Introduction
An exchange rate specifies the number of units of a given currency that can be purchased for one unit of another currency (Baumol, W & Blinder, A 2004). Exchange rates appear in the financial sections of newspaper each day. Basically, the exchange rates are pertaining to Foreign Exchange rates. As Sloman, J & Sutcliffe, M (2001) stated, Foreign Exchange pertains to currency and money claims, such as bank balances and bank drafts, expressed in the equivalent value in foreign money. Thus, a pound sterling note is money in the United Kingdom, but is foreign exchange in the U.S. A deposit of 00 in an American bank to the account of a French company constitutes that amount of foreign exchange in France. The term foreign exchange is also used to refer to transactions involving the conversion of money of one country into that of another or to the international transfer of money and credit instruments (Sloman, J & Sutcliffe, M 2001). The use of foreign exchange arises because different nations have different monetary units, and the currency of one country cannot be used for making payments in another country. Because of trade, travel, and other transactions between individuals and business enterprises of different countries, it becomes necessary to convert money into the currency of other countries in order to pay for goods or services in those countries. Basically, Heij, Franses, Kloek, & de Boer, (2004) argued that the transfer of money values from one country to another and the determination of the price at which the currency of one country will be surrendered for that of another constitute the main problems of foreign exchange.
Exchange Rate, in relation to foreign exchange of money is the price of a country’s currency expressed in terms of one unit of another country’s currency. Ordinarily, and without government restrictions, the rate of exchange, or the price of the currency of one country in terms of that of another, will depend on overall supply and demand and on the relative purchasing power of the two currencies, that is, on the competitive position of the two countries in world markets. Gold and wealth tend to flow from countries that buy more than they sell abroad. Since 1973 major currencies have fluctuated in importance, but those of West Germany, Switzerland, and Japan have remained fairly strong. At times, speculation in foreign exchange by dealers, brokers, or others becomes a major influence on exchange rates according to Heij, Franses, Kloek, & de Boer (2004).
Exchange rate policy has two dimensions (Heij, Franses, Kloek, & de Boer 2004): the extent of convertibility and the specific institutional arrangements that determine the day-to-day setting of exchange rates. Asia, including Japan, has a history of procrastination in freeing up trade in assets and financial services. This reluctance to some extent reflects the high degree of financial repression prevalent in Asian financial markets, the absence of effective sterilization tools, and the poor quality of balance sheets in the aftermath of a long period of mismanaged finance. The good macroeconomic performance of Asia has a surprising and perhaps strange counterpart in the neglect of financial markets as opposed to forced savings mechanisms. Thus, the lack of an open capital account also reflects a supporting policy for domestic management of the macro economy. It also, of course, reflects a determination to capture domestic savings for domestic investment. It might perhaps be claimed that restrictions on convertibility have worked in the past-that there was more investment and growth, and fewer disturbances were imported via the capital account.
That view, of course, expresses the underlying sense that capital movements are mostly a nuisance. If countries with high domestic saving rates had accompanying high rates of efficient investment, that would not be altogether implausible. Of course, if saving is inadequate or investment is inefficient, there can be little support for closing the capital account to the market. According to McDonald, IM (1995), even where a country can plausibly claim high saving and efficient investment, failure to implement the decentralization required for an open capital account becomes increasingly difficult to defend. If transition to an open market is accepted in principle, steps should be taken to put it into practice. An appropriate regulatory structure has to be established and pre-emptive clean-up operations in the balance sheets of existing institutions have to be carried out. There seems little reason to delay an inevitable process. From this discussion, this paper will be discussing the issues related to fixed exchange rate policy and its advantages and disadvantages in relation to the current global economic environment.
Discussions
From the end of World War II until August 1971, the world was on a fixed exchange rate administered by the International Monetary Fund (IMF) (Soper, J 2004). Under this system, the U.S. dollar was linked to gold ( per ounce), and other currencies were then tied into dollar (Soper, J 2004). Exchange rates between other currencies and the dollar were controlled within narrow limits but then adjusted periodically. For example, in 1964 the British pound was adjusted to .80 for £1, with a 1 percent permissible fluctuation about this rate.
As for its advantages, fixed exchange rates are able to provide a source of consistency, and the governments are no longer permitted to utilize competitive reductions or depreciations just to encourage exports. Accordingly, being members of the International Monetary Fund, the nations are allowed to uphold the manipulations and controls on operations in the capital values which are considered as the net flow of both domestic and foreign acquisitions of their assets (Feldstein, 1998).
