Getting down and dirty with the exchange rate system

Exchange rate systems can be classified under the two broad categories of fixed and floating rates. In real life, exchange rate mechanisms are a mix of these, with some countries having abandoned exchange rates completely due to macro economic crisis. This phenomenon occurs when a nation loses faith in its own currency and adopts another currency as a medium of exchange. The usual choice for such currencies is the US dollar and the phenomenon is often termed as the Dollarization of the economy.

Fixed rate system

Broadly, there are three types of fixed rate systems in existence. The first is a currency board, which is a rigidly fixed system. The second is a traditional fixed rate system, which has some inbuilt flexibility. The third is a currency peg, which allows minor fluctuations in the currency value.

Currency board
The currency board is an arrangement by which, the value of a currency is fixed by the government and the nation undertakes to exchange the designated foreign currency for the local currency at the fixed rate. This implies that the quantum of domestic currency is based on the amount of designated foreign currency held by the nation. Intuitively, this also means that the nation does not issue its currency by fiat and thus does not follow an independent monetary policy. The currency board is well suited to nations that wish to instill confidence in their currency or may have been through a macroeconomic crisis. The Hong Kong dollar and the Argentinean Peso are prime examples of a currency board.

Fixed rate system or the currency peg
The currency peg traditionally is not as rigid as the currency board. Under this system, the government or the central bank undertakes to buy and sell foreign exchange at the fixed rate. The key difference between the currency board and the fixed rate system is that the latter allows periodic adjustments in the exchange rate.

The crawling peg
The crawling peg is another form of fixed exchange rate system that allows a narrow fluctuation of about 1% to 2% in the currency value. Under the crawling peg, the domestic currency can be pegged to a single foreign currency or a basket of foreign currencies. The narrow fluctuation band permitted under this system reduces the need for frequent interventions by the central bank to keep the value stubbornly fixed. The Bahamas and Marshall Islands have pegged their currencies to the U.S. dollar; Niger and Senegal to the French franc; and Bangladesh, Czech Republic and Thailand to a basket of several select currencies.  

The currency peg systems allow some autonomy to central banks in following independent monetary policies. At the same time, the fixed rates also put a restrain on the central banks from following too loose a monetary policy.

The fixed exchange rate systems are attractive to foreign investors they cover their exchange rate risk. The system also helps keep inflation low, which in turn leads to low interest rates. This helps establish a virtuous cycle of investment and economic growth.  

The floating exchange rate system

This kind of exchange rate system is a market friendly system, where the value of the currency is determined by market forces. Supply of the currency and demand for it help determine the value of the currency. Such systems are usually found in mature economies like the US, Europe and Japan. Under this system, it is usually unlikely for the central bank to intervene in the forex markets. The central banks intervene only if any wide and unexpected fluctuations occur in the currency value. 

In theory the floating rate system is best equipped to correct any imbalances in an economy. Let’s understand this via a case study:

  • Let’s assume that an economy has been hit by a slowdown.
  • Slowdown implies reduction in employment and contraction of demand
  • Contraction in demand will imply a lower demand for the local currency for buying goods and services
  • This will lead to depreciation in the local currency
  • Depreciation of the local currency will make imports more expensive
  • This will stimulate demand for local goods and services and help generate employment in the local economy; (a self correction mechanism of imbalances in the case of floating rates)

 

Adoption of the floating exchange rate system requires great prudence in both the monetary and fiscal policies and such systems are best suited to mature economies.

Managed float
The managed float is a system, which allows the currency to float, but currency stability is managed by the central bank. Under this system the currency is allowed to move in response to macroeconomic parameters, but the central bank frequently uses open market operations to cushion sudden and wide fluctuations. Nations that have adopted a managed float are usually transitioning economies, which plan to achieve the full float as their economies mature further. Nations following a managed float, usually have sufficient autonomy to follow their own independent monetary policies. Prime examples include India, Taiwan and Venezuela.

Dollarization and the dual exchange rate system
Certain nations adopt the dollar as the medium of exchange officially or unofficially, once their own currencies become worthless. Zimbabwe is a nation, where the economy stands dollarized, and a majority of transactions are dollar denominated, with its own currency having lost its value due to hyperinflation. Inflation in Zimbabwe is running at over 350,000% and prices in the local currency double once every week or even faster rendering the local currency worthless.

While, the Zimbabwe government chose to maintain an official exchange rate pegged to the dollar, in reality, the black market determines the true value of the local currency and this is usually the reference rate for business transactions. This implies that there exists a dual exchange rate system, the official exchange rate and the unofficial exchange rate. This in itself leads to further black market activities due to the arbitrage opportunity presented by the two exchange rates and leads to further erosion of faith in the local currency.