Currency Regime: Classification

Currency Regimes is nothing but the system adopted by any country to manage its currency exchange rate. No single currency is regime is good for all countries, at all time. Fixed vs. Floating is oversimplified dichotomy, there is in fact a continuum of flexibility along which it is possible to place most currency regimes.

Currency Union / common currency system:

·         Currency Union means two or more nations sharing same currency.

·         One of the main goal of currency union is to synchronize and manage each county’s monetary policy.

·         It helps in reducing transaction cost in cross-border trade

·         The theory of optimum currency region (OCR) published by Mundell in 1961 describes which region should form currency union.

Example include European Monetary Union (Euro).

  

Currency Board:

·         Currency board is monetary authority which act as a regulator of nation’s exchange rate and makes decision about valuation of nation’s currency.

·         Three major elements of currency board are:

a)      exchange rate that is fixed to an anchor currency

b)      Automatic convertibility, that is right to exchange domestic currency at fixed rate decided by currency board whenever desired

c)      Long term commitment to system

·         Currency board system can be credible only if central bank holds sufficient official foreign exchange reserves to at least cover the entire narrow money supply.

·         Economic credibility, low inflation and lower interest rates are some advantages of this system.

·         Limitation of currency board system is it brings some restrictions on the central banks role.

·         By using a currency board a country is no longer in control of its monetary policy.

Example: Bulgaria in 1997 adopted currency board system to successfully recover from banking crisis in the country.

Truly fixed:

·         Fixed Exchange rate system is a system wherein the central bank interferes with the exchange rates with a view to keep it fixed.

·         There is a necessity for the country to keep a lot of foreign exchange reserves because whenever it makes use of these reserves to keep the exchange rate fixed.

·         Since the exchange rates are fixed, a trader of this country need not resort to hedging in order to protect itself from exchange rate risks.

·         The importer and exporters of this country know that the exchange rate is fixed so they don’t need to worry about it and can concentrate on their business.

·         Since the exchange rate is fixed, there is no speculation involved in it.

Adjustable peg:

·         It’s a currency regime in which the authorities declare the regime as a fixed currency regime but keep an option of adjustment if considerable changes in the economic fundamentals.

·         Most countries declare their regime as fixed but periodically undergo realignment to balance the economy.

·         Periodic adjustments are done to improve country’s competitive advantage in export market.

·         Klein & Marion 1994 report that mean duration of pegs among world economies is about 10 months.

·         When exchange rate has been fixed for several years it generates sense of complacency about the currency risk leading to large, unhedged currency positions that can greatly increase the cost of depreciation.

Example: Chinese Yuan

Crawling peg:

·         A system of exchange rate adjustment in which a currency with a fixed exchange rate is allowed to fluctuate within a band of rates.

·         The par value of the stated currency is also adjusted frequently due to market factors such as inflation. This gradual shift of the currency's par value is done as an alternative to a sudden and significant devaluation of the currency.

·         This system helps in avoiding instability which may occur due to discrete and infrequent adjustments

·         It also Minimizes the rate of uncertainty and volatility since the fluctuation in the exchange rate is kept minimal

Example: In the 1990s, Mexico had fixed its peso with the U.S. dollar. However, due to the significant inflation in Mexico, as compared to the U.S., it was evident that the peso would need to be severely devalued. Because a rapid devaluation would create instability, Mexico put into place a crawling peg exchange rate adjustment system, and the peso was slowly devalued toward a more appropriate exchange rate.

Basket peg:

·         The exchange rate is fixe in terms of weighted basket of currencies instead of any one major currency.

·         This approach makes sense for countries with trade patterns that are highly diversified geographically.

·         In most countries which use this system keep weights secrete and adjust the weights or levels whenever situation arises.

·         The benefits of this regime include stabilizing trade balances, capital flows, and gross domestic product (GDP) for countries that trade with diverse countries.

·         This currency regime suffers from the issues like complexity, no transparency, and no verifiability.

Managed float:

·         It is a system wherein the exchange rates fluctuate but the central bank of the country attempts to influence the exchange rate by buying and selling of currencies.

·         It is a hybrid of Fixed and Floating exchange rate regimes.

·         Generally the central bank may set a range between which it will not interfere with the exchange rates. Only if the exchange rates vary beyond this range then the central bank responds to bring the value back within the range.

·         In managed floating exchange regime, if a currency is valued above its range, then the central bank will sell some of its currency from the reserve so by increasing the supply of their currency in the foreign market, the value of the currency will decrease.

·         In Managed floating regime, there is sterilized intervention. Consider the case of India- suppose Rupee is appreciating, then the central bank i.e. RBI would intervene in the market and buy USD from the foreign exchange thus strengthening the dollar and weakening the rupee. This is done mainly so that the exporter does not suffer loss because of the change in the exchange rate. In doing this, RBI has increased the rupee supply leading to inflation. In order to contain that, RBI will suck out the liquidity it infused due to its dollar buying by issuing government bond, raising CRR, etc. This is sterilized intervention by the RBI. It is observed in economies adopting managed floating exchange rates

Free Float:

·         Free Floating exchange rate regime is a system where the central bank of the country does not interfere with the exchange rate and allows the foreign exchange market to affect the exchange rates.

·         The supply and demand for the particular currency in the foreign exchange market will decide the exchange rate.

·         In a floating regime, central banks are extremely reluctant to interfere with the exchange rate unless and until it is absolutely necessary.

·         The exchange rate will show a lot of short-run volatility with ups and downs from day to day.

·         The free floating nature of the exchange rate acts as an economic stabilizer in response to market forces. For example: Consider that the currency of a country depreciates because their imports are more than their exports. On account of the depreciating currency, the exports of this country will become cheaper and import will become costlier. Since the exports have become cheaper, the quantity demanded for exported products will increase. Also due to costlier imports, the quantity of imported products demanded will decrease.

·         The country requires lesser foreign exchange reserves as compared to a country following fixed exchange rate system. It is mainly because the central bank does not interfere with the foreign exchange rates using their reserves.

·         The negative point for this kind of exchange rate system is that the exporters and importers of the country need to indulge in hedging in order to protect their investments from the changes in the foreign exchange rates.

·         Floating rate systems will give rise to speculations. So speculations will be an inherent part of the floating exchange rate systems.

Example: Germany, France and UK are some of the economies following free floating exchange rate regime.