FINA 611 - CHAPTER 1

International Monetary System (IMS): The international monetary system can be defined as the structure within which:
foreign exchange rates are determined, international trade and capital flows are accommodated, adjustments to the balance of payments made It also includes all of the instruments, institutions and agreements that link together the worlds currency and money markets. Currencies of most nations are based on agreements in force between their governments and the International Monetary Fund (IMF).

International Monetary Fund (IMF):

In 1944, the Allied Powers met at Bretton Woods, New Hampshire, to create a new international monetary system to liberalize international trade and to adjust financial flows among countries. The Bretton Woods Agreement established a US dollar based international monetary system and provided 2 new institutions: IMF and World Bank. The IMF aids countries with balance of payments and exchange rate problems. The International Bank for Reconstruction and Development (World Bank) initially aided in post-war reconstruction, but since has supported general economic development. The IMF and World Bank started their activities in 1946. The members of the IMF and World Bank are the same; it means that the members of IMF are the members of World Bank as well. IMF was originally funded by each member subscribing to a quota based on expected post World War II trade patterns. Then they decided to set quotas based on some macroeconomic indicators of each member such as national income and foreign trade volumes. These members have the highest voting rights in IMF respectively: 1) USA 2) Japan 3) Germany 4) France 5) UK

Special Drawing Rights (SDR):

SDR is an international reserve asset created by the IMF to supplement existing foreign exchange reserves serving as a unit of account for the IMF and other international and regional organizations. Previously currencies of 16 industrial countries were taken into consideration in valuing SDR. It has been defined several times; it was the weighted value of currencies of 5 IMF members having the largest exports during 1981 and September 2001 which was due to the re-calculation every 5 years. Now as of April 28, 2001, the composition of SDR was as the followings: US$ = 45%, EURO = 29%, Yen = 15% and Sterling = 11%. Member countries hold SDRs in the form of deposits in the IMF. There are two principles in selecting national currencies for SDR composition: First principle: a candidate country to be selected need to have the highest goods/services export volume Second principle: its national currency should extensively be used in international transactions and foreign exchange markets.

Currency Terminologies:
Exchange rate is the price of one countrys currency in units of another currency or commodity (gold or silver). If the government of a country regulates the rate at which the currency is exchanged for other currencies, the system or regime is classified as a fixed or managed exchange rate regime. The rate at which the currency is fixed, or pegged, is frequently referred to as its par value. If the government does not interfere in the valuation of its currency in any way, the currency is classified as floating or flexible. Devaluation of a currency refers to a drop in the foreign exchange value of a fixed currency. The par value is reduced. Revaluation of a currency refers to a rise in the foreign exchange value of a fixed currency. The par value is increased. Depreciation of a currency refers to a drop in the foreign exchange value of a floating currency. Its opposite is appreciation. Soft or weak currency expresses that currency which is expected to devalue or depreciate. This currency is also a type of currency which is being artificially sustained by the government. The opposite of soft or weak currency is Hard Currency which is expected to revalue or appreciate relative to major trading currencies. Spot exchange rate is the quoted price for foreign exchange to be delivered immediately, or in two days for inter-bank transactions.

Forward Rate is the quoted price for foreign exchange rate to be delivered at a specified date in the future. The rate can be guaranteed by a forward exchange contract. Forward Premium or Discount is the percentage difference between the spot and forward exchange rate. The formula will be; S F 360 100 F n Eurocurrencies are domestic currencies of one country on deposit in a second country. Ex. Eurodollar is a US dollar denominated interest-bearing deposit in a bank outside the US.

History of the International Monetary System: The International Monetary System includes two extreme classifications of
currency regimes: Fixed Exchange Rate system and Floating Exchange Rate system: 1. Fixed Exchange Rates System: In this system, the currency is pegged to another currency at a fixed rate. Gold standard and Bretton Woods System are two previous examples to this system. Problems with Fixed exchange rates; a) Foreign Balance Adjustment: Those countries having a trade deficit will have a foreign reserves shortage and they will need to make devaluation. b) Liquidity Problem: The countries having a trade deficit can finance the temporary deficits, but the central banks should have enough reserves to do that. c) Trusting Problem: When a problem happens in a fixed parity, speculators will escape to more stable currencies, this time the government may apply devaluation. 2. Floating or Flexible Exchange Rate System: Allowing a currency to fluctuate freely and there is no government intervention. Exchange rates are determined by completely supply and demand in the market.

