The International Monetary System: Part I: Mechanism and Operation (Le systéme monétaire

international) (El sistema monetario internacional)

Author(s): Irving S. Friedman
Source: Staff Papers (International Monetary Fund), Vol. 10, No. 2 (Jul., 1963), pp. 219-245
Published by: Palgrave Macmillan Journals on behalf of the International Monetary Fund
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 The International
Monetary
System
Part I: Mechanism and Operation

IrvingS. Friedman*
HE PURPOSE of thispaperis to describetheoperations of the
international monetary systemand to evaluateitsefficacy to meet
existingand foreseeable problems.The attemptis made to put the
essentialcharacteristics of the entiremonetary systemin a realistic
perspective and to lay a betterbasis forstudying and evaluatingpar-
ticularproblems importantly affectedby the operationsofthesystem.1
as
Something complicated as the presentinternationalmonetary sys-
tem cannot,of course,be describedand evaluatedfullyin anything
shortof a lengthy volume.Muchmustbe omitted;in particular, the
historicaldevelopment ofthepresentsystemand somecloselyrelated
subjects,suchas theinternational transmissionofbusinesscyclesand
the functioning of the pricemechanism-especially in the principal
industrialcountries-fall outsidethescopeofthispaper.
The presentis a particularly timein whichto describethe
difficult
international monetary system, becausemuchof it is in ratherrapid
evolution;examplesare the role of the forwardmarketand the
defensesof the system.Institutionsand practicescurrentbefore
WorldWar II have beenimitatedand to someextentreintroduced,
but postwarconditions have made important innovations necessary.
The changesin progress, however, may be added reasonsfortaking
stockof the presentsituationand forseekingto evaluatepossible
futuredevelopments.
The international monetarysystemencompassesmanythings;a
precise and still all-inclusive definitionis mostdifficultto set forth.
It is hoped,however, thata discussionof the following subjectswill
covertheessentialelements neededforan understanding and evalua-
tion of the system: the principalfeaturesof the international
* Mr. Friedman,Director of the Exchange RestrictionsDepartment,is a
graduateof ColumbiaUniversity and was formerlywiththe U.S. Treasury.He is
the authorof ForeignExchangeControland the Evolutionof the International
PaymentsSystem(1958) and of articlesin financialjournals; and a joint author
ofPostwarUJS.EconomicPolicy (1948).
1 This studyis based on the observationsand experienceof the authorover
a considerableperiodof yearsand on discussions
withcolleaguesin the Fund and
withfinancialauthoritiesand bankersin many countries.It is also indebtedto
the writingsof many different authors,includingMessrs. Altman,Coombs,
Holtrop,Jacobsson,Martin,and Roosa. Detailed acknowledgment is not possible.
219

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220 INTERNATIONAL MONETARY FUND STAFF PAPERS

payments system; its elements of flexibilityor adaptability; the

devices available to manage it; and the national and international
defensesor safeguardswhich exist to supportit and to preventits
failure.
Over the years, many differenttypes of monetarysystemshave
been used, at times withoutany consciouschoice having been made.
At present,however,it is not likelythat any systemwould be pursued
more or less by accident and withoutdeliberatechoice. The existing
system has the great competitiveadvantage that it does exist; at
the same time, constant suggestionsfor reforms,and even for the
adoption of entirelydifferent systems,must be expected,since others
can be invented with relative ease. To appreciate this, it is only
necessaryto recollectthe fervorwith whichtrade quotas, discrimina-
of currencieshave been advocated in recent
tion, and inconvertibility
years, while a returnto the internationalgold standardand complete
freedomof tradehas foundequally ferventsupport.
Any modernsystemmust serve purposes regardedas cogent and
relevant for the present and foreseeablefuture. Probably the best
single statementof the purposesof the presentsystemis to be found
in ArticleI of the Articlesof Agreementof the InternationalMone-
tary Fund (IMF), viz., "to facilitate the expansion and balanced
growthof internationaltrade, and to contributetherebyto the pro-
motionand maintenanceof highlevels of employment and real income
and to the developmentof the productiveresourcesof all members
as primary objectives of economic policy."2 The more immediate
purposesof the system,whichare really the agreed ways and means
to achieve the general objectives,are also set forthin ArticleI: the
promotionof exchangestability,the maintenanceof orderlyexchange
arrangementsamongmembers,the avoidance of competitiveexchange
depreciation,and the establishmentof a multilateralsystemof pay-
ments in respect of currenttransactions. To help to achieve these
purposesthe Fund was givenlarge financialresourcesin the hope that
its members,by having resourcesmade available to themunder ade-
quate safeguards,would be able to "correctmaladjustmentsin their
balance of payments without resortingto measures destructiveof
national or internationalprosperity."3By the pursuit of policies
appropriateto these purposes,countrieswould shortenthe duration
and lessen the degree of the disequilibriumin their international
balances of payments.
One obvious fundamentalaspect of the presentsystem,like many
other obvious fundamentalfacts,tends to be neglected: any system
2 International
MonetaryFund, Articlesof Agreement:ArticleI (ii).
3 Ibid.: ArticleI (v).

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 THE INTERNATIONAL MONETARY SYSTEM 221
todaymustbe based on the existenceof nationalgovernments and
nationalsovereignty and on thedelegation of certainpowersto inter-
nationalinstitutions. It can be neither
theextension bycommon usage
of thepracticesof one country(or a fewcountries)northeabolition
ofnationalboundaries forfinancialpurposes.It has to be trulyinter-
national,and any evaluationof a givensystemmustmake some
assumption as to how farnationalgovernments are willingto go in
creatingsupranational institutions
andbeingregulated bysupranational
policiesin the financialfield,and, on the otherhand,how farthey
wishto insistthattheirownfinancial policiesand practicesdominate
theactionsof others.If theunderlying politicalassumptions are such
thatthe systemmightnotbe viablein timesof stress,thisshouldbe
pointedout.
The principalcharacteristics ofthepresentsystemand its elements
of flexibilityare describedbelow.It is hopedto review, in subsequent
articles,the monetarymeasuresthat may be takento managethe
systemand its existing"defenses," and to attemptan evaluationof
the systemincluding, if possible,themannerin whichthedeveloping
countries fitintoit.

Principal Features of the International Payments System

The mainfunction oftheinternational payments systemis to enable
payments to be made to consummate the internationalpurchaseand
sale of goodsand servicesand flowsofcapital.The principalfeatures
discussedbeloware thenatureorusabilityofthecurrencies earnedor
receivedfrominternational the natureor international
transactions,
usabilityof the currencies heldby residents of the countriesissuing
the
them, exchange rate at which currenciesare boughtand sold,the
marketsin whichsuchtransactions takeplace,andtheuse ofreserves.
EXTERNAL CONVERTIBILITY
Most of the worldtradein goodsand servicesis paid forin cur-
rencies4whichcan be freelyexchanged forothercurrencies,including
thatoftheoriginalsupplierofthegoodsor services.Withfewexcep-
tions,the governments of countriesoutsidethe Soviet bloc allow
whenacquiredby nonresidents,
theircurrencies, to be converted into
othercurrencies.Some limitationmay be placed,however,on the
conversionof such currenciesacquiredthroughcapitaltransactions,
such as director portfolio
investments.In thissense,the currencies
4 The word "currencies" is used here to cover all the
many forms of means of
payment actually employed.

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222 INTERNATIONAL MONETARY FUND STAFF PAPERS

earned may be said to be "externallyconvertible"5(i.e., convertible

by persons outside of the countryconcerned) for "currenttrans-
actions" (i.e., not of a capital nature). In practice,an importerof
goods or servicesin a countrywhose currencyis externallyconvertible
is freeto pay the exporterof the goods or servicesin (1) the currency
of the importingcountry(which the exportercan then sell for other
currenciesor can hold in a bank deposit-i.e., a nonresidentconvertible
account-which can later be used for any purpose, includingcon-
version into other currencies),or (2) other convertiblecurrencies
(includingthat of the exportingcountry)obtainedby the importerin
the foreignexchangemarket. The latterkind of paymentmergesinto
internalconvertibility, discussedbelow.
External convertibilitymakes it unnecessaryfor countrieswhose
exchange receipts are very largely in convertiblecurrencies(as are
thoseof the industrialcountries)to discriminate, by means of licensing
in
systems, regard to the currencyused for paymentsforimportsand
invisibles. As a consequence,discriminationhas become much less
importantin internationaltrade, althoughsome remains as a result
of continuedbilateralism;however,bilateral agreements(as well as
other formsof discriminationfor balance of paymentsreasons) are
used primarilyby the developingcountries.While bilateral trading
agreementsare still used to some extentby the industrialcountries,
they are not of major significancein determining the patternof inter-
national trade and paymentsbecause,as a generalrule,thesecountries
do not try to discriminatein favor of particularbilateral partners.
These statementsmustbe qualifiedin respectof recipientsof tied aid.
Althoughthis aid is usually extendedby countrieswhose currencies
are convertible,the recipientcountries,in orderto use it, may have
to resortto some formof discriminationin theirexchangeand trade
policies; thus such aid, taken beyond certain limits, recreates the
economiceffectsof inconvertibility.

