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CHAPTER 1.

THE EXCHANGE RATES AND INTERNATIONAL MONETARY ENVIRONMENT

The increased volatility of exchange rates is one of the main economic developments of the
past 30 years. Policies to forecast and react to exchange rate fluctuations are still evolving as
understanding of the functioning of the international monetary system grows. Although
volatile exchange rates may increase risk, they also create profit opportunities for both firms
and investors. In order to manage foreign exchange risk, the management must first
understand how the international monetary system functions.

1. INTERNATIONAL MONETARY SYSTEM

The international monetary system can be defined as the structure within which foreign
exchange rates are determined, international trade and capital flows are accommodated, and
adjustments to the balance of payments made. It also includes all of the instruments,
institutions and agreements that link together the world’s currency and money markets.

Currencies of most nations are based on agreements in force between their governments and
the INTERNATIONAL MONETARY FUND (IMF).

The International Monetary Fund (IMF)

In 1944, the Allied Powers met at Bretton Woods, New Hampshire, to create a new
international monetary system to liberalize international trade and to adjust financial flows
among countries. The Bretton Woods Agreement established a US dollar based international
monetary system and provided 2 new institutions: IMF and World Bank. The IMF aids
countries with balance of payments and exchange rate problems. The International Bank for
Reconstruction and Development (World Bank) initially aided in post-war reconstruction, but
since has supported general economic development. The IMF and World Bank started their
activities in 1946. The members of the IMF and World Bank are the same, it means that the
members of IMF are the members of World bank as well.

Membership and Quotas

To carry out its task, the IMF was originally funded by each member subscribing to a quota
based on expected post World War II trade patterns. Quotas were paid 25% in gold and 75%
in the country’s local currency. Quotas have been expanded and revised many times since
1944 to accommodate growth world trade, new membership, and changes in relative
importance of member countries. Quotas are set based on some macroeconomic indicators of
each member such as national income and foreign trade volumes. These quotas are evaluated
in every 5 years and it might be increased according to the world liquidity need.

o During 1998-99, total number of members in IMF has been out of 182 countries.
o Quotas have increased from SDR 146 billion to SDR 212 billion approved by Board
of Governors on Jan 30, 1998.
o As of the end of 1998-99, IMF’s Paid In Quotas reached SDR 208 billion (US$ 281
billion).
o And lastly, IMF’s liquidity ratio has increased to 89%.
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At present (as of April 30, 1999), the largest voting rights and controls for countries:

Exhibit 1.1 The Highest Voting Rights in IMF

Country %
USA 17.53
Japan 6.29
Germany 6.15
France 5.08
UK 5.08

Source: IMF, 2003

Special Drawing Rights (SDR)

SDR is an international reserve asset created by the IMF to supplement existing foreign
exchange reserves serving as a unit of account for the IMF and other international and
regional organizations. Previously currencies of 16 industrial countries were taken into
consideration in valuing SDR. It has been defined several times; it was the weighted value of
currencies of 5 IMF members having the largest exports during 1981 and September 2001
which was due to the re-calculation every 5 years. Now as of April 28, 2001, the composition
of SDR was as the followings: US$ = 45%, EURO = 29%, Yen = 15% and Sterling = 11%.
Consequently, the value of SDR can be expressed in any currency. There are two principles in
selecting national currencies for SDR composition: One is related with foreign trade volume
and the second is financial markets. That is, according to the first principle a candidate
country to be selected need to have the highest goods/services export volume and according to
the second principle its national currency should extensively be used in international
transactions and foreign exchange markets (Seyidoğlu, 2003: 48-49). On the other hand,
individual countries hold SDRs in the form of deposits in the IMF.

2. CURRENCY TERMINOLOGY

It is better first to understand the basic terms about currency terminology before starting to
study international monetary environment:

 Exchange rate is the price of one country’s currency in units of another currency or
commodity (gold or silver).

 If the government of a country regulates the rate at which the currency is exchanged for
other currencies, the system or regime is classified as a fixed or managed exchange rate
regime.

 The rate at which the currency is fixed, or pegged, is frequently referred to as its par
value.

 If the government does not interfere in the valuation of its currency in any way, the
currency is classified as floating or flexible.
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 Devaluation of a currency refers to a drop in the foreign exchange value of a currency.

The par value is reduced. Its opposite is revaluation. The percentage change in the value
will give the degree of devaluation/revaluation of a currency, that is:

previous value - current value

percentage change 
current value

 Weakening or depreciation of a currency refers to a drop in the foreign exchange value of

a floating currency. Its opposite is appreciation.

 Soft or weak currency expresses that currency which is expected to devalue or depreciate.
This currency is also a type of currency which is being artificially sustained by the
government. The opposite of soft or weak currency is Hard Currency which is expected to
revalue or appreciate relative to major trading currencies.

 Spot exchange rate is the quoted price for foreign exchange to be delivered at once, or in
two days for inter-bank transactions.

 Forward Rate is the quoted price for foreign exchange rate to be delivered at a specified
date in the future. The rate can be guaranteed by a forward exchange contract.

 Forward Premium or Discount is the percentage difference between the spot and forward
exchange rate. The formula will be;

S  F 360
  100
F n

 Eurocurrencies

Eurocurrencies are sometimes viewed as another kind of money, although in reality they are
domestic currencies of one country on deposit in a second country.

Ex. Eurodollar is a US dollar denominated interest-bearing deposit in a bank outside the US.

