Between 1900 and 2000 many countries in Asia, Africa and Latin America emerged from colonial rule and the consequent ‘legacy’ exchange rate regimes that were imposed upon them. Inevitably a narrative of the evolution of the international financial system is principally a narrative of negotiations and agreements reached between developed countries.
Developments in the international monetary system are given below:
I. Pre-Bretton Woods Period (1870s-1943) – Gold Standard, Gold Exchange Standard
II. Bretton Woods Period (1944-971) – Snake in the tunnel
III. Post-Bretton Woods Period (1972 onwards) – Jamaica Accord, Plaza Accord, Louvre Accord, European Monetary System.
I. Pre-Bretton Woods Period (1870s-1943):
During the 18th and 19th centuries, England, France and Germany dictated terms for institutional structures and international trade. Their decisions changed fortunes of many of the countries that the three colonized. Their strategies were symbiotic and occasionally antagonistic with each other.
World trade was the dominant form of cross-border flow of funds. The exchange rate system in force was based on a precious metal (either silver or gold). Legal tender was currency in the form of gold and/or silver coins that co-existed along with paper currency backed by precious metals (usually gold). If gold and silver coins were legal tender, it was called ‘bimetallism’.
Gold coins could be freely minted due to gold mined in Australia and California. France had bimetallism until 1878 and the United States till 1873. Some countries such as China and India minted only silver coins. Pound notes were in circulation in United Kingdom, and francs were in circulation in France.
The Gold Standard:
This was an exchange rate in which gold coins were freely minted by the central bank of a country. The UK adopted it in 1821, Germany in 1875, France in 1878, the United States in 1879, and Russia in 1897.
Its main features were:
i. Gold jewellery could be converted into gold coins and used as legal tender.
ii. If there was a paper currency also circulating as legal tender, it was convertible into gold coins at a pre-determined ratio called mint parity. Paper currency was also legal tender and it was backed by gold (expressed in terms of gold) held by the central bank.
iii. If the central bank specified that a pound note was equal to one ounce of gold, then the pound note carried an implicit promise (made by the central bank) to convert the paper currency into gold at the ratio specified.
How did the gold standard work? Consider two countries ‘A’ and ‘B’ on the gold standard. Each had its own paper currency. The value of A’s paper currency in terms of B’s paper currency was determined by the currency/gold ratios of each country. The citizens of each country could choose to pay for purchases from the other country, either in gold or in the paper currency. Suppose Britain and France was on the gold standard.
£1 = 1 oz of gold
1 franc (FFr) = 0.5 oz of gold
£/Fr rate was £1 = 2 FFr
Suppose a citizen of UK purchased an item worth 10 francs from a French supplier. He could either pay £5 (since £1 = 2 FFr) in gold or in francs. If British imports from France were greater than British exports to France (Britain has a trade deficit with France) then gold moved from Britain to France. Since paper currency was backed by gold, the central bank of each country on the gold standard had to maintain gold reserves.
The amount of paper currency in circulation (and money supply) was determined by the mint parity, and the amount of gold with the central bank. Central banks had to safeguard their gold reserves. If Britain had a trade deficit with France, gold moved from Britain to France, leading to a contraction of money supply in Britain and an increase in money supply in France.
Because of increase in money supply, prices in France would tend to rise (inflation). Conversely because of fewer pounds in circulation in Britain (decrease in money supply) there would tend to be a decline of prices in Britain. The inflation in France would make French goods more expensive. The same product that sold for 10 francs might sell for 15 francs. This would discourage British buyers.
On the other hand, the French would find that British goods were cheaper. The result? British imports from France will fall, its exports to France will rise and Britain will run a trade surplus. This will move gold from France to Britain, leading to a contraction in money supply in France and an increase in money supply in Britain. The chain repeats again in the opposite direction and this goes on.
So under the gold standard there was a self-balancing mechanism called the price specie mechanism at work through which inflation in one country would alter its trade surplus into a deficit due to which prices would fall.
