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Evolution of the Foreign Exchange Market and its Development

Given the global nature of the forex exchange market, it is important to learn some of the important historical events relating to currencies and currency exchange. In this section we’ll review the international monetary system and how it has evolved to its current state.

The Foreign Exchange Market as we know it, began to develop after the Second World War. Between the two world wars a period existed when currencies operated under a fixed exchange rate system based on the gold & silver standards.


Gold Standard System

The creation of the gold standard monetary system in 1875 marks one of the most important events in the history of the forex market. Before the gold standard was implemented, countries would commonly use gold and silver as means of international payment. The main issue with using gold and silver for payment is that their value is affected by external supply and demand. For example, the discovery of a new gold mine would drive gold prices down.

The underlying idea behind the gold standard was that governments guaranteed the conversion of currency into a specific amount of gold, and vice versa. In other words, a currency would be backed by gold. Obviously, governments needed a fairly substantial gold reserve in order to meet the demand for currency exchanges. During the late nineteenth century, all of the major economic countries had defined an amount of currency to an ounce of gold. Over time, the difference in price of an ounce of gold between two currencies became the exchange rate for those two currencies. This represented the first standardized means of currency exchange in history.

The gold standard eventually broke down during the beginning of World War I. Due to the political tension with Germany, the major European powers felt a need to complete large military projects. The financial burden of these projects was so substantial that there was not enough gold at the time to exchange for all the excess currency that the governments were printing off.

Although the gold standard made a small comeback during the inter-war years, most countries had dropped it again by the onset of World War II. However, gold never ceased being the ultimate form of monetary value.


Major Landmarks that have influenced the Foreign Exchange Market

  • Bretton Woods Agreement

  • Smithsonian Agreement

  • The European Snake

  • OPEC Oil Crisis

  • European Monetary System

  • Maastricht Treaty

  • Euro Emergence



Before the end of World War II, the Western Allied Powers believed that there would be a need to set up a monetary system in order to fill the void that was left behind when the gold standard system was abandoned. The Bretton Woods Conference, held in New Hampshire in 1944 was an attempt to restore some order to the relationships between international currencies and the international payment system.

 Bretton Woods led to the formation of the following:


  1. A method of fixed exchange rates;

  2. The US Dollar replacing the gold standard to become a primary reserve currency; and

  3. The creation of three international agencies to oversee economic activity: the International Monetary Fund (IMF), International Bank for Reconstruction and Development (now part of the World Bank), and the General Agreement on Tariffs and Trade (GATT).


One of the main features of Bretton Woods is that the US Dollar replaced gold as the main standard of convertibility for the world’s currencies and furthermore, the US Dollar became the only currency that would be backed by gold. (This turned out to be the primary reason why Bretton Woods eventually failed.) The Agreement also saw the replacement of Sterling by the US Dollar as the dominant currency on the Market by pegging par-values of convertible currencies against the US Dollar.



Over the next 25 years or so, the United States had to run a series of balance of payment deficits in order to be the world’s reserve currency. By the early 1970s, US Gold reserves were so depleted that the US Treasury did not have enough gold to cover all the US Dollars that foreign central banks had in reserve. Between Bretton Woods (1944) and 1971 various degrees of convertibility existed and the era saw the emergence of "strong" and "weak" currencies. In the early 60's the first doubts about the strength of the US Dollar began to spread with subsequent exchanges of gold for US Dollar. This period also saw devaluation of Sterling in 1967 and the French Franc in 1969, and the revaluation of the Deutsche Mark. The downward pressure on the US Dollar had become huge, fuelled by a huge balance of payment deficit. Major countries (Germany, Holland, Switzerland, Japan) either formally revalued their currencies or let them float upwards. Finally, on August 15, 1971, US President Richard Nixon closed the gold window, and the US announced to the world that it would no longer exchange gold for the US Dollars that were held in foreign reserves. This event marked the end of Bretton Woods. The United States Government put an end to the convertibility of the Dollar in December 1971 at the Smithsonian Conference. The Dollar was devalued and a new realignment of currencies took place.