Eurocurrency Characteristics

 Eurodollar time-deposit maturities range from call money and overnight funds to longer
periods
 Certificates of deposits are usually 3 months or more existing in m.$ increments
 Eurodollar deposit is not a demand deposit; not written as loans for reserves in the banks’
books
 No transfer by check
 Transferred by wire or cable transfer of an underlying balance held in the correspondent
bank
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The next section the chapter provides the historical past of the International Monetary System
together with new concept: the European Monetary System. Contemporary currency regimes
and emerging market crises are also examined in the chapter.

3. HISTORY OF THE INTERNATIONAL MONETARY SYSTEM

The International Monetary System includes two extreme classifications of currency regimes:
Fixed Exchange Rate system and Floating Exchange Rate system:

1. Fixed Exchange Rates System

In this system, the currency is pegged to another currency at a fixed rate. Gold standard and
Bretton Woods System are two previous examples to this system.

Problems with Fixed exchange rates;

a. Foreign Balance Adjustment

Those countries having a trade deficit will have a foreign reserves shortage and they
will need to make devaluation.

b. Liquidity Problem
The countries having a trade deficit can finance the temporary deficits, but the central
banks should have enough reserves to do that.

c. Trusting Problem
When a problem happens in a fixed parity, speculators will escape to more stable
currencies, this time the government may apply devaluation.

2. Fluctuating or Flexible Exchange Rate System

Allowing a currency to fluctuate freely and there is no government intervention. Exchange
rates are determined by completely supply and demand in the market.

Fixed vs. Flexible Exchange Rates

In the fixed or managed exchange rate system, the currency was fixed and managed by the
government. However, in a floating exchange rate system the government does not interfere
in the valuation of the currency.

A nation’s choice as to which currency regime it will follow reflects national priorities on
macro economy including inflation, unemployment, etc…

 Fixed rates provide stability in international prices for trade and lessen risks for the
businesses.
 Fixed rates are anti-inflationary and require countries to follow restrictive monetary and
fiscal policies. This restrictiveness can be a burden to economy and creates high
unemployment and slow economic growth.
 Fixed rates require central banks to maintain large international reserves in the defense of
their fixed rate, which is a burden to many nations.
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 Fixed rates are inconsistent with economic fundamentals as the structure of the economy
changes, and trade relations and balances evolve. So exchange rates should also change.

A Brief History of Currency Regimes:

The Gold Standard (1876-1913)

Gold was used as a medium of exchange and a store of value since the days of Pharaohs
(about before 3000 B.C.). The Greeks and Romans used gold coins and passed on this
tradition through the mercantile era to the 19th century. It was the first systematic standard and
had the most popular age during 1870-1914. The Gold standard gained acceptance as an
international monetary system in Europe in the 1870s. USA was something of a latecomer to
the system, not officially adopting the standard until 1879.

Under the Gold standard each country set the rate at which its currency could be converted to
a weight of gold. For example, USA set its currency for $20.67/ounce of gold until World
War I. The British pound was pegged at £4.24/ounce of gold. As long as both currencies were
freely convertible into gold, $/£ exchange rate was:

$20.67 /ounce of gold

 $4.86656 / L
L4.2474/ounce of gold

There was no need for foreign exchange markets in the countries because they defined their
currencies in terms of gold standard. But during World War I, the countries have canceled the
convertibility of gold with currencies. The governments started to intervene into the
economies. And lastly after the Great Depression in 1929s, the gold standard was completely
left.

The Interwar Years and World War II (1914-1944)

During World War I and the early 1920s, currencies were allowed to fluctuate over fairly
wide ranges in terms of gold and each other. Theoretically, supply and demand for a country’s
exports and imports caused moderated changes in an exchange rate about a central
equilibrium value. Unfortunately, such flexible exchange rates did not work in an
equilibrating manner. International speculators sold the weak currencies short, causing them
to fall further in value. The reverse happened with strong currencies. Fluctuations in currency
values could not be offset by the relatively thin forward exchange market at exorbitant cost.
The net result was that the volume of world trade did not grow in the 1920s in proportion to
world GNP and declined to a very low level with Great Depression in the 1930s. Several
attempts were made to return to the Gold standard during the interwar years. The following
countries returned to gold in the following years:

USA ………….. 1919 UK …………… 1925 France ………… 1928

When UK returned back to gold at its pre-war parity rate of $4.86/L, unemployment and
economic stagnation in the UK increased, all in order to restore confidence in the exchange
rate system. USA adopted a modified gold standard in 1934 when $ devalued from
$20.67/ounce of gold to $35/ounce of gold. Gold was traded only with foreign central banks,
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not private citizens. From 1934 to the end of World War II, exchange rates were theoretically
determined by each currency’s value in terms of gold. During World War II and its immediate
aftermath, many of the main trading currencies lost their convertibility into other currencies.
The Dollar was the only major trading currency that continued to be convertible.

Bretton Woods System (1945-1973)

The system has been put into action in 1945 in Bretton Woods town in USA and finished at
1973. The members in IMF had pegged their currencies into USA dollar in a fixed rate, which
is called (fixed) dollar parity. And dollar had been pegged into the gold. So other currencies
had been pegged into the gold indirectly.

According to the system, each country would permit their currencies to fluctuate around the
dollar within 1% limits. However, higher fluctuations would be prevented by central bank
intervention into the market by buying or selling dollars. And in the case of a problem in
balance of payments to make devaluation would require an approval of IMF.

Bretton Woods had made USA a central bank of the world. Dollar had been a common
monetary value in the world. Everything was being measured by dollar.

