History of the foreign

Overview
This chapter describes the history of exchange rate
regimes over the past century and the experience
gained from them. There have been a number of
exchange rate regimes over the past one hundred
years or so. Exchange rate regimes are agreements,
institutions, treaties or practices which govern the
setting of exchange rates between countries. This
means that an exchange rate regime regulates more
than merely the question of whether exchange rates
are set flexibly on the market, or are fixed by the
intervention of central banks. The first regime to be
presented is the gold standard established by the
industrialized nations towards the end of the 19th
century. It was the gold standard which first produced
the notion of foreign exchange dealing as we
know it today. During and between the two world
wars, political events overshadowed the foreign
exchange markets. To restore a stable economic environment,
the industrialized nations established
a system of fixed exchange rates which set the framework
for foreign exchange dealing. The collapse of
this system of fixed interest rates in the early 1970s
laid the foundations for the subsequent exchange
rate regime. The market prices for USD, JPY, CHF and
EUR are flexible. In contrast, the currencies of the
European Union stuck largely to fixed parities in the
days before monetary union.
The gold standard was established in the 1870s as an
instrument of confidence. At that time, the global
economy was dominated by Britain, and administered
by London, the global financial centre. The degree of
political stability guaranteed by British dominance
was the condition for the emergence and continuation
of this gold-based, multilateral exchange rate
regime. For the first time, widespread international
trade based on the clearing balances of commercial
banks was possible. The gold standard implied a
system of fixed exchange rates. All participating currencies
were pegged to gold at a fixed parity, and
4. History of the foreign
exchange market
The gold standard
(1880–1914 and 1918–1939)
36
central banks had to maintain gold reserves to cover
their currencies.
International payments were based on gold. At the
same time, there was also a free market for gold.
Gold could be imported and exported everywhere
without restriction, and could be turned into coin
against payment of a mintage fee. Because gold supported
all the participating currencies, and because
gold coin was legal tender, the gold standard currencies
enjoyed widespread acceptance. The fixed
exchange rates between the currencies were derived
from the parities of the individual currencies to gold.
Gold coverage and the free movement of gold guaranteed
the stability of these parities, although minor
fluctuations in exchange rate parities could occur
because of the transport and costs of gold-based
transactions.
Originally, membership of the gold standard required
the central banks of the member countries to redeem
the banknotes they issued against gold at any time
on demand, and to cover a certain percentage of
the money stock in circulation by gold reserves. This
was the “Gold Specie Standard.” The exchange
and reserve requirement meant that liquidity in the
economy depended directly on gold production
and industrial demand for gold, and this represented
a substantial monetary restriction. The world supply
of gold is, after all, not linked to the liquidity requirements
of the individual economies, and is determined
by gold mining and the discovery of new gold deposits.
Through the gold coverage, the gold supply in a
country determined the volume of money in circulation.
Trade deficits or surpluses were neutralized by
flows of gold. A trade deficit automatically represented
an outflow of gold. At the same time, this
meant a drop in domestic money supply. The reduction
in the money supply led to higher interest rates, and
Gold specie currencies
Trade imbalances were
corrected by the automatic
function of gold
37
thus to potential capital – and gold – inflows. The
lower money supply automatically meant lower
prices, and thus greater international competitive
strength. Rising exports then returned the trade
balance to equilibrium and the money supply started
expanding again. This “automatic function” of gold
automatically imposed trade balance equilibrium on
countries. The domestic economy was therefore
directly exposed to developments abroad. Britain’s
leading role as a trading power and global creditor
meant that the Bank of England was able to exercise
considerable influence on the development of the
global economy.
This system collapsed with the outbreak of the First
World War. Financing the wartime economies
demanded the immediate and massive creation of
money. This saw prices climb rapidly in some countries,
a situation which was incompatible with rigid
gold coverage. During the war, many countries
decoupled themselves completely from the foreign
exchange market through foreign exchange rationing,
i.e. government control of the import and
export of foreign currencies.
