M A Eco s4, p4&5 (Opt MB) U2, Eng

Class : M.A.
I (Economics) Semester : 4
Paper : 4&5 (Opt.III Money & Banking) Unit : II
Medium : English
Lesson No.
2.1 : International Monetary System: Bretton Woods
System and Its Breakdown.
2.2 : International Monetary Fund (IMF)
2.3 : International Bank for Reconstruction and

Development (IBRD/ World Bank)
2.4 : International Financial Institutions (IDA, IFC, MIGA, ADB)
2.5 : International Banking
Department website : www.pbidde.org

M.A. (ECONOMICS) SEM. IV PAPER- ECO 404-405 (OPTION-III)
MONEY AND BANKING
LESSON NO. 2.1
INTERNATIONAL MONETARY SYSTEM

(Bretton Woods System and Its Breakdown)
International monetary system includes any form of prevalent order

according to which exchange and trade take place between various countries
of the world. The basic purpose of any such system is to make possible an
efficient allocation of world's real resources and to facilitate efficient trade
in real goods and services. International monetary system helps in achieving
greater international division of labour and specialization and facilitates the
process of exchange between the countries.
Main Functions
Dom estic monetary system of a country helps in achieving efficient
allocation of resources and greater division of labour by facilitating the process
of exchange. The inte rnational monetary system has to play this role at
international level. But unlike the monetary system of a country, international
monetary system lacks the strong political backing of the government. It has
to d e p e n d o n t he w i l l i ng c o o p e rat i o n o f i n te rn at i o n al c o m m u ni t y . F o r
successfully helping international economic growth and trade, international
monetary system has to perform following functions :
1. I nternational m onetary sys tem must create an international
medium of exc hange and payment (Anything which serves as medium of
exchange at international level constitutes international liquidity).
2. International medium of exchange should have stable value so
that it creates confidence in itself in the world community.
3. International medium of exchange should be in adequate supply
so that neither there is scarcity nor surplus of international liquidity.
4. The medium should not provide undue advantage to any one
country in the form of seignorage.
5. I t should provide stability in the international economic
r e l a t i o n s b y m a k i n g a r r a n g e m e n t s f or c o r r e c t i n g b a l a n c e o f p a y m e n t
disequlibrium, and stability in exchange rates.
Broadly speaking, international monetary system can be of two types.
First, it can leave the determination of exchange rate completely to market
forces. The balance of payments would fade into background in such a system
since it would at all times be instantaneously adjusted by changes in the
exchange rate.
1
M.A. (Economics) Sem. IV 2 Option : Money & Banking
Secondly, an international monetary system may be based on fixed exchange

rates, with attendant problems of adjusting balance of payments by means other
than exchange rate fluctutions.
Background of Present International Monetary System
The present international monetary system is a product of evolution as
well as deliberate planning. The dominant centre of international trade and
finance was London. Sterling and other currencies were freely convertible at
given ratio into gold, which was the basis of their convertibility at fixed rates
a into each other. There was no major currency crisis during that period, and
no major currency had to be devalued or revalued. Disequilibrium in balance
of payments was promptly corrected; the system worked successfully, and
international trade and finance flourished during this period.
Gold and sterling constituted international liquidity. Growth of world
stock of gold for monetary use and sterling balance contributed to growth of
international liquidity. Sterling balances could be acquired by countries
outside U.K. through various forms of loans from U.K. or by way of a balance of
payments surplus. Britain's position as an international investor facilitated
the flow of sterling into even the remotest corners of the world. Whoever
c o nt r o l l e d t he av a i l a b i l i t y o f s te rl i n g b al a nc e c o n tr o l l e d a n i m p o rta n t
component of international liquidity. This was done by the Bank of England,
whose dominance in international monetary affairs was almost legendary
during this classical period of gold standard.
World War I gave a serious blow to the British leadership from which it
never recovered. The war efforts forced Britain to sell parts of her foreign
investments. Capital was badly needed to revitalize exhausted industries and
it was, therefore, no longer available for overseas investment. The place of
U.K. began to be taken up by the United States. In short the world economy
had undergone a fundamental shock which would require major realignment
in the relative positions of most of the countries. During first half-decade after
the war, the international monetary situation was too unsettled to suggest
even the existence of a monetary system. It was a period of temporary transition.
Exchange rates had to float because no one knew just how to stabilize them in
the face of the great upheaval the world had just witnessed.
The mid 1920's saw a concerned effort by major nations to re-establish
the gold standard in essentially its old form. The world economy was taken
over by the crisis created by the great depression. One can conclude that in
the period between the two world wars international monetary system did not
work successfully. This was a period of turbulence because of transition from
international order under British leadership to an era of nationalism.
International Monetary System since World War II

The Second World War brought an end to the existing order. The world
underwent a fundamental shock to its economic structure and this resulted
in a realignment of economic relations between various countries. The U.S.
emerged as the leader of the western world.
During war the U.S. supplies of armaments and essential consumer goods
provided material backbone of the allied war efforts. After war the U.S. provided
economic aid for reconstruction of European economies. Simultaneously the
end of the war brought in process the disintegration of colonialism; and an
era of national independence for colonies began. In this situation of protection,
Western economic interests in the colonies on the way to achieve
independence became a serious question in this situation. Western countries
conv e ned a confe re nce at B re tton W ood s i n 19 4 4 to d e sig n a work a b le
international monetary system. The conference was attended by the
representatives of 44 “United and Associated Nations”. The task was to restore
an international m onetary order w hich had b een s cattere d by economic
depression and war. At the conference, two proposals were submitted. British
proposal was prepared by J.M. Keynes, the world renowned economist, and
U.S. proposal was prepared by Harry Dexter White. Ultimately, the U.S. proposal
was accepted and the British view was accommodated into it. The result of
this conference was a comprehensive blue print of an international monetary
system. This sought to combine certain features of the old gold standard with
a greater degree of flexibility and some measures of control over international
liquidity. Under Bretton Woods Agreement, International Monetary Fund (IMF)
was created for governing international monetary system. Article I of the
Agreement states the following objectives of IMF :
1. To promote international monetary co-operation through a permanent
institution which provides the machinery for consultation and
collaboration on international monetary problems.
2. To facilitate the expansion and balanced growth of international trade
and to contribute thereby to the production of and maintenance of high
levels of employment of the productive resources of all members as
primary objective of economic policy.
3. To promote exchange rate stability, to maintain orderly exchange
arrangement among members, and to avoid competitive exchange
depreciation.
4. To assist in the establishment of a multilateral system of payment in
respect of current transactions between members and in the elimination
of the foreign exchange restrictions which hamper the growth of world
trade.
5. To give confidence to members by making the Fund's resources available

to them under adequate safeguard, thus providing them with opportunity
to correct maladjustment in their balance of payments without resorting
to measures destructive to national or international prosperity.
6. In accordance with the above, to shorten the duration and lessen the
degree of disequilibrium in the international balance of payments of
members.
For playing this role, it was decided to create a fund or a pool of many
different currencies on which individual countries would be able to draw in
times of need. Each country deposits its quota with the IMF, 25 percent of
which must be deposited in gold or U.S. Dollar, while the remaining 75 percent
is in country's own currency. Equipped with deposits of gold, dollar and all
member currencies, the fund could begin its operations. The IMF sells a
particular foreign currency to a country, which needs that currency for this
pegging operation in the foreign exchange market. The buying country pays
with its own currency. These purchases are more properly viewed as foreign
currency loans, since the buying country is expected to sell these foreign
funds back to the IMF with the period upto three to five years. A country can
automatically borrow upto 25 percent of its quota. This automatic drawing
right is called a country's gold tranche*. Borrowing in excess of the gold
tranche is possible, but not automatic. Such borrowing falls into a country's
credit tranche. In order to make credit loans, the IMF has to be persuaded
that borrowing country is taking appropriate steps to adjust its balance of
payments deficit. This persuasion becomes more difficult as the credit tranche
percentage increases. When the IMF's holding of a country's borrowing has
reached 200 percent of its quota, this country has reached the limits of its
credit tranche. In addition, IMF collects a service charge on all drawings.
This charge rises with percentage of its quota a country wishes to borrow, and
with the length of time a drawing has been outstanding.
IMF and International Liquidity
International liquidity includes the official reserves which include the
gold held by the central banks, foreign currency held by central banks or
t r e as u r i e s , b o r ro w i n g f a c i l i ti e s a v a i l a b l e f r o m i n t e r n a t i o n a l m o n e t a r y
institutions. Drawing facilities are available from the Fund under different
schemes and financial assets which are mobilised when need arises. One of
the functions of the IMF is to provide adequate supply of international liquidity.
Und e r the F und s y stem , there are v arious com p o ne nts of internati onal
* (Now it is called reserve tranche)

liquidity.
1. Official Holdings of Monetary Gold.
2. Foreign Exchange Reserves and
3. Special Drawing Rights (SDR's)
W ith ex p a ns i on of w o rl d trad e , d e m an d f o r i nter nat i on al l iqui d ity
increases. This requires corresponding increase in the supply of various
components of liquidity. But under IMF system, expansion in the liquidity
has not kept pace with expansion of international trade. This resulted in
continuous decline in the ratio of reserves to imports. This ratio stood at 37
p erc ent in 1 96 6 , wh ich d ecl ined to 25 p erc e nt i n 19 78 . This p oi nts to
inadequacy of international liquidity.
The Fund has been dealing in global liquidity and the principal source
of supply of balance of payments credit for most of its members, with its total
quotas of SDR 39,0165 billion and borrowings made from the members under
different schemes. The Fund is an important source of international liquidity
of its memb ers . First is unc onditional liquid ity which m emb ers c an use
au tom atic ally . T his is a d raw ing fac ili ty und e r g old tranch e. Seco nd ly ,
conditional liquidity, the use of which is subject to certain conditions imposed
by the IMF, includes drawings under credit tranche. Besides one gold tranche
and four-credit tranche, the members have access to permanent facilities for
specific purposes, like compensatory financing, buffer stock financing facility
and extended facility. The Fund also makes available temporary facilities to
its members with borrowed resources.
Special Drawing Rights
The Special Drawing Rights scheme was first agreed in 1967 and ratified
in 1969. SDR is a kind of paper gold created by IMF. It amounted to SDR 21.4
billion by January 1981. Under the SDR scheme, each member is entitled to
participate in the Special Drawing Right Department. The member participating
in the SDR's is able to use its holding of SDR's when facing balance of payment
difficulties. This enables the country concerned to obtain convertible currency.
The use of SDR's allocated to members is unchallengeable. This means SDR's
are a form of unconditional liquidity.
T hus , d raw i ng f ac il itie s un d e r d i f f e re nt t ranc he s an d SD R' s are a
component of the international liquidity. The major source of international
liquidity remains the reserves of foreign exchange and gold. Monetary gold is
growing at a very slow rate. The only component with flexible supply that
remains is reserves of foreign exchange. It can be said that all components of
liquidity under the IMF system have failed to keep pace with expansion of
world trade. Therefore, there is a problem of inadequacy of international
liquidity.
U.S. Balance of Payments and International Liquidity
U.S. dollar is used as the main key currency in the world today (other
being the pound sterling but it is less important). The supply of dollar in the
world depends on the U.S. deficit in balance of payment. This is essential for
the proper functioning of the international monetary system. The increased
dollar supply in the world market amounts to U.S. liabilities abroad. To
maintain convertibility of dollar into gold, the U.S. had to increase her reserves
of gold. The U.S. failure to do that created a problem of confidence in the
dollar. This ultimately led to devaluation of dollar and instability in the value
of the most important component of international liquidity. The net increase
in gold stock is only about 2 percent per year and the increase in liquidity
has to be greater if the international monetary system is to function. The only
way international liquidity can grow under the present set up is by increase
in dollar holdings through increased U.S. balance of payments. But increased
U.S. deficits make the dollar a weak currency and undermine its status as a
key currency. Thus, the present international monetary system is based on
an internal contradiction. Secondly, the U.S. can create international liquidity
b y p ri nt ing m o re d o ll ars wh e re as o t he r c o u ntri e s e a rn i t b y e x p o rti n g
commodities. Therefore, the present system provided undue seignorage for
the U.S. vis-a-vis other countries.
Working of the Bretton Woods System
The Bretton Woods system was an expression of power relations between
the U.S. and its allies. It contributed greatly to be consolidation of U.S.
hegemony and dominance-dependence relationship between the U.S. and
othe r countrie s, which joine d IMF sy stem . Sovie t Un ion and other Eas t
European countries, which joined it later on, withdrew from IMF. Since U.S.
dollar was held outside the U.S.A. as a universally accepted means of payment
and asset, Washington was in a position to increase the money supply without
giving rise to significant inflationary pressures at home. The U.S. retained its
privileged position in this respect for 20 years.
Till 1967, the U.S. was almost always in surplus in its trade balance.
From monetary angle, this supplied the world community with international
liquidity. But its economic and political consequences were questionable.
The dollar outflow financed enormous direct and portfolio investment abroad
on the part of U.S. Multinational Corporation, which has enabled them to
acquire large sections of the productive capacity of Western Europe and the
Third World. Military expenditure abroad and bilateral loans reinforced the
U.S.Military might, as well as political influence. From economic viewpoint,
they also b ooste d U.S. ex ports and contrib uted to a large ex te nt to the
maintenance of the U.S. trade surplus. Dollars received by a country found
their way primarily to central banks, which put them against currency thus
increasing domestic money supply. The French government rightly qualified
it as U.S. export of inflation to other countries.
Since mid 1960's, the economy faced stiff competition from the Western
Europe and Japan. In the world market, U.S. deficit in balance of payments
increased tremendously. The U.S. authorities relied on the privileged position
of dollar and allowed these deficits to persist. The U.S. became the most
indebted country of the world. The holding of dollars by private banks outside
the U.S. created Eurodollars in huge quantity. This began to create panic,
pushing holders of dollars to ask for gold.
I n the m eantim e, ag reement was reac hed on the nee d to create an
international reserve asset, which would take some of the burden of expanding
international liquidity from the U.S. dollar. The new asset took the form of
Special Drawing Rights (S.D.Rs) : Agreement on establishment of S.D.Rs was
reached in 1967 and ratified in 1969. While the S.D.Rs scheme may be seen
as a step in the right direction, its inadequacies in relation to the need are
evid ent.
Creation of SDR's could not save the system. In August 1971, the U.S.
administration announced a unilateral decision to suspend convertibility of
gold. In December of the same year, the Smithsonian Conference of the Group
of ten (G-10)* decided on a general realignment of parties which introduced a
new form of revolution. In March 1973 industrialized countries introduced
the practice of floating exchange rates modified by central bank intervention.
Floating rates were in violation of the provisions of IMF concerning par values
and exchange stability, but this did not raise any protest from the IMF. Instead,
IMF bodies were given the task of legitimizing "managed floating" of exchange
rates through an amendment of the article of Agreement.
It is now acknowledged that the international monetary system
instituted at Bretton Woods did not work satisfactorily. A need was felt to
reform and reconstruct the international monetary system.
Plans to Reform International Monetary System
There were many proposals to reform the international monetary system.
We briefly describe the following proposals :
1. Harrod Plan;
* G-10 includes United States, Canada, Japan, Belgium, France, Italy,

