Foreign Currency Exchange and Risk

This article focuses on the rise and fall of the Bretton Woods (agreement) system. There will be a discussion of the role of the US dollar during this period as well as the role of the International Monetary Fund. The article will conclude with an explanation of how the Bretton Woods system ties into the study of International Political Economy.

Keywords Berlin Wall; Bretton Woods (agreements) system; Capitalism; Cold War; International Monetary Fund (IMF); International Political Economy; Liberalism; Marxism; Mercantilism; World Bank

Finance > Foreign Currency Exchange & Risk

Overview

Bretton Woods System

It was at the 1944 Bretton Woods International conference that a system of fixed exchange rates was adopted. In addition, the International Monetary Fund was established and charged with maintaining stable exchange rates at the international level. The Bretton Woods (agreement) system was concerned with developing and implementing the rules and regulations for global commercial and financial transactions. The International Bank for Reconstruction and Development (now known as the World Bank) was established as a result. This was the first effort to create a system that would control monetary dealings between independent nation-states. The greatest accomplishments of the Bretton Woods (agreement) system occurred when each country agreed to implement a financial policy that would maintain the exchange rate of its currency as a fixed market price in terms of gold. The International Monetary Fund had the ability to create connections between momentary imbalances of payments. Unfortunately, the arrangement disintegrated in 1971 as a result of the United States' suspension of convertibility from dollars to gold. The system was dismissed, and in its place, a method of floating exchange rates was initiated.

When there is a reference to the Bretton Woods system, most are referring to the international monetary regime that existed between the 1940s and the early 1970s. This system set precedent. It was the first attempt at a "fully negotiated monetary order intended to govern currency relations among sovereign states. This regime was designed to combine binding legal obligations with multilateral decision-making conducted through an international organization, the IMF, endowed with limited supranational authority" (Cohen, n.d., par. 1). The approach was built on constant and changeable exchange rates. Three of the most significant points of the agreement were:

  • When a country signed the agreement, it was agreeing to submit their exchange rate to international disciplines, which implied that the country would surrender its national sovereignty to a global corporation.
  • A nation wasn’t required to deflate the domestic economy when it faced chronic BP deficits.
  • The dollar was the standard to which all other currencies were pegged. However, it should be noted that the United States “did not have the authority to set the exchange rate between the dollar and any other currency” (The Bretton Woods System, n.d., ¶ 4).

The Role of the US Dollar

As mentioned in the third point mentioned above, the dollar became the dominant currency. In the 1950s, the United States became the foremost reserve nation, and the dollar replaced the worth of gold as a crucial and prominent global reserve advantage. However, it should be noted that this development was not planned; “all of the non-Communist countries maintained a stable relationship between their currencies and the dollar through the British pound; and the United States balance of payments was more important than those of other countries because other countries were holding the US dollar as the principal reserve asset” (The Bretton Woods System, n.d., “The Role of the US Dollar”).

During this period, the United States “was the dominant world power. As a result, over half of the international money transactions were financed in terms of the dollar. In addition, the United States produced more than half of the world output and owned about one third of the gold in the world. As the Bretton Woods system evolved, the reserves of most countries became a mixture of gold and dollars. Therefore, the US dollar became increasingly more important. Unfortunately, the United States was unable to eliminate increasing trade deficits, which eventually undermined the Bretton Woods system” (The Bretton Woods System, n.d., “The Role of the US Dollar”).

Application

International Monetary Fund

The establishment of the International Monetary Fund (IMF) and the World Bank is probably one of the most important success stories for international economic cooperation. During the last sixty years, there have been many changes in terms of the political and economic climate on a global level, which have caused the world's top international financial institutions to shift in terms of how they operate their businesses. Given the number of financial crises that have surfaced during the last ten years, many scholars and practitioners in the field have called for a reform in how the international financial system is structured. These crises have exposed the weaknesses of the international financial system and highlight the fact that globalization has pros (benefits) and cons (risks).

Goals of the IMF

“The IMF was established to provide member countries with the necessary funds to cover short-term balance of payments problems. The Fund in turn received resources from members who were allotted quotas. Once a country enters the Fund, it receives a par value of its currency expressed in terms of gold or in terms of the US dollar using the weight of gold in effect on July 1, 1944 ($35 per troy oz). All exchange transactions between member countries were to be effected at a rate that diverged not more than 1% (which approximates gold import/export points) from the par values of the respective currencies” (The Bretton Woods System, n.d., “Contents of the Articles of Agreement”).

