11. Exchange Rate Determination – Fundamentals of International Business

CHAPTER 11

Exchange Rate Determination

LEARNING OBJECTIVES

After reading this chapter, you should be able to:

  • Identify the characteristics of the international monetary system
  • Understand the basics of exchange rates
  • Outline the history of the Bretton Woods Agreement
  • Explain the functioning of the foreign exchange market

THE FALAFEL INDEX

The Falafel Index, is the Middle East’s answer to the Big Mac Index. The Big Mac Index is a standard global tool for measuring purchasing power. This index determines the purchasing power of different currencies by comparing the prices of McDonald’s signature hamburger—the Big Mac in various countries across the world. This makes it a tool of comparison of the purchasing power of different currencies.

The Big Mac, is used as a common measuring rod, since it represents a standard bundle of goods purchased by consumers across 120 countries. The Big Mac however, is not a standard ‘market basket of goods’—the goods and services that a typical consumer purchases in a month in the Middle East. The index cannot be used as basis for comparison in this region, since the Big Mac is purchased mainly by expats, the rich, and the locals who look out for the occasional Western meal.

The Falafel as a staple meal of the region, is a far more suitable tool of comparison. The falafel sandwich, made of crispy golden balls of chickpeas served in pita bread, crunchy tomatoes and cucumbers, with tahini and sweet and sour pickles are an apt representation of regional purchasing preferences, and a more accurate basis for an index.

The use of Falafelnomics finds compelling arguement in the fact that there is likely to be less difference in operating costs between falafel stands than McDonald’s franchises across the region. Falafel shops are usually humble franchises and serve food that is locally sourced. This cuts down the impact of transportation costs, which is a significant factor contributing towards the difference in price of the Big Mac in different countries. The regional availability of the ingredients of a falafel sandwich also contributes to its cost consistency and finds favour in its use as a regional index.

References: The Big Mac index, https://www.economist.com; The Falafel Index: A Way To Assess Purchasing Power In The Middle East, https://www.forbes.com, last accessed on 15 October 2018.

BASICS OF FOREIGN EXCHANGE

Cross-border transactions of trade and investment occur through an exchange of currencies between buyers and sellers.

There are two major aspects of exchange rates that are of relevance in the understanding of foreign exchange policy: the ‘HOW’ and ‘WHY’ of exchange rates.

  1. How exchange rates are determined?
  2. What is he purpose of determination of exchange rates?

Exchange Rate Determination

For instance, the value of the Indian rupee in terms of the dollar is INR 76 on 18 October 2018 but it was 75 the next day. This means that to buy something in the foreign exchange market for a dollar would cost INR 76 on a certain day of the month but would cost less the next day. How and why does this happen? To understand this we need to examine the fundamentals of the foreign exchange market.

 

The exchange rate is a price. It is the price of domestic currency in terms of a foreign currency also called the reference currency.

The foreign exchange market is the place where prices of currencies are fixed and decided. Just as the price of a commodity is fixed in the market for goods and services, the price of the exchange rate is also determined in the market for foreign exchange. The demand for a foreign currency is linked to payments for imports or for making investments abroad by residents of the home country. The supply of foreign currency comes from export earnings and from investments into the home country by residents of other countries. However, sometimes governments or their central banks intervene in the foreign exchange market in order to satisfy certain domestic economy requirements.

The foreign exchange market functions like any other market and is influenced by the forces of demand and supply in setting an equilibrium price.

Demand for a currency

The demand for a currency is a derived demand. It is derived from the demand for goods and services of the country to which the currency belongs. For instance, the demand for the euro (€) in the foreign exchange market is derived from the demand for European goods, services and euro-dominated financial assets. To buy European goods, an American consumer will have to exchange US dollars for euros. This creates the demand for euros in the foreign exchange market. This demand is expressed as the price of the US dollar in terms of the euro ($/€) for an American consumer.

The euro may increase or decrease in value compared to the US dollar. An increase in value of the euro in terms of the US dollar is equivalent to an increase in the price of goods in Europe. This usually results in reducing the demand of European goods and services for the American consumer. As the US dollar value of the euro falls, the American demand for European goods will rise. The demand curve for a currency is thus downward sloping—just like it is for any other commodity, indicating an inverse relationship between price and quantity demanded.

Supply of a Currency

The supply of Euros is derived from the demand for American goods and services in Europe. If a European resident wants to buy American goods he has to buy US dollars in exchange for Euros. As the dollar value of the Euro increases, it brings down the cost of American products in terms of Euros. This causes an increase in the European demand for dollars and consequently an increase in the supply of Euros. The supply curve for foreign exchange is thus upward sloping, indicating a direct relationship between its price and quantity supplied.