Netherlands, Sweden, U.K. and Germany.
2. Keynes Plan;
3. Bernstein Plan and;
4. Triffin Plan;
1. Harrod's Plan : Harrod, the British economist, argued that a
substantial increase in the price of gold would solve the problem of
international liquidity. For instance, doubling the price of gold will double
the value of the monetary stocks in gold. This will lead to large increase in
world liquidity . The increase in the price of g old also imp lies worldwide
devaluation of currencies. It is also argued that this will lead to increase in
the production of gold on the one hand and dishoarding of gold on the other.
All these factors, it is added, will increase international liquidity. This proposal
had several drawbacks.
(i) It will benefit a small number of countries, which have a large stock of
gold. South Africa and the (former) Soviet Union would be the main
beneficiaries as they are the largest producers.
(i i) It will go against those who have co-operated with the present system
by holding reserve currencies.
(iii) Doubts are also expressed on the increase in the stocks of monetary
g old.
(iv) This will lead to inflationary pressures in the world economy.
To sum up, an increase in the price of gold will hardly solve the problem
of international monetary system.
2. Keynes' Plan : This was proposed in 1943 as a background for
the discussion of how the international monetary system should be organized
after the World War II was over. A central feature of this proposal is the
establishment of a clearing union. It aims at creation of an international
Central Reserve Bank. A new international currency unit, called bancor, with
a fixed value will be created. Holding of foreign currency will be abolished.
Gold will be used for international monetary purposes. Thus, when the system
was fully developed, only two means of international payments will be in use;
gold and bancor. A country can acquire bancor in two ways. It can sell gold
or use its overdraft facilities with the clearing union. The exchange of gold
and bancor is one way i.e. gold can be used to acquire bancor, but bancor
cannot be used to buy gold.
Keynes' plan is based on the concept that deficits or surplus in balance
of payment change in cyclical fashion. A deficit country can borrow from the
clearing union by using overdraft facilities. Each member has a quota in the
union depending on the sum of its imports and exports. If a country uses
more than one fourth but less than half of its quota it will pay a charge of one
percent per year on its borrowing. If it uses more than one half of the quota, the
charge will be 2 percent. An interesting feature of the plan is that the surplus
countries too will have to pay a charge if they are excessively liquid. If a surplus
country has a credit balance with the union of more than one half of its quota, it
will have to pay a charge of one percent per year.
The basic philosophy behind the plan is that external imbalances are of
a cyclical and short-term nature. Connected with nature of imbalances is the
adjustment mechanism, which works through expenditure reducing for deficit
country and expenditure increasing in the surplus country. Capital
movements can also play the same role, which are encouraged by the Keynes
Plan. Another feature of this proposal is that it makes no provision for gradual
long-term increase in international liquidity. The perfect state it envisages
is th at all ex te rna l b ala nc e s are in equ ili b ri um w he re no in ternation al
liquidity is needed.
3. The Bernstein Plan : The central theme of this plan is to give
IMF a large place in the present international monetary system. It intends to
extend the operation of IMF. It is suggested that IMF quota should be integrated
into each country's working balance and as a result, amount of international
liquidity will increase.
It suggests creation of Reserve Unit of Account within the IMF. The
country should deposit its own equivalent currency with the reserve unit
account department to get these units. The unit would then be used in
settlement of balance of payment accounts. The creation of these units would
be a way of institutionalizing capital movements.
According to this proposal, international liquidity can be increased. This
can be done by increasing the total amount of reserve units.
This proposal has many attractive features. It is based on the existing
institutions and is a feasible proposal. The main drawback of the proposal is
that it does not solve the confidence problem. Reserve units will have to be
guaranteed in gold value. In absence of this, chances of the system breaking
down are much greater. There are problems connected with interest charges
from the deficit and surplus countries.
4. The Triffin Plan : Like the Bernstein Plan, the Triffin Plan also
starts from the IMF and seeks its extension. But it is a more ambitious plan.
Triffin has attacked the irrationality of a system so dependent on gold. He has
argued that sooner or later, paper money will replace present hybrid system
with its element of community money.
The basic solutions to the problem of international monetary system lies
in a centralization of world reserves. Members of IMF will have to start opening
deposits with the IMF which will act as the Central Bank. The deposits will
originally be created by a transfer of existing reserves from the central banks
to the Fund. The IMF will get reserves and the central banks will be credited
with deposits with the IMF. The deposit with IMF will carry a gold guarantee.
Triffin suggests that members be required to hold at least 20 percent of their
total reserves as deposit with the Fund. In due course of time, IMF will expand
act iviti es an d wi ll ac quire inte rnati onal re se rv es in th e for m of fore ign
currency. It will be permitted to gradually liquidate its holdings of those
currencies and in the end , there will be only two means of international
liquidity : deposits with IMF and gold.
This plan empowers the Fund to engage in open market operations to
regulate international liquidity. The increase in the securities portfolio of
the IMF can be used to increase international liquidity. To avoid inflationary
expansion, Triffin suggested annual increase of monetary reserves, something
like, 3,4 or 5 percent per year.
The major weakness of this plan is that Triffin retains gold as a means of
international liquidity. Any move to convert IMF certificates into gold can
create serious confidence problems. Triffin moves in the direction of a World
Central Bank. This seems utopian.
On a pragmatic level, it can be argued that there is little reason to believe
that countries will be willing to surrender their sovereignty over an important
part of their economic policy to IMF.
II
INTERNATIONAL LIQUIDITY :
The late Jacobson said, “By liquidity, I understand the supply of credit
in national currencies as needed to finance and provide the means of payment
for trade and production. “International liquidity consists essentially of the
resources available to national monetary authorities to finance potential
balance of payments deficit. It may consist in the possession of assets like
gold, foreign exchange, and in the ability to borrow internationally. Thus, in
its international setting, liquidity includes all those assets including SDR's,
which are generally acceptable without loss of value for settling international
debts. It may include the following :
Gold stocks with Central Banks and with the IMF, foreign exchange
reserves of countries, drawing rights of member countries with IMF, credit
arrangement between countries, country's capacity to borrow in the money
markets of another country, accumulation facilities (these arise when a foreign
country accepts payment of debts in debtor's currency like sterling balance
accumulated during World War II, Euro Dollar, SDRs etc.
Problem of International Liquidity

There is no agreement among the economists about the true nature of
the problem of international liquidity. Some economists feel that the problem
i s qu a nt it ati v e an d i s o f th e i na d equ acy o f th e m ea n s of in te rna tio na l
payments. Others feel that the problem is qualitative in nature and pertains
to the form and composition of international reserves for liquidity purposes.
There are others who present the problem of international liquidity in a
different way—they clain that the problem is more of confidence. It arises due
to lack of adjustment on account of fixed exchange rates (as had been the case
under Bretton Woods System till 1976).
According to them, the problem is one of adjustment. It may be true that
a part of the problem of international liquidity (that is providing the means of
international payments) may be that of confidence and adjustment. But it is
mainly the problem of inadequacy of reserves to cope with the expanding
requirements of international trade. It has been found that the growth in the
liquidity has not kept pace with the growth in the world trade. During the
sixties and the seventies, the world trade almost doubled in a decade but the
world reserves increased by hardly 25 percent to 30 percent in a decade and
even this increase was unevenly distributed not only amongst developed
countries but also between developed and underdeveloped countries, thereby,
causing a serious shortage of international liquidity. The average annual
increase in world trade in the decade 1960-70 was 8% to 10% while the
annual average percentage change in reserves was hardly 3% between 1960-
70. International monetary arrangement, based on gold or gold exchange
standard or dollar and sterling as international reserves, could no longer
i ns p ire c o nf i d e n ce and p ro v i d e f or in c re as e d qu antu m o f i nte rna ti o na l
liquidity on account of expanding world trade. Apart from this, the most
baffling has been the problem as to the form the new international reserve
assets should take. Opinions differed in the past amongst leading countries
as to the true nature and form of the new international reserve asset.
Problem of Adequacy :
It is rather difficult to determine as to what will constitute the adequate
level of international liquidity under the dynamic conditions of expanding
world trade and growth in developing economies. It is said that the quantum
of international money needed by the world depends on the size of
international trade, that is, more trade will require more money to finance it.
But this is not true because trade is not financed normally by reserves.
International reserves finance not the volume of international trade but the
balance of payment deficits. The amount or the quantity of international reserves

needed, therefore, varies with the size of the swings in the balance of payments.
It may, therefore, be said that in a sense, the aggregate needs on international
liquidity are in one way related to factors like world trade, capital movements
and imbalance in balance of payment. But their adequacy is also affected by
psychological attitudes towards what is minimum or desired levels or natural
reserves by reserved movements and by the use of available credit facilities.
Because other influencing factors cannot be quantified, growth in imports seems
to be the most relevant indicator of the need for reserves. According to Triffin,
“The ratio of gross reserves to annual imports is the first and admittedly rough
approach to the appraisal of reserves adequacy.” But it is not easy to determine
the correct ratio of gross reserves to annual imports. It will thus be seen that the
factors, which determine the adequacy of international liquidity, are, in practice,
not precisely measurable. It is not simply a matter of arithmetical relationship.
B ro a d ly s p e ak i n g , t h e qu e s t i o n o f ad e qu a cy o f l i q u i d i t y , n at i o na l an d
international, is a matter of judgement, depending on the economic circumstances
prevailing in a country, on the time and on the purpose for which the reserves
are to be used. We may conclude that a country will regard its liquidity or reserves
as adequate when, in its opinion, the level of liquidity or reserves are sufficient
to meet unforeseen deficits in its balance of payment without adopting restrictive
policy affecting economic growth and international trade.
Importance :
The importance of international liquidity lies in providing means by
which dise quilib rium in the B OP s of d iffere nt countries particip ating in
i n te rna ti o n al tra d e i s s et tl e d . A s s u c h, i t he l p s i n the s m o o th f l o w o f
international trade by facilitating the availability of international means of
payment. It must be understood that these means of reserves are used to finance
deficit in the BOPs. These reserves are not used to finance the inflows or
outflows of trade. Changes in the balance of payments to temporary deficits
and surplus must be met by transfers of gold, convertible currencies or
international borrowing facilities. All these go to constitute international
liquidity. The greater the stock of these items of international liquidity held
by any country and by countries in the aggregate, the less will be the need for
changes in ex change rates. I n a world, in which there are consid erable
fluctuations in economic activities, accompanied by a growth demand for
stability the importance of international liquidity reserves lies in serving as a
buffer, giving each country some leeway for the regulation of its national
income and employment and providing it with a means to soften the impact of
economy fluctuations arising on account of international trade and
transactions. A greater world holding of international liquidity reserves becomes

