Relationship of international finance and monetary system

relationship of international finance and monetary system

This chapter discusses the international monetary system, the IMF and the World former McKinsey consultants make and sustain professional relationships. . past years leading to the development of the modern global financial system. International Monetary System vs. International Financial System — and the. Significance for Policy Makers by Gail D. Fosler. December International. Part of International Finance For Dummies Cheat Sheet. The international monetary system is a way for people to conduct business with each other from.

They were generally supported by the city state authorities, who endeavoured to ensure they retained their values regardless of fluctuations in the availability of whatever base or precious metals they were made from. Coins were in use in India from about BC; initially they played a greater role in religion than in trade, but by the 2nd century[ clarification needed ] they had become central to commercial transactions.

Monetary systems that were developed in India were so successful that they spread through parts of Asia well into the Middle Ages. In Venice and the other Italian city states of the early Middle Ages, money changers would often have to struggle to perform calculations involving six or more currencies.

This partly led to Fibonacci writing his Liber Abaci which popularised the use of Indo-Arabic numeralswhich displaced the more difficult Roman numerals then in use by western merchants. When a given nation or empire has achieved regional hegemonyits currency has been a basis for international trade, and hence for a de facto monetary system. This was succeeded by Roman currency of the Roman Empiresuch as the denariusthen the Gold Dinar of the Ottoman Empire, and later — from the 16th to 20th centuries, during the Age of Imperialism — by the currency of European colonial powers: With the growth of American power, the US dollar became the basis for the international monetary system, formalised in the Bretton Woods agreement that established the post—World War II monetary order, with fixed exchange rates of other currencies to the dollar, and convertibility of the dollar into gold.

The Bretton Woods system broke down, culminating in the Nixon shock ofending convertibility; but the US dollar has remained the de facto basis of the world monetary system, though no longer de jure[ dubious — discuss ], with various European currencies and the Japanese yen also being prominent in foreign exchange markets. Since the formation of the Eurothe Euro has also gained use as a reserve currency and a medium of transactions, though the dollar has remained the most important currency.

A dominant currency may be used directly or indirectly by other nations: Until the 19th century, the global monetary system was loosely linked at best, with Europe, the Americas, India and China among others having largely separate economies, and hence monetary systems were regional.

European colonization of the Americasstarting with the Spanish empire, led to the integration of American and European economies and monetary systems, and European colonization of Asia led to the dominance of European currencies, notably the British pound sterling in the 19th century, succeeded by the US dollar in the 20th century.

Some, such as Michael Hudsonforesee the decline of a single base for the global monetary system, and the emergence instead of regional trade blocs ; he cites the emergence of the Euro as an example. See also Global financial systemsworld-systems approach and polarity in international relations.

International monetary systems

It was in the later half of the 19th century that a monetary system with close to universal global participation emerged, based on the gold standard. History of modern global monetary orders[ edit ] The pre WWI financial order: From the to the outbreak of World War I inthe world benefited from a well-integrated financial order, sometimes known as the "first age of globalisation".

In the absence of shared membership of a union, transactions were facilitated by widespread participation in the gold standardby both independent nations and their colonies.

relationship of international finance and monetary system

Great Britain was at the time the world's pre-eminent financial, imperial, and industrial power, ruling more of the world and exporting more capital as a percentage of her national income than any other creditor nation has since. In fact Great Britain's capital exports helped to correct global imbalances as they tended to be counter-cyclical, rising when Britain's economy went into recession, thus compensating other states for income lost from export of goods. In contrast to the Bretton Woods system, the pre—World War I financial order was not created at a single high level conference; rather it evolved organically in a series of discrete steps.

The Gilded Agea time of especially rapid development in North America, falls into this period.

International monetary systems - Wikipedia

Between the World Wars: The years between the world wars have been described as a period of "de-globalisation", as both international trade and capital flows shrank compared to the period before World War I. During World War I, countries had abandoned the gold standard. Except for the United States, they later returned to it only briefly.

By the early s, the prevailing order was essentially a fragmented system of floating exchange rates. To protect their reserves of gold, countries would sometimes need to raise interest rates and generally follow a deflationary policy.