The countries had kept their foreign reserves in dollar basis, which was one of the poorest
features of the system.

In the following years, when USA faced a deficit in balance of payments, the dollar based
reserves in foreign central banks had increased, which exceeded the stocks of the gold in USA
at the same time. USA had made devaluation into its currency but it failed and the
convertibility of dollars with the gold had been stopped and the system had finished at 1973.

Currency Arrangements (1973 – Present)

Since March 1973, exchange rates have become much more volatile and less predictable than
they were during fixed exchange rate period, when changes occurred infrequently. In general
dollar has been volatile and has weakened somewhat over the long run. On the other hand
Japanese Yen and German Mark have strengthened. The emerging market currencies have
been exceptionally volatile and generally weakened.

Exhibit 2.2 summarizes the important currency events over the world since 1971.
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Exhibit 1.2 World Currency Events, 1971 – 2002

Date Event Impact

August 1971 Dollar Floated Nixon closes the U.S. gold window, suspending purchases or sales
of gold by U.S. Treasury; temporary imposition of 10% import
surcharge

December 1971 Smithsonian Agreement Group of Ten reaches compromise whereby the US$ is devalued
to $38/oz. of gold; most other major currencies are appreciated
versus US$

February 1973 U.S. dollar devalued Devaluation pressure increases on US$ forcing further devaluation
to $42.22/oz. of gold

Feb-March 1973 Currency markets in crisis Fixed exchange rates no longer considered defensible; speculative
pressures force closure of international foreign exchange markets
for nearly two weeks; markets reopen on floating rates for major
industrial currencies

June 1973 U.S. dollar depreciation Floating rates continue to drive the now freely floating US$ down
by about 10% by June

Fall 1973-1974 OPEC oil embargo Organization of Petroleum Exporting Countries (OPEC) imposes
oil embargo, eventually quadrupling the world price of oil;
because world oil prices are stated in US$, value of US$ recovers
some former strength

January 1976 Jamaica Agreement IMF meeting in Jamaica results in the “legalization” of the
floating exchange rate system already in effect; gold is
demonetized as a reserve asset

1977-1978 U.S. inflation rate rises Carter administration reduces unemployment at the expense of
inflation increases; rising U.S. inflation causes continued
depreciation of the US$

March 1979 EMS created European Monetary System (EMS) is created, establishing a
cooperative exchange rate system for participating members of the
EEC

Summer 1979 OPEC raises prices OPEC nations raise price of oil once again

Spring 1980 U.S. dollar begins rise Worldwide inflation and early signs of recession coupled with real
interest differential advantages for dollar – denominated assets
contribute to increased demand for dollars

August 1982 Latin American Debt Crisis Mexico informs U.S. Treasury that it will be unable to make debt
service payments; Brazil and Argentina follow within months

February 1985 U.S. dollar peaks The U.S. dollar peaks against most major industrial currencies,
hitting record highs against Deutschemark and other European
currencies

Source: Eiteman, Stonehill and Moffet (2004): 29-30.

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Exhibit 1.2 World Currency Events, 1971 – 2002 (Contined)

Date Event Impact

February 1987 Louvre Accords Group of Six members state they will “intensify” economic policy
coordination to promote growth and reduce external imbalances

September 1992 EMS crisis High German interest rates induce massive capital flows into
Deutschemark-denominated assets causing the withdrawal of the
Italian lira and British pound from the EMS’s common float

July 31, 1993 EMS realignment EMS adjusts allowable deviation band to  15% for all member
countries (except Dutch guilder); U.S. dollar continues to weaken;
Japanese yen reaches ¥100.25/$

January 1994 EMI founded European Monetary Institute (EMI), the predecessor to the
European Central Bank, is founded in Frankfurt, Germany

December 1994 Peso collapse Mexican peso suffers major devaluation as a result of increasing
pressure on the managed devaluation policy; peso falls from
Ps3.46/$ to Ps5.50/$ within days; the peso’s collapse results in a
fall in most major Latin American exchanges in a contagion
process – the tequila effect

August 1995 Yen peaks Japanese yen reaches an all time high versus the U.S. dollar of
¥79/$; yen slowly depreciates over the following two year period,
rising to over ¥130/$

June 1997 Asian crisis Thai Baht is devalued in July, followed soon after by the
Indonesian rupiah, Korean won, Malaysian ringgit, and Philippine
peso; following initial exchange rate devaluations, Asian economy
plummets into recession

August 1998 Russian crisis On Monday August 17, the Russian Central Bank devalues the
rouble by 34%; rouble continues to deteriorate in the following
days sending already weak Russian economy into recession

January 1, 1999 EURO launched Official launch date for the single European currency, the euro; 11
European Union member states elect to participate in the system,
which irrevocably locks their individual currencies rates between
them

January 1999 Brazilian real crisis Brazilian real, initially devalued 8.3% by the Brazilian
government on January 12, is allowed to float against the world’s
currencies

February 2001 Turkish Lira Turkish Lira floated due to balance of payments imbalances, rising
external debt, and capital flight

January 1, 2002 Euro coinage Euro coins and notes are introduced in parallel with home
currencies; national currencies are phased out during the six month
period beginning January 1

January 8, 2002 Argentine peso crisis Argentine peso, its value fixed to the U.S. dollar at 1:1 since 1991
through a currency board, is devalued to Ps1.4/$; the devaluation
follows months turmoil; the ouster of three presidents in three
weeks, continuing bank holidays, and riots in the streets of Buenos
Aires

Source: Eiteman, Stonehill and Moffet (2004): 29-30.

