Fixed Foreign Exchange Rate Regime
There are two major types of foreign exchange regimes: fixed exchange rate policy and floating. As its literal meaning on appearance, a fixed exchange rate is a regime in which a country’s currency exchange rate is tied to the currency of another country or the price of gold. A floating exchange rate policy, instead, gives the currency a much wider range to float without predominant regulatory control. The price of a particular currency in this scenario is almost purely driven by the relative supply and demand of the currency in the foreign exchange market. We will define the exchange rate in our discussion as the rate at which a domestic currency can be converted to one unit of U.S. Dollar, the value of which is assumed unchanged, we will now proceed with our discussion of the fixed-rate system. (1)(2)
The general purpose of implementing a fixed foreign exchange rate policy is to keep a currency’s value within a narrow range, namely more stable and controlled. By pegging its own currency value with a major currency like dollar, a country is able to provide greater certainty for both exporters and importers, ensuring efficiency and effectiveness. The associated costs will reasonably become lower, encouraging trades and boosting a country’s overall competency as a trading partner. In addition to this general effect, a fixed exchange rate policy will also expand an exporter’s price advantage when the exchange rate lags behind the currency’s true value, nominally higher on presence. Allowing central banks’ intervention to happen, a fixed system decides that the rates will have slower reaction to or, in order words, be a less accurate representation of the real currency value. Despite the fact that the extent of such price discrepancy may not be huge, its existence will still grant the exporters a temporary price advantage, as their goods become cheaper in comparison. (1)(3)
Consequently, fixed-rate regime are widely adopted among developing countries, due to the massive role international trade and exports play in their economies. By employing comparative advantage in labor, these countries usually focus on achieving mass production in low-end manufacturing industries, selling their low-cost products to wealthier economies, and receiving a great amount of foreign reserve in return. (1)(3)
Other than its benefit on trade, fixed-rate regime also suppresses inflation. Instead of arguing a causal relationship between the two elements, positive correlation is a more accurate interpretation. The key bridge that connects the two is interest rate, along with other monetary policies. While a lower interest rate generates more inflation, it also presses down return on domestic assets, making them less attractive to foreign investment. Consequently, the supply of the country’s currency will become comparatively larger than its demand, fueling up the exchange rate. Therefore, when a country, who applies a fixed-rate system, faces a surging exchange rate moving out of the dedicated radius, implementation of policies that enlarge demand or diminish supply, such as raising interest rates and bank reserve requirements, are going to tighten inflation subsequently. Put differently, since exchange rates represent the real value of a currency and the fixed-rate regime constricts the fluctuation of rate, the system is essentially restricting the movement of currency value. Any regulatory modulation that aims to achieve the restrictive effect on exchange rate, will also limit the currency value foundation from which other indicators, like inflation, are derived. (1)(4)
The helpful pressure a fixed-rate system has on inflation is another reason for its popularity among developing countries due to their relatively frequent encounter with inflation that is more drastic than the one faced by developed countries as they are undergoing the fast stage of economic expansion. Developing economies favor a fixed-rate system to protect the vulnerable economy against speculation and keep foreign direct investment conservative. The latter, namely speculation, will be largely limited under a fixed-rate system because the decided range of fluctuation, which the government dedicates to, will be the theoretical maximum for speculation, without further consideration of special scenarios such as an organized, large-scale speculative attack. (1)(4)
Despite of all the benefits mentioned above, a fixed-rate system limits a central bank's latitude of interest rate adjustment, an essential practice for meeting the need of economic growth. The only exception to this claim will be a circumstance where free flow of foreign capital is prohibited. This limitation has been simulated by Mundell-Fleming Trilemma Model, first proposed by Robert Mundell and Marcus Fleming. As argued by the trilemma, an economy can only choose two out of the three options at the same time, which are free flow of foreign capital, a fixed exchange rate system, and independent monetary policy. It will not be possible to implement all three policies concurrently. (1)(5)(6)(7)(8)(9)
For example, when foreign capital is attracted to an economy where the interest rate is higher, conversion from foreign currency to the domestic currency will increase accordingly, building up demand for the domestic currency and making it more expensive. A higher price tag will then be attached to the currency, namely a lower foreign exchange rate. Thus, the regulator will be left no choice but to lower its interest rate in order to stabilize its currency price, which is not necessarily helpful to the economy with ramifications such as its inflaming effect on inflation. An alternative to offset the effect of such huge foreign capital inflow is to print more of an economy’s own currency and sell them in the exchange market but this procedure leads to an almost identical, or even more harmful result. On the contrary, when an economy needs stimulation from a relatively low interest rate, it will find itself having a hard time with its fixed-rate system if it is not willing to sacrifice foreign investment. (5)(6)(7)(8)(9)
Even though a fixed-rate regime protects a developing economy against speculation as mentioned above, it will require a large pool of foreign reserve to support such protective endeavors. Furthermore, the “fixed” nature of the system is a double-edged sword. While it does function effectively when facing small speculation attempts, it will accumulate huge potential energy, like a dam, when defending against a prodigious speculation because the regime is designed to hold, not to release. The system prevents the market from adjusting freely when a currency becomes over- or undervalued, absorbing all market turbulence mainly by buying or selling domestic currency. (1)(10)
Let’s take Contagion as an example. The dam broke at the point when Thailand ran out of its foreign reserve to purchase back the overselling Baht in the market. A huge flood of financial crisis subsequently swamped the Thai economy, marked by a 120% plummet of Baht during a six-months period from June 1997 to January 1998. Given that a floating-rate system may not be effective when facing small-scale and regular speculations, it will provide no more than a minute chance for a huge financial disaster of this kind to happen as the market adjusts the price automatically when there is disproportional buying or selling. Taking such an immense hit, Thailand still hasn’t fully recovered after more than twenty years. It is said that fifty-years’ accumulation of wealth was plundered from the country. The painful history of Thailand should caution all developing countries using the fixed exchange rate regime. (1)(10)(11)
Work Cited
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