BLW 3204- INERNATIONAL ECONOMIC LAW

LECTURE NOTES- WEEK 6

COURSE INSTRUCTOR : ANAM PATRICK

THE INTERNATIONAL FINANCIAL SYSTEM

PART A

▪ Nature of the international financial system.

▪ Bretton Woods Agreements.
▪ The International Monetary Fund: Objectives, Organization, and Functions.

▪ Nature of the international financial system.

▪ International monetary law constitutes a core sector of international economic law.
International trade in goods and services and other international business
transactions rest on cross-border payments and capital movements
which, as a rule, affect two or more currency areas.

▪ In the post‐1945 international economic and monetary order three international

institutions have played a key role (): the General Agreement on Tariffs and
Trade, which later became the World Trade Organization (WTO); the
International Monetary Fund (IMF) and the World Bank. While the WTO is
concerned with trade in goods and services as well as intellectual property
rights, IMF and World Bank focus on the international monetary and
financial system.

▪ The system established by the Conference of Bretton Woods (1944), with the
Articles of Agreement of the International Monetary Fund (IMF), aims to create an
international monetary order based on the free convertibility of
currencies.

▪ According to Article IV, section 1 of the IMF Agreement, the members of the Fund
expressly recognize that the essential purpose of the international monetary system
is to provide a framework that facilitates the exchange of goods,
services, and capital among countries, and that sustains sound
economic growth, and that a principal objective is the continuing
development of the orderly underlying conditions that are necessary for
financial and economic stability.

▪ The regulation of currency exchange vitally affects competitive conditions in

international trade and business. Again and again, States resort to currency
manipulation as an instrument to place their own economy in an advantageous
 position on the international markets. By means of an undervalued exchange
rate, either by devaluation or by artificially keeping its own currency
down (eg by massive purchase of foreign currencies), States may distort
international competition in favour of their own export industry.

▪ Financial aid to countries with balance of payment problems, in particular heavily

indebted countries, provided by governments and international organizations such
as the International Monetary Fund (IMF) has become an important mechanism to
stabilize currencies.

Bretton Woods Agreements

Background:
▪ In the decades before the First World War, the major economic powers (France,
Germany, the United Kingdom and the United States) tied their currencies to
gold. Under the ‘gold standard’ the parity of the Franc, the Mark, the Pound Sterling
and the US Dollar remained stable. This system of rigid exchange rates also extended to
other States, which pegged their currency against one of the lead currencies or to gold
and kept reserves in this currency or in gold.

▪ The turbulence generated by changing exchange rate policies of the major powers
after the First World War (especially in the 1930s), with manipulative devaluations
and other protectionist strategies, inspired the negotiation of a legally
entrenched universal regime designed to establish monetary relations with
freely convertible currencies and stable exchange rates as a basis of economic
growth towards the end of the Second World War.

▪ The Conference of Bretton Woods (1944) adopted the Articles of Agreement on the
International Monetary Fund (IMF) and shaped the international monetary system for
decades. It also created the Agreement on the International Bank for Reconstruction of
Development (the World Bank).

▪ The main actors at the Conference were the chief negotiator for the United States,
Harry Dexter White and, for the United Kingdom, Lord John Maynard Keynes.
The IMF established a kind of ‘currency pool’ with the purpose to assist Member States
with balance of payment problems and thus to ensure the liquidity on the international
markets.

▪ The Bretton Woods system rested on two pillars: the free convertibility of
currencies and fixed exchange rates. The dollar was pegged against gold and
the United States guaranteed the convertibility of the dollar into gold
(0.88671 g gold per dollar).
 ▪ The IMF Agreement of 1944 allowed fluctuations of the exchange rates within a
corridor of 1 per cent. To counter fluctuations beyond this margin, central banks of
Member States were bound to intervene, buying or selling US dollars. With
the US dollar being the lead currency with guaranteed convertibility into gold, the United
States had no obligation to intervene. In the case of a ‘fundamental disequilibrium’ in the
balance of payments, the exchange rates had to be adjusted. All these parameters
constituted a system of fixed exchange rates with graded flexibility.

▪ In the first decades of the post-Second World War era, the Bretton Woods system of
fixed but adjustable exchange rates ensured considerable stability of monetary relations
among the Member States. However, in the 1960s, increasing excessive government
spending and inflation in the United States caused an expansion of the dollar volume out
of proportion with the US gold reserves. The gross overvaluation of the dollar made the
system of fixed exchange rates and the convertibility into gold unsustainable. In 1971, the
US government suspended the convertibility of the US dollar into gold, and the Bretton
Woods system of fixed parities ultimately collapsed in March 1973, when major
currencies started floating against each other. Floating exchange rates enabled
economies to respond better to external shocks like the oil crisis of 1973.