Bird’s-eye View

There are several factors which affect the equilibrium exchange rate. The important ones include inflation rate, interest rate, growth rate, political and economic risk, investor expectations and central bank reputations.

The equilibrium exchange rate is the point at which the demand for Euros / Dollars (€/$) intersects the supply for Euros / dollars (€/$). It is the spot exchange rate at a given point in time.

The existence of a single equilibrium exchange rate is only a hypothetical explanation here for simplicity. In actual practice, exchange rates are quoted as a pair–the bid rate (buy) and the ask rate (sale) by the foreign exchange dealer. You have already studied these rates in the previous chapter.

Fixed and Flexible Exchange Rate Systems

Exchange rates are classified on a scale that has fixed exchange rates at one end and flexible/floating exchange rates at the other. There are several other gradations on the scale, and, in reality, most currencies exist somewhere in the middle of this scale.

 

Under the fixed exchange rate system, the monetary authority or the central bank of the country determines the value of foreign exchange.

The exchange rate is said to be fixed if the monetary authority or the central bank of the country determines its value, in response to certain policy requirements. China for instance keeps its ex change rate fixed at a rate that benefits its exporters, since exports are a very important source of foreign exchange and revenue.

 

The exchange rate is said to be floating if it is determined by the free forces of demand and supply of the foreign exchange market.

On the other hand, the exchange rate is said to be floating if it is determined by the free forces of demand and supply of the foreign exchange market.

In between the two extremes lies the managed exchange rate system, which is also known as the dirty float. Under this system the exchange rate is determined by market forces, but its value is maintained within a specified range according to the need of the economy.

Movements of exchange rates are known as devaluation or depreciation and revaluation or appreciation. when it is determined under the fixed exchange rate system. For example, if the value of the rupee falls from 40 to 45 per USD, the rupee is said to undergone devaluation. Devaluation reduces the value of the domestic currency in terms of the foreign currency. As you can see in the example here, one dollar was equivalent to 40 INR before devaluation. However, after devaluation we need 45 INR to purchase one dollar. Revaluation is the opposite of devaluation, and refers to the upward movement or increase in the value of the domestic currency in terms of the foreign currency. Depreciation refers to a fall in value of domestic currency in terms of a foreign currency under a flexible or floating exchange rate system, and appreciation is the increase in value of domestic currency vis-à-vis foreign currency under the system.

 

The devaluation of a currency refers to a decline in the domestic currency value in terms of the foreign currency under a fixed exchange rate system. Revaluation is the upward movement or increase in the value of the domestic currency in terms of the foreign currency.
Under the floating exchange rate system, a decline in the domestic currency value in terms of the foreign currency is called depreciation and an upward movement or increase in the value of the domestic currency in terms of the foreign currency is called appreciation.

Currency Convertibility

The second aspect of exchange rate policy is concerned with the purpose for which currencies need to be exchanged for each other. For example, if an Indian tourist is going on vacation in Malaysia, he will need the Malaysian Ringgit to be able to purchase goods and services there. On the other hand, Indian imports from Korea have to be paid for in the Won. Similarly, if an Indian business magnate wants to purchase a flat in London, he will have to pay for it in pounds and he can only do so if the government’s exchange rate policy permits such a transaction. This aspect of exchange rate determination is called convertibility.

Currency convertibility refers to the freedom to exchange domestic currencies for foreign currencies for a given purpose and at a given conversion rate. The rules regarding exchange rate determination and currency convertibility vary from country to country, and depend on a host of factors—its balance of payments position, the state of its internal economy, and various other policy considerations.

Currency convertibility is measured on a scale which ranges from full convertibility to full inconvertibility. In practice however, there are two main points on the convertibility scale which are important

  1. Current account convertibility refers to the freedom to convert domestic currency into other convertible currencies for current account transactions, that is for the purchase and sale of goods and services in international trade. For example, if the Indian rupee is convertible on current account, an Indian firm should be able to freely convert rupees into yen to purchase goods from a Japanese company.
  2. Capital account convertibility, therefore, refers to convert domestic currency into foreign currency for transactions in financial and other assets. For example, if a currency is convertible on capital account, the residents of the domestic currency can freely convert it into other (convertible) currencies to purchase and maintain bank accounts abroad. Similarly, residents of other countries should also be able to freely convert their currencies into the domestic currency to purchase domestic capital and money market instruments. In other words, capital account convertibility is associated with the vision of free capital mobility.