The greatest need for this could arise in a downturn, just when leaders would have preferred to lower rates to encourage growth. Economist Nicholas Davenport [9] had even argued that the wish to return Britain to the gold standard "sprang from a sadistic desire by the Bankers to inflict pain on the British working class. Over half of dollar and euro credit to borrowers outside the United States and euro area remains in the form of bank loans. The pass-through is slower for bonds, given their generally fixed rates and longer maturity, but then quantities can respond too.

In particular, some stocks of dollar bonds have changed quite markedly in response to unconventional monetary policy Chapter IV. Low yields reflecting the Federal Reserve's large-scale purchases of Treasury and agency bonds, among other factors, led US and global investors to seek yield in lower-quality bonds.

Investor demand for such bonds proved highly responsive to the compression of the term premium, as measured by the spread between Treasury bond yields and expected bill yields: By the same token, the recent ECB large-scale bond purchases and compression of term premia on euro-denominated bonds raise the question of whether borrowers outside the euro area will take advantage of the funding opportunity.

In fact, by the end of the stock of euro bonds issued by such borrowers was already growing as fast as its dollar counterpart. Post-crisis, offshore dollar credit has grown fastest in those jurisdictions where it has been cheapest relative to local funding, especially emerging market economies EMEs.

This is one reason for the rapid growth in various quantitative measures of "global liquidity", which denotes the ease of financing in global financial markets Box V. A Mapping the dollar and euro zones This box uses simple regression methods to place currencies in three zones of influence corresponding to the main international currencies based on the currencies' degree of co-movement.

The three reference currencies are the dollar, the euro beforethe Deutsche mark and the yen, consistent with their status as the three most transacted currencies in the world in the BIS Triennial Central Bank Survey. The dollar share is calculated in two steps. First, each currency is placed in or between zones.

The dollar zone weight is calculated as 1 minus the corresponding regression coefficients. For example, the Hong Kong dollar is pegged to the US dollar, so the coefficients are zero and the dollar zone weight is 1. For the intermediate case of sterling, in the pound's estimated coefficient is 0.

The international monetary and financial system

The results in Graph V. A show the dollar to be more global, the euro to be more regional and the yen to lack much external influence. This sum is then expressed as a share of the total GDP of the 43 major economies analysed, including those of the United States, the euro area and Japan.

There is strong cross-sectional evidence that a currency's co-movement with the dollar shapes the currency composition of its external portfolio, both official and private. For the two dozen economies that disclose the currency composition of official reserves, the dollar zone weight accounts for about two thirds of the variation in the dollar share across countries.

And in larger samples, the dollar zone weight is also strongly linked with the dollar share of cross-border bank deposits or loans and international bonds. The underlying motivation is the same for the official and private sectors: Monetary regimes also interact indirectly, through central bank responses to each other's policies. This behaviour is sometimes explicitly noted, as in the cases of the Central Bank of Norway and the Swiss National Bank with reference to ECB policy, but appears to be widespread.

One reason is to limit exchange rate movements. Exchange rate flexibility has often been described as insulating the domestic economy from external developments, but this insulation is often overstated. In particular, appreciation can lead lenders to consider firms with debts denominated in foreign currency as better capitalised and therefore more creditworthy, reducing perceived risks associated with lending and increasing the availability of credit.

Then, depreciation can lead to financial distress among firms with foreign currency debt. During the dollar's downswing from to with an interruption in latemany central banks resisted unwelcome appreciation against the dollar, in setting their own policy rates and by intervening in the currency market. Indeed, many countries - not only EMEs but also advanced economies - appear to have kept interest rates below those that traditional domestic benchmarks would indicate, partly in response to low rates in core currencies.

In the s, policy rates were broadly in line with the Taylor rule, a simple interest rate rule prescribing a mechanical reaction to the output gap and the deviation of inflation from target. In the early s, however, actual policy rates drifted persistently below the levels implied by the Taylor rule, suggesting that monetary policy became systematically accommodative Graph V.

Many advanced economies apparently hesitated to raise interest rates during the boom, and have maintained them near zero since the crisis.

For their part, EME authorities appear to have set policy rates low out of concern over capital flows and appreciation Graph V. The empirical significance of US interest rates in influencing policy rates elsewhere provides additional evidence for follow-the-leader behaviour Box V.

