978-0132718974 Chapter 6 Solution Manual Part 1

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Money and Banking

I. Text Materials

The world’s money and banking system is neither coherent nor well organized. In the absence of

a convenient set of laws or regulations, custom and practice regulate much of it. The system is

highly informal.

On the international plane, its players include national institutions governed by national laws, as

well as international agencies, such as the International Monetary Fund (IMF) and the Bank for

International Settlements. On the domestic level, each country has its own national monetary

system and its own specialized and often unique institutions.

Money

According to one dictionary, money is “anything customarily used as a medium of exchange and

measure of value.” Economists generally attribute three characteristics to money: it acts (1) as a

means of exchange, (2) as a unit of measure or value, and (3) as a medium for storing value over

time.

Money can be both private and official. Private money commonly consists of a basket of official

currencies or a stock of rare metal or any other commodity that is easily transferable and

reasonably nonspoilable. Official money is a unit of exchange issued by a government agency or

government-controlled financial institution.

Private money can be used only for making payments between private parties who agree in

advance to its use. Most official money can be used to pay debts of any kind, whether private or

public. Some types of official money, known as reserve currencies, may be used only by

governments to pay other governments.

The Value of Money – While the value of property and services is measured by money, the value

of official money is nominally constant. The obligation does not change because the purchasing

power or conversion value of the currency has fluctuated. This principle is known as nominalism.

If the parties to a contract have not taken care to anticipate changes in the value of the currency

they use, the principle of nominalism “puts the risk of depreciation on the creditor and the risk of

appreciation (or revaluation) on the debtor and neither party can be heard to complain about

unexpected losses.” Application of the principle of nominalism can be avoided in the special case

where currency is to be delivered not as money, but as a commodity.

The Choice of Money – In domestic transactions, obligations are paid in local currency. In

international transactions, the parties must designate the money that the buyer has to deliver.

Actually, two monies have to be selected. First is the money of account, which is the money that

Money and Banking

expresses the amount of obligation owed. Second is the money of payment, which is the money

that the buyer must use to pay for the items purchased. In most situations, the money chosen for

both will be the same, but it does not have to be.

Contracting parties need to select the place of payment. This is important because virtually all

countries allow a foreign money obligation to be satisfied by payment in the local currency at the

exchange rate effective on the date payment is due. Absent a selection by the parties, the courts

will determine the place of payment.

By choosing a money of account, a money of payment, and a place for payment, the parties to a

contract are also authorizing the courts in the states that issue those monies or the court in the

state wherein payment is to take place to resolve disputes related to the interpretation or

performance of the contract.

Case 6-1: Republic of Argentina et al. v. Weltover, Inc. et al.

Facts: Argentina issued bonds that came due in 1982. It did not have sufficient foreign reserves to

Issues: (1) Did the unilateral rescheduling of the Bonods have a direct effect within the U.S. so

Holdings: (1) Yes. (2) Yes.

Law: (1) An effect is direct if it follows as an immediate consequence of the defendant’s action.

Explanation: (1) Because New York was the place for performance, the rescheduling had a direct

Order: The trial court had jurisdiction over Argentina.

Maintaining Monetary Value – One of the devices for avoiding inflation or deflation is

inclusion of a maintenance of value clause in the sales contract. Such a clause stipulates that the

price is to be adjusted according to the inflation rate.

A seller of commodities can also avoid the problem of inflation and the buyer the problem of

deflation by designating a money of account that traditionally maintains its value. The currency

most commonly used for this purpose is the American dollar.

A third mechanism for avoiding currency fluctuations is the use of a currency basket. That is, the

money of account in a contract is defined by a weighted average of a selected group of currencies.

The basket (or group of currencies) may be created ad hoc for a particular agreement. Parties will

use an official basket currency established by intergovernmental organizations, such as the IMF’s

SDR.

Money and Banking

The SDR is an international reserve asset that member countries can add to their foreign currency

and gold reserves and use for payments requiring foreign exchange.

The International Monetary Fund (IMF)

Origin of the IMF – The set of rules and procedures by which different national currencies are

exchanged for each other in world trade is known as the international monetary system.

The first modern international monetary system was the gold standard. In operation during the

late nineteenth and early twentieth centuries, it provided for the free circulation between nations

of gold coins of standard specification. The principal disadvantage of the gold standard was its

inherent lack of liquidity: The world’s supply of money was necessarily limited by the world’s

supply of gold. Additionally, any sizable increase in the supply of gold, such as the discovery of a

rich new mine, would cause prices to rise abruptly.

