EXCHANGE RATE REGIMES Learning Objectives

International Finance

After completing this chapter, you should be able to understand:

What do you mean by exchange rate and its regime. Gold Standard System Flexible exchange rate system. Central bank measures to balance the exchange rate.

Exchange Rate Regimes Structure

7.1 Exchange RateRegimes 7.2 The Gold Standard System 7.3 Mint Par of Exchange 7.4 Gold Points 7.5 Bretton Woods System 7.6 Triffin’s Paradox 7.7 Smithsonian Agreement 7.8 Snake in the Tunnel System 7.9 Special Drawing Rights 7.10 Fixed Exchange Rate System 7.11 Flexible Exchange Rate System

Exchange Rate Regimes Structure

7.12 Currency Intervention 7.13 Methods of Control 7.14 Clean Float 7.15 Dirty Float 7.16 Adjustable Peg System 7.17 Crawling Peg System 7.18 Neutralization of Reserves 7.19 Fixed vs. Flexible Exchange System 7.20 The Gold Standard vs. Bretton Woods System 7.21 Summary 7.22 Self Assessment Questions

Exchange Rate Regimes 7.1 Exchange Rate Regimes

Over the past 140 years several systems have been used for valuing currencies. Four such systems were used universally for significant periods and had a profound impact on how exchange rates between currencies were to be established. These systems are called “Exchange Rate Regimes”

1. Barter System: which provided valuation based on goods against goods. 2. The Gold Standard (1870 – 1932) provided for valuation against gold on fixed basis. 3. The Bretton Woods System (1946 – 1971) provided valuation against US $ on fixed basis. 4.TheFlexibleExchangeRateSystem(1978–tilltodate) provided valuation through supply & demand forces. Exchange Rate Regimes 7.2 The Gold Standard System

The Gold Standard was the first universally implemented exchange rate system. It was promoted by the Bank of England and established world wide in 1870. Main Features:

1. Every country was required to establish Central Bank to function as the custodian of the country’s monetary gold reserves. 2. Every Central Bank was to be provided the sole authority to issue paper money (Bank Notes) within the area under its jurisdiction.

Exchange Rate Regimes 7.2 The Gold Standard System

3. Each Central bank was required to establish a fixed official price for gold in terms of the domestic currency. 4. Every Central Bank was required to provide an irrevocable promise on each paper note to redeem thesameondemandintermsofspecifiedquantity of gold. 5. Each Central Bank was required to provide unconditional guarantee to buy and sell unlimited quantity of gold at the fixed official price. 6. The total supply of money supply in circulation to be limited to the value of gold reserves with the Bank. Exchange Rate Regimes 7.3 Mint Par of Exchange

The mechanism for establishing exchange rates between currencies under the Gold Standard was called the ‘Mint Par of Exchange’. The exchange rates between two currencies were represented by the ratio of the official gold prices for the two currencies.

Exchange Rate Regimes 7.4 Gold Points TheGoldStandardprovidedforfixedexchangerates. However, imbalance of trade between two countries on a day-to-day basis resulted in the exchange rate in the domestic market moving on either side of the central exchange rate, providing opportunities for arbitrage between the two rates . The extreme points of this zone are called the upper and lower gold points. Each currency pair had a unique set of gold points . Thus the in built mechanism for balancing trade in the Gold Standard was called as Price Specie Adjustment Mechanism. Exchange Rate Regimes 7.4 Gold Points Gold Standard Advantages: 1. It was an easy system to introduce and operate. 2. It provided for a very high level of stability in exchange rates. 3.The‘PriceSpecieAdjustmentMechanism’provides in built system for achieving trade equality. 4. It provided a fully secured system for settlement on international transactions.

Exchange Rate Regimes 7.4 Gold Points Gold Standard Disadvantages: 1. The cost of manufacturing gold gradually increased to levels beyond official prices. 2. Countries with persistent trade deficit suffered from recessions resulting in reduced investments accompanied by unemployment. 3. The system had no flexibility to adjust money supply in times of economic crisis. 4. To avoid the negative effects of reduced money supply, countries would break the equality between gold reserves and money supply, thereby diluting the system. This is neutralization of reserves. It resulted in the failure of the system in 1932. Exchange Rate Regimes 7.5 Bretton Woods System also known as IMF’s exchange rate system. A) Bretton Woods System

The continuing second world war made any cooperation on the economic front impossible. There was a need for an economic system which would again make international trade and investments possible. To make this possible, it was necessary to have a stable exchange rate accompanied by an arrangementthatwouldhelpcountriesovercome their short term balance of payments problems . Exchange Rate Regimes 7.5 Bretton Woods System

A) Bretton Woods System –contd.

