The International Monetary System Part I: Mechanism and Operation

The Purpose of this paper is to describe the operations of the international monetary system and to evaluate its efficacy to meet existing and foreseeable problems. The attempt is made to put the essential characteristics of the entire monetary System in a realistic perspective and to lay a better basis for studying and evaluating particular problems importantly affected by the operations of the System. 1 Something as complicated as the present international monetary system cannot, of course, be described and evaluated fully in anything short of a lengthy volume. Much must be omitted; in particular, the historical development of the present System and some closely related subjects, such as the international transmission of business cycles and the functioning of the price mechanism—especially in the principal industrial countries—fall outside the scope of this paper.


The Purpose of this paper is to describe the operations of the international monetary system and to evaluate its efficacy to meet existing and foreseeable problems. The attempt is made to put the essential characteristics of the entire monetary System in a realistic perspective and to lay a better basis for studying and evaluating particular problems importantly affected by the operations of the System. 1 Something as complicated as the present international monetary system cannot, of course, be described and evaluated fully in anything short of a lengthy volume. Much must be omitted; in particular, the historical development of the present System and some closely related subjects, such as the international transmission of business cycles and the functioning of the price mechanism—especially in the principal industrial countries—fall outside the scope of this paper.

The Purpose of this paper is to describe the operations of the international monetary system and to evaluate its efficacy to meet existing and foreseeable problems. The attempt is made to put the essential characteristics of the entire monetary System in a realistic perspective and to lay a better basis for studying and evaluating particular problems importantly affected by the operations of the System. 1 Something as complicated as the present international monetary system cannot, of course, be described and evaluated fully in anything short of a lengthy volume. Much must be omitted; in particular, the historical development of the present System and some closely related subjects, such as the international transmission of business cycles and the functioning of the price mechanism—especially in the principal industrial countries—fall outside the scope of this paper.

The present is a particularly difficult time in which to describe the international monetary system, because much of it is in rather rapid evolution; examples are the role of the forward market and the defenses of the System. Institutions and practices current before World War II have been imitated and to some extent reintroduced, but postwar conditions have made important innovations necessary. The changes in progress, however, may be added reasons for taking stock of the present situation and for seeking to evaluate possible future developments.

The international monetary system encompasses many things; a precise and still all-inclusive definition is most difficult to set forth. It is hoped, however, that a discussion of the following subjects will cover the essential elements needed for an understanding and evaluation of the system: the principal features of the international payments system; its elements of flexibility or adaptability; the devices available to manage it; and the national and international defenses or safeguards which exist to support it and to prevent its failure.

Over the years, many different types of monetary Systems have been used, at times without any conscious choice having been made. At present, however, it is not likely that any system would be pursued more or less by accident and without deliberate choice. The existing system has the great competitive advantage that it does exist; at the same time, constant suggestions for reforms, and even for the adoption of entirely different Systems, must be expected, since others can be invented with relative ease. To appreciate this, it is only necessary to recollect the fervor with which trade quotas, discrimination, and inconvertibility of currencies have been advocated in recent years, while a return to the international gold standard and complete freedom of trade has found equally fervent support.

Any moderm system must serve purposes regarded as cogent and relevant for the present and foreseeable future. Probably the best single statement of the purposes of the present system is to be found in Article I of the Articles of Agreement of the International Monetary Fund (IMF), viz., “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.”2 The more immediate purposes of the system, which are really the agreed ways and means to achieve the general objectives, are also set forth in Article I: the promotion of exchange stability, the maintenance of orderly exchange arrangements among members, the avoidance of competitive exchange depreciation, and the establishment of a multilateral system of payments in respect of current transactions. To help to achieve these purposes the Fund was given large financial resources in the hope that its members, by having resources made available to them under adequate safeguards, would be able to “correct maladjustments in their balance of payments without resorting to measures destructive of national or international prosperity.”3 By the pursuit of policies appropriate to these purposes, countries would shorten the duration and lessen the degree of the disequilibrium in their international balances of payments.

One obvious fundamental aspect of the present system, like many other obvious fundamental facts, tends to be neglected: any system today must be based on the existence of national governments and national sovereignty and on the delegation of certain powers to international institutions. It can be neither the extension by common usage of the practices of one country (or a few countries) nor the abolition of national boundaries for financial purposes. It has to be truly international, and any evaluation of a given system must make some assumption as to how far national governments are willing to go in creating supranational institutions and being regulated by supranational policies in the financial field, and, on the other hand, how far they wish to insist that their own financial policies and practices dominate the actions of others. If the underlying political assumptions are such that the system might not be viable in times of stress, this should be pointed out.

The principal characteristics of the present system and its elements of flexibility are described below. It is hoped to review, in subsequent articles, the monetary measures that may be taken to manage the system and its existing “defenses,” and to attempt an evaluation of the System including, if possible, the manner in which the developing countries fit into it.

Principal Features of the International Payments System

The main function of the international payments system is to enable payments to be made to consummate the international purchase and sale of goods and services and flows of capital. The principal features discussed below are the nature or usability of the currencies earned or received from international transactions, the nature or international usability of the currencies held by residents of the countries issuing them, the exchange rate at which currencies are bought and sold, the markets in which such transactions take place, and the use of reserves.

External Convertibility

Most of the world trade in goods and services is paid for in currencies4 which can be freely exchanged for other currencies, including that of the original supplier of the goods or services. With few exceptions, the governments of countries outside the Soviet bloc allow their currencies, when acquired by nonresidents, to be converted into other currencies. Some limitation may be placed, however, on the conversion of such currencies acquired through capital transactions, such as direct or portfolio investments. In this sense, the currencies earned may be said to be “externally convertible”5 (i.e., convertible by persons outside of the country concerned) for “current transactions” (i.e., not of a capital nature). In practice, an importer of goods or services in a country whose currency is externally convertible is free to pay the exporter of the goods or services in (1) the currency of the importing country (which the exporter can then sell for other currencies or can hold in a bank deposit—i.e., a nonresident convertible account—which can later be used for any purpose, including conversion into other currencies), or (2) other convertible currencies (including that of the exporting country) obtained by the importer in the foreign exchange market. The latter kind of payment merges into internal convertibility, discussed below.