The gold standard was replaced by the gold bullion standard. Under this system, states no longer

minted gold coins; instead, they backed their paper currencies with gold bullion and agreed to buy

and sell the bullion at a fixed price. With the onset of the worldwide Great Depression of the

1930s, the exchange of currencies became both unreliable and expensive. Nations with limited

gold reserves were forced to abandon the gold standard, and because their money no longer bore

a fixed relation to gold, its exchange became difficult.

Representatives of 44 nations attended the UN Monetary and Financial Conference (known as the

Bretton Woods Conference) to draft the charter for the International Monetary Fund (IMF). The

IMF came into being on December 29, 1945. The IMF was created to combat the international

monetary and trade conditions that had helped to produce and prolong the Great Depression of

the 1930s. The conditions were identified as (1) currency inconvertibility and (2) the lack of a

standard for determining the value of national currencies.

The Articles of Agreement establish a system of currency exchange and a system for currency

support. They also establish a system of surveillance to ensure that member states abide by a code

of conduct in their external monetary relations—specifically, that they do not borrow or lend at

unsustainable levels, engage in protracted one-way interventions in the exchange market, or

follow unwarranted monetary or fiscal policies for balance-of-payments purposes.

In addition to currency exchange, currency support, and surveillance, the IMF maintains an

extensive program of technical assistance through staff missions to member states.

IMF Quotas – To become a member of the IMF, a state must contribute a certain sum of money

called a quota subscription.

The quota is based on the relative size of a member state’s economy, and it serves various

purposes. First, members’ quotas make up a pool of funds on which the IMF can draw to lend to a

particular member having financial difficulties. Second, quotas determine how much a

contributing member can borrow from the IMF and how much it will receive in periodic

allocations of SDRs. Third, quotas determine the members’ voting power in the IMF.

Quotas for a state seeking to join the IMF are determined initially by the IMF staff based on

formulas that take into consideration the state’s gross domestic product, its current account

Money and Banking

transactions, the variability of its current receipts, and its official reserves. Then the IMF

Executive Board and finally the IMF Board of Governors must approve the quota.

The Board of Governors is required to make a general review of quotas at intervals of not more

than five years and propose any adjustments that it considers appropriate. Any quota change is not

effective for a particular state until the state itself both approves of the change and pays for it.

Organization of the IMF – The Board of Governors is the highest authority of the IMF. The

election of directors, the conditions for the admission of new members, the adjustment of quotas,

and certain other important matters remain the responsibility of the Board of Governors. They

convene at an annual meeting and may participate in votes by mail or by other means during the

remainder of the year. Many of the powers of the Board of Governors have been delegated to an

Executive Board made up of 24 directors and a managing director, who serves as its chairman.

IMF Operations

A member state obligates itself upon joining the IMF to observe a code of conduct. This code

requires the state to (1) keep other members informed of its arrangements for determining the

value of its money relative to the money of other states, (2) refrain from placing restrictions on

the exchange of its money, and (3) pursue economic policies that will increase in a constructive

and orderly way both its own national wealth and that of all the IMF member states.

Should a state persistently ignore the code of conduct, the Board of Governors may declare that it

is ineligible to borrow money from the IMF; or, as a last resort, an offending member can be

expelled from the IMF by a vote of “a majority of the Governors having 85 percent of the total

voting power.”

The IMF is responsible for (1) supervising a cooperative system of currency exchange, (2)

lending money to members in order to support their currencies and their economies, and (3)

providing auxiliary services to assist members in establishing and carrying out their external debt

and other financial policies.

Currency Exchange

Currency Exchange Obligations of IMF Member States – The currency exchange mechanism

established in 1945 by the Articles of Agreement of the IMF was called the par value system.

That is, every member of the IMF, on joining the Fund, had to declare a value at which its

currency could be converted into gold.

The member states adopted the Second Amendment to the Articles of Agreement in 1976,

effective in 1978. This new accord, which remains in effect today, allows members to define the

value of their currency by any criteria except gold.

Although a member is free to adopt its own exchange arrangements, it is forbidden to manipulate

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.

A member is also required to collaborate with the Fund to promote exchange stability, to maintain

orderly exchange arrangements with other members, and to avoid competitive exchange

alterations.

Money and Banking

Members with floating exchange rates are required to intervene on the foreign exchange market

as necessary to prevent or moderate sharp and disruptive fluctuations from day to day and from

week to week in the exchange value of its currency.

Enforcement of Exchange Control Regulations of IMF Member States – Article VIII, Section

2(b), of the Articles of Agreement of the IMF provides: “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.”

The purpose of this provision is twofold: (1) to prevent one IMF member from frustrating the

legitimate exchange controls of another member and (2) to deter private persons from violating

exchange control regulations.