In early 1972 the German Government viewing the Smithsonian agreement with scepticism, encouraged its partners in Europe to form a mini-system. The heart of this system was that European Currencies would maintain narrow bands with each other and would float together against the US Dollar. This system became known as the SNAKE. The Foreign Exchange Markets were experiencing levels of fluctuations totally new to the participants. The US Dollar was so weak that the German and Japanese Central Banks introduced controls to restrict Dollar inflows. Fixed rates within agreed bands were no longer possible. Hence the Smithsonian Agreement was dead.



In 1973 fixed exchange rates were a thing of the past. An ad hoc system of floating rates existed. It was envisaged that in a floating system currencies would find their own true levels. An embargo by Arab, and Arab supporting oil producing countries on nations who supported Israel in the 1973 Yom Kippur War led to oil shortages and price rises. Through a series of rapidly developing events, oil prices quadrupled by the end of 1973 and oil had to be paid for in Dollars. A huge demand for Dollars ensued. The Dollar strengthened and interest rates in the US reached very high levels. Countries which relied on oil imports now had a huge demand for Dollars where a short time back they were introducing controls to restrict the inflow of Dollars.



The E.M.S. was a modified and was a more elaborate version of the SNAKE. Its overall objective was not only to stabilise the currencies of the European Economic Community (EEC) countries, but also to unify them at some future date.

Specifically its objectives were -

  • Stability

  • To strengthen Economic and Monetary Co-operation.

  • To encourage Economic and Political Integration.

  • To set up a European Central Bank.                  

The cornerstone of the system was the Parity Grid. This Grid set constraints on exchange rate movements and imposed specific obligations on the individual Central Banks. Each Bank was required to keep the market rate for its currency within a certain band against all other member currencies.



In December, 1991, representatives of 12 European countries met in the little Dutch town of Maastricht with the bureaucratic goal of better coordinating economic policy. What emerged was a radical plan to ditch national currencies for a common money managed by a European Central Bank. The Treaty was signed on 7th February 1992 in Netherlands. Maastricht is perhaps the best known and most controversial of the European treaties. It defined the three stages of EMU which eventually led to the single currency, and set out the convergence criteria or economic tests that member states have to pass. Strict rules for those joining were agreed, including targets for inflation, interest rates and budget deficits. The treaty had a tough time coming into force and faced an unprecedented pressure in most countries. It however, finally came into force in November 1993.



In January 1999, Euro was launched as an electronic currency used by banks, forex dealers, big firms and stock markets in 11 countries - Belgium, Germany, France, Spain, Italy, Ireland, Luxembourg, Netherlands, Austria, Portugal & Finland. Greece joined on the 1 January 2001. In 2002, Euro notes and coins became legal tender in 12 countries.

How does the Euro work?

While, the interest rate is set by the European Central Bank (ECB), based in Frankfurt, Monetary policies are co-ordinated by Euro members and an independent monetary institution, the European System of Central Banks (ESCB).


The EU criteria to join the Euro

  • Annual government deficit must not exceed 3% of GDP

  • Total outstanding government debt must not exceed 60% of GDP

  • Rate of inflation within 1.5% of the 3 best performing EU countries

  • Average nominal long term interest rate must be within 2% of the average rate in the three countries with the lowest inflation rates

  • Exchange rate stability, meaning that for at least 2 years the country concerned has kept within the 'normal' fluctuation margins of the European Exchange Rate Mechanism (ERM)




After the Bretton Woods system broke down, the world finally accepted the use of floating foreign exchange rates during the Jamaica agreement of 1976. This meant that the use of the gold standard would be permanently abolished. However, this is not to say that governments adopted a pure free-floating exchange rate system. Most governments employed one of the following three exchange rate systems that are still used today:

  • Dollarization;

  • Pegged rate; and

  • Managed floating rate.



