International Finance

Third edition

by Keith Pilbeam

Chapter 11 - The International Monetary System

Chapter Introduction
The international monetary system is broadly defined as the set of conventions, rules, procedures and institutions that govern the conduct of financial relations between nations. In this chapter we look in some detail at the development of the post-Second World War international monetary system. An understanding of the historical, institutional and economic developments that have occurred since the end of the Second World War are an essential background to the study of international finance. Many of the proposals for reform of the international monetary system have been based upon the desire to avoid the problems and mistakes of the past. There are many facets of the postwar system that merit attention and that are studied in this chapter. Among these are the Bretton Woods system and its eventual breakdown, the move to floating exchange rates, economic events of the 1970s including two oil shocks, and the economic policy divergences of the 1980s. The setting-up of the European Monetary System leading eventually to achievement on 1 January 1999 of Economic and Monetary Union in Europe is probably the most significant event to occur in the evolution of the international monetary system since the breakdown of the Bretton Woods system.

The 1990s witnessed considerable currency turmoil, firstly afflicting developed economies with speculative attacks launched against a number of EMS currencies including the British pound, the Italian lira and the Spanish peseta. The EMS crisis was followed by a series of currency and financial crises afflicting emerging market economies. In 1994–95 Mexico suffered what has become known as the ‘Tequila crisis’, but this proved to be merely a taster for the currency and financial turmoil that was to follow. In July 1997, a Thai baht devaluation marked an abrupt end to the ‘Asian miracle’ and the start of the ‘Asian financial crisis’ which involved roughly one and a half years of unprecedented turbulence in the region’s financial and currency markets. Barely had the Asian crisis started to subside, when a new crisis broke out following an effective Russian default on its domestic and foreign currency debts; the Russian crisis was accompanied by concerns for the global capital markets when Long- Term Capital Management (LTCM), a hedge fund with massive speculative positions in the financial markets, was effectively bankrupted. The Russian crisis had a direct impact on Brazil which had its own currency crisis in 1999. The new century started out with its own set of crises, starting with a devaluation of the Turkish lira in 2001. This was followed by the largest ever default on $100 billion of external debt by Argentina in January 2002, and the ending of its experiment with a currency board system that had since 1991 pegged its currency at a one peso–one US dollar parity. The Argentinian crisis eventually impacted upon Uruguay which was forced to float its currency later in the year.

Much of the story of the postwar international monetary order is about the central role of the US dollar which, despite the birth of the euro, remains the major international currency. However, even the dollar has been subjected to considerable turbulence in the foreign exchange markets in recent years; it appreciated sharply and unexpectedly against the euro upon the latter’s birth from $1.174/C=1 in January 1999 to $0.827/C=1 on 26 October 2000, where it steadied and began to depreciate and then rally back until 11 June 2001, when it started to depreciate from $0.843/C=1. Mounting concerns about the size of the US current account deficits and cuts in US interest rates to historically low levels by the Federal Reserve led to substantial falls in the US dollar from mid-June 2001. The frequent currency crises and ever-increasing international movements have led some commentators to argue that there is no room for a halfway house when it comes to the choice of exchange rate regime. They have argued that the international monetary system will increasingly become bipolar with countries adopting the extremes of either a ‘hard peg’ or a floating exchange rate. This view has recently been challenged on empirical grounds and there have been a number of recent studies that attempt to empirically examine the relative merits of fixed, floating and intermediate exchange rate regimes on the basis of their association with economic performance, which we shall review. We conclude by examining some recent and older proposals for reform of the international monetary system.