CHAPTER 24: International Financial Institutions and

Regulations
FOCUS OF THE CHAPTER
The need to rebuild and reconstruct war-ravaged economies after World War II and the
collapse of the Soviet Union led to the creation of international financial institutions. This
chapter will examine three such institutionsthe Bank for International Settlements,
the International Monetary Fund, and the World Bankas well as the Bretton
Woods System and the European System of Central Banks.

Learning Objectives:

Explain why international financial institutions emerged

Describe the origins, development, and current functions of international financial
institutions
Identify the roles played by the Bank for International Settlements, the International
Monetary Fund, the World Bank, and the European Bank for Reconstruction and
Development
Explain how the European exchange rate mechanism works
Describe the history and stages of development of the European Monetary
System
and the emergence of the European Central Bank

SECTION SUMMARIES
Forces Creating International Financial Institutions
The rise of international cooperative ventures is believed to stem from: problems of
maintaining gold standards; countries artificially depreciating their currencies to induce a
favourable balance of trade; and the destruction of the two World Wars. These institutions
provided rules of cooperation and financial resources. Although all the institutions
discussed in this chapter have failed in certain objectives, they have survived because for
the countries which hold memberships in them, the cost of not cooperating is greater than
the benefits of cooperating.

The Bank for International Settlements

Based in Switzerland, the Bank for International Settlement (BIS) is the worlds oldest
international financial institution. It acts as a central bank for central banks in Europe,
and was created after WWI, by the central banks of the United States, Great Britain,
France, Germany, Italy, Belgium, and Japan to coordinate German war reparations.

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The BIS uses the gold franc as its unit of account. Among its mandates, the BIS serves as
a forum where central banks can discuss and coordinate their countrys monetary
policies. It can also a) buy and sell gold and foreign exchange; b) make advances or
borrow from its member central banks; c) buy, sell, or discount bills such as treasury bills
or other marketable securities; d) act as an agent or correspondent for any central bank;
and e) compile data relating to the performance of the international financial system. It
also serves as a forum for international monetary cooperation which is especially crucial
when an interest rate differential causes conflict between member countries. In recent
years, the BIS has become more renowned for international banking supervision as a
result of a decision by the G-10 in 1974 to establish the Basel Committee on Banking
Supervision.

The Bretton Woods Conference

At the end of World War II, representatives from the allied countries met in Bretton
Woods, New Hampshire, to create an international financial system that was multilateral
and stable. Key features to this enhanced stability were to be freer trade, a system of fixed
exchange rates, and convertible (tradable) currencies. To manage the new system, the
group of representatives created two institutions: the International Monetary Fund and the
International Bank for Reconstruction and Development (also known as the World Bank).

The Bretton Woods Adjustable Peg Exchange Rate System: Under the adjustable
pegged exchange rate system, members established fixed exchange rates, but allowed the
rates to fluctuate freely within a narrowly defined band. Member countries agreed: a) to
establish a par value for their currencies (in effect pegging their exchange rates to the US
dollar and fixing the value of their currency to the price of gold) and to maintain the
exchange rate within 1% of par; and b) to change that par value only on approval of the
International Monetary Fund (IMF), which the IMF would grant only to correct a
fundamental disequilibrium in the balance of payments. As was discussed in Chapters 8
and 22, the loss of reserves comes from a balance of payment deficit, and the rise of
reserves from a balance of payment surplus. Note as well that if a country is selling
reserves to hold the fixed exchange rate, it eventually will run out of reserves and
encounter problems with changes in its money supply.
To facilitate the ideals of the system, the creators allowed some flexibility in
exchange rate movements; endowed the IMF with a pool of foreign reserves on which
members could draw; provided would-be borrowers with advice on the management of
their economies; and also provided a mechanism for changing the par value if a countrys
balance of payments was in disequilibrium.
There is strong evidence that throughout much of the Bretton Woods era, the
economic growth rate was relatively high and inflation relatively low.

The End of the Bretton Woods System: Two continuing problems with the system were
its lack of a formal mechanism to generate exchange rate adjustments and countries
reluctance to change par values. The 1971 Smithsonian Agreement was an attempt to
improve the system by increasing the price of gold and by increasing the range of
fluctuation of exchange rates. However, by 1973, the major economic powers switched to
a de facto flexible exchange rate system which is still in effect today.