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4. CONTEMPORARY CURRENCY REGIMES

The World’s monetary system is made up of currencies from many countries and two
composite currencies: EURO (that replaced the 11 national European currencies on January 1,
1999) and SDR.

European countries are preparing for a single currency, the Euro, introduced in 1999 and
replace most of the EU’s individual currencies.

Many nations have created a variety of monetary systems in terms of their agreement with
IMF.

Previous IMF Classification of Currency Arrangements

The previous structure of the exchange rate regimes until the year of 2000 according to IMF
classification is of 10 types over the world as shown below:

Pegged To another Currency

Some 62 countries out of 167 members of IMF pegged their currency to some other currency.
For example, US dollar is the base for 20 other countries and French franc is the base for 14
other countries, all issued by former French colonies in Africa.

Pegged To a Basket

Some 21 countries pegged their currency to a composite “basket” of currencies, where the
basket consists of a portfolio of currencies of their major trading partners. The base value of
such a basket is more stable than any single currency.

Flexible against a Single Currency

4 countries in the Persian Gulf area maintain their currency within a limited range of
flexibility with the US dollar.

Joint Float

10 members of the EU have a cooperative agreement to maintain their currencies within a set
range against other members of their group of whose structure is called European Monetary
System (EMS). In essence EMS is a peg of each country’s currency to all the others, and a
joint float of all of the currencies together against non-EMS currencies.

Adjusted According To Indicators

2 countries, Chile and Nicaragua, adjust their currencies more or less automatically against
changes in a particular indicator, such as real effective exchange rate, which reflects inflation
adjusted changes in that currency with its major trading partners.
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Managed Float

Some 40 countries maintain managed float. Each central bank sets the nation’s exchange rate
against a predetermined goal, but allows the rate to vary. There is an intervention in
determining exchange rates.

Independently Floating

55 countries allow full flexibility through an independent float. These countries’ currencies
are the most important currencies over the world other than those in EMS system. Central
banks permit market forces to determine exchange rates. However, there might be an
intervention in some of them from time to time.

New IMF Classification of Currency Regimes:

Exchange Arrangements with No Separate Legal Tender: The currency of another country
circulates as the sole legal tender or the member belongs to a monetary or currency union in
which the same legal tender is shared by the members of the union.
Currency Board Arrangements: A monetary regime based on an implicit legislative
commitment to exchange domestic currency for a specified foreign currency at a fixed
exchange rate, combined with restrictions on the issuing authority to ensure the flilfillment of
its legal obligation.
Other Conventionai Fixed-Peg Arrangements: The country pegs its currency (formally or de
facto) at a fixed rate to a major currency or a basket of currencies, where the exchange rate
fluctuates within a narrow margin or at most +1% around a central rate.
Pegged Rate within Horixontal Bands: The value of the currency is maintained within
margins of fluctuation around a formal or defacto fixed peg that are wider than ~1% around a
central rate.
Crawling Pegs: The currency is adjusted periodically in small amounts at a fixed,
preannounced rate or in response to changes in selective quantitative indicators.
Exchange Rates within Crawling Bands: The currency is maintained within certain fluctuation
margins around a central rate that is adjusted periodically at a fixed preannounced rate or in
response to change in selective quantitative indicators.
Managed Floating with No Preannounced Path for the Exchange Rate: The monetary
authority influences the movements of the exchange rate through active intervention in the
foreign exchange market without speciiying, or pre~committing to, a pre-announced path for
the exchange rate.
Independent Floating: The exchange rate is market-determined, with any foreign exchange
intervention aimed at moderating the rate of change and preventing undue fluctuations in the
exchange rate, rather than at establishing a level for it.

Currency Boards

Eight countries, including Argentina and Hong Kong, are utilizing currency boards as a means
of fixing their exchange rates. In 1991, Argentina move its previous managed exchange rate
of the Argentine peso to a currency board, which fixed peso’s value to the US $ on a one to
one basis. This fixed rate was preserved by requiring every peso to be backed by gold or
dollars held on account in banks in Argentina.

Dollarization
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Several countries (only Panama, Ecuador and Liberia – three relatively small countries) that
have been suffered for many years from currency devaluation, primarily as a result of
inflation, have taken steps toward dollarization, the use of the US $ as the official currency of
the country. Argentina, however, may be the next.

5. ATTRIBUTES OF THE “IDEAL” CURRENCY

1. Fixed Value
Fixed value of currencies relative to others that traders and investors be certain today and
in the future.

2. Convertibility
Full convertibility of a currency so that traders and investors can easily move funds from
one country to another requiring complete freedom of monetary flows.

3. Independent Monetary Policy

Each country set their own domestic monetary and interest rate policies to pursue national
economic policies.

All of these attributes cannot be achieved at the same time, for example, countries whose
currencies are pegged to each other agree to both a common inflation and interest rate policies
as in EMS. On the other hand, inflation rates differ among countries. Countries having higher
inflation rates are likely to have higher unemployment rates as well. And if there is an interest
rate difference, then funds will be moved from lower interest rate countries to higher interest
rate countries.

6. THE EUROPEAN UNION (EU) AND THE EUROPEAN MONETARY SYSTEM

(EMS):

Europe has, for centuries, been the scene of frequent and bloody wars. In the period 1870-
1945, France and Germany fought each other three times to devastating effect. A number of
European leaders came to the conclusion that the only way to secure a lasting peace between
their countries was to unite them economically and politically.

