Economics of the International Financial System

Sukumar Nandi

• Publisher: Routledge India
• Year: 2017
• ISBN:
  9781317342229
• Edition: 1
• Topic: Business
• Subtopic: Finance
• Index: Business

Economics of the International Financial System offers an illuminating, engaging and lucid account of the working of 21st-century global political economy. From a macroeconomic perspective, it explores how major capitalist economies are closely integrated with each other in that none can remain unaffected by economic events around the globe.

The book is one of the first in its genre to examine:

• the origin and relevance of international money as a concept and phenomenon;

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• the structure of various money markets;

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• the nature and functioning of major international financial institutions such as the World Bank, International Monetary Fund (IMF) and International Bank for Reconstruction and Development (IBRD); and

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• the dynamics of the new world financial system that emerged after the demise of Bretton Woods system.

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This will form an essential reading for students and scholars of international monetary economics, international corporate finance, researchers, policymakers, bankers and financial executives.

1

Introduction: The International Monetary System

The notion of a ‘global monetary system’ usually means the gold exchange standard that was adopted after World War II in the Bretton Woods Agreement, in which each member state is to fix its currency with specified units of gold. In reality, it is a fixed exchange rate system in which each country is to maintain a fixed exchange rate vis-à-vis the USD while the USD is to maintain fixed parity with specified units of gold. The agreement adopted the USD as the international currency, and the United States made the commitment of giving one ounce of gold for every 35 USD surrendered. From 1960 onwards, the United States became involved in the war in Vietnam and that military expenditure drained their economy too much. The result was the quick depreciation of the USD and that had been reflected in the continuous higher prices of gold. From the official 35 USD per ounce that anchored the international monetary system, the USD declined to 40 USD/oz in 1968, 65 USD/oz in 1972 and 100 USD/oz in 1973.

The decline of the USD being the symptom of the decline of American economic system induced the French critique of the political implications of the USD-centric international monetary system, a gold exchange standard where the USD was designed to be used as the underlying reserve assets, in lieu of gold. Charles de Gaulle, the President of France in the 1960s, campaigned against USD as international currency and the huge economic power the United States enjoyed as a result. Also, the United States experienced a huge outflow of gold through the committed gold window mainly to the European countries. In the face of it, the United States came out of the commitment of gold window of giving one ounce of gold for every 35 USD in 1971, and with it the Bretton Woods system collapsed.

Post-1971, the world adjusted to a flexible exchange rate system whereby the member countries have adjusted the exchange rates of their domestic currencies vis-à-vis USD, which continued to depreciate, and it was reflected in the increasing price of gold in terms of USD. Economists call it as Bretton Woods II phase when USD continued to maintain its principal currency status. As the issuer of the currency, the United States enjoyed advantages from its role at the centre of the international monetary system. The principal benefits that accrue to a country as the issuer of reserve currency (USD) is the seigniorage, that is, the difference between the face value and the cost of issuing new money including interest payment and also the cost of monitoring the currency outside the country. Apart from the seigniorage, the country also enjoys advantages like balance of payments flexibility and competitive advantages for the domestic financial services.

What is the future of the USD as an international currency? The analysis of this question raises a prior question: why does any particular national currency come to be used extensively at the international level as a means of exchange, unit of account, and store of value? This question has attracted the attention of the economists, as they have highlighted various economic determinants of international currencies like confidence of the foreigners on the stability of the value of the currency, the existence of a well-developed and open financial market within the issuing country, and the extensive transaction network of the issuing country. Thus, economists have identified three factors — confidence, liquidity and transaction network — to be the key determinants of international currencies, though there is no consensus. Some economists predict that the dollar’s international role is about to decline in the near future, while others foresee little change in its status in the coming years. The lack of consensus is also sometimes a product of the fact that economists are focusing on different functions that the USD performs as an international currency.

The emergence of the euro from 2000 onwards has shifted attention to its possibility of becoming a rival of the USD as the currency of the second largest economy Japan, the yen, could not muster the confidence of nations to be used as a reserve currency. Confidence in a currency is derived not just from the economic fundamentals, but from the size of the issuing state and also the broader international security power of the issuing country. According to Andrews Walter (2006), monetary power can be cultivated by a consistent conservative monetary policy at the domestic level that is credibly embedded within domestic politics and institutions, as he highlights the case of stable value of the pound sterling in the nineteenth-century United Kingdom that inspired such confidence. Walter also notes that the atmosphere of the United Kingdom was linked to its limited government, the narrow electoral franchise and the conservative financial control of the Bank of England.