▪ The 1976 Amendment of the IMF Articles (in force since 1978), fundamentally reformed
Article IV and allows Member States to choose exchange arrangements freely, except
pegging their currency to gold. Article IV, section 2(b) of the IMF Agreement states:
“Under an international monetary system of the kind prevailing on January 1, 1976,
exchange arrangements may include (i) the maintenance by a member of a value
for its currency in terms of the special drawing right or another
denominator, other than gold, selected by the member, or (ii) cooperative
arrangements by which members maintain the value of their currencies in
relation to the value of the currency or currencies of other members, or (iii)
other exchange arrangements of a member’s choice.”
Currency Exchange Regimes
▪ Currency exchange may be subject to one of two different model: the liberal system of
free convertibility of currencies or the restrictive regime of currency exchange control.
▪ liberal system of free convertibility:- allows the exchange of the domestic or other
currencies for different currencies.
▪ restrictive regime of currency exchange control.: tightly regulate currency exchange and
the acquisition of foreign currencies. This kind of control was applied in the communist
States of the former ‘Eastern bloc’. It still prevails in countries with a Statetrading
monopoly regime. Exchange controls are a heavy barrier to international trade
Monetary Unions:
▪ Monetary unions (currency unions)5 are the most advanced forms of economic
integration. Monetary unions in a narrow sense rest upon an agreement between two
or more States (or other territorial entities) to share a common currency and to pursue a
common monetary policy.
 ▪ There must be a common central bank with the authority to issue the common
currency and, thus, a transfer of monetary powers to be shared by all members. The
main benefit lies in the elimination of transactions costs and the stabilization
of exchange rates due to aggregated economic power. Monetary unions suppose a
high / stable degree of economic convergence including fiscal policy, as there
is no national exchange policy to address gaps in economic growth rates between
members, balance of payment problems, and other domestic or international
disturbances. Examples: European Economic and Monetary Union and the
Eastern Caribbean Currency Union.

▪ The former French colonies in West Africa and in Central Africa have preserved the
legacy of a common currency (‘CFA Franc’). The West African Financial Community
(Communauté Financière d’Afrique) and the Central African Financial Cooperation
(Coopération Financière Africaine) each constitute a monetary union with a common
currency issued by a regional central bank. Their currencies (West African CFA Franc,
Central African CFA Franc) are legal tender only in the respective monetary union, but
are, in practice, fixed at par value and administered under the auspices of the French
ministry of finances as elements of a single currency zone (‘CFA zone’). Both CFA Francs
are pegged to the Euro.
Case Study: The EU
▪ The rules on the European Economic and Monetary Union (EMU), as designed in the
Treaty of Maastricht (1992), provide the framework for the establishment of the
Euro in 1999, as the common currency for the participating States.

The International Monetary Fund: Objectives, Organization, and Functions.

i. Objectives

The objectives of the IMF are found in Article 1 of the IMF Agreement:

The purposes of the International Monetary Fund are:

(i). To promote international monetary cooperation through a permanent institution

which provides the machinery for consultation and collaboration on international
monetary problems.

(ii) To facilitate the expansion and balanced growth of international trade, and
to contribute thereby to the promotion and maintenance of high levels of employment
and real income and to the development of the productive resources of all members as
primary objectives of economic policy.

(iii) To promote exchange stability, to maintain orderly exchange arrangements

among members, and to avoid competitive exchange depreciation

iv) To assist in the establishment of a multilateral system of payments in

respect of current transactions between members and in the elimination of
foreign exchange restrictions which hamper the growth of world trade.
 (v) To give confidence to members by making the general resources of the Fund
temporarily available to them under adequate safeguards, thus providing them with
opportunity to correct maladjustments in their balance of payments without resorting to
measures destructive of national or international prosperity.

