Current International Monetary System

European Monetary System

Following the collapse of the Bretton woods system on August 15, 1971, the EEC countries agreed to maintain stable exchange rates by preventing exchange fluctuations of more than 2.25%. This arrangement was called "European snake in the tunnel" because the community currencies floated as a group against outside currencies such as the dollar. By 1978, the snake turned into a worm (with only German mark, Belgian franc, Dutch guilder, Danish krone). However, a new effort to achieve monetary cooperation was launched. By March 1979, EC established European Monetary System, and created the European Currency Unit (ECU).

Prevent movements above 2.25 % around parity in bilateral exchange rates with other member countries.
The European Monetary Cooperation Fund allocates ECUs to members' central banks in exchange for gold and dollar deposits. 20% of the quota must be paid in gold. ECU was an artificial currency and used in all intrasystem balance of payments settlements. ECU was replaced by euro (at 1:1) on January 1, 1999.
provision of credit facilities for compensatory financing.

In 1987 the EC made a dramatic effort to relaunch the drive toward economic union, and adopted the Single European Act (SEA). By SEA the EC must establish a single market by 1992.

For EMS to work, European countries have to surrender monetary sovereignty to the EMS. Then the EMS can create a single European Central bank (June 1998) and a single European currency (euro 2001).

The European Union began to circulate euro since 2001 and the symbol of the new currency is . Not all members of the EU joined the single currency. Since its inauguratation in 2002, euro has gained ascendancy and is valued at about $1.46 as of December 2007.
See their Timetable.

Current Foreign Exchange Practices

♦ As a general rule, small countries should peg the value of their currencies to a major currency or a baske of major currencies. But there is little harm in floating their currencies.

♦ Large countries should adopt floating to insulate their economies from excessive foreign shocks. China should float yuan. During the foreseeable future (next five decades), four major currencies (USD, euro, yen and yuan) will float their currencies. India and Russia may follow suit eventually. Large countries may not only hurt themselves but also disrupt world trade when their currencies are pegged to another currency to gain a large trade surplus.

♦Currencies of other industrial currencies are floating with respect to the dollar. Other than that, the current system is a mixture of exchange rate arrangements.

10 European currencies were aligned within margins of 2.25%, but they jointly float against the dollar and others. Irish pound, Italian lira, Luxembourg Franc, German mark, Belgian Franc, Dutch gilder, French Franc, Danish Krone, Spanish peseta (plus British pound). Italian lira and Spanish peseta have wider margins of 6%. This arrangement was further simplified by the creation of euro, effectively creating the euro area.
Swiss Franc, Canadian dollar, British pound, the Japanese yen and the U.S. dollar are floating.
The remaining currencies of LDCs pegged to major currencies or baskets, as of March 31, 1991.
Imports of East Asian countries are often invoiced in dollars. For example, about 70% of Japan's imports are invoiced in dollars. This dollar invoicing practically expands the dollar area to include Japan and other East Asian countries (Ronald McKinnon).
27 pegged to $
+ 14 pegged to French Franc
+ 5 pegged to another currency
+ 6 to SDR
+ 34 to Non-SDR baskets
____________________________
= 86 countries
10 members of EMS
+ 5 limited flexibility relative to $
+ 5 peg, but adjusted frequently
+ 22 (managed float/wide band around a peg)
+ 27 independent floating
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= 68 countries
Total: 154 countries
The current system is a system of currency areas:
Dollar area (including East Asia that practices dollar invoicing), euro area, SDR area. Eventually, currencies of Brazil, Russia, India and China will become increasingly important during the next four decades.

Figure from Joseph Daniels and David Van Hoose

As of 2007, 111 countries adopted fixed exchange rates. Specifically, 41 countries have no separate legal tender, 7 countries have currency boards, 52 countries have fixed pegs, 6 horizontal bands, and 5 crawing pegs.

76 countries adopted floating. (source: IMF).