necessary to maintain stable exchange rates over the whole business cycle than
to meet any seasonal or short run fluctuations. It is in this sense that adequacy
or otherwise of foreign liquid reserves is an important determinant of the levels
of world trade and economic activity. If there are enough or sufficient international
liquid reserves, specially with those countries which are likely to incur deficits,
there will be less worry or panic for adjustment. On the other hand, if there is
too little international liquidity in the world, deficit countries will have no or
little time to adjust and they will be forced to impose restrictions on trade and
capital movements. As a result, the world growth is turning the terms of trade in
an unfavourable manner for developing economies. Easy access to international
liquidity reserves makes it possible for the swings in the balance of payments to
be financed, otherwise, the world trade may be strangled for want of international
liquidity. It implies not only sufficient quantity but the right composition and
distribution of international liquidity reserves.
International monetary system based on IMF or Bretton Woods system
had been the chief source and mechanism by which international liquidity
had been provided in the past. It was one of the main objectives of the IMF.
The Fund, since its inception, had been trying hard to cope with the problem
of international liquidity, in various ways, that is, by increasing quantity, by
chang ing the c om position and by ensuring equitable d istribution of the
available sources. The fund managed the various forms and means of providing
international liquidity like gold, foreign exchange, quotas and other borrowing
facilities and credit arrangements. There is no disagreement amongst the
ec onom ists tha t t he I M F m ust s ome how b e s o re form ed as to a ug m e nt
international liquidity. In fact, the IMF continues to hold a commanding
position on two fronts, exchange stability and international liquidity. Its
attempts and achievements in fostering the growth of international liquidity
have, no doubt, been impressive but a bigger and more important rule lies
ahead in making need based allocation of quotas and SDRs.
Exchange Rate Adjustment
Exchange rate adjustment is an important method of coping with the
problems (shortage or otherwise) of international liquidity. The pertinent fact
still remains that adjustment must occur, failing which any kind of monetary
or reserve arrangement will collapse. Concentration on liquidity problem and
its solution through satisfaction with the ways the adjustment mechanism is
working. Quite apart from the quantity or reserves, an adjustment mechanism
between different economies is also essential. An arrangement of sufficient
reserves but fixed exchange rates could not be enough because it meant a
persistent imbalance between a weak and a strong currency. Under IMF system
countries were allowed to adjust their exchange rate upto 10 percent without
consulting the Fund and if a country could prove that it had a fundamental
disequilibrium in the BOPs, it was allowed to depreciate its currency by more
than 10 percent. But the circumstances during the sixties and the seventies
rendered the Bretton Woods system of par value and fixed exchange rates
entirely useless. Experts like Machlup, Mundell, Bernstein, Triffin, Harberler,
Friedman and Meade supported the case for flexible and freely floating rates
to overcome the problem of international liquidity through exchange rate
adjustments. The IMF system of fixed exchange rates broke under the stresses
and strains of an unbalanced development of the world economy, especially
during the seventies in disorderly movements of short-term capitial.
As a result, there had to be a transition of the present system of floating
and flexible exchange rates, which was fairly swift. As the picture emerged,
31 currencies were floating while 86 currencies used some peg or the other;
55 were pegged to the U.S. dollar, 13 to the French Franc, 4 to the pound
sterling, and 3 to other currencies. Some countries peg their currencies to a
composite of the currencies of their main trading partners. Under the ‘Jamaica
Plan’ of March/June 1976, gold stands dethroned. The Jamaica Plan, no doubt,
provided a freedom of choice but not a freedom of behaviour. The new Articles
of the Fund establish a set of obligation, both for the members and for the
Fund's regulatory role as regards exchange rates, by exercising firm
surveillance over member's policies and actions regarding exchange rates.
Und er t his surv eillanc e the Fund wi ll see the cou ntries p ursue ord erly
exchange arrangement and a stable system of exchange rates, and must avoid
manipulating exchange rates to prevent effective BOPs adjustment or to gain
an un f ai r c om p et i ti ve ad v an ta g e . T h e F und w il l b e a b l e to re c o m m en d
ex c han ge arrang em e nts that are in conform ity w ith t he d e velop m ent o f
international monetary system.
Under the Jamaica Plan, the Fund has also tried to increase the overall
i n te r n ati o n al l i qu i d i ty b y s u p p l e m e nt i ng a nd i n c r e a s i n g the s u p p l y o f
c o n d i ti o n al l i qu i d i t y i n v ari o u s w a y s ; ( a) b y i n c r e as i n g q u o ta s , ( b ) b y
introduction of new credit facilities over and above the regular credit traches,
(c) by creating a new international reserve asset called the SDRs.
(a) IMF Quotas and International Liquidity
Each member of the Fund is assigned a quota. The subscription of each
member is equal to its quota.
Whenever international liquidity is to be increased, the usual way is to
increase the Fund's total resources by increasing quotas generally. Quotas
once fixed can be changed or adjusted according to variations in circumstances.

The IMF has reviewed the quotas of its members from time to time. Until now
the quotas were expressed in terms of gold or hard currencies but after the
Jamaica Plan, quotas would be expressed in SDRs. In March, 1976 Fund's
Governors voted for the 6th revision resulting in a substantial increase in Fund
Quotas. This expanded the resources of the Fund by about one third, from SDR
29.2 billion to SDR 39 billion thereby giving a fillip to international liquidity.
India's quota also increased from 940 million SDR's though in terms of overall
IMF reserves, India's quote stands reduced from 3.22 percent to 2.93 percent.
This may appear strange but India and other non-oil producing countries (rich
and poor) had agreed for a cut in percentage in order to enable the new rich oil
producing countries to benefit from percentage increase in accordance with their
newly acquired wealth. The sixth revision increased the Fund's resources by
33.6 per cent. The increase in USA's quota was nearly 25 percent, U.K's by 4
percent. France's by 28 percent, Italy's 24 percent, Japan's by 38 percent and
India's by 22 percent. But one unsatisfactory feature of distribution of quotas
and of international liquidity based on such distribution is the lack of equity
and uniformity amongst members. This revision did not make the distribution of
international liquidity in any way better in the past. Hence, the problem of
unequal distribution of international liquidity still remains.
(b) The Trust Fund and Credit Arrangements :
International liquidity has been augmented by what is called IMF reserve
position, also called' IMF Tranche Positions'. These have been an important
element of international liquidity. These reserve positions have been
increasing over the years. A member's IMF position in the Fund represents
the amount that a mem ber, facing balance of payment deficit m ay d raw
essentially automatically under the Fund's gold tranche. In other words, these
reserves of gold and credit tranche position in the IMF refer to the short-term
financial assistance to its members to meet balance of payments deficits. Under
gold tranche, a member could draw on the Fund without any question being
asked. It represented unconditional liquidity. After it, a member could draw
from the first or subsequent credit tranches, if the countries made reasonable
efforts to solve their problems by setting right the deficit. However, requests
for drawing beyond the first subscription was 25 percent of the quota, it
represented the gold tranche, and each credit tranche was equivalent to one
fourth of the quota. The Fund also provided liberal credit facilities, allowed
frequent waivers, stand by agreements, and general arrangements to borrow all
with a view to meeting the increased requirements of international liquidity.
Under the Jamaica Plan supply of liquidity has been increased by the Fund
also by the creation of new facilities. Before the Jamaica Plan of 1976, there was
the compensatory financing facility in 1963, the buffer stock financing facility in
1969, the Extended Fund facility in 1974 and the Trust Fund facility in 1976,
created out of the profits of gold sales by the IMF. Besides, fund also provided a
temporary oil facility, which was in operation in 1974 and 1975.
(c) SDRs and Jamaica Plan 1976
A number of confrontations took place between US and other countries
regarding the amount and magnitude of the creation of SDRs; till they finally
agreed to create $9.5 billions (about Rs. 7125 crores) worth new money (paper
gold) between 1970 and 1972 alongwith increase in quotas worth $6 million
to $ 7 million to solve the problems of international liquidity. In this way, for
the first time, a supplement of existing unconditional liquidity came into being
by a deliberate decision of the international community itself rather than
through an erratic accumulation of gold and reserve currencies. By March
31, 1973 out of 125 members of the IMF, 113 were participants in the SDR
scheme. During the course of its working, many limitations came to the surface.
For example, their quantity and the rate of growth were found to be inadequate.
T h eir natu re and sc op e and u se w ere fou nd l im i ted b ec ause they we re
available for meeting the balance of payments difficulties only. IMF had to
play an active role and direct designation. The distribution was found to be
unjust. Developed countries felt that their creation gave undue advantage to
developing economies and additional liquidity created by them was the main
caus e of glob al inf lation. Major d isagre em ent am ongs t m em b e rs of IMF
prevented the activation of the scheme for second basic period and this gave
a setback to the whole scheme. Developed countries argued that existing
reserves were in excess of needs and as such they had not been interested in
the cre ation of more SDRs. T he Fund allocated 40 32. 7 million SDR s on
January 1, 1979 to 137 members. India would receive SDRs 120 million each
year in the terms of its quota in the fund.
However, under the Jamaica or Kingston Plan, SDRs occupy a significant
place. Numerous changes have been made in the Articles of the Fund in March
1976 at Jamaica dealing with special drawing rights. As such the present
international monetary system may rightly be described as 'SDR' standard as
against gold standard or gold exchange standard or the dollar standard of
Bretton Woods System. SDR as the Fund's unit of account will be increasingly
used in international transactions. As such the reformed system envisaged under
the above reforms at Jamaica is an internationally managed system. Participants
will have full freedom to enter into transaction in SDRs without being subject to
some of the requirements in the present articles. The possible uses of SDRs
operations and transac tions have been expanded. The Fund will also be
empowered to permit more public (though not non-official) entitles to hold SDRs.
Lord Keynes, in his proposal for an International Clearing Union, wrote of the
need to establish “an instrument of international currency having a general
acceptability between nations." The amendment of the Articles of the Fund at
Jamaica continues the process of establishing the SDR as such and members
are required to collaborate with the Fund in pursuit of the objective of making
the SDR, the principal reserve asset of international monetary system. Its link
with gold has been given up. Gold is no more in the picture and stands dethroned.
In order to make SDR an effective international asset, there will be both
immediate changes in the characteristics of the assests and possibilities for
further development. Immediately; there will be far greater freedom for members
to engage in transactions by agreement in SDRs and much wider possibilities
for transfer of SDRs to and from the Fund itself. Official entitles will hold more
SDRs and engage in broader range of transactions than at present. Provisions
have also been made in the above plan for the Fund to permit new forms of
operations in SDRs, for example loans or grants, thus, helping to bring the
characteristics of SDRs closer to those of traditional reserve assets.
IInd Amendment to Fund's Article 1978
The second Amendment to the Fund's Article of Agreement came into
effect on April 1978. It generated important changes in the fund's activities
including surveillance over members, exchange arrangements, changes in
the role of gold and wider uses of the SDR, as well as important innovations in
the Fund's operations and transactions. In addition, the Fund's resources
were enhanced in 1978, when its Board of Governors adopted two major
resolutions, one of which enables members to raise their quotas in the fund
from the present equivalent of SDR's 39 billion to SDR's 58.6 billion as a result
of the completion of the Seventh General Review of Quotas; the other provide
for the allocation of SDR Department in the three years 1979-81. In addition,
the Fund Executive Board made further changes in the basket of currencies
that d e term ines the value of the SDR and estab lished a m ethod f or its
adjustments. Moreover, virtually all of the quota increases that were proposed
in February 1976 under the Sixth General Review of Quotas came into effect
in 1978 as a result of the completion of Seventh General Review of Quotas in
1978.
Other steps to improve the SDRs are in hand. SDRs can now be exchanged
freely among the participants against currency and such voluntary transfers have
already taken place on a large scale. In addition, the interest rate on the SDR
will be increased and it will be possible to use SDRs to settle obligations without
changing them first into currencies to lend SDRs, and to pledge them as security
for a loan by another central bank or Government. Further improvements are
high on the agenda. They include forward operations in the SDRs and swap of
SDRs and enlarging the number of official institutions that may deal in SDRs.
The last point is potentiality of great significance for enlarging the volume of
SDR denominated financing in the private markets, since many of the institutions
unlike in the Fund, have direct links with the private market. Once such
institution holds SDRs in their books, they are likely to increase their SDR
denominated liabilities by developing transactions in the private markets.
Conclusions
It is thus clear that the new international monetary system emerged out of
the present amendment of the IMF Article of Jamaica. The new articles are
complete in themselves and confirm the role of the Fund in overseeing the
international monetary system. They provide a much more workable basis for
the Fund's financial operations than the existing Articles. There are far reaching
changes in the field of exchange rates and the Fund is given a variety of powers
and possibility. In this respect the role of gold stands reduced and the role of
SDR is strengthened and the new Articles provide the Fund with powers so that
its ow n role , an d the m one tary sy ste m it sel f , can res p ond to c hang i ng
circumstances within an agreed legal framework. It is evident that the Fund will
remain at its centre circumstance. Any discussion of the future of the Fund after
Jamaica has to deal with two important and closely interrelated subject of
exchange stability and international liquidity. A bigger battle, however, lies ahead
i.e. a need-based allocation of quotas and SDR; the new Article put the SDR into
central place that was vacated by gold. The value of the SDR is no longer
determined in grams of gold but in terms of package of 16 currencies (and now
five major currencies only). Hence the Fund will continue to hold a commanding
position in the international monetary system and arrange for both adjustment
as well as increased international liquidity. It is, thus, wrong to say that with the
abolition of conventional Bretton Woods System (1946), the IMF is over. As a
matter of fact, IMF has been radically empowered to perform its new role in a
more effective manner under the dynamic circumstances of world economy. That
is why it is said that the new international monetary system is not evolving but
emerging as a result of Articles of Jamaica in 1976.
Summary :
1. The greatest problem is that of increasing the reserves of countries to
meet the BOPs difficulties, popularly known as the problem of
international liquidity.
2. International liquidity includes the resources and the means available
to national monetary authorities to meet the BOPs exchange, ability to
borrow internationally assets available to national monetary authorities
like gold,foreign exchange SDRs etc.
3. The problem of international liquidity arises due to lack of confidence,
adjustment and quantity. It also includes the problems of components
of international liquidity.
4. Its importance lies in providing enough means of international
payments to meet the requirements of setting international debt and of
meeting the BOPs difficulties.
5. IMF has been the main source of providing international liquidity by
increasing its quantum by changing compositions and by ensuring
distribution of the means of international payments.
6. Gold, which was the kingpin of the system stands dethroned. Gold is no
more an international asset nor the par values expressed in gold, Gold
revaluation as a solution for increasing international liquidity did not
work.
7. A flexible system of exchange rate adjustment is a must to cope with
the problem of inadequacy of international reserves. Fixed exchange
rates of the old Bretton Woods System have been replaced by flexible
rates under IMF control.
8. Under the Jamaica Plan of March 1976, IMF Articles have been amended
to establish a trust fund increase in quotas and credit arrangement of
the IMF.
9. Special Drawing Rights, called SDRs or paper gold is the new
international reserve asset, created in 1969. This new reserve asset
replaced gold.
10. Member countries can draw on the IMF and make use of these rights to
meet BOPs difficulties.
SUGGESTED READINGS
1. John Evans : International Finance
2. Bo Sodersten : International Economics
3 Vaish and Sudama Singh : International Economics
SUGGESTED QUESTIONS
1. Discuss Bretton Woods System.
2. Give the main funtions of international monetary system.
MONEY AND BANKING
LESSON NO. 2.2 AUTHOR : DR. M.L. SHARMA
INTERNATIONAL MONETARY FUND (IMF)

The collapse of gold exchange standard in the 1930's, competitive exchange
depreciation, exchange restrictions, wide fluctuation in the exchange rates,
discriminating trade policies, and general uncertainty about the medium of
international exchange were some of the factors responsible for economic
instability and decline in world trade in the post-world war period. The lack of
cooperation in matters of trade and payment was the main problem in the field
of international economic policy. The international community was, therefore, in
search of a substitute for the old gold standard and an alternative to a system of
completely free exchange control. It was also considered desirable to evolve an
in te rn atio nal m onet ary sy ste m , w hi c h c ou ld re co nc il e the auton om y o f
international economy with the discipline of international me chanism of
payments. A conference was, therefore, organised in 1944 under the auspices
of the United Nations at Bretton Woods in U.S.A. The conference was attended
by the representatives of 44 countries. Many experts contributed to the Bretton
Woods Agreement but the major influence was exterted by Lord Keynes and
Harry Dexter White, Under Secretary of the US Treasury. As a result of the Bretton
Woods Agreement, the International Monetary Fund (IMF) was set up in 1945
and started functioning in 1947.
Objectives of IMF
The International Monetary Fund started functioning on the 1st of March
1947, with the following objectives :
(1) To promote international monetary co-operation amongst the various
member countries.
(2) To facilitate the expansion and balanced growth of international trade
and to contribute thereby to the promotion and maintenance of high
level of employment and real income.
(3) To promote exchange stability to maintain orderly exchange
arrangements among members, and to avoid competitive exchange
depreciation.
(4) To assist in the establishment of multilateral system of payment in
respect of current transactions between members and in the elimination
of foreign exchange restrictions which hamper the growth of world trade.
(5) To give confidence to the members by coming to their timely rescue by
giving them short period monetary resources to help them tide over the
temporary maladjustments in their balance of payments, without
20
resorting to measures, destructive to national or international prosperity.