The IMF continues to diligently work at providing continuous improvement in practices that affect many sectors. For example, this body continues to:

  • Encourage members to provide public press releases that would detail the IMF Executive Board's evaluation of a nation's finances and policies.
  • Encourage members to provide information about the policies in place regarding the following and restoring of financial stability under the IMF regime.
  • Help countries implement guidelines, such as the Reports on the Observance of Standards and Codes, that will evaluate a nation’s development in practicing globally accepted standards.
  • Address gaps in regulatory standards through the Basle Committee on Banking Supervision.
  • Encourage members to put procedures in place when they are not experiencing any problems so that they are not responding to a crisis. It's an opportunity to be proactive versus reactive.
  • Help countries evaluate their obvious weaknesses and decide which exchange rate program is most appropriate for their needs.

Viewpoint

International Political Economy (IPE)

Many IPE researchers have highlighted the significance of the relationship between economic and political factors with regard to international relations. IPE scholars are interested in the Bretton Woods system because of its significance in providing the foundation for the development of formal regime theory. The Bretton Woods system was a well designed regime that was negotiated and a part of the IMF. "The circumstances of the system's birth and life cycle offered scholars invaluable material for assessing the relative importance of diverse variables in promoting or inhibiting economic cooperation among governments"(Bretton Wood System, p. 10). The Bretton Woods system demonstrated that a social order could be durable at the international level. This factor provides the significance of the system to the IPE theory.

Influence of Political Factors on Economics

Many IPE scholars will argue that the international economic system and the international political system work in unison. Economic partnerships are determined by political and diplomatic relationships and vice-a-versa. According to Spero (1990), political factors affect economic outcomes in three ways, and they are:

  • The political system shapes the economic system because the structure and operation of the economic system is determined by the structure and operation of the international political system. One could see the influence of the international political system on the international economic system by reviewing the political developments during three periods of time in history. The three periods are nineteenth-century imperialism, the post-World War II era of cold war between the Soviet Union and the Western free world led by the United States, and the post-Berlin Wall demolition and the demise of the Soviet Empire era (Phatak, Bhagat, & Kashlak, 2005).
  • Period 1: Nineteenth-century imperialism and mercantilism were driven by two major political factors: The powerful nation-states in Europe (i.e. the United Kingdom, France, Germany and Holland) who had equal military power, and; nationalism practiced by these nation-states. These countries encouraged their citizens to practice and participate in activities which enhanced national pride, national identity, self-sufficiency, wealth and economic power. Cooperative relations between nations were not popular. Each country wanted to promote itself. Both of these two factors led these nation-states to pursue empire building, which encouraged colonialism in Asia, Africa and Latin America. The objectives of the nation-states were to obtain raw material and minerals from the colonies, process the goods into finished products in their home countries, and market the products in the colony markets. The nation-states sought to accumulate wealth and power so that their citizens could have full employment at the expense of colonized countries whose markets and production were controlled by the nation-states. The European nation-states divided the world into parts that were controlled by each. The British controlled most of western and southern Asia and parts of Africa. The French controlled Southeast Asia and northwest Africa. The Dutch controlled Indonesia and parts of Central and South America, and the Germans controlled parts of Western Africa. Wars broke out between the different nation-states as each attempted to take control of the other's territory. The British and French fought for control of India, and the British and Dutch fought for control over parts of Africa. European imperialism determined trade and investments. As a result, the political system was controlled by colonialism and empire building. Period 2: As the imperialist system ended after World War II, the United Kingdom's dominance in the West came to an end. However, two other superpowers emerged — the United States and the Soviet Union. A new political and economic system developed as the result of the rivalry between these two countries. The new political system was bipolar and hierarchical. The United States led the West and Japan. The Soviet Union led the Soviet bloc in the East, which comprised of countries behind the Iron Curtain. The developing countries in the third world remained politically subordinate to their colonial mother countries. The United States and the Soviet Union battled in what was known as the Cold War. This political system determined the post-World War II international economic system. There were two different economic systems. The United States and the West supported a capitalist system, which encouraged free enterprise and free market economic systems. The Soviet Union and the East supported a Socialist/Marxist economic system, which called for a centralized economy controlled by the government where citizens were not allowed to have private property. Period 3: There was another change in the late 1980s and 1990s as the post-World War II international economic system crashed. Poland and Hungary began to support a democratic state, the Berlin Wall fell, and the Soviet Union broke up. Countries that once supported the socialist model began to embrace capitalism. Russia became a democracy, and China, Vietnam and India opened their markets to foreign investments and trade.
  • Political concerns often shape economic policy because economic polices are frequently dictated by overriding political interests. Internal political processes have a part in the determination of national economic policy. Economic policy is the outcome of the political bargaining process that is responsible for resolving the conflict over the outcomes preferred by different groups, each representing distinct and often conflicting interests. The overriding political and strategic interests of a nation help determine its international economic policy, which results in international economic policy becoming a tool to fulfill a nation's strategic and foreign policy objectives. International economic policy can sometimes be beneficial to multinational corporations (MNCs), especially if it is being driven by political considerations.
  • International economic relations themselves are political relations because both types of interaction are processes by which state and non-state players attempt to manage their conflicts and cooperate to achieve common goals. International economic relations may be viewed as the outcome of the political process involving the management of conflict and cooperation over the acquisition of scarce resources among the various members of the political system in the absence of a centralized world government. Both international and political interactions range from conflict to cooperation. The conflict among the members of the political system may be rooted in a struggle for greater power and national sovereignty. National sovereignty is associated with national wealth. A country that is not independently wealthy becomes dependent on others and loses some of its national sovereignty. Therefore, most countries seek wealth in a political system, and the pursuit of this goal in the presence of scarce resources frequently leads to conflict among the system members.

