INTERNATIONAL MONETARY SYSTEM

• IMS has evolved over the course of centuries and

defines the overall financial environment in which
MNCs operate.
• IMS plays a crucial role in the financial
management of a MNC business and economic
and financial policies of a country.
• IMS will continue to evolve in the future as the
international business and political environment
of the global economy continues to change.
  
 

Specie Commodity Standard

• In earlier days trade payments were settled
through barter arrangement.
• On account of inconsistency and inconvenience,
traders began using metals like gold and silver to
settle the payments.
• Subsequently metals took the form of coins that
had the stamp of sovereignty on the basis of
weight and fineness of the metal and that was
the beginning of the Specie Commodity Standard.
• The coins were called ‘full-bodied’ coins meaning
that their value was equal to the value of the
metal contained in it.
  
 

Specie Commodity Standard

• Over a period of time other metals with a lower value
was mixed with gold coins, as a result value of the
metal came to be lower than the face value of the coin.
• These coins were known as ‘debased coins’.
• Full-bodied coins were primarily used for store of
value.
• To act as a store of value, coins must be reliably saved,
stored, and retrieved and also be usable as a medium
of exchange when it is retrieved.
• The value of the money must also remain stable over
time.
• The full-bodied coins were driven out of circulation by
the year 1560 by the debased coins.
  
 

Specie Commodity Standard

• The Coinage Act or the Mint Act of 1792 of the USA
established dollar as the monetary unit of the country,
declared it as a lawful tender and also fixed its value in
terms of gold and silver.
• The mint ratio between gold and silver was 1:15 in the
United States and 1:15.5 in France.
• The difference in the bimetallic standard between the US
and the France led to the export of gold from US to France
for the purchase of silver.
• This led to diminution of gold stock in the US and the
country was forced to adopt a monometallic silver
standard.
• Therefore in 1834, the 15:1 ratio of silver to gold was
changed to a 16:1 ratio by reducing the weight of the
nation's gold coinage.
• Now what is the impact on Dollar???
  
 

Specie Commodity Standard

• This created a new U.S. dollar that was backed
by 1.50 g (23.22 grains) of gold.
• However, the previous dollar had been
represented by 1.60 g (24.75 grains) of gold.
• The result of this revaluation, which was the
first ever devaluation of the U.S. dollar, was
that the value in gold of the dollar was
reduced by 6%.
  
 

Specie Commodity Standard

• In 1853, the weight of US silver coin was reduced.
This led to placing the nation effectively on the
gold standard.
• With the enactment of the National Banking Act
in 1863 by the US Government, the dollar
became the sole currency of the United States
and remains so today.
• The Bland Allison Act of 1878 required the
government to purchase between USD 2 million
and USD 4 million worth of silver bullion each
month at market prices and to coin it into Silver
dollars as a subsidy for the politically influential
silver producers.
  
 

Specie Commodity Standard

• The discovery of large silver deposits in the
western regions of the United States in the late
19th century created a political controversy.
• Due to the large influx of silver, the value of silver
in the nation's coinage dropped considerably.
• The Eastern banking and commercial interests
advocated a sound money policy and a switch to
the gold standard.
• The status of silver was slowly diminished
through a series of legislative changes from 1873
to 1900, when a gold standard was formally
adopted.
  
 

Gold Standard
• From 1876 to 1913, the exchange rates were dictated by
the gold standard.
• The gold standard lasted for nearly 40 years and the centre
of the international financial system during this period was
London, indicating the preeminence position it enjoyed
during the hey days of British rule across the globe.
• Every country adopting the gold standard had its own
traditional and customary norms.
• The fundamental rule of the gold standard was that each
country should set a par value for its currency in terms of
gold and enforce its value in commerce and trade.
• Thus each and every country has to establish the rate, at
which its currency should be converted into the weight of
gold.
  
 

Gold Standard
• A true gold standard came in 1900 with the
passage of the Gold Standard Act.
• Thus US made gold the sole legal-tender
coinage of the United States, and set the value
of the dollar at $ 20.67 per ounce (66.46 ¢/g)
of gold.
• This made the dollar convertible to 1.5 g
(23.22 grains), the same convertibility into
gold that was possible on the bimetallic
standard.
  
