Evolution of Exchange Rate Regimes

Evolution of Exchange Rate Regimes

07 Nov 2019 10:48 AM
 

Foreign exchange rate system evolution

The forex rate exchange rate regimes that are prominent today didn't exactly start the way it exists now. Initially, before the inception of the foreign exchange markets, the gold standard was the norm where the value of a country's currency was tied to the gold it possessed. The effect of keeping inflation in check was served by the value of money backed by a fixed asset-gold. However, this standard limited the competitive advantage of countries that didn't hold abundant gold reserves and failed to consider businesses and individuals' value resourcefulness to an economy. Thus, the US ended the Gold standard in 1971. 

A new global monetary system was established in 1944, enforced by the Bretton Woods agreement wherein a global currency replaced the gold standard. However, the Bretton Woods fixed exchange rate system collapsed after three decades. Since the US had 75% of the world's gold supply at that time, the maintenance of a fixed exchange rate by countries between their currency and the US dollar led to the dollar's increased value and demand.  

In a failed attempt to revive the fixed exchange rates, US President Richard Nixon temporarily suspended the dollar's convertibility to gold in 1971. By March 1973, with the inception of major currencies floating against each other, the modern foreign exchange market started its shift from a fixed exchange rate to a floating exchange rate system. Thus, a global decentralized, over the counter (OTC) market for trading currencies evolved, determining the forex rates for each currency. 

The evolution of the fixed and floating exchange rate system witnessed new emergences and many downfalls over the years ranging from the International Gold Standard during 1875-1914 to the Bretton Woods System during 1945-1972 to morph into the foreign exchange system prevalent today. The shift has been noticed in not just the evolving systems but also the preferences of countries and its outlook towards the pegged and floating exchange regime with the development of economies and trade. While during the mid-1970s, a massive chunk of countries, amounting to nearly 83%, had some sort of pegged exchange rate, the 1990s observed the gravitation of economies towards the floating exchange rate system.

Depending upon whether the foreign currency exchange rates fluctuate constantly or not, there are two types of exchange rates: fixed and flexible exchange rates. The government of a country can allow the market forces and the economic condition to determine the rate of conversion, or the government can fix a rate by pegging the value of their currency with a stronger and stable currency of another country. No consensus has been reached regarding the perfect foreign exchange rate regime for an economy as the benefits that a country gets would be dependent on characteristics like inflation rate, the magnitude of financial development, size of the economy, capital mobility, etc.

Fixed Exchange Rates

The official rate set and maintained by the government is the fixed or pegged foreign exchange rate. A country holds forex reserves in order to sustain the determined pegged rate agreed between the participating countries and thus witnesses the buying and selling of its own currency by the central bank in the forex market. In a country with fixed exchange rates, the home currency's value is pegged to a major world currency that enables, especially, for the weaker economies to benefit from stimulated trade and greater certainty of navigation against adverse market movements and an upper hand in terms of forex risk management.  

Depending on the working mechanism of the fixed exchange rate system, it is classified into the following:

  1. Currency Board - In a  currency board, the management of the exchange rate and money supply is under the purview of a monetary authority that withholds the decisions regarding the value of the nation's currency.  in the case of a currency board. It is a fixed exchange rate regime based on maintaining foreign currency reserves to back all domestic currency units that are in circulation with it. Due to the 100% reserve requirement wherein the full convertibility of domestic currency into a reserve is ascertained, a limitation is imposed on issuing or printing new money to avoid affecting the exchange rate.  The currency board facilitates low inflation and relative stability, thereby promoting trade and investment due to stabilized exchange rates. The disadvantages of the currency board include the absence of monetary independence due to strictly limited monetary policy. One example of a currency board is in Hong Kong, wherein all the Hong Kong dollars are fully backed with US dollars maintaining a 100% reserve requirement. 
  2. Dollarization - When a country uses US dollars in addition to or instead of their own domestic currency, it is known as dollarization. Dollarization is adopted by weaker economies or developing countries that have an unstable environment for economic growth and hyperinflation, causing the domestic currency to lose value. The advantages that dollarization facilitates for a country is the enhanced economic stability by utilizing the US dollar for day-to-day transactions to counter the reduced buying power. Loss of economic autonomy in monetary policy is the disadvantage that dollarization has on a country.  Zimbabwe is one example of dollarization that adopted US dollar usage as legal tender in 2009. However, outlawing the US dollar use, a new Zimbabwe dollar was introduced in February 2019 called the Real Time Gross Settlement dollar. 
  3. Currency Union - Currency union or monetary union witnesses the pegging of exchange rates of two or more economies to the same reference currency wherein the participating countries may also share a common currency. This system offers the advantage of lowered costs of transborder transactions. The disadvantages that a country might encounter on joining a currency union includes the loss of autonomy of monetary policies, huge costs associated with adopting new currency and the inability to cope with external shocks. The Euro and the CFA Franc are a few examples of currency unions.

