issue 168 - February 1987
3. Lives in
Keeping imports, exports and exchange rates at suitable levels is a delicate balancing act - with heavy penalties for any country that gets it wrong.
Money moves fast. Foreign exchange markets can take a dislike to francs or yen or pounds and buy and sell them quicker than you can turn a page of the NI.
You weren't, by the way, just about to turn the page were you? Getting a bit impatient?
Just wondered what this month's country profile was.
Cameroon - and illuminating as always. But there's time enough for that. What we need to explore now are the mysterious forces that send currencies racing after each other across the world's computer screens. Rumour, gossip and hunch (or 'speculation' as the professionals would have it) are all the key elements in a giant game that blends Space Invaders with stud poker.
But for all the speculation and the politicking, the flows of finance should ultimately be based on honest trade and investment. These should make us all richer.
Now that sounds interesting.
A theoretical example. Let's say the British are skilled and efficient brewers of beer but they find baking bread a long and difficult process. The French, on the other hand, don't know much about the amber liquid but have got what it takes to bake a crisp white loaf.
If the French and the British decided to co-operate (this is a theoretical example) they could specialize in what they are most efficient at. They could then share the abundance of food and drink between them and they'd both be better off.
Constipated and drunk?
We're talking about the quantity of output here. Quality is quite a separate question.
You can show that specialization is a good idea even if the British are the most efficient at producing everything. In this case they concentrate on their areas of greatest advantage and allow neighbouring countries to produce things in which British superiority is not quite so marked. This again results in more goods being available for everybody. (If you're having trouble swallowing this, substitute 'Japanese' for 'British' in the above.)
I think I've got it.
That's the theory of 'comparative advantage'. With free trade we're all supposed to live happy ever after. But there are complications. And one of these is currency. If people are buying and selling goods for cash across frontiers they are going to have to accept each other's money in payment. That means deciding what the relative values of their currencies will be: the exchange rate.
So they go to Thomas Cook and ask.
That's too easy. You're an intelligent person. You want to know how these figures are arrived at. Not that there is just one factor which determines it. There are quite a few, but one will certainly be how much of each country's currency is generally available.
A change of continent (this is an international magazine). Let's suppose Canadian storekeepers buy coffee from Brazilian farmers. They can't simply offer Canadian dollars - even though they do have a very fetching portrait of the Queen. The farmers in Brazil can only spend cruzados.
Enter the foreign exchange dealer. She or he will keep bags of all sorts of currencies and can exchange dollars for cruzados. If at a later date the Brazilians want to buy Canadian tractors the exchange process is reversed. The farmers use cruzados to buy dollars.
How do they arrive at the exchange rate then?
Partly it will be the supply and demand created by trade. If Canada starts to export fewer tractors and import more coffee the foreign exchange dealers will have spare dollars on their hands. If people don't want a particular commodity (even money) its value will fall.
Dealers would then drop the price of dollars to get rid of them. When the value of the dollar falls, Canadian tractors look cheaper to people elsewhere. This should increase sales and soak up the spare dollars. So the market place should continually adjust the exchange rate to keep trade in balance.
Seems simple enough.
It's not that simple. There are many other influences on the flow of currencies. Interest rates also play an important part. If interest rates in Canada are higher than in the US, say, this will draw money into Canada and push up the value of the Canadian dollar.
But trade does play a central role. A couple of technical terms. If a country imports more than it exports it is said to have a balance of trade deficit and this will contribute from the financial point of view to a 'balance of payments' deficit And if the exchange rate is determined purely by market forces it is said to be 'floating'.
Am I supposed to be taking notes?
No. That's the beauty of buying a magazine. You can keep it for reference. You did pay for this copy, didn't you?
Today's floating exchange rates and lack of controls in many countries on the buying and selling of foreign currency explain why the international financial system has become so dynamic - or chaotic, depending on your point of view.
It wasn't always like this. Up until the 1970s most exchange rates were fixed by governments. Indeed in earlier days they were set in terms of so many dollars or pesos to an ounce of gold: the gold standard. It used to be thought that if money were not ultimately linked to some solid valuable commodity it would not have any value.
But money has turned out to be a lot stranger than that. If something is generally accepted as a form of exchange - be it a dollar bill, a cheque, an IOU or even a used bus ticket - then it can count as money.
Pity I threw my last bus ticket away.
I did say it had to be accepted. If you do find someone who is happy to be paid in used bus tickets I'd be grateful for an introduction.
But back to the chaos. Even when there was a gold standard and fixed exchange rates the world's trading and monetary system was thought to be dangerously unstable.
The depression of the 1930s taught some salutary lessons. It became clear that if nations which were trading with each other did not act co-operatively then economic problems in one country could have a knock-on effect around the world - and cause a global recession.
The heart of the problem was usually the balance of payments. Suppose Canada had a temporary imbalance: there was a long labour dispute at the tractor factory that was reducing export earnings. Meanwhile just as much coffee was still being imported at the same price. Something would have to be done.