External convertibility makes it unnecessary for countries whose exchange receipts are very largely in convertible currencies (as are those of the industrial countries) to discriminate, by means of licensing Systems, in regard to the currency used for payments for imports and invisibles. As a consequence, discrimination has become much less important in international trade, although some remains as a result of continued bilateralism; however, bilateral agreements (as well as other forms of discrimination for balance of payments reasons) are used primarily by the developing countries. While bilateral trading agreements are still used to some extent by the industrial countries, they are not of major significance in determining the pattern of international trade and payments because, as a general rule, these countries do not try to discriminate in favor of particular bilateral partners. These statements must be qualified in respect of recipients of tied aid. Although this aid is usually extended by countries whose currencies are convertible, the recipient countries, in order to use it, may have to resort to some form of discrimination in their exchange and trade policies; thus such aid, taken beyond certain limits, recreates the economic effects of inconvertibility.

Internal Convertibility

Internal convertibility confers on residents the same right to convert their national currency into other currencies which external convertibility confers on nonresidents. After World War II, countries whose currencies were inconvertible restored external convertibility first. Therefore, under present conditions, if a currency is internally convertible, it is necessarily externally convertible as well. Residents of most industrial countries do not yet have complete freedom to exchange their own currency into foreign currencies at official rates of exchange. However, the list of purposes for which foreign exchange is freely made available to residents has by now been greatly extended. Whereas, formerly, payments for many imports of goods and services were severely restricted, existing restrictions are confined mainly to capital payments.

The freedom to purchase foreign currencies for certain purposes does not mean, in practice, that ail externally convertible currencies are used to an important extent to make international payments. Payments are generally made in U.S. dollars or sterling even when no residents of the United States or the United Kingdom are parties to the transaction; prices, shipping documents and other contracts, freight charges, etc., are frequently expressed in one of these currencies. Occasionally, other currencies are used, particularly in transactions between two non-dollar, non-sterling countries. Payments may also be made by crediting the convertible currency account of the payee (or his bank), but if this is done conversion when requested is usually into U.S. dollars or sterling. Gold itself is used from time to time to make international settlements, particularly those of a governmental character or between central banks; however, the use of gold for these purposes is relatively infrequent. Part of the explanation for the use of the U.S. dollar as a reserve currency is its convertibility into gold at a fixed price, but its widespread use for international payments is another important recommendation, and this applies even more forcibly to sterling. It is noteworthy that during recent years, when the U.S. balance of payments has been in deficit and there has been talk of dollar “weakness,” the international use of the dollar seems actually to have increased. The pound sterling also, despite the United Kingdom’s balance of payments difficulties, remains a widely used international medium of payment.

Countries exercising controls over capital transactions find it difficult to refrain from screening payments for ail purposes, including payments for imports and invisibles, in order to prevent disguised capital flight. The screening process may not be onerous and, through the use of such devices as open general licenses for broad categories of transactions and the delegation of authority to commercial banks to deal even with doubtful and borderline requests for permission to purchase foreign exchange, it may result in having little, or virtually no, effect on current transactions. Nevertheless, so long as there are limitations on the amount of foreign exchange which residents can purchase, whatever the reasons and however valid they may be, a full convertibility system does not exist. All that can be said is that the significance of the inconvertibility still remaining is much less than in the 1950’s, both because it now affects only slightly the international exchange of goods and services and because it does not interfere with the convertibility of earnings or other foreign exchange receipts by nonresidents.

It is true that many industrial countries retain quantitative restrictions on some imports, and that these restrictions on international trade affect the volume and pattern of payments. Generally, however, these trade restrictions in the industrial countries are not, technically, restrictions on international payments as such. Thus, countries with convertible currencies may employ quantitative restrictions and quotas without technically impairing the convertibility of their currencies, even though the economic effects of these restrictions are very similar to limitations on internal convertibility. This similarity is reflected in the provisions of the General Agreement on Tariffs and Trade (GATT) dealing with such quantitative restrictions—especially in the role given to the Fund in judging the extent to which such restrictions are needed for balance of payments purposes, and in the closeness with which the definition of discrimination in the exchange field, authorized under the Fund Agreement, is paralleled by that of discrimination authorized under the GATT.6 Where trade restrictions are maintained to protect the balance of payments, there is close cooperation between the Fund and the GATT on the question of whether the restrictions are more intense than the balance of payments position requires.7 However, the trade restrictions maintained today by the industrial countries are not usually maintained for balance of payments purposes; this means either that the country does not claim that its balance of payments necessitates the maintenance of such restrictions, or that it considers that they could be eliminated without intolerable effects on its balance of payments. The General Agreement also contains provisions requiring countries to account for import restrictions not maintained for balance of payments reasons. Thus, trade restrictions which significantly affect the volume and direction of payments are subject to international discussion, whether or not they are maintained to protect the balance of payments.

Par Values and Margins

In countries where par values have been agreed with the International Monetary Fund, the purchase and sale of currencies are supposed to take place at exchange rates based upon these parities and within limited margins. Par values are expressed in gold, or in terms of the U.S. dollar of the weight and fineness in effect on July 1, 1944. The par values of the principal industrial countries are given in Table 1.

Table 1.

Principal Industrial Countries: Par Values Agreed with the International Monetary Fund

(In units of national currencies per U.S. dollar)

article image
No official buying or selling exchange rate has been announced. It is understood that the authorities maintain the exchange rate within the margins of 1 per cent on either side of parity with the U.S. dollar.

a Old francs.

New francs.

U.S. dollars per pound sterling.

Par values are thus unitary rates, although, as discussed below, they can be part of multiple currency Systems. In the industrial countries, the exchange rates are essentially unitary; where multiple currency features exist, they do not alter the fundamental character of the system.