It was a simple mechanism which relied on the following factors:
i. There was enough gold to meet the international trade requirements of all the countries in the world.
ii. Countries did nothing to derail the mechanism. For instance, if France ran a trade surplus due to which the supply of gold with its central bank rose, the latter could have taken steps not to increase the number of francs in circulation, thereby snapping the link between gold reserves and money supply and between money supply and prices.
iii. Each country had to be committed to observing the rules of the game, so that all the countries on the gold standard could benefit. Domestic concerns—such as expansion or contraction of money supply and its attendant impact on inflation and economic growth—were of secondary importance.
Variants of the Gold Standard:
The gold standard worked only as long as the above conditions were met. But by 1914, countries began feeling the strain of maintaining it. The outbreak of World War I was both a reason and an excuse for moving away from the gold standard. Defence-related expenditure of major European powers (Britain, France and Germany) swelled. Imports shot up and gold reserves got depleted to pay for the excess of imports over exports. Countries stopped the free shipment of gold for trade payments in order to conserve gold reserves.
a. Gold Bullion Standard:
Some countries adopted the gold bullion standard, in which gold coins were withdrawn from circulation. Only paper currency was legal tender, and it was expressed in terms of a fixed quantity of gold. Since the currency was backed by gold, the central bank had to maintain gold reserves. Paper currency was used for settlement of transactions within a country, but gold was still used for international settlement.
If there was any imbalance in the market value of one currency in terms of another, the actions of market participants restored equilibrium. Britain was on the gold bullion standard between 1925 and 1931, and the USA between 1922 and 1933. Let us assume that,
£1 = 1 oz of gold and 1 $ = 0.5 oz of gold
then, £1 = 2$
However, if £1 = 1.8 $, then the dollar is overvalued and the existing exchange rate is not what it ought to be, given the gold backing each currency.
Market participants would scent an opportunity to make profits and take the following steps:
1. Sell dollars and buy pounds. For every $1.8, a market participant would get £1.
2. Surrender this pound at the Bank of England and get 1 ounce of gold.
3. Ship this gold to the USA.
4. Since $1 = 0.5 oz of gold, surrender 1 oz of gold to the Federal Reserve Bank and collect $2. The profit is $2 – $1.8 = $0.2. The similar actions of all market participants will lead to a demand for pounds. This will raise its price, and the pound/dollar exchange rate would resettle at £1 = $2.
b. Gold Exchange Standard:
A modified version of the gold bullion standard was the gold exchange standard. Under this system, a country’s currency was expressed in terms of another country’s currency, which was on the gold bullion standard. The advantage was that only the central bank of the country on the gold bullion standard had to maintain gold reserves, but the central bank of the country on the gold exchange standard had to hold reserves of the currency to which its currency was linked.
This foreign currency could be used (in addition to gold) to make international payments. The gold exchange standard was considered a more efficient version of the gold standard since it conserved on gold, and reduced the need for the central bank to hold gold since foreign currency was an acceptable method of making cross-border payments.
The two principal advantages of the gold standard (and its variants) were the price specie mechanism and exchange rate stability. When Britain, France, Germany, Russia, UK and USA were on the gold standard, the exchange rates of their currencies were remarkably stable. But the disadvantage was that gold was a limiting factor. As world trade increased, the amount of gold being mined was inadequate to meet international trade requirements.
In the post-World War I period, Germany witnessed severe economic and civil unrest. Germany, Hungary and Poland began experiencing hyperinflation. Countries began devaluing their currency so as to grab a larger share of the export market from other countries, and experimenting with the best exchange rate system to adopt based on their own economic strengths and weaknesses. The USA, which had abandoned the gold standard before the war and shifted to the gold bullion standard, started abandoning the gold standard in 1933.
The 1929 stock market crash in the USA sent hundreds of firms into bankruptcy and triggered a run on banks. British and German banks faced similar threat. Britain’s adverse Balance of Payments led to a decline in confidence in the pound sterling as gold reserves were getting drained to meet trade deficits. Britain went off the gold standard in 1931 and let the pound’s value against other major currencies be determined by market forces.