(vi) In accordance with the above, to shorten the duration and lessen the degree of
disequilibrium in the international balances of payments of members.

ii. Membership:
▪ The IMF currently has 187 Member States. Each member is assigned a quota
expressed in special drawing rights (Article III, section 1 of the IMF Agreement). The
contributions of each member to the IMF’s capital stock (subscription) are equal to its
quota (Article III, section 1 second sentence). The largest share is allocated to the United
States, the smallest to Tuvalu.
▪ The quotas (Article III, sections 1 and 2 of the IMF Agreement) result from a number of
weighted variables which reflect its relative position in the global economy: GDP with a
weight of 50 per cent, openness to trade with a weight of 30 per cent, variability of
current receipts (eg earnings from the export of goods and services) with a weight of 15
per cent, gold and international currency reserves with a weight of 5 per cent.
▪ Quotas are determined and adjusted by the Board of Governors. They cannot be
changed without assent of the respective Member State. The quotas determine the
voting power of each member, its representation in the Executive Board and
its access to financing by the IMF. The voting rights of members are weighted
according to a complex system (Article XII, section 5 of the IMF Agreement). The
total votes of each member shall be equal to the sum of its basic votes (equal for each
member) and its variable, quota-based votes.

Recent reforms on Quota System:

▪ Recent reforms of the quota system have considerably enhanced the position of some
industrialized States as well as dynamic emerging market and developing countries such
as Brazil, the People’s Republic of China, India, Mexico, Singapore, South Korea, and
Turkey. Under the 2010 reform of the quota system (not yet in force), the largest quota
shares will be assigned to the United States (about 16.5 per cent), Japan (about 6.1
per cent), the People’s Republic of China (6.1 per cent), Germany (6.1 per
cent), France (4.0 per cent), the United Kingdom (4.0 per cent). Italy (3.0
per cent), India (2.6 per cent), the Russian Federation (2.6 per cent),
Canada (2.2 per cent), and Saudi Arabia (2.0 per cent).

iii. Organization

▪ The main organs of the Fund are the Board of Directors and the Executive Board
chaired by the Managing Director. The representative body and supreme organ of the
IMF is the Board of Governors, with each member appointing a Governor (usually the
minister of finance or the president of its central bank) and an Alternate (Article XII,
section 2 of the IMF Agreement).
 ▪ The Executive Board with 24 executive directors conducts the business of the
Fund (Article XII, section 3 of the IMF Agreement). The executive directors have the
aggregated voting power of the group of countries which elected them (Article XII,
section 3(i) of the IMF Agreement).
▪ The operations and transactions of the IMF are carried out either by the General
Department or the Special Drawings Rights Department (Introductory Article,
section 2, Article V, section 3, Article XVI, sections 1 and 2 of the IMF Agreement).
Important decisions (eg the adjustments of quota under Article III, section 2(c)) require
a majority of 85 per cent of the total voting power. This vests the United States (as the
only member) with a veto power.
▪ Questions of interpretation of the IMF Agreement arising between the Fund and a
member or between members shall be decided by the Executive Board or, if required by a
member, by the Board of Governors (as a rule deciding through its Committee on
Interpretation) (Article XXIX (a) and (b) of the IMF Agreement).
▪ Amendments of the IMF Agreement, as a rule, must be approved by the Board of
Governors and accepted by three-fifths of the members with 85 per cent of the total
voting power, in certain cases by all members (Article XXVIII of the IMF Agreement).

iv. Financing of the IMF

▪ In the past, financing of the IMF had massively shifted from quota-dependent payments
of subscriptions of each member to credits granted by a number of members on the basis
of individual agreements.
▪ Another important source of financing are voluntary contributions of members to a trust
fund for low-income countries (the Poverty Reduction and Growth Fund).

v. IMF Members’ General Obligations and the Surveillance of Exchange

Rate Policies: Stability and Fair Competitive Conditions

General obligations of members and the 2007 surveillance decision

▪ Article IV, section 1 of the IMF Agreement lays down the general obligations of members:
[E]ach member undertakes to collaborate with the Fund and other members to assure
orderly exchange arrangements and to promote a stable system of exchange rates. In
particular, each member shall:

(i) endeavour to direct its economic and financial policies toward the objective of
fostering orderly economic growth with reasonable price stability, with due regard to its
circumstances.

(ii) seek to promote stability by fostering orderly underlying economic and financial
conditions and a monetary system that does not tend to produce erratic disruptions.

