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IMF History (1966-1971) Volume 2
Chapter

The Role of Exchange Rates in the Adjustment of International Payments (September 1970)

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International Monetary Fund
Published Date:
February 1996
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A Report by the Executive Directors

Table of Contents

Part I: Review and Analysis

A. The Present System

Chapter 1. Exchange Rates in the Bretton Woods System

a. The exchange rate in its international aspect

The rate of exchange has a key role in the modern national economy. Yet an exchange rate, as the price of one currency in terms of another currency, is not subject to the effective control of a single country. A national authority can, by its own action, alter the rates of exchange between its own currency and all other currencies at any moment of time; but individually these exchange rates will also be subject to the influence of other national authorities.1

This multinational character of exchange rates was unobtrusive as long as exchange rates were held within narrow limits in relation to a constant parity, or responded freely to market forces in exceptional cases in which the fixed parity had to be abandoned. This was broadly the position under the gold standard maintained by the leading countries during the half century before 1914. The maintenance of exchange rates at particular levels might itself involve a variety of problems for national economies, but these problems were not generally regarded as amenable to the deliberate adjustment of exchange rates. Over the past half century, as governments have taken more responsibility for the performance of their national economies, they have become more concerned with the appropriateness of the exchange rates of their currencies. In certain circumstances, the adjustment of exchange rates can play a helpful supporting role in the management of a national economy. But this same adjustment will cause reciprocal and inverse changes in exchange rates of other currencies, and may thereby cause new problems in the management of other national economies. Thus, the pursuit of exchange rate policies by national authorities necessitates a mechanism of international coordination to ensure that the several policies are mutually compatible. The fulfillment of national needs demands the protection of international safeguards.

The problems that arise when national authorities pursue active policies to influence exchange rates and other key instruments affecting their external finances without a framework of international coordination were illustrated in the 1920’s and 1930’s. National actions on exchange policies, taken without due regard to their repercussions on other countries, frequently caused mutual conflict and disturbance. Initial misalignment of exchange rates of major currencies contributed to a breakdown of exchange stability; subsequently, the absence of an agreed code of behavior contributed both to troublesome instability in exchange rates and to the spread of defensive restrictions on trade and payments. International trade suffered, and national economies turned inward.

The determination of national governments to provide the framework in which legitimate national economic goals could be pursued in international harmony underlay the creation of the International Monetary Fund after World War II. The provisions of the Fund’s Articles of Agreement relating to the system of par values, and in particular to the adjustment of par values, are an integral part of the whole Bretton Woods structure, and they need to be considered in the context of the Fund’s purposes. The purposes of the Fund as stated in Article I are as follows:

  • (i) To promote international monetary cooperation through a permanent institution which provides the machinery for consultation and collaboration on international monetary problems.

  • (ii) To facilitate the expansion and balanced growth of international trade, and to contribute thereby to the promotion and maintenance of high levels of employment and real income and to the development of the productive resources of all members as primary objectives of economic policy.

  • (iii) To promote exchange stability, to maintain orderly exchange arrangements among members, and to avoid competitive exchange depreciation.

  • (iv) To assist in the establishment of a multilateral system of payments in respect of current transactions between members and in the elimination of foreign exchange restrictions which hamper the growth of world trade.

  • (v) To give confidence to members by making the Fund’s resources temporarily available to them under adequate safeguards, thus providing them with opportunity to correct maladjustments in their balance of payments without restorting to measures destructive of national or international prosperity.

  • (vi) In accordance with the above, to shorten the duration and lessen the degree of disequilibrium in the international balances of payments of members.

  • The Fund shall be guided in all its policies and decisions by the purposes set forth in this Article.

The principles of exchange rate adjustment, as established in Article I and Article IV of the Fund Agreement, can be summarized in the following broad terms. Member countries have accepted a limitation on their immediate freedom of action over the exchange rate by undertaking certain international obligations, of which some are specific and others general in character. Members undertake to consult the Fund on all proposed adjustments in their parities, and accept the right of the Fund to concur or object to such proposals in all but certain specified cases; more generally, member countries are guided in their exchange rate policies by the purposes and procedures of the Fund. The international community in turn accepts the right of individual countries, subject to the international obligations just mentioned, to adjust their exchange rates to fulfill legitimate domestic objectives, as well as agreed international objectives. A change in the parity of a member’s currency may be made only on the proposal of the member; but members agree that they will not propose such a change except to correct a fundamental disequilibrium. The par values of currencies are expressed in terms of the common denominator of gold or of a United States dollar of a fixed gold content (see page 280).

The concept of fundamental disequilibrium is discussed in greater detail on pages 307–10. Together with the purposes of the Fund of promoting exchange stability, maintaining orderly exchange arrangements, and avoiding competitive exchange depreciation, the provisions on fundamental disequilibrium provide safeguards against unjustified adjustment of exchange rates, such as would create undue difficulties for other countries. The concept of fundamental disequilibrium is also related to the Fund’s other purposes. Thus, if a member country maintains balance in its external payments only by continued recourse to foreign exchange restrictions which hamper the growth of world trade, it could be judged to be in fundamental disequilibrium. Equally, the readiness of the Fund to make its resources temporarily available to members to assist them to correct payments imbalances in an acceptable way helps avoid the need for exchange rates to be adjusted to deal with disequilibria that are temporary or that can more appropriately be corrected by other measures; the availability of the Fund’s resources also helps members avoid or minimize recourse to payments restrictions. As indicated in Article I (v), the purpose of the financial assistance provided by the Fund is to further the adjustment of international payments without resorting to measures destructive of national or international prosperity. This objective has been reflected in the development of the Fund’s tranche policies, delineating the broad terms on which its resources are made available. The ability of the Fund to extend assistance in accordance with these policies has been enhanced by periodic increases in Fund quotas, and by provision of supplementary resources through members’ lendings to the Fund, principally under the framework of the General Arrangements to Borrow.

The use made by member countries of exchange rate adjustment is also influenced in various ways by the availability of liquidity that can be used without policy conditionality. Important influences in this context have been the decisions by member countries of the Fund to establish and then to activate the Special Drawing Account in the Fund, as well as the arrangements made by some members, or their central banks, to extend mutual bilateral credits to other monetatry authorities.

The stabilization of exchange rates around par values agreed with the Fund, changeable on the basis of agreed principles and in accordance with agreed procedures, has become known as “the par value system” or, more broadly, as “the Bretton Woods system”; the latter appellation emphasizes the interconnection between the arrangements for exchange rates and other aspects of the Bretton Woods philosophy.

b. The exchange rate in its domestic aspect

For any particular economy, the exchange rate of the domestic currency sets the price of foreign exchange. As such, the exchange rate (or strictly, the network of exchange rates between the domestic currency and the various other currencies) performs certain basic functions of the price mechanism in influencing the allocation of resources and contributing to the balancing of supply and demand of the commodity in question—in this case, foreign exchange. But the role of the exchange rate is much wider than this. The price of foreign exchange has an important influence on basic financial magnitudes in a national economy. The exchange rate influences the allocation of expenditures as between domestic and foreign goods, and thereby the flow of aggregate domestic output, incomes, and spending. Especially where the foreign sector is large, the intended effect of exchange rate adjustments in promoting a desired switch in output and expenditure as between the domestic sector and the foreign sector may be accompanied by additional and undesired effects on aggregate spending and on the level of domestic prices and costs. The exchange rate also influences the supply of domestic money, as well as the demand for domestic money and for other assets through its effect on relative prices of domestic and foreign assets. In many countries, the authorities have looked on the exchange rate as a fixed point of reference which provides a useful discipline for the maintenance of financial stability domestically; this is discussed further on page 297.

For reasons of this kind, national authorities normally find it desirable wherever feasible to focus their economic policy on a stable exchange rate, to be adjusted only where this is necessary to avoid undesirable distortions in the domestic economy. Where such distortions occur, and threaten to persist, adjustment of the exchange rate may be called for. Such adjustment will normally need to be accompanied by carefully matched adjustments in other policies influencing the flow of domestic expenditures. This will be necessary to ensure that the positive function of exchange adjustment, of influencing the allocation of resources between the domestic and foreign sectors, is successfully implemented and is not associated with damaging side effects. There are therefore special domestic reasons for seeking stability in exchange rates so far as possible. Such considerations apply to all countries in some measure; they apply particularly strongly to countries connected by close trading relationships or special regional associations.

Insofar as payments imbalances result from seasonal or cyclical influences, adjustment of exchange rates is clearly inappropriate. Temporary imbalances of this kind, which do not represent fundamental disequilibria, do not call for measures specifically designed to correct the external imbalance (though certain corrective measures may of course be desirable on domestic grounds). Such temporary external imbalances can appropriately be financed through official reserves or official credits. Adjustment of exchange rates may also be inappropriate to deal with imbalances caused by capital movements that appear temporary in nature. In these cases, the national authorities have the choice between deterring the capital flows through various regulatory measures, and financing or accepting and perhaps neutralizing such flows, which may be feasible up to a certain point. Problems concerning capital movements are discussed in a number of sections in this report, in particular on pages 291–92 and 311–14.

The most frequent source of troublesome payments imbalance in modern conditions is an excess of domestic spending over available domestic resources. This draws in additional imports and may also divert domestic output from export markets. The ensuing external deficit represents excess absorption by the domestic economy; restoration of balance, in whatever way, will necessitate the elimination of this excess absorption through a reduction in domestic spending in relation to domestic output. Since output cannot easily be increased in such conditions, balance must be restored by means of a reduction in domestic spending. Policy correctives such as fiscal or monetary restraints will help to restore balance both in the domestic economy and in external payments—the payments disequilibrium being a reflection of the disequilibrium between monetary demand and productive capacity in the domestic economy. If the correctives are applied at an early stage, they should usually be sufficient, in such conditions, to restore external equilibrium without unnecessary damage to the domestic or international economy.

However, not all troublesome payments disequilibria are of a kind that can appropriately be remedied by adjusting the flow of total domestic expenditure. The payments disequilibrium may have been caused by an excess (or a deficiency) of domestic spending, but delay in corrective action may have led to a disparity in domestic and international prices, creating a new and more enduring source of disequilibrium. In such cases, even after domestic expenditures are adjusted in real terms, domestic costs may remain out of line and external equilibrium will not be restored. In these conditions, adjustments in domestic financial policy need to be accompanied or followed by a change in relative prices to give additional stimulus for a switch in domestic output toward (or away from) exports and substitutes for imports, and for a switch in domestic expenditures toward (or away from) domestic goods as against foreign trade goods. The external orientation of the economy may need to be accentuated, or reduced. Adjustment of the exchange rate effects this change in relative prices in a nondiscriminatory way. Exchange rate adjustment may also be required to deal with payments disequilibria caused by particularly unfavorable (or particularly favorable) developments in foreign markets, or in domestic productivity.

In cases of the kind discussed in the previous paragraph, adjustments in domestic expenditure alone cannot remove external imbalance without worsening the domestic imbalance. At the same time, adjustment in the exchange rate will usually need to be flanked by adjustments in domestic policies if external balance is to be restored together with internal financial balance. A devaluation will need accompanying measures to restrain domestic demand, except where a large deficiency of demand currently exists, in order to provide the necessary room in the internal economy for the desired switch of resources from domestic to external use to take place without endangering domestic financial stability. Adjustment in the exchange rate permits such a switch in the allocation of resources, but does not by itself assure it. A revaluation will need accompanying measures to expand domestic demand, except where demand is currently excessive, to assure the desired switch of resources from external to domestic use. Exchange rate adjustment is sometimes an aid to necessary internal adjustment; but if used as a substitute for internal adjustment, it is unlikely to be consistent with the maintenance of internal financial stability.

Chapter 2. The Working of the System

a. Market convertibility in modern conditions

Convertibility of currencies at stable exchange rates may take a number of technical forms. The regime that has emerged since World War II is described in this chapter, Its practical characteristics, inevitably, were foreseen only in part by the Fund’s founders.

Article IV, Section 1 (a) of the Fund Articles states: “The par value of the currency of each member shall be expressed in terms of gold as a common denominator or in terms of the United States dollar of the weight and fineness in effect on July 1, 1944.” Obligations in connection with par values and exchange stability include the following main provisions:

Article IV, Section 3. Foreign exchange dealings based on parity

The maximum and the minimum rates for exchange transactions between the currencies of members taking place within their territories shall not differ from parity

  • (i) in the case of spot exchange transactions, by more than one percent; and

  • (ii) in the case of other exchange transactions, by a margin which exceeds the margin for spot exchange transactions by more than the Fund considers reasonable.

Article IV, Section 4. Obligations regarding exchange stability

(a) Each member undertakes to collaborate with the Fund to promote exchange stability, to maintain orderly exchange arrangements with other members, and to avoid competitive exchange alterations.

(b) Each member undertakes, through appropriate measures consistent with this Agreement, to permit within its territories exchange transactions between its currency and the currencies of other members only within the limits prescribed under Section 3 of this Article. A member whose monetary authorities, for the settlement of international transactions, in fact freely buy and sell gold within the limits prescribed by the Fund under Section 2 of this Article shall be deemed to be fulfilling this undertaking.

The undertaking to maintain dealings in foreign exchange within the permitted margins from parity is implemented by countries other than the United States through official intervention in exchange markets, or through official dealings in foreign currency at fixed buying and selling rates where exchange markets are narrow or do not exist. In either case, official operations are confined or mainly confined to transactions in terms of one foreign currency. This is referred to informally as the intervention currency, to which the domestic currency is “pegged.” The U.S. dollar is the main intervention currency; the pound sterling, the French franc, and the Belgian franc are intermediary or regional intervention currencies, and are themselves pegged to the U.S. dollar. Rates against currencies other than the intervention currency are maintained within the permitted margins by market arbitrage or by the possibility of such arbitrage. The United States, as the center country in the network of exchange rate relationships, generally allows the market value of the U.S. dollar in terms of other currencies to result from initiatives taken by the authorities of the other country concerned. The United States initiates certain official operations in a foreign exchange, but maintains the external value of its currency by standing ready to buy and sell gold for its own currency at a fixed rate. In addition, the United States accepts the obligations of Article VIII including the obligation relating to the convertibility of balances of its currency.2

b. Margins on spot rates

Article IV, Section 3 regulates the extent to which exchange transactions between the currencies of members taking place within their territories may deviate from parity. For spot exchange transactions (i.e., transactions for prompt settlement) the maximum permitted deviation or margin is 1 per cent on either side of parity. The range of fluctuation from one margin to the other is referred to informally as the band of fluctuation. In practice, as noted above, Fund members maintain exchange margins in terms of an intervention currency. It follows that the exchange rate between the currencies of any two countries which each set their margins against the same intervention currency can diverge from parity by the sum of the margins maintained by the two countries. A decision of the Fund taken in 1959 permits margins for spot transactions to a maximum of 2 per cent where this results from the maintenance of margins of not more than 1 per cent against a convertible currency.3

The margins currently maintained against the intervention currency fall within a range of 0.7-0.9 per cent in the case of member countries in which rates move from day to day in exchange markets (Table 1); and deviations between third currencies have been far smaller than the theoretical maximum (Chart 3, page 284). Table 1 shows the margins around parity against the U.S. dollar maintained by 16 developed countries since the beginning of 1959, expressed in terms of currency units and percentages of par. These margins, or intervention limits, are made known by each country, and in the case of member countries of the European Monetary Agreement, the margins are officially notified under that Agreement. For 15 of the 16 countries in the table, the intervention currency is the U.S. dollar, so that the margins shown are those maintained vis-à-vis the intervention currency; the exception is Portugal, for which sterling is the intervention currency, against which Portugal maintains margins of below 1 per cent, but resultant margins against the U.S. dollar slightly above 1 per cent. The table shows a slight tendency, since 1959, for exchange margins around parity against the intervention currency to be moved closer toward the 1 per cent maximum allowed under Article IV, Section 3. (The margins maintained by Switzerland, which is not a member of the Fund, are about 1¾ per cent on either side of the gold parity, implying a band width of 3½ per cent; however, the Swiss authorities have maintained the Swiss franc consistently above par and fluctuations since 1959 have in practice been confined within a band of about 1¼ per cent.)

Chart 1.Movements in Parities of Currencies of Selected Industrial Countries, January 1947 to June 19701

(January 1947 = 100)

1 The rates indicated are the par values agreed with the Fund except in the following cases: Swiss franc (nonmember currency); Japanese yen, to May 1953; Italian lira, to March 1960; French franc, January 1948–December 1960; Canadian dollar, see footnote 2.