II. Bretton Woods Agreement:
In July 1944, 44 countries met in Bretton Woods, New Hampshire to hammer out a new exchange rate system and international financial architecture. Their point of reference was the gold standard and the new version was built around some of its key characteristics. After rounds of negotiation, in which the British and the American representatives had different views on what this new system should look like, the American delegation triumphed. Two international agencies (the IMF and the World Bank) were set up, and a new exchange rate system called the Bretton Woods system was developed. The IMF was charged with the responsibility to monitor and oversee the new exchange rate system.
The principal features of the Bretton Woods system agreed to by the member-countries were:
i. Paper currency was the legal tender of the 44 member-countries.
ii. The US dollar would be expressed in terms of gold. It was decided that $35 was equal to one ounce of fine gold. Only the United States would hold gold as reserves. The US central bank could issue only as many dollars as the gold reserves available with it. This meant that only the USA was on the gold bullion standard.
iii. The remaining 43 countries would link each of their currencies to the US dollar. The value of each currency against the US dollar was to be determined by each country. This value was called the par value. For instance the French franc could have had a par value of 5 FFr = 1 USD. Therefore, 43 countries were on the gold exchange standard.
iv. The market value of the currency was permitted to fluctuate within ± 1% of the par value. The upper limit and the lower limit of the fluctuation were called support points. In the above example, the support points for the franc would be 5.05 FFr and 4.95 FFr.
v. Each member-country’s central bank had to ensure that the market value of the currency fluctuated only within the support points. If the support points were likely to be breached, the central bank would have to buy (or sell) US dollars. If the market value of the franc dropped to 5.03 FFr/USD, then the French central bank would start selling US dollars (this would increase the supply of dollars) and buy francs (increasing the demand for francs). The actions would increase the value of the franc against the dollar.
vi. Each member-country could devalue its currency up to 10% of the exchange rate. Any devaluation above this required IMF permission.
vii. International payments could be made either in gold or in US dollars. Thus, officially the dollar became an international reserve currency, and a denomination currency for cross- border payments. The central banks of each of the 43 member-countries were permitted to hold US dollars as reserves. They did not have to hold gold, unless they wanted to.
Though the Bretton Woods system no longer exists, the trend of holding US dollar reserves continues. The advantages of the Bretton Woods system were that the dollar became an international reserve currency overcoming the limited supplies of gold, member-countries could earn interest on their dollar reserves (unlike in the case of gold reserves), and the security requirements needed for gold reserves were no longer necessary.
Drawbacks of the System:
The Bretton Woods system also called the Bretton Woods Agreement or BWA contained a number of inherent flaws that rendered it unworkable in the long term. First, it was merely a variant of the gold exchange standard, and as such it was also constrained by the availability of gold. If the demands of world trade outstripped gold supplies, the BWA would collapse since the US dollar was linked to gold. On the demand side, the average growth rate of GNP of the developed countries rose from 4% in the 1950s to 5% in the 1960s, while international trade grew at 6% in the 1950s and 8% in the 1960s.
Further, the BWA relied on the demand for gold being met from newly mined gold, but this was inadequate to meet demand. In the 1950s, newly mined gold was supplemented by Russia’s sale of gold and this was enough to cater to the demand. By 1966, barely 22 years after the system came into being, demand for gold overtook supply, causing the price of gold to rise. Demand outstripped supply in the years 1966, 1967 and 1968. Since the Bretton Woods system relied on a dollar-gold peg, gold had to have a fixed real price in order for the system to be sustainable.
The BWA permitted member-countries to accumulate US dollars as reserves. Dollar reserves could be accumulated when a member-country consistently had a positive balance of trade with the USA (its exports to the USA were greater than its imports from the USA), so that the member- country received more dollars for its exports than the dollars it paid for its imports. Professor Robert Triffin argued that in order for the US dollar to successfully become a reserve currency, the United States would have to do precisely this.
But the US government’s ability to create dollars was a function of its gold reserves since the United States (under this system) was still on the gold standard. The USA could not consistently run trade deficits because it could not print more dollars than the gold reserves it held. He pointed out that when the US gold reserves fell short of the amount of US dollars in circulation, even if the USA continuously had balance of trade deficits, the BWA itself would fail. This was called the Triffin Paradox.
