International Monetary System and the Balance of Payments

OPENING CASE: Will the Stars Shine on Astra Again?

PT Astra is one of the oldest and largest conglomerates in Asia, at one point having employed 125,000 people. After borrowing in dollars from foreign banks, Astra’s fortunes plummeted with the collapse of the Indonesian rupiah. A new president installed in 1998, Rini Soewandi, did much to turn the company around until her ouster in 2000. Now, with deals struck with the Indonesian Bank Restructuring Agency (IBRA) and the International Monetary Fund (IMF), Indonesia and Astra may again have reason to be optimistic.

Key Points

Astra was a domestically oriented firm.

Even so, it was not impervious to international competitive issues, such as changes in the value of the Indonesian rupiah.

As global competition increases, domestically protected companies face greater and greater challenges internally and outside of their country.

Case Questions

Who wins and who loses from a weak U.S. dollar?

The big winners from a weak U.S. dollar are America’s exporting industries because a weak dollar makes American products seem cheaper to foreign buyers. U.S. exporters further benefit from a weak dollar because imports from foreign countries appear to be more expensive. However, American companies that produce their products in foreign markets do not benefit from the weak dollar, and all companies are adversely affected by the uncertainty that is associated with a weak dollar. American producers are also affected by the increased inward investment from companies that shift production to the U.S.

How do the weak Asian currencies affect producers in the United States?

U.S. corporations are concerned about the Asian crisis on several fronts. Some companies will be competing against unusually low priced imports, others will find that their Asian exports have slowed. Still others may find that they will face increased competition in other markets, such as Latin America, from Asian exporters. Some companies, particularly those that import raw materials from Asia do stand to gain from the currency crisis, however.

Get Help With Your Essay

If you need assistance with writing your essay, our professional essay writing service is here to help!
Find out more about our Essay Writing Service

CHAPTER SUMMARY

Chapter Six explores the international monetary system and the balance of payments. The chapter traces the history of the international monetary system beginning with the gold standard and ending with the current system of a managed float. It then goes on to examine the different accounts and balances in the balance of payments.

I. HISTORY OF THE INTERNATIONAL MONETARY SYSTEM

The international monetary system establishes the rules by which countries value and exchange their currencies. It also provides a mechanism for correcting imbalances between a country’s international payments and its receipts.

The accounting system that governs the international monetary system is the balance of payments (BOP). The BOP records international transactions and supplies vital information about the health of a national economy and likely changes in its fiscal and monetary policies.

Teaching Note: bs00559_

Students may find it helpful to use a time line when discussing the different exchange-rate systems that have taken place over the last century.

The Gold Standard

The gold standard, under which countries agreed to buy and sell their paper currencies in exchange for gold on the request of any individual or firm, was the international monetary system in place in the nineteenth century.

The gold standard had the effect of creating a fixed exchange-rate system because each country tied or pegged the value of its currency to gold. An exchange rate is the price of one currency in terms of a second currency. The par value of a currency is its official price in terms of gold.

For nearly a century (from 1821 until 1918), the most important currency in international business was the British pound sterling; thus, the international monetary system was frequently referred to as the sterling-based gold standard during this time. Show Map 6.1 here. image2

The Collapse of the Gold Standard

As countries suffered through the economic chaos of World War I, the sterling-based gold standard came unraveled; however, it was readopted in the 1920s.

In spite of its resuscitation, the gold standard ended in 1931 when Britain, under pressure to honor guarantees made under the system, allowed its currency to float (the pound’s value was determined by the forces of supply and demand).

While some countries, primarily those in the British Commonwealth, pegged their currencies to the pound after the gold standard was abandoned, others linked their currencies to the U.S. dollar or the French franc. In addition, many countries engaged in a beggar-thy-neighbor policy, in which nations deliberately devalued their currencies in the hope of making their goods cheaper in the world marketplace. Figure 6.1 should be discussed here. image2

The Bretton Woods Era

In 1944, representatives of 44 countries met to construct a postwar international monetary system that would create an environment of worldwide peace and prosperity. The representatives agreed to renew the gold standard on a modified basis, and they created two new international organizations, the International Bank for Reconstruction and Development and the International Monetary Fund, to assist the rebuilding of the world economy and monetary system.

