GLOBAL MONETARY SYSTEM

Global Monetary System and Foreign Exchange-What to DO?



Global Monetary System and Foreign Exchange-What to DO?

Introduction

A foreign exchange market is the institution for the exchange of one state's currency with that of another state; actually, “the market” is made up of many different markets because the trade between individual currencies—say, the euro and the U.S. dollar—each constitutes a market. The foreign exchange (or forex or FX) markets are the original and oldest financial markets and remain the basis upon which the rest of the financial structure exists and is traded in: Foreign exchange markets provide international liquidity, preferably with relative stability. There are two key related governance issues: (1) systemic governance, that is, the international monetary system, and (2) the governance problems faced by individual governments given the currency markets.

Discussion

The foreign exchange market is a twenty-four-hour over-the-counter (OTC) and dealers' market, meaning that transactions are completed between two participants via telecommunications technology. The currency markets are also further divided into spot markets—which are for two-day settlements—and the forward, swap, interbank futures, and options markets. London, New York, and Tokyo dominate foreign exchange trading. The currency markets are the largest and most liquid of all the financial markets; the latest triennial figures from the Bank of International Settlements (BIS) put daily global turnover in the foreign exchange markets at $1.9 trillion in April 2004. It is sobering to consider that an annual world trade's foreign exchange is traded in just less than every five days on the currency markets, although the widespread use of hedging and exchanges into and out of vehicle currencies—as a more liquid medium of exchange—means that such measures of financial activity can be exaggerated (Bank for International Settlements, 2005).

The original demand for foreign exchange arose from merchants' requirements for foreign currency to settle trades. However, now, as well as trade and investment requirements, foreign exchange is also bought and sold for risk management (hedging), arbitrage and for speculative gain. Therefore, financial (Bank for International Settlements, 2005), rather than trade, flows act as the key determinant of exchange rates; for example, interest rate differentials act as a magnet for yield-driven capital. Thus, the currency markets are often held to be a permanent and ongoing referendum on government policy decisions and the health of the economy; if the markets disapprove, they will vote with their feet and exit a currency. However, debates about the actual versus potential mobility of capital remain contested, as do those about whether exchange rate movements can best be characterized as rational, “overshooting,” (Bank for International Settlements, 2005) or speculatively irrational. Certainly more needs to be done on the actual causes of foreign exchange movements.

Historically, different international monetary systems have emphasized different policy mixes; for instance, the Bretton Woods system emphasized the first two at the expense of free capital movement (Mosley, 2004). The collapse of the system destroyed the stability and predictability of the currency markets. The resultant large fluctuations meant a rise in exchange rate risk (as well as in profit ...