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The International Monetary Fund. CHAPTER 16. Introduction. 1941 is a turning point in the history of global financial arrangements British economist John Maynard Keynes wrote a proposal for an International Clearing Union (ICU) Known as the Keynes Plan

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  • 1941 is a turning point in the history of global financial arrangements
    • British economist John Maynard Keynes wrote a proposal for an International Clearing Union (ICU)
      • Known as the Keynes Plan
      • Subsequently taken up by the British Treasury
    • US Treasury official Harry Dexter White wrote a proposal for an International Stabilization Fund (ISF)
      • Subsequently embraced wholeheartedly by US Treasury Secretary Henry Morgenthau
      • Known as the White Plan
  • Two plans were taken up at the Bretton Woods Conference in July 1944
    • White Plan gained prominence, resulting in creation of the International Monetary Fund (IMF) and the International Bank for Reconstruction and Development (the World Bank)
monetary history
Monetary History
  • Throughout 20th century, countries struggled with various arrangements for the conduct of international finance
  • None proved satisfactory
  • In each case, the systems set up by international economists were overtaken by events
    • Appears international financial system had a dynamic of its own
the gold standards
The Gold Standards
  • Late 19th and early 20th centuries were characterized by a highly integrated world economy
    • Supported from approximately 1870 to 1914 by an international financial arrangement known as the gold standard
      • Each country defined the value of its currency in terms of gold
      • Most countries also held gold as official reserves
        • Since value of each currency was defined in terms of gold, rates of exchange among the currencies were fixed
  • When World War I began in 1914, the countries involved in that conflict suspended the convertibility of their currencies into gold
    • After the war, unsuccessful attempt to return international financial system back to gold standard
gold exchange standard
Gold-Exchange Standard
  • In 1922, there was an attempt to rebuild the pre-World War I gold standard.
  • New gold standard was different from the pre-war standard due to then current gold shortage
    • Countries that were not important financial centers did not hold gold reserves but instead held gold-convertible currencies
    • For this reason, the new gold standard was known as the gold-exchange standard
      • Goal was to set major rates at their pre-war levels, especially British pound
        • In 1925, it was set to gold at the overvalued, pre-war rate of US$4.86 per pound
          • Caused balance of payments problems and market expectations of devaluation
  • At a system-wide level, each major rate was set to gold
    • Ignoring the implied rates among the various currencies
    • Politics of the day prevailed over economics
gold exchange standard6
Gold-Exchange Standard
  • Gold-exchange standard consisted of a set of center countries tied to gold and a set of periphery countries holding these center-country currencies as reserves
    • By 1930, nearly all the countries of the world had joined
    • However system’s design contained a significant incentive problem for the periphery countries
      • Suppose a periphery country expected that the currency it held as reserves was going to be devalued against gold
        • Would be in interest of country to sell its reserves before devaluation took place so as to preserve value of its total reserves
        • Would put even greater pressure on center currency
        • As the British pound was set at an overvalued rate there was a run on the pound (1931)
          • Forced Britain to cut pound’s tie to gold, leading to many other countries following suit
          • By 1937, no countries remained on gold-exchange standard
gold exchange standard7
Gold-Exchange Standard
  • Overall standard was not a success
  • Some international economists (e.g. Eichengreen, 1992) have even seen it as a major contributor to Great Depression
  • Throughout 1930s a system of separate currency areas evolved
  • Combination of both fixed and floating rates
  • Lack of international financial coordination helped contribute to the economic crisis of the decade
  • At the worst of times, countries engaged in a game of competitive devaluation
the bretton woods system
The Bretton Woods System
  • During World War II, United States and Britain began to plan for the post-war economic system
  • White and Keynes understood the contribution of previous breakdown in international economic system to war
    • Hoped to avoid same mistake made after World War I
    • But were fighting for relative positions of countries they represented
    • White largely got his way during 1944 Bretton Woods Conference
      • Conference produced a plan that became known as the Bretton Woods system
the bretton woods system9
The Bretton Woods System
  • Essence of the system was an adjustable gold peg
    • US dollar was to be pegged to gold at $35 per ounce
    • Other countries of the world were to peg to the US dollar or directly to gold
      • Placed the dollar at the center of the new international financial system
    • Currency pegs were to remain fixed except under conditions that were termed “fundamental disequilibrium”