The United States ran trade deficits in 1962, 1965, 1966, 1967, 1968 and 1969. It also had a Balance of Payment deficit in 1962, 1967 and 1970 due to several reasons. The US economy grew at a slower pace than the economies of Europe, which rapidly grew to meet the post-War demand for goods and services. Also, many American multinationals saw opportunities in post-War Europe, and there was an increase in FDI outflows from the USA. It also became embroiled in the Vietnam War and its expenditure increased. The net result was an increase in dollars in circulation (monetary expansion), an outflow of dollars from the USA, and an increase in the dollar reserves of member- countries.
The US government took several measures to reduce dollars outflows. It reduced foreign aid, sourced US military purchases from American suppliers even though their prices were higher, and tried to reduce imports by exhorting its citizens to’ buy American’. To discourage US investors from buying securities in foreign markets, an interest equalization tax was imposed on the interest income earned on these securities.
The Federal Reserve Bank used moral suasion and requested American banks to reduce loans meant for use overseas. This was called the Federal Credit Restraint. Program or FCRE In 1968, the Federal Reserve Bank made this restriction mandatory. Many American MNCs were aggressively expanding into Europe and Latin America. When they found that American banks refused loans beyond a specified limit, the MNCs turned to European banks. This gave a huge fillip to the development of the Eurocurrency market.
Lastly, to take pressure off the dollar as an international reserve currency, the IMF created SDRs in 1969, an artificial currency that member-countries could hold as reserves instead of holding US dollars. None of these measures had the intended effect. America’s BOP deficit did not turn into a surplus (except temporarily) nor did the pressure on the US dollar subside. American FDI flows to the rest of the world did not reduce and American investors continued to make portfolio investment overseas.
By 1970, there was a crisis of confidence with respect to the US dollar. The Japanese yen and the Deutschmark were undervalued against the dollar. But in order to maintain the fluctuations of 1% around the par values of the yen and the mark, the Japanese and German central banks had to intervene repeatedly and make huge purchases of the dollar. This resulted in their accumulating vast dollar reserves. It was apparent that these interventions were unable to solve the fundamental weaknesses of the Bretton Woods system.
International markets were abuzz with rumours that if the dollar reserves of member-countries were surrendered to the Federal Reserve, it did not have enough gold to give in exchange. On August 15, 1971, President Nixon of the USA unilaterally announced that the US dollar was no longer convertible into gold. In doing so he confirmed the rumours. The announcement removed the link between the dollar and gold that was the essence of the exchange rate system. The Bretton Woods system collapsed.
Post-Bretton Woods Scenario:
Though the USA effectively abandoned the BWA, there was no other exchange rate system to take its place. Despite its shortcomings, the BWA did have the virtue of keeping exchange rate volatility to a minimum. The yen/dollar exchange rate remained at Y360/$ between 1948 and 1970. The exchange rates of major currencies (US dollar, Canadian dollar, pound, French franc, yen and German mark) were determined by market forces.
Smithsonian Agreement:
In December 1971, the G10 countries (Belgium, Britain, Canada, France, Holland, Italy, Japan, United States, Sweden and West Germany) met at the Smithsonian Institution in Washington. They adopted a new exchange rate system called the Smithsonian Agreement. It was merely a variant of the Bretton Woods system.
The comparison between BWA and the Smithsonian Agreement is given below:
Bretton Woods Agreement versus Smithsonian Agreement:
Bretton Woods Agreement:
i. The US dollar was linked to gold.
ii. $35 = 1 oz of fine gold
iii. The US dollar was convertible into gold.
iv. Each member-country fixed the par value of its currency against the US dollar.
v. Exchange rates were allowed to fluctuate 1% above or below the par value.
vi. The upper and lower support points were fixed.
vii. The central bank of each member-country had to intervene in the foreign exchange market to ensure that the support points were not breached.
Smithsonian Agreement:
i. The US dollar was linked to gold.
ii. $38 = 1 oz of fine gold
iii. The US dollar was convertible into gold.
iv. Each member-country fixed the par value of its currency against the US dollar.
v. Exchange rates were allowed to fluctuate 2.25% above or below the par value.
vi. The upper and lower support points were fixed.
vii. The central bank of each member country had to intervene in the foreign exchange market to ensure that the support points were not breached.
