During this era the exchange rate was stable. Prior to World War I, a country’s monetary unit was defined in terms of certain weight of gold.
During this era London, a financial centre for 90 percent of world trade, dominated the international finance. Sterling was the sole reserve currency, as it was convertible into gold at the Bank of England. Interestingly the Bank of England had only two to three percent of gold backing to the actual money supply.
ii. The two World Wars:
A Flexible Exchange System – With the outbreak of the World War I, the currencies values highly fluctuated in terms of gold, especially in the early 1920s. After the First World War, the UK lost its dominance and the US also emerged as a leading creditor.
Many attempts were made to restore the gold standard – by the US in 1919, the UK in 1925 and France in 1928. But the great Depression of 1929-32, did not allow them to continue. To increase exports, country after country devalued it currency and resorted to exchange controls too.
iii. The Bretton Woods Agreement:
Fixed Exchange Rates (1945-73) – The monetary disorder faced during the previous era of 1914-45 forced the countries to devise some way to go in for fixed exchange rate system. In 1944, the Bretton Woods Agreement was signed by 44 countries to create a fixed exchange rate system. Under this system, each currency was fixed by government action within a narrow range of values relative to gold or some currency of reference.
The US dollar was used most frequently as a reference currency to determine the relative price of all other currencies. At Bretton Woods Conference it was also felt that there is need for a new world monetary system and accordingly IBRD (for long-term development and reconstruction loans) and IMF (for short-term balance-of- payments adjustment loans) were created for reconstruction of war ravaged world economy.
The main objective of this new order was to help expansion of international trade and the use the US dollar as a standard of value. The Agreement also called for stability of exchange rates through the concept of fixed but adjustable rates. The main features of the system were the US was to maintain the value of gold at $35 per ounce and that each country was to define its currency in terms of gold or dollars.
Each currency was permitted to fluctuate within + 1 percent of the par value through buying or selling foreign exchange and gold as needed. However, if a currency became too weak to maintain its par value, it was free to devalue its currency up to 10 percent without formal approval of the IMF.
iv. Bretton Woods System’s Break Down:
By 1971, the large adverse balance of payments position of the US, which began in late 1940s, exploded. It led to depletion of US gold and other reserves during 1960s and early 1970s. Under such circumstances, the US without any IMF consultation suspended the conversion of dollars into gold, permitted the dollar to float vis-a-vis other currencies, imposed a 10 percent surcharge on most imports, and imposed direct controls on wages and prices. Dollar was devalued in 1971 and again in 1973. Other countries also followed the US in terms of devaluation and exchange controls.
In order to solve these problems the Group of Ten (US, Belgium, England, France, West Germany, Italy, Japan, the Netherlands, Sweden, and Switzerland) entered into an agreement (The Smithsonian Agreement) whereby the US agreed to devalue the dollar from $35 per ounce to $38.
In return other countries agreed to revalue their currencies against the dollar. In turn other countries agreed to revalue their currencies and to expand the trading band from 1 percent to 2.25 percent. But this agreement came to an end in March 1973.
The Floating System:
Post-1973 – With the collapse of the Bretton Woods Agreement Exchange rates have been floating every day. The volatile and less predictable exchange rates were due to the impact on the new monetary order by the events – 1973 oil crisis; the instable US dollar during 1977-78 (loss of confidence), during 1981-85 (strengthening), during 1985-88 (sinking), during January to June 1989 (strengthening);diversification of monetary reserves by central banks after 1979; the dissolution of the Soviet Union in December 1991; Asian Financial crisis in 1997-98; European currency crisis in September 1992 and in July 1993; the creation of a single European market in 1993, a 40 percent depreciation of the Mexican peso between December 1994 and January 1995; currency crisis in emerging market economies (Russia in 1998, Brazil in 1999, Turkey in 2001, and Argentina and Venezuela in 2002); the replacement of Eurozone currencies with the euro in 2002; appreciation of Chinese Renminbi in July 2005; surging Oil prices till late 2008 and decline thereafter; global meltdown; and sovereign debt crisis in Euro zone leading to surge in gold prices.
Since 1973, most countries of the world have permitted their currencies to float, with frequent central bank intervention to keep average exchange rate at a level suitable to their economic policy.
