IFS-Exchange Rate Regimes

INTERNATIONAL FINANCIAL SYSTEMS
Presented by: Sarah Khan
Shaista Yasin
Shahzad Asghar
Shanti Samaroo
Sofian Husni Shiyab

Exchange Rate Regimes
in the
International Financial System

CONTENTS
 Introduction----Sofian (tentative)
 Foreign Exchange and Money Supply (Sofian)
 Exchange Rate Regimes in the IFS (Done - Sarah)
 Balance of Payments (Done –Shanti)
 Role of International Monetary Fund (Done – Shanti)
 Capital Accounts (Shaista)
 The Financial Institutions Industry ---TO BE DONE
 Summary ---TO BE DONE

EXCHANGE RATE REGIMES IN THE
INTERNATIONAL FINANCIAL SYSTEM
There are two basic types of exchange rate
regimes in the international financial system:
─Fixed exchange rate regime
─Floating exchange rate regime

FIXED EXCHANGE RATE
In a fixed exchange rate regime, the values of
currencies are kept pegged relative to one currency so
that exchange rates are fixed.
The currency against which the others are pegged is
known as the anchor currency

FLOATING EXCHANGE RATE
In a floating exchange rate regime, the values of
currencies are allowed to fluctuate against one another.
When countries attempt to influence exchange rates via
buying and selling currencies, the regime is referred to as
a managed float regime (or a dirty float).

FIXED EXCHANGE RATE SYSTEMS
Bretton Woods
1. Created the International Monetary Fund (IMF),
which sets rules and provides loans to deficit
countries
2. Setup the International Bank for Reconstruction
and Development (World Bank), which provides
loans to developing countries

FIXED EXCHANGE RATE SYSTEMS CONT’D
Bretton Woods
3. The U.S. emerged from WWII as the world’s largest
economic power. The U.S. dollar was called the
reserve currency, meaning it was used by other
countries to denominate the assets they held in
international reserves.
4. The system was abandoned in 1971.

FIXED EXCHANGE RATE SYSTEMS:
HOW THEY WORK
There are essentially two situations where a central
bank will act in the foreign exchange market. There
are when the domestic currency is either:
─Overvalued
─Undervalued

FIXED EXCHANGE RATE SYSTEMS: HOW
THEY WORK
 When the domestic currency is overvalued, the central
bank must purchase domestic currency to keep the
exchange rate fixed. As a result, the central bank loses
 When the domestic currency is undervalued, the
central bank must sell domestic currency to keep the
exchange rate fixed. As a result, the central bank gains

HOW THEY WORK
 Devaluation can occur when the domestic currency is
overvalued. Eventually, the central bank may run out
of international reserves, eliminating its ability to
prevent the domestic currency from depreciating.
 Revaluation will occur when the central bank decides
to stop intervening when its domestic currency is
undervalued. Rather than acquiring international
reserves, it lets the par value of the exchange rate
reset to a higher level

HOW THEY WORK
 An important implication—if a country ties its
exchange rate to an anchor currency of a larger
country, it loses control of its monetary policy.
 However, this does force the more disciplined
policies of the larger country on the smaller
country—usually ensuring a low inflation rate

EURO’S CHALLENGE TO THE US DOLLAR
With the introduction of the euro in 1999, the dollar
is losing position as the reserve currency. With the
euro integrating European finance, it is more likely
that international transactions will use the euro.
However, the European Union must start to function
as a cohesive political entity for the euro to gain
further ground – which is unlikely in the near future.

EXCHANGE RATE REGIMES IN THE INTERNATIONAL
FINANCIAL SYSTEM: MANAGED FLOAT
 Central banks are reluctant to give up their ability to
intervene in foreign exchange markets.
 Limiting changes in exchange rates makes it easier
for firms and individual to plan purchases/sales in
the international marketplace.

EXCHANGE RATE REGIMES IN THE INTERNATIONAL
FINANCIAL SYSTEM: MANAGED FLOAT
 Countries with a trade surplus are reluctant to allow
their currencies appreciate since it hurts domestic
sales.
 On the other hand, countries with a trade deficit do
not want to see their currency lose value since it
makes foreign goods more expensive.

BALANCE OF PAYMENTS
Balance of payments (BOP) is an accounting record of monetary
transactions between a country and the rest of the world. The BOP
accounts are usually prepared for a specific period, usually one year, and
are recorded in a single currency, typically in the domestic currency of that
country.
The balance of payments provides us with important information about
whether or not a country is “paying its way” in the international economy.

