International Finance Mahdi Ahmadyar

Bakhtar University S12BBA0059

INTERNATIONAL MONETARY SYSTEMS

Definition: International monetary system refers to the set of

policies, institutions, practices, regulations, and
mechanisms that determine the rate at which one
currency is exchanged for another.

I. ALTERNATIVE EXCHANGE RATE SYSTEMS

FLOATING RATE SYSTEMS

 Exchange rates are determined by the interaction of currency

demand and supply, without direct intervention by
government authorities.

 As exchange rates change continuously, it is difficult to know

how much a future foreign currency cash flow will be worth.

 What influences the supply and demand for foreign

currencies?

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MANAGED FLOAT SYSTEMS

 Many countries, such as the U.S. and Japan, with floating

currencies have attempted, via central bank intervention, to
smooth out exchange rate fluctuations. Such a system of
managed exchange rates is called a managed float.

 Three categories of central bank intervention:

1. Short-term: Smoothing out daily fluctuations

2. Intermediate-term: "Leaning against the wind"

3. Unofficial pegging

TARGET ZONE ARRANGEMENT

 Exchange rates are maintained within a specific margin

around agreed-upon, fixed central exchange rates.

 European Monetary System (EMS)

 The EMS began operating in March 1979. Its purpose is to

foster monetary stability in the European Community
(EC).

 European Currency Unit (ECU)

 A currency unit which is a weighted average of a fixed

amounts of currencies in the region. The weights are
determined by the relative strengths of each country.

– The ECU functioned as a unit of account, as a means of

settlement, and as a reserve asset for the members of the
EMS.

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 Exchange Rate Mechanism (ERM)

– Each currency has an agreed upon central rate

denominated in ECU. The central rate can be adjusted
under appropriate circumstances.

– Bilateral cross-rates are determined from the central

rates.

– Central banks try to limit exchange rate fluctuations

around the central rates.

 ECU to EURO (€)

– On January 1, 1999, the member states of the EU

initiated the European Monetary Unification (EMU),
the establishment of a single currency for Europe.

– Euro notes and coins will not begin to circulate until

January 1, 2002.

– From January 1 until July 1, 2002, euro currency will

circulate jointly with national monies and both may be
used for cash transactions. After July 1, 2002 the
national monies will no longer be a legal tender and
only euros may be used.

 What have we learned from the EMS, regarding the

problems that a target-zone system is likely to encounter?

– Maintenance of a target-zone arrangement requires

close coordination of macroeconomic policies.

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FIXED RATE SYSTEMS

 Central banks must buy or sell the currency in order to

maintain the exchange rate at a determined level (in practice,
within a narrow pre-determined range).

 When will a central bank buy foreign exchange?

 If fixed exchange rates can be maintained, these systems are

attractive because the value of foreign currency cash flow is
known.

 Problems

 Fixed rates forge a direct link between domestic and

foreign inflation rates.

 When exchange rate corrections arrive, they are usually

large.

 When the government cannot sustain the fixed rates, the

currency is either devalued or revalued.

 Devaluation of a currency, in its narrow and semantically

correct sense, refers to a drop in the foreign exchange
value of a currency that is pegged to gold or to another
currency. In other words, the par value is reduced. The
opposite of devaluation is revaluation.

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 Fixed versus Flexible exchange rates

 The key arguments for flexible exchange rates rest on (i)

easier external adjustments and (ii) national policy
autonomy.

– As long as the exchange rate is allowed to be

determined according to market forces, external balance
will be achieved automatically.

– With flexible exchange rates, government can use its

monetary and fiscal policies to pursue whatever
economic goals it chooses. Under a fixed rate regime,
the government may have to take contractionary
(expansionary) monetary and fiscal policies to correct
the BOP deficit (surplus) at the existing exchange rate.

 A possible drawback of a flexible exchange rate regime is

that exchange rate uncertainty may hamper international
trade and investment, whereas fixed rates provide stability
in international prices for the conduct of trade.