Post world war, the trends in international monetary system had gradually started revealing imbalances in monetary resources.

Representatives of forty five major economies met at Bretton Woods, USA, in July 1944 to finalize a new exchange rate system based on stability and flexibility to be universally implemented after the second world war.

Exchange Rate Regimes 7.5 Bretton Woods System

A) Bretton Woods System –contd.

The conference in 1945 saw the birth of two leading world institutions – International Monetary Fund (IMF) International Bank of Reconstruction and Development (IBRD) With the objective of financing and assisting the need based nations to overcome their balance of payments deficits.

Exchange Rate Regimes 7.5 Bretton Woods System

A) Bretton Woods System –contd.

The IMF was given the mandate to establish a suitable exchange rate system. The fixed exchange rate system proposed by IMF was implemented in 1946.

In this system, all members were to fix par value of their currency either in terms of Gold or in US Dollar.

TheparvalueofGoldindollarwasfixedat$35per ounce. Exchange Rate Regimes 7.5 Bretton Woods System A) Bretton Woods System-contd. The monetary authorities (US Federal Reserve bank) provided an unconditional guarantee to buy and sell unlimited quantity of gold at this price and thus support their exchange rate. This system was called ‘Gold Convertibility Clause’ Even though the member countries had an option of pegging their currencies to either gold or to US dollar, the only reserve mentioned in the agreement establishing the system was gold. Thus effectively, each currency was redeemable in US dollars, and US dollars were redeemable in gold. Exchange Rate Regimes 7.5 Bretton Woods System A) Bretton Woods System –contd. US dollar thus became the means of international settlements. Variations in the exchange rates were permitted on either side of the parity in the range (+/-) 1%. The end points of the variation zone were called ‘Support Points’ or ‘Intervention Points’. The system introduced the concept of Central bank intervention as a means of ensuring protection of parity values.

Exchange Rate Regimes 7.5 Bretton Woods System A) Bretton Woods System –contd. The IMF also provided a commitment to the member countries to provide financial assistance to countries facing temporary balance of payments deficits. In case there are some structural imbalances , the member countries could devalue the currencies in consultation with IMF. Thus the system was also called ‘The Adjustable Peg System’. Finally, IMF’s supervisory authority was accepted by all members for 1) Exchange rate management & 2) The domestic foreign exchange market.

Exchange Rate Regimes 7.5 Bretton Woods System B) Reasons for the failure of Bretton Woods System There was an excessive demand for US dollars in the international financial markets. There was a continuous deficit on USA’s Balance of Payment (trade deficit) as countries such as Japan and West Germany enjoyed export benefits against US economy. The system did not provide for a revision in the price of gold in terms of US dollars. Hence, it was not possible to devalue US dollar despite continuous trade deficit. Exchange Rate Regimes 7.5 Bretton Woods System B) Reasons for the failure of Bretton Woods System – contd. The system was too rigid. In 1967, Britain devalued its Pound. In 1968, there was an outflow of capital from France due to political disturbances. In 1969, Germany devalued its Franc.

All these had compelling effect in the form of either creating worldwide ill-liquidity or devaluation of dollar thereby leading to break down of Bretton Woods System by 1970. Exchange Rate Regimes 7.6 Triffin’s Paradox

Prof. Triffin, an economist, predicted that the continuous deficit in balance of trade incurred by the US would reduce its acceptability in the international markets since supply would keep increasing without a downward revision in the value of USD. He predicted that the system would disintegrate due to this basic weakness in the system that it did not provide periodic review of the value of USD In 1968 Gold Convertibility Clause was invoked but the US Federal Reserve Bank could not honor its commitment. A formal withdrawal from the system was announced by the US inExchange 1971. (as Rate predicted Regimes by Prof. Triffin) 7.7 Smithsonian Agreement 1. The G 10 countries (USA, UK, West Germany, France, Japan, Canada, Italy, Sweden, Belgium and Holland) met at the Smithsonian Institute in Washington in December 1971 and reached an agreement to re-introduce the Bretton Woods System with certain modifications. 2. The main amendments: e)All other countries fixed new parities against USD

Exchange Rate Regimes 7.7 Smithsonian Agreement – contd.

