International Finance: Foreign Exchange Market
International finance plays a fundamental role in determining the future of the leading financial institutions. Given the need for globalization especially in the 21st Century, it is noted that the success of global markets is founded on the effectiveness of the leading financial institutions such as World Bank and other international financial bodies. Through globalization, financial trading is made simpler. The acceptance of common trading currency in the global financial markets has made it easy for traders to export or import essentials. However, economists have noted that amid the increasing need for globalization of the financial markets, it is important to integrate foreign financial markets to pave way for globalization and international trade (Goodhart, & Mizen, 2003, pp.78). Besides, liberalization of capital and money market would make it the implementation of international trade policies simpler and realistic. Such a move starts with globalization of Forex markets. Liberalization of financial institutions starts with the flexibility in the currency exchange across the international boundaries. This is an indication of the importance of financial sector (especially currency market).
Historically, Forex trade is traced back in the 19th century immediately after the birth of international gold standard monetary unit. Although even before the 1875 gold standard, it economists and financial experts revealed countries used silver and gold in making international payments. The use of silver and gold as internationally accepted medium of payment was hampered by the fact that these commodities often suffer from devaluation (Goodhart, & Mizen, 2003, pp.45). Discoveries of new gold and silver deposits (among other external factors) led to changes in demand and supply market, hence devaluation, a factor which shaped the history of Foreign Exchange markets to what they are today. The main objective of the international gold standard was to act as a guarantee for other currencies so that all the currencies are valued in specific units of gold. Gold therefore acted as a back-up to all the currencies measured in ounces (Walmsley, 2000, pp.24).
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Following the increasing demand for gold as an internationally accepted monetary unit, countries (through their monetary institutions) were forced to increase their gold reserves. The foreign exchange rate between the trading partners was determined the differences in the gold ounce. This rich history of Forex exchange market was drastically changed following the re-birth of the international foreign exchange standards. The use of gold standards as an internationally accepted monetary unit came to an end during the World War I when Germany proposed the use of military projects in the larger European economies (Einzig, 2009, pp.34). The focus on military projects led to a financial drain on European super powers as there was inadequate amount of gold to back up the printing of excess currencies, hence the historical change in the foreign exchange trading policies.
The abolishment of international gold monetary system in the forex market left a void in this sector. The allied countries got concern on the way forward with respect to FX market. The 1944 Bretton Woods convention was held to attempt to solve the FX problem, which was an international worry (Coyle, & Chartered Institute of Bankers, 2000, pp.62-3). The Bretton Woods convention gave birth to the popular Bretton Woods Monetary policies and system, which are still being used in international trade and foreign exchange sectors. The convention also recommended for the establishment of financial institutions (popularly referred to as Bretton Institutions) such as World Bank.
Other recommendations made by the convention were; the use of US Dollar as the new ultimate exchange currency in place of the worn-out gold standards, the US Dollar as the only currency with the right to gold backing, and the establishment of at least three international monetary authorities charged with the responsibility of guarding and regulating all foreign financial transactions. This forex systems where US Dollar was the only currency with legal backing of gold only lasted for twenty five years. By august 1971, the U.S government officially declared the end of gold backed US Dollar system (Walmsley, 2000, pp.87). Eight years after the collapse of the USD, the European Monetary System was introduced to gain financial independence from the USD.
Years after the World War II, financial liberalization was realized. This was a significant step in dealing with the volatility in the foreign exchange sectors. As observed by economist and financial market experts, the demands and market condition are diverse in every economy, an implication that each economy should operate an independent foreign exchange policies with are deemed appropriate and relevant (Goodhart, & Mizen, 2003, pp.134).
Countries therefore adopted the Smithsonian Agreement of 1971 which allowed for greater degree of fluctuation band for all the leading currencies. The collapse of the European Joint Float of 1973 and the Bretton Woods Accord prompted the need for currency independence. To avoid the mistakes made by the earlier foreign exchange regimes, a switch to free-floating monetary system took place (Einzig, 2009, pp.52). Although this happened by default, it marked the success in the FX market. Since then, depending on the nature and state of the economy, different countries maintain different foreign exchange regimes. However, the most common FX regime in the 21st century is the free float system or semi-pegged. Under the free float exchange rate regime, the exchange rate is determined by the market forces of demand and supply for the currencies. Although independent, foreign exchange markets are regulated by the monetary authorities through the central bank’s monetary committees, chaired by the governor. Unlike in the earlier centuries where currency trading was regulated, today, currency trading is open to everyone, which has caused an influx of speculations by financial institutions, brokerage houses, individuals, and hedge funds (Coyle, & Chartered Institute of Bankers, 2000, pp.48). In conclusion, the free-float exchange rate regime is very ideal for the foreign exchange markets of today.
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