Chapter Five

International Monetary System and Key

International Financial Institutions

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International Monetary System (IMS)
• International monetary system (which sometimes
is called international monetary order or regime)
refers to the rules, customs, instruments,
facilities, and organizations for effecting
international payments.

• For countries to participate effectively in the

exchange of goods, services, and assets, an
international monetary system is needed to
facilitate economic transactions.
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 Criteria for evaluating an IMS
• Adjustment refers to the process by which the balance of payment
disequilibria can be corrected. A good IMS is one that minimizes the
cost of and the time required for adjustment.

• Liquidity refers to the amount of international reserve assets that

are available to settle temporary balance of payments disequilibria.
A good IMS is one that provides adequate international reserves so
that nations can correct balance of payments deficits without
deflating their own economies or being inflationary for the world as
a whole.

• Confidence refers to the knowledge that the adjustment

mechanism is working adequately and that international reserves
will retain their absolute and relative values. Thai is, it combines
both i) and ii) above.

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 Evolution of the IMS
The Gold Standard (1880 - 1914)
• The gold standard operated from about 1880 to the outbreak of
World War I in 1914.

• The gold standard refers to the monetary system in which gold

acted as a standard of value in the sense that the country's
monetary unit is either made of gold of specific weight and
purity or its value is defined in terms of certain specified weight
of gold of specific purity.

• In other words, the gold standard is an international monetary

system where the value of each currency was fixed in terms of
gold.

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 Evolution of the IMS
• The gold standard was a fixed exchange rate system in
which gold was the only international reserve asset.

• Under the gold standard, each nation defined the gold

content of its currency and passively stood ready to
buy or sell any amount of gold at that price.

• Because many currencies, including the dollar, the

British pound sterling, and the French franc, were
simultaneously tied to gold for extended periods, these
currencies could also be exchanged among themselves
at a fixed rate.

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 Evolution of the IMS
• For example, if 1£ = 100 grains of gold and if $1 is 25 grains
of gold, then the exchange rate, $/£ = 4. In other words, 4
dollars are needed to purchase on pound sterling.

• Since the gold content in one unit of each currency was

fixed, exchange rates were also fixed. This was called the
mint parity.

• The exchange rate could then fluctuate above and below

the mint parity (i.e., within the gold points) because of the
cost of shipping, insurance, packing, and interest charges
on transit from one country to another.

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 Evolution of the IMS
 The Interwar Experience (1918 - 1939)

• This period was characterized by hyperinflation to finance the

war, the great depression, financial instability, adoption of
trade protection and autarky, and beggar my neighbor
policies.

• With the outbreak of World War I in 1914, the classical gold

standard came to an end.

• The period between 1919 and 1924 was characterized by

wildly fluctuating exchange rates. This led to a desire to return
to the stability of the gold standard.

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 Evolution of the IMS
• Starting in 1925, an attempt was made by Britain and other
nations to reestablish the gold standard (the United States
had already returned to the gold standard in 1919).

• This attempt failed with the deepening of the Great

Depression in 1931.

• There followed a period of competitive devaluations as

each nation tried to "export" its unemployment.

• This, together with the serious trade restrictions imposed

by most nations cut international trade almost in half.

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 Evolution of the IMS
The Bretton Woods System ( 1944 - 1971)
• After the abandonment of the gold standard, there was no
generally accepted exchange rate regime. Some countries
formed themselves into "currency blocs", most notably the
"Sterling era" (the U. K. plus the commonwealth, but
excluding Canada, Egypt, some Scandinavian countries, and
for some time Japan), and a "dollar bloc" centered on the
United States.

• In 1944, representatives from the United States, the United

Kingdom, and 42 other nations met at Bretton Woods, New
Hampshire, USA, to decide on what international monetary to
establish after the war.
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 Evolution of the IMS
• The system devised at Bretton Woods called for the
establishment of the International Monetary Fund (IMF)
and the World Bank (WB).