While this simple exercise has important limitations, it points to competitive easing as a way of sustaining external demand. More than 20 central banks have eased monetary policy since Decembersome explicitly responding to external conditions Chapter IV. B Global liquidity as global credit aggregates Over the past several years, the BIS has developed indicators to track global liquidity conditions.

The term global liquidity is used to mean the ease of financing in global financial markets. Total credit outstanding is one of its main footprints, as it shows the extent to which bond markets and banks have led to the build-up of exposures. In covering US dollar and euro credit, this box focuses on the two largest components of global credit through which the monetary policies of the respective currency areas directly influence financial conditions in the rest of the world.

Global credit can be extended through bank loans or bonds, and each has a domestic and an international component. B shows dollar- and euro-denominated debt, broken down by the location of the borrower.

The international credit component tends to be more procyclical and volatile.

Global Financial and Monetary Systems in 2030

International bank lending in both dollars and euros outpaced domestic credit in the boom that preceded the Great Financial Crisis, and contracted once the crisis broke out Graph V. Bright-hand panels. Bond markets partly substituted for impaired bank lending in the immediate aftermath of the crisis, and increased demand for funding went hand in hand with higher yield spreads. In this second phase of global liquidity, bond markets and the asset management industry have taken centre stage in shaping global liquidity conditions.

Resistance to appreciation has also taken the form of currency intervention, which itself feeds back into global monetary ease. Many central banks have intervened directly in the foreign exchange market, typically buying dollars, and then investing the proceeds in bonds issued by the major governments. Unlike major central banks' large-scale domestic bond purchases, reserve managers have not sought to lower yields in the bond markets in which they invest.

As a result, monetary policies of advanced and emerging market economies have reinforced each other. Easy monetary conditions at the centre have led to easy monetary and financial conditions in the rest of the world: In turn, their foreign exchange intervention has raised official investment in major bond markets, further compressing bond yields there.

With central banks and reserve managers bidding for duration shoulder to shoulder with pension funds and life insurers, bond yields have declined to record lows and the term premium has turned negative Chapter II. Interaction of financial regimes Financial market integration has allowed common global factors to drive capital flows and asset prices.

The common factors have partly shifted between the two phases of global liquidity, pre- and post-crisis. C International monetary spillovers Over recent years, interest rates in EMEs and advanced economies moved closely together with interest rates in large advanced economies, particularly the United States. This close correlation could reflect the response to common macroeconomic developments affecting all countries. But it could also reflect global interest rate spillovers from large advanced economies.

To shed light on this question, a panel of 30 emerging market and advanced economies over the period is investigated in a regression analysis. The analysis shows a strong relationship between changes in interest rates prevailing in these economies and changes in US interest rates, even after controlling for domestic macroeconomic conditions and the global business and financial cycle.

For short-term interest rates, a basis point change in US rates is associated with an average 34 basis point change in emerging market and small advanced economies Table V. Cfirst column. For long-term interest rates, the effect is stronger: Besides US interest rates, the degree of global investor risk aversion, as measured by the VIX, also consistently emerges as an important driver of these interest rates.

Furthermore, the persistently low global policy rates relative to Taylor rule-implied levels since the early s Graph V. Specifically, a basis point cut in the US federal funds rate is found to lower EME and other advanced economy policy rates by 43 basis points relative to the levels implied by a standard normative Taylor rule Table V.

Cthird column. When estimating a descriptive Taylor rule, the estimated impact of the US policy rate is even higher: In sum, the results suggest an economically significant causal relationship from US interest rates to interest rates in emerging market and other advanced economies.

The bank flows that dominated in the first, pre-crisis, phase of global liquidity drew on easy leverage, predictable policy rates and low volatility, as proxied by the VIX. In a sample of 31 EMEs between early anda rise in the share of cross-border bank funding, extended both directly to domestic non-banks and indirectly through banks, helped boost the ratio of bank credit to GDP Graph V.

Banks found non-core liabilities abroad to fund booming credit at home.

relationship of international finance and monetary system

Here, the larger the net debt inflows, including both portfolio and bank flows, the larger the increase in an economy's ratio of bank credit to GDP Graph V. The inclusion of Ireland, Spain and the United Kingdom shows that a domestic credit boom's reliance on external financing is not a symptom of financial underdevelopment. In fact, in the subsample of 23 advanced economies the reliance on capital inflows is greater than among EMEs, as the steeper fitted line suggests.

