Current International Monetary System

  1. European Monetary System 

Following the collapse of the Bretton woods system on August 15, 1971, the EEC countries agreed to maintain stable exchange rates by preventing exchange fluctuations of more than 2.25%. This arrangement was called "European snake in the tunnel" because the community currencies floated as a group against outside currencies such as the dollar.

By 1978, the snake turned into a worm (with only German mark, Belgian franc, Dutch guilder, Danish krone). However, a new effort to achieve monetary cooperation was launched. By March 1979, EC established European Monetary System, and created the European Currency Unit (ECU).

European Monetary System, 1979

Adopted a wider band than the IMF. (1%)

To prevent movements above 2.25 % around parity in bilateral exchange rates with other member countries.


Quota: The European Monetary Cooperation Fund, now part of European Central Bank, allocates ECUs to members' central banks in exchange for gold and dollar deposits.

20% of the quota must be paid in gold (and 80% in USD). ECU was an artificial currency and used in all intrasystem balance of payments settlements. ECU was replaced by euro (at 1:1) on January 1, 1999.

provision of credit facilities for compensatory financing.


Then the EMS created the European Central bank (June 1998) and a single European currency (euro 2002).

Euro: Since its inauguratation in 2002, euro has gained ascendancy, but sovereign debts of PIIGS (Portugal, Ireland, Italy, Greece and Spain) nations have weakened the euro.



  2. Recommended Foreign Exchange Practices (Choi)
small countries

As a general rule, small countries (whose trade shares are less than 1% of world trade) should peg their currency to a major currency or a basket of major currencies. But there is little harm in floating their currencies.

The peg should be set at a level to ensure balanced trade. (Remember Greece's debt crisis. Currency overvaluation is deflationary, raising unemployment. Most countries prefer undervaluation to develop trade surpluses.)

Developing countries There are some developing countries that rely heavily on exports of a few primary products. Also, some countries trade mostly with one country (e.g., oil). In this case, pegging to a major currency is acceptable.
large/medium-sized countries

Countries whose trade shares exceed 1- 2 % of world trade (27 countries) should adopt floating rates to insulate their economies from excessive foreign shocks.

If intervention is desired, the pegged exchange rate should be negotiated between the two countries to insure stable and balanced trade.

If a country's import or export share exceeds 5% of world trade, the country should definitely float its currency.

For example, China's export share is about 12% (China's export = $2.27T, GWP = $78T, global trade volume = $19T in 2014), and it should float yuan to protect consumer welfare. (As the reserve asset increases, its real value in terms of yuan or imported goods declines.)

In the foreseeable future (by the next decade, if not sooner), four major currencies (USD, euro, yen and yuan) will float their currencies. India and Russia may follow suit eventually. Large countries may not only hurt themselves (profit from currency intervention will be negative) but also disrupt world trade when their currencies are pegged to another currency to gain a large trade surplus.

Reserve Limit

Foreign exchange reserve should be less than half of the export volume. At most, it should not be more than the annual export volume.

Japan: pop = 127 million, GDP = $4.6 trillion,
share in global exports = 3.6%, $683 billion.
Foreign exchange reserve = $1,233 billion.

Japan's foreign exchange reserve exceeds this limit.

China: pop = 1.36 billion, GDP = $10.4 trillion (2014),
share in global exports = 12.3%, $2,342 billion.
China's foreign exchange reserve = $3,526 billion. (X = $2.2)

US: pop = 319 million, GDP = $17.4 trillion (2014)
share in global exports = 8.5%, $1,620 billion.
US foreign exchange reserve = $125 billion (less than 10% of exports, X=$2.3T).

Euro area:$340 billion in 2014.

Using EU (Reserve = $68B) as the standard, China's FX reserve should not be more than $100B). Thus, more than 90% of China's FX reserve (roughly, $3T) is held to delay depreciation of USD to promote China's exports.

Prolonged undervaluation of one's currency necessarily results in an ever-increasing reserve of overvalued currencies, and inescapable losses from currency intervention.