 

Features of Gold Standard

1. Country adopting the gold standard shall fix the
value of currency in terms of specific weight and
fineness of gold and guarantees a two way
convertibility
2. Export and import of gold shall be allowed so
that it can flow freely among the countries
adopting the gold standard
3. Apex monetary institution shall hold gold
reserves in relationship to the currency it has
issued and
4. Government shall allow unrestricted minting of
gold and melting of gold coins at the option of
the holder
  
 

Features of Gold Standard

• Since fixed weight of gold formed the basis for a
unit of currency and as free flow of gold was
permitted among the countries adopting the gold
standard, the gold standard carried an automatic
mechanism for domestic price stability, fixed
exchange rates and adjustment in balance of
payment.
• The exchange rate mechanism depended upon
the content of gold in different countries.
• Let us say that the pound sterling contained a half
ounce of gold and one dollar bill contained one
fourth ounce of gold, the exchange rate was fixed
at £ 1 = $ 2.
  
 

Features of Gold Standard

• The United States set the value of the dollar at $
20.67 per ounce of gold and the British pound
was pegged at £ 4.2474 per ounce of gold.
• Thus the dollar to pound ( $ / £ ) exchange rate
was determined as follows:
$ 20.67 per ounce of gold
--------------------------------- = $ 4.8665 per £
£ 4.2474 per ounce of gold
•  Todays Rate: GBP 1= USD 1.67
  
 

Features of Gold Standard

• The rate was known as the mint rate or the
mint exchange rate.
• The actual exchange rate remained close to
mint rate and the free flow of gold between
the two countries ensured not much deviation
in the exchange rate.
• This led to fixed parity between the currencies
and helped to preserve the value of each
individual currency in terms of gold.
  
 

Features of Gold Standard

• In the event of occurrence of a transportation cost or
transaction cost, the dollar pound exchange rate would
fluctuate above or below the fixed rate.
• Let us assume hypothetically that the value of the
dollar had depreciated to $ 5 per £.
• This will give an opportunity for the arbitrageurs to
move in.
• The arbitrageurs would buy one ounce of gold in the
US for $ 20.67and sell it in Great Britain for £ 4.24 and
then exchange the pound for the dollar in the forex
market for $ 5 x $ 4.24 = $ 21.20, thus making a profit
of $ 21.20 -$ 20.67 =$ 0.53 per ounce.
• This process would continue till the original parity was
established.
  
 

Features of Gold Standard

• Definition of 'Arbitrageur'
• A type of investor who attempts to profit from
price inefficiencies in the market by making
simultaneous trades that offset each other and
capturing risk-free profits.
• An arbitrageur would, for example, seek out price
discrepancies between currencies listed on more
than one exchange, and buy the undervalued
currency on one exchange while short selling the
same number of overvalued currency on another
exchange, thus capturing risk-free profits as the
prices on the two exchanges converge.
  
 

Features of Gold Standard

• The gold standard maintained a reasonable equilibrium
through the principles of price-specie flow mechanism.
• This arrangement restored automatic adjustment in
the balance of payments.
• Eg: in the event Great Britain faced a deficit on its trade
account leading to outflow of gold for trade settlement
and reducing the money supply with in the country, the
emerging deflation would make the British exports
competitive and the resultant rise in exports would
eventually wipe out any deficit on this account.
• On the other side, reduced money supply pushes up
the interest rate and the credit restrictions imposed by
the apex banks will push up the bank interest rate,
resulting in the foreign investment moving into the
economy and off-setting any deficit on the capital
account.
  
 

Decline of the Gold Standard

• The gold standard as an international monetary
system was accepted by most of the countries
until the First World War broke out in 1914.
• The warring nations required huge money supply
for financing the activities borne out of war.
• This was not possible under the gold standard.
• The strained relations among the warring nations
further impeded the free flow of gold from one
nation to another.
• The exchange rate parity hither to followed by
the various nations went hay wire.
  