Following are the advantages of a fixed exchange rate:

  1. For the steady growth of the trade of a country, especially one which is economically weaker, the stability in foreign exchange rates brings great advantage. The reduced uncertainty of forex rate fluctuations and the minimised need for forex risk management due to pegging prevents the incomes of exporters and the costs of imports from being affected. Moreover, the reduced forex risk associated with international trade and investments is also the major benefit that a fixed exchange rate provides to a country. 
  2. The stability in the exchange rates acts as a deterrence to the threat of speculation in the forex market. It discourages flight of capital wherein there is a strengthened sense of security in traders regarding successful international payments. 
  3. There is a high possibility of currency depreciation in a poor developing country due to fluctuating exchange rates which is navigated in the case of pegged exchange rates. Also, it further reduces the chances of a government adopting irresponsible monetary policies since the balance of payment deficits can be tided over without changing any domestic policies. 
  4. The stability provided by pegged exchange rates attracts investments due to reduced associated risks that eventually lead to economic growth. 
  5. One of the major advantages that pegged exchange rates bring to smaller economies is that it aids the competitiveness of goods in the international market. Another merit is the profitability that trade relations between countries with low production costs harbour with countries with comparatively stronger currencies. It leads to domestic products' competitiveness abroad and profitability at home.

Following are the disadvantages of Fixed exchange rates:

  1. The biggest disadvantage of the pegged exchange rate regime is the management of large forex reserves by the countries, wherein the ability of market adjustments is reduced to counter the issue of currency becoming over and undervalued. Also, maintaining the fixed exchange rate while avoiding economic changes from adversely affecting it is highly cost and time-intensive.
  2. Persistent balance of payment deficits can lead to a situation for a country where certain internal measures need to be taken to counter it, which tend to contract economies. The measures that might include devaluation of currency eventually lead to heightened unemployment, lower economic growth and high inflation.

Floating Exchange Rates

Contrary to the pegged exchange rate, the private market drives and determines the floating exchange rates through supply and demands. It is also referred to as flexible exchange rates. Due to the volatile nature of the forex market and the various factors influencing it, the floating exchange rates fluctuate constantly. The possibility of the central bank's intervention to ensure stability and avoid inflation is not completely absent. Following are the types of floating exchange rates:

  1. Free float - A free float exchange rate regime doesn't witness intervention from the government for regulating the exchange rates. Rather the market forces and the supply and demand influence the foreign exchange rates creating high risks due to volatility and the fluctuating exchange rates. 
  2. Managed float - Some countries might prefer a managed floating approach which serves as a middle ground between a fixed exchange rate regime and a flexible exchange rate regime. This means that the floating exchange rate is followed within a limited range wherein the government and central bank might step in and take necessary actions in case of adverse exchange rate movements. The volatility of currencies and the risks associated with fluctuating exchange rates are managed under this regime. The buying of large amounts of pesos by the  American government in 1994 is an instance of government intervention to maintain the trade status quo by halting the peso's rapid value loss. 

Following are the advantages of floating exchange rates:

  1. One of the primary benefits of the floating exchange rates regime is the automatic ability to tide over the balance trade deficits by the market forces of demand and supply. The excess supply of home currency upon arrival of the balance of trade deficits causes the exports to become cheaper and imports to become more expensive, thereby boosting a country's exports. This allows for the BOP accounts to reach equilibrium and enables automatic adjustment of an economic crisis without government intervention.
  2. The flexible exchange rate regime extends to the domestic economy to remain fortified against the external shocks, including the threat of importing inflation from the outside. Moreover, another major benefit that this regime provides to a country is the navigation of the capital and time-intensive management of foreign exchange reserves to manage adverse unforeseen market developments.

Following are the disadvantages of floating exchange rates:

  1. The uncertainty and forex risks that the exporter, importers and investors of a country are subjected to constitute the major disadvantage of the floating exchange rate regime. The need for foreign exchange risk management to mitigate business losses is prominent especially for longer forex transactions subjected to unforeseen forex rate fluctuations.   
  2. The floating exchange rates might discourage investments due to the profit and loss implications that fluctuating exchange rates might create for foreign investment deals.
  3. This creates a wider scope for speculations which can foster disruptive money flows such as the flight of money in case of speculations by the investors regarding further anticipated decline of forex rate.

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