Foundations of International Political Economy

IPE is composed of a range of theoretical frameworks, and the foundations are established based on ideologies between states and markets. "The key difference between competing theoretical claims in IPE relates to the normative position that scholars adopt on the preferred mix of values to be embedded with the state-market nexus" (Murphy & Tooze, 1991, p. 2). Strange (1988) categorized these values into four domains which were safety, affluence, independence and justice. The most favored blend of these four values changes depending on the theoretical beliefs of the scholar (Watson, 2005). The different beliefs include:

Conclusion

It was at the 1944 Bretton Woods International conference that a system of fixed exchange rates was adopted. In addition, the International Monetary Fund was established and charged with maintaining stable exchange rates at the international level. The Bretton Woods system was charged with developing and implementing the rules and regulations for global commercial and financial transactions. The International Bank for Reconstruction and Development was established as a result. It was the first effort at creating a system that would control financial relations between independent nation-states.

The program was associated with stable but changeable exchange rates. Three of the most significant points of the agreement were:

  • When a country signed the agreement, it was agreeing to submit their exchange rate to international disciplines, which implied that the country would surrender its national sovereignty to an international organization.
  • A nation wasn’t required to deflate the domestic economy when it faced chronic BP deficits.
  • The dollar was the standard to which all other currencies were pegged. However, it should be noted that the United States lacked the authority to establish the exchange rate between the dollar and other forms of currency (The Bretton Woods System, n.d.).

“The IMF was established to provide member countries with the necessary funds to cover short-term balance of payments problems. The Fund in turn received resources from members who were allotted quotas. Once a country enters the Fund, it receives a par value of its currency expressed in terms of gold or in terms of the US dollar using the weight of gold in effect on July 1, 1944 ($35 per troy oz). All exchange transactions between member countries were to be effected at a rate that diverged not more than 1% (which approximates gold import/export points) from the par values of the respective currencies” (The Bretton Woods System, n.d., “Contents of the Articles of Agreement”).

The Bretton Woods system was a well designed regime that was negotiated and a part of the IMF. "The circumstances of the system's birth and life cycle offered scholars invaluable material for assessing the relative importance of diverse variables in promoting or inhibiting economic cooperation among governments"(Bretton Wood System, p. 10). The Bretton Woods system demonstrated that a social order could be durable at the international level. This factor provides the significance of the system to the IPE theory.

Terms & Concepts

Berlin Wall: A great barrier that enclosed the entirety of West Berlin, closing off any access to East Germany from West Berlin. Established between 1961 and 1989, the Berlin Wall acted as a representation of the division and separation of East and West Germany following the Cold War.