At the end of the war, there was an attempt to restore
the stability of the gold standard. Britain, which
had only been able to finance the war by tapping
the financial strength of the New World, now had to
share leadership of the global economy with the
USA. The shift in the flows of goods and capital was
immense. Agreement was reached on the introduction
of the Gold Bullion Standard. The traditional
Gold Specie Standard, in which gold could be used
directly as a means of payment, was abolished. For
the first time, government currency reserves were
allocated a central bank guarantee function in addition
to gold, and the system of fixed coverage was
dropped. This meant that the countries were now
free to set the amount of money in circulation. The
only obligation imposed on the central banks was
A new start with the Gold
Bullion Standard
after the First World War
38
to ensure that exchange rates remained fixed at the
gold-based parities by intervening directly in the
foreign exchange market.
This was not a particularly good time for proving that
such a system would work, however. Money was
created at an ever increasing rate by resorting to the
printing press, above all in an attempt to reduce the
debt or reparation payments resulting from the war.
This saw an increasing gulf between the inflation
rates in the individual countries, and the attempt to
restore the agreed original parities was unsuccessful.
Monetary expansion increased the downward pressure
on a range of currencies, even resulting in competitive
devaluation. Devaluation was achieved by
expansion of the money stock.
The new attempt to create a stable monetary system
ultimately collapsed due to the lack of any coordinated
monetary policy by the countries involved. The
political and institutional stability needed to curb the
devaluation pressure, and inflation simply did not
exist. The stock market crash of 1929 triggered the
Great Depression. The worldwide economic crisis at
the beginning of the 1930s was inevitable and resulted
in most countries abandoning the gold standard.
Again, they instituted exchange controls in an attempt
to maintain an artificial exchange rate for their currency,
or went a step further and prohibited foreign
exchange dealing outright. The restrictions this imposed,
including on global trade, merely accelerated
the pace of economic decline. The downward spiral
towards instability could not be halted.
Even before World War II had drawn to a close, the
USA and Britain started work on creating a new
world economic order. This multilateral trading and
monetary system was designed to be anchored in the
organizations of the United Nations. However, as the
world congealed into “Eastern” and “Western”
The gold exchange
standard (1944–1971): the
Bretton Woods system –
goals and functions
39
blocs, it was no longer possible to embed this system
in functions of the UN. Instead, the Bretton Woods
conference in July 1944 created the Bretton Woods
institutions as a separate international treaty regime.
The goal of this new trading, monetary and financial
system was to reconstruct Europe and restore the
system of international trade and links between currencies.
The International Monetary Fund (IMF) was
established to monitor the new global monetary
system. Membership in the IMF obliged a country to
respect particular monetary policy rules, and guaranteed
help in times of financial crisis. Each member
currency agreed a parity with the IMF, expressed
either in gold or in US dollars.
Under the IMF Treaty, the countries were required to
guarantee the fixed USD parity in foreign exchange
trading. The spot rate had to remain within a ±1%
margin of the agreed USD parity. The parity could be
supported on the foreign exchange market by central
bank intervention. The margin was twice as large
(±2%) for the bilateral rates of the non-USD currencies,
derived from the two dollar parities. In practice,
central bank intervention to stabilize exchange rates
tended to start at the margin limits of ±0.75% and
1.5%.
Example:
Gold parities and arbitrage
The USA fix the dollar price of gold at USD 35 per
ounce. France fixes the franc price at FRF 210 per
ounce. This gives a franc/dollar exchange rate of
6 USD/FRF. If the currencies were to be traded at
USD/FRF 6.20, there would be scope for a triangular
arbitrage operation: in France, it would be possible to
purchase gold for FRF 210 per ounce. The gold could
be converted into dollars in the USA for USD 35 per
ounce. The dollars could be reconverted into FRF at a
rate of USD/FRF 6.2 (USD 35 x USD/FRF 6.2 = FRF 217).
This would mean a gain of FRF 7 per ounce of gold.
Of course, immediate capital movements would not
40
have produced such a fluctuation in the exchange
rate in the first place.