The International Bank for Reconstruction and Development, also known as the World Bank, was established in 1945 to finance reconstruction of war-torn European economies, and when this was completed, focused on building the economies of lesser-developed nations.

The World Bank has created three affiliated organizations: the International Development Association, the International Finance Corporation and the Multilateral Guarantee Agency which together comprise the World Bank Group. Show Figure 6.2 here. image2

The World Bank lends only for “productive purposes” and follows a hard loan policy (it makes loans only if there is a reasonable expectation that they will be repaid).

The International Development Association (IDA) was established in response to criticism from poorer countries that World Bank policies favored countries well along the path to economic development. The IDA offers soft loans (those that bear significant risk of not being repaid).

The International Finance Corporation (IFC) is charged with promoting the development of the private sector in developing countries, while the Multilateral Investment Guarantee Agency (MIGA) encourages direct investment in developing countries by offering private investors insurance against non-commercial risk.

Regional development banks parallel the efforts of the World Bank as they promote the economic development of poorer countries within their regions. The text provides an example of how the Asian Development Bank and the World Bank coordinated their efforts to finance a hydroelectric power plant in Nepal.

The International Monetary Fund. The International Monetary Fund’s (IMF) primary responsibility is to oversee the functioning of the international monetary system.

To join the IMF, countries must pay a deposit, called a quota. Quotas are important because they determine a country’s voting power within the organization, serve as part of a nation’s official reserves, and determine a country’s borrowing power from the IMF.

A country is allowed to borrow up to 25% of its quota from the IMF. Additional borrowings require that countries agree to IMF conditionality.

A Dollar Based Gold Standard. Under the international monetary system established at Bretton Woods, all countries agreed to peg the value of their currencies to gold (the dollar was pegged to gold at a value of $35 per ounce). Thus, the agreement was a fixed exchange rate system. In addition, the U.S. agreed to redeem the dollar for gold at the request of foreign central banks. In this way, the dollar played a key role in the Bretton Woods system. Show Figure 6.3 here. image2

The Bretton Woods system provided a generally stable environment for international business because under the agreement each country agreed to maintain the value of its currency within ±1 percent of its par value.

An additional feature of the Bretton Woods agreement was an adjustable peg mechanism that allowed a country to alter the value of its currency in extraordinary circumstances. The text provides an example of the circumstances that prompted Great Britain to readjust the pound’s peg value in 1967.

The End of the Bretton Woods System

The reliance on the U.S. dollar eventually led to the downfall of the Bretton Woods system. Since the supply of gold did not expand in the short term, the dollar became the source of additional liquidity to finance expanding international trade. However, as foreign dollar holdings began to increase, doubt about the ability of the U.S. to live up to its Bretton Woods’ obligation began to rise.

The Tiffin paradox arose because foreign banks needed to increase their holdings of dollars to finance expansion of international trade, but the more dollars they owned, the less faith they had in the ability of the U.S. to redeem the dollars for gold.

The IMF attempted to alleviate the situation by creating an additional source of international liquidity, the special drawing right (SDR). The SDR, a weighted average of the market value of five major currencies, is used by IMF members to settle official transactions at the IMF.

The SDR did not have the desired effect of reducing the glut of dollars held by foreigners, and by 1971, it became clear that the U.S. did not have enough gold to meet the demand of those who wanted to exchange dollars for gold. Nixon officially ended the system, and currencies began to float against each other.