A country can restrict the convertibility of its currency through several different measures. Some of these are as follows:

  • Import restrictions such as licence or quota systems
  • Restrictions on the remittance of foreign exchange such as profits, dividend or royalty
  • Surrender of hard currency export earnings to the central bank
  • Mandatory government approval for using a firm’s retained foreign exchange earnings
  • Pre-deposit of foreign exchange expenditure for import business in interest free accounts with the central bank for a certain period
  • Credit ceilings for foreign firms
  • Restriction or prohibition on offshore deposits or investment of hard currencies
  • Use of multiple exchange rates simultaneously for different items of balance of payments

Bird’s-eye View

The exchange rate mechanism of a country has two basic features—the manner in which the exchange rate is determined (price) and the purpose for which currency exchange takes place (convertibility). The exchange rate and the degree of convertibility may both be measured on a scale.

FACTORS AFFECTING THE EXCHANGE RATE

The equilibrium exchange rate changes with a change in demand and supply for a currency. The following factors have an influence on the equilibrium exchange rate:

Relative Inflation Rates

In order to understand the impact of inflation on the exchange rate we continue with the example of US dollars and euros. Let us assume the supply of US dollars exceeds its demand in the domestic market – this causes inflation. Inflation causes the prices of US goods to rise relative to the prices of European goods. This in turn pushes down the demand for US commodities and increases the demand for their European substitutes in the European market. As European consumers demand more of local commodities compared to American goods and services, this reduces the supply of euros available in the foreign exchange market. This causes the euro supply curve to shift to the left and a change in the equilibrium exchange rate.

In the American economy, rising prices of their domestic goods make American consumers look for European imports as substitutes. This causes an increase in the demand for Euros in the US also.

Thus, we find that consumers, in both US and Europe, shift their purchases due to a change in prices of US commodities driven by inflation in the domestic economy. Inflation in the US economy increases European exports to the US and decreases US exports to Europe.

This leads to a new equilibrium exchange rate – which shows a depreciation of the US dollar relative to the euro and an appreciation of the euro relative to the dollar. Thus, we find that if a nation has consistently high rate of inflation, its currency value will depreciate relative to the values of other currencies with lower inflation rates. This relationship is known as Purchasing Power Parity.

Relative Interest Rates

A difference in interest rates of two countries also has an impact on their equilibrium exchange rates. Suppose real US interest rates rise in comparison to the same in Europe, it causes investors in both countries to switch to US dollar denominated securities to get the benefits of higher rates of interest. This leads to a depreciation of the Euro in the absence of government intervention. Thus, change in interest rates also leads to a change in the exchange rates.

Relative Economic Growth Rates

A country that has a high rate of economic growth will attract foreign investment in search of domestic assets. Assuming the US has a higher rate of growth than Europe, this will lead to foreign investment moving to the US and in turn, will cause demand for the US dollar to rise. This causes the domestic currency to emerge as the stronger currency. In general, economic growth causes the domestic currency to become stronger as compared to the foreign currency.

Political and Economic Risk

The exchange rate is also affected by political and economic risks in a country. Since investors by temperament are risk averse, they prefer to hold currencies of nations with stable political and economic environments in order to minimize the risk of their portfolio.

Expectations and the Asset Market Model of Exchange Rates

Investor expectations also play a significant role in the determination of exchange rates. The currency is a financial asset and an exchange rate is simply the relative price of financial assets of two different countries in terms of each other. The current value of any currency—for example, the US dollar—depends on the desire of the people to hold US dollars and US dollar denominated assets today as much as they had a preference for them yesterday.

The asset market model view of exchange rate determination, thus, says that the exchange rate between two currencies represents the price which just balances the relative supplies of and demand for currency denominated assets. Currency values are thus forward looking and determined by investor expectations of the future.

Central Bank Reputations and Currency Values

The value of a currency is linked to the reputation of the central bank which is issuing it. The central bank is a country’s official monetary authority which has the sole authority to use instruments of monetary policy to achieve price stability, low interest rates or a target currency value.

A currency is considered fiat money if its value is linked to a commodity such as gold. Till 1971, all major currencies of the world were linked to and derived their value from gold. In the absence of such a commodity link, the value of a currency is determined by the central bank which issues it. An increase in the supply of a currency causes inflation and a depreciation in the value of the currency. The value of a currency also depends on expectations of central bank behaviour – and the expectation of the central bank to increase or decrease the amount of currency in circulation in future will have an impact on its current value. This gives a currency a brand value just like any other commodity, and it derives this value from the reputation of the central bank which is issuing it

THEORIES OF EXCHANGE RATE DETERMINATION INTEREST RATE PARITY

Interest rate parity is an arbitrage condition which is necessary for international financial markets to be in equilibrium. It is a manifestation of the Law of One Price, which was popularized through the writings of economists such as John Maynard Keynes.