2 Fluctuating rate, September 30, 1950 to May 1, 1962; and June 1, 1970—.

3 Fluctuating rate, September 29 to October 24, 1969.

Chart 2.Movements in Parities of Currencies of Industrial Countries, January 1959 to June 19701

(January 1959 = 100)

1 See footnote 1 of Chart 1.

2 January 1959 to June 1970.

3 Fluctuating rate from January 1959 to May 1, 1962.

4 Fluctuating rate from September 29 to October 24, 1969.

5 Fluctuating rate June 1, 1970—.

Table 1.Exchange Rate Margins Against the U.S. Dollar, January 1959 to June 30, 1970:1 16 Developed Countries(Margins above (+) and below (−); in per cent and units of national currency)
Sources: Organization for European Economic Cooperation, European Monetary Agreement, Annual Report of the Board of Management, 1955–64 (Paris); International Monetary Fund, Annual Report on Exchange Restrictions, 1959, 1968, and 1969; and other sources.

Officially notified margins under the European Monetary Agreement.

Shown as at January 1959 and for years in which changes were made.

Of national currency.

U.S. cents.

Canadian dollar parity 1.08108 per U.S. dollar from May 2, 1962.

Sources: Organization for European Economic Cooperation, European Monetary Agreement, Annual Report of the Board of Management, 1955–64 (Paris); International Monetary Fund, Annual Report on Exchange Restrictions, 1959, 1968, and 1969; and other sources.

Officially notified margins under the European Monetary Agreement.

Shown as at January 1959 and for years in which changes were made.

Of national currency.

U.S. cents.

Canadian dollar parity 1.08108 per U.S. dollar from May 2, 1962.

Chart 3.Monthly Average Spot Rate: Deviations from Par

Sources: U.S. Federal Reserve Bulletin, monthly issues; International Financial Statistics.

1 Because of the fluctuation of the deutsche mark outside normal margins in the period September 29 to October 24, 1969, the average for September 1969 has been calculated from average daily rates for the period September 2 to September 23, 1969, and no calculations have been made for October 1969.

The movement of market rates within these margins is illustrated in the accompanying charts, which plot movements in average monthly exchange rates on the U.S. dollar alongside monthly movements in reserves (Chart 4, page 286). The charts reflect the fact that intervention by monetary authorities in most countries has not been confined to fulfilling the announced commitment to maintain exchange rates within the declared margins. Thus reserve movements occurring while the rates are well within the margins have been far larger than could be accounted for by transactions outside the exchange markets. In a number of cases, exchange rates have become slightly more responsive to market pressures in recent years, i.e., the exchange authorities have allowed market pressures to be absorbed somewhat more by movements in the exchange rate before (or while) themselves absorbing the pressures by official intervention, entailing flows from or to official reserves. At the same time, the exchange authorities seek to avoid unduly sharp day-to-day movements in the rates. The charts show that for most of the currencies, the exchange rate in recent years has moved fairly extensively within the margins, with reserve losses being associated with a rate falling toward its lower limit and reserve gains associated with appreciation of the rate toward the ceiling.

Chart 4.Movements in Reserves Compared with Movements in Spot Exchange Rates in Relation to Parities and Exchange Margins

Note: Reserve movements are end-monthly, as shown in International Financial Statistics. Spot exchange rate movements, on the U.S. dollar, are monthly averages, derived from the Federal Reserve Bulletin, except in months of, and preceding, parity changes where end-monthly rates are derived from IFS.

1 Fluctuating rate from June 1, 1970—,

Practices differ a good deal more for countries whose currencies are less used in international transactions. For the most part, developing countries and other primary producing countries have established set rates at which foreign currency is bought and sold. Where periodic adjustments are made in the administratively set rates, these adjustments may have some of the effects of a movement in market-determined rates in the same range. The countries that peg their currencies to sterling, to the French franc and other regional intervention currencies in almost all cases maintain fixed buying and selling rates for these currencies; it follows that fluctuations against other currencies correspond with the fluctuations of the regional intervention currency.

As indicated earlier in this chapter, market movements in currencies other than the U.S. dollar are regulated, directly or indirectly, by market intervention between the domestic currency and the U.S. dollar. It follows that the U.S. dollar fluctuates in value in terms of other currencies within the regular margins set against the dollar by other countries, i.e., in practice by about one half the theoretical range in which currencies fixed in relation to the dollar can fluctuate against each other.

c. Forward rates

The Fund Articles contain another obligation governing rates for exchange transactions within members’ territories. Members have undertaken that rates for exchange transactions other than spot transactions shall not differ from parity by a margin which exceeds the margin for spot exchange transactions by more than the Fund considers reasonable.4 These other exchange transactions include transactions in forward exchange (i.e., transactions for settlement at some future date such as one month or three months hence). The Fund has never adopted a policy with regard to rates for forward exchange transactions. The exchange authorities of countries with convertible currencies have not maintained these rates within a specified or constant range, though a number of these authorities have intervened in these markets on an ad hoc basis to moderate market pressures or to exert an indirect influence on spot transactions; such intervention in the forward markets has at times taken place on a substantial scale and for considerable periods.

For the currencies of the main industrial countries, forward exchange rates on maturities of three months or less, which account for the greater part of forward exchange transactions, have mostly remained within 1 per cent of parity against the U.S. dollar (Chart 5, above), and within a smaller margin of the spot rate.5 However, considerably wider deviations from parity on these forward rates have prevailed at times when important changes in parities were in prospect and when the authorities refrained from systematic support of their currencies in forward markets. Thus, in 1968–69 deviations from par on three months rates against the U.S. dollar ranged up to 3 per cent for sterling and up to 7¾ per cent for French francs; forward margins on cross rates, e.g., between the deutsche mark and the French franc and the pound sterling, were substantially larger than the rate against the dollar. These margins reflected the prevailing speculation on prospective changes in parities.

Chart 5.Three-Month Forward Rates: Deviations from Par

(In per cent, end of month)

Note: Rates in domestic markets as shown in International Financial Statistics; except for the rate of the French franc from May 1968 to June 1970, based on quotations in the New York market.

* No forward rate given for the deutsche mark for end-September 1969, when the parity was not effective.

In circumstances in which speculative forces of this kind are active, a good deal of trade financing previously undertaken through spot transactions has been switched to forward markets, insofar as this has been permitted under exchange control. In more settled periods, the proportion of trade transactions at forward rates has been modest. Firm and comprehensive figures are not available; incomplete information suggests that in some countries the proportion of trade invoiced in foreign currency that has been settled at forward exchange rates has been as low as 10 per cent in quiet times; in other countries, the comparable proportion has been around 25 per cent for a number of years.

d. Capital transactions

At the time that the Fund Articles were drawn up almost three decades ago, a prevailing concern among countries was to ensure the removal of restrictions on international payments and transfers in connection with current transactions. This is reflected in Article I (iv), which lists among the purposes of the Fund, “the establishment of a multilateral system of payments in respect of current transactions between members and … the elimination of foreign exchange restrictions which hamper the growth of world trade.”6 The emphasis on current transactions is also reflected in the obligation concerning convertibility of foreign-held balances under Article VIII, Section 4.7 Members of the Fund are specifically authorized to exercise such controls as are necessary to regulate international capital movements, provided these do not unduly delay or otherwise restrict payments for current transactions; in addition, the Articles limit the ability of members to use the Fund’s resources to meet a large or sustained outflow of capital, and the Fund may request a member to exercise controls on capital movements to prevent such use of the Fund’s resources.

In practice, the intended distinction in the treatment of payments for current transactions and for capital transactions has been only partially observed. This has reflected a recognition that international capital flows of a number of kinds have an important positive role to play in the development of the world’s productive resources. Perhaps equally important, the form in which major countries have established convertibility of their currencies—through the mechanism of exchange markets—has not been susceptible to a close distinction between current and capital transactions in exchange regulations. In a number of these countries, to be sure, such a distinction has been made in exchange regulations applying to domestic residents. In some countries, access to foreign exchange on the official market has been reserved for payments in connection with current transactions; as a result, parallel markets have usually emerged in foreign exchange available to domestic residents for foreign investment. In some other cases, access to the official foreign exchange market has not been available for settlements of capital transactions (and certain current transactions) by nonresidents as well as residents, resulting in a separate exchange rate for capital transactions. But in general, the countries that have attained formal convertibility (see Section e) have taken the view that the increasing integration between the major economies imposes practical limits on the extent to which restrictions can be placed on capital flows without risking restriction or distortion of trade and other current payments.

Admittedly, controls on certain capital flows (principally outflows of domestic funds) have not only been retained in a number of countries, but in some countries have been newly imposed, or reimposed. For the most part, however, such newly imposed controls have been intended as temporary in duration. The views taken on the feasibility and desirability of capital controls have been influenced by changing circumstances. The rapid growth in the size of international markets in short-term funds in the late 1960’s, mainly in the form of “Euro” markets in bank deposits denominated in foreign currency, induced a number of major countries to impose or extend regulatory measures to influence flows of short-term capital between these markets and their domestic currency. At the same time, comprehensive and effectively restrictive controls on international capital movements were widely considered neither feasible nor, at least in their entirety, desirable.

Thus, effective controls on international capital movements have been considered, on the whole, as less practicable, and at least until recently, also as less desirable, than was envisaged by the founders of the Fund. At the same time, partly in association with the increasing integration of the world economy, the actual and potential movements have become very large—far larger than expected in 1958 on the eve of the general move by European countries to external convertibility. As a result of both these broad developments, international capital movements have played a larger role in exchange markets and in the working of the international monetary system than was originally envisaged. The emergence of large and effectively integrated capital markets in conditions of currency convertibility has created a huge and progressively increasing pool of liquid funds which may be switched between currencies for precautionary or speculative reasons at times of particular uncertainty. This has contributed to the strains to which the system has been subjected, as discussed in Chapter 3.

e. Observance of par value obligations

The basic exchange rate regime under the par value system may be described in general terms as a stable exchange rate fluctuating within defined and narrow limits around the par value, with access to the exchange market freely permitted for transactions in connection with current payments and transfers. As of June 30, 1970, 34 of the Fund’s 116 member countries had accepted the obligations of Article VIII, Sections 2, 3, and 4. In four of these countries the obligation to maintain exchange rates within the required margins of parity was not currently being observed. The remaining 30 countries, accounting for about 71 per cent of world trade, maintain an effective par value. Among the other Fund member countries, which continue to have recourse to Article XIV, some 27 countries maintain effective par values and refrain from imposing substantial restrictions on current payments and transfers; while a further 17 maintain stable rates and avoid restrictions on current transactions without as yet having declared a par value. Together, therefore, a total of 74 member countries are effectively, though not always formally, adhering to the basic features of the par value system. They account for some 78 per cent of world trade. The remaining Fund member countries either maintain significant restrictions on current payments or, in some cases additionally, have failed to maintain effective par values.

The Fund and its member countries have recognized that conformity with the full requirements of the par value system must in some cases be a gradual process, proceeding in line with members’ capabilities. Where the circumstances of particular members have not permitted observance of these requirements, the Fund has tolerated and even encouraged the adoption of certain temporary expedients. Broadly, the countries for which exceptions have been tolerated or encouraged have made important progress in the major sphere of reducing dependence on payments restrictions, and in moving toward a multilateral system of payments by reducing discrimination and recourse to multiple exchange rates. These countries have thereby improved their prospects of eventual observance of par value obligations. Steady progress has also been made in the move to Article VIII status by member countries as a whole.

f. Attitude toward fluctuating rates

A number of instances have arisen in which member countries have felt unable to avoid recourse to a fluctuating exchange rate. The Fund is not empowered by its Articles to approve a regime of a unitary fluctuating rate, but it can give temporary approval to a fluctuating rate when it is a multiple currency practice. The Fund has recognized the demands of the situations in which fluctuating rates, whether of the one kind or the other, have been adopted. This has occurred in a variety of circumstances; a broad distinction may be made between the circumstances that have led to initial appreciations of currencies beyond the permitted margins, and the markedly different circumstances that have led to initial depreciations beyond the permitted margins. The first, and much the less frequent, of such circumstances has occurred where countries whose external financial positions have been particularly strong have felt their domestic financial stability to be threatened by speculative inflows of capital and perhaps also by general inflationary impulses from the world economy; and where such countries have not felt able, for a variety of reasons, to decide on a new par value to which their currency should be appreciated. Speculative inflows of capital of this kind have also in some cases had unsettling effects on the countries that were the source of the capital flows, and on the international monetary system at large. In certain cases, the country receiving the speculative inflow has sought to curb the flow by ceasing systematic official intervention in support of its par value. Practices of this kind were adopted by Canada in 1950, being maintained in that case for over 11 years; and by Germany in 1969, being maintained in that case for under one month. In both cases, the Fund recognized the exigencies of the situation and urged the national authorities to re-establish an effective par value as soon as feasible. On May 31, 1970, the Government of Canada announced that as a result of additions to its over-all foreign exchange position at a pace it considered unmanageable, it had decided for the time being not to maintain the exchange rate of the Canadian dollar within the prescribed margins around parity; the Fund took note of this action and welcomed the intention of the Canadian authorities to remain in close consultation with the Fund with a view to the resumption of an effective par value at the earliest possible date. The problems involved in cases in which countries feel overwhelming pressure on their par value and do not feel able at that time to propose a new par value are discussed further on pages 313–14.

The more frequent cause of the maintenance of a fluctuating rate has been that the national authority concerned has felt unable to establish or sustain stability in its domestic finances. Domestic financial stability is a necessary basis for exchange stability, even if it is not always a sufficient basis. The Fund has always sought to encourage the pursuit of sound financial policies. In several member countries, however, the requisite degree of domestic financial stability has not been attained, and a considerable degree of inflation has remained rooted in the economy. In such circumstances, the Fund has recognized that a member’s attempt to maintain a stable exchange rate would in practice involve increasing recourse to trade and payments restrictions, which would in turn tend to isolate the economy from the international economy in a damaging way, and thereby tend to exacerbate the distortions caused by inflation itself. If an open economy is to be maintained or restored in such conditions, and the competitiveness of the economy is to be safeguarded, it may well be necessary to have recourse to a flexible exchange rate.

Experience in a number of countries has suggested that a fluctuating (and in practice depreciating) exchange rate has been successful in these conditions in preventing or correcting the inward turn in the economy that severe inflation otherwise tends to involve. Less developed countries that have resorted to a fluctuating rate have in most cases reduced their dependence on exchange and trade restrictions substantially. In Latin America, the introduction of a new and more flexible exchange system has often been accompanied by the elimination of all exchange restrictions. However, the reduction in trade restrictions has been much less widespread, due in part to the maintenance of trade restrictions for protective reasons.

The success of these countries in reducing restrictions, although based in the first instance on replacing direct controls by price limitations, has been given a more assured basis where the better incentives provided by a realistic exchange rate have stimulated export growth on the scale needed to provide for growing import needs. The record of export growth is generally satisfactory among those Fund members with fluctuating rates that have either effectively stabilized their internal costs, or that have permitted the exchange rate to move broadly in line with the rise in domestic prices and costs relative to those abroad.

Fund members that have had resort to systems of fluctuating rates have in a number of cases continued to experience an unusual degree of inflation; in general, however, the degree of inflation was much larger before greater exchange flexibility was introduced. In some cases, this reflects the fact that a fluctuating rate was introduced as part of a general program of stabilization or was subsequently buttressed by such a program.

Toleration of a fluctuating rate in circumstances of this kind has in no case been based on a preference on the part of the Fund for a flexible exchange rate regime in conditions of internal financial stability. The aim has been in the first instance to minimize the use of trade and payments restrictions and in due time to provide the conditions for the adoption, or readoption, of an effective par value, and the achievement of full financial stability. While the Fund has tolerated or encouraged the maintenance by a number of member countries of a fluctuating rate as an interim step toward eventual stabilization, the Fund has regarded such arrangements as exceptional in character and suitable only for particular circumstances. They are designed to limit the damage caused by domestic financial instability. The exceptional nature of these arrangements has been well understood, and their existence has not undermined the par value system as a whole. Clearly, the deliberate adoption of a fluctuating rate by Fund members that played a major role in trade and payments, and were not suffering from problems of acute domestic instability, would carry different implications.