Currency parity realignments could be decided unilaterally,
but had to be confirmed and announced
by the IMF. A condition for realigning a currency was
an evident, fundamental payments imbalance. This
conditional flexibility was the result of the common
desire to secure the system against competitive
devaluation. Again, to avoid devaluations as much as
possible, members were allowed to apply for credit
from the IMF in the event of balance of payments
problems. The credits were designed to prevent
liquidity shortages suffocating the economy in the
case of high balance of payments deficits where
the central bank had to balance out goods and
capital transactions.
Despite periodic crises, the international monetary
system created at Bretton Woods proved to be stable
for around a quarter of a century. The system revolved
around the role of the dollar as the key or anchor
currency. It was marked by the dominance of the USA
and underpinned by the massive gold reserves which
had flowed into the USA since the country’s rise
as the leading industrial nation. In the early stages,
stability was transmitted to the system by the
strength of the dollar.
Cracks in the Bretton Woods system started becoming
apparent in the 1960s. From 1958 to 1960, the USA
recorded balance of payments deficits again for the
first time. To maintain dollar parity, the European central
banks had to introduce their domestic currencies
onto the market, which drove up inflationary expectations.
The fear of inflation caused a run on gold,
the exchange of which was still guaranteed, and the
market price exceeded the fixed rate of USD 35 per
troy ounce. To head off this crisis on the gold market,
the central banks decided to cooperate in a gold
pool. The objective of the pool was to guarantee
The history of the Bretton
Woods system
the gold price at the official level of USD 35 per troy
ounce by means of intervention.
High growth rates and rising balance of payments
surpluses in the Netherlands and Germany resulted in
pressure to revalue the NLG and DEM in early 1961.
Between 1963 and 1967, sterling was maintained
artificially at the pegged level by support buying,
primarily by the Fed, but ultimately had to be devalued
in 1967. In the long run, the gold losses of the
central banks exceeded the gold pool, and it was
killed off in 1968. The gold market then split into a
cordoned-off central bank market with a fixed gold
price and a “public” gold market with flexible prices.
The system now started to fall apart at the seams.
The social unrest in France in May 1968 resulted in an
exodus of capital which saw the Banque de France
losing the bulk of its currency reserves. The FRF had
to be devalued by 11.1%. Ever increasing capital
inflows into Germany ended in a further revaluation
of the DEM by 9.3% in 1969. US short-term foreign
liabilities outstripped falling US gold reserves. Confidence
in the dollar disappeared. The enormous level
of defence expenditure as a result of the Cold War
and the escalating Vietnam War resulted in high
budget deficits in the USA at the end of the 1960s.
To cut the cost of public-sector borrowing, interest
rates were kept artificially low with the aid of monetary
policy. Money supply growth started to push up price
levels, and a realignment in the dollar parity was
overdue. For the first time ever, the USA recorded a
trade deficit in 1970: the era of huge balance of payment
surpluses had passed. Capital flowed increasingly
out of the dollar, to the higher interest rates and
potentially stronger currencies in Europe.
Without any prior public debate, President Nixon
announced the unilateral suspension of the dollar’s
convertibility into gold in August 1971. This allowed
gold to be finally withdrawn from the exchange rate
system before any devaluation of the dollar, which
would have had to be implemented in the IMF and
41
The collapse of the Bretton
Woods system
42
thus in full sight of the market. In the same year,
many countries started loosening the ties between
their exchange rates and the parities. The aim was to
allow the market to set exchange rates by “floating”
their currencies. The European countries agreed
on an attempt to maintain the parities between their
currencies in the European currency snake.
When the dollar was finally devalued in December
1971, a last-ditch attempt was made to save the
Bretton Woods system. The Smithsonian Agreement
defined new parities. The fluctuation margins of the
currencies to the dollar were expanded to 2.25%.
The official price of gold was increased to USD 38.
Gold convertibility was not reintroduced. Capital still
flowed into Switzerland, Japan, the Netherlands and
Germany. Sterling and the lira were unable to maintain
their parities. Despite further revaluations, the
stronger economies were unable to meet their intervention
obligations. They could only buy dollars by
printing more money, forcing them towards an inflationary
monetary policy. In the spring of 1973, they
finally severed their currencies from dollar parity. The
IMF’s role was transformed into that of monitoring
a global system of flexible exchange rates, approving
regional exchange rate regimes with fixed parities.
