Understanding Exchange Rate Regimes Note
Investments Team | Nov 27, 2020
Investments Team | Nov 27, 2020 |
Exchange rates can be defined as the value of one currency for the purpose of conversion to another. An example is how many Kenyan shillings you would need to own one US Dollar. However, just like in the exchange of goods and services, we must take into account what determines that price, since governments can influence it, and even fix it. As such, the monetary authority of a country or currency union manages the currency in relation to other currencies and the foreign exchange market through exchange rate regimes which are the frameworks under which the price is determined.
Initially, most countries used the gold standard whose value was directly linked to gold and the money supply was tied to their trade balance; but in the 1930s, most countries abandoned it for the Bretton Woods model due to decline in global trading activities. The Bretton Woods Agreement was negotiated in July 1944 by delegates from 44 countries at the United Nations Monetary and Financial Conference held in Bretton Woods, New Hampshire. Thus the name “Bretton Woods Agreement. Under this model, the value of the US dollar was pegged on Gold and all the other currencies were pegged on the value of the US dollar.
Types of Currency Regimes across the World:
There are three broad exchange regimes used by various governments across the world, these three regimes are (i) Fixed exchange rate regime (ii) Floating exchange rate regime and, (iii) Pegged exchange rate regime:
- Fixed exchange rate regime:
This is a currency system in which the monetary authority, or the Central Bank of a given country, tries to maintain a currency value that is constant against another country’s currency, a basket of other countries’ currencies or a specific commodity e.g. gold. An example of a countries using a fixed regime is Saudi Arabia, UAE and Qatar. The purpose of a fixed exchange rate system is to keep a currency's value within a narrow range. The main advantages of this regime are;
- The regime encourages foreign direct investments –Due to the currency stability provided by the regime, foreign investors are less concerned with protecting themselves from sudden changes in the currency's value and thus they feel a sense of protection on their investments,
- This regime keeps inflation in check - since inflation is defined as a general increase in prices and a fall in the purchasing power of money. If the exchange rate is allowed to decline - import goods tend to become more expensive which then fuels inflation, this situation can be avoided by making the exchange rate fixed.
- Allows for the adoption of stable macroeconomic policies – With a fixed regime governments are discouraged from adopting irresponsible macro- economic policies like currency devaluation. Moreover, under the fixed exchange rate system, deflationary policies can even be pursued to tide over any Balance of payment deficits, even without bringing any change to the prevailing domestic policies.
- Prevents speculative behaviours in the market – When an exchange rate remains unchanged for a long period of time, and with no signs of changing in the immediate future, it eliminates speculation in the foreign exchange market and discourages the flight of capital. As exchange rates stays fixed, traders have a sense of confidence that international transactions can be made safely and without the danger of losses.
However, some of the notable disadvantages include;
- It is expensive to maintain as it requires huge reserves of foreign currency - For the effectiveness of a stable exchange rate, the necessary condition is the adequacy of holding, foreign exchange reserves. Poor developing countries find it difficult to maintain an adequate volume of foreign exchange reserves. Speculators then anticipate currency devaluation in advances if BOP needs to be corrected. Before 1970, fixed exchange rate, in fact, prevailed because of low volume of global trade and, hence, low volume of foreign exchange reserves.
- Bypasses the international competitive environment - The continuous changes in international competitive environment are not reflected under the fixed exchange rate system. Thus, to make the local products more competitive in the foreign market, a country has to change the domestic economic policies so that the country’s export products can get a larger foothold in the foreign market.
- Sacrifices key macroeconomic objectives - When countries with fixed regimes experience large and persistent foreign trade deficits, they have a shortage in foreign exchange reserves where they then opt for a currency devaluation and take some internal measures to reduce their deficits. These harsh internal measures tend to contract economies leading to a rise in prices and unemployment. These then reduce economic growth.
- Floating exchange rate regime:
This is an exchange rate regime where the currency value of a given country is allowed to vary according to the foreign exchange market. An example is Kenya where we have a floating regime. The currency fluctuates in relation to what is happening in the market and therefore the rate is determined by the forces of demand and supply. However, there might be periods of intervention though they are aimed at preventing undue fluctuations rather than setting the rate. The key advantages of a floating regime are;
- Provides for an automatic adjustment of the balance of payment - The main advantage of the flexible exchange rate is that the trade Balance of payment disequilibrium gets corrected automatically with any change in the exchange rate. If a trade deficit arises, there would be an excess supply of the local currency leading to a fall in exchange rate from the movements in the market forces of demand and supply. This causes export goods to be cheaper and import goods to be expensive and a flexible will automatically adjust the imbalance.