If one wants to assess how the international and domestic political sources as mentioned above can influence the future of the USD as an international currency, one seems to pull in different directions. On one hand, the domestic military power of the United States boosts foreign confidence in the USD, particularly at the moments of international political instability when the USD has been regarded as a ‘safe haven’ currency. On the other hand, the atmospheres of inflation in the domestic level in the United States and the high levels of public debt have created doubts about the soundness of USD.

Foreign confidence in the currency of European Union, Euro is boosted by the fact that it has been embedded by the Union in a very conservative ‘domestic’ institutional context. Not only the European Central Bank has been mandated to pursue low-inflation policy, but its ability to fulfill this mandate has been strengthened by its legal independence from the government influences. On the other hand, confidence in Euro is undermined by the broader uncertainties about the strength of European political cooperation and the inability of Europe to project its power in a unified manner at the international level (McNamara, 2008).

Foreign confidence in a currency is also influenced by the openness of the financial market at the domestic level as well as the projected political power of the country at the global level. The inadequacy on both counts makes the Chinese yuan a non-starter at the present moment, in spite of the huge international reserves, China has accumulated and has achieved a very fast economic growth that makes the economy second in the world in size (Water, 2010).

The analysis projected above indicates that it requires many-dimensional considerations to understand the implications of an economic event at the global level. The chapters in this book try to explain these aspects in a theoretical as well as practical manner. For the latter, many cases are added to explain the geo-political situations. First, the concept of international money is taken in Chapter 2. The history of money shows that its origin is connected to a temple of Hera, that is located on the top of a hill called Capitoline. The latter is one of the famous seven hills in the city of Rome. Explaining the origin of money, the discussion continues to explain the relationship money has with gross domestic product and price level. The strength of money as a store of value is reflected in its purchasing power, and the purchasing power of monies of different countries can be compared through the theory of purchasing power parity. In the context of open economy, growth of money supply creates twin effects in the economy — its effect on interest rate and its effect on price level. If interest rate is treated as a price of capital, then the growth of money supply at the domestic level creates effects on the balance of payments of the economy through the price effects on commodities and capital.

One important power of the sovereign state is the authority to issue paper currency that can be treated as sovereign debt, and citizens accept that as money and use it as a medium of exchange. This paper currency may or may not be fully backed by reserves in gold and other foreign currency, and if it is not backed, then it is called fiat money or fiduciary issues. In today’s world, all currencies are fiat money. This aspect of money sometimes creates potential problem as the sovereign state issues paper currency to claim resources from the market. This is the genesis of inflation in an economy. This interrelationship between money and inflation is explained in Chapter 3, which also analyses the concept of seigniorage, which the issuer of paper currency enjoys as the difference between the face value of the currency and the cost of production of the currency and the cost associated with the maintenance of the currency.

The multinational corporations (MNCs) are important players at present in the international financial system. The integration process in the world economy has been quickened by the activities of the multinational corporations through the expansion of business. The nature of their activities is explained in Chapter 4. The activities of the MNCs in the emerging market economies have been supplemented by capital flows often in the form of direct foreign investment. Different forms of this investment along with the role of technology in the market expansion in the emerging market economies have been explained.

The present form of the international financial architecture is the outcome of a long historical process of evolution in response to different financial events at various points of history and this has been taken up in Chapter 5. After World War I, many countries adopted an exchange standard that included both gold and foreign exchange, and this system paved the way for the use of USD exchange rate regime after World War II. The international monetary system set in place at Bretton Woods differed from the gold exchange standard, as USD had been given the all-important role of key currency. The United States committed to exchange USDs for gold at the fixed rate of 35 USD an ounce and other currencies were to keep their par values at a fixed exchange rate vis-à-vis the USD. The burden of intervention was to be borne by the non-reserve currency countries. The system broke down in 1971 when the United States came out unilaterally from the commitment of gold window and after that Bretton Woods Agreement collapsed. But a new system has been continuing since then with flexible exchange rate system, though the USD remains the international currency.

Since 1980, international economic system has undergone rapid changes most of which were to address the challenges of globalization of the world economy. One of the many facets of the challenges is the international liquidity problem that persisted in spite of the Robert Triffin’s special drawing rights (SDR) experiment that started in late 1960. In this perspective, Stiglitz (2006) describes the global greenbacks system as one in which new reserves could be created every year and which would not be given to the wealthiest countries. He proposes the creation of a trust fund of conventional hard currencies so that countries in crisis can exchange their global greenbacks for currencies needed for payments. Chapter 6 analyzes all changes made post-1980 period including the responses from International Monetary Fund (IMF).

Chapter 7 explains the dynamics of sovereign currency and how governments in member states deal with it. One principal duty of the government is to take measures so that domestic economic system runs smoothly with stability and currency is an important instrument in that process. So each government issues currency in the domestic market that acts as money. But many governments use this power for the exploitation of domestic citizens by printing currency and commanding resources from the economy in lieu of it. The result will be runaway inflation as historic inflation in Germany before the World War II is recorded. Apart from dealing with all these aspects, this chapter also explains the economics of Indian rupee along with its historical roots.