Chapter 3. Achievements and Problems of the System

In this chapter, an attempt is made to outline in broad terms the main achievements of the existing exchange rate regime, and the main problems it has encountered. On the basis of this discussion, pages 302–304 will then seek to identify the general scope that may exist for improving the system or its working, while safeguarding its essential achievements. Chapters 5 and 6 will discuss in more detail the advantages and disadvantages of proposals under which a limited degree of additional flexibility might be attained.

a. The system and its implementation

The existing arrangements for exchange rate regulation, as described in earlier sections, encompass three main elements. These are: a broad set of basic principles; a set of institutional arrangements in harmony with these principles; and the way in which these institutional arrangements are used in practice. “The existing system” thus encompasses principles, procedures, and policies. Modifications in the operation of the system could, within certain limits, be consistent with maintaining the essential features of the system, and such modifications in certain directions might further the implementation of the basic principles of the system. Expressed in these general terms, this proposition is hardly controversial. But to give flesh to this proposition, two difficult and inevitably contentious issues have to be considered. The first such issue is how far the desirable and undesirable features of past experience are to be attributed to the basic principles of the par value system, or to their implementation, or to extraneous features of the international economy. The second issue is how far modifications in institutional arrangements and in policies can go while remaining consistent with the basic principles of the system. The starting point of the analysis that follows must necessarily be the system as it has worked in practice: the discussion should help to bring out the factors to which the achievements and limitations of that experience are to be attributed.

b. Achievements

The quarter century during which the Bretton Woods system has been in operation has been a period of unparalleled economic growth; albeit accompanied by continuing domestic inflation.8 Plainly this record has been the result of a complex of factors. Of central importance has been the determination of governments to take responsibility for the economic performance of their country. In order to discharge that responsibility, as was foreseen by the founders of the Fund, the national authorities have had to combine active domestic policies with active international collaboration. The Bretton Woods structure has been the cornerstone of this collaboration, and in this important general sense, its role in contributing to the achievements of the world economy in this period is undoubted. The contribution of the particular exchange rate arrangements that have been adopted and of the exchange rate policies that have been pursued is obviously much more difficult to identify. A more direct attribution may be made in connection with specific aspects of the par value system, which are discussed below.

(1) absence of competitive depreciation

A major concern of the Fund Agreement, as reflected in Article I (iii),9 has been to avoid competitive exchange depreciation. In the 1930’s, conditions of widespread unemployment and deficiency of global demand were especially conducive to the aggressive use of exchange rate policy. Since World War II, the uninterrupted expansion of the world economy and the general tendency for demand in the major economies to be excessive rather than deficient would in themselves have reduced the risk of competitive depreciation, since countries no longer feel primarily dependent on additional exports or reductions in imports as a source of employment.

However, these conditions have not disposed entirely of the risk of competitive depreciation, which might still occur in cases where particularly high priority was put on major gains in a country’s international competitive position. The fact that competitive depreciation has been virtually absent from the international monetary scene since World War II must therefore be counted as a significant achievement of the arrangements for exchange adjustment under the par value system. The functioning of this system in the past 25 years has made a reality of the principle of international consultation on the adjustment of the exchange rate. As experience has grown, the role of international opinion in influencing national decisions on exchange adjustments has increased. The principle that the determination of the rate of exchange for each currency is a matter of international concern has become embedded in working arrangements and in habits of thought among the authorities concerned with exchange rate questions. This process, which could only result from the accumulation of practical experience, reinforces in an important way the safeguards provided in the Articles of Agreement against competitive depreciation.

(2) exchange stability

The related objectives of promoting exchange stability and maintaining orderly exchange arrangements among members have also been achieved in substantial degree. For the greater part of the period, and with the exceptions noted below, exchange rates of the major convertible currencies have been stable within the narrow margins around parity; the number of currencies achieving convertibility on this basis has gradually increased, so as to cover the predominant portion of world trade, as noted on page 292; and the system of exchange market intervention in support of par value obligations has worked smoothly. The arrangements under which countries other than the United States regulate their currency against the U.S. dollar, or against another currency that is in turn pegged on the dollar, while the United States itself pursues a generally passive policy in exchange markets, have provided a way of avoiding conflict between the actions of exchange authorities of different countries, without necessitating the elaboration of a set of rules or understandings on policies of exchange support. The relative narrowness of margins around parity has also contributed to this end, confining fluctuations around par to amounts that have no significant impact on competitiveness in international trade.

The maintenance of stable exchange rates for substantial periods of time has probably contributed to the very rapid growth of international trade;10 and has almost certainly added to the international flow of capital. A full assessment of these effects would, however, need to take two qualifying considerations into account. First, the maintenance of stability in exchange rates has on certain occasions involved costs as well as benefits for the national and international community. This effect comes most conspicuously into view at times of intense speculation, during which the continued willingness of the exchange authorities to deal in foreign exchange against domestic currency at a rate that appears likely to be changed by a substantial step, induces speculative movements of capital and speculative acceleration of merchandise transactions of certain kinds. A more continuing cost arises from distortions in domestic economic policy that have occasionally been induced by undue delay in making needed adjustments in exchange rates. Such distortions include restrictions on trade and payments, inappropriate levels of aggregate demand in the economy, and perpetuation of imbalance between the domestic and foreign trade sectors of the economy.

Secondly, trade and capital flows of other kinds may have been adversely affected by the comparative sharpness in the occasional adjustments in exchange rates of major currencies that have taken place, and also by the effects of market speculation on the possibility of such adjustments. The most prolonged period of speculation began with anticipation of the devaluation of sterling in fall 1967, and ended with the revaluation of the deutsche mark in fall 1969. In this two-year period, speculation was sufficiently strong on two occasions to necessitate a partial closing of exchange markets for a few days, and on other occasions involved difficult conditions and extremely high margins in markets for forward exchange (see Chart 5, page 290). The length of this period of speculative disturbance was clearly attributable to the delays in making needed parity adjustment, rather than to the system of parity adjustment; and in the absence of these delays, the size of the adjustments might possibly have been smaller. Some general considerations influencing the timing of adjustments in parities are discussed on pages 298–99. Adjustment in parities by a single step, even in the absence of undue delay, tends to involve some uncertainty and disturbance to traders. However, the significant question is whether a different method of adjusting exchange rates, e.g., through more continuous movements, would cause greater or less uncertainty and unsettlement.

(3) a fulcrum for domestic stability

In many countries the authorities have regarded a stable par value as a valuable aid in maintaining domestic economic stability. The existence of a fixed point of reference in the economy’s external relationships has been found a useful discipline. In some countries, adjustments in domestic financial policies, prompted by the discipline of a fixed exchange rate, have been capable of maintaining external balance without entailing significant conflict with the requirements of policy from a domestic standpoint. In a second group of countries, which have not succeeded in dispensing with eventual exchange adjustment, the norm of fixity in the exchange rate has nonetheless been considered as an aid to equilibrium, both in the domestic economy and externally. In such countries also, the need to defend a fixed exchange rate against depreciation may promote political willingness to impose unpopular domestic restraints; and where the attempt to defend the parity is ultimately unsuccessful, the psychological shock of a devaluation may promote broad support for the adoption of the necessary associated measures to curtail domestic demand. It is feared in these countries that a comparable adjustment, achieved in a more continuous way without the trauma implicit in the act of exchange adjustment as a last resort, would exert less pressure for domestic corrective measures, both as preventive measures to forestall the need for exchange adjustment, and as accompanying measures to assure the success of such adjustment when it becomes unavoidable. The effects that more continuous movements in exchange rates might have on maintenance of domestic financial discipline are referred to from other standpoints on pages 299–301. On the other hand, as indicated on page 300, in some countries that have been more successful than others in curbing inflation, maintenance of a fixed exchange rate has increased the difficulty of preserving domestic financial stability.

(4) regional relationships and effects on third countries

Stable exchange rates may be particularly valued by countries with small or very open economies. This is the position of many developing countries and more developed primary producing countries, as well as of a number of smaller industrial countries. Such countries may in some cases maintain a fixed currency relationship with one or more other countries with which they have close regional associations or particular financial or economic links. In certain regional groupings, such as the European Economic Community and the Central American Common Market, particular importance is placed on maintenance of fixed relationships in exchange rates among members of the group.

In countries with relatively open economies and large foreign sectors, changes in domestic expenditure are transmitted to the trade balance to a proportionately greater degree than can be expected in more self-sufficient economies. This may reduce the need for exchange adjustment in response to disturbances in the domestic economy, though it may increase the need for exchange adjustment in response to changes in world market conditions. At the same time, exchange adjustment by other countries, and particularly by countries that are important trading or financial partners, may involve difficult choices for the smaller partner countries. They have to decide whether to make an equivalent change, thereby maintaining the exchange relationship with their major trading partner but effecting a change against the rest of the world; or to maintain their parity in terms of gold and the U.S. dollar, thereby breaking the previous currency link.

Exchange adjustments by the United Kingdom and France have posed problems such as these for other countries in the sterling area and in the franc area. The sterling area countries have shown divergent responses, while the franc area countries have mostly aligned their rates with the French franc; thus, all the 14 African countries that maintain close financial links with France through an Operations Account at the French Treasury reduced their exchange rates in line with the adjustment of the French franc in August 1969. More frequent movements in the exchange rate of sterling and the French franc would in themselves have caused greater problems for these countries, which include many developing countries. However, the total impact would have to take into account any lessening in the size of individual exchange adjustments and any effects on the cumulative size of the exchange rate changes; also to be taken into account would be any effects on the capacity of the industrial economies concerned to expand their markets and their supply of external capital and aid.

The arrangements under which the main trading countries peg their exchange rates on the U.S. dollar have enabled these countries to retain full initiative over their exchange rates against the dollar. Countries pegging their rates on the U.S. dollar have been affected by adjustments in exchange rates by other countries in an indirect way. The adjustments have had beneficial effects on third countries to the extent that they have contributed to the growth of the economies, markets, and capacity to provide capital and external aid of the adjusting country; they may have had adverse effects on competitiveness of other countries. For the most part, this latter influence is confined to relationships among industrial countries, which compete mainly among themselves. For primary producing countries, the effect of exchange adjustments by countries other than their reserve center is likely to depend in most cases mainly on the more general effect of such adjustments in strengthening the economy of the country adjusting its exchange rate; though parallel exchange adjustments by primary producing countries that peg their currency on that of the adjusting country may have significant effects on competitiveness of other primary producing countries. This subject is discussed further in Chapter 6, Section d.

c. Problems

The main problems encountered in the operation of the par value system—which, like the achievements associated with that system, may not always be attributable or fully attributable to the system itself—may be grouped under three main heads.

(1) delays in adjustment

It is generally agreed that adjustments in par values have in a number of cases been unduly delayed. This has been given particular attention in the case of the relatively small number of par value adjustments of major currencies. These delays have sometimes tended to aggravate problems of domestic economic management, and have sometimes also aggravated the external disequilibrium. This latter effect has in turn tended to foster the use of trade and payments restrictions (discussed under (2) below) and has necessitated an ultimate exchange adjustment of larger size than might have been necessary if the adjustment had been made earlier. Delays in parity adjustment have also led to the building up of large speculative positions. Insofar as exchange adjustments are made only when the likelihood of a substantial movement in the exchange rate in a given direction becomes strong, market speculation, and anticipatory transactions of a variety of kinds, plays a generally disequilibrating rather than equilibrating role. That is to say, market speculation in such circumstances must be expected to augment movements in official reserves rather than to reduce reserve movements. At the same time, successful speculation will tend to carry substantial individual rewards. Monetary authorities are naturally not anxious to validate speculation of this kind by acting in the way that speculators had anticipated, partly because this could give new stimulus to similar speculation on a future occasion. Considerations of this kind may intrude into the process of decision making on exchange rates and may add a further impetus to delay in adjustment.

How far problems such as these should be considered as weaknesses of the system, or as weaknesses in its operation, or as necessary costs that in the long run are outweighed by compensating advantages of the exchange rate regime in which these delays occur, are difficult questions involving a number of interrelationships. Delay in parity adjustment reflects to some extent a general disposition among policy makers to regard exchange adjustment as a last resort (or at least as a later resort). It reflects a decision at a given moment of time to try other methods of adjustment first, or to await more definitive evidence that adjustment is required. In the latter case, it will be necessary either to finance the existing disequilibrium through the use of reserves or borrowings, or to suppress the disequilibrium through measures such as temporary trade and payments restrictions or acceptance of a degree of domestic deflation or inflation that is not considered sustainable for a longer period. In some cases, abstention from exchange adjustment at a relatively early stage of the emergence of disequilibrium has been followed by correction of the disequilibrium by other measures, or by automatic forces, so that “delay” in parity adjustment has permitted avoidance of parity adjustment; in other cases, where exchange adjustment has taken place, a longer delay might conceivably have avoided the need for such adjustment, e.g., where other equilibrating forces were in train.

If preservation of exchange stability in cases such as these is to be given high priority, then this will inevitably involve risks of postponing exchange adjustment in cases where such adjustment subsequently turns out to have been necessary. Room undoubtedly exists for countries to improve their methods of diagnosis and of implementing the decisions that follow from such diagnosis. But the incidence of damaging delays in exchange adjustment is likely to be associated in some measure with the way in which the par value system is operated. The damage resulting from undue delay in exchange adjustment may be considered in part as an unnecessary cost, which could be avoided by better policies, but in part also as a cost that is associated with possible benefits, viz., the avoidance of premature adjustments. Considerations relating to the timing of exchange adjustment in various circumstances are discussed further on pages 308–10 and 311–13.

(2) deviations from basic objectives

A second problem arising from the way that the par value system has been operated in the past is partly related to the first problem, by making the general cost of delayed exchange adjustment high in relation to the general benefit from the avoidance of premature adjustment. When exchange adjustment has been delayed or avoided, this has frequently been at the expense of suppressing or financing a continuing disequilibrium, rather than inducing corrective measures to remove the disequilibrium. As a result, the necessity for ultimate exchange adjustment has been increased rather than avoided, and undesirable distortions have been built into the national and international economy. In a number of cases, financial authorities have shown themselves more willing, or more able, to defend their exchange parity through recourse to restrictions on international payments than through the appropriate adjustment of domestic financial policies.

In cases where a continued deficit reflects the persistence of inflation, and where external resources to finance the deficit are readily available through the use of reserves or unconditional borrowing facilities, the pressure to correct the inflation lying at the root of the payments disequilibrium may for a time be smaller than if the real cost of the inflation were exposed and transmitted to the domestic public at large through a depreciated exchange rate. In other cases, where countries have been more successful in curbing inflation than the world economy at large, so that their currencies have become undervalued, domestic financial stability itself has been weakened by defense of an exchange parity.

Where exchange adjustment is avoided by recourse to restrictions on trade and current payments, or by harmful distortions in domestic economies, this will involve the sacrifice of certain goals of the Bretton Woods system. Actions of this kind are not of course inherent in the system; rather, they represent its misapplication. Treatment of maladjustments in payments balances through measures destructive of national or international prosperity is at variance with the purposes of the Fund.11 The proper role of exchange adjustment in contributing to the achievement of the several objectives of economic policy has gained increasing recognition in recent years. Insofar as countries give primacy to domestic objectives, the maintenance or restoration of balance of payments equilibrium is likely to involve the necessity of direct action on the balance of payments. In these circumstances, abstention from exchange adjustment may be more likely to lead to direct action on the external account in other forms, of a discriminatory and restrictive nature, than to induce the adoption of desirable measures of domestic adjustment. Imposition of restrictions on trade and payments even for temporary periods may often cause more disturbance to the smooth flow of international trade than would follow from moderate adjustments in exchange rates.

(3) likelihood of frequent disequilibria

It is sometimes suggested that certain developments in modern economies have increased the likelihood that disequilibria between major economies may arise fairly frequently, or even continuously; and that the appropriate treatment for such disequilibria is adjustment of exchange rates in amounts that may be kept to modest proportions provided the adjustments are promptly and smoothly effected. The main developments cited as contributing to more frequent and perhaps continuous disequilibria are:

  • (a) differing degrees of resistance to inflation among competing countries; such differences may reflect the prevailing ability of some countries to achieve certain major economic objectives with a lower rate of inflation than has been found possible in other countries; or they may reflect differing policy choices among countries with regard to these objectives, in the limited range within which such choices may exist;

  • (b) the increasing integration of international money and capital markets, which reduces the ability of individual countries to follow independent monetary policies, in the absence of effective controls on international capital movements;

  • (c) the increasing integration in the world economy since World War II caused by reductions in tariffs and in transport costs, and by widespread diffusion of very rapid technological change; the latter development has contributed to exceptionally rapid growth of productivity in certain countries, which has in turn involved important differences in rates of growth of productivity among national economies.

