ex$ansion of credit $ortfolio of the #anks! %he latter
had an im$ortant im$act on the money su$$ly of the mem#er countries!
%e +econd *mendment of IMF *rticle
%he Second 5mendment of the IMF 5rticles came into effect on 5$ril 1/= and it
formally ave the IMF mem#ers a lare deree of discretion in the selection of their
exchane rate arranements! IMF had #een ured to ado$t a $olicy of 2 firm surveillance2
over the exchane rate $olicies of the mem#ers!
%he Second 5mendment 5rticle IJ defined the res$onsi#ility of the mem#ers!
6ach mem#er 'as o#lied to notify the IMF of its exchane rate arranement! %he
mem#ers 'ere free to select the exchane rate arranement they 'ould think riht for
their interest" #ut they 'ere to su$$ly information to the Fund! 5lso a mem#er 'as to
avoid mani$ulatin exchane rates in order to $revent effective #alance of $ayments
adjustments or to ain an unfair com$etitive advantae over other mem#er 'hich miht
hurt the interest of the latter! In a 'ay the Second 5mendment reduced the $o'er of the
IMF drastically!
*&&reciation of A+ dollar
Burin the $eriod 1/< & 1/;" ES dollar ex$erienced su#stantial a$$reciation
aainst major currencies! %he nominal effective exchane rate a$$reciated #y ;< $er cent
and the same thin ha$$ened 'ith the real rate! %his 'as the results of the diverent
macroeconomic $olicies $ursued #y the Enited States" Qa$an and 6uro$ean countries! %he
ES authorities follo'ed a relaxed fiscal $olicy #ut a tiht monetary $olicy" 'ith the
)=
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#udet deficit skyrocketin from ESB 10 #illion in 1/=/ to ESB )ermany" Qa$an" Enited States"
Enited indom&& met at Claza otel in Se$tem#er 1/; and after the deli#erations of
their res$ective vie' $oints" they issued a +ommuni(ue 'hich is kno'n a Claza 5ccord!
5ccordin to the 5ccord" the exchane rate of ES dollar did not accurately reflect the
chanes in the economic fundamentals like the measures Qa$an 'as to take to stimulate
domestic demand" or the ES commitment to reduce #udet deficits! %here 'as also
areement for the de$reciation of dollar and the countries areed to coo$erate on this
issue! %he dollar started to decline and the extent of the decline of dollar caused concern
amon the mem#ers!
In Fe#ruary 1/=" the >&= countries .+anada and 5ustralia toether 'ith >&;
rou$ met in Caris to consider the situation of declinin ES dollar and reached an
areement kno'n as ,ouvre 5ccord! In this" the >&= countries areed that further decline
of dollar 'as not desira#le and the then exchane rates 'ere true reflections of the
economic fundamentals! Im$licit had #een the areement that the ES dollar should #e
ke$t 'ithin a ; $er cent taret #and aainst the deutschmark and the yen! *ut the accord
could not com$letely $revent the decline of dollar!
In Octo#er 1/=" there had #een a colla$se in the stock markets around the 'orld and
as a conse(uence the dollar came under $ressure as the crash in the stock market induced
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the fear of 'orld recession! %he overnments of some industrialized countries started the
loosenin of their monetary $olicies and reducin the interest rates! In Qanuary 1/" the
trade deficits of the Enited States sho'ed the sin of im$rovements" and ES dollar
started the recovery $hase!
International $a&ital Flows
%he flexi#le exchane rate system in the 'orld had #een associated 'ith an
increasin strenth of the international money manaers 'ho 'ere a#le to make lare
scale ca$ital movement from one country to another 'ithin a very short time! %he trans&
#order ca$ital flo's had #een effected to make $rofit either from the $ossi#le fluctuations
of the exchane rates due to the $otential chanes in the short&term interest rates or the
$otential chanes in the $rices of the stocks in 'ell&interated stock exchanes of
different countries! %he first reason had #een man&made on some occasions leadin to a
$re&$lanned attack on a currency and this has led to a desta#ilization of the currency"
'hen the concerned central #ank failed to take care of its total lia#ility denominated in
the form of total currency in circulation 'ith the #anks and the $u#lic! %his ty$e of
situation had #een very common in the 1//erman reunification
and the reluctance of other mem#er states to $ursue $olicies" 'hich could have checked
inflation! %he Mexican crisis had resulted as a com#ination of several factors after
Mexico ex$erienced hue ca$ital inflo' till 1//8 'hen the crisis occurred! %he forces
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'ere as follo's: First" interest rates increased in the Enited States makin investment in
Mexico less attractive! Second" a re#ellion in the state of +hia$as increased dou#ts
amon the investors a#out the $olitical sta#ility! 5lon 'ith that 'hen one $residential
candidate of a $olitical $arty 'as assassinated" ca$ital inflo' to Mexico reduced
drastically and Mexico had to use its de$leted reserve to save the currency!