The fixed exchange rate system was restored at the Smithsonian Conference in late 1971. Under the new agreement, the dollar was devalued to $38 per ounce of gold, and the par value of strong currencies was revalued upward. In addition, the band of fluctuation within which currencies were allowed to fluctuate was widened to ± 2.25 percent. Discuss Table 6.1 here. image2

Performance of the International Monetary System since 1971

The Smithsonian agreement proved to be short-lived as central banks conceded they could not successfully resist free-market forces. Since 1973, many currencies have operated under a flexible (or floating) exchange-rate system within which currency values are determined primarily by supply and demand. Occasionally, a central bank will intervene and affect exchange rates leading to the term “managed float” or dirty float. Insert Table 6.2 here. image2

Discuss Bringing the World into Focus:globe

Fixed versus Flexible Exchange Rates

This box discusses the how the fixed and flexible exchange rate systems each reach equilibrium. The fixed system through the purchase and sale of gold, the flexible system through changes in supply and demand (and therefore value) for a country’s currency.

Under the Jamaica Agreement, established in 1976, each country was free to adopt whatever exchange-rate system best met its requirements. Some countries (i.e., the U.S.) chose a floating exchange rate, while others opted for a fixed exchange-rate system by pegging their currencies to another.

The European Monetary System (EMS) was established by EU members in 1979 to manage currency relationships among themselves. Most EMS members participate in the exchange-rate mechanism, in which participants maintain fixed exchange rates among their currencies (within a ±2.25 percent band) and a floating rate against the U.S. dollar and other currencies.

The EMS members also created a new index currency, the European Currency Unit, which is a weighted “basket” of the currencies of the EU members that is used for accounting purposes within the EU. Map 6.2 shows the current status of the world’s exchange rate movements. image2

While the EMS has been helpful in curbing inflation and in promoting intra-EU investment, it has also been adjusted 39 times because of differences in the monetary policies of EU members.

The current international monetary system is based on flexible-exchange rates, although some countries (i.e., the EU) have chosen to maintain fixed exchange-rate systems.

Other Postwar Conferences. The world’s central banks meet periodically to iron out policy conflicts among themselves. One such meeting, the Plaza Accord (held in 1985), resulted in an agreement to let the dollar’s value fall. Discuss Table 6.1 here. image2

A second meeting, the Louvre Accord, was called in 1987 to stabilize the dollar. Discuss Figure 6.4 here. image2

Because a depreciation in a firm’s home currency makes it easier for the firm to export, and defends it from the threat of imports, exchange rates are very important to firms. In fact, the text points out that it was an appreciation of the mark against the dollar that led BMW to invest in the U.S.

Discuss Bringing the World into Focus:globe

Should Bretton Woods be Restored?

A debate still brews over the benefits of fixed exchange rate systems (such as the one developed at Bretton Woods) compared to the benefits of a flexible, market-driven, system such as we have today. Fixed rate system proponents are troubled by current volatility in foreign exchange markets. Flexible system proponents argue that a fixed system does not avert crises, and that flexible systems allow countries more autonomy in dealing with internal economic issues.

The International Debt Crisis. The international debt crisis grew out of events that occurred shortly after the flexible-exchange rate system of 1973 began, when Arab nations quadrupled the price of oil. Banks recycled the petrodollar in the form of loans to countries that were damaged by the rise in oil prices. However, many countries borrowed more than they could repay.

Various efforts were made to resolve the crisis. The 1985 Baker Plan stressed the importance of debt rescheduling, tight IMF-imposed controls over domestic fiscal and monetary policies, and continued lending to debtor countries in hope that economic growth would allow them to repay their creditors. The plan had limited success.

The 1989 Brady Plan focused on the need to reduce the debts of the troubled countries by writing off parts of debt or providing countries with funds to buy back their loan notes at below face value.

The international monetary system suffered a crisis in July 1997, when investors began to distrust the abilities of Thai borrowers to repay their debts. Thailand was forced to unpeg its currency from a dollar denominated basket of currencies, resulting in a rapid deterioration in the currency’s value. The crisis quickly spread to neighboring countries setting off a major international currency crisis. Discuss Figure 6.5 here. image2

II. THE BALANCE OF PAYMENTS ACCOUNTING SYSTEM

The balance of payments (BOP) accounting system is a double-entry bookkeeping system designed to measure and record all economic transactions between residents of one country and residents of all other countries during a particular time period.

