Chapter 10 Outline

Exchange Rate Regimes in Practice

A number of different exchange rate policies are pursued by governments around the world. These range from a pure "free float" where the exchange rate is determined by market forces to a pegged system that has some aspects of the pre-1973 Bretton Woods system of fixed exchange rates. Figure 10.2 summarizes the different exchange rate policies adopted by member states of the IMF in 1987. While over half of IMF members allow their currencies to float freely or intervene in only a limited way (the so-called managed float), a significant minority use a more inflexible system under which they peg their currencies to other currencies, such as the US dollar or the French franc. Still other countries have adopted a somewhat more flexible system under which their exchange rate is allowed to fluctuate against other currencies within a target zone. In this section, we will look more closely at the mechanics and implications of exchange rate regimes that rely on a currency peg or target zone.

Pegged Exchange Rates and Currency Boards

Under a pegged exchange rate regime a country will peg the value of its currency to that of a major currency so that, for example, as the US dollar rises in value, its own currency rises too. Pegged exchange rates are popular among many of the world's smaller nations. As with a full fixed exchange rate regime, the great virtue claimed for a pegged exchange rate regime is that it imposes monetary discipline on a country and leads to low inflation. For example, if Mexico pegs the value of the peso to that of the US dollar so that $1 is equal to 8.80 Mexican pesos, then the Mexican government must make sure the inflation rate in Mexico is similar to that in the United States. If

Figure 10.2

How IMF Members Determine Exchange Values

Source: IMF data.

the Mexican inflation rate is greater than the US inflation rate, this will lead to pressure to devalue the Mexican peso (i.e., to alter the peg). To maintain the peg, the Mexican government would be required to rein in inflation. Of course, for a pegged exchange rate to impose monetary discipline on a country, the country whose currency is chosen for the peg must also pursue sound monetary policy.

There is some evidence that adopting a pegged exchange rate regime does moderate inflationary pressures in a country. A recent IMF study concluded that countries with pegged exchange rates regimes had an average annual inflation rate of 8 percent, compared with 14 percent for intermediate regimes and 16 percent for floating regimes.⁸ However, many countries operate with only a nominal peg and in practice are willing to devalue their currency rather than pursue a tight monetary policy. It can be very difficult for a smaller country to maintain a peg against another currency if capital is flowing out of the country and foreign exchange traders are speculating against the currency. Something like this occurred in 1997 when a combination of adverse capital flows and currency speculation forced several Asian countries, including Thailand and Malaysia, to abandon pegs against the US dollar and let their currencies float freely. Malaysia and Thailand would not have been in this position had they dealt with a number of problems that began to arise in their economies during the 1990s, including the excessive private-sector debt and expanding current account trade deficits.

Hong Kong's experience during the 1997 Asian currency crisis, however, has added a new dimension to the debate over how to manage a pegged exchange rate. During late 1997 when other Asian currencies were collapsing, Hong Kong maintained the value of its currency against the US dollar at around $1=HK$7.8 despite several concerted speculative attacks. Hong Kong's currency board has been given credit for this success. A country that introduces a currency board 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 equal at the fixed exchange rate to at least 100 percent of the domestic currency issued. The system used in Hong Kong means its currency must be fully backed by the US dollar at the specified exchange rate. This is still not a true fixed exchange rate regime, because the US dollar, and by extension the Hong Kong dollar, floats against other currencies, but it has some features of a fixed exchange rate regime.

Under this arrangement, the currency board can issue additional domestic notes and coins only when there are foreign exchange reserves to back it. This limits the ability of the government to print money and, thereby, create inflationary pressures. Under a strict currency board system, interest rates adjust automatically. If investors want to switch out of domestic currency into, for example, US dollars, the supply of domestic currency will shrink. This will cause interest rates to rise until it eventually becomes attractive for investors to hold the local currency again. In the case of Hong Kong, the interest rate on three-month deposits climbed as high as 20 percent in late 1997, as investors switched out of Hong Kong dollars and into US dollars. The dollar peg, however, held, and interest rates declined again.

Since its establishment in 1983, the Hong Kong currency board has weathered several storms, including the latest. This success seems to be persuading other countries in the developing world to consider a similar system. Argentina introduced a currency board in 1991, and Bulgaria, Estonia, and Lithuania have all gone down this road in recent years. Despite growing interest in the arrangement, however, critics are quick to point out that currency boards have their drawbacks.⁹ If local inflation rates remain higher than the inflation rate in the country to which the currency is pegged, the currencies of countries with currency boards can become uncompetitive and overvalued. Also, under a currency board system, government lacks the ability to set interest rates. Interest rates in Hong Kong, for example, are effectively set by the US Federal Reserve. Despite these drawbacks, Hong Kong's success in avoiding the currency collapse that afflicted its Asian neighbors suggests that other developing countries may adopt a similar system.

Target Zones: The European Monetary System

An exchange rate system based on target zones involves a group of countries trying to keep their currencies within a predetermined range, or zone, of other currencies in the group. The exchange rate mechanism (ERM) that was a central part of the European Monetary System (EMS) of the European Union between 1979 and 1999 is the most famous example of this kind of system.