%he Aussian crisis in the aftermath of 1// 'as a culmination of external shock
like a decline in the $rices of ra' materials to an asymmetric ex$ectations of the
creditors! %he decline of tax recei$ts of the overnment due to the fall in the $rice of oil
led to an im#alance in the #udet of the Aussian overnment! %he $arliament #locked the
reform $ro$osal of the overnment and the currency #ecame 'eak due to ca$ital fliht!
In this situation Aussia souht hel$ from the IMF and after some controversy ot a loan
of 11!8 #illion! %his created an u$'ard ex$ectation in the financial market and investors
started #uyin short&term rou#le de#t to earn very hih interest rates! Interestinly no
one understood that rou#le miht de$reciate further #ecause of hih interest rates" and
this $recisely did ha$$en! In 5uust 1// Aussia allo'ed the rou#le to float and
sus$ended the redem$tion of rou#le denominated de#t! %he de$reciation of rou#le
initiated a PrunP on the #ank" as de$ositors 'anted to 'ithdra' rou#les to #uy dollars!
%he #anks 'ere the holders of lare de#ts 'hich 'ere PfrozenP and so they could not $ay
their de$ositors! %he country had to suffer for the irrational decision of the investors first
to $ut money 'ith 'ron ex$ectations and then 'ithdra' ca$ital leadin to the colla$se!
,ookin at the evolution of the international monetary system one finds several
im$ortant conclusions! First" the maintenance of the fixed exchane rate system in the
#einnin and the flexi#le exchane rate system since the early 1/=
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Enited States to allo' other countries adjust their exchane rates vis&T&vis ES dollar
solved the n&th country $ro#lem in the initial years till 1/0
ex$erienced deficit in the #alance of $ayments and other countries accumulated dollar
reserves and they su#stituted old reserves #y dollars! %he Enited States tried to solve
this $ro#lem #y a realinment of the exchane rates #y Smithsonian 5reement in 1/=1!
*ut this arranement fell a$art in 1/=@ 'hen the ES5 devalued the dollar unilaterally!
%his induced other overnments to float their currencies!
%he second lesson of the evolution of the international financial system is the
market #ehaviour in the $eed exchane rate system! When the latter is firmly in order"
investors are tem$ted to take advantae of the interest rate differences 'ithout coverin
their forein exchane ex$osure! *ut the moment market sus$ects the dura#ility of the
$eed rate system" the investors rush for cover! %he resultin conversion of currencies
and the lare amount of ca$ital flo's can $roduce the antici$ated exchane rate chane"
'hich the investors a$$rehended! %his has ha$$ened time and aainG this ha$$ened in
6uro$e in 1//)&/@" Mexico in 1//;" 5sia in 1//=&/ and in Aussia in 1// .>oldstein"
1//G 5dams et al" 1//! %he re$eated crises has reo$ened the de#ate a#out 'hether
restrictions should #e im$osed on the international ca$ital flo's" 'hat should #e the
a$$ro$riate exchane rate arranement for the ne' market economies and 'hether IMF
needs restructurin! Some economists are in favour of introducin some sort of a tax on
the international ca$ital flo's as suested #y %o#in! %his 'ill make the transfer a #it
costly #ut o$inion differs on this issue! o'ever" 'e 'ill have a close look at this issue
later in this cha$ter! 5ain the enormity of the crisis as seen in 5sia in 1//=&/ has
induced thinkin alon the line 'hether the IMF in its $resent form can take care this sort
of $ro#lem in future!
c%ange ate *rrangements
In recent times different countries have arraned different ty$es of exchane rate
arranements and #roadly these can #e $ut in the follo'in cateories:
&&&&+urrency $eed to another stron currency or SBA
&&&&+urrency $eed to a currency com$osite
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&&&& flexi#le exchane rates of a sinle currency
&&&& flexi#le exchane rate under coo$erative arranement
&&&& More flexi#le or manaed floatin exchane rate
&&&& Inde$endent floatin exchane rate
+ountries like 5nola" ,i#eria" Ira(" Oman" Canama" Syria and *eliz have $ein
arranements 'ith ES dollar! 5ain countries like *enin" +ameroon" +ono" Mali and
Seneal have a fixed $e system 'ith French franc! %he countries like ,y#ia and
Myanmar have $eed their currency 'ith SBA" 'hile some countries have $ein
arranement 'ith s$ecific currency&&&e!!" *hutan 'ith Indian ru$ee" *runei 'ith
Sina$ore dollar" 6stonia 'ith >erman mark and San Marino 'ith Italian ,ira!
