Class 7-8

International Monetary System

and Balance of Payments
Chapter 7: Griffin & Pustay
1. Learning Objectives
Role of international monetary system in promoting
international trade and investment
Evolution and functioning of Gold Standard
Role of Bretton Woods Institutions (BWIs): World Bank
Group and International Monetary Fund
Evolution of flexible exchange rate system
Function and structure of the balance of payments
accounting system
Balance of Payments
1. Opening case: A Global Currency
War?
Global currency systems have witnessed several non-
weaponized wars which have led to bleeding of not only the
concerned economies but economies at large, even on a
global scale. Great depression of the 1930s
Currency rates affect competitiveness of a countrys exports,
the intensity of threats to domestic firms vulnerable to
foreign imports, and a countrys ability to attract FDI.
2008-09 subprime meltdown in USA: huge US budget
deficits, low interest rates, low currency rate put Latin
American countries like Brazil to disadvantage.
Shinzo Abbes similar policy in 2012 affected China, South
Korea, Taiwan and EU in predicament.
China also follow depressed Yuan policy facing global
criticism.
2. International Monetary System
and Balance of Payments
International monetary systems are sets of
internationally agreed rules, conventions and
supporting institutions, that facilitate international trade,
cross border investment and generally the reallocation of
capital between nation states.
The international monetary system establishes the rules
by which countries value and exchange their currencies
with other countries currencies. It also provides a
mechanism for correcting imbalances between a countrys
international payments and its receipts.
Further, the cost of converting foreign money into a firms
home currency a variable critical to the profitability of
international operations depends on the smooth
functioning of international monetary system.
2. International Monetary System
and Balance of Payments
International business people also monitor the
international monetary systems accounting system, the
balance of payments (BoP)
The BoP accounting system records international
transactions and supplies vital information about the
transactions and supplies vital information about the
health of the national economy and likely changes in its
fiscal and monetary policies.
BoP statistics can be used to detect signs of trouble that
could eventually lead to governmental trade restrictions,
higher interests rates, accelerated inflation, reduced
aggregate demand, and general changes in the cost of
doing business in any given country.
3. History of International Monetary
System
Gold Standard: First country to adopt Gold Standard in 1821
was Britain. Under Gold Standard, countries agreed to buy and
sell their paper currencies in exchange of gold to allow free
export of gold bullions and coins. Gold was a medium of
exchange. During the 19th century, most other important trading
countries Russia, Austria-Hungary, France, Germany, USA
did the same.
Fixed exchange rate system pound sterlings par value 4.247
for one ounce of gold, dollars par value $20.67 for an ounce of
gold. US-UK exchange rate: PS 4.247 = $20.67 or 1 PS =
$4.867.
Because of British dominance in international politics until WWI,
the international monetary system . So, sterling based gold
standard was in operation. London became the dominant
international financial center, a status it still holds.
3. History of International Monetary
System
The Gold standard leads all countries to the balance of
payments equilibrium (i.e. BOP = 0)
BOP<0 outflow of golddomestic credit holding

reduced Ms falls
P falls X increases Current Account

Balance rises BOP>0Ms increases P rises

export falls BOP =0
i rises capital inflow BOP = 0
So, the system hit by shock will restore the equilibrium.