(6) To shorten the duration and lessen the degree of disequilibrium in the
international balance of payments of members.
The above mentioned objectives as embodied in the Articles of Agreement
clearly indicate the obligations of the International Monetary Fund. These
objectives indicate that the IMF shall be required to regulate monetary relationship
among the member countries in accordance with the code of good conduct, and
also to provide finance to members facing balance of payments deficit.
Organisation of IMF
The total membership of IMF was only 45 at the time of its inception on
March 1, 1947. In April 2012, the IMF had a total membership of 188. The
capital resources of the IMF consist of the total of the quota allotted to member
countries. The quota of a member country is based upon its importance as
measured by the value of the foreign trade, gross national product, gold and
foreign exchange and certain other related factors. Each member country is
required to contribute its quota both in terms of gold as well as in its national
currency. Each member has to pay its quota in gold (either 20 percent of the
quota or 10 percent of its entire gold and dollar holding whichever is less).
The aggregate of quota amounted to $ 7.5 billion on 1st March, 1946.
The IMF has also appointed certain Central Banks as its gold depositories
where members can deposit gold to the credit of IMF. The gold and the national
currencies deposited with the IMF are the properties of the IMF. The IMF
utilizes its g old hold ings to acquire dollars and other currencies for its
operations. The IMF holds two kinds of accounts with the Reserve Bank of
India, A/C No. 1 and A/C No. 2. The A/C No. 1 is the major account in which
the proportion of India’s IMF quota subscription and other payments in rupees
are cred ited and through which all the major transac tions with the IMF
involving purchase of foreign currencies (sale of rupees) are routed. For day to
day use, the IMF maintains A/C No. 2 with the Reserve Bank of India. This is a
current account. Deposits in A/C No. 2 produce their impact on the supply of
money in India.
There are two bodies to run the management of the IMF (1) The Board of
Governors and (2) The Board of Executive Directors. Every member country
appoints one Governor and one alternate Governor. The alternate Governor
participates in the meeting in the absence of the Governor. The Board of
Governors meet every year and formulates the general policy of the IMF. Thus,
the Board of Governors is a decision making body of IMF. There are 24 members
in the Board of Directors. Of these, eight countries each appoint an Executive
Director : the United States, Japan, Germany, France, the UK, China, the Russian
Federation and Saudi Arabia. The remaining 16 Directors represent constituencies

consisting of 4 to 22 countries. The Board of Directors has to carry out the day to
day working of the IMF. The chief executive of the IMF is the Managing Director.
The head office of the IMF is at present located at Washington D.C.(USA).
Functions and Working of the IMF
1. Determination of Exchange Rates :
The very first article of the IMF agreement stipulates that one of the
purposes of the IMF is to promote exchange stability. The IMF adopted the ‘par
value’ system* of determining the exchange rates for member countries. Under
the ‘par value’ system, each member country is required to define the value of
its currency in terms of weight of gold as a common denominator or in terms
of the United States dollar of the weight and fineness which in effect on July
1, 1944 was $ 35 = one ounce of gold of 0.995 fineness. The initial par value
of the Indian rupee, established with the IMF on December 18, 1946 was
0.268601 gram of fine gold or 30.2250 U.S. cents. In other words, the exchange
rate determined in the terms of par value was Rs. 30.30 = $1.00. When all the
member countries express the values of their currencies in gold or dollars, it
becomes easier for the IMF to fix the foreign exchange rate of the concerned
countries.
2. Management of Exchange Stability :
In order to facilitate multilateral trade among member countries, the
IMF bars competitive exchange alternation and requires each member-country
to “maintain orderly exchange arrangement with other members.” It does not
mean that the IMF favours a fixed exchange rate system. As a matter of practice
and principle, the IMF is against the floating exchange rate policy. The IMF
believes in the merits of stable exchange rate policy. In order to achieve the
goal of exchange stability, the IMF provides for a 10 percent adjustment, upward
or downward, in the external value of member country’s currency without its
prior approval, and for a more than 10 percent adjustment with its prior
consent. It must, however, be pointed out that the adjustment in the external
v a l u e o f t h e c u r r e n c y i s p e r m i t t e d o n ly f o r c o rr e c t i n g a f u n d a m e n t a l
disequilibrium in a member country’s balance of payments. The downward
adjustment in the external value of the Indian rupee was made when the rupee
was devalued on September 18, 1949 and again on June 6, 1966. Thus, the
IMF seeks to manage the stability of exchange rate. It must, however, be pointed
out that from December 18, 1975 the IMF allowed the fluctuation in the exchange
* Par value : The official fixed exchange rate of currencies in terms of gold or US dollar,
as declared to IMF.
rate of member’s currency within a wider margin of 2.25 percent in place of old
margin of 1 percent, in either direction of the parity relationship.
(3) Establishment of a Multilateral System of Payments and Elimination
of Foreign Exchange Restrictions :
Article I (IV) of the IMF agreement indicates that IMF shall operate to
assist in the establishment of multilateral system of payments in respect of
current transactions between m embers and in the elimination of foreign
restrictions which hamper the growth of world trade. In order that this objective
may be achieved, Article VIII provides that no member-country may, without
the approval of the IMF, impose restrictions on the making of payments or
transfers for current international transactions or engage in discriminatory
currency arrangements of multiple currency practices. It is also stipulated
that the monetary authority of each m ember- c ountry shall convert any
balances which another member-country’s monetary authority has acquired
from or needs for current transactions, into gold or into currency of that
member- country. In short, all the member- countries shall abolish restrictions
upon current payments, avoid discriminatory currency practices and promote
convertibilities of foreign held balances. As a result, multilateral system of
payments will be established and trade volume will be increased.
4. Lendings to members to cover up deficits in Balance of Payments :
The IMF’s resources consist of a common pool of gold and currencies,
which in turn consist of an aggregate “quota” paid in or payable by its members
countries. The IMF lends to a member country which is in need of a short-
term credit to settle current deficit in its balance of payments. The deficit
country “borrows”, the necessary funds in exchange from the IMF with its
own currency. It implies that a deficit country ”borrows” the necessary funds
in exchange for its I.O.U.s If the short-term credit thus acquired helps the
deficit country to overcome its adverse balance of payments, the country is
required to ‘repurchase’ its own currency in exchange for gold or ‘convertible
currencies’. As a result, the IMF is protected against quick depletion of its
scarce currencies (e.g. dollar resources). It must however be pointed out that
a member-country can buy foreign exchange from the IMF upto an amount
equal to 25 percent of its quota in any given year. However, the currency of a
member country with the IMF at any time should not exceed 200 percent of
its quota. Let us suppose, as an example, that the quota of a member country
is $ 100 million comprising $ 25 million in gold and $ 75 million in its own
national currency. If this country wishes to obtain some foreign currency from
the IMF, it cannot secure the foreign currency of the value greater than $ 125
million. The IMF charges rate of interest, which varies between 0.5 and 2.5
percent. It also levies service charges to the extent of 0.75 percent on its loans.
These drawings of the member-countries from the IMF are conditional.
5. Dealing with the problem of ‘scarce currencies’ :
The currency of a member- country is said to be ‘scarce’ if its supply is
less than its demand. If a country sells its goods to other countries but does
not buy from them, then the other countries are not able to acquire the
currency of the former. As a result, the currency of the export surplus country
becomes scarce in relation to demand. Dollar, for most of the times, has been
a scarce currency. The IMF can deal with the problem of dollar scarcity in two
ways, namely, (a) by increasing its supply of dollars through purchase of dollars
with its gold and (b) by declaring the dollar to be a ‘scarce currency’. If the
IMF’s gold assets are enough to buy all the dollars needed by deficit members,
then it will not have to ration its scarce dollar holdings among the dollar
needing members. Fundamentally, however, it is more important to correct a
sustained disequilibrium between those members whose currencies are scarce
and those whose currencies are not scarce, because that is what gives rise to
a general scarcity of the former’s currencies. This suggests that the burden of
responsibility should not rest on the shoulders of deficit countries alone.
6. The Special Drawing Rights (Paper Gold) :
Under the original articles of the IMF it had powers to lend to member
co untrie s , b ut thi s l end ing was c ond i tio nal , a nd it was rep aya b le . T he
unprecedented growth in international trade in the post war era has posed a
serious problem of international liquidity. The introduction of special drawing
rights (SDRs) by the IMF was an important step in improving international
liquidity. The plan for SDRs was approved in September, 1967 and were
introduced in 1969. The essence of these special drawing rights (SDRs) is
th at th e y c r e a te a n ew i n te rn at i o n al re s e rv e a s s e t. T h e y c a n b e u s e d
unconditionally by the participating countries, and they are not backed by
any assets. Unlike existing IMF drawing rights, SDRs are not created by
countrie contribution of gold and currency to the IMF and once drawn they
do not have to be paid back to the fund. The peculiarity of the new drawing
rights is that they would not be treated as borrowing as the existing claims on
IMF are. The SDRs are sometimes nicknamed ‘paper gold’. They could be used
as gold in as much as they would be the ultimate resource for purchasing
other currencies. They are not pieces of paper like bank notes or treasury
bills. They are simply entries in a special account kept by the IMF. The SDRs
are allocated to each member country in proportion of its IMF quota. They can
only be transferred to another member country in exchange of usable foreign
exchange. It means they cannot be spent directly on goods and services. In