%he countries 'ho have a $ein arranement 'ith a currency com$osite are:
*anladesh" *urundi" +y$rus" Fiji" Iceland" Qordan" Malta" Slovak Ae$u#lic" %ona and
Januatu!
%he countries like *ahrain" atar" Saudi 5ra#ia and E56 have currency 'hich are
(uite flexi#le thouh not of the elite rou$! On the other hand the countries like 5ustria"
*elium" Benmark" Finland" France" >ermany" Ireland" Italy" ,uxem#our" Netherlands"
Cortual and S$ain have flexi#le and elite currencies 'hich are also sta#le throuh
coo$erative arranements! %hese countries #elon to the elite O6+Brou$!
Some countries have currencies 'hose exchane rates are descri#ed as manaed
floatin! %heir list is (uite lon and the $rinci$al countries in this rou$ are&&& 5leria"
*razil" +hile" +hina" +osta Aica" 6y$t" >eoria" unary" Indonesia" Israel" Iran"
Malaysia" Cakistan" Aussia" Sina$ore" Sri ,anka" %hailand" Jenezuela and Jietnam! %his
$osition 'as as on Qune 1//=!
Some countries have o$ted for an inde$endent floatin exchane rate reime and this
list is very lon! Some of these countries are: India" 5l#ania" 5ustralia" +anada" >hana"
Qamaica" enya" ,e#anon" Mexico" Ceru" S'eden" S'itzerland" Enited States and
Uam#ia!
%he a#ove sho's that the exchane rate arranements of the different mem#ers of the
IMF are of various nature and this has made the system much more com$lex! 6ach
country follo's a course reardin its currencyPs exchane rate accordin to the strenth
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of the economic fundamentals! In fact the Second 5mendment of IMF 5rticles in 1/=
has em$o'ered the mem#ers to choose their o'n exchane rate reime and su$$ly
information to the Fund accordinly!
%e oin a )ro&osal on $a&ital Mo(ement
Crofessor Qames %o#in arues that in a 'orld of flexi#le exchane rates the
dynamics of the short term ca$ital flo's has a desta#ilizin effects on the sta#ility of the
exchane rates and in fact it can disru$t the 'hole $rocess . %o#in" 1/=:
National economies and national overnments are not ca$a#le of adjustin to
massive movements of funds across the forein exchanes" 'ithout the real
hardshi$ and 'ithout sinificant sacrifice of the o#jectives of national economic
$olicy 'ith res$ect to em$loyment" out$ut" and inflation .$!1;8!!
%o#in arues that in the hihly interated 'orld of today it is difficult for the
national economies to $ursue inde$endent monetary $olicies! If domestic interest rate
rises" this can induce a shar$ a$$reciation of the currency in real sense! 5ain" a fall in
the interest rate 'ill lead to a real de$reciation! %his sort of effect 'ill have adverse
im$act on the economic $arameters of the economy and %o#in suests that a tax can #e
im$osed on all forein exchane transactions so that the desta#ilizin effects are
reduced ! %he $ro$osed tax 'ill reduce the incentive for the s$eculators to instiate hue
ca$ital flo' in and flo' out of the economy in res$onse to a small interest rate chane!
%o#in suests that this ty$e of tax should #e im$osed on all ty$es of forein exchane
transactions 'ithout exce$tion and then only it 'ill #e effective! %houh it may have a
neative effect on the international trade" %o#in thinks that the trade&off is 'orth'hile as
it 'ill have a sta#ilizin effects on the exchane rate and throuh that on em$loyment and
income!
Many economists #elieve that %o#inPs tax is a #it harsh measure as a flat tax on all
forein exchane movements can reduce the de$th and #readth of the markets and the
conse(uent reduction in li(uidity can increase the volatility of the market" and it is an
o$$osite and un'elcome situation than 'hat is desired! 5lso 'ith todayPs innovative
financial markets" it is hihly $ro#a#le that the tax 'ill #e circumvented as financial
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innovation 'ill induce a re$lication of instruments that 'ould remain unaffected #y the
tax!
