Capital Markets & Derivatives MBA7007 Page 1

Capital Markets & Derivatives

James Macleod-Nairn (st05002068)

Muhammad Fareed Hassan Khan (st20054212)

Jaume Casabella (st20047331)

Thrupti shivaprasad (st20052961)

Sonia garg (st20047793)

Due: 19th May 2014

Word count: 2740

“While the debate of fixed versus floating exchange rate regime has been a prominent

issue in international capital markets for many years, a verdict has finally been

reached that the latter is better.”

Capital Markets & Derivatives MBA7007 Page 2

STUDENT NAME: James Macleod-Nairn PROGRAMME: MSc Finance

STUDENT NUMBER: 05002068 YEAR: 2013/14 GROUP: NA

Module Number: MBA7007 Term: 2 Module Title: Capital Markets & Derivatives

Tutors Responsible For Marking This Assignment: Sandy Kyaw

Module Leader: Sandy Kyaw

Assignment Due Date: 19/5/14 Hand In Date: 19/5/14

ASSIGNMENT TITLE: Fixed Vs Floating Exchange Rate Regime

SECTION A: SELF ASSESSMENT (TO BE COMPLETED BY THE STUDENT)

In relation to each of the set assessment criteria, please identify the areas in which you feel you have strengths and

those in which you need to improve. Provide evidence to support your self-assessment with reference to the

content of your assignment.

STRENGTHS AREAS FOR IMPROVEMENT

I certify that this assignment is a result of my own work and that all sources have been acknowledged:

Signed:____________________________________ Date___________________

SECTION B: TUTOR FEEDBACK

(based on assignment criteria, key skills and where appropriate, reference to professional standards)

STRENGTHS

AREAS FOR IMPROVEMENT AND TARGETS FOR

FUTURE ASSIGNMENTS

MARK/GRADE AWARDED DATE: SIGNED

Capital Markets & Derivatives MBA7007 Page 3

Introduction

As global capital markets have developed, global economies have become more

interconnected, the deregulation of financial markets, substantial increases in global trade

and countries lifting exchange rate controls; the debate over whether a fixed or a floating

exchange rate regime is more advantageous than the other continues, this being due to it

being an ever growing factor affecting economic growth. Exchange rates have become more

important for international trade, this can be seen in the increase in the amount of trading in

the Forex markets per day from $1.5 trillion in 1998 to $5.3 trillion in 2013 (BIS, 2014). Any

large swings in the price of domestic currency can have a positive or negative impact on the

cost of imports and exports; therefore having a direct impact on the growth of that economy

and its trading partners.

This essay will try to address the issue of whether or not a floating exchange rate regime is

superior to a fixed exchange rate regime. Firstly, looking at the benefits and negatives of a

fixed exchange rate and secondly; addressing the benefits and disadvantages of a floating

exchange rate. Finally, addressing the argument of whether one regime is better than the

other for countries today.

Each country, through different mechanisms, manages the value of its currency. As part of

this function, it determines the regime or system of exchange rate to be applied to its

currency. However, as highlighted by Obstfeld and Rogoff (1995, pg. 2) they suggest that

“the precise dividing line between a fixed rate... and a floating one is not clear cut: as the

official buying and selling rates move farther apart, the exchange-rate arrangement

approaches a free float”. Fixed rate tends to be managed within bands and countries may

have to increase these bands depending on certain factors; such as inflation. This clearly

highlights that the difference between rates is ambiguous and therefore making a clear

distinction is very difficult.