As stated in International Monetary Fund (1987), the mission of the IMF in this system is to promote international cooperation and to supervise enforcement of the rules. This mandate includes monitoring the compliance of member countries with the fund’s Articles of Agreement and periodic consultations with their governments about their macroeconomic policies (James, 1996). The fund also extends financial assistance to different nations which are the members of the IMF with balance-of-payments deficits. However, the fund’s resources are meant to be provided on an interim basis while governments address the underlying causes of the external disequilibrium and enact policies to correct it.
Conditionality is the mechanism whereby the IMF ensures that nations employ the necessary adjustments. In this regard, the provision of the assistance of the International Monetary Find is considered as dependent on a government’s agreement to a program of specific policies, and its subsequent adherence to that program. Credit is disbursed in periodic installments as a government fulfills its obligations; otherwise a program may be suspended or terminated.
When the International Monetary Fund started its operations with the nations with balance-of-payments deficits during the 1950s, the IMF is in need pf economic models coming from the external sector that would let it to recommend the governments about the most efficient and appropriate policy measures (Polak, 1998). One of the initial planning tools established by the International Monetary Fund was the so-called “financial programming”. This program observes the balance of payments as a monetary trend. Herein, the increase in national credit directs to an increase in spending and a deficit in the balance of payments.
From this, we may argue that the fluctuations in exchange rates occur because of the changes in supply of and demand for dollars, pounds and other currencies. These supply and demand changes have two primary sources. First, changes in the demand for currencies depend on changes in imports and exports of goods and services. For example in the current global financial setting, some of U.S. importers must buy British pounds to buy British goods, whereas British importers must buy U.S. dollars to pay for U.S. goods. If U.S. imports from Britain exceeded U.S. exports to Britain, there would be a greater demand for pounds than for dollars, and this would drive up the price of the pound relative to that of the dollar. Thus the current exchange rate of pound may increase compared to dollar. The U.S. dollar would be said to be depreciating, because a dollar would now be worth fewer pounds, whereas the pound would be appreciating.
And from this, the implementation of fixed exchange rate in a form of currency boards creates an option to countries to avoid inflation (Hoguet, GR 2001). A country ties its currency to a low-inflation currency, makes a firm commitment, and, as a result, achieves low inflation. However, it is important to remember that the fixed exchange rate gives roughly the same rate of inflation only in tradable goods, which provides the price anchor. The overall inflation rate is, however, an average of tradables and nontradables. According to Hoguet, GR (2001), when inflation in tradables is fixed, the inflation rate of nontradables will be determined by the relative productivity growth in nontradable sectors of goods and services vis-à-vis tradables. This explains why a currency board country may have relatively high inflation although its currency is pegged to a low-inflation country’s currency. For example, high productivity growth in the nontradables sector was one of the reasons for high inflation in Hong Kong during the 1983–95 period.
As for its disadvantages, the lack of credibility or doubt about it explains, to a large extent, why currency boards are subject to speculative attacks (Dumas & Solnik 1995). From this point of view, one must ask how financial market participants view the monetary policy actions: Do they perceive them as temporary and justifiable (the expansion of the monetary base through the central bank’s discount window despite declining foreign reserves), or as something similar that has led to devaluation (or a series of devaluations) in the past? It seems that formal institutions or laws cannot remove skepticism about governments’ ability to carry out commitments if they have repeatedly been broken in the past. Even with a strong macroeconomic performance, consolidating credibility may take time.
In addition to this, when currency boards are subject to speculative attacks, devaluation can be avoided, but usually only at the cost of financial crisis. This was the case, for example, in America. The combination of a fixed exchange rate, a current account deficit, large short-term international debt, and a weak banking system explains why America became the victim of the housing bubble, even though it had a currency board regime. Consequently, America suffered from capital outflow. At the end, the country may still avoid a full collapse of confidence, but suffered from a deep financial crisis, recession, and high unemployment.
An additional observation related to devaluation is that in principle, if there is no explicit or implicit currency denomination mismatch, then the devaluation improves banks’ balance sheets. The devaluation can improve balance sheets if you have an external shock and a certain loss becomes nonperforming, so devaluation can liquidate the debt. Devaluation also helps stimulate the demand for deposits, and it can prevent runs of banks.
Apparently, labor market flexibility and coordination is crucial under the currency board regime. Given the argument of labor market flexibility, the exchange rate should be fixed in a country/within an area in which there is factor mobility (labor and capital). However, this is easier said than done: How to bring about labor market flexibility? Would it actually be possible to convince politicians or trade unions that in the long run workers are going to be just as well off with nominal wage flexibility downward as by sticking to nominal wage levels while nominal demand declines when there is, for example, a capital outflow?