%e 4.< +tudy for World Monetary eform
%he 5sian crisis in 1//= induced the >&= countries 7 the = countries are&&& the
ES5" +anada" Enited indom" France" >ermany" Italy and Qa$an 9 for a fresh study for
revam$in the 'orld monetary system and the finance ministers of the seven countries
#ouht out a Ae$ort entitled " trengthening the nternational *inancial Architecture"
'hich 'as acce$ted in a summit in +olone in Qune 1///! %he Ae$ort identifies five
main areas 'hich are to looked into for strenthenin the 'orld monetary system . >&="
1///!%he areas are:
&& trans$arency and #est $ractices
&& stron financial reulation in industrial countries
&& stron macroeconomic $olicies and financial system in emerin countries
&& im$rovin crisis and manaement 'ith $rivate sector involvement
&& $romotin social $olicies to $rotect the $oor
Aeardin the transparencythe Ae$ort em$hasizes that trans$arency is needed to
ensure that information a#out existin conditions" decisions and actions of the authority
should #e made accessi#le" and easily understood #y the economic aents! When the
latter et sufficient market information" they can efficiently allocate the resources to
minimize the risks! %rans$arency also $romotes healthy market ex$ectations of the aents
that hel$ maintain sta#ility in the system!
Monetary authorities should $u#lish information a#out their reserve $osition" the
leverae $osition and external inde#tedness! %he countries are to #e encouraed to a$$ly
uniform standards and sound $ractices to foster the develo$ment of sound financial
system! International institutions should disclose their evaluations of the res$ective
countriesP financial system!
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+tronger Financial egulation
%he Ae$ort em$hasizes that inade(uate and inefficient evaluation of the credit
$ro$osals are also res$onsi#le for the creation of #ad asset! 6xcessive risk takin alon
'ith hih deree of leverae can make the financial system fraile and s$read neative
ex$ectations! %he Ae$ort identifies three areas 'hich are to #e addressed #y the
industrial countries and these are:
&&im$rovin risk measurement and its manaement
&&assessin the im$lications of the activity of the highly leveraged institutions!
and"
&&evaluation of the im$lications of the activities of the Offshore Financial +entres
%he three areas are inter&connected as it is the offshore reions 'here the $ro#a#ility is
very hih that hihly leveraed financial institutions are enaed in hih risk #usiness!
%he resultant loss" 'hen it ha$$ens" erodes the #ottom line of the $arent institutions!
+trong Macroeconomic )olicy
%he Ae$ort devotes considera#le s$ace to discuss the s$ectrum of
macroeconomic and financial $olicies the emerin countries should ado$t in the current
lo#al scenario! One im$ortant area is the exchane rate reime 'hich should #e
su$$orted #y consistent macroeconomic and fiscal $olicies #y the res$ective
overnments! %he financial system should also 'ork in an efficient manner #y
maintainin a $ro$er leverae $osition!
%he Ae$ort also asks the >&= rou$ for its firm commitment to 'ork toether 'ith
the im$ortant financial institutions of the 'orld to im$rove the standard of su$ervision of
#ankin and financial system! It also re(uests the overnments of the emerin countries
to narro' do'n the zone of the overnment uarantee for $rivate sector loan so that the
$ro#lem of moral ha1ards can #e minimized!
%he >&= countries also caution the emerin countries 7 there are 11 in the rou$
and they are&&&& 5rentina" 5ustralia" *razil" +hina" India" Mexico" Aussia" Saudi 5ra#ia"
orea" South 5frica and %urkey 9 to $roceed for ca$ital account li#eralization 'ith $ro$er
se(uencin of $olicies and creation of necessary infrastructure! %he International
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Monetary Fund .IMF and other similar institutions are asked to monitor closely the
transorder ca$ital flo's to minimize the $otential desta#ilizin effects of the latter! It is
reconized that the international ca$ital market has an im$ortant role for the
im$rovement of $roductivity in the emerin countries!%he re$ort also asks the emerin
countries to ado$t #est $ractices reardin de#t manaement 'ith reater reliance on lon
term de#t" if $ossi#le" denominated in domestic currency and removal of #iases that
encourae short term !
$risis )re(ention and $risis Management
Aeardin crisis $revention the >&= re$ort envisaes a frame'ork for $reventin
crisis 'ithout introducin moral hazards! %he main element in this frame'ork is the
involvement of $rivate creditors in all the as$ects of de#t manaement strateies! %he
Ae$ort reconizes that the official financial assistance in certain situations can $lay an
im$ortant role in the $revention of crisis" and even 'hen crisis occurs" in limitin the
risk of contaion! 5lso the Ae$ort ures the emerin countries to develo$ a mechanism
for a more consistent and systematic dialoue 'ith the main creditors for the
restructurin of loan and thus s$readin the lia#ility over a larer time horizon so that the
risk of contaion remains limited!
%he Ae$ort advises the de#tor countries to esta#lish sound and efficient
#ankru$tcy $rocedures and stron judiciary to $romote trans$arency and e(uity in the
insolvency reime! %he Ae$ort $uts em$hasis on #oth the commitment of countries to
meet their o#liations and market disci$line!