So, in 1950, the French Foreign Minister Robert Schuman proposed integrating the coal and
steel industries of Western Europe. As a result, in 1951, the European Coal and Steel
Community (ECSC) were set up, with six members: Belgium, West Germany, Luxembourg,
France, Italy and the Netherlands. The power to take decisions about the coal and steel
industry in these countries was placed in the hands of an independent, supranational body
called the "High Authority". Jean Monnet was its first President.

Within a few years, these same six countries decided to go further and integrate other sectors
of their economies. In 1957 they signed the Treaties of Rome, creating the European Atomic
Energy Community (EURATOM) and the European Economic Community (EEC). The
member states also set about removing trade barriers between them and made plans to form a
"common market".
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In 1967, the institutions of the three European communities merged. It was from this date
onwards that one Commission, one Council of Ministers and a European Parliament came
into operation.

Originally, the members of the European Parliament were chosen by the national parliaments.
However, in 1979, the first direct elections were held, allowing citizens of the member states
to vote for the candidate of their choice. Since then, direct elections have been held every five
years.

The Treaty of Maastricht (1992) introduced new forms of co-operation between member
states’ governments - for example, on defense and in the area of "justice and home affairs".
By adding this inter-governmental co-operation to the existing "Community" system, the
Maastricht Treaty created the European Union (EU).

Economic and political integration between member states of the European Union has meant
that these countries have had to make joint decisions on many matters. Accordingly, they
have developed common policies in a very wide range of fields - from agriculture to culture,
from consumer affairs to competition and from the environment and energy to transport and
trade.

In the early days, the focus was on a common trade policy for coal and steel and a common
agricultural policy. Additional policies were added over time as the need arose. Some key
policy aims have been adapted in the light of changing circumstances. For example, the aim
of the agricultural policy is no longer to produce as much food as cheaply as possible. Instead,
it is to support farming methods that produce healthy, high-quality food without damaging the
environment. The need to protect the environment is now an issue which is taken into account
in all EU policies.

The European Union's relations with the rest of the world have also gained importance. As
well as negotiating major trade and aid agreements with other countries, the EU is also
developing a Common Foreign and Security Policy.

It took some time for the Member States to remove all the barriers to trade between them and
to turn their "common market" into a genuine single market in which goods, services, people
and capital could move freely. The Single Market was formally completed at the end of 1992,
although there is still work to be done in some areas - for example, in creating a genuinely
single market in financial services.

During the 1990s it became increasingly easy for people to move around Europe as passport
and customs checks had been abolished at most of the EU's internal borders. EU citizens, as a
consequence, experienced greater mobility. Since 1987, for example, more than a million
young Europeans have embarked on study courses abroad, benefiting from the financial aid
granted by the EU.

EU is of European countries which set up five institutions each playing a specific role. These
are:

 European Parliament which is elected by the peoples of member states,

 Council of the European Union representing the governments of the member states,
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 European Commission driving force and executive body,

 Court of Justice ensuring compliance with the law, and
 Court of Auditors controlling sound and lawful management of the EU budget.

These institutions are flanked by five other important bodies:

 European Economic and Social Committee expressing the opinions of organized civil
society on economic and social issues,
 Committee of the Regions expressing the opinions of regional and local authorities,
 European Central Bank which is responsible for monetary policy and managing the
euro,
 European Ombudsman dealing with citizens' complaints about maladministration by
any EU institution or body, and
 European Investment Bank helping achieve EU objectives by financing investment
projects.

The Birth of a Global Currency: EURO

25 members of EU now are also the members of EMS. They heavily rely on trade among
themselves. The EMS has undergone a number of major changes since its inception in 1979,
including major crises and reorganizations in 1992 and 1993, and conversion of 11 members
to the EURO on January 1, 1999. In December 1991, the members of the European Union met
at Maastrict, the Netherlands and concluded a treaty that changed Europe’s currency future.

The Future of the EMS and Maastrict

In DEC 91, EU members met at Maastrict (Netherlands) and concluded a treaty:

Treaty:

Timetable
They specified a timetable and plan to replace all individual currencies with EURO. Other
steps would lead to a full European Monetary Union (EMU) as latest as the end of 1998.

Convergence Criteria
The EMU would be implemented by a process called convergence, which includes:

 Nominal inflation should be at most 1.5% above the average for the three members of EU
with the lowest inflation rates during the previous year
 Long term interest rates should be at most 2% above the average for 3 members with the
lowest interest rates.
 Fiscal deficit should be at most 3% of GDP.
 Government debt should be at most 60% of GDP.

Strong Central Bank

A strong central bank called European Central Bank (ECB) was to be established and Host
City will be Frankfurt, Germany.
14

It will promote the price stability within the EU.

European Monetary Unification: The Launch of the Euro

In 1992, the EU decided to adopt economic and monetary union (EMU). This involved the
introduction of a single European currency managed by a European Central Bank. The single
currency - the euro - became reality on 1 January 2002, when euro notes and coins replaced
national currencies in twelve of the 15 countries of the European Union at that time (Belgium,
Germany, Greece, Spain, France, Ireland, Italy, Luxembourg, the Netherlands, Austria,
Portugal and Finland).

On Jan-1, 1999, the member states of the EU initiated European Monetary Unification
(EMU), which is the establishment of a single currency for Europe. On December 31, 1998,
the final fixed rates between the 11 participating currencies and the euro were put into place.
On January 4, 1999, the EURO was officially traded.