 A “good” (or ideal) international monetary system should

provide (i) liquidity, (ii) adjustment, and (iii) confidence.

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II. HISTORY OF THE INTERNATIONAL MONETARY
SYSTEMS

BRETTON WOODS AGREEMENT

 Bretton Woods was named after the site at which it took

place. The agreement lasted from 1946 until 1971.

 Under the Bretton Woods System, the U.S. dollar was

convertible into gold at $35/ounce.

 Other currencies were pegged to the US$ or gold.

Example: The German DM was set equal to 1/140 th of an

ounce of gold, or about $0.25.

 Under this form of gold exchange standard, only the U.S.

dollars were convertible into gold at the official par value.

Other member nations were not required to exchange their

currency for gold, but pledged to intervene in the currency
markets if their currency moved more than 1% from its
official rate.

 The Bretton Woods conference created two well-known

institutions to implement this fixed-rate system. They are the
International Monetary Fund (IMF) and the World Bank.

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POST BRETTON WOODS (Exhibit 3.1)

 After the 1973-74 Oil Crisis (270-310 ¥/$)

US: High inflation, stagnant economy.

Growing government budget deficit.
Current account deficit.

Japan: High inflation rate, but fell quickly.

Current account surplus starts to increase due to
weak yen.

 1977-78 (260-210 ¥/$)

US: Fed switched its policy to stabilizing money supply than

interest rates. Growing government deficit leads to
higher interest rates.

 1978-83 (around 220-250 ¥/$)

Reaganomics: Lower inflation and high interest rates.

Capital inflow due to high interest rates and
strong dollar.

Japan: More current account surplus due to the strong dollar

(cheap yen).

 1985-87 (250 to 120 ¥/$)

US: Stagnant economy and the sinking dollar. Slow growth

relative to other economies.
Government deficit.

Japan: Period of a bubble – High yen, high stock market, high

interest rates

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 1988-90 (120-150 ¥/$), 1990-94 (130-100 ¥/$), 1995 (100-80
¥/$)

Japan: Burst of the bubble, stagnant economy, even higher

yen.

 1996: Back to around 100¥, and $ up to 120¥ in January 1997

and 146¥ in June 1998.

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III. THE INTERNATIONAL MONETARY FUND

 The IMF is the key institution in the current international

monetary system.

 The IMF was created to administer a code of fair exchange

practices and provide compensatory financial assistance to
member countries with BOP difficulties.

 Membership and quotas

 To carry out its task, the IMF was originally funded by

each member subscribing to a quota based on expected
post-World War II trade patterns.

 Relative size of quotas is important as a determinant of

voting power. The industrialized countries have always
maintained voting control because they supply most of the
quotas.

 In addition to its quota resources, the IMF has access

under certain circumstances to funds that it borrows in the
world’s capital markets.

 Special Drawing Rights

 The SDR is an international reserve asset created by the

IMF to supplement existing foreign exchange reserves.

 Defined initially in terms of a fixed quantity of gold, the

SDR has been redefined several times. It is currently the
weighted value of currencies of the five IMF members
having the largest exports of goods and services.

 Individual countries hold SDRs in the form of deposits in

the IMF. These holdings are part of each country’s
international monetary reserves.

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I. THE CASE OF HONG KONG

 A fixed exchange rate system against the US dollar, at

US$1=HK$7.80, established in 1983.

CURRENCY BOARD SYSTEM

 Definition: A currency board is a system aimed at

establishing a fixed exchange rate between the domestic
currency and an external currency. A currency board fixes its
exchange rate by making a commitment to exchange
domestic currency for foreign currency at a pre-specified rate.

 Local currency in circulation, therefore, needs to be at least

100% backed by foreign reserves. Local notes are issued only
when there is a demand for foreign exchange to be converted
into the local currency.

 CB reserves are invested in low-risk assets mainly

denominated in the reserve currency, earning interest.

 Under a traditional currency board system, interest rates bear

the burden of adjusting to market forces. The monetary base
is completely flexible.