3. The basic idea behind these amendments was to provide greater export competitiveness to the US economy to help them to reduce their trade deficit andre-introduceafixedpriceforgoldfor conversion. 4. However, the US suffered a record deficit in 1972 resulting in further devaluation of the USD to $42.22 per ounce of Gold. 5. In February 1973, the OPEC group of Countries increased crude oil prices by several hundred % points, increasing deficits of all other countries. The above agreement was thus abandoned in 1973. Exchange Rate Regimes 7.8 Snake in the Tunnel System

1. The Smithsonian Agreement of 1971 provided for wider variation zone of (+/-) 2.25% from revised parity rates. 2. The member countries of the European Economic Community (EEC) were in favor of greater stability in their exchange rates and, therefore, voluntarily accepted a smaller variation zone of (+/-) 1.125% for their currencies. 3. This required higher degree of financial discipline. The rates of these countries moved in narrower band (The EEC Snake) within wider Smithsonian tunnel. Exchange Rate Regimes 7.8 Snake in the Tunnel System - contd.

4. After the Smithsonian Agreement was abandoned in 1973, the ‘Snake’ concept was incorporated into the ‘Parity Grid’ mechanism which was the basis of European Monetary System introduced in 1979. 5. This helped to achieve economic convergence among members of the European Union which, ultimately , lead to the introduction of the common currency ‘Euro’ (€) in 1999. Birth of ‘Euro’ (€)

Exchange Rate Regimes 7.9 Special Drawing Rights

Special Drawing Rights (SDRs) are an international reserve asset created by the IMF in 1969. It’s also knownas‘PaperGold’asSDRisexpectedto replace the gold which is the most important international monetary asset.

They were allotted to the members in 1970. Since then a total SDR 21.4 billion have been allotted to the members. This allotment was in the proportion in quotas (subscriptions) countries paid for their membership.

Exchange Rate Regimes 7.9 Special Drawing Rights - contd. Main Features:

SDRs is the creation of IMF It is not linked to any single currency, nor does its creation depend on supply/stock of gold. It does not belong to any single country. All member countries have a claim on SDRs It is not tangible but just a book entry. Its value is determined by a basket of currencies such as USD, GBP, EUR, & JPY and the value is usually expressed in USD. The basket is revised every five years.

Exchange Rate Regimes 7.9 Special Drawing Rights - contd. Attempts to facilitate growth of international Main Features: trade. The currencies selected belonged to the countries with the largest exports of goods & services. At present SDRs used for transactions among the governments. ItistheunitofaccountoftheIMFandother international organizations. SDRs are also held by 15 ‘prescribed’ international institutions. IMF can allot more SDRs in the same proportion in order to maintain liquidity Exchange Rate Regimes 7.10 Fixed Exchange Rate System

A. Meaning:

1) The fixed or the ‘pegged’ exchange rate system is asysteminwhichthecentralbankwhichisthe monetary authority of a country pegs (fixes the value of) the domestic currency to a foreign currency or a basket of foreign currencies or SDRs or bullion (gold and / or silver) . 2) The currency against which the rate is pegged is generally fully convertible. The multiple used for the peg is called parity.

Exchange Rate Regimes 7.10 Fixed Exchange Rate System - contd.

A. Meaning: contd.

3) The most widely used currency for pegging by most countries following this model is the US dollar (USD)

4) Only small economies follow this system today.

5) China is only major economy which currently uses the fixed exchange rate system. The Chinese Yuan is pegged to the US dollar.

Exchange Rate Regimes 7.10 Fixed Exchange Rate System contd.

B. Merits of Fixed Exchange Rate System

1) Stability in Exchange: The fixed exchange rate system provides for stability in exchange rates and does not expose importers and exporters of a countrytoexchangeraterisk.