      • However, concept was never carefully defined
  • Countries were to make their currencies convertible to US dollars as soon as possible
    • But process did not happen quickly
the bretton woods system10
The Bretton Woods System
  • Problems became apparent by end of 1940s
    • Growing non-official balance of payments deficits of United States
      • Deficits reflected official reserve transactions in support of expanding global dollar reserves
    • Although Bretton Woods agreements allowed par values to be defined either in gold or dollar terms
      • In practice, the dollar became central measure of value
triffin dilemma
Triffin Dilemma
  • Belgian monetary economist Robert Triffen described problem of expanding dollar reserves in his 1960 book Gold and the Dollar Crisis
    • Problem became known as the Triffin dilemma
  • Contradiction between requirements of international liquidity and international confidence
    • “Liquidity” refers to the ability to transform assets into currencies
  • International liquidity required a continual increase in holdings of dollars as reserve assets
    • As dollar holdings of central banks expanded relative to US official holdings of gold, however, international confidence would suffer
      • Triffin argued that US could not back up an ever-expanding supply of dollars with a relatively constant amount of gold holdings
triffin dilemma13
Triffin Dilemma
  • In October 1960 London gold market price rose above $35 to $40 an ounce
    • Calls for a change in the gold-dollar parity
    • In January 1961, the Kennedy Administration pledged to maintain $35 per ounce convertibility
      • U.S. joined with other European countries and set up a gold pool in which their central banks would buy and sell gold to support the $35 price in London market
  • At 1964 annual IMF meeting in Tokyo, representatives began to talk publicly about potential reforms in international financial system
    • Attention was given to the creation of reserve assets alternative to US dollar and gold
  • In 1965, the United States Treasury announced that it was ready to join in international discussions on potential reforms
    • Johnson Administration was more flexible than the Kennedy Administration
triffin dilemma14
Triffin Dilemma
  • British pound was devalued in November of 1967
    • President Johnson issued a statement recommitting the United States to $35 per ounce gold price
  • However, in early months of 1968, the rush began
  • In early 1971, capital began to flow out of dollar assets and into German mark assets
    • German Bundesbank cut its main interest rate to attempt to curb purchase of marks
    • Germany and a few other European countries joined Canada’s floating dollar rate in 1971
      • Thereafter, capital flowed from dollar assets to yen assets
  • US President Nixon accepted US Treasury Secretary John Connally’s recommendation to close its “gold window”
    • Effort to force other countries to revalue against US dollar
the non system
The Non-System
  • At Smithsonian conference in 1971, several countries revalued their currencies against dollar
    • Gold price was raised to $38 per ounce
    • Canada maintained its floating rate
  • In June 1972, a large flow out of US dollars into European currencies and Japanese yen occurred
    • Flows stabilized, but new crisis reappeared in January 1973
      • Swiss franc began to float
      • In February, there was pressure against German mark and there were closures of foreign exchange markets in both Europe and Japan
        • On February 12th, US announced a second devaluation of the dollar against gold to $42
the non system16
The Non-System
  • During 1974 and 1975, countries went through nearly continuous consultation and disagreement in a process of accommodating their thinking to floating rates
  • In November 1975, proposed amendment to IMF’s Articles of Agreement restricted allowable exchange rate arrangements to
    • Currencies fixed to anything other than gold
    • Cooperative arrangements for managed values among countries
    • Floating
the operation of the imf
The Operation of the IMF
  • IMF is an international financial organization comprised of 183 member countries
  • Purposes, as stipulated in its Articles of Agreement, are to
    • Promote international monetary cooperation
    • Facilitate the expansion of international trade
    • Promote exchange stability and a multilateral system of payments
    • Make temporary financial resources available to members under “adequate safeguards”
    • Reduce the duration and degree of international payments imbalances
the operation of the imf18
The Operation of the IMF
  • Major decision-making body is its Board of Governors
    • Each member appoints a Governor and an Alternate Governor
  • Day-to-day business rests in the hands of Executive Board
    • Composed of 22 Executive Directors plus Managing Director
      • Six of the 22 Executive Directors are appointed by largest IMF quota holders
      • Remainder elected by groups of member countries not entitled to appoint Executive Directors
      • Managing Director is appointed by Executive Board and is traditionally European (often French)
        • Chairs Executive Board and conducts IMF’s business
      • Currently three Deputy Managing Directors
the operation of the imf20
The Operation of the IMF
  • Most important feature of IMF is its quota system
