Critical Comparison of Fixed and Floating Exchange Rate Mechanisms Assignment

Critical Comparison of Fixed and Floating Exchange Rate Mechanisms Assignment Words: 2404

Introduction This paper will examine independently floating exchange rate arrangements and other conventional fixed peg arrangements in separate sections. Each section contains four parts: ???An examination of the mechanics of the regime; ???A discussion of its advantages and disadvantages; ???An analysis of the experiences of selected nations and how these experiences highlight the strengths and weakness of the system; and ???My final thoughts on that particular exchange rate regime. 1. Conventional fixed peg arrangements a. Mechanics of conventional fixed peg arrangements

Fixed peg arrangements are recognized by the IMF as a fairly inflexible exchange rate regime. Countries in this category peg their currency, either formally or on a se facto basis, to another currency or a basket of currencies at a fixed rate. Such a basket would contain the currencies of major trading or financial partners which are weighted to reflect distribution of sales, services and cash flows. The exchange rate is allowed to fluctuate within limits one percent above and below the fixed central rate. It is the role of the nation’s monetary authority to maintain the fixed parity using either direct or indirect intervention.

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Direct intervention involves buying and selling the currency in the foreign exchange market, whereas indirect intervention involves the aggressive use of interest rate policy, foreign trade regulation or the intervention by other public institutions. b. Advantages and disadvantages of fixed peg arrangement It is argued that fixed rates provide certainty for international businesses by eliminating foreign exchange risk which will encourage foreign investment and that fixed rates should eliminate destabilizing speculation. This is often seen as the most compelling endorsement of fixed rate regimes.

However this argument is fallacious if the level of the peg is unsustainable. An unsustainable peg will lead to currency reserves being run down causing a currency crisis. Such circumstances were seen in the lead up to the Asian financial crises of the 1970s where the Thai baht was fixed to a basket of currencies at an unsustainable level and eventually went into freefall when as the balance of payments deficit became unmanageable. The example of Thailand also illustrates that fixed rates do not preclude speculation as the Thai baht was subject to fierce speculative bids especially by the George Soros’ Fund.

Therefore a fixed peg arrangement will only be advantageous if the peg is appropriately set and extremely well managed by the government. Despite the exchange arrangements being rather inflexible, there still exists the possibility within fixed peg arrangements for traditional central bank functions as well as the opportunity for the adjustment of the exchange rate by the nation’s monetary authority. Although possible, adjustment of the exchange rate can only occur infrequently and not fast enough to appropriately respond to market forces.

Often the exchange rate can dominate policy such that interest rates and other policies may be set to maintain the fixed rate without a great deal of consideration for what is best for the economy. A country which pegs its currency to another currency may not have the same monetary policy or inflationary conditions. If a nation with high inflation is pegged to a nation with lower inflation the high inflation country will be under constant pressure to remain competitive and may ultimately have to allow a devaluation of the currency. Speculative short selling of the currency will add further downward pressure.

Such competitiveness can only be maintained in the short-term. Another disadvantage is that fixed exchange rate arrangements require large holdings of foreign exchange reserves. c. Experiences of countries with fixed peg arrangements An examination of Zimbabwe illustrates the perils of fixed peg arrangements (see graph 1 below). Zimbabwe utilized money creation and the sale of Reserve Bank of Zimbabwe securities to fund deficits leading to four-figure inflation. This highlights the extent to which maintaining a fixed peg can interfere with monetary policy.

Analysts argue that to create a stable currency in Zimbabwe a dynamic foreign exchange market is needed ??? the government must stop using interest rates and tariffs to inhibit the flow of funds in an attempt to maintain a pegged exchanged rate. GRAPH 1 ??? Source: Yahoo finance While the example given by Zimbabwe paints a fairly bleak picture of fixed peg arrangements, there are examples of governments using such arrangements in their favour. China is indeed an example of a country that has used the mechanics of a fixed exchange rate for their benefit.

The CCP used fixed rate regimes to successfully stabilize prices after World War II. For many years the Chinese government refused to revalue their currency despite the none-too-subtle pressure from the US. One of the main reasons for the Chinese’s government’s refusal to revalue the Yuan was to maintain China’s international competitiveness which fueled China’s unprecedented growth levels. Thus the example set by China prior to 2005 shows that a fixed peg can be advantageous in creating an undervalued currency which will lead to benefits in the global market.

