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TEXT 3.* GOVERNMENT POLICIES TOWARD THE FOREIGN EXCHANGE MARKET

The two major aspects of government policy toward the foreign exchange market are the degree of exchange rate flexibility and restrictions (if any) on use of the market.

Policies toward the exchange rate cover a spectrum from a clean float, where it is determined entirely by non-official supply and demand to managed or dirty float when government carry out official intervention on the market. The other kind of exchange rate policy is fixed exchange rate, when a national currency is fixed to a commodity like gold, a single currency or a currency basket. The government must also decide the width of a band around the central fixed rate. If the fixed rate is not permanently set, the government may change it from time to time. If it occurs often, it is called adjustable peg, if rarely, the term is crawling peg.

The government may also exercise a fifth option—to surrender by changing the fixed rate (revaluation or devaluation) or by shifting to a floating exchange rate.

Government intervention in the foreign exchange market is closely related to official reserves transactions and the official settlements balance of the country's balance of payments. If the government attempts to prevent the value of its currency from declining, it must buy domestic currency and sell foreign currency in the foreign exchange market. The government can use its official reserve holdings as a source of foreign currency to sell in the intervention or it can borrow. This provides the financing for the country to run an official settlements balance deficit. If instead the government attempts to prevent the value of its currency from rising, it must sell domestic currency and buy foreign currency. The government can use the foreign currency that it buys to increase its official reserve holdings (or to repay past borrowings).

The success or failure of different exchange rate regimes has depended his­torically on the severity of the shocks with which those systems have had to cope. The fixed-rate gold standard seemed successful before 1914, largely because the world economy itself was more stable than in the period that followed. Many countries were able to keep their exchange rates fixed because they were lucky enough to be running surpluses at established exchange rates without having to generate those surpluses with any contractionary macroeconomic policies. The main deficit-running country, Britain, could control interna­tional reserve flows in the short ran by controlling credit in London, but it was never called upon to defend sterling against sustained attack. During the stable prewar era, even floating-exchange-rate regimes showed stability (with two brief possible exceptions).

The interwar economy was chaotic enough to put any currency regime to a severe test. Fixed rates broke down, and governments that believed in fixed rates were forced into flexible exchange rates. Studies of the interwar period showed that in cases of relative macroeconomic stability, flexible rates showed signs of stabilizing speculation. Those signs were less evident in economies whose money supplies had "run away" or whose previous fixed exchange rates were far from equilibrium.

Postwar experience showed some difficulties with the Bretton Woods system of adjustable pegged exchange rates set up in 1944. Under this system, pri­vate speculators were given a strong incentive to attack reserve-losing currencies and force large devaluations. The role of the dollar as a reserve currency also became increasingly strained in the Bretton Woods era. Under Bretton Woods, foreign central banks acquired large holdings of dollars through official intervention, when the United States shifted to running official settlements balance deficits. At first, these were welcomed as additions to official reserve holdings in these foreign countries, but the dollars became unwanted as the reserves grew too large. Foreign central banks' conversions of dollars into gold decreased U.S. official gold holdings, further reducing foreign officials' confidence in the dollar. The United States had to adjust its balance-of-payments position or change the rules. The United States opted for new rules, divorcing the private gold market from the official gold price in 1968, suspending gold convertibility and forcing a devaluation of the dollar in 1971, and shifting to general floating in 1973.

The current exchange rate system permits each country to choose its own exchange rate policy. Two major blocs exist, one of currencies pegged to the U.S. dollar and the other of the euro and currencies pegged to it. The euro is the successor to previous schemes, including the Exchange Rate Mechanism of the European Monetary System, as the countries that are members of the EU seek a zone of exchange rate stability for transactions within the union.

The dollar bloc and the euro bloc float against each other, and the currencies of a number of industrialized countries—Australia, Canada, Japan, New Zealand. Sweden, Switzerland, and the United Kingdom—float independently. For countries with flexible exchange rates, governments generally are skeptical of purely market-driven exchange rates, and they practice some degree of management of the floating rate.

Most developing countries have a pegged exchange rate of some sort, but the trend is toward greater flexibility and floating. A series of exchange rate crises in the 1990s and early 2000s, including the Mexican peso in 1994, the Asian crisis (Thai baht, Malaysian ringgit, Indonesian rupiah, and South Korea won) in 1997. the Russian ruble in 1998, the Brazilian real in 1999, the Turkish lira in 2001, and the Argentinean peso in 2002, shows the difficulty of defending a pegged rate against speculative flows of short-term capital when the speculators have a one-way speculative gamble against a currency that they believe is misvalued.

Discussion points:

1. Explain the difference between (a) managed and clean float (b) adjustable and crawling peg.

2. "The emergence of expectations that a country in the near future will impose exchange controls will probably result in upward pressure on the exchange rate value of the country's currency." Do you agree or disagree? Why?

3. A government has just imposed a total set of exchange controls to prevent the exchange rate value of its currency from declining. What effects and further developments do you predict?