To understand this, we assume that an American investor has USD 1 to invest over one year. He has the choice of investing it either in the US market at the domestic rate of interest or he may invest it in a foreign country such as the UK at the rate of interest prevailing there. In order to invest in the foreign market, the investor has to hedge against the exchange rate risk through a forward transaction. Hedging the exchange risk through the forward contract ensures that the investment in UK is redenominated in dollar terms. The foreign UK investment along with the forward hedging becomes a perfect substitute for the domestic US investment. The investor is now indifferent to investing in the US or the UK, since the returns from both markets are equal.

Arbitrage equilibrium thus ensures that the future dollar proceeds (and the US dollar interest rates) from investing in the either of the two investment options is exactly the same.

Bird’s-eye View

Interest rate parity is an arbitrage condition which is necessary for international financial markets to be in equilibrium.

A formal statement of IRP is:

OR

where F – Forward exchange rate

S – Spot exchange rate

i$ – Interest rate in US

i£ – Interest rate in UK

The IRP has an immediate implication for exchange rate determination since it is an arbitrage equilibrium which involves the spot exchange rate. To understand this, we rewrite the IRP condition in terms of the spot exchange rate.

Equation 11.3 indicates that, if the forward exchange rate is given, then the spot exchange rate depends on relative interest rates. Thus, an increase in the US rate of interest will lead to an increase in the value of the US dollar. This is due to the fact that a higher interest rate in the US will attract global capital to the US markets, increasing the demand for dollars and causing a rise in the value of the dollar.

The Interest rate parity does not hold under two conditions:

  1. Transactions costs: The existence of transaction costs causes a difference in the interest rates at which the arbitrager borrows and lends, leading to a bid – ask spread. This causes the deviation from the IRP condition.
  2. Capital controls: It is seen that for various macro economic reasons governments across the world impose controls on both inbound and outbound capital flows. This can lead to a distortion in the arbitrage process and lead to a deviation from IRP condition.

Purchasing Power Parity

Application of the Law of One Price to a standard commodity basket gives us the theory of Purchasing Power Parity (PPP). The basic idea of the PPP was first given by David Ricardo and others in the nineteenth century, but it became popular through the writings of Swedish economist–Gustav Cassel–in the 1920s. The PPP theory emerged in the backdrop of hyperinflation in countries like Hungary, Germany and the erstwhile USSR. It was seen that as the purchasing power of these currencies declined sharply, there was a simultaneous depreciation of these currencies against stable currencies like the US dollar. This led to the increased popularity of the PPP theory.

According to this theory, the exchange rate between currencies of two countries should be equal to the ratio of their price levels.

Bird’s-eye View

The theory of Purchasing Power Parity states that, the exchange rate between currencies of two countries should be equal to the ratio of their price levels.

Thus, if P$ is the price of a standard commodity basket in the US market and P is the price of a similar basket of goods in India, then the exchange rate between the dollar and the rupee should be

where S is the US dollar price of one rupee.

Alternately, we may write equation 11.4 as

According to the PPP, if the standard commodity basket costs $225 in the US market and ₹150 in the Indian market, then the exchange rate would be $225/₹150 = $1.50/₹.

The PPP thus, requires that the price of the standard commodity basket must be the same across countries when measured in a common currency. PPP is the manifestation of the Law of One Price to the standard consumption basket. It is another way of defining the equilibrium exchange rate.

The Big Mac Index, compiled by the Economist magazine,1 is an example of the use of PPP to compare the prices of the Big Mac Burger across countries of the world. However, as the opening case explains, it is not a very accurate explanation of the economic situation of the Middle East, hence, the use of the Falafel Index has been proposed.

FISHER EFFECT

The Fisher Effect is a parity condition which relates inflation rate with interest rate. According to this theory, a change in the expected domestic inflation rate leads to a proportionate change in the domestic interest rate. We assume that ρ$ is the equilibrium expected ‘real’ interest rate in the US. If the expected real interest rate is 2 per cent and the expected inflation rate is 4 per cent in the US, it means that the effective interest rate is actually 6 per cent. At an interest rate of 6 per cent the lender is fully compensated for the effect of inflation on his expected return of 2 per cent.

Bird’s-eye View

The Fisher Effect is a parity condition which relates inflation rate with interest rate. According to this theory, a change in the expected domestic inflation rate leads to a proportionate change in the domestic interest rate.

The Fisher Effect states that the expected inflation rate is the difference between the nominal and real interest rates in a country.

Assuming that the real interest rate is the same between countries, that is ρ$ = ρ£, since there are no restrictions on capital flows between countries. If we combine this with the relative PPP theory, we get the International Fisher Effect. This states that the nominal interest rate differential reflects the expected change in exchange rate. For instance, if the interest rate is 5 per cent in the US and 7 per cent in the UK, the dollar will appreciate by 2 per cent per annum against the British pound.

When the International Fisher Effect is combined with the IRP, we get the Forward Expectations Parity (FEP). The FEP states that any forward premium or discount is equal to the expected change in the exchange rate.