The Articles of Agreement of the Fund provide that the maximum and minimum rates for spot exchange transactions between the currencies of its members taking place within their territories shall not differ from these par values by more than 1 per cent.8 This 1 per cent is called the margin; the combination of margins on either side of par can result in a spread of 2 per cent between the lowest and highest limits between any two member currencies. In practice, the industrial countries have fixed their currencies in terms of the U.S. dollar. If the exchange rate of each currency vis-à-vis the U.S. dollar varies within a margin of one half of 1 per cent, giving a spread of 1 per cent, the exchange rate between two such currencies can vary within a margin of 1 per cent or a spread of 2 per cent. Therefore, margins of more than one half of 1 per cent vis-à-vis the U.S. dollar could give rise to margins of more than 1 per cent between other currencies and therefore margins greater than specified in the Articles of Agreement. A decision taken by the Fund in July 1959, however, permits the spread between the maximum and minimum rates to be as much as 4 per cent whenever such rates result from the maintenance of margins of no more than 1 per cent from parity for a convertible currency.9 Thus, even currencies that are based on par values agreed with the Fund can fluctuate considerably in terms of other currencies without changes in par values or any other official action. The importance of the width of this spread can be seen by calculating the possible cost to a speculator of taking an uncovered position within the spread, keeping in mind that his costs are calculated on a per annum basis. An error in forecasting a movement of the exchange rate during the period of the transaction (from one day to many months), even if the movement of the rate is within the permitted spread, may well involve a considerable loss. Thus, from a business point of view, the existing spreads are by no means “narrow.” In this connection, attention is drawn to the steps taken by Japan in April 1963 to widen the margins of exchange rates for the yen to magnitudes similar to those prevailing in connection with European currencies (see Table 1).

The existence of a relatively wide spread helped to create conditions which encouraged the rebuilding of free exchange markets in the 1950’s after many years of disuse. During World War II, and for a number of years afterward, central banks were the principal institutions buying and selling foreign exchange; exchange controls closely regulated the activities of commercial banks in the foreign exchange field and the prewar exchange dealers disappeared from the scene. During the 1950’s, the relaxation of exchange controls led to the gradual reintroduction of exchange markets and to the revival of arbitrage facilities, both spot and forward. As a consequence, exchange markets now offer extensive protection against exchange risks, while also allowing trading for speculative purposes (i.e., in order to profit by changes in the exchange rate) rather than for the payment of debts arising out of the international trade in goods and services. While to the theorist the problem of exchange rates may be essentially one of judging the desirability of the present system of fixed rates compared with fluctuating rates, to the operator it may well appear that the real problem is whether the present margins permit too much room for fluctuation, possibly with the effect of encouraging adverse capital movements as well as creating uncertainties in international trade. Central bank authorities, having the power to intervene and greatly to influence the market, have continually to decide at what rate to aim. This means that the expectations of the exchange speculator, based on his judgment of market conditions, may be completely thwarted by massive actions undertaken by the central bank authorities.

For a business engaged in international transactions, the possibilities of variations within the spread create conditions not too unlike a free market with a fluctuating rate—the difference being, of course, that the monetary authorities will intervene to prevent the emergence of rates beyond the limits of the spread. In practice, this means that, if a currency is under pressure—in that demand for that currency to consummate international transactions is less than supply (whatever the source of demand and supply) and the exchange rate falls in terms of foreign currencies—the monetary authorities will provide additional foreign exchange to keep the rate from falling below the agreed margin. In these circumstances, the country is using its monetary reserves to defend its exchange rate. On the other hand, if a currency is strong, so that the demand for it is outrunning the supply, the exchange rate will be bid up to the upper limit and the monetary authorities will buy foreign exchange to prevent further appreciation of the currency.

Within the spread, it is quite possible for the monetary authorities of different countries to have intervention policies which differ both from each other’s and even from previous policies of their own. The policy may be to allow the exchange rate to move within the more or less full range of the spread, the authority intervening only at the limits or very close thereto. Alternatively, it may be to intervene earlier, so as to affect the trend in the market or even to bring about a de facto stability at a level well within the limits of the spread. These different approaches, and variants of them, are ail possible within the present international system. Moreover, the authorities may intervene to influence the rate not only for spot exchange transactions but also for forward transactions. For the latter, the international rules are less specific. Under the Fund Agreement, the margin by which forward transactions may exceed the margin for spot transactions is not to be “more than the Fund considers reasonable.”10 The Fund has not defined reasonableness, leaving it to individual monetary authorities (if they so choose) and to market forces to determine the forward rates, although it would be able to assert its authority if developments were regarded as unsatisfactory from an international viewpoint. The fact that there are no fixed limits to the movements of forward exchange rates introduces a further element of flexibility into the system.

In recent years, the central banks of a number of the industrial countries have adopted a rather passive attitude toward intervention, in the sense that the spot exchange rates have been allowed to reach or come very close to either the upper or the lower limit before foreign exchange is bought or sold. This is reflected in the extended periods of time during which the exchange rates were at their upper (or lower) limit, as shown in Chart 1 (inserted between pp. 230 and 231). Such passivity may well lead to an expectation of a change in the par value, and there are indications that central banks are now intervening more actively to influence trends in the exchange markets and particularly to narrow the range of fluctuation. Although institutional differences are marked from country to country, the intervention of the central banks normally takes place through the commercial banking system; this practice is usual in the United Kingdom. The Bank of England, as manager of the Exchange Equalization Account, has for many years operated to prevent unwanted fluctuations of the rate, and so far as possible to prevent it from bumping against the margins. It does not stand committed to protect the spot rate at any one point within the margins, but it endeavors to keep the rate at a level which reflects the underlying state of the market.11 Its operations are usually conducted secretly, so that the public does not always receive information about its intervention. Speculators know, however, that attempts to exploit temporary weak-nesses in the position of the pound may prove very costly.

Recent movements in the forward exchange rates of some industrial countries are recorded in Chart 2 (inserted between pp. 230 and 231). The Bank of England is free to operate in the forward exchange market, although it is under no obligation to keep the forward rate within fixed limits. The Exchange Equalization Account does at times deal in the forward market, but since 1951 the authorities have not sought to peg the forward rate within any small predetermined margin from the official spot rate.12

Other central banks have also intervened in the forward market; for example, the Deutsche Bundesbank in 1961 provided forward cover to the German commercial banks at no charge or at a charge lower than the market; and the Banca d’Italia during the same year provided Italian banks with substantial and varying amounts of foreign exchange on a swap basis. Probably the most important of ail have been the recent measures taken by the U.S. financial authorities to influence forward rates; these will be discussed in a later article.

