Term Paper on International Financial System | Business

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Term Paper # 1. Introduction to International Financial System:

The term International financial system implies a mechanism of interrelated parts, functioning for some clearly defined goals according to known laws. The major attributes of International financial system are knowledge, certainty and predictability. To describe it as a system is over simplification, but it is permitted in the interests of economic analysis. When we move from the precise formulations and general prescriptions of economic theory to the real world of policy, it is necessary to remember that we have the realm of system and precision for a world of approximation.

The concept of International financial system arises mainly from two sources:

1. Structure of Wider Relationships:

Within this structure international financial system is concerned with:

(i) Flows of current and capital funds

(ii) Relationships between national currencies

(iii.) Monetary systems

(iv) Central Bank.

2. Parallelism:

This system is the apparent parallelism between money’s role in a domestic closed economy and its role in world of many countries. There is a parallelism in the institutions also and their relations in both national and international systems. This parallelism is however limited.

Term Paper # 2. Elements of International Financial Systems:

An international financial system has four elements:

1. International Money:

A certain form of internationally acceptable money which is to be used for clearing residual payments, balances with other countries and for holding reserves to meet external defects.

2. Institutional Arrangements:

These can be in the form of international banking system, money market, foreign exchange markets and the media, through which international money may circulate, through-out the system.

3. Mechanism for the Distribution of International Money:

It should have a proper mechanism whereby the distribution of International money can be adjusted by acting upon the balance of payments.

4. Central Power:

This system should also include a central power to control the working of international financial arrangements.

Term Paper # 3. Historical Perspective International Financial Systems:

Looking at the International financial system in historical perspective, it appears that there are four periods that correspond to four different international financial systems.

These four different systems are:

1. International gold standard

2. Gold exchange standard

3. Bretton woods system

4. Floating exchange rate.

1. International Gold Standard:

This period ended with the beginning of the First World War, although its beginning was not agreed upon by the scholars.

By international gold standard is meant an international financial system where all participating countries have legally:

(i) Defined the unit of account (rupee, dollar, pound etc. monetary unit of the country) in terms of gold.

(ii) Established a mechanism whereby their local currencies are kept equal in value to gold and to each other.

(iii) Fixed the external value of their currencies through the medium of gold.

(iv) Their monetary authorities are willing to buy and sell gold at a fixed price in unlimited amounts.

Mechanism of Gold Standard:

The mechanism of gold standard can be explained in terms of the following:

(i) Maintenance of exchange stability

(ii) Automatic restoration of balance of payments

(iii) Equilibrium in the movement of capital

(iv) Parity of price level.

The gold standard was put into operation in Britain in 1821. By 1914 this was the dominating system all over the world except China, Mexico and some minor countries. Till 1914, the Gold Standard had its centre in London and London market also played the role of a World Central Bank. It advanced short term loans to the countries which suffered adverse balance of payments.

With the outbreak of First World War in 1914, the Gold Standard was suspended everywhere for two reasons:

(i) To avoid a continuous adverse balance of payments.

(ii) To prevent gold exports from falling in the hands of the enemies.

2. Gold Exchange Standard:

With the cessation of the war and restoration of peace, monetary authorities of all countries planned to revive the gold standard. The war had created wild inflation, chaos and confusion in the international financial systems and it was believed that the restoration of the gold standard would again ease the situation. At the international conference at Brussels in 1922, monetary experts agreed to reintroduce gold standard.

But with paper currency having become popular in many countries and in view of the scarcity of gold and other considerations, it was thought that the Gold Standard of the past could not be revived. Instead, the Gold Exchange standard was prescribed at Geneva Conference (1920).

The U.S.A. was the first to adopt the Gold Standard in 1924 with England following suit in 1925. Other European countries followed the lead in returning to the gold standard. France joined late in 1928 and the restoration became complete.

