International Financial Institutions: International Monetary Fund (IMF)

Origin

The IMF also called the Fund is an International monetary institution/ supranational financial institution established by 45 nations under the Bretton Woods Agreement of 1944. Such an institution was necessary to avoid repetition of the disastrous economic policies that had contributed to Great depression of 1930’s. The principal aim was to avoid the economic mistakes of the 1920s and 1930s. It started functioning from March 1, 1947. In June, 1996, the Fund had 181 members. The IMF was established to promote economic and financial co-operation among its members in order to facilitate the expansion and balanced growth of world trade. It performs the activities like monitoring national, global and regional economic developments and advising member countries on their economic policies (surveillance); lending member hard currencies to support policy programmes designed to correct BOP problems; offering technical assistance in its areas of expertise as well as training for government and central bank officials.

Objectives

The fundamental purposes &   objectives   of   the   Fund   had been laid down in Article 1 of the original Articles of Agreement and they have been upheld in the two amendments that were made in 1969 & 1978 to its basic charter. They are as under:

  1. To promote international monetary co-operation through a permanent institution which provides the machinery for consumption & collaboration in international monetary problems.
  2. To facilitate the expansion and balanced growth of international trade.
  3. To promote exchange stability, to maintain orderly exchange arrangements among members, and to provide competitive exchange depreciation.
  4. To assist in the establishment of a multilateral system of payments in respect of current transactions between member and in the elimination of foreign exchange restrictions which hamper the growth in the world trade.
Read the rest

Is there an Optimal Exchange Rate Regime?

Starting from the gold standard regime of fixed rates, passing through the adjustable peg system after the Second World War, it has finally ended up with a system of managed floats after 1973. Since 1985, the pendulum has started swinging, though very slowly and erratically, in the direction of introducing some amount of fixity and rule based management of exchange rates.

Despite these empirical facts, there is a school of thought within the professional which argues that in the years to come there will be only two types of exchange rate regimes: truly fixed rate arrangements like currency unions or currency boards, or truly market determined, independently floating exchange rates. The “middle ground” – regimes such as adjustable pegs, crawling pegs, crawling bands and managed floating – will pass into history. Some analysts even predict that three currency blocks – the US dollar block, the Euro block and the Yen block – will emerge with currency union within each and free floating between them. The argument for the impossibility of the middle ground refers to the “impossibility trinity” i.e., it asserts that a country can achieve any two of the following three policy goals but not all three:

1. A stable exchange rate

2. A financial system integrated with the global financial system i.e., an open capital account; and

3. Freedom to conduct an independent monetary policy

Of these, (1) and (2) can be achieved with a currency union board, (2) and (3) with an independently floating exchange rate and (1) and (3) with capital control.… Read the rest

The Current Scenario of Exchange Rate Regimes

Now the IMF classifies member countries into eight categories according to the Exchange rate regime they have adopted. A brief summary of IMF’s classification is given below:

1. No Separate Legal Tender Arrangement

This group includes
a) Countries which are members of a currency union and share a common currency like the twelve members of the European Currency Union (ECU), who have adopted Euro as their common currency or
b) Countries which have adopted the currency of another country as their currency. IMF’s 1999 Annual Report on Exchange Arrangements and Exchange Restrictions indicates that 37 countries belong to this category.

2. Currency Board Arrangement

A regime under which there is a legislative commitment to exchange the domestic currency against a specific foreign currency at a fixed exchange rate coupled with restrictions on the monetary authority to ensure that this commitment will be honored. This implies constraints on the ability of the monetary authority to manipulate domestic money supply. In its classification referred to above, IMF has classified eight countries – Argentina, Bosnia, Brunei, Bulgaria, Djibouti, Estonia, Hong Kong, and Lithuania – as having a currency board system. However, Hanke (2002) argues that none of these countries can be said to conform to all the criteria of an orthodox currency board system. According to him, legislative commitment to convert home currency into a foreign currency at a fixed rate is just one of the six characteristics of an orthodox currency board arrangement.