EVOLUTION OF THE GLOBAL MONETARY SYSTEM

The Gold Standard (1876–1914)

The concept of money has a history dating back at least 2500 years. Money, as we see it today, is essentially paper and plastic money, but before the invention of paper, money consisted of coins generally made of gold or silver. Money had (and still has) intrinsic value because of its comparative rarity, and, thus, perceived value, of previous metals such as gold and silver.

The origin of the gold standard can be traced to the practice of using gold coins as a medium of exchange, unit of account and store of value in ancient times. When international trade was limited in volume, payment for goods purchased from other nations was in gold and silver coins. However, as international trade expanded after the Industrial Revolution, shipping large quantities of gold and silver coins became impractical. This gave rise to the need for paper currency, and governments of the world agreed to convert paper currency into gold on demand at a fixed rate.

The history of the gold standard can be traced to 1717 when the price of gold was fixed at 3 pounds 17 shillings, 10½ pence per ounce. Great Britain officially adopted the gold standard in 1821 and established the conversion of gold into currency, or vice versa, until World War I. In 1879, Germany, France and the US adopted gold as the monetary standard.

The gold standard was accepted as an international monetary system during the 1870s. Under this system, each country pegged (fixed the value of) its money to gold. The government of each country using the gold standard agreed to buy or sell gold on demand at its own fixed parity rate. This established the value of each individual currency in terms of gold and also fixed a parity or equation of equivalence for conversion between different currencies of the world.

Under this system, it was very important for a country to maintain adequate gold reserves as a backing for its currency’s value. The gold standard worked adequately, until the outbreak of World War I interrupted trade flows and the free movement of gold and major trading nations suspended the gold standard.

The relationship between countries using gold was determined by the amount of gold of a given quality that backed the respective currency. For example, before 1914, the British pound sterling contained 113.066 grains of pure gold and the United Sates dollar contained 23.22 grains. Thus, the gold content of the pound was 4.866 times greater than that of the dollar. The exchange rate at the time was logically GBP 1 = USD 4.866.

The limited supply and uneven distribution of gold prevented its widespread use in international transactions. As a result, the gold standard was given up in 1914. After World War I, the gold standard was re-established, but it was finally given up by Britain in 1931, the US in 1933, and in all other countries by 1937.

The gold standard was linked to classical economic theory, which assumed that:

  • There was full employment of resources and, thus, a rise in the quantity of money could ensure an increase in the general price level.
  • Prices and wages are flexible (that is, they would move up or down).

However, the Great Depression of the 1930s disproved these assumptions. Keynesian economic theory explained that the assumption of full employment was a special rather than a general case, and the assumption of price and wage flexibility was not valid for our modern economic system. This meant that the government had to intervene in the economic system to ensure full employment and fight depression, rather than waiting for automatic adjustments to take effect as classical economists had recommended.

The gold standard had the desirable quality of exchange stability, but it subjected the economy to the undesirable processes of deflation or inflation. This is why it was totally abandoned before World War II.

The destruction of many of the powerful economies of the world led to a global need for economic reconstruction and for a better basis for an international monetary system.

The Inter-war Years and World War II (1914–44)

The US returned to a modified gold standard in 1934, when the US dollar was devalued to USD 35 per ounce of gold from the USD 20.67 per ounce price in effect, prior to World War I. Although the US returned to the gold standard, gold was traded only between foreign central banks, not between individual citizens. From 1934 to the end of World War II, exchange rates were determined, in theory, by each currency’s value in terms of gold. During World War II and its immediate aftermath, however, many of the main trading currencies lost their convertibility into other currencies. The dollar was the only major trading currency that continued to be convertible into gold.

The Bretton Woods System (1944–73)

In 1944, at the height of the World War II, representatives from 44 countries met at Bretton Woods in New Hampshire to design a new international monetary system. The system was aimed at facilitating economic growth and post-war reconstruction of the war-ravaged economies. This led to a consensus on the desirability of the fixed exchange rate mechanism for the global economy. The meeting also established two multinational institutions, the International Monetary Fund (IMF) and the World Bank (WB), to act as regulators of the global economy. Their respective tasks were to maintain order in the international monetary system and promote general economic development.

Under the provisions of the Bretton Woods Agreement signed in 1944, the government of each member country pledged to maintain a fixed, or pegged, exchange rate for its currency vis-à-vis the dollar or gold. Since one ounce of gold was set equal to USD 35, fixing a currency’s gold price was equivalent to setting its exchange rate relative to the dollar. For example, the Deutsche mark was set equal to 1/140 of an ounce of gold, meaning it was worth 50.25 USD 35/DM140. Participating countries agreed to try to maintain the value of their currencies within a 1 per cent band by buying or selling foreign exchange or gold as needed. Devaluation was not to be used as a competitive trade policy, but a devaluation of up to 10 per cent was allowed without formal approval by the IMF. A devaluation of more than 10 per cent was allowed only if the IMF agreed that a country’s balance of payments was in a ‘fundamental disequilibrium’. It was felt that devaluation saved the country in question from the painful adjustment process of a persistent trade deficit that would lead to a balance of payments restoration only through a steep rise in prices.