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 Many people believe that the collapse of the Bretton Woods System was due to
the unwillingness of some industrialized countries to defend the overvalued US currency.
Another explanation is that, since the system placed the world on a US-dollar standard,
US monetary policy dictated world inflation rates, and other countries in the system
refused to support US inflationary policies. In addition, the growing freedom of capital
movement, after countries dropped capital control, meant growing pressure on exchange
rates that central banks could not contain.

The International Monetary Fund (IMF)

The IMF was founded to promote international cooperation in economic matters; to
provide a forum in which members could agree on a common code of conduct in their
financial affairs; and to aid nations in solving their balance of payments problems.
Recently the IMF has taken on the new role of coordinating lending and borrowing
functions, and of helping emerging economies develop sound policies via a policy of
surveillance. Under the policy of surveillance, the IMF provides comprehensive appraisal
of the countrys economic policies and exchange rate regime.

Organization and Structure: More than 100 countries are members of the IMF. It is
headed by a managing director, who chairs a board of governors. Each members voting
and borrowing rights are a function of its quota (membership fee). The quotas provide the
financial resources that the IMF uses to assist its members. A member country can easily
borrow up to 25% of its quota, which is called the first tranche. Borrowing against
additional tranches becomes progressively more difficult. The IMFs ability to impose
stringent economic discipline on loan recipients played a crucial and successful role in
the international debt crisis of the early 1980s and in managing the transition of the
former socialist block countries to market economies.

SDRs: One of the difficulties faced by the IMF, the shortage of gold and US dollars in
the world trading system, gave rise to the Triffin Paradox. One response to this problem
was the creation of the special drawing right (SDR) in 1969. The SDR is a unit of
account which represents a weighted average of a basket of currencies. It supplements
existing world reserves by giving countries access to a new source of liquidity.
The SDR has not become a more important currency. This may be due in part to
the creation of a host of new financial instruments by the financial markets in the Western
industrialized countries, which effectively eliminated the worldwide shortage of liquidity.
Nevertheless, SDRs have been important for developing countries as a source of
additional financial resources. Other facilities available from IMF include standby
arrangements, extended facilities, and enhanced structural adjustment facilities.

Financial Liberalization: The IMFs mandate seems to include liberalization of trade and
capital movements. Some believe that financial liberalization has been largely responsible
for the recent Asian crisis. Without proper regulatory and supervisory structures financial
crises become more likely. The IMF has therefore taken responsibility to increase the
surveillance of the financial market practices of emerging market economies.

The Future of the IMF: In recent years, in the wake of several economic crises, the
IMFs primary role has been a surveillance function. However, critics argue that the
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IMF acts to increase the role of market discipline. Others argue that the IMF should
act as an international country-rating agency, and become an international bankruptcy
court. The adoption of flexible exchange rates by most industrial countries and the
increase in IMF membership have placed tremendous pressure on the IMF to reform.
Supporters of the IMF argue that quick action by the IMF can prevent the contagion
effect in financial crises.

The World Bank

The International Bank for Reconstruction and Development (IBRD), more often
referred to as the World Bank, facilitates lending and other financial needs of developing
countries. The World Bank aids developing countries by: 1) assisting in reconstruction
and development; 2) promoting private foreign investment; 3) making loans from its own
funds and channelling aid from the developed countries; 4) guaranteeing loans made to
members; and 5) promoting the growth of international trade. The World Bank,
conceived at the Bretton Woods Conference, and the IMF are sister institutions. The
funds loaned out by the Bank are raised through members subscriptions, through the
retention of earnings on previous loans, and through the sale of bonds. In the late 1970s,
the World Bank moved towards helping countries restructure their entire economies or
vital sectors of it, rather than lending for specific reconstruction projects. For certain
purposes, the World Bank acts through affiliates, such as the International Development
Association (IDA) and the International Finance Corporation (IFC). However, many,
including Nobel laureate Joseph Stiglitz, have criticized the World Banks lending
policies as outdated.

The European Bank for Reconstruction and Development (EBRD)

The European Bank for Reconstruction and Development was set up in 1990 to help the
former Communist countries of Europe make the transition to capitalism. It is the
international institution responsible for advising and implementing transitional policies in
emerging markets. The financial sectors have proven to be the slowest to reform among
the various sectors of emerging economies.
The Asian Development Bank (ADB) which makes loans and provides technical
assistance in the Asia-Pacific region is another multilateral finance agency.