3. Conventional Fixed Pegs Arrangement

This is identical to the Bretton Woods system where a country pegs its currency to another or to a basket of currencies with a band of variation not exceeding +1% around the central parity.… Read the rest

Exchange Rate Regimes: The Bretton Woods System

Bretton Woods is the name of the town in the state of New Hampshire, USA, where the delegations from over forty five countries met in 1944 to deliberate on proposals for a post-war international monetary system. The two main contending proposals were “the White plan” named after Harry Dexter White of the US Treasury and the “Keynes plan” whose architect was Lord Keynes of the UK. Following the Second World War, policy makers from victorious allied powers, principally the US and UK, took up the task of thoroughly revamping the world monetary system for the non-communist world. The outcome was the so called “Bretton Woods System” and the birth of new supra-national institutions, the International Monetary Fund (the IMF or simply the “Fund”) and the World Bank.

Under this system US Dollar was the only currency that was fully convertible to gold; where other countries currencies were not directly convertible to gold. Countries held US dollars, as well as gold,  for use as an international means of payment.

The system proposed an international clearing union that would create an international reserve asset called “bancor”. Countries would accept payment in bancor to settle international transactions without limit. They would also be allowed to acquire bancor by using overdraft facilities with the clearing union.

In return for undertaking this obligation, the member countries were entitled to have access to credit facilities from the IMF to carry out their intervention in the currency markets.

The novel feature of regime which makes it an adjustable peg system rather than a fixed rate system like the gold standard was that the parity of a currency against the dollar could be changed in the face of a fundamental equilibrium.… Read the rest

Exchange Rate Regimes: International Gold Standard (1875- 1914)

Though in Great Britain currency notes from the Bank of England were made fully redeemable for gold during 1821, the first full-fledged gold standard was adopted by France  in 1878. Later on United States adopted it in 1879 and Russia and Japan in 1897, Switzerland, and many Scandinavian countries by 1928.

An international Gold Standard is said to exist when;

  • Gold alone is assured of unrestricted coinage
  • There is a  two way convertibility between gold and national currencies at a stable ratio
  • And gold may be freely imported and exported.

In order to support unrestricted convertibility into gold, bank notes need to be backed by gold reserve of a minimum stated ratio. In addition, the domestic money stock should rise and fall as gold flows in and out of the country.

  • In a version called Gold Specie Standard, the actual currency in circulation consists of gold coins with a fixed gold content.
  • In a version called Gold Bullion Standard, the basis of money remains a fixed rate of gold but the currency in circulation consists of paper notes with the monetary authorities. i.e., the central bank of the country standing ready to convert on demand, unlimited amounts of paper currency into gold and vice versa, at a fixed conversion ratio. Thus a Pound Sterling note can be exchanged for say, X ounces of gold while a Dollar note can be converted into say, Y ounces of gold on demand.
  • Finally, under the version Gold Exchange Standard, the authorities stand ready to convert, at a fixed rate, the paper currency issued by them into paper currency of another country which is operating a gold specie or gold bullion standard.
Read the rest

Foreign Exchange Risk or FOREX Risk

Foreign Exchange dealing is a business that one get involved in, primarily to obtain protection against adverse rate movements on their core international business. Foreign Exchange dealing is essentially a risk-reward business where profit potential is substantial but it is extremely risky too.

Foreign exchange business has the certain peculiarities that make it a very risky business. These would include:

  • Forex deals are across country borders and therefore, often foreign currency prices are subject to controls and restrictions imposed by foreign authorities. Needless to say, these controls and restrictions are invariably dictated by their own domestic factors and economy.
  • Forex deals involve two currencies and therefore, rates are influenced by domestic as well as international factors.
  • The Forex market is a 24-hour global market and overseas developments can affect rates significantly.
  • The Forex market has great depth and numerous players shifting vast sums of money. Forex rates therefore, can move considerably, especially when speculation against a currency rises.
  • Forex markets are characterized by advanced technology, communications and speed. Decision-making has to be instantaneous.
Description of Foreign Exchange Risk

In simple word FOREX risk or Foreign Exchange risk is the variability in the profit due to change in foreign exchange rate. Suppose the company is exporting goods to foreign company then it gets the payment after month or so then change in exchange rate may effect in the inflows of the fund. If rupee value depreciated he may loose some money. Similarly if rupees value appreciated against foreign currency then it may gain more rupees.… Read the rest