International Monetary Fund

The United Nations Monetary and Financial Conference held in Bretton Woods, New
Hampshire, in July 1944 was called to develop a structured international monetary system. As a
result of this conference, the International Monetary Fund (IMF) was formed. The major
objectives of the IMF, as set by its charter, are to;

1) Promote cooperation among countries on international monetary issues,

2) Promote stability in exchange rates,

3) Provide temporary funds to member countries attempting to correct imbalances of

international payments,

4) Promote free mobility of capital funds across countries, and

5) Promote free trade. It is clear from these objectives that the IMF’s goals encourage increased
internationalization of business.

The IMF is overseen by a Board of Governors, composed of finance officers (such as the head of
the central bank) from each of the 185 member countries. It also has an executive board
composed of 24 executive directors representing the member countries. This board is based in
Washington, D.C., and meets at least three times a week to discuss ongoing issues. One of the
key duties of the IMF is its compensatory financing facility (CFF), which attempts to reduce the
impact of export instability on country economies. Although it is available to all IMF members,
this facility is used mainly by developing countries. A country experiencing financial problems
due to reduced export earnings must demonstrate that the reduction is temporary and beyond its
control. In addition, it must be willing to work with the IMF in resolving the problem. Each
member country of the IMF is assigned a quota based on a variety of factors reflecting that
country’s economic status. Members are required to pay this assigned quota.

The amount of funds that each member can borrow from the IMF depends on its particular quota.
The financing by the IMF is measured in special drawing rights (SDRs). The SDR is not a
currency but simply a unit of account. It is an international reserve asset created by the IMF and
allocated to member countries to supplement currency reserves. The SDR’s value fluctuates in
accordance with the value of major currencies. The IMF played an active role in attempting to
reduce the adverse effects of the Asian crisis. In 1997 and 1998, it provided funding to various
Asian countries in exchange for promises from the respective governments to take specific
actions intended to improve economic conditions.

Funding Dilemma of the IMF

The IMF typically specifies economic reforms that a country must satisfy to receive IMF
funding. In this way, the IMF attempts to ensure that the country uses the funds properly.

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However, some countries want funding without adhering to the economic reforms required by
the IMF.

For example, the IMF may require that a government reduce its budget deficit as a condition for
receiving funding. Some governments have failed to implement the reforms required by the IMF.

IMF Funding during the Credit Crisis

In 2008, the IMF used $100 billion to provide short-term loans for temporary funding for
developing countries that were devastated by the credit crisis. These funds represented 50
percent of the IMF’s total resources. The IMF organized a $25 billion package of loans for
Hungary and a $16 billion loan for Ukraine. It also provided funding to some other Eastern
European countries and to Brazil, Mexico, and South Korea. The governments of Eastern Europe
had borrowed from European banks, and had they defaulted on their loans, more problems might
have been created for those banks that had provided loans.

World Bank

The International Bank for Reconstruction and Development (IBRD), also referred to as the
World Bank, was established in 1944. Its primary objective is to make loans to countries to
enhance economic development. For example, the World Bank recently extended a loan to
Mexico for about $4 billion over a 10-year period for environmental projects to facilitate
industrial development near the U.S. border. Its main source of funds is the sale of bonds and
other debt instruments to private investors and governments. The World Bank has a profit-
oriented philosophy. Therefore, its loans are not subsidized but are extended at market rates to
governments (and their agencies) that are likely to repay them.

A key aspect of the World Bank’s mission is the Structural Adjustment Loan (SAL),
established in 1980. The SALs are intended to enhance a country’s long-term economic growth.
For example, SALs have been provided to Turkey and to some less developed countries that are
attempting to improve their balance of trade. Because the World Bank provides only a small
portion of the financing needed by developing countries, it attempts to spread its funds by
entering into co-financing agreements. Co-financing is performed in the following ways:

• Official aid agencies. Development agencies may join the World Bank in financing
development projects in low-income countries.

• Export credit agencies. The World Bank co-finances some capital-intensive projects that are
also financed through export credit agencies.

• Commercial banks. The World Bank has joined with commercial banks to provide financing
for private-sector development. In recent years, more than 350 banks from all over the world
have participated in co-financing, including Bank of America, J.P. Morgan Chase, and Citigroup.