In so intervening, the central bank may be motivated by a desire to influence not only the rate of exchange, the reserve position, or the flow of capital, but also domestic liquidity.13 Of course, in practice its operations affect ail these, and perhaps other, factors simultaneously, and they may merely afford different routes by which to achieve the same end—the defense of the external value of the currency at a desired level and without impairment of its convertibility.14

Role of Foreign Exchange Markets

The basic structure of the international payments system comprises the “external” and “internal” convertibility of currencies, the system of par values and margins, and central bank intervention on the exchange markets. The system operates through foreign exchange markets made up principally of commercial banks. Thus, most international financial transactions are handled on a commercial basis through the operation of foreign exchange markets linked through exchange rate and interest rate arbitrage. Commercial banks in the industrial countries are, by and large, free to deal in ail of the currencies of these countries (as well as some others), so that they are free to take advantage of interest rate differentials in different money markets. The excellence of moderm communications obviates disparities in exchange rates through the ability of commercial banks to consummate quickly foreign exchange purchases and sales. This re-creation of the function of the foreign exchange markets has been one of the most important and yet neglected developments in postwar international finance. It began on a regional basis shortly after the establishment of the European Payments Union (EPU) in 1951. For some years, separate exchange markets for EPU currencies and the dollar existed simultaneously. The establishment of external convertibility of the main currencies in 1958 meant the elimination of the wall between these separate markets and their merger into one exchange market for convertible currencies.

However, experience soon indicated that, despite the many similarities to prewar exchange markets, the new conditions in the world economy created novel situations in the exchange markets, calling for a constant reappraisal of central bank policies. These new conditions included, for example, large accumulations of dollar balances, commitments to full employment policies, limitations on capital movements, and eagerness to maintain the foreign currency value of direct investments. A major policy instrument for coping with these situations has been direct intervention by the central bank in the exchange market.

Such direct intervention works instantaneously, whereas other influences exerted by the monetary authorities through open market operations, other public debt measures, or changes in relevant rates or reserve requirements, are usually taken after a time lag and are subject to a further time lag before they take effect. Aside from central bank intervention, the position of currencies in the exchange markets is largely the result of transactions made by private individuals, reflecting ail the factors that affect any commercial market. In particular, apart from such intervention, the differences between rates for forward transactions and those for spot transactions are determined by market conditions. Given the possibility of exchange rate variations, as described above, as well as interest differentials, the forward market becomes an important indicator of expectations with respect to exchange rates. It is simple arithmetic to calculatewhether, at any given moment, commercial traders, whatever their motives, are expecting a fall or a rise in the exchange rate, and whether that fall or rise reflects an expectation of a change in the par value. For this reason, forward exchange rates have become increasingly important as indicators of the external financial position of a country and its prospects. Indeed, it may be said that such quotations are becoming more important than changes in gold or foreign exchange reserves as indicators of the strength or weakness of a currency. The exchange market has become the battlefield for defending the external value of a currency.

Just as variations in monetary reserves have, in the past, been overemphasized as indicators of external financial positions—so that even sophisticated analysts have, at times, neglected other major factors such as competitiveness, relative monetary conditions, and the use of exchange and trade restrictions—there is now a danger that changes in exchange rates within the permitted margins will be overmagnified in importance. Trained and experienced speculators often misread the significance of variations of exchange rates. Perhaps the principal error made is in underestimating the role of central bank intervention, actual or potential, supported by the existing defense mechanisms. Too much emphasis cannot be placed on the fact that, for the business and banking world, there are free exchange markets and moving rates. The current margins offer considerable room for variation, and permit both the encouragement of equilibrating capital movements and the cumulative process of disequilibrating capital movements. This is particularly true when a change in the exchange rate is expected by some of those engaging in speculative transactions.

In addition to the official exchange markets, in which the rates are kept within the permitted spreads, there are free markets for a number of currencies, reflecting their limited convertibility for capital transactions, as described above. Examples are the market for security sterling and the reinvestment dollar market in the United Kingdom, and the free market for capital transactions and for transactions in certain invisibles in Belgium. These free markets cannot be taken as indicative of a country’s balance of payments position or prospects; they are too narrow and oversensitive. However, the rates quoted in these markets do affect the attitude of individuals and businesses engaging in foreign exchange transactions. Thus, when the reinvestment dollar rate in London goes to a considerable premium, it may be due to many causes other than the foreign exchange position— causes such as divergences between the return on capital on the New York and London Stock Exchanges and the limitation on capital exports by residents of the United Kingdom. Similarly, exchange transactions in the Belgian free market may reflect only the willingness of individuals to pay a premium to consummate transactions not permitted by the Belgian exchange control authorities at the official rate. Even so, when these markets vary markedly from the official rates, they are likely to be read as indicating “strength” or “weakness” in currencies, particularly “weakness.”

Within this framework, the foreign exchange markets may be said to perform the functions described in the following paragraphs.

Exchange arbitrage

Because of the freedom with which funds can be moved from one country to another and the close and rapid communications between countries, the exchange markets provide more or less uniform spot rates through exchange arbitrage.

Trade credit

The establishment of foreign exchange markets facilitates the international extension of trade credit which, in general, fosters the growth of trade. The relaxation or absence of exchange controls, such as the requirement to surrender exchange receipts, makes it possible for the exporter to extend credit, while financial institutions with worldwide connections enable him to dispose of commercial paper with relative ease and minimum risk of loss. Similarly, the importer now has access to money markets anywhere in the countries with convertible currencies, which enables him to take advantage not only of interest rate differentials but also, more generally, of national differences in liquidity conditions. The highly developed commercial banking systems of the United Kingdom and the United States, and their elaborate and efficient network of international connections, make London and New York key centers for obtaining trade credit as well as foreign exchange.

Short-term movements of capital

Short-term capital movements have been greatly facilitated by the establishment of foreign exchange markets. Even under conditions of inconvertibility, short-term movements took place in such forms as leads and lags in payment for goods and services; but these capital flows were haphazard, were frequently disequilibrating with respect to the balance of payments, and were costly to reserves. Convertibility enables short-term capital movements of many varieties (with daily new inventions) to take place easily. Such movements may be either equilibrating or disequilibrating, although the system of margins tends to make them equilibrating under normal conditions (i.e., when there are no prospects of changes in par values or the reintroduction of inconvertibility and when the balance of payments difficulties are regarded as essentially temporary and reversible). The reason is that the speculator knows that when the rate approaches the lower limit, there is no room for further deterioration, and there is always the possibility of central bank intervention at any point.

An interesting recent development in exchange markets has been the creation of facilities for nonresidents to hold time deposits denominated in foreign currencies. These foreign currencies are usually U.S. dollars and the market is referred to as the Euro-dollar market.15 The importance of time deposits denominated in foreign currencies is that no forward cover is needed and, therefore, the profit margin to the depositor increases. The prevailing interest rates in those markets lie between the comparable deposit and lending rates in the domestic money markets of many countries. A substantial volume of international trade is financed through the ready and less restrictive credit facilities available in the Euro-dollar market.