While a number of these developments have had beneficial effects, they have tended to increase the difficulties of managing national economies on the basis of a constant exchange rate. Whether and how far these difficulties could be eased by allowing exchange rates to move in a more continuous fashion, or to fluctuate by slightly greater amounts around a given parity, is more difficult to determine. A slight widening of the margins around par, as discussed in Chapter 6, may be expected to provide somewhat greater scope for conditions in national money markets to diverge, at least temporarily, from conditions in international markets. More continuous movements of exchange rates over time might in certain conditions help to modify the disturbances caused by a rate of inflation above or below the international average. Countries with extremely high rates of inflation have found that virtually continuous adjustments in exchange rates may be needed to maintain competitiveness and an open economy (see Chapter 2, Section f). Whether more continuous movements in exchange rates would also be appropriate to cope with relatively small differences in inflation prevailing in major economies is more problematical. Persistent differences in this direction would create problems of anticipatory capital movements. It is difficult, as emerges in Chapter 5, to judge how these speculative flows would compare in size to similar movements under present arrangements for adjustment at normally less frequent intervals but by individually larger amounts. It is equally difficult to judge the effect on maintenance of domestic financial discipline of depreciation of exchange rates of deficit countries at an earlier stage. On the one hand, earlier recourse to exchange adjustment would minimize the cushioning provided by drawing on additional resources from abroad and would thus transmit the effects of excess demand more immediately into the domestic economy of the deficit country; inflation would become domestically more painful, and might therefore be more strongly resisted. On the other hand, the external constraint on inflation provided by the need to defend a given parity would weaken, and this might weaken the political and psychological resistances to inflation in the way indicated on page 297.

d. Some observations on the balance between devaluations and revaluations

The exchange adjustments that have taken place under existing arrangements have for the most part, by number, been downward adjustments. It has been suggested that additional emphasis may need to be given, in the arrangements for exchange adjustment or in their implementation, to maintaining a more even balance between devaluations and revaluations. This question needs to be viewed in the context of a number of relevant considerations.

The balance between devaluations and revaluations will have an important impact on countries that keep their own parities unchanged. Insofar as the payments positions of such countries are relatively strong, the impact on their balance of payments of a predominance of devaluations may be equilibrating rather than disturbing, tending to prevent or to curb the emergence of excessive surpluses. Thus, the predominance of devaluations in the second half of the 1940’s was an appropriate counterbalance to the excessive payments strength of the United States in this period. Where, however, the countries keeping their parities unchanged are no longer in the strongest payments positions, a predominance of devaluations will involve a worsening of their competitive positions that could itself become a cause of balance of payments difficulties. In the long run, maintenance of a fixed parity of any currency will be possible without frictions only if (a) the position of such a currency remains strong, compared with the position of other currencies, or if (b) devaluations of other currencies are offset at least to some extent by revaluations of currencies in a stronger position than the currency whose parity is unchanged. Generally, and over a period of time, a predominance of exchange rate adjustments in one direction, taking account of the size of the adjustments and the relative importance of the currencies concerned, will tend to increase their number, since it will require such adjustments to be made by countries that are originally in a balanced payments position to a greater extent than if movements in both directions were reasonably matched.

By far the greater part of adjustments in par values continues to comprise devaluations. However, among the limited number of adjustments in par values of major currencies, the balance has become more even in recent years. Thus, in the par value adjustments undertaken among industrial countries in the 1960’s, weighted by the relative size of these countries’ exports, revaluations came close to offsetting devaluations (Table 2). Before the advent of the Bretton Woods system, by contrast, explicit revaluation of a currency was extremely rare.

Table 2.The Balance Between Revaluations and Devaluations Among Industrial Countries, 1960–69(In per cent)
Change in Par Value

(1)
Country Share in Exports of Industrial Countries 1

(2)
Weighted Change in Par Value (1) x (2)
100

(3)
1961
Germany+5.015.2+0.76
Netherlands+5.05.2+0.26
1962
Canada−11.827.3−0.86
1967
United Kingdom−14.310.4−1.49
Denmark−7.91.8−0.14
1969
France−11.18.3−0.92
Germany+9.316.1+1.50
Net weighted change in par values of industrial countries, 1960–69−0.89
Source: International Financial Statistics, March 1964 and March 1970.

In year of parity changes.

Par value adopted in May 1962, compared with level of floating exchange rate in January 1960.

Source: International Financial Statistics, March 1964 and March 1970.

In year of parity changes.

Par value adopted in May 1962, compared with level of floating exchange rate in January 1960.

Whereas external pressures continue to be stronger in deficit countries than in surplus countries (since reserve accumulation is not subject to limit in the same way as exhaustion of reserves or of borrowing facilities), these external pressures are no longer generally—as was the case in the 1930’s—accompanied by internal pressures for currency depreciation as a support for employment and domestic income. Now that domestic concern tends more often to be with inflationary pressure and excess demand, exchange adjustment will more often contribute to domestic stabilization in the countries whose external payments positions permit an appreciation of their currency, rather than in the countries whose external positions require a depreciation. It would not, however, be in the interests of the international community if currency revaluation were to be used as a counterinflationary device by countries that were not in a position to absorb the effects on their external payments. Revaluation in such circumstances could, for example, increase the pressure on these countries to maintain restrictions on trade and payments.

The appropriate balance between devaluations and revaluations in the system as a whole will depend at any time on the pattern of payments imbalances and on the circumstances of member countries. Payments disequilibria in either direction need to be dealt with in a timely way.

B. Proposals for Changes

General criterion

The considerations discussed in earlier chapters help to identify the general scope that may exist for improving the mechanism of exchange rate adjustment as it has operated hitherto while retaining its basic achievements. This general criterion narrows the range of possible improvements to various methods of achieving a limited increase in potential flexibility through modification in institutional arrangements or in policy attitudes consistent with the underlying philosophy of the Bretton Woods system.

The basic achievements of the par value system and of its operation hitherto, as discussed on pages 294–97, may be summarized under the following three heads.

(1) Acceptance of the principle that the determination of the rate of exchange for each currency is a matter of international concern; and implementation of that principle in the formulation of policy actions by the relevant authorities.

(2) Attainment of a high degree of stability in exchange rates of major currencies, with a limited number of exceptions in cases where continued exchange stability was clearly not consistent with the circumstances of member countries; this general degree of exchange stability permitting countries that are in a position to do so to focus their policies of domestic and external financial management on their par value as a fixed point of reference.

(3) Maintenance of generally orderly exchange arrangements, and avoidance of competitive exchange depreciation.

The main areas in which improvements in the operation of the par value system may be sought, as discussed on pages 298–301, may in turn be summarized under two heads.

(1) Reducing delays in needed adjustment of par values, while minimizing the risk of encouraging premature or unnecessary adjustments; a particularly important consideration in this context would be to minimize recourse to restrictions on trade and current payments.

(2) Effecting needed adjustment in exchange rates more smoothly, and with smaller attendant movements of speculative funds in a disequilibrating direction.

In addition, there has been discussion of what would be, over time, an appropriate relationship between downward and upward adjustments in parities.

The central issue is to determine the extent to which progress along these lines might be secured while maintaining the basic achievements of the par value system summarized above. The following chapter explains why three radical proposals for alteration of the mechanism of exchange rate adjustment have been found unacceptable. Chapters 5 and 6 deal with possible adaptations of the functioning and procedures of the par value system.

Chapter 4. Regimes Inconsistent with the Par Value System

a. Freely floating exchange rates

The essential advantage claimed for a system of freely floating exchange rates is that it leaves decision making on the appropriate pattern of exchange rates to automatic forces of the market. It could thereby, in theory, do away with the need for countries to hold official reserves for the purpose of influencing the exchange rate or the balance of payments, and could also in theory remove the need for other official policies directed to the balance of payments. An essential drawback of such a system is that national authorities could not be expected in modern conditions to adopt a policy of neutrality with respect to movements in an economic variable of such importance to the domestic economy as the rate of exchange, with its effects on prices, incomes, employment, and the structure of industry as between domestic and foreign sectors. For this reason, assurance of market equilibrium in the over-all balance of payments, through such variation in the exchange rate as is necessary to attain it, would not remove the possible sources of concern that national authorities may legitimately feel about their external finances. Speculative capital movements would at times tend to exaggerate rather than to offset underlying payments disequilibria, and at such times, fluctuations in rates would be substantial in the absence of official intervention. The fluctuations in exchange rates that occurred, and the absence of any limits on the scope for potential fluctuations, would involve damaging uncertainties for international trade.

For the reasons indicated in the previous paragraph, the determination of exchange rates would in practice not be left entirely to market forces. In place of a system of freely floating rates, there would emerge a system of fluctuating rates, influenced by official intervention. National authorities would continue to formulate and to implement policies directed to their country’s balance of payments; yet the absence of par values and of the associated international procedures for adjusting exchange rates would leave a vacuum in the necessary provisions for international coordination of exchange rate policies. Countries would need to find a new set of safeguards, comparable to the safeguards that have been built up under the par value system, against arbitrary actions and conflicts between national policies in the determination of exchange rates. Yet construction of international safeguards adequate to ensure that intervention by national authorities in exchange markets was mutually compatible and acceptable would either lead quickly back to a regime of par values, or would involve international supervision and control of national exchange rate actions, and perhaps also of other aspects of national policies, to a degree that seems unlikely to be acceptable to national authorities.

A general system of fluctuating rates would have special consequences for small countries and countries with particular regional associations. Such countries would in many cases seek to maintain a fixed currency link with certain other countries, and this would involve the establishment or strengthening of regional currency areas.

b. Substantially wider margins

Proposals for a substantial widening of the permitted margins of fluctuation around parity—to, say, 5 per cent compared with the present maximum of 1 per cent against an intervention currency—aim at achieving in many respects the same objectives as those of freely fluctuating rates. The system is, however, subject to the constraint of an internationally agreed parity; accordingly, the basic feature of the present system, international agreement on exchange rates, is preserved in principle, although the significance of the par value inevitably tends to decline as margins become wider. The main operational difference between substantially wider margins and freely fluctuating rates would be in the existence of limits to the fluctuation of the rate, at which the exchange authorities would be committed to intervene.

The main advantages claimed for a system of substantially wider margins are (a) encouragement of market equilibration, and discouragement of disequilibrating speculation, lessening the need for reserve movements and providing greater scope for independent monetary policies, through influences of the kind discussed in Chapter 6 in the context of a slight widening of margins; (b) attainment of a smoother transition between changes in par value; and (c) achievement of some equilibrating effects on current account transactions, permitting a more gradual adjustment to incipient long-term disequilibria. However, if the substantial widening of margins were to increase the likelihood of parity changes of a given amount taking place, the equilibration noted under (a) above could in certain conditions be replaced by disequilibrating influences (see also page 317).

Perhaps the most serious problem that would be posed by a substantial widening of margins would be the risk that countries would find their competitive positions subjected to sudden and inappropriate changes as a result of temporary market developments or of administrative actions of other countries through official intervention in exchange markets. While the permitted margin for deviations in exchange rates around parity remains relatively narrow, the safeguard against such a risk resides in the international procedures by which these parities are adjusted. If the permitted margins were widened to a point at which movements in rates within the margins could be expected to affect international competitiveness in a significant degree, the safeguard provided by the procedure of parity adjustment would no longer be adequate. Special problems would also arise for countries with particular regional relationships; these problems would be similar in kind to those discussed in Chapter 6, Sections c and d, but greater in degree.

A widening of the margins by substantial amounts would also provide more leeway for continuous fluctuation in exchange rates than would be desired by many countries on domestic grounds. Such countries could of course abstain from taking advantage of the new facility to the full extent, since the provisions on exchange margins have always been permissive, authorizing maximum deviations rather than requiring national authorities to allow deviations to the indicated amount. However, even countries that made no change in their own arrangements would be affected indirectly by an increase in fluctuation in their exchange rates against the currencies of countries that did take advantage of the permissible wider margin, especially where trade with these latter countries comprised a substantial share of external trade and national product of the country making no change in its exchange arrangements.

The principle that the rate of exchange of each currency is a matter of international concern, which is an essential safeguard provided by the par value system, would therefore not be compatible with a widening of permitted fluctuations around par that reached substantial proportions, at least in the absence of an elaboration of a new set of rules relating to official intervention in exchange markets. A substantial widening of scope for fluctuation around par values might also be considered inconsistent with another basic characteristic of the par value system, the stability of exchange rates at realistic levels.

On these grounds, neither fluctuating exchange rates nor a substantial widening of margins can recommend themselves as advantageous for the Fund membership at large.

This is not necessarily to preclude the possibility that, in exceptional circumstances, a fluctuating rate or a substantial widening of margins might be helpful to a country with special problems, and that such an expedient might be found internationally acceptable for a temporary period. If the international community were prepared to grant a special dispensation in such a case, this might need to be supported by the application of special conditions, to take the place of the safeguards residing in the basic provisions which were no longer being observed.

c. Automatic adjustment of parities

The proposals for new institutional arrangements to effect parity changes automatically and at fixed intervals in accordance with the movement of selected indicators include a number of variants, which in some cases allow a measure of discretion in the application of the relevant formula. Under one family of proposals, the parity of a currency would be determined by a mathematical formula based on an average of spot market rates over a predetermined previous period; the formula would be applied so as to result in parity changes at frequent intervals—quarterly, monthly, or even weekly—and would limit the maximum cumulative movement in parity to a modest annual amount, such as 2 or 3 per cent in one direction. Under other proposals, parities would be determined by a formula based on movements in reserves over some recent period (and perhaps also in relation to certain trend or target movements in reserves for the country concerned). A third series of proposals envisage a formula based on a composite indicator including data on reserve movements, spot market rates, and perhaps also forward rates. Variants of each of these three families of proposals would introduce an element of discretion (itself of varying degree) on the extent to which the chosen formula were followed in adjustment of parities; thus, the indicators of reserve movements and of market rates might be regarded as “presumptive criteria,” which would be followed in the absence of good reasons to the contrary. In certain proposals, such discretion would be exercised at least in part by an international authority such as the Fund. Virtually all the main proposals allow for the possibility of a larger adjustment in parity, which could override the automatic or discretionary indicator, but this provision is intended to be confined to exceptional or emergency use.

By basing the criteria of parity adjustment in the normal case on some objective quantitative indicator of the balance of payments, rather than on a general judgment of whether an exchange adjustment is necessary in connection with a fundamental disequilibrium in the economy (see Chapter 5, Section a), proponents of such schemes look for three main benefits. Firstly, movement in parities in a more continuous way is expected to be less disruptive, and less exposed to disequilibrating speculation, than less frequent adjustments by larger amounts. Secondly, more continuous movement in parities in response to financial indicators is expected to make adjustment of exchange rates more readily accepted by the public and less sensitive to political considerations. Thirdly, the possibility for exchange rates to move more freely, provided by the first two influences, is expected to reduce the pressure for suppression of disequilibria through restrictions on trade or payments or through distortion of domestic policies; it is also expected to reduce the pressure and need for undue reliance on financing of payments imbalances. However, it is recognized that substantial needs for official financing may remain.

Against these possible benefits, the automatic or near automatic linkage of exchange rate adjustment to balance of payments indicators would involve overriding disadvantages. The need for adjustment of the exchange rate cannot be judged from the position of the balance of payments alone, without reference to the condition of the domestic economy (see also page 308). Movements in market exchange rates and in reserves at any time are influenced by cyclical factors and other temporary phenomena which have no enduring effect on competitiveness and call for no adjustment in the exchange rate. If the parity is made to respond automatically to market forces of this kind, this will involve continuous movement in parities in cases where absolute stability might otherwise be achieved, and is likely in some cases to involve movements in an inappropriate direction. Moreover, the removal of political and psychological constraints on adjustment of exchange rates will not be advantageous in cases where such constraints have strengthened the hands of the domestic authorities in securing acceptance of necessary domestic adjustments that would otherwise be resisted. Finally, national authorities might choose to avoid what they regarded as an inappropriate movement in their exchange rate. In that event they might either suppress the payments disequilibrium through restrictions on external trade or payments; or they might prefer to adjust the exchange rate, independently of the formula or indicators, by an amount sufficient, with any necessary accompanying domestic measures, to correct the disequilibrium at once.