A capital outflow (which pushes down the value of a floating

domestic currency) causes a contraction in the money supply
and pushes up interest rates. Higher interest rates, in turn,
induce capital inflow, reversing the original outflow, and
stabilizing the exchange rate.

The possibilities of arbitrage imply that interest rates would

not persistently deviate much from those applicable to the
reserve currency.

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 Currency Attack:

In the case of a currency attack, the monetary base will have

to shrink under the currency board system and may easily
lead a liquidity crunch (of local currency) and banking crisis.
This happened in Argentina in 1995. But Argentina was able
to hold onto the peg to the US$.

THE HONG KONG CURRENCY BOARD

 HK dollar is fully backed by the US dollar.

[Reserve US$ held by the Hong Kong Monetary Authority]

× [ Promised exchange rate  HK$7.80/US$]
= [Level of monetary base in HK$]

 With a currency board system, HKMA never runs out of

foreign currency, even if everyone who held HK$ wanted to
convert to US$, i.e., a currency attack. Thus, it is easy to
avoid currency devaluation.

In fact, HK Government has far more US dollar asset than the

HK$ monetary base converted to US$. The US$ asset is
technically managed by the Exchange Fund.

 When the note-issuing banks (NIBs) need to issue HK$ notes,

they submit US dollars to the Exchange Fund (EF) in return
for non-interest-bearing Certificates of Indebtedness (CIs) at
the fixed rate of HK$7.80:US$1.

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 Today, we have more developed and “deep” monetary
systems, so that currency in circulation no longer means
money supply, and it is the interbank balance, not the total
money supply, that determines interest rates.

Modern currency boards require the interbank clearing

balance to be backed by foreign exchange reserves in
addition to the stock of currency in circulation.

Capital outflow (downward pressure on HK$)  B   i 

 capital inflow (HK$ strengthens)

Capital inflow (upward pressure on HK$)  B   i  

capital outflow (HK$ weakens)

 Before 1988: HongkongBank had all the control!

 The HongkongBank (HKB) assumed the role of clearing

house for all commercial banks. Interbank payments were
settled at the end of each working day at the HKB.

 The settlement system was characterized by a three-tiered

structure:
(i) Management Bank of the Clearing House of the Hong
Kong Association of Banks, HKB;
(ii) 10 Settlement Banks; and
(iii) 159 Subsettlement Banks.

 Each bank kept a non-interest bearing clearing account

with a respective bank one level up the hierarchy. Negative
balances were penalized.

 The HKB had the unique ability to influence the interbank

market and, in turn, interest rates.

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 July 1988: Accounting Arrangements

 The “Accounting Arrangements” agreed between the EF

and the HKB required HKB to maintain a “Balance” with
the EF, equivalent to that of its net clearing balance
(NCB) – the net amount of funds that all other banks place
with it.

The “Balance” is non-interest bearing and represents a

level of interbank liquidity.

 NCB > Balance  HKB pays penalty interest to the EF.

NCB < Balance  There is an opportunity cost to HKB.

 The Accounting Agreements transferred control over

interbank liquidity from the HKB to the EF.

Note: A small open economy with a fixed exchange rate

cannot have an independent monetary policy. HK’s money
supply is determined by its balance of payments. The EF
can influence interbank liquidity and interest rates, but not
the money supply.

 March 1990: Exchange Fund Bills

 The EF began issuing short-term EF Bills in March 1990

and EF Notes in May 1993, as instruments for banks to
manage their liquidity.

Banks enter into swap or repurchase agreements with the

EF to obtain HK$ liquidity when needed.

 The Bills and Notes do not exist as physical securities but

only as book entries. All transactions are paperless.

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 June 1992: Liquidity Adjustment Facility (LAF)

 The LAF, HK’s version of a discount window, operated

daily after the close of the HK$ interbank market.

 Overnight liquidity assistance could be obtained through

entering overnight repo (repurchase agreements) of
eligible securities.