Thus, the foreign exchange markets result in the financing of world trade through the commercial banks assisted by the stabilizing movements of short-term funds. As a consequence, the strength of the transaction motive for holding official reserves is close to zero. The basic economic motive for holding reserves which remains is the precautionary motive, i.e., to defend the exchange rate and convertibility.

Role of official reserves

The monetary authorities’ reserves in the form of gold or foreign currencies are therefore held to enable them to intervene in the foreign exchange market and avoid unwanted fluctuations in the exchange rate which may result from a disequilibrium in the balance of payments. Five kinds of disturbances leading to such a disequilibrium may be distinguished: The first are transitory or seasonal disturbances. The need for reserves resulting from these disturbances may be very limited, since they may be absorbed by changes in the holdings of foreign exchange of the commercial banks or by international banking or trade credit. The second kind of disturbance may arise from the course of business cycles in the country concerned or in other countries. It is more or less certain that the foreign exchange markets would not be able wholly to meet the needs arising from fluctuations in the balance of payments. Reserves are therefore needed to give time to take suitable anticyclical measures and to avoid responding to the disequilibrium in the balance of payments by measures which might be unnecessarily drastic, since the course of business cycles is reversible. A third kind of disturbance may arise from structural changes, such as alterations in cost-price relations or in the demand for imported commodities compared with domestic commodities. Under these circumstances, reserves will give the policy makers time to implement appropriate economic remedies. A fourth kind of disturbance may arise if domestic policies designed to affect longer-run trends (e.g., increases in the rate of growth) are inconsistent with equilibrium in the balance of payments. Reserves are then necessary, at least for some period of time, until policy measures consistent both with the domestic goals and with equilibrium in the balance of payments can become effective. A fifth kind of disturbance may result from the destabilizing effect of speculation. Reserves are then needed quickly in order to defend the external value of the currency in the hope of bringing about a change in expectations, although other techniques discussed below could, at times, be better methods of defense.

The need for reserves is therefore not directly related in an important sense to the volume of trade. Hence no quantitative formulation relating the need to the volume of trade is practicable. The need depends rather on the character and magnitude of the disturbances which cause disequilibria in the balance of payments. Moreover, the use of reserves may be reduced by the availability of substitutes, especially foreign short-term borrowing. Before the question whether available reserves are adequate can be answered, it is therefore necessary to review the available international credit facilities and the techniques of monetary cooperation which have as their aim reductions of the need for reserves; at that time also, more will be said about the volume, composition, and distribution of existing reserves.

Elements of Flexibility in the International Payments System

To defend the international payments system, considerable financial resources have been set aside and other measures taken, so that changes in the structure of the system are no ordinary occurrences. However, before discussing the management of the system and its defenses, the possibilities and nature of changes in it should be recalled; otherwise the system may well be misunderstood. In what follows the possibilities of changes in rates within the permitted spread and of variations in forward quotations are not treated as elements of “flexibility,” although in practice they make the system more adaptable to external financial changes without altering its basic structure. In this sense, the possibility of limited rate fluctuations is a form of defense of the existing structure as well as a flexible element within it.

Changes in Par Values

As discussed above, the international payments system is based on the maintenance of stable par values agreed with the Fund. It deliberately rejects rates which are free to fluctuate outside the permitted margins (and their peculiar stepsisters, multiple rates) in favor of stability. The reason for this rejection is not that fluctuating rates have no merits, but that their merits are regarded as outweighed by their demerits, particularly for the industrial countries but also (with only temporary and occasional exceptions) for other countries. Ail other aspects of the international monetary system are affected by this primary decision. The operations of the exchange market and both the need for, and the implications of, the use of restrictions would be very different if the international monetary system were based on fluctuating rates. However, the emphasis placed on stability must not be allowed to obscure the fundamental fact that par values can be changed. The Fund’s Articles of Agreement state that the Fund shall raise no objection if a proposed change in par value, together with ail previous changes, whether increases or decreases, does not exceed 10 per cent of the initial par value.16 Other changes require the concurrence of the Fund. A change in a par value is not to be proposed unless it is necessary to correct a fundamental disequilibrium, but the Fund is required, under the Articles of Agreement, to concur in any proposed change if it is satisfied that the change is necessary to correct such a disequilibrium.17 In practice, this is not a serious limitation on a country’s freedom of action in the exchange rate field since it would not be interested in changing the whole structure of its exchange rates unless confronted with a persistent and intolerable external deficit or surplus. Under such circumstances, it could be confident of international concurrence in a proposed change in par value. The obligation to consult the Fund, however, does mean that a country cannot engage in exchange rate manipulation to give it advantages over other countries, which are not warranted by differences in prices, costs, money supply, or productivity.

This element of flexibility in the present system does not mean that a country can change easily from one par value to another. Many factors militate against frequent changes in par values by the industrial countries. For the countries whose currencies are used as monetary reserves by other countries (the United Kingdom and the United States), there is always the consideration that changes in their exchange rates will alter the value of reserves held by other countries, and also of privately held funds. It is not the common practice to guarantee against exchange depreciation deposits held by nonresidents, including those held by other monetary authorities, or to guarantee deposits held by residents in their own currency against changes in their value in foreign currencies. Nevertheless, the acceptance of deposits by nonresidents, particularly monetary authorities, biases the reserve currency country toward doing everything possible to avoid causing losses by a change in par values. Moreover, a devaluation may greatly weaken the eagerness (not to say the willingness) of other countries to hold reserves in the currency that has been devalued. Even for the industrial countries other than the main reserve countries, many weighty factors (excluding political considerations) militate against frequent changes in par values. These include the fear of adding more elements of uncertainty to international transactions and domestic business decisions by enhancing the likelihood of future exchange rate adjustments beyond the permitted spreads; the fear of adding to inflationary or deflationary pressures; and the fear of frustration as a result of offsetting countermeasures taken by other countries, including changes in their par values. From a narrower technical point of view, there is the additional consideration that, if a par value is to be changed, the authorities have to make a judgment as to what the new par value should be. It is, in fact, difficult to determine when an exchange rate needs alteration and the precise amount of any change. Purchasing power parity and other similar calculations may be helpful, at least in indicating the direction and rough magnitude of needed change. But the selection of a new par value involves many elements of judgment not subject to quantification; these include judgment on the economic, financial, and monetary conditions in the country concerned relative to those in the principal competitor and customer countries, future policies of the country contemplating a change, and the rate that would end expeditions of further adjustments. On balance, it is probably safe to conclude that even if a country should believe that the international community would be ready to accept a proposed change in its par value in order to correct a fundamental disequilibrium, that country will usually try to avoid a change, in the hope that other domestic policies or changes in conditions abroad will make a change unnecessary.