In our discussion of the European Union (EU) in Chapter 8, we noted that the EU is committed to monetary union, including establishment of a single currency. The process began January 1, 1999, and it should be completed by January 1, 2002.¹⁰ A formal commitment to a common currency dates back only to the Maastricht Treaty in December 1991, but it has been an underlying theme in the EU and a subject of debate for some time. To establish a common currency, the EU needed to achieve convergence between the inflation rates and interest rates of its member states. The European Monetary System (EMS) was a mechanism for attaining this goal.¹¹

When the EMS was created in March 1979, it was entrusted with three main objectives: (1) to create a zone of monetary stability in Europe by reducing exchange rate volatility and converging national interest rates; (2) to control inflation through the imposition of monetary discipline; (3) to coordinate exchange rate policies versus non-EU currencies such as the US dollar and the yen. In 1991, the objective of paving the way for introduction of a common currency in 1999 was added to this list. Two instruments were used to achieve these objectives, the European currency unit (ecu) and the exchange rate mechanism.

The Ecu and the ERM

The ecu was a basket of the EU currencies that served as the unit of account for the EMS. One ecu comprised a defined percentage of national currencies. The share of each country's currency in the ecu depended on the country's relative economic weight within the EC. Thus, for example, 30.1 percent of the ecu's value was established by the value of the German deutsche mark in 1989 because that was the estimate of Germany's relative strength and size within the EU economy at the time.

Until 1992, the exchange rate mechanism worked as follows: Each national currency in the EU was given a central rate vis-à-vis the ecu. For example, in September 1989, one ecu was equal to DM2.05853, to FFr6.90404, or to £0.739615. This central rate could be changed only by a commonly agreed realignment. From these central rates flowed a series of bilateral rates--the French franc against the Italian lira, the German deutsche mark against the British pound, and so on. For example, the given figures vis-à-vis the ecu indicate that the bilateral rate for exchanging deutsche marks into francs was DM1 = FFr3.3539 (i.e., FFr6.90404/DM2.05853). The bilateral rates formed a cat's cradle known as the ERM parity grid, which was the system's operational component. Before 1992, the rule was that a currency must not depart by more than 2.25 percent from its bilateral central rate with another ERM participating currency.

Intervention in the foreign exchange markets was compulsory whenever one currency hit its outer margin of fluctuation relative to another. The central banks of the countries issuing both currencies were supposed to intervene to keep their currencies within the 2.25 percent band. The central bank of the country with the stronger currency was supposed to buy the weaker currency, and vice versa. It tended to be left to the country with the weaker currency to take action.

To defend its currency against speculative pressure, each member could borrow almost unlimited amounts of foreign currency from other members for up to three months. A second line of defense included loans that could be extended for up to nine months, but the total amount available was limited to a pool of credit--originally about 14 billion ecus--and the size of the member's quota in the pool. Additional funds were available for maturities from two to five years from a second pool of about 11 billion ecus (originally). However, as a condition of using these funds, the borrowing member had to commit itself to correcting the economic policies causing its currency to deviate.

Performance of the System

Underlying the ERM were all the standard beliefs about the virtues of fixed rate regimes that we have discussed. EU members believed the system imposed monetary discipline, removed uncertainty, limited speculation, and promoted trade and investment within the EU. For most of the EMS's existence, it achieved these objectives. When the ERM was established, wide variations in national interest rates and inflation rates made its prospects seem shaky. For example, in early 1979, inflation was running at 2.7 percent in Germany and 12.1 percent in Italy. By 1992, however, both inflation rates and interest rates had converged somewhat. As this occurred, the need for intervention and realignments declined, and the system appeared to become more stable.

However, there had long been concern within the EU about the vulnerability of a fixed system to speculative pressures. Many of these concerns were realized dramatically in September 1992, when two of the major EMS currencies--the British pound and the Italian lira--were hit by waves of speculative pressure. Dealers in the foreign exchange market, believing a realignment of the pound and the lira within the ERM was imminent, started to sell pounds and lira and to purchase German deutsche marks. This led to a fall in the value of the pound and the lira against the mark on the foreign exchange markets. Although the central banks of Great Britain and Italy tried to defend their currencies by raising interest rates and buying back pounds and lira, they were unable to keep the values of their currencies within their respective ERM bands. As a consequence, first Great Britain and then Italy pulled out of the ERM, leaving the EMS on the brink of collapse.

The speculative pressures and subsequent withdrawal of Britain and Italy from the ERM led the EU countries to make two major changes to the EMS in August 1993. First, the 2.25 percent fluctuation bands were widened to 15 percent. The idea was to loosen the rigidities in the system and hence reduce the scope for speculation. Second, the EMS no longer obligated the central banks of countries with strong currencies to intervene in the foreign exchange market to purchase weaker currencies. This change essentially recognized what had already occurred. In the crisis of September 1992, for example, the German central bank did not intervene aggressively to help keep the value of the British pound within the prescribed fluctuation bands.¹²

After 1993 this modified system again performed fairly well. The biggest strain occurred in March 1995 when speculative pressures again forced devalutations of two EMS currencies, this time the Spanish peseta and Portuguese escudo. This was a relatively minor crisis compared with that of September 1992.¹³ By mid-1998, the system appeared to have delivered what it was designed to do--low and convergent inflation rates among the EU's member states. In 1998, the average annual rate fell to 1.6 percent (1993 = 4 percent), with the differential between the lowest and the highest rates at 1.7 percent (1993 = 5 percent). On January 1, 1999, the exchange rates of 11 EU states were fixed against national currencies and the euro became a full-fledged currency for commercial purposes, replacing the ecu basket of currencies. Until 2002, the euro will be used in financial markets only. On January 1, 2002, the single currency will become part of daily life, as euro notes and coins finally come into circulation.