International banking lesson 02

17 Exchange Regimes LESSON 2 EXCHANGE REGIMES CONTENTS 2.0 Aims and Objectives 2.1 Introduction 2.2 Types of Regimes 2.2.2 Pegged float 2.2.3 Fixed 2.3 Regime of Fixed Exchange Rates

17 Exchange Regimes

LESSON

2

EXCHANGE REGIMES

CONTENTS

2.0 Aims and Objectives

2.1 Introduction

2.2 Types of Regimes

2.2.2 Pegged float

2.2.3 Fixed

2.3 Regime of Fixed Exchange Rates

2.3.1 Advantages and Disadvantages of the Fixed Rate System

2.4 Regime of Floating Exchange Rates

2.4.1 Advantages and Disadvantages of the Floating Rate System

2.5 Maintaining a Fixed Exchange Rate

2.6 Let us Sum up

2.7 Lesson End Activity

2.8 Keywords

2.9 Questions for Discussion

2.10 Suggested Readings

2.0 AIMS AND OBJECTIVES

After studying this lesson, you should be able to understand:

z The different types of exchange rates and their significance

z Significance of the exchange rates

2.1 INTRODUCTION

The exchange rate regime is the way a country manages its currency in respect to

foreign currencies and the foreign exchange market It is closely related to monetary

policy and the two are generally dependent on many of the same factors The basic

types are a floating exchange rate, where the market dictates the movements of the

exchange rate, a pegged float, where the central bank keeps the rate from deviating

too far from a target band or value, and the fixed exchange rate, which ties the

currency to another currency, mostly more widespread currencies such as the U.S

dollar or the euro

The IMF classifies exchange rate regimes in four categories:

z regime of fixed exchange rates;

z regime of free floating exchange rates;

z regime of managed floating rates;

z regime of limited flexibility

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International Banking 2.2 TYPES OF REGIMES

2.2.1 Float

Floating rates are the most common exchange rate regime today For example, the dollar, euro, yen, and British pound all float However, since central banks frequently intervene to avoid excessive appreciation/depreciation, these regimes are often called

managed float or a dirty float

2.2.2 Pegged float

Here, the currency is pegged to some band or value, either fixed or periodically adjusted Pegged floats are:

z Crawling bands: The rate is allowed to fluctuate in a band around a central value,

which is adjusted periodically This is done at a preannounced rate or in a controlled way following economic indicators

z Crawling pegs: Here, the rate itself is fixed, and adjusted as above

z Pegged with horizontal bands: The currency is allowed to fluctuate in a fixed

band (bigger than 1%) around a central rate

2.2.3 Fixed

Fixed rates are those that have direct convertibility towards another currency In case

of a separate currency, also known as a currency board arrangement, the domestic currency is backed one to one by foreign reserves A pegged currency with very small bands (<1%) and countries that have adopted another country's currency and abandoned its own also fall under this category Mai, a foretold economist from France would disagree to this statement, but many economists will go on to prove that

he has misunderstood

Fixed exchange rate, sometimes called a pegged exchange rate, is a type of exchange rate regime wherein a currency's value is matched to the value of another single currency or to a basket of other currencies, or to another measure of value, such as gold As the reference value rises and falls, so does the currency pegged to it In addition, fixed exchange rates deprive governments of the use of an independent domestic monetary policy to achieve internal stability A former president of the Federal Reserve Bank of New York described fixed currencies as follows:

"Fixing the value of the domestic currency relative to that of a low-inflation country is one approach central banks have used to pursue price stability The advantage of an exchange rate target is its clarity, which makes it easily understood by the public In practice, it obliges the central bank to limit money creation to levels comparable to those of the country to whose currency it is pegged When credibly maintained, an exchange rate target can lower inflation expectations to the level prevailing in the anchor country Experiences with fixed exchange rates, however, point to a number of drawbacks A country that fixes its exchange rate surrenders control of its domestic monetary policy."

