There has been an increasing number of global currency and financial crisis following the breakdown of the Bretton Woods system in the early 1970s. These financial crises have affected even the most stable economies and there is an urgent need to reform the global financial architecture so that, in the future, such crisis can be better managed and eventually prevents them from reoccurring.
Fixed exchange rate regimes
Following World War II, many countries abandoned the inefficient gold standard to join the Bretton Woods System. The system promoted a fixed exchange rate which was linked to the US Dollar thereby making the US economy stronger. The Bretton Woods System created the International Monetary Fund (IMF) which was mainly responsible of providing support to weaker economies while fostering growth and development. Another institution created under the system was the World Bank which had the responsibility to finance construction and building as a result of the damage caused during the world war.
McKinnon (1962) was among the first authors to argue that the fixed exchange rate under the Bretton woods system enhanced the market stability which considerably reduced the exchange rate exposure as well as transaction costs and stimulated international trade. This is in line with a more recent study by Raguseo and Sebo (2008) who showed that there is an increase in trade intensity within European countries upon adoption of the fixed currency (Euro) of the European Union (EU). However, due to various reasons including the high inflation rate that persisted, the Bretton Woods system failed.
Following the breakdown of the Bretton Woods system in the early 1970s, a number of attempts were made to reinstate a fixed exchange rate regime, such as the European Monetary System (EMS) from the late 1970s to early 1990s, but none of them were successful. Since then, the international monetary system was left to float freely. The free floating rate system is characterized by high volatility in currency markets and has witnessed many financial crises. The most recent ones are the Asian Financial crisis (1997-1999) and the Mexican Peso Crisis (mid 1990s). Since then, many proposals have been put forward by academics and professionals to reform the global financial architecture among which the main ones will be reviewed hereafter.
So far, the only successful monetary system maintaining a fixed exchange rate has been the European Union which was formally approved in 1993 through the Maastricht treaty which introduced the Euro currency. However, in the wake of the current world financial crisis (resulting from the US Subprime Mortgage Crisis), the strength and stability of the Euro is yet to be tested.
Governance of capital flows in a global economy
In the aftermath of the Asian Financial Crisis, the then US Secretary Rubin called for a strengthening of the international financial architecture (Rubin, 1999). During the past decades, many academics, professionals and policy makers (including the government) have put forward a number of proposals to reform the international financial architecture.
The global financial architecture revolves around a principle of laissez-faire, that is, it to let currencies and financial markets to be adjusted by market forces. Hence this gave rise to the worldwide acceptance of an open capital account and discouraged countries to make use of capital controls resulting in financial markets around the world to be more integrated (Bagella, Hassan and Lothian, 2002). This high degree of market integration is vulnerable to the contagion effect of financial crisis.
Akyuz and Cornford (1999) argued that the Bretton Woods system made no provision for rules and regulations regarding international capital movements since the latter were not relevant under a fixed exchange rate system which maintained a stable currency. However, even after the breakdown of the Bretton Woods system, there was an increasing need for such regulations to enhance the international financial system but no such regime was introduced. The Bank for International Settlements (BIS) was set up only to manage certain features of capital flows and supported a limited number of countries only.
Due to the abovementioned issues, many academics and professionals proposed that there should be an international institution to regulate the international capital movements. In this respect, Eatwell and Taylor (1998) proposed that there should be a mega-power agency, namely the World Financial Authority (WFA), to regulate and supervise all financial institutions around the world.
The idea of having a World Financial Authority is further supported by Frenkel and Menkhoff (2000) who argued that once the WFA established, the IMF should be converted into a lender of last resort. However, this proposal might not be feasible since governments may not be willing to give up much of their decision and policy making power thereby losing sovereignty and also, there is the risk that the super-agency is not able to reach the anticipated level of efficiency (White, 1999).
The contagion effect of financial crisis has showed that the existing financial architecture should be reformed to adapt to a more globalised and integrated world economy. Soros (1998) argued that the increase in the frequency of financial crisis in the past decades is due to an inadequate global institutional framework which should have been in place to regulate capital flows at an international level. He therefore proposed that an International Credit Insurance Corporation should be set up to reduce excessive credit accumulation thereby minimising fluctuation in bank lending across borders.
Fischer (1999) proposed that the existing macroeconomic policies, banking and financial practices as well as disclosure of information should be improved in the capital flow recipient nations and also, in the capital flow source nations. Another key player, as argued by the author, would be the International financial institutions (including IMF and World Bank) who would be responsible to redesign the global financial architecture and to strengthen the role of the IMF as a lender of last resort. This would be much more feasible as compared to having a new international regulatory and supervisory body which might be difficult to implement.
The idea of target zones
The floating exchange rate regime has been in place since the collapse of the Bretton Woods system but has not delivered any of the anticipated effects such as stability in exchange rates, increased macroeconomic policy independence or even improvement in the balance of payments. Moreover, the floating rate system has been characterised by volatile exchange rate systems and currency misalignments (Jacque, 1981).
Bloomfield (1983) who reviewed the book written by Kenneth Dam (1982) argued that the author discussed the failure of IMF in properly communicating the obligations and arrangements under the floating exchange rate system. Moreover, no proper guidelines were given on market interventions and on surveillance procedures. Given this lack of policy coordination and poor institutional guidelines, it comes with no surprise that the floating rate era has brought in many financial crises during the past decades.
Akyuz and Cornford (1999) argued that exchange rates misalignments are attributable to the G-3 countries (that is France, Germany and United Kingdom) and the major reserve currencies (namely the dollar, euro and the yen). The G-3 countries have very large economies as compared to developing countries and thus, they rely less on international trade. Another key aspect is that the major industrialised countries have the ability to mitigate foreign exchange risk as they can borrow, lend or deal in their own currencies.
Edison, Miller and Williamson (1987) were among the first authors who proposed the introduction of target zones using any of the three major currencies so that a stable exchange rate system can be created. This is in line with the ideas of Zhou Xiaochuan, the governor of the People’s Bank of China, who recently proposed the creation of target
zones using the main currencies as a means to reach the ultimate objective of having an international currency for all countries provided there is enough support from the major political leaders of industrialised countries (Zhou, 2009).
However, it is important that countries have a coordinated macroeconomic policy and intervene in markets when necessary so as to keep the exchange rate exposure low and maintain stability in the target zones. A stable environment in target zones will promote growth opportunities and also reduce volatility in currency markets as it has been observed in the case of the European Monetary System (Krugman and Miller, 1993). Such a system could be monitored by the IMF.
However, Frankel (1999) argued that target zones allow currencies to float in a pre-specified range with respect to a currency in another zone. He discussed that if the range is narrow, then it will resemble the fixed exchange rate regime under the N umé r o 42 -Novembre-Décembre 2009 Page 5 Bretton woods system whereas if the range is sufficiently wide, it will therefore resemble the actual current floating rate system. Hence target zones are not advisable since both the fixed and floating exchange rate eras have witnessed a number of financial crises and failed to maintain global financial stability.
Zhou (2009) argued about having a world currency as initially proposed by Rogoff (1999) who stated that a world currency should be created and issued by a World Monetary Authority which would also be acting as a world regulator as well as a lender of last resort. However, it would be rather difficult for such an arrangement to work properly since the economic policies and situation of countries are too diverse ranging from highly industrialised to underdeveloped countries.
To be continued.
By Roshan Boodhoo,
Managing Director, Alliance Trust Co.(Mauritius).
Courtesy: Conjoncture, Bilingual Journal of PluriConseil.