INTERNAL CONVERTIBILITY

Internal convertibilityconferson residentsthe same rightto con-

vert their national currencyinto other currencieswhich external
convertibilityconferson nonresidents.AfterWorld War II, countries
whose currencieswere inconvertiblerestoredexternal convertibility
first. Therefore,under presentconditions,if a currencyis internally
5 "External" and "internal"
convertibilityare more or less equivalent, respec-
tively, to "nonresident" and "resident" convertibility,terms used in the literature
on this subject. None of these terms occurs in the Articles of Agreement of the
Fund. (For the Fund terms, see particularly Articles VIII, XIV, and XIX of
the Agreement.)

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 THE INTERNATIONAL MONETARY SYSTEM 223
convertible, it is necessarily externally convertible as well.Residents
of most industrialcountriesdo not yet have completefreedomto
exchangetheirown currency intoforeign currencies at official
rates
of exchange. However, the list of purposes for which foreignexchange
is freely madeavailableto residents has bynowbeengreatly extended.
Whereas,formerly, payments formanyimports of goodsand services
wereseverelyrestricted, existingrestrictions are confined mainlyto
capitalpayments.
The freedomto purchaseforeigncurrencies forcertainpurposes
does not mean,in practice,thatall externally convertible currencies
are used to an important extentto make international payments.
Paymentsare generally madein U.S. dollarsor sterling evenwhenno
residents of the UnitedStatesor the UnitedKingdomare partiesto
the transaction;prices,shippingdocumentsand other contracts,
freight charges, etc.,are frequently expressed in oneofthesecurrencies.
Occasionally,othercurrencies are used,particularly in transactions
between twonon-dollar, non-sterling countries. Payments mayalso be
made by creditingthe convertible currencyaccountof the payee
(or his bank),butifthisis doneconversion whenrequested is usually
into U.S. dollarsor sterling.Gold itselfis used fromtimeto time
to makeinternational settlements, particularly thoseofa governmental
character or betweencentralbanks;however, theuse ofgoldforthese
purposesis relatively infrequent. Part ofthe explanation fortheuse
of theU.S. dollaras a reservecurrency is its convertibilityintogold
at a fixedprice,but its widespread use forinternational payments is
another important recommendation, and this applies even more forcibly
to sterling.It is noteworthy thatduringrecentyears,whentheU.S.
balance of paymentshas been in deficitand therehas beentalk of
dollar"weakness,"the international use of the dollarseemsactually
to have increased.The poundsterling also,despitetheUnitedKing-
dom'sbalanceof paymentsdifficulties, remainsa widelyused inter-
nationalmediumofpayment.
Countries exercising controls overcapitaltransactions findit difficult
to refrainfromscreening paymentsforall purposes,includingpay-
mentsforimports and invisibles, in orderto prevent disguisedcapital
flight. The screening processmay not be onerousand, throughthe
use of such devicesas open generallicensesforbroadcategoriesof
transactions and the delegationof authority to commercial banksto
deal even withdoubtfuland borderline requestsforpermission to
purchaseforeign exchange, it mayresultin havinglittle,or virtually
no, effect on current transactions. Nevertheless, so longas thereare
limitations on the amountof foreignexchangewhichresidentscan
purchase, whatever thereasonsand however validtheymaybe,a full

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224 INTERNATIONAL MONETARY FUND STAFF PAPERS

convertibilitysystemdoes notexist.All thatcan be said is thatthe

significanceoftheinconvertibility stillremaining is muchlessthanin
the 1950's,bothbecauseit nowaffects onlyslightly theinternational
exchangeof goodsand servicesand becauseit doesnotinterfere with
the convertibilityof earningsor otherforeignexchangereceiptsby
nonresidents.
It is truethatmanyindustrial countriesretainquantitative restric-
tions on some imports,and that theserestrictions on international
tradeaffect thevolumeand patternofpayments.Generally, however,
thesetraderestrictions in theindustrial countries are not,technically,
restrictionson international payments as such. Thus,countries with
convertible currenciesmayemployquantitative restrictionsandquotas
withouttechnically impairingthe convertibility of theircurrencies,
eventhoughtheeconomic effectsoftheserestrictions are verysimilar
to limitations on internalconvertibility. This similarity is reflected
in tne provisionsof the GeneralAgreement on Tariffsand Trade
(GATT) dealingwithsuchquantitative restrictions-especially in the
rolegivento theFundin judgingtheextentto whichsuchrestrictions
are neededforbalance of paymentspurposes,and in the closeness
with whichthe definition of discrimination in the exchangefield,
authorizedunderthe Fund Agreement, is paralleledby that of dis-
crimination authorizedunderthe GATT.6 Wheretraderestrictions
are maintainedto protectthe balance of payments, thereis close
cooperationbetweenthe Fund and the GATT on the questionof
whetherthe restrictions are moreintensethan the balanceof pay-
mentspositionrequires.7However,thetraderestrictions maintained
today by the industrialcountries are not usually maintained for
balance of paymentspurposes;this meanseitherthat the country
does not claimthatits balanceof payments necessitates themainte-
nance of such restrictions, or that it considersthat theycould be
eliminated without intolerableeffectson itsbalanceofpayments.The
GeneralAgreement also containsprovisionsrequiringcountriesto
accountforimport restrictions
notmaintained forbalanceofpayments
reasons.Thus,traderestrictions whichsignificantly affectthevolume
and directionof paymentsare subjectto international discussion,
whether ornottheyaremaintained toprotect thebalanceofpayments.
PAR VALUES AND MARGINS
In countrieswherepar values have been agreedwiththe Inter-
nationalMonetaryFund,thepurchaseand sale ofcurrencies
are sup-
6 See ArticlesXII-XV of the GATT.
7 The particularly
only important industrial countries not members of the International
Monetary Fund are Switzerland and those in the Soviet bloc.

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 THE INTERNATIONAL MONETARY SYSTEM 225

posedto take place at exchangeratesbased upontheseparitiesand

withinlimitedmargins.Par valuesare expressed in gold,or in terms
of theU.S. dollarof theweightand fineness in effecton July1, 1944.
Theparvaluesoftheprincipal countries
industrial aregiveninTable 1.
Par valuesare thusunitaryrates,although, as discussedbelow,they
can be partof multiplecurrency systems. In theindustrial countries,
the exchangeratesare essentially unitary;wheremultiplecurrency
featuresexist,theydo not alter the fundamental characterof the
system.
The Articlesof Agreement of theFund providethatthemaximum
and minimum ratesforspot exchangetransactions betweenthe cur-
renciesof its members takingplace withintheirterritories shall not
differfromthesepar values by morethan 1 per cent.8This 1 per
centis calledthe margin;the combination of marginson eitherside
of par can resultin a spreadof 2 per centbetweenthe lowestand
highestlimitsbetweenany two membercurrencies. In practice,the
industrialcountries have fixedtheircurrencies in termsof the U.S.
dollar.If the exchangerateof each currency vis-a-vistheU.S. dollar
varieswithina marginof onehalfof 1 percent,givinga spreadof 1
per cent,the exchangerate betweentwo such currencies can vary
withina marginof 1 per centor a spreadof 2 per cent.Therefore,
marginsof morethanone halfof 1 percentvis-a-vistheU.S. dollar
could give rise to marginsof morethan 1 per centbetweenother
currencies and thereforemarginsgreaterthanspecified in theArticles
of Agreement. A decisiontakenby theFund in July1959,however,
permitsthe spreadbetweenthe maximumand minimum ratesto be
as muchas 4 percentwhenever suchratesresultfromthemaintenance
of marginsof no morethan1 per centfromparityfora convertible
currency.9 Thus,evencurrencies thatare basedon par valuesagreed
withtheFund can fluctuate considerably in termsof othercurrencies
withoutchangesin par valuesor anyotherofficial action.The impor-
tance of the widthof this spreadcan be seen by calculatingthe
possiblecost to a speculatorof takingan uncovered positionwithin
the spread,keepingin mindthat his costsare calculatedon a per
annumbasis. An errorin forecasting a movement of the exchange
rate duringthe periodof the transaction(fromone day to many
months),even if the movement of the rate is withinthe permitted
spread,may well involvea considerable loss. Thus,froma business
pointofview,theexisting spreadsare by no means"narrow."In this
connection, attentionis drawnto the stepstakenby Japanin April
8 ArticleIV, Section3 (i).
9 International MonetaryFund, SelectedDecisions of the ExecutiveDirectors
(Washington, D.C., September1962),p. 11.

