Chapter 21.



21 Exchange rate regimes

With an increasingly integrated world economy there is ongoing debate about the most suitable type of global exchange rate system. Some argue for greater fixity of exchange rates while others believe a system of independent floaters is, though far from ideal, the best available. The major currencies float freely against each other, while others seek more stable arrangements; for example, many small countries peg their currencies to “anchor” currencies. While larger countries are adhering to flexible rates, an exception is Europe’s proposed monetary union, whereby several major currencies will merge into a single currency. Although a floating system has advantages, it has one major drawback, that is, exchange rate volatility, which is costly to business and is accompanied by sustained misalignments. Consequently, interest has rekindled in the theory of optimum currency areas. Attention has also focused on measures available to the authorities to moderate currency variation, such as direct intervention, altering domestic interest rates, capital controls and others. None provide a definitive solution to the problem of volatility. Exchange rate expectations cannot be controlled contrary to long run fundamentals. Economic and Monetary Union (EMU) is a major initiative by European governments to impose stability on Europe’s monetary arrangements. Opinions on its are still divided. Potential gains exist, but too much rigidity may weaken member states’ capacity to adjust to both external and internal shocks.

Questions for Discussion

Q1. Discuss the advantages of the system of independent floating exchange rates. Does the choice of a floating regime indicate that the authorities do not care about the level of the exchange rate?

A system of independent floating exchange rates gives economies a degree of monetary policy independence. For example, on leaving the ERM the UK authorities gained a substantial degree of monetary autonomy (see ex. 3). This monetary autonomy can be used to influence the exchange rate. Switzerland used it to insulate its economy from inflationary forces in the 1970s. The UK has used it to enhance the competitiveness of British exports.

Floating exchange rates are a form of automatic stabilisers to adverse shocks. The swift adjustment of market determined exchange rates helps countries to remove excessive trade balance deficits/surpluses. Moreover, a floating regime tends to promote exchange rates moving in the direction of purchasing power parity (otherwise there exists potential arbitrage possibilities). The use of the floating exchange rate as an automatic stabiliser is even more important given price inflexibility in the labour and product markets. In order to avoid unemployment adverse shocks may require either wage/price flexibility or exchange rate flexibility. Exchange rates are not subject to institutional rigidities present in the labour/goods markets (wage bargaining, minimum wages, menu costs etc.) and thus may prove to be a more expedient method of adjusting to shocks to the system, both politically and economically.

Finally floating exchange rates place less stringent official foreign reserve requirements on countries. As CBs no longer need to intervene in the currency markets to maintain a particular exchange rate, they will not need a high level of foreign reserves. This point is of particular importance to emerging economies who may have scant foreign reserves. Most countries, even free floaters, consider the level of the exchange rate to be important and many will try to influence it indirectly (hence ‘dirty floating’).

Q2. Why are some European politicians willing to surrender control of monetary policy and face stringent budgetary rules in return for monetary unification?

Outline the economic benefits of EMU. Saving the single market and having a say in the formation of Europe's monetary policy are big factors for France but cut little ice in Germany. Some political leaders are convinced that the economic benefits outweigh the economic costs. Another possibility is that they consider the political benefits sufficient to outweigh any possible economic losses. Clearly opinions differ throughout the EU on these important issues. Many in Britain for example are convinced neither of the economic or political advantages of participating in EMU. Economists can help by pointing out the conditions for economic gains to be obtained. Advocates of the Stability and Growth Pact would say that fiscal constraints are not something which offset the gains from EMU but rather are an essential precondition of such gains being obtained.

Q3. What criteria would need to be satisfied for the countries of the EU to constitute an optimal currency area? Does the EU at present satisfy these criteria in your view?

Optimum currency areas are groups of economic regions whose economies are closely linked by trade and by factor mobility. The constituent economies should have a similar economic structure. Finally the degree of fiscal federalism in the area should be high (ability to transfer resources from members with healthy economies to those with ailing economies) Such an area’s economic interests are best served by a fixed exchange rate.

Is the EU an optimum currency area?

Whilst the extent of intra-European trade has increased over the years, most EU members still only export about 10 - 20 % of their output to other members. This is relatively small compared to the extent of inter-state trade in the US.

Labour force mobility is quite low in the EU. A brief glance at the diverse unemployment rates present in the EU is testament to this. (The UK in 1997 has an unemployment rate of less than 6%, and France greater than 12%.) We can largely ascribe this lack of mobility to linguistic and cultural differences amongst the member states which will not be easily eradicated.

EU countries do not share a similar economic structure. Countries of northern Europe tend to be more endowed with capital and labour than those of southern Europe. Moreover the business cycle is not exactly synchronised across the EU (see chapter 16). In the mid 1990s some countries are booming (UK, Ireland) whilst others were stagnant (France, Germany).

