Currency Transactions and International Settlements - Essay Example

CURRENCY TRANSACTIONS AND INTERNATIONAL SETTLEMENTS Introduction An incumbent international currency holds a built-in advantage in retaining its status, and in so doing, it pays for central banks to hold its foreign exchange Reserves in a currency widely used for settling international financial transactions in which the markets are liquid and stable. It follows that it will pay for them in the same currencies held by other international investors in order to hold their reserves, including other central banks. This is a network externality that brings an element of path dependence to the development of reserve-currency status (Eichengreen 1997). This scenario is epitomized by the monetary importance of the pound sterling as a reserve currency in the 20th century; when Great Britain’s dominance in the international financial and commodity markets was still on thrive (Redish 1990). Even during the abundance of the late-19th century pound sterling standard, the currency’s domination had not yet been completed (ibid). Other factors such as another countrys arrival account for a significantly larger share of international financial and commercial transactions can manage to offset the advantages of incumbency. Likewise, the network externalities that have long worked in favor of a dominant currency suddenly started working against it, alongside with the initial scenario of a new dominant currency in an onset (Eichengreen 1997). Creating a stable market sufficient enough to be attractive to international investors, including central banks requires periodic liquidity management and lender-of-last-resort operations. This implies that the domestic central bank will in turn have regulatory and supervisory authority over the market in whose management is engaged (ibid). The dollar’s ability to acquire reserve currency status had a significant effect on the rise of U.S. international economic power which gave way to the creation of a Federal Reserve willing and able enough to carry out international transactions. In contrast, the Maastricht Treaty faced a strong division between responsibility for monetary policy and responsibility for regulation and supervision, whose responsibility will rest on national authorities (Triffin 1964). Historical Evidence of International Currency: Prospect for Managing International Markets The practice of holding foreign currencies by bankers and governments is traced back over centuries, but it was only in the 19th century that holding foreign assets as a reserve against official liabilities became a standard practice (Nurkse 1944). It so happened when liquid financial markets, modern central banks, and the international gold standard emerged. It may be inferred that the rise of these practices was correlative of modern economic growth which began thriving in the 19th century (ibid). Commodity money already dominated domestic and international transactions even prior to the industrial revolution. It was considered impractical to use token coins and paper money if there were inadequate standardization that would make counterfeiting easy (Redish 1990). It is significant to note that the development of the steam engine brought steam power to a booming industry, which effectively removed this constraint. It likewise facilitated the advent of the gold standard, whose spread had been previously limited due to the fact that the smallest gold coin was considered too valuable for daily transactions (Bell 1956). Prior to the gold coin, it is significant to mention that most countries had been on the silver standard first or on some forms of bimetallic standard, for which the government posed to mint fixed quantities of silver and gold bullion into legal tender, and small-denomination coins composed of silver were made to address day-to-day small transactions (ibid). When the steam engine was utilized to the mint and token coinage became practical, the main intent to go onto gold meant acquiring an adequate stock of the yellow metal. Government enabled themselves to accomplish this by suspending its commitment to purchase silver and allowing its internal price to decline below world levels (Eichngreen 1997). The export of silver and import of gold then followed suit, which the authorities turned into coin in unlimited amounts. But it was later contemplated that the transformation could be accomplished even faster if the metallic basis of the money supply was concentrated only in the hands of the official men who were given the authority to circulate internally are only token coins and paper money. In this regard, the government or central bank could exchange the nation’s silver for gold in the open market (Redish 1990). However, in poorer nations where there was scarcity of precious metals such as silver and gold, there was a natural temptation to acquire financial assets that bore interests, which were convertible into gold. This temptation was pursued with the government having secure the needed resources needed in establishing gold convertibility through a foreign loan (Lindert 1969). The existing exchange reserves of a country could serve as collateral, while the lender would typically require the borrowing government to keep some of the proceeds of the loan on deposit in the issuing financial center (ibid). The practice of requiring the maintenance of gold convertibility was authorized by a number of important gold standard countries. (Bloomfield 1959). It was only after 1870 that the holding of foreign exchange reserves became widespread. In 1880, the foreign exchange reserves of government and central banks were placed at 10 per cent of their gold reserves, having