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 TABLE 1. PRINCIPAL INDUSTRIAL COUNTRIES: PAR VALUES AGREED WITH THE INTERNATIO

(In units of national currenciesper U.S. dollar)

Initial Par Values Changes in Par Values

Member
Country Currency Rate In effectforperiod Rate In effectforperi

Austria Schilling 26.000 May 4, 1953 to present - -

Belgium Franc 43.8275 Dec. 18, 1946 to 50.000 Sept. 22, 1949 to pr
Sept. 21, 1949
Canada Dollar 1.000 Dec. 18, 1946 to 1.100 Sept. 19, 1949 to
Sept. 18, 1949 Sept. 29, 1950
No par value Sept. 30, 1950 to
May 1, 1962
1.08108 May 2, 1962 to pres
France Franc 119.1072 Dec. 18, 1946 to No par value Jan. 26, 1948 to
Jan. 25, 1948 Dec. 28, 1958
493.7062 Dec. 29, 1958 to
Dec. 31, 1959
4.937063 Jan. 1, 1960 to pres

Germany,Fed. Rep. Deutsche Mark 4.200 Jan. 30, 1953 to 4.000 Mar. 6, 1961 to pres
Mar. 5, 1961
Italy Lira 625.000 Mar. 30, 1960 to present - -
Japan Yen 360.000 May 11, 1953 to present - -
Netherlands Guilder 2.65285 Dec. 18, 1946 to 3.800 Sept. 21, 1949 to
Sept. 20, 1949 Mar. 6, 1961
3.620 Mar. 7, 1961 to pres
Sweden Krona 5.17321 Nov. 5, 1951 to present -- -

United Kingdom Pound Sterling .248139 Dec. 18, 1946 to .357143 Sept. 18, 1949 to pre
Sept. 17, 1949

1 No officialbuyingor sellingexchangerate has been announced. It is understoodthat the authoritiesmaintainthe

cent on eitherside of paritywiththe U.S. dollar.
2 Old francs.
8 New francs.
4 U.S. dollarsper pound sterling.

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 THE INTERNATIONAL MONETARY SYSTEM 227
1963to widenthemargins ofexchange ratesfortheyento magnitudes
similarto thoseprevailingin connection withEuropeancurrencies
(see Table 1).
The existence ofa relatively widespreadhelpedto createconditions
whichencouragedthe rebuildingof freeexchangemarketsin the
1950'saftermanyyearsof disuse.DuringWorldWar II, and fora
numberof yearsafterward, centralbanksweretheprincipalinstitu-
tionsbuyingand sellingforeign exchange;exchangecontrolsclosely
regulated the activitiesof commercial banksin the foreign exchange
fieldand the prewarexchangedealersdisappearedfromthe scene.
During the 1950's,the relaxationof exchangecontrolsled to the
gradualreintroduction of exchangemarketsand to the revivalof
arbitrage facilities,bothspotand forward. As a consequence, exchange
marketsnow offerextensive protectionagainstexchangerisks,while
also allowingtradingforspeculativepurposes(i.e.,in orderto profit
by changesin the exchangerate) ratherthan forthe paymentof
debts arisingout of the international trade in goods and services.
Whileto thetheorist theproblem ofexchange ratesmaybe essentially
one of judgingthe desirability of the presentsystemof fixedrates
comparedwithfluctuating rates,to the operatorit may well appear
thattherealproblemis whether thepresent margins permittoomuch
roomforfluctuation, possiblywiththe effect of encouraging adverse
capitalmovements as well as creatinguncertainties in international
trade. Centralbank authorities, havingthe powerto intervene and
greatly to influence the market, have continually to decideat what
rateto aim. This meansthattheexpectations oftheexchangespecu-
lator,basedon hisjudgment ofmarketconditions, maybe completely
thwartedby massive actions undertakenby the central bank
authorities.
For a businessengagedin international transactions, thepossibilities
of variationswithinthe spreadcreateconditionsnot too unlikea
freemarketwitha fluctuating rate-the difference being,of course,
thatthemonetary authoritieswillintervene to prevent theemergence
of ratesbeyondthelimitsofthespread.In practice, thismeansthat,
if a currency is underpressure-inthatdemandforthatcurrency to
consummate international transactionsis less thansupply(whatever
the sourceof demandand supply) and the exchangerate falls in
termsof foreigncurrencies-themonetaryauthorities will provide
additionalforeignexchangeto keep the rate fromfallingbelowthe
agreedmargin.In thesecircumstances, thecountry is usingits mone-
tary reservesto defend its exchange rate. On theotherhand,if a cur-
rencyis strong, so thatthedemandforit is outrunning thesupply,the
exchangerate will be bid up to the upperlimitand the monetary

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228 INTERNATIONAL MONETARY FUND STAFF PAPERS

authorities willbuy foreign exchangeto preventfurther appreciation

of the currency.
Withinthespread,it is quitepossibleforthemonetary authorities
of different countries to have intervention policieswhich differboth
fromeach other'sand even frompreviouspoliciesof theirown.The
policymay be to allow the exchangerate to movewithinthe more
or less full rangeof the spread,the authorityintervening only at
thelimitsor veryclosethereto. Alternatively,it maybe to intervene
thetrendin themarketorevento bringabouta
earlier,so as to affect
de factostabilityat a levelwellwithinthelimitsofthespread.These
different approaches,and variantsof them,are all possiblewithin
thepresentinternational system.Moreover, theauthoritiesmayinter-
veneto influence theratenotonlyforspotexchangetransactions but
also forforward transactions. For the latter,the internationalrules
are less specific.Underthe Fund Agreement, the marginby which
forward transactions may exceedthemarginforspottransactions is
not to be "morethan the Fund considersreasonable."'0The Fund
has not definedreasonableness, leavingit to individualmonetary
authorities (if theyso choose)and to marketforcesto determine the
forwardrates,althoughit wouldbe able to assertits authority if
were as
developments regarded unsatisfactory from an international
viewpoint. The factthatthereare no fixedlimitsto the movements
of forwardexchangeratesintroduces a further elementof flexibility
intothesystem.
In recentyears,the centralbanksof a numberof the industrial
countries have adopteda ratherpassiveattitudetowardintervention,
in the sensethatthe spotexchangerateshave beenallowedto reach
or comeverycloseto eithertheupperor thelowerlimitbeforefor-
eign exchangeis boughtor sold. This is reflected in the extended
periodsof timeduringwhichthe exchangerateswereat theirupper
(or lower)limit,as shownin Chart1 (insertedbetweenpp. 230 and
231). Suchpassivitymaywelllead to an expectation of a changein
the par value,and thereare indications thatcentralbanksare now
intervening moreactivelyto influence trendsin theexchangemarkets
and particularly to narrowthe rangeof fluctuation. Althoughinsti-
tutionaldifferences are markedfromcountryto country, the inter-
ventionof the centralbanks normallytakes place throughthe
commercialbankingsystem;this practiceis usual in the United
Kingdom.The Bank ofEngland,as manageroftheExchangeEquali-
zation Account,has formanyyears operatedto preventunwanted
fluctuations of the rate,and so far as possibleto preventit from
10 Article IV, Section 3 (ii).