    • Determine both the amount members can borrow from the IMF and their relative voting power
      • Higher a member’s quota, the more it can borrow and the greater its voting power
  • Members’ quotas are their subscriptions to the IMF
    • Based on their relative sizes in the world economy
    • Pays one fourth of its quota in widely-accepted reserve currencies (US dollar, British pound, euro, or yen) or in Special Drawing Rights
    • Pays remaining three-quarters of quota in its own national currency
the operation of the imf21
The Operation of the IMF
  • The IMF engages in four areas of activity
    • Economic surveillance or monitoring
    • Dispensing of policy advice
    • Lending
      • Perhaps most important
    • Technical assistance
  • If an IFM member faces balance of payments difficulties
    • Can automatically borrow one fourth of its quota in the form of a reserve tranche
    • When the IMF lends to a member country, what actually happens is domestic country purchases international reserves from the IMF using its own domestic currency reserves
      • Member country is then obliged to repay IMF by repurchasing its own domestic currency reserves with international reserve assets
      • IMF lending is known as a “purchase-repurchase” arrangement
  • Credit tranches
    • Originally, each were equal to ¼ of the members’ quotas
    • In the late 1970s, credit tranches were increased to 37.5% of quota
    • First credit tranche is more or less automatic
    • Second through fourth credit tranches require that the member adopt policies (conditionality) that will solve balance of payments problem at hand
      • Effectively limits a member country’s credit to 150 percent of its quota
        • As IMF evolved, it created a number of special credit facilities that extend potential credit beyond 150% level
  • Drawings on IMF by its members have to be repaid
    • Five-year limit was established
ideal role of the fund
Ideal Role of the Fund
  • Development of a country requires an inflow of private foreign savings
  • Inflow would cover a current account deficit often caused by import of capital goods
  • Occasionally, this private foreign savings disappears
    • Resulting in a balance of payments crisis
      • In these instances IMF steps in
        • Member draws on its reserve and credit tranches
        • Repaying credit tranche debts in five years time
          • Thus, IMF offers short-term credit, stepping in to replace private foreign savings on those rare occasions
history of imf operations 1950s 1960s
History of IMF Operations—1950s-1960s
  • In its initial years, the IMF was nearly irrelevant
  • However, Suez crisis of 1956 forced Britain to draw on its reserve and first credit tranches
  • Japan drew on its reserve tranche in 1957
  • Between late 1956 through 1958 IMF was involved in policies that lead to the convertibility of both British pound and French franc
  • Concerned about the United States’ ability to defend the dollar and other major industrialized countries’ abilities to maintain their parities
    • IMF introduced the General Arrangements to Borrow (GAB) in October 1962
      • Involved the central banks of ten countries setting aside a $6 billion pool to maintain stability of Bretton Woods system
        • Countries involved became known as Group of Ten or G-10 and comprised a rich countries club
history of imf operations mid to late 1960s
History of IMF Operations—Mid-to-Late 1960s
  • By 1965, US faced two unappealing options
    • Reduce world supply of dollars to enhance international confidence by reducing international liquidity
    • Expand world supply of dollars to enhance international liquidity by reducing international confidence
      • But where was the world to turn for a reserve asset?
        • 1964 and 1968 annual meetings of IMF resulted in creation of a new reserve asset to supplement both gold and dollar
          • Known as a special drawing right or SDR
history of imf operations special drawing rights 1970s
History of IMF Operations—Special Drawing Rights, 1970s
  • Came into being in July 1969
  • In 1971, when United States broke gold-dollar link, the SDR was redefined in terms of a basket of five currencies—dollar, pound, mark, yen, and franc
  • Allocated in proportion to members’ quotas
  • Never played the important role envisaged for them
    • Perhaps best seen as one of many attempts to resolve Triffin dilemma
history of imf operations 1970s
History of IMF Operations, 1970s
  • Oil price increases of 1973-1974 caused substantial balance of payments difficulties for many countries of the world
  • In June 1974, the IMF established an oil facility to assist these countries
    • Acted as an intermediary, borrowing funds from oil producing countries and lending them to oil importing countries
  • A second oil facility was established in 1975
    • Slightly more strict than the first
  • During this time, a bias towards private-sector lending helped to prevent sufficient increases in IMF quotas
    • Given the limits of the quota system, IMF was becoming more of a financial intermediary—less of an international cooperative credit arrangement
history of imf operations 1970s 1980s
History of IMF Operations, 1970s-1980s
  • In 1976, IMF began to sound warnings about sustainability of developing-country borrowing from commercial banking system
    • Banking system reacted with hostility to these warnings
      • Argued Fund had no place interfering with private transactions
