CONCEPTUAL QUESTIONS
2.3 EXCHANGE RATE SYSTEMS
As the name suggests, the BoP is a double-entry system that is intended to record both sides of every cross-border transaction. Because only one side of a transaction typically is reported to the local monetary authorities, the BoP includes a ‘‘net errors and omissions’’ account to ensure that inflows equal outflows. This account is an attempt to infer cross-border activity from imbalances elsewhere in the BoP. Illegal drug trafficking, for example, is unlikely to be reported by the traffickers. Purchases and sales of short-term financial claims also are often unreported and can account for a sizable proportion of the ‘‘net errors and omissions’’ account. Errors and omissions were $235 billion in the United States during 2010, or about 1.6 percent of the $14.72 trillion in U.S. GDP.
Hard pegs Soft pegs Floating arrangements
Exchange arrangements Conventional peg arrangements, Floating (largely market determined with no separate legal stabilized arrangements, crawling and without exchange rate targets) tender, and currency pegs, crawl-like arrangements, Free floating (market determined board arrangements and pegs within horizontal bands with very infrequent intervention) Africa Djibouti Angola, Bangladesh, Botswana, Cape Burundi, Congo, Egypt, Ghana, Kenya,
Verde, Comoros, Eritrea, Ethiopia, Guinea, Liberia, Mauritania, Mauritius, Lesotho, Libya, Malawi, Morocco, Gambia, Madagascar, Mozambique, Namibia, Rwanda, Seychelles, Nigeria, São Tomé & Príncipe, Sierra Leone, Swaziland, Somalia, South Africa, Sudan, Tunisia, Yemen, Zimbabwe Tanzania, Uganda, Zambia CAEMC: Cameroon, Chad, Congo,
Central African Rep., Gabon, Equatorial Guinea
WAEMU: Benin, Burkina Faso, Côte d'Ivoire, Guinea-Bissau, Mali, Niger, Senegal, Togo
Asia & Brunei Darussalam, Bhutan, China, Fiji, Maldives, Afghanistan, Australia, Cambodia, Pacific
regions
Kiribati, Micronesia, Mongolia, Nepal, Samoa, India, Indonesia, Japan, Korea, Marshall Islands, Solomon Islands, Sri Lanka, Laos, Malaysia, Myanmar, Pakistan, Palau, Timor-Leste, Tonga, Vietnam New Zealand, Papua New Guinea,
Hong Kong SAR Philippines, Singapore,
Thailand, Vanuatu
Europe Bosnia and Herzegovina, Azerbaijan, Belarus, Croatia, Denmark, Albania, Algeria, Armenia, Georgia, Bulgaria, Lithuania, Kazakhstan, Macedonia, Russian Fed., Czech Rep., Hungary, Iceland, Montenegro, Tajikistan, Turkmenistan, Uzbekistan Kyrgyz Rep., Moldova, Norway,
San Marino Poland, Romania, Serbia, Sweden,
Switzerland, Ukraine, United Kingdom Eurozone: Austria, Belgium, Cyprus, Latvia, Slovakia, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg, Malta, Netherlands, Portugal, Slovenia, Spain Middle East Bahrain, Iran, Iraq, Jordan, Kuwait, Israel, Turkey
Lebanon, Oman, Qatar, Saudi Arabia, Syria, United Arab Emirates
Americas Ecuador, El Salvador, Argentina, Aruba, Bahamas, Barbados, Brazil, Canada, Chile, Colombia, Panama Belize, Bolivia, Costa Rica, Guyana, Dominican Rep., Guatemala, Haiti,
Honduras, Netherlands Antilles, Jamaica, Mexico, Paraguay, Peru, ECCU: Dominica, Nicaragua, Suriname, United States, Uruguay Grenada, Antigua & Trinidad & Tobago, Venezuela
Barbuda, St. Lucia, St. Kitts & Nevis, St. Vincent & the Grenadines
FIGURE 2.5 IMF Classifications of Exchange Rate Regimes
Source:IMF (www.imf.org). CAEMC — Central African Economic and Monetary Community. ECCU — Eastern Caribbean Currency Union. WAEMU — West African Economic and Monetary Union.
the yuan. Sometimes these changes are planned, such as when a pegged system automatically adjusts to inflation differences with the currency serving as the peg.
At other times, the market might force a government to change its peg.