short, SDR is an international medium of exchange and store of value.
Alongwith financial help, the IMF also grants technical assistance to
the member countries. The experts and specialists of the IMF render valuable
help to the member countries in solving their complicated economic and
monetary problems. In fact, the under-developed countries have been helped
in the formulation of their monetary, fiscal and exchange policies. Thus, the
IMF helps the member countries to stabilize their economies.
Fund Lending
Initially, the purpose of IMF lending was to provide member countries
resources to correct maladjustments in their balance of payments. In practice,
the purpose of IMF lending has changed since its organization. Over time, the
IMF's financial assistence has evolved from helping countries deal with short
term trade fluctuations to supporting adjustment and addressing a wide range
of balance of payments problems resulting from terms of trade shocks, natural
disasters, economic transition, poverty reduction and economic development,
and banking and currency crises.
Following are the main lending facilities of IMF:
(i) Stand By Arrangements (SBA):- This is a non- concessional loan facility. The
SBA is designed to help countries address short term balance of payments
problems. Programme targets are designed to address their problems and
disbursements are made conditional on achieving these targets (conditionality)
1
the length of SBA is typically 12- 24 months, and replayment is due within 3
4
-5 years of disbursement. SBA was upgraded in 2009 to be more flexible,
borrowing limits were doubled, and conditions were simplified.
(ii) Flexible Credit Line (FCL):- FCL is for countries with very strong
fundamentals, Policies, and track records of policy implementation. The
length of the FCL is either one year or two years with an interim review of
continued qualification after one year. Access is determind on a case by case
basis and is available in a single disbursement. Disbursements under FCL are
not conditional on implementation of specific policy understandings as is the
case under SBA, However, repayment term is the same as under SBA.
(iii) Precautionary and Liquidity Line (PLL):- PPL provides financing to meet
actual or potential balane of payments needs to countries with sound policies
and is intended to serve as insurance and help resolve crises. Duration of PLL
arrangements range from 6 month to one or two years. Access under 6 months
PLL arrangement in limited to 250 percent of quota in normal times, but can be
raised to 500 percent of quota in exceptional circumstancs. One to two year PLL
arrangements are subject to an annual access limit of 500 percent of quota.
(iv) Extended Fund Facility (EFF):- This facility was established in 1974 to help
countries address medium and long term balance of payments problems.
Arrangements are for a period of 3 - 4 year. Repayment is due with 4
-10 years.
(v) Rapid Financing Instrument (RFL):- RFL provides rapid financial
assistance to member countries facing an urgent balance of payments need,
without the need for a full- fledged programme. These loans are subject to the
same terms as FCL, PLL and SBA, with a repayment period of 3 - 5 years.
Concessional Lending Facilities:
These facilities are to help the low income countries. Loans are
available under the Poverty Reduction and Growth Trust (PRGT) scheme at
concessional rates of interest. This scheme was introduced in 1999. In 2010
the IMF revamped these concessional lending facilities. Three types of loans
were created under PRGT:
(i) Extended Credit Facility (ECF): - This succeeds the PRG facility as the
funds's main tool for providing medium- term support to low income countries
with protracted balance of payments problems. Financing under ECF carries a
zero interest rate.
(ii) Stand by Credit Facility (SCF): - This provides financial assistance to low
income countries with short term balance of payments needs. The facilities
allows for high access and carries a low interest rate.
(i) Rapid Credit Facility (RCF): - Provides rapid financial assistance with
limited condionality to low income countries facing on urgent balance of
payments needs. Financing under RCF carries a zero interest rate, has a grace
period of 5 years, and a final maturity of 10 years.
IMF and Under-developed Countries
The stable exchange rate system was set up in the Bretton Woods System.
The developing countries have been favouring stable exchange rate system
because it is in the interest of such countries. These countries often face
adverse balance of payment problem. The stable exchange rate system with
the support of international liquidity is a better arrangement because they
are in a better position to pursue their development programmes under such
international monetary system. The developing economies, want an adequate
supply of international liquidity to meet the adverse balance of payments. But
the allocations of SDRs to under developed countries has been much less as
compared to their requirements.
The adverse balance of payment of under-developed countries has also
been affected further by rise in oil prices. In order to meet the situation created
by the rise in oil prices and consequent effect on balance of payments, the
IMF created an “oil facility arrangement.” Though the oil facility of 1975 gave
some relief to the under-developed countries, yet the scheme has not benefited
them substantially owing to insignificant amount of facility. These countries
had to drop some of the projects envisaged under the development plans.
The world economic developments in 1971 were characterized by the
realignment of major currencies. Currency floats became the order to the day.
It led to the demise of the ‘Par Value’ system enshrined under IMF agreement.
It must however, be pointed out that most of the under-developed countries
did not resort to floating currency system. They have been supporting the
case for a fixed exchange rate system because of the relative absence of
u nc ertain ex ch an ge ra te u nd er th is sy s t em . I n s hort , the I MF ha s no t
succeeded in safeguarding the interests of under developed countries. The
deficits in balance of payments, adverse terms of trade, rising bill of oil import,
u nc e rt ain ty of the i nfl o w of ai d , i ns i gn i fi c an t ava i lab il i ty of S DR s an d
fluctuations in the exchange rates suggest that the IMF should evolve suitable
policies to suit the interests of developing economies.
Critical Appraisal of the Policies of IMF, with special reference to Triffin Plan
Robert Triffin predicted the breakdown of the international monetary
system evolved at the Bretton Woods. His prediction recorded in his classic
book “Gold and the Dollar Crisis” proved true with the advent of 1970s.
The International Monetary System under the auspices of the IMF has
been relying on a major national currency, the US dollar. This is clear from
the fact that the dollar was chosen as a common denominator in terms of which
all exchange rates were in fact defined and readjusted from time to time. The
dollar was regarded as the main component of international reserve
accumulation by all countries other than the United States. As a result, the
dollar came to be used as the main instrument for central bank interventions
in the exchange markets and for the settlement of balance of payments,
surpluses and deficits. But at the same time gold formed the basis of the
monetary system institutionalized in the form of the IMF because of the
convertibility of dollar into gold. This meant, in practice, that the growth of
international reserves became more and more a byproduct of the United States
b alance of paym ents deficits . As a result, the de ficits in the b alance o f
payments of the United States resulted in its indebtedness to foreign central
banks (dollar balance). The United States was required to convert the dollar
balance of foreign central banks into gold.
This system worked reasonably well as long as the deficits in the balance
of payments of the United States did not exceed the normal needs for the growth
of world reserves. As a matter of fact, 96 percent of the overall deficits of the

Un ited Sta tes b ala nc e of p ay me nts w ere fin ance d by the acc ep ta nce o f
American dollars as international reserves by other countries. In 1971, the
position was such that the world, having acquired dollar balances for the
American gold reserves finally lost its confidence in the dollar as the principal
reserve currency. This forced U.S.A. to abrogate convertibility of dollar into
gold on August 15, 1971. The countries having surplus balance of payments
had to adopt the floating rate system because of the inflationary implications
of rising dollar balance with them. In short, the inconvertibility of the dollar
and the generalized adoption of floating rates is the basic contraception of
the Bretton Woods agreement. These were the manifestations of the total
breakdown of the international monetary system institutionalized in the form
of the IMF. Gold has been dethroned from its position of constitutional head
of the international monetary system. Thus, we see Triffin’s prediction come
true : “man made credit reserves will continue to displace and will eventually
replace gold reserves just as man- made credit money has long replaced gold
money in every national monetary system, the world over.” He had criticised
the use of gold as a component of international liquidity on the ground that
for a long time, the monetary stock of gold has been rising more slowly than
the volume of world trade. It is significant to point out than even though the
IMF evolved, in 1969, SDRs as an international liquidity, the fixation of its
value in terms of gold proved ineffective. In accordance with the
recommendations made by the G-20 (the committee of twenty), the SDRs was
delinked from gold in July 1974. Triffin argued that it does not sound logical
that gold should also compete with the newly created reserve asset, SDR.
Triffin had given a proposal for reform of the international monetary
system. He had advocated the centralization of reserves and establishment of
an international reserve-creating institution. He suggested to adopt the model
of domestic monetary systems and establish an international reserve creating
institution to perform tasks similar to those of domestic central banks.
A new international monetary system was born on January 8, 1976 as a
result of the conference of the G-20. The old Bretton Woods monetary system
had collapsed on December 18, 1971 when the dollar was devalued. The basic
features of the new monetary system were as follows. Firstly, the new monetary
system now gave legal recognition to the fluctuation of currencies in the
foreign exchange market of the world. Secondly, the new monetary system
instituted a “Special Trust Fund” with the same proceeds of gold stock of the
IMF. This fund was intended to be utilized to help the developing countries to
meet chronic deficits in their balance of payments. However, the assistance from
this fund would be given only to those developing countries whose per capita
was less than $ 360. Thirdly, the quotas of the member countries in the capital
resources of the IMF had been increased by 33 percent under the new system.
Fourthly, the paper gold i.e. SDRs has been declared as the principal reserve
asset of the international monetary system.
T he above d is cussion clearly b rings out that the I MF s uc ceed ed in
achieving such objectives like exchange rate stability, convertibility of a new
currency and multilateral payments system. But it could work satisfactorily
only in the first two decades of its existence. The reliance on one national
currency (dollar) and convertibility of dollar into gold, enshrined under the
IMF agreement, brought a halt and ultimately collapse of the Bretton Woods
sy ste m in the b eg i nni ng of 1 9 7 0s . T ri ffi n had alw ay s b ee n ag ai ns t the
induction of gold in the edifice of International Monetary System. Fortunately
in the amended 1976 international monetary system, the yellow metal was
dethroned from its central position.
SUGGESTED READINGS
3 Vaish and Sudama Singh : International Economics
SUGGESTED QUESTIONS
1. Discuss the objectives and organisation of IMF.

2. What are the funtions of IMF.
3. Discuss the main fund lending facilities of IMF.
4. Write short notes on:
i. Special Drawing Right (SRD's)
ii. Quotas
iii. IMF and India.
MONEY AND BANKING
LESSON NO. 2.3 AUTHOR : DR. M.L. SHARMA
INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT(IBRD)

(WORLD BANK)*
The International Bank for Reconstruction and Development, better known
as the World Bank, was established at the same time as the International Monetary
Fund to tackle the problem of international investment. Since the IMF was designed
to provide temporary assistance in correcting balance of payments difficulties, an
institution was also needed to assist long-term investment purposes. Thus, IBRD
was founded in 1944 and began its operations in 1946 for promoting long-term
investment loans on reasonable terms. The Second World War had given a severe
blow to global trade by disrupting the world economies. The economies of England,
Germany, France and other countries had suffered on a large scale. Economic
reconstruction was the immediate need of war-torn Europe. Besides, the task of re-
building the war shattered economies of European countries was another problem
which required urgent attention. This problem was that of vast gap of economic
inequalities between the developed and developing countries. The entire countries
of Asia, Africa and Latin America were immersed in seething poverty. The widening
gap in the living standards of the rich and poor nations breeded social unrest and
political upheavals which had the potential of originating the flames of war once
again. It was realised that the only way to ensure lasting world peace was by
erad icating poverty in the underdevelope d economies throug h economic
development of these countries. To solve this problem, the Bretton Woods Conference
established the International Bank for Reconstruction and Development.
Functions :
IBRD is an inter-government institution, corporate in form, the capital
stock of which is entirely owned by its members.
The main functions of the Bank are :
(1) to assist in reconstruction and development of the economies of its
member governments by faciliting investment of capital for productive
purposes;
(2) to p ro m o te f o re i g n p ri v at e i n v e s t m e n t b y g u ara nt e e s o r th ro ug h
participation in loans and other investments made by private investors;
(3) where private capital is not available on reasonable terms, to make loans
for productive purposes out of its own resources or out of the funds
* The World Bank comprises IBRD and IDA, whereas the World Bank Group comprises IBRD, IDA,
IFC, Multilateral Investment Guarantee Agency (MIGA) and International Centre for Settlement of
Investment Disputes (ICSID)
30
borrowed by it;
(4) to promote the long-term balanced growth of international trade and
the maintenance of equilibrium in balance of payments by encouraging
international investment for the development of the productive
resources of member countries.
A little reflection will reveal that the objectives of the IMF and IBRD are
complementary . Both aim at increasing the level of national inc ome and
standard of living of the member nations. Both serve as lending institutions,
the IMF for short term and the IBRD for long term capital. Both aim at promoting
the balanced growth of international trade.
Organisation of the Bank
Initially, only a country which was a member of IMF could become a
member of IBRD. But now, other countries can also become a member if the
application of a country is supported by 75 percent existing members. Thus
any country is eligible for membership of the Bank if it subscribes to the charter
of the bank. The bank has a Board of Governors, Executive Directors, a
President and other staff. All powers of the bank are vested in the board of
governors. Each governor has the voting power, which is proportional to the
financial contribution of the government, which it represents. The voting power
of the big shareholders far outweighs the voting power of the smaller ones.
The Board of Governors meet once a year. This annual meeting is an important
occasion for informal exchange of views at high level on major international,
financial and monetary issues.
The initial authorised capital of the World Bank was 10 billion, subscribed
by its members in accordance with their economic growth. The United States
of America is the largest subscriber, followed by the United Kingdom. Each
country’s quota is divided into three parts :
(i) Two percent of the subscription is payable in gold or U.S. dollars and is
freely available for lending :
(i i) 18 percent of the subscription is payable in member’s own currency
and is available for lending with the consent of the member country
whose currency is involved; and
(iii) The remaining 80 percent of the subscription is not payable for lending
but is subject to call as and when required to meet the Bank’s
obligations.
T he sub scrib ed capital of the B ank is increas ed as a re sult of the
enhancement of its resources in the form of increase in member’s susbcription
an d al so d u e to th e i nc reas e i n m em b er sh ip . T he p rin ci p al p urp os e o f
increasing World Bank’s capital resources is to increase its ability to lead for
economic development. The Bank also borrows from international capital
market through sale of securities.
Aims
The fundamental aims and objectives of the Bank are :
(i) To provide a catalyst by which production may be generally stimulated
and private investment encouraged.
(i i) To encourage necessary action by the member governments to ensure
that the Bank’s loans will actually prove productive; and
(iii) To initiate and develop plans to see to it that the Bank’s resources are
used wisely from the standpoint of the world.
The World Bank is more than the usual type of lending institutions. Its
concern is primarily to ensure that its loans make the greatest possible
contribution to increasing the production, raising the living standards and
opening opportunities for further investment in the borrowing member country.
Recently, the scope of Bank’s assistance to the members has been considerably
widened. In its early years, most of the economies borrowed for purposes like
dams, roads and power plants. Now, Bank is also lending for “purposes”, like
education, population, planning, urbanisation, water supply and sewerage.
Granting of Loans
In the granting of loans and their administration, there are four stages
involved. The first stage may be characterised as exploratory and preliminary
investigation. At this stage, there are discussions between a mission sent by
the prospective borrower about the latter’s ability to repay the loan.
If the mission is satisfied with preliminary investigation then the second
stage of investigation of the specific project starts. The mission investigates
the specific project in its technical, financial and administrative aspects —
whether the project plans have been properly drawn, whether the required
local capital would be entrusted to capital management etc.
If the second stage of technical investigation is satisfactory, the third
stage of negotiation of the terms of loans starts. This involves borrowing country
and checks the end use to which funds are put, in order to determine the part
of total investments to be provided by the Bank, the interest rate, the period of
the loan and securing of several assurances and guarantees for safeguarding
the interests of Bank.
The final stage is that of the administration of the loan which is a special
feature of the Bank loans. The Bank representatives visit borrower country to
determine that the use conforms to the loans agreement.
Guiding Principles of the Bank
In its lending operation, the Bank is guided by certain guidelines which
have been formulated on the basis of the Articles of Agreement.
I n t he f i rst i n st anc e , t he B a nk sh o ul d as s e s s p ro p er ly re p ay m en t
prospects of the loans. For this, it should consider the availability of natural
resources and existing productive plant capacity to exploit the resources and
operate the plant, and the country’s past debt record, and technical soundness
and high priority nature of the project.
Thirdly, it is the Bank’s policy to maintain continuing relation with
borrowers so as to check the progress of the projects and to keep in touch with
financial and economic development in the borrowing country.
The rate of interest charged by the Bank is based on the rate, which it would
itself have to pay to borrow money at the time the loan is made, plus one percent
commission charge which is allocated to a special reserve.
The Bank has advanced loan for specific development project in the fields
o f ag r i c u l tu r e , e le c tri c p o w e r, tra ns p ort , te le c o m m u ni c a ti o n, i n d u str y ,
population planning, water supply, project preparation, urban development
and education. Bank’s loans are long term loans granted on the conventional
rate of interest for projects of economic priority.
An intermediate financial facility was created in 1975-76 to enable the
Bank to provide development assistance on term's intermediate between those
of the Bank and IDA.
A m ajority of I BR D’ s lo ans have g one to de ve lop in g co untries for
development projects. These loans were meant for the creation and
development of infrastructure projects in the developing countries in Africa,
Asia and Western Hemisphere. More than 10 percent of the total loan assistance
has been given for the development of electric power projects. About 72 percent
of the total am o unt ha d b e en utilis e d for p rov id ing transp ortation and
telecommunication facilities. About 22 percent of the total accumulative loan
amount has financed the development of agriculture and rural development
projects. Rest of the loan assistance has been given for the development of
education, project preparation and technical assistance, population, planning,
water supply and sewerage. Region wise, about 7 percent of the total loan
amount has been given to South Asia and pacific region countries. Africa
claimed about 13 percent of the total loan assistance provided by the Bank.
The substantial growth in the lending activities of the Bank would not
have been possible without a corresponding expansion in its resources. The
paid-in capital of the Bank has risen to more than four fold. Besides the
increase in its capital resources, the Bank has also borrowed funds on a mass
scale by successfully floating loans in the international financial market.
Investors of about hundred countries hold the security of the Bank which
have been established in the money markets of Belgium, Canada, Germany,
Italy, Netherlands, Switzerland, U.K. and U.S.A. and thirteen petroleum-
exporting countries including Saudi Arabia.
Technical Assistance :
T he B ank , ap art f ro m g ran ti n g lo ans , ha s al so p r ov id ed te ch ni c al
assistance in developing countries through various Survey Missions which
make intensive studies of national resources of developing member countries.
The Economic Development Institute of the Bank was established in 1955 to
provide training for senior officials of member countries.
In 1965, IBRD established a machinery- convention on the Settlement
of Disputes between states. Under the convention, an International Centre
for Settlement of Investment Disputes (ICSID) has been established for providing
facilities for settlement by voluntary recourse to conciliation or arbitration of
investment disputes between contracting states and foreign investors who
are nationals of other contracting states.
W orld Bank has als o prom oted international p eace by suc cess fully
resolving d ifficult international disp utes — between UK and UAE on the
nationalisation of Suez Canal; between India and Pakistan over sharing of
waters of Indus System of Rivers.
World Bank and India
In addition to the conventional loans, which it has made available for
development projects, the Bank has made sincere efforts to secure outside
assistance from developed countries for underdeveloped countries. The Bank
has taken the lead in organising aid coordination mechanism for a number of
developing countries, which receive assistance from several bilateral and
multilateral sources. It has helped in the establishment of International
Development Association from which underdeveloped countries can borrow
in hard currencies without worrying to repay in the same currencies. Another
c o n t ri b u t i o n o f th e W o rl d B a nk w a s t he am e nd m e nt to th e c h art e r o f
International Finance Corporation to enable it to provide equity to private
industrial undertakings in underdeveloped countries. These developments
have helped the developing countries to effectively implement their
development plans. Moreover, lending has been in favour of agriculture and
rural development, transaction and industrial sectors where development is
vital for the development of member countries. India is a founder member of
the Bank and holds a p ermanent seat on the Bank’s Board of executive
d i r e c t o r s . I n v i e w o f it s a c h i e v e m e n t , t h e r o l e o f t h e B a n k h a s b e e n
c o m m e n d a b l e . T h e p r o o f o f i t s p o p u l a ri ty i s t h e r a p i d i nc r e a s e i n i ts
memb ership. The Bank has se nt several miss ions to India to assess the
country’s developme nt p rogramm es and also for field surveys of various
projects. The Bank has appointed a resident representative in New Delhi who
remains in close contact with the government of India in regard to the country’s
development plans and the projects.