During this period, the US dollar was the main reserve currency held by central banks and was the key to the web of exchange rate values. Unfortunately, the US ran persistent and growing deficits on its balance of payments during this period. A heavy capital outflow of dollars was required to finance these deficits and to meet the growing demand for dollars from investors and businesses. Eventually, the heavy overhang of dollars held abroad resulted in a lack of confidence in the ability of the US to meet its commitment to convert dollars to gold. On 15 August 1971, the US responded to a huge trade deficit by making the dollar inconvertible into gold. A 10 per cent surcharge was placed on imports, and a programme of wage and price controls was introduced. Many of the major currencies were allowed to float against the dollar. The dollar then began a decade of decline.

In December 1971, the major trading nations of the world signed the Smithsonian Agreement in Washington DC, according to which the US agreed to devalue the dollar to USD 38 per ounce of gold. In return, the other counties present agreed to revalue their own currencies upward in relation to the dollar by specified amounts. Actual revaluation ranged from 7.4 per cent by Canada to 16.9 per cent by Japan. Furthermore, the allowed floating band around par value was expanded from +1 per cent to + 2.25 per cent.

Due to high inflation in the US, the dollar devaluation remained insufficient to restore stability to the system. By 1973, the dollar was under heavy selling pressure even at its devalued rates. By late February 1973, a fixed rate system did not appear feasible given the speculative flows of currencies. The major foreign exchange markets were actually closed for several weeks in March 1973. When they reopened, most currencies were allowed to float to levels determined by market forces. This marked the beginning of change to a floating exchange rate system.

The Post-Bretton Woods System: 1973–Present

This period is characterized by a floating exchange rate system and has since given way to several hybrid systems that are prevalent all over the world today. We look at the prominent exchange rate mechanisms in the global economy today.

Bird’s-eye View

The present monetary system originated with the gold standard and developed in different phases over the years. The present global monetary system evolved out of the Bretton Woods Conference held in 1973.

CONTEMPORARY EXCHANGE RATE SYSTEMS

The classification of current exchange rate systems given here is based on a taxonomy developed by the IMF since 1971, which was revised in 1998 and again in 2009. The basic purpose of revision was to allow greater consistency and objectivity of classifications across countries, expedite the classification process, conserve resources and improve transparency, with benefits for the IMF’s bilateral and multilateral surveillance.

Fixed Exchange Rate System

Under a fixed rate system, governments (through their central banks) buy or sell their currencies in the foreign exchange market whenever exchange rates deviate from their stated par values. In the present-day context, a purely fixed rate system is employed by only a few centrally planned economies such as Cuba and North Korea. In these economies, it is generally mandatory that a local firm’s foreign exchange earnings be surrendered to the central bank, which in return pays the firm a corresponding amount of local currency on the basis of governmental priorities.

Independent Float System

The floating exchange rate regime was formalized in January 1976 following the collapse of the fixed exchange rate system. Approximately 55 countries currently allow full flexibility through an independent float, also known as a clean float. Under the floating exchange rate system, an exchange rate is allowed to adjust freely to the supply and demand of one currency for another. This category contains currencies of both developed countries (such as the US) and developing countries (Peru, for example). Central banks of these countries allow exchange rates to be determined by market forces alone. Although some central banks may intervene in the market from time to time, such intervention usually attempts to reduce speculative pressures on their currency. Further, central banks intervene only as one of many anonymous participants in the free market in an occasional, non-continuous manner.

Currency Board Arrangement

The currency board arrangement is an example of a hard peg. Under this system, a country commits itself to converting its domestic currency on demand into another currency at a fixed exchange rate. To make this commitment credible, the currency board holds reserves of foreign currency at the fixed exchange rate equal to 100 per cent of the currency issued. The currency board can issue additional domestic notes and coins only if it has foreign exchange reserves to back it. This limits the ability of the government to print money and create inflationary pressures. Another advantage of this system is that it has greater political commitment, often reflected in a central bank law or constitutional amendment, thereby making it hard to reverse, and acting as a deterrent to speculative attacks. Two prominent examples of the currency board arrangement are Hong Kong and Argentina. Hong Kong established a currency board arrangement in 1983, Argentina in 1991 (which it subsequently abandoned in 2001), and Bulgaria, Estonia and Lithuania in recent years.