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Main Body

Historically, fixed rates have been integral to growth in many parts of the world; the best

example of this was after the economic recession that followed the Second World War. The

system implemented by the Bretton Woods agreements allowed Western Europe to recover

steadily by keeping fixed exchange rates against the US dollar until 1970; which was vital for

stable economic growth in the region. In addition, EEC members agreed to a fixed

exchange followed by the EMS system from 1971 to 1992; which functioned relatively well

during this period. However this did not last, the demise of these systems was due to many

factors; such as differing economic policies, conditions of the member states and speculative

attacks. These systems as capital markets evolved could not be sustained due to shifting

capital flows which impacted weak currencies and these adjustable pegged currencies were

causing more harm than good. Many of these countries were forced to depreciate which

only exacerbated their problems; as indicated by Gerlach and Smets (1994, pg. 20) that

“forced depreciation of one currency affects the competitiveness of countries whose

currencies are still pegged, and that this increases the speculative pressure and speeds up

their collapse”.

While these systems did collapsed after some time, there are nations today that still utilise

these mechanisms; according to Shalifay (2013) there are currently 36 nations still utilising a

fixed exchange rate, 19 of these are pegged to the Euro and 13 to the US$, the vast majority

of these are developing countries, this indicates that there may still be a benefits to having

such a regime. As Shalifay (2013) indicates that by having a fixed rate it would provide

currency stability, thereby “alleviating currency worries since FX volatility is near zero.

However “they are susceptible to large one-off moves and de-peg risk”. An example of this

was the case of Mexico in 1994, where it decided to de-peg against the US$ and its currency

depreciated. In hindsight, its lack of credibility makes a fixed exchange rate more vulnerable

to attack because it was unable to convince investors and price setters of its long term

unconditional commitment to its exchange rate targets. As highlighted by Gil-Diaz (1998, pg.

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305) “even though the virtually fixed exchange rate exhibited its virtues by stabilising prices ...

it also became increasingly untenable within the environment create: an ever greater fragility

of the economy to a speculative attack”.

Obstfeld and Rogoff (1995, pg. 2) also suggest that “The fundamental problem with a fixed

exchange rate is that the government must be prepared to forgo completely the use of

monetary policy for stabilisation purposes”. For example when a country has a sudden

dramatic fall in the demand for its exports, this would have a negative impact, but with a

fixed exchange the harm is exacerbated; “with no way for the relative prices of exports and

imports to adjust in the short run, domestic employment and output must fall” (Obstfeld and

Rogoff, pg. 2). In addition to this, as indicated by the Mundell-Fleming model this regime

prohibits the central bank from utilising monetary policy to gain macroeconomic stability, as

indicated by Di Bartolomeo (2003, pg. 2) “the monetary policy has no real effects… any

attempt to raise the level of real output fails and implies reduction of the foreign currency

reserves of the central bank”.

However, as suggested by Obstfeld and Rogoff (1995) some of the benefits of such a

regime are that; firstly with a floating exchange rate inherently comes unpredictable volatility,

both in the long and short term. Secondly, by having the currency pegged to a low inflation

currency such the US$ and Euro, will help to restrain domestic inflation pressures. Thirdly,

countries that have had price-level instability and are disinflating after these periods, “fixed

rates have the attraction of anchoring price inflation for internationally traded goods and

providing a guide for private-sector inflation expectations” (Bruno 1991, cited by Obstfeld

and Rogoff, 1995, pg. 4). Finally, pegging the domestic currency to a foreign currency

makes trade and investment between the two countries easier and more predictable, and is

especially useful for small economies in which the foreign trade is a large part of their GDP.

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Currently the majority of developed countries have a flexible or free-floating exchange rate;

as countries become more developed they find that either by their choice or by external

pressures they adopt a floating regime. A recent example of this was China, when it decided

to increase the band from 1% to 2%; it decided to do this due to its belief that its economy

was strong enough for exchange rate reforms to be implemented after utilising a pegged

exchange rate. However it will not become a fully flexible just yet, but is making steps

towards this. Recently, some countries have moved from a fixed to a floating, some have

done so relatively smoothly by using managed floats, crawling pegs, horizontal pegs and soft

pegs then moving to a free float. However as indicated by Duttagupta et al (2005) some

transitions have not gone so well, from 1990 to 2002 almost half of transitions from fixed to

floating were crisis-driven. But “regardless of whether flexible exchange rate regimes are

adopted under stress or under orderly conditions, their success depends on the effective

management of a number of institutional and operational issues” (Duttagupta et al, 2005, pg.