Under that timetable, the new currency (EURO) replaced individual currencies of
participating members on January 1, 2002 which means that the individual coins and notes of
the national currencies are gradually withdrawn from circulation and replaced with euro notes
and coins. On January 1, 2002 the euro banknotes and coins were introduced in 12 member
states with seven different banknotes and eight coins. The purpose of EURO is to increase the
economic growth and potential of EU. The 11 participating members (EU11) in Euro are;
Austria, Belgium, Finland, France, Germany, Ireland, Italy, Luxembourg, the Netherlands,
Portugal and Spain.

The coins – just 50 billion of them – have one one side common to all 12 countries and a
reverse side specific to each country, while the 14.5 billion banknotes look the same
throughout the euro area. Altogether, the banknotes and coins produced total over €664
billion1.

A Growing Family

The EU has grown in size following successive waves of accessions. Denmark, Ireland and
the United Kingdom joined in 1973, followed by Greece in 1981, Spain and Portugal in 1986
and Austria, Finland and Sweden in 1995. The EU25 consists of EU11 plus Denmark, Greece,
Sweden, UK, and countries which joined the EU in May 1, 2004 that are Estonia, South
Cyprus, Malta, Poland, the Czech Republic, Hungary, Latvia, Lithuania, Slovakia, and
Slovenia. Turkey, Bulgaria and Romania are now candidate countries waiting to be a member
in the EU. To ensure that the EU can continue to function efficiently with 25 or more
members, the decision-making system must be streamlined. It is for this reason that the Treaty
of Nice lays down new rules governing the size of the EU institutions and the way they work.
It came into force on 1 February 2003.

7. EMERGING MARKET CRISES

1
http://eupopa.eu.int
 15

The Great World Depression (1929)

It was a depression firstly started in USA in 1929 and affecting the entire world in a very
short period of time. In November 24, 1929, there has been a crisis in Walt Street Stock
Exchange, which caused large decreases in industrial production, GNP, and highly increases
in unemployment rates. The basic reason behind Great Depression is insufficient aggregate
demand. There had been positive developments in the world economy. There were rapid
increases in world production until 1928. But during 1928-1929, there have been in raw-
material and goods stocks which caused the prices to fall. Then unemployment raised in some
countries. Unemployment in some of the countries has been: USA 12 million, Germany 6
million, England 2.6 million, and Italy 1 million. The world trade volume decreased very
significantly because of the great depression. The real GDP of USA declined by 40% during
the great depression. The USA put restrictions on its imports and credits to be provided for
other countries. This affected other countries and they started to put restrictions on their
imports too. The great depression fastened the end of the gold standard, after the depression
the countries started to leave the system and in 1933 it was completely left. The USA adopted
a modified gold standard in 1934 when $ devalued by 69% against the gold. The great
depression affected all the world economies because of their dependence on the USA. The
other reasons behind the crisis were lack of enough liquidity in financial markets, problems in
BOP and excess supply or shortage demand.

The Asian Crisis (1997)

The roots of the Asian currency crisis extended from a fundamental change in the economics
of the region, the transition of many Asian nations from net exporters to net importers;
starting from 1990s they started to have trade deficits. They needed capital inflows to
maintain the stability in their balance of payments but when these stopped, crisis was
inevitable.

The most visible roots of the crisis were in the excesses of capital flows into Thailand in 1996
and early in 1997. With rapid economic growth and rising profits forming the backdrop, Thai
firms, banks and finance companies had ready access to capital on the international markets,
finding US $ debt cheap offshore. As capital flows into the Thai market hit the record rates,
some participants raised the question about the economy’s ability to repay the rising debt. The
Baht came under sudden and severe pressure.

Thai government and central bank intervened in the foreign exchange markets directly (using
up precious hard currency reserves) and indirectly (by raising interest rates to attempt to stop
the continual outflow). The Thai investment markets ground to a halt. This caused massive
currency losses and bank failures. On July 2, 1997, the Thai central bank finally allowed the
Baht to float. The baht fell 17% against US $ and over 12% against Japanese Yen in a matter
of hours.

Within days, in Asia’s own version of the tequila effect, a number of neighboring Asian
nations, some with and some without characteristics similar to Thailand’s, came under
speculative attack by currency traders and capital markets. So crisis jumped to other Asian
nations and devaluations took start.
16

Causal Complexities behind Asian Crisis

Difficulties in Balance of Payments

Corporate Socialism: Influence of governments and politics in business arena
Corporate Governance: Bad management because of large family corporations and their
strong control over their corporations.
Banking Liquidity and Management: Liquidity crisis and bad banking regulatory
structures and markets.

The Asian Economic Crisis Had Global Impacts

What started as a currency crisis quickly became a region-wide recession. The slowed
economies of the region quickly caused major reductions in world demands for many
products, especially commodities. World oil markets, copper markets and agricultural
products all saw severe price falls as demand fell. These price drops were immediately
noticeable in declining earnings and growth prospects for other emerging economies. The
problems of Russia and Brazil were reflections of those declines.

The Russian Crisis (1998)

The Russian crisis was the culmination of continuing deterioration in general economic
conditions in Russia. During 1995-1998, Russian governmental and non-governmental
borrowers went to the international capital markets for large quantities of capital. Servicing
this debt soon became an increasing problem, as dollar debt required dollar debt-service. The
foreign debt of Russia was a major reason behind the crisis that put pressure on the rubble. In
the spring of 1998, Russian exports were declining of which one of the reasons was Asian
Crisis in 1997. The Russian Rubble operated under Managed Float. So the pressures on the
Rubble increased. On Friday August 7, 1998, central bank announced that its hard currency
reserves had fallen by $800 million to $18.4 billion on July 31.