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The World Bank recently established the Multilateral Investment Guarantee Agency
(MIGA), which offers various forms of political risk insurance. This is an additional means
(along with its SALs) by which the World Bank can encourage the development of international
trade and investment.

The World Bank is one of the largest borrowers in the world; its borrowings have amounted to
the equivalent of $70 billion. Its loans are well diversified among numerous currencies and
countries, and it has received the highest credit rating (AAA) possible.

World Trade Organization

The World Trade Organization (WTO) was created as a result of the Uruguay Round of trade
negotiations that led to the GATT accord in 1993. This organization was established to provide a
forum for multilateral trade negotiations and to settle trade disputes related to the GATT accord.
It began its operations in 1995 with 81 member countries, and more countries have joined since
then. Member countries are given voting rights that are used to make judgments about trade
disputes and other issues.

International Financial Corporation

In 1956 the International Financial Corporation (IFC) was established to promote private
enterprise within countries. Composed of a number of member nations, the IFC works to
promote economic development through the private rather than the government sector. It not
only provides loans to corporations but also purchases stock, thereby becoming part owner in
some cases rather than just a creditor. The IFC typically provides 10 to 15 percent of the
necessary funds in the private enterprise projects in which it invests, and the remainder of the
project must be financed through other sources. Thus, the IFC acts as a catalyst, as opposed to a
sole supporter, for private enterprise development projects. It traditionally has obtained financing
from the World Bank but can borrow in the international financial markets.

FOREIGN EXCHANGE MARKETS

Foreign Exchange Quotations

Spot Market Interaction among Banks

At any given point in time, the exchange rate between two currencies should be similar across
the various banks that provide foreign exchange services. If there is a large discrepancy,
customers or other banks will purchase large amounts of a currency from whatever bank quotes a
relatively low price and immediately sell it to whatever bank quotes a relatively high price. Such
actions cause adjustments in the exchange rate quotations that eliminate any discrepancy.

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Bid/Ask Spread of Banks. Commercial banks charge fees for conducting foreign exchange
transactions. At any given point in time, a bank’s bid (buy) quote for a foreign currency will be
less than its ask (sell) quote. The bid/ask spread represents the differential between the bid and
ask quotes and is intended to cover the costs involved in accommodating requests to exchange
currencies. The bid/ask spread is normally expressed as a percentage of the ask quote.

EXAMPLE

To understand how a bid/ask spread could affect you, assume you have $1,000 and plan to travel
from the United States to the United Kingdom. Assume further that the bank’s bid rate for the
British pound is $1.52 and its ask rate is $1.60. Before leaving on your trip, you go to this bank
to exchange dollars for pounds. Your $1,000 will be converted to 625 pounds (£), as follows:

¿ $ 1,000
Amount of USD ¿ be Converted = =£ 625
Price charged by bank per pound $ 1.60

Now suppose that because of an emergency you cannot take the trip, and you reconvert the £625
back to U.S. dollars, just after purchasing the pounds. If the exchange rate has not changed, you
will receive

£625 × (Bank’s bid rate of $1.52 per pound) = $950

Due to the bid/ask spread, you have $50 (5 percent) less than what you started with. Obviously,
the dollar amount of the loss would be larger if you originally converted more than $1,000 into
pounds.

Due to the bid/ask spread, you have $50 (5 percent) less than what you started with. Obviously,
the dollar amount of the loss would be larger if you originally converted more than $1,000 into
pounds.

Comparison of Bid/Ask Spread among Currencies.

The differential between a bid quote and an ask quote will look much smaller for currencies that
have a smaller value. This differential can be standardized by measuring it as a percentage of the
currency’s spot rate.

Ask rate−Bid rate

Bid /ask spread=
Ask rate

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Cross-Exchange Rate Quotations

A cross-exchange rate is an exchange rate between a currency pair where neither currency is the
U.S. dollar. The cross-exchange rate can be calculated from the U.S. dollar exchange rates for
the two currencies, using either European or American term quotations. For example, the €/£
cross-rate can be calculated from American term quotations as follows:

S ($ /£ )
S( € I £)=
S( $ /€ )

Triangular arbitrage

Is the process of trading out of the a home currency into a second currency, then trading it for a
third currency, which is in turn traded for a home currency. The purpose is to earn an arbitrage
profit via trading from the second to the third currency when the direct exchange rate between
the two is not in alignment with the cross-exchange rate.