Long run price stability because money supply

restricted by gold supply.
3. History of International Monetary
System
Collapse of the Gold Standard: World War I and inter-
war crises led to the collapse of the Gold Standard in
1931.
Several attempts to recover the system Brussels
meeting 1920 and Genoa in 1922 failed to bring back
confidence in sterling. Bank of England also failed to
maintain its pledge to respect par value.
Economic crises led to competitive devaluation and
payment systems got stuck up. Tariffs were raised.
Eventually, international economic conflict was replaced
by military conflicts World War II, 1939-45.
3.1 Bretton Woods Era
Inflation, unemployment, costs of rebuilding war-torn
economies created political instability
that led to fascists and dictators take powers in many
country.
In 1944, representatives of 44 countries met at Bretton
Woods in new Hampshire, USA to rebuild the
economies and create conditions for peace, stability
and growth.
Emergence of Bretton Woods Institutions (BWIs)
International Bank for Reconstruction and Development
(IBRD) and International Monetary Fund (IMF).
3.1 Bretton Woods Era WB Group
World Bank is the name of a group of institutions of
which the first one was IBRD.
Primary and initial goal of IBRD was to rebuild and
reindustrialize war-torn Europe.
With generous assistance of the US sponsored Marshall
Plan, IBRD accomplished the task by mid-1950s.
The mandate of IBRD was reoriented to the
development of the poorer newly decolonized
developing countries.
As the mission of IBRD expanded, new and new
institutions were added to the WB group:
3.1 Bretton Woods Era: WB Group
International Development Association (IDA) in 1960
International Finance Corporation (IFC) in 1956
International Center for Settlement of Investment
Disputes (ICSID) in 1966, and
Multilateral Investment Guarantee Agency (MIGA) in
1988
IBRD Lending: Weighted decision making based on
economic powers and contribution of members to
IBRD funding with USA claiming the largest chunk
(15%), followed by Japan (now China).
To finance lending operations, WB borrows money in
its own name from the international capital markets
3.1 BWIs: World Bank Group
and lends the fund to needy country at market rate of
interests. In 2012, WB made $20.6 bn loan
commitments.
According to WB charter, it cannot make loan to
finance trade deficits. Its lending is for productive
purposes to stimulate economic growth. Indonesia was
provided with a $200 m loan to modernize its national
highways.
IBRD lending is made to government institutions or in
some cases private sector agencies backed by
government. IBRD follows hard loan policy with
capability of loan repayment.
Usually, IBRD makes short term lending.
3.1 BWIs: World Bank Group
IDA Lending: Hard loan policy of IBRD led to severe
criticisms in the 1950s from the poorer countries and
development community. IDA was created to mitigate
the needs of the poorer countries, particularly LDCs
Soft loans that bear significant risk of not being paid;
Low or zero interests with a small service charge
(0.75%); long maturities of 35-40 years with 10 years
grace period
Resources from membership contribution and profits of
IBRD lending
Guinea received $25 m for reducing water pollution and
controlling water born diseases. Total loan
commitments in 2012 $14.5 billion.
3.1 BWIs: World Bank Group
IFC Lending: IFC created in 1956 is dedicated to
private sector development in developing countries.
Like an investment banker, IFC provides debt and
equity capital to developing countries acting as a
mediator for private investors who otherwise would not
have invested in those countries.
Thus, IFC provides guarantee against commercial risks.
Bangladeshs Lafarge Surma cement Ltd was given a
$10 m in equity capital and $35 million loan to help
build a cement plant with 1.2 m tons of cement
annually.
Total loan commitment $15.5 bn in 2012.
3.1 BWIs: World Bank Group
MIGA Lending: MIGA encourages private sector lending in
politically volatile and emerging countries with non-commercial
risks by covering political risk insurance. MIGA issued $18 m of
political risk insurance for a telecom project in Senegal. In 2012,
MIGA underwrote a total of $2.7 b in political risks.
ICSID in Investment Disputes: ICSIDs mandate is to
undertake dispute settlement activities between the recipient
countries and the WB agencies and other investors.
As of 27 July 2012, 246 of 390 registered arbitration cases were
concluded. as of 30 June 2012, the ICSID's tribunal had resolved
nearly two thirds (62%) of disputes while the remainder (38%)
were settled or discontinued.
To conclude, WB group is committed to investment promotion in
developing countries.
A number of regional development banks like Asian Development
3.2 BWIs : International Monetary
Fund (IMF)
Bretton Woods System: As the World War II was coming
to an end, the Allied Power leaders were concerned about
how to avoid the inter-war chaotic monetary and exchange
rate systems and ensure growth with stability and free trade
through orderly international payments.
44 countries met at Bretton Woods, New Hampshire to
design a new international monetary whch can avoid the
pitfalls of the interwar crises but retain the automatic
stabilizing role of the gold standard.
International Monetary Fund established to maintain order in
monetary system.
Fixed exchange rate pegged to US dollar, which in turn
pegged to gold at $35 per ounce of gold.
3.2 IMF: BWIs System 1944-73
Countries maintained their currencies plus-minus 1% of the
fixed rate; buy/sell own currency to maintain par value.
IMF maintained exchange rate discipline; national
government were required to manage inflation through
controlling money supply;
Flexibility in the system was maintained by IMF by providing
loans to members with BOP with the condition to bring down
inflation and relieving pressure to devalue.
Excessive drawing from IMF funds came with IMF
supervision;
Allowed 10% devaluations and more with IMF approval
Membership 187 by 2003
3.2 IMF: Collapse of the Bretton
Woods System
Because of increase in demand for dollars for rising
international transactions, international circulation of
dollars exploded creating pressures on dollars to
devalue;
Foreign governments started to lose faith in dollars, a
phenomenon known as Triffin Paradox;
Nixon ended gold convertibility of US dollar in 1971
US dollar was devalued and speculations led to
pressure for further devaluation.
Bretton Woods fixed exchange rates abandoned in
January 1972.
3.2 IMF: Collapse of Bretton Woods
System
New international crisis following 1973 oil embargo and
piling up of BOP deficits of developing and poor countries.
Jamaica Agreement 1976: Floating exchange rates
declared acceptable.
Gold declared as reserve assets;