Reserve currencies

Money supply M1 of the US: $19 trillion

$ held overseas: $7 trillion.

shares of global FX reserves:

USD = 59% (2021, lowest in 25 years)

Euro = 20%

Yen = 4.5% = British Pound

Chinese yuan = 1.1%

Current system Currencies of other industrial countries are floating with respect to the dollar. Accordingly, the current system is a mixture of exchange rate arrangements.
 Export volume in 2017

China = $2.15 trillion, EU = 1.92 trillion, US trade = $1.57 trillion in 2017.

US trade deficit in 2017 = $566 billion

US-China trade deficit = $375 billion



  3. Current Foreign Exchange Practices  

Euro area includes most of the European countries, except Swiss Franc and British pound. More european currencies are expected to join the euro zone.


Swiss Franc, Canadian dollar, British pound, the Japanese yen, Euro, and the U.S. dollar are floating.


The remaining currencies of LDCs are pegged to major currencies or baskets. 

 Asia (dollar invoicing)

Imports of East Asian countries are often invoiced in dollars. For example, about 70% of Japan's imports are invoiced in dollars. Dollar invoicing practically expands the dollar area that includes Japan and other East Asian countries (Ronald McKinnon).

 dollar peg is declining, IMF report 2016

 As of 2016, 55 countries fixed exchange rates (43% of 169 members).

71 countries adopted floating exchange rates (37%).

USD has been the dominant exchange rate anchor, but the share of countries that pegged exchange rates to USD has been declining (20% in 2016).

Euro's share of countries using it as anchor has been stable (13%)

Inflation targeting, 20%.

Global trade volume: about $20 trillion
Global merchandise trade: about $15 trillion
Global oil trade: about $1.4 trillion (invoiced in USD)




  4. Managed Float   
 intervention has not declined

 The current system is a managed float, rather than pure or clean float.

Since 1973, the amount of intervention by national monetary authorities has not declined.

The largest holders of international reserve assets are (2020):

China = $3.15 trillion (more than 25% of its GDP, 2021)
Japan = $1.42 trillion (30%)
Europe = $0.085 trillion (4%)
Switzerland = $0.6 trillion
Saudi Arabia = $0.6 trillion
Russia = $0.39 trillion)
US = $244 billion (0.6%, 2022)

 Reasons (i) The response of imports and exports is not spontaneous, but occurs only after a lag (which can take up to a year or more). During the period of adjustment, some surpluses and deficits appear in the balance of payments, which must be financed by the monetary authorities.

(ii) Wide fluctuations of exchange rates may have undesirable effects on inflation, employment and international competitiveness. Thus, central banks may go beyond smoothing daily and weekly fluctuations and maintain the exchange rates at target levels. (this is acceptable.) In this sense, the managed float resembles adjustable peg system.

(iii) In recent years, large countries (e.g., Japan and China) continue to hold large amounts of foreign exchange reserve, instead of smoothing exchange rate fluctuations. (Profits from such currency intervention are negative)


  5. Jamaica Accord 
  Beginning 1972, US and European countries negotiated on the reform of the international monetary system. After four years, an agreement on an amendment of the Articles was reached in Jamaica in January 1976.

A new Article IV of Agreement was approved by the Board of Governors in April 1976, and was ratified by 2/3 of the member nations in 1978. 

  second amendment (copy), 1978

the first amendment permitted creation of SDR.

The contents are:

(i) legitimizing floating rates . A member country is free to choose its own exchange rate system. "Don't step on the grass" or make a path to help pedestrians.

freely floating, managed float, pegged to a currency or a group of currencies or SDR. Not to gold.

(ii) The Fund will exercise surveillance over the exchange rate policies, and adopt specific principles to guide member countries.

(iii) By an 85% supermajority, the Fund may reintroduce a system of adjustable peg. However, a member may remain without a par value. (US can veto).

(iv) downgrade the monetary role of gold (gold cannot be used for international transactions). IMF still holds 103 million ounces.

(v) designate SDR as the principal reserve asset in the international monetary system.

Is it a good idea to Invest in Gold?