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 THE INTERNATIONAL MONETARY SYSTEM 229
bumping againstthemargins.It doesnotstandcommitted to protect
the spot rate at any one pointwithinthe margins, but it endeavors
to keepthe rateat a levelwhichreflects theunderlying stateof the
market."lIts operationsare usuallyconductedsecretly, so thatthe
public does not always receiveinformation about its intervention.
Speculators know,however, thatattemptsto exploittemporary weak-
nessesin the positionof the poundmay proveverycostly.
Recentmovements in theforward exchangeratesofsomeindustrial
countries are recordedin Chart2 (inserted betweenpp. 230 and 231).
The Bank of Englandis freeto operatein the forwardexchange
market,althoughit is underno obligationto keep the forward rate
withinfixedlimits.The ExchangeEqualizationAccountdoesat times
deal in the forward market,but since1951the authorities have not
to
sought peg the forward ratewithinany small predetermined margin
fromtheofficial spotrate.12
Othercentralbankshave also intervened in the forward market;
for example,the DeutscheBundesbankin 1961 providedforward
coverto the Germancommercial banksat no chargeor at a charge
lower than the market;and the Banca d'Italia duringthe same
year providedItalian banks withsubstantialand varyingamounts
of foreign exchangeon a swapbasis.Probablythemostimportant of
all havebeentherecentmeasurestakenby theU.S. financial authori-
ties to influence forwardrates; thesewill be discussedin a later
article.
In so intervening, the centralbankmay be motivatedby a desire
to influencenotonlytherateofexchange, thereserveposition, orthe
flowof capital,but also domesticliquidity.13 Of course,in practice
its operationsaffectall these,and perhapsother,factorssimultane-
ously,andtheymaymerelyafford differentroutesbywhichto achieve
the same end-the defenseof the externalvalue ofthecurrency at a
desiredlevel and withoutimpairment of its convertibility.l4

ROLE OF FOREIGN EXCHANGE MARKETS

The basicstructureoftheinternational
payments systemcomprises
the "external"and "internal"convertibility
of currencies,
thesystem
of par values and margins,and centralbank intervention on the
11Committeeon the Workingof the MonetarySystem[RadcliffeCommittee],
Report (Cmnd.827,London,August1959),par.326.
12
Ibid.,pars.327 and 707.
13European MonetaryAgreement,Third Annual Report of the Board of
Management(Paris,1962),pars.102and 103.
14 This
paragraphdoes not attemptto deal withthe hardquestionof the func-
tionsofforward exchangemarketsunderpresent-day conditions.

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230 INTERNATIONAL MONETARY FUND STAFF PAPERS

exchangemarkets.The systemoperatesthroughforeignexchange
marketsmadeup principally of commercial banks.Thus,mostinter-
nationalfinancialtransactions are handledon a commercial basis
the of
through operation foreignexchange markets linked through
exchangerate and interestrate arbitrage.Commercial banksin the
industrialcountries are, by and large,freeto deal in all of the cur-
renciesof thesecountries(as well as someothers),so thattheyare
freeto take advantageofinterest ratedifferentials
in differentmoney
markets.The excellenceof moderncommunications obviatesdispari-
ties in exchangerates throughthe abilityof commercial banksto
consummatequickly foreignexchangepurchasesand sales. This
re-creationof the function of the foreignexchangemarketshas been
one ofthemostimportant and yetneglected developments in postwar
internationalfinance.It beganon a regionalbasis shortlyafterthe
establishment of the EuropeanPaymentsUnion (EPU) in 1951.
For someyears,separateexchangemarketsforEPU currencies and
the dollarexistedsimultaneously. The establishment of externalcon-
vertibilityof the main currencies in 1958 meantthe elimination of
the wall betweentheseseparatemarketsand theirmergerintoone
exchange marketforconvertible currencies.
However,experience soon indicated that,despitethemanysimilari-
ties to prewarexchangemarkets,the new conditionsin the world
economycreatednovelsituations in theexchangemarkets, callingfor
a constantreappraisalof centralbankpolicies.Thesenewconditions
included,forexample, largeaccumulations ofdollarbalances,commit-
mentsto fullemployment policies,limitationson capitalmovements,
and eagerness to maintaintheforeign currencyvalueofdirectinvest-
ments.A majorpolicyinstrument forcopingwiththesesituations has
beendirectintervention by the centralbankin theexchangemarket.
Suchdirectintervention worksinstantaneously, whereasotherinflu-
ences exertedby the monetaryauthoritiesthroughopen market
operations,otherpublicdebtmeasures,or changesin relevantrates
or reserverequirements, are usuallytakenaftera timelag and are
subjectto a further time lag beforetheytake effect.Aside from
centralbank intervention, the positionof currencies in the exchange
marketsis largelythe resultof transactions made by privateindi-
viduals,reflectingall the factorsthataffectany commercial market.
In particular,apart fromsuch intervention, the differencesbetween
rates for forwardtransactions and those forspot transactions are
determined by marketconditions. Giventhe possibility of exchange
rate variations,as describedabove,as well as interestdifferentials,
the forwardmarketbecomesan important indicatorof expectations
withrespectto exchangerates.It is simplearithmetic to calculate

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 CHART 1. SOME INDUSTRIAL COUNTRIES IN EUROPE: SPOT EXCHANGE RATES AGAINST THE U.S. DOLLAR, DAIL

(In per centabove [+] or below[-] par withthe U.S. dollar)

+1.60

+1.40
Belgion FrGenc> kSwiss Franc 1

+1.20 '! Aw f

Netherland
+0.20

U.S. dollar

-0.20
Deutsche Mark
-0.40
Sterling
-0.60
March6
-0.80 i
J F M A M J J A S 0 N D J F M A M J J A S 0
1961 1962

Source: Bank forInternational

This content downloaded fromChart
Settlements. reproduced
128.255.6.125 with
on Sun, permission.
03 Jan 2016 20:29:01 UTC
All use subject to JSTOR Terms and Conditions
OUNTRIES IN EUROPE: SPOT EXCHANGE RATES AGAINST THE U.S. DOLLAR, DAILY, JANUARY 1961-MARCH 1963

(In per centabove [+] or below[-] par withthe U.S. dollar)

+ 1.60

+1.40
Swiss Franc
+1.20

+1.00

·V
v^ French Franc
+0.80
g
I/llaianL ira ,...
+0.60
"',~I~~M ,

r; ;' ___ 19/ X8 +0.40

Netherlandsuilder
+0.20

Par with
U.S. dollar

-0.20
Deutsche Mark
-0.40
ling
-0.60
March29
I I I I I I I I I I I I ii t i I -0.80
S 0 N D J F M A M J J A S 0 N D J F M AM J
1962 1963

Chartreproducedwithpermission.
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All use subject to JSTOR Terms and Conditions
 CHART 2. SOME INDUSTRIAL COUNTRIES IN EUROPE: FORWARDEXCHANGE RATES AGAINST THE U.S. DOLLAR,

(In per cent)

+5

+3

+2

A,A,^~~~~~I

-v

J F M A M J J A S O N D J F M A M J J A S

1961 1962
Source: Bank forInternational Settlements.Chartreproducedwithpermission.
1 Three-month ratescalculated as a downloaded
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128.255.6.125 on(-)Sun,on
03the
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2016 20:29:01 UTC the U.S. dollar in percentage
All use subject to JSTOR Terms and Conditions
 EXCHANGERATESAGAINSTTHE U.S. DOLLAR,DAILY, JANUARY
ITRIESIN EUROPE: FORWARD 1961-MARCH1963'
(In per cent)

O N D J F M A M J J A S O N D J F M A M J

1962 1963
)roducedwithpermission.
a discount(-) on the spot rates content the
Thisagainst U.S. dollar
downloaded in percentages
from 128.255.6.125 per annum.
on Sun, 03 Jan 2016 20:29:01 UTC
All use subject to JSTOR Terms and Conditions
 THE INTERNATIONAL MONETARY SYSTEM 231

whether,at any given moment,commercialtraders,whatevertheir

motives, are expectinga fall or a rise in the exchange rate, and
whetherthat fall or rise reflectsan expectationof a changein the par
value. For this reason, forwardexchangerates have become increas-
ingly importantas indicatorsof the externalfinancialposition of a
countryand its prospects.Indeed, it may be said that such quotations
are becomingmoreimportantthan changesin gold or foreignexchange
reservesas indicatorsof the strengthor weakness of a currency.The
exchangemarkethas becomethe battlefieldfordefendingthe external
value of a currency.
Just as variations in monetaryreserves have, in the past, been
overemphasizedas indicatorsof externalfinancialpositions-so that
even sophisticated analysts have, at times, neglected other major
factors such as competitiveness,relative monetary conditions,and
the use of exchange and trade restrictions-thereis now a danger
that changes in exchangerates withinthe permittedmarginswill be
overmagnified in importance.Trainedand experiencedspeculatorsoften
misread the significanceof variations of exchangerates. Perhaps the
principal errormade is in underestimating the role of central bank
intervention,actual or potential,supportedby the existingdefense
mechanisms.Too much emphasis cannot be placed on the fact that,
for the business and bankingworld,thereare freeexchangemarkets
and moving rates. The currentmargins offerconsiderableroom for
variation,and permitboth the encouragementof equilibratingcapital
movementsand the cumulative process of disequilibratingcapital
movements.This is particularlytrue when a change in the exchange
rate is expectedby some of those engagingin speculativetransactions.
In addition to the officialexchangemarkets,in whichthe rates are
kept withinthe permittedspreads,thereare freemarketsfora number
of currencies,reflectingtheirlimitedconvertibility for capital trans-
actions, as described above. Examples are the market for security
sterlingand the reinvestmentdollar marketin the United Kingdom,
and the freemarket for capital transactionsand for transactionsin
certain invisiblesin Belgium. These freemarketscannot be taken as
indicative of a country'sbalance of paymentsposition or prospects;
they are too narrow and oversensitive.However, the rates quoted
in these marketsdo affectthe attitudeof individualsand businesses
engagingin foreignexchangetransactions.Thus, when the reinvest-
ment dollar rate in London goes to a considerablepremium,it may
be due to many causes other than the foreignexchange position-
causes such as divergencesbetween the return on capital on the
New York and London Stock Exchangesand the limitationon capital
exports by residents of the United Kingdom. Similarly, exchange