Bretton Woods (Agreements) System: An agreement made in 1944 that established a fixed exchange rate in terms of gold for all forms of the most prominent currencies. The arrangement took place in Bretton Woods, New Hampshire, and occurred at the same time as the creation of the International Monetary Fund.

Capitalism: A financial system where the modes of production and dispersion are possessed through private or corporate ownership and where the growth is directly related to the gathering and reinvesting of profits acquired in free markets.

Cold War: The period of political anxiety and military antagonism that occurred between the Soviet Union and the United States after World War II. The rivalry is not considered to be a full-blown war.

International Monetary Fund (IMF): An institution of over 180 nations who agreed to advocate worldwide financial cooperation as well as the wellness and endurance of the international monetary system. Every nation within the IMF donates by paying quotas, which emulate the nation's role in the global economy and decide what its voting power will be (the United States has a 17% voting stake, for example). The IMF supports worldwide economic growth by granting loans and technical assistance to countries in need. The organization was established in 1944 with the help of 45 nations who wished to avoid the issues and uproar experienced during the Great Depression.

International Political Economy: A social science and historical perspective that analyzes international relations in combination with political economy. It is about the consequences on an international level of the interaction between the state (politics) and the market (economics).

Liberalism: The belief that focuses on the influence of markets in increasing aggregate social welfare. This form of global political economy follows the idea that market surpluses are not possible over time and striving for them only impedes upon any chance for effective production and sales.

Marxism: The philosophy of international relations that emphasizes such relations as being a constant battle between wealthy and impoverished social classes instead of a scramble between national states and national governments.

Mercantilism: The idea that global political economy concentrates primarily on the influence of state power in gathering trading arrangements for the states’ advantage. Mercantilism follows the belief that states should strive to promote and pursue maximized exports and minimized imports.

World Bank: An organization whose focus is on foreign exchange reserves and the balance of trade.

Table 1: Beliefs

Legend for Chart: A - Philosophy B - Beliefs A B Liberalism Focuses on how the regulatory authorities of the state allow individuals to establish systems of exchange that operate on the basis of free will. It is assumed that individuals can organize the demand and supply sides of commodity markets, which would create a coherent economic structure. A Panglossian position is desired, and occurs when the people equate free will with a prosperous order based on market exchange. Marxism Challenges the liberalism view. Marxists argue that as long as wealth is generated by a capitalist economy, individuals will never have free will. Rather, they are subordinates of the system. Wealth is linked to surplus value extraction, which requires the public authority to exploit the people in order to generate production. The system only works for a few people — the elite. Distributive justice is not possible in a market that does not advance the majority. Feminism Focuses on the exploitation of a capitalist economy. However, their focus is not on class. It's on gender assumptions. Feminism supporters assert that women should be able to fully participate in the economy without constraints of a male dominated economic. In addition, they should receive equal pay for equal work. Mercantilism This philosophy does not agree with the three positions listed above. These followers do not focus on the social systems established to create wealth. Their position is that wealth creation is a means, not an end. Scholars support strategies that strengthen the capacity of a state through a dynamic and successful economy. Their major position is that: Strong states are the only entities that can provide security for their citizens, and; only secure societies can introduce a legal framework that allows for justice claims to be rectified in a fair and objective manner. Economic management is subordinate for the preservation of existing state structures. Ecology Ecologists share the same concern for security issues as mercantists, but in a different way. Ecologists highlight the environment as a security issue, and they believe the process of international economics management should not take place on a national level. Rather, it should be in line with global interest which promotes protecting the earth's shared ecosystem. The economy is the focus of environmental issues. Prosperity is based on production systems that view nature as a commodity. Neo-Gramscian Focus on the impact of market ideology in the structuring of everyday life. This philosophy has Marxist origins, and highlights both the exploitative nature of capitalism as well as the strategic use of the state's practice of putting capitalist production above justice. Market ideology emphasizes how the economy provides the material basis of identity and the individual's sense of where they fit into society (i.e. worth is based on economic position). Since capitalism is the acceptable view of the majority, it becomes hard for individuals to use alternative forms of defining self. There is a sense of status quo and no challenge to the way the market operates. Post-structuralism Also focuses on the ideology of everyday life. However, they do not believe that the economy provides a material basis of everyday life. Neo-Gramscians highlight the institutional coherence that capitalist production has on society, but post-structuralists do not believe that an institutional unity exists. Rather, emphasis should be placed on the analysis of how identities are formed through the normalization of economic viewpoints. The state is unable to sustain conditions that lead to a prosperous or just society because such a condition does not exist. The objective of post-structuralists is to understand how states evaluate economic ideologies and determine their feasibility for everyday life (Watson, 2005, p. 22-25).