The European Economic Community (EEC) was established
in 1958. The members of the EEC achieved
closer economic integration during the 1960s. As the
markets for goods began to converge, the capital
markets moved with them. The economic partners
understood the need for a synchronized monetary
policy. Unilateral economic policies at the cost of the
trading partners should be prevented at all costs. For
this reason, the EEC member States tried to maintain
a system of narrow-band parities before the collapse
of the Bretton Woods system. As far as possible, the
currencies fluctuated together, with additional external
margins – especially against the dollar. If one currency
changed against the USD, all other exchange
rates were realigned against the USD accordingly,
European monetary
regimes: the currency
snake and the EEC
giving rise to the term “currency snake.” The system
was the forerunner of the European Monetary
System (EMS), established in 1979.
The establishment of the EMS anchored the currency
snake in a settlement currency, the ECU – European
Currency Unit. The EMS replaced the fixing of all currencies
to a single benchmark, for example gold, by a
basket of currencies consisting of the member currencies.
The relationship between the currencies
contained in the basket was defined. Adding up the
member currencies results by definition in exactly
1 ECU. The composition of the currency shares in the
ECU at that time had been in existence since 1989
until the end of 1998. As a unit of account, the ECU
was used to set the central rates of the EMS member
currencies. The weighting of the currencies originally
reflected the relative size of the country, based mainly
on gross domestic product and the volume of trade.
They then reflected realignments to the central rates.
Currencies which joined the EMS after 1989 were
no longer weighted in the ECU basket. Instead, a
43
The EMS and the ECU
Calculation of the ECU and parities in the EMS
Currency Share of the Weighting Central rate DEM rate
currency in (12/97) 1 ECU =
1 ECU (12/97)
DEM 0.6242 32.08% 1.94583 –
FRF 1.332 20.14% 6.614 3.35
NLG 0.2198 9.87% 2.22661 1.13
BEF 3.301 8.10% 40.7642 20.63
LFR 0.130 0.32% 40.7642 20.63
ITL 151.8 7.84% 1937.16 –
DKK 0.1976 2.63% 7.52606 3.81
IEP 0.008552 1.12% 0.763225 0.41
GBP 0.08784 13.12% 0.669259 –
GRD 1.440 0.46% 310.863 –
ESP 6.885 4.12% 167.119 85.07
PTE 1.393 0.69% 201.994 102.51
44
Margins and intervention
obligations
direct parity was set corresponding to the exchange
rate to the ECU or the euro. As in all fixed rate
systems, bilateral parities could be derived from the
central rates.
In the EMS, the exchange rate could only fluctuate
around the bilateral central rates within a set margin.
The goals of the EMS were to ensure exchange rate
stability and the economic convergence of the member
countries, while at the same time keeping inflation
rates low. To achieve this goal, the EMS margins
were defined with a spread of ±2.25% around the
central rate, which was later expanded to ±15%. As
in the Bretton Woods system, the upper and lower
bands denoted the central bank intervention points.
In the EMS, the central banks were obliged to underpin
the value of the currency against all other member
currencies. Normally, a currency fluctuated within
the band around the central rate, unless “disruptions”
systematically pushed it towards the edge of its band.
The central bank of the weaker currency had to intervene
at the latest when the edge of the band was
reached by selling currency reserves against its own
currency. If the currency reserves were insufficient,
the central banks of the weaker currencies could borrow
funds from the central banks of the stronger currencies.
This asymmetrical intervention mechanism
was a major factor contributing to the need to orient
the monetary policy of the member countries to the
strongest currency. Intervention normally only occurred
in an invisible interim band. Such interventions
meant that fewer reserves had to be used in support of
buying operations, and the foreign exchange market
was deterred from speculating. If any disruption caused
a permanent shift in purchasing power, the parity could
be realigned. This was done by changing the central
rate of a currency to the ECU. If one parity was
changed, then obviously all other parities in the parity
grid of the currency concerned had to be changed as
well.