The IMF members formalised the floating exchange rates in the Jamaica Agreement in 1976.
Since there are different currencies in different countries and they have different values in terms of each other, it would be logical to study the exchange rate regimes.
Financial market is a mechanism that allows people to buy and sell (trade) financial securities (such as stocks and bonds), commodities (such as precious metals or agricultural goods), and other fungible items of value at low transaction costs and at prices that reflect the efficient-market hypothesis. Financial markets facilitate raising of short-term funds (money market), capital (in the capital markets), transfer of risk (in the derivatives markets), and international trade (in the currency markets).
Financial market is a very general term. The complete global economy has different types of financial markets. Financial markets are normally classified as money or capital markets and primary or secondary markets. The financial markets can be divided into the following:
i. Money markets, which provide short term debt financing and investment.
ii. Capital markets which consist of:
a. Stock markets (Primary Market), which provide financing through the issuance of shares or common stock, and enable the subsequent trading thereof (Secondary Market).
b. Bond markets, which provide financing through the issuance of bonds, and enable the subsequent trading thereof.
iii. Commodity markets, which facilitate the trading of commodities.
iv. Derivatives markets, which provide instruments for the management of financial risk.
v. Futures markets, which provide standardised forward contracts for trading products at some future date; see also forward market.
vi. Insurance markets, which facilitate the redistribution of various risks.
vii. Foreign exchange markets, which facilitate the trading of foreign exchange. Another way of classifying the financial markets can be as under:
Primary and Secondary Markets:
A primary market is the market where companies sell new security issues, either debt or equity, directly to the investors. Net proceeds from the sale of new securities go to the issuing company. The issuing company takes the help of underwriter(s).
A secondary market is a market where existing securities are resold to other investors. These markets are important as they enable investors to buy and sell securities as frequently as they can. A company whose securities are marketable and have liquidity (ability to convert into cash) enjoy lower funding costs, as compared to the ones who do not have an active secondary market.
Exchanges and Over-the-Counter Markets:
Financial markets may be called ‘organised’ (more commonly called as Exchanges) or ‘Over-the- Counter’ (OTC) markets. BSE, NSE, or New York Stock Exchange is part of organised markets.
The securities not listed with any stock exchange are sold and purchased in the OTC market. OTC market has no central trading location. To sell or buy unlisted securities, one has to contact the OTC dealers who ‘make the market’ in such securities.
Normally securities of small or unknown companies’ stocks are traded here. However, of late a growing number of large companies, such as Microsoft, many bank and insurance company stocks, a majority of corporate bonds and preference shares, national treasury and government bonds are also being traded herein.
Money Market and Capital Market:
Money markets are for short-term debt instruments, which have maturities of less than one year. The term money market is used because these instruments are close substitutes for cash.
Capital markets are the markets where intermediate-term and long-term debt and corporate stocks are traded. BSE, NSE, NYSE, NASDAQ are capital markets.
Public and Private Markets:
Public markets are those markets where general public can sell or buy securities through their brokers. BSE or NSE is a public market.
On the other hand, private markets refer to direct transactions between the buying and selling parties. Such transactions are known as private placements. Speed and low transaction costs are the biggest benefits of direct negotiation. However, such securities may not be tradable in stock exchanges. Only large firms may be able to handle private market transactions.
The Derivatives or Futures and Options Markets:
Over the last decade and a half, various financial derivatives have emerged and been transacted in the different markets. Before the proliferation of financial derivatives, foreign exchange forwards was the only derivative instrument active in the forex market.
Chicago Board of Trade is the world’s oldest derivatives exchange and Chicago Board of Options Exchange has’ pioneered the derivatives revolution of modern times. Chicago Mercantile Exchange is the second largest exchange of the World for the trading of futures and option futures. The largest derivatives trading in OTC market is conducted in the UK (double to the US transactions).
The capital markets across the world have been liberalised particularly in the last decade of the previous century and the first decade of 21st century. The liberalisation has been because of the following reasons:
i. Liberalisation leads to better allocation of resources.
ii. Technical enforcement of capital controls has proved to be very difficult and modern means of telecommunication have increased the capacity of traders to circumvent such controls.
iii. Capital controls proved rather ineffective in the long run.
iv. They often seemed counterproductive in the sense that they slowed down the necessary adaptation of the economy.