Current Exchange Rate Arrangements

Floating Exchange Rate System:

Floating exchange rates are neither characterized by par values, nor by official exchange rates. This allows complete flexibility of exchange rates unlike the rigidity of currency movements under the fixed rate system.

Independently floating:

Under the ‘independent’ or ‘free’ float, the exchange rates are market-determined and central banks intervene only to moderate the speed of change or to prevent excessive fluctuations without any attempt to maintain it or drive it to a particular level.

About 35 countries, including the US, the UK, Japan, Switzerland, Germany, France, New Zealand, Mexico, Australia, Canada, and Brazil have adopted independently floating exchange rate regimes.

Managed float with no pre-determined path for the exchange rate:

Although currencies are allowed to fluctuate on a daily basis with no official boundaries, national governments may and sometimes do intervene so as to prevent their currencies from moving too far in a certain direction.

Such a system is known as ‘managed’ or ‘dirty’ float contrary to ‘free’ or ‘clean’ float wherein currencies are allowed to move freely without government intervention. Such exchange rate arrangements prevail in about 48 countries, including India, Singapore, the Russian Federation, Malaysia, Kenya, Thailand, Indonesia, Tanzania, Bangladesh, and Mauritius.

The managed float system is criticized on the ground that it allows governments to manipulate exchange rates for the benefit of their countries at the expense of others. For instance, a government may weaken its currency to attract foreign demand with an objective to stimulate its stagnant economy.

Pegged Exchange Rate System:

Pegging value of home currency to a foreign currency or a basket of currencies is known as pegged exchange rate system. Although the home currency value is fixed in terms of a foreign currency or unit of account to which it is pegged, it is allowed to move in line with that currency against other currencies. IMF classifies pegging exchange rate system as soft and hard pegs.

Soft pegs:

Conventional fixed peg:

The currency fluctuates for at least three months within a band of less than 2 per cent or ±1 per cent against another currency or a basket of currencies. The basket of currencies is formed from the geographical distribution of trade, services, or capital flows.

The monetary authority stands ready to maintain the fixed parity through direct intervention (i.e., via sales or purchase of foreign exchange in the market) or indirect intervention (i.e., via aggressive use of interest rate policy, imposition of foreign exchange regulations, exercise of moral suasion that constrains foreign exchange activity, or through intervention by other public institutions).

About 70 countries follow the conventional fixed peg arrangements, out of which 63 countries are pegged against a single currency whereas seven countries are pegged against other currency composites. The United Arab Emirates, Saudi Arabia, Qatar, Argentina, Egypt, Ethiopia, Kuwait, Oman, Syria, Venezuela, Vietnam, and Zimbabwe are among the 40 countries that peg their currencies to the US dollar.

The currencies of 19 countries, including Senegal, Niger, Gabon, Cameroon, and Malta, are pegged to the euro. Nepal and Bhutan peg their currencies to the Indian rupee, whereas the currencies of Swaziland, Namibia, and Lesotho are pegged to the South African Rand. Fiji, Iran, Morocco, Samoa, Seychelles, and Vanuatu peg their currencies against other currency composites.

Intermediate pegs:

Pegs within horizontal bands:

Currencies are generally not allowed to fluctuate beyond ±1 per cent of the central parity. Denmark, Slovak Republic, and Cyprus follow such an exchange rate system within a cooperative arrangement, whereas Hungary and Tonga adopt other band arrangements.

Crawling peg:

Under the crawling peg system, a currency is pegged to a single currency or a basket of currencies, but the peg is periodically adjusted with a range of less than 2 per cent in response to changes in selective micro-economic indicators, such as inflation differentials vis-a-vis major trading partners.

Maintaining a crawling peg imposes constraints on the monetary policy in a manner similar to a fixed peg system. China is among the six countries following such an exchange rate system, apart from Botswana, Azerbaijan, Iraq, Nicaragua, and Sierra Leone.

Crawling bands:

The currency is adjusted periodically at a fixed rate or in response to changes in selective quantitative macroeconomic indicators, with a range of fluctuation of 2 per cent or more. The degree of exchange rate flexibility is a function of the bandwidth.

The commitment to maintain the exchange rate within the band imposes constraints on monetary policy making, with the degree of policy independence being a function of the bandwidth. Costa Rica is the only country following the crawling bands exchange rate system.

Hard pegs:

Currency board arrangements:

Currency board arrangements refer to a monetary regime based on an explicit legislative commitment to exchange domestic currency for a specified foreign currency at a fixed exchange rate. It combines restrictions on the issuing authority to ensure the fulfilment of its legal obligations.

The board must maintain foreign currency reserves for all the currency that it has printed. A currency board facilitates the stabilization of a country’s currency and maintains the confidence of foreign investors. About 13 countries have such arrangements. For instance, Hong Kong SAR, Djibouti, and Dominica have such an arrangement with the US dollar.

The currency board of a country maintains a reserve of the US dollar for every unit of home currency circulated. Bulgaria, Estonia, Lithuania, and Bosnia have such arrangements with euro, and Brunei Darussalam with Singapore dollars. Since 1983, Hong Kong has tied the value of the Hong Kong dollar with the US dollar.

Arrangements with no separate legal tender:

Replacement of a country’s local currency with US dollars is termed as ‘dollarization’. It may be formal or informal. Under this regime, the currency of another country circulates as the sole legal tender (formal dollarization) or the member belongs to a monetary or currency union in which the same legal tender is shared by the members of the union.

Adopting such an exchange rate regime implies the complete surrender of the monetary authority’s independent control over domestic policies. Ecuador, El Salvador, Marshall Islands, Micronesia, Palau, Panama, and Timor-Leste do not have their own separate legal tender, and instead use the US dollars, whereas the euro is used in Montenegro and San Marino, and the Australian dollar in Kiribati.

Consequent to the sharp depreciation of about 97 per cent in the Sucre, Ecuador’s currency, against the US dollar from 1990 to 2000, due to unstable trade conditions, high inflation, and volatile interest rates, Ecuador decided to replace its currency with the US dollar. As a result, dollarization showed positive effects as the economic growth increased and the inflation declined by November 2000.