Formation of a -ew 4rou&! 4.20
On the initiative of >&= a ne' rou$ has #een created in the 'orld scene and it is
called >&)&= is of the vie' that they $ro$ose to esta#lish a ne'
mechanism for informal dialoue in a frame'ork of *retton Woods institutional system "
and to #roaden the dialoue on key economic and financial issues amon major emerin
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economies for the $romotion of 'orld ro'th and sta#ility! Some sort of a collective
management of the world financial systemhas #een the motivatin force #ehind the
formation of >&)
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sta#ility of this system . 6ichenreen" 1///G *linder"1///" >oldstein"1/// ! %here has
#een a #road consensus a#out 'hat the emerin countries should do reardin external
financial transactions and these are: ado$tion of a floatin exchane rate reime" less
reliance on forein currency #orro'in and extreme cautious a$$roach reardin ca$ital
account li#eralization! 5lon 'ith these elements there has #een an em$hasis on the role
of market in the ne' scheme of thins!
%here are still certain ray areas 'hich are to #e looked into! %he sta#ility of the
'orld system de$ends on the interde$endence #et'een the macroeconomic $olicies of
the lo#al financial $o'ers" $articularly the Enited States" 6uro$ean Enion and Qa$an!
*ut the $resent arranement may not #e considered as sufficient! 5s for exam$le" the lo'
interest rate $olicy as 'ell as 'eak yen $olicy $ursued #y *ank of Qa$an since the middle
of 1//; had #een necessary to fiht the domestic recession! *ut this $olicy led to a hue
Qa$anese investment in the ES5 at a chea$ cost and also hue Qa$anese loan to South
5sia! In early 1/// there had #een a shar$ reversal of the yen decline vis&T&vis ES dollar
and the >&= $assively acce$ted that thouh it 'as not ood for the recovery of Qa$an! %he
market took the sinal that yen 'as oin to a$$reciate further 'hich 'as consistent 'ith
the 5merican attem$t to reduce the deficit in current account in its trade 'ith Qa$an!
%here is $erha$s another issue 'hich should #e addressed $ro$erly and it is the
li(uidity of IMF" 'hich o#tains its resources throuh (uota su#scri$tions from mem#ers!
In return" IMF creates international li(uidity! %his is su$$lemented 'ith the creation of
the S$ecial Bra'in Aihts.SBA! *ut in the $resent scenario of market&led 'orld
financial system 'hat is feared is that IMF may create too much li(uidity in the system
'hich it may not endure! *ein the international lender of last resort IMF should not
create any moral hazard $ro#lem so far as the manaement of the current account of
individual mem#er is concerned! *ut the market $erce$tion should #e clear that IMF has
the means to $revent a crisis situation of a $articular mem#er from deeneratin into a
systemic insta#ility!
%his cha$ter ex$lains in detail the evolution of the 'orldPs financial system" and
the descri$tion of the ne' financial architecture 'ill not #e com$lete 'ithout a
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discussion of the ne' ex$eriment of the t'entieth century" i!e!" the formation of
6uro$ean Enion and the ne' currency 6uro! We 'ill discuss this in the next section!
uro&ean Anion and uro
%he sinle currency of 6uro$ean Enion 6uro 'as launched on Qanuary 1" 1///
and it is a com$osite currency consistin of 1) currencies 'hose 'eihts are
$ro$ortionate to the im$ortance of the economy! %he currencies 'ith their res$ective
'eihts are discussed in detail in +ha$ter 8! ere 'e discuss the systemic im$act of the
6uro on the lo#al financial system!
5t the time of launch" 6uro 1 K Es 1!1= and that 'as the theoretical value! *ut
durin the last t'o years 6uro has lost heavily aainst ES dollar and in Becem#er )
leacy currencies 'ill #e 'ithdra'n and in Quly" )reece. from Qanuary1" )
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similarity" same ty$e of external shocks 'ould create different ty$e of effects and the
countries 'ould re(uire different exchane rate $olicies!
Second" the economies of the countries under 6E should #e $ro$erly interated
such that they face the same $hase of #usiness cycles at the same time! %his 'ill facilitate
ado$tin same interest rate $olicy and one monetary $olicy! %his condition is touh #ut
very im$ortant" #ecause if interest rates deviates from one another" diverse ca$ital
movements 'ill create $ro#lems for the sinle monetary $olicy! %he latter is crucial for
the credi#ility of 6uro #ein the sinle currency in 6E! It 'ill #e a difficult $ro$osition
for the 6uro$ean +entral *ank .6+* to fiht inflation in one country 'ith hih interest
rate and tackle recession in another country 'ith lo'er rate of interest!
