Chapter 5
Exchange Rate Systems

questions

1. How can you quantify currency risk in a floating exchange rate system?

Answer: To characterize the risk of a currency position, you must try to characterize the conditional distribution of the future exchange rate changes. With floating exchange rates, historical information provides useful information about this distribution. For example, you can use data to measure the average historical dispersion (standard deviation or volatility) of the distribution. The higher this volatility, the riskier are positions in this currency. It is also possible to rely on more forward-looking information using the options markets (see Chapter 20). Finally, we should point out that volatility is an adequate indicator of risk when exchange rate changes are approximately normally distributed. In reality, the distribution of exchange rate changes displays fat tails, even in floating exchange rate systems, and this increases the risk of currency positions.

2. Why might it be hard to quantify currency risk in a target zone system or a pegged exchange rate system?

Answer: If the peg or target zone holds for a long time, historical volatility appears to be zero or very limited, but this may not accurately reflect underlying tensions that may ultimately result in a devaluation or revaluation of the currency. Hence, the true currency risk does not show up in day-to-day fluctuations of the exchange rate. It is hard to quantify this “latent volatility.”

3. What is likely to be the most credible exchange rate system?

Answer: Among fixed exchange rate systems, a monetary union with a common currency is likely the most credible exchange rate system. But even here, we see tensions within the Economic and Monetary Union in Europe that could lead to a breakup of the euro. The inability of Greece and the other peripheral countries to devalue their currencies is leading to a protracted period of high unemployment with associated fiscal deficits and an inability to regenerate growth. Ultimately, one of the problem countries might withdraw from the EMU or the strong countries, like Germany and Finland, might withdraw rather than subsidize their inefficient neighbors.

4. How can a central bank create money?

Answer: First, because the central bank operates the only authorized printing press in the country, it can actually print money to pay its bills or to acquire assets, thereby increasing the money supply. Second, the central bank can create money by increasing the reserve accounts financial institutions hold with it. For example, if the central bank buys an asset (a government bond say) from a financial institution, it credits the financial institution’s reserve account at the central bank for the purchase price of the bond. Because this financial institution can now use this credit to its account to lend money to individuals and businesses, the central bank has, essentially, created money.

5. What are official international reserves of the central bank?

Answer: Official reserves consist of three major components: foreign exchange reserves, gold reserves, and IMF-related reserve assets, with the first being by far the most important component. Foreign exchange reserves are all the foreign currency denominated assets the central bank holds, and mostly consist of foreign government bonds.

6. What is likely to happen if a central bank suddenly prints a large amount of new money?

Answer: Whereas there are theories that predict that changes in the supply of money have real effects on the economy in the short run, it is likely that if the central bank showers the economy suddenly with money, the only result will be higher inflation. This is because the demand for money ultimately depends on the amount of real transactions in the economy and how much money is needed to facilitate these transactions. Additional supply of money is unlikely to make people consume more or work harder.

7. What is the effect of a foreign exchange intervention on the money supply? How can a central bank offset this effect and still hope to influence the exchange rate?

Answer: When a central bank buys (sells) foreign currency, its international reserves increase (decrease), and the money supply increases (decreases) simultaneously. To offset the effect on the money supply, the foreign exchange intervention can be sterilized; that is, the central bank can perform an open market operation that counteracts the effect on the money supply of the original foreign exchange intervention. The direct effects of a sterilized intervention are two-fold. First, it forces a portfolio shift on private investors, by replacing foreign bonds with domestic bonds (or vice versa). This may affect expectations and prices. Second, the actions of the central bank in the foreign exchange markets, while very small relative to the nominal trading volumes, may still manage to squeeze foreign exchange inventories at dealer banks and generate pricing effects. Indirectly, the central bank can signal its opinion on the fundamental value of the exchange rate through an intervention that consequently affects market expectations. There is no consensus on how effective sterilized interventions are in affecting the level and volatility of exchange rates.

8. How can a central bank peg the value of its currency relative to another currency?

Answer: To peg the value of its currency to another currency, the government must make a market in the two currencies. If there is excess supply of the foreign currency (which is equivalent to excess demand for the domestic currency) that would drive down the domestic currency price of the foreign currency, the government must buy the private excess supply of foreign currency and deliver domestic currency to those demanding it. On the contrary, if there is excess demand for foreign currency (which is equivalent to excess supply of domestic currency) that would drive up the domestic currency price of the foreign currency, the government must supply the foreign currency and demand the domestic currency to prevent the foreign currency from appreciating in value.