On Monday, August 10, Russian stocks fell more than 5% as investors feared Chinese
renminbi devaluation. This also affected export sales of Russia negatively. Then, a panic and
speculations started in Russia market, these created also pressure on the Russian Rubble. On
August 17, the rubble was allowed to fall by 34% during the year. So the rubble has started to
devalue against foreign currencies. It is hard to say when a crisis begins or ends, but for the
Russian people and the Russian economy, the deterioration of economic conditions continues.
The collapse of the rubble and of Russia’s access to the international capital markets has for
many brought into question the benefits of a free market economy2.

The Brazilian Crisis (1999)

The majority of economic and financial analysts around the world never debated in 1997 and
1998 whether the Brazilian real would be devalued, only when and by how much. The

2
See Eiteman, Stonehill and Moffet (2003), p.46.
 17

government’s inability to resolve continuing current account deficits and domestic

inflationary forces made the devaluation of the real an eventuality.

The devaluation of the real started on January 12, 1999. Although the Brazilian government
had successfully held the value of the real quite stable for an extended period, the fact that the
exchange rate had not been allowed to adjust to relative inflationary forces (ex. US inflation
had averaged 2.0% or less for the same period of time), coupled with stagnating economic
growth, led investors to look elsewhere for economic returns. Increased volatility in the
marketplace in the latter half of 1998, particularly the Russian economic collapse in August of
1998, set the stage for the devaluation of the real.

8. HISTORY OF TURKISH LIRA (TL) DEVELOPMENTS

Turkey has used Managed Float system in the past until February 21, 2001. This important
date has been a turning point of TL at which free floating exchange rate system has been
adopted by Ecevit-Bahceli-Yılmaz Coalition Government.

The first devaluation on TL has been made in September 7, 1946 by 54.3% because of the
inflationary pressures and aims to increase exports. During the early years of the Republic of
Turkey (1923-1946) TL was allowed to fluctuate around 4% annually against foreign
currencies. The rate of TL for $ before II: World War was 1$: 1.29 TL, but after the war, it
was 1$: 2.80 TL.

The inflationary pressures have been further increased during 1960s. The second historical
devaluation of TL against other currencies has been made in August 4, 1958 by 68.9%. But
this was not an immediate devaluation but a gradual devaluation by which folded exchange
rate application has started and continued until August 9, 1960.

Other Devaluation Events of TL

Devaluation by 23% against US $ (immediate devaluation)

Devaluation by 26.3% (immediate devaluation)

March 1978: 1$: 19.25 TL 1$: 25 TL

April 1979: 1$: 25 TL 1$: 35 TL

April 1979: Folded Exchange Rate Application

May 1979: 1$: 42 TL
June 1979: 1$: 47.1 TL

January 24, 1980: Devaluation by 32.7%, after then small devaluations has been made

1$: 47.1 1$: 70 TL (gradual, folded)

May 1981: Exchange rates have been announced on Daily Basis so to achieve Full
Convertibility of TL, however, it was not achieved. Rates were determined
18

by Central Bank of Turkey.

Tendencies for Liberalization have started by January 24, 1980 decisions and apart from May
1, 1981 it was aimed to prevent extreme depreciation of TL by applying small devaluations
not exceeding 5%.

TL has been devalued by 40%

TL gained Full Convertibility in world markets against foreign currencies approved by IMF

April 5, 1994 Immediate Devaluation of TL approximately by 150%

But during the year TL has been devalued around 170% against foreign currencies.

February 21, 2001 (Wednesday) a turning point of TL and Turkish

Economy

TL has been shifted from Managed Float into Free Floating Exchange Rate System that was
the first experience in Turkish Economy.

Turkey had attended Bretton Woods meetings and approved Bretton Woods agreement in
1944. However, due to the intensive exchange rate controls since 1930s Bretton Woods
system was not so applicable for Turkey. For example, there was no legal exchange rate
market, TL was not convertible, and parity rates had been implemented by laws and
regulations rather than by the central bank.

When Bretton Woods system collapsed, TL was devalued and pegged to US $ again. This peg
was more flexible than before because there were periodical arrangements in TL once in a few
months that continued between 1971 and 1981.

Liberal trade regime has taken place starting from January 24, 1980 in Turkey. Daily
adjustments in exchange rates by the central bank started aiming to reach the equilibrium
value of TL. After having full convertibility of TL approved by IMF, exchange rate policies
applied in Turkey were based on flexible system. Exchange rates started to change based on
free market forces but the central bank of Turkey from time to time were intervening into the
market to prevent extreme fluctuations or speculative changes. This system was managed
float system in reality.

In the beginning of 1990s, due to the excess interventions of the central bank TL appeared to
be overvalued against foreign currencies. On the other hand, interest rates were higher as a
result of government policy. These developments caused devaluation of TL once again as a
result of April 4, 1994 Economic Sustainability Measures.

Another crisis in Turkey occurred in February 2001. Turkey made a standby agreement with
IMF in 2000 to control inflation which was depending on an exchange rate policy of
something currency board based on exchange anchor. A limitation to print money was
restricted and drawing TL to the market was pegged to foreign exchange inflows to Turkey. A
basket comprising of US dollar and Deutsch Mark was set and TL would be allowed to
 19

devalue against this basket at most 20% that was also equal to the planned inflation rate.
Otherwise, the central bank would need to make intervention to the market.

