Brief history and Some important concepts

The International monetary system, World Bank, Exchange regime,

Eurocurrency, Eurodollar, The birth of Euro. Etc.

New institutions in the post-war International monetary system

• International Monetary Fund (IMF)• The International Bank for Reconstruction and

Development (World Bank)

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International Monetary Fund (IMF)

– The International Monetary Fund was created to:

• Help countries defend their currencies against cyclical, seasonal, or random occurrences

• Assist countries having structural trade problems if they promise to take adequate steps to correct these problems

• Special Drawing Right (SDR) is the IMF reserve asset, currently a weighted average of four currencies

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The role of IMF

Managing director of IMF Christine Lagarde interview on StGallen Symposium: 2nd , May http://t.co/AXwcb24Zyy •3 points for recovering world economy:Monetary policy combined with fiscal consolidation where it is needed at the right paceUnleash entrepreneurial potential

Q: Banking union? What lies ahead? Would EU in its current form survive? Watch the video.

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The role of World Bank

• The World Bank helped fund post-war reconstruction and has since then supported general economic development

” We are not a bank in the ordinary sense but a unique partnership to reduce poverty and support development.”

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President of WB: Jim Yong Kim

Five Institutions, One GroupThe World Bank Group organization chart

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The World Bank mission: reduce poverty worldwide

Among others, combating Financial Crisis. Moving swiftly, the Bank Group expands and speeds up lending, assistance and advice to hard-hit developing countries. In fiscal year 2009, the Bank Group committed nearly $60 billion to support countries affected by the crisis, a 54% increase over the previous year, and a record high for the institution.Watch a video of Jim Yong Kim at Georgetown University: http://www.youtube.com/watch?v=2ebIoJOkEWs

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Exhibit 3.1 The Evolution of Capital Mobility

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Eurocurrency and Libor

• Eurocurrencies (p27-p29)– domestic currencies of one country deposited in

another country. (consists of Eurodollar market. Euroyen, Euroeuro,

Eurosterling)Eurodollar: U.S.-dollar denominated deposits at

foreign banks or foreign branches of American banks locating outside of the United States

– Eurodollars escape regulation by the Federal Reserve Board.

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• Eurocurrency Interest Rates: Libor– In the Eurocurrency market, the reference rate of

interest is the London Interbank Offered Rate (LIBOR)

This rate is the most widely accepted rate of interest used in standardized quotations, loan agreements, and financial derivatives transactions

– There are Pibor, Fibor Mibor (before 1999), Stibor (Stockholm Interbank Offered Rate) and now Euribor

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History of the International Monetary System

History of the International Monetary System

• Fixed Exchange Rates (1945-1973)

– The currency arrangement negotiated at Bretton Woods and monitored by the IMF worked fairly well during the post-WWII era of reconstruction and growth in world trade

– The US dollar became the main reserve currency held by central banks

– Eventually, the heavy overhang of dollars held by foreigners resulted in a lack of confidence in the ability of the US to met its commitment to convert dollars to gold

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History of the International Monetary System

– The lack of confidence forced President Richard Nixon to suspend official purchases or sales of gold by the US Treasury on August 15, 1971

– This resulted in subsequent devaluations of the dollar

– Most currencies were allowed to float to levels determined by market forces as of March, 1973

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History of the International Monetary System

• An Eclectic Currency Arrangement (1973 – Present)– Since March 1973, exchange rates have become

much more volatile and less predictable than they were during the “fixed” period

– There have been numerous, significant world currency events over the past 30 years

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Exhibit 3.2 The IMF’s Exchange Rate Index of the Dollar

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Exhibit 3.3 World Currency Events, 1971-2011

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Exhibit 3.3 World

Currency Events,

1971-2011(cont.)