9. Describe two channels through which foreign exchange interventions may affect the value of the exchange rate.

Answer: There is a direct and an indirect channel. As indicated in question 7, the direct effect of forex purchases or sales is likely small, because trading volumes are so large in the forex market, but there may be some short-term effects if the inventories of dealer banks are adversely affected by the intervention. If not sterilized, interventions affect the money supply, but that effect too, is likely to be small relative to the size of the money supply. The indirect channel refers to the fact that an intervention can alter peoples’ expectations and affect their investments, thus helping to push the exchange rate in the direction the central bank desires. For example, the intervention may be a signal to the public of the central bank’s monetary policy intentions, or it may signal the central banks inside information about future market fundamentals, or it may signal to investors that a currency’s exchange rate is deviating too far from its long-run equilibrium value. The signal is costly and therefore potentially more credible, because if the central bank is wrong and, for example, buys an “undervalued” currency, which keeps depreciating, the intervention will lose money.

10. What was the Bretton Woods currency system?

Answer: In the Bretton Woods System, in place between 1944 and 1971, the participating countries agreed to an exchange rate regime that linked their exchange rates to the dollar. They could fluctuate in a 1% band around a fixed parity. The dollar itself had a fixed gold parity ($35 per ounce). When a country ran into a temporary balance of payments problem (a current account deficit) that threatened the currency peg, it could draw on the lending facilities of the IMF, also established at Bretton Woods in 1944, to help it defend the currency. Countries were also allowed to change their parities when their balances of payments were considered to be in “fundamental disequilibrium.” The system broke down when President Nixon abandoned the U.S. commitment to exchange dollars for gold in August 1971.

11. How do developing countries typically manage to keep currencies pegged at values that are too high? Who benefits from such an overvalued currency? Who is hurt by an overvalued currency?

Answer: Such a situation is difficult to maintain, because if the exchange rate overvalues the local currency on the foreign exchange markets, there will be an excess supply of the local currency—everybody will want to turn in local currency to the central bank, receive foreign currencies, and invest them abroad. If this situation persists, the central bank’s foreign reserves will dwindle quite fast. The only way to sustain such a system is to impose exchange controls. The central bank of the developing country must ration the use of foreign exchange, manage who gets access to it, and restrict capital flows; in short, it must strictly control financial transactions involving foreign currencies. That currencies of developing countries are primarily traded by the central bank of the country or by a number of financial institutions with strict controls on their use of foreign currency (i.e. the currencies are inconvertible), is helpful to maintain such a system. It is clear who benefits and who loses from this situation. The fixed exchange rate undervalues the foreign currency and overvalues the domestic currency, thereby subsidizing buyers of foreign currency (such as importers and those investing abroad) and taxing sellers of foreign exchange (such as exporters and foreign buyers of domestic assets). Not surprisingly, one main reason for the popularity of over-valued exchange rates is that such situations increase the external purchasing power of the political elite.

12. What are the potential benefits of a pegged currency system?

Answer: Some believe that fixed exchange rate systems bring with it policy discipline and stability. A fixed exchange rate should discourage over-expansionary fiscal or monetary policies, which would cause inflation and a loss of competitiveness under a fixed exchange rate system. Hence, fixed exchange rates should induce the kind of policies that help control inflation. The absence of day-to-day exchange rate volatility in such a system should eliminate the uncertainty that comes with floating exchange rates and which might hamper international trade. Note that the argument that exchange rate volatility hampers international trade is far from generally accepted. For example, it ignores the possibility to hedge currency fluctuations. Moreover, pegged exchange rate systems are not without risks, and may show considerable “latent variability,” see Question 2. Such devaluation risk also complicates international trade.

13. Describe two different currency systems that have been introduced in countries such as Hong Kong and Ecuador to improve the credibility of pegged exchange rate systems.

Answer: Hong Kong has a currency board system. A currency board is a monetary institution that issues base money (notes and coins, and required reserves of financial institutions) that is fully backed by a foreign reserve currency and fully convertible into the reserve currency at a fixed rate and on demand. Hence, the domestic currency monetary base is 100% backed by assets payable in the reserve currency. In practical terms, this requirement bars the currency board from extending credit to either the government or the banking sector. Ecuador instead has officially adopted the U.S. dollar as its currency. This is an example of (“Official”) dollarization, which occurs when a foreign currency has exclusive or predominant status as full legal tender in a particular country.

14. What is the difference between a target zone and a crawling peg?

Answer: In a target zone, the currency is allowed to fluctuate in a percentage band around a “central value.” One can view a pegged system as a target zone system with a very narrow band. In a crawling peg system, the fixed rate or band is adjusted over time, typically in a pre-determined way as a function of the inflation differential between the crawling peg country and the country to whose currency the peg is set. Such a system is often used in developing countries, where the “crawl” of the band prevents the country from losing too much competitiveness when its inflation rate is higher than that of the benchmark country.

