Part 1　Global Financial Environment

Project 1　International Monetary System

The price of every thing rises and falls from time to time and place to place； and with every such change the purchasing power of money changes so far as that thing goes.

——Alfred Marshall

Learning Objectives

This project begins with a brief history of the international monetary system from the days of the classical gold standard to the present time. The next section describes contemporary currency regimes and their construction and classification， fixed versus flexible exchange rate principles， and what we would consider the theoretical core of the project—the attributes of the ideal currency. The following section describes the introduction of the euro and the path toward monetary unification， including the continuing expansion of the European Union. This is followed by a section that analyzes the regime choices of emerging markets. The final section analyzes the trade-offs between exchange rate regimes based on rules， discretion， cooperation， and independence.

Task 1　Overview of International Monetary System

1.1　History of the International Monetary System

International monetary system is broadly defined as a complex set of conventions， rules， procedures and institutions that govern the conduct of financial relations between nations. Usually the system needs to determine an international currency as a medium of exchange in international transactions， how the international currency is related to the currencies of different countries， how balance of payment disequilibrium is resolved and the consequences that the adjustment process will have on the countries involved.

Different systems have different ways to deal with those issues. Over the ages currencies have been defined in terms of gold and other items of value， and the international monetary system has been subject to a variety of international agreements. A review of these systems provides a useful perspective against which to understand today’s system and to evaluate weaknesses and proposed changes in the present system.

1.1.1　The Gold Standard， 1876—1914

Since the days of the pharaohs （about， 3000 B.C）， gold has served as a medium of exchange and a store of value. The gold standard as an international monetary system gained acceptance in Western Europe in the 1870s. The United States was something of the latecomer to the system， not officially adopting the standard until 1879.Under the gold standard， the rules of the game were clear and simple. Each country set the rate at which its currency unit （paper or coin） could be converted into a weight of gold. The United States， for example， declared the dollar to be convertible to gold at a rate of 20.67 per ounce （a rate in effect until the beginning of World War Ⅰ）. The British pound was pegged at 4.2474 per ounce of gold. As long as both currencies were freely convertible into gold， the dollar/pound exchange rate was：

=4.8665/

Because the government of each country on the gold standard agreed to buy or sell individual currency in terms of gold， and therefore exchange rates between currencies was fixed. Maintaining adequate reserves of gold to back its currency’s value was very important for a country under this system. The system also had the effect of limiting the rate at which any individual country could expand its money supply implicitly. Any growth in the amount of money was limited to the rate at which official authorities could acquire additional gold. The gold standard worked adequately until the outbreak of World War Ⅰ interrupted trade flows and the free movement of gold. This event caused the main trading nations to stop operation of the gold standard.

1.1.2　The Interwar Years and World War Ⅱ， 1914—1944

The gold standard worked adequately until the outbreak of World War Ⅰ. The war caused Great Britain， France， Germany， and Russia to suspend redemption of banknotes in gold and impose embargoes on gold exports. Germany， Austria， Russia and other countries experienced hyperinflation. Those events threw the international monetary system into turmoil.

During the World War Ⅰ and the early 1920s， currencies were allowed to fluctuate over fairly wide ranges in terms of gold and each other. A lot of countries used “predatory” depreciation of their currencies as a means of gaining advantages in the world export market. International speculators were very active in the financial market. They sold the weak currencies and bought the strong currencies， causing the weak currencies to fall further and the strong currencies stronger.

Fluctuations in currency values could not be offset by the relatively illiquid forward exchange market except at over more cost. The net result was that the volume of world trade did not grow in the 1920s in proportion to world gross domestic product but instead declined to a very low level with the arrival of the Great Depression in the 1930s.

The United States adopted a modified gold standard in 1934 when the U.S. dollar was devalued to 35 per ounce of gold from the 20.67 per ounce price in effect before World War Ⅰ. Contrary to previous practice， the U.S. Treasury traded gold only with foreign central banks， not private citizens. From 1934 to the end of World War Ⅱ， exchange rates were theoretically determined by each currency’s value in terms of gold. During World War Ⅱ and its confusion results， however， many of the main trading currencies lost their convertibility into other currencies. The dollar was the only major trading currency that continued to be convertible.

As a matter of fact， paper standards came into being when the gold standard was abandoned in real. Since the inconvertibility of the most currencies， currency speculation during this period was rampant， causing wild fluctuations in exchange rates. In sum， no coherent international monetary system accepted during this period with profoundly detrimental effects on international trade and investment. As a result， the volume of international trade declined to a very low level with the protectionist policies adopted by many countries.

1.1.3　Bretton Woods and the International Monetary Fund， 1944

In 1944， at the height of World War Ⅱ， representatives from 44 countries met at Bretton Woods， New Hampshire of the United States， to design a new international monetary system. The motivation behind creating a new international monetary system was the desire to avoid the breakdown in international monetary relations that had occurred in the 1930s. The 1930s were marked by major trade imbalances which in turn led to the adoption of widespread trade protectionism， the adoption of deflationary policies， competitive devaluations and the abandonment of the gold exchange standard. There was general agreement that fixed exchange rates were desirable.

The Bretton Woods Agreement reached in 1944 at Bretton Woods conference created the International Monetary Fund （IMF）， The IMF helps countries with balance of payments and exchange rate problems. Two other important institutions that arose at the end of the war were the International Bank for Reconstruction and Development known today as the World Bank and the General Agreement on Tariffs and Trade （GATT）. The World Bank financed postwar reconstruction and assisted in economic development with funds for social capital projects such as dams， ports， and other social infrastructure. The function of GATT， founded in 1948， was to promote the reduction of trade barriers and settle trade disputes among member nations.

