International Finance Law
2. INTERNATIONAL FINANCIAL SYSTEM
The international financial system refers to the arrangements for the management of international currencies and payment. This includes informal and formal treaties, agreements and rules of practices that allow currencies to be exchanged and current payments to be made on a cross-border basis. Informal arrangements have always been possible although formal mechanisms generally date from the adoption of the Gold Standard in the 1800s. Exchange rates may either be managed on an automatic basis (using a fixed commodity or floating currency system), an exchange standard regime (with one currency being fixed to a commodity such as gold and all other currencies fixed to the standard currency), multilateral exchange rate management (through policy co-ordination and short-term payment adjustments) or a full monetary union (with a common currency such as in the Euro area which came into effect on 1 January 1999 and with notes and coins being issued on 1 January 2002).
(1) Gold Standard 1816-1933
The Gold Standard was only officially adopted by Britain in 1816 although it had been in operation on a de facto basis for almost a century before. This operated as a fixed commodity system with currencies being tied to a standard weighted measure of gold which had the advantage of controlling inflation and promoting financial stability although this necessarily restricted monetary policy and control of the money supply. The original system was replaced by the Gold Exchange Standard with sterling being fixed to the value of gold and other currencies fixed to sterling until 1914 and outbreak of the World War I. A attempt was made to restore convertibility of gold under the Gold Standard Act 1925 although this was abandoned in September 1931. All gold was nationalised by the Federal Reserve in 1934 under the Gold Reserve Act. While the US dollar had replaced sterling as the main reserve currency from 1914 onwards, any attempt to managed the international currency system was abandoned during the 1930s until this was superseded by a dollar exchange standard from 1944.
(2) Bretton Woods 1944-1973
The new dollar exchange standard was set up by the Allies at the Mount Washington in Bretton Woods, New Hampshire in July 1944 ten months before the end of World War II. This provide for the creation of an alternative reserve system following the financial instability of the inter-war period. Under the Bretton Woods arrangements, the value of the US dollar was fixed to gold and all other currencies fixed to the dollar subject to a formal adjustment mechanism. The system came into effect in March 1947 although full currency convertibility was not restored in Europe until December 1958. Under the arrangements, participating countries could exchange US dollars for gold at any time under a ‘Gold Window’.
Convertibility was subsequently suspended on 15 August 1971 following the pressure created by a growing US balance of payments deficit and speculative attacks with President Richard Nixon announcing the closure of the Gold Window in a radio address to the nation. An attempt was made by a specially convened group to design an alternative arrangement under the Committee of Twenty and its Outline of Reform document in June 1974 and the earlier Smithsonian Agreement in December 1971 although these efforts were abandoned and currencies allowed to float from 1973. The adoption of a formal international floating exchange rate arrangement was agreed with an amendment to the Articles of Agreement of the International Monetary Fund (IMF)[1] in 1976 and a revised Article IV and enhanced and extended surveillance and conditionality. The Betton Woods Treaty had also provided for the establishment of the IMF and the International Bank for Reconstruction and Development (subsequently part of the World Bank group).[2]
The Bretton Woods conference had also attempted to establish an International Trade Organisation (ITO) although this was not ratified by the US Congress with a separate General Agreement on Tariffs and Trade (GATT) coming into effect instead. A World Trade Organisation[3] would eventually be set up in 1995 under the Marrakech Agreement which replaced the GATT.
(3) Petro-Dollars and the Debt Crisis 1974-1989
As the price of oil had been denominated in dollars, the OPEC countries introduced significant increases to compensate for the 25% drop in the value of the dollar following the abandonment of the Bretton Woods system. This led to a series of oil price hikes in 1973/74 and 1979 which was aggravated by instability in the Middle East especially with the Yom Kippur War in October 1973. The large amounts of new funds received by the oil exporting countries were then recycled in the form of ‘Petrol-dollars’ through the main international financial markets including, in particular, the City of London. This resulted in further substantial growth in the late 1970s and especially in the Euro-dollar markets including the syndicated loan and Eurobond sectors.
