International Financial System - Assignment Example

Table of Content Changes in World Financial System Question1: Introduction…………………………………………………………2 2. The Depression and Second World War (1933-1945)………………………….2 3. Why Bretton Woods System Failed?...................................................................4 4. Application of the Theory of Optimal Currency Area………………………….4 5. Evaluation of Single Currency and OCA Theory……………………………….5 6. Conclusion……………………………………………………………………...6 7. References……………………………………………………………………….7 Single Currency and the United Kingdom 1. Introduction…………………………………………………………………….10 2. The Likely Benefits to the UK from adopting Euro……………………………11 3. The Likely Disadvantages to the UK from adopting Euro…………………......13 4. Conclusion & Recommendations…………………………………………….....14 5. References……………………………………………………………………….16 Question 1: Changes in the World Financial System 1. Introduction The world’s financial system based on Gold Standard was at its peak starting from 1901, reaching a crisis by 1932. Industrial and advanced nations were very well acknowledging the need of a lender of last resort. The First World War brought to an end the convertibility of Gold Standard to the Bank of England in 1914. England practiced a list of currency controls including monetizing of Postal Money Orders and Treasury Notes to initiate reforms in the banking system and control movement of gold. The cost of war compelled both the UK and the US to stop the use of the gold standards. Germany shifted to paper currency (Action Forex 2010). In 1925, the UK returned to the gold standard at the suggestion of its economists at the before-war gold price initiating deflationary trends in the economy. Due to high rate of deflation, the gold standard got out of practice again in 1931, followed by other nations including Sweden in 1929 and the US in 1933 (Action Forex 2010) 2. The Depression and Second World War (1933-1945) The international gold standard was declared dead in 1933 at the London Conference although all major nations including the UK, the US, Italy and France wanted return to the international gold standard. The proposal of drawing rights with the aim of stabilizing exchange rates also could not be initiated. The reason of the collapsing gold standard was attributed to the US and the UK forcing low peg to gold, as a result no consensus could e reached among major countries on returning back to gold standard. Increased tariff barriers was also one of the reasons hindering other nations to support return to the gold standard; also other nations doubted Britain’s intentions of getting the benefit in the commonwealth by not effectively forcing fiscal measures (Action Forex 2010). Some of the rescue options included reining in of foreign capital flow to safeguard emerging economies, strengthening the monetary power of the IMF and codification of debt rescheduling by permitting countries to request IMF to file for a debt hold agreement (Mandel & Foust 1998). From 1939 to 1942 Britain exhausted all its stock of gold in purchasing ammunition, which made it clear that return to the gold standard was not possible. The predictions of John Maynard Keynes got proved to become a part of the “stability pact” finding Keynes voice heard in the Bretton Woods Agreement, signed on 1944 (Action Forex 2010). Bretton Woods Agreement was signed for the establishment of International Bank for Reconstruction (IBRD, the World Bank), the International Trade Organization (ITO), and the International Monetary Fund (IMF). A system of exchange rate management was deployed, which was working till 1970. Currency conversion was made mandatory by the member countries of the agreement, which became functional only in 1959, culminating in the setting of IMF and IBRD (Wikipedia).The system couldn’t work beyond 1971 due to increasing financial glitches and one-sided termination of conversion of dollar into gold by the United States. This action of the United States created furors in the international economy, and a new situation surfaced making the dollar “reserve currency” for the member nations that signed the agreement. The Bretton Woods Agreement served the need of reorganising the whole of Europe to face the economic after-effects of First World War. The token of it was a loan of $250 million awarded to France in 1947 by the World Bank – the first act to amend the deteriorating economy of France. Bretton Woods Agreement resulted in large scale movements of currencies. It was also felt that a fixed exchange rate was a hurdle in the way of pursuing independent monetary and fiscal policies by the member states of the Bretton Woods Agreement. According to Braithwaite and Drahos (2001), a number of related problems that were reason to the birth of the Bretton Woods Agreement included among others deficiency of gold, exchange rate instabilities, the circulation of “hot” money in and out from the system, and the deficiency of a mechanism to fix balance of payment problems. 