India has gained from assistance given to it by the Bank. It was due to
its concerted efforts that a consortium of twelve lending Western countries
known as ‘Aid India Club’ comprising of the U.K., U.S.A., Germany, Japan,
France, Canada, Italy, Sweden, Austria, Belgium, Netherlands and Holland
was formed.
But, much more significant is the involvement of the Bank in India’s
development programmes. The proof is the massive assistance of 85.472
million, which she received from the members of the consortium for
development programmes during the Third five-year plan and the non- project
aid of $ 3,700 million would never have been made available without the
support of the Bank. Apart from providing the massive loan assistance, the
Bank also paid the foreign exchange cost amounting to $ 862,000 for a study
aimed at improving the transport of coal in India. In 1965, the Bank helped in
financing a survey of transport in the eastern region in order to enable the
Government to formulate a transport investment programme for the fourth and
fifth five year plans (1966-76).
The Bank also gave a loan of $ 39 million in 1971 and 1972 to the Punjab
Agricultural Project to boost farm production. Projects financed with the help
of the Bank have strengthened the Indian economy.World Bank is the largest
financier of India's National Aids Control programme (NACP) with a commitment
of around US $ 275 million in interest free credits.
The World Bank Group has granted massive loan and credit assistance
of more than 9 million to India for the planned economic development of the
country’s economy.
Critical Appraisal
The ‘modus operandi’ of the Bank has been criticised on various grounds.
Firstly, it is alleged that the Bank charges a very high rate of interest on its
loan, even when the loans given by it are guaranteed by Governments of the
borrowing member countries and there is no risk of loss of capital. The purpose
of the Bank to make economically weak nations as strong can be fulfilled
only when the rate of interest charged by it, is low enough for all countries to
enable them to take loans from the Bank more frequently.
Secondly, the Bank’s insistence on judging the repaying capacity of a
borrowing country before granting the loan is faulty. The repaying capacity
follows rather than proceeds the utilization of the loan. It is created as the
project financed by loans materialize. Trying to estimate repaying capacity
before granting the loans betrays lack of judgement on the part of the Bank.
Thirdly, the Bank is a non- political and nonpartisan financial institution.

It is expected to treat all members equally, being enjoined not to discriminate
against some and in favour of others in the granting of loans. However, in practice,
loans have not been given purely on economic considerations. It is only recently
that the economically backward countries of Asia and Africa have caught the
eyes of the Bank and even now these areas are not getting the attention they
need. The Third World countries, Europe and Western Hemisphere are smaller
both from population and area considerations and even then they have received
huge amount of loans. All this cannot be defended on economic consideration
alone.
Fourthly, the Bank is still far from playing an effective role in reshaping
the economic structure of member countries because the amount of financial
help given by it, falls far short of the vast requirements of resources needed
for accelerating the process of economic development.
Inspite of these shortcomings, in evaluating the Bank’s role we should
not forget the limitations with which the Bank works. The Bank has been
largely instrumental in quickening the tempo of economic development in
different countries of the world. Although the Bank has failed to finance all
the development projects, it has financed a large number of them, which have
proved quite successful. In future, the Bank will be in a stronger position to
render financial assistance to the member countries with its increased capital
resources and the active co-operation of its affiliates, I nternational
Development Association and International Finance Corporation. We will study
about these institutions in the next lesson.
SUGGESTED READINGS
3 Vaish and Sudama singh : International Economics
SUGGESTED QUESTIONS
1. Discuss the objectives and funtions of World Bank.
2. Write a detailed note on World Bank and India.
3. Explain the organisation of World Bank.
M.A. (ECONOMICS) SEM. IV PAPER ECO-404-405
OPTION (III)
MONEY AND BANKING
LESSON NO. 2.4 AUTHOR: ANITA GILL
INTERNATIONAL FINANCIAL INSTITUTIONS: IDA, IFC, ADB
Structure of the Lesson

2.4.1 Introduction
2.4.2 Objective of the lesson
2.4.3 International Development Association (IDA)
2.4.3.1 Objective of IDA
2.4.3.2 Membership and organizational structure
2.4.3.3 Working and lending policy
2.4.3.4 Evaluation of IDA
2.4.4 International Finance Corporation (IFC)
2.4.4.1 Objectives of IFC
2.4.4.4 Evaluation of IFC
2.4.5 Asian Development Bank (ADB)
2.4.5.1 Objectives of ADB
2.4.5.4 Evaluation
2.4.6 A note on MIGA and ICSID
2.4.7 Summary
2.4.8 Suggesting Readings
2.4.9 Questions for practice
2.4.1 Introduction
In the previous lessons, we studied about the International Monetary Fund
(IMF) and the World Bank (or IBRD). In this lesson we will study about some other
international financial institutions. These are the IDA, IFC, and ADB. Of these,
IDA and IFC are members of the World Bank Group, while the ADB is a regional
development bank aimed at facilitating economic development of Asian countries.
M.A. (ECONOMICS) SEM. IV 38 MONEY & BANKING
In addition, information will also be provided on two other members of the World
Bank Group – the Multilateral Investment Guarantee Agency (MIGA), and the
International Centre for Settlement of Investment Disputes (ICSID).
2.4.2 Objective of the lesson
The objective of this lesson is to know about and evaluate some international
financial institutions which are actively engaged in assisting the economic
development of developing countries.
2.4.3 International Development Association (IDA)
The IDA is the soft lending window of the World Bank. It was established in
1960 as a development finance institution, with its headquarters at Washington,
D.C., United States. The need for setting up this institution arose because
developing countries were not able to afford IBRD (International Bank for
Reconstruction and Development, or World Bank) lending, and needed more
favourable lending terms. Although IFC was established in 1956, developing
countries persisted in their demand. In 1969, their demand met the approval of the
World Bank's Board of Governors, and in January 1960, 15 countries signed the
articles of agreement which led to the establishment of IDA. This institution
provides financial assistance for purposes which are not catered by World Bank,
such as sanitation, urban development etc. The IDA is the single largest provider of
finance for economic and human development projects in the poor countries.
2.4.3.1 Objectives of IDA
The main objective of the IDA, as stated earlier, is to help the poorest of poor
countries in growing quickly and equitably. Specifically, it aims at:
(i) poverty reduction in poor countries by providing finance at concessional
rates;
(ii) to work for the development of human capital in poor countries, which
includes population control, health, nutrition and education;
(iii) to serve as a complement to the objectives and activities of the World Bank.
2.4.3.2 Membership and Organizational Structure
IDA's membership is available only to those countries who are members of
the IBRD. AT present it has 172 member countries. The members of IDA are
divided into two parts – Part I consisting of developed countries, and Part II
comprising developing countries. Member countries replenish the funds of IDA
through contributions. Apart from this, IBRD and IFC provide it with
supplementary funds. Every three years, the member nations providing funds
gather to replenish the IDA's resources.
The IDA is governed by the Board of Governors of the World Bank. It
consists of one governor per member country (who is usually the finance minister of
the country). The Board of Governors delegates authority to the Board of Directors
for its daily matters. The President of the World Bank Group chairs the Board of
Directors. Besides, the Board has 25 executive directors.
In order to provide assistance, IDA assesses countries on the basis of their
poverty and lack of credit worthiness for IBRD borrowing. For this, per capita
income, non access to private capital market, and policy performance in pro-growth
and anti-poverty reforms of the borrower country is taken into account. IDA lends
to countries to finance projects for developing infrastructure, education, sanitation
facilities, healthcare, clean water, and environmental issues. The loans carry a
maturity period of 25 to 40 years, with a grace period of 5 to 10 years. The loans
do not carry any rate of interest for countries who are regular IDA – eligible
borrowers; otherwise it varies from 1.25% to 2.8 per cent. The Country Policy and
Institutional Assessment (CPIA) development indicator of the World Bank is used
for prioritizing lending to each country.
The IDA has allocated nearly half of its resources towards financing projects
in African countries. The projects are in the sphere of electricity, roads, and
education. In South Asia, IDA has focussed on education, healthcare,
transportation, agriculture and energy.
2.4.3.4 Evaluation
The IDA has done commendable work since its establishment in 1960. Its
financial assistance has resulted in lower birth and death rates, decline in infant
mortality rate, and increase in average life expectancy and education in many
countries. However, resources with IDA are limited to support its good work. The
voluntary contributions made to IDA are not a regular feature. Moreover,
sometimes the sanctioned amount is not fully disbursed.
2.4.4 International Finance Corporation (IFC)
The IFC is an international financial institution, which is also a member of
the World Bank Group. It was established in 1956, and is known as the private
sector arm of the World Bank Group. Its headquarters are in Washington, D.C.,
United States. The IFC supplements the financing activities of the World Bank. The
idea of setting up IFC was proposed in 1950, for the purpose of making private
investments in developing countries served by the World Bank. The IFC was to
invest in private firms, rather than lending to governments, but it was not to
manage the projects in which it invested.
2.4.4.1 Objectives
The main aim of the IFC is to help people escape poverty and attain better
standards of living.It creates opportunities for achieving this aim by mobilizing
financial resources for private enterprise, supporting businesses and other private
sector entities, creates jobs and delivers necessary services to the poor and
vulnerable.It aims at increasing sustainable agricultural opportunities, improve
health and education, infrastructure and invest in climate health. The IFC thus
supplements the financing activities of the World Bank. It seeks its objectives by
providing and bringing together finance, technical assistance and management.
Thus,it provides not only financial and technical assistance, but also equity capital.
Like IDA, the membership of IFC is open only to countries who are members
of the World Bank. It is a corporation whose shareholders are member
governments who provide paid-in capital, vote on matters of policy and approve its
investing activities.
The IFC is governed by its Board of Governors comprising of one governor
per member country. Again, the governor is usually the country's finance minister.
The Board of Governors usually delegate their corporate powers and authority over
daily matters to the Board of Directors. The Board of Directors consists of 25
executive directors, with the President of the World Bank Group acting as the
Chairman of the Board. Each executive director's vote is weighted in accordance
with the total share capital of the member countries represented by that director.
At present, there are 182 member countries. Although the IFC co-ordinates its
activities with the other institutions of the World Bank Group, it generally operates
independently, as it has a separate legal and finance autonomy.
2.4.4.3 Working and Lending Policy of IFC
The IFC provides financial assistance in the form of loans, equity, syndicated
loans and liquidity management. These loans do not require government
guarantee. The IFC makes loans to business and private projects generally with
maturities of 7-12 years. The repayment schedule and grace period of each loan is
decided separately. Long-term loans are provided either on project-cost basis or
corporate finance basis. The loans which are written against IFC's own account are
known as A-loans. In case IFC's own funds do not permit making big loans,
commercial banks and other financial institutions join in loan syndication. Such
loans are known as B-loans.
Apart from granting loans in hard currencies, the IFC also tries to structure
loan products in local currencies. For example, in 2011, its disbursement portfolio
included loans denominated in 45 local currencies. Also, the IFC was authorized in
1961 to make equity investments. It usually invests for a period of 8-15 years, and
then exits through sale of shares on a domestic stock exchange. However, despite
investing in a company, the IFC does not play an active role in the management of
the company.
The IFC has also started a global trade finance programme, through which it
guarantees trade payment obligations of over 200 approved banks in around 80
countries to mitigate the risk for international transactions.
The IFC also provides a range of advisory services. These services are for the
purpose of supporting corporate decision making regarding business, environment,
sustainability etc. Its advice targets governance and managerial capacity. In
addition, it advises governments on infrastructure development and public-private
partnerships. In 2009, the IFC established the IFC Asset Management Company,
which is its wholly owned subsidiary and manages all capital funds to be invested
in emerging markets.
2.4.4.4 Evaluation of IFC
The IFC is assessed by an independent evaluator each year. It has received
high credit ratings by international credit rating agencies due to its strong financial
standing with adequate capital, geographic diversification, and management
policies. It helped developing countries to deal with the aftermath of the crisis of
2008, by providing credit to small and medium businesses. However, it faces
higher risks than other multilateral institutions due to its emphasis on private
sector investing.
2.4.5 Asian Development Bank (ADB)
Although international development banks had been established for catering
to the development needs of member countries, their norms could not be applied to
each region equally, because each region has separate economic needs.
Particularly, it was Japan that felt that its interest in Asia was not served by the
World Bank. ADB was set up in this context. Though, the efforts had started in
1963, it was only after USA and Japan offered to subscribe US $ 200 million each
in 1965, that ADB came into being from 22 August 1966, and began functioning in
December 1966. Its membership was open to the regional countries and the non-
regional developed countries (to obtain resources). The headquarters of the bank is
at Manila, Philippines.
2.4.5.1 Objectives of ADB
The main aim of ADB is to promote economic development and cooperation
in countries of Asia and Far East. For this purpose it provides loans and equity
capital, technical assistance for preparing and carrying out development projects.
It also helps mobilize additional resources within the region and attract investment
from outside. It is committed to providing loans for social issues such as