The European Monetary System (EMS)

The European Monetary System was an attempt to integrate the currencies of the
European Community (EC). By fixing exchange rates, but permitting them to fluctuate
within a target zone, the system is able to prevent large swings in a countrys current
account when there are large fluctuations in the nominal exchange rate. The target zone
system is called the exchange rate mechanism (ERM).

Some History: Six European countries (Belgium, France, West Germany, Italy,
Luxembourg, and the Netherlands) signed the Treaty of Rome in 1957, which led to the
formation of the European Community, and, in 1968, agreed to take steps to integrate
their monetary policies. This system was designed to be a miniature version of the
Bretton Woods system, consisting of a pool of reserves to help members maintain a fixed
exchange rate and prevent speculative attacks against their currencies. Exchange rate

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fluctuations within the European Community would be narrowed to a band (target range)
smaller than that of the IMF. If the exchange rates could not be maintained within the
zone, the EMS would revalue the currencies.
Despite a variety of setbacks and delays, the EMS began to operate in 1979. The
systems monetary unit, called the European currency unit (Ecu), represented a weighted
basket of European currencies. The EMS realigned (revalued) the currencies if the
exchange rates could not be maintained within the zone. Apparently there was stability in
exchange rates between 1987 and 1992, which puzzled economists.

The Target Zone System in Action: Essential to the EMS was the target zone, an
exchange rate system in which the exchange rate for the participating country is
permitted to fluctuate within a specified range. In practice the target zone has often not
been credible, necessitating frequent realignment, i.e., changing the value of the fixed
exchange rate. One simple way to test the credibility of the target zone is to use the
theory of uncovered interest rate parity, discussed in Chapter 8.

European Monetary Union

The Delors Report (1989) laid out the ground rules leading to the European Monetary
Union (EMU) and the introduction of a single currency. The Maastricht Plan (1991)
called for full EMU by 1999. In 1995, leaders of the EU announced plans for a single
currencythe Euroand reaffirmed the launch date of January 1, 1999. During the next
phase of the transition, which began in 1992, EC members were to achieve convergence
in monetary and fiscal policies, and thereby, in inflation rates.
By 1998, the governments in the EU decided that 11 countries had fulfilled the
five convergence conditions (see page 445 in the text) necessary for membership. The
development of the Euro was accompanied by a single market program which
eliminated all intra-EC barriers which limited the movement of capital within the EC.
Effectively, the EMU means the elimination of sovereignty in monetary matters for
member states. To complement the EMU, the heads of state of the EU adopted the
Stability and Growth Pact. Essentially, the Pact consists of regulations and financial
penalties to ensure budget discipline.
The European Central Bank (ECB) opened in 1998 in Frankfurt, Germany. The
central banks of the EMU members together form the European System of Central Banks
(ESCB). The European Monetary Institute (EMI) was opened in 1994 to prepare for the
technical needs of the switch to a single currency and to report to the EU on progress
toward convergence by member countries. On January 1, 2002, the Euro was introduced
and is now essentially the only legal tender in 11 EU countries.

Objectives and Tasks of the ESCB: The European System of Central Banks (ESBC)
includes the European Central Bank, which is the central bank for members of the
EMU, and the central banks of the individual member countries of the EMU. The primary
objective of the ESCB is the maintenance of price stability. Price stability is defined as an
inflation rate of less than 2% in a Europe-wide index of consumer price indexes. The
ESBC is also responsible for: defining and implementing monetary policy in the EMU;
conducting foreign exchange operations; holding and managing member states foreign
exchange reserves; and helping to promote payment systems.

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Currency Unions: In a currency union (for instance, the EMU), two or more jurisdictions
share a single currency. The success of a currency union depends on the mobility factor
the freedom of capital and labour to move across regions, and a minimum of barriers to
trade. Economists think there are five essential ingredients of an optimum currency
area: labour mobility; capital mobility; openness and regional interdependence;
industrial and portfolio diversification; and wage and price flexibility.
Interest in currency unions has been heightened by the breakup of the Soviet
Union and of Czechoslovakia. In Canada, the idea of a currency union has attracted
attention recently because of the deprecation of the Canadian dollar against the US dollar
since mid-1998 to early 2003. Some believe a shared currency with the US would be
advantageous to Canada.
It is important to note that, although a country entering into a monetary union
eliminates all nominal differences in exchange rates between members of the union, the
variability of the real exchange rate is not eliminated. However, since the real exchange
rate represents a combination of factors, this variability may represent price level
flexibility, in which case the US and Canada might be good candidates for a monetary
union.