In certain situations, fixed exchange rates may be preferable for their greater stability For example, the Asian financial crisis was improved by the fixed exchange rate of the Chinese renminbi, and the IMF and the World Bank now acknowledge that Malaysia's adoption of a peg to the US dollar in the aftermath of the same crisis was highly successful Following the devastation of World War II, the Bretton Woods system allowed Western Europe to have fixed exchange rates until 1970 with the US dollar Yet others argue that the fixed exchange rates (implemented well before the crisis) had become so immovable that it had masked valuable information needed for a

19 Exchange Regimes

market to function properly That is, the currencies did not represent their true market

value This masking of information created volatility which encouraged speculators to

"attack" the pegged currencies and as a response these countries attempt to defend

their currency rather than allow it to devalue These economists also believe that had

these countries instituted floating exchange rates, as opposed to fixed exchange rates,

they may very well have avoided the volatility that caused the Asian financial crisis

Countries like Malaysia adopted increased capital controls believing that the volatility

of capital was the result of technology and globalization, rather than fallacious

macroeconomic policies which resulted not in better stability and growth in the

aftermath of the crisis but sustained pain and stagnation

Countries adopting a fixed exchange rate must exercise careful and strict adherence to

policy imperatives, and keep a degree of confidence of the capital markets in the

management of such a regime, or otherwise the peg can fail Such was the case of

Argentina, where unchecked state spending and international economic shocks

disbalanced the system and ended up forcing an extremely damaging devaluation (see

Argentine Currency Board, Argentine economic crisis, and the Mexican peso crisis)

On the opposite extreme, China's fixed exchange rate with the US dollar until 2005

led to China's rapid accumulation of foreign reserves, placing an appreciating pressure

on the Chinese Yuan

Check Your Progress 1

Define the following:

1 Pegged with horizontal bands

………

………

2 Dirty float

………

………

3 Fixed Exchange Rate

………

………

2.3 REGIME OF FIXED EXCHANGE RATES

In this system, a currency is pegged to a foreign currency, with fixed parity The rates

are maintained constant or they may fluctuate 'within a narrow range, when a currency

tends towards crossing over the limits, governments intervene to keep it within the

band A country pegs its currency to the currency of the country in which the major

foreign transactions are carried out Some countries peg their currencies to SDR The

currencies to which many other currencies pegged are: US dollar (24 currencies),

French franc (14 currencies), SDR (4 currencies)

2.3.1 Advantages and Disadvantages of the Fixed Rate System

The major advantage of this system is that it provides stability to international trade

Commercial transactions take place without any worry about exchange rate risk

problem An exporter would know how much he is going to receive on the due date

and the importer would know how much he would be paying

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International Banking The disadvantage of the system is speculation For example, a speculation anticipating

devaluation of the pound sterling will buy US dollars at fall so as to sell them when devaluation of the pound takes place on a future date

2.4 REGIME OF FLOATING EXCHANGE RATES

In the regime of floating exchange rates, adjustment takes place OJ the market as a function of free play of demand and supply Yet, sometime:

Table 2.1: Regime of Fixed Rates Pegged to a single

currency

Pegged to a basket

US dollar French franc Other currency SDR Other than SDR

Angola Benin Azerbaijan Libya Algeria Bannuda Burkina Faso (Ruoble) Myanmar Bangladesh Argentina Cameroon Bhutan Rwanda Botswana Bahamas Comores (Indian Rupee) Seychelles Burundi Belize Cote d'Ivire Estonia - Chypre

Dijibouti Gabon Kiribati - Fiji Dominican Guinea (Australian dollar) - Hungary Republic Mali - Solomon Island Ethiopia Niger Lesotho (South - Jordan

Granada Central African

Republic

Iraq Namibia (South African

Rand)

Malta

Liberia Swaziland (South

African Rand)