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 offer 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 however， the IMF cannot promise to take adequate steps to correct their problems. If persistent deficits occur， however， 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 in terms of gold but were not required to exchange their currencies for gold. Only the dollar remained convertible into gold （at 35 per ounce）. Therefore， each country established its exchange rate vis-a-vis the dollar， and then calculated the gold par value of its currency to create the desired dollar exchange rate. For example， the gold parity of the British pound was 3.58134 gram of fine gold， and the good parity of U.S. dollar was 0.888671 gram of fine gold. Thus the dollar-per-sterling rate was fixed at 3.58134/0.888671=4.03/. This exchange rate was the par value between the dollar and the sterling. Therefore， the system established the link between the U.S. dollar and gold， and the link among other nations’ currencies and the U.S. dollar. Other nations’ currencies were indirectly linked to gold. Participating countries agreed to try to maintain the value of their currencies within 1% （later expanded to 2.25%） of par by buying or selling foreign exchange or gold as needed. For example， if one British pound is equal to 4.03 dollar， then， the width of the floating range of the pound should be between 4.0703（4.03+0.0403） and 3.9897（4.03-0.0403）dollars.

Under the Bretton Woods system， nations used the U.S. dollar to settle international claims and debts. This made the dollar primary reserve currency of the system， or the currency accepted as a means of exchange in international transactions. Typically， only the United States settled international debts with gold under this system.

The Bretton Woods system ran smoothly and looked successful for almost two decades after the World War Ⅱ. The system provided world economy with a stable exchange rate arrangement. It promoted economic growth of many nations and a rapid increase in world trade. The Bretton Woods system was not without its shortcomings， however. Since there was a limit to the U.S. gold stock， the dollar would not increase in value relative to gold， but it could always decrease in value. When the U.S. experienced long-term deficits of its international balance of payments， it would be very difficult for U.S. to maintain the dollar’s mint parity to gold.

Through the 1950s and into the 1960s， the international economy outgrew the system. European economies grew rapidly， and the American dollar’s strength declined. American dollars were being spent overseas， in the form of foreign aid， defense spending， investment， trade， and tourism. This outflow of dollars into the international economy was not reciprocated by annual inflow of currency. This brought about a deficit in the capital account resulting in a balance of payment deficit.

Link It Up：Hammering Out an Agreement at Bretton Woods

The governments of the Allied powers knew that the devastating impacts of World War Ⅱ would require swift and decisive policies. A full year before the end of the war， representatives of all 45 allied nations met in the summer of 1944 （July 1～22） at Bretton Woods， New Hampshire， for the United Nations Monetary and Financial Conference. Their purpose was to plan the postwar international monetary system. It was a difficult process， and the final synthesis was shaded by pragmatism. The leading policy makers at Bretton Woods were the British and the Americans. The British delegation was led by Lord John Maynard Keynes， termed “Britain’s economic heavy weight.” The British argued for a postwar system that would be decidedly more flexible than the various gold standards used before the war. Keynes argued， as he had after World War I， that attempts to tie currency values to gold would create pressures for deflation in many of the war-ravaged economies. And these economies were faced with enormous re-industrialization needs that would likely cause inflation， not deflation.

The American delegation was led by the director of the U.S. Treasury’s monetary research department， Harry D. White， and the U.S. Secretary of the Treasury， Henry Morgenthau， Jr. The Americans argued for stability （fixed exchange rates） but not a return to the gold standard itself. In fact， although the U.S. at that time held most of the gold of the Allied powers， the U.S. delegates argued that currencies should be fixed in parities， but redemption of the gold should occur only between official authorities （central banks of governments）.

On the more pragmatic side， all parties agreed that a postwar system would be stable and sustainable only if there was sufficient credit available for countries to defend their currencies in the event of payment imbalances， which they knew to be inevitable in a reconstructing world order.

The conference divided into three commissions for weeks of negotiation. One commission， led by U.S. Treasury Secretary Morgenthau， was charged with the organization of a fund of capital to be used for exchange rate stabilization. A second commission， chaired by Lord Keynes， was charged with the organization of a second “bank” whose purpose would be for long-term reconstruction and development. A third commission was to hammer out details such as what role silver would have in any new system. After weeks of meetings the participants came to a three part agreement—the Bretton Woods Agreement. The plan called for：

（1）Fixed exchange rates， termed an “adjustable peg” among members；

（2）A fund of gold and constituent currencies available to members for stabilization of their respective currencies， called the International Monetary Fund （IMF）；

（3）A bank for financing long-term development projects （eventually known as the World Bank）.

One proposal resulting from the meetings， which was not ratified by the United States， was the establishment of an international trade organization to promote free trade. That would take many years and conferences to come.

1.1.4　Fixed Exchange Rates， 1945—1973

The currency arrangement negotiated at Bretton Woods and monitored by the IMF worked fairly well during the post World War Ⅱ period of reconstruction and rapid growth in world trade. However， widely diverging national monetary and fiscal policies， differential rates of inflation， and various unexpected external shocks eventually resulted in the system’s demise. The U.S. dollar was the main reserve currency held by central banks and was the key to the web of exchange rate values. Unfortunately， the United States ran persistent and growing deficits in its balance of payment. A heavy capital outflow of dollars was required to finance these deficits and to meet the growing demand for dollars from investors and businesses. Eventually， the heavy overhang of dollars held by foreigners resulted in a lack of confidence in the ability of the United States to meet its commitment to convert dollars to gold.