Though the G10 agreed to make the Smithsonian Agreement work, Canada allowed the exchange rate of its dollar to be fixed by market forces, while the remaining nine countries adhered to the agreement. In spite of this, as world capital flows increased, Britain went off the Smithsonian Agreement in June 1972. In February 1973, the huge volume of dollar sales in international foreign exchange caused the US dollar to depreciate against major currencies.
Though there was sustained intervention by central banks of the G10 countries (by buying dollars), it was not enough to convince the markets that the dollar was priced correctly according to the par values in the Smithsonian Agreement. The G10 countries felt that the Smithsonian Agreement was unworkable, and they abandoned it in March 1973.
Snake in the Tunnel:
France and Germany decided to form a coalition of European nations with the objective was to developing a trading bloc that would be on more equal footing with the United States, and would eventually coordinate their macro-economic policies. In 1958, the Premiers of France and Germany initiated steps that led to the creation what was then known as the European Economic Community (EEC) and is now called the European Union (EU).
When the Smithsonian Agreement was adopted by the G10 in December 1970, the EEC decided that this was an opportunity to practice and exhibit cohesiveness. It decided that though the Smithsonian Agreement permitted a fluctuation of around 2.25% around each country’s par value against the US dollar, each EEC country would let its currency fluctuate only within a range of 1.125% around its par value.
This agreement was called the ‘snake in the tunnel’ because the currency fluctuations of EEC countries’ currencies were in a tighter band around their par values, as compared to other countries that followed the Smithsonian Agreement.
III. Post-Bretton Woods Era (1972 Onwards):
a. Jamaica Accord (1976):
From March 1973 onwards, the exchange rates of major currencies in the world (US dollar, yen, mark and franc) were determined by the supply and demand for each of them. This is called a floating (or flexible) exchange rate regime. It was given official sanction in January 1976 by IMF member-countries which met in Jamaica.
This was called the Jamaica Accord. Its key features were:
i. The IMF accepted the floating exchange rate system.
ii. The central bank of each member-country was permitted to intervene in the foreign exchange market to prevent unnecessary volatility in its currency.
iii. Gold was no longer accepted as a reserve asset by the IMF. Each member-country had deposited gold with the IMF, creating gold holdings. The IMF sold some of its gold holdings, and returned the rest to each member-country.
Under the floating rate system, exchange rates began fluctuating against each other. The value of a country’s currency in terms of another (or the exchange rate) is a function of demand and supply in the foreign exchange market. The demand for foreign exchange arises due to imports, FDI outflows and portfolio investments overseas. The supply of foreign exchange arises from exports, FDI inflows and overseas portfolio investment inflows.
The US dollar continued to be accepted as the international reserve currency and as the invoicing currency. Central banks continued to hold 75% of official reserves in dollars. Though exchange rates were supposed to be determined by market forces alone, central banks intervened from time to time to ‘guide’ the exchange rate to levels they considered were appropriate.
The US had a deficit of $160 billion by 1985. Though this should have caused the US dollar to depreciate against major currencies, the US Federal Reserve’s tight monetary policy meant that interest rates in the USA (adjusted for expected inflation) were higher than in other countries. Money flowed into USA, and the dollar appreciated against major currencies.
The US dollar could buy more of foreign goods, but US goods became more expensive to the rest of the world. The result was that US imports increased, exports decreased, and the USA began having a deteriorating Balance of Trade. The central banks of Britain, France, Germany and Japan consistently sold dollars in a bid to make the dollar decline against their currencies in foreign exchange markets.
b. Plaza Accord (1985):
The dollar’s continued strength against major currencies in the mid- 1980s was hurting the competitiveness of American companies and raised demands for restrictions on imports into the United States. In September 1985, the G5 countries (Britain, France, Germany, Japan and the United States) met at the Plaza Hotel in New York, and formally agreed to make their central banks act in a coordinated manner and intervene in foreign exchange markets to bring down the value of the dollar. This was called the Plaza Accord. It led to coordinated intervention by central banks. Its success surpassed expectations, and between 1985 and 1987 the dollar fell by an average of 35% against major currencies.
c. Louvre Accord (1987):
The Plaza Accord was too successful. As the dollar continued to slide against major currencies, countries began worrying that their exports to the USA would become too expensive causing them to experience Balance of Trade difficulties. In 1987, the G7 countries (Britain, Canada, France, Germany, Italy, Japan and the United States) met at the Louvre Museum in Paris and entered into an agreement called the Louvre Accord.
