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International Finance: Coursework 2

Module Title: International Finance

Module Code: 7BSP 0354

(MSc International Business)

Module Leader: Edward Kerr

Submitted By: Mahmudul Hasan

SRN: 09213521

Word Count: 2462

Date of Submission: 01/02/2011

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Table ofContentsAbstract ...................................................................................................................... 2

Section One: Answer of the Question (A) ................................ ................................ ... 3

1.1 Introduction ................................ ................................ ................................ ........... 3

1.2 The Gold Standard (1880-1914) ................................ ................................ ........... 3

1.3 The Interwar and World War II (1914 -1945) ......................................................... 4

1.4 The Bretton Woods System (1945-1973) ................................ ............................. 5

1.5 The Post Bretton Woods to the Present ................................ ............................... 6

1.6 Conclusion ................................ ................................ ................................ ............ 6

Section Two: Answer of the Question (B) ................................ ................................ ... 7

2.1 Introduction ................................ ................................ ................................ ........... 7

2.2 The Euro and the United Kingdom................................ ................................ ........ 7

2.3 Advantages and Disadvantages of the UK Joining the Euro ................................ 8

2.4 Conclusion ................................ ................................ ................................ ............ 9

References ............................................................................................................... 10

Appendix1 ................................ ................................ ................................ ................. 11

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Abstract

This report examines the changes of the international financial system. It shows the

underlying reasons of changing the financial system. International financial system

faced various problems over the times and had adopted different policy in particular

situation. The different monetary crisis, oil crisis, currency crisis and after all

launching of the euro had enormous effect on the international financial system. This

report also evaluates why UK did not join the euro. It shows that economic costs

were higher than its benefits of joining the euro .

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Section One: Answer of the Question (A)

1.1 Introduction

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The rapid growth of trade and financial flows from the late nineteenth century led to

the internationalisation of finance. The financing of foreign trade and other

international transaction had become quite complex. Therefore, the international

financial system had adopted varies systems during the past centuries to meet the

demands of a raising international trade and an expanding international flow of

capital. The changes of worlds financial system and the reasons for those changes

are discussed bellow in a chronological order.

1.2 The Gold Standard (1880-1914)

In the pre 1914 era, the worlds most of the major trading nations adopted an

international monetary system called the gold standard. Under the gold standard, the

international monetary system was largely decentralized and market-based.

Countries were pegged to gold, which remove the uncertainty of transaction between

different countries (Morrison: 2006). Countries used gold as a medium of exchange

and a store of value and this system had a stable exchange rate. Each country set

the rate at which its currency unit could be converted to a specific amount of gold on

demand, therefore exchange rates between countries was fixed. For instance, Great

Britain pegged the pound sterling at 4.2474 per ounce of gold. The United States

agreed the dollar to be convertible to gold at a rate of $20.67 per ounce of gold. The

two currencies could be freely convertible into gold and could be exchanged for the

stated amount of gold. Under this situation, the dollar/pound exchange rate was

perfectly determined at $20.67/4.2474 or $4.8665/ 1 (Eiteman et al: 2007).

Prior to First World War, the key international currency was British pound starling for

financing trade and investment and almost 90 percent of world trade took place in

London because of Londons dominance in international finance. Sterling was

convenient because it was universally used and convertible into gold at the Bank of

England. International trade was denominated in sterling rather than gold (Kim and

Kim: 1999).

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The gold standard broke down during the First World War because war interrupted

trade flows. Moreover, countries used precious metal to purchase military supplies

and restricted free movement of gold market, thus causing currencies to float.

Therefore, widespread inflation occurred because of the financing for war

expenditure (Morrison: 2006).

1.3 The Interwar and World War II (1914-1945)

After the First World War, the gold standard was briefly reinstated from 1925 to 1931

as the Gold Exchange Standard. The value of currencies fluctuated widely in terms

of gold in early 1920s, and this led to return to the stability of the gold standard. In

April 1925, United Kingdom re-established the convertibility of the pound into gold

and returned to the gold standard. Other countries also went back to gold (USA

returned to gold in 1919). However, the gold standard was different from that whichhad existed before the World War I. The key difference was that instead of two

international reserve assets (gold and sterling) , there were several. The United

States and France had become more important in international finance, and dollar

and franc deposits were used for much financing. Another important different was

that flexibility in costs and prices no longer existed as it had before the First W orld

War (Buckley: 2004, Salvatore: 2001).