2) Currency Valuation Process: the central bank can effectively ensure that the exchange rate reflects underlying changes in economy since it directly controls the currency valuation process.

Exchange Rate Regimes 7.10 Fixed Exchange Rate System - contd.

B. Merits of Fixed Exchange Rate System- contd.

3) Helps the Government: it helps the government to control inflation and in the long run help to maintain low interest rates so essential for growth.

4) Lesser Operating Costs: It is an easier system for importers and exporters and has lesser operating costs since traders are not required to hedge their transactions to protect from adverse exchange rate fluctuations.

Exchange Rate Regimes 7.10 Fixed Exchange Rate System - contd.

C. Demerits of Fixed Exchange Rate System

1) Inefficient Resource Management: in order to successfully utilize the system, the central bank must hold substantial amounts of foreign currency toparticipateinthedomesticmarket.Thisresults in inefficient resource management. 2) Real Value: at times, the real value of the currency maybecomeunacceptabletoforeignentities.This may call for revaluation or devaluation of the currency.

Exchange Rate Regimes 7.10 Fixed Exchange Rate System - contd.

C. Demerits of Fixed Exchange Rate System- contd.

3) No Self Balancing Mechanism: the fixed exchange rate system does not automatically regulate the inflow and the outflow of foreign currency investments to counterbalance trade imbalances. Thus, there is no self balancing mechanism. 4) Competitive advantage: the central bank could use this system to gain a competitive advantage in international trade by not revaluing the currency despite consistent trade surplus.

Exchange Rate Regimes 7.11 Flexible Exchange Rate System

1. Meaning: 1)TheFlexibleExchangerateSystemorthefloating exchange rate system can be described as a system of exchange rate management where the relative value of the domestic currency as against foreign currencies is determined by market forces of demand and supply.

2) Under this system, the central bank of a country does not participate in the currency valuation process. It neither sets a target rate nor does it participate in domestic foreign exchange market. Exchange Rate Regimes 7.11 Flexible Exchange Rate System - contd. 1. Meaning: contd. 3) Most major economies of the world employ this or variations of this system. As a result, today, currencies of the world can be broadly classified as: 1) Freely floating currencies such as US Dollar, British Pound, etc. (not controlled by intervention) . 2) Pegged currencies such as Chinese Yuan etc. (held stable through intervention within variation zone); and 3) Currencies subject to Managed Float such as Indian Rupee etc. where volatility eliminated through intervention without any target level. Exchange Rate Regimes 7.11 Flexible Exchange Rate System - contd. B. Merits of Flexible Exchange Rate

1. Determination of the currencies values: the system provides for determination of currencies values based on market forces of supply and demand. Such rates reflect the true economic fundamentals of the currency. 2. High degree of transparency: rates under this system are independent of any overt influence by either the government or the central bank. It is, therefore, possible to take logical investment decisions when using such rates.

Exchange Rate Regimes 7.11 Flexible Exchange Rate System - contd. B. Merits of Flexible Exchange Rate –contd.

3. Efficient reserve management: there is no intervention from the central bank. It is , therefore, possible for the country to use its reserves in optimum manner without having to maintain a large part for intervention. 4. Market established exchange rates: exchange rates are market established. They depreciate or appreciate gradually and domestic importers and exporters are able to factor such changes into their business costs.

Exchange Rate Regimes 7.11 Flexible Exchange Rate System - contd. B. Merits of Flexible Exchange Rate –contd.

5. Current account deficits: This system has a built-in mechanism which helps countries to deal with their current account deficits i.e. export and imports are properly monitored.

Exchange Rate Regimes 7.11 Flexible Exchange Rate System - contd. C. Demerits of Flexible Exchange Rate 1. Destabilization of the currency: This system may expose the country’s currency to speculative pressures and lead to its destabilization. 2. Inflationary pressures: It may lead, in absence of intervention, to inflationary pressures on economy causing interest rates to rise in the long run. 3. Uncertainty: Theflexibleexchangeratesystem provides for variable rate, and variability means uncertainty which inhibits international trade.

Exchange Rate Regimes 7.11 Flexible Exchange Rate System - contd. C. Demerits of Flexible Exchange Rate – contd.