Fixed exchange rates link employment to inflation.
There are two major drawbacks to a fixed exchange rate system. First, fixed exchange rates forge a direct link between inflation and employment. Suppose Chinese inflation is high relative to Indonesian inflation in a fixed exchange rate regime. The yuan prices of Chinese goods will rise at a fast rate with relatively high yuan inflation, while prices in Indonesia will increase at the lower rupiah inflation rate. With a fixed exchange rate between yuan and rupiah, Chinese products will become relatively more expensive than Indonesia’s products in international markets.
Eventually, consumers will shift purchases away from high-priced Chinese goods and toward low-priced Indonesian goods. This in turn shifts employment away from China and toward Indonesia, resulting in rising unemployment in China and rising employment in Indonesia. As employment shifts toward Indonesia, Chinese wages will fall and Indonesian wages will rise. In this way, a fixed exchange rate system links cross-country inflation differences to wage levels and employment conditions.
The second drawback of a fixed exchange rate system is the difficulty of sustaining fixed exchange rates when they diverge from market rates. By standing ready to buy or sell currencies at official exchange rates, governments are attempting to preempt the function of the forex (FX) market. If an official rate differs from the market rate, the government will suffer a loss of value as counterparties attempt to buy the undervalued currency and sell the overvalued currency at the official rate. If a government refuses to trade at the official exchange rate, it impedes the cross-border flow of goods, services, and capital. Governments cannot indefinitely impose their will on financial markets; the markets ultimately prevail. And when a devaluation arrives in a fixed rate system, it is often a whopper.
Governments are most adamant about maintaining fixed rates when their currency is under pressure because it is overvalued. Devaluations typically come on the heels of claims that the government has full confidence in the currency and will maintain the fixed rate system at all costs. This only encourages currency speculators to bet against the beleaguered currency. When overvalued currencies collapse, government officials are quick to blame currency speculators for precipitating the collapse. Because changes tend to come infrequently but in large increments in a fixed exchange rate system, the apparent absence of currency risk is an illusion.
The apparent absence of currency risk in a fixed rate system is an illusion.
Many governments nevertheless attempt to peg or manage their currency values in relation to another currency, such as the euro, U.S. dollar, or South African rand, or to a composite index. Denmark attempts to peg the value of the krone within a band around the value of the euro. Saudi Arabia tries to peg the value of the riyal to the dollar because oil — its major export — is globally priced in dollars.
Other countries try to maintain a peg to the value of a composite index, such as the IMF’s special drawing right.Special drawing rights (SDRs)are an international reserve account created by the IMF and allocated to member countries to supplement their foreign exchange reserves. SDRs are not actual currencies. Rather, they are bookkeeping units of account that are traded only between central banks as they manage their BoP and foreign exchange positions.
Floating Rate Systems Floating exchange rate systems allow currency values to fluctuate according to market supply and demand without direct interference by government authorities. In these systems, there are no official bounds on currency values. Nevertheless, government intervention in the foreign exchange markets can and does have an impact on currency values, especially in the short term. An increase in a currency value under a floating exchange rate system is called anappreciation and a decrease in a currency value is called adepreciation.As under fixed exchange rates, when one currency rises in value, the other must fall.
In floating rate systems, values are determined by supply and demand.
The major advantage of a floating exchange rate system is that changes in inflation, wage levels, and unemployment in one country are not forced on another country, as they are in a fixed exchange rate system. Consider our earlier example of a fixed exchange rate system with higher inflation in China than in Indonesia.
With a fixed exchange rate, international consumers eventually will see lower prices on Indonesian goods than on Chinese goods because of higher Chinese inflation and the fixed exchange rate. This will be good for the Indonesian economy and bad for the Chinese economy, unless China can either bring inflation under control or adjust the exchange rate. Floating exchange rates can adjust to the differential inflation, and allow a single worldwide price for goods from all countries. Floating rate systems tend to insulate domestic economies from changes in inflation, wage levels, and unemployment in other countries.
The major disadvantage of a floating rate system is the flip side of its major strength. Because exchange rates change continuously, it is difficult to know how much a future cash flow in a foreign currency will be worth in the domestic currency. The good news with floating rate systems is that the financial markets develop financial contracts (currency forwards, futures, options, and swaps) that allow market participants to hedge their exposures to currency risk.