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International Monetary System &

Foreign Exchange Market


An efficient International Monetary System is a necessary pre
condition for the smooth functioning & expansion of International
business.
(i)Pre- Bretton Woods Period
Until World War- I & beyond major Industrialized nations of the world
traded under, a fixed exchange system, Gold Standard.

Under this system, each nation defined its currency in terms of gold.

Money issued by member countries had to be backed by reserves of


gold.

Gold would act as an automatic adjustment, flowing in & out of


countries & automatic altering the gold reserves of that country if
imbalances in trade occur.

Exchange rate
between nations

$ 200/10grms of gold
Rs. 2000/10grms of gold
or 1 $ = Rs. 10

$ 0.1/ Re

Under the Gold Standard, Money Supply was directly linked to the
stock of Monetary Gold.

Gold Standard could not with stand abnormal periods like war &
depression.

The Bretton Woods System (1944-1971)

The govts. of 44 allied nations gathered together in Bretton Woods, New


Hampshire in 1944 to plan for the post war international monetary system.
For the new Monetary System to be stable & sustainable :- It
Should be able to provide sufficient liquidity to countries during
periods of crisis. (stable exchange rates)

Any new system had to have facilities for the extension of credit for
countries to defend their currency values. (multilateral credit
mechanism)

The Bretton woods agreement called for :

Fixed exchange rates between member countries termed as


adjustable Peg.

The establishment of a fund of gold & currencies available to


members for stabilization of their respective currencies (the IMF)

The establishment of a bank that would provide funding for long-run


development projects World Bank.

The international monetary system that existed from 1947 to 1971 is


generally known as the par value system or pegged exchange rate
system.

Under this system, each member country of the IMF was required to
define the value of its currency in terms of gold or the US dollar & to
maintain (to peg) the market value of its currency within _+1%

Value of dollar was set @ $ 35 per ounce gold.

US promised that all US $ in the hands of central banks would be


redeemed in gold, upon demand, at a fixed price of $35 per ounce.

Break Down of the Bretton Woods System & Emergence of


Managed Floating Floating Exchange Rate 1973
Since March 1973, the worlds major currencies have floated
in value versus each other.

Bretton Woods System failed because the governments all over the
world were unable to maintain their parity under the gold or Dollar
system since it required reserve assets. An expansion in trade required
increase in international liquidity.

The persistent & burgeoning BOP deficit of the US & the huge
accumulation of the dollar outside the US led to the breakdown of the
par value (US liabilities rose to $68 billion) Central Bank of Germany
alone held enough dollar to exhaust entire gold of US.

Foreign Exchange Markets became hectic in early 1971, and Central


banks, with the strongest currencies, had to buy massive amounts of
dollar in order to maintain exchange rates at the official par value
(+1%). So, the Central Banks became increasingly reluctant to continue
the stabilization procedure.

Speculators & MNCs became very eager to unload dollars & to acquire
other currencies.

IMFs par value system officially ended on 15, Aug 1971. President
Nixon withdrew USs commitment to buy & sell gold @$35 per ounce,
thus abrogating the IMF agreement.

The collapse of the agreement resulted in a floating exchange rate.


Monetary authorities have not been allowing their currency values to
be determined solely by demand & supply, but have been intervening
from time to time to keep the exchange rate within desired rates
Managed float.

Indian rupees was pegged to a basket of five currencies for its rate
determination. These currencies are $, , Franc,Yen & Deutch mark.

The breakdown of the par value system led to floating of major


currencies.

Different exchange rate systems prevail today.

Former Governor RBI, Bimal Jalan, observes that the debate on


appropriate policies relating to FE markets centers around : Exchange rates should be flexible & not fixed or pegged.

Countries should be able to intervene or manage exchange rates to


act at least to some degree if movements are believed to
destabilize in the short run.

Reserves should be sufficient to take care of fluctuations in capital


flows & liquidity at risk.

EMS, ECU & EURO


EEC (European Economic Community) established a common
exchange rate system.

In 1979 New arrangement EMS (European Monetary System) was


introduced stability of fixed exchange rates among themselves & having
flexibility in exchange rates with the rest of the world.
EMS is a system of fixed but adjustable exchange rates. Each currency
had a central rate expressed in terms of
European Currency Unit(ECU).

The ECU consisted of a basket of fixed amounts of currencies of the


common market countries.
The central rates determined a grid of bilateral central rates with
fluctuations margin of +2.5%
Intervention by the participating central banks kept the exchange rates of
Their currencies within the margins in EMS currencies.

Intervention in other currencies (US) was allowed & had been undertaken
on a substantial scale.
The grid of bilateral central rates & intervention limits was supplemented
by the divergence indicator, which showed the movement of the
exchange rate of each EMS currency against the (weighted) average
movement of others

If a currency crossed a threshold of divergence, this led to a presumption


that the authorities concerned would correct the situation by taking
adequate measures.
ECU is central of EMS. It served as a unit of a account for exchange rate
mechanism & for the operations in both the intervention & the credit
mechanism.

Central banks participating in the exchange rate mechanism of the EMS


received an initial supply of ECUs at the start of the EMS, against the
deposit of 20% of both their gold holdings & gross US reserves with the
European Monetary Cooperation Fund.
To finance interventions in EMS currencies, there were mutual credit
lines among the central banks (a very short term financing facility)

In EMS, adjustments of central rates were Subject to mutual agreement


By a common procedure which comprised all countries participating in
The exchange rate Mechanism & Commission.
An agreement was concluded at Maastricht Summit(1991) by EC leaders
on the requirements & time table for EMU & for the move to common
European Monetary Policy.
It specified 3 stages transition to EMU (European Monetary Union).