No. Gold price rose from $184 in 1974 to $1200 in 2014. (6-fold increase in 40 years. (growth rate is about 4.5% per year)

DJ index rose from 3000 in 1974 to 17800 in 2014 (5% per year for 116 years). However, gold earns no interest while stocks earn dividends (2.7% per year). Thus, net growth rate is 5% + 2.7% = 7.7%. While there might be temporary gains, gold is NOT a good long-term investment.

If checking account balance exceeds $250,000, gold may be an option to protect assets from inflation.



  6. Principles adopted in 1977 
 Three principles   (i) A member shall avoid manipulating exchange rates to prevent balance of payments adjustments or to gain unfair advantage over other countries. (e.g., do not devalue to maintain a large surplus)
   (ii) a member should intervene in the exchange markets if necessary to counter disorderly conditions.
  (iii) A member should take into account the interests of other member countries, including the countries whose currencies they use to intervene.
 Problem  IMF has little displinary power


  7. Evaluation of Managed Float (Choi) 

(i) Managed floats have not reduced international trade and investment or caused a disintegration of international capital market.

(ii) The pivotal role of $ has diminished (as prime reserve asset ⇒ SDR). Whether the yuan will play a major role remains to be seen. Exchange control over the yuan should be removed before it plays a more important role in the financial market.


(i) exchange rates have been volatile. Increasingly, there are economists who claim that there is overmuch instability.

(ii) IMF does not have any power to discipline members that violate the rules. Losses from currency undervaluation are built-in penalties. All it can do is to reject loan requests of such countries which are leastly likely to ask for loans. There is no mechanism to settle disputes.

(iii) IMF's asset is puny. Also, international reserve assets of some countries far exceed the assets of the IMF (SDR 977 billion = $1 trillion). PBOC's asset is much greater ($4.2 trillion).

(iv) Major industrial countries use SDR, but not small countries.



  8. New Problems 
  Only currencies of small countries should be pegged to major currencies such as dollar or a basket of currencies, but the currencies of major currencies should float vis-á-vis dollar.
[vis-á-vis, from French = in relation to, relative to, face-to-face, counterpart]
 Plaza Agreement G-5 (West Germany, France, Japan, US and UK) stabilized Japanese yen in the mid 1980s. (Plaza Accord, 1985) 
  When the currency of a large country is undervalued, another currency is overvalued. Accordingly, it creates a problem similar to that when a government defends a weak currency.
China's Policy In July 2005, China adopted a new policy, pegging Renminbi to a basket of currencies (USD, euro, yen and won), but it is not freely floating vis-à-vis other currencies.

As of June 2015, China's foreign exchange reserve surges to $3.99 trillion, but has since declined. Such intervention has resulted in a huge loss to China.

This is one reason for the US and EU to lower the interest rates.

Instead of raising the value of Renminbi to bring about trade balance, China buys land in other countries to affect regional influence.

Xi Jinping adopted One Belt One Road Initiative in 2013 to develop overland silk road through Central Asia (Silk Road Economic Belt), and the Maritime Silk Road in the Pacific Ocean to offset US influence in Asia. After buying a large amount of gold, China uses its surpluses to buy land in the Middle East and Asia.

China and Russia to adopt a new currency in order to bypass SWIFT payment system due to US imposed economic sanctions.

BRICS countries are to launch a new reserve currency. To be decided in Aug 2023 meeting.

(Choi's) Recommendations

For RMB to play a more important role in the financial market, it should be made fully convertible (so China stops losing money in the Forex market) and float RMB vis-á-vis USD and other currencies.

Once RMB is freely convertible , there would be four major currencies in the foreign exchange markets: RMB, yen, euro and USD (and GBP).

US should negotiate with currency manipulating trading partners (EU, China, Japan and South Korea) that have large trade surpluses with the US

US bilateral trade deficit

China: $375 billion

EU: $151 billion

Japan: $69 billion.

China's debt is over 400% of its GDP.
Japan's government debt is $10 trillion (240% of its GDP: IMF)