This lack of confidence forced President Richard Nixon to suspend official purchases or sales of gold by the U.S. Treasury on August 15， 1971， after the United States suffered outflows of roughly one-third of its official gold reserves in the first seven months of the year. Exchange rates of most of the leading trading countries were allowed to float in relation to the dollar and thus indirectly in relation to gold. By the end of 1971， most of the major trading currencies had appreciated vis-a-vis the dollar. This change was in effect a devaluation of the dollar.

A year and a half later， the U.S. dollar once again came under attack， thereby forcing a second devaluation on February 12， 1973； this time by 10% to 42.22 per ounce of gold. By late February 1973， a fixed-rate system no longer appeared feasible given the speculative flows of currencies. The major foreign exchange markets were actually closed for several weeks in March 1973. When they reopened， most currencies were allowed to float to levels determined by market forces. Par values were left unchanged. The dollar floated downward an average of another 10% by June 1973.

1.1.5　Floating Exchange Rate System，1973—Now

The floating exchange rate is the rate free to go wherever the market equilibrium is. The government lets the market determine the exchange rate.An example is the IMF’s nominal exchange rato index of the U.S.dollar and significant events from 1957 to 2007 in Figure 1.1.There are two kinds of floating exchange rate： clean float and managed float. Clean float rate refers to the exchange rate solely determined by the market forces. In some countries， the exchange rates are basically determined by the supply and demand in the foreign exchange market. The governments， however， often try to have a direct impact on the exchange rates through official intervention. In this case， the countries are said to adopt managed float rate system.The managed float is sometimes called the dirty float.

1.1.5.1　The Jamaica Accord，1976

Although the world was operating under a floating rate system， it was illegal form， the viewpoint of the IMF， because the constitution of the IMF forbade floating rates. In January 1976， the members of the IMF amended the constitution of the IMF， thus formally legitimizing the new floating exchange rate system. The key elements of the Jamaica Accord include：

（1）Member countries were basically free to choose any exchange rate system they wanted；

（2）Gold was abandoned as a reserve asset；

（3）The conference aimed at increasing the importance of SDRs in international reserves， and there was a declaration that the SDR should become the“principal reserve asset”.

After Jamaica accord， the IMF continued its role of helping countries cope with macroeconomic and exchange rate problems， albeit within the context of a radically different exchange rate regime.

The Special Drawing Right （SDR） 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 is also the base against which some countries peg the exchange rate for their currencies.

1.1.5.2　The Plaza Agreement （1985） and the Louvre Accord，1987

The Plaza Agreement in 1985 was to reduce the speculation for the U.S. dollar. The U.S. economy experienced high inflation and high unemployment in the 1980s. The high U.S. interest rates attracted international capitals from all over the world. As a result， the dollar had a relentless substantial appreciation from 1980 to 1985. The group of five （France， Germany， Japan， the United Kingdom， and the United States） met at the Plaza Hotel in New York in September， 1985 to reach the Plaza Agreement. The purpose was to intervene collectively to drive down the value of the dollar. The efforts by the central bankers of the group five appeared to achieve its goal and the dollar did depreciate against the major currencies within the next two years.

The 1987 Louvre Accord was， on the other side， to declare that the monetary authorities would cease to drive down the value of the dollar， because the dollar had fallen to the same price where it had started in 1981. G-7 countries would only intervene in the foreign exchange market as needed to ensure stability.

1.2　The Creation of the Euro

The 1991 Treaty of Maastricht and European Monetary Union： The most important international monetary development of the last half century is European Economic and Monetary Union （EMU）， which aims for economic and monetary union within EMU countries. EMU is a single currency area within the European Union （EU） single market， now known as the euro zone， in which people， goods， services， and capital are supposed to move without restrictions. To achieve this objective， participating countries traded their currencies for the euro（）.

Originally， only 11 countries met the convergence criteria. Up till now there are 19 countries that use the euro， The euro began trading on world currency markets in 1999. It had a parity of 1.17/against the U.S. dollar and many economists expected it to strengthen， but contrary to expectations the first few years of its existence the value of the euro slid steadily following its introduction. However， as Figure 1.2 shows， the euro has since made a dramatic recovery and the U.S. dollar has declined in value in part due to concerns about the need to correct an ever-widening U.S. current account deficit. The euro’s future looks to be bright because of the various safeguards that have been put in place to ensure that it will be a sound low-inflation currency.

1.3　Currency Turmoil and Crises Post-now

1.3.1　The Mexican Peso Crisis of 1995

After using a large part of its official reserve holdings to defend the peso exchange rate， the Mexican government had to abandon its heavily managed rate in late 1994. The CFA franc， a currency used by 13 African countries， was devalued by 50 percent in 1994， after it had been pegged at the same rate to the French franc for 45 years. In 1996， the Venezuelan government abandoned its pegged rate， and the Bolivar declined by 42 percent in one day. In May 1997， the Czech government， after spending about 30 percent of its international reserves to defend the pegged rate it had maintained for 6 years， shifted to a floating exchange rate， and the koruna declined by about 10 percent during the first few days of the float.

1.3.2　The Asian Contagion of 1997

In 1997， the Asian crisis hit. In July the Thai government gave up its pegged exchange rate for the Thai baht. By the end of the year the baht’s value had fallen by 45 percent against the U.S. dollar. Then the Malaysian government floated its currency， and the ringgit fell by 35 percent. Soon Indonesia switched to a float， and the rupiah fell by 47 percent. In November the Korean government gave up its defense of the won， whose value then fell by 48 percent.