BALANCE OF PAYMENTS (CONT’D)
Balance Sheet effect: Debit Items Credit Items
Transactions: Uses of funds / Imports Sources of funds / Exports
Items such as: * imports * exports
* Giving / Lending foreign aid * receipt of foreign aid
* domestic spending abroad * receipt of loans
* domestic investments abroad * investment from foreign countries
Effect: Deficit / negative impact Surplus / positive impact
Most often, the accounts are not in balance, meaning that all debits ≠ all credits. Therefore:
Credits > Debits ---surplus
Credits < Debits ---deficit
This surplus / deficit position is referred to as “balance of payments”.

There are two components of the Balance of Payments accounts
Capital Accounts Current Accounts
Current account + Capital Account = net change in government international reserves
or
official reserve transactions balance
The Capital Account shows the net change in ownership of foreign assets. It records the net receipts of capital
transactions such as purchases of stocks, bonds, and bank loans.
The Current Account is the sum of
Balance of Trade + Factor Income + Cash transfers
The current account shows the net amount of a nation’s total exports of goods, services and transfers and its total imports
of them. As the name suggests, it is a record of all international transactions that involve currently produced goods and
services.
Balance of Trade: net earnings on merchandise exports - payments for merchandise imports
Factor Income: earnings on foreign investments – payments made to foreign investors eg Loan repayments
Cash Transfers: net difference between cash inflows and outflows

Cash transfers and Factor Income are derived from the following categories:
 Investment income
 Service transactions
 Unilateral transfers (gifts, pensions, and foreign aid)
Note: “balance of trade” excludes transactions in financial assets and liabilities.
The current account balance indicates whether a nation (both private sector and government sector combined) is
increasing or decreasing its foreign reserves.
Surplus indicates that the nation is increasing its claims on foreign wealth and thus is increasing its holdings of
foreign assets
Deficit indicates that the nation is reducing its holdings of foreign assets and foreign countries are increasing their
claims
When economists refer to a surplus or deficit in the balance of payments, they actually mean a surplus or deficit in the
official reserve transaction balance. The reserve account shows the net amount of international reserves that are used by
governments (represented by their central banks) to finance international transactions.

What does the current account deficit tell us about a nation?
 Consumption: Partly the deficit is the result of a period of sustained economic growth and strong consumer
demand for goods and services –the manufacturing sector is not large enough to meet all of the demand for
consumer goods anddurables, so to satisfythis excess demand, goods and services need to be imported
 Currency : The trade deficit in goods is affected by the strength of the nation’s exchange rate i.e the rate at which
the domestic currencyis traded on the international market
 Other economies: Two major export markets (the USA and the Euro Zone) have both experienced technical
recessions at points in the recent past. Due to the slow growth or minute growth, exports to these market will be
negativelyaffected
 Investment Income: This reflects the amount of overseas investments

………. There are grounds for worrying about the current account deficit
 The deficit reflects an unbalanced economy with consumers spending beyond their means
 The deficit reflects a loss of cost and price competitiveness in export sectors – some of which is the result of a
poor supply side performance in terms of low productivity, insufficient research and development and a lack of
innovation and other forms of non-price competitiveness
 A rising current account deficit may lead to increasing import penetration in domestic markets, which threatens
jobs and living standards in the medium term
 There is no guarantee that the free flow of capital into a country will continue – this will then create a “financing
problem”. It is a bit like the bank deciding to stop lending you money when you keep going back to them to ask
them to give you another extension to your overdraft or loan!
Day to day the current account deficit is not a major problem for as it is easier to finance a current account deficit because
of globalisation and international financial market liberalisation. Even if a country is running a current account surplus,
provided there is a capital account surplus, there is no fundamental economic constraint.
Trade deficit is not always a signal of a deteriorating economy as it is relative to the business cycle. For example, in a
recession, countries tend to export more, thereby creating more jobs with the increased demand, whilst in during
expansion, countries tend to import more, whereby it provides goods beyond the economy’s ability to meet supply.
A current account deficit is not necessarily or automatically a bad thing! Much depends on
 The causes of a current account deficit
 Whether or not the deficit is likely to correct itself as an economy moves through a normal cycle
 Whether or not the deficit can be easily financed through attracting sufficient capital inflows

Why do balance of payments problems occur?
Bad luck, inappropriate policies, or a combination of the two may
create balance of payments difficulties in a country—that is, a situation
where sufficient financing on affordable terms cannot be obtained to
meet international payment obligations. In the worst case, these
difficulties can build into a crisis.
The resulting effect is that the country's currency may be forced to
depreciate rapidly, making international goods and capital more
expensive, and the domestic economy may experience a painful
disruption. These problems tend to also spread to other countries. The
causes of such difficulties are often varied and complex. Key factors
have included :
 weak domestic financial systems;
 large and persistent fiscal deficits;
 high levels of external and/or public debt;
 exchange rates fixed at inappropriate levels;
 natural disasters;
 armed conflicts
 a sudden and strong increase in the price of key commodities
such as food, fuel.