If banks had surplus funds in their settlement accounts

(which do not earn any interest), they had the incentive to
lend the funds to the HKMA through the LAF at the LAF
Bid Rate (which stood at 4% just before it was abolished
in September 1998).

Other banks that found themselves with a negative

balance, could borrow at the LAF Offer Rate (7% until
September 1998).

 The LAF Bid and Offer Rates were the benchmark interest
rates, and were kept close to the US Federal Funds Rate.

 In theory, HK’s overnight HIBOR should stay within the

LAF Bid and Offer Rates.

 April 1993: The Establishment of the HKMA

The HKMA was formally established on April 1, 1993,

merging the Office of the Exchange Fund (responsible for the
management of foreign exchange reserves), the Monetary
Affairs Branch of the Government and the Office of the
Commissioner of Banking.

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 December 1996: Implementation of the RTGS System

 The Real Time Gross Settlement (RTGS) system was put in

place in December 1996.

 Interbank clearing switched from HKB to the Hongkong

Interbank Clearing Limited (HKIC) under the HKMA.

 Each of the 175 licensed commercial banks now keeps a

clearing account with the HKIC. Transactions are settled
gross and real-time. These (non-interest bearing) clearing
accounts constitute the aggregate balance of settlement
accounts.

 Under the RTGS system, each transaction between two

licensed banks needs to be adequately funded prior to
settlement. No negative settlement balance is allowed at
any time for any bank.

Intraday liquidity can be obtained through conducting

intraday repos of eligible securities with the HKMA.
These intraday loans, by definition, must be repaid by the
end of the working day.

 September 1998: Seven-Point Measures

 Following a period of frequent speculative attacks on the

HK$, the HKMA unveiled major changes to the monetary
system on September 5, 1998. The aim was to strengthen
the currency board arrangement and restore confidence in
the linked exchange rate.

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 Seven Technical Measures

1. Convertibility: The HKMA has extended the

convertibility undertaking by the currency board from
only currency in circulation (at HK$7.80:US$1) to
include commercial banks’ clearing balances (at
HK$7.75:US$1).

However, the HKMA does not guarantee conversion for

banks for funds from US$ to HK$ at a fixed rate. It,
thus, remains the banks’ responsibility to ensure that
there are sufficient HK$ in the clearing accounts upon
settlement.

2. Bid Rate of the LAF is removed. Banks will, therefore,

no longer deposit funds with the HKMA overnight and
will seek to lend out all their funds during the day in the
interbank market.

3. The LAF is renamed the Discount Window (DW). The

LAF Offer Rate is renamed the Base Rate (BR) based
on which discount rates for use in overnight repos are
calculated.

The BR will be announced each morning before the

market opens. Initially, the BR will be the average of
the overnight and 1-month HIBOR of the previous day.
Eventually, a methodology will be developed so as to
make BR determination transparent and automatic.

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4. Banks are given greater access to day-end liquidity
through repos at the DW using EF paper, which is fully
backed by the foreign exchange reserves.

The restriction that discourages “repeated borrowing”

through penal interest rates is removed, which
effectively makes EF paper fully transferable with
clearing balances.

5. New EF paper will only be issued upon foreign capital

inflow, so as to make the backing more credible. (As at
the end of August, foreign exchange reserves, including
unsettled contracts, still represented 3.6 times the
enlarged monetary base.)

6. The first half of each licensed bank’s EF paper holdings

will be discounted at BR, and the next half will be
discounted at BR+5% or overnight HIBOR, whichever
is higher.

7. With regard to existing eligible papers for LAF

discounting, AAA-rated paper and Specified
Instruments will follow the discount rate schedule
outlined in Measure 6, while other eligible papers will
be discounted at a 25bp premium. The repeated
borrowing penalty continues to apply to instruments
other than EF paper. No new issues of paper other than
EF paper will be eligible at the DW.

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 Three Points to Note

1. A licensed bank, if perceived to be abusing the DW in

an attempt to “facilitate manipulation that may
destabilize the currency or money markets”, can be
denied access to the DW.