Money is truly international in nature whether it is the Indian rupee or the Euro. The international flows of money as the reverse flow of commodities at some times are facilitated by the international banking system. The latter maintains wide networks in the world to transfer money from one corner of the globe to another. This complex process has been explained in Chapter 8 that also explains the activities of the offshore financial centres. In this connection, the activities of money laundering, that has become a chronic problem in the newly emerging markets, has been examined in detail.

The value of the domestic currency in terms of the foreign currency (say, USD) is determined in the foreign exchange market in case of a currency that is a fully floated one. The foreign exchange market is integrated with both money market and the capital market of the domestic economy, and the interest rate plays an important role in determining both the spot rate and forward rate of the foreign currency. All these dynamics are explained in Chapter 9. Again, Chapter 10 analyzes the dominant theories of exchange rate determination. The determination of exchange rate of the domestic currency is influenced both by monetary factors and real factors. While interest rate plays a crucial role, the situation in balance of trade of a country can influence the course of movement of the exchange rate. Economists also try to determine the equilibrium exchange rate in terms of the equilibrium of the balance of trade of the country, as the exchange rate of the domestic currency is an important factor for the competitive strength of the domestic economy in foreign trade transaction. Apart from this, there is the concept of purchasing power parity of the domestic currency that relates the purchasing power of the domestic currency with the exchange rate.

In open economy situation, a country faces the ‘open economy trilemma’, which means that of the three factors a country faces — a fixed exchange rate, perfect capital mobility and an independent monetary policy — the country is to choose any two of the three, as it cannot get all the three simultaneously¹. Thus the country faces capital mobility along with the transmission of changes in the foreign interest rate in the domestic economy. This influences the movement of the exchange rate of the domestic currency. This is a complex process and the country has to adjust its monetary policies for maintaining stability of the exchange rate. This theoretical explanation is provided in Chapter 11.

Under globalization, capital flows in the reverse direction of water, i.e., capital flows upwards in terms of returns on it. Also, the country as the issuer of domestic currency should maintain the economic policies in such a way that the citizens have confidence in the currency they hold. When this is absent, people want to get rid of the currency like a hot potato. Thus, capital flight and also flight from currency have been common in history, and a recent example is the Asian currency crisis during 1997–99 when countries like Thailand, South Korea, Malaysia, Indonesia, and Philippines suffered in the form of a contagion. These aspects are explained in Chapter 12.

Foreign direct investment has played an important role in the industrialization of emerging countries mainly in two ways: it brought necessary capital in some capital-poor economies and the industries established by foreign direct investment led to diffusion of improved technology to the existing firms in the host country. The situation is not different in the case of India and all these are analyzed in Chapter 13.

From 1980 onwards, one common experience in the development history of the world is that many emerging economies have attempted to build up large international reserves as a cushion for the stability of the exchange rate and also for unforeseen fluctuations in the balance of trade situations. In this context, some Asian countries like China and Japan top the list. In 2010, about 40 per cent of the world’s international reserves was held by the Asian region, and the size of China’s international reserve was about USD 3 trillion. What is the optimum size of international reserves and what are the factors that determine the size of it are theoretical issues and these are explained in Chapter 14.

The formation of the European Union and the adoption of euro as the common currency by the member states of the European Union are unique experiments in recent history, and it has been the logical outcome of Robert Mundell’s thesis of optimum currency areas. This aspect has been explained in detail in the last chapter, i.e., Chapter 15.

Conclusion

The broad objective of this book is to bring into focus the overall situation of the international financial system in its present dynamic context. Each chapter gives the up-to-date situation along with the theoretical background so that the reader can understand the inner dynamics of the situation. The references list of further reading help the potential researchers to move ahead in their further intellectual pursuits. All other annotations made in the text are placed in references at the end of the book.

¹  For explanation, see Obstfeld and Taylor, (2003).

2

Money in Economics of the Open Economy

2.1 Introduction: What is Money?

Economists define ‘money’ as a set of assets in the economy that people use to buy goods and services from other people. According to Friedman (1992), anything can be money like gold, silver, copper, etc., as what makes these commodities valuable is not what they are but what they are used for. The value of money is the value people attribute to what they want to exchange in exact quantity. As a medium of exchange, money establishes a standard of value and as money, in whatever form, is held in between exchanges, money becomes a store of value.

The definition of money, as explained above, has a reference to relationship and this aspect has attracted the attention of philosophers. According to Simmel (1978, 120),

Since money expresses the value relatio...