However, as illustrated by Zimbabwe, more often than not fixed exchange rates lead to overvalued currencies and devaluation. GRAPH 2 ??? Source: http://research. stlouisfed. org/fred2/series/DEXCHUS? rid=17=1 However on 21 July 2005 the People’s Bank of China announced that China was replacing the pegged exchange rate system with a managed floating exchange rate system referenced to a basket of currencies and revalued the renminbi at around 8 per US dollar as can clearly be seen on graph 2.

This is perhaps indicative of the fact that a rigid peg cannot be maintained indefinitely and that eventually the pressures exerted by the foreign exchange market must be allowed to influence the exchange rate. d. Thoughts on fixed peg arrangements While fixed exchange rates are not wholly unbeneficial, I do not find the arguments in favour of such mechanisms at all compelling. It is conceivable that in the short-term a fixed peg may provide stability but in most cases such a rate cannot be feasibly maintained in the long run.

For most countries the maintenance of the fixed rate is a huge drain on foreign currency reserves and ultimately leads to devaluation. I believe that China is a rare case in that we are dealing with an undervalued currency which is the opposite of most instances. Ultimately fighting the pressure of the foreign exchange market is not advisable and will lead to currency instability if not done with exceptional skill and foresight by the government. 2. Independently floating exchange rates a. Mechanics of independently floating exchange rates

Independently floating exchange rate arrangements allow the exchange rate to be determined by the market and are classified by the IMF as the most flexible exchange rate regime. Any official intervention is not for the purpose of establishing a set level for the exchange rate but rather is aimed at preventing fluctuations or moderating the rate of change. Most nations that operate under floating rate systems adopt inflation targeting, but some nations utilize a monetary aggregate target or IMF-supported monetary program.

An inflation targeting framework sets out medium term inflationary targets which the nation’s monetary authority aim to meet. Monetary aggregate targeting involves setting target growth rates for reserve money, M1 or M2. b. Advantages and disadvantages of independently floating exchange rates Clean floats are in many ways diametrically opposed to fixed exchange rate regimes, and as such many of the weaknesses of fixed peg arrangements translate into strengths of the floating exchange rate system.

One of the main advantages of floating exchange rates is that they allow governments the freedom to pursue their own internal policy to achieve goals such as full employment and economic growth. Because government intervention is limited, the government can set monetary goals and other policy on their own merits without first having to think about how that will affect their exchange rate. Floating exchange rates are also more flexible and are thus able to better adjust to external shocks.

The importance of this greater flexibility was highlighted by the change in the global economy as a result of the OPEC oil shock which caused many fixed exchange rate nations to become uncompetitive given their soaring rates of inflation. Furthermore, a nation who does not actively intervene in the foreign exchange market need not hold huge foreign exchange reserves and thus does not incur the large opportunity cost of such funds. Despite these compelling arguments in favour of floating exchange rates there are nonetheless disadvantages associated with floating exchange rates.

There is always a danger that in a floating rate system there will be large fluctuations in the exchange rate that will increase the risk of transnational trade and lead to a lack of investment. However most nations who use such an exchange rate system do intervene to some degree in order to ‘smooth out’ the transition from one exchange rate to another and to moderate the rate of such movements and therefore such wide fluctuations are rare in reality. Inflationary problems and speculation are also issues for floating rate countries.

If import prices rise relative to export prices then there is upward inflationary pressure. However many nations employ inflationary targets in conjunction with the floating exchange rate in order to counteract this problem. While some argue that currency speculation is destabilizing, as long as such speculation does not become widespread with many investors taking the same position (such as during the Asian financial crises where numerous investors sold the Asian trigger currencies short causing huge downward pressure) then speculation should be no more harmful than it is in any other market. c.

Experiences of countries with independently floating exchange rates The Australian dollar was floated in December 1983 and in the immediate years the Australian dollar did experience some volatility (see graph 3 below) as well as some prominent speculative activity, but with the maturity of the market the volatility has declined as has the presence of these speculative ‘cowboys’. The floatation of the dollar achieved one of its main goals which was to regain the control of monetary power and stop the importation of foreign inflation that was inherent to the preceding fixed rate arrangement of the 1970s.

More recently in Australia we have seen inflation go beyond the target level which is illustrative of the susceptibility of floating exchange rates to inflationary pressure. However such inflation has been managed by numerous sequential increases in the cash rate by the RBA. GRAPH 3 ??? Source: www. aph. gov. au/library/pubs/rn/2004-05/05RN28-1. GIF There was pressure in 1998 for the Philippines to reinstate the fixed rate arrangement of the past but then central bank chief Gabriel Singson refused to do so stating that controls were unmanageable and encouraged capital flight.