Finally the degree of European fiscal federalism is quite limited. Despite the importance of EU structural funds to some of the poorer nations, the EU’s powers to tax and transfer resources from one area to another is small relative to those of national governments powers, (EU fiscal intervention is less than 2% of EU GDP). Furthermore, given the current political environment it is unlikely that member will elect to transfer fiscal authority to a EU body in the near future.

Thus, the evidence suggests that the EU at present is not an optimum currency area. A key issue is whether monetary union could itself change institutional parameters and help the EU to become one.

Q4. Discuss the economic advantages and disadvantages to the UK of participation in EMU.

Using the text (pp. 603-606), the standard advantages and disadvantages to the UK of participation in EMU can be outlined. Static gains include:

• the elimination of transactions costs.

• the reduction of other bank charges, commissions and delays associated with cross-border bank payments.

• the elimination of exchange rate uncertainty and hedging costs.

• greater transparency in prices.

There are also dynamic gains of the form:

• greater economies of scale and benefits in terms of market depth and efficiency through completion of the internal market in financial services.

• the reduction in uncertainty (about exchange rates and monetary and fiscal policy) could encourage investment and raise the growth rate.

These dynamic gains could be further enhanced if business expectations were boosted by a successful launch of EMU. If the European Central Bank (ECB) performs its duty, low inflation will prevail and the new single currency will compete with the dollar and yen as a major international currency and reserve asset, enhancing the role of the EU in the international monetary system. By participating the UK can share in these gains.

The disadvantages of participation can be listed as:

• loss of autonomy in economic policy (loss of the exchange rate as an instrument of economic adjustment at national level and surrender of monetary policy to the ECB).

• efforts to meet the fiscal requirements may prove contractionary.

See also the discussion on the economic impact of EMU (pp. 605-606) concerning methods to deal with asymmetric shocks, and question for discussion 3.

As well as the above costs and benefits (which will effect different countries in different ways) the UK must consider advantages and disadvantages particularly relevant to its own economy. The UK has important trade links with EU countries, which could be jeopardised through non-participation, for example, in 1995 exports to and imports from the EU accounted for 20 per cent of the UK’s GDP (source: Economist Intelligence Unit, Country Report). By participating, the UK can avoid losses in competitiveness caused by appreciations to which sterling may be subjected. Against this must be weighed the dangers of asymmetric shocks which domestic policy would be debased from addressing. Problems for the banking system in adopting the single currency and abandoning sterling must also be considered.

As with every country in the EU, the UK must analyse carefully the extent of benefit and loss in both a general and specific sense in its decision whether or not to participate in EMU.

Q5. What is an “anchor” currency? Why should a country wish to “anchor” its currency to another?

An “anchor” currency is one to which the currency of another country, particularly prone to currency instability and speculative attack, can be tied. That country pre-commits to some range of variation around the anchor currency. An anchor should be the currency of a stable, low-inflation country. Domestic monetary and fiscal policies in both countries must be consistent with this exchange rate policy, and the authorities must be able to defend the arrangement through intervention in the forex market. Clarification of the precise relationship with the anchor is also required. Political will to maintain the arrangement is a necessity, which requires keeping adjustment costs to the minimum. Excessive adjustment costs may make the link unworthwhile. In addition (as the text outlines on pp. 592-3) the theory of optimum currency areas stresses the following important requirements for such a link:

• substantial trade and investment links (see box 21.1, pp. 587-589)

• similar economies with regard to structure and policy

• extensive labour mobility between the countries in question

• wage and price flexibility

• counter-cyclical fiscal transfers are desirable but not essential in the presence of the three gone before

• establishment of credibility associated with the link.

Small countries which feel vulnerable to speculative attack will seek security by linking their national currency to an anchor. Small industrial countries will usually have close trading links with one dominant trading partner. By anchoring its currency, these small countries can eliminate the harmful effects of exchange rate fluctuations. Domestic industry can feel more secure as they will be less prone to these harmful fluctuations, and the country is less prone to speculative attack if the link is credible. In addition it’s inflation rate can converge to the low level of this trading partner, for example, Austria and Germany (see box 21.1, p. 587).

Q6. Evaluate the measures available to the authorities to moderate currency variation in a floating exchange rate regime.

There are five main measures available to the authorities to moderate currency variation in a floating exchange rate regime:

1. Direct intervention in the forex market involves selling foreign exchange (official) reserves to prevent a depreciation and buying them to prevent an appreciation.

2. Intervention through interest rates involving a change in the rate at which banks borrow from the central bank, which raises rates throughout the economy. In theory, this makes it more expensive for the speculator to sell domestic currency (in terms of opportunity cost).

3. Impediments to short-term capital movements involves throwing “sand in the wheels” of the forex market through, for example, direct controls on capital movements, taxation of gains from currency speculation, enforcement of high capital reserve requirements and others (p. 595).