Stage 1 Launched in July 1990, the free internal market of EC would be


completed & obstacles to financial integration removed. Member countries
to coordinate monetary & fiscal policy.

Stage 2 Began Jan 1994, worked towards a common Monetary Policy,


establishment of the European Monetary Institute(EMI) which would
develop a framework for closer coordinate of monetary policies that affect
EMU area as a whole & establishment European Central Bank(ECB)

Stage 3 Establishment of common currency, the Euro in 1999.


The Euro
was launched by 11 of 15 members of the union on Jan 01, 1999
The exchange rate 1 = US $ 1.17
= 0.70
= 133
Duetch Mark = 1.96
Rs.= 49
Britain, Denmark & Sweden opted out Greece could not satisfy eligibility
Criteria (joined 2001)
Deadline for withdrawing national currencies was July1, 2002.

In the beginning Euro had 2 conversion rations.


Internal for participating currencies to be converted into Euro during
transition It was fixed.
External Exchange rates against currencies outside the Euroland
Market determined.

Monetary policy decisions for the Euro area are made by


the European Central Bank (ECB) which along with National
Central Bank of all EU members comprise - European
System of Central Banks.

Benefits of Euro
Single Currency brings.
Single interest rate.
Eliminate currency risk.
Give equity & bond markets the necessary.
Scope & liquidity to attract big investors.

Consumers benefit price transparency in Euro saves cost of


hedging against exchange rate risk

Companies Ease of outsourcing, relocation of production bases, M&As,


Transportation procedures & marketing etc.

Market Foreign Exchange


F.M. Means
The process of converting one currency into another or
Foreign Currencies.

Functions of F.E. Market


Transfer of purchasing power (from currency to another or one
country to another)
Provision of credit (Exporters Pre-shipment & imports post- shipment)
Provision of Hedging facilities (covering of export risk)

Methods of Affecting International Payments


1.Transfer (Bank to Bank by Electronic or other way)
2.Cheques & Bank Drafts
is an unconditional order in
3.Foreign Bills of Exchange

writing, addressed by one person


to another, requiring the person
to whom it is addressed to pay a
certain sum on demand

4. Documentary (or Reimbursement credit)


5. Opening of L/C by the importer of a credit in favor of exporter at a ban
exporters country.

Imports
Bank

Exporters
Country Bank

Bill of lading to exporter

It informs the importer by L/C that it


will pay the sum in exchange of BOL &
shipping documents.

hedging on FE Market
Spot & Forward Exchanges

cover the risks arising out of


fluctuations in F.E. rates
Delivered at a specified future
date (on a price agreed upon in
the contract)

FE transactions are completed on


the spot or immediately

Forward Exchange Rate


At par quoted equivalent to the spot rate at the time of making the
contract.
At premium w.r.t. spot rate when one $ buys more units of another
currency in the forward than in the spot market

At discount w.r.t. spot rate when one dollar buys fewer rupees in the
forward than the spot market.
Premium & discount are expressed as a % deviation from the spot rate
on a per annum basis.

Futures Have standard features while a forward contract may be


customized.
Contract size & maturity dates are standardized
Can be traded only on organized exchanges & traded competitively.
An initial margin must be deposited into a collateral account to establish
a futures position.

Options While the forward or futures contract protects the


purchaser of the contract from the adverse exchange rate
movements, it eliminates the possibility of gaining a windfall
profit from favorable exchange rate movements.

Option combines advantages of futures & spot. An option is a


contract or financial instrument that gives holder the right, but
not the obligation, to sell or buy a given quantity of an asset at
a specified rate at a specified future date.

An option to buy the underlying asset is known as a call option and an


option to sell the underlying asset is known as a put option. The buyer of
the option is known as the long & the seller of an option is known as the
writer of the option or the short. The price for the option is known as
premium.

2 types of options
European
Exercised only at the
maturity or expiration
date of the contract

&

American
exercised at any time
during the contract.

Swap Operation Simultaneous sale of spot currency for the


forward purchase of the same currency or the purchase of spot
for the forward sale of the same currency. The spot is swapped
against forward.

Arbitrage is the simultaneous buying & selling of Foreign Currencies


with the intention of making profits from the difference between the
exchange rate prevailing at the same time in different markets.

Determination of Exchange Rates


Purchasing Power Parity Theory In the absence of govt. control
exchange rate between two currencies is determined by the price levels
in respective countries.
Balance of Payments or the Demand & Supply Theory F.E. under
free market conditions is determined by the conditions of demand &
supply in the F.E. market.

Exchange Control is an important means of achieving certain nationa


objective like an improvement in BOP position, restriction of essential
imports, facilitation of import of priority items, control of outflow of
capital & maintenance of external value of currency.
Daily buying & selling

Control is by exchange control authority


RBI
FEDIA
Legal Provision
FERA 1973 & FEMA 1999.

Exchange Rate Systems : Fixed exchange rate


Flexible exchange rate
1. Fixed exchange rate Stable or pegged exchange rate
Gold standard

2. Flexible exchange rate works on market mechanism

Exchange rate & convertibility of rupee :


After collapse of Bretton Woods systems in 1971, rupee was pegged to
pound sterling for four years
In 1935 was linked to 14 currencies & later to 5 currencies of Indias
major trading partners till 1980s external payments crisis in 1991
(rupee was devalued by 18% in July 1991)

In 1992 rupee was partially convertible through LERMS


60% - Market rate
Dual exchange rate
40% - Officially fixed rate
Current account convertibility on trade account 1993.
Capital account convertibility
Devaluation

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