QUESTIONS

1. Give a full definition of arbitrage.

Answer: Arbitrage can be defined as the act of simultaneously buying and selling the same or
equivalent assets or commodities for the purpose of making certain, guaranteed profits.

2. Discuss the implications of the interest rate parity for the exchange rate determination.

Answer: Assuming that the forward exchange rate is roughly an unbiased predictor of the future
spot rate, IRP can be written as: S = [(1 + I£)/(1 + I$)]E[St+1[It]. The exchange rate is
thus determined by the relative interest rates, and the expected future spot rate, conditional on all
the available information, It, as of the present time. One thus can say that expectation is self-
fulfilling. Since the information set will be continuously updated as news hit the market, the
exchange rate will exhibit a highly dynamic, random behavior.

3. Explain the conditions under which the forward exchange rate will be an unbiased predictor
of the future spot exchange rate.

Answer: The forward exchange rate will be an unbiased predictor of the future spot rate if (I)
the risk premium is insignificant and (ii) foreign exchange markets are informational efficient.

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TERMS:

No separate legal tender:

The currency of another country circulates as the sole legal tender. Adopting such an
arrangement implies complete surrender of the monetary authorities' control over the domestic
monetary policy. Examples include Ecuador, EI Salvador, and Panama.

Currency board:

A currency board arrangement is a monetary arrangement based on an explicit 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. This implies that domestic currency is usually fully backed by foreign assets,
eliminating traditional central bank functions such as monetary control and lender of last resort,
and leaving little room for discretionary monetary policy. Examples include Hong Kong,
Bulgaria, and Lithuania.

Conventional peg:

For this category the country formally (de jure) pegs its currency at a fixed rate to another
currency or a basket of currencies, where the basket is formed, for example, from the currencies
of major trading or financial partners arid weights reflect the geographic distribution of trade,
services, or capital flows. The anchor currency or basket weights are public or notified to the
IMP. The country authorities stand ready to maintain the fixed parity through direct intervention
(i.e., via sale or purchase of foreign exchange in the market) or indirect intervention (e.g., via
exchange-rate-related use of interest rate policy, imposition of foreign exchange regulations,
exercise of moral suasion that constrains foreign exchange activity, or intervention by other
public institutions). There is no commitment to irrevocably keep the parity, but the formal
arrangement must be confirmed empirically: the exchange rate may fluctuate within narrow
margins of less than ± I percent around a central rate--or the maximum and minimum value of
the spot market exchange rate must remain within a narrow margin of 2 percent for at least six
months. Examples include Jordan, Saudi Arabia, and Morocco.

Stabilized arrangement:

Classification as a stabilized arrangement entails a spot market exchange rate that remains within
a margin of 2 percent for six months or more (with the exception of a specified number of
outliers or step adjustments) and is not floating. The required margin of stability can be met
either with respect to a single currency or a basket of currencies, where the anchor currency or
the basket is ascertained or confirmed using statistical techniques. Examples are China, Angola,
and Lebanon.

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Crawling peg: Classification as a crawling peg involves the confirmation of the country
authorities' de jure exchange rate arrangement. The currency is adjusted in small amounts at a
fixed rate or in response to changes in selected quantitative indicators, such as past inflation
differentials vis-a-vis major trading partners or differentials between the inflation target and
expected inflation in major trading partners. Examples are Bolivia, Iraq, and Nicaragua. Crawl-
like arrangement: The exchange rate must remain within a narrow margin of'2 percent relative to
a statistically identified trend for six months or more (with the exception of a specified number
of outliers), and the exchange rate arrangement cannot be considered as floating. Usually, a
minimum rate of change greater than allowed under a stabilized (peg-like) arrangement is
required. Ethiopia is an example.

Pegged exchange rate within horizontal bands:

The value of the currency is maintained within certain margins of fluctuation of at least ± 1
percent around a fixed central rate, or the margin between the maximum and minimum value of
the exchange rate exceeds 2 percent. Examples include Kazakhstan and Syria. Other managed
arrangement: This category is a residual, and is used when the' exchange rate arrangement does
not meet the criteria for any of the other categories. Arrangements characterized by frequent
shifts in policies may fall into this category. Examples are Costa Rica, Vietnam, and Russia.