%hird" the mem#er states should have a common economy in the sense that the
movement of ca$ital" la#our as 'ell as commodities should face no restrictions across the
$olitical #orders! %his im$lies a sinle market condition and the industries in the
concerned countries should #e ready to face this com$etition!
%he three conditions as outlined a#ove are necessary for the esta#lishment of the
o$timum currency areas! %he fact is that 6E mem#er states are yet to achieve this stae!
*ut the Maastricht %reaty tried to ensure that the eleven countries 'ere similar #y
im$osin four convergence criteria related to the exchane rate" inflation rate" interest
rates and the $u#lic deficit . #udet deficit in relation to the ross domestic $roduct!
First" the exchane rate of the country must remain 'ithin the normal fluctuation margin
of the 6xchane Aate Mechanism 7 6AM9 for ) years! Second" the rate of inflation should
#e no more than 1!; $er cent a#ove the averae rate of the three #est $erformin mem#er
states! %hird" the lon term interest rate should #e in line 'ith the #est countries in term
of $erformances! Fourth" the #udet deficit should #e no more than @ $er cent of the
ross domestic $roduct of the country!
On the surface the success of the converence criteria in the case of 11 countries
sho's the success of the common currency! *ut round reality may remain different!
When all ca$ital market instruments are converted to common currency" the interest rates
'ill convere" #ut that 'ill not ensure the similarity of the o#jective situations of the
ca$ital markets of the mem#er states! Failure of this im$lies that ca$ital 'ill not move to
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the ca$ital $oor reions as ex$ected initially! 5ll these sho' the difficulties in the 'ay of
the mem#er states under 6E formin the o$timum currency areas!
%he literature ex$lains the o$timum currency areas as an ideal state and it defines
'hether a rou$ of countries can enter into a monetary union 'ithout much neative
externality! In a sense every country 'ith its o'n currency is a monetary union" #ut that
does not uarantee that the country $resents an o$timum currency areas! *i countries
like the Enited States" Aussia" +hina and India are not o$timum currency areas" as
different states either in the Enited States or in India do not exhi#it the similarity of the
economic structures as descri#ed under the o$timum currency areas!
*ut the monetary unions do function and this they do 'ith relative success
#ecause of the functionin of some adjustment mechanism like flexi#ility of factor $rices
and mo#ility of la#our and ca$ital across the reions! Flexi#le 'aes and interest rates
'ill clear the markets and that takes care of the unem$loyment and under em$loyment of
factors of $roduction! Free and unrestricted mo#ility of ca$ital and la#our is very
im$ortant in this adjustment mechanism 'ithout 'hich sectoral unem$loyment 'ill
$revail!
What is the real situation in 6uro$ean EnionV Bifferent studies suest that the
cultural and linuistic differences amon the countries in 6uro$e form a sinificant
#arrier to la#our mo#ility! It has to try hard to achieve the ty$e of la#our mo#ility as seen
in the Enited States! *ut socioloists raise a more fundamental issue and that is 'hether
the social friction that may result duo to la#our mo#ility in the face of cultural differences
are desira#le from the sta#ility as$ect of the society! %his is an a$$rehension and for this
economics has no ans'er!
%he success of the 6uro 'ill de$end larely on the role of the 6uro$ean +entral
*ank . 6+*" 'hich is located in Frankfurt and 'hich is controlled #y a set of
inde$endent central #ankers 'ho are not vulnera#le to the $olitical o$inion! %he 6+*
'ill see rouh days ahead as it tries to im$ose strict monetary and fiscal disci$line on the
'eaker countries for the sta#ility of 6uro and its success 'ill de$end to 'hat extent it can
'ithstand the $otential $olitical $ressure! %he formation of 6uro$ean Enion and its
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im$act is discussed in this cha$ter from the $ers$ective of the theory of o$timum
currency areas! %he structure of the currency 6uro and its recent chanes are ex$lained in
+ha$ter 8!
$%a&ter 3#
International Mo(ement of Money! %e Institutions
"n a world of banks and insurance companies! money markets
and stock exchanges! money is $uite different thing from what it
was before these institutions came into being".
7 icks" 1/0=: $! 1; 9
Money as a commodity is lo#al #y nature and its movement is facilitated #y
'ell&esta#lished institutions like money market" ca$ital market and the market for forein
currencies! %he latter is $art of money market #ut for the convenience of analysis 'e
discuss it se$arately! In todayPs 'orld of interated treasury o$erations of #anks and
other financial institutions the $ersons involved in the movement of money across the
$olitical #oundaries are the same 'orkin simultaneously in the three markets as
mentioned! %he money market and the ca$ital market have #een descri#ed earlier" and let
us take the forein exchane market!