Large amounts of the new funds available had been lent by major international banks to emerging market governments to fund domestic infrastructure and other investment projects. The petrol-dollars were accordingly recycled from the oil exporting to the oil importing countries. Following a downturn in global markets in the early 1980s, some countries were unable to continue to service their debt levels with Mexico announcing on 13 August 1982 that it would have to suspend payments. This became known as the ‘Third World’ Debt Crisis which spread to other Latin American and then Asian countries. Brazil defaulted on 10 November 1982 with 37 other countries following in Latin America, the Caribbean, Africa and Eastern Europe. A total of US$140bn in commercial bank debt had to be rescheduled during the 1980s. The total amount of the debt stock had then increased to US$200bn by the mid-1980s with two major long-term management initiatives being launched by US Treasury Secretary James Baker in October 1985 (based on a sustained growth and balance of payment adjustments package) and by Nicholas F Brady in March 1989 (including the conversion of bank debt into guaranteed ‘Brady Bonds’).
Mexico’s total debt stock had been reduced by 15% and bank debt by 30% under the Baker and Brady plans although further difficulties recurred following political assassinations and economic instability in March and September 1994. The value of peso collapsed by 50% on 10 January 1995 with US$28bn of government bonds (tesebonos) being dumped, despite President Ernesto Zedillo promising that there would be no repeat moratorium although a massive private sector and US government supported guarantee package had to be put in place worth almost US$50bn with two further IMF standby facilities of almost US$18bn.
(4) Asian and Russian Crises 1997-1998
Many Asian economies including Hong Kong, Japan, Singapore, Taiwan, Thailand and the Republic of Korea had enjoyed spectacular growth of over 5% GNP between 1965 and 1990 and over 9% between 1992 and 1995. Difficulties nevertheless remained with the high levels of short-term investment involved, high levels of bank credit, poor loan practices (or ‘crony capitalism’) and fundamentally weak systems of banking and financial control. The Asian crisis began in Thailand with the collapse in the value of the Thai baht on 2 July 1997 with the government abandoning its peg against the US dollar. Despite an immediate recovery, concerns remained with regard to the strength of the financial system. The crisis quickly spread to Malaysia, Indonesia and The Philippines with average currency depreciations of between 25-33%. The Hong Kong dollar was subject to a speculative attack with the crisis spreading to South Korea and economic damage suffered in Japan. The contagion had spread to Latin America by the end of 1997. Brazil had to protect the real early in 1998 with Russia defaulting on its debt in August 1998.
(5) Credit Crisis 2007-2008
Financial turmoil arose again ten years and one month later with the credit crisis beginning on 9 August 2007. Concerns had arisen with regard to the stability of US sub-prime mortgage market which had been used to support asset-backed securities including collateralised debt obligations (CDOs), large amounts of which had been sold on to off-balance sheet structured investment vehicles (SIVs) or other bank ‘conduits’. The CDOs had been highly rated by rating agencies which had not taken into account the possibility of significant levels of default on the underlying mortgages involved as a result of poor or fraudulent sales practices in the unregulated US mortgage market. Significant losses were reported by many major financial institutions with inter-bank markets consequently drying up on 9 August 2007 as banks had to hoard cash rather than on-lend to each other. The US Federal Reserve and other central banks attempted to inject significant amounts of liquidity into the markets during the last quarter of 2007 and early 2008 with only limited effects.
The major UK casualty was the Northern Rock Bank which had a low (28%) deposit cover ratio and was dependent on the mortgage securitisation market for the majority of its funding. With the combined effects of the collapse in the asset-backed securities market and the drying up of credit on the inter-bank markets, Northern Rock was forced to approach the Bank of England for emergency assistance on 14 September 2007. The Government through the Treasury was forced to make a number of announcements to confirm support for the bank to prevent a further bank run in September 2007. Northern Rock was subsequently taken into public ownership (nationalised) on 17 February 2008 after the Government was unable to agree a private sector solution. A number of official documents have since been issued examining the crisis and its causes and the national, European and international levels, with an increasingly complex series of regulatory responses being produced.
[1] http://www.imf.org/