Floating Exchange Rate Systems Era

The Floating Rate Exchange Systems Era: 1973-onwards

This period of floating rates experienced a relatively high volatility of the exchange rates.  The US dollar surged ahead against all major currencies till 1984 and then the intervention of G-10 countries helped the sliding down of the dollar.  The period also witnessed two quick shocks due to the excessive hike of the petroleum prices in 1973 and 1977 and that induced inflation in the world and changed the terms of trade of the petroleum importing countries.  The major characteristics of this period can be put in order.

  • The USA experienced a large current deficit, which touched $ 100 billion in 1990 with a very low saving-income ratio at the domestic level.  On the other hand Germany and Japan experienced large current account surplus.
  • There has been a global insolvency problem as a large number of countries became unable to service their debts.  The petro dollars in the initial period were recycled by the international banks to the needy Third World countries at high nominal interest rates.  Subsequently inflation came down, but interest rate did not.  This led to a substantial rise in real interest rate and put a higher debt burden on the developing countries.
  • There has been a definite change in the balance of economic power in the world with the rise of Japan and Germany as economic power houses.  Particularly, Japan supplied capital to a large number of countries including the USA.  On the other hand Germany along with European Union has become a significant economic force to reckon with.
  • The world has also seen huge amounts of trans-border capital flows and this has been helped by technological innovation.  There has been a phenomenal increase in the volume of business of international forex market and international market of derivatives.  In 1997 the average daily transaction of international forex market reached $ 3 trillion.
  • Along with the increase in business there has been a perceptible increase in the volatility in the market.  This is the result of increasing uncertainty about the perception of the market operations.  But this increasing risk factor has induced development in the derivative market.

On November 1, 1993 the Maastricht Treaty came into force and created the European Union.  By the end of 1997, eleven members of EU have fulfilled the criteria for the launch of the common currency EURO from January 1, 1999.  When Euro will replace the currencies of the members on January 1, 2002, it will be the currency of one of the largest economic blocks of the world.  Then its relation with the US dollar will be worthy of watching.

The floating exchange rate regime (since 1973) ultimately became unsatisfactory at the international level.  This was mainly due to three reasons.  First, inflation had been a common world phenomenon and there was hardly any uniformity regarding this in member countries.  This was because of the divergent macro economic policies followed by the members.

Second, the world economy was subject to two severe shocks, the OPEC oil price hike in 1973 and 1979.  It was difficult for any exchange rate mechanism to absorb this shock.  It reinforced inflation in the oil importing countries and altered the terms of trade.

Third, the international financial system was being dominated by the rising tide of international capital flows.  This started creating uncertainty and consequently the exchange rate volatility increased.

The USA on the one side and Europe and Japan on the other were advancing disparate arguments at diplomatic levels for the stability of the exchange rate system.  While the USA was arguing that Japan and Europe should adopt expansionist policies so that the USA could increase exports and cut down deficits in current accounts, Japan argued that the USA should take measures to reduce budget deficit, as the latter was the root cause of the current account deficit.

In September 1985 the finance ministers of the G-7 countries met in Plaza Hotel in New York and reached an agreement that the US dollar should be allowed to fall.  They agreed to a target zone for the US dollar.  In February, 1987 the ministers of G-7 met again, at Louvre in Paris and agreed that the fall of the US dollar had been adequate and should be stabilised.

Since the Plaza-Louvre accord the central banks of G-7 countries have conducted concerted interventions several times for the stabilization of the dollar and they have been successful.  On certain occasions central banks of three countries intervened in unison and have been able to achieve the targets.

The relationship between IMF and the G-7 countries (the USA, Canada, France, Germany, Italy, Japan, the United Kingdom) is unique in the sense that these countries have a long history of meeting on economic and financial matters of common concern at intervals since 1970.  The arrangement was formalized at the 1982 Versailles Summit of the G-7, where these seven countries declared their eagerness to strengthen their cooperation with the IMF in its work of surveillance.  During the period 1981 to 1985 the USA followed a policy of “benign neglect” regarding the exchange rate of the dollar and G-7 countries became active for the stabilization of the exchange rate regime.  Since then these countries have been active for the management of the world exchange rate system.

The power the G-7 countries exercise in the management of the world financial system is derived from the voting power within the IMF.  These countries control about 47 per cent of the votes in the Board of Governors of the IMF and slightly over 50 per cent in the Executive Board.  In the latter the Canadian and Italian directors exercise the votes of all countries that have elected them and where the voting power of a few new members is not exercised.