Funds for Economic Development role of IMF and World Bank - Term Paper Example

 «Bretton Woods Agreement» Abstract: This paper will throw light in detail over Bretton Woods Agreement (1944) and its breakdown in 1970s after which international monetary framework was developed and implemented. The researcher will first define Bretton Wood System and then highlight its key features in detail to providers the insight over strength of this monetary system. The paper then moves on with an explanation over breakdown of Bretton Woods System followed by a discussion over how international monetary framework has replaced the system. Finally, the author will provide a compare and contrast analysis over sustainability factor of both system supported by pertinent facts. Before 1944, the world lacked an internationally recognized global exchange and monetary system. In addition, there were no international financial institutions, which could financially assist war – hit, poor or least developed nations in grappling with monster of poverty, unemployment, financial problems and foreign trade issues. The international community observed a remarkable change in 1944, after Second World War, when world’s leading nations signed an agreement named Bretton Woods to establish a global money exchange and financial system. The major reason behind that agreement was to commence reconstruction and rehabilitation of nations (especially European) that were adversely affected from global war and to avoid consistent devaluation of currencies. Indeed, an international monetary system was developed and implemented through creation of financial institutions named International Monetary Fund (IMF) and World Bank. As far as this system is concerned, it is worthwhile to mention the fact it was based on the value of the US dollar that would be used as the international currency. The US dollar could be exchanged for or converted in other currencies at predefined fixed rates set by international institutions such as IMF and World Bank. Indeed, the importers and exporters were informed to use US dollar as a major currency for all trade related payments worldwide. Apart from this, the Bretton Woods agreement also defined the Gold Standard to link paper currencies to specific values and gold. Indeed, the value of US dollar was related with the price of gold in international markets to ensure sustainability. For instance, the system also defined bands and revealed that exchange rates could ‘fluctuate within + 1% against US currency’, which was permitted to ‘fluctuate within + 2% against all non-US currencies’ (PowerPoint Presentation: Bretton Woods Agreement). It should also be pointed out that countries had to negotiate with International Monetary Fund if they observed any appreciation (overvaluation) or deprecation (undervaluation) of currencies. As a result, the previously defined exchange rates could be adjusted to bring in-line with recent under- or overvaluation. At that time (during 1944 – 1970), this above mentioned principle of Bretton Woods System was considered as the actual strength of the monetary framework because it aimed to ensure certainty, sustainable economic and financial growth / development as well as to reduce the probability of global financial crises and credit crunch like situation. In simple words, the Bretton Woods Agreement was an attempt to promote economic stability through implementation of a strong financial system, which together would not only help poor and less developing nations in alleviating with poverty and unemployment but also in controlling periodic price hikes or inflation in domestic markets (Chowala et al, 2009). Key Features: This section will individually discuss the main features of Bretton Woods System, which are as under: Fixed exchange rates were regulated by IMF: The International Monetary Fund was established to foster economic growth, stability and certainty across the globe. The financial institution regulated the currency exchange rate against US Dollar so that non-US currencies could be exchanged for US currency. Indeed, the idea was to ensure entire international trade (and payments) would be conducted in US Dollars supported by fixed exchange rates to maintain stability in trade and commerce activities. (Dooley, 2002) Built-in flexibility: Countries were instructed to report IMF in case of undervaluation or overvaluation of currencies against US dollar because of various factors such as political uncertainty, law and order crisis, economic instability, Balance of Payment (BOP) and other issues etc. In simple words, if a country observe economic growth due to increase in Gross Domestic Product, Trade Surplus (Exports – Imports), efficient economic framework and mechanism, strong foreign policy and cordial diplomatic relationships with nations worldwide, its currency would appreciate because of economic betterment. In contrast, if economy is unstable due to decline in domestic business activities, military war, trade deficit, Balance of Payment crises, current account deficit, political uncertainty etc., the currency would depreciate. Hence, nations had to request IMF to adjust the exchange rates because of such fluctuations so that nations could smoothly conduct conversion transactions regarding foreign trade. (Liebscher, 2004) Funds for Economic Development – role of IMF and World Bank: One of the best features of Bretton Woods Agreement was the focus on economic recovery through increase in global trade and through reconstruction and rehabilitation of poor economies and failed nations. The World Bank (also named as International Bank of Reconstruction and Development) was formed to collect funds from all countries worldwide after which it would analyze the economic scenario in poor nations and offer funds for development. Indeed, the economic managers and pundits employed at World Bank first tend to discover economic weaknesses of under developing countries after which they devise an improvement framework comprising economic and fiscal growth targets. The managers then negotiate the amount of loan to be sanctioned at a discounted interest rate, which has to be used according to World Bank’s will for accomplishment of predefined targets aiming monetary, economic and social improvements. For instance, any underdeveloped country that obtained loans from either IMF or World Bank could spend the money on public sector development projects such as infrastructure facilities (roads, transportation and telecommunication network), utilities (natural gas, electricity, water, extraction of coal, minerals and other natural resources etc.), agricultural development (increasing fertile land, crops production, research for creation of new seeds for greater yield etc.), educational programs (schools, colleges, universities, technical institutions, laboratories etc.), healthcare programs (hospitals, trauma centers, maternity homes, childcare institutes etc.) and technological advancements (Research & Development institutions for production of high tech machinery and other capital goods to enhance efficiency and productivity through utilizing minimum inputs) (Liebscher, 2004). In this way, the World Bank and IMF had contributed to promote growth and economic prosperity in developing countries that needed financial assistance. Nevertheless, the European nations such as France, Germany and others obtained loans during late 1940s and in 1950s to ensure economic recovery through reconstruction and development. The public assets that were sabotaged during World War 2 were reconstructed to increase confidence of general public and business community. As a result, the business activities and projects that came to a standstill were restarted followed by an increase in production, consumption, employment and number of transactions. The global economy recovered and trade boosted after formation of IMF and World Bank. Enforcement mechanism - role of IMF: IMF was, indeed, the main actor in this scenario as the institution was directly responsible to enforce the rules of the Bretton Woods System and monetary framework. It is worthwhile to mention the fact that IMF was actually formed to regulate exchange rates and to assist in successful implementation of entire Bretton Woods System. For instance, the sole purpose of IMF was to avoid nations from becoming bankrupt and an economically failed state. IMF, in collaboration with USA, United Kingdom, France, Germany, Soviet Union (USSR) and other advance and developing countries developed a fund of billions of dollars, which was aimed to help nations avert Balance of Payment crises. It should be recalled that all international payments were to be made in US Dollar; therefore, dollar – starved nations having greater US Dollar outflows (imports and loan repayments) and reduced monetary inflows (foreign aids, exports, Foreign Direct Investment and remittances) were obliged to contact IMF and negotiate loans so that they could make international dollar payments. These loans have then to be repaid at an agreed upon interest rate. (PowerPoint Presentation: Bretton Woods Agreement). The loan sanctioning would obviously benefit a country in the short run facing BOP crises as it would increase its foreign dollar reserves and enable to make payments. In other words, nations could avoid bankruptcies and domestic financial crises through immediate assistance of IMF. However, it should also be emphasized that United States of America was at liberty to pay its foreign or balance of payments (BOP) in dollars instead of local currencies of nations to which payments had to be made. (PowerPoint Presentation: Bretton Woods Agreement). Summarizing the above, the Bretton Woods Agreement lasted for 26 years (1944 – 1970) as it failed in 1970 – 1971 due to certain economic breakdowns and weaknesses in US economy. Since, the US currency had remained the dominant part of former international financial system, any underlying economic weaknesses or shortcomings in US system would have adversely impacted the value of its currency. The next section will demonstrate why the previous system observed a breakdown and how it had been replaced with a new international monetary framework. Failure of Bretton Woods System: It is worthwhile to mention the fact that every system or agreement has certain shortcomings and loopholes that may lead to its failure or breakdown. Indeed, the Bretton Woods Agreements although appears to be quite strong because it used Gold Standard, fixed yet adjustable exchange rates, the regulation by leading international financial institutions such as IMF and World bank, even though the system failed in 1970s and a new international monetary framework was applied. The major reason, in simple words, which led to failure of Bretton Woods Agreement in 1973, was the absolute dependence over US Dollar that was directly linked with US economic survival, growth and sustainability. It should be pointed out that all other currencies could be exchanged or converted into US dollar at the predefined fixed exchange rate regulated by IMF and the US currency was valued after analyzing gold prices. Hence, in this way, all international trade payments had to be made in dollar, which enjoyed the most power against all leading currencies in the world economic system. The USA also observed phenomenal economic growth because of this currency power as it helped in continuously expanded its economy and emerged as World’s super power. Indeed, the nation was a permanent member of United Nations Security Council and had a vast foreign agenda with numerous underlying aims and objectives. The country was also militarily well – established to ensure security and safety of US citizens against USSR and other powers. For instance, the USA attacked Vietnam in 1966 and got entangled into a disastrous 10 – year war, which not only increased its military expenditures but also adversely affected its economic growth. Four years later in 1970, the country’s economy had been facing an economic and financial crisis like situation, which also impacted the value of dollar and its exchange rate against gold. Indeed, the super power was facing yet another liquidity crisis that also shattered consumer and business confidence across USA. Obviously, this also resulted in de - valuation / over - valuation of dollar and an over - valuation / under - valuation in currencies of other nations, which benefited some and disadvantaged many other world economies because of trade losses due to fluctuations in exchange rates. Because of constant increase in costs of Vietnam War, the economic pundits of USA and IMF managers evaluated that US dollar had become highly over – valued, which in turn, compelled President Richard Nixon to announce that US Dollar would no longer be convertible to gold. This announcement to made in 1971 and finally the Bretton Woods financial system was not longer workable in 1973 because USA was