Detailed Information about Bretton Woods Exchange Rate System and The Special Drawing Rights (SDRs)

Bretton Woods Exchange Rate System (1944)

In 1944, as World War II drew toward a close, the Allied Powers met at Bretton Woods, New Hampshire, in order to create a new post-war international monetary system. The Bretton Woods Agreement, implemented in 1946, whereby each member government pledged to maintain a fixed, or pegged, exchange rate for its currency vis-à-vis the dollar or gold. These fixed exchange rates were supposed to reduce the riskiness of international transactions, thus promoting growth in world trade. The Bretton Woods Agreement established a US dollar-based international monetary system and provide for two new institutions, The IMF and the World Bank. The IMF aids countries with balance of payments and exchange rate problems. The International Bank for Reconstruction and Development (World Bank) helped post-war reconstruction and since then has supported general economic development.

The IMF was the key institution in the new international monetary system, and it has remained so to the present. The IMF was established to render temporary assistance to member countries trying to defend their currencies against cyclical, seasonal, or random occurrences. It also assists countries having structural trade problems if they take adequate steps to correct their problems. However, if persistence deficits occur, the IMF cannot save a country from eventual devaluation. In recent years it has attempted to help countries facing financial crises. It has provided massive loans as well as advice to Russia and other former Russian republics, Brazil, Indonesia, and South Korea, to name but a few.

Under the original provisions of the Bretton Woods Agreement, all countries fixed the value of their currencies for gold. Only the dollar remained convertible into gold (at $35 per ounce). Therefore, each country decided what it wished its exchange rate to be vis-a-vis the dollar and then calculated the gold per value of its currency to create the desired dollar exchange rate. Participating countries agreed to try to maintain the value of their currencies within 1% (later expanded to 2 ¼ %) of par by buying or selling foreign exchange or gold as needed. Devaluation was not to be used as a competitive trade policy, but if a currency became too weak to defend, a devaluation of up to 10% was allowed without formal approval by the IMF. Larger devaluations required IMF approval.

The Special Drawing Rights (SDRs)

The Bretton Woods also known as IMF system was an improvement on the gold standard. The IMF system had all the merits of the gold standard minus its demerits. It ensured exchange stability without the country having to undergo the expense of maintaining a costly currency system. Under the IMF system, exchange parities were fixed in gold but it was unnecessary to keep large gold reserves for currency purposes. Besides gold stocks and current output were utterly inadequate to meet the requirements of over-expanding volume of international trade, thus giving rise to the serious problem of international liquidity. The IMF sought to provide multilaterism. The IMF quota facilitated foreign exchange transactions and there was no need to export gold to meet a trade deficit. It also facilitated convertibility of currencies and provided adequate and convenient currency reserve for the use of member countries. However, fast changing circumstances are necessitated changes in the IMF system. In September 1967, the Board of Governors approved a plan for a new type of international asset known as the SDRs (Special Drawing Rights).

SDRs is an international reserve asset created by the IMF to supplement existing foreign exchange reserves. It serves as a unit of account for the IMF and other international and regional organizations, and it is also the base against which some countries peg the rate of exchange for their currencies. Defined initially in terms of a fixed quantity of gold, the SDR has been redefined several times. It is currently the weighted value of currencies of the five IMF members having the largest exports of goods and services. Individual countries hold SDRs in the form of deposits in the IMF. These holdings are part of each country‘s international monetary reserves, along with official holdings of gold, foreign exchange, and its reserve position at the IMF. Members may settle transactions among themselves by transferring SDRs.

Under the Scheme, the IMF is empowered to allocate to various member countries SDR‘s on a specified basis, which in effect amounts to raising the limit to which a member country can draw from the IMF in time of need. Besides, the SDR‘s supplement gold, dollars and pounds sterling most countries use as monetary reserves. They can be used unconditionally by the participating countries to meet their liabilities and they are not backed by gold. They are meant to be used by the Central banks of the Fund‘s member countries. With the SDR‘s, the Central banks can buy whatever currencies they need for settling their balance of payments deficits. The resources of the new scheme are not a pool of currencies but simply the obligation of participating members to accept the SDR‘s for settlement of payments between them. Thus, SDR‘s serve as an international money as good as other reserve currencies.

But a nicely and diligently built up system of exchange stability by the IMF collapsed like a house of cards. This was caused by the dollar crisis created by the adverse American balance of payments. Among the measures taken by the American administration, there was one which delinked dollar from gold. The delinking of dollar from gold knocked out the very foundation of the IMF. In January 1975, the IMF abolished the official price of gold and SDR‘s have instead become the basis of the present international monetary standard. The SDR‘s are not convertible into gold; that is why alternatively the present standard may also be referred to as Paper Gold Standard.

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