Several attempts were made to restore the gold standard during the 1920s.

However, those attempts failed for many reasons. France passed a law in 1928 for

settlement of its balance of payment surpluses in gold rather than in pounds or other

currencies. When France converted all of its previously accumulated pound into

gold, the UK was forced to devalue the pound and t he gold exchange standard came

to an end in 1931. Moreover, the Great depression of 1929 to 1932 and the

international financial crisis of 1931 were also underlying reason s of the collapse of

the gold standard (Salvatore: 2001).

From 1931 to 1936, the period was great instability and competitive devaluations of

currencies. The United State devalued the dollar from $20 to $35 per ounce of gold

in order to stimulate its exports. Country after country devalued their currencies to

maintain trade competitiveness. Governments also resorted to exchange controls in

an attempt to manipulate their net export. During World War II, government priorities

had shifted from exchange rate stability to domestic economic concerns. Trade

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transaction with enemy countries became illegal, and much of the trade that

continued between friendly nations was under various inter -governmental

agreements. There was virtually no role for international finance. Therefore, most of

the major trading currencies lost their convertibility into other currencies. The dollar

was the only main trading currency that continued to be convertible (Eiteman et al:

2007, Kim and Kim: 1999, Salvatore: 2001).

1.4 The Bretton Woods System (1945-1973)

At the end of the Second World War, the leading nations agreed upon the need for a

new monetary system. The Allied powers met at Bretton Woods, New Hampshire, in

July 1944 to create a new international financial system. The Bretton Woods

conference also provided two new organisations: the International Monetary Fund

(IMF) and the International Bank for Reconstruction and Development (World Bank).The IMF was set up to promote monetary stability. On the other hand, the World

Bank provided fund and assistance to countries for postwar reconstruction and

general economic development.

The Bretton Woods Agreement established a US dollar -based international monetary

system (Eiteman et al: 2007). The main feature of Bretton Woods was a system of

fixed exchange rates that could be adjusted only in exceptional circumstances.

Under this system, countries fixed the value of their currencies in term of gold or US

dollars but were not required to exchange their currencies for gold. Only the US

dollar remained convertible into gold at $35 per ounce of gold. The US dollar was

used most frequently as a reference currency to establish the relative prices of all

other currencies (Buckley: 2008, Eiteman et al: 2007, Kim and Kim: 1999).

The Bretton Woods system played a positive role in a rapid growth in world trade

during its early years. However, widely diverging national monetary policies,

differential rates of inflation, and other external shocks eventually resulted in the

failure of the system. The US balance of payments turned into deficit average $3

billion per year in 1958, whereas European nations and J apan turned into trade

surplus. The US dollar was the main reserve currency and the key to the web of

exchange rate values. Therefore, countries accumulated dollar reserves in order to

meet any excess demands. The foreign official dollar holdings increased from $13

billion in 1949 to $40 billion in 1970. Moreover, US gold reserve declined from $25

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billion to $11 billion at the same time. Eventually the heavy overhang of dollars held

by foreign countries resulted in a lack of confidence in the ability of the Unit ed States

to convert dollars to gold. On August 15, 1971, this lack of confidence forced

President Richard Nixon to announce that the dollar would no longer be convertible

to gold. With the Smithsonian Agreement on December 1971, the US devalued the

dollar from $35 per ounce of gold to $38. The Agreement was not successfulbecause of another huge US balance of payment deficit and the US again devalued

the dollar to $42.22 per ounce of gold. The Agreement ended in March 1973 and the

system collapsed (Eiteman et al: 2007, Kim and Kim: 1999, Pilbeam: 2006,

Salvatore: 2001).