On these grounds, a regime under which parities would be adjusted automatically at fixed intervals on the basis of some predetermined formula would not be consistent with the basic principles of the par value system and does not recommend itself as advantageous.

At the same time, certain objectives sought by proponents of these schemes may possibly be achieved by more limited changes in the institutional arrangements or in the implementation of the par value provisions. Proposals to this effect are discussed in the following chapter; another limited adaptation in the application of the par value system, a slight widening of margins around par, is discussed in Chapter 6.

Chapter 5. Changes in Par Values: Criteria and Procedures

This chapter considers the effects and feasibility of possible measures through which changes in par values, in upward and downward directions, might be made more timely and less disruptive. Section a discusses the criteria of par value adjustment under existing arrangements, and the extent to which changes in par values might be made more promptly, and perhaps also in smaller steps, under these arrangements. Section b discusses possible new arrangements under which prompt and perhaps also more frequent adjustment of parities might be facilitated, and the impact of different arrangements and different practices of adjustment of par values on the problem of disequilibrating capital movements. Section c discusses the pressures which may arise in exceptional circumstances for the nonobservance of par value obligations for a temporary period before resuming observance of them at the existing parity or at a new parity.

a. The concept of fundamental diseqilibrium and use of the existing arrangements

The Articles of the Fund provide that “A member shall not propose a change in the par value of its currency except to correct a fundamental disequilibrium.”12 The Articles also provide that the Fund shall concur in a proposed change made in conformity with the stipulated procedures “if it is satisfied that the change is necessary to correct a fundamental disequilibrium….” 13 The term “fundamental disequilibrium” is not defined in the Articles, and the Fund has never attempted to formulate a definition. The concept is a profound and subtle one, which lies at the heart of the Bretton Woods system, and has been tested by experience with that system.

A basic feature of the concept of fundamental disequilibrium is that although its ultimate focus is on the balance of payments it is related to a general condition of the member’s economy and does not require that an imbalance must have developed in the balance of payments. This, in turn, reflects the underlying philosophy of the Bretton Woods system that while attainment of balance in international payments must be a focal point of concern for the international financial community, it is not to be regarded as an objective in isolation from other objectives of the international monetary system. These objectives include the expansion and balanced growth of international trade on the basis of a liberal and nondiscriminatory regime of trade and payments, to contribute to the promotion of high levels of employment and real income and to the development of the productive resources of all the Fund’s members as primary objectives of economic policy.14 In this conception, attainment of payments balance through the use of measures destructive of national or international prosperity would clearly not comprise a durable payments equilibrium.

Thus, the criterion of fundamental disequilibrium is wider than the occurrence of a disequilibrium in the actual balance of payments, as measured by movement in reserves and the probable accompanying movement of the market rate of exchange within the band around parity. For example, the concept of fundamental disequilibrium could include a balance of payments position that would have shown a deficit but for restrictions on trade and payments; or a situation of equilibrium (or surplus) in the balance of payments that would turn into a deficit but for an unacceptably low rate of economic activity in the country; or a situation of equilibrium (or deficit) in the balance of payments that would turn into a surplus but for exports of capital at a rate that the country concerned did not wish to continue, or but for the country’s acquiescence in an unacceptably high rate of inflation. Where a disequilibrium in the balance of payments is suppressed by measures that are clearly harmful to the international community, such as restrictions that are inconsistent with the objectives of the Fund, or of other international economic organizations to which the member country adheres, the existence of a fundamental disequilibrium is generally apparent. Where, on the other hand, the suppressed disequilibrium reflects the particular policy preferences of the national authorities (as in the last examples cited above) the condition of fundamental disequilibrium is essentially related to these national policies.

The concept of fundamental disequilibrium also encompasses a time dimension of which short-term balance of payments statistics may not be a good reflection. Indeed, the provisions on the use of the Fund’s resources, permitting a member to finance a deficit for a temporary period in lieu of changing the parity of its currency in a way that might otherwise be necessary, imply a concept that is applicable over a certain period of time. Other examples may be noted. A country that has been in severe deficit for a number of years and has reached a low level of reserves, such as the United Kingdom in 1969 or France after 1958, may be experiencing a balance of payments surplus and reserve increases (and perhaps an exchange rate close to its upper limit) without any presumption that its currency should be revalued. Conversely, reserve losses and a balance of payments deficit, coming after a period of sustained surplus, as experienced for example by the United States in the 1950’s, do not necessarily provide a case for devaluation. Moreover, it would be clearly inappropriate to adjust parities in response to balance of payments disequilibria of a seasonal or short-term cyclical nature.

The concept of fundamental disequilibrium does not itself specify at what stage of a disequilibrium the exchange rate should be adjusted, as compared with recourse to other measures of adjustment through domestic policies. Nor does the concept specify the proportionate role that an exchange adjustment shall play in correcting a fundamental disequilibrium, in association with other corrective measures. The concept does imply that where other measures can be taken to restore payments balance without damage to national or international prosperity, these should be preferred to exchange adjustment. Whether and how far such other measures can be taken without damage will depend on the size and nature of the imbalance in relation to prevailing economic conditions. Thus, where the domestic measures that would contribute to external balance would also help to preserve or restore internal balance, domestic measures will be needed in any case; and unless the external disequilibrium is exceptionally large, a member may be well advised to apply such domestic correctives before proposing a change in par value, in particular if there can be reasonable hope that the domestic correctives will make exchange rate adjustment unnecessary.

A different situation, however, exists where the requirements of internal and external stabilization point in opposite directions for domestic policy (e.g., where an external surplus coincides with excessive strain on domestic resources). There is then no such presumption in favor of domestic measures directed to restoring external equilibrium, since such measures, at least if unaccompanied by exchange adjustment, will intensify the domestic disequilibrium. In a situation of the kind described in the previous paragraph, with no conflict between requirements of domestic and external stabilization, the existence of a fundamental disequilibrium is unlikely to be clear cut in its earlier stages. Where conflict of this kind does exist, with internal and external considerations pulling in opposite directions as regards domestic stabilization measures, this conflict itself, if of a persistent character, may indicate a fundamental disequilibrium. In this kind of situation, therefore, a fundamental disequilibrium is likely to be more immediately apparent, even when it is not substantial in size. It should be emphasized that even where no conflict exists between the requirements of internal and external equilibrium as regards the direction of domestic stabilization measures, the extent of such measures as are appropriate on domestic grounds may be inadequate to remove the external disequilibrium, and this inadequacy will be a sign of fundamental disequilibrium.

Under conditions of generally buoyant demand such as have prevailed since World War II, in which countries are likely to be faced more frequently with inflationary conditions than with inadequate demand, conflict between the requirements of external and internal equilibrium is more likely to occur for countries with persistent or excessive external surpluses than for countries with persistent deficits. In a number of past instances, surplus countries have faced conflicts of this kind, and in a smaller number of instances, these conflicts have eventually been resolved, at least for a time, by resort to revaluation—viz., the revaluation of 5 per cent by Germany in 1961, the consequential revaluation by the same amount by the Netherlands at that time, and the revaluation by 9.3 per cent by Germany in 1969.

The exchange adjustment in these instances was not made at an early stage of the emergence of symptoms of fundamental disequilibrium. This delay in resort to exchange adjustment was attributable to a variety of influences, including the general view taken at the time of the appropriate role of exchange rate adjustment. The delay was not attributable to any prohibitive characteristic of the existing provisions for exchange adjustment in the Fund Articles. The procedures of Article IV and the concept of fundamental disequilibrium permit an adjustment of exchange rates necessary to correct a fundamental disequilibrium to be undertaken promptly, and prompt reaction to a fundamental disequilibrium would also normally reduce the size of the appropriate change in parity. Further, to the extent that such a policy conflict recurred (e.g., because the country concerned had a persistently lower rate of inflation than its trading partners), further changes in parity might be necessary to correct the associated fundamental disequilibria and this also would be consistent with the Articles. Each such change would need to be based on the presence (or proven imminence) of a fundamental disequilibrium.

Thus, under the provisions of the existing system and in appropriate circumstances, changes in parity could be envisaged that were smaller in size and that were undertaken at an earlier stage of a payments disequilibrium than has generally been the case in the past. Some adaptation might, however, be required in the general attitude toward the implementation of these provisions. In the past, adjustment of parities has often been considered appropriate only when evidence of fundamental disequilibrium has become overwhelming. If it were desired to increase the likelihood that necessary exchange adjustment would be prompt and to reduce the risks of delay, such adjustment might be implemented as soon as evidence of fundamental disequilibrium had become substantial, rather than overwhelming.

As has been pointed out earlier in this report (pages 298–99), a reduction in the chances of undue delay in adjustment of exchange rates may carry an attendant risk of inducing premature or unnecessary exchange adjustment, and perhaps also of weakening the pressure for desirable domestic correctives. Both these risks could be reduced if greater readiness on the part of members to adjust exchange rates at an early stage of an emerging disequilibrium were confined to cases in which the application of domestic correctives capable of substantially reducing or eliminating the external disequilibrium were inappropriate or unattainable. Where internal and external requirements pointed in the same direction, primary reliance would still ordinarily be placed on domestic measures: indeed, the possible need for exchange adjustment could often not be established in these cases until domestic measures necessary for domestic equilibrium had been implemented.

Avoidance of large disequilibria in the external payments of individual countries is a matter of international as well as national concern. This is recognized in the procedures of the Fund for consulting with members on their economic policies and performance, and on the observance of their Fund obligations. Whilst changes in par values may be made only on the proposal of the member, reviews of this kind are focussed on the over-all outcomes of countries’ balance of payments policies and on observance of members’ obligations to avoid restrictions on trade and on current payments. In this way, the process of international consultation and review can play its part in inducing prompt action to deal with disequilibria through measures that may if necessary include exchange adjustment.

A general approach of this kind should be facilitated by recent improvements. During the second half of the 1960’s the international monetary system was believed by some to be so fragile that there was a strong tendency on the part of the major countries to forestall the devaluation of any major currency lest it upset the stability of other currencies. This attitude contributed to a general willingness to extend balance of payments credits and to tolerate the application of trade and payments restrictions. It is to be hoped that this particular phase has come to an end with the adjustment of the parities of three major currencies, the establishment and activation of the special drawing rights facility, and the arrangements guarding against a drain of gold from monetary reserves and allowing for the possibility of some inflow of gold. With the help of these improvements and adaptations, it would seem that the risk that a parity change for one currency would spread instability in the system as a whole has been considerably alleviated.

b. Possible measures to facilitate prompt adjustment of parities.

It has been suggested that prompt and smooth adjustment of parities might be promoted by new facilities under which changes in parities up to a limited specified amount could be effected under special procedures. One such proposal would permit changes in parities up to amounts such as 3 per cent in any twelve-month period and up to a cumulative amount such as 10 per cent in any five-year period without the concurrence of the Fund; this would require amendment of the Articles of Agreement. The aspects of this proposal relating to the Fund’s jurisdiction over exchange rates are considered in Part II of this report, in which reference is also made to other related proposals (Part II, pages 323 and 326).

The stated economic objective of proposals of this kind is to make it easier for members to adjust exchange rates in appropriate circumstances pari passu with the development of a fundamental disequilibrium, thereby avoiding unnecessary delays in exchange adjustment, the building up of large fundamental disequilibria, and the eventual recourse to sharp adjustments; the possible need for recurrent small adjustments may arise from a variety of influences, including differences in the degree of resistance to inflation among competing countries.

These proposals are based on the view that evidence that a fundamental disequilibrium is likely to be emerging might be available, even though it would not yet be possible to establish that a fundamental disequilibrium had already emerged; and that a smooth adjustment to such emerging disequilibrium may be desirable so as to minimize speculative disturbances.

On the other hand, it may be argued that undue risks would be involved in basing changes in exchange rates, even within confined limits, merely on anticipation.

One objective of proposals for smoother adjustment of parities, as well as of proposals for a slight widening of margins to be discussed in the next chapter, is to reduce exposure to anticipatory movements of capital. Speculative capital movements in anticipation of changes in parities, as discussed on page 299, may be disturbing in two ways: they will increase official reserve movements; and they may intrude into the process of decision making on exchange rates and on other aspects of economic policy. The considerable growth in the size of actual and potential movements of short-term capital and the problem this has posed for member countries, have been discussed earlier in this report (pages 291–92).15 In general, exposure to anticipatory capital movements will be the larger, (a) the more likely the prospect of a given movement in the exchange rate taking place at a given time, (b) the smaller the prospect of a movement in the reverse direction, and (c) the larger the size of the expected movement. Under the existing arrangements, in cases where exchange adjustments are delayed, speculation will be increased by all three of these influences. A policy under which adjustments in parities are made more promptly will normally permit the size of the adjustment to be smaller, and will thereby tend to reduce influence (c). However, once such a policy becomes known and anticipated by the market, this will tend to increase the likelihood of a parity adjustment in given circumstances and will thereby tend to intensify speculation under influence (a).

This counterpull reflects a more general conflict of considerations regarding the most appropriate policy attitude to be adopted toward application of the provisions for exchange rate adjustment under the Bretton Woods system. A policy attitude that might make changes in par value relatively likely in the event of disequilibria will help to prevent the maintenance of an unrealistic rate of exchange; but it will tend to induce speculative capital movements of a destabilizing kind whenever there is a disequilibrium that might give rise to a parity change under this policy attitude. By contrast, an attitude under which par value changes are resisted as long as possible will tend, in cases of moderate disequilibria in which exchange adjustment proves ultimately avoidable, to encourage stabilizing movements of short-term capital, based on confidence in the prevailing parity. A policy attitude of this kind may thereby permit a country to sail through disequilibria of a moderate size with a minimum of difficulty; but once having adopted this approach, a country might find it difficult to make a parity change that was unavoidable until it was overdue.

Proposals that have the effect, under a variety of possible arrangements, of adjusting parities in a more frequent or continuous way should reduce the incentive for anticipatory capital movements insofar as they reduce the size of the prospective adjustment. However, this objective will in some cases be attained, again, only at the expense of increasing the likelihood of adjustment taking place. This would be especially so in the event that small adjustments in parities were announced in advance, even if a degree of discretion on the implementation of the proposed adjustments were retained. (Exposure to anticipatory speculation would tend to be smaller under schemes providing for automatic adjustment of parities in response to market indicators, as discussed in Chapter 4, Section c, but might still be serious in cases where a substantial disequilibrium implied the prospect of a continuing movement in the rate in one direction.) If a future movement in the exchange rate in a particular direction became more predictable, but the size of the prospective adjustment became smaller, this would make it more feasible to regulate and partly deter anticipatory movements of funds through offsetting movements of interest rates. The need to establish an offsetting interest differential might however involve a more continuing constraint on monetary policy. The extent to which a prospective small movement in the exchange rate would induce anticipatory movements of funds in the absence of the necessary action to effect an offsetting movement in the interest rate differential is subject to a wide range of estimation. Exposure to disequilibrating speculation might be slightly reduced by some widening in the permitted margins of fluctuation around par, weakening the link between the parity and the market rate.

It is difficult to make any general judgment on whether anticipatory capital movements would be a greater problem under schemes for more continuous movements in parities than under existing arrangements. Much would clearly depend on the way in which existing arrangements were used, on the precise form that the new arrangements were to take, and on the particular circumstances encountered. On the whole, schemes providing for smaller and more frequent adjustments might reduce the likelihood of the most severe speculative pressures and make it more practicable to contain such pressures by directing monetary policy to the needs of the external balance; but they might increase the frequency and duration of smaller pressures, which could still be substantial, so that external considerations formed a more continuing constraint on monetary policy.

Schemes for more prompt and perhaps also more frequent or continuous adjustment of par values would not therefore remove the potential conflict between attainment of the flexibility needed for payments adjustment and avoidance of disruptive speculation. A slight widening in margins of fluctuation around par, discussed in the following chapter, might on occasion be of some help in this context, but this would be unlikely to be of major significance. A system of adjustable par values, whether adjustments are made frequently or infrequently, requires substantial resources of official financing through reserves and credit availabilities in order to provide adequate resources to deal with disruptive speculation.