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232 INTERNATIONAL MONETARY FUND STAFF PAPERS

transactionsin the Belgian freemarketmay reflectonly the willing-

ness of individualsto pay a premiumto consummatetransactionsnot
permittedby the Belgian exchange controlauthoritiesat the official
rate. Even so, when these marketsvary markedlyfromthe official
rates,theyare likelyto be read as indicating"strength"or "weakness"
in currencies,
particularly"weakness."
Withinthis framework, the foreignexchangemarketsmay be said
to performthe functionsdescribedin the followingparagraphs.

Exchange arbitrage
Because of the freedomwith which fundscan be moved fromone
countryto anotherand the close and rapid communicationsbetween
countries,the exchange markets provide more or less uniformspot
rates throughexchangearbitrage.

Trade credit
The establishmentof foreignexchangemarketsfacilitatesthe inter-
national extensionof trade creditwhich,in general,fostersthe growth
of trade. The relaxation or absence of exchange controls,such as
the requirementto surrenderexchangereceipts,makes it possible for
the exporterto extendcredit,while financialinstitutionswith world-
wide connectionsenable him to dispose of commercialpaper with
relative ease and minimumrisk of loss. Similarly,the importernow
has access to money markets anywherein the countrieswith con-
vertiblecurrencies,which enables him to take advantage not only of
but also, more generally,of national differ-
interestrate differentials
ences in liquidityconditions.The highlydeveloped commercialbank-
ing systemsof the United Kingdom and the United States, and their
elaborate and efficientnetworkof internationalconnections,make
London and New York key centersforobtainingtrade creditas well
as foreignexchange.

Short-term movementsof capital

Short-termcapital movementshave been greatlyfacilitatedby the
establishmentof foreignexchangemarkets.Even under conditionsof
inconvertibility,short-termmovementstook place in such formsas
leads and lags in paymentfor goods and services; but these capital
flowswere haphazard, were frequentlydisequilibratingwith respect
to the balance of payments,and werecostlyto reserves.Convertibility
enables short-termcapital movementsof many varieties (with daily
new inventions)to take place easily. Such movementsmay be either

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 THE INTERNATIONAL MONETARY SYSTEM 233

equilibratingor disequilibrating,
although thesystemofmargins tends
to makethemequilibrating undernormalconditions (i.e.,whenthere
are no prospectsof changesin par values or the reintroduction of
inconvertibilityand whenthe balance of paymentsdifficulties are
regardedas essentially temporary and reversible).The reasonis that
the speculatorknowsthatwhenthe rateapproachesthe lowerlimit,
thereis no roomforfurther deterioration,and thereis alwaysthe
possibilityof centralbankintervention at any point.
An interesting recentdevelopment in exchangemarketshas been
the creationof facilitiesfor nonresidents to hold time deposits
denominatedin foreigncurrencies.These foreigncurrenciesare
usuallyU.S. dollarsand themarketis referred to as theEuro-dollar
market.l5The importance of timedepositsdenominated in foreign
currenciesis thatno forward coveris neededand,therefore, theprofit
marginto the depositorincreases.The prevailinginterestrates in
thosemarketslie betweenthe comparabledepositand lendingrates
in the domesticmoneymarketsof many countries.A substantial
volumeof international tradeis financed through the readyand less
restrictive
creditfacilitiesavailablein theEuro-dollar market.
Thus,theforeign exchangemarketsresultin thefinancing ofworld
tradethrough thecommercial banksassistedby thestabilizing move-
mentsof short-term funds.As a consequence, the strength of the
transaction motiveforholdingofficial reservesis close to zero.The
basic economicmotiveforholdingreserveswhichremainsis thepre-
cautionary motive,i.e.,to defendtheexchange rateand convertibility.

Role ofofficial
reserves
The monetary reservesin the formof gold or foreign
authorities'
currencies
are therefore
heldto enablethemto intervene in theforeign
exchangemarketand avoid unwantedfluctuations in the exchange
rate whichmay resultfroma disequilibrium in the balanceof pay-
ments.Five kindsof disturbancesleading such a disequilibrium
to
The firstare transitory
may be distinguished: or seasonaldisturb-
ances.The needforreserves
resultingfromthesedisturbances maybe
verylimited,sincetheymay be absorbedby changesin theholdings
of foreignexchangeof the commercialbanks or by international
bankingor tradecredit.The secondkindof disturbance may arise
fromthe courseof businesscyclesin the countryconcernedor in
15See especiallyO. L. Altman,"Foreign Marketsfor Dollars, Sterling,and
Other Currencies,"StaffPapers, Vol. VIII (1960-61),pp. 313-52,and "Recent
Developmentsin Foreign Markets for Dollars and Other Currencies,"Staff
Papers,Vol. X (1963), pp. 48-96. See also, European MonetaryAgreement,op.
cit.,par.79.

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234 INTERNATIONAL MONETARY FUND STAFF PAPERS

othercountries. It is moreor less certainthatthe foreign exchange

marketswouldnot be able whollyto meetthe needsarisingfrom
fluctuationsin thebalanceofpayments. Reservesare therefore needed
to give time to take suitableanticyclicalmeasuresand to avoid
responding to the disequilibrium in the balance of paymentsby
measureswhichmightbe unnecessarily drastic,sincethe courseof
businesscyclesis reversible. A thirdkindof disturbance may arise
fromstructuralchanges,such as alterationsin cost-pricerelations
or in the demandforimported commodities comparedwithdomestic
commodities. Underthesecircumstances, reserveswillgivethepolicy
makerstimeto implement appropriate economicremedies. A fourth
kindof disturbance may ariseif domesticpoliciesdesignedto affect
longer-run trends(e.g., increasesin the rate of growth)are incon-
sistentwithequilibrium in the balance of payments.Reservesare
thennecessary, at leastforsomeperiodoftime,untilpolicymeasures
consistent bothwiththe domesticgoals and withequilibrium in the
balanceofpayments can becomeeffective.A fifth kindofdisturbance
may resultfromthe destabilizing effectof speculation. Reservesare
thenneededquicklyin orderto defendthe externalvalue of the
currencyin the hope of bringingabout a changein expectations,
althoughothertechniquesdiscussedbelowcould,at times,be better
methods ofdefense.
The need forreservesis therefore not directlyrelatedin an im-
portant sense to the volume of trade.Hence no quantitativeformula-
tionrelatingtheneedto thevolumeoftradeis practicable. The need
dependsratheron the characterand magnitudeof the disturbances
whichcause disequilibria in the balanceof payments. Moreover, the
use of reservesmay be reducedby the availabilityof substitutes,
especiallyforeign short-term borrowing. Beforethe questionwhether
availablereserves are adequatecan be answered, it is therefore
neces-
sary to reviewthe available international creditfacilitiesand the
techniques ofmonetary cooperationwhichhaveas theiraimreductions
of the need forreserves;at thattimealso, morewill be said about
the volume,composition, and distribution of existingreserves.