1.5 The Post Bretton Woods to the Present

In March 1973, major trading countries allowed their currencies to float eitherindependently or jointly according to the market forces. After that, the present

managed floating exchange rate system was born. Since March 1973, exchange

rates have become much more volatile and less predictable. The 1976 Jamaica

Accords formalized the managed floating system and allowed countries the choice of

foreign exchange regime. The IMF classifies all exchange rate regimes into eight

categories such as currency board, fixed page, crawling page, managed floating,

independent floating. There were number of events that have affected international

financial system since March 1973. The most important events include the oil crisisin 1973 and 1978, European currency crisis in 1992 and 1993, the emerging market

currency crisis, and the introduction of the euro in 1999 (Eiteman et al: 2007, Kim

and Kim: 1999, Pilbeam: 2006, Salvatore: 2001).

1.6 Conclusion

This section of the report has examined the changes of international financial system

from gold standard to present. The above discussion shows that the internationalfinancial system underwent the various changes. From the end of the World War II to

1973, international trade operated under a fixed exchange system. After that, most of

the countries have adopted the managed floating exchange rate syste m. Today, the

international financial system is composed of national currencies, artificial currencies

(such as SDR), and new currency (euro). All the currencies are linked each other

through currency regimes.

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Section Two: Answer of the Question (B)

2.1 Introduction

Euro is the official single currency of the euro zone. Today, it is used by more than

20 countries. In December 1991, major European countries met in Maastricht and

signed the Maastricht Treaty. European Union leaders agreed to establish a single

currency the euro by January 1, 1999, with a common monetary policy. They set

the five criteria called convergence for entry to the euro currency. Majority of

countries could not meet the criteria by 1999. In spite of this situation, EU leaders

decided that 11 countries had come close enough to qualification and would

establish the euro on January 1, 1999. Consequently, the notes and coins in new

currency were first issued in physical form to public on 1st January 2002.

2.2 The Euro and the United Kingdom

The UK did not join the euro in 1999. The UK government set own convergence

criteria that must be met before it will join the euro (see appendix1). In 2003, the UK

Government declared that the conditions laid down in its five tests were not

sufficiently met and the UK remains outside the euro (Mulhearn and Vane: 2008).

Furthermore, there are some another economic reasons of UKs decision not to join

in euro. The UK stock of household debt is significantly higher than the EU , while the

UK government expenditure and taxes are lower than most EU countries.

Consequently, a small increase in interest rates has a big effect on consumer

expenditure. Moreover, the monetary policy in the UK focuses on the price stability

for achieving sustainable growth in output and employment. However, the European

Central Bank adopted an intermediate monetary policy and interest rates, which

were not suitable for all its member countries. For instance, the interest rates were

too low for Ireland and Spain. They faced excessive growth and the danger of

inflation and required a more restrictive monetary policy. On the other hand, the

interest rates were too high for Germany and Italy . They faced anaemic growth and

required lower interest rates. Therefore, the UK government wanted to retain control

over its interest rates and did not join the euro (Mulhearn and Vane: 2008, Salvatore:

2001).

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Similarly, William Jefferson Hague1(2009) has pointed out that why UK did not join

the euro. He states, The economic reasons are simply stated: British families have

many more of their mortgages in floating interest rates than people on the continent;

we have a much bigger financial services sector, and more of our trade and

investments are denominated in U.S. dollars. He further argues that the right level of

interest rates set for people in Greece, Germany or Italy is not necessarily the rightone for UK. [The Mail Online Exclusive Article: 2009]

2.3 Advantages and Disadvantages of the UK Joining the Euro

The obvious benefit of UKs entry into the European single currency is the p otential

expanded trade. UK does significantly more trade with the eurozone than US, which

is its second largest trade partner. If UK joins the euro, it would eliminate the

transaction cost in relating to currency conversion and encourage further tradebetween these countries.

Table1: Percentage of shares of UK trade in 2000 [Layard et al: 2002].

Similarly, since the euro lunched, trade between eurozone countries have increased

20% relative to their GDP. In contrast, UKs trade with the EU countries has

decreased relative to its GDP (Layard et al: 2002).

Year France Germany UK

1998 28 27 232001 32 32 22

change +4 +5 -1

Table2: Trade with other E.U countries (as % of GDP) [Layard et al: 2002].

1Presently, William Jefferson Hague is the British Foreign Secretary and First Secretary of State.