1.3.3　The Fall of the Russian Ruble in 1998

In 1998， the Russian government shifted to a floating rate and the ruble declined by 60 percent in value against the dollar in about a month and a half. From April 1998 to January 1999， the Brazilian government used about half of its official reserves defending the pegged value of the real. Capital outflows and other speculative pressures increased， and Brazil shifted to a floating rate in January 1999. In two and a half weeks the real declined by 39 percent. In early 2001 the Turkish government abandoned the pegged exchange rate for the Iira， and its value fell by almost half during the year. In early 2002 the Argentinean government shifted to a floating exchange rate for its peso. The value of the peso plummeted， and Argentina’s economy imploded.

Task 2　Contemporary Currency Regimes

Since 1973， exchange rates have become much more volatile and less predictable than they were before.Governments around the world pursue a number of different exchange rate policies. Today’s international monetary system is a mixture of all currency regimes. These range from a pure “free float” where the exchange rate is determined by market forces to a pegged system that has some aspects of the Bretton Woods system of fixed exchange rates.

2.1　IMF’s Exchange Rate Regime Classifications

The IMF classifies all exchange rate regimes into eight specific categories. The eight categories span the spectrum of exchange rate regimes from fixed to independently floating.

（1）Exchange arrangements with no separate legal tender. The currency of another country circulates as the sole legal tender or the member belongs to a monetary or currency union in which the same legal tender is shared by the members of the union.

（2）Currency board arrangements. A monetary regime based on an implicit legislative commitment to exchange domestic currency for a specified foreign currency at a fixed exchange rate， combined with restrictions on the issuing authority to ensure the fulfillment of its legal obligation.

（3）Other conventional fixed peg arrangements. The country pegs its currency （formally or de facto） at a fixed rate to a major currency or a basket of currencies （composite）， where the exchange rate fluctuates within a narrow margin or at most ±1% around a central rate.

（4）Pegged exchange rates within horizontal bands. The value of the currency is maintained within margins of fluctuation around a formal or de facto fixed peg that is wider than ±1% around a central rate.

（5）Crawling pegs. The currency is adjusted periodically in small amounts at a fixed， preannounced rate or in response to changes in selective quantitative indicators.

（6）Exchange rates within crawling pegs. The currency is maintained within certain fluctuation margins around a central rate that is adjusted periodically at a fixed preannounced rate or in response to changes in selective quantitative indicators.

（7）Managed floating with no preannounced path for the exchange rate. The monetary authority influences the movements of the exchange rate through active intervention in the foreign exchange market without specifying， or precommitting to， a preannounced path for the exchange rate.

（8）Independent floating. The exchange rate is market-determined， with any foreign exchange intervention aimed at moderating the rate of change and preventing， undue fluctuations in the exchange rate， rather than establishing a level for it.

It is important to note that only the last two categories， including 80 of the 186 countries covered， are actually “floating” in any real degree. Although the contemporary international monetary system is typically referred to as a “floating regime”，it is clearly not the case for the majority of the world’s nations.

2.2　Fixed Versus Flexible Exchange Rate

A nation’s choice as to which currency regime to follow reflects national priorities about all facets of the economy， including inflation， unemployment， interest rate levels， trade balances， and economic growth. The choice between fixed and flexible rates may change over time as priorities change.

Link It Up：Swiss National Bank Sets Minimum Exchange Rate for the Franc

The current massive overvaluation of the Swiss franc poses an acute threat to the Swiss economy and carries the risk of a deflationary development. The Swiss National Bank （SNB） is therefore aiming for a substantial and sustained weakening of the Swiss franc. With immediate effect， it will no longer tolerate a EUR/ CHF exchange rate below the minimum rate of CHF 1.20. The SNG will enforce this minimum rate with the utmost determination and is prepared to buy foreign currency in unlimited quantities.

Even at a rate of CHF 1.20 per euro， the Swiss franc is still high and should continue to weaken over time. If the economic outlook and deflationary risks so require， the SNG will take further measures.

2.2.1　Fixed Exchange Rate System

Fixed exchange rate is the rate which is officially fixed by the government or monetary authority and not determined by market forces. Only a very small deviation from this fixed value is possible. In this system， foreign central banks stand ready to buy and sell their currencies at a fixed price. A typical kind of this system was used under Gold Standard System in which each country committed itself to convert freely its currency into gold at a fixed price. In other words， value of each currency was defined in terms of gold， and therefore， exchange rate was fixed according to the gold value of currencies that have to be exchanged.

The advantages and disadvantages of this system are listed below.

Merits：

（1）It ensures stability in exchange rate which encourages foreign trade；

（2）It contributes to the coordination of macro policies of countries in an interdependent world economy；

（3）Fixed exchange rate ensures that major economic disturbances in the member countries do not occur；

（4）It prevents capital outflow；

（5）Fixed exchange rates are more conducive to expansion of world trade because it prevents risk and uncertainty in transactions；

（6）It prevents speculation in foreign exchange market.

Demerits：

（1）Fear of devaluation. In a situation of excess demand， central bank uses its reserves to maintain foreign exchange rate. But when reserves are exhausted and excess demand still persists， government is compelled to devalue domestic currency. If speculators believe that exchange rate cannot be held for long， they buy foreign exchange in massive amount causing deficit in balance of payment. This may lead to larger devaluation. This is the main flaw or demerit of fixed exchange rate system；

（2）Benefits of free markets are deprived；

（3）There is always possibility of under-valuation or over-valuation.