So long as par values and the associated limits to the range of exchange rate variation at any particular time are maintained, therefore, adjustments in par values are likely to be exposed to some degree of anticipatory speculation. This exposure may itself be considered a necessary price for the associated benefits of exchange stability. In the general case, the constraint exerted by this exposure to speculation should be maintainable within tolerable bounds provided that adjustments in exchange rates are not excessively delayed.

c. Temporary deviations from par value obligations

As indicated in Chapter 2, Section f, a number of instances have arisen hitherto in which member countries have felt unable to avoid recourse to a fluctuating exchange rate. The Fund can presently give temporary approval to a fluctuating rate when it is a multiple currency practice. But the Fund is not empowered by its Articles to approve a regime of a unitary fluctuating rate. On past occasions in which exceptional pressures have induced individual countries to suspend the observance of their par value obligations and to move to a fluctuating rate, the Fund has recognized the exigencies of the situation or has merely taken note of such action. The Executive Directors have given preliminary consideration, as noted in Part II, pages 328–30, to whether it might be desirable to amend the Articles of Agreement so that the Fund would be able to approve departures from normal par value obligations on a temporary basis, and if so, under what circumstances and subject to what safeguards.

The various circumstances in which Fund members have had resort to fluctuating rates have been described in Chapter 2, Section f. The question whether new procedures might be applied in cases where members temporarily resort to a fluctuating rate has been considered particularly, though not exclusively, in the context of the nonobservance for a brief period of par value obligations under pressure of heavy capital movements in exceptional conditions.

In the normal case, it should be emphasized, pressures on a parity arising from capital inflows or outflows need to be dealt with in other ways than the nonobservance of parity obligations. Depending on the particular circumstances, the appropriate remedy may include the financing of the capital movement by use of reserves or official credits; deterrence of capital movements through domestic monetary or fiscal measures, which may give differential treatment to external funds, or deterrence through capital controls; and, in appropriate circumstances, adjustment of the parity to a new level through the regular procedures. The particular circumstances in which it may prove necessary to fend off the pressures by ceasing to maintain the parity will be confined to cases in which a change in parity is called for, but cannot be implemented for political or administrative reasons; or to conditions of particular uncertainty in which a member feels that the need to change the parity, or the appropriate level of a new parity, cannot be assessed with reasonable assurance. In circumstances of either kind, continued attempts to defend a par value that no longer commands general acceptance may involve unacceptable disturbances and costs, both for the countries concerned and for the international community.

In such conditions, suspension of observance of the margin provisions for a temporary period, i.e., adoption of an effectively fluctuating rate as a transitional device pending a move to a new par value or the arrival of conditions in which the existing par value regains credibility, may be the only available means of shielding official reserves from the impact of mounting speculative flows. This will alleviate pressure not only on the country concerned but also on the countries that were the source or the destination of the speculative flows. It should be emphasized that the most effective way of avoiding these speculative problems is by taking preventive action, through implementation of the necessary measures of adjustment at the appropriate time. It may reasonably be expected that countries will seek to avoid prolonged uncertainty over their parities and the resultant domestic and international disturbances.

Circumstances in which it might be judged that a period of fluctuation was essential to establish the appropriate level for a new parity would be of an exceptional kind, in which extraordinary disturbance in underlying conditions appeared to make a period of market fluctuation a necessary guide to the rate which would secure an adequate measure of confidence. In the overwhelming majority of cases, however, the adjustment will be effected with fewer disruptions and in a more appropriate way by institution of a new parity under the regular procedures, supported by accompanying policy measures in the domestic sphere and where necessary also by loans or credits assuring the authorities of the means to defend the new parity.

Thus, in exceptional circumstances where a national authority believes that adjustment of its par value is desirable, but is politically unable to implement such adjustment, or is quite uncertain as to the appropriate size of the adjustment, domestic and external disturbances may be lessened by suspending the application of normal par value obligations for a temporary period, rather than continuing to defend an apparently outdated parity. Such a move to a transitional fluctuating rate may in certain circumstances lead to the establishment of a new parity, after the transition, at a more appropriate level than might otherwise have been attained. In order to minimize possible disturbances caused by a temporarily fluctuating rate, a number of important conditions need to be met: consultation with the Fund must be intensive and close, and the authorities must be prepared within a reasonable period to adopt an effective parity at a realistic level. Put another way, a transitional fluctuating rate may help make the best of a temporary absence of the conditions needed for a successful instantaneous parity adjustment; but a continued absence of such conditions would cause major problems for any exchange rate regime based on effective par values.

Chapter 6. Effects of a Slight Widening of Exchange Rate Margins

Article IV, Section 3 permits member countries to maintain margins on spot exchange transactions of a maximum of 1 per cent on either side of parity; a decision of the Fund taken in 1959 permits margins for spot transactions to a maximum of 2 per cent where this results from the maintenance of margins of not more than 1 per cent against a convertible currency, which will normally be the member’s intervention currency. (See also Chapter 2, Section b.) Fluctuations within these margins can have important effects on transactions between money markets for purposes of arbitrage or for precautionary or speculative purposes; they thereby tend to influence the flow of capital, and more specifically the flow of short-term money market funds. If the margins around par were to be widened by a substantial amount, the ensuing scope for fluctuations in market rates, in addition to their effects on capital movements, would also have significant effects on current payments. If, for example, the margins could extend to 5 per cent vis-à-vis an intervention currency, this would entail a band of 10 per cent for market fluctuations against that currency (and still larger possible fluctuations in cross rates against other currencies). This would provide scope for exchange adjustments within the band of a magnitude as large as or even greater than adjustments that have taken place in the past in par values themselves.

For this reason, as indicated in Chapter 4, a widening of margins by substantial amounts could not be considered as a technical adjustment within the framework of the present par value system; it would partially replace, rather than reinforce, exchange adjustment through the established procedure for adjustment of par values. At the same time, it is not self-evident that the present limit of 1 per cent in the operational margin is the maximum that can be tolerated without risk of replacing rather than reinforcing the procedure for adjusting exchange rates through the par value mechanism. Of course, if a slight widening of margins were combined with more frequent recourse to adjustment of parities, the resulting increase in exchange rate flexibility might have more general effects, and would need to be considered as a whole.

a. Effects of slightly wider margins without parity changes

Proposals to allow a slightly larger range of fluctuation in market exchange rates around a given parity have a long history, reaching back to suggestions for a widening of effective gold points under the gold standard of the nineteenth century. The proposals have always been related primarily to the impact on short-term capital movements. Two closely associated objectives have been uppermost: avoidance of pressure on the central reserve, through the encouragement of equilibrating capital movements (or discouragement of disequilibrating movements) in the sense of avoiding or limiting movements in official reserves or credits; and provision of a larger freedom of maneuver for domestic monetary policy to be adjusted to the demands of domestic conditions. Slightly wider margins may be expected to contribute somewhat to these objectives if two general conditions are met: that the exchange authorities permit market rates to move fairly freely within the widened band; and that the prospect of a change in parity of a given size is not increased beyond a certain point (see Section b below).

For convenience of analysis, it is assumed in the first instance that parities remain unchanged and that confidence in the existing parity is maintained. A second initial assumption is that the exchange authorities permit market pressures to be fully reflected in movements in market rates within the limits set by the margins, i.e., that they intervene only at the band limits. The following hypothetical example assumes that a given disturbance, or influence on the basic payments balance, occurs when the market rate is at a discount of ½ per cent from par and has a tendency to push the rate toward its lower limit.16 The market is assumed to retain confidence in the parity, and to judge that the weakness in the payments balance will be reversed or offset in the foreseeable future. Some subsequent recovery in the market rate is therefore expected. The extent of this recovery, if the rate had fallen to a lower limit of 2 per cent below par, would be by a maximum of 4 per cent, if the recovery were strong enough to carry the rate to its upper limit. Under margins of 1 per cent, by contrast, the scope for a recoil in the rate, from lower to upper margins, would be 2 per cent.

In these conditions, therefore, the initial fall in the rate would be more likely to attract anticipatory purchases, based on expectations of a subsequent recoil in the rate, under the wider margins than under the narrower margins. As a result of this, there would be a greater chance that official support purchases at the lower margin might be avoided or reduced in volume. Thus, under the 1 per cent margin, these purchases would become necessary once the market rate had reached a discount of 1 per cent from parity; under 2 per cent margins, it is possible that sufficient anticipatory purchases by market operators would produce balance between market demand and supply before the rate had fallen to the lower margin of 2 per cent below par. This general influence would in itself either (a) economize in the need for reserve movements or other official financing, or (b) permit, without increasing the need for official financing, a larger imbalance, e.g., as a result of a differential between monetary conditions in domestic and world markets, that was either temporary or was expected subsequently to be offset by other influences, the temporary imbalance being financed by market equilibration. Movements of funds in response to differences in interest rates would involve an increased exchange risk, and would thereby be deterred to some extent. In this way, wider margins would create somewhat greater elbow room for central banks and other monetary authorities.

The extent of the stabilizing influence on short-term capital flows that may be expected from wider margins under the conditions thus far assumed—official intervention only at the upper and lower limits, and confidence in the existing parity—would not be likely to provide substantial and sustained insulation from interest rates in the world market where the widening of margins was only slight. It should be recalled that the prospective insulation provided by the widening of the margins is dependent, in the above example, on the expectation of a subsequent recoil in the market rate back toward parity, i.e., on a removal of the disequilibrium. This prospect could itself be undermined by the maintenance of interest rates as a sustained differential from the world market level.

The effects of a more active policy of official intervention in the exchange market than has been assumed so far would be broadly as follows. Because the stabilizing effect of wider margins on capital movements depends essentially on a prospective recoil in the spot rate—with a relatively sharp initial movement followed by the prospect of an at least partial reversal—it is evident that such effects would not be secured if official tactics were such as to prevent the initial rate movement from taking place. Indeed, if importance is attached by an exchange authority to minimizing the degree of day-to-day fluctuation or movement of rates within the band, to the extent of checking an incipient market trend by heavy intervention, then a widening of the band, with its increased scope for market movements, might in certain circumstances increase rather than decrease official support purchases and sales. It could thereby have a disequilibrating influence on movements of short-term capital. However, not all tactics of official intervention within the band would have this perverse effect.

b. Effects on transition to a new par value

This section considers the effects of slightly wider margins in conditions in which the earlier assumption of continued confidence in the existing parity does not hold. A slight widening of margins is then very unlikely to prevent disequilibrating speculation (unless the expectation of a parity change is so weak as to be offset by the increased scope for a possible recoil in the market rate in the event that the parity is not changed). The question is rather whether the wider margins would tend to reduce, or to increase, the volume of such adverse speculation.

A slight widening of margins could be expected generally to increase the risks involved in adverse speculation of this kind and thereby to reduce the potential profitability of such speculation. Market speculation will normally be related to the expected movement in the market exchange rate, rather than in the parity itself. A slight widening of margins will reduce the size of the movement in market rates that will necessarily be associated with a change in parity, as well as increasing the scope for movement in the market rate in the event that the parity is not changed. At a time when a parity change is expected, the market rate is usually close to the limit in the direction of the expected change (unless the rate is held at some other point by official intervention), as speculators anticipate such a change; subsequently, where the expected parity change takes place, the market rate is often close to the opposite limit, as speculators take their profits. Thus, the extent of the minimum movement in the spot rate to be anticipated as a result of a given parity change, which will be the relevant consideration for speculators along with the likelihood of the change, will normally be the expected parity change minus the size of the band. The margins around par in effect permit part of the exchange adjustment to be effected in advance of the parity change, and another part to be effected after the change has taken place. The size of the margins will determine what proportion of any given parity change can be effected through market movements in this way.

Increasing the size of the band in relation to that of the typical parity change should therefore be expected to reduce somewhat the extent to which prospective parity changes attract destabilizing speculation, by somewhat reducing the prospective profits of those speculating on such changes. This could give slightly greater freedom of maneuver to the monetary authorities in deciding on parity changes, and contribute to a slightly smoother process of exchange adjustment. It would in itself tend to curb the amount of adverse speculation, as noted above. If the slight widening of margins also somewhat increased the likelihood of a parity change of a given amount, this would be an offsetting influence, tending in itself to increase anticipatory speculation. On balance, taking the two influences together, speculation would be more likely to be reduced, the smaller the typical parity change in relation to the widening of margins, and the smaller any increase in the likelihood of a parity change of given size. Speculation would tend to be increased, the larger any increase in the likelihood of a parity change of given size, and the larger the typical parity change in relation to the widening of margins. The effect of slightly wider margins in smoothing the transition from one parity to another would be negligible if parity changes were expected to be as large as in the adjustments of 1949, of up to 30 per cent; the influence may begin to be of some significance for parity changes in the more recent 10–15 per cent range; it would be most important in a regime of parity adjustments by predominantly smaller amounts.

c. Effects on forward rates, on third countries, and on regional relationships

Increasing the scope for spot rates to move would tend to increase the proportion of transactions undertaken in the forward exchange market. This would be expected for trade and other current account transactions, and also for certain capital transactions. Since forward rates may deviate from parity by more than the margin permissible for spot rates, a switch of this kind toward settlement of current transactions at forward rather than spot rates would mean that the average rate applying to current transactions could move by more than the movement in the spot rate itself. However, the widening in the spot margins would tend in itself to narrow the differential between the spot rate and the forward rate at times when a given change in parity was considered possible, since greater scope would exist for the spot rate to move part of the way toward the expected future spot rate. If controls were maintained on the access of traders to the forward exchange market, as is currently the case in some countries, this would prevent the insuring of exchange risks which is normally open to traders, and in conjunction with wider margins, would expose traders to additional such risks.

Countries that, in their particular circumstances, found the possible advantages of wider margins, assuming these to have become permissible under international procedures, of little relevance, or outweighed by the possible disadvantages, would continue to enjoy the present option to maintain margins against their intervention currency narrower than the permitted maximum. But the scope for fluctuations in the rate for their currency against the currencies of countries that had adopted wider margins would widen as a result of the actions of the latter countries. Margins on cross rates between any two currencies pegged on the same intervention currency, e.g., between the main European currencies which are pegged on the U.S. dollar, would increase to the extent of the sum of the widening of margins against the U.S. dollar undertaken for the two currencies, i.e., by twice the widening of the margin if the same widening is undertaken for both currencies. The theoretical scope for the mutual fluctuations, which would occur only between two currencies that change places at opposite extreme limits against the dollar, is rarely reached in practice, as noted on pages 281 and 289 and shown in Chart 3, page 284. For the industrial countries, fluctuations in exchange rates measured against the weighted average of movements in other currencies, have deviated significantly from their movement against the U.S. dollar alone only at times of parity changes.

A second, potentially more far-reaching problem concerning third currency relationships would arise if a regional group of countries desired to maintain greater stability in rates between their own currencies than in their rates vis-à-vis their intervention currency. It should be noted that even if it proved feasible to narrow the spot margins in intraregional relationships, intratrade might still be open to disturbance unless economic integration had proceeded so far as to preclude par value changes within the group, and the anticipation of such changes in the forward exchange market.

d. Effects on developing countries and other primary producing countries

For the most part, as indicated earlier in this report, developing countries and other primary producing countries have not attempted to make use of variations in exchange rates within the permitted margins to induce market equilibration of payments flows. The benefits that might be gained by allowing exchange rates to be determined through the interplay of market forces within the permitted margins have in most cases been judged to be small or insignificant. The view has evidently been taken that any such possible benefits are outweighed by the convenience, including administrative convenience, of maintaining foreign exchange dealings at fixed buying and selling rates. In circumstances where the volume of transactions between domestic and foreign currencies is small, and organized money markets are small or nonexistent, the potential effects of fluctuations around par will also tend to be small. These limitations apply in particular to the smaller and less developed of primary producing countries; a number of primary producing countries have well-functioning domestic money markets, though some of these are insulated from international money markets by pervasive controls on capital transactions.

A number of primary producing countries have on occasion changed their set buying and selling rates in relation to par with a view to influencing flows of short-term capital. In other cases, primary producing countries have maintained dual exchange rates, with a fixed rate—based on par where this is effective—for transactions related to trade and perhaps other current account payments, and with a fluctuating rate for capital transactions. In many such cases, deviations in the capital rate from par have been substantial; however, in certain instances, such deviations have remained relatively modest, and in these cases, fluctuations in the capital rate have fulfilled some of the functions that might be expected of a slight widening of margins around par in the case of a unified rate. A slight widening of margins would provide flexibility over a broader area than a fluctuating capital rate, but the extent of flexibility for capital transactions would generally be smaller than provided by a fluctuating capital rate.