The G7 agreed to ensure stability in exchange rates and the dollar’s downward slide. They decided to coordinate their efforts in foreign exchange markets, so that exchange rates moved within target zones as to reduce currency volatility, and coordinate their macroeconomic policies to ensure that interventions were sustainable. The target zones were never publicly revealed. This is called the managed float or dirty float system. Since then all developed countries, and many developing countries (including India) are on the managed float.
But some countries are not. They are China and Indonesia. Both these countries fixed the value of their currencies (the Chinese renminbi/yuan and the Indonesian Ringitt) in terms of the US dollar in the aftermath of the Asian currency crisis. They did this to drastic fall in the currency (in the case of Indonesia) and to ensure a stable exchange rate.
Monetary and Fiscal Policies under the Floating Exchange Rate Regime:
Exchange rates are determined by market forces alone. A country with trade surpluses will find its currency appreciating and one with trade deficits will find its currency depreciating. If the link runs from trade surpluses (or deficits) to currency appreciation (or depreciation), will the reverse also hold true? That is, can currency depreciation cause a trade deficit to either shrink, or get converted into a trade surplus? And if this is so, do countries deliberately attempt to let their currencies decline in value? The answer is yes to both questions. This is called currency manipulation.
Currency Depreciation:
The central bank follows a liberal monetary policy. Money supply increases, and the value of the currency falls. There is however, a danger of inflation. To prevent this, the central bank raises interest rates. Currency depreciation causes the country’s exports to rise. Imports become more expensive and an existing trade deficit decreases.
Currency Appreciation:
The central bank follows a tight monetary policy. Expected inflation rates are low, and real interest rates remain high. Attracted by higher real interest rates, capital flows into the country. The demand for the country’s currency rises, and the currency appreciates. Exports become expensive, imports increase, and an existing trade surplus, shrinks.
Currency manipulation charges lay at the heart of the 2010 currency debate between China and USA in 2010 with each accusing the other. In November 2010, the US Federal Reserve increased money supply by buying bonds, causing the dollar to decline in value. This prompted China to accuse the USA of currency manipulation.
European Monetary System (1979):
In 1958, France and Germany took the initiative to push for greater European unity. And create a trading bloc that would include regional cooperation in the framing of monetary policies, trade negotiations, increasing intra- European trade and eventually paving the way for monetary union through the adoption of a single currency for all like-minded European countries. The European Economic Community (EEC, later renamed as European Union or EU) was formed. In March 1979, the EU introduced the European Monetary System (EMS), with the objective of creating a common currency.
The EMS introduced the Exchange Rate Mechanism (ERM) and the European Currency Unit (ECU):
i. The ECU was a ‘basket’ currency. It existed between 1979 and 1999, though it was not legal tender. It ceased to exist when it was replaced by the euro in January 1999.
ii. The ECU was the weighted average of the currencies of EU countries (except Britain and Greece). The weight of each currency was determined by the country’s GNP and its share in intra-EU trade.
iii. The EMS functioned through the ERM. Any country which agreed to be a part of it was called an EMS country.
iv. The European Commission fixed the par value of each EMS country’s currency in terms of the ECU. The par value of each currency was called the ECU central rate.
v. The exchange rate of between two EMS countries depended on their individual ECU central rates. Each EMS currency was permitted to vary around its ECU central rate by 2.25%.
But the actual deviations in some cases were greater than this—the Italian lira varied widely around its ECU central rate, and was devalued in 1985 and in 1990. In 1992, Italy withdrew from the ERM though it remained in the EU. In December 1991, EU members signed the Maastricht Treaty, which set a timeline of January 1999 for the introduction of a common currency called euro. The euro was introduced as scheduled. It is currently legal tender in EU countries, and has replaced local currencies such as the German mark and the French franc, which have been abolished.