What has happened to the par values of the currencies of the industrial countries since the establishment of the Fund is shown in Table 1. Generally speaking, the par values agreed in 1946 merely continued for the industrial countries the exchange rates that emerged from World War II. The devaluations in 1949 were a delayed adjustment to the changes brought about by the War; before they could be undertaken intelligently, they had to await the achievement of substantial progress in the industrial and agricultural reconstruction of Western Europe. These devaluations opened a postwar phase that has lasted more than 13 years, despite dramatic changes in the economies concerned, great changes in commercial policies, and repeated international political crises.

The relative infrequency of changes in par values in this period reflects the decision by the various countries that further changes were not needed. Experience has shown that the factors which affect, in substantial measure, the foreign exchange value of currencies do not change rapidly. Even important changes in such major economic factors as wages, money supply, and levels of income and employment have been absorbed without the need to alter exchange rates and without an adverse effect on output—provided, of course, that such changes, though substantial, have not resulted in price levels of a quite different order of magnitude. Increases in prices and unit costs over a few years, greater by say 5 per cent in one industrial country than in another, have readily been absorbed within the existing rate structure, whereas a considerably larger relative change, say 25 per cent or more, would probably have undermined the existing structure. Precision in such matters is not possible. Many other important factors have to be considered, including taxation, the possible flow of capital, government commitments abroad, the size of reserves, and the business outlook. Easy assumptions that changing conditions must mean corresponding changes in par values are unwise; there is considerable built-in resistance to such changes.

Large capital movements may weaken the external position of a currency and even create expectations of a change in par value, but they need not lead to changes not warranted by underlying conditions, unless there is a failure in the existing machinery for international monetary cooperation. Such erratic movements can be dangerous, but the mechanism for handling them efficiently and safely is well established.

Relatively short-lived inflations or deflations may be endured without threatening the monetary structure because adequate corrective measures can be taken to end the inflation or deflation and/or to adjust the exchange rate to a new equilibrium position, which is then defended by domestic policies. On the other hand, a severe and protracted inflation or deflation in one or more of the major industrial countries would represent a serious threat to the international payments system; it is difficult to envisage the maintenance of the exchange rate structure and of convertibility under such conditions. However, even if the possible effects of a sharp deterioration in the international political situation are not considered, there are many reasons for believing that a severe and prolonged deflation or inflation would not be tolerated by any major industrial country. The problem for such countries arises from more slow-moving factors, which alter the position of the economy concerned relative to that of others and give rise to a possible need for an eventual exchange rate adjustment.

Today, neither its fixity nor its flexibility is dangerous for the international payments system; rather, as in many other things, the danger comes from the overwhelming importance of political factors in decisions on economic policy. Since discussions of exchange rates even by economists and financial technicians frequently have emotional overtones, it is no wonder that political leaders attach so much significance to actions in this field. But the emotional reaction has this justification: major exchange rate adjustments in the currencies of the industrial countries have a great impact on the entire economic and social life of the nation concerned and of other countries as well.

Fluctuating Rates and Multiple Currency Practices

The present international payments system does not contemplate the use of fluctuating rates, i.e., rates which may move beyond the limits of the permitted margins in response to market forces (the monetary authorities limiting their intervention to smoothing operations and not resisting basic trends). Indeed, the Fund’s Articles of Agreement do not even provide a mechanism for international approval of such a system, unless the fluctuating rate is part of a multiple currency system. For this reason, when Canada adopted a fluctuating rate system in 1950, the Fund could neither approve nor disapprove this action. Instead, the Fund “recognized the exigencies of the situation that led Canada to the proposed plan and took note of the intention of the Canadian Government to remain in consultation with the Fund and to re-establish an effective par value as soon as circumstances warrantee!.”18 Such consultations did take place, and in 1962 the Fund approved a new par value for Canada.

Obviously, it is possible to argue that an international payments system based on fluctuating rates is superior to the present one; such arguments are put forward every day. But whatever their merits, it is a simple fact that the present system precludes such rates. It is always possible, and often sensible, to consider alternative payments systems, but reforms and improvements must be distinguished from suggestions for the substitution of one system for another; a fluctuating rate system would be an international payments system essentially different from the present one.

Similarly, widespread use of multiple exchange rates by the industrial countries would come close to upsetting the present system, even though the Fund Agreement makes possible the approval by the Fund of multiple currency practices. For example, if multiple import and export rates were used, concepts that underlie the present system—such as avoidance of competitive depreciation and of other measures destructive to the prosperity of other countries—would be most difficult to apply. Once more, this is particularly true of the reserve currencies. In fact, multiple exchange rates are found to some extent in the industrial countries, e.g., Belgium, the Netherlands, and the United Kingdom ; they arise in the free exchange markets for securities and some other capital transactions (discussed on pp. 231-32). They are beneficial in those markets, particularly in permitting a greater liberalization of capital movements and a simplification of exchange control machinery; but if the difference in quotations becomes substantial and protracted, multiple rates do have the potential disadvantage of casting doubt on the validity of the official rates based on the par value.

Capital Controls

As indicated above, the convertibility system does not apply to all international payments, even among the industrial countries. Members of the International Monetary Fund may exercise such controls of capital transfers as are necessary to regulate international capital movements as long as they do not restrict current payments. 19 Nevertheless, the establishment of aviable international payments system would not have been possible without freedom of capital movements from the United States. Although the trend has been toward the elimination of capital controls, most industrial countries still maintain some restrictions which limit the outflow of capital to other countries. Some countries maintain such controls for balance of payments reasons (e.g., the United Kingdom) ; others in order to safeguard the autonomy of their monetary policy (e.g., the Scandi-navian countries and Austria). A more general reason is to guard against the unexpected. The industrial countries in Europe, other than Germany and Switzerland, do not permit their residents to hold assets abroad except for specified purposes and under specified conditions, although such permission has been given with increasing liberality.