- A free floating regime reduces the negative effect of external shocks - Countries that adopt the floating regime are protected from the negative effects, the domestic economy remains insulated from external shocks and pressures such as the financial crisis since the rates will change accordingly in response to the external shocks and the threat of ‘importing inflation’ from outside the country is reduced.
- Removes the conflict between the internal and external objectives - Surplus and deficit in trade accounts get corrected automatically in a free floating regime. As for a fixed exchange rateregime , the removal of trade deficits requires the adoption of internal policies like fall in income and price level at the expense of external policies. Because of its self-adjusting nature the government can put more effort in tackling internal problems of inflation, unemployment and not be worried by corrections in trade deficits.
The main limitation is that;
- A free floating regime limits foreign direct investments – Unregulated floating exchange rate can discourage foreign investment due to erratic exchange rates. Because of the uncertainty associated with this exchange rate involving profit and loss implications of foreign investment deals, a country might experience a destabilizing in effect from the decumulation of capital. Case in point, when multinational companies are paying out dividends to their parent companies a strong domestic currency limits their returns.
- There exists uncertainty and risks - Flexible exchange rate presents an atmosphere of uncertainty and confusion among cross-border traders and investors. The vulnerability to uncertainty effects is greater because the exchange rate fluctuates freely. Suppose, a Kenyan trader dispatches an export invoice to foreign buyers who does not know at what price foreign currency will be converted into the Kenyan shilling. This kind of uncertainty impedes trade, though it can be largely minimized through forward exchange contracts.
- This regime encourages speculation – This regime may encourage speculative trading in currencies, consequently, when the exchange rate declines, speculators anticipate that such would continue to decline further and the possibility of the flight of money to another country will occur. This will then cause a further fall in the exchange rate and the greater the speculation against the currency, the deeper the consequential economic crises.
- Pegged exchange rate regime:
This is an exchange rate regime of a given economy that has their currency pegged to some band or value, which is either fixed or periodically adjusted. For example, with the Kenyan Shilling, it was pegged to the US dollar, so that whenever the dollar rose in value, so would the shilling. This makes up part of a country’s exchange-rate policy, helping to stabilise the exchange rate between countries. The band is determined by international bilateral agreements or by a monetary authority and are adjusted periodically in response to economic conditions and indicators. An example of countries using this regime is; Ethiopia and China – whose currencies are fixed to a basket weighted towards the US dollar. The pegging can take the form of a crawling band, crawling peg or horizontal bands.
The main advantage of a pegged regime is;
- Reduces uncertainty making the currency movements more predictable – Pegging currency helps make trading a lot more predictable, which is incredibly useful for countries that rely a lot on exports for their GDP. The country, exporters and importers do not have to worry about changing exchange rates and their impact upon trade. Pegged exchange rates system allow companies to foresee how their commodities will be valued in the international market which would, in turn, allow them to predict the quantities required. Thus, they are able to protect themselves from losses related to foreign exchange.
- Reliable monetary policy – When a currency is pegged it makes its movements a lot more predictable, which can be useful for traders using online platforms. When such a large currency, such as the US dollar is predicted to increase in value, savvy traders can invest in one of its pegged currencies which will inevitably follow suit. Most countries that adopt the pegged regime are developing nations who have a reputation on promoting corruption. Hence, the level of trust in relation to their leaders coming up with their monetary policy is low and thus, they result to outsourcing their policy to developed countries. This would as a result reduce the possibilities of sabotage from local leaders causing hyperinflation.
However, some disadvantages include;
- Heavy reliance on foreign countries – Countries whose currencies are pegged to another country’s currency are at a risk of increased foreign influence particularly due to the fact that their monetary policy is determined by a foreign country. This often leads to conflicting situations for instance, if the foreign nation were to increase their interest rates due to concerns on their inflation and despite the unfavourable effects it would have on the local currency, the domestic country will have to give in to their demand because are no longer in control of their domestic matters.
- Difficulty in the correction of Balance of payment imbalances – Unlike the automatic adjustment of Balance of payments disequilibrium under a floating rate system, the pegged regime amplifies disequilibrium and thus, countries that have adopted the system tend to be susceptible to instability in the Balance of payments.
In conclusion, different Foreign exchange regimes have their advantages and their limitations and therefore the choice of a particular regime is subject to an individual country’s monetary and economic objectives. Major world economies such as the USA and Japan have floating currency regimes, while fixed currency regimes are mostly common with emerging countries, largely because they receive most of their income in form of other currencies.