IFIN – Lecture 3

International monetary system

Balance of Payments

/Michał Dzieliński, Stockholm Business School 1

Commodity money
● For most of its 5,000-year history, the value of money
was derived from what it was made of.

/Michał Dzieliński, Stockholm Business School 2

The Gold Standard
● The Gold Standard (1876-1913) was a more practical
version of commodity money.
– “Rules of the game” were simple, each country set the
rate at which its currency unit could be converted to a
weight of gold.
– Currency exchange rates were in effect “fixed”.
– Expansionary monetary policy was limited to a
government’s supply of gold.
– Was in effect until the outbreak of WWI when the free
movement of gold was interrupted.
● During the subsequent inter-war years currencies were
allowed to fluctuate with substantial volatility.

/Michał Dzieliński, Stockholm Business School 3

The Bretton Woods system (1944-73)
● WWII was a catastrophe not just in terms of lives lost but
also for the economies of developed (European) countries.
● USA was the only country capable of supporting the global
economy, holding 60% of the world’s gold reserves.
● Thus, US dollar was declared the only currency convertible
to gold at a rate of $35 per ounce. All other currencies had
to maintain a fixed exchange rate to the dollar.
● This established the USD as the world’s reserve currency.
● To oversee the system, two institutions were created:
– The International Monetary Fund
– The International Bank for Reconstruction and
Development (The World Bank)

/Michał Dzieliński, Stockholm Business School 4

The Bretton Woods collapse
● The currency arrangement negotiated at Bretton Woods
worked fairly well during the post-WWII era of
reconstruction and growth in world trade.
● However, some problems were built into the system:
– the growing demand for dollars from foreigners
required heavy capital outflow from the USA…
– …which created inflationary pressure and undermined
the confidence in the ability to maintain the gold peg.
● Coupled with external shocks (Vietnam war, oil shock), it
forced the devaluation of the dollar, which was later
“floated” and the gold peg abandoned.

/Michał Dzieliński, Stockholm Business School 5

The floating dollar

/Michał Dzieliński, Stockholm Business School 6

What comes next?

Source: www.coinmarketcap.com

/Michał Dzieliński, Stockholm Business School 7

Typology of exchange rate regimes

/Michał Dzieliński, Stockholm Business School 8

Exchange rate regimes in practice

/Michał Dzieliński, Stockholm Business School 9

Why do different regimes exist?
● Fixed exchange rates are by definition stable. Isn’t that
always desirable?
● Depends on what you have to give up in return.
● The Impossible Trinity:
1. Exchange rate stability
2. Full financial integration
3. Monetary independence
● Financial integration means capital can freely flow in and
out of the country.
● Monetary independence = control of the money supply

/Michał Dzieliński, Stockholm Business School 10

The Impossible Trinity

/Michał Dzieliński, Stockholm Business School 11

The man who broke the Bank of England
● George Soros, founder of the Quantum Fund
● Is credited with pushing the UK out of the
ERM by building up a massive short position
in the pound (around USD 10bln)
● His profit was said to be around USD 1bln.
● Exchange Rate Mechanism was a precursor to the euro.
● A system of fixed exchange rates among participants.
● The UK signed up in Oct 1990 at 𝐺𝐵𝑃/𝐷𝐸𝑀 2.95 with a
floor of 2.77  below that the BoE had to intervene
● The rate was considered too high given that inflation in
UK was well above inflation in Germany.

/Michał Dzieliński, Stockholm Business School 12

The pound and the ERM
3.00 Change in UK reserves (USD bln) GDP/DEM 4
3
2.80
2

2.60 1
0
1990-10-01

1992-12-01
1990-12-01
1991-02-01
1991-04-01
1991-06-01

1991-08-01
1991-10-01
1991-12-01

1992-02-01

1992-04-01
1992-06-01
1992-08-01
1992-10-01

1993-02-01
1993-04-01
1993-06-01
2.40 -1
-2
2.20
-3
2.00 -4

● Things came to a head in September 1992, when…

● …after a particularly heavy rout on Wednesday 16th,
United Kingdom left the ERM.

/Michał Dzieliński, Stockholm Business School 13

Fixed or floating?
● A nation’s choice as to which currency regime to follow reflects
national priorities about:
– inflation, unemployment, interest rate levels,
– trade balances,
– and economic growth.
● The choice between fixed and flexible rates may change over
time as priorities change.
● Countries would prefer a fixed rate regime for the inherent anti-
inflationary pressure from stability in international prices.
● However, a fixed rate regime requires the central bank to
maintain large quantities of foreign currencies and gold to
defend the exchange rate.