• The IMF was established for the purposes of :

• i) overseeing that nations followed a set of agreed rules

of conduct in international trade and finance, and

• ii) providing borrowing facilities for nations in temporary

balance of payments difficulties.

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 Evolution of the IMS
• The Bretton Woods system was a gold-exchange standard
which is an international monetary system where the price
of one currency (say, the dollar) is tied to gold but all other
currencies are tied to the value of that currency the dollar).

• The United States was to maintain the price of gold fixed at

$35 per ounce and be ready to exchange on demand
dollars for gold at that price without restrictions or
limitations.

• Other nations were to fix the price of their currencies in

terms of dollars (and thus implicitly in terms of gold).

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 Evolution of the IMS
The Collapse of the Bretton Woods (1967 - 73)

• The beginning of the events that led to the breakdown

of the Bretton Woods is usually identified as the
devaluation of the pound Sterling in 1967, which could
not be averted even with substantial help from the
United States and other countries.

• The problem was aggravated by oil price increases of

1973 - 74, increases in commodity prices, deterioration
of terms of trade of oil importing countries, and
appreciation of US dollar.

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 Evolution of the IMS
• The fundamental cause of the collapse of the Bretton
Woods is related to:

• Adjustment problem: that is, lack of adjustment

mechanism. Individual countries had prolonged balance of
payments deficits or surpluses. This was particularly true
for the United States (deficits) and West Germany
(surpluses).
• Liquidity problem: that is, unavailability of international
reserves, and
• Confidence problem: that is, balance of payments deficits
persisted and this undermined confidence in the dollar.

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 Evolution of the IMS
 The Present (1973 onwards)- Managed Floating
/Hybrid System

• Allow the currency to float, but intervention in foreign

exchange markets by monetary authorities to smooth
out short term fluctuations without attempting to
affect the long run trend in exchange rates.

• In other words, the exchange rates are flexible

(through the forces of demand and supply) with
occasional intervention to stabilize the rates.

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 Key International Financial Institutions
 The International Monetary Fund (IMF)

• IMF was formed in 1944 at the Bretton Woods Conference primarily

by the ideas of Harry Dexter White and John Maynard Keynes, and
came into formal existence in 1945 with 29 member countries.

• Currently it has 198 member countries and its headquarter is based

in Washington, D.C.

• It main aims are to foster global monetary cooperation, secure

financial stability, facilitate international trade and sustainable
economic growth, and reduce poverty around the world while
periodically depending on the World Bank for its resources.

• It now plays a central role in the management of balance of

payments difficulties and international financial crises.
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 Key International Financial Institutions
 The World Bank (WB)

• WB is an international financial institution that provides loans and grants

to governments of poor countries for the purpose pursuing capital
projects.

• It was also formed in 1944 with IMF at the Bretton Woods Conference an
it’s also headquartered in Washington, D.C.

• The WB comprises two institutions: the International Bank of

Reconstruction and Development (IBRD), and the International
Development Association (IDA).

• The WB is the component of the World Bank Group which is an extended

family of five international organizations, and parent organization of the
WB, the collective name given to the first two listed, IBRD and the IDA.
The additional three are International Finance Cooperation (IFC),
Multilateral Investment Guarantee Agency (MIGA), and International
Center for Settlement of Investment Disputes (ICSID)
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 International Capital Flows and
Multinational Corporations
• The traditional literature has long assumed that factors of
production are mobile within countries, but immobile between
countries. However, today there is a movement of resources from
one country to another.

• We shall also focus on multinational corporations (or multinational

enterprises or transnational corporations/enterprises) since they
are important vehicles for the movement of foreign direct
investment (FDI).

• These terms all refer to the same phenomenon – production is

taking place in plants located in two or more countries but under
the supervision and general direction of the headquarters located in
one country.