To a considerable extent, however, primary producing countries have had resort to other means of absorbing sudden strains on their payments balances. These means have included, besides the use of official reserves, resort to official borrowing and commercial credits; accumulation of payments arrears; introduction of trade or payments restrictions; and departures from an effective par value through resort to a fluctuating rate or a regime of multiple rates. While it is clearly desirable to avoid expedients such as the last three kinds, the size of the strains involved—together with the country’s circumstances—in many cases make it unlikely that a more active use of the facility for variations of the rate within the existing margins, or an active use of slightly widened margins, would elicit sufficient equilibrating movements of capital to avoid the necessity for resort to other measures.

Fluctuations in exchange rates around par cannot therefore be expected to have significant benefits in inducing equilibrating movements of capital in primary producing countries in cases where domestic money markets are narrow, where capital movements are effectively controlled, or where pressures on the balance of payments are so large and continuing that they have to be absorbed by larger continuing departures from par or the official rate. It may be recalled that it is the prospect of inducing equilibrating or deterring disequilibrating movements of capital, in certain conditions, that is a principal prospective benefit of a slight widening of margins. Many primary producing countries might therefore not avail themselves of any new facility permitting a slight widening of margins. It should be emphasized that this judgment is inevitably of a very general nature, which is not intended to cover the particular circumstances of all countries in this group.

The remainder of this section considers the possible effects on primary producing countries of a slight widening of exchange margins undertaken by other countries. The position of primary producing countries that themselves pegged their currencies to the U.S. dollar would not be affected directly by the facility for a slight widening of margins, as long as the United States maintained its present position in exchange arrangements and its generally passive exchange rate policy. For primary producing countries that peg to currencies other than the U.S. dollar, in particular to sterling and the French franc, any increase in fluctuation between their intervention currency and other currencies would be transmitted to their own currencies.

Because the currencies of primary producing countries in almost all cases are held at a fixed relationship to the intervention currency—whether the U.S. dollar, sterling, the French franc, or other intervention currencies—the cross rates between currencies of these primary producing countries and the currencies of other primary producing countries move in the same way as cross rates between the respective intervention currencies themselves. Thus, cross rates between an African currency pegged on sterling and another African currency pegged on the French franc follow the movements in the sterling-French franc rate, in relation to par (see Chart 3, page 284, and page 318). Equally, cross rates between the currencies of countries in the overseas sterling area or the franc area on the one hand, and the currencies of primary producing countries pegged to the U.S. dollar on the other hand, move parallel to the movement of the dollar rate of sterling or the French franc.

Thus, a widening in margins of a currency that served as an intervention currency for a given country would increase the scope for movements in market rates of the given currency against currencies not pegged to the same intervention currency. Demand for forward exchange cover could be expected to increase, and this might necessitate the establishment of additional facilities for forward cover in the currency of the primary producing country concerned. Perhaps more important, occasions could arise in which movements in the regional intervention currency against the U.S. dollar imparted to the primary producing country an undesired deterrent to exports and stimulus to imports, and other occasions could arise when there was an inappropriate impetus in the opposite direction. This would be a magnification, by a factor equal to the widening of margins, of the influence which presently exists to the extent of 0.7–0.8 per cent of the parity vis-à-vis the U.S. dollar, corresponding to the margin maintained against the U.S. dollar by the European currency.

The relatively small movements in rates against currencies outside the regional area under present margins have not generally been a subject of concern, even though at times such movements may have been inappropriate from the standpoint of the payments position of a primary producing country in the regional area. The fixed link between the center currency and the other regional currencies may be seen as part of the general association in a currency area, of which the advantages and drawbacks can only be assessed as a whole. The significance of problems such as these would depend to a substantial degree on the relative importance, for the primary producing country concerned, of trade and payments relationships within the regional area on the one hand, and outside the area on the other hand. In general, the smaller the proportion of trade and payments taking place with countries outside the area, and the smaller the proportion of trade invoiced in outside currencies, the less significant will be the effects of fluctuations vis-à-vis the currencies outside the area. Conversely, where a substantial proportion of trade and payments takes place with countries outside the area, or is invoiced in outside currencies, the fluctuations vis-à-vis the currencies of these countries outside the regional area will be of greater significance.

For primary producing countries generally, a widening of margins by slight amounts by industrial countries other than the country whose currency was used as the intervention currency would not be likely to have significant direct effects. It may be recalled in this context that no significant effects are expected from such a move on the competitiveness of the industrial countries directly concerned. The indirect effects, in line with the considerations mentioned on pages 297–98, would depend mainly on such effects as the slight widening of margins might have on the economic growth, productivity, imports and capacity to supply development aid or investment capital in the country making the adjustment. An industrial country that decided to widen its exchange margins would presumably do so in order to achieve certain objectives, such as avoidance of certain disruptions to its payments balance that might otherwise occur, attainment of somewhat greater autonomy for domestic monetary policies, or a smoothing in the impact of a change in its par value. Insofar as the widening of margins succeeded in achieving objectives such as these, this might well be of benefit to other countries, which could be adversely affected by attempts of the given country to deal with payments constraints through imposition of trade or payments restrictions or through measures that had adverse effects on economic growth and on the size of its market for imports. Other countries would also benefit, from the standpoint of reducing disruptions, from any smoothing in the impact of changes in par values of major currencies through less abrupt changes in market rates made possible by wider margins.

These favorable indirect effects are likely in many or most cases to be of minor significance and they could not always be counted on. At the same time, the direct and essentially negative effects of wider margins in some industrial countries on primary producing countries are also likely to be of relatively small significance in many cases; the main exceptions might be in the sphere of administrative inconvenience. But whilst slightly wider margins in certain industrial countries might not have very sizable effects on primary producing countries as a group, the wide range of possible effects, and their importance for particular countries, emphasize the need for the interests of these countries to be taken fully into consideration in any changes that might be made in the margin provisions and in the way in which such changes were applied.

Part II: Implications for Policy

1. Introduction

Part I of this report has discussed in some detail the role of exchange rates in the adjustment of international payments in accordance with agreed objectives of economic policy. In the present Part, the Executive Directors turn to an assessment of the policy implications of this analysis for the Fund and its member countries. This assessment is based on a wide ranging study undertaken by the Fund in the past 18 months, in which the operation of the existing system has been extensively reviewed. Consideration has also been given to a wide variety of proposals for modifying the manner or the extent of exchange rate adjustment, either under existing procedures or under new procedures. Detailed attention has not, however, been given to the possible forms that any amendments of the Articles of Agreement might take, if on further investigation they came to be judged necessary and desirable.

The breadth and complexity of the issues involved in determining the desirable role and mechanism of exchange rate adjustment have been illustrated in the discussion in Part I. It is evident from this analytical review that any particular regime of exchange rate adjustment combines both advantages and disadvantages when compared with other possible arrangements. Judgment on the advisability of instituting any change in existing arrangements or in their implementation, therefore involves a weighing of the balance between potential benefits and potential costs.

While it is desirable to keep under review the instruments and procedures which might help the evolution of timely and effective national or international policies, it is also clear that technical or organizational arrangements can never serve as substitutes for correct policy decisions. These arrangements are no more than the tools for the policy makers and in the final analysis the outcome will depend on whether, when, and how well these tools are used.

Their study of the exchange rate mechanism has convinced the Executive Directors that the basic principles of the Bretton Woods system are sound and should be maintained and strengthened. These principles are conducive to the implementation of effective policies, both nationally and internationally. The par value system, based on stable, but adjustable, par values at realistic levels, remains the most appropriate general regime to govern exchange rates in a world of managed national economies. The risks for both the international and national economies that would be involved in any general departure from this regime would not be justified by such special benefits as could be foreseen from such a departure. The Fund’s Annual Report for 1969 emphasized

that any changes that might be made should preserve the essential characteristics of the par value system, which remain as beneficial for the world as they were when written into the Fund’s Articles of Agreement 25 years ago: that the stability of exchange rates at realistic levels is a key contribution to the balanced expansion of international trade, and that the determination of the rate of exchange for each currency is a matter of international concern (p. 32).

2. Basic principles of the par value system

(1) The par value system provides a framework for the maintenance of stability and order in exchange rates which is an essential condition for the expansion and balanced growth of international trade. Stability, as was recognized at Bretton Woods and as the Fund has stressed, does not mean rigidity. The Fund observed in this connection in its 1969 Annual Report:

If exchange rates that are no longer appropriate are nevertheless maintained, they contribute to the persistence of payments disequilibria, the encouragement of speculation, and crises in the exchange markets. Moreover, undue rigidity of exchange rates may lead to the very developments that the par value system is intended to avoid, including restrictions on current transactions, the imposition or intensification of capital controls, and the sluggish growth of development aid (p. 31).

(2) It is a basic principle of the par value system that changes in parities must be related to the correction of a fundamental disequilibrium. Under the Articles, this principle is applied through the following provisions: “A member shall not propose a change in the par value of its currency except to correct a fundamental disequilibrium,” and “The Fund shall concur in a proposed change … if it is satisfied that the change is necessary to correct a fundamental disequilibrium” (Article IV, Section 5 (a) and (f)). However, the Executive Directors have discussed, without reaching an agreed conclusion, proposals for a modified application of this principle, which would facilitate a speedier response to an emerging or imminent fundamental disequilibrium.

The term “fundamental disequilibrium” is not defined in the Articles and the Fund has never attempted to formulate a definition. It has become clear in the Fund’s practice that the criterion of fundamental disequilibrium is not confined to the occurrence of an overt disequilibrium in the balance of payments. The criterion can relate also to the performance of the domestic economy, to the purposes of the Fund,1 and to the policies and policy preferences of its members. The concept of fundamental disequilibrium is discussed more extensively in Part I on page 276 and pages 307–10. Because of the important role that this concept plays in the par value system, the Fund will continue to study the statistical and other elements to be taken into account in the exercise of judgment with respect to the presence and magnitude of fundamental disequilibria.

(3) It is another basic principle of the par value system that a change in the par value of a member’s currency may be made only on the proposal of the member. The importance that was attached to Article IV, Section 5 (b) in which this principle is enunciated is evident from the fact that it is one of the three provisions in the Articles that can be amended only with the agreement of all members.2 It is the view of the Executive Directors that this provision continues to be appropriate. This does not, of course, preclude the expression of views by the Fund at any time under established procedures.

(4) It is a further basic principle of the par value system that changes in parities are matters of international concern which therefore should be governed by agreed international procedures. Under the Articles all changes in parities must be preceded by consultation with the Fund. In addition, under Article IV, Section 5 (c), changes in parities require the concurrence of the Fund except that the Fund may not object when “the proposed change, together with all previous changes, whether increases or decreases, does not exceed ten per cent of the initial par value….”3 Many members have made one or more changes in par value which in total have exceeded ten per cent of their initial par values; these members can therefore no longer avail themselves of the leeway provided under this provision. The Executive Directors have discussed proposals under which this leeway would be restored for all members, or abrogated for all. They have also discussed a proposal for the introduction of other provisions under which a special procedure might be applied to changes in par value up to a specified magnitude in certain conditions. This proposal is set out on page 326 below.

3. Alternative regimes

The same considerations which have led the Executive Directors to reaffirm the basic features of the Bretton Woods system also lead them to reject three alternative exchange rate regimes that have been suggested, viz.,

  • (i) a regime of fluctuating exchange rates,

  • (ii) a regime based on parities agreed with the Fund but allowing substantially wider margins,

  • (iii) a regime under which parities would be adjusted at fixed intervals on the basis of some predetermined formula which would be applied automatically.

In rejecting these alternative exchange rate regimes, the Executive Directors do not fail to recognize that any one of these regimes could in some respects and on certain assumptions perform more satisfactorily than the present par value system. Thus if a regime of fluctuating exchange rates were operated without official intervention in the exchange markets, this would necessarily keep these markets in short-run equilibrium and would hence preclude the heavy drains on the official reserves of some countries (and the large increases in the official reserves of other countries) that have often plagued monetary authorities in recent years. A system of parities with far wider margins than those observed at present could, at least in some circumstances, achieve a similar effect on exchange markets as would freely fluctuating rates, while preserving, though to an inadequate extent, the concept of international agreement in connection with exchange rates. Finally, the formula approach to parity changes would in its nature avoid delays in parity changes, though it might well involve delays in adjustment of parities by the necessary amount.

The benefits that have been noted would not be inconsequential, but they need to be considered in the context of the associated serious drawbacks of these regimes, and of the grave risks that would be entailed in an abandonment of the safeguards of the par value system. For the reasons indicated in Part I,4 the disadvantages that these alternative regimes would entail in terms of the purposes of the Fund and of the ability of member countries to achieve their objectives would clearly outweigh their potential advantages.

4. Proposals for adapting the par value system

The conclusion that the par value system is the most suitable general exchange rate regime for the members of the Fund carries with it a duty for the Fund and its members to make this system as effective as possible for achieving the purposes of the Fund. This implies, for the Fund, the need to review and where necessary to adjust its criteria, procedures and operational practices to ensure that they are as well suited as possible to this end. For the members of the Fund, this implies, first, pursuit of internal policies that will keep the growth in aggregate demand in line with the development of available resources; for while inflationary pressures are not the only sources of exchange rate difficulties, they have certainly been the most frequent sources in the past. Second, it implies a willingness, in instances where exchange rate changes are appropriate to restore equilibrium, to make such changes at a time and in a manner most likely to enhance their effectiveness. The latter consideration is of particular importance because in present conditions of international mobility of capital, expectations that parities may be changed can lead to large and disruptive movements of funds. The impact of such expectations has been increased because of the much larger role that international capital movements now play in the working of the international monetary system than was envisaged when the Bretton Woods system was established. The increased role of international capital movements, and the particular role now played by the markets in Euro-currency deposits, have been discussed in Part I, pages 291–92 and 311–14; an extensive review of developments in the Euro-currency markets is contained in the 1970 Annual Report of the Executive Directors, pages 90–96.

The extent to which adaptations in exchange arrangements and policies might be desirable in order to deal with the problem of speculative capital movements is likely to depend at least to some extent on the desire and ability of countries to impose effective controls, or to intensify existing controls, on international capital movements. It may be recalled that such controls are not inconsistent with the Fund Articles provided they do not restrict payments for current transactions. There seems to be general agreement that the imposition of such controls, whether on movements of capital into or out of countries, would always risk some impediment to current transactions or to capital movements of a beneficial nature, and in addition might involve difficulties in making such controls effective in some cases. Some members take the view that the potential benefits of such controls under present conditions outweigh these disadvantages; other members believe that the balance of advantage lies against the imposition of controls, at least as a general policy.

The specific areas in which the exchange rate policies of members and the procedures of the Fund have been reviewed from the standpoint of attaining the most smooth and effective operation of the par value system are discussed below under three heads: (a) prompt adjustment of parities in appropriate cases; (b) a slight widening in the margins around parity; and (c) temporary deviations from par value obligations.

An aspect of particular importance in connection with any changes in arrangements that might be considered desirable is the extent to which they would involve amendment of the Articles of Agreement and whether the benefits to be derived from the new arrangements would justify amendment. Amendment of the Articles, except for the provisions mentioned in Article XVII (b), requires approval by the Board of Governors by the majority of votes cast and acceptance by three fifths of the members, having four fifths of total voting power.

a. Prompt adjustment of parities in appropriate cases

In conformity with the basic principles outlined above, and with the analysis in Part I, the occurrence of payments imbalances does not in itself justify adjustment of the parity. A disequilibrium in the balance of payments is not fundamental if it results from temporary (e.g., seasonal or short-term cyclical) factors and may be expected to disappear without either a change in parity or the impairment of national or international prosperity. Moreover, in the many cases in which the domestic correctives needed to contribute to payments equilibrium would also contribute to the improvement of domestic financial balance, the existence of a payments imbalance does not necessarily imply the existence of a fundamental disequilibrium. This is also true where the imbalance can be corrected by acceptable international measures outside the exchange rate field. In both types of cases the application of alternative correctives should have priority, and it may often be advisable to await their results before deciding on an adjustment of the parity.

Where disequilibria in external payments can be corrected satisfactorily without recourse to exchange rate adjustment, this would be the preferred solution. Exchange stability makes a particular contribution where it creates or reinforces support for the maintenance of domestic price stability. At the same time, a country that succeeds in maintaining stability in domestic prices, or at least in keeping price increases to a lesser pace than its trading partners, may find that stability threatened by the maintenance of an unchanged parity; in such circumstances, i.e., in the absence of satisfactory policies or corrective adjustments abroad, appreciation of the currency will help a country to protect its domestic price stability.