Another crucial question related to currency board economies is how to deal or avoid credit squeeze/capital flights which is now present in United States of America? In United States of America, lowering the banks’ reserve requirements during the run of deposits make help them. Actually, the example of Hong Kong shows in turn that modifications in the regulatory structure can reduce the need for a lender of last resort. In addition, permitting the internationalization of the financial sector can help both to reduce the vulnerability of banks to negative external shocks and to smooth out capital flows (because foreign-owned subsidiaries can draw from credit lines to their parent banks when confronted with negative external shocks). A country can avoid capital inflow–outflow shocks, to some extent at least, by also making a government run on a budget deficit or by borrowing abroad. Indeed, some fiscal flexibility has proved to be useful under the currency board regime. In case of adverse-terms-of-trade shock or a capital outflow problem, it helps if a government can engage in temporary fiscal expansion, which could involve more foreign debt. This would offset, partly, the domestic deflationary effects resulting otherwise from the currency board arrangement. However, not all countries have permanent access to the international capital market. Given this, a government might find it useful to have a systemic liquidity policy, which would take into account the short-term liabilities of both the private and the public sector, in both local and foreign currency. All in all, there seems to be a some kind of trade-off between the use of reserves to support convertibility and maintain credibility or to support the banking system. Can a country have a currency board with a credible commitment to a fixed exchange rate, and simultaneously enough room for maneuvering in terms of banking and monetary policy? Perhaps with high enough excess reserves and access to credit, a country could actually have it both ways.
From the discussion and with regards to the current global financial status, we may say that the financial crisis in America, EU integration and future enlargement may raised a whole new set of questions related to the future perspectives of the currency boards. In particular, we are quite reluctant whether a currency board is an appropriate monetary framework for joining the EU, and, eventually, for participation in the euro zone. In general, there is no obvious reason why a central bank that runs a currency board should not be in a position to fulfill all the requirements the Treaty on European Union lays down in the area of central bank independence. In regards to price stability as the primary objective of central bank policy, a currency board has no policy tools at its disposal to directly fight inflation. However, empirical evidence has shown that a currency board tends to deliver low inflation or even price stability. Monetary policy cooperation among EU countries is based on the existence of market-based monetary policy instruments, and on their effective use, if the need arises. Under a pure currency board regime, there is no (active) monetary policy.
Conclusion
For our conclusion, we may argue that a currency board country cannot fully participate in an institutionalized exchange rate cooperation of a standard EU type, which requires flexible use of interest rates. Since a currency board does not allow for any direct control of price level and interest rate developments, meeting the monetary convergence criteria can also become more complicated. So far, Lithuania is the only Eastern European currency board country that has officially announced the exit program. Technically, exit would mean moving away from the strict concept of a currency board and loosening of the backing rule, thereby building up more room to act as a lender of last resort in any future crisis. However, the main problem related to exit is that of credibility. A lot will depend on how well the monetary authorities deal with their new monetary freedom.
To conclude, given the experience with and effects of financial crisis from United States of America, turbulence in worldwide capital markets, transition in Central and Eastern Europe, and EU integration, the appropriateness and long-term viability of currency boards will require continuous monitoring and reassessing in the years to come.
References:
Baumol, W & Blinder, A 2004, Economics: Principles and Policy, 10th edn., Thomson South-Western, Ohio. pp. 55-90
Dumas, B & Solnik B 1995, “The world price of foreign exchange rate risk.” Journal of Finance (50), pp. 445-479.
Feldstein, M 1998, “Refocusing the IMF.” Foreign Affairs 77 (2): pp.20–33.
Heij, C, Franses, P, Kloek, T & de Boer, P 2004, Econometric Methods with Applications in Business and Economics, Oxford University Press, Oxford. pp. 48-63.
Hoguet, GR 2001, Benchmark Blues. The International Monetary Fund Vol. 15, p. 44.
International Monetary Fund (1987). Theoretical Aspects of the Design of Fund Supported Adjustment Programs. IMF Occasional Paper no. 55. Washington, DC: IMF. p.1
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Sloman, J & Sutcliffe, M 2001, Economics for Business, 2nd edn., Pearson Education, London. pp. 56-59
Soper, J 2004, Mathematics for Economics and Business: An Interactive Introduction, Blackwell Publishing, Massachusetts. pp. 99-264.
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