Fixed vs. Flexible Exchange Rates:

Fixed rates provide stability in international prices for trade and lessen risks for the businesses. Fixed rates are anti-inflationary and require countries to follow restrictive monetary and fiscal policies. This restrictiveness can be a burden to economy and creates high unemployment and slow economic growth. Fixed rates require central banks to maintain large foreign reserves in the defense of their fixed rate. Fixed rates are inconsistent with economic fundamentals as the structure of the economy changes, and trade relations and balances evolve. So exchange rates should also change.

Previous IMF Classification of Currency Arrangements: (until the year of 2000)

1. Pegged To another Currency: 62 countries out of 167 members of IMF pegged their currency to some other currency. For example, US dollar is the base for 20 other countries and French franc is the base for 14 other countries, all issued by former French colonies in Africa. Pegged To a Basket: 21 countries pegged their currency to a composite basket of currencies, where the basket consists of a portfolio of currencies of their major trading partners. The base value of such a basket is more stable than any single currency. Flexible against a Single Currency: 4 countries in the Persian Gulf area maintain their currency within a limited range of flexibility against the US dollar. Joint Float: 10 members of the EU have a cooperative agreement to maintain their currencies within a set range against other members of their group of whose structure is called European Monetary System (EMS). It is a peg of each countrys currency to all the others, and a joint float of all of the currencies together against non-EMS currencies. Adjusted According To Indicators: 2 countries, Chile and Nicaragua, adjust their currencies more or less automatically against changes in a particular indicator, such as real effective exchange rate, which reflects inflation adjusted changes in that currency with its major trading partners. Managed Float: 40 countries maintain managed float. Each central bank sets the nations exchange rate against a predetermined goal, but allows the rate to vary. There is an intervention in determining exchange rates. Independently Floating: 55 countries allow full flexibility through an independent float. These countries currencies are the most important currencies in the world other than those in EMS system. Central banks permit market forces to determine exchange rates. However, there might be an intervention in some of them from time to time.

2.

3.

4.

5.

6.

7.

New IMF Classification of Currency Regimes:

1. Exchange Arrangements with No Separate Legal Tender: The currency of another country circulates as the sole legal tender or the member belongs to a monetary or currency union in which the same legal tender is shared by the members of the union. Currency Board Arrangements: A monetary regime based on an implicit legislative commitment to exchange domestic currency for a specified foreign currency at a fixed exchange rate, combined with restrictions on the issuing authority to ensure the fulfillment of its legal obligation. Other Conventional Fixed-Peg Arrangements: The country pegs its currency (formally or de facto) at a fixed rate to a major currency or a basket of currencies, where the exchange rate fluctuates within a narrow margin or at most 1% around a central rate. Pegged Rate within Horizontal Bands: The value of the currency is maintained within margins of fluctuation around a formal or de facto fixed peg that are wider than 1% around a central rate. Crawling Pegs: The currency is adjusted periodically in small amounts at a fixed, preannounced rate or in response to changes in selective quantitative indicators. Exchange Rates within Crawling Bands: The currency is maintained within certain fluctuation margins around a central rate that is adjusted periodically at a fixed preannounced rate or in response to change in selective quantitative indicators. Managed Floating with No Preannounced Path for the Exchange Rate: The monetary authority influences the movements of the exchange rate through active intervention in the foreign exchange market without specifying a preannounced path for the exchange rate. Independent Floating: The exchange rate is market-determined, with any foreign exchange intervention aimed at moderating the rate of change and preventing undue fluctuations in the exchange rate, rather than at establishing a level for it.

2.

3.

4.

5.

6.

7.

8.

Attributes of the Ideal Currency:

1. 2. Fixed Value: Fixed value of currencies relative to others that traders and investors be certain today and in the future. Convertibility: Full convertibility of a currency so that traders and investors can easily move funds from one country to another requiring complete freedom of monetary flows. Independent Monetary Policy: Each country set their own domestic monetary and interest rate policies to pursue national economic policies.

3.

All of these attributes cannot be achieved at the same time, for example, countries whose currencies are pegged to each other agree to both a common inflation and interest rate policies as in EMS. On the other hand, inflation rates differ among countries. Countries having higher inflation rates are likely to have higher unemployment rates as well. And if there is an interest rate difference, then funds will be moved from lower interest rate countries to higher interest rate countries.

EMS and Maastricht Treaty: In DEC 91, EU members met at Maastricht (Netherlands) and concluded a treaty:
Timetable: They specified a timetable and plan to replace all individual currencies with EURO. Other steps would lead to a full European Monetary Union (EMU) as latest as the end of 1998. Convergence Criteria: The EMU would be implemented by a process called convergence, which includes: 1. 2. 3. 4. Nominal inflation should be at most 1.5% above the average for the three members of EU with the lowest inflation rates during the previous year Long term interest rates should be at most 2% above the average for 3 members with the lowest interest rates. Fiscal deficit should be at most 3% of GDP. Government debt should be at most 60% of GDP.