education, health, population, urban development, and environment.
ADB admits members of the United Nations Economic and Social
Commission for Asia and the Pacific (UNESCAP). It had 31 members at the time of
establishment, but now has 67 members – 48 from within Asia and the Pacific, and
19 from outside. Like the World bank, it has a weighted voting system where votes
are distributed in proportion with the member country's capital subscription.
The policy making body is the Board of Governors which is composed of one
representative from each member state. This Board elects a Board of Directors,
twelve in number, from amongst themselves. The chairman of the Board of
Director is the President of the ADB. The President is elected by the Board of
Governors for a term of five years. Every member country has one basic vote plus
additional votes in proportion to their number of shares held in the capital
structure.
2.4.5.3 Working and Lending Policy
ADB offers two types of loans – one is "hard" loans (offered on commercial
terms) from ordinary capital resources (OCRs); the other are "soft" loans (on
concessional conditions) offered from the Asian Development Fund (ADF). OCRs
comprise of equity and borrowings. ADF is replenished by member countries. The
replenishment is authorized from time to time by a resolution of the Board of
Governors.
A member developing country can borrow from ADB for a public or private
sector enterprise. ADB aids only economically and socially viable projects. The
maturity period is between 10 to 30 years, with a grace period of 2 to 7 years. The
concessional loans have a longer maturity period of 35 to 40 years, with a grace
period of 10 years. OCR and ADF loans often involve supplementary loans also.
ADB also offers Technical Assistance Development Special Fund (TASF) for
financing technical assistance operations and Japan Special Fund (contribution of
Japan) for financing or co-financing technical assistance projects through equity
investment.
2.4.5.4 Evaluation of ADB
At the organizational level, ADB has two types of evaluation. One is self
evaluation which is conducted by the units responsible for designing and
implementing strategies. The other is Independent Evaluation. ADB's Independent
Evaluation Department (IED) conducts systematic and impartial assessment of the
programmes and projects.
However, it has been repeatedly pointed out by the critics that ADB's
lending, policy and staffing decisions are extensively influenced by its two major
donors i.e. Japan and U.S. ADB has also been accused of bypassing rural
population in its growth programmes, and causing social and environmental
damage due to lack of oversight.
2.4.6 A note on MIGA and ICSID
The Multilateral Investment Guarantee Agency (MIGA) is also an
international development finance institution, which was set up in 1988, with the
World Bank Group as its parent organization. The headquarters of MIGA at
Washington D.C., USA. MIGA provides an investment insurance facility to help
investors overcome political and other non-commercial risks while investing in
developing countries. Its aim is to promote foreign direct investment (FDI) in
developing countries so as to promote economic growth and reduce poverty.
The membership of MIGA is only for those countries who are members of
the World Bank. It is governed by a Council of Governors which represents its
member countries. This Council delegates powers to a Board of Directors
comprising of 25 directors.
MIGA offers insurance cover for five types of non-commercial risks: currency
inconvertibility and transfer restriction; government expropriation; war, terrorism
and civil disturbance; breaches of contract; and the non-honouring of sovereign
financial obligations.
MIGA is evaluated by the World Bank's Independent Evaluation Group. This
evaluation is carried out every year.
The International Centre for Settlement of Investment Disputes (ICSID), as
the name suggests, is a dispute resolution organization concerned with conciliation
of legal disputes between international investors. It was set up in 1966, and is a
member of the World Bank Group. The ICSID is governed by its Administrative
Council, which consists of one representative from each of the centre's contracting
member states. It is chaired by the President of the World Bank Group. The
Council is supported by a Secretariat to conduct the Centre's proceedings.
The ICSID offers institutional and procedural support to conciliation
commissions, tribunals and committees instated of conducting such proceedings
itself.
Although availing of ICSID conciliation and arbitration is entirely voluntary,
but once the parties consent to arbitration under the ICSID Convention, neither
party can withdraw its consent.
2.4.7 Summary
In this lesson, we have studied about some international financial
institutions, other than the IBRD. These are the IDA, the IFC and the ADB. While
the IDA is the soft lending window of the World Bank, the IFC supplements the
financing activities of the World Bank by giving equity finance and loans without
the guarantee of the government of the borrowing country. The ADB is a regional
development bank of the Asian region.
2.4.8 Suggested Readings
(i) V. Sharan: International Financial Management
(ii) Official website of the concerned organization
2.4.9 Questions for Practice
(i) Write a detailed note on the working and lending of Asian Development Bank
(ii) What are the objectives of IDA?
(iii) Write a note on MIGA.
(iv) Write a brief note on IFC.
M.A. (Economics) Part-II Paper III & IV (Option-IV)
Option: Money and Banking
Lesson No. : 2.5 Author: ANITA GILL
INTERNATIONAL BANKING
Structure of the Lesson: -