Access to capital markets in European countries is limited either by purpose or by nationality. For example, the United Kingdom has permitted readier access to the London capital markets by sterling area residents than by residents of other countries. France has pursued a similar policy with respect to the new countries which were formerly dependent territories of France. This does not mean that capital exports to other areas do not take place—indeed, liberalization of capital movements is much greater de facto than de jure—but rather that the capital exports are limited in amounts and carefully scrutinized in the light of exchange control criteria. On the other hand, there are very few restrictions on the inflow of capital into the industrial countries, either direct or indirect (e.g., limitations on the transfer of profits, dividends, amortizations, etc., arising from the capital inflow). Thus, many countries allow nonresidents to take advantage of opportunities to earn interest and other forms of income by trans-ferring funds either on short-term or long-term account. This freedom, which has been achieved only during the last few years, has made the international payments system more vulnerable to the strains, sometimes sudden, of large disequilibrating capital movements. On the other hand, equilibrating capital movements have now become a normal part of the functioning of the international payments System. Successful management of the payments system necessitates forestalling unwanted capital movements or, if this is impossible, containing their harmful effects so as to avoid causing enduring damage to the economy and the monetary system. To prohibit an outflow of capital is an approach which has the alluring appeal of simplicity in times of stress and may seem to be a reliable and quick preventive of trouble. But such a prohibition may only divert capital movements into other channels, like leads and lags in payments for trade, illicit purchases of foreign investments, or purchases of gold for hoarding. It may also undermine confidence in the currency and even create expectations of restrictions on current payments or a change in the par value. Such easy generalizations may be dangerous, however; much depends on other measures taken simultaneously, on the past practices of the country concerned, on the cause of the unwanted capital movement, on the expected duration of the controls, etc.

In the postwar period, the significance of the widespread existence of capital controls was greatly reduced by the fact that they did not exist in the country which was for many years by far the principal exporter of capital, namely, the United States; nor did they apply to the export of capital from London to the sterling area or from France to the franc area.

Restrictions on Current Payments

The present international payments system is based on the under-standing that countries will do their utmost to avoid introducing or intensifying restrictions on current payments or, in other words, retreating from the convertibility of their currencies for current international transactions. So long as member countries continued to avail themselves of the transitional arrangements under Article XIV of the Fund Agreement20—or in the parlance of the Fund were “Article XIV countries”—they had not taken the final formal step to declare their currencies convertible for current transactions. The possibility of their reverting to some form of inconvertibility remained significant, although, as noted above, de facto convertibility was established late in 1958. The door was closed, but not locked.

However, most of the industrial countries, including the United States and the United Kingdom, have now accepted Article VIII of the Agreement, under which countries undertake to avoid restrictions on current payments. Thus, there is a strong presumption that if such countries have balance of payments difficulties they will try to find solutions which avoid measures “destructive of national or international prosperity.”21 Exchange restrictions on current transactions clearly fall into this category. Even so, the legal possibility remains that, with the approval of the Fund, a member country may impose restrictions on the making of payments for international transactions. Accordingly, the Fund, when considering the general problems posed by the assumption of Article VIII status by a number of European countries, which had been availing themselves of the transitional provisions of Article XIV, set out its attitude on the use of such restrictions in a decision of June 1, 1960.22 This decision clarified the point that Article VIII status meant locking the door against the further use of restrictions on current payments, even if a key remained to be used in extremis. For this reason, the decision stated that it would be desirable that, as far as possible, such countries should satisfy themselves that they were not likely to need recourse to restrictions on current payments in the foreseeable future before they gave notice that they accepted the obligations of Article VIII. The decision also provided that, if members for balance of payments reasons proposed to maintain or introduce measures which would require approval under Article VIII, the Fund would grant approval only where it was satisfied that the measures were necessary and that their use would be temporary while the members sought to eliminate the need for them. Provision was made for continued consultations between the members and the Fund with respect to further maintenance of measures for which approval was required under Article VIII. In this way, the maintenance of convertibility by the avoidance of restrictions on current payments is to be given a very high priority by the countries concerned, but restrictions are not ruled out as a possible emergency temporary measure.

This safety valve in the international payments system is different in character from the possibility of changes in par values. The latter do not in principle represent retrogression from the international payments system unless a change is not economically warranted (e.g., if the magnitude of the change exceeds substantially the change needed to overcome a fundamental disequilibrium). A change in par value may well be a means of strengthening the international payments system, if the change is made when needed and in the appropriate magnitude. It eliminates the disturbances resulting from the persistent disequilibrium. A justified change does not act as a restraint on international trade or on growth and employment in other countries. Moreover, any change is presumed to be made lasting by appropriate domestic policies.

In sharp contrast to this, the reintroduction of restrictions of payments on an extensive scale by an industrial country would, at least temporarily, weaken if not disrupt the international payments system —the extent of the harm done depending on the magnitude of the trade of the industrial country and on the consequent actions of other countries. Such restrictions may be useful to meet the occasional temporary needs of industrial countries while more appropriate domestic policies are being adopted and their effects awaited ; but restrictions cannot be widely used for a protracted period without endangering the entire international payments system and ail that depends upon it.

Thus, the present international payments system is a deliberate choice among the means of conducting international financial relations. It is not rigid, and it makes provision for both adapting to enduring changes and meeting sudden and grave financial crises. However, the system has two permanent features—the use of par values and the convertibility of currencies for current transactions; without these features, it would cease to exist. But par values are subject to lasting change, so that, in a sense, convertibility becomes the fixed characteristic of the system. It is not surprising, therefore, that so much effort has gone into creating conditions that make possible the maintenance of convertibility in ail circumstances. The measures taken will be dealt with in a subsequent article on the management of the convertibility system and the techniques available for its defense.

Le système monétaire international


Le système monétaire international se trouve à l’heure actuelle en pleine évolution, surtout en ce qui concerne le marché des changes à terme et les défenses du système. Cependant, comme tout autre système praticable, il ne peut se devélopper que dans les limites imposées par l’existence de la souveraineté nationale.