Managed Float

The current system is a managed float, rather than pure or clean float. The amount of compensatory financing or intervention of national monetary authorities has not declined. The reasons are:

The response of imports and exports is not spontaneous, but occurs only after a lag (which can take up to a year or more). During the period of adjustment, some surpluses and deficits appear in the balance of payments, which must be financed by the monetary authorities.
Wide fluctuations of exchange rates may have undesirable effects on inflation, employment and international competitiveness. Thus, central banks may go beyond smoothing daily and weekly fluctuations and maintain the exchange rates at target levels. In this sense, the managed float resembles adjustable peg system.

JAMAICA ACCORD

Beginning 1972, US and European countries negotiated on the reform of the international monetary system. After four years, an agreement on an amendment of the Articles was reached in Jamaica in January 1976.

Floating of currencies had been forbidden under the Bretton Woods system, but was tentatively adopted as a temporary arrangement in 1973. Now the managed float is firmly established as it appeared as the only viable system for two reasons (i) continued growth of world trade without excessive fluctuations in exchange rates, (ii) the floating system coped with two oil crises with relative ease.

A new Article IV of Agreement was approved by the Board of Governors in April 1976, and was ratified by 2/3 of the member nations in 1978. The content of the second amendment (copy) (first permitted creation of SDR) is:

legitimizing floating rates. A member country is free to choose its own exchange rate system.
freely floating, managed float, pegged to a currency or a group of currencies or SDR. Not to gold.
The Fund will exercise surveillance over the exchange rate policies, and adopt specific principles to guide member countries.
By an 85% majority, the Fund may reintroduce a system of adjustable peg. However, a member may remain without a par value. (US can veto).
downgrade the monetary role of gold (gold cannot be used for international transactions).
designate SDR as the principal reserve asset in the international monetary system.

Principles adopted in 1977

a member shall avoid manipulating exchange rates to prevent balance of payments adjustments or to gain unfair advantage over other countries. (e.g., do not devalue to maintain surplus)
a member should intervene in the exchange markets if necessary to counter disorderly conditions.
A member should take into account the interests of other member countries, including the countries whose currencies they use to intervene.

Evaluation

Floating rates have not reduced international trade and investment or caused a disintegration of international capital market.
have not resulted in quick adjustment in trade flows (deficits/surpluses persisted)
exchange rates were volatile.
Increasingly there are economists who claim that there is overmuch instability. The Asian currency crisis in 1997 is a good example.
It has been argued that only currencies of small countries might be pegged to major currencies such as dollar, but the currencies of major currencies should float vis-á-vis dollar. However, G-4 stabilized Japanese yen in the mid 1980s.
Pivotal role of $ has diminished (as prime reserve asset => SDR). Whether euro will play a major role remains to be seen. Due to China's pegging of yuan to USD, euro has steadily appreciated. This trend will continue until China stops its pegging to USD.
IMF does not have any power to discipline members that violate the rules. All it can do is to reject loan requests of such countries which are leastly likely to ask for loans. There is no mechanism to settle currency disputes. Also, international reserve assets of some countries far exceed the assets of the IMF.

Plaza Agreement and Louvre Accord

In September 1985, the Group of Five (US, UK, Japan, Germany, and France) met at the Plaza Hotel in New York. In the Plaza Agreement, the G5 announced that they would collectively intervene to lower the value of dollar, which was believed to be too high at the time.

In February 1986, the Group of Seven (G5 + Italy and Canada) met at Louvre in France, and announced that dollar reached a level consistent with the underlying economic conditions, and that they would intervene only as needed to insure stability. These countries intervene at times, on unannounced basis. Under the Louvre Accord, nations will intervene on behalf of their currencies as needed. Thus, we are under a managed float.

New Problems

Even though the Group of Seven have stayed away from routine exchange rate management, there still are a number of countries that peg their currencies to the dollar. When these pegged currencies are undervalued, such pegging in general causes US trade deficits. For example, US bilateral trade deficit with China in 2005 was $201 billion. In July 2005, China adopted a new policy, pegging Renminbi to a basket of currencies (USD, euro, yen and won), but it is not freely floating vis-à-vis other currencies. As of December 2007, international reserve asset of the European Central Bank is only about 360 billion euro, but China's cumulative trade surplus is over $1.4 trillion.

Mundel's alternative view