2.2.2　Flexible Exchange Rate System

The system of exchange rate in which rate of exchange is determined by forces of demand and supply of foreign exchange market is called Flexible Exchange Rate System. Here， value of currency is allowed to fluctuate or adjust freely according to change in demand and supply of foreign exchange.

There is no official intervention in foreign exchange market. Under this system， the central bank， without intervention， allows the exchange rate to adjust so as to equate the supply and demand for foreign currency.In India， it is flexible exchange rate which is being determined. The foreign exchange market is busy at all times by changes in the exchange rate. Advantages and disadvantages of this system are listed below.

Merits：

（1）Deficit or surplus in BOP is automatically corrected；

（2）There is no need for government to hold any foreign exchange reserve；

（3）It helps in optimum resource allocation；

（4）It frees the government from problem of BOP.

Demerits：

（1）It encourages speculation leading to fluctuations in foreign exchange rate；

（2）Wide fluctuation in exchange rate hampers foreign trade and capital movement between countries；

（3）It generates inflationary pressure when prices of imports go up due to depreciation of currency.

2.3　Distinction Between Fixed Exchange Rate and Flexible Exchange Rate

Fixed exchange rate is the rate which is officially fixed in terms of gold or any other currency by the government. It does not change with change in demand and supply of foreign currency. As against it， flexible exchange rate is the rate which， like price of a commodity， is determined by forces of demand and supply in the foreign exchange market. It changes according to change in demand and supply of foreign currency. There is no government intervention.

2.4　Emerging Markets and System Choices

The 1997—2005 periods saw increasing pressures on emerging market countries to choose among more extreme types of exchange rate regimes. The increased capital mobility pressures have driven a number of countries choose between either a free-floating exchange rate or the opposite extreme， a fixed-rate regime such as currency board or even dollarization.

2.4.1　Currency Boards

A currency board is a monetary authority which is required to maintain a fixed exchange rate with a foreign currency. This policy objective requires the conventional objectives of a central bank to be subordinated to the exchange rate target.

Currency boards supply currency on the basis of 100 percent foreign reserves. For example， if the currency board in Hong Kong issues one Hong Kong dollar， and the fixed exchange rate it maintains is HK 7.75 per U.S. Dollar， anybody who wants to obtain HK 7.75 from the currency board has to give it 1， and anybody who has Hong Kong dollars issued by the currency board can require it to give up 1 for every HK 7.75 As reserves， a currency ward holds low-risk， interest-bearing bonds and other assets denominated in he anchor currency. A currency board’s reserves are equal to 100 percent or lightly more of its notes and coins in circulation， as set by law. A currency board generates profits from the difference between the interest earned on its reserve assets and the expense of maintaining its liabilities—its notes and coins in circulation. It remits to the government all profits beyond what it needs to cover its expenses and maintain its reserves at the level： set by law. An orthodox currency board has no discretion in monetary policy， market forces alone determine the money supply.

Argentina abandoned its currency board in January 2002 after a severe recession. To some， this emphasized the fact that currency boards are not irrevocable， and hence may be abandoned in the face of speculation by foreign exchange traders. However， Argentina’s system was not an orthodox currency board， as it did not strictly follow currency board rules—a fact which many see as the true cause of its collapse. They argue that Argentina’s monetary system was an inconsistent mixture of currency board and central banking elements. It is also thought that the misunderstanding of the workings of the system by economists and policymakers contributed to the Argentine government’s decision to devalue the peso in January 2002. The economy fell deeper into depression before a recovery began later in the year.

2.4.2　Dollarization

Several countries have suffered currency devaluation for many years， primarily as a result of inflation， and have taken steps toward dollarization. Dollarization is the use of the U.S. dollar as the official currency of the country. Panama has used the dollar as its official currency since 1907. Ecuador， after suffering a severe banking and inflationary crisis in 1998 and 1999， adopted the U.S. dollar as its official currency in January 2000.

Full dollarization， however， is an almost permanent resolution： the country’s economic climate becomes more credible as the possible speculative attack on the local currency and capital market virtually disappears. The small nations can achieve economic stability through dollarization. The main reason a country would do this is to reduce its country risk， thereby providing a stable and secure economic and investment climate. Countries seeking full dollarization tend to be developing or transitional economies， particularly those with high inflation. The diminished risk encourages both local and foreign investors to invest money into the country and the capital market. And the fact that an exchange rate differential is no longer an issue helps reduce interest rates on foreign borrowing.

Three major arguments exist against dollarization. The first is the loss of sovereignty over monetary policy. This is， however， the point of dollarization.Second， the country loses the power of seignorage， the ability to profit from its ability to print its own money. Third， the central bank of the country， because it no longer has the ability to create money within its economic and financial system， can no longer serve the role of lender of last resort. This role carries with it the ability to provide liquidity to save financial institutions that may be on the brink of failure during times of financial crisis.

There is no doubt that for many emerging markets， a currency board， dollarization， and free floating exchange rate regimes are all extremes. In fact， many experts feel that the global financial marketplace will drive more and more emerging market nations onward one of these extremes. As shown in Figure 1.3， there is a distinct lack of middle ground between rigidly fixed and free-floating extremes. In anecdotal support of this argument， a poll of the general population in Mexico in 1999 indicated that 9 out of 10 people would prefer dollarization over a floating-rate peso. Clearly， there are many in the emerging markets of the world who have little faith in their leadership and institutions to implement an effective exchange rate policy.