Elements of Flexibility in the International

Payments System
To defendtheinternational
payments system,considerable
financial
resourceshave been set aside and othermeasurestaken,so that
changesin the structure
of the systemare no ordinaryoccurrences.
However,beforediscussingthe management of the systemand its

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 THE INTERNATIONAL MONETARY SYSTEM 235
defenses, and natureof changesin it shouldbe re-
the possibilities
called; otherwise the systemmay well be misunderstood. In what
follows ofchangesin rateswithinthepermitted
thepossibilities spread
and of variationsin forward quotationsare not treatedas elements
of "flexibility,"althoughin practicethey make the systemmore
adaptable to externalfinancialchangeswithoutalteringits basic
structure. In thissense,the possibility
of limitedratefluctuationsis
a formofdefenseoftheexisting structureas wellas a flexible
element
withinit.

CHANGES IN PAR VALUES

As discussedabove,the international payments systemis based on

the maintenance of stablepar values agreedwiththe Fund. It de-
liberatelyrejectsrateswhichare freeto fluctuate outsidethe per-
mittedmargins(and theirpeculiarstepsisters, multiplerates) in
favorof stability. The reasonforthisrejection is notthatfluctuating
rateshaveno merits, butthattheirmeritsare regarded as outweighed
by their demerits, particularly forthe industrial countriesbut also
(withonlytemporary and occasionalexceptions) for othercountries.
All otheraspectsof the international monetarysystemare affected
by thisprimary decision.The operations oftheexchangemarketand
boththeneedfor,andtheimplications of,theuse ofrestrictions would
be verydifferent if the international monetary systemwerebased on
fluctuating rates.However,theemphasisplacedon stabilitymustnot
be allowedto obscurethe fundamental factthatpar values can be
changed.The Fund'sArticlesof Agreement statethattheFundshall
raiseno objectionif a proposedchangein par value,together withall
previouschanges,whether increasesor decreases,does not exceed10
per cent of the initialpar value.16Otherchangesrequirethe con-
currence of the Fund.A changein a par value is notto be proposed
unlessit is necessary to correcta fundamental disequilibrium,butthe
Fund is required, underthe Articlesof Agreement, to concurin any
proposedchangeifit is satisfied thatthechangeis necessary to correct
sucha disequilibrium.'7 In practice,
thisis nota seriouslimitation on
a country's freedom ofactionin theexchange ratefieldsinceit would
notbe interested in changing thewholestructure ofits exchange rates
unless confronted witha persistent and intolerableexternaldeficit
or surplus.Undersuchcircumstances, it couldbe confident of inter-
nationalconcurrence in a proposedchangein parvalue.The obligation
to consultthe Fund, however,does mean that a countrycannot
16 Article
IV, Section 5.
17 Ibid.

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236 INTERNATIONAL MONETARY FUND STAFF PAPERS

engage in exchangerate manipulationto give it advantages over other

countries,which are not warranted by differencesin prices, costs,
moneysupply,or productivity.
This elementof flexibilityin the presentsystemdoes not mean that
a countrycan change easily fromone par value to another.Many
factorsmilitateagainst frequentchanges in par values by the indus-
trial countries.For the countrieswhose currenciesare used as mone-
tary reservesby othercountries(the UnitedKingdomand the United
States), there is always the considerationthat changes in their
exchangerates will alter the value of reservesheld by othercountries,
and also of privatelyheld funds.It is not the commonpractice to
guaranteeagainst exchangedepreciationdepositsheld by nonresidents,
includingthose held by othermonetaryauthorities,or to guarantee
deposits held by residentsin their own currencyagainst changes in
their value in foreigncurrencies. Nevertheless,the acceptance of
depositsby nonresidents, particularlymonetaryauthorities,biases the
reserve currencycountrytoward doing everythingpossible to avoid
causinglosses by a changein par values. Moreover,a devaluationmay
greatly weaken the eagerness (not to say the willingness)of other
countriesto hold reserves in the currencythat has been devalued.
Even forthe industrialcountriesotherthan the main reservecountries,
many weighty factors (excluding political considerations)militate
against frequentchanges in par values. These include the fear of
adding more elementsof uncertaintyto internationaltransactionsand
domestic business decisions by enhancing the likelihood of future
exchangerate adjustmentsbeyondthe permittedspreads; the fear of
adding to inflationaryor deflationarypressures;and the fear of frus-
tration as a result of offsettingcountermeasurestaken by other
countries,includingchanges in their par values. From a narrower
technicalpoint of view,thereis the additional considerationthat,if a
par value is to be changed,the authoritieshave to make a judgment
as to what the new par value should be. It is, in fact, difficult to
determinewhen an exchange rate needs alteration and the precise
amount of any change. Purchasing power parity and other similar
calculations may be helpful,at least in indicatingthe directionand
rough magnitude of needed change. But the selection of a new
par value involvesmany elementsof judgmentnot subject to quanti-
fication;theseincludejudgmenton the economic,financial,and mone-
tary conditions in the countryconcernedrelative to those in the
principal competitorand customercountries,futurepolicies of the
countrycontemplating a change,and the rate that would end expecta-
tions of furtheradjustments. On balance, it is probablysafe to con-
clude that even if a countryshould believe that the international

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 THE INTERNATIONAL MONETARY SYSTEM 237

communitywould be ready to accept a proposed change in its par

value in orderto correcta fundamentaldisequilibrium,that country
will usually try to avoid a change,in the hope that other domestic
policiesor changesin conditionsabroad willmake a changeunnecessary.
What has happened to the par values of the currenciesof the
industrialcountriessince the establishmentof the Fund is shown in
Table 1. Generally speaking,the par values agreed in 1946 merely
continuedforthe industrialcountriesthe exchangerates that emerged
fromWorld War II. The devaluationsin 1949 were a delayed adjust-
ment to the changes broughtabout by the War; beforethey could
be undertakenintelligently, theyhad to await the achievementof sub-
stantial progressin the industrialand agriculturalreconstruction of
WesternEurope. These devaluationsopened a postwarphase that has
lasted morethan 13 years, despitedramaticchangesin the economies
concerned,great changes in commercialpolicies, and repeated inter-
national political crises.
The relative infrequencyof changes in par values in this period
reflectsthe decisionby the various countriesthat furtherchangeswere
not needed. Experience has shown that the factorswhich affect,in
substantialmeasure,the foreignexchangevalue of currenciesdo not
change rapidly. Even importantchanges in such major economic
factorsas wages,moneysupply,and levels of incomeand employment
have been absorbed without the need to alter exchange rates and
withoutan adverse effecton output-provided, of course,that such
changes, though substantial,have not resulted in price levels of a
quite differentorderof magnitude. Increases in prices and unit costs
over a few years, greaterby say 5 per cent in one industrialcountry
than in another,have readily been absorbed withinthe existingrate
structure,whereas a considerablylarger relative change,say 25 per
cent or more,would probablyhave underminedthe existingstructure.
Precisionin such mattersis not possible. Many otherimportantfac-
tors have to be considered,includingtaxation, the possible flow of
capital, governmentcommitmentsabroad, the size of reserves,and
the businessoutlook.Easy assumptionsthat changingconditionsmust
mean correspondingchanges in par values are unwise; there is con-
siderablebuilt-inresistanceto suchchanges.
Large capital movementsmay weaken the externalposition of a
currencyand even create expectationsof a change in par value, but
theyneed not lead to changesnot warrantedby underlyingconditions,
unless there is a failure in the existingmachineryfor international
monetarycooperation.Such erraticmovementscan be dangerous,but
the mechanism for handling them efficientlyand safely is well
established.

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238 INTERNATIONAL MONETARY FUND STAFF PAPERS

Relativelyshort-lived inflations
or deflationsmaybe enduredwith-
out threatening the monetary structure becauseadequatecorrective
measurescan be takento end the inflation or deflationand/orto
adjustthe exchangerateto a newequilibrium position, whichis then
defendedby domesticpolicies.On the otherhand,a severeand pro-
tractedinflation or deflationin one or moreof the majorindustrial
countrieswouldrepresent a seriousthreatto the international pay-
mentssystem;it is difficult to envisagethe maintenanceof the
exchangerate structure and of convertibilityundersuch conditions.
However, even if the possibleeffectsof a sharpdeterioration in the
internationalpoliticalsituationare not considered, thereare many
reasonsforbelieving thata severeand prolonged deflation or inflation
wouldnotbe toleratedby anymajorindustrial country. The problem
forsuchcountries arisesfrommoreslow-moving factors,whichalter
the positionof the economyconcerned relativeto thatof othersand
giveriseto a possibleneedforan eventualexchange rateadjustment.
Today, neitherits fixitynor its flexibility is dangerousforthe
internationalpaymentssystem;rather,as in manyotherthings,the
dangercomesfromthe overwhelming importance of politicalfactors
in decisionson economicpolicy.Since discussions of exchangerates
even by economists and financialtechnicians frequently have emo-
tionalovertones,it is no wonderthatpoliticalleadersattachso much
significanceto actionsin this field.But the emotionalreactionhas
thisjustification:majorexchangerate adjustments in the currencies
of theindustrialcountries havea greatimpacton theentireeconomic
and sociallifeof thenationconcerned and of othercountries as well.