5).

From recent research that investigated emerging markets and floating exchange rates;

Calvo and Reinhart (2002, pg. 404) concludes that the “fear of floating is pervasive for a

variety of reasons, particularly among emerging market countries” and that these countries

may be reluctant to employ such a regime. In addition they indicate that “interest rate policy

is (at least partially) replacing foreign exchange intervention as the preferred means of

smoothing exchange rate fluctuations”. Also, they conclude that theoretically fixed and

floating may differ, but in reality countries may use different regimes and one may not be the

same as the other, therefore it is difficult to distinguish between them.

As more countries have moved from a being a developing to a developed economy; there

has been a necessity to shift from fixed to floating regimes, on the other hand there have

been countries that have changed regime only then to return back; this may be partly due to

lack of financial institutions or favourable macroeconomic conditions. Two examples of this;

was Venezuela in 2002-03 when it had a negative balance of payments and switched to a

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free-float which caused its currency to depreciate dramatically and Russia 1993-95 when it

had a debt crisis in 1998 forcing it to tighten its currency. Though more recently, as capital

mobility has increased and the outflow and inflow of capital has surged; the possibility of

crises and shocks have dramatically increased therefore applying more incentive for nations

to adopt greater currency flexibility. Not only this, as countries such as China start to change

their investment and trade policies to be more open, this in turn necessitates a more market

determined interest and exchange rate.

However, this is not suitable for developing countries as their financial markets are not

strong enough and cannot stand up to speculation and could be put into a difficult situation

very easily from a few transactions increasing volatility. Conversely, the opposite might be

the case; according to research conducted by Feldmann (2013) switching to a pegged or

intermediate regime can substantially reduce unemployment; “because they may lower

transaction costs and reduce policy uncertainty. This may increase trade and the real

interest rate, increasing investment, growth and labour demand”.

Overall, as highlighted by Caramazza and Aziz (1998) “Neither of the two main exchange

regimes ranks above the other in terms of its implications for macroeconomic performance”.

What is important is that over time different considerations may impact on the choice of

regime, they highlight that because of the increase in the volatility of capital flows countries

may have no choice in the regime it has and flexibility in inevitable. However they suggest

that a fixed exchange may be more beneficial for short term stabilisation when inflation is

high, but as capital inflows increase it runs the risk of overheating the economy; therefore it

would be prudent to adopt greater flexibility to deal with these pressures. However, as

suggested by Eichengreen et al (1995, pg. 2) the precise motivations for a transition may be

different “few consistent correlations link regime transitions… to macroeconomic or political

variables. Transitions between exchange rate regimes are largely idiosyncratic, and are

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neither consistently provoked ex ante by systematic imbalances, nor typically justified ex

post by subsequent changes in policy”.

Furthermore, speculation plays an important part in exchange rate regimes and the impact it

may have on a country. Both regimes are susceptible to speculative attacks, however fixed

regimes can be damaged greater because it would have to hold greater reserves to keep it a

specified level; as in the case with the East-Asian and Argentine financial crises but also in

the UK when it was forced to leave the ERM in 1992.

In addition sterilised market intervention under a fixed regime can force it to adopt a more

flexible regime; under both regimes, the central bank utilise “sterilised” exchange market

intervention without fully enacting monetary policy. According to Obstfeld and Rogoff (1995,

pg. 4) this activity is not effective; “because they do not change relative money supplies,

sterilised interventions can have only modest effects, if any, on interest and exchange rates”.

In addition, as suggested by Christensen (2004, pg. 26) “that a strategy of relying solely on

monetary and sterilization measures without support from fiscal (or other macroeconomic)

policies to cushion the economy from the expansionary impact of capital inflows under fixed

exchange rate systems may not succeed”. For example, in the Czech Republic mid 90’s; this

policy created a cycle of high interest rates, continuing sterilisation interventions and

increased capital inflows. After a while this policy become very costly and unsustainable for

the central bank to pursue, after which they were forced to widen the exchange rate bands.