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In addition, Layard et al (2002) , Mulhearn and Vane (2008) point out the major

benefits of UK joining the European single currency. These are as follows:

elimination of currency fluctuations risk, increased price transparency, and capital

market integration.

One of the major benefits of joining the euro is that it will eliminate exchange rate

uncertainty and risk. Exchange rate movement results in uncertainty about the future

costs of goods and it may affect investment and economic growth. With single

currency, any company can design its business system for maximum efficiency,

which would lead to higher productivity. As is observed from table2, Germany and

France experience more trade when exchange risk is eliminated. In contrast, UK

experiences opposite with existing exchange rates risk. Another benefit of adopting a

common currency is that it results in greater transparency in price comparisons .

Comparing prices between different countries product is difficult due to the different

exchange rates. Therefore, single currency will promote greater competition between

firms and benefits the consumer (Layard et al: 2002, Mulhearn and Vane: 2008) .

On the other hand, the most serious disadvantage of joining a common currency is

that UK will lose its freedom to set national monetary policy and interest rates. As is

discussed above, the common monetary policy and interest rates are not suitable for

all countries. Therefore, UK needs its own monetary policy and interest rates to

survive. Moreover, UK would lose control over its fiscal policy. The ECB has fixed

that the annual budget deficit cannot exceed 3 percent of GDP. If UK is in trouble, it

will not be able to borrow money to help its elf (Layard et al: 2002).

2.4 Conclusion

This section of the report has examined the underlying causes of why the UK did not

join the euro. It has also explored the advantages and disadvantages of the UK

joining the euro. From the above discussion, it has been seen that the economic

costs is much more higher than its benefits of joining the euro. If the UK had joined

the euro, it would lose its monetary independency. Therefore, it can be said that the

benefits are significantly large to the UK from adopting this policy.

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References

Buckley, A. (2004), Multinational Finance, 5 th edition, Harlow: FT-Prentice Hall.

Buckley, P.R.(2008) International Financial System, Netherlands: Kluwer LawInternational.

Eiteman, K. D., Stonehill, A. I. and Moffett, M. H.(2007), Multinational Business

Finance, 11th edition, Boston: Pearson.

Kim, H.S. and Kim, H.S.(1999), Global Corporate Finance: Text and Cases, 4 th

edition, Oxford: Blackwell Publishers Ltd.

Morrison, J.(2006) The International Business Environment, 2 nd edition, Hampshire:

Palgrave Macmillan.

Mulhearn, C. and Vane, R.H. (2008) The Euro: Its Origins, Development And

Prospects, Cheltenham: Edward Elgar Publishing Ltd.

Pilbeam, K.(2006) International Finance, 3rd edition, Hampshire: Palgrave Macmillan.

Salvatore, D.(2001) International Economics, 7 th edition, New York: John Wiley &

Sons.

Hague, J. W. (2009), Why Britain will never join the euro under the Tories , The Mail

Online Exclusive Article, online, Available at:

http://www.dailymail.co.uk/debate/newsdebate/article -1103618/EXCLUSIVE-Why-

Britain-join-euro-Tories-WILLIAM-HAGUE.html. [Accessed on: 22/01/2011]

Layard, R., Buiter, W., Huhne, C., Hutton, W., Kenen P. and Turner, A. (2002) Why

Britain Should Join the Euro, online, Available at:http://cep.lse.ac.uk/layard/RL334D.pdf. [Accessed on: 19/01/2011]

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Appendix1

The UK set five economic tests, which assess:

1. Convergence: whether business cycles and economic structures with the euroarea will allow the UK to live comfortably with euro interest rates on a permanent

basis;

2. Sufficient Flexibility: if problems emerge in particular in labour markets- is there

sufficient flexibility to deal with them;

3. Effect on Investment: whether investment will be boosted in the long term;

4. Effect on Financial Services: whether financial services will benefit through an

improvement in the competitive position of the UKs financial services industry,

particularly the Citys wholesale markets;

5. Effect on Growth Stability and employment: whether joining the euro will promote

higher growth, stability and employment. [Mulhearn and Vane: 2008]