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Unit 2: International Monetary System

Breakdown of the Bretton Woods System Notes

The Bretton Woods System worked without major changes from 1947 till 1971. During this
period, the fixed exchange rates were maintained by official intervention in the foreign exchange
markets. International trade expanded in real terms at a faster rate than world output and
currencies of many nations, particularly those of developed countries, became convertible.
The stability of exchange rates removed a great deal of uncertainty from international trade and
business transactions thus helping the countries to grow. Also, the working of the system
imposed a degree of discipline on the economic and financial policies of the participating
nations. During the 1950s and 1960s, the IMF also expanded and improved its operation to
preserve the Bretton Woods System.

The system, however, suffered from a number of inherent structural problems. In the first place,
there was much imbalance in the roles and responsibilities of the surplus and deficits nations.
Countries with persistent deficits in their balance of payments had to undergo tight and stringent
economic policy measures if they wanted to take help from the IMF and stop the drain on their
reserves. However, countries with surplus positions in their balance of payments were not
bound by such immediate compulsions. Although sustained increases in their international
resources meant that they might have to put up with some inflationary consequences, these
options were much more reasonable than those for the deficit nations.
The basic problem here was the rigid approach adopted by the IMF to the balance of payments
disequilibria situation. The controversy mainly centres around the ‘conditionality issue,’ which
refers to a set of rules and policies that a member country is required to pursue as a prerequisite
to using the IMF’s resources. These policies mainly try and ensure that the use of resources by
concerned members is appropriate and temporary. The IMF distinguishes between two levels of
conditionality – low conditionality where a member needs funds only for a short period and
high conditionality where the member country wants a large access to the Fund’s resources. This
involves the formulation of a formal financial programme containing specific measures designed
to eliminate the country’s balance of payments disequilibrium. Use of IMF resources, under
these circumstances, requires IMF’s willingness that the stabilisation programme is adequate
for the achievement of its objectives and an understanding by the member to implement it.

2.1.4 The Flexible Exchange Rate Regime, 1973 – Present

The turmoil in exchange markets did not cease when major currencies were allowed to float
since the beginning of March 1973. Since 1973, most industrial countries and many developing
countries allowed their currencies to float with government intervention, whenever necessary,
in the foreign exchange market. The alternative exchange rate systems which followed are
mentioned below:

Crawling Peg (Sliding or Gliding Parity): A cross between a fixed rate system and a fully
flexible system are the semi-fixed systems such as the crawling peg and the wide band.
They differ from fixed rates because of their greater flexibility in terms of the exchange
rate movement. But they are not a floating system either because there is still a limit with
regard to how far the exchange rate can move.

Because the infrequent adjustment of the IMF’s par value system necessitated a large
devaluation at a larger rate, the crawling peg rate was developed. The idea was to adjust
the rate slowly by small amounts at any point in time on a continuous basis to correct for
any overvaluation and undervaluation. The continuous but small adjustment mechanism
(e.g., as little as 0.5 per cent a month or 6 per cent for the whole year) was designed to
discourage speculation by setting an upper limit that speculators could gain from
devaluation in one year.

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