15. How can central banks defend their currency—for example, if the currency is within a target zone or pegged at a particular value?

Answer: The monetary authorities in the countries with weaker currencies have three basic defense mechanisms available: interventions, interest rate increases, and capital controls. Interventions (see Questions 7 and 9) to support the local currency may result (when not sterilized) in a lower money supply, reduced liquidity in the money market, and therefore higher interest rates. Central banks can also directly raise the interest rates they control (typically, the rate at which banks can borrow from the central bank), both to make currency speculation more costly and to signal commitment to the central rate. Finally, the authorities can limit foreign exchange transactions through capital controls, which may include taxes on (or outright prohibition of) the purchases of most foreign securities by the country’s residents.

16. What was the EMS?

Answer: EMS stands for European Monetary System, a target zone system that operated in Europe between 1979 and 1999. Exchange rates were, for most of the time, maintained between bands of 2.25% around central rates. The countries participating in the EMS were a gradually increasing number of European Union countries.

17. What is a basket currency?

Answer: A basket of currencies is a composite currency consisting of various units of other currencies. Examples include the ECU (European Currency Unit) in the EMS and the SDR (Special Drawing Right) of the IMF.

18. What did the Maastricht Treaty try to accomplish?

Answer: The 1991 Maastricht Treaty mapped out the road to economic and monetary union within the European Union to be finalized by 1999. The Treaty called for eliminating all remaining restrictions on the movement of capital and payments between member states and between member states and third countries; the creation of a European central bank, and the introduction of a new currency, the euro, in 1999. The monetary union was indeed established (but not all EU countries participate).

19. What is an optimum currency area?

Answer: An optimum currency area is an area that balances the microeconomic benefits of perfect exchange rate certainty against the costs of macroeconomic adjustment problems. The area is therefore suitable for the introduction of a single currency and monetary union. Sharing a currency across a border enhances price transparency (that is, makes prices easier to understand and compare across countries), lowers transactions costs, removes exchange rate uncertainty for investors and firms, and enhances competition. The potential cost of a single currency is the loss of independent monetary policies for the participating countries. If countries experience adverse shocks, such as a sudden fall in demand for a country’s main export product or a sudden increase in the price of one of the main inputs for a country’s manufacturing sector, it can no longer stave off a recession or unemployment through monetary policy actions when it has a common currency. It also cannot devalue its currency to try to regain competitiveness.

20. Do you believe its monetary union will be beneficial for Europe?

Answer: The gains are already being realized throughout Europe—for example, car prices have decreased and converged across Europe. Academic research documents sizable economic benefits following the introduction of the euro in terms of price convergence, lower costs of capital, and increased trade. For example, the European Commission has estimated the microeconomic gains of monetary union to amount to 0.5% of GDP of the entire EU—a substantial sum. On the other hand, the sovereign debt crises in Greece, Ireland, and Portugal, and potentially in Spain, and the persistent high unemployment rates in these countries while Germany thrives suggest that asymmetric macroeconomic adjustment costs are present and are causing strain within Europe.

21. Do you think the euro will survive? The survival of the euro will depend on the political will of the strong countries to bail out the weaker countries. It is difficult to image that a weak country will abandon the euro and reissue its own money. This would surely be quite inflationary and could not be done without also adopting severe capital controls. A more likely scenario is that strong countries decide that they can no longer afford to bailout the weaker countries, which causes a crisis of confidence in the European banking system and a call for the reissuance of the Deutsche mark. Things would have to get very bad before the political process would lead to the breakdown of the euro.

problems

1. Toward the end of 1999, the central bank (Reserve Bank) in Zimbabwe stabilized the Zimbabwe dollar, the Zim for short, at Z$38/USD and privately instructed the banks to maintain that rate. In response, at the end of 1999, an illegal market developed wherein the Zim traded at Z$44/USD. Are you surprised at rumors that claim corporations in Zimbabwe were “hoarding” USD200 million? Explain.

Answer: The existence of an illegal exchange market indicates that the Zim is incorrectly valued at Z$38/USD. Clearly, the Zim is over-valued at the official rate (See Exhibit 5.10 for an example of such a situation). At this “artificial” exchange rate everybody wants to turn in Zim to the central bank, receive foreign currency and invest them abroad. To maintain the overvalued rate without losing all its international reserves, the government must control the use of foreign exchange (impose exchange controls). It likely forces exporters to convert their foreign exchange at the official rate, which is too low. Given this situation, hoarding foreign exchange is a rational response. Anyone who earns foreign exchange has an incentive to hold on to the foreign exchange until the Zim is valued correctly, i.e. after it is devalued. Moreover, given high inflation in Zimbabwe and a highly unstable political regime, U.S. dollars are a better store of value than Zimbabwe dollars. The situation in Zimbabwe subsequently deteriorated into hyperinflation, and the abandonment of the Zim.