It can be invoked in three situations: (1) as a defense to a suit for the breach of an executory

contract, (2) as a cause of action for a foreign government to compel rescission or to obtain

damages after the execution of a contract that violated its exchange provisions, and (3) as a cause

of action for a private person to compel rescission or to obtain damages after the execution of a

contract that violates a foreign exchange provision.

The IMF Agreement grants to the Executive Board of the Fund the authority to interpret the

provisions of the Agreement. Pursuant to this authority, the directors have interpreted Article VIII,

Section 2(b), to mean that the principle of unenforceability is “effectively part [of every member

country’s] national law.”

The IMF directors have not interpreted the meaning of the term exchange contracts. Courts on the

European continent define exchange contracts as contracts that “in any way affect a country’s

exchange resources.” American and British courts hold that an exchange contract is one having as

its immediate object the exchange of international mediums of payment, which is usually the

exchange of one currency for another. This interpretation excludes (1) securities contracts, (2)

sales contracts (including sales of precious metals), and (3) loans (including letters of credits).

Case 6-2: Wilson, Smithett & Cope, LTD v. Terruzzi

Facts: Terruzzi, an Italian national resident in Milan, invested in metals futures on the London

Issue: Is a metals futures contract a “currency exchange contract”?

Holding: No.

Law: IMF Article VIII (2)(b) is to be narrowly interpreted. A currency exchange contract is one

Explanation: The suggestion (by English international lawyer Dr. F. A. Mann) that the term

Money and Banking

Order: Terruzzi is liable to WSC.

Enforcement of Exchange Control Laws in the Absence of IMF Membership – The provision

in Article VIII, Section 2(b), of the IMF’s Articles of Agreement requiring member states to give

effect to the currency exchange regulations of other members is at odds with a longstanding

choice-of-law rule that holds that states do not enforce the revenue laws of other states. The civil

code in civil law countries often expressly prohibits the enforcement of foreign revenue laws,

including currency exchange regulations. The common law countries apply a court-made rule to

the same effect.

The rationale for this rule (both in civil law and common law countries) is that the enforcement of

foreign revenue laws infringes on the sovereign rights of the forum state. The rule and the

rationalization have been criticized, however, as legally and economically unsound in light of the

contemporary interdependence of nations. Nevertheless, the rule continues to be universally

observed.

Because most nations of the world are members of the IMF, the provision in Article VIII, Section

2(b), of the IMF Articles of Agreement effectively overrides the traditional nonenforcement rule

in most cases. Of course, not all countries are members of the IMF. When their currency

exchange regulations are at issue, those regulations will not be enforced abroad.

Case 6-3: Menendez v. Saks and Company

Facts: In 1960, Cuba nationalized five cigar manufacturing companies. The owners then fled to

Issues: (1) Was this contract governed by Cuban law? (2) Are Cuba’s currency regulations

enforceable in the U.S.?

Holdings: (1) No. (2) No.

Law: (1) “Where a contract or agreement authorizes performance in any of several places, the

Explanation: (1) The contracts were actually paid in New York, so the governing law is New

Money and Banking

Order: The original owners were to be paid directly in U.S. dollars for any sales made prior to

the nationalization of their companies.

Enforcement of Other IMF Member State Currency Exchange Obligations – Article VIII,

Section 2(a) forbids member states from imposing restrictions on the payments or transfers

involving current international transactions. A current international transaction is any transaction

other than the transfer of capital. Restrictions on the following are forbidden:

All payments due in connection with foreign trade, other current business, including services,

and normal short-term banking and credit facilities.

Payments due as interest on loans and as net income from other investments.

Payments of moderate amount for amortization of loans or for depreciation of direct

investments.

Moderate remittances for family living expenses.

Section 3 of Article VIII forbids a member from engaging in any “discriminatory currency

arrangements” or “multiple currency practices,” and Section 4 requires a member to buy its own

currency from other members who have acquired it as the result of “current transactions.”

Sections 5, 6, and 7 require members to furnish information to the IMF, to consult with other

members when adopting special or temporary currency exchange restrictions, to collaborate in

promoting international liquidity, and to work with other members to make the “special drawing

right the principal reserve asset in the international monetary system.”

Except for Section 2(b) of Article VIII, the member states’ obligations do not give rise to any

private rights. As a consequence, the other provisions of the IMF Articles of Agreement are

seldom the subject of court disputes.

Exemptions for New Members from IMF Member State Currency Exchange Obligations –

Article XIV sets out transitional provisions that give a new member the option of maintaining the

restrictions on payments and transfers for current international transactions in effect on the date it

becomes a member. Only those restrictions may be maintained. Any later restrictions will

automatically fall under Article VIII and will require IMF approval.