There are several reasons why international business people should pay attention to the BOP. First, BOP statistics help identify emerging markets for goods and services. Second, they can warn of possible new policies that may alter a country’s business climate, thereby affecting the profitability of a firm’s operations in that country. Third, they can indicate reductions in a country’s foreign reserves, which may mean that a country’s currency will depreciate in the future. Fourth, they can signal increased riskiness of lending to particular countries.

The Major Components of the BOP Accounting System

The BOP accounting system can be divided into four major accounts: the current account; the capital account; the official reserves account; and the errors and omissions account.

Current Account

The current account records exports and imports of merchandise and services, investment income, and gifts. Table 6.3 summarizes the debit and credit entries for transactions involving the current account. image2

To the U.S., a sale of a Ford Escort to a Japanese businessman in Osaka is a merchandise export, and the purchase of a Sony television from Japan by an American student is a merchandise import. The difference between a country’s exports and imports of goods is called the balance on merchandise trade. The U.S. has a merchandise trade deficit because it has been importing more than it exports, while Japan has a merchandise trade surplus because it has been exporting more than it imports.

The sale of a service (i.e., consulting services) to a resident of another country is a service export, while the purchase of a service by a resident of another country is a service import. The term trade in invisibles is also used to describe trade in services. The difference between a country’s export of services and its imports of services is called the balance on services trade.

Income (i.e., interest and dividends) French residents earn from their foreign investment is viewed as an export of the services of capital by France. Income earned by foreigners from their investments in France is known as an import of the services of capital by France.

Unilateral transfers are gifts between residents of one country and another country.

Current account balance measures the net outflow or inflow resulting from merchandise trade, service trade, investment income and unilateral transfers.

Capital Account

The capital account records capital transactions — purchases and sales of assets — between residents of one country and those of other countries. Capital account transactions can be divided into foreign direct investment (FDI) and portfolio investment. The former is any investment made for the purpose of controlling the organization in which the investment is made, while the latter is any investment made for purposes other than control. Both types of investment are discussed in Chapter One. Discuss Table 6.4 here.

Short-term portfolio investments are financial instruments with maturities of one year or less. Long-term portfolio investments are stocks, bonds, and other financial instruments issued by private and public organizations that have maturities greater than one year and that are held for purposes other than control.

Current account transactions affect the short-term components of the capital account because the first entry in the double-entry BOP accounting system involves the purchase or sale of something, and the second entry typically records the payment or receipt of payment for the thing bought or sold. (See Building Global Skills at the end of the chapter for an example of the process.)

Capital inflows are credits in the BOP accounting system and occur either when foreign ownership of assets in a county increases or when ownership of foreign assets by a country’s residents declines. The text provides examples of both situations.

Capital outflows are debits in the BOP accounting system and occur either when ownership of foreign assets by a country’s residents increases or when foreign ownership of assets in a country declines. The text provides examples of both situations. Table 6.5 summarizes the impact of various capital account transactions on the BOP. image2

Official Reserves Account

The official reserves account records holdings of the official reserves held by a national government including gold, convertible currencies (currencies that are freely exchangeable in world currency markets), SDRs, and reserve positions at the IMF.

Errors and Omissions

The errors and omissions account is used to make the BOP balance in accordance with the following equation: Current Account + Capital Account + Errors and Omissions + Official Reserves = 0.

A large portion of the errors and omissions account is probably due to underreporting of capital account transactions. It is becoming more and more difficult to keep track of legal capital transactions as they become increasingly sophisticated and grow in volume. Other errors and omissions are deliberate actions and are frequently illegal. Flight capital, for example, is money sent abroad by foreign residents seeking a safe haven for their assets, hidden from the sticky fingers of their home governments.

Discuss Bringing the World into Focus: globe

Ben Franklin, World Traveler

This Going Global Box examines the process of determining how much U.S. currency is held by foreigners. The Box notes that current estimates are that some 49% of U.S. currency in circulation in 1999 was held by foreigners. These foreign holdings act as interest-free loans to the U.S.