In cases where exchange rates should be adjusted either upward or downward, delay in effecting such adjustment will clearly aggravate the underlying disequilibrium. Prompt response to such disequilibria is therefore desirable. The procedures of Article IV and the concept of fundamental disequilibrium permit an adjustment of a par value that is necessary to correct a fundamental disequilibrium, even though that disequilibrium may require for its correction a change in parity that would be smaller than members have with few exceptions proposed in the past. Also, to the extent that a fundamental disequilibrium recurred, e.g., because of a persistent divergence in relevant trends of the domestic and international economies, a change in parity may have to be repeated in order to correct recurring fundamental disequilibria and this also would come within the purview of the present Articles of Agreement. However it would not be consistent with the Articles to make changes in par values that were so small that they were judged to be incompatible with the concept of correction of a fundamental disequilibrium, or so frequent that they were judged to undermine the maintenance of exchange stability. No a priori rules can be adopted by which to make effective judgments of this kind; the circumstances of each case must be taken into account.

Distinctions based on the size of par value changes are contained in those provisions of Article IV, Section 5 (c) which separate proposals by members for changes in parities into three groups for the purpose of regulating the nature and the speed of the response by the Fund to such proposals. These classes are determined by the cumulative size (without regard to sign) of all changes, including the proposed change, compared to the member’s initial par value. If this cumulative change is 10 per cent of the initial par value or less, the Fund is not entitled to object; if the cumulative change is larger, the Fund may concur or object; it then has 72 hours to declare its attitude if the cumulative change does not exceed 20 per cent of the original par value but may take a longer period—which is not defined—if the cumulative change is in excess of 20 per cent of the initial par value. The Executive Directors have found that, where in accordance with normal practice close contact has been maintained between the Fund and a member, a period of 72 hours normally is sufficient for responding to a member’s proposal for a change in par value.

As stated above, in certain cases prompter and smaller adjustments in members’ parities would help to avoid the building up of large fundamental disequilibria and the eventual recourse to sharp adjustments. It has been explained that the provisions of the Articles empower the Fund to concur in members’ proposals for prompter and smaller changes in parities, whenever these are necessary to correct a fundamental disequilibrium. However, the suggestion has been made that, in order to facilitate small and gradual changes in parity as disequilibria develop and to avoid unnecessary delays in adjustment that may occur for various reasons, the Articles of Agreement might be amended to allow members to make changes in their parities without the concurrence of the Fund as long as such changes did not exceed, say, 3 per cent in any twelve-month period nor a cumulative amount of, say, 10 per cent in any five-year period.5 Under this proposal, the Fund could be empowered to question improper use of this special facility. Different views exist as to whether an amendment of this nature, or variants of it, would facilitate the application of the basic principles of the par value system and would be compatible with the purposes of the Fund; further study of these questions is therefore appropriate.

The basic principle that a change in par value may be made only on the proposal of the member does not prevent the Managing Director, when he feels it necessary to do so, from exploring with a member questions relating to that member’s parity, in a manner compatible with the sensitivity of the subject. In the course of its general functions, the Fund pays attention to the appropriateness of the rate of any member’s currency. Moreover, in accordance with the Fund’s policy on the use of its resources,6 the Fund normally considers the appropriateness of the exchange rate of the currency of any member that envisages making a transaction in the higher credit tranches.

The counterpart to a policy of prompt changes in parities when changes are needed is the defense of any parity that is appropriate to a country’s underlying situation, even though it may at a particular time be buffeted by strong movements in reserves. Where the reserve movement is a heavy inflow, the problem will be to deal with the inflow without provoking undesirable effects on the domestic economy. Pressures on a parity may be still greater where the country is faced by a large outflow of reserves. In either case, and depending on circumstances that may differ from country to country, it may or may not be desirable and possible to alleviate the situation by recourse to controls on capital movements. The country whose currency is under downward pressure will in any event have to be able to use adequate reserves to defend the rate. In terms of national policies, this requires the persistent pursuit by countries of balance of payments and reserve policies that will result over time in adequate reserves. Internationally, it requires an appropriate policy on reserve creation that makes it possible for countries to realize reasonable reserve aims. The facility for special drawing rights is intended to provide the means of meeting this requirement. Where movements of funds are very large, however, reserves that are adequate for normal purposes may not suffice. To supplement them, the countries that are most subject to large short-term capital flows have instituted a network of swap credit facilities among themselves. All members of the Fund, moreover, can have recourse to the Fund’s resources in the credit tranches. The fact that such use is conditional has the advantage from the international point of view that access to the higher credit tranches involves inter alia an international judgment as to the appropriateness of the exchange rate in defense of which balance of payments assistance is being sought. The general increase in Fund quotas that is now under way pursuant to the fifth general review of quotas will enlarge substantially members’ access to international liquidity of this character.

b. A slight widening in the margins around parity

For the reasons developed on pages 305–306 of Part I, a substantial widening of the permitted margins for market rates would risk the erosion of the safeguard that internationally agreed parities provide against changes in a country’s competitive position as a result of actions by other countries. The same objection would not apply to the introduction of a possibility for members to adopt slightly wider margins, if they wanted to do so, under which fluctuations in market rates continued to be confined to magnitudes that could be expected to have only a minor effect on countries’ competitive positions. It would be difficult to determine how far one could go beyond the present margins before the potential disadvantages of a widening of margins would outbalance any potential benefits from such widening, and the Executive Directors have not reached a common view on this question. The answer to this question could depend inter alia on whether Fund approval would be required before an individual member could apply wider margins.7

As discussed in Chapter 6 of Part I, a slight widening of margins could have three possible advantages. First, by increasing the scope for movements in exchange rates around par, it would somewhat reduce the sensitivity of short-term capital movements to divergences in conditions in national money markets, and would thereby allow somewhat greater independence for national monetary policies. Second, the increased scope for market movements around par could, in certain circumstances, reduce pressure on official reserves, by encouraging anticipatory movements of private funds in a stabilizing direction. Thirdly, the moderate increase in scope for market rates to move in response to market pressures would slightly reduce the prospective profitability of speculation on possible parity changes, and could be of some help in smoothing the transition from one parity to another; this influence would be significant only where the typical size of parity changes was relatively small. Against these possible advantages, a slight widening in margins could also involve certain disadvantages both for the member adopting them and for other countries. Since all provisions for the widening of margins under discussion would leave each member the option not to adopt margins wider than those applied at present, any members or groups of members that considered such margins disadvantageous to themselves could refrain from adopting them for their own currencies. Members that did not themselves adopt wider margins might be unfavorably affected by the effects of the adoption of such margins by other members; the increased scope for fluctuation of market rates, which could often be considered advantageous in its effect on capital movements, might have unwelcome effects especially on trade and current payments, though these effects would not be expected to be substantial with a widening of margins that remained relatively slight. In addition, a widening of margins, even by slight proportions, could introduce undesired disturbances in the economic and financial relations among certain groupings of members and might create special difficulties for many primary producing countries.

It may be recalled that the present arrangements, under which member countries are permitted margins of up to one per cent against their intervention currency and cumulated margins against other currencies of up to 2 per cent, are validated under the Fund’s jurisdiction to give temporary approval of multiple currency practices, in accordance with an Executive Board Decision of 1959 (see Part I, page 281). It would not be possible for the Fund, however, to approve a further widening of margins that would involve margins against the member’s intervention currency in excess of one per. cent. The Executive Directors have considered the 1959 Decision in connection with the question whether it would be desirable to amend the margin provisions so as to allow a slight widening in the effective permissible margins. Further study is needed to determine whether any such amendment, if it were to be judged desirable, should take the form of a provision establishing new margins, or permitting the Fund to establish appropriate margins for all currencies or in individual cases. A related question that would need to be considered concerns the safeguards and conditions that the Fund might impose.

c. Temporary deviations from par value obligations

While the Executive Directors have reaffirmed their belief, for the reasons indicated earlier in this report, that adherence to the principles of the par value system continues to be strongly in the interests of individual member countries and of the international community at large, they recall that occasions have arisen in the past in which exceptional pressures induced individual countries to suspend the observance of their par value obligations and to move to a fluctuating rate. Under the Articles, the Fund is not authorized to approve such action where the resulting rate is a unitary rate;8 however, the Fund can recognize the exigencies of the situation which brought about such action, or it can merely take note of it. The question has been raised whether it might be desirable to amend the Articles of Agreement so that the Fund would have the authority to approve such departures from normal par value obligations, and if so, under what circumstances and subject to what safeguards.

This question involves a variety of considerations. From a general standpoint, the granting of legal authority for the Fund to approve departures from the basic par value regime might involve the danger of making such departures appear less serious a breach in the basic regime than is the case while these departures remain clearly outside the legal regime of the Fund. Under the Articles, the Fund has found it possible to exercise its influence in connection with actions taken by members outside the Articles and to indicate in advance the circumstances in which it would refrain from taking action open to it under various provisions against a member in breach of its par value obligations.9 On the other hand, the granting of legal authority to approve departures might enable the Fund more effectively to deal with such cases, by making such approval contingent on the observance of specific conditions by members that had suspended the implementation of their par value obligations. The explicit provision of authority for the Fund to give approval to departures from the normal par value regime would enable members in these circumstances to remain within the law and could help ensure that such departures took place under safeguards to protect the interests of the international community and to encourage the establishment of an effective par value as soon as possible.

In regard to this question, the Executive Directors are agreed that any departure by a member country from its par value obligations would necessitate, from the standpoint of the international community, the institution of adequate safeguards to take the place of the safeguards of the par value system which the member was no longer observing. The appropriate safeguards to be applied could vary from case to case. They would need to be effective for the international community and at the same time of such a character that the national authority most directly concerned would be able to observe them in the exceptional circumstances that would be likely to be prevailing at the time. They would include in all cases close consultation between the Fund and the member with respect to its exchange arrangements, and normally also with respect to the other aspects of its economic and financial policies which will have a bearing on those arrangements. Such safeguards should, moreover, provide assurances against the imposition or intensification of restrictions on trade and current payments, and preferably should provide for a reduction in any such restrictions. They should reflect the Fund’s emphasis on the temporary character of any departure from the par value obligations and should include periodic and intensive reviews by the Fund with a view to the establishment by the member concerned of an effective par value under the normal regime of the Articles.

The Executive Directors have not come to a final view on the various issues raised by temporary deviations from the par value regime and intend to give them further consideration.

In a number of Annual Reports, in particular those of 1951, 1962 and 1969, the Executive Directors addressed themselves to a review of certain of the exchange rate provisions of the Articles. This is the first occasion on which the Fund has undertaken a comprehensive review of the mechanism of exchange rate adjustment. This report indicates that, in the view of the Executive Directors, the par value system retains its validity. The functioning of this system will be the subject of a continuing review in the period ahead. In this context the Executive Directors intend to give particular attention to the issues that remain open in this report, including their legal aspects.

In this report, the term “exchange rate” refers to the exchange rate of a given currency against any other currency; it is also used as a shorthand expression for the network of exchange rates between the given currency and all other currencies. The term “parity” or “par value” refers to the value of the currency as expressed in terms of gold or the U.S. dollar of fixed gold weight. The par value of a currency under the Fund Articles is defined on p. 280 below.

Article VIII, Section 4 (a) states:

(a) Each member shall buy balances of its currency held by another member if the latter, in requesting the purchase, represents

  • (i) that the balances to be bought have been recently acquired as a result of current transactions; or

  • (ii) that their conversion is needed for making payments for current transactions.

The buying member shall have the option to pay either in the currency of the member making the request or in gold.

E.B. Decision No. 904-(59/32), adopted July 24, 1959.

Article IV, Section 3 (ii), cited on p. 280.

The flat percentage margin between the three months forward rate and the parity or the spot rate referred to here should be distinguished from the margin expressed in terms of its annual interest equivalent (of about 4 times the flat percentage margin in the case of three-month forward maturities and about 12 times the flat margin on a one-month maturity, etc.), which is relevant in the context of interest arbitrage.

See p. 275.

See p. 281, footnote 2.

In the period 1948–69, consumer prices in industrial countries, weighted by these countries’ share in exports to other industrial countries, showed an annual increase averaging 3 per cent. In the same period, prices in world trade, as measured by the indices of export prices of industrial countries weighted in the same way, showed an annual increase averaging ¾ per cent.

Cited on p. 275.

World exports in the period 1951–69 increased by an annual average of 6.8 per cent in value and 6.2 per cent in volume; in the period 1958–69, the average annual increase was 8.0 per cent in value and 7.5 per cent in volume.

Viz., Article I (v), cited on p. 275.

Article IV, Section 5 (a).

Article IV, Section 5 (f), states: “The Fund shall concur in a proposed change which is within the terms of (c) (ii) or (c) (iii) above if it is satisfied that the change is necessary to correct a fundamental disequilibrium. In particular, provided it is so satisfied, it shall not object to a proposed change because of the domestic social or political policies of the member proposing the change.”

Article I, cited on pp. 275–76.

An extensive review of the rapid growth of the market in Euro-currency deposits is contained in the 1970 Annual Report of the Executive Directors, pp. 90–96.

For most currencies, whose exchange rates are expressed in terms of the number of domestic units in relation to one U.S. dollar, a depreciation in the currency involves a rise in the operative figure expressed in domestic currency; thus, the lower exchange margin, setting the limit for downward deviations from par, is at a higher number of domestic units to the dollar than the parity. Rates for the pound sterling and some associated currencies, which are expressed in terms of U.S. dollars for one unit of domestic currency, show the operative figure moving in the same direction as the currency’s external value.

The purposes of the Fund as set out in Article I are reproduced in Part I, pp. 275–76.

Article XVII (b).

Furthermore, the requirement of Fund concurrence is unnecessary “… if the change does not affect the international transactions of members of the Fund” (Article IV, Section 5 (e)). No change has been recognized under this provision in the history of the Fund.

See in particular pp. 304–307.

It will be recalled that some members still have available to them a certain leeway to make changes in par values without the concurrence of the Fund under Article IV, Section 5 (c) (i). Proposals for possible changes in this provision were mentioned on page 323 above.

“Requests for transactions beyond [the first credit tranche] require substantial justification. They are likely to be favorably received when the drawings or stand-by arrangements are intended to support a sound program aimed at establishing or maintaining the enduring stability of the member’s currency at a realistic rate of exchange” (Annual Report, 1962, p. 31).

The size of the margin mentioned in the course of the Executive Directors’ discussions was 2 per cent, or at most 3 per cent, against an intervention currency.

Where the member adopts multiple rates for its currency, the Fund has the authority to approve a fluctuating rate under its jurisdiction with respect to multiple currency practices.

In this connection, reference may be made in particular to Annual Report, 1951, from which the following passages are quoted:

But there may be occasional and exceptional cases where a country concludes that it cannot maintain any par value for a limited period of time, or where it is exceedingly reluctant to take the risks of a decision respecting a par value, particularly when important uncertainties are considered to exist…. (p. 39).

What should be the Fund’s attitude toward these exceptional cases which, from time to time, have been presented to the Fund and may be again presented in the future? …

The circumstances that have led the member to conclude that it is unable both to maintain the par value and immediately select a new one can be examined; and if the Fund finds that the arguments of the member are persuasive it may say so, although it cannot give its approval to the action. The Fund would have to emphasize that the withdrawal of support from the par value, or the delay in the proposal of a new par value that could be supported, would have to be temporary, and that it would be essential for the member to remain in close consultation with the Fund respecting exchange arrangements during the interim period and looking toward the early establishment of a par value agreed with the Fund. No other steps would be required so long as the Fund considered the member’s case to be persuasive, but at any time that the Fund concluded that the justification for the action of the member was no longer sustainable, it would be the duty of the Fund so to state and to decide whether any action under the Fund Agreement would be necessary or desirable (p. 40).

Exceptions to it can be justified only under special circumstances and for temporary periods. The economic and financial judgment of the Fund in such cases must be tempered by recognition of its responsibilities in the wider field of international relations (p. 41).

The statement in Annual Report, 1951, was repeated in Annual Report, 1962 (pp. 58–62), and further support for its approach is evident in the section of the latter report dealing with “Postwar Experiences with Fluctuating Rates” (pp. 62–67).

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