THE EXCHANGE RATE REGIMES

 THE EXCHANGE RATE REGIMES

An exchange rate regime is the system by which a country manages its currency in respect to foreign currencies. It refers to the method by which the value of the domestic currency in terms of foreign currencies is determined. There are two major types of exchange rate regimes at the extreme ends; namely:

(i) floating exchange rate regime (also called a flexible exchange rate), and

(ii) fixed exchange rate regime

Under floating exchange rate regime, the equilibrium value of the exchange rate of a country’s currency is market-determined i.e the demand for and supply of currency relative to other currencies determine the exchange rate. There is no predetermined target rate and the exchange rates are likely to change at every moment in time depending on the changing demand for and supply of currency in the market. There is no interference on the part of the government or the central bank of the country in the determination of exchange rate. Any intervention by the central banks in the foreign exchange market (through purchases or sales of foreign currency in exchange for local currency) is intended for only moderating the rate of change and preventing undue fluctuations in the exchange rate, rather than for establishing a particular level for it. Nevertheless, in a few countries (for example, New Zealand, Sweden, the United States), the central banks almost never interfere to administer the exchange rates. Nearly all advanced economies follow floating exchange rate regimes. Some large emerging market economies also follow the system.

A fixed exchange rate, also referred to as pegged exchanged rate, is an exchange rate regime under which a country’s Central Bank and/ or government announces or decrees what its currency will be worth in terms of either another country’s currency or a basket of currencies or another measure of value, such as gold. For example: a certain amount of rupees per dollar. (When a government intervenes in the foreign exchange market so that the exchange rate of its currency is different from what the market would have produced, it is said to have established a “peg” for its currency). In order to sustain a fixed exchange rate, it is not enough that a country pronounces a fixed parity: it must also make concentrated efforts to defend that parity by being willing to buy (or sell) foreign reserves whenever the market demand for foreign currency is lesser (or greater) than the supply of foreign currency. In other words, in order to maintain the exchange rate at the predetermined level, the central bank intervenes in the foreign exchange market.

We are often misled to think that it is common for countries to adopt the flexible exchange rate system. In the real world, there is a spectrum of ‘intermediate exchange rate regimes’ which are either inflexible or have varying degrees of flexibility that lie in between these two extremes (fixed and flexible). For example, a central bank can implement soft peg and hard peg policies. A soft peg refers to an exchange rate policy under which the exchange rate is generally determined by the market, but in case the exchange rate tend to be move speedily in one direction, the central bank will intervene in the market. With a hard peg exchange rate policy, the central bank sets a fixed and unchanging value for the exchange rate. Both soft peg and hard peg policy require that the central bank intervene in the foreign exchange market. The tables 4.4.1 and 4.4.2 show respectively, the IMF classifications and definitions of prevalent exchange rate systems and the latest available data (as on April 30, 2016) on the distribution of the 189 IMF members based on their exchange rate regimes.
                                                            Table No: 4.4.1

                                 IMF Classifications and Definitions of Exchange Rate Regimes

Exchange Rate Regimes			Description
Exchange                     arrangements separate legal tender Dollarization	with	no	Currency of another country circulates as sole legal tender or member belongs to a monetary or currency union in which same legal tender is shared by members of the union.

Currency Board Arrangements Hong Kong Dollar	Monetary regime based on implicit national commitment to exchange domestic currency for a specified foreign currency at a fixed exchange rate.
Other       conventional      fixed       peg arrangement Chinese Yuan	Country pegs its currency (formal or de facto) at a fixed rate to a major currency or a basket of currencies where exchange rate fluctuates within a narrow margin or at most ± 1% around central rate
Pegged exchange rates within horizontal bands	Value of the currency is maintained within margins of fluctuation around a formal or de facto fixed peg that are wider than ± 1% around central rate.
Crawling Peg	Currency is adjusted periodically in small amounts at a fixed, preannounced rate in response to changes in certain quantitative indicators.
Crawling Bands	Currency is maintained within certain fluctuation margins say ( ±1-2 %) around a central rate that is adjusted periodically
Managed       floating       within       no preannounced path for exchange rate: Indian Rupee	Monetary authority influences the movements of the exchange rate through active intervention in foreign exchange markets without specifying a pre-announced path for the exchange rate
Independent floating US Dollar, Japanese Yen, New Zealand Dollar	Exchange rate is market determined, with any foreign exchange intervention aimed at moderating the rate of change and preventing undue fluctuations in the exchange rate, rather than at establishing a level for it

Table No:  4.4.2

Distribution of IMF Members Based on Exchange Regime

Exchange Rate Arrangement	% of IMF Members
Hard peg	13.0
No separate legal tender	7.3
Currency board	5.7
Soft peg	39.6
Conventional peg	22.9
Stabilized arrangement	9.4
Crawling peg	1.6
Crawl-like arrangement	5.2
Pegged exchange rate within horizontal bands	0.5
Floating	37.0
Floating	20.8
Free floating	16.1
Other managed Arrangements	10.4

Source: Annual Report on Exchange Arrangements and Exchange Restrictions, IMF

In an open economy, the main advantages of a fixed rate regime are:

I. A fixed exchange rate avoids currency fluctuations and eliminates exchange rate risks and transaction costs that can impede international flow of trade and investments. A fixed exchange rate can thus greatly enhance international trade and investment.

II. A fixed exchange rate system imposes discipline on a country’s monetary authority and therefore is more likely to generate lower levels of inflation.

III. The government can encourage greater trade and investment as stability encourages investment.

IV. Exchange rate peg can also enhance the credibility of the country’s monetary- policyI. However, in the fixed or managed floating (where the market forces are allowed to determine the exchange rate within a band) exchange rate regimes, the central bank is required to stand ready to intervene in the foreign exchange market and, also to maintain an adequate amount of foreign exchange reserves for this purpose.

Basically, the free floating or flexible exchange rate regime is argued to be efficient and highly transparent as the exchange rate is free to fluctuate in response to the supply of and demand for foreign exchange in the market and clears the imbalances in the foreign exchange market without any control of the central bank or the monetary authority. A floating exchange rate has many advantages:

(i) A floating exchange rate has the great advantage of allowing a Central bank and /or government to pursue its own independent monetary policy

(ii) Floating exchange rate regime allows exchange rate to be used as a policy tool: for example, policy-makers can adjust the nominal exchange rate to influence the competitiveness of the tradeable goods sector

(iii) As there is no obligation or necessity to intervene in the currency markets, the central bank is not required to maintain a huge foreign exchange reserves.

However, the greatest disadvantage of a flexible exchange rate regime is that volatile exchange rates generate a lot of uncertainties in relation to international transactions, and add a risk premium to the costs of goods and assets traded across borders. In short, a fixed rate brings in more currency and monetary stability and credibility; but it lacks flexibility. On the contrary, a floating rate has greater policy flexibility; but less stability.