This is indicative of the view of some central banks that floating exchange rates are preferable even in the face of devaluation. d. Thoughts on floating exchange rates Floating exchange rates seem to be the most appropriate exchange rate mechanism. While fixing the rate may have short term benefits and be seen to protect domestic interests, inevitably such intervention cannot be sustained long term. Therefore even in the face of devaluation, I believe floating rates are still preferable because fixing the rate will be at best a stall and ultimately lead to currency crises if the government persists with the peg.

See for example Classification of Exchange Rate Arrangements and Monetary Policy Framework ??? as of July 30, 2003 (2003) International Monetary Fund www. imf. org/external/np/mfd/er/2006/eng/0706. htm as at 30 August 2008. De Facto Classification of Exchange Rate Regimes and Monetary Framework ??? as of July 31, 2006 (2006) International Monetary Fund www. imf. org/external/np/mfd/er/2006/eng/0706. htm as at 30 August 2008. Ibid. Further work ??? the advantages and disadvantages of fixed exchange rates (2007) Biz/Ed www. bized. co. uk/virtual/bank/economics/markets/foreign/further1. htm at 30 August 2008.

Lloyd and Sawyer ‘The Asian economic and financial crisis: the effects of market integrations and market fragility’ (1998) Melbourne Institute Bulletin. Ibid. Above n 1. Above n 4. Ibid. Ibid. Munoz, Central bank quasi-fiscal losses and high inflation in Zimbabwe: a note (2007) IMF www. imf. org/external/pbs/cat/longres. cfm? sk=20630 at 3 September 2008. Reynolds, Zimbabwe’s recovery and Nepad (2008) SARPN www. sarpn. org. za/documents/d0001186/index. php at 31 August 2008. Liew and Wu, The making of China’s exchange rate policy: from plan to WTO entry (2007). Ibid. Ibid. Above n 1. Ibid. Above n 3.

Ibid. Ibid.. Ibid. Above n 1. Above n 3. Fraser, B. W. , ‘Australia’s recent exchange rate experience’ (1992). Talk by Governor Fraser to Association Cambiste Internationale Congress, Sydney, 29 May 1992. Ibid. Philippines won’t fix peso exchange rates (2000) Asian Economic News ;finarticles. com/p/articles/mi_m0WDP/is_1998_Sept_14/ai_53013417; at 1 September 2008. References Aldcroft and Oliver, ‘Exchange rate regimes in the twentieth century’ (1998). De Grauwe, Dewachter and Embrechts, ‘Exchange rate theory’ (1993). Fraser, B. W. , ‘Australia’s recent exchange rate experience’ (1992).

Talk by Governor Fraser to Association Cambiste Internationale Congress, Sydney, 29 May 1992. Goldstein, Morris, ‘Adjusting China’s exchange rate policies’ (2004) Revised version of paper presented at the International Monetary Fund’s seminar on China’s foreign exchange system, Dalian, China May 26-27, 2004. Classification of Exchange Rate Arrangements and Monetary Policy Framework ??? as of July 30, 2003 (2003) International Monetary Fund www. imf. org/external/np/mfd/er/2006/eng/0706. htm as at 30 August 2008. De Facto Classification of Exchange Rate Regimes and Monetary Framework ??? as of July 31, 2006 (2006) International Monetary Fund www. mf. org/external/np/mfd/er/2006/eng/0706. htm as at 30 August 2008. Lloyd and Sawyer ‘The Asian economic and financial crisis: the effects of market integrations and market fragility’ (1998) Melbourne Institute Bulletin. Further work ??? the advantages and disadvantages of fixed exchange rates (2007) Biz/Ed www. bized. co. uk/virtual/bank/economics/markets/foreign/further1. htm at 30 August 2008. Liew and Wu, ‘The making of China’s exchange rate policy: from plan to WTO entry’ (2007). McKinnon, Ronald, ‘Why China should keep its exchange rate pegged to the dollar: a historical perspective from Japan’ (2006).

Munoz, Central bank quasi-fiscal losses and high inflation in Zimbabwe: a note (2007) IMF www. imf. org/external/pbs/cat/longres. cfm? sk=20630 at 3 September 2008. Pentecost, ‘Exchange rate dynamics’ (1993). Philippines won’t fix peso exchange rates (2000) Asian Economic News finarticles. com/p/articles/mi_m0WDP/is_1998_Sept_14/ai_53013417 at 1 September 2008. Reynolds, Zimbabwe’s recovery and Nepad (2008) SARPN www. sarpn. org. za/documents/d0001186/index. php at 31 August 2008. Shapiro, A. C. , ‘Multinational financial management’, 8th ed. (2006).

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