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 International Capital Flows and
Multinational Corporations
• Multinational corporations are firms that own, control or manage
production and distribution facilities in different countries; they are
the major providers of FDI.

• We need to distinguish between “foreign direct investment” and

“foreign portfolio investment.” FDI is real – investment in factories,
capital goods, land, and inventories. It involves ownership and
control. Portfolio investments are investments in financial assets
such as bonds and stocks.

• Such investments take place primarily through financial institutions

like banks and investment funds. Although direct investments may
be made by individuals or partnerships, most FDI is undertaken by
multinational enterprises.

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 International Capital Flows and
Multinational Corporations
• Direct investment is typically industry- specific taking two
forms: horizontal and vertical integration. Large
corporations integrate horizontally by opening new
subsidiaries in various parts of the world. In other words, it
is the production abroad of a differentiated product that is
also produced at home.

• Vertical integration is the expansion of the firm backwards

or forwards. Expansion backwards involves the supply of its
own raw materials and intermediate products; while
expansion forwards involves the provision of its own sales
and distribution networks. One reason for vertical
integration is to reduce risk.

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 International Capital Flows and
Multinational Corporations
• The basic motive of both direct and portfolio
investments is to earn higher returns with a
lesser risk. For example, the theory of portfolio
diversification postulates: portfolio diversification
and risk diversification.

• Portfolio diversification is investing in different

financial assets; while risk diversification is
investing in different nations and currencies. In
other words: “Do not put all your eggs on one
basket.”

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 What are other reasons for international
movement of capital?
• In response to large and rapidly growing markets in the
recipient country,
• In response to a high per capita income (a higher
purchasing power) in the recipient country,
• To secure access to mineral or raw material deposits to
process and sell them in more finished forms,
• In response to tariffs and non-tariff barriers which can
induce an inflow of FDI,
• In response to low relative wages in the host country,
• For defensive purpose to protect market share, and
• As a means of risk diversification.

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 The Concept of Dutch Disease
• Dutch disease is an economic term for the negative consequences
that can arise from the spike in the value of a nation’s currency.
• It is primarily associated with the new discovery of exploitation of a
valuable natural resource and the unexpected repercussions that
such a discovery have on the overall economy of a nation.
• It has two major economic effects resulting from a higher local
currency:
– It decreases the price competitiveness of exports of the affected
country’s manufactured goods
– It increases imports
• In the long run, these factors can contribute to unemployment, as
manufacturing jobs move to lower-cost countries. Meanwhile, non-
resource based industries suffer due to the increased wealth
generated by the resource based industries.

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 The Concept of Dutch Disease
• The term Dutch disease was coined by the Economist magazine in
1977 when the publication analyzed a crisis that occurred in the
Netherlands after the discovery of vast natural gas deposits in the
North Sea in 1959.

• The newfound wealth and massive exports of oil caused the value
of the Dutch guilder to rise sharply, making Dutch exports of all
non-oil products less competitive on the world market.
Unemployment rose from 1.1% to 5.1%, and capital investment in
the country dropped.

• Dutch disease become widely used in economic circles as a

shorthand way of describing the paradoxical situation in which
seemingly good news, such as the discovery of large oil reserves,
negatively impacts a country’s broad economy.

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 Issues on Foreign Aid and
International Debt Crises
• On 12 August 1982, the Mexican government
announced that it could not meet its forthcoming debt
repayments on its $80 billion of outstanding debt to
international banks (The Mexican Moratorium).

• This was the first sign of the international debt crisis.

Other countries also followed suit.

• The debt crisis encompasses a wide set of countries

from low income developing nations to middle income
countries.
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 Factors For LDCs Debt Problem
– Oil Price Increases of 1973 – 74 and 1979 – 81
• The two “Oil Shocks” resulted in huge oil import bills of
many LDCs. This necessitated borrowing to finance the
additional import expenditures. Much of the borrowing
was from industrialized countries’ commercial banks,
which were recycling dollars deposited in them by
members of OPEC.

