Exchange Rate System - Assignment Example

Finance and Accounting Table of Contents Question 3 Question 2 4 Question 3 5 Question 4 6 Question 5 7 Reference List 9 Question The vulnerability towards the crisis becomes an important determinant that might drive policymakers towards choosing a specific exchange rate system. The financial crisis in the earlier times, more specifically during the 1990s was exposed towards being susceptible to different kinds of exchange rate regimes crisis. Such crisis was associated with the large volumes in capital flows under the strong forces of a globalised world. With increased mobility of the capital, most of the regimes that came in the intermediate times were considered to be prone towards the crisis. Exchange rates that are pegged have been considered to be vulnerable to speculative flows of capital within nations. The government and the banking system determine the flow of foreign currencies. However, conventional wisdom states that countries which operate on a currency system of fixed exchange rate is less prone to the crisis primarily because of the features of stabilisation from the viewpoint of defending the exchange rates. Figure 1: Speculative attacks on currency and position of the central bank (Source: Feenstra and Taylor, 2014) Attention has also been drawn towards the recent cases of speculative attacks of currency boards of Hong Kong and Argentina (Feenstra and Taylor, 2014). This task of defending the exchange rate has been extremely expensive for those facing situations of recession and unemployment. Such currency boards turn out to be more effective in defending the exchange rates. While discussing about the flexible exchange rate system and its vulnerability to the exchange rate crisis, the free floating exchange rate system appears to be strongly established ad providing very little or no room for attack of any crisis situation caused by speculative attacks on the money. Hence, one can state that the free floating system of exchange rate is less vulnerable to crisis situations. Under the system of managed floating exchange rates, the advantage of lack of any formal commitment towards pegging the exchange rates allows the nation to remain invulnerable to crisis situations. A peg that comes about unannounced can be easily adjusted with the pressures experienced from the market while a minor crisis can be managed by pegging adjustments. Under the drawling bands system of exchange rate management, the intermediate situation of the exchange rates makes them vulnerable to the crisis situations. Examples to this situation have been Mexico, Russia and Indonesia. Even in situations where the crawling band manages to pull a nation out of crisis, the contagions might be held responsible for making them vulnerable. Question 2 The fixed exchange rate system is seen as a transparent system for monetary policy. This fixed exchange rate regime has the advantage where it saves on huge amounts of transactions costs by maintaining a stable level of exchange rates. Countries which have a weak financial image can keep their currencies anchored to a credible banking system and thereby gain some monetary credibility. However, contrary to the traditional view that allows advantage of reduction in exchange rate risk by undertaking fixed exchange rates, present times state that such economies do not have the required financial tools that might help them with hedging currency risks in the long term. There exists some price that is paid by governments for the maintenance of fixed exchange rates. Here, the common element for all kinds of foreign exchange rate regimes that are fixed or pegged is that they need to maintain this fixed rate. Such maintenance of fixed rates of exchange needs a huge amount of reserves because the central bank is constantly selling or buying the local currency. The example of fixed exchange rate system can be taken from the situation of China. Chinese foreign exchange reserves kept on rising and within 2 years, it was much above the Japan reserves of foreign exchange. China was forced to convert to the flexible exchange rate regime because the rise in reserves had increased money supply in the economy which could be the potential cause for high levels of inflation in China. Price rise can create havoc in such economies and the Chinese CPI or the consumer price index had gone up to 5% (Feenstra and Taylor, 2014). On the flip side, in the event of limited reserves, pegging system of managing fixed exchange rates might render a nation’s currency vulnerable to extreme devaluation. The Thai experience in 1997 when the government was unable to manage fixed exchange rate of the Thai baht owing to limited reserves, is an example of the costs that a nation has to bear under the system. Figure 2: Country facing excessive reserve situation: The case of China (Source: Feenstra and Taylor, 2014) Flexible exchange rates allow a nation to maintain an independent monetary policy without running into pressures for managing anchors of the currency. Experience suggests that flexible exchange rate systems have higher resilience in facing shocks that are external in nature and are also more capable of distributing the adjustment burden between the domestic economy and the external sector. Question 3 Depreciation of a currency is responsible for the rise