Task 3　European Monetary System

After the demise of the Bretton Woods system in 1971， European leaders began looking for a new approach to ensure currency stability. The road towards today’s Economic and Monetary Union and the euro area can be divided into five phases.

3.1　From the Treaty of Rome to the Werner Report， 1957—1970

The international currency stability that reigned in the immediate post-war period did not last. Turmoil on international currency markets between 1968 and 1969 threatened the common price system of the common agricultural policy， a main pillar of what was then the European Economic Community. In response to this troubling background， Europe’s leaders set up a high-level group led by Pierre Werner， the Luxembourg Prime Minister at the time， to report on how EMU could be achieved by 1980.

3.2　From the Werner Report to the European Monetary System， 1970—1979

The Werner group set out a three-stage process to achieve EMU within ten years， including the possibility of a single currency. The EU Member States agreed in principle in 1971 and began the first stage-narrowing currency fluctuations. However， a fresh wave of currency instability on international markets squashed any hopes of tying the Community’s currencies closer together. Subsequent attempts at achieving stable exchange rates were hit by oil crises and other shocks until， in 1979， the European Monetary System （EMS） was launched.

3.3　From the start of EMS to Maastricht， 1979—1991

The EMS was built on exchange rates defined with reference to a newly created European Currency Unit（ECU）， a weighted average of EMS currencies. An exchange rate mechanism （ERM） was used to keep participating currencies within a narrow band. The EMS represented a new and unprecedented coordination of monetary policies between EU countries， and operated successfully for over a decade. This success provided the impetus for further discussions between EU countries on achieving economic and monetary union. At the request of the European leaders， the European Commission President， Jacques Delors， and the central bank governors of the EU Member States produced the “Delors Report” on how EMU could be achieved.

3.4　From Maastricht to the Euro and the Euro Area， 1991—2002

The Delors Report proposed a three-stage preparatory period for economic and monetary union and the euro area， spanning the period 1990 to 1999. Preparations involved： completing the internal market （1990—1994）， namely through the introduction of the free movement of capital preparing for the European Central Bank （ECB） and the European System of Central Banks （ESCB）， and achieving economic convergence （1994—1999） fixing exchange rates and launching the euro （1999 onwards）European leaders accepted the recommendations in the Delors Report. The new Treaty on European Union， which contained the provisions needed to implement EMU， was agreed at the European Council held at Maastricht， the Netherlands， in December 1991. This Council also agreed the “Maastricht convergence criteria” that each Member State would have to meet to participate in the euro area.

After a decade of preparations， the euro was launched on 1 January 1999. At the same time， the euro area came into operation， and monetary policy passed to the European Central Bank （ECB）， established a few months previously—1 June 1998—in preparation for the third stage of EMU. After three years of working with the euro as “book money” alongside national currencies， euro coins and banknotes were launched on 1 January 2002 and the biggest cash changeover in history took place in 12 EU countries （Austria， Belgium， Finland， France， Germany， Greece， Ireland， Italy， Luxembourg， the Netherlands， Portugal and Spain）.

3.5　The Largest-ever Currency Changeover

The introduction of euro banknotes and coins in 2002 was the largest-ever currency changeover. In preparation for it， around 14 billion notes and 52 billion coins were produced， of which some 7.8 billion notes and 40 billion coins were distributed at the beginning of January 2002 to 218，000 banks and post offices， 2.8 million sales outlets， and 302 million individuals in the 12 participating countries. In parallel， a large proportion of the 9 billion national notes and 107 billion national coins in circulation were withdrawn. The success of this huge operation was due to the thorough preparations， the active participation of all sectors involved， and the enthusiasm of the public.

The euro area today， since the introduction of euro notes and coins in 2002， 19 EU countries have joined the euro area. 340 million Europeans use the euro every day—it is the second most—used currency worldwide. While the UK decided to leave the EU in 23th June， 2016，which is called Brexit，all EU-27 Member States are legally committed to joining the euro at some stage， with the exception of Denmark. The Danish krone， however， participates since 1999 in the Exchange Rate Mechanism Ⅱ， where its central exchange rate to the euro is fixed and fluctuates only within a narrow band. The Bulgarian levis pegged to the euro at a constant rate. Croatia also targets a stable nominal exchange rate with the euro. This is why it is essential to frame specific euro area questions within the broader framework of the European Union， to maximize synergies with existing and future instruments and frameworks. Meanwhile， “Brexit” brings new opportunities for UK， but it also faces new challenges. The impact of Brexit on sterling could take 10 years or so.

Task 4　Exchange Rate Regimes： What Lies Ahead？

All exchange rate regimes must deal with the trade-off between rules and discretion， as well as between cooperation and independence.Figure 1.4 illustrates the trade-offs between exchange rate regimes based on rules， discretion， cooperation， and independence.

（1）Vertically， different exchange rate arrangements may dictate whether the country’s government has strict intervention requirements rules or whether it may choose whether， when， and to what degree to intervene in the foreign exchange markets discretion.

（2）Horizontally， the trade-off for countries participating in a specific system is between consulting and acting in unison with other countries cooperation or operating as a member of the system， but acting on their own independence.

Regime structures like the gold standard required no cooperative policies among countries， only the assurance that all would abide by the “rules of the game”.Under the gold standard in effect prior to World War Ⅱ， this assurance translated into the willingness of governments to buy or sell gold at parity rates on demand. The Bretton Woods Agreement， the system in place between 1944 and 1973， required more into cooperate to a higher degree to maintain the dollar-based system. Exchange rate systems， like the European Monetary System’s fixed exchange rate band system used from 1979 to 1999， were hybrids of these cooperative and rule regimes.