2.5.1 Introduction
2.5.2 Objectives
2.5.3 Development of International Banks (Structural Changes)
2.5.3.1Traditional international banks
2.5.3.2Euro banks
2.5.3.3Off-shore Banking Centres
2.5.3.4Syndication of lending
2.5.4 Motivating Factors
2.5.5 Scope of International Banking
2.5.6 Direct International Lending by Commercial Banks
2.5.7 Alternative Organisational Formats for International Banking
2.5.8 Control of International Banks
2.5.9 Summary
2.5.11 Questions for Practice
2.5.1 Introduction
We are already familiar with the structure and functions of commercial banks
acting domestically, i.e. within the physical bounds of the country. The second half
of the twentieth century, however, witnessed the emergence and fast expansion of
multinational corporations (MNCs), and with this arose the need for greater sources
of funds, and required an expansion in the dimensions of services of commercial
banks. This led to the development of a number of agencies and instruments through
which funds move internationally to the resource needy institutions or firms. The
channels for the flow of funds, i.e. the resource-providing agencies may be official
or non-official (i.e. non-governmental). The official agencies can be classified as (i)
multilateral agencies like the international development banks (World Bank, IFC
etc.) and regional development banks (Asian Development Bank) (ii) bilateral
agencies, such as the different governmental agencies. The non-official channel
comprises the borrowing and the lending streams such as the international banks
on the one hand, and the securities market on the other. International banks, thus,
occupy an important position as a non-official funding agency. In this lesson we
45
M.A. (Economics) Sem. IV 46 Paper : Money & Banking
will study their development, reasons behind their emergence, their different
organisational formats etc.
2.5.2 Objectives
The main objective of the present lesson is to familiarize the students with
the concept of international banks. We have already mentioned that the development
of MNCs has necessitated the flow of finance beyond the physical boundaries of any
country. International banks have become a major source of such finance. How
these banks have undergone a structural change over the years, what were the
motivating factors behing their emergence and development, all this will be dealt
with in this lesson. The student will also obtain information regarding the scope of
international banking, lending by international banks, and also the need to control
such banks despite their usefulness, in the present lesson.
2.5.3 Development of International Banks (Structural Changes)
This essentially means the structural changes that these banks have
undergone, especially since the twentieth century. These changes can be broadly
divided into three main parts, as discussed below:
2.5.3.1 Traditional international banks
Beginning from the first half of the twentieth century and till the late 1950s,
international banks were mainly domestic banks performing the functions of
international banks. In other words, they operated in foreign countries accepting
deposits from and making loans to the residents of the host countries. They dealt in
the currency of the host countries, and at the same time, dealt in foreign currency
also to make finance available for foreign trade transactions. The traditional
international bank is subjected to the rules and regulations of the host country.
The deposits and loans of these banks are remunerated at the interest rate set by
the interest rates prevailing among the domestic banks in the host country.
2.5.3.2 Euro Banks
Towards the early 1960s, banks with purely international character emerged.
These banks came to be known as Euro Banks. Such banks deal with both the
residents and the non-residents, but they deal essentially in any currency other
than the currency of the host country. For example, a Euro bank located in London
will deal with any currency, but not the British Pound. Also, unlike the traditional
international banks, the deposits and loans of the Euro bank are remunerated at
the interest rate set by the market forces operating in the Euro-curency market.
(Euro-currency market is concerned with the deposit and lending operations
conducted by banks in currencies other than those of the countries in which the
banks operate). The Euro banks are free from the rules and regulations of the host
country. This is because Euro banks do not have an impact on the domestic economy
as they are concerned with placement of funds (which is in form of foreign currency)
from one foreign market to the other and hence do no affect the balance of payments
of the host country.
One of the reasons for the emergence of Euro Banks was that after Stalin's
death, the then USSR moved towards an expansion of trade with the West and the
South. Since the US Dollar was the most powerful and used currency in international
transactions, the USSR also used and earned dollars through trade. But due to the
cold war between USSR and USA, the former deposited its earned dollars in banks
outside USA. The preferred banks were mostly in London and other European
countries, because of their superior infrastructure and stable political climate. These
dollar deposits came to be known as Euro Dollars, and the banks accepting such
deposits were now known as Euro banks.
Moreover, due to the foreign exchange crisis in 1955-57, the British
government placed restrictions on the use of pound sterling for external transactions
and the dollar was in great demand in the UK for external transactions. Also, the
emerging convertibility of some European currencies by late 1950s led to the
emergence of an active foreign exchange market in Europe linking the US dollar
with those currencies. These links enhanced the use of US dollar by the banks
located in Europe.
Apart from this, some other factors like the introduction of Voluntary Foreign
Credit Restraint Programme in 1965, limiting the ability of US based banks to lend
directly to non-residents also supported the opening of foreign branches of US banks,
mainly in Europe. Further, restrictions imposed by the European governments on
holding of deposits by non-residents in domestic currency and on paying of interest
on non-resident deposits encouraged non-residents to hold deposits in Euro banks
(which were not subject to such restrictions).
All these factors led to the emergence and spread of Euro banks.
2.5.3.3Off-shore Banking Centres (OBCs)
In the 1970s emerged another type of international banks, which came to be
known as off-shore banking centres (OBCs). OBCs dealt only with non-residents,
and did not deal in the currency of the host country. OBCs channelled funds from
one country to another without influencing the domestic financial market.
OBCs mainly came up in places/countries where governmental control and
regulations were non-interfering, tax rates were low, necessary infrastructure existed
and where economic and political conditions were stable. Hence, places like London,
Singapore, Hongkong, Luxembourg, Bahamas, Kuwait, Bahrain etc. attracted OBCs.
In its purest form, an OBC offers some banking services to local residents
but its reason for being is to allow non-residents to conduct banking operations
with minimal government control. The country in which such a centre is located
derives some income and employment from the centre's activity, and its government
obtains some revenues from the taxes, fees and other charges levied on the banks
that avail themselves of its hospitality.
A common feature of off-shore banking is the use of shell branches, which are
nothing more than booking offices. Upon payment of a low fee and meeting minimum
capital requirements, a bank can set up an OBC that requires only a handful of
employees and an office with good communication facilities. All of a shell's transactions
are worked out elsewhere, and yet a country in which transactions are booked is
considered, from the legal perspective, to be the home of resulting financial obligations.
In some OBCs, private banks play a prominent role. The clientele of these
facilities consist largely of wealthy individuals who find it advisable to arrange for
the management of at least some of their wealth outside their home countries.
2.5.3.4Syndication of Lending
Another structural change that took place during the 1970s was in the form
of syndicated lending. This development mainly took place in the wake of the
international oil price rise, when a number of oil-importing countries had to resort
to bigger loans which were not within the capacity of a single bank to provide. The
banks then joined hands for providing these large loans and to reduce the individual
risk of lending. Such lending came to be known as syndicated lending.
In syndicated Euro currency market lending, a bank known as the lead
manager or loan arranger assumes primary responsibility for working out the loan
terms and bringing in other banks, known as participating banks, to share in the
loan. Frequently, one or more banks other than the lead manager play some role in
these arrangements. Such banks are known as co-lead managers to distinguish
them from participating banks. A co-manager's main distinction is that it often
accepts a larger share of the loan. In addition, a bank known as the agent bank,
which is likely to be a managing bank, oversees the loan by collecting payments
due and distributing them to the other lending banks.
To achieve and hold a high ranking as a syndicated Eurocurrency loan
arranger is an important objective for banks that participate heavily in international
lending. This is largely because of the fee income that is generated directly by the
loan arrangement process.
After studying the changing structure of international banking in different
forms, let us study the motivating factors behind the banks going international.
2.5.4 Motivating factors
Banks' international lending has expanded in response to several factors.
Some of these factors are:
(i) Spread of multinational enterprises
This is basically the tendency of banks to follow their clients abroad. A
particular bank serving a particular multinational corporation (MNC) prefers to
accompany it. When a MNC moves abroad and sets up its subsidiaries in different
countries the bank too moves there to provide banking services to its clients. Since
that bank is close to the parent company, it can provide necessary services to the
client in a better way. In this regard the bank enjoys an edge over other banks.
(ii) Differences in the cost of capital
Another reason responsible for internationalisation of banks is the difference
in the cost of capital among different countries. Since capital is abundant in
industrialised countries, its cost is low. In developing countries, capital is scarce
and hence its cost is high. Naturally, a bank moves its operation from an
industrialised country to a developing country.
(iii) Gain from portfolio diversification
The process of diversification brings in stability in profits of the banks and
also reduces their systematic risk. The more the spread of a bank over different
countries, the greater the diversification it derives.
(iv) Increasing custodial function
Custodial services are granted to clients who make investment in overseas
securities. The banks have to collect the securities, collect dividend and offer other
related services. The rapid growth in such services require banks to have overseas
offices, and thus banks have moved abroad.
(v) Avoidance of regulations
Banks also move abroad to avoid reserve requirements, cumbersome reporting
requirements, corporate taxes and such other regulations that are found in the
domestic jurisdiction.
On the reverse, banks' international lending has also expanded as a result
of encouragements from both home and host country governments.
2.5.5 Scope of International Banking
Commercial banks dominate forex dealing. They are predominant among
financial institutions that engage in direct lending (i.e. lending that does not occur
through the medium of securities). They are involved in the creation of negotiable
CDs, bankers' acceptance and commercial paper (none of which are usually classified
as securities).
They are increasingly prominent in the international aspects of markets in
securities, not only because they lend money for purchases of securities, but also because
they perform investment banking functions, borrow by issuing internationally traded
securities of their own, and buy securities as investments. Included among the securities
that they buy as investments are not only obligations issued by their own govts, but
also securities issued by other govts. and pvt. corporations.
In investment banking, financial firms assist govts., private corporations and
international organisations to raise funds by issuing securities. Investment banks
manage, underwrite, and serve as marketing agents for new security issues. As
underwriters, they temporarily purchase securities from their issuers with the
intention of reselling them for profit net of the underwriting fees that they receive.
Merchant Banks blur the lines between commercial and investment banking.
They are largely British in origin, and historically associated with trade financing. These
firms typically conduct deposit banking while simultaneously engaging in operations
with new security issues that are associated with investment banks.
Deposit and direct lending operations of merchant banks are confined almost
exclusively to their corporate and governmental clients. They have very limited
retail commercial banking ties with the general public.
Some merchant banks, like some investment banking firms, and even some
commercial banks, have attained prominence as investment managers for
institutional investors notably pension funds.
Supplementing operations of commercial, investment and merchant banks
are those of various govt. agencies and international organizations that are in the
broad sense of the word, “banks” (IMF, World Bank group). These are divided as
those that are primarily concerned with financing trade, and those that are primarily
concerned with financing economic development. In general, official banks that
finance trade tend to be govt. owned institutions designed to stimulate exports.
Development banks are often jointly operated by various govts. for the benefit of
particular world regions, but also common are institutions run by a single govt.
Let us now test our knowledge gained so far of international banks by
answering these questions:
SELF-CHECK EXERCISE
Q1: What do you know about Euro banks?
Q2: Why do banks go international?
2.5.6 Direct International Lending (DIL) by Commercial Banks
Commercial Banks have largely dominated the activity of direct lending.
The history of DIL by commercial banks is as old as the history of banking itself. In
medieval times, not only did foreigners borrow from money lenders in northern
Italy and elsewhere, but merchants also frequently lent to the residents of the
countries to which they travelled - the dry-fruit and nuts selling ‘Kabuliwala’ lending
to Indian residents (mostly in Bengal) is the most common example. The loans were,
very often, for the purpose of movement of goods. Borrowing by rulers striving to
extend and consolidate their power was not unknown.
Over the centuries, although banking practice has changed dramatically,
features of banks' international lending has remained broadly similar. Such lending
has tended to develop in the financial centres of countries that have accumulated
relatively large pools of savings. As these countries expanded their international
trade, their banks tended to increase their financing of domestic firms' imports and
exports. With the expansion in the operations of trading and manufacturing firms
of domestic origin abroad, domestic commercial banks tended to establish offices
abroad to lend not only to these firms, but also to local firms that either had business
ties to domestic firms, or were otherwise engaged in international trade.
International banking has had its most spectacular growth since the late 1950s.
We already have studied the structural changes and motivating factors behind
internationalisation of banks.
Although most of the direct international lending by banks is effected through
the Eurocurrency market, a large volume of such lending can be classified as
traditional. International lending which is traditional is subject to the conventions
of domestic lending. In the United States, the prime interest rate is used as a
benchmark loan rate for both international and domestic bank loans (the
conventional definition of prime rate is that it is the short-term rate charged by US
banks to their best or prime business customers). In Eurocurrency lending, the
benchmark bank lending rate is the LIBOR (London interbank offered rate).
The prime rate and the LIBOR are not strictly comparable, because U.S. banks
often require business borrowers to maintain minimum amounts, known as
compensating balances, on deposit. No such balances are required in Eurocurrency
lending. However, the interest rate is the key factor in the choice between
Eurocurrency borrowing and traditional borrowing. Although the tilt is usually
towards the Eurocurrency market, traditional borrowing is favoured when a foreign
firm wishes to cultivate a relationship with a particular local bank.
Traditional bank borrowing commonly finances international trade. One
reason for this is that governments commonly sponsor credit insurance programs
to stimulate exports by protecting lending domestic banks and exporting firms from
the commercial and political risks associated with credit purchases of exports. Also,
small scale borrowers involved in international trade tend to rely on traditional
financing sources. Traditional borrowing also has an edge over Eurocurrency
market in terms of convenience and familiarity.
Although the Eurocurrency market and traditional banking markets are
imperfect substitutes, they are close enough that traditional banking markets are
greatly affected by developments in the Eurocurrency market. Growth in the
Eurocurrency market is, many times, at the expense of the traditional market.
2.5.7 Alternative Organisational Formats for International Banking
The process of internationalisation is a complex one, and in deciding how to
arrange their international operations, commercial banks can adopt various
organisational forms. The choice depends on a bank's goals, its volume of business
and the rules and regulations in the host country. The different forms and ways in
which a bank goes international are:
2.5.7.1 Correspondent Banking
A correspondent banking relationship exists when a bank uses the services of
another bank with a separate corporate identity that is located in another city or country.
The latter performs all the transactions on behalf of the former. The relationship is
often reciprocal. The services include forex transactions, originating and processing of
bills of exchange, providing credit information about potential borrowers, etc.
Correspondent banking system does not involve additional establishment cost.
With a given outlay a bank can achieve greater geographic coverage in its operations
with correspondents than by using some other alternative. The host coutry bank is
frequently in touch with the local customers, the benefit of which is reaped by the
international bank.
The main disadvantages of this system is that the host-country bank does
not always prove sincere, as it is more concerned about its own business. There is
a lack of full control and the range and extent of services offered is limited.
2.5.7.2 Representative Offices
This is a medium of internationalisation in those cases where the host
government does not permit any branch of a foreign banking company or provides
only a limited entry for the foreign banks. These offices are mainly to conduct
operations that do not requrie deposit and lending facilities in the host countries.
Representative offices locate potential borrowers, furnish intelligence about local
business conditions, and provide assistance to clients who either do business in
the host countries or are interested in doing business there.
The greatest advantage of representative offices is that the cost of operation is
minimum. But the disadvantage is that it cannot penetrate deep into the foreign market.
2.5.7.3 Foreign Branches
A foreign bank branch is a deposit banking unit that is legally an office of a
corporation that is headquartered in a country other than the one in which the unit
operates. This format offers the best possibilities for achieving unified and efficient
full-service banking across international boundaries. A branch office can lend far
greater sums than it can generate from its own resources because the resources
that are potentially at its disposal are those of the entire corporation.
A major factor behind the extensive reliance on the branch format in foreign banking
operations is that it provides greater security to a bank's customers than separately
incorporated banking units. The branches perform all types of banking functions.
Since foreign branches are not incorporated units, they are subject to home
country regulations that apply to the companies of which they are parts.
2.5.7.4 Foreign Banking Subsidiaries
Opening up of subsidiaries or affiliates is another way of going international.
Under this process the parent bank pariticipates in the equity capital of the host
country bank. One advantage of this mode is that the parent company has control
over the functioning of the subsidiary and is able to implement its policy. Due to
the existence of the host-country bank, it comes easily in contact with the local
customers. But often, there is a conflict between the parent company and the
subsidiary on the issue of implementing a particular policy.
2.5.7.5 Consortium Bank
When the volume of business is very large and beyond the means of a particular
bank, a few international banks come together to set up a consortium bank in a host
country. It represents a separate establishment. The different parent units represent
on the board of control according to their investment in the capital stock of the
consortium bank. The consortium bank suffers from the disadvantage that sometimes
conflict arises among the parent units, which impairs their functioning.
Let us attempt to answer a few questions now:
SELF-CHECK EXERCISE
Q1: Discuss foreign branches as a format for international banking.
Q2: Briefly explain direct international lending by commercial banks.
2.5.8 Control of International Banks
Although international banks have several advantages, there is also a need
to control their activities. The control involves two issues - why should they be
controlled, and secondly, how should they be controlled.
There are four main reasons as to why should these banks be controlled.
(i) International banks encourage inflation because they add to the stock
of money through credit creation.
(ii) Sometimes, these are responsible for bank failures because they siphon
off suddenly a large amount of cash to other countries and create
liquidity problem in the banking sector.
(iii) International banks charge high interest rates causing unmanageable
indebtedness among the borrowing governments.
(iv) They do not adhere to the credit allocation policy of the host
government, hence do not normally participate in the social objectives
of the host country government.
The other issue that arises is the mode of control of international banks. One
way to control these is to control their activities by imposing statutory reserve
requirements on them. This will ensure equity between them and the domestic
banks. It will also help to control the money supply vide the national monetary
policy. It may also encourage business to be conducted on-shore, which may be
advantageous for the national authorities.
However, imposition of reserve requirements by a few governments cannot
be effective as international banks will move their offices to countries with less
restrictive regulations. So it is necessary to have a consensus on this issue among
the host governments.
Another way of control is to impose some control on the convertibility of
currency. It is suggested that payments in foreign currency should be approved by
the monetary authorities of the host country, but again, it will be very difficult to
monitor thousands of transactions.
Moral persuasion is one way in which international banks should be urged
not to take steps that dilutes the interest of the host country or its banking sector.
Hoever, the best way to control international banks is to raise the operational
standard of the domestic banking industry so that it can face the challenges posed
by the international banks.
2.5.9 Summary
International banks have come a long way and undergone substantial
structural changes. Factors responsible for internationalisation of banks have been
the tremendous growth in international trade and in the activities of the
multinational corporations. International banks operate abroad through various
organisational formats. Since the functions of international banks are not striclly
regulated, they do not always act in the interest of the host country. Hence there is
a need for control on their activities.
(i) John S. Evans : International Finance: A Markets Approach
(ii) V. Sharan : International Financial Management.
2.5.11 Questions for practice
(A) Long-Answer Questions
1. Discuss the alternative organisational formats for international
banking.
2. Trace the structural changes that have taken place in the
development of international banks.
(B) Short-Answer Questions
1. Give the scope of international banks.
2. Why should international banks be controlled?
3. Write a brief note on off-shore banking centres.

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Class : M.A.

2.2 : International Monetary Fund (IMF)

2.3 : International Bank for Reconstruction and

2.4 : International Financial Institutions (IDA, IFC, MIGA, ADB)

2.5 : International Banking

Department website : www.pbidde.org

INTERNATIONAL MONETARY SYSTEM

International monetary system includes any form of prevalent order

Secondly, an international monetary system may be based on fixed exchange

International Monetary System since World War II

5. To give confidence to members by making the Fund's resources available

* (Now it is called reserve tranche)

* G-10 includes United States, Canada, Japan, Belgium, France, Italy,

Problem of International Liquidity

balance of payment deficits. The amount or the quantity of international reserves

transactions. A greater world holding of international liquidity reserves becomes

once fixed can be changed or adjusted according to variations in circumstances.

INTERNATIONAL MONETARY FUND (IMF)

resorting to measures, destructive to national or international prosperity.

Federation and Saudi Arabia. The remaining 16 Directors represent constituencies

exchange. It means they cannot be spent directly on goods and services. In

of world reserves. As a matter of fact, 96 percent of the overall deficits of the

1. Discuss the objectives and organisation of IMF.

INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT(IBRD)

development plans and the projects.

Thirdly, the Bank is a non- political and nonpartisan financial institution.

INTERNATIONAL FINANCIAL INSTITUTIONS: IDA, IFC, ADB

Structure of the Lesson

from outside. It is committed to providing loans for social issues such as

Structure of the Lesson: -

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