Le présent article traite de l’un des aspects de ce système: celui qui touche aux paiements internationaux. Les principaux éléments qui y sont passés en revue sont les suivants: la convertibilité extérieure et intérieure des principales monnaies, le rapprochement des taux de change par l’adoption de parités et de marges fixes pour les fluctuations de taux, et le fonctionnement des marchés de change, y compris les effets des marges permises, l’arbitrage du change, le crédit au commerce, les mouvements à court terme des capitaux, et le rôle des réserves officielles. Naturellement il s’agit essentiellement des principaux pays industriels, dont les monnaies (surtout le dollar et la livre sterling) sont de la plus haute importance dans les paiements internationaux.

La flexibilité du système réside dans la possibilité de changer les parités, d’avoir des taux fluctuants et des changes multiples, et d’établir des côntreles du capital. Les restrictions sur les paiements courants sont d’une autre nature. En effet, tandis que le systéme du Fonds Monétaire International autorise les côntreles du capital, qu’il tolère l’emploi de taux fluctuants et de changes multiples à titre d’expèdients provisoires, et que la méthode consistant à corriger par des changements de parités les differences persistantes qui se font jour constitue une partie intégrante de ce système, les restrictions sur les paiements courants représentent un mouvement régressif vers un système atomis-tique. L’auteur conclut en disant que, des deux traits principaux du système, à savoir l’utilisation de parités et la convertibilité des monnaies, c’est le second qui constitue la caractéristique essentielle du système des paiements internationaux à l’heure actuelle.

Dans de prochains articles nous passerons en revue les mesures monétaires que l’on peut prendre pour faire fonctionner ce système, ainsi que ses défenses, et nous tenterons d’évaluer le système dans son ensemble.

El sistema monetario internacional


El sistema monetario internacional se encuentra hoy día en estado de evolución, particularmente en lo que respecta al mercado de cambios a término y a las defensas del sistema. Su desarrollo, no obstante, como el de cualquier otro sistema factible, está sujeto a las limitaciones impuestas por la existencia de la soberanïa nacional.

Este artículo se ocupa de la parte del sistema monetario encargada de llevar a cabo los pagos internacionales. Los aspectos más salientes aquí descritos son la convertibilidad externa e interna de las principales monedas, la coordinación de los tipos de cambio mediante la adopción de paridades y de márgenes fijos para las fluctuaciones de los mismos, el funcionamiento de los mercados cambiarios, incluyendo los efectos ejercidos por los márgenes permitidos, el arbitra je de divisas, el crédito comercial, los movimientos de capital a corto plazo y el papel de las reservas oficiales. Necesariamente se concentra la atención en los principales paises industriales cuyas monedas (especialmente el dólar y la libra esterlina) son de vital importancia para los pagos internacionales.

Se encuentran en el sistema elementos que le imprimen flexibilidad, tales como la posibilidad de modificar las paridades de las monedas y de aplicar tipos de cambio fluctuantes, practicas de tipos de cambio múltiples y contreles de capital. Las restricciones a los pagos consentes son de naturaleza distinta, ya que si bien el sistema del Fondo Monetario Internacional permite la aplicación de contreles de capital y tolera los tipos de cambio fluctuantes y las prácticas de tipos de cambio múltiples como medidas de carácter provisional, y dado que las modificaciones de la paridad constituyen un método (que forma parte integrante del sistema) para corregir las discrepancias per-sistentes que sur jan, las restricciones a los pagos corrientes significan una retrogresión hacia el sistema atomistico. El autor llega a la conclusion de que de los dos aspectos fundamentales del sistema—el uso de paridades y la convertibilidad de las monedas—es esta ûltima la que constituye la caracteristica esencial del sistema de pagos internacionales de hoy día.

En artículos subsiguientes se pasará revista a las medidas de carácter monetario que pueden adoptarse para administrar el sistema y sus defensas, y se tratará de hacer una evaluación conjunta del mismo.


Mr. Friedman, Director of the Exchange Restrictions Department, is a graduate of Columbia University and was formerly with the U.S. Treasury. He is the author of Foreign Exchange Control and the Evolution of the International Payments System (1958) and of articles in financial journals; and a joint author of Postwar UJS. Economic Policy (1948).


This study is based on the observations and experience of the author over a considerable period of years and on discussions with colleagues in the Fund and with financial authorities and bankers in many countries. It is also indebted to the writings of many different authors, including Messrs. Altman, Coombs, Holtrop, Jacobsson, Martin, and Roosa. Detailed acknowledgment is not possible.


International Monetary Fund, Articles of Agreement: Article I (ii).


Ibid.: Article I (v).


The word “currencies” is used here to cover all the many forms of means of payment actually employed.


“External” and “internal” convertibility are more or less equivalent, respectively, to “nonresident” and “resident” convertibility, terms used in the literature on this subject. None of these terms occurs in the Articles of Agreement of the Fund. (For the Fund terms, see particularly Articles VIII, XIV, and XIX of the Agreement.)


See particularly Articles XII-XV of the GATT.


The only important industrial countries not members of the International Monetary Fund are Switzerland and those in the Soviet bloc.


Article IV, Section 3 (i).


International Monetary Fund, Selected Decisions of the Executive Directors (Washington, D.C., September 1962), p. 11.


Article IV, Section 3 (ii).


Committee on the Working of the Monetary System [Radcliffe Committee], Report (Cmnd. 827, London, August 1959), par. 326.


Ibid., pars. 327 and 707.


European Monetary Agreement, Third Annual Report of the Board of Management (Paris, 1962), pars. 102 and 103.


This paragraph does not attempt to deal with the hard question of the functions of forward exchange markets under present-day conditions.


See especially O. L. Altman, “Foreign Markets for Dollars, Sterling, and Other Currencies,” Staff Papers, Vol. VIII (1960-61), pp. 313-52, and “Recent Developments in Foreign Markets for Dollars and Other Currencies,” Staff Papers, Vol. X (1963), pp. 48-96. See also, European Monetary Agreement, op. cit., par. 79.


Article IV, Section 5.




International Monetary Fund, Annual Report, 1951, p. 45.


Article VI, Section 3, of the Fund Agreement.


Under Article XIV, Section 2, member countries availing themselves of the “transitional arrangements” may “maintain and adapt to changing circumstances (and, in the case of members whose territories have been occupied by the enemy, introduce where necessary) restrictions on payments and transfers for current international transactions.”


Article I (v).


Selected Decisions of the Executive Directors, op. cit., pp. 56-58.