– Recession in the Industrialized Countries

• The oil shocks resulted in recession in developed
countries which in turn affected exports by LDCs.

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 Factors For LDCs Debt Problem
– The Behavior of Real Interest Rates
• The real interest rate was low and thus encouraged LDCs to
undertake new loans.

– The Decline in Primary – Product Prices:

• The terms of trade of oil – importing countries deteriorated
and this necessitated additional borrowing in order to
finance needed imports for development.

– Domestic Policies within the LDCs

• The loans were used for consumption rather than for
productive investment, thus repayment prospects were
poor and new borrowing was needed.

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 Factors For LDCs Debt Problem
– Capital Flight
• A factor associated with increasing indebtedness was
capital flight from LDCs. In Latin American countries, in
particular, inflation was taking place and many domestic
citizens sent funds to industrialized countries’ banks.

– Loan Pushing
• There is a hypothesis that the industrialized countries’
banks were awash in funds (importantly from the recycling
of petrodollars), and thus loans were made available and
did not adequately take risk factors into account.

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 The Role and Viewpoints of the
Actors in the Debt Crisis
• There are different views on how to manage
the crisis. First, who are the actors in the debt
crisis? The actors are:
• International Banks – Commercial Banks
• The Authorities of the Developed Nations
• International Institutions – IMF and WB
• Debtor Nations

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 The Role and Viewpoints of the Actors in
the Debt Crisis
• Commercial Banks: argue that the debt problem is a
temporary liquidity problem, so give the debtor nations
some time. Commercial banks preferred rescheduling debt
repayments and at the same time ensuring that additional
interest are paid on the postponed principal repayments.

• They are opposed to granting debt forgiveness arguing that:

– a) Granting debt forgiveness for one country would lead other
debtors to seek similar relief,
– b) Debt relief might discourage the debtors from taking the
measures necessary to improve their economic performance.
The banks have also been keen to treat each debtor on a “Case
by Case” approach because each debtor faces different
circumstances.

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 The Role and Viewpoints of the Actors in
the Debt Crisis
• National Authorities (of the lender):
• Their concern is to avoid the collapse of their banking system.
Because of their strategic and economic interests, the
authorities are prepared to allow some concessions.

• International Institutions (IMF and WB):

• The IMF wants the debtor countries to accept an IMF
sponsored adjustment package (IMF Conditionality), for
example, reduction of government budget deficits and money
supply, devaluation, elimination of government subsidies,
elimination of distorted price controls, and allowing markets
to function. The WB has been concerned about the costs in
terms of slower development that debt repayments impose
upon debtor nations.

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 The Role and Viewpoints of the Actors in
the Debt Crisis
• The Debtor Nations – They claim that the
debt issue is not their making, but due to a
combination of external factors beyond their
control. They felt that the creditor banks
should consider the possibility of debt
forgiveness.

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 Possible Remedies for Resolving the
Debt Crisis
• There are three sets of proposals:
– Alter the structure and nature of the debt (Commercial
banks view) – e.g., lengthening the time horizon to make it
more manageable for repayment of the debt.
– Economic reform in the debtor nations (IMF and WB view)
– The argument is that the reforms will improve the debtor
nations’ ability to service their debts.
– Debt forgiveness – Write off part of the debts the debtors
owe by:
• Reducing the principal owed,
• Reducing the interest payments below the market rates,
• Mixture of the above two.

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 The Paris Club
• In response to Argentina’s debt problems and the
difficulties being encountered by developing countries in
repaying their external debts, creditor governments formed
what is known as the Paris Club in 1956.

• The Paris Club is a consortium of industrialized countries’

governments, whose objective is to provide a framework
for rescheduling debt repayments to official creditors.

• Any creditor government may apply for membership of the

Paris Club which conducts negotiations between a debtor
government and the creditor governments and meetings
are usually chaired by a senior French Treasury Official.

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