This chart of the DEM/FRF exchange rate and its fluctuation
bands (see below) illustrates clearly that even
after the introduction of the EMS, there is no evidence
at all of any long-term fixed exchange rate. The
frequency of parity realignments did not decline until
the mid-80s.
In the early phase, the EMS was accompanied by frequent
parity realignments. Due to its strength and
the reputation of the Bundesbank, at that time one of
the most independent central banks in the world, the
DEM emerged as the anchor currency. In addition,
the Bundesbank held the largest currency reserves
and was thus in a position to be able to support
potentially any exchange rate. This gave the other
currencies an opportunity to latch onto the DEM, with
its stable inflation, and thus import monetary stability.
In France, for example, the rate of inflation dropped
45
4.0
3.5
3.0
2.5
2.0
1.5
1.0
1960 1965 1970 1975 1980 1985 1990 1995
DEM/FRF
upper band
lower band
DEM/FRF and the development of the EMS
Early phase marked
by gearing of monetary
policy to the DEM
46
from over 14% to around 3% during this period. The
transition to lower inflation rates was also accompanied
by greater fiscal discipline. The abrupt halt to
the extremely rapid rise in the dollar and the subsequent
strengthening of the DEM in 1985 resulted in
further parity shifts.
From 1987 to the beginning of the 1990s, there was
a period of true stability, marked by the convergence
of the economies and harmonization of monetary
policy. However, the sudden end of the Cold War
with German unification in 1990 was bound to have
an effect on exchange rates. German unification
brought with it a fundamental change in the economic
and monetary policy of the anchor country. As a
result of the decision on transfers to eastern Germany,
German fiscal policy was forced to steer a distinctly
more expansionary course, while monetary policy
tried to combat the consequences of the overinflated
money supply following monetary union in Germany.
The exceptionally high level of capital spending
needed in eastern Germany also played its part in
pushing up interest rates in Germany. It was inevitable
that the DEM had to become more appealing,
to be able to attract capital. The result was a crisis in
the EMS in September 1992. The GBP and the ITL left
the exchange rate mechanism and floated freely on
the market. Other currencies could only be supported
by massive shifts in reserves. When another crisis
loomed in 1993, the EMS countries decided to allow
a new convergence phase, and the bands were
widened to ±15%.
At the latest when the two Germanys came together,
it had become clear to even the most ill-informed
observer that European monetary policy was dominated
by the central bank of the anchor currency, the
DEM. This realization was a driving force behind the
decision by the other members to move to a monetary
union with a new European Central Bank (ECB).
The Maastricht Treaty came into force in November
Stability phase at the end
of the 80s and the EMS
crisis after reunification
in Germany
The Maastricht Treaty and
monetary union
1993. It governed the transition to European Economic
and Monetary Union (EMU): the harmonization
of monetary policy in the European System of Central
Banks (ESCB) and the introduction of the euro as a
pan-European currency. Criteria governing the economic
situation of the member states were formulated
in the Maastricht Treaty as guidelines for the
transition to EMU. These convergence criteria aim to
ensure that the transition to a common monetary
policy runs as smoothly as possible. The following
years were marked by attempts by all member States
of the European Union to meet these convergence
criteria.
Within a monetary area, a common currency eliminates
the uncertainties which cause exchange rate
fluctuations in international trade transactions. Externally,
trade is still exposed to the fluctuations of flexible
exchange rates. Whereas in the European Union,
it was and is evident that efforts were being made to
avoid these fluctuations, at least for most of the volume
of trade, Swiss monetary policy was still driven by
the wish to remain independent. In fact, the role of
the CHF far exceeds the importance of Switzerland in
the global economy. Although Swiss gross domestic
product only accounts for around 1% of global
income, the CHF is still the sixth most important
trading currency in the world.
Example:
Bank for International Settlements (BIS)
currency turnover statistics
Switzerland has also been able to retain its status
as a currency dealing centre. Despite the growing
concentration of European foreign exchange dealing
in London, Switzerland is still in third place, and
a clear concentration on Zurich is evident within the
country itself. The following chapter describes how
foreign exchange dealing is handled in practice.