The foreign exchange market is the largest and most liquid market
in the world and plays a vital role in the economy. Currencies are always
traded in pairs in the foreign exchange market. Most dynamic and active as it
includes all facets of buying, selling & exchanging currencies 24 X 7 X
365. The main participants in the market
are banks, central banks, exporters, importers, brokers, investors, speculators,
and governments.
Foreign
exchange regimes refer to the systems implemented by countries to determine the
value of their currencies compared to other currencies. These regimes can range
from fixed exchange rates to floating exchange rates, and intermediate arrangements
in between. There are factors influencing the exchange rate.
• Interest rates.
• Differentials in Inflation.
• Cross currency investment.
• Government fiscal and monetary policy.
• Trade and current account deficits.
• Various political factors and events
such as natural disasters, war, revolutions, etc.
Before 1973, two broad exchange rate regimes existed; the classical
Gold Standard and the Breton Wood Standard. With the abandonment of the Breton Wood
Agreement in 1973, the modern foreign exchange market was born. In the current
system, exchange rates among the major currencies such as the US Dollar, the Euro,
and the Japanese Yen, fluctuate in response to market forces, while some countries
are still using fixed exchange rate policies & some economies have a wide
variety of exchange rate arrangements by practicing intermediate exchange rate
policy. However, there is a tendency to move to a floating exchange policy by
many of those countries.
This report provides an overview of various foreign exchange
regimes and periods of exchange rate arrangements, highlighting their
characteristics, advantages, disadvantages, organizational structures required
for their administration, and reasons for their failures (if abandoned).
Additionally, it discusses the impact on monetary policy independence and the suitability
of different regimes for developed and developing countries such as Sri Lanka.
2. Fixed Exchange
Rate
Countries, that use fixed exchange rate policies, restrict the exchange
rate fluctuation in response to the market forces. Currency is tied or pegged
to another country’s currency or price of gold. For example, the Sri Lankan
Rupee was tied to the US Dollar at LKR202/- in 2021 and did not allow change
according to the market forces. Fixed exchange rate can be beneficial in some
economic conditions and it can also make things difficult for some of the
market forces. Hence, there are advantages as well as disadvantages in fixed
exchange rate policy.
2.1 Advantages of Fixed Exchange Rate
Fixed exchange rate policy can help to stabilize the currency in a
country and that makes it easier for businesses to plan and carry out their
activities to grow the business. This will help investors of other countries to
know exactly how much they will be paid in foreign currency and return on their
investment. This can boost the consumption level, as prices of imports will
have a stable price. Given below are the advantages of fixed exchange rates.
2.1.2 Control currency fluctuations
When a country experiences a highly volatile exchange rate, it
makes it difficult for businesses to plan their future activities. The fixed
exchange rate will not have that issue. Since the purchasing power can be
maintained at the same level, money circulation will be high due to high
economic activities in the market. A fixed exchange rate will eliminate the
arbitrage opportunity and it will prevent such unfavourable conditions.
Less fluctuation will provide exchange rate certainty to importers and
exporters.
2.1.3 Encourage investments
Investors can have long-term plans since they know the exact return
on their investments. This will help businesses to grow as they can attract
more investors. Cross-border trading
activities will grow as investors/ traders can easily convert their money into
the currency of the country they want to invest.
2.1.4 Maintain inflation at low levels
Fixed exchange rate helps developing countries control the
devaluation of their currency and keep inflation at a low level. Can maintain
the prices of imported goods and services at affordable levels for citizens and
it will create a dynamic & stable economy for developing countries.
2.2 Disadvantages of Fixed Exchange Rate
Since Fixed Exchange Rate policy neglects the behaviour of the
market forces there are some disadvantages as well. When there is no adjustment
to the local currency, Imports & exports can become cheaper or more expensive
than expected. Though it controls the inflation short term there is a
possibility to rise inflation level over time. Given below are the disadvantages
of fixed exchange rates.
2.2.1 Creates trade deficits.
Imported products & services become cheaper for consumers and the
country will have to import more to cater to the demand of the citizens. Intern
imports will be more than exports, which can lead to a high trade deficit and
economic issues.
2.2.2 Rebalancing is not possible
Fixed exchange rate limits the central bank’s freedom to make
adjustments to the interest rates. When the deficit is high, will not be able
to make necessary adjustments to control the situation. For example, if the
country’s currency is weak, it will have to devalue its currency to boost exports. This can lead to higher inflation and reduce economic growth.
2.2.3 Difficulty in achieving macroeconomic
objectives
Countries that have a high dependency on exports can hurt export earnings once they convert into domestic currency. Exporters
may prefer to keep their earnings in foreign currency from outside the
country.
2.2.4 Require higher interest rates
Higher interest
rates are necessary with fixed exchange rates to maintain currency stability.
Businesses find it challenging to borrow money and export their products.
3. Floating Exchange
Rate
A floating exchange rate policy allows determining the domestic
currency exchange rate against foreign currencies through a supply and demand
mechanism. Since the domestic currency is fully liberalized, the Central bank
or the government is not directly involved in deciding the exchange rate. The
exchange rate fluctuates frequently and may even change several times per day.