Mechanism:

The countries which had adopted gold exchange standard chose London, New York or Paris to keep their reserves. They announced convertibility of their domestic currencies into pounds, dollars and francs and tried to secure exchange stability.

In the reviewed gold standard system, gold coins were not brought into circulation. It was in the form of gold bullions.

Collapse of Gold Exchange Standard:

Although full-fledged gold standard was back in the field of international financial system by 1928, it had very short innings. In practice, it could not function smoothly as in the pre-war era. It lasted for a bare three years and that too in an unsatisfactory manner and ended when Great Britain renounced it in September 1931. Greece, Portugal, Japan and S. Africa also followed the U.K., Australia, New Zealand and most of South America had gone off the gold standard before Great Britain. U.S.A. went off in 1933 and France in 1936.

The world, in general, thus abandoned the gold standard again by 1936, leading to the final and complete breakdown of the post war gold standard.

3. Bretton Woods System:

With the abandonment of the gold standard in 1930’s by the major countries of the world, a vacuum was created in the field of international trade. The world trade and growth suffered a great deal which led to strains and conflicts among nations.

Term Paper # 4. Need for a New System:

Due to the above mentioned reasons it was realised that the financial disorders of the world could be corrected only by mutual agreement between nations having international economic relations.

As it was not possible to revive the gold standard, a new monetary system had to be found which could provide the following:

(i) Sufficient flexibility

(ii) International assistance without affecting the internal economic order of the country.

(iii) Efficient payment mechanism.

(iv) High and stable level of foreign trade.

The formulation of the new system underwent the following stages:

i. Experts from USA prepared a proposal known as ‘White Plan’ and experts from U. K. prepared a proposal known as Keynes Plan. In 1944, a conference was held at Bretton Woods to discuss a joint plan on the establishment of International Monetary Fund of the USA and Associated nations.

ii. Bretton Woods conference worked out the statutes for the two institutions:

i. International Monetary Fund (IMF)

ii. International Bank for Reconstruction and development (IBRD) or a World Bank.

The IMF became operational in March 1947 but it could come into its full operation only in 1959.

iii. Though the Bretton Woods system completed 14 years of full operation, yet it faced a new and sometimes hostile environment due to the following reasons:

(a) During this period, new structural changes had manifested themselves, the nature, direction and strength of which were full of doubts.

(b) The dollar problem whose early virulence threatened the stability of the world economy in late 1940’s and early 1950’s had waved and was replaced in 1960’s by excess of dollars.

(c) The great industrial power of U. S. was challenged by resurgence of industrial growth in Western Europe and by its reorganisation through the European common market.

(d) In the trade field, there was threat of compartmentalisation of the world economy.

Due to all these problems, since 1960’s the Bretton Woods system operates with great strain and the recurrent financial crisis since 1968 had been met by modifications in the system.

iv. The Bretton Woods system of international financial relations ended in August 1971. Though the conditions improved a little in 1973, the confidence problem of dollar continued. Elsewhere, countries pursued their own policies.

In 1973, Bretton Woods’s system almost died.

4. Floating Exchange Rate:

There was no system to formally replace the Bretton Woods system after 1973. After 1973, the Governments let their currencies float. At first, the float was expected to be temporary. An attempt was made to design a new monetary system in which the exchange rate would be pegged but more readily adjustable than under Bretton Woods’s system. But these efforts failed in the wake of first oil shock and the Articles of Agreement of the IMF were amended to legalise floating.

But Governments did not allow exchange rates to float freely because exchange rate fluctuations affected their economies in larger and different ways.

In 1978, the members of the European Community established the European Monetary System to peg the exchange rates connecting their own currencies. Under the Plaza and Louvre agreement, U.S. joined with other countries in an effort to reverse the depreciation of dollar.

Experience with floating rates is hard to evaluate because in the years of floating there have been high inflation rates and deep recessions that should not be blamed on exchange rates regime. These disorders have produced new problems, including the debt problem of less developed countries.