still in the state of war and it did not want to eradicate its power status it gained in prior years. Nevertheless, the Vietnam War was ended that in 1975 – 1976 but Bretton Woods System was replaced by a new international monetary system to ensure flexibility, stability and sustainability in world economy. It should also be emphasized that then economists also opted to find pertinent solutions to reduce liquidity and business / consumer confidence crisis, yet they were unable to resolve the crisis like situation. In fact, that was also the major reason why the US economy failed to recover and handle the crises at that time. Some proponents and researchers have highlighted the fact that efforts to resolving one major issue at hand led to deterioration of other situation. Finally, the entire scenario went out of control that, in turn, led to abolishment of former system and the replacement with a new International Monetary Framework. The New International Monetary Framework: The proponents and economists have argued that the new international monetary framework could not be called as a proper system unlike Bretton Woods Agreement. Indeed, there are certain reasons behind this believe and the most common of those is that it was developed immediately without proper homework to replace the old system established in 1944. The new framework has four important features that will be discussed in this section to make a compare and contrast analysis. Floating Interest Rates: The first major feature of the new framework is that it does not have any fixed and adjustable predefined interest rates, rather the exchange rate are determined from ‘demand and supply’ patterns and market forces. Indeed, the governments of nations may intervene through their Federal Banks, which could focus on maintaining any particular exchange value of currency. For example, the State Bank of any third world nation may intervene to maintain exchange rate if it observes any unnecessary under- or over – valuation in its currency so that it could avert Balance of Payments (BOP) crises, Current Account and Trade deficits. In simple words, the IMF does not regulate any exchange rates neither there is any gold standard for valuation and exchange of US Dollar. For instance, the exchange rates fluctuate on a daily, monthly or yearly basis depending upon demand and supply of US dollar in local markets followed by various economic and political factors (Chowla, 2009). Dollar is still used as an international currency: The next core feature of new international monetary framework is that US Dollar is still used as a major currency for trade in international markets. For instance, all payments and transactions in international oil, cotton, goods, financial and commodity markets are completed in US Dollars. Hence, it is justified to argue that US currency still enjoys the dominant position in the world. But, this should also be noted that European Union has also established Euro as one of the strongest currencies across the globe, mainly because Euro is used as a mode of payment all across Europe as well as used in trade between or among European nations. Some countries have also started trading in Euro during 2008 – 2010 after weakening of US Dollar due to wars in Iraq / Afghanistan followed by economic and financial crises in USA. Nevertheless, the Dollar’s retention also benefits US economy in a way it could borrow money from international financial institutions at cheaper rates that later prove to be noxious for well – being and sustainability of global financial system. Next, US economy is said to be the largest economy in the world in terms of consumption and aggregate demand so nations still rely on valuation of dollar and US economic growth (Chowla, 2009). Little Control over International Monetary System: It is worthwhile to mention that international financial institutions such as IMF and World Bank has no real control over international monetary system unlike Bretton Woods System in which it regulated exchange rates. For instance, IMF today may certainly not influence world’s advance or developed nations because it is not permitted to intervene. Rather, IMF may only influence the policies of third world poor and developing countries, which obtain IMF loans and thus have to obey the conditions (harsh of course) such as eradication of subsidies, electricity price hikes etc. Nevertheless, the Asian countries blamed that IMF lost its value and authenticity in 1997 when there were financial crises that led to closures of industries in Malaysia and Japan. Hence, the Asian nations do not agree with the argument to let IMF play a major role and control international monetary framework (Chowla, 2009). Business Model: The current international monetary system uses the IMF and World Bank supported business model that focuses heavily on free market enterprise system in which governments’ control over markets and business decisions is minimized and concept of efficiency is promoted through in-time accomplishment of targets and objectives. The business model also defines the importance of exports, foreign reserves, current account and trade surplus because it talks about economic well – being and sustainability (Chowla, 2009). Conclusion: In conclusion, the world still needs a comprehensive and sustainable international financial and monetary system because the Bretton Woods System failed in 1970s, while the current framework also failed in 2008 – 2009 because of credit and liquidity crunch in US markets and later in world’s leading economies. In short, there is dire need that economists and financial executives should focus on developing a new financial system to avert any other financial crisis in near future. Bibliography / References: Chowla, Peter, Barbara Sennholz and Jesse Griffiths (2009) “Bretton Woods Project” [Online] Available at http://www.brettonwoodsproject.org/update/67/bwupdt67_ai.pdf Liebscher, Klaus (2004) “The Importance of the Bretton Woods Institutions for Small Countries - Opening Address” Proceedings of OeNB Workshops [Online] Available at http://www.oenb.at/de/img/the_importance_of_the_bretton_woods_institutions__tcm14-23779.pdf Dooley, M., Folkert, D. and P. Garber (2002) “An essay on the revived Bretton Woods system” NBER Working Paper 9971, September Garber, P. (1993) “The collapse of the Bretton Woods fixed exchange rate system”, in Bordo, M. and Eichengreen, B. 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