Demand & supply of a currency is affected by several factors such as interest rate, import & export of the country, foreign
direct investments & other cross-border investments. For example, if a country
can attract foreign direct investments (FDIs), demand for the domestic currency
will increase and it will make the domestic currency stronger. However, there
can be situations where the exchange rate is too low or too high &requires
interference to direct the rates to the desired levels. A floating exchange
rate policy limits the ability of the Government or Central bank to interfere in
such situations.
3.1 Advantages of Floating Exchange Rate
3.1.1 Rate will be determined by the market
Since the currency is fully liberalized, no need to have
established mechanisms to continuously monitor the exchange rate and maintain it
at a particular level. Hence, no need to put effort into managing the exchange
rate the central bank can focus more on its core activities.
3.1.2 Liberalization of the currency
Governments
and central banks can be very independent in a country with a freely floating
exchange rate. For instance, when the Dollar's interest rates increase, all
currencies that are tied to it must also make the corresponding adjustments. As
a result, countries whose currencies are pegged to the dollar have only a
limited degree of independence, as opposed to those whose currencies are
allowed to float.
3.1.3 Minimize Speculative Attacks
Since currency faces necessary adjustments in real-time according
to the demand & supply of the currencies and chances of speculative attacks
are lower due to the market being well aware of the real value of the currency.
When a currency not moving according to the market forces speculators can make
an opportunity to move the currency up or down to make a quick profit.
3.1.4 No need to maintain large reserves
To defend the exchange rate of the domestic currency Central Bank
has to hold massive reserves. The Central Bank has to be involved in buying
& selling foreign currency to maintain the currency at desired exchange
rate levels in the absence of a floating exchange rate policy. Holding foreign
exchange for trading purposes is an expensive strategy and this is one of the
major advantages of floating exchange rate policy.
3.2 Disadvantages of Floating Exchange Rate
3.2.1 Risk of Volatility.
If the currency is subject to fluctuation and does not have a
stable rate there can be a large increase or decline within a single trading
day. Therefore, traders find it difficult to engage in foreign trade since they
are not aware of the exact prices that their goods will bring them. Sudden
movements in the currency market can cause losses to companies that are
actively involved in foreign trade.
3.2.2 Might not achieve expected objectives
due to lack of discipline
As the currency is subject to free-floating there should be an
efficient internal control mechanism to prevent misusing of the system by
influential forces to get an undue advantage.
3.2.3 Can restrict economic growth and
recovery.
When there is a stable currency, it will help for economic growth
of the country. Hence, high volatility may hinder economic growth in some
cases. At the same time when currency starts depreciating by large amounts that
will lead to serious issues in the import & export market
3.2.4 Difficult to have a long-term strategy
for a country
If the domestic currency keeps on depreciating, a country can
limit the imports and allocate more resources to drive exports. If the currency
appreciates, it makes imports a better option. Hence, if the exchange rate keeps
on fluctuating country cannot have a long-term strategy to allocate resources
accordingly.
4. Intermediate
Exchange rate arrangements
Sticking to either a floating or fixed exchange policy may reduce
the flexibility of a country to manage the economy. Hence, countries especially
developing countries have more tendency to intermediate or manage exchange rate
arrangements. Changes in the exchange
rate will have a direct impact on the prices of imports and exports. An
increase in the exchange rate of domestic currency will reduce the prices of
imports and increase the prices of exports. In such situations, the government
will have to resort to different exchange rate arrangements to manage the
economy. Intermediate exchange rate arrangements will give flexibility for
governments to adopt the most suitable exchange rate arrangement.
4.1 Advantages of Intermediate Exchange Rate
Arrangements
4.1.1 Can manage the rate effectively
If the domestic currency rate keeps falling, can intervene and
control the situation by adopting suitable arrangements. When the domestic
currency rate keeps rising that may hurt exports of the
country. In such situations, an intermediate exchange rate policy can manage
the situation fast.
4.1.2 Can reduce the uncertainty
Exchange rates work best when it is consistent, predictable, and
not open for speculators. If the exchange rates can work at their best that
will ensure transparent & effective trading in the country.
4.2 Disadvantages of Intermediate Exchange Rate
Arrangements
4.2.1 Might not achieve expected objectives
due to lack of discipline
The absence of an efficient internal control mechanism to prevent
misusing of the system by influential forces may lead to the adaptation of a biased
exchange rate arrangement, which can be beneficial only for a set of
influential forces.
4.2.2 Need resources to manage the exchange
rate
Since continuous monitoring is required and the need to allocate
different resources at different exchange rate arrangements, a high level of
resources should be maintained and that can be a costly affair for a country.
5. Organizational
structures required to administer the exchange rate arrangement and reasons for
failures
It is important to have an efficient organizational structure to
administer the exchange rate arrangements in the country and the level of
interference can be changed according to the exchange arrangement that the country
has been resorted to. Organizational structures have control over the Information
available to market participants to make their pricing decisions. The
organizational structures and foreign exchange regulations determine the way in
which a particular economy manages the foreign exchange.