Recent research examining the cause and effect of countries choice in exchange rate

regimes and concludes that similar countries with similar economies may choose different

regimes; they “choose radically different exchange rate regimes without substantive

consequences for macroeconomic outcomes like output and growth” (Rose 2011, pg1), also

that there are different regime classifications, therefore making it difficult to make empirical

comparison between different regimes. Therefore the choice of exchange rate regime

becomes a controversial matter among the practitioners and academics alike. In order to

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have a correct exchange rate regime for a particular economy, some empirical evidence on

economic performance is essential. Regime choices are influenced by a number of

determinants. An exchange rate regime has an important impact on macroeconomic policies

with in the developing/developed countries and is therefore highly regarded as in important

ingredient for the formulation of macroeconomic policy.

No single currency regime is right for all countries or at all times. The choice between fixed,

floating or other exchange rate regimes ought to depend on a country’s individual

circumstances. Some commentators have argued that in order to avoid the currency crisis,

one must go all the way to one of the extremes of freely floating or genuinely fixed exchange

rates (Frankel, 1999).

Although there are many gradations, it can be said that for relatively poor countries with a

little access to international capital markets, pegged exchange rate regimes work amazingly

well delivering both low inflation and relatively high exchange rate regime durability, however

universally fixed exchange rate regimes are unstable and crisis prone. As for the richer

countries and financially more developed ones, they take advantage by moving to more

flexible exchange rate systems. Indeed, for the advanced economies, flexible exchange rate

systems are more durable and they yield high growth without creating any inflationary

pressures on the economy. In the case of emerging markets, the exchange regime does not

appear to have a systematic effect on inflation or growth although it is believed that pegs are

distinctly more vulnerable to banking and exchange rate crisis (Husain et al 2005).

According to Robert Mundell’s “A Theory of Optimum Currency Area”, the choice of

exchange rate regime is made on the basis of some structural and macroeconomic factors

such as size, degree of openness or the level of economic development of a particular

country. Also those political and institutional factors such as political instability, central bank

independence or the government temptation vigour are the important criteria to influence the

choice of exchange rate regime (Daly and Sami, 2009).

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It has been recently suggested by Stone et al (2008) that there are two schools of thought

about the future of exchange rate regimes; firstly there could be a move toward currency

blocks because they offer considerable benefits and that there will be fewer independent

currencies, however they indicate that “this would simplify cross-country transactions but

preclude each country in a bloc from operating an independent monetary and exchange rate

policy”. The second; is that the advantages of floating regime and it giving the country

independent monetary policy will mean the continuation of a number of independent national

currencies.

Conclusion

Overall, a fixed exchange rate does provide benefits for developing countries by helping to

peg its currency to a low inflation currency. However these countries generally are more

susceptible to different crises; such as banking, currency or both. As countries’ economies

develop, they become more advanced and gain closer ties with international financial

markets; the benefits of adopting a floating exchange rate increase. There are nations that

continue to have a fixed rate, but there are recent examples of countries that have moved

from a fixed to a more flexible regime such as: Brazil, Chile, Poland and Israel etc. “The

trend toward greater exchange rate flexibility is likely to continue as deepening cross-border

linkages increase the exposure of countries with pegged regimes to volatile capital flows

because flexible regimes offer better protection against external shocks as well as greater

monetary policy independence” (Duttagupta et al 2005, pg. 5).

In conclusion, both regimes have different and distinct advantages and disadvantages, from

recent examples the appropriateness of one regime from another may differ from one

country to another and what may work for one may not for another. Therefore countries

need to consider these issues when adopting a certain mechanism especially the need to

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consider whether they have the necessary readiness of institutions and whether their

economies are capable of dealing with it.

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