Bibliography

Cohen, B. (n.d.). Bretton woods system. Retrieved September 19, 2007, from 0http://www.polsci.ucsb.edu/faculty/cohen/inpress/bretton.html.

Murphy, C., & Tooze, R. (1991). Introduction. In C. Murphy & R. Tooze (eds.), The New International Political Economy. London: Lynne Reener.

Phatak, A., Bhagat, R., & Kashlak, R. (2005). International management. New York, NY: McGraw-Hill/Irwin.

Spero, J. (1990). The politics of international economics relations, (4th ed.). New York, NY: St. Martin's Press.

Strange, S. (1988). States and markets: An introduction to international political economy. London: Pinter.

The Bretton Wood System (n.d.). Retrieved on September 19, 2007, from http://www.econ.iastate.edu/classes/econ355/choi/bre.htm.

Watson, M. (2005). Foundations of international political economy. New York, NY: Palgrave Macmillan.

Suggested Reading

Cross, J., Schwartz, M., & Gradwohl, C. (2004). Inflation and foreign currency risks of placing debt in Mexico. Tax Management International Journal, 33, 426-427.

Dominguez, K. E., Fatum, R., & Vacek, P. (2013). Do Sales of Foreign Exchange Reserves Lead to Currency Appreciation?. Journal Of Money, Credit & Banking (Wiley-Blackwell), 45, 867-890. doi:10.1111/jmcb.12028 Retrieved November 27, 2013 from EBSCO online database Business Source Complete with Full Text:http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=88979851&site=ehost-live

Euro adoption to remain policy focus. (2007). Emerging Europe Monitor: Central Europe & Baltic States, 14, 8. Retrieved September 19, 2007, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=26560697&site=bsi-live

Iglesias, E. M. (2012). An analysis of extreme movements of exchange rates of the main currencies traded in the Foreign Exchange market. Applied Economics, 44, 4631-4637. doi:10.1080/00036846.2011.593501 Retrieved November 27, 2013 from EBSCO online database Business Source Complete with Full Text:http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=64903160&site=ehost-live

Kai, S., & Li, N. (2012). Adjusting the Currency Composition of China's Foreign Exchange Reserve. International Journal Of Economics & Finance, 4, 170-179. doi:10.5539/ijef.v4n10p170 Retrieved November 27, 2013 from EBSCO online database Business Source Complete with Full Text:http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=82577341&site=ehost-live

Lustig, H., & Verdelhan, A. (2007). The cross section of foreign currency risk premia and consumption growth risk. American Economic Review, 97, 89-117. Retrieved September 19, 2007, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=24362768&site=bsi-live

Practical tips in an uncontrollable environment. (2007). Government Procurement, 15, 24-25. Retrieved September 27, 2007, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=26387791&site=bsi-live

Ramona, O. (2013). THE US DOLLAR, THE EURO, THE JAPANESE YEN AND THE CHINESE YUAN IN THE FOREIGN EXCHANGE MARKET - A COMPARATIVE ANALYSIS. Studies In Business & Economics, 8, 102-107. Retrieved November 27, 2013 from EBSCO online database Business Source Complete with Full Text:http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=91964969&site=ehost-live

Sorensen, S. M., Zhaohui, X., & Kyle, D. L. (2012). Currency Translation's Effects on Reported Earnings and Equity: An Instructional Case. Issues In Accounting Education, 27, 837-854. doi:10.2308/iace-50081 Retrieved November 27, 2013 from EBSCO online database Business Source Complete with Full Text:http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=91713079&site=ehost-live

Trevino, L., & Thomas, S. (2001). Local versus foreign currency ratings: What determines sovereign transfer risk? Journal of Fixed Income, 11, 65-77.

Essay by Marie Gould

Marie Gould is an Associate Professor and the Faculty Chair of the Business Administration Department at Peirce College in Philadelphia, Pennsylvania. She teaches in the areas of management, entrepreneurship, and international business. Although Ms. Gould has spent her career in both academia and corporate, she enjoys helping people learn new things — whether it's by teaching, developing or mentoring.