3. Why Bretton Woods System Failed? The Bretton Woods System collapsed because rules were not followed for converting the dollar into gold and the exchange rate mechanism not working, thus, causing shortage of liquidity resulting in creating currency crisis. Due to the Vietnam War, the US had to pay its debt, letting the balance of payment to remain in deficit. The other nations started converting their dollars into gold as the confidence in the credibility of dollar started diminishing. It triggered the US reaction by declaring in August 1971 that it was suspending the arrangement of converting the dollar into gold (Wiggin 2006). 4. Application of the Theory of Optimal Currency Area Economic theories on probability of risks can play havoc with the financial system, as asset pricing models and portfolio theory by Harry Markowitz, Merton Miller and William Sharpe in 1990 did, ignoring the possibility of sudden disasters (Baker 2010). The theory of optimal currency area (OCA) relates to the alternatives between floating exchange rate and fixed exchange rate and not between closely pegged rates and a common currency (Kenen 1997). The truth is that political lineage in stead of economic issues decides the operations of currency regimes. The theory of optimum currency areas (OCA) although supports other options but exceptions also point towards the prevalence of political tendencies such as in the case of African franc zone attending to the cause of old colonial powers, the US dollar in Panama and Liberia indicates towards political bonds (Mussa 1997). Taking the example of euro becoming the common currency of the European countries, Sweden’s conducting of referendum on becoming a member of the single currency euro in September 2003 was one such rare event that checked the application of Optimum Currency Area (OCA) approach. A debate arose among economists on the Swedish membership in the Economic and Monetary Union (EMU). 5. Evaluation of Single Currency and OCA Theory Advantages and demerits of the membership were evaluated on the basis of the theory of OCAs, advantages accruing from efficiency gains from common currency. Global dealings on reduced cost, no scope of doubt over fluctuating exchange rate within the unified economies would boost foreign trade and competition as well as economic growth and employment. Demerits included loss of freedom in pursuing a monetary policy and fixing interest rate in the perspective of domestic market. A free Swedish currency was viewed as a guarantee for security (Jonung 2004). As per the OCA theory, the primary advantage was between efficiency gains from unified currency i.e. from the fixed Krona rate and from the prospects of domestic endurance from the changing Krona rate. Voters to the Swedish referendum were divided on the expected leveraging from two situations of Common currency and own currency. The analysis of voters’ tendencies exhibited the ranking of OCA theory in decision making to choose from the micro-economic benefits and macro-economic stability as perceived by all sections of society. Other than the implications in the OCA approach, political and ideological factors also impressed upon the results of the Swedish referendum on currency-based economic unification (Jonung 2004). 6. Conclusion The present monetary system takes the US dollar as the “anchor currency” for all global transactions. Gold functions as a reserve; it is held in great quantities as a hedge against the US dollar, which is available in abundance as a liquid currency. Gold functions as a financial asset of all central banks besides foreign currencies and government bonds (Action Forex 2010). 7. References Action Forex, 2010. Gold Standard from peak to crisis (1901-1932). Action Forex. Available from: http://www.actionforex.com/articles-library/financial-glossary/gold-standard-20041205393/ [Accessed 17 January 2011]. Baker, Stephanie., 2010. Taleb says investors should sue Nobel Panel for losses. Bloomberg. Available from: http://www.businessweek.com/news/2010-10-08/taleb-says-investors-should-sue-nobel-panel-for-losses.html [Accessed 17 January 2011]. Braithwaite, John., Drahos, Peter., April 2009. Bretton Woods: birth and breakdown. Global Business Regulation. Available from: http://www.globalpolicy.org/component/content/article/209/42675.html [Accessed 17 January 2011]. Kenen, Peter B., 1997. Preferences, domains, and sustainability. The American Economic Review, 87 (2), pp. 211-213. In: Papers and proceedings of the hundred and fourth annual meeting of the American Economic Association. Available from: http://www.jstor.org [Accessed 17 January 2011]. Jonung, Lars., 2004. The political economy of monetary unification: the Swedish euro referendum of 2003. Cato Journal, 24 (1/2). Available from: www.Proquest.com [Accessed 17 January 2011]. Mandel, Michael J., Foust, Dean., 1998. How to reshape the world financial system. Business Week, no. 3599, Business Source Complete. Available from: www.web.ebscohost.com [Accessed 21 January 2011]. Mussa, Michael., 1997. Political and institutional commitment to a common currency. The American Economic Review, 87 (2). Available from: http://www.jstor.org [Accessed 17 January 2011]. Wiggin, Addison., 2006. Bretton Woods Agreement. The Daily Reckoning. Available from: http://www.dailyreckoning.com.au/bretton-woods-agreement/2006/11/29/ [Accessed 19 January 2011]. Wikipedia 2009. United Nations monetary and financial conference: Mount Washington Hotel. 