4. Describe the current global exchange rate regime

5. Talk about the Russian government’s exchange rate policy.

Text 4*. Moving to a Flexible Exchange Rate: How, When, and How Fast?

1. Read the text and summarize it in 5-6 sentences.

2. Analyze the presence and relevance in Russia of the ‘four ingredients generally needed for successful exchange rate flexibility.’

Although many countries still have fixed or other forms of pegged exchange rate regimes, a growing number—including Brazil, Chile, Israel, and Poland—have adopted more flexible regimes over the past decade. The trend toward greater exchange rate flexibility is likely to continue as deepening cross-border linkages increase the exposure of countries with pegged regimes to volatile capital flows because flexible regimes offer better protection against external shocks as well as greater monetary policy independence. Regardless of whether flexible exchange rate regimes are adopted under stress or under orderly conditions, their success depends on the effective management of a number of institutional and operational issues.

Some countries have made the transition from fixed to flexible exchange rates gradually and smoothly, by adopting intermediate types of exchange rate regimes—soft pegs, horizontal and crawling bands, and managed floats—before allowing the currency to float freely. Other transitions have been disorderly—that is, characterized by a sharp depreciation of the currency, including a large share of the exits to flexible exchange rate regimes during 1990–2002. But whether an exit from a fixed rate is orderly or not, it is always complicated.

What conditions are necessary for a successful shift from a fixed exchange rate to one that is determined, at least in part, by market forces? How fast should the transition be? And in what sequence should the policies needed for flexibility be put in place?

Country experiences indicate that four ingredients are generally needed for a successful transition to exchange rate flexibility:

• a deep and liquid foreign exchange market;

• a coherent policy governing central bank intervention in the foreign exchange market (the practice of buying or selling the local currency to influence its price, or exchange rate);

• an appropriate alternative nominal anchor to replace the fixed exchange rate; and

• effective systems for reviewing and managing the exposure of both the public and the private sectors to exchange rate risk.

The timing and priority accorded to each of these areas naturally vary from country to country depending on initial conditions and economic structure. It is no doubt better to plan an exit in a calm economic environment.

But even planned exits do not necessarily last. Many countries have reversed course after adopting exchange rate flexibility. Either macroeconomic conditions or a lack of institutions or both may contribute to the reversal from a float to a fixed regime.

Finally, both fixed and floating exchange rates have distinct and different advantages. No single exchange rate regime is appropriate for all countries in all circumstances. Countries will have to weigh the costs and benefits of floating in light of both their economic and their institutional readiness.

SELF-STUDY PROJECT*

TRANSLATE THE FOLLOWING, USING GLOSSARY MADE UP BASED ON PREVIOUS MATERIALS ON INTERNATIONAL FINANCIAL SYSTEM OF RELEVANT TERMS AND EXPRESSIONS

1. Исторически платежные балансы регулировались с помощью фиксированных курсов валют на базе золотого стандарта.

2. В большинстве стран в начале прошлого века бумажные банкноты свободно обменивались на золото.

3. Дефицит платежного баланса приводил к оттоку золота из страны.

4. Избыток экспорта и недостаток импорта компенсировались притоком золота в страну, имеющую положительное торговое сальдо.

5. Страна с дефицитом платежного баланса, наоборот, лишалась значительной части золота и соответственно денежных средств.

6. Большинство стран, внешняя торговля которых определяла положение на мировых валютных рынках, обладали уравновешенным платежным балансом или его положительным сальдо.

7. Период между мировыми войнами характеризовался жестокими валютными потрясениями, поколебавшими систему фиксированных курсов,

8. Попытки поддержать фиксированные валютные курсы в подобной ситуации оказались тщетными.

9. Неконтролируемый рост денежной массы приводил к значительным снижениям курсов.

10. Переход к гибким валютным курсам позволил реально отразить различия в состоянии национальных хозяйств и покупательной способности отдельных валют.

11. После войны многие страны ввели фиксированный курс с единовременным пересмотром (система «регулируемой привязки» валюты).

12. Это позволило достигнуть компромисса между корректируемыми и фиксированными курсами.

13. В 1970 г. США, чья валюта являлась основой международных расчетов, столкнулись с рядом трудностей.

14. Дефицит американского платежного баланса поставил под сомнение надежность использования валюты одной страны в качестве основы для фиксации валютного курса.

15. США объявили о прекращении обмена долларов на золото и заявили о введении «свободного плавания» валют.

16. Особо следует выделить развитие программы регулирования платежных балансов европейских стран, где она проводилась в жизнь наиболее последовательно

17. Специфика регулирования расчетов между западноевропейскими странами определялась двумя обстоятельствами.

18. В европейских странах велика доля внешней торговли в общем объеме валового национального продукта.

19. Успехи интеграции привели к унификации методов регулирования платежных балансов.

20. Задача сглаживания колебаний валют стала важным элементом западноевропейского интеграционного процесса.

21. Европейские страны договорились о сокращении пределов взаимных колебаний курсов валют пределами 2,25% в обе стороны, в соответствии с т. н. системой «змея в тоннеле».