4. Enhanced international co-ordination of economic policies to maintain the viability of exchange rate zones (within which their currencies would be allowed to fluctuate). Such co-ordination would involve interest rate reductions and measures to expand aggregate demand by the government with the depreciating currency in order to prevent further depreciation of their neighbour’s currency.

5. Ministerial and government statements on exchange rate policy can have a calming effect on the market (though, if not careful, they can easily back-fire).

Each of these five measures has its own limitations, none providing a definitive solution to exchange rate volatility. Careful evaluation of each is required (see pp. 594-596). Official reserves are finite and often ineffective in the presence of large capital flows. It may also have adverse implications for monetary policy. In buying foreign reserves with domestic currency to ease upward pressure on the exchange rate, the resultant expansion in domestic money may be excessive in relation to monetary targets. Higher interest rates affect all borrowers, including the business sector, not just currency speculators. Governments with high debt/GDP ratios will face higher debt-servicing costs. Higher rates can also add to forex market nervousness and create further havoc, and are hard to sustain for the sole purpose of defending a currency. Impediments to capital movements are popular but have limited long-term usefulness due to the difficulties in identifying speculative transactions, and their effect on genuine long-term investors who are penalised in terms of higher long-term interest rates. The problem with policy co-ordination is that national interests will always take precedence over international priorities. Ministerial and government statements can help calm the market, but can also exacerbate the situation with contradictory statements and repeated assurances.

These measures will be effective only if the exchange rate position is credible, and the decision on which to use must be made carefully. If retreat is necessary, retreat to a defensible position is the only option. Speculators must be convinced that the traded sector can ‘live’ comfortably with the new rate. As the Mexican peso crisis portrayed, this is not an easy task (see pp. 597-598).

Exercises

Q1. The forex market is not the only market to exhibit volatility. Think of the stock market or the housing market. Why should governments intervene to stabilise prices in one but not the other? What is so special about the exchange rate?

Although governments do intervene to some extent in the housing market and in the stock market, only very rarely would they do so for countercyclical stabilisation reasons.

The basic reason is that the exchange rate affects a very significant range of prices in the economy - especially in a small open economy. The exchange rate therefore can have repercussions on the general price level, on inflation policy on a country's cost competitiveness, and on the level of employment. Hence governments see it as important to overview the exchange rate level and also the exchange rate regime. Whether such concern can be translated into effective action is another matter. This chapter indicates that the exchange rate can be influenced in a sustainable way only if other aspects of policy are consistent with the exchange rate policy.

Q2. Examine the UK’s current exchange rate regime. Why has this regime been chosen? List (a) the advantages and (b) the disadvantages of the present regime.

Since its withdrawal from the Exchange Rate Mechanism (ERM) in 1992, the pound sterling has been broadly free floating. The UK maintains no commitment to any fixed parity bands in its exchange rate policy.

The present regime was chosen following the UK's withdrawal from the ERM. This withdrawal was caused by speculative pressure on the pound, resistance to which proved excessively costly, in terms of loss official reserves and real economic costs. However, the UK is committed to low inflation. Hence, its exchange rate policy is not a matter of indifference. The effects on inflation of exchange rate changes are closely monitored.

(a) The advantages of the floating system are as follows

• the UK can adjust its economy to competitive realities if its currency becomes overvalued

• increased autonomy in the conduct of monetary policy, particularly relevant to the UK with its commitment to low inflation

(b) The disadvantages of the floating system are:

• exchange rate volatility which inhibits trade and investment (see p. 590)

• irrational and speculative forces exacerbate the problem of volatility and can also lead to sustained mis-alignments

• domestic stabilisation measures can be undermined.

During 97 the pound sterling rose sharply in value. At the time of writing this threatens to cause considerable disruption to the traded sector of the British economy.

Q3. In January 1994, the currencies of the French franc zone in Africa devalued by about 50 per cent relative to the franc. This was followed by a rise in their inflation rate from 0.5 per cent per year in 1990-93 to 33% in 1994. GNP, which had been falling in real terms by 1 per cent annually in 1990-93, rose by 1.5 per cent in 1994. What happened to the real exchange rate of the devaluing countries? In your view, are these observations consistent with what exchange rate theory would lead one to expect?

In January 1994 the nominal exchange rate of the devaluing countries experienced a devaluation of 50 per cent. The real exchange rate equals the nominal exchange rate less the inflation differential between the relevant countries. Following the rise in their price level to 33 per cent, the real exchange rate devalued by about 20 per cent.

Countries in the French franc zone in Africa would be regarded as small open economies (SOEs). As a result of the devaluation, they would have experienced a rise in the price of their imports and a rise in the price of their exports. But the effect is not complete because of the exclusion of non-traded goods and services. Hence, as expected, there is some real effect but this is much less than the nominal effect.

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