Belgium, Austria, Canada, Finland, Denmark, Sweden, and Germany as the principal countries that held exchange reserves at this time (Eichngreen 1997). From this point, the share of foreign exchange in world reserves started to rise then. Later, Japan received exchange reserves from China in the form of an indemnity as a result of her victory in the Sino-Japanese War. In 1890s, Russia started to hold the proceeds of her foreign loans in Berlin and Paris, using them as the basis for her market operations in order to stabilize her currency, and her example was emulated by Austria (Bloomfield 1959). At this time, sterling was the leading reserve currency, facilitating international transactions. Holding balances in London was the convenient way to effect balance-of-payments settlements with Britain being the leading trading nation. Following this was sterling as the convenient currency in which to borrow, with London being the apparent place to hold the proceeds (Eichengreen and Flandreau 1996). Hence, the Bank of England grew increasingly larger on its lender-of-last-resort responsibilities which consequently guaranteed the liquidity of the London market. It is noteworthy to mention that until 1871, sterling was the only major currency which was unconditionally convertible into gold that even the French franc then, which was the second most important reserve currency, could be convertible into gold only at the option of the authorities (Michaud and Upper 2008). Changes in Currency Transaction & International Settlements The period since 1971 was characterized by generalized development of a more multi-polar world economy alongside with diversification of the currency denomination of official foreign exchange reserves (Eichengreen 1997). The United States, which used to have a large share of world trade, and the dollar, which was the universal currency for international transactions, was competed by a number of countries pegging their exchange rates against the dollar as a reference currency for international financial transactions. With this, central banks have diversified their holdings (Kapoor 2007). The dollar’s prestige has been rising in the 1990s, which continued up to 1996. On the other hand, the deutsche mark’s and yen’s shares showed decline in the 1990s. These trends suggest that incumbency continues to exert influential effects except when swamped by policy instability, while a more diversified world trading and financial system suggests more diversified reserve holdings (Eichengreen 1997). With the facilitation and regulation of currency transaction and international settlements, the Bank for International Settlements (BIS) was established by the Hague Agreements on January 20, 1930, which originally intended to facilitate Germany’s payment of reparations following World War I. Right now, it is an international organization that fosters international monetary and financial cooperation and serves as a bank for central banks as well as a focal point for research and cooperation in international banking regulation (Bank for International Settlements). The proposal for a currency transaction tax (CTT) or the so-called Tobin tax was first established in the 70s, but it is said that nothing has been done towards implementing such a tax (Tuomioja 2000). On the contrary, the liberalization of financial transfers and capital markets was on its accelerated pace and the proposal remains valid and has been supported through the efforts of NGO networking (ibid). The CTT was conceptualized within the context of increasing transparency in international organizations as well as the ability to respond to the instability caused by free movement of capital and the challenges of globalization. In connection to this, comprehensive international systems were introduced whose purpose was to counter disturbances within international finance, such as clarifying short-term speculative capital movements (ibid). The Currency Transaction Tax implies levying on every currency change, which is set on level, low enough not to hinder any transactions needed to finance long-term capital investment and real trade in goods and services, but high enough to discourage levels of destabilizing speculative money movements. With a vast amount of daily currency transactions, a tax of just 1% will enable to generate more income than official development aid from industrialized to less-developed nations. It is then contemplated that the introduction of the Currency Transaction Tax could solve the problems that exist hand-in-hand with development financing (Tuomioja 2000). However, the CTTs ability to prevent any of the more serious financial crises of recent years involving extreme currency fluctuations is still held unanswered. Speculations show that technical difficulties and unworkability of the tax and the lack of universal support make it unenforceable (ibid). The participation of governments is usually taken crucial for the implementation of the CTT. With the existence of the euro and the EU countries commitment to the European Monetary Union, it is far beyond conceiving that individual EU countries could act independently of the EU on the CTT. With the currency fluctuations inside the Euro zone being reduced, the sense of urgency was likewise diminished concerning the risks of speculative currency fluctuation (Eichengreen and Frankel 1996). It was analyzed that the Euro has not insulated Europe from the potential instability of international financial markets. Thus, Europe too has a vital interest in pursuing international financial stability, an insight that is quite apart from considerations of balanced global development (Eichengreen 1997). Reforming the International Financial Institutions Towards More