4. Balance of payment problems: countries with inelastic import demands incur repeated deficits balance of payment problems which leads to high inflation , poverty and unemployment.

5. Distorted exchange rates: heavy capital inflows and outflows could distort the exchange rate leading to an inaccurate representation of the underlying economy.

Exchange Rate Regimes 7.12 Central Bank Intervention/Currency Intervention

Theflexibleexchangeratesystem,bydefinition, provides for variability in exchange rates. Such rates become volatile due to speculative activities. To avoid the adverse impact of instability, most small and medium countries have opted for ‘managed float system’. This implies that the respective central bank would actively participate in the domestic markets to maintain stability and guide exchange rates to desired levels. There are four forms of interventions.

Exchange Rate Regimes 7.12 Central Bank Intervention/Currency Intervention

Verbal intervention: senior officials of the central bank make public announcements of their views regarding the ongoing exchange rates with the hope that they will influence the strategies of market participants. Thus there would be desired effect on exchange rates. Money Market intervention: instability of exchange ratesisgenerallyduetospeculativeactivity.By changing the CRR, SLR or the bank rate, the central bankaltersthevolumeandcostatwhichfundsare available to speculators.

Exchange Rate Regimes 7.12 Central Bank Intervention/Currency Intervention

Securities Market intervention: through selling or repurchasing government securities, the central bank changes the amount of money supply in the system. This directly affects the volume of funds in the economy. Active intervention: the Central bank directly buys or sells foreign currencies in the domestic market to achieve pre-decided results. This is the most potent form of intervention in the managed float system and has been successfully used by the Central Bank all over the world.

Exchange Rate Regimes 7.13 Methods of Control

The problem to control and check violent and adverse fluctuations in the rate of exchange and for getting stabilityintheratelargelydependsuponthe equilibriuminthedemandandsupplyforcesofforeign exchange or in different items of balance of payments. There are nine important measures available for exercising control over exchange rate movements. 1. Minimization of trade deficit: a) boost exports; b) control imports. To achieve this i) impose duties on imports and ii) provide incentives to exports.

Exchange Rate Regimes 7.13 Methods of Control - contd.

Exchange Rate Regimes 7.14 Clean Float

It is also called as “Free Float” and is a model under which there is no official participation in establishing currency values. The central bank does not set any target range or price and the value of a currency is determined by the market forces of demand & supply.

The central bank or the Government does not participate in establishment of exchange rate. The disadvantage of this system was that currencies of weaker economies became vulnerable to speculative attacks but most major economies floated their currencies. Exchange Rate Regimes 7.15 Managed or Dirty Float Most medium and small economies pegged their currencies to USD or any other major international convertible currency or their basket or to the SDR. Under dirty float, the currency is determined by the market forces of supply and demand ; but whenever any volatility in the rate is perceived, the central bank intervenes by participating in domestic foreign exchange market to restore stability. Intervention is also expected to ensure that the value of the currency reflects underlying status of the economy.

It thus combines the best features of the fixed & variable exchange rates.

Exchange Rate Regimes 7.16 Adjustable Peg System

1. As the name suggests the Adjustable Peg System provides for revision to the parity rate based on specific economic parameters.

2. The Bretton Woods System itself is also viewed as an Adjustable Peg System because it provided for parity rate changes in consultation with the IMF

Exchange Rate Regimes 7.17 Crawling Peg System

One of the systems developed under Adjustable Peg Concept. The revision in the parity rates are connected to inflation rates. Thus the system relies heavily on Purchasing Power Parity Theory. First the currency is pegged to one major international convertible currency say USD. Next this parity rate is revised at predetermined intervals based on inflation rate differential between the domestic currency and the host currency to which it was pegged. Exchange Rate Regimes 7.17 Crawling Peg System- contd.

Benefits of this system-

Theexchangeratereflectsthechangesin underlying economy vis-à-vis the host currency. The need for interventions is reduced. Provides for better utilization of foreign currency reserves.