Forein exchane is enerally referred to as the instruments " communications or
orders that results in a chane of o'nershi$ of demand #ank #alances a#road! %hus
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forein exchane is defined as any order" communication or any instrument that
necessitates the recei$t or $ayment of funds in a currency other than the currency of the
market 'here the settlement for the order or communication is made! %he instruments are
enerally 'ire transfers" checks" airmail $ayment orders and #ills of exchane! So any
instrument that can #e sent to another country and effect a transfer in the o'nershi$ of
demand #alances in #anks is a $iece of forein exchane! We can thus include 'ithin this
definition forein cash" forein stocks and #onds" credit card vouchers" travelerPs checks
etc!!
%e Market for Foreign $urrencies
%he market for forein currencies or forein exchane market .F6M is the
market for tradin in diverse currencies 'hich are all soverein money uaranteed #y the
res$ective overnments and issued #y the central #anks 'ith ade(uate reserves as the
#ackin of the res$ective lia#ilities! 6ach transaction involves the exchane of one
currency" say ES dollar" #y the currency of another country" say Indian ru$ee" and in most
of the cases it is #y chanin o'nershi$ of de$osit #alances in #ankin system! It is
al'ays money aainst money! 5t the smallest level it can #e as artless as the tout
chanin ES dollar aainst ru$ee in the market $lace at Mum#ai or the $orter chanin
the dollar for ru$ee at the Calam air$ort! 5t the other extreme it may #e so$histicated
electronic hook&u$ ta#les 'ith com$uter and tele$hones" fax machines and telex in the
forein exchane dealin rooms of the #anks in major financial centres like Mum#ai"
,ondon" Ne' ork etc! transactin in millions of currencies of different denominations
'ithin a short time! %he essential $rocess is the same " only modern technoloy has
facilitated the transfer of hue volume 'ithin a very short time! %he 'orld has #ecome a
very short $lace in the dealin room! It is not a market 'here t'o $arties meet each other
face to face" #ut it is an electronically o$erated market and this sort of market functions
)8&hours a day around the lo#e and handles over /; $er cent of total #usiness!
%he $layers in the market are individuals" traders" financial institutions"
commercial #anks" #rokers and central #anks! %he traders in the market o$eratin from
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the dealin rooms are dedicated to orderin the movement of money in and out of the
account their #anks maintain in other #anks and corres$ondent institutions around the
'orld! %he F6M is closely linked 'ith #oth the ca$ital market and the money market
since in the recent lo#alization of finance" many investors and other $artici$atin aents
are to o throuh financial intermediation across the $olitical #orders and from one
currency to another to reach their counter&$arty! %he modern arranement of interated
treasury manaement is the loical outcome of the close interation of the three markets!
%he nature of the movement of the exchane rates of different currencies are a
su#ject matter hotly $ursued #y #oth the academicians and the traders 'ho man the
terminals in the dealin rooms! %he theoretical ex$lanations are com$lex and sometimes
tricky . Nandi"1//0 and one non&mathematical 'ay of understandin the market is
$rovided in the %echnical 5nalysis literature! %he latter is not $ursued in this #ook as it is
too s$ecialized a su#ject and the reader is advised to see any #ook on the su#ject for
further discussion!
%e FM and ime Bones
%he lo#al F6M o$erations is a )8&hour cycle! On any 'eek day this market
o$ens in 5uckland" Wellinton and Sydney" then %okyo o$ens" follo'ed #y on on
and Sina$ore an hour later! When it is mid&day in the far east" *ahrain and other Middle
east markets o$en and a fe' hours later the 6uro$ean markets o$en! It is then mid&
afternoon in the Far 6ast as centre as Uurich" *asle" >eneva" Frankfurt" Munich and
,ondon o$en in the early trade hours! 5fter lunch in these markets" the eastern markets
close" #ut Ne' ork o$ens! %he market then s$reads to'ards the 'estern side of the
Enited States in $laces as +hicao" ,os 5neles! When the evenin sets in 5merica" Ne'
Uealand and 5ustralian #anks o$en the next day and thus the )8&hour cycle #ecomes
com$lete!
%he res$ective countryPs rules and reulations #ein uni(ue that 'ay uide the
o$eration in each market! In some exchane rate is fixed" in others it is flexi#le and
relatively free 'hile in some $laces it is a manaed float ty$e! *ut the $layers are of a
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common mould any'here in the 'orld and the $roduct is the forein exchane! In s$ite
of the fact that forein exchane reimes vary across the countries" the $layers in the
market determine the exchane rate and make the market! %his they do #y chanin the
s$reads #et'een the #id -ask rates and sometimes throuh the hel$ of the #rokers and
also #y creatin $ositions in the ex$ectations of influencin the future rates of the
currencies!