Effective Currency Transactions At present, money has become a commodity rather than a means of exchange, traded at a volume of over US$ 1.9 trillion dollars per day which moves around the world without restriction, with an objective of seeking maximum short-term profits (Currency Transaction Tax, retrieved on April , 2008)). The conception of reforming the International Financial Institutions (IFI) has evolved in a positive stance both in the inter-governmental level and among institutions. New important insights emerged, which seem to address the lessons learned from the past G-7, IFIs and the Bank of International Settlement (BIS), which have already worked on issues pertaining to currency settlement at some considerable length and produced a set of policies and measures in which some are being applied and some, under discussion and development (Tuomioja 2000). However, there is no consensus yet on certain key issues as the division of work between the IMF and the World bank in crisis management, which is a matter of great importance. Tuomioja stated that that this development, which seemed to be modest, has meant tangible progress from the point of view of crisis prevention and management, although many proposed measures still need to be worked on. The realm of reforming the international financial scenario is not a clear environment yet, in which one could see the battle lines separating the good from the bad. There are differences between governments among the OECD countries, between OECD countries and developing countries, between governments and the financial community, and between institutional actors and NGOs. Further, these groupings are homogenous and are split on several issues. It only shows that the wide variety of options faced by governments do not make it easy for progress to come into light. Likewise, there is no reliable way to test the achievements that have been reached in terms of currency transaction, so far as practice is concerned. Tuomioja points out that it is only through a crisis and how governments and how the international community avoids them could serve as a proof for reliability. The lack of proper regulation and supervision are primary concerns of both the less-developed and developed countries. Finland has particularly experienced this inadequate financial supervision in the late 80s where lack of a critical belief in capital market liberalization alongside with its rushed implementation contributed to severe banking and currency crisis. This suggests entering the recession in a very badly prepared manner in which other countries showed a similar experience (Tuomioja 2000). It is likewise notable of mentioning that it has been generally accepted that all exchange policies and systems require a macro-economic policy that will support the needed stability. It is difficult to expect a currency regime to ensure that all wrong decisions in economic, monetary and financial policies are corrected and appropriately modified (Kapoor, Hillman, and Spratt 2007). However, international financial systems should lend support in making stability take place offering all-embracing solutions are a hard contemplation. Conclusion Currency transaction and international settlements have been a great deal of concern, as well as a point of contention of different countries and institutions even in the beginning. The ability and reliability to manage financial transactions and regulate currency reserves are the focal points of this concern, the most important aspect of which is to handle financial activity in the regions and the world. Today, currency transaction is facilitated through a myriad of policies which nations abide, providing order in international markets and the management of their finances. Globalization poses as both a new trend and challenge by which international settlements may be managed more appropriately. REFERENCES Bank for International Settlements. Retrieved on April 19, 2008 from http://www.riskglossary.com/link/bank_for_international_settlements.htm BLOOMFIELD, Arthur, 1959. Monetary policy under the international gold standard. New York. Federal Reserve Bank of New York. Currency Transaction Tax. Retrieved on April 19, 2008 from http://www.currencytax.org/ Eichengreen, Barry, 1997. The euro as a reserve currency. EICHENGREEN, Barry and FLANDREAU, Marc, 1996. The geography of gold standard. Jorge Braga de Macedo, Barry Eichengreen, and Jaime Reis (eds). Currency Convertibility: The Gold Standard and Beyond. London: Routledge. Pp 113-143. EICHENGREEN, Barry and FRANKEL, Jeffrey, 1996. The SDR, reserve currencies, and the future of the international one tray system. The Future of the SDR. Washington, D.C.: IMF. pp. 337. KAPOOR, Sony, HILLMAN, David and SPRATT, Stephen (2007): Taking the next step - implementing a currency Transaction Development Levy. Unpublished. LINDERT, Peter, 1969. Key currencies and gold, 190-1913. Princeton Studies in International Finance. Princeton University. MICHAUD, François-Louis and UPPER, Christian, 2008. What drives interbank rates? Evidence from the Libor panel. BIS Quarterly Review. 3 March. NURKSE, Ragnar, 1944. International currency experience. Geneva: League of Nations. REDISH, Angela, 1990. The evolution of the gold standard in England. Journal of Economic History. pp. 789-805. TRIFFIN, Robert, 1964. The evolution of the international monetary system: historical reappraisal and future perspectives. Princeton Studies in International Finance. Princeton University. TUOMIOJA, Erkki, 2000. Perspectives for currency transaction taxes as a part of a new international financial architecture. The First Inter-parliamentary Meeting on the Tobin Tax the European Parliament Brussels. 28 June. Read More