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International Financial Management

Notes

Caselet Currency Reserve

he outbreak of the current crisis and its spillover in the world have confronted us
with a long-existing but still unanswered question, i.e., what kind of international
Treserve currency do we need to secure global financial stability and facilitate world
economic growth, which was one of the purposes for establishing the IMF? There were
various institutional arrangements in an attempt to find a solution, including the Silver
Standard, the Gold Standard, the Gold Exchange Standard and the Bretton Woods system.
The above question, however, as the ongoing financial crisis demonstrates, is far from
being solved, and has become even more severe due to the inherent weaknesses of the
current international monetary system.
Theoretically, an international reserve currency should first be anchored to a stable
benchmark and issued according to a clear set of rules, therefore to ensure orderly supply;
second, its supply should be flexible enough to allow timely adjustment according to the
changing demand; third, such adjustments should be disconnected from economic
conditions and sovereign interests of any single country.

Source: International Financial Management, Madhu Vij, Excel Books.
2.3 European Monetary System

European countries were concerned about the negative impact of volatile exchange rates on
their respective economies since the collapse of the Bretton Woods Agreement on fixed exchange
rates in the early 1970s. Attempts were made to salvage the Bretton Woods System by defining
the parities and widening the bands of variations to 2.25%. This was the Smithsonian Agreement
which was signed in December 1971 and was also known as the ‘snake’. The ‘snake’ was designed
to keep the European Economic Community (EEC) countries exchange rates within a narrower
band of 1.125% for their currencies. Thus this system allowed a wider band of 2.25% against the
currencies of other countries while maintaining a narrower band of 1.125% for their currencies.
The ‘snake’ got its name from the way EEC currencies moved together closely within the wider
band allowed for other currencies like the dollar.
The snake was adopted by the EEC countries because they felt that stable exchange rates among
the EEC countries was essential for deepening economic integration and promoting intra-EEC
trade. Members of the EEC rely heavily on trade with each other so the day to day benefits of a
relatively stable exchange rate between them could be perceived to be great. However, the
snake arrangement was replaced by the European Monetary System (EMS) in 1979 and has since
then undergone a number of major changes including major crisis and reorganisation in 1992
and 1993. The chief objectives of the EMS were to:
1. Form a “zone of monetary stability” in Europe.

2. Coordinate the exchange rate policies vis-á-vis the non EMS currencies.
3. Help in the eventual formation of a European Monetary Union. The EMS had three
components:

(i) Exchange Rate Mechanism (ERM)
(ii) European Currency Unit (ECU)
(iii) European Monetary Cooperation Fund (EMCF)

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