The present international monetary system is characterized by no rules， with varying degrees of cooperation. Although there is no present solution to the continuing debate over what form a new international monetary system should take many believe that it could succeed only if it combined cooperation among nations with individual discretion to pursue domestic social， economic， and financial goals.

Mini Case

The Revaluation of the Chinese Yuan

The Chinese renminbi（RMB） or yuan（CNY） is going global. Trading in the RMB is closely controlled by the People’s Republic of China （PRC）， the Chinese government， with all trading inside China between the RMB and foreign currencies， primarily the U.S. dollar， being conducted only according to Chinese regulations. Its value， as illustrated in Figure 1.5， has been carefully controlled. Although it has been allowed to revalue gradually against the dollar overtime， most indicators and analysts believe it to still be grossly undervalued.

The Chinese government， however， is now starting to relax restrictions， releasing the Yuan to move toward prominence as a truly global currency. The first and foremost traditional role for currency trading is through its use in the settlement of trade transactions—the denomination of exports （which generate foreign currency inflows traditionally） and imports （which use up foreign currency reserves traditionally） in the currency，and that is already changing rapidly. In 2009， of the 1.2 trillion of Chinese exports only about 1% were denominated in RMB. By the end of the first quarter of 2011， in a little more than one year， that percentage had risen to 7%.The Chinese government had now reversed its policy and was now encouraging exporters to convert to RMB invoicing. A Chinese exporter is typically paid in U.S. dollars， and has historically not been allowed to keep the dollar proceeds in any bank account. Exporters are required to exchange all foreign currencies for RMB at the official exchange rate set by the PRC. All hard-currency earnings from massive Chinese exports are therefore turned over to the Chinese government.

The result has been a gross accumulation of foreign currency （3.2 trillion at end of year 2011） not seen in global business history.But now， with RMB denomination of exports， foreign buyers are now being pushed to the exchange markets to acquire RMB for purchases， increasing trade-related currency trading.

Inevitably， the currency of an economy of the size and scope of China’s will result in more and more of its currency leaving China. Although it has restricted the flow of yuan out of China for many years ultimately more and more will find its way beyond the reach of the onshore authorities. Once out of the reach of Chinese authorities， the yuan will be traded freely without government intervention. China knows this all too well， and has therefore adopted a gradual policy of developing the trading in the yuan，but through its own onshore offshore market， Hong Kong.

Offshore （Hong Kong） Trading

Hong Kong is a product of the “one country two systems” development of the PRC. Although a possession of the PRC， Hong Kong （as well as Macau） has been allowed to continue to operate and develop along its traditional free-market ways， but for currency purposes， Hong Kong was offshore. Hong Kong’s own currency， the Hong Kong dollar （HKD），has long floated in value against the world’s currencies.

But Hong Kong has a preferred access to yuan under PRC rules. Beginning in January 2004， Hong Kong residents were allowed to hold RMB in cash and bank deposits. They were allowed to obtain these balances through limited trading； daily transfers were limited to RMB 20，000 （roughly 2，400 at the exchange rate of RMB 8.27/USD at the time）. Although this did allow a legal conduit for the movement of RMB out of the onshore market， its volume was so small it was inconsequential. This currency， however small in volume， is now referred to as CNH （as shown in Figure 1.6）， Hong Kong-based trading in RMB.

It has been the basis for some limited financial product development， but has been significantly lacking in trading volume until recently. This market is now starting to boom， with RMB deposits in Hong Kong banks recently estimated at end of year 2011 at nearly 90 billion. This has not， however， sated the thirst for RMB by a multitude of different traders outside of mainland China. As a result， a market has grown over the past decade for CNY-NDFs， no deliverable forwards （NDFs） based on the officially cited value of the CNY by the Chinese government. These are forward contracts whose value is determined by the PRC-posted exchange value of the CNY， but are no deliverable， meaning they are settled in a currency like the dollar or euro， not the CNY itself （because that would take access to physical volumes or deposits of RMB）.The flow of RMB into the Hong Kong market， however， boomed in 2010 and 2011 as a result of a series of regulatory changes by the PRC. In July 2010， the PRC began allowing unlimited exchange and flow of RMB into Hong Kong for trade related transactions—payments for imports denominated in Chinese RMB.

The Question of Backflow

The challenge to the growth of the Hong Kong offshore market is what to do with the growing balances of RMB.

Although the RMB may flow from the onshore Chinese mainland into Hong Kong for import purchases， the receivers of the RMB will recycle these flows into the Hong Kong market upon receipt as the currency has no real trading use outside of Hong Kong or China as a whole. According to a variety of Hong Kong-based currency analysts， unless the holders of these RMB balances in Hong Kong can gain access to the onshore market—mainland China—the market will still be limited in its growth potential.

Charles Li， Chief Executive of HKEx （Hong Kong Exchanges and Clearing Limited）， had a unique way of explaining why the accumulating RMB in Hong Kong needs greater backflow ability to China （followed by Morgan Stanley’s graphical depiction of the fish process in Figure 1.7）.

To understand the different challenges in these three stages， the following analogy might be of some help. If we see RMB flows as water and RMB products as fish， the logic will be clear. Fish do not exist where there is no water and they cannot survive if the water is stagnant. Without nutrients in the water， fish don’t grow. The nutrients， representing returns on RMB products， can only come from the home market. That’s why the offshore RMB must be allowed to flow back， at least at the initial stage.