 

Decline of the Gold Standard

• During WW I, US corporations had large debts payable to
European entities and they began liquidating their debts in
gold.
• USD to GBP exchange rate reached as high as $ 6.75, far
above the parity of $ 4.8665.
• This caused large outflow of gold. In July 1914, the New
York Stock Exchange was closed and the gold standard was
temporarily suspended.
• In order to defend the exchange value of the dollar, the US
Treasury issued emergency currency under the Aldrich-
Vreeland Act, and the newly-created Federal Reserve
organized a fund to clear the debts to foreign creditors.
• These efforts were largely successful, and the Aldrich-
Vreeland notes were retired starting in November 1914 and
the gold standard was restored and the NYSE re-opened in
December 1914.
• How did the US emerge stronger in WWI????
  
 

Decline of the Gold Standard

• From 1915-17, US remained neutral in the war
• US banned gold export, thereby suspending the gold
standard for foreign exchange.
• US demanded repayment of war debts from France
and France asked compensation from Germany to
meet the war debt.
• The United States finally joined the war in 1917.
• Now it enjoyed a huge trade surplus with the European
Nations.
• Hence the USD became stronger and the European
currencies became weaker and the US began to
assume the role of the leading creditor nation.
• For the above reasons, the gold standard was
suspended during WW I
  
 

Decline of the Gold Standard

• After the end of the WW I, the nations on Gold
Standard re-entered.
• The US returned to gold in 1919, Great Britain in
1925, France in 1926 and Switzerland in 1928.
• All other European countries followed soon after.
• The pound sterling returned at the old mint
exchange rate of $ 4.8665 per £.
• As Great Britain had liquidated most of its foreign
investment in financing the war and the pound
stood overvalued and completely exposed.
  
 

Decline of the Gold Standard

• A great depression swept the world in 1929 and lasted
for nearly ten years.
• The depression originated in the US, starting with the
stock market crash of Oct 1929, known as the Black
Tuesday but quickly spread to almost every country in
the world.
• During the period of great depression, almost every
major currency abandoned the gold standard.
• The Bank of England abandoned the gold standard in
1931 as speculators demanded gold in exchange for
currency. This pattern was repeated throughout Europe
and North America.
• In the US, the Federal Reserve was forced to raise
interest rates to protect the gold standard for the US
dollar.
  
 

Decline of the Gold Standard

• The production of gold during 1915-22 was
much lower and this resulted in a scramble for
gold.
• In early 1933, in order to fight the deflation,
the US suspended the gold standard except
for foreign exchange, revoked gold as
universal legal tender for debts, and banned
private ownership of significant amounts of
gold coin.
• After the US abandoned the gold standard,
other nations followed suit.
  
 

Gold Exchange Standard

• In the year 1934, the US returned to a modified gold
standard.
• For foreign exchange purposes, the set $ 20.67 per
ounce value of the dollar was lifted, allowing the dollar
to float freely in foreign exchange markets with no set
value in gold.
• This was however terminated after one year.
• The US finally devalued its dollar from the previous rate
of $ 20.67 per ounce to $ 35.00 per ounce, making the
dollar more attractive for foreign buyers.
• The higher price increased the conversion of gold into
dollars, allowing the US to effectively corner the world
gold market.
• The modified gold standard was known as the Gold
Exchange Standard.
 

Bretton Wood System

• Established in 1944 and named after the New Hampshire
town where the agreements were drawn up, the Bretton
Woods system created an international basis for
exchanging one currency for another.
• It also led to the creation of the International Monetary
Fund (IMF) and the International Bank for Reconstruction
and Development, now known as the World Bank.
• IMF was designed to monitor exchange rates and lend
reserve currencies to nations with trade deficits, the IBRD
to provide underdeveloped nations with needed capital
— although each institution's role has changed over time.
• Each of the 44 nations who joined the discussions at
Bretton Woods contributed a membership fee to fund
these institutions; the amount of each contribution
designated a country's economic ability and dictated its
number of votes.
 

