BY : DHULAR

EXCHANGE RATE SYSTEMS AND ARRANGEMENTS IN PRACTICE

CONTEMPORARY EXCHANGE RATE SYSTEMS The classification of current exchange rate

systems is based on a taxonomy developed by 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 recourses and improve transparency, with benefits for the IMF’s bilateral and multilateral surveillance.

Key changes to the classification system include: Replacing the current distinction between managed

and independent floating with two new categories: floating and free floating, with clear definitions;

Drawing a distinction between formal fixed and crawling pegs, and arrangements that are merely peg-like or crawl-like;

Increasing the transparency of the system by basing it on rules that can be implemented using specified information, with a more clearly stated role for judgement.

Fixed Rate System Governments (through their central bank) buy or

sell their currencies in the foreign exchange market whenever exchange rates deviate from their stated par values.

In 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 mandatory that a local firm’s foreign exchange earnings be surrendered to the central bank, which in turn pays the firm a corresponding amount in state-owned users 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 clean float.

Under the floating exchange rate system, an exchange rate is allowed to adjust freely to supply and demand of this currency for another.

Consequently there is usually no need for an economy to undergo the painful adjustment process set in motion by a decrease or increase in the money supply. This category contains currencies of both developed countries and developing countries.

Central bank of these countries allow exchange rates to be determined by market forces alone.

Although some centrals 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.

ARGUMENTS FOR THE FIXED EXCHANGE RATE SYSTEM

Types of arguments.. Monetary discipline

Volatility of exchange rates

Trade balance adjustments

Monetary discipline A certain amount of monetary discipline

are there due to the impact of expansionary monetary policy on inflation.

Governments and political pressures may lead to expand money supply, leading to inflation.

Volatility of exchange rates Freely floating rates may cause uncertainty

due to speculation in the foreign exchange markets.

Under the floating system, international speculators can cause wide swings in the values of different currencies.

This swings are the result of the movement of investment flows in search of better returns and the enormous speed of capital flows whose scale dwarfs that of trade flows.

Trade balance adjustments Arguments in favour of floating rates explain

that they help in a less painful trade balance adjustment.

Critics explain the existence of a trade deficit through a saving investment relationship rather than through the external value of its currency.

Depreciation of currency leads to inflation, because, the resulting increase in import prices wipe out any apparent gains in cost competitiveness.

Exchange rate Arrangements in practice:

Classification given by the IFM in 1998-2009:

1. Exchange Arrangements with No Separate Legal Tender2. Currency Board Arrangements3. Other Conventional Fixed Peg Arrangements4. Pegged Exchange Rates within Horizontal Bands 5. Crawling Pegs 6. Exchange Rates within Crawling Bands 7. Managed Floating with No Predetermined Path for the Exchange Rate8. Independently Floating

Hard Pegs This means fixing the exchange rate between

two currencies.

A hard peg means that the country tries to keep it's currency at the exact same exchange rate as another currency (usually it is a country trying to keep its currency pegged to the USD). 

Hard pegs follow the anchor currency more strictly.

Currency Board Arrangements

Based on an explicit legislative commitment to exchange domestic currency for a specified foreign currency at a fixed exchange rate, combined with restrictions on the issuing authority to ensure the fulfillment of its legal obligation.

Domestic currency will be issued only against foreign exchange and that it remains fully backed by foreign assets, eliminating traditional central bank functions, such as monetary control and lender-of-last-resort, and leaving little scope for discretionary monetary policy.

Some flexibility may still be afforded, depending on how strict the banking rules of the currency board arrangement.

Exchange Arrangements with No Separate Legal Tender

The currency of another country circulates as the sole legal tender (formal dollarization)

the member belongs to a monetary or currency union in which the same legal tender is shared by the members of the union.

It implies the complete surrender of the monetary authorities' independent control over domestic monetary policy.

Other Conventional Fixed Peg Arrangements

The country (formally or de facto) pegs its currency at a fixed rate to another currency or a basket of currencies, where the basket is formed from the currencies of major trading or financial partners and weights reflect the geographical distribution of trade, services, or capital flows.

The currency composites can also be standardized, as in the case of the SDR. There is no commitment to keep the parity irrevocably. The exchange rate may fluctuate within narrow margins of less than ±1 percent around a central rate-or the maximum and minimum value of the exchange rate may remain within a narrow margin of 2 percent-for at least three months.

The monetary authority stands ready to maintain the fixed parity through direct intervention (i.e., via sale/purchase of foreign exchange in the market) or indirect intervention (e.g., via aggressive use of interest rate policy, imposition of foreign exchange regulations, exercise of moral suasion that constrains foreign exchange activity, or through intervention by other public institutions).

Flexibility of monetary policy, though limited, is greater than in the case of exchange arrangements with no separate legal tender and currency boards because traditional central banking functions are still possible, and the monetary authority can adjust the level of the exchange rate, although relatively infrequently.

Soft Pegs A soft peg is a term used for countries

with a fixed exchange rate regime. Soft pegs generally let their exchange

rate fluctuate through a desired bracket. A soft peg means the country tries to

keep the currency exchange rate basically about the same, but allows it to fluctuate up and down a little.