This event occurs when a country decides not to issue its own currency and adopts a foreign currency as its national currency. Although dollarization usually enables a country to be seen as a more stable place for investment, the drawback is that the country’s central bank can no longer print money or make any sort of monetary policy. Some of the countries that have dollarized are El Salvador, Panama, Ecuador, etc.


Pegged Rates

Pegging occurs when one country directly fixes its exchange rate to a foreign currency so that the country will have somewhat more stability than a normal float. More specifically, pegging allows a country’s currency to be exchanged at a fixed rate with a single or a specific basket of foreign currencies. The currency will only fluctuate when the pegged currencies change. For example, China pegged its Yuan to the US Dollar at a rate of 8.28 Yuan to 1 USD, between 1997 and July 2005. The downside to pegging would be that a currency’s value is at the mercy of the pegged currency’s economic situation.


Managed Floating Rates

This type of system is created when a currency’s exchange rate is allowed to freely change in value subject to the market forces of demand and supply. However, the government or central bank may intervene to stabilize extreme fluctuations in exchange rates. For example, if a country’s currency is depreciating far beyond an acceptable level, the government can raise short-term interest rates. Raising rates should cause the currency to appreciate slightly; but understand that this is a very simplified example. Central banks typically employ a number of tools to manage currency.




India’s exchange rate policy has evolved over time in line with the gradual opening up of the economy as part of the broader strategy of macroeconomic reforms and liberalization since the early 1990s. This change was also warranted by the consensus response of all major countries to excessive exchange rate fluctuations that accompanied the abolishment of fixed exchange rate system. Below is the chronology of the Indian exchange rate.


1947 to 1971 – EARLY STAGES

  • Par Value system of exchange rate.

  • Rupee’s external par value was fixed in terms of gold with the pound sterling as the intervention currency.

  • Devaluation in September 1949 and June 1966

  • Stable rate between 1966 - 1971

  • Foreign Exchange Regulations Act (FERA) placed in 1957

  • Rupee pegged to Sterling in December 1971

  • To ensure stability of the Rupee and to avoid the weaknesses associated with a single currency peg, September 1975 onwards the Rupee was pegged to a basket of currencies. Currency selection and weight assignment was left to the discretion of the RBI and not publicly announced.


1978 to 1992 – FORMATIVE PERIOD

  • RBI allowed Banks to undertake intra-day trading but had to maintain “square” or “near square” position at the end of the business hours every day

  • Exchange rate determined by RBI against basket peg

  • Daily announcement of rates by RBI to ADs with a spread of 0.5 percent

  • ADs permitted to trade in cross currency

  • Volumes increased as two-way prices against INR and crosses started to be quoted by major banks

  • The ‘Guidelines for Internal Control over Foreign Exchange Business’ were framed in 1981.

  • The foreign exchange market was still highly regulated with several restrictions on external transactions, entry barriers and transactions costs. Foreign exchange transactions were controlled through the FERA. These restrictions resulted in an extremely efficient unofficial parallel (hawala) market for foreign exchange.



  • In late 80s and 1990-91 India faced acute Balance of Payment (BOP) imbalance that was accentuated by Gulf crisis

  • India then embarked on structural reforms

  • Wide ranging reform measures announced

  • Two-step INR devaluation by 9% and 11% was done in July 1991

  • Effectively pegged exchange rate regime came to an end

  • Dual exchange rate system – Liberalised Exchange Rate Mechanism System (LERMS) was introduced in March 1992

  • In March 1993 dual exchange rate was replaced by a unified exchange rate system

  • Restrictions on a number of current account transactions were relaxed

  • India finally achieved ‘Current Account Convertibility’ in August 1994

  • Tremendous growth in foreign exchange market volume was witnessed

  • Measures towards liberalising the capital account were also implemented