Fire the workers.
I'm beginning to wonder if you're the kind of reader we want for this magazine. I was thinking more of patient negotiation.
But even this would still leave a temporary problem. If the foreign-exchange dealers had too many Canadian dollars they would stop accepting them. Canada would not then be able to buy anything else - no matter how essential the imports were.
There are two classic solutions to this if exchange rates are fixed. One is to put up barriers to the import of coffee, say. Tariffs would push up its price in Canada and fewer cups would probably be drunk - or you could set quotas to determine exactly how much could be imported. The second alternative is suddenly to devalue the currency to make imports more expensive and exports cheaper.
I thought exchange rates were fixed.
Well, fixed until the government decides to change them. The problem with both these options is that they invite retaliation from other countries. If Brazil sees its balance of payments under threat because of reduced sales to Canada it might feel entitled to put up tariff barriers against Canadian goods - paper, say. It could also devalue the cruzado and Canada would be back where it started.
Sounds like free competition to me, everyone for themselves.
Exactly. But with individual countries protecting their balance of payments and putting up tariff barriers, international trade would start to shrink. And that would, according to the theory of comparative advantage, make the world as a whole poorer.
Enter the International Monetary Fund - the IMF.
As in 'IMF riot', 'IMF austerity package' and 'IMF loan'?
The very same. But it didn't start out with such dubious connotations. The IMF arose out of an international conference in Bretton Woods in New Hampshire in 1947.
Two economists, John Maynard Keynes and Harry S White, brought out proposals to reform the international monetary system. Two of the most significant products of this were the IMF and the World Bank.
The International Monetary Fund was created with contributions from member governments (originally 44). The money could then be lent to any member that had temporary balance of payments problems. When the imbalance had been corrected the loan could be repaid. Meanwhile the country concerned need not resort to tariff barriers or devaluations. It could import the goods it needed and world trade could thus continue unaffected.
Seems like a good idea.
It was. If the problem was indeed temporary - and essentially an internal one - then it might be corrected by changing national government policy. So an IMF loan would be useful.
An internal problem?
It might be any number of things. It could be for example that wages had been increasing too rapidly. This could create an excess in 'demand' - for cars perhaps. If local factories were unable to produce a sufficient number then the demand would have to be met by drawing in imports.
Governments can try to reduce demand. One way is to increase taxes to reduce spending power. But tax increases can take time before they affect people's behaviour. Certainly much longer than it would take to block imports of Japanese cars using quotas.
An IMF loan will help to smooth the process out IMF loans in the early years went to developed countries that were in temporary difficulties. And for this purpose they worked reasonably well.
You mean nobody complained.
Oh, there were still complaints - but on nothing like the same scale as you will find now. The difference today is that the bulk of the loans are being made to poor countries. And their situation is very different. They often have much more permanent problems, with causes outside their control.
Because the IMF has not fully allowed for this it has met fierce opposition - as we shall see later.
Don't want to get you overexcited. Plenty of time yet. In any case we need to fit the World Bank into the picture.
The IMF is rather like a high street bank in that its clients can have deposits there but alternatively borrow when they are in trouble.
The World Bank is more like an investment or merchant bank. It arranges funds for longer-term projects like building dams or roads; the official name is the International Bank for Reconstruction and Development
Its 'shareholders' are the world's governments. But the funds it actually hands out are raised on the world's financial markets - from banks, or other large investors.
Why don't they cut out the World Rank and lend the money directly themselves?
Some projects might not look too attractive to investors: so they would worry about not being repaid. But if the World Bank has investigated the scheme and the money passes through the Bank's hands then the loan is as secure as the World Bank itself. And that's pretty secure. The Bank's capital base is guaranteed by the world's governments. And the World Bank, unlike most commercial banks, never lends more than this guaranteed sum.
Moreover the Bank is always a 'preferred creditor', which means it has to be paid before everybody else. In fact the World Bank can rightly claim that it has never had a bad debt - never lost a cent.
In financial terms certainly. Though its projects have often been social, political and ecological disasters. This is because the people who lend the money need to be paid commercial rates. So World Bank projects tend to be those that will quickly generate the necessary foreign exchange. There is, therefore, a heavy emphasis on export industries - even if this means, for example, sweeping local Indian tribes aside in order to export the timber from their forests.
So the World Bank is a bad thing?
Not as good a thing as it might be. But I should add that the Bank does also work in less commercial ways. One of its offshoots is the International Development Agency which lends money to the poorest countries at very low rates of interest. Because this has an element of aid and loses money its funds have to be replenished every so often by member governments. So it is much less constrained by the need for a rapid return.
Very worthy I'm sure. Now can I turn the page?
Now you can turn. Just one page at a time though.
The World Bank
With around ten billion dollars passing through it's hands each year, the World Bank is one of the biggest development agencies. In the past it has usually lent money for specific projects which it identifies and appraises - 90 per cent of the $165 million committed since 1945 has been of this type.