At the time the IMF Agreement was first signed in 1945, only the United States and nine other

Latin American countries did not claim this exemption. As of 2007, more than 166 states had

agreed to comply with the obligations imposed by Article VIII.

Currency Support

The IMF serves as a short-term source of funds for member states having difficulty meeting their

balance-of-payments obligations. These funds are drawn principally from the quota subscriptions

paid by members, although the IMF also borrows from commercial banks.

IMF Facilities – The IMF’s financial resources are made available to its members through a

variety of IMF facilities. These facilities are funded from (1) the General Resources Account, (2)

the Special Disbursement Account, and (3) the Enhanced Structural Adjustment Facility Trust

Fund.

Regular IMF Facilities

Money and Banking

Facilities available to all IMF member states include the following:

Reserve Tranche: Each member has an IMF tranche that it may withdraw at any time and that

technically does not constitute the use of an IMF credit. This tranche consists of that share of a

member state’s quota that it did not contribute in its own currency (i.e., 25 percent of its quota).

Credit Tranche: A member is entitled to four credit tranches, each equivalent to 25 percent of its

quota.

Extended Fund Facility: These facilities help member states overcome balance-of-payments

problems for longer periods and for amounts larger (i.e., up to 140 percent of the member’s

quota) than those available under the credit tranche.

Standby Arrangements: These facilities are in essence bridging loans provided to member states

while the IMF deliberates about whether to provide other funds to the particular member state.

Concessional IMF Facility

This facility is designed for low-income member countries with protracted balance-of-payment

problems. The Poverty Reduction and Growth Facility (PRGF) provides loans at concessional

interest rates of 0.5 percent per annum to such countries.

Special IMF Facilities

Compensatory Financing Facility: This facility helps a country deal with a temporary depletion of

its foreign exchange reserves when this comes about as the consequence of economic

developments beyond its control (such as a crop failure or natural disaster).

Supplemental Reserve Facility: This facility provides short-term financial assistance for

exceptional balance-of-payments difficulties due to a large short-term financing need that is the

result of a sudden and disruptive loss of market confidence.

Contingent Credit Lines: This is a precautionary facility designed to help members with strong

economic policies and sound financial systems that find themselves threatened by a crisis

elsewhere in the world economy—a phenomenon known as financial contagion.

IMF Conditionality – Use of the IMF’s resources is limited by the policies set out in the Articles

of Agreement and the policies adopted under them. This requirement is known as IMF

conditionality.

The essence of conditionality is that access to the IMF’s credit tranches and other credit facilities

is linked to a member’s progress in implementing policies to restore balance-of-payments

viability and sustainable economic growth. It is based not on a rigid set of operational rules but on

a general set of guidelines.

Development Banks

The International Bank for Reconstruction and Development (IBRD)—known informally as the

World Bank—was established, along with the IMF, at the United Nations meeting at Bretton

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Woods in 1944. Membership in the bank is restricted to the members of the IMF. The World Bank

provides development financing to the national governments and political subdivisions of its

member states.

Complementing the World Bank are two subsidiaries: the International Development Agency

(IDA) and the International Finance Corporation (IFC). The IDA provides less restrictive

financing for less developed countries, and the IFC provides loans to private enterprises.

The World Bank is also responsible for managing the Trust Fund of the Global Environment

Facility (GEF), which provides grant and concessional monies to developing countries to fund

projects dealing with four global environmental problems: climate change, biological diversity,

international waters, and ozone layer depletion.

The International Fund for Agricultural Development (IFAD), an international development

organization, was created by a special UN conference held in Rome in 1976. Membership is open

to any UN member. The IFAD’s primary objective is to provide financing for projects that

introduce, expand, and improve food production systems in its developing member states.

Regional development organizations exist to promote the economic and social development of

regional groups. National development agencies exist in virtually every developed country.

Controversies at the World Bank – Fraud seems to be endemic in World Bank projects. The

World Bank is a deeply troubled institution where corruption may have meant the loss of $100

billion or more over the years. It is also not clear to many what the $20 billion in loans and grants

the bank makes each year are accomplishing.

While many may bid for a contract to build a road or to provide tractors, the bank provides the

cash while the borrowing government chooses the winning bid. Some estimates indicate that the

bank will finance 45,000 contracts a year.

The themes of corruption and ethics brought the World Bank into greater public view in the

spring of 2007 when Paul Wolfowitz, the president of the bank, was questioned for arranging a

sweetheart deal for his companion, Shaha Ali Riza, who had worked at the bank for seven years

before his arrival. At the time of the Wolfowitz resignation, many critics of the bank were

contending that it no longer had a useful role to play in global development.