Other errors and omissions are related to the current account, particularly merchandise exports and trade in services.

The U.S. Balance of Payments in 1999

U.S. merchandise exports were $684.3 billion in 1999. Automobiles and auto parts were the largest component of U.S. merchandise exports. Table 6.6 and Figure 6.6 give a more detailed breakdown of import and exports by industry. Discuss Table 6.6 here. image2

U.S. merchandise imports totaled $1,029.9 billion in 1996. The leading import was automobiles and auto parts. Insert Figure 6.6 here. image2

U.S. exports of services were $271.9 billion in 1999, with travel and tourism being the largest portion.

The U.S. tends to import more goods from its major trading partners than it exports to them, however, it tends to export more services to them that it imports from them. Figure 6.7 depicts trade in services and should be discussed here. image2

The capital account shows that in 1999, U.S. FDI outflows were $150.9 billion, while FDI inflows were $275.5 billion. New U.S. long-term international portfolio investments were $128.6 billion in 1999, while new foreign long-term portfolio investments in the U.S. were $343.6 billion. The capital account balance was $311.2 billion in 1999, as foreigners bought more U.S. assets than U.S. residents bought foreign assets.

The official reserves account transactions were $8.7 billion, and the errors and omissions account was $11.6 billion.

Defining Balance of Payments Surpluses and Deficits

When people talk about a balance of payments surplus or deficit, they are talking about a subset of BOP accounts. For example, a merchandise trade surplus occurs when a country exports more than it imports. Other balances that are often mentioned include the balance on services, the balance on goods and services, the current account balance, and the basic balance (the sum of the current account and net long-term capital investment).

The official settlements balance reflects changes in a country’s official reserves; it essentially records the net impact of the central bank’s interventions in the foreign exchange market in support of the local currency.

Which BOP concept to use depends on the issue confronting the international business person or policy maker. There is no single measure of a country’s global economic performance. The balance on goods and services reflects the combined international competitiveness of a country’s manufacturing and service sectors. The current account balance shows the combined performance of the manufacturing and service sectors and also reflects the generosity of the country’s residents as well as income generated by past investments. The basic balance combines current account transactions with long-term capital investments. The official settlements balance is a record of supply and demand for a country’s currency. Discuss Figure 6.8 here.

CLOSING CASE

Recent U.S. BOP Performance: Is the Sky Falling?

The closing case provides two divergent views as to how the U.S. BOP should be interpreted. One perspective looks at the last decade’s BOP favorably, the other perspective does not.

Key Points:

Over the last decade the U.S. BOP has reflected a large annual deficit in the current account, a large annual surplus in the capital account, and relatively small changes in the official reserves account.

This BOP can be interpreted in two ways. First, that U.S. firms are uncompetitive in foreign markets, and foreigners are taking over the country by buying up valuable U.S. assets. Second, that the U.S. is attracting foreign investment through foreign country current account surpluses.

Both views are consistent with the data.

Those who favor the first argument believe that the U.S. must reduce its BOP deficit by following policies to make U.S. firms more competitive in foreign markets and by following policies to keep imported goods out.

People who believe the second argument is true feel that the country should strive to do anything possible to become more attractive to foreign investors.

It is important for companies to understand BOP statistics because they are the key to the type of international trade policy the U.S. will pursue.

Case Questions

What is more important to the U.S. economy–exports or foreign capital inflows?

The answer to this question depends on whether one takes the view that the last decade’s BOP indicates that the U.S. is becoming uncompetitive in foreign markets, or the view that the BOP indicates that the U.S. is in a good position relative to foreign rivals. Those who support the former viewpoint would probably argue that exports are more important to the U.S. economy, while those who feel that the U.S. is attracting investment because its prospects are very attractive are likely to believe that foreign capital inflows are more important.

What is the connection between the U.S. current account deficit and capital account surplus?