 

The currency board arrangement is a system under which a country commits itself to converting its domestic currency on demand into another currency at a fixed exchange rate.

Soft Pegs

Under a conventional pegged exchange rate regime, a country aligns or pegs the value of its currency to that of a major currency like the US dollar. Pegged exchange rates are a common practice among small nations with weak economies—China is an exception, as it has also pegged its currency, the yuan to the US dollar since 1994. A government can peg its currency to either another single currency or to a ‘basket’ of foreign currencies. Today, 62 of the 167 members of the IMF peg their currency to some other currency. The US dollar is the base for 20 other currencies (for example, Argentina, Iraq, Panama, Venezuela, Dominica, and Hong Kong). The French franc is the base for 14 currencies (all issued by former French colonies in Africa). Similarly, six of the new countries created with the break-up of the Soviet Union peg their currency to the Russian ruble.

Other countries peg their currency to a composite basket of currencies, where the basket consists of a portfolio of currencies of their major trading partners. The base value of such a basket is more stable than any single currency. Under this regime, a country can peg its currency to the standard basket such as the Special Drawing Rights or SDR peg, (such as Libya and Myanmar), or to its own basket, designed to fit the country’s unique trading and investing needs (such as Bangladesh, Cyprus, Czech Republic, Iceland, Jordan, Kuwait, Nepal, Thailand, and Morocco). In the latter approach, the basket normally contains currencies of major trading partners, weighted according to trading relations with the focal country.

Crawling Peg

The crawling peg system is situated between the fixed-rate and floating-rate systems. It is an automatic system for revising the exchange rate, establishing a par value around which the rate can vary up to a given percentage point. The par value is revised regularly according to a formula determined by the authorities. Once the par value is set, the central bank intervenes whenever the market value approaches a limit point. Suppose, for example, that the par value of the Indian rupee is 30 rupees for one dollar, and that it can vary +2 per cent around this rate, between INR 30.60 and INR 29.40. If the dollar approaches the rate of INR 30.60, the central bank intervenes by buying rupees and selling dollars. If the dollar approaches INR 29.40, the central bank intervenes by selling rupees and buying dollars. If it hovers around a limit point for too long, causing frequent central bank intervention, a new par value closer to this point is established. Suppose the dollar was hovering around 30.60. The government might then establish the new par value at 30.60 with new limit points at INR 31.21 and INR 19.99.

Pegged Exchange Rates within Horizontal Bands

Under this arrangement, the value of the currency is maintained within certain margins of fluctuation of at least ±1 per cent around a fixed central rate, or the margin between the maximum and minimum value of the exchange rate exceeds 2 per cent. It includes arrangements of countries in the Exchange Rate Mechanism (ERM) of the EMS, which was replaced with the ERM II on 1 January 1999, for those countries with margins of fluctuation wider than ±1 per cent. The central rate and width of the band are public or notified to the IMF.

Floating Arrangements

A floating exchange rate is a market determined currency. Under this arrangement the central bank may intervene either directly or indirectly in the market to prevent undue fluctuations in the exchange rate, but it is never done to get the exchange rate at a specific level. Indicators for managing the rate are broadly judgemental (for example, balance of payments position, international reserves, parallel market developments).

Free Float

A floating exchange rate can be classified as free floating if intervention occurs only exceptionally, aims to address disorderly market conditions, and if the authorities have provided information or data confirming that intervention has been limited to three instances at most during the previous six months, each lasting no more than three business days. If the information or data required are not available to the IMF staff, the arrangement will be classified as floating.

Managed Float

The managed float, also known as a dirty float, is employed by governments to preserve an orderly pattern of exchange rate changes and is designed to eliminate excess volatility. Each central bank sets the nation’s exchange rate against a predetermined goal, but allows the rate to vary. In other words, rate change is not automatic but based on the government’s view of an appropriate rate in the context of the country’s balance of payments position, foreign exchange reserves and rates quoted outside the official market. Rather than resist the underlying market forces, the authorities occasionally intervene by buying or selling domestic currency to smooth the transition from one rate to another. At other times they intervene to moderate or counteract self-correcting cyclical or seasonal market forces. The rationale for the managed float is to improve the economic and financial environment by reducing uncertainty. For instance, government intervention may reduce exporter’s uncertainty caused by disruptive exchange rate changes. Currently, about 40 countries (including Brazil, China, Egypt, Hungary, Korea, Israel, Poland, Turkey and Russia) maintain a managed float system. The challenge behind this approach is to define just what is meant by ‘excess volatility’. It is also questionable whether governments are more capable than markets in determining what is fundamental and what is temporary and self-correcting.