Pegged Exchange Rates within Horizontal Bands

The value of the currency is maintained within certain margins of fluctuation of at least ±1 percent around a fixed central rate or the margin between the maximum and minimum value of the exchange rate exceeds 2 percent.

It also includes arrangements of countries in the exchange rate mechanism (ERM) of the European Monetary System (EMS) that was replaced with the ERM II on January 1, 1999.

There is a limited degree of monetary policy discretion, depending on the band width.

Crawling Pegs

The currency is adjusted periodically in small amounts at a fixed rate or in response to changes in selective quantitative indicators, such as past inflation differentials vis-à-vis major trading partners, differentials between the inflation target and expected inflation in major trading partners, and so forth.

The rate of crawl can be set to generate inflation-adjusted changes in the exchange rate (backward looking), or set at a preannounced fixed rate and/or below the projected inflation differentials (forward looking).

Maintaining a crawling peg imposes constraints on monetary policy in a manner similar to a fixed peg system.

Exchange Rates within Crawling Bands

The currency is maintained within certain fluctuation margins of at least ±1 percent around a central rate-or the margin between the maximum and minimum value of the exchange rate exceeds 2 percent-and the central rate or margins are adjusted periodically at a fixed rate or in response to changes in selective quantitative indicators.

The degree of exchange rate flexibility is a function of the band width. Bands are either symmetric around a crawling central parity or widen gradually with an asymmetric choice of the crawl of upper and lower bands (in the latter case, there may be no preannounced central rate).

The commitment to maintain the exchange rate within the band imposes constraints on monetary policy, with the degree of policy independence being a function of the band width.

Managed Floating with No Predetermined Path for the Exchange Rate

The monetary authority attempts to influence the exchange rate without having a specific exchange rate path or target.

Indicators for managing the rate are broadly judgmental (e.g., balance of payments position, international reserves, parallel market developments), and adjustments may not be automatic. Intervention may be direct or indirect.

Independently Floating

The exchange rate is market-determined, with any official foreign exchange market intervention aimed at moderating the rate of change and preventing undue fluctuations in the exchange rate, rather than at establishing a level for it.

Free Float If intervention and aims to address disorderly

market conditions.

And if the authorities have provided info / 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 info / Data required are not available to the IMF staff, the arrangement is classified as floating.

Exchange rate arrangements 1998 2009Hard pegs 23 23Currency board 13 13Arrange with no separate legel tender

10 10

Soft pegs 81 78Conventional peg 68 46Peg-like arrangement - 21Pegged exchange rate with horizontal bands

3 3

Crawling peg 8 5Crawling band 2 -Crawl-like arrangement - 3Floating Arrangements 84 75Managed float 44 40Independent float 40 -Free float - 35Residual - 12Total 188 188

ARGUMENTS FOR THE FLOATING EXCHANGE RATE SYSTEM

Under the fixed exchange rate system the monetary authority is constrained from expanding its money supply by the need to maintain exchange rate parity.

Increase in money supply leads to inflation Contraction in money supply causes interest rate to be

high in order to reduce demand for money. Under Floating exchange rate the use of monetary policy

instruments enable the government to meet desired goal. (eg: an increase in money supply to stimulate domestic

demand and reduce unemployment does not interfere with the need to maintain exchange rate parity)

The government can reduce money supply without an adverse impact on exchange parity

Monetary policy autonomy

Help to ensure the independence of trade policies

A rapid growth in the money supply will trend to raise domestic price and lower interest rate in short run

It cause a deficit in the current account and latter in capital account

A flexible rate limited in balance of trade for a certain period of time

A depreciation of currency help the balance of trade only if it reduce the relative price of locally produced goods

In long run it will lead to rise the cost of living.

Trade policy independence

Flexible exchange rate help to reduce trade imbalance

In fixed rate system a recession is required to reduce real income or price in the event of a trade deficit

In flexible rate only reduce the foreign exchange value of currency

Adjustment mechanism

Liquidity issues

In flexible exchange rate it is not required to hold foreign reserve by RBI

The problem of insufficient foreign exchange reserve does not exist with truly flexible rates

Import restrictions

flexible exchange rate also avoid the need for strict import restrictions, which are costly to enforce, distort trade and hence invite criticism and even retaliation from trade partner countries.

Currency Convertibility

currency convertibility is an aspect of countries exchange rate policies. It refers to the easy with which domestic currency can be traded for foreign currency for a particular usage and at a given exchange rate.

The foreign exchange control measure used by government under fixed or floating includes

Import restrictions such as license or quota system 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 firms

retained foreign exchange earnings Credit ceilings for foreign firms Restrictions or prohibitions on offshore deposits or

investment of hard currencies Use of multiple exchange rates simultaneously for

different items of balance of payment

Exchange Rate Management in India

India was under fixed exchange rate regime till March 1992. The exchange rate of the Rupee was determined and

adjusted by the Central Bank (Reserve Bank of India). The Rupee was adjusted to a basket of currencies,

comprising of currencies of important trade partners of India like US, Britain, Japan etc.

The exchange rate was determined by the government and enforced by pegging operations (intervention in the currency market) and exchange controls by the central bank.

Normally the rate was continuously adjusted by small margins to adjust with changing inflation rates, international economic changes and trade requirements. Such a system caused lots of difficulties and complications for international traders.