Strong Central Bank: A strong central bank called European Central Bank (ECB) was to be established and Host City will be Frankfurt, Germany. It will promote the price stability within the EU.

EMERGING MARKET CRISES:

The Great World Depression (1929): Reasons: Shortage demand in USA Insufficient Liquidity and crisis in US markets Problems in CA and BOP The crisis started in USA and jumped to the entire world. Happenings: Real GDP of USA declined by 40% Unemployment rate jumped up immediately Imports were restricted Trade balance was damaged World trade was damaged

The Asian Crisis (1997): Started in Thailand in 1997 and jumped to other Asian countries Reasons: Change from net exporters to net importers position Heavy foreign debt and capital outflows of Asian countries, especially Thailand So sudden and severe pressure on Thai Baht On July 2, 1997, the baht was allowed to float 17% against US$ and over 12% against Japanese Yen: That means Devaluation The crisis jumped to other Asian and world countries as a speculative attack. Result of Asian Crisis: Recession in Asia and Other markets Prices and aggregate demand declined Crisis jumped to other countries as well Causal Complexities behind Asian Crisis: Difficulties in Balance of Payments Corporate Socialism: Influence of governments and politics in business arena Corporate Governance: Bad management because of large family corporations and their strong control over their corporations. Banking Liquidity and Management: Liquidity crisis and bad banking regulatory structures and markets.

The Russian Crisis (1998): Reasons: Deterioration of economic conditions in Russia for the years Heavy foreign debt that put pressure on the ruble Declining export revenues and damaging trade balance, one because of the Asian crisis in 1997

Happenings: On August 10, stock prices fell by 5% that created panic in the Russian markets So on August 17, the ruble was allowed to devalue by 34% during the year

The Brazilian Crisis (1999): Reasons: Governments inability to resolve CA deficits Domestic inflationary forces Lack of adjustments or floating in real for other currencies (For example, International Fisher effect) Happenings: These created a pressure in the real and devaluation started in January 12, 1999 The Russian and the Brazilian crises were also reflections of the Asian Crisis in 1997.

Turkish Lira Crises: First Devaluation: September 7, 1946 by 54.3% (immediate) Second Devaluation: August 4, 1958 by 68.9% (gradual) 1978: 23% devaluation against US $ (immediate) 1979: 26.3% devaluation (immediate) 1991: Full Convertibility of TL approved by IMF April 5, 1994: 150% immediate devaluation and 170% gradual devaluation February 21, 2001: TL moved from Managed Float into Free (Flexible) Floating Exchange Rate System, however, it is not a pure flexible system following again a managed float system. Common Characteristic of all the world crises: Problems in BOP and CA

Foreign Exchange Rate Determinants:

Interbank Quotations:
1. First, majority of the countries express foreign exchange prices for one US dollar which is known as European terms. The following quote is an example to European terms: 105.00 / US $ or 1 US $ : 105.00 This quote shows the amount of Japanese Yen that can be purchased for one US $ which can be also named as Japanese terms. Additionally, when for example, TL is expressed in terms of US $, the quote is said to be in Turkish terms. European terms were adopted in 1978 to facilitate worldwide trading through telecommunications. 2. Second, several countries express US dollar price for one unit of other currencies which is known as American terms. The following quote is an example to American terms: US $ 0.0095 / or 1 : 0.0095 US $ The above quote shows the amount of US $ that can be purchased for one Japanese Yen which can be calculated by taking the reciprocal of the rate presented in European terms. Therefore,
1 US$ 0.0095 / Yen Yen105.00 / US$

Direct and Indirect Quotas:

1. A direct quote is a quotation expressing home currency price in terms of a foreign currency. Consider the following rates: EURO 1.47 / GBP or 1 GBP: 1.47 EURO This rate shows the amount of EURO that can be purchased for one British pound sterling. It is a direct quote in EURO area showing the internal value of EURO for one unit of pound sterling 2. An indirect quota is a quotations expressing foreign currency price in terms of a home currency. Taking the reciprocal of above quotation, we get: GBP 0.68 / EURO or 1 EURO: 0.68 GBP This quotation shows the amount of GBP that can be purchased for one EURO. It is this time a direct quote in U.K. showing the internal value of GBP for one unit of EURO and is an indirect quote in the EURO area showing the external value of EURO against GBP.

Bid and Ask Quotations:

Bid is the price in one currency at which a dealer will buy another currency (willingness to buy). Ask (offer) is the price at which a dealer will sell the other currency (willingness to sell). To make profit, ask price is greater than bid price. The difference between the two will give the spread (profit).