Target-zone Arrangement

The target-zone arrangement is virtually a joint float system cooperatively arranged by a group of nations sharing some common interests and goals. Under a target-zone arrangement, countries adjust their national economic policies to maintain their exchange rates within a specific margin around agreed-upon, fixed central exchange rates. Such an arrangement exists for the major European currencies participating in the EMS. Members of the European Union have a cooperative agreement to maintain their currencies within a set range against other members of their group. The EMS is, essentially a peg of each country’s currency to all the others, as well as a joint float of all member currencies together against non-EMS currencies.

Bird’s-eye View

Contemporary global exchange rate systems exist on a scale with the fixed or pegged exchange rate at one end and floating exchange rate at the other end. Actual systems in use are a combination of above-mentioned two systems including the managed float, the crawling peg, target zone arrangements and currency boards.

CHAPTER SUMMARY
  • Exchange rates are determined by the demand and supply of one currency relative to the demand and supply of another. The exchange rate system is termed as fixed if the central banks fix the value of the domestic currency vis-à-vis the foreign currency and as floating if the value is market-determined. Another aspect of the exchange rate policy is convertibility, which refers to the ease with which domestic currency can be traded for foreign currency, for a particular usage and at a given exchange rate.
  • The earliest monetary system was the gold standard, which began in 1821 and finally expired in 1937. The gold standard was a fixed exchange system. A newer version, the gold exchange standard system, was instituted in 1945 as a consequence of the Bretton Woods Agreement. This fixed exchange system had its demise in 1976 following the Jamaica conference of the IMF. The failure of this system was due largely to the decline in the US balance of payments and the inability of the US with its original large stock of gold to continue to support the dollar. The US dollar, you will recall, was the international currency after World War I.
  • The foreign exchange market, which is a global network of banks, brokers and dealers, is linked by electronic communications systems. Its main trading centres are London, New York and Tokyo, but other centres permit the market to operate 24 hours a day.
  • The primary function of the market is to convert one currency into another. A second function is to provide insurance against foreign exchange risk. International businesses participate in the foreign exchange market to facilitate trade transactions, to invest spare cash in short-term money markets abroad and to engage in currency speculation.
  • The spot exchange rate is the exchange rate at which a dealer converts one currency into another on a particular day. The forward exchange rate is an exchange of currencies at some specified date in the future and is a means of reducing foreign exchange risk.
  • A swap is the simultaneous purchase and sale of a given amount of foreign exchange for two different value dates.
  • Eurocurrency is defined as any currency banked outside its country of origin, and we noted that it owes its popularity to the absence of government control. This characteristic applies also to eurobonds in the international bond market, where there are both foreign bonds and eurobonds. Shares in companies are increasingly available for buying and selling on stock exchanges around the world.
  • There are several factors which affect the equilibrium exchange rate. The important ones include inflation rate, interest rate, growth rate, political and economic risk, investor expectations and central bank reputations.
  • Interest rate parity is an arbitrage condition which is necessary for international financial markets to be in equilibrium.
  • The theory of Purchasing Power Parity states that, the exchange rate between currencies of two countries should be equal to the ratio of their price levels.
  • The Fisher Effect is a parity condition which relates inflation rate with interest rate. According to this theory, a change in the expected domestic inflation rate leads to a proportionate change in the domestic interest rate.
KEY TERMS
  • Foreign exchange rate
  • Foreign exchange transaction
  • Bid
  • Spot rate
  • Forward rate
  • Swap fixed exchange rate system
  • Floating exchange rate system
  • Currency board arrangement
  • Crawling peg system
  • Managed float
  • Target-zone arrangement
  • Currency convertibility
  • Currency crisis
  • Capital market
  • Eurocurrency
  • Eurobond
DISCUSSION QUESTIONS
  1. Trace the different stages of the evolution of the modern monetary system.
  2. Distinguish between the fixed and floating exchange rate regime. Which system do you think is suitable in the current international business scenario?
  3. Critically examine the evolution of the Indian rupee on its path to convertibility. Is it true that the cautious approach of the Reserve Bank of India has helped to insulate the Indian economy from the turmoil of the global financial markets?
  4. What is currency convertibility? Explain its importance as an aspect of a country’s exchangerate policy.
  5. Write short notes on the following:
    1. Managed float vs independent float
    2. Currency board arrangement
    3. Crawling peg vs fixed peg
    4. Target zone arrangement
  6. Write short notes on:
    1. Interest rate parity
    2. Purchasing Power Parity
    3. Fisher Effect
  7. What are the factors which affect and influence the value of the equilibrium exchange rate?
  8. Explain how the forces of demand and supply contribute in setting the equilibrium exchange rate.
EXAMINATION QUESTIONS
  1. Briefly explain the evolution of the international monetary system from the Bretton Woods era till the present. (15)

    [B.Com (Hons.), 2011]