2. The HKMA is responsible for managing the fiscal

reserves and will remain active in the foreign exchange
and money markets in response to the need to provide
funding for the budget deficit.

3. The HKMA remains alert to extreme conditions in the

interbank market and reserves the right to lend and
borrow in the market to dampen these conditions.

 What are the major effects of the Seven-Point Measures?

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SPECULATIVE ATTACKS ON THE HK DOLLAR

 An Example:

Assume a current exchange rate of HK$7.75:US$1.

A customer of Bank A sells HK$7.75 billion by instructing

the bank to debit his HK$ account by HK$7.75 billion and
credit his US$ account by US$1 billion.

 Any bank, facing this particular customer instruction,

would not maintain such a large currency mismatch
between its assets and liabilities and hence would seek to
square its position by selling HK$ in the foreign exchange
market in exchange for US$.

 If the sale of HK$ is so large that there are not enough

buyers to absorb them all, the HKMA will become the
residual buyer.

 The institution that Bank A sells HK$ in the foreign

exchange market will have to deliver the sum of HK$ in
two days’ time.

 What would happen to the interest rates? Why?

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 The Mexican Crisis: January 1995 (Exhibit 3.2)

 Despite a balanced budget inflation of 27% (versus 150%

in 1987), Mexico had two problems:

1. Foreign currency reserves fell from $30 billion in early

1994 to only $5 billion by November 1994 as the
government pegged the peso at artificially high levels.
2. Commercial banks and the government had rolled over
$23 billion of short-term peso debt into similar short-
term tesebonos whose principal was indexed to the
dollar. These obligations rose with the value of the
dollar.

 December 1994 - January 1995: Peso fell 50% against the

dollar, doubling the peso value of Mexico’s tesebono
obligations.

 Mexico’s peso crisis was severe but relatively short-lived.

 During the Mexican peso crisis in January 1995, the HK$

came under a speculative attack and depreciated from
HK$7.7375:US$1 at the beginning of the year to
HK$7.7725:US$1 on January 12.

 The Asian Financial Crisis: October 1997 (Exhibit 3.3)

 Thailand fell first, with problems that resembled Mexico’s.

 Like Thailand, Indonesia and Korea suffered from fixed

exchange rates, large current account deficits, large
amounts of short-term foreign currency debt used to
support speculative property ventures, and declining
competitiveness.

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 Hong Kong:

Selling pressure on HK$ intensified on October 21,

following the devaluation of the NT dollar. The HKMA
absorbed a substantial amount of HK$ on October 21, to
be settled on October 23 (Black Thursday).

On Thursday morning, the aggregate balance totaled HK$2

billion but as much as HK$6 billion was due to be settled
on that day. This was the amount that banks sold to the
currency board on behalf of their customers on Tuesday.

In the face of this acute shortage of HK$ liquidity and in

fear of being penalized for repeatedly using the LAF,
banks bid aggressively in the interbank market for HK$
funds during the morning of October 23. Overnight
HIBOR shot up to nearly 300% just before noon.

In the end, HK$ were bought back from the HKMA, some
for early settlement. The demand for HK$ drove the
exchange rate as high as HK$7.50:US$1 in the afternoon.

The HK$ that were bought were due for settlement until
the following Monday (October 27) so banks ended up
having to borrow HK$ at very high interbank rates to
cover their positions over the weekend.

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 Exhibit 3.1
Nominal Value of the US$ under Floating Rates, 1961-1995

22
 Exhibit 3.2
Mexican Peso Crisis

1.2

1.0

0.8 Mexican stock market value, in peso

(December 31, 1993 = 1.00)

0.6

0.4

0.2

1994 1995

Exhibit 3.3
Asian Contagion
(December 31, 1996 = 1.00)
1.2

1.0

0.8

Thai bhat
0.6
Korean won
0.4

Indonesian rupiah
0.2

0.0
1996 1997 1998

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