Bretton Wood System

• The Bretton Woods system was history's first
example of a fully negotiated monetary order
intended to govern currency relations among
sovereign states.
• In principle, it was designed to combine legal
obligations with multilateral decision conducted
through an international organization the IMF.
• In practice, the initial scheme, as well as its
subsequent development and ultimate demise,
were directly dependent on the preferences and
policies of its most powerful member, the US.
 

Bretton Wood System

• Here a compromise was sought between the polar
alternatives of either freely floating or irrevocably
fixed rates.
• What emerged was the 'pegged rate' or 'adjustable
peg' currency regime, also known as the par value
system.
• Countries were obligated to declare a par value (a
'peg') for their national money and to intervene in
currency markets to limit exchange rate fluctuations
within maximum margins (a 'band') one per cent
above or below the parity
• Countries also retained the right to alter their par
value to correct a 'fundamental disequilibrium' in
their balance of payments.
 

Bretton Wood System

• What emerged largely reflected US preferences: a system
of subscriptions and quotas embedded in the IMF, which
itself was to be no more than a fixed pool of national
currencies and gold subscribed by each country.
• Countries were assigned quotas, roughly reflecting their
relative economic importance.
• The subscription was to be paid 25 % in gold or currency
convertible into gold (effectively the dollar, which was the
only currency then still directly gold convertible for
central banks) and 75 % in the country’s own money.
• Each country was then entitled, when short of reserves,
to borrow needed foreign currency in amounts
determined by the size of its quota
 

Bretton Wood System

• Nations were in principle forbidden to engage in discriminatory
currency practices or exchange regulation, with only two
practical exceptions.
• First, convertibility obligations were extended to current
international transactions only. Governments were to refrain
from regulating purchase and sale of currency for trade in
goods or services. They were formally encouraged to make use
of capital controls to maintain external balance in the face of
potentially destabilizing 'hot money' flows.
• Second, convertibility obligations could be deferred if a
member so chose during a postwar 'transitional period.'
Members deferring their convertibility obligations were known
as Article XIV countries and members accepting them were
known as Article VIII countries.
• One of the responsibilities assigned to the IMF was to oversee
this legal code governing currency convertibility.
 

Chronology of Bretton Wood System

• The chronology of the Bretton Woods system can be divided into
two periods: the period of 'dollar shortage," lasting roughly until
1958; and the period of 'dollar glut,' covering the remaining
decade and a half
• The period of the dollar shortage was the heyday of America's
monetary hegemony.
• The term 'dollar shortage,' universally used at the time, was
simply a shorthand expression for the fact that only the US was
then capable of assuring some degree of global monetary stability;
only the US could help other governments avoid a mutually
destructive scramble for gold by promoting an outflow of dollars
instead.
• Dollar deficits began in 1950, following a round of devaluations of
European currencies and shortfalls in the US balance of payments.
• The period upto 1958 was rightly called one of 'beneficial
disequilibrium.'
 

Chronology of Bretton Wood System

• The US balance of payments plunged to a $ 3.5 billion gap
in 1958 and to even larger deficits in 1959 and 1960.
• In 1958 Europe's currencies returned to convertibility.
• Subsequently, the eagerness of European governments to
obtain dollar reserves was transformed into what seemed
an equally fervent desire to avoid excess dollar
accumulations.
• Before 1958, less than 10 % of America's deficits had been
financed by calls on the US gold stock and the balance
being financed with dollars.
• During the next decade, almost two thirds of America's
cumulative deficit was transferred in the form of gold,
mostly to Europe. Bretton Woods was clearly coming under
strain.
 

Chronology of Bretton Wood System

• By Mid 60s, negotiations began to create the Special Drawing
Rights (SDR), an entirely new type of international reserve asset.
• Governments hoped that with SDRs in place, any future threat of
world liquidity shortage would be averted. On the other hand,
they were totally unprepared for the opposite threat - a reserve
surfeit - which is in fact eventually emerged in the late 1960s.
• Earlier in the decade a variety of defensive measures were
initiated in an effort to contain mounting speculative pressures
against the dollar.
• These included a network of reciprocal short term credit facilities
called swaps among the central banks as well as enlarged lending
authority for the IMF.
 