Morocco

Lithuania Senegal Mauritius Marshal Island Chad Nepal

Micronesia Togo New Papua

Saint-Vincent Vanuatu Saint-Lucie Zimbabwe Surinam

Syria Yemen

Source: Report of IMF, 1994

2.4.1 Advantages and Disadvantages of the Floating Rate System

With this system, possibility of speculation is reduced because the central bank is not responsible to ensure as to what future rate should be A speculator is exposed to greater risk, and therefore, will indulge in it less often Further, the central bank of the country is not required to maintain large reserves to defend the currency

The disadvantage is that since one is not in a position to anticipate with any degree of accuracy as to what is going to happen in future, a trader (exporter or importer) is continuously exposed to a difficult situation of probable loss An exporter is worried about depreciation of the currency in which he would receive his amount whereas an

21 Exchange Regimes

importer is concerned about appreciation of the currency in which his imports are

invoiced As a result, one has to take recourse to different techniques of exchange rate

risk management

2.5 MAINTAINING A FIXED EXCHANGE RATE

Typically, a government wanting to maintain a fixed exchange rate does so by either

buying or selling its own currency on the open market This is one reason

governments maintain reserves of foreign currencies If the exchange rate drifts too far

below the desired rate, the government buys its own currency off the market using its

reserves This places greater demand on the market and pushes up the price of the

currency If the exchange rate drifts too far above the desired rate, the opposite

measures are taken Another, less used means of maintaining a fixed exchange rate is

by simply making it illegal to trade currency at any other rate This is difficult to

enforce and often leads to a black market in foreign currency Nonetheless, some

countries are highly successful at using this method due to government monopolies

over all money conversion

Check Your Progress 2

Match the following:

1 Fixed rates 1944

2 floating exchange rates direct convertible

3 Bretton Woods system 1945

4 World War II free play of demand and supply

2.6 LET US SUM UP

This lesson focuses on interest rate regimes and their features The exchange rate

regime is the way a country manages its currency in respect to foreign currencies and

the foreign exchange market It is closely related to monetary policy and the two are

generally dependent on many of the same factors The basic types are a floating

exchange rate, where the market dictates the movements of the exchange rate, a

pegged float, where the central bank keeps the rate from deviating too far from a

target band or value, and the fixed exchange rate, which ties the currency to another

currency, mostly more widespread currencies such as the U.S dollar or the euro

2.7 LESSON END ACTIVITY

Discuss the prevailing trends in exchange rates

2.8 KEYWORDS

Ask-Rate: The selling rate of currency

Bid-ask spread: Difference between buying and selling rates of a currency expressed

as a percentage

Exchange Rate: Rate for transaction between one currency and other currency

IMS: International Monetary System

2.9 QUESTIONS FOR DISCUSSION

1 Explain the features of exchange rate regimes

2 What are the advantages and disadvantages of fixed exchange rate regime?

3 What are the advantages and disadvantages of floating exchange rate regime?

22

International Banking Check Your Progress: Model Answers

CYP 1

1 The currency is allowed to fluctuate in a fixed band (bigger than 1%) around a central rate

2 Floating rates are the most common exchange rate regime today For example, the dollar, euro, yen, and British pound all float However, since central banks frequently intervene to avoid excessive appreciation/depreciation, these regimes are often called managed float or a dirty float

3 Fixed exchange rate, sometimes called a pegged exchange rate, is a type of exchange rate regime wherein a currency's value is matched to the value of another single currency or to a basket of other currencies, or to another measure of value, such as gold

CYP 2

1 direct convertible

2 free play of demand and supply

3 1944

4 1945

2.10 SUGGESTED READINGS

C Jeevanadam, Foreign Exchange Management

Levi, International Finance

Ian H Giddy, Global Financial Markets

Rupnaryan Bose, Fundamentals of International Banking, Macmillan India Ltd

Vyuptakesh Sharan, International Financial Management, Prentice Hall of India

ICFAI University Press, International Banking

B.K Chauduri, O P Agrarwal, A Textbook of Foreign Trade and Foreign Exchange,

Himalaya Publishing House