Bretton Woods system

Bretton Woods: the Dollar Exchange Rate Regime

The “Revived Bretton Woods system” identified in 2003

The Current Hybrid System

After the breakdown of the Bretton Woods system, the international monetary system reverted to a more decentralized, market-based model. Major countries floated their exchange rates, made their currencies convertible, and gradually liberalized capital flows. In recent years, several major emerging markets adopted similar policies after experiencing the difficulties of managing pegged exchange rate regimes with increasingly open capital accounts. The move to more market-determined exchange rates has increased control of domestic monetary policy and inflation, accelerated the development of financial sectors, and, ultimately, boosted economic growth.

Unfortunately, this trend has been far from universal. In many respects, the recent crisis represents a classic example of asymmetric adjustment. Some major economies have frustrated real exchange rate adjustments by accumulating enormous foreign reserves and sterilizing the inflows. While their initial objective was to self-insure against future crises, reserve accumulation soon outstripped these requirements. In some cases, persistent exchange rate intervention has served primarily to maintain undervalued exchange rates and promote export-led growth. Indeed, given the scale of its economic miracle, it is remarkable that China’s real effective exchange rate has not appreciated since 1990

Exchange-Rate Regime

An exchange-rate regime is the way an authority manages its currency in relation to other currencies and the foreign exchange market. It is closely related to monetary policy and the two are generally dependent on many of the same factors.

The basic types are a floating exchange rate, where the market dictates movements in the exchange rate; a pegged float, where a central bank keeps the rate from deviating too far from a target band or value; and a fixed exchange rate, which ties the currency to another currency, mostly more widespread currencies such as the U.S. dollar or the euro or a basket of currencies.

Types of Exchange Rate Regime

Float

Floating rates are the most common exchange rate regime today. For example, the dollar, euro, yen, and British pound all are floating currencies. However, since central banks frequently intervene to avoid excessive appreciation or depreciation, these regimes are often called managed float or a dirty float.

Pegged Float

Pegged floating currencies are pegged to some band or value, either fixed or periodically adjusted. Pegged floats are:

Crawling Bands

The rate is allowed to fluctuate in a band around a central value, which is adjusted periodically. This is done at a preannounced rate or in a controlled way following economic indicators.

Crawling Pegs

The rate itself is fixed, and adjusted as above.

Pegged with Horizontal Bands

The rate is allowed to fluctuate in a fixed band (bigger than 1%) around a central rate.

Fixed

Fixed rates are those that have direct convertibility towards another currency. In case of a separate currency, also known as a currency board arrangement, the domestic currency is backed one to one by foreign reserves. A pegged currency with very small bands (< 1%) and countries that have adopted another country’s currency and abandoned its own also fall under this category.

Dollarization occurs when the inhabitants of a country use foreign currency in parallel to or instead of the domestic currency. The term is not only applied to usage of the United States dollar, but generally to the use of any foreign currency as the national currency. Zimbabwe is an example of dollarization since the collapse of the Zimbabwean dollar.

European Monetary System

European Monetary System (EMS) was an arrangement established in 1979 under the Jenkins European Commission where most nations of the European Economic Community (EEC) linked their currencies to prevent large fluctuations relative to one another.

After the demise of the Bretton Woods system in 1971, most of the EEC countries agreed in 1972 to maintain stable exchange rates by preventing exchange rate fluctuations of more than 2.25% (the European “currency snake”). In March 1979, this system was replaced by the European Monetary System, and the European Currency Unit (ECU) was defined.

The basic elements of the arrangement were:

The ECU: With this arrangement, member currencies agreed to keep their FX rates within an agreed band which the narrow band of +/- 2.25% and a wide band of +/-6%.

An Exchange Rate Mechanism (ERM)

An extension of European credit facilities.

The European Monetary Cooperation Fund: created in October 1972 and allocates ECUs to members’ central banks in exchange for gold and US dollar deposits.

Although no currency was designated as an anchor, the Deutsche Mark and German Bundesbank soon emerged as the centre of the EMS. Because of its relative strength, and the low-inflation policies of the bank, all other currencies were forced to follow its lead if they wanted to stay inside the system. Eventually, this situation led to dissatisfaction in most countries, and was one of the primary forces behind the drive to a monetary union (ultimately the euro).

Periodic adjustments raised the values of strong currencies and lowered those of weaker ones, but after 1986 changes in national interest rates were used to keep the currencies within a narrow range. In the early 1990s the European Monetary System was strained by the differing economic policies and conditions of its members, especially the newly reunified Germany, and Britain (which had initially declined to join and only did so in 1990) permanently withdrew from the system in September 1992. Speculative attacks on the French Franc during the following year led to the so-called Brussels Compromise in August 1993 which established a new fluctuation band of +15%.

The Outstanding Issues in the International Monetary and Financial Systems

The outstanding issues in the international monetary and financial systems can be listed under the following headings:

The governance and regulation of the capital and monetary flows:

The management of financial crisis and the foundation of the bank of Last Resort.