FLUCTUATING RATES AND MULTIPLE CURRENCY PRACTICES

The presentinternational paymentssystemdoes not contemplate

the use of fluctuating rates,i.e., rateswhichmay movebeyondthe
limitsof the permitted marginsin responseto marketforces(the
monetary authorities limitingtheirintervention to smoothing opera-
tionsand not resisting basic trends).Indeed,the Fund'sArticlesof
Agreement do not even providea mechanismforinternational ap-
proval of such a system,unlessthe fluctuating rate is part of a
multiplecurrency system.For thisreason,whenCanada adopteda
fluctuating rate systemin 1950,the Fund couldneitherapprovenor
disapprovethisaction.Instead,the Fund "recognized the exigencies
of the situationthatled Canada to theproposedplan and tooknote
of the intention of the CanadianGovernment to remainin consulta-
tionwiththeFund and to re-establish an effective
par value as soon

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 THE INTERNATIONAL MONETARY SYSTEM 239
as circumstanceswarranted."18Suchconsultations didtakeplace,and
in 1962theFundapproveda newparvalueforCanada.
Obviously,it is possibleto arguethat an international payments
systembased on fluctuating ratesis superiorto thepresentone; such
arguments are put forwardeveryday. But whatevertheirmerits,it
is a simplefactthat the presentsystemprecludessuchrates.It is
alwayspossible,and oftensensible,to consideralternative payments
systems,but reforms and improvements mustbe distinguished from
suggestionsfor the substitutionof one for
system another; a fluctuat-
ingratesystemwouldbe an international payments systemessentially
fromthepresent
different one.
Similarly,widespread use of multipleexchangeratesby the indus-
trialcountrieswouldcomecloseto upsetting thepresentsystem, even
though the Fund Agreement makes the
possible approvalbytheFund
of multiplecurrency practices.For example,if multipleimportand
exportrateswereused,conceptsthat underliethe presentsystem-
suchas avoidanceof competitive depreciation and of othermeasures
destructiveto the prosperity of othercountries-would be mostdiffi-
cult to apply. Once more,this is particularly true of the reserve
currencies.In fact,multipleexchangeratesare foundto someextent
in the industrialcountries, e.g.,Belgium,the Netherlands, and the
UnitedKingdom;theyariseinthefreeexchange markets forsecurities
and someothercapitaltransactions (discussedon pp. 231-32). They
are beneficialin thosemarkets,particularly in permitting a greater
of capitalmovements
liberalization and a simplificationof exchange
controlmachinery; but if the differencein quotationsbecomessub-
stantialand protracted, multiplerates do have the potentialdis-
advantageof castingdoubton thevalidityof the official ratesbased
ontheparvalue.

CAPITAL CONTROLS

As indicatedabove, the convertibility systemdoes not apply to

all internationalpayments,even among the industrialcountries.
Membersof the International MonetaryFund may exercisesuch
controlsof capitaltransfersas are necessaryto regulateinternational
capitalmovements as as
long they do notrestrict
current payments.l9
Nevertheless,the establishment of a viable internationalpayments
systemwould not have been possiblewithoutfreedomof capital
movements fromthe UnitedStates. Althoughthe trendhas been
towardthe elimination of capitalcontrols,mostindustrialcountries
18 International Monetary Fund, Annual Report, 1961, p. 45.
19Article VI, Section 3, of the Fund Agreement.

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240 INTERNATIONAL MONETARY FUND STAFF PAPERS

stillmaintainsomerestrictions whichlimitthe outflow of capitalto

othercountries.Some countries maintainsuch controlsforbalance
of paymentsreasons(e.g.,the UnitedKingdom);othersin orderto
safeguardthe autonomyof theirmonetary policy (e.g.,the Scandi-
navian countriesand Austria). A moregeneralreasonis to guard
againstthe unexpected.The industrialcountriesin Europe,other
thanGermanyand Switzerland, do notpermittheirresidents to hold
assets abroad except for specifiedpurposesand under specified
conditions, althoughsuchpermission has beengivenwithincreasing
liberality.
Accessto capitalmarketsin Europeancountries is limitedeither
by purposeor by nationality. For example,the UnitedKingdomhas
permitted readieraccess to the Londoncapitalmarketsby sterling
area residents thanbyresidents ofothercountries. Francehas pursued
a similarpolicywithrespectto thenewcountries whichwereformerly
dependentterritories of France. This does not mean that capital
exports to other areas do not take place-indeed,liberalization of
capitalmovements is muchgreaterde factothande jure-but rather
thatthecapitalexportsare limitedin amountsand carefully scrutin-
ized in thelightofexchangecontrolcriteria. On theotherhand,there
are veryfewrestrictions on the inflowof capitalintothe industrial
countries, either director indirect(e.g.,limitations on the transfer
of profits,dividends,amortizations, etc., arising from the capital
inflow).Thus,manycountries allownonresidents to take advantage
of opportunities to earninterest and otherformsof incomeby trans-
ferring fundseitheron short-term orlong-term account.Thisfreedom,
which has been achieved only duringthe last few years, has
made the international paymentssystemmore vulnerableto the
strains,sometimes sudden,oflargedisequilibrating capitalmovements.
On theotherhand,equilibrating capitalmovements havenowbecome
a normalpartof the functioning of the international payments sys-
tem. Successfulmanagement of the paymentssystemnecessitates
forestalling unwantedcapital movements or, if this is impossible,
containingtheirharmfuleffectsso as to avoid causingenduring
damageto the economyand the monetarysystem.To prohibitan
outflowof capital is an approachwhichhas the alluringappeal of
simplicityin timesof stressand may seem to be a reliableand
quickpreventive of trouble.But sucha prohibition may onlydivert
capitalmovements intootherchannels, likeleadsandlagsin payments
fortrade,illicitpurchasesof foreigninvestments, or purchasesof
gold for It
hoarding. may also undermine confidence in the currency
and evencreateexpectations of restrictions on current payments or a
changein thepar value.Sucheasy generalizations maybe dangerous,

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 THE INTERNATIONAL MONETARY SYSTEM 241

however; much depends on othermeasurestaken simultaneously,on

the past practices of the country concerned,on the cause of the
unwantedcapital movement,on the expecteddurationof the controls,
etc.
In the postwarperiod,the significanceof the widespreadexistence
of capital controlswas greatly reduced by the fact that they did
not exist in the countrywhich was formany years by far the prin-
cipal exporterof capital, namely, the United States; nor did they
apply to the export of capital fromLondon to the sterlingarea or
fromFrance to the francarea.

RESTRICTIONS ON CURRENT PAYMENTS

The presentinternationalpaymentssystemis based on the under-

standingthat countrieswill do their utmostto avoid introducingor
intensifyingrestrictionson currentpayments or, in other words,
retreatingfromthe convertibility of theircurrenciesforcurrentinter-
national transactions.So long as membercountriescontinuedto avail
themselvesof the transitionalarrangementsunder Article XIV of
the Fund Agreement20-orin the parlance of the Fund were "Article
XIV countries"-they had not taken the final formalstep to declare
their currenciesconvertiblefor currenttransactions.The possibility
of theirrevertingto some formof inconvertibility remainedsignificant,
although,as noted above, de facto convertibility was establishedlate
in 1958.The doorwas closed,but not locked.
However, most of the industrial countries,includingthe United
States and the United Kingdom,have now accepted ArticleVIII of
the Agreement,under which countriesundertake to avoid restric-
tions on currentpayments.Thus, there is a strongpresumptionthat
if such countrieshave balance of paymentsdifficulties they will try
to find solutions which avoid measures "destructiveof national or
internationalprosperity."21Exchange restrictionson currenttrans-
actions clearly fall into this category.Even so, the legal possibility
remainsthat, with the approval of the Fund, a membercountrymay
imposerestrictions on the makingof paymentsforinternationaltrans-
actions.Accordingly, the Fund, whenconsideringthe generalproblems
posed by the assumption of Article VIII status by a number of
European countries,which had been availing themselves of the
20
UnderArticleXIV, Section2, membercountriesavailingthemselvesof the
"transitional arrangements"may "maintainand adapt to changingcircumstances
(and, in the case of memberswhoseterritories
have been occupiedby the enemy,
introducewhere necessary)restrictionson paymentsand transfers for current
international transactions."
21 ArticleI
(v).