- IMF returned gold reserves to at current prices;

-Proceeds placed in trust fund to help poor countries;
IMF quota member countries contributions increased;
-Membership increased to 182
-Less developed oil importing countries given more access to
IMF fund;
-IMF help countries with macro economic and exchange rate
problem.
3.3 Post-Bretton Wood International
Monetary System
1980s Latin American Debt Crisis: Oil embargo by the
OPEC countries led to accumulation of huge petro-dollars
with the OPEC countries deposited with western banks.
Reckless lending to to developing countries which the
Latin American countries failed to pay back. IMF had to
relax rules, underwrite debts to ease the situation.
Asian Finacial Crisis: 1997 Asian Financial Crisis was
caused by investment boom, excess capacity, high debt
and expanding imports.
By mid-1997, several key Thai financial institutions were
on the verge of default. Thailand allowed Baht to float.
IMF provided a $17 billion bailout loan package.
Required high taxes, public spending cuts, privatization
3.3 Post-Bretton Wood International
Monetary System
and higher interests
Speculation caused other Asian currencies including
Malaysian Ringit, the Indonesian Rupaih and
Singapore Dollar to fall.
IMF provided a $37 billion aid package for Indonesia;
It provided a $55 billion aid package for South Korea
3.3 Post-BWI International Monetary
System

Mexican Currency Crisis, 1995: The

Mexican currency resulted from high
Mexican debts and pegged currency
which did not allow adjustment of
prices.
IMF created a $50 billion fund to
prevent defaulting;
Required tight monetary policy and cuts
in public spending
3.4 How has the IMF Done?
By 2010, the IMF was committing loans to 68 countries in
economic and currency crisis;
All IMF packages require tight macroeconomic and
monetary policies.
However, the critics worry:

- one-size-fits-all approach to macro-economic policy is

inappropriate in many cases;
-Too powerful for an institution without any real
mechanism for accountability
-However, in recent years, shown signs of flexibility by
urging countries to adopt fiscal stimulus and monetary
easing policies in the wake of the 2008-09 global financial
crisis.
4. Balance of Payments System
4.1 BoP Accounting System
4.2 Major Components of the BoP Accounting
System
4.2.1 Current Account
4.2.2 Capital Account
4.2.3 Official Reserve System
4.2.4 Errors and Omissions
4. Balance of Payments System

4.3 Defining BoP Surpluses and Deficits