Floating:

A floating exchange rate is largely market determined, without an ascertainable or predictable

path for the rate. In particular, an exchange rate that satisfies the statistical criteria for a stabilized
or a crawl-like arrangement will be classified as such unless it is clear that the stability of the
exchange rate is not the result of official actions. Foreign exchange market intervention may be
either direct or indirect, and serves to moderate the rate of change and prevent undue fluctuations
in the exchange rate, but policies targeting a specific level of the exchange rate are incompatible
with floating. Examples include Brazil, Mexico, Turkey, and India.

Free floating:

A floating exchange rate can be classified as free floating if intervention occurs only
exceptionally and aims to address disorderly market conditions and if the authorities have
provided information or data confirming that intervention has been limited to at most three
instances in the previous six months, each lasting no more than three business days. Examples
are Canada, Japan, Korea, D.K., U.S., and euro zone.

The European Currency Unit (ECU) is a "basket" currency constructed as a weighted average
of the currencies of member countries of the European Union (EU). The weights are based on
each currency's relative GNP and share in intra-EU trade. The ECD serves as the accounting unit
of the EMS and plays an important role in the workings of the exchange rate mechanism.

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The Exchange Rate Mechanism (ERM) refers to the procedure by which EMS member
countries collectively manage their exchange rates. The ERM is based on a "parity grid" system,
which is a system of par values among ERM currencies. The par values in the parity grid are
computed by first defining the par values of EMS currencies in terms of the ECD.

WHAT ARE THE BENEFITS OF MONETARY UNION?

1. Transaction cost reduction

2. The euro as an international currency

3. Reducing the risk of exchange rate fluctuation

4. Increased price transparency

5. Single market

6. Preventing competitive devaluation and speculation

THE BALAMCE OF PAYMENT

1. The balance of payments can be defined as the statistical record of a country's international
transactions over a certain period of time presented in the form of double-entry bookkeeping.

2. In the balance of payments, any transaction resulting in a receipt from foreigners is recorded
as a credit, with a positive sign, whereas any transaction resulting in a payment to foreigners is
recorded as a debit, with a minus sign.

3. A country's international transactions can be grouped into three main categories: the current
account, the capital account, and the official reserve account. The current account includes
exports and imports of goods and services, whereas the capital account includes all purchases
and sales of assets such as stocks, bonds, bank accounts, real estate, and businesses. The official
reserve account covers all purchases and sales of international reserve assets, such as dollars,
foreign exchanges, gold, and SDRs.

4. The current account is divided into four subcategories: merchandise trade, services, factor
income, and unilateral transfers. Merchandise trade represents exports and imports of tangible
goods, whereas trade in services includes payments and receipts for legal, engineering,
consulting, and other performed services and tourist expenditures. Factor income consists of
payments and receipts of interest, dividends, and other income on previously made foreign
investments. Lastly, unilateral transfer involves unrequited payments such as gifts, foreign aid,
and reparations.

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5. The capital account is divided into three subcategories: direct investment, portfolio
investment, and other investment. Direct investment involves acquisitions of controlling interests
in foreign businesses. Portfolio investment represents investments in foreign stocks and bonds
that do not involve acquisitions of control. Other investment includes bank deposits, currency
investment, trade credit, and the like.

6. When we compute the cumulative balance of payments including the current account, capital
account, and the statistical discrepancies, we obtain the overall balance or official settlement
balance. The overall balance is indicative of a country's balance-of-payments gap that must be
accommodated by official reserve transactions. If a country must make a net payment to
foreigners because of a balance-of payments deficit, the country should either run down its
official reserve assets, such as gold, foreign exchanges, and SDRs, or borrow anew from
foreigners.

7. A country can run a balance-of-payments surplus or deficit by increasing or decreasing its

official reserves. Under the fixed exchange rate regime, the combined balance on the current and
capital accounts will be equal in size, but opposite in sign, to the change in the official reserves.
Under the pure flexible exchange rate regime where the central bank does not maintain any
official reserves, a current account surplus or deficit must be matched by a capital account deficit
or surplus.

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