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242 INTERNATIONAL MONETARY FUND STAFF PAPERS

transitionalprovisionsof ArticleXIV, set out its attitudeon the use

of such restrictionsin a decision of June 1, 1960.22This decision
clarifiedthe point that Article VIII status meant locking the door
against the furtheruse of restrictionson currentpayments,even if a
key remainedto be used in extremis.For this reason, the decision
statedthat it would be desirablethat,as faras possible,such countries
should satisfythemselvesthat they were not likely to need recourse
to restrictionson currentpaymentsin the foreseeablefuturebefore
they gave notice that they accepted the obligationsof ArticleVIII.
The decision also providedthat, if membersforbalance of payments
reasons proposed to maintain or introducemeasures which would
require approval underArticleVIII, the Fund would grantapproval
only where it was satisfiedthat the measures were necessary and
that their use would be temporarywhile the memberssought to
eliminatethe need for them. Provisionwas made for continuedcon-
sultationsbetweenthe membersand the Fund withrespectto further
maintenance of measures for which approval was required under
Article VIII. In this way, the maintenanceof convertibilityby the
avoidance of restrictionson currentpaymentsis to be given a very
highpriorityby the countriesconcerned,but restrictions are not ruled
out as a possibleemergencytemporarymeasure.
This safetyvalve in the internationalpaymentssystemis different
in characterfromthe possibilityof changesin par values. The latter
do not in principlerepresentretrogression fromthe internationalpay-
ments system unless a change is not economicallywarranted (e.g.,
if the magnitude of the change exceeds substantially the change
needed to overcomea fundamentaldisequilibrium).A change in par
value may well be a means of strengthening the internationalpay-
ments system,if the change is made when needed and in the appro-
priate magnitude. It eliminatesthe disturbancesresultingfromthe
persistentdisequilibrium.A justifiedchangedoes not act as a restraint
on internationaltrade or on growthand employmentin othercoun-
tries. Moreover, any change is presumed to be made lasting by
appropriatedomesticpolicies.
In sharp contrastto this,the reintroduction of restrictionsof pay-
ments on an extensivescale by an industrialcountrywould, at least
temporarily,weaken if not disruptthe internationalpaymentssystem
-the extent of the harm done dependingon the magnitudeof the
trade of the industrial countryand on the consequent actions of
othercountries.Such restrictionsmay be usefulto meetthe occasional
temporaryneeds of industrialcountrieswhilemoreappropriatedomes-
22 Selected Decisions of the Executive Directors, op. cit., pp. 56-58.

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 THE INTERNATIONAL MONETARY SYSTEM 243
ticpoliciesarebeingadoptedandtheireffects awaited;butrestrictions
cannotbe widelyused fora protracted periodwithoutendangering
theentireinternationalpayments systemand all thatdependsuponit.
Thus, the presentinternational paymentssystemis a deliberate
choiceamongthe meansof conducting international financialrela-
tions.It is not rigid,and it makesprovisionforbothadaptingto
enduringchangesand meetingsuddenand grave financialcrises.
However,the systemhas two permanent features-theuse of par
values and the convertibilityof currencies forcurrent transactions;
withoutthesefeatures, it wouldcease to exist.But par values are
subjectto lastingchange,so that,in a sense,convertibility becomes
the fixedcharacteristicof the system.It is not surprising,
therefore,
thatso mucheffort has goneintocreatingconditions thatmakepos-
sible the maintenanceof convertibility in all circumstances. The
measurestakenwillbe dealtwithin a subsequent articleon theman-
agementof the convertibility systemand the techniquesavailable
foritsdefense.

Le systememonetaireinternational

Resume
Le systememonetaire internationalse trouvea l'heureactuelleen
pleineevolution,surtouten ce qui concernele marchedes changes
a termeet les defensesdu systeme.Cependant,commetout autre
systemepraticable,il ne peut se developperque dans les limites
imposeespar l'existencede la souverainete nationale.
Le presentarticletraitede l'undes aspectsde ce systeme:celuiqui
toucheaux paiementsinternationaux. Les principaux elements qui y
sontpassesen revuesontles suivants:la convertibilite exterieureet
interieuredes principalesmonnaies,le rapprochement des taux de
changepar l'adoptionde pariteset de margesfixespourles fluctua-
tionsde taux,et le fonctionnementdes marchesde change,y compris
les effetsdes margespermises,l'arbitragedu change,le creditau
commerce, les mouvements a courttermedes capitaux,et le roledes
reservesofficielles.
Naturellementil s'agitessentiellement
des princi-
dontles monnaies(surtoutle dollaret la livre
paux pays industriels,
sterling)sont de la plus haute importancedans les paiements
internationaux.
La flexibilitedu systemeresidedans la possibilitede changerles
d'avoirdestauxfluctuants
parites, et des changesmultiples,
et d'etablir

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244 INTERNATIONAL MONETARY FUND STAFF PAPERS

des controlesdu capital. Les restrictionssur les paiementscourants

sont d'une autre nature. En effet,tandis que le systemedu Fonds
Monetaire Internationalautorise les contr6lesdu capital, qu'il tolere
l'emploide taux fluctuantset de changesmultiplesa titred'expedients
provisoires,et que la methodeconsistanta corrigerpar des change-
mentsde parites les differences persistantesqui se fontjour constitue
une partie integrantede ce systeme,les restrictionssur les paiements
courantsrepresentent un mouvementregressifvers un systemeatomis-
tique. L'auteur conclut en disant que, des deux traits principauxdu
systeme,a savoir l'utilisationde parites et la convertibilitedes mon-
naies, c'est le second qui constituela caracteristiqueessentielledu
systemedes paiementsinternationauxa l'heure actuelle.
Dans de prochains articles nous passerons en revue les mesures
monetairesque l'on peut prendrepour faire fonctionnerce systeme,
ainsi que ses defenses,et nous tenteronsd'evaluer le systemedans
son ensemble.

El sistema monetario internacional

Resumen
El sistema monetariointernacionalse encuentrahoy dia en estado
de evolucion,particularmente en lo que respectaal mercadode cambios
a terminoy a las defensas del sistema. Su desarrollo,no obstante,
como el de cualquierotrosistemafactible,esta sujeto a las limitaciones
impuestaspor la existenciade la soberanianacional.
Este articulose ocupa de la parte del sistemamonetarioencargada
de llevar a cabo los pagos internacionales.Los aspectos mas salientes
aqui descritosson la convertibilidadexternae internade las principales
monedas,la coordinaci6nde los tipos de cambio mediantela adopci6n
de paridades y de margenesfijospara las fluctuacionesde los mismos,
el funcionamiento de los mercadoscambiarios,incluyendolos efectos
ejercidos por los margenes permitidos,el arbitraje de divisas, el
creditocomercial,los movimientosde capital a cortoplazo y el papel
de las reservas oficiales. Necesariamentese concentrala atenci6nen
los principales paises industrialescuyas monedas (especialmenteel
d6lar y la libra esterlina) son de vital importanciapara los pagos
internacionales.
Se encuentranen el sistemaelementosque le imprimenflexibilidad,
tales como la posibilidadde modificarlas paridades de las monedasy
de aplicar tipos de cambio fluctuantes,practicas de tipos de cambio

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 THE INTERNATIONAL MONETARY SYSTEM 245

multiplesy controlesde capital. Las restriccionesa los pagos corrien-

tes son de naturaleza distinta,ya que si bien el sistema del Fondo
Monetario Internacionalpermitela aplicacion de controlesde capital
y tolera los tipos de cambio fluctuantesy las practicas de tipos de
cambio muiltiplescomo medidas de caracter provisional,y dado que
las modificacionesde la paridad constituyenun m6todo (que forma
parte integrantedel sistema) para corregirlas discrepancias per-
sistentesque surjan, las restriccionesa los pagos corrientessignifican
una retrogresion hacia el sistema atomistico. El autor llega a la con-
clusion de que de los dos aspectos fundamentalesdel sistema-el uso
de paridades y la convertibilidadde las monedas-es esta ultima la
que constituyela caracteristicaesencial del sistema de pagos inter-
nacionales de hoy dia.
En articulos subsiguientesse pasara revista a las medidas de
caractermonetarioque pueden adoptarse para administrarel sistema
y sus defensas,y se tratara de hacer una evaluacion conjunta del
mismo.

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