Chapter One - The International Monetary System and Currency

Section 1. Introduction.

THE INTERNATIONAL MONETARY SYSTEM facilitates the settlement of international balance of payments between countries1. Its connection is its impact upon exchange rates that in turn impacts currency values2. The global economy has become reliant upon fluid international currency exchange rate expectations, as sovereign activity has accelerated dramatically. The risk associated with international sovereigns has increased as well. Market risk is the focus in this respect to enhance the understanding of the exposure. To adequately lay a foundation for market risk requires establishing the fundamentals. At the core of the international monetary system is currency.

Basically the balance of payment account is the standard of one side of the equation of a T account in which there is a credit entry and the other a debit entry. Those totals theoretically are to be balanced. The debit and credit of that account comprises the current account3 side of the accounting equation. All indebtedness reflected necessitates the need to finance the short fall. In the alternative if there is a surplus within this accounting measure, an exporting of capital adjusts the imbalance.

In concept, international economics is geared to a mercantile system. The mercantile concept is an economic system of political and economic policy, evolving with the modern national state in its rivalry with other nations. This system regards money as a store of wealth and the objective of the state is the importation of currency by the act of exporting the utmost possible quantity of its products. It seeks in theory to import as little as possible, thereby establishing a favorable balance of trade.4

There are two dominant themes that are enshrined in international economics that influence currency exchange rate movement. One factor, trade balance, is considered by traditional concept to influence exchange rate expectations. The other significant economic influence upon the exchange rate equilibrium is capital movement between global financial markets. It has taken on a much greater importance in recent years with innovation and technology.

Trade is without question a vital component. There is an absolute linkage between trade and a country’s currency exchange rate. That effect can drive the economy or have a degenerative result. The effects are two fold. A country that is afflicted with persistent trade deficits will encounter a loss of purchasing power parity of its currency as a general thesis. The effects of a loss of purchasing power parity will likely cause a downward pressure upon its exchange rate. The debilitating affect results because an inflationary environment is created.

Imports place in to motion a demand for higher prices. The imports necessary to the economy and production such as commodities, materials, and agriculture products result in a rise in the cost of production, along with the cost of consumer goods. This differs from a surplus economy.

A surplus economy will experience a persistent upward pressure upon its exchange rate. A rising exchange rate economy will result in their exports becoming more expensive in the open market. Imports to their economy will in turn become less expensive. To counter balance this effect, the surplus economy will experience a need to export capital to balance the trade surplus. This requires that the economy lend to other countries to provide them with the requisite credit.

The other country doing business with the surplus economy will exert demand upon the currency of the surplus economy that in turn exerts an upward pressure on their currency. Without corrective adjustments, the surplus economy can experience deflation, theoretically. The slowing can result from less production required to produce goods for export; that is its rate of capacity can decrease and employment then rise.

The lower prices of imports can have a mixture of effects and is dependent upon the fiscal and monetary policies of the surplus country. Theoretically lower import prices will lower the costs of production, goods being imported more cheaply because of the greater purchasing power parity. In turn that will lower output, provided that domestic producers do not lower prices. This economic result generally leads to lower interest rates and less expansive prices, but a slower economy.

The other significant influence, capital movement, is derived from the affects of demand upon a country’s supply flow of foreign exchange. The balance of payments accounting concepts also incorporates the affects of credit and debit to a country’s current account. If a country exports goods, it increases its supply of foreign exchange. That results from people in other countries buying their goods in exchange for their currency. The country that sells goods has a gain in foreign exchange.

On the other hand, the importing of goods increases the demand for foreign exchange of other countries. The transactions of exporting capital by loans, also increases its demand for foreign exchange. Therefore a summary result of foreign exchange flows is that a country with a trade deficit is forced to import capital to finance its trade deficit. That in fact is borrowing to finance the purchase of imports for production that are eventually sold. A result of a trading deficit is that demand for the deficit country’s currency is less than the demand for other currencies; its exchange rate will realize a downward pressure.

As to the supply and demand for foreign currency, the supply for foreign exchange arises from the forces of items stipulated as credits or the forces of items stipulated as credits of foreign exchange.5 Demand for foreign exchange is generated from the type of activities listed as debits and or minus items.6

If there is a surplus in the balance of payments of a given country, it substantiates that the supply of foreign exchange exceeds the demand for it and therefore the exchange rate value of that foreign currency will theoretically decline; foreign currency depreciating relative to the domestic currency. A deficit in the balance of payments implies that the demand for the foreign exchange is greater than the supply. The value of foreign currency then theoretically would appreciate relative to domestic currency.7

Section 2. International Monetary System.

The significance about the international monetary system and currency is how it relates to the balance of payments. The financing of the balance of payments surpluses and deficits of countries is its primary function. That the international financial system serves such an essential function illustrates why it is vital to understand its mechanics. Currency is the core component around which the financial system is constructed. It is the reason that such an emphasis is placed upon market risk; currency is the foundation upon which those risks evolve, whether directly or indirectly.

The International Monetary Fund (IMF) establishes the structure and regulation of member nations’ currency. Fundamentally there is probably no single area that is more important to an understanding of currencies than the concepts of structure contained in the International Monetary Fund rules of order. It is an important component in formulating an essential foundational understanding of currency principles.

However to establish the proper foundational premise, there is first a necessity to develop the linkage of balance of payments and the essence of the international financial system that serves to finance surplus and deficit balances between countries. Understanding the transition from the gold standard to the floating exchange mechanism is part of establishing a working foundation.

Commencing in 1945, the external foreign exchange rate financial system had functioned utilizing two methods, one the gold standard, the other the floating exchange rate system used by the modern world today. Providing a brief overview of the gold standard that the international financial system employed from 1945 until 1973 will accomplish the necessary factual transition. It provides for the evolution from gold to floating exchange rates and enables one to appreciate how the risks developed.

In a gold standard financial system sovereigns fixed the value of their currency in relation to gold. It required a willingness to buy or sell gold at an established price. Using the gold standard method resulted in a fixed-exchange ratio in contrasting one sovereign’s currency value against another. This was defined as the par or parity rate of exchange.8 The fixed rate of exchange was stable and the values of exchange did not vary above or below par, except for the movement attributed to shipping costs of gold itself.

Utilizing this type of financial system for valuing currency, the value of a unit of currency could rise only to an upper limit referred to as the gold export point. That demarcation was the amount in excess of the par value of exchange, plus the amount of shipping cost. Accordingly, the price of foreign currency could not fall below par in excess of the cost of shipping gold. The lower limit of the foreign exchange rate was designated the gold import point.

Using the gold standard, the money...