The connection between the current account deficit and the capital account surplus is that one cannot exist without the other; the accounts have an inverse relationship. In a sense then, the means by which the U.S. is able to run a deficit in its current account (by importing more than it exports) is to finance the deficit with its capital account.

Which of the following groups is likely to endorse the “sky is falling” view of the U.S. BOP?

Import-threatened firms such as textile producers

Textile workers

A cash-starved California biotechnology company

Merrill Lynch

Boeing Aircraft, one of the country’s largest exporters

Consumers

Import-threatened firms such as textile producers, and textile workers are likely to endorse the “sky is falling” perspective of the U.S. A cash starved biotech firm is likely to view foreign investment favorably, as is Merrill Lynch. Consumers probably do not endorse the “sky is falling” perspective unless they happen to be employed by a firm that is threatened by imported goods. Finally, export-oriented Boeing Aircraft is not likely to endorse a “sky is falling” perspective.

Additional Case Application

Instructors may wish to raise the issue of whether the BOP should be considered an accurate measure of economic performance for the U.S. or other service-oriented economies. The class can be divided into two groups. One group can be assigned responsibility for analyzing the position of the U.S. when service trade is not included in the overall BOP. The second group can analyze the economic well being of the U.S. when trade in services is incorporated into its economic measures. The two groups can then present their findings to the rest of the class.

CHAPTER REVIEW

What is the function of the international monetary system?

The international monetary system establishes the rules by which countries value and exchange their currencies. In addition, the system provides a mechanism to correct imbalances that may exist between a country’s international payments and its receipts.

Why is the gold standard a type of fixed exchange-rate system?

The gold standard is a type of fixed exchange-rate system because under the system each country pegged the value of its currency to gold. Currencies are then exchanged using the stated amount of gold. The text provides an example of the process using the U.S. dollar and the British pound.

What were the key accomplishments of the Bretton Woods conference?

The key accomplishments of the Bretton Woods conference included an agreement to renew the gold standard on a modified basis, and an agreement to create two international organizations, the International Bank for Reconstruction and Development and the International Monetary Fund, to assist in the rebuilding of the world economy and the international monetary system.

Why was the IFC established by the World Bank?

The International Finance Corporation was created in 1956 to promote the development of the private sector in developing countries. To that end, the IFC (in collaboration with private investors) serves as an investment banker as it provides debt and equity capital for commercial activities that show promise.

Why are quotas important to IMF members?

Quotas (the deposits countries pay to join the organization) are important to IMF members for several reasons. First, a country’s quota determines its voting power within the IMF. Second, a country’s quota serves as part of its official reserves. Third, quotas determine a country’s borrowing power from the IMF.

Why did the Bretton Woods system collapse in 1971?

A key part of the Bretton Woods system was the agreement by the United States to exchange its currency for gold. During the 1950s and 1960s, foreigners happily held onto dollars. However, as their holdings increased, they began to question the ability of the United States to redeem their dollars for gold. After an attempt by the IMF to increase liquidity in the system using special drawing rights, the Bretton Woods system collapsed in 1971 amid fears that the United States did not have enough gold on hand to meet the demands of those who wanted to exchange their dollars for gold.

Describe the differences between a fixed exchange-rate system and a flexible exchange-rate system.

Under a fixed exchange-rate system, the price of a given currency does not change relative to other currencies. Under a flexible exchange-rate system, currencies fluctuate according to supply and demand.

List the four major accounts of the BOP accounting system and their components.

The four major accounts of the BOP accounting system are the current account, the capital account, the official reserves account, and the errors and omissions account. The capital account summarizes merchandise exports and imports, service exports and imports, investment income, and gifts for a given country. The capital account provides a record of a country’s capital transactions including purchases and sales of assets. The official reserves account provides a summary of a country’s official reserves including gold, convertible currencies, SDRs, and reserve positions at the IMF. Finally, the errors and reserves account provides a mechanism for ensuring that the BOP balances.

What factors cause measurement errors in the BOP accounts?