(iii) avoid manipulating exchange rates or the international monetary system in order to
prevent effective balance of payments adjustment or to gain an unfair competitive
advantage over other members; and (iv) follow exchange policies compatible with the
undertakings under this Section
Article IV, section 3 mandates the IMF with the surveillance over exchange rate policies of
the Member States:

(a) The Fund shall oversee the international monetary system in order to ensure its
effective operation, and shall oversee the compliance of each member with its
obligations under Section 1 of this Article
(b) in order to fulfil its functions under (a) above, the Fund shall exercise firm
surveillance over the exchange rate policies of members, and shall adopt specific
principles for the guidance of all members with respect to those policies. Each
member shall provide the Fund with the information necessary for such surveillance,
and, when requested by the Fund, shall consult with it on the member’s exchange
rate policies. The principles adopted by the Fund shall be consistent with
cooperative arrangements by which members maintain the value of their currencies
in relation to the value of the currency or currencies of other members, as well as
with other exchange arrangements of a member’s choice consistent with the
purposes of the Fund and Section 1 of this Article. These principles shall respect the
domestic social and and political policies of members, and in applying these
principles the Fund shall pay due regard to the circumstances of members.political
policies of members, and in applying these principles the Fund shall pay due regard
to the circumstances of members.

vi. Convertibility of Currencies and Restriction of Exchange Controls

The principle of free convertibility of currencies is enshrined in Article VIII of the

IMF Agreement which restrains exchange controls. The Agreement distinguishes
between current transactions and the transfer of capital. Whilst restrictions
on payments for current transactions are, in principle, prohibited, members enjoy
ample freedom to control capital movements.

current transactions
▪ Subject to narrow exceptions, no member shall, without approval of the IMF, impose
‘restrictions on the making of payments and transfers for current transactions’
(Article VIII, section 2(a) of the IMF Agreement) or engage in ‘any discriminatory currency
arrangements or multiple currency practices’ (Article VIII, section 3)
▪ Payments for current transactions are defined in Article XXX(d) of the IMF Agreement:
(1) all payments due in connection with foreign trade, other current
business, including services, and normal short-term banking and credit
facilities;
(2) payments due as interest on loans and as net income from other
investments
3) payments of moderate amount for amortization of loans or for depreciation of
direct investments; and
(4) moderate remittances for family living expenses.
 Article VIII, section 4(a) of the IMF Agreement provides the convertibility of foreign-
held balances in context with current transactions: Each member shall buy balances of
its currency held by another member if the latter, in requesting the purchase, represents:
(i) that the balances to be bought have been recently acquired as a result of current
transactions; or (ii) that their conversion is needed for making payments for current
transactions.

Capital transfers under the IMF Agreement

▪ The IMF Agreement places little restraint on exchange controls. Article VI, section 3
stipulates:
▪ Section 3. Controls of capital transfers Members may exercise such controls as are necessary
to regulate international capital movements, but no member may exercise these controls in a
manner which will restrict payments for current transactions or which will unduly delay
transfers of funds in settlement of commitments, except as provided in Article VII, Section
3(b) and in Article XIV, Section 2.

▪ The question, whether the prohibition of discriminatory restrictions (Article VIII, section 3
of the IMF Agreement) also extends to the transfer of capital, was resolved in 1956 by a
controversial decision of the Executive Board in favour of members’ discretion: Members are
free to adopt a policy of regulating capital movements for any reason, due regard being paid
to the general purposes of the Fund. They may, for that purpose, exercise such controls [ . . .
] without approval of the Fund.

▪ However, full effectiveness of capital controls implies, to some extent, control of current
transactions, which fall under the IMF’s mandate of surveillance.

Freedom of payment and capital transfers under other universal or regional regimes

▪ Several universal or regional regimes further liberalize payments for current transactions
and the movement of capital. Under WTO law, the General Agreement on Trade in
Services (GATS) extends the liberalization of services under specific commitments to
associated capital transfers and payments (Article XI:1). The exception of Article XII of the
GATS allows restrictions in the case of balance of payment problems. However, these
restrictions must conform to the IMF Agreement (Article XII:2 of the GATS).

▪ Within the OECD, the Code of Liberalization of Capital Movements and the Code of
Liberalization of Current Invisible Operations provide for the progressive abolition of
restrictions on cross-border capital transactions and payments associated with an invisible
operation (e.g the import of services), in terms legally binding for OECD Member States.

▪ The freedom of capital movements under regional trade or integration arrangements and
international investment agreements (guaranteeing the freedom to repatriate invested
capital and earnings) have considerably curtailed the ambit of permitted capital controls.(
 European Union has established the most liberal and most comprehensive regime for free
movements of capital and payments (Articles 63 of the TFEU, Capital Movements
Directive 88/361/EEC, Payment Service Directive 2007/64/EC).

▪ In ECJ Case C-112/05 Commission of the European Communities v Federal Republic of

Germany [2007] ECR I-8995.( Volkswagen Case) the ECJ held that;

“The freedom of capital movements prohibits even non-discriminating measures such as

restrictions on the rights of major private shareholders of a company, if they may
dissuade investors from other EU countries to acquire a substantial share in a company.”

vii. Exchange Control Regulations and their Extraterritorial Effect

▪ It is crucial for the parties to an international business transaction to know whether or

not the exchange control regulations of a State are recognized or even enforced in other
countries.