In the second, post-crisis, phase of global liquidity, the term premium on sovereign bonds has become a more important driver of funding conditions.

relationship of international finance and monetary system

Although cross-border bank credit has continued to expand strongly in EMEs, it has contracted sharply among advanced economies, while bond financing has surged across the board.

Even as bond flows have gained prominence, the term premium has emerged as the salient global price of risk in integrated financial markets. Studies of the spillovers across global bond markets around official large-scale bond purchase announcements have highlighted the strong co-movement of bond yields.

If investors treat bonds denominated in different currencies as close substitutes, purchases in one market also depress yields elsewhere. In addition, local currency EME bonds have also co-moved much more closely with Treasuries than a decade ago.

In particular, there are signs that the euro area bond market has been moving its US counterpart. Anticipation of ECB large-scale bond purchases put downward pressure on French and German bond yields and, through co-movement of term premia, on US bond yields as well, despite the expected divergence in policy rates Graph V. This contrasts with the experience in earlywhich epitomises previous patterns. At the time, the Federal Reserve was raising the policy rate while the Bank of France and the Deutsche Bundesbank were reducing theirs, but the backup in US bond yields was transmitted to Europe Graph V.

Global financial conditions have consequently loosened to an extent that may not prove consistent with lasting financial and macroeconomic stability.

Credit booms in EMEs and some advanced economies less affected by the crisis have built up tell-tale financial imbalances.

In the short run, the IMFS has tilted conditions towards expansion. But in the longer run, financial busts, were they to materialise, would tilt them towards contraction. Monetary policy divergence across key currencies and renewed dollar appreciation pose risks. Ease in the euro area might prolong global ease, if firms and governments around the world can substitute euro funding for dollar funding.

However, the large stock of dollar debt outstanding means that a tightening of dollar credit is likely to prove consequential. Thus, renewed dollar strength could expose vulnerabilities Chapter IIIespecially in those firms that have collectively borrowed trillions of dollars. Admittedly, it is well known that the US economy has a short position in the dollar that funds a long position in other currencies. And by the same token, the rest of the world must hold more dollar assets than dollar liabilities and thus enjoy valuation gains in aggregate when the dollar appreciates.

But even in a country with a long dollar position, the distribution of currency positions across sectors matters greatly for the outcome. For example, in many EMEs the official sector has a long dollar position whereas the corporate sector carries a short one Box V. Absent transfers from the gaining official sector to the losing corporate sector, the economy may well be hurt by dollar strength.

relationship of international finance and monetary system

Dollar strength, monetary policy divergence and heavy official holdings in the global bond market could lead to volatility. Were EMEs to draw down reserves substantially, their selling bonds in the key currencies could create unprecedented cross-currents in global bond markets.

ECB and Bank of Japan bond purchases, EME selling and, eventually, the Federal Reserve's not rolling over maturing bonds could confront the remaining private investors with a difficult and shifting problem of bond pricing. Limits and prospects in international policy coordination Policies to address the issues raised in this chapter require more than each country managing its inflation and business cycle.

A broader notion of keeping one's house in order suggests policymakers deploy monetary, prudential and fiscal policies to manage financial cycles to ensure lasting monetary, financial and macroeconomic stability Chapters I and IV. The resulting reduction in the frequency and depth of credit booms and busts would greatly reduce negative cross-country spillovers. D Valuation effects of dollar appreciation This box uses the example of Korea to illustrate that dollar appreciation can deliver wealth gains to non-US residents as a whole, while still representing a tightening of financial conditions for non-US firms that have funded themselves in the dollar.

The Korean official sector can gain from dollar appreciation but need not adjust its spending, while the Korean corporate sector can lose net worth and face tighter credit. It is by now well known that dollar appreciation boosts US net international liabilities. Accordingly, the rest of the world's wealth increased. Typical of the rest of the world, Korea's net international investment position as a whole gained from dollar appreciation.

Still, Korean firms that have borrowed dollars can still see their net worth fall. Dollar appreciation leads to official gains that are not conveyed to firms that lose net worth.