As Mr. Li （and Morgan Stanley） make so vividly clear， for the RMB market in Hong Kong to grow and sustain it needs the ability to return to the Chinese mainland freely to have a “purpose”—to gain returns from RMB based trading and commercial purposes. The RMB can only be used in China， and China’s State Administration of Foreign Exchange （SAFE） must approve all transfers of RMB into the country on a case-by-case basis， even from Hong Kong.

Breadth and Depth of RMB Trading

Although the quotation of CNH deposit rates are listed on the counters of most Hong Kong banks today， side-by-side with U.S. dollar and Hong Kong dollar rates， there will continue to be a limited demand for these funds by the institutions themselves in the near future unless the PRC allows greater backflow into the onshore market. The offshore Hong Kong market took a highly visible step forward in August 2010 with the launch of an RMB denominated corporate bond issue for McDonald’s Corporation （U.S.）.

19 August 2010，Standard Chartered Bank（Hong Kong） Limited proudly announces the launch of a RMB corporate bond for the Bank’s Multinational Corporate Client McDonald’s Corporation. It is the first ever RMB bond launched for a foreign Multinational Corporate in the Hong Kong debt capital market signifying the commencement of a new funding channel for international companies to raise working capital for their China operations. It is also a significant contribution to the development of the offshore RMB debt capital market in Hong Kong. The RMB 200 million 3% notes due September 2013， was targeted at institutional investors.

The bonds， colloquially termed Panda Bonds or the Dim Sum Bond Market，was the first issue denominated in RMB by a nonfinancial non-Chinese firm in the global market. Although small in size， roughly 30 million， the issue was something of a sign of what the future might hold for multinational enterprises operating in the world’s second largest economy： the ability to both operate and fund their business growth in Chinese RMB. The McDonald’s issuance was followed by a larger 150 million RMB-bond by Caterpillar Corporation （U.S.），and in January 2011 by a CNY 500 million （75.9 million）issuance by the World Bank.

Are the Tides Turning？

The year 2011 saw a number of rather surprising changes in markets and regulations which may foretell the true globalization of the yuan. It is important to remember that one of the ongoing concerns of the Chinese government over the globalization of the yuan is that deregulation could result in a flood of capital into the Chinese market—into RMB accounts—driving the currency’s value up over time and damaging export competitiveness.

（1）The Chinese economy’s rate of growth slowed in 2011， and may have slowed dramatically in the last quarter of the year. Chinese factory activity showed declines， as a multitude of economic factors， including rising wage rates in the coastal provinces， hampered Chinese export competitiveness. A number of other major emerging markets， including India， also showed sluggish growth.

（2）A number of analysts and sources （including the Economist’s own Big Mac Index） began noting that the exchange value of the yuan may be approaching parity in the latter half of 2011. This would mean that the Chinese government’s management of the currency’s trading has found a “resting spot” in terms of value.

（3）Many market analysts and economists are predicting that the RMB will globalize rapidly， taking on the role of a reserve currency within the next decade. Forecasts of its share of global reserves vary between 15% and 50% by the year 2002.

Global Currency

The globalization of the Chinese yuan could quickly go far beyond being widely traded. The growing debate was whether the yuan could potentially become a reserve currency （also commonly referred to as an anchor currency）—a currency that much of the world’s governments and central banks would acquire and hold and use as part of their foreign currency reserves. The continued fiscal deficits dilemmas in the United States and among European Union members had both resulted in a growing unease in the world’s central banks over the ability of the dollar and the euro to maintain their value over time. Could， or should， the yuan serve as such a replacement？ One theoretical concern about becoming a reserve currency was the Triffin Dilemma （or sometimes called the Triffin Paradox）. The Triffin Dilemma is the potential conflict in objectives which may arise between domestic monetary and currency policy objectives and external or international policy objectives when a country’s currency is used as a reserve currency. Domestic monetary and economic policies may on occasion require both contraction and the creation of a current account surplus （balance on trade surplus）. But if a currency is to be used as a reserve currency， other countries will require the country to run current account deficits， essentially dumping growing quantities of the currency on global markets. This means that a country like the United States needs to become internationally indebted as part of its role as a reserve currency country. In short， when the world adopts a currency as are serve currency， demands are placed on the use and availability of that currency which many countries would prefer not to deal with. In fact， both Japan and Switzerland had both worked for decades to prevent their currencies from gaining wider international use， partially as a result of these complex issues.

Outside of reserve currency status， there are a multitude of other factors and levels of trade and capital market developments related to a currency which could determine the degree to which it could be considered “international” in character.Table 1.1 provides a very recent assessment across currencies by the IMF as to which currencies are more international or global than others. Note the relatively low ranking for the RMB—at this time—in the first three categories of being widely used as a reserve currency， in international trade and capital payments， and currency trading.Many experts have speculated for years that it would take nearly a generation before the yuan might find its way into the international marketplace. Those forecasts had now changed. It was globalizing， and fast. The growth of the offshore yuan market in Hong Kong represented only the first step on that journey—but an obviously important one for the RMB.

Case Questions

1.How does the Chinese government limit the use of the Chinese currency， the RMB， on the global currency markets？

2. What are the differences between the RMB， the CNY， the CNH， and the CNY-NDF？

3. Why was the McDonald’s bond issue so significant？

4. Will—if ever—the RMB become a truly global currency？