▪ As a rule, States are free to give or to deny legal effect to exchange control regulations of
other countries. These regulations pursue specific sovereign interests of the State
concerned, which other countries need not share or even merely recognize.Hence,
national courts tend not to enforce or implement foreign exchange control regimes,
unless there is a treaty obligation to give effect to such foreign restrictions.
Article VIII, section 2(b)11 obliges the IMF members to give effect to the exchange
control regulations of another member affecting ‘exchange contracts’: Exchange
contracts which involve the currency of any member and which are contrary to the
exchange control regulations of that member maintained or imposed consistently with
this Agreement shall be unenforceable in the territories of any member. In addition,
members may, by mutual accord, cooperate in measures for the purpose of making the
exchange control regulations of either member more effective, provided that such
measures and regulations are consistent with this Agreement.

viii. Special Drawing Rights

▪ Signifies an international reserve asset administered under the auspices of the IMF.
The special drawing right (SDR) is not a currency, but rather an interest-bearing
asset apt to be changed into freely usable currencies of IMF members. Its
fungibility depends on the willingness of IMF members and certain international financial
institutions such as the World Bank (‘prescribed holders’) to hold, recognize, and
honour obligations denominated in SDRs.

▪ The value of an SDR (determined with 70 per cent of the total voting power, Article XV,
section 1 of the IMF Agreement) is defined as a basket of four weighted currencies
(reviewed and adjusted every five years)
▪ The IMF allocates SDRs to members in proportion with their quota (Article XV,
section 2, Article XVIII of the IMF Agreement). If a member holds SDRs in excess of
 its quota, it earns interest. Conversely, in case of a shortfall it has to pay
interest.
▪ In economic terms, the allocation of SDRs allows a member to exchange its own
national currency for other, ‘freely usable currencies’ as defined in Article XXX(f)
of the IMF Agreement, i.e. actually the Euro, the Japanese Yen, the Pound
Sterling and the US Dollar.

▪ With the IMF acting as an intermediary, there is a voluntary trade of SDRs between
members acting as willing sellers and willing buyers (Article XIX, section 2(b) of
the IMF Agreement). Over the years, this voluntary market became the dominant
mechanism for changing SDRs into currencies. In addition, the IMF can fall back
on a designation mechanism, designating members (with a strong balance of payments
position) to buy SDRs with freely usable currencies from other members (Article XIX,
section 2(a) of the IMF Agreement).

xi. Use of the Fund’s Financial Resources for Members in Economic

Difficulties

Assistance in case of balance of payment problem

▪ A core function of the IMF is providing loans to member countries with a balance of
payment deficit. Balance of payment deficits arise from a surplus of the outgoing
payments and capital transfer over ingoing payments. Balance of payment problems can
cause the country’s currency to depreciate, even disrupt the whole economy. By assisting
countries with difficulties to find financing at affordable conditions to meet their net
international payments, the IMF operates as ‘lender of the last resort’(Article V, section
3 of the IMF Agreement governs the use of the Fund’s general resources)

Drawing on reserve tranche

▪ If the IMF’s holdings of a member’s currency (excluding the holdings that correspond to
the member’s use of the Fund’s resources) are inferior to its quota, the member is in a
‘reserve tranche position’. With its own currency, it may draw up the full amount of its
reserve position, purchasing other currencies or SDRs (Article V, section 3(b) of the IMF
Agreement). This transaction is not qualified as an IMF loan and is not subject to the
obligation to repurchase.

Credit facilities
▪ The regular framework for IMF lending to members is related to the four credit tranches
which each amount to 25 per cent of a member’s quota. Whilst a member can relatively
easily accede to loans in the first tranche, borrowing in the higher tranches is tied to
adjustments in the economic policy (conditionality).
Conditionality
Conditionality became associated with the so-called ‘Washington Consensus’ which
stands for a number of reform goals pursued by the IMF and other Washington-
based financial institutions (in particular the World Bank), especially in context
with financial assistance to Latin American countries. The term ‘Washington Consensus’,
coined by the economist John Williamson, essentially refers to • fiscal discipline; •
reordering of public expenditure priorities; • tax reform; • liberalizing exchange rates;
• competitive exchange rates; • trade liberalization; • liberalization of inward foreign
direct investment; privatization; • deregulation; and • property rights.

#END