25 November 2009. Available from: http://en.wikipedia.org/wiki/United_Nations_Monetary_and_Financial_Conference [Accessed 17 January 2011]. Question 2: Single Currency and the United Kingdom 1. Introduction The United Kingdom has shown apprehension on joining the single currency due to the ambiguity on the business and industrial benefits over the single currency regime. The single currency, the €, came into being on 1st January 1999. The European Monetary Union (EMU) is the authorised organisation to set exchange rates as per its monetary policy activated by the European Central Bank (ECB). Although the UK fulfilled the macro economic performance standards known as convergence criteria yet it has been hesitant in joining the EMU (ALoA 2005). The June-2001general election became the debating platform on the UK’s entry into the eurozone on primary issues related to the national freedom and political ideology. Both the political parties, the Labour Party and the Conservative Party had difference of opinions. Popular opinion of the masses was against adopting euro (Webster & Howell 2011). The stand of the UK government has been in favour of the Euro membership in principle only. The road leading to the joining the euro poses no hurdles to the UK government but it has set 5 economic parameters to be attained enabling decision making on this issue of crucial importance. There are discussions on having a referendum on opting the euro as single currency after the new constitution of the EU takes over the old constitution for better decision making (NHS Scotland 2008). There has been confusion prevailing over whether Britain’s entry in the euro zone would be a political or economic decision. Jack Straw, Home Secretary, has expressed his views that such a decision would be taken on political grounds but the Chancellor, Gordon Brown, has stressed on the significance of the Five Tests, relating the issue to economic decision making (Trueman 2010). The 5 parameters are: 1. Long-term convergence between Britain and the economies of a single currency; 2. Whether there is enough flexibility to manage the economic change; 3. Impact on investment; 4. Impact on our financial services industry; and 5. Employment concerns. Out of the 5 stipulated parameters, the UK government has cleared the euro as a single currency on investment, financial services and growth while it has not given the green signal on convergence and flexibility issues (NHS Scotland). 2. The Likely Benefits to the UK from adopting Euro 1. No Transaction Cost. The cost of changing the Pound into Euro and vice versa would get removed as within the EU a common currency euro would be used (ALoA 2005). Having a common currency impacts trade positively; it has been explained with he help of gravity model of bilateral trade by Rose (2000)), stating that trade increases in triples if currency is common in comparison to countries with individual currencies. Another study by Glick and Rose (2001)) from 1948 to 1997 finds very positive impact of joining currency unions, resulting in almost doubling business among member countries (Spencer 2004). 2. No Exchange Rate Volatility. Business transactions across the country borders would become smooth due to stable exchange rate. It would add to the competitiveness and profits of the UK business and industry. Pound’s volatile behaviour during 1989-2000 against the German Mark lowered its sheen and value to one-third (ALoA 2005) but taking the lessons from the 1992-93 exchange rate mechanism crises, a traditional open macroeconomic model exhibited different equilibria in view of the European currency crises. The related literature offers a view of the “self-fulfilling speculative attack” (Pill 1998). 3. Reduced Long-term Interest Rates. It is expected that if the UK joins the single currency, the interest rates would come down to the previous as they used to prevail in the powerful European economies such as in Germany. Reduced interest rated would boost investment and decrease business costs (ALoA 2005). 4. Sustained Competitive Advantage to the City. London has been the major financial city of Europe. In the absence of the UK as a member of the euro, Frankfurt and other European big cities are capturing all business opportunities on which London’s share as a major city holds its right. It would be difficult to keep and secure more business if the UK doesn’t become a member of the single euro currency (ALoA 2005). 