I. Evolution and Shortcomings of the International Financial System

1. A historical overview of the international financial system

The development of the international financial system is closely related to transnational trade and the flow of international capital. Although trade relations between the Eastern and the Western world date back a very long way, it was after trade routes expanded during the Age of Discovery, with the opening of new sea routes and international division of labor, that the international financial system came into being.

Originally gold and silver were used as instruments of payment in international trade, and therefore the system of the time was called bimetallism, meaning that each nation set a fixed rate at which their own currency could be exchanged for gold or silver. By doing so, the price relations between gold and silver were actually confirmed by the authorities. In the 1850s gold became less scarce as huge amounts of gold newly discovered in America and Australia were imported to Europe, and the metal’s actual value declined to a certain extent compared to that of silver. Silver, whose actual value was higher than its statutory value, was withdrawn from circulation.

In the mid-and-late 1870s, nations such as Great Britain, France and the US enacted laws to ban the free coining of silver, and therefore the international monetary system progressed to a gold standard system, which lasted until the outbreak of World War I in 1914. Under this system, each nation determined the gold content of its currency, committed to buying and selling gold in any amount at this exchange rate in a continuous manner, and at the same time gold could be freely exported and imported. Since the gold content of the currencies of various nations was fixed, the exchange rate was thus fixed. In actual practice, during the period of the gold standard, the exchange rates among the major powers did indeed remain relatively stable, which created a favorable environment for international trade and investment. Within the framework of the gold standard, when a nation had a trade surplus, i.e. exports outstripping imports, there would be a net import of gold of an equal value leading to an increase in the price levels of products from the trade surplus country and gradual recovery of trade balance. The gold standard had its problems, however. To begin with, the earth offers a limited supply of gold and the whole globe would be confronted with a pressure of deflation due to economic growth. Secondly, it was impossible to prevent governments from abandoning the gold standard for political purposes or other reasons. For example, Great Britain during the Napoleonic Wars and America during the Civil War both suspended the exchange between gold and paper currencies.

After the outbreak of World War I in 1914, Britain, France, Germany and other countries suspended the exchange for gold and prohibited its export, marking the end of the classical gold standard. Many countries suffered from hyperinflation, and a succession of predatory depreciation strategies brought about wild fluctuations in exchange rates. The gold standard was badly missed, and was revived for the stability it brought. The US and Britain reinstated the convertibility of their currencies for gold and lifted the gold embargo in 1919 and 1925 respectively. However, the onset of the Great Depression led to a collapse in confidence and gold convertibility was made impossible due to runs on gold. As a result, governments were forced to give up exchange for gold and set floating exchange rates again. Until the last days of World War II there was no global unified monetary system, so that speculation and exchange rate fluctuations undermined international trade and investment, and a new system was urgently needed.

In July 1944, delegates from 44 countries gathered in Bretton Woods in New Hampshire to discuss and determine the post-war international monetary system. The Bretton Woods system was thus created, together with two new international institutions, the International Monetary Fund (IMF) and the World Bank. This system was in fact a gold exchange standard, that is to say, the US bore the responsibility to maintain gold at a price of 35 USD per ounce and committed itself to fulfilling, at any time, the demands of exchanging the USD for gold at such a price. Other countries set the parity between their domestic currencies and the USD and ensured that their exchange rates fluctuated within a 1% band of the agreed-upon parity by intervening in their foreign exchange markets. The IMF, on the other hand, supervised whether member states followed the various codes of conduct relating to international trade and finance and provided nations facing short-term difficulties in balance of international payments with credit assistance. If confronted with a fundamental disequilibrium, a state might alter the exchange parity of its domestic currency with the approval of IMF. In summary, the Bretton Woods system can be seen as an adjustable pegged exchange rate regime, which was intended to avoid a recurrence of the disorder in international trade and finance seen during the two world wars.

In the late 1950s, as post-war reconstruction was completed, Europe and Japan saw rapid economic development, while the US gradually turned itself from a trade surplus country into a trade deficit country and had to pay off its international deficit with large sums of USD. This is where the Triffin Dilemma came about: at 35 USD per ounce America’s gold reserves were insufficient to cover all the USD in circulation due to the ever-expanding USD stock, and a global crisis of confidence in the USD would undoubtedly be triggered, resulting in a run on gold, and ultimately leading to a breakdown of the system. On August 15, 1971, the US government declared a termination of the USD-gold exchange; in 1973, a succession of monetary authorities in Europe, Japan and other countries also decided to abandon the fixed exchange rate under the Bretton Woods system, and allowed floating rates instead.

In January 1976, the IMF member states met in Jamaica and signed the Jamaica Agreement. The prevailing managed float regime was officially established, under which nations can adopt floating exchange rates, and intervention with foreign exchange markets to settle gratuitous fluctuations is allowed. With this system, various nations still need their international reserves to intervene in the foreign exchange markets; while the USD is the most important global international reserve since the US ranks first in the world’s economy.Even to this day, the international monetary system remains an inheritance of the Jamaica Agreement, and various nations have chosen different exchange rate arrangements, from giving up independent legal tender, through a complete dollar peg, to a crawling peg, and ultimately to a free floating exchange rate.

With deeper international labor division and trade comes the development of cross-border investment and finance. Many multinational corporations set up production facilities outside their homeland, which is called foreign direct investment (FDI). According to a UN survey, the growth rate of global FDI stocks is double that of global trade. In addition the World Bank, which was founded at the Bretton Woods Conference in 1944, has witnessed a shift of mission: from promoting post-war reconstruction to advancing the cause of poverty-reduction in nations worldwide, and to providing low-interest loans, interest-free loans, and grants to developing countries in order to support investment in fields such as education, public health, pubic administration, infrastructure, agriculture, environment, management of natural resources, and the development of financing and private sectors.