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HISTORY OF FOREIGN EXCHANGE MARKET

At the end of World War II, the major countries of the world set up the International Monetary Fund (IMF). The IMF is an international organization that monitors balance of payments and exchange rate activities. In July 1944, at Bretton Woods, New Hampshire, 44 countries signed the Articles of Agreement of the IMF. At the centerpiece of those agreements was the establishment of a worldwide system of fixed exchange rates between countries. The anchor for this fixed exchange rate system was gold. One-ounce of gold was defined to be worth 35 U.S. dollars. All other currencies were pegged to the U.S. dollar at a fixed exchange rate. For example the Japanese’s Yen was set at 360 yen to a dollar, the British Pound was set at $ 4.80.
Foreign Currency History

Although the fixed exchange system served well during the 1950 and early 1960, it came under increasing strain in the late 1960s and by 1971 the order was almost collapsed. Most economists trace the break up of the fixed exchange rate system to the US macroeconomic policy package of 1965-68 to finance both the Vietnam conflict and its welfare programs, President Johnson backed an increase in US government spending that was not financed by an increase in taxes. Instead, it was financed by an increase in money supply, which in turn, led to rise in price inflation from less then 4 percent in 1966 to close to 9 percent by 1968. With more money in their pockets the American spent more, particularly on imports, from here the US trade balance started to deteriorate rapidly.

The rise in inflation and the worsening of US trade position gave support to the speculation in the foreign exchange market that the dollar would be devalued. Things came to a head on spring 1971, when US trade figures were released, which showed that for the first time since 1945, the United States was importing more then it was exporting. This set off the massive purchases of deutsche marks by the speculators who guessed that the DM would revalue against the dollar. On a single day May, 4, 1971 the Bundesbank had to buy $ 1 billion to hold the dollar/DM rate at its fixed exchange rate given the great demand for DMs. On the morning of May 5, the Bundesbank purchased another $ 1 billion during the first hour of trading. At that point, the Bundesbank faced the inevitable and allowed its currency to float.

In the weeks following the decision to float the DM, the market became increasingly convinced that the dollar would have to be devalued. However, devaluation of the dollar was not an easy matter. Under the Bretton Woods provisions, any other country could change its exchange rates against all currencies simply by fixing its dollar rate at a new level. But as the key currency in the system, the dollar could be devalued only if all countries agreed to simultaneously revalue against the dollar. And many countries did not want this since it would make their products more expensive relative to US products.

President Nixon in August 1971 announced that dollar was no longer convertible in to gold. He also announced that a new 10% tax on imports would remain in effect until the US’s trading partners agreed to revalue their currencies against the dollar. This brought the partners on the bargaining table, and in December 1971 an agreement was reached to devalue the dollar by 8 percent against the foreign currencies. The import tax was than removed.

The problem was not solved, however. The US balance of Payment position continued to deteriorate throughout 1972, while the money supply continued to expand at inflationary rate. Given the more solid reason to believe that the dollar was overvalued. After a massive wave of speculation in February, which culminated with European Central banks spending upto $3.6 billion. On March 1 to try to prevent their currencies form appreciating, the foreign exchange market was close down. When the market reopened on March 19, the currencies of Japan and most European countries were floating against the dollar.

After Bretton Woods
Switching away form the fixed currency system after 27 years out of necessity, not by choice was a difficult task. The Smithsonian agreement reached in Washington in December 1971 had a transactional role to the free-floating markets. This agreement failed to address the real cause behind the international economic and financial pressure, focusing instead on increasing the range of currency fluctuation. From 1 percent the band of foreign currencies fluctuation was expanded to 4.5 percent.

Parallel to Washington’s efforts, the European Economic Community, established in 1957, tried to move away from the US dollar block toward the Deutsche mark block, by designing its own monetary system. In April 1972, West Germany, France, Italy, the Netherlands, Belgium and Luxembourg developed the European joint Float. Under this system the member countries were allowed to move between 2.25 percent band, known as the snake, against each other, and collectively within 4.5 percent band, known as the tunnel, against the US dollar.

Unfortunately, both the Smithsonian Institution Agreement and the European Joint Float did not address the independent domestic problems of the member countries from the bottom up, attempting instead to focus solely on the large international picture and maintain it by artificially enforcing the intervention points. By 1973, both systems collapsed under heavy market pressures.

The idea of regional currency stability with the goal of financial independence form the US dollar block persisted. By July 1978, the members of the European Community approved the plans for the European Monetary System: West Germany, France, Italy, Netherlands, Belgium, Great Britain, Denmark, Ireland and Luxembourg. The system was launched in March 1979, as a revamped European Joint Float, or a MINI Bretton Woods Accord. Additional features, such as the threshold of divergence, were designed to protect this monetary system from the fate of the previous ones. Judging from its expended life span, until 1993 at least the EMS was obviously better. Until it proved to be devastating in 1992, when the Pound fell against the dollar form 2.01 to 1.4000 with days.

The Floating Exchange Rate Regime
The floating exchange rate regime that followed the collapse of the fixed exchange rate system was formalized in January 1976 when IMF members met in Jamaica and agreed to the rules for the international monetary system that are in place today.

The Jamaica Agreement
The purpose of the Jamaica meeting was to revise the IMF’s Articles of Agreement to reflect the new reality of floating exchange rate. The main elements of the Jamaica agreement include the following:

  • Floating rates were declared acceptable. IMF members were permitted to enter the foreign exchange market to even out “unwarranted” speculative fluctuations.
  • Gold was abandoned as reserve assets. The IMF returned its gold reserve to members at the current market price, placing the proceeds in a help fund to help poor nations.
  • Total IMF quotas- the amount member countries contributes to IMF – were increased to $41 billion. Since then they have been increased to $180 billion.

Exchange Rates since 1973
Since March 1973 exchange rates have become much more volatile and far less predictable than they were between 1945 and 1973. This volatility has been partly due to a number of unexpected shocks to the world monetary system, including:

  • The oil crisis in 1971, when OPEC quadrupled the price of oil. The harmful effect of this on the US inflation rate and trade position resulted in further decline in the value of the dollar.
  • The loss of confidence in the dollar that followed the rise of US inflation in 1977 and 1978.
  • The oil crisis of 1979, when OPEC once again increased the price of oil dramatically- this time it was doubled.
  • The unexpected rise in the dollar between 1980 and 1985, despite a worsening balance of payment picture.
  • The rapid fall of the US dollar between 1985 and 1987.

Free Floating
The major currencies such as US dollar move independently of the other currencies. The currency may be traded by anybody so inclined. Its value is a function of the current supply and demand forces in the market, and there are no specific intervention points that have to be observed. Of course, the Federal Reserve Bank irregularly intervenes to change the value of the US dollar, but specific levels are ever imposed. Naturally, free-floating currencies are in the heaviest trading demand.
This system of free floating of currencies against the dollar provides ample opportunities to the investors to judge and trade these currencies. This system of free floating proves to be the best market available all around the world with same kind of exposure and opportunities to trade and make full use of foreign exchange market.

 

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