Chronology of Bretton Wood System

• By Mid 60s, negotiations began to create the Special Drawing
Rights (SDR), an entirely new type of international reserve
asset.
• Governments hoped that with SDRs in place, any future threat
of world liquidity shortage would be averted. On the other
hand, they were totally unprepared for the opposite threat - a
reserve surfeit - which is in fact eventually emerged in the late
1960s.
• Earlier in the decade a variety of defensive measures were
initiated in an effort to contain mounting speculative pressures
against the dollar.
• These included a network of reciprocal short term credit
facilities called swaps among the central banks as well as
enlarged lending authority for the IMF.
 

Chronology of Bretton Wood System

• A second source of strain was inherent in the structure of the par
value system: How could governments be expected to change
their exchange rates if they can not even tell when a fundamental
disequilibrium existed?
• And if they were inhibited from re-pegging the rates, then how
would international payments equilibrium be maintained?
• The Bretton Woods system rested on one simple assumption - that
economic policy in the US would stabilize.
• During the first half of the 1960s, America's foreign deficit actually
shrank as a result of a variety of corrective measures adopted at
home. After 1965, however, US became increasingly destabilized,
as a result of increased government spending on social programs
at home and an escalating war in Vietnam. America's economy
began to overheat and inflation began to gain momentum, causing
deficits to widen once again.
 

Chronology of Bretton Wood System

• Inflation everywhere began to accelerate, exposing all
the latent problems of Bretton Woods.
• The pegged rate system was incapable of coping with
widening payments imbalances, and the confidence
problem was worsening as speculators were encouraged
to bet on devaluation of the dollar or revaluations of the
currencies of Europe or Japan.
• On 15 August 1971, the Richard Nixon administration
suspended the convertibility of the dollar into gold,
freeing the greenback to find its own level in currency
markets.
  
 

Smithsonian Arrangement
• From Aug to Dec 1971, most of the major currencies
were allowed to fluctuate.
• The US dollar dropped in value against a number of
major currencies.
• Several nations imposed trade and exchange controls
and it was feared that such protective measures might
endanger the institution on international commerce and
trade.
• To mitigate these problems, the worlds leading trading
countries called ‘Group of Ten’ met at the Smithsonian
Institute in Washington DC and formed the Smithsonian
arrangement to restore stability of the system.
  
 

Smithsonian Arrangement
• Smithsonian arrangement called for realignment of the
par value of major currencies to conform to their
realistic values.
• Gold parity of the US dollar was changed from $ 35 to $
38.02 per troy ounce of gold resulting in devaluation of
8.57%.
• Currencies of surplus countries were revalued upwards
by percentages ranging from 7.4% in respect of the
Canadian dollar to 16.9% in respect of the Japanese yen.
• Currencies were permitted to fluctuate over a wider
band than in the past.
  
 

Smithsonian Arrangement
• Although a currency was allowed to fluctuate with in a
margin of 2.25% from the central rates without the
government intervention, it could fluctuate by as much
as 9% against any currency except the dollar.
• Since a currency was permitted to fluctuate up to 2.25%
on either side of the central rat,, its total fluctuation
against the dollar could be as high as 4.5%.
• Purpose of Smithsonian arrangement was to infuse
greater flexibility into the par value system.
  
 

Case Study 4 :Greece Economy

• In the beginning of 2009, the Greece economy collapsed
and the country was bailed out to the tune of over $100
billion.
• Unions and the socialists are upset that the Greek
government has to cut their pay and benefits to just
keep them employed.
• Greece already has a VAT of 21 % which has been
increased to 23% after the collapse.
• Imagine 23% being added to the cost of everything you
buy.
• Greece has announced a 20% pay cut to public
employees and a hiring freeze for the next 3-5 years.
  
 

Case Study 4 :Greece Economy

• Today Greece roughly has a debt of 150 % of GDP.
Q
• i) Analyse the real issue of the collapse of the Greece
economy.
• ii) What is happening in Europe can and may very well
happen in India. Discuss
• iii) A bloated broke government that can’t pay for it’s
own survival is a recipe for new taxes and one other
thing, a disaster. Comment in Detail.