5. Financial and capital markets upon joining the EMU would surge with liquidity. Investors from all financial institutions including banks, insurance companies, investment funds, pension funds etc would leverage from a vast offering of investment and saving opportunities. Funding opportunities for equity issuers and borrowers would increase because of bigger capital market. Risk to investors’ total portfolio would reduce with the increased spread. Business transactions would become transparent, removing doubt and increasing liquidity (Spencer 2004). 3. The Likely Disadvantages to the UK from adopting Euro 1. Transitional Costs. Changing to the new accounting and pricing systems to the € would put huge burden on the UK businesses. It would add about £5 billion in cost to the UK industry. 2. Inflation Potential. The cost of transferring to the euro would have to be shared by the consumers causing inflationary trends in the UK domestic market (ALoA 2005). 3. Cause Regional Unemployment. Common perception is that entering the euro zone would increase the unemployment rate in micro cities because by pursuing the macro economic policies across Europe by the European Central Bank would enhance the business only in leading industrial and financial city centres of European countries including the UK, thus, affecting the far away regions. The reduced flexibility of the UK government in fixing interest rates would widen the economic gap between the richest and poorest regions in Europe (ALoA 2005). 4. Ineffective Management of Recessionary Forces. A single macro economic policy for the whole of Europe would not suit the individual countries’ needs. Countries leading in coming out of recession to such countries that have not recovered yet or are facing opposite trends would find it difficult to pursue a suitable monetary policy on interest rates. A combined monetary policy equally applicable to all EMU members would be like assuming that economic cycles in all member countries would run on similar tracks, which is just far away from truth; Italy and Ireland have undergone the same situation of running of economic cycles of both the countries on different tracks, causing difficulty in managing opposite market forces (ALoA 2005). 5. Forced Flexibility of Labour Market. Entering into the EMU would compel the labour force to go beyond their own territory in search of jobs as the whole of Europe would become a common platform for finding employment. Labour would need to be flexible enough to move to such locations as Hamburg, Barcelona, Paris, or wherever the opportunities are available (ALoA 2005). 4. Conclusion & Recommendations All the disadvantages attached to joining the EMU such as regional imbalances, labour immobility and deficiency in economic flexibility have affected the UK economy even without the EMU. On the other hand, a changeover to the euro with no possibility of changing exchange rate would be made available with an incentive to take the plunge (Mussa 1997) but considering the latest trends in Eastern Europe, the debt in both public and private requires severe cost cutting to remain in the eurozone. There is greater possibility over increased cost of borrowing by the European countries, further heightening the chances of regional imbalances and create more tensions (Ilargi 2010). Such a dismal scenario on regional tensions due to Europe wide debt requiring high cost cutting is a signal for the UK to show disinclination towards its entry to the Eurozone. 5. References ALoA. 2005. EU – the single currency and single market. ALoA, no. 4. Available from: http://www.ngfl-cymru.org.uk/vtc/bus_studs/WJEC%20Business/Core%20Notes/Single%20market%20and%20currency.pdf [Accessed 17 January 2011]. Ilargi, 31 October 2010. Night of the living debt. The Automaticearthblog. Available from: http://theautomaticearth.blogspot.com/2010/10/october-31-2010-night-of-living-debt.html [Accessed 17 January 2011]. Mussa, Michael., 1997. Political and institutional commitment to a common currency. The American Economic Review, 87 (2). Available from: http://www.jstor.org [Accessed 17 January 2011]. NHS Scotland, 2008. Financial performance management & accounting: euro conversion. NHS Scotland. Available from: http://www.fpma.scot.nhs.uk/euro_conversion.htm 2008 [Accessed 19 January 2011]. Pill, Huw., 1998. Review of: Financial markets and European monetary cooperation: The lessons of the 1992-93 exchange rate mechanism crisis. Journal of Economic Literature, 36 (3). Available from: http://web.ebscohost.com [Accessed 17 January 2011]. Spencer, Kyle., 2004. Penny wise and Pound foolish, the UK should adopt the Euro. Rensselaer Polytechnic Institute, Lally School of Management and Technology. Available from: http://www.ewp.rpi.edu/hartford/~stoddj/BE/UKkEuro.htm [Accessed 21 January 2011]. Trueman, Chris., 2010. What are the arguments for and against joining the Euro. Available from: http://www.historylearningsite.co.uk/euro.htm [Accessed 19 January 2011]. Webster, Graham., Howell, Kerry E., 2011. The European single currency: attitudes towards UK participation in the Eurozone. International Journal of Applied Finance for Non-Financial Managers, 1(3). Available from: http://www.managementjournals.com/journals/finance/article87.htm [Accessed 19 January 2011]. Read More