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Ask Mint | IMF, focusing on market stability, keeps a watch on exchange rates

Ask Mint | IMF, focusing on market stability, keeps a watch on exchange rates
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First Published: Sun, Nov 16 2008. 11 54 PM IST

Updated: Sun, Nov 16 2008. 11 54 PM IST
It is easy to identify a killer carrying a smoking gun in his hands. But in international trade and commerce, most of the wars take place without any shots being fired. The culprit may be hiding behind the smokescreen of a strictly controlled foreign exchange market in which the exchange rates of currencies do not reflect the fundamentals. For such situations, we surely need a Dr Fixit to prevent currency wars among nations and to ensure that the world economy continues to prosper amid recurring financial crises. Where does the International Monetary Fund (IMF) fit into all this? Let’s find out.
Jinny: Hi, Johnny! Why do you look confused? Do you have any new questions in your mind?
Johnny: We have talked so many times about the different push and pull pressures of the foreign exchange market. Can you tell me about the role of the IMF in all this?
Jinny: IMF was created in 1945 after several rounds of discussions among the founding members at Bretton Woods, New Hampshire, in the US. The World Bank was also born out of the same conference. Since both these institutions share their place of birth, they are also called the Bretton Woods sisters. But both institutions have different mandates.
While the World Bank is more focused on long-term goals such as poverty alleviation and human welfare, IMF is more focused on maintaining stability in the international financial markets. That’s obviously not an easy job. International financial instabilities most often have roots in domestic factors. So IMF has to keep a close watch on all the domestic factors in member countries that can have an effect on the world economy. It monitors exchange rates and provides short-term financing for balance of payment adjustments.
In addition, IMF also provides technical assistance to member countriesto improve their financial systems.
Johnny: IMF surely does seem to do a lot of good work. But tell me, Jinny, what prompted world leaders to form an institution such as IMF after World War II?
Jinny: The idea of forming an institution such as IMF was born out of the experiences prior to the war, when trigger-happy governments freely indulged in a spate of currency devaluations in pursuit of what was called “beggar thy neighbour” policies.
During the Great Depression, countries tried to shift the burden of their economic hardship by artificially making their imports costlier and their exports cheaper by devaluing their currency. They thought cheaper exports would boost demand for domestic goods, leading, in turn, to greater production and lower unemployment at home. But the actual experience proved that when all countries are following the same short sighted policy, all of them collectively end worse off.
By the end of World War II, world leaders had realized that for long-term economic prosperity, it was important that countries conduct their international trade and commerce with utmost fairness. IMF was created to keep a watch on the exchange rates of countries so that no country could take unfair advantage by keeping its currency artificially overvalued or undervalued.
Initially, the Bretton Woods system relied on a modified version of the gold standard under which the member countries agreed to keep their exchange rates fixed with the US dollar by maintaining US dollars as their reserve currency.
The US government, on its part, agreed to maintain a parity of one dollar with 35 ounces of gold. So, keeping a reserve of the US dollars was as good as keeping a reserve of gold. Any change in the exchange rate by member countries required IMF’s prior approval and could be carried out only for a very sound reason.
However, this system of fixed exchange rates came to an end in the 1970s when the US abandoned the parity of US dollars with gold. Since then the task of IMF has become even more challenging.
Different countries now follow different exchange rate systems. While many countries follow a free-float system in which the market forces of demand and supply determine the exchange rate of currencies, there are still many countries that try to keep their exchange rates at a particular level through market interventions.
IMF now has to keep a closer watch. Large deviations of exchange rates from the fundamentals of the economy can make a country vulnerable to speculative attacks and lead to a balance of payment crisis.
Johnny: What role does IMF play if any country is facing a balance of payment crisis?
Jinny: IMF acts as “lender of last resort” for countries facing a balance of payment crisis. The aim is to shorten the duration of the crisis and prevent it from spreading to other countries.
Different borrowing facilities of IMF have different names. The most common short-term financing is called “standby arrangements” and a longer-term financing is called “extended fund facility”. Borrowings from IMF come with the famous IMF conditionalities of dos and don’ts for the borrowing country.
Johnny: That’s true, Jinny. Borrowings in an hour of need always come with strings attached. I will ask you about some of the famous IMF conditionalities some other time.
What: The International Monetary Fund, or IMF, consists of representatives of the 185 countries that make up its global membership.
Who: Countries take emergency assistance from IMF by purchasing foreign exchange from IMF reserve assets.
How: IMF resources come mainly from the quotas that each country deposits when it joins IMF.
Where: IMF is headquartered in Washington, DC.
Shailaja and Manoj K. Singh have important day jobs with an important bank. But Jinny and Johnny have plenty of time for your suggestions and ideas for their weekly chat. You can write to both of them at realsimple@livemint.com
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First Published: Sun, Nov 16 2008. 11 54 PM IST