Some of these factors can directly affect a country's trade account, reducing
exports or increasing imports. Others may reduce the financing available for
international transactions; for example, investors may lose confidence in a
country's prospects leading to massive asset sales, or "capital flight.“
In either case, diagnoses of, and responses to, crises are complicated by
linkages between various sectors of the economy. Imbalances in one sector
can quickly spread to other sectors, leading to widespread economic
disruption.
In such cases the International Monetary Fund (IMF) intervenes:
 For instance, a country facing a sudden drop in the price of a key export
may simply need financial assistance to tide it over until prices recover
and to help ease the pain of an otherwise sudden and sharp adjustment.
 A country suffering from capital flight needs to address the problems that
led to the loss of investor confidence: perhaps interest rates that are too
low, a large government budget deficit and debt stock that is growing too
fast, or an inefficient, poorly regulated domestic banking system.

INTERNATIONAL MONETARY FUND (IMF)
The International Monetary Fund (IMF), established in 1944, is an
organization of 187 countries, working to foster global monetary
cooperation, secure financial stability, facilitate international trade,
promote high employment and sustainable economic growth, and reduce
poverty around the world.

(CONT’D)
Headquartered in Washington, D.C, the IMF tracks global economic trends
and performance, alerts its member countries when it sees problems on the
horizon, provides a forum for policy dialogue, and passes on know-how to
governments on how to tackle economic difficulties.
An important task of the IMF is helping countries benefit to from
globalization while avoiding potential downsides. The global economic
crisis has highlighted just how interconnected countries have become in
today’s world economy.
In many ways the IMF's main purpose—to provide the global public good
of financial stability—is the same today as it was when the organization
was established. It continues to:
 provide a forum for cooperation on international monetary problems
 facilitate the growth of international trade, thus promoting job creation,
economic growth, and poverty reduction;
 promote exchange rate stability and an open system of international
payments; and
 lend countries foreign exchange when needed, on a temporary basis
and under adequate safeguards, to help them address balance of
payments problems

(CONT’D)
The IMF supports its membership by providing
 policy advice to governments and central banks based on
analysis of economic trends and cross-country experiences;
 research, statistics, forecasts, and analysis based on tracking of
global, regional, and individual economies and markets;
 loans to help countries overcome economic difficulties;
 concessional loans to help fight poverty in developing countries;
and
 technical assistance and training to help countries improve the
management of their economies.

(CONT’D)
The IMF's main goal is to ensure the stability of the international monetary
and financial system. It has three main tools at its disposal to carry out its
mandate:
 surveillance
 technical assistance and training
 lending
Surveillance: it regularly monitors global, regional, and national
economic developments as it seeks to assess the impact of
the policies of individual countries on other economies.
Technical assistance and training: is offered in several areas, including fiscal
policy, monetary and exchange rate policies, banking and
financial system supervision and regulation, and statistics, to
assist member countries in strengthening their capacity to
design and implement effective policies.

(CONT’D)
Lending: The IMF is also a fund that can be tapped to facilitate
recovery, in the event that member countries experience
difficulties financing their balance of payments.
The IMF also provides low-income countries with loans at a
concessional interest rate through the Poverty Reduction and
Growth Facility (PRGF) and the Exogenous Shocks Facility
(ESF).
The PRGF provides funds at a concessional interest rate to
low-income countries to address protracted balance of
payments problems, whilst the Stand-By Arrangements
(SBA), which charge market-based interest rates on loans to
assist with short-term balance of payments problems.

(CONT’D)
The International Monetary Fund was originally set up under the Bretton
Woods system to help countries deal with balance-of-payments problems
and stay with the fixed exchange rates by lending to deficit countries.
When the Bretton Woods system of fixed exchange rates collapsed in 1971,
the IMF took on new roles.
Although the IMF no longer attempts to encourage fixed exchange rates, its
highly controversial role as an international lender has become more
important recently. This role first came to the fore in the 1980s during the
Third World debt crisis, in which the IMF assisted developing countries in
repaying their loans.
The financial crises in Mexico in 1994–1995 and in East Asia in 1997–
1998 led to huge loans by the IMF to these and other affected countries to
help them recover from their financial crises and to prevent the spread of
these crises to other countries.