Exchange Rate Regimes 7.18 Sterilization / Neutralization of Reserves Active interventions in the form of actual purchase/sale of foreign currencies by the Central bank result in altering both the foreign currency reserve of the country and the money supply in the economy. Such interventions are of two types: a) Sterilized Intervention b) Non- Sterilized Intervention

Sale or purchase of foreign currency There is no such offsetting operation is offset by a corresponding and thus the exchange rate is purchase or sale of government influenced through monetary securities to minimize / eliminate system. the effect on domestic money supply. Exchange Rate Regimes 7.19 Fixed vs. Flexible Exchange System

Fixed Exchange System Flexible Exchange System

Provides for stable exchange Provides for variable exchange rates. rates

Promotes trade and Promotes transparency in investment price discovery Rates are artificially controlled Market established rates and hence may not reflect reflect the true state of the correct state of the underlying economic changes economy Exchange Rate Regimes 7.19 Fixed vs. Flexible Exchange System –contd.

Fixed Exchange System Flexible Exchange System

Subject to revaluation / Subject to appreciation / devaluation by monetary depreciation through market authority. forces One time, unpredictable Depreciation / appreciation is effect of revaluation / gradual and can be devaluation cannot be built reasonably predicted and into trade negotiations factored into prices.

Provides greater control to Lesser control with monetary monetary authority over authority over inflation inflation

Exchange Rate Regimes 7.19 Fixed vs. Flexible Exchange System –contd.

Fixed Exchange System Flexible Exchange System

Risk management systems Risk management systems not needed, hence cost of needed to control variability of operation are lower rates Greater need for reserves in Reserves can be utilized liquid form for effective productively as they are not intervention as & when required for rate control required Maintains low interest rates Susceptible to high interest and helps achieve a higher rates and lower growth of per per capita income capita income

Exchange Rate Regimes 7.20 The Gold Standard vs. Bretton Woods System

Promoted by the Bank of Introduced by the IMF in England and introduced in 1946 was the first 1870, was the first universally implemented universally implemented system for determining foreign exchange rate semi fixed foreign determination system exchange rate (Adjustable Peg System). Only gold was used as Gold/US Dollars were reserve asset. accepted as reserve.

Exchange Rate Regimes 7.20 The Gold Standard vs. Bretton Woods System

The Central Bank of each Only Federal Reserve country was required to Bank of the US was announce an official price required to fix the price of for gold in terms of gold in terms of US dollars domestic currency. Each Central Bank gave The Federal Reserve Bank an unconditional gave an unconditional guarantee to buy or sell guarantee to buy or sell unlimited quantity of gold unlimited quantity of gold at the official price. at 1 ounce gold = USD 35 Exchange Rate Regimes 7.20 The Gold Standard vs. Bretton Woods System

Every currency note carried an Every currency note carried an irrevocable promise of irrevocable promise of redemption against specific redemption against specific quantity of gold. amount of USD.

The system failed because it Oversupply of US Dollars lacked flexibility for changing reduced the acceptability of money supply. currency Each currency pair had a Each currency pair had a unique gold point standardized variation range.

Exchange Rate Regimes 7.20 The Gold Standard vs. Bretton Woods System

International settlements were International settlements were arranged in terms of gold. arranged in terms of USD.

Mechanism for calculating Mechanism for calculating exchange rates was Mint Par of exchange rates was the Par exchange system value mechanism Reserves did not earn any USD reserves could be interest invested to get return on investment. No commitment, no monitoring The IMF functioned as of Mint parities supervisor of Par Value Mechanism

Exchange Rate Regimes 7.21 Summary

An exchange rate is just the value of one currency in terms of another. The term exchange rate regime relates to the mechanism, procedures, and institutional framework for determining exchange rates at a point of time and changes in them over time, including factors which induce the changes. Atoneendofthespectrumwehaverigidorfixed exchange rates and at the other end, perfectly flexible or floating exchange rates. Spanning them are hybrids with varying degree of limited flexibility.

Exchange Rate Regimes 7.22 Self Assessment Questions 1. Explain the salient features of Gold Standard System. 2. Describe the characteristics of Bretton Woods system and explain the reasons for its failures. 3. What are SDRs and describe their attributes in details. 4. Bring out the various exchange rate mechanisms available under currency calculation.

Exchange Rate Regimes Exchange Rate Regimes

Let us now move to chapter 08 “Euro Currency (Offshore) Market”

Good Luck!