The Foreign Exchange System

The Reform of the IMF

The Governance and Regulation of Financial Flows

The Breton Woods system provided no governance for international financial flows. Although Keynes was quite keen on the topic, the other conferees did not seem in 1944 to be much concerned about it. However, the achievement of capital account convertibility in the advanced countries as of 1959 (some four years after realizing current account equilibrium) and the subsequent development of capital markets in the 60’s, 70’s and 80’s propelled this issue to the fore. In the wake up of the Asian crisis in 1977, and the demonstrated globalization of financial markets, it could no longer be ignored.

The articles of agreements of the IMF contained disparate references to financial flows in articles IV and VI. As indicated above, Article IV made the free exchange of finance among member states a fundamental objective of the IMF. Article VI provides permissibility of capital controls as long as they do not impede or restrict payments made from the current account transactions (the balance of trade and unilateral transfers). It also disallows the use of the resources of the fund to support large capital outflows.

The concern with the growth of financial instability impelled the G7 (the group of seven major industrial countries) in February 1999 to establish the “Financial Stability Forum” with the aim of promoting international financial stability through improved exchange of information, cooperation with respect to financial supervision and surveillance, and streamlining standards and norms in the various participant countries. Naturally, this work cannot be confirmed to financial flows and the financial institutions, as it has direct implications with respect to macroeconomic policies, the various standards of the financial system and its judicial framework.

In each of the various areas, a key standard was established with a lead institution responsible for developing the necessary codes, rules, norms and standards. Consequently, the BIS has over the last decade been the forum in which officials from the participating countries and international organizations, without the presence of private sector agents, have concluded numerous agreements aiming at establishing cooperative modalities for collecting systematically information on capital and monetary flows and disseminating them to members and public.

The forum has reached numerous agreements on codes of behavior such as the code of “Good Practices on Transparency in Monetary and Financial Policies”, and the same for transparency in fiscal policy. It reached agreements on financial regulation and supervision such as “The Core Principles of Effective Banking Supervision” and those of security and insurance.

It also agreed on regulation standards for insolvency, for corporate governance, for auditing and accounting and principles to deal with money laundering. It also agreed to rules and procedures for the treatment of important financial concepts such as risk and exposure as well as setting up modalities of cooperation among officials of member states. An important part of what was achieved is the collection of data and the establishment of a shared database.

Unfortunately, the private sector was not involved directly in devising the new rules and principles and not asked to share any responsibilities. Furthermore, no modalities were agreed for securing its continuous involvement in financial governance, let alone setting up a non-voluntary code of investors’ behavior.

All of this work, with all its due importance, amounted in effect to organizing in the source countries the supervision of their institutions and setting up financial regulations and behavior standards for their institutions. Naturally, global financial governance involves conduct in crises, obligations on the source authorities as well as the recipient country authorities and above all, setting up proper models of conduct and codes of standards for private investors. But this was not to be, as the private sector participation remained strictly voluntary.

As noted earlier, the increased globalization of the world economy and the evolved integration of financial markets have resulted in enormous increase in cross border financial flows, with a concomitant increase in financial instability and frequent eruptions of financial and currency crisis. No doubt, the purpose of the new codes and standards can increase financial stability and prevent, or at least, forewarn of impending crises.

In this context, several other proposals have been put forward to set up a system authority to carry out and enforce financial governance since the 1980’s. Some proposals suggest the creation of a worldwide supervisory and regulatory authority, the “World Financial Authority”, to regulate and supervise all institutions and markets.

Another variant more concerned with system issues and policies, developed proposals to establish a super agency over all the relevant international organizations to be responsible for the whole system: its policies, regulations, supervision, and crisis management.

All these proposals share the aim of establishing a global authority with a global perspective and enforceable authority to deal with the application of regulations, codes of behavior, and methods of controls and rules of functioning on radically different basis than the piece meal, patchy approach of the present institutions. It is argued that the globalization of the world economy now calls for such an approach.

Another problem concerns the treatment of private sector. Since the private investors and speculators in the source countries are responsible for the bulk of the financial flows, the voluntary character of the application of the established rules and codes to them stands in stark contrast to the summons to obey with consequent sanctions addressed to the recipient and their private concerns.

A code of behavior for investors would be an enormous development. However, there are several objections to such a binding code. The first argue that it is exceedingly difficult to enforce it. The second is an efficiency argument about the distortion of allocation of international investment funds in case of insolvency controls.

The third concerns the deterrence to capital movements it might bring about, in particular, inflows to the poorer countries. The fourth is the desirability of avoiding bureaucratic decision – making and conflict of jurisdictions in case of crisis. The counter arguments are familiar from the work of the BIS and the literature on capital controls and the Tobin tax.

Briefly, it is argued that feasibility is an open empirical question; that the efficiency argument assumes that a code – free system is optimal and is already in place and that the fear of bureaucratic conflicts is exaggerated. On balance, a universal code applied by all an impartial international authority, such as the IMF, should be feasible.