Foreign c%ange Market! Microstructural ynamics
%he forein exchane market is characterized #y the AeutersP B)
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%he #rokers in the F6M o$erate in the interank markets and in some countries
#et'een the customers and the #anks! %he #rokers do not set the rates in the markets" #ut
their #ids and offers are $assed on to the commercial #anks and these reflect the demand&
su$$ly factors in the markets! %hese facilitate the determination of final rates #y the
#anks! %he existence of #rokers #roadens the markets and makes it more efficient!
*rokers enerally do not take a $osition in the markets and they 'ork as liaison! When
the trade occurs #et'een the customer and the #ank" #rokers do not a$$ear in #et'een"
#anks often take their services 'hen market is volatile ! Of course the #rokers have their
o'n customer #ase and they take commissions from #oth sides of transactions! *anks
often use #rokers in forein exchane transactions to maintain anonymity until the
closin of the deals and-or 'hen they 'ant to reduce the $a$er 'ork of their o'n! %he
im$ortance of #rokers is related to the nature and oranization of the markets" and if there
is a drastic chane in the oranization of the markets . as are seen no'&a&days 'ith the
arrival of ne' technoloy and ne' ty$es of money" $osition of the #rokers 'ill chane
also!
$ommercial 7anks
%he commercial #anks are the larest $layers in the forein exchane market and
they conduct their o$erations throuh their dealin rooms! %he latter are connected 'ith
the lo#al markets #y all modern adets of telecommunications! %he traders in these
dealin rooms determine the areate demand and su$$ly of any currency and throuh
these they determine the $rice! %he dealin rooms have electronic tradin arranements
'ith the hel$ of on&line com$uters" the latter link $artici$atin #anks on a one&on&one
#asis so that traders car reconize on their monitor 'ho the counter&$arty is" the amount
of #id or offer" the rates etc! %he deal "if areed u$on" can #e closed 'ith the stroke of a
sinle key of the com$uter! %he relia#ility of the deal is uaranteed as every transaction is
electronically stored and thus documented! %he market information and the dealin
facility are $rovided #y com$anies like Aeuter! 5lso other $roviders like *loom#er
and niht Aider are in the same cateory of #usiness!
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5ll over the 'orld the dealin rooms are #usy 'ith the trade of five $rinci$al
currencies & ES dollar" >erman mark" S'iss franc" *ritish $ound and Qa$anese yen! No'
another currency has joined the leaue and that is 6uro! 5 second layer of currency is
com$osed of French franc" Italian lira" *elian franc" +anadian dollar and Butch
uilders! Other currencies are traded in lo' volumes " and one reason for this is that
traders do not create $ositions in third layer currencies !
+ommercial #anks maintain demand accounts at major #anks in all the countries
'hose currencies are traded! ,eadin #anks may maintain several corres$ondents at main
financial centers of the same country to handle #usiness of the customers! In the major
dealin room of the #ank several traders may #e involved in trade o$erations of one
major currency" and the +hief Bealer remains res$onsi#le for the #ankPs lo#al $osition
in the currency" as he must #e continuously monitorin the net $osition of that currency!
%he chief dealer must #e alert a#out the likely movement of the currency in near future"
'hich may #e a day" one 'eek or one month! *anks enaed in international o$erations
do essentially international #ankin and it is taken u$ in +ha$ter ;!
urocurrency Markets
6urocurrency markets are s$ecialized money and ca$ital markets" controlled and
administered mainly #y commercial #anks in offshore financial centers . OF+ ! %he
assets and customers are enerally outside the countries of the centers! 6uro¤cies
are currencies handled #y the #anks outside the countries of their oriin! %hese are mostly
hard currencies like ES dollar" yen" >erman mark" S'iss francs and French francs! 6uro&
#anks in offshore centers maintain accounts in different currencies in #anks in Ne' ork"
,ondon and such main financial centers and they transfer money accordin to the needs
of the customers from these accounts!
%he history of the eurocurrency markets is very interestin! In the 1/;
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#anks! %he modern 6urocurrency markets develo$ed from these first roots and today the
$otential of this market has attracted many financial centers in this #usiness like >eneva"
,uxem#our" 5msterdam" *russels" %oronto etc! 5t $resent more than ;< countries have
#ankin reulations that $ermit the o$enin of time de$osits accounts in forein
currencies on the #ooks of their financial institutions on #ehalf of their non&resident
foreiners! %he currencies circulatin in this #usiness are currencies 'hich are ca$ital
account converti#le" thouh major currencies are only a fe' in num#er! %he countries of
oriin of these currencies have #ankin reulations allo'in their