(CONT’D)
Should the IMF Be an International Lender of Last Resort?
In industrialized countries when a financial crisis occurs and the financial system
threatens to seize up, domestic central banks can address matters with a lender-of-
last-resort operation to limit the degree of instability in the banking system. In
emerging market countries, however, where the credibility of the central bank as an
inflation fighter may be in doubt and debt contracts are typically short-term and
denominated in foreign currencies, a lender-of-last-resort operation becomes a
double-edged sword—as likely to exacerbate the financial crisis as to alleviate it.
Central banks in emerging market countries therefore have only a very limited ability
to successfully engage in a lender-of-last-resort operation.
However, liquidity provided by an international lender of last resort does not have
these undesirable consequences, and in helping to stabilize the value of the domestic
currency, it also strengthens domestic balance sheets. Moreover, an international
lender of last resort may be able to prevent contagion, the situation in which a
successful speculative attack on one emerging market currency leads to attacks on
other emerging market currencies, spreading financial and economic disruption as it
goes.
Because a lender of last resort for emerging market countries is needed at times, and
because it cannot be provided domestically, there is a strong rationale for an
international institution to fill this role.

(CONT’D)
Indeed, since Mexico’s financial crisis in 1994, the IMF and other international
agencies have stepped into the lender-of-last-resort role and provided
emergency lending to countries threatened by financial instability.
However, this support brings risks of its own, especially the risk of the
perception that it is standing ready to bail out irresponsible financial
institutions may lead to excessive risk taking of the sort that makes financial
crises more likely. In the Mexican and East Asian crises, the governments
used IMF support to protect depositors and other creditors of banking
institutions from losses. This safety net created a well-known moral hazard
problem because the depositors and other creditors had less incentive to
monitor these banking institutions and withdraw their deposits if the
institutions were taking on too much risk.
To counteract this risk the international lender of last resort can
 make it clear that it will extend liquidity only to governments that put the
proper measures in place to prevent excessive risk taking
 reduce the incentives for risk taking by restricting the ability of
governments to bail out stockholders and large uninsured creditors of
domestic financial institutions.

(CONT’D)
One problem that arises for international organizations like the IMF
engaged in lender-of-last-resort operations is that they know that if they
don’t come to the rescue, the emerging market country will suffer extreme
hardship and possible political instability.
How Should the IMF Operate? Just as giving in to ill-behaved children
may be the easy way out in the short run, but supports a pattern of poor
behaviour in the long run, some critics worry that the IMF may not be
tough enough when confronted by short-run humanitarian concerns.
For example, these critics have been particularly critical of the IMF’s
lending to the Russian government, which resisted adopting appropriate
reforms to stabilize its financial system. The IMF has also been criticized
for imposing on the East Asian countries so-called austerity programs that
focus on tight macroeconomic policies rather than on microeconomic
policies to fix the crisis-causing problems in the financial sector.

(CONT’D)
In the past it has been seen that in crisis situations, central banks can lend
much more quickly than the IMF because they have set up procedures in
advance to provide loans, with the terms and conditions for lending agreed
upon beforehand.
The need for quick provision of liquidity, to keep the loan amount manageable,
argues for similar credit facilities at the international lender of last resort, so
that funds can be provided quickly as long as the borrower meets conditions
such as properly supervising its banks or keeping budget deficits low.
A step in this direction was made in 1999 when the IMF set up a new lending
facility, the Contingent Credit Line, so that it can provide liquidity faster
during a crisis.

(CONT’D)
Because IMF lending facilities were originally designed to provide funds
after a country was experiencing a balance-of-payments crisis and because
the conditions for the loan had to be negotiated, in crisis situations it can
several months before the IMF makes funds available, and if much larger
sums of funds are needed to cope with the crisis, the resources of the IMF
can often be stretched.
The debate on whether the world will be better off with the IMF operating
as an international lender of last resort is currently a hot one. Much attention
is being focused on making the IMF more effective in performing this role,
and redesign of the IMF is at the center of proposals for a new international
financial architecture to help reduce international financial instability.

(CONT’D)
At the recent Davos Forum, held last weekend in Switzerland, Mexico's
central bank chief, Agustin Carstens, believed that a consensus was
building on boosting the IMF's resources to help European countries and
others that might need aid from the global lender, whilst Countries
beyond the 17-country bloc wants to see its members stump up more
money before they commit additional resources to the IMF.
At that meeting IMF chief Christine Lagarde led a global push for the
euro zone to boost its financial firewall, saying "if it is big enough it will
not get used."

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