However, high inflation created suspicions whether the government would be able to continue
with the estimated target of exchange rates level. This, on the other hand, caused and attracted
speculation in the markets and lead foreign investors liquidate their funds in Turkey and
transfer to their own countries. As a result of these speculative attacks, the official reserves
position of the central bank was damaged. The government, this time, tried to continue with
the stability program with credits provided by the IMF for a while.

On the other hand, speculative attacks and fund outflows were not stopped. Therefore,
expected crisis came true and TL was left flexible against foreign currencies in February 21,
2001. However, this new flexible system was due to some interventions by the central bank
when needed. Therefore, it was not a pure flexible system. Later, an intention letter was
prepared and an agreement was made with IMF to reach Stable Economic Transition Program
(Seyidoğlu, 2003: 37-38).
20

Table XX. TL Against Some Foreign Currencies

Annual Average Exchange Rates

Years TL/US $ TL/STG TL/KL TL/DM US$/STG US$/KL US$/DM

1964 9.00 25.20 25.20 2.80 2.80
1965 9.00 25.20 25.20 2.80 2.80
1966 9.00 25.20 25.20 2.80 2.80
1967 9.00 24.75 24.75 2.75 2.75
1968 9.00 21.60 21.60 2.40 2.40
1969 9.00 21.60 21.60 2.40 2.40
1970 10.84 26.02 26.02 2.40 2.40
1971 15.14 36.94 36.94 2.44 2.44
1972 14.30 35.76 37.32 2.50 2.61
1973 14.28 34.99 40.84 2.45 2.86
1974 14.06 32.80 38.52 2.33 2.74
1975 14.50 32.20 39.44 6.07 2.22 2.72 0.42
1976 16.20 29.24 39.53 6.54 1.80 2.44 0.40
1977 18.20 31.72 44.59 7.72 1.74 2.45 0.42
1978 24.60 47.15 65.92 11.95 1.92 2.68 0.49
1979 36.80 77.93 103.78 22.04 2.12 2.82 0.60
1980 75.10 174.24 212.53 42.76 2.32 2.83 0.57
1981 113.00 228.06 268.94 49.80 2.02 2.38 0.44
1982 163.75 294.37 345.51 67.52 1.80 2.11 0.41
1983 231.83 351.02 440.48 89.22 1.51 1.90 0.38
1984 367.40 490.37 624.58 129.65 1.33 1.70 0.35
1985 528.30 686.24 866.41 181.43 1.30 1.64 0.34
1986 682.58 999.78 1,324.21 314.84 1.46 1.94 0.46
1987 871.98 1,433.97 1,813.72 486.49 1.64 2.08 0.56
1988 1,422.00 2,549.69 3,038.20 817.43 1.79 2.14 0.57
1989 2,139.52 3,493.64 4,206.22 1,129.53 1.63 1.97 0.53
1990 2,618.98 4,663.48 5,523.38 1,621.05 1.78 2.11 0.62
1991 4,199.67 7,415.84 8,144.81 2,537.31 1.77 1.94 0.60
1992 6,896.25 12,130.06 14,230.32 4,418.55 1.76 2.06 0.64
1993 11,106.99 16,702.24 20,998.67 6,716.20 1.50 1.89 0.60
1994 29,915.67 46,085.94 54,798.64 18,548.15 1.54 1.83 0.62
1995 46,554.51 72,398.16 95,673.66 32,070.17 1.56 2.06 0.69
1996 82,150.50 127,813.53 171,459.04 54,069.90 1.56 2.09 0.66
1997 154,893.30 249,061.51 293,620.12 87,409.75 1.61 1.90 0.56
1998 261,777.29 432,938.10 505,340.60 149,151.63 1.65 1.93 0.57
 $/STG TL/$

-
0.50
1.00
1.50
2.00
2.50
3.00
19
64

-
50,000.00
100,000.00
150,000.00
200,000.00
250,000.00
300,000.00
19
65 19
64
19
66 19
65
19 19
67 66
19 19
68 67
19 19
69 68
19 19
70 69
19 19
71 70
19 19
72 71
19 19
73 72
19 19
74 73
19 19
75 74
19 19
76 75
19 19
77 76
19
19 77
78
19
19 78
79
19
19 79
80
19
19 80
81
19
19 81

Years
82

US $ / Pound STG
19
Years

19 82
83
19
19 83
84
19
Annual Average TL/US $ (1964-1998)

19 84
85 19
19 85
86 19
86
19
87 19
87
19
88 19
88
19
89 19
89
19
90 19
90
19
91 19
91
19
92 19
92
19 19
93 93
19 19
94 94
19 19
95 95
19 19
96 96
19 19
97 97
19 19
98 98
21
22

US $ / South Cyprus Lira

3.50

3.00

2.50

2.00
$/KL

1.50

1.00

0.50

-
64

65

66

67

68

69

70

71

72

73

74

75

76

77

78

79

80

81

82

83

84

85

86

87

88

89

90

91

92

93

94

95

96

97

98
19

19

19

19

19

19

19

19

19

19

19

19

19

19

19

19

19

19

19

19

19

19

19

19

19

19

19

19

19

19

19

19

19

19

19
Years

US $ / DM

0.80

0.70

0.60

0.50
$/DM

0.40

0.30

0.20

0.10

-
1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998
Years