TEXT 5. ROLE OF INTERNATIONAL FINANCIAL INSTITUTIONS

A. FACTS: (based on IMF publications)

International financial institutions have different specific objectives and different areas of specialization and expertise. In spite of the different mandates of these institutions, there are similarities in the broad types of contribution that they make to capacity building and in the mechanisms through which these contributions are made. The emphasis that these institutions have placed on coordination and the complementarity of their efforts strengthens the effectiveness of their contributions to capacity building.

First, international financial institutions provide financing—usually loans but also, in some cases, a significant grant element—to help the country's authorities attain objectives agreed upon in consultation with the former. The financing may support specific investments—in, for example, infrastructure and capacity building—or it may be part of a sector-specific or economy-wide adjustment program.

Second, international financial institutions support national authorities' efforts to design policies to achieve specific economic and social targets. This usually entails extensive consultations with both officials and private sector representatives, and between the headquarters and resident staffs of the international financial institutions to identify the bottlenecks and most important issues that the country faces. These are generally followed by preparation of a written report summarizing the findings and proposed policy recommendations of the international financial institutions' staffs. The policy packages agreed upon may include funds or other assistance specifically targeted on enhancing capacity in social or economic areas.

Third, international financial institutions encourage the development, dissemination, and adoption of internationally accepted standards and codes of good practice in economic, financial, and business activities. The adoption and implementation of such standards and codes contribute to the development and improved functioning of domestic institutions, which, in turn, can help countries better integrate themselves into the world economy and benefit from growing globalization.

Fourth, international financial institutions provide training on a multitude of topics. This training can take place within the framework of a specific project that a country implements with the support of an international financial institution—for example, projects calling for reform of public enterprises, the civil service, tax administration, or the financial sector. It can also be provided in courses, workshops, and seminars offered by the training institutions of international financial institutions.

And, fifth, international financial institutions collaborate—in Africa and other regions—with regional training and research institutions (including the African Capacity Building Foundation and the African Economic Research Consortium) to facilitate knowledge transfer; train economic analysts, officials, and "trainers"; and support economic research.

B. OPINION

The Role of International Financial Institutions in Addressing the Financial Crises of the 21st Century: Confrontation or Cooperation? (excerpts)

By Edwin M. Truman, Senior Fellow, Peterson Institute for International Economics, 2011.

The role of international financial institutions is to promote cooperation. They have limited scope to confront their members because their authority derives from those same members, which have ceded a small measure of sovereignty to them. The question I address is whether nations have ceded too much sovereignty to international financial institutions. My answer is negative. Whether the international financial institution is formal, like the International Monetary Fund (IMF), informal, like the Financial Stability Board (FSB), or institutionalized, like the euro area, an excessive attachment to national sovereignty is holding back cooperation.

The principal institutions of international economic and financial cooperation are: the International Monetary Fund; the World Bank group and the various regional development banks; the World Trade Organization, which evolved out of the General Agreement on Tariffs and Trade; and the Bank for International Settlements (BIS) and the cluster of groups that generally meet at the BIS in Basel, Switzerland, in particular the Financial Stability Board (FSB), formerly the Financial Stability Forum.

All of these institutions trace their origins to the end of World War II or before. Until about a decade ago, these institutions were largely dominated by the North Atlantic powers, Europe, the United States, Canada, and that honorary western economy, Japan. The finance ministries and central banks of these nations cooperated informally to guide the IMF, in articular, and the operation of the economic and financial system, in general, via the Group of Ten (G-10) countries (eight West European nations plus Canada, Japan, and the United States) or the Group of Seven (G-7) countries, which excluded the four smaller European nations. In the wake of the Asian financial crises of the late 1990s, the Group of Twenty (G-20) was created at the level of finance ministers and central bank governors, including the G-7 countries, Australia, and large emerging market and developing countries.

However, the G-7 nations conspired to ensure that the G-20 was not centrally involved in

pressing global economic and financial issues. All this changed in the fall of 2008 when the global financial crisis entered its virulent phase. The G-20 met at the leaders’ level for the first time. One of their first institutional acts was to force the transformation of the G-7-centric Financial Stability Forum into a body, the Financial Stability Board, that parallels the G-20 in its representation.

The G-20 has advanced international cooperation, but progress to date has been limited by three factors: a reluctance of the Europeans to give up their disproportionate representation in the major institutions, uneven pressure for change coming from the United States, and the fact that, as more countries have emerged on the global stage as important players demanding a say, cooperation has become more difficult.

One aspect of the third factor is that the new players did not share in shaping the written and unwritten rules and conventions of the global economic and financial system. Consequently, they have not internalized a responsibility for sustaining the system. In other words, the desirability of sharing sovereignty is even less well developed among the emerging and developing economics than it is within the traditional North-Atlantic consortium.

National sovereignty and multilateral cooperation are indeed complementary in the sense that without greater international cooperation, the value of national sovereignty is nugatory. Without international cooperation, the international financial institutions are rendered powerless. Cooperation is essential to maintain and promote economic growth and stability.