/Michał Dzieliński, Stockholm Business School 14

Lessons for emerging economies

/Michał Dzieliński, Stockholm Business School 15

Exchange rate regimes over time

● As capital flows gain importance, more and more nations

embrace floating exchange rates.

/Michał Dzieliński, Stockholm Business School 16

Keeping track of international flows
● The measurement of all international economic
transactions between the residents of a country and
foreign residents is called the balance of payments (BoP)
● A BoP is a statement of cash flows over an interval of
time, typically one year.
– A credit is an event, such as the export of a good or
service, that records foreign exchange earned – an
inflow of foreign exchange to the country.
– A debit records foreign exchange spent, such as
payments for imports or purchases of services – an
outflow of foreign exchange.

/Michał Dzieliński, Stockholm Business School 17

The basics of BoP
● The BoP must balance – it cannot be in disequilibrium
unless something has not been counted or has been
counted improperly.
● The BoP has three major sub-accounts—the current
account, the capital account, and the financial account.
● In addition, the official reserves account tracks
government currency transactions.
● A fifth account, the net errors and omissions account is
produced to preserve the balance of the BOP.

/Michał Dzieliński, Stockholm Business School 18

BoP accounts - USA over the last decade

● The current and financial accounts dominate and typically move

in opposite directions!
● Current account  trade in goods and services
● Financial account  direct and portfolio investment (distinction
depends on the level of control)
● Negative entries in the reserves account mean reserves
actually increase.

/Michał Dzieliński, Stockholm Business School 19

Portfolio investment defined
● This is the net balance of capital that flows in and out of
the U.S. but does not reach the 10% threshold of direct
investment.

● The purchase of debt securities across borders is

classified as portfolio investment because debt securities
by definition do not provide the buyer with ownership or
control.

● Portfolio investment is motivated by a search for returns

rather than to control or manage the investment. (though
some are concerned about Chinese influence in the USA)

/Michał Dzieliński, Stockholm Business School 20

Mechanics of the BoP

/Michał Dzieliński, Stockholm Business School 21

Disentangling the BoP of USA

● US trade deficit is on the rise for 20 years…

/Michał Dzieliński, Stockholm Business School 22

Disentangling the BoP of USA

● …paid for by portfolio investment (debt).

/Michał Dzieliński, Stockholm Business School 23

Mechanics of the BoP

● Negative current account coupled with net financial

inflows are symptomatic of a country using debt to pay to
for its trade deficit.

/Michał Dzieliński, Stockholm Business School 24

China breaking the rules

● “Twin surplus” for the last 10 years.

/Michał Dzieliński, Stockholm Business School 25

 Twin surplus: reasons and consequences
● The twin surplus has two distinct (but related) drivers:
1. Massive increase in exports, mostly of goods
2. China becoming a very attractive location for
production – “the global factory”
● Where does all this money go?

millions of US dollars 2005 2006 2007 2008 2009 2010 2011 2012 2013
A. Current account 134,082 231,844 353,183 420,569 243,257 237,810 136,097 215,392 182,807
B. Capital account 4,102 4,020 3,099 3,051 3,938 4,630 5,446 4,272 3,052
C. Financial account 96,944 45,285 91,132 37,075 194,494 282,234 260,024 -36,038 323,151
D. Net errors and
omissions 15,847 3,502 13,237 18,859 -41,181 -53,016 -13,768 -87,071 -77,628
E. Reserves and related
items -250,975 -284,651 -460,651 -479,554 -400,508 -471,658 -387,799 -96,555 -431,382

/Michał Dzieliński, Stockholm Business School 26

Twin surplus: reasons and consequences
● China has amassed the largest foreign reserves in history.

600 4,000
USD bln
500
3,000
400
300 2,000
200
1,000
100
0 0

annual cumulative
● The reserves allow the Chinese government to manage the
value of the yuan and its impact on competitiveness.

/Michał Dzieliński, Stockholm Business School 27

 Thank you!

/Michał Dzieliński, Stockholm Business School 28

Hard pegs
● The most restrictive regime – basically implies giving up
control over own currency.

● Dollarization: Panama, Zimbabwe

● Currency boards: Hong Kong (USD), Bulgaria (EUR)

/Michał Dzieliński, Stockholm Business School 29

Soft pegs

● Typical fixed exchange rate regimes.

/Michał Dzieliński, Stockholm Business School 30

Floating exchange rates
● No explicit commitment to maintain a certain level of
exchange rate to any other currency.

● Rather, it is determined by market forces although some

government intervention is usually involved.

/Michał Dzieliński, Stockholm Business School 31