  • The 1980s began with a significant increase in real interest rates and a significant decline in non-oil commodity prices
    • Increased cost of borrowing and reduced export revenues
history of imf operations 1980s
History of IMF Operations—1980s
  • In 1982, IMF calculated that US banking system outstanding loans to Latin America represented approximately 100% of total bank capital
    • In August 1982 Mexico announced it would stop servicing its foreign currency debt
    • At the end of the month, Mexican government nationalized its banking system
  • 1982 also found debt crises beginning in Argentina and Brazil
    • Argentina: Overvalued exchange rate, used as a “nominal anchor” to curb inflationary expenditures
    • Brazil: Rates of devaluation did not keep up with rates of inflation, causing an overvalued real exchange rate
history of imf operations 1980s33
History of IMF Operations, 1980s
  • International commercial banks began to withdraw credit from many of the developing countries of the world
    • Debt crisis became global
    • Within a few years of outbreak phenomenon of net capital outflows appeared
      • Involved capital account payments of debtor countries exceeding capital account receipts
  • By second half of 1980s, some debt was trading at discounts in secondary markets
    • In 1989, US Treasury Secretary Nicholas Brady proposed a plan in which IMF and World Bank lending could be used by developing countries to buy back discounted debt
      • Amounted to partial and long-needed debt forgiveness, were approved by the IMF and became known as the Brady Plan
      • Also allowed for extending time periods of debt and provided for new lending
history of imf operations 1990s
History of IMF Operations, 1990s
  • Starting in the 1990s, private, non-bank capital began to flow to developing countries in the form of both direct and portfolio investment
  • Number of highly-indebted countries began to show increasing unpaid IMF obligations
  • In November 1992, a Third Amendment to the Articles of Agreement allowed for suspension of voting rights in the face of large, unpaid obligations
  • Mexico underwent a second crisis in late 1994 and early 1995
    • IMF was unable to respond effectively—US Treasury assembled a loan package
history of imf operations 1990s35
History of IMF Operations, 1990s
  • In 1997-1998, crises struck a number of Asian countries—most notably Thailand, Indonesia, South Korea, and Malaysia and also Russia
    • Resulted in sharp depreciations of the currencies
    • In the cases of Thailand, Indonesia, and South Korea, IMF played substantial and controversial roles in addressing crises
      • Loan packages were designed with accompanying conditionality agreements
      • Supplementary Reserve Facility was introduced to provide large volumes of high-interest, short-term loans to selected Asian countries
      • In October and November 1998, IMF put together a package to support Brazilian currency, the real
        • Attempt to prevent Asian and Russian crises from spreading to Latin America
        • Still, Brazil was forced to devalue the real in January 1999
history of imf operations 1990s36
History of IMF Operations, 1990s
  • Recent years have witnessed important changes at the IMF
    • In 1997 General Agreement to Borrow was supplemented by the New Arrangement to Borrow
      • Involves 25 IMF members agreeing to lend up to US$46 billion to IMF in instances where quotas prove to be insufficient
    • In 1999, a new lending facility was added
      • Poverty Reduction and Growth Facility was created to replace the 1987 Enhanced Structural Adjustment Facility
        • Represents beginning of an attempt to integrate poverty reduction consideration into macroeconomic policy formation of IMF
    • In 1999, quotas were increased by 45% to a total of US$283 billion
an assessment
An Assessment
  • When IMF opened for business in 1947, its quotas were approximately 13% of world imports
    • Quotas failed to address the needs of the post-war European economy
  • Since 1947, IMF quotas as a percent of world imports have fallen to approximately 4%
  • A number of observers have questioned whether IMF has succeeded in addressing global liquidity
  • John Maynard Keynes envisioned a global central bank with an international currency
    • This central bank would be responsible for regulating expansion of international liquidity
      • In light of concerns over liquidity, some observers have called for a return to the global central bank idea
an assessment38
An Assessment
  • Keynes’s original Bretton Woods proposal also included adjustment requirements being distributed among deficit and surplus countries
    • However adjustment is solely the responsibility of deficit countries
    • Deficit countries are required to adjust no matter what the source of the deficit
    • Dell (1983) argues that requisite adjustments are too severe and violate purposes of IMF
  • Reform of existing IMF framework could involve
    • Reconstituting it more along the lines of a world central bank
      • Reaffirming role of the SDR as a reserve asset
      • Giving IMF independent responsibility for regulating world liquidity through expanded quotas and SDR management
    • Redesigning adjustment mechanisms to spread responsibility over deficit and surplus countries
  • Changes are radical and would require a complete redrafting of the IMF’s Articles of Agreement