2. In Chapter 3, we described how exchange rate risk could be hedged using forward contracts. In pegged or limited-flexibility exchange rate systems, countries imposing capital controls sometimes force their importers and exporters to hedge. First, assuming that forward contracts are to be used, and an exporter has future foreign currency receivables, what will the government force him to do? Second, how does this help the government in defending their exchange rate peg?

Answer: Exporters, who have foreign currency receivables, have an incentive to lag the foreign currency payments (e.g. by giving generous trade credit), if they think their domestic currency is under pressure and may be devalued. Doing so allows them to potentially profit from an impending devaluation of the local currency. Of course, extending trade credit involves an opportunity cost, but the interest rates reflect some probability that the peg will hold. Hence, if the currency is actually devalued, lagging the payment is beneficial ex-post. Lagging foreign currency payments causes further pressure on the local currency as the exporter’s demand for local currency is postponed. A forced hedge would require the exporter to sell the foreign currency forward for the local currency. Hence, there is immediate positive demand for the local currency. That the demand is in the forward market is inconsequential. Because of covered interest rate parity, if the forward rate decreases (in local currency per foreign currency) it would result in lower local interest rates. This is because the spot rate is fixed and the foreign interest rate is not likely affected. Hence, this relieves the speculative pressure.

3. In years past, Belgium, a participant of the former EMS, and South Africa operated a two-tier, or dual, exchange rate market. The two-tier market was abolished in March 1990 in Belgium and in March 1995 in South Africa. Import and export transactions were handled on the official market, and capital transactions were handled on the financial market, where the “financial” exchange rate was freely floating. Discuss why such a system may prevent speculators from profiting when betting on devaluation.

Answer: Speculators will try to profit by buying foreign exchange forward, deposit money in foreign accounts or buy foreign securities, hoping to repatriate capital after the devaluation happens. All these transactions imply selling local currencies in the foreign exchange market. With the double tier market, the “financial” exchange rate immediately reacts to the selling pressure and the local currency instantly depreciates so that the speculators cannot profit from their actions. Of course, exporters and importers can still engage in leading and lagging operations, and they massively did so.

4. The Kuna is the currency of Croatia. Find the web site of Croatia’s central bank, and determine the exchange rate system Croatia runs? Suppose the Kuna weakens substantially relative to the euro. Which action can the central bank take to keep its currency system functioning properly?

Answer: The web site of Croatia’s central bank, called the Croatian National Bank, is at http://www.hnb.hr/eindex.htm. Under the Tab entitled Exchange Rate List, there is another Tab entitled About the Exchange Rate. Here is what was written on June 2, 2011:

HOW IS THE KUNA EXCHANGE RATE SET? Croatia implements the exchange rate regime of managed floating, where the exchange rate of the domestic currency is not fixed against another foreign currency or basket of currencies, but is rather freely determined by the foreign exchange market. The exchange rate thus floats depending on the foreign exchange supply and demand on the foreign exchange market. However, the Croatian National Bank prevents too excessive exchange rate fluctuations by occasional market interventions in an attempt to maintain relative stability of the exchange rate.

Hence, if the currency weakens substantially, the central bank can intervene directly on the foreign exchange market. It may also increase the domestic interest rate.

5. Type “People’s Bank of China” into your favorite search engine and go to the English versions of the web site. Under “Statistics” find the Balance Sheet of the Monetary Authority. Calculate the growth rate of base money and the growth rate of international assets for the last few years. How much foreign exchange intervention is China doing? Are they sterilizing it?

Answer: The URL for the English version of the People’s Bank of China is http://www.pbc.gov.cn/publish/english/963/index.html where you will find a Tab entitled “The Balance Sheet of the Monetary Authority.” The base money supply corresponds to the row entitled Reserve Money, which is the sum of Currency and Deposits of Financial Corporations. During 2010, Reserve Money grew by 29.75% from 142,815.58 to 185,311.08 or by 42,491.50, where the units are 100 million yuan. The line labeled Foreign Assets grew by 14.59% from 188,021.75 to 215,419.60 or by 27,397.85, also in units of 100 million yuan. The fact that Reserve Money grew by more than Foreign Assets indicates that the foreign exchange intervention is likely not sterilized.