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Exhibit 3.6 The U.S. Dollar/Euro Rate, 1999 - 2011

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US dollar/Euro ($/€) 04,01,1999-13,05,2013source: ECB

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JPY vs. Euro rate (04,01,1999-13,05,2013) source: ECB

CNY vs. EUR (2005-2013)

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The IMF’s Exchange Rate Regime Classifications

• The International Monetary Fund classifies all exchange rate regimes into eight specific categories

– Exchange arrangements with no separate legal tender– Currency board– Other conventional fixed peg– Pegged exchange rates within horizontal bands– Crawling pegs– Exchange rates within crawling pegs– Managed floating– Independent floating

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The IMF’s Exchange Rate Regime Classifications

Exhibit 3.4 presents the IMF’s regime classification methodology in effect since January 2009

•Category 1: Hard Pegs– Countries that have given up their own sovereignty over monetary

policy E.g., dollarization or currency boards

•Category 2: Soft Pegs– AKA fixed exchange rates, with five subcategories of classification

•Category 3: Floating Arrangements– Mostly market driven, these may be free floating or floating with

occasional government intervention•Category 4: Residual

– The remains of currency arrangements that don’t well fit the previous categorizations

Exhibit 3.4 IMF Exchange Rate Classifications

Exhibit 3.4 IMF Exchange Rate Classifications (cont.)

Fixed Versus Flexible Exchange Rates

• A nation’s choice of currency regime to follow depends on many variables:– inflation, – unemployment, – interest rate levels, – trade balances, and – economic growth.

• The choice between fixed and flexible rates may change over time as priorities change.

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Fixed Versus Flexible Exchange Rates Fixed rate regime has advantages and

disadvantages: stability in international prices inherent anti-inflationary nature of fixed prices

but: Need for central banks to maintain large

quantities of hard currencies and gold to defend the fixed rate

Fixed rates can become incompatible with economic fundamentals as time goes.

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Emerging Markets and Currency Regime Choices

Currency board regime

a country’s central bank commits to back its monetary base (its money supply) entirely with foreign reserves. 1 Argentina Peso=1 USD

This means that a unit of domestic currency cannot be introduced into the economy without an additional unit of foreign exchange reserves being obtained first.

I. Argentina moved from a managed exchange rate to a currency board in 1991

II. In 2002, the country ended the currency board as a result of substantial economic and political turmoil

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Exhibit 3.8 The Currency Regime Choices for Emerging Markets

Emerging Markets and Regime Choices

• Dollarization is the use of the US dollar as the official currency of the country.– Panama has used the dollar as its official currency

since 1907– Ecuador replaced its domestic currency with the

US dollar in September, 2000 Exhibit 3.7 shows Ecuadorian Sucre movement vs the U.S. Dollar

prior to Dollarization

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Exhibit 3.7 The Ecuadorian Sucre/U.S. Dollar Exchange Rate, November 1998-March 2000

Currency Regime Choices for Emerging Markets

• Some experts suggest countries will be forced to extremes when choosing currency regimes - either a hard peg or free-floating(Exhibit 3.8)

• Three common features that make emerging market choices difficult:1. weak fiscal, financial and monetary institutions2. tendencies for commerce to allow currency substitution and the

denomination of liabilities in dollars3. the emerging market’s vulnerability to sudden stoppages of outside

capital flows

The Euro: Birth of a European Currency• In December 1991, the members of the

European Union met at Maastricht, the Netherlands to finalize a treaty that changed Europe’s currency future.

• This treaty set out a timetable and a plan to replace all individual ECU currencies with a single currency: the euro.

View Funding fathers of Euro (http://www.ecb.int/events/conferences/html/symposium_video.en.html)

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The Euro: Birth of a European Currency

• To prepare for the EMU, a convergence criteria was laid out whereby each member country was responsible for managing the following to a specific level:– Nominal inflation rates– Long-term interest rates– Fiscal deficits– Government debt

• In addition, European Central Bank (ECB), was established in Frankfurt, Germany.

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Effects of the Euro

• The euro affects markets in three ways:

1. Cheaper transactions costs in the Euro Zone

2. Currency risks and costs related to uncertainty are reduced

3. Price transparency and increased price-based competition

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Exchange Rate Regimes: the future?All exchange rate regimes must deal with the tradeoff between rules and freedom (vertical axis), as well as between cooperation and independence (horizontal axis) (see Exhibit 3.9)

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Rules

Freedom

CooperationindependenceThe pre WWI Gold Standard required adherence to rules and allowed independenceThe Bretton Woods agreement (and to a certain extent the EMS) also required adherence to rules in addition to cooperationThe present system is characterized by no rules, with varying degrees of cooperation

3.9 The Trade-Offs Between Exchange Rate Regimes

Free floating

Fixed exchange rate

Independent Currency board

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