The World Bank is less likely to put its financial muscle behind privatization or trade

liberalization in countries that do not want either. It may find more efficient ways of dealing with

corruption, both inside the bank and without. It is likely to find a way to persist, if only because it

has considerable institutional momentum.

The Bank for International Settlements

The Bank for International Settlements (BIS) is headquartered in Basel, Switzerland. Founded in

1930, it has three main purposes: (1) to act as a bank for the world’s central banks, (2) to promote

international monetary cooperation, and (3) to act as an agent for international settlements.

The legal structure of the BIS is somewhat unique. While it is clearly endowed with an

international personality and the privileges and immunities of an international organization, it is

also a limited company incorporated under Swiss law.

Money and Banking

The central banks of 58 countries are represented at the BIS. General meetings of shareholders

are held at least once a year, and voting rights are exercised in proportion to the number of shares

subscribed in the state that a central bank represents.

The Central Bank’s Bank – Beyond placing surplus funds in the international marketplace, the

BIS occasionally makes liquid resources available to central banks. Such transactions (called

facilities) include swaps of currency for gold, credits advanced against a pledge of gold or

marketable short-term securities, and, less frequently, unsecured credits and standby credits. The

bank also carries on exchange transactions in foreign currency and gold both with the central

banks and with the markets. The bank has undertaken a new role as a source of large-scale,

short-term bridging loans to help the central banks of developing countries with their

balance-of-payments difficulties.

Promoter of International Monetary Cooperation – The bank’s offices in Basel regularly host

meetings of the world’s finance ministers, central bank governors, and banking experts. The BIS

also staffs the permanent secretariats that collect data on national banking regulations and

national surveillance systems, identify problem areas, and suggest measures for safeguarding

bank solvency and liquidity. In addition, the bank itself collects and publishes banking statistics

on a quarterly basis.

Agent for International Settlements – Much of the impetus for the creation of the BIS came

from the need to settle the problem of German reparations to the victorious allies in the aftermath

of World War I. The BIS was put in charge of the loans floated by Germany and Austria, and it

managed them until the onset of World War II. From time to time since then, the bank has entered

into settlement arrangements with various countries and international organizations.

BIS and Basel III – Within the BIS, the Basel Committee on Banking Supervision provides a

forum for regular cooperation on banking supervisory matters. Its objective is to enhance

understanding of key supervisory issues and improve the quality of banking supervision

worldwide. It seeks to do so by exchanging information on national supervisory issues,

approaches, and techniques, with a view to promoting common understanding.

The Committee encourages contacts and cooperation among its members and other banking

supervisory authorities. In addition to undertaking the secretarial work for the Committee and its

many expert subcommittees, it stands ready to give advice to supervisory authorities in all

countries.

Basel III is a comprehensive set of reform measures, developed by the Basel Committee on

Banking Supervision, to strengthen the regulation, supervision, and risk management of the

banking sector. The reforms target bank-level regulation, aiming to raise the resilience of

individual banking institutions in periods of stress and systemwide risks. These reforms are

complementary insofar as greater resilience at the individual bank level reduces the risk of

systemwide shocks.

The general idea is to raise reserve requirements for most banks, and impose even higher “loss

absorbency capacity” for those financial institutions that pose systemic risks to the financial

system. Global “systemically important financial institutions” (SIFIs) will be identified, and

additional loss absorbency requirements are to be imposed.

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Regional Monetary Systems

Several groups of countries have set up regional monetary organizations. These vary in their

structure and evolution, from those that emulate the IMF in promoting currency exchange and

financial support for balance-of-payments obligations to those that have established a complete

monetary union.

The most developed monetary unions are the West African Economic and Monetary Union

(UEMOA), the Eastern Caribbean Currency Authority (ECCA), and the Economic and Monetary

Community of Central Africa (CEMAC).

The EU is currently in the process of establishing a fully integrated economic and monetary union

(known as the European Monetary Union, or EMU). Because the Maastricht Treaty envisioned

that some EU member states would not be participating in the EMU, it established a rather

complex structure to oversee the EU’s monetary policies. This is known as the European System

of Central Banks (ESCB).

The main responsibilities of the ESCB are (1) defining and implementing the monetary policy of

the EU, (2) conducting foreign exchange operations, (3) holding and managing the official

foreign reserves of the EU member states, and (4) promoting the smooth operation of payment

systems. The ESCB is governed by the decision-making bodies of the ECB: the Governing

Council, the Executive Board, and the General Council.

On January 1, 1999, the ESCB began functioning as the central banking authority for the EU. On

that same date, the euro became the new currency for the EMU.