Even when making project loans, however, the Bank has always had a significant political influence. The grandiose title of its annual 'World Development Report' evidences as the scale of it's concerns. Meticulously produced, this combines one of the most authoritative sources of statistics with the Bank's particular world view.
This view is not uninfluenced by the fact that the US, by virtue of the scale of its contributors effectively has a veto on any Bank policy. The percentage of the votes shared out in June 1986 among the 150 members were as follows:
The President of the Bank is always an American and nominated by the US President. Former Defence Secretary Robert McNamara (1976 - 81) has been one of the most influential incumbents. He said that the Bank would do more to help the poorest, but there was more rhetoric than reality to his proposal. His successor Tom Clausen (1981-86) was a hard-nosed banker who did not even bother with the rhetoric. He came from BankAmerica (where he made his contribution to the international debt crisis) and has since returned there.
Barber Conable took the reins in July 1986. 'Barbara who?' was the general response outside the US to this appointment. Americans knew him as a Republican Congressman of financially conservative views and an enthusiastic proponent of free trade. He has not committed himself much to date except to confirm the Bank's new direction of making more 'policy orientated' loans. These are aimed, for example, at tiding countries over while they restructure their economies. There is something of the flavour of the IMF about this - there are conditions applied. But the loans tend to be longer term.
This leads the Bank into more explicitly political territory than before, which may not please all of the Bank's 7,000 or so employees who see themselves more as development experts. Some fear - probably for good reason - that their advice may not be considered as impartial as it used to be.
The US has, for example, recently blocked a $26 million World Bank loan to Costa Rica negotiated in May 1986, saying that Costa Rica must stop subsidizing prices paid to small producers of corn, rice and beans. 'Why is there this ideological fanaticism about prices?' asks Planning Minister Otton Solis. He says that the US has already forced Costa Rica to lift food subsidies to producers, reduce tariffs on imported goods and dismiss 4,000 public sector employees.
Other countries have also balked at World Bank ideology and looked for alternatives. In Senegal, for example, for a programme to restructure the sugar industry, the Bank has been insisting that the sugar complexes be handed over to private management. The Government rejected this and said that the Bank's project was too expensive and required too much foreign technical assistance. It has now been replaced by French financing.
It should be added, however, that the Bank gets criticized from the right as well as the left. Conservatives accuse it of pandering to corrupt and inefficient governments who are not prepared to accept the full discipline of the market place.
The International Monetary Fund
The head of the IMF is traditionally a West European. Michel Camdessus, former Governor of the Bank of France has just been appointed as the Fund's Managing Director.
The distribution of votes within the IMF is, however, similar to that in the World Bank. The US again has a dominant position that reflects the size of its contributions to the Fund. The Soviet Union has declined to join an organization whose purpose it sees as merely to preserve capitalism. The votes are:
The voting pattern, as well as the contributions to and withdrawals from the Fund are based on a country's 'quota'. This is in turn based on a formula which includes such factors as national income, foreign exchange reserves and the scale of foreign trade. Each member has to pay a quarter of its quota into the fund in foreign exchange.
Funds may be withdrawn in 'tranches'. The 'reserve' tranche, which is effectively the same money that the country has itself paid in, may be borrowed with no conditions applied. Next comes the 'first credit tranche' which is 25 per cent of the quota; weak conditions apply to this. Then there are the 'upper credit tranches', also 25 per cent each and to which stringent conditions apply.
To qualify for the upper credit tranches, the government concerned has to sign a 'standby arrangement' with the IMF - a letter of intent committing it to make policy changes and meet targets Standby arrangements usually run for one year.
The recognition that this was too short a period resulted in the addition in 1974 of an Extended Fund Facility which permits the drawing of 140 per cent of the quota over two to three years - but again based on very stringent conditions By the end of 1984 member countries had concluded 550 stand by arrangements and 34 Extended Fund Facility arrangements with the Fund.
The Fund can also create and hand out a new kind of money. When it became clear, in 1969, that world trade had grown to levels greater than could be coped with by the quantity of dollars and gold available, the IMF's governors created their own currency to add to them. These are called 'Special Drawing Rights' (SDRs). The value of the SDR is based on a weighted mixture of five major currencies - the US dollar, the French franc, the D-Mark, the pound sterling and the yen.
You won't see SDRs being spent in stores. The IMF allocates them to governments and they can count them as part of their foreign exchange reserves. It was thought that they might be a painless way of giving money to poor countries. But in fact they have been distributed to all members largely on the basis of quotas.
When handing out dollars or SDRs the IMF asserts that it does so in a non-political way. Some people may find this puzzling. Chileans, for example, will remember that while socialist President Allende was refused a standby arrangement the right-wing Pinochet regime had no difficulty in getting a loan when it seized power'.
Being refused money by the IMF has implications beyond the immediate loss of the loan. It is then quite difficult to get funds from elsewhere: the IMF's attitude serves to define the credit-worthiness of a nation.
1 The IMF and the Debt Crisis. Körner et al. Zed Books. 1986