Currency boards and central Banks are the two main organizational
structures that countries have. For example, Singapore has a currency board
system to manage their foreign exchange simply because they wanted to have
monetary discipline within the country rather than undisciplined money printing
by a central bank. Likewise, there are pros and cons in each organizational
structure and the impact of such structures varies depending on the economic
condition of the country.
5.1 Fixed Exchange Rate
5.1.1 Required Organizational Structure
The central bank and the government are the key players who are
responsible for managing the exchange rate. Central Bank monitors and
formulates short and long-term strategies to manage the currency. The
government is responsible for having the right policies in place to support the
Central Bank's decisions in managing the currency.
5.1.2 Reasons for Failure
•
To defend the
fixed rate Central Bank should have a sufficient foreign exchange reserve and the
absence of the same will lead to a failure.
•
Biased and
miscalculated decisions of the authorities.
•
Lack of reserves
will lead to hasty decisions by authorities that can lose the market confidence
level.
5.2 Floating Exchange Rate
5.2.1 Required Organizational Structure
Activities of the market participants are determined by the
exchange rate through supply and demand. Hence minimal intervention by the government.
The central bank plays a role in monitoring and influencing monetary
conditions.
5.2.2 Reasons for Failure
•
High volatility,
which can breach the expected levels.
•
No control over
external factors.
•
Since there is no
control over the activities, difficult to take corrective measures fast when
there is an adverse condition in the market.
5.3 Intermediate Exchange Rate
5.3.1 Organizational Structure:
The
central bank has a huge role to play when there is an Intermediate Exchange
Rate arrangement in the country. The Central Bank has to coordinate with the
government and the relevant institutions to identify the right exchange rate
arrangement for the country.
5.3.2 Reasons for Failure
•
Inability of the Central
Bank to make decisions due to undue influences from influential parties.
•
Policies may not
align with market expectations.
6. Impact on
monetary policy independence and suitability of different regimes for developed
countries and developing countries such as Sri Lanka.
"Monetary policy is the process by which a Central Bank
manages the supply and the cost of money in an economy mainly with a view to achieving
the macroeconomic objective of price stability. The CBSL possesses a wide range
of tools to be used as instruments of monetary policy. The main instruments are the policy interest
rates, open market operations (OMOs), and the statutory reserve ratio (SRR). In
addition, bank rates, refinance facilities, quantitative restrictions on
credit, ceilings on interest rates and moral suasion can also be used. The CBSL
has the independence of choosing appropriate instruments to conduct monetary
policy." (www.cbsl.gov.lk).
Central Bank intervenes directly or indirectly to avoid
substantial and quick changes in the value of the Exchange rates. Central Bank
can use several strategies in their monetary policy to influence the exchange
rates. When the central bank raises interest rates, investors expect a higher
interest rate, and demand for the local currency will rise. When the Central Bank
lowers interest rates, investors will go for alternative options, and demand
for the local currency will fall.
Monetary policy independence is the key requirement for a country
to manage the supply and the cost of money in an economy. Undue influences by
political forces & influential market forces can have a negative impact on
the domestic currency and there is a possibility of losing credibility.
A high level of monetary policy independence can be seen mostly in
developed countries. Developing countries are experiencing political pressure
on their monetary policy and having difficulties in achieving the macroeconomic
objective through their monetary policy.
For example, the Central Bank of Sri Lanka fixed the exchange rate
at 202 Sri Lankan rupee per US Dollar in 2021 & tried hard to defend the
currency by selling foreign reserves. When the reserves continued to deplete
the Central Bank stopped selling dollars. Absence of a clear plan to attract
dollars into the country, thereafter rupee started depreciating rapidly.
In Thailand, the Thai Central Bank has done the same thing in
1997. They fixed the exchange rate at 25 Thai baht per US dollar. However, the
inflation within the country had been at higher levels and there was pressure
to maintain the currency at 25 Thai baht. They have depleted the USD 25 billion
of their foreign reserves by trying to defend the currency. Later they did not
have foreign reserves to defend the currency, they had to give up and overnight
Thai baht fell from 25 to 50 per US dollar. What Thailand has done after that
was a good lesson for countries like Sri Lanka. They came up with strict
budgetary measures cutting down non-essential government expenditure to improve
revenue. They boost domestic production, and tourism & open up all the
possible channels to attract foreign currency into the country. They were able
to bring the value of the baht from 50 to 30 per US dollar within five years
simply because they had a clear plan.
China's monetary policy is mainly focusing on exports and domestic
production, through the People's Bank of China. Their target is to keep the
Yuan's exchange rate below its real value. By devaluing the Yuan they make the
exports cheaper for other countries, which in turn increases their domestic
production. China is achieving its objectives by printing more Yuan and injecting
it into the market, creating reserves in other currencies, and regularly buying
US Treasury bonds.
7.
Conclusion
Each foreign currency regime has its advantages and disadvantages.
Regime which suited to one country may not suited to another. The advantages of
a floating rate system can be disadvantages of a fixed rate system. One country
may see that an intermediate exchange rate system is the best choice. The
choice depends on the country’s exposure to the foreign exchange market and its
long & short-term objectives. It is important to have an independent monetary
policy, which has complete power over the country's money supply and is free of
government influence.