MULTIPLE-CHOICE QUESTIONS

1. Which of the following is not a founding member of the Bank for International
Settlements?
a) the United States
b) Great Britain
c) Canada
d) Japan

2. Under the Bretton Woods pegged exchange rate system, members of the IMF agreed
a) to follow a completely flexible exchange rate system.
b) to use a common currency.
c) to establish a par value for their currencies and to maintain the exchange rate
within 1% of par.
d) to form the European Monetary Union.

3. Which of the following provides reasonable grounds for a change in the par value of a
currency under the Bretton Woods system of fixed exchange rates?
a) a fiscal deficit associated with a current account deficit
b) an increase in imports of goods and services
c) a fundamental disequilibrium in the balance of payments
d) a temporary increase in the current account deficit in the balance of payments

4. In general, the Bretton Woods era was characterized by

a) relatively high unemployment rates and low economic growth rates.
b) relatively high economic growth rates and low inflation rates.
c) relatively low economic growth rates and low inflation rates.
d) relatively high economic growth rates and high inflation rates.

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5. Which of the following is not correct about Special Drawing Rights (SDR)?
a) SDR is a unit of account.
b) SDR was created by the World Bank.
c) SDR is currently defined as a weighted average of selected currencies.
d) SDR has no physical existence.

6. In helping developing countries, the World Bank does all of the following except
a) promoting private foreign investment.
b) making loans from its funds.
c) assisting in reconstruction and development.
d) promoting protectionism in trade.

7. The European Bank for Reconstruction and Development

a) is also called the World Bank.
b) is also called the European Central Bank.
c) was created at the Bretton Woods conference.
d) was created to help the transition to capitalism of the former Communist countries of
Europe.

8. The primary objective of the European System of Central Banks is

a) to maintain price stability.
b) to maintain exchange rate stability.
c) to promote capital mobility.
d) to ensure wage-price flexibility.

9. Which of the following is true?

a) Canada has a target zone with the United States and Mexico.
b) Canada has a currency union among its provinces.
c) Canada has a currency union with the United States and Mexico.
d) Canada has a target zone with the US and a currency union with Mexico.

10. A monetary union

a) eliminates real exchange rate variability among its members.
b) increases nominal exchange rate variability among its members.
c) eliminates both real exchange rate variability and nominal exchange rate variability
among its members.
d) eliminates nominal exchange rate variability but not real exchange rate variability
among its members.

PROBLEMS

1. What is the Triffin Paradox? Explain.

2. What is a currency union? Briefly state the essential ingredients of "an optimum
currency union."
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3. What is SDR? How can it increase liquidity in the world financial system?

4. Explain how the World Bank helps developing countries in their development efforts.

ANSWER SECTION

Answers to multiple-choice questions:

1. c (see page 434)

2. c (see page 436)
3. c (see page 436)
4. b (see page 437)
5. b (see page 439)
6. d (see pages 441-442)
7. d (see page 442)
8. a (see page 449)
9. b (see page 452)
10. d (see page 453)

Answers to problems:

1. An inherent inconsistency in the Bretton Woods system is referred to as the Triffin

Paradox (named after Robert Triffin of Yale University). Under the Bretton Woods
system, the US dollar became the most important reserve currency. Therefore, the supply
of world reserves depended heavily on the balance of payments deficits of the United
States. The US would have to persistently run balance of payments deficits to supply a
steady and constant flow of reserves to the world. However, this would lead to a decrease
in the value of the US dollar relative to gold, the other major reserve asset. This
inconsistency is referred to as the Triffin Paradox.

2. A group of jurisdictions sharing a common currency form a currency union (e.g., the
European Monetary Union). The essential ingredients of an optimum currency union"
would include the following: 1) free movement of labour (labour mobility); 2) free
movement of capital (capital mobility); 3) openness and regional independence; 4)
industrial and portfolio diversification; and 5) wage and price flexibility.

3. The Special Drawing Right (SDR) is a unit of account created by the IMF as a
response to the shortage of world liquidity under the Bretton Woods system. It is a
weighted average of a basket of currencies. The IMF establishes a Special Drawing
Account for each member to borrow from the IMF. These loans supplement existing
world reserves and increase liquidity in the world financial system.

4. The World Bank helps developing countries in their development efforts by doing the
following: 1) assisting in reconstruction and development; 2) promoting private foreign
investment; 3) making loans from its own funds and channelling aid from the developed
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countries; 4) guaranteeing loans made to members; and 5) promoting the growth of
international trade.

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