in export demand of a nation where the flexible exchange rate regime is in practice. Here, when the value of a currency goes down, people find it cheaper to import goods from this nation due to the fall in its currency value. Additionally, foreign countries feel that they can now buy more of the good produced in such a country at cheaper prices than before. Hence the import demand for the country goes down along with the export demand rise. This is true in case of the flexible exchange rate system which faces the market demand for currency. The other group which is the adopters of fixed exchange rate system faces higher political costs because it becomes difficult for advanced countries to exit from the pegged exchange rate system and the peg shall allow for a system of exchange rates which creates way for depreciation and high favours for growth performance. The example of the Black Wednesday can be taken in this regard where the collapse of the peg destroyed the reputation of the politician and the credibility among the policy makers. In such cases, trust can be regained with difficulty. It has been identified above that fixed exchange systems have higher economic costs because the country has to constantly adjust its reserves to keep the domestic currency pegged with the central bank. Higher reserves have the potential to increase inflation while lower reserves might cause currency devaluations. Hence when it becomes difficult to identify and quantify such devaluations, political costs are implied. These political costs come in the form of reserve losses and rise in external debt of the government when the country’s banking system and the government try to maintain secrecy about their positions of international reserves and their foreign exchange operations. It is only in the event that the limit for external reserves has been reached that costs and banking crisis emerge that a country moves toward an exchange rate crisis (Rajapatirana and Seerattan, 2000). Question 4 Developing countries choose exchange rate regimes that are completely different from that adopted by developed countries. Developing countries have been observed to be often affected by the absence of credibility and also have limited levels of access to the international markets. Additionally developing countries have a highly pronounced affect on the trade volatility experienced within the exchange rates along with high liability of dollarization and a very prominent impact of exchange rate fluctuations over the domestic inflation rate of the nation. These features render it unsuitable for developing nations to adopt a system of flexible exchange rates. Hence it has been argued that developing countries resist exchange rate movements that are quite significant (Feenstra and Taylor, 2014). A country is to transfer itself to a flexible exchange rate policy only when the country experiences needs a successful indicates four basic characteristics traits. 1. The country has a deep and well integrated and liquid market of foreign exchange. 2. It has a coherent policy for governing the central bank i8nterventions with reference to foreign exchange markets. This refers to the practice of buying and selling of the domestic currency which has an influence over the exchange rate and the price. 3. The country has an appropriate anchor for the replacement of the fixed exchange rate system 4. The country has also got to formulate a managing and reviewing committee for the higher exposure to exchange rate risks for both the private as well as the public sectors. The foreign exchange market in a developing nation is largely shallow and highly inefficient. This is more so because of high level of control regulations in their foreign exchange transactions. The interbank foreign exchange markets are also small and limited in their scope. It can also be said that rigidity of exchange rates might itself contribute towards the illiquidity in developing nation’s foreign exchange markets. Hence fixed exchange rate systems are more suited to developing nations while developed countries are more likely to have flexible exchange rate regime (Duttagupta, Fernandez and Karacadag, 2005). Question 5 Twin crisis is a term that came into being during the crisis that came about in the 1980 and the 1990 and it included a huge collapse of banking system and an immense devaluation of currencies. Here, the relation between the currency crisis and the banking crisis was establish that either of the crisis can be the cause of the other one. The twin crisis primarily relies on the phenomenon where emerging nations experience a twin phenomenon. 1. Fixed exchange rate governments experience a vulnerability to speculative attacks 2. Domestic banks of emerging nations experience a mismatch between domestic assets and foreign liabilities and hence get exposed to risks of exchange rate fluctuations (Royal Economic Society, 2012). This can have a twofold effect which is labelled as the twin crisis. 1. Attacks on the currency yield depreciation that might reduce the value of investment in banks and thereby the worth of their liabilities. Foreign creditors in turn have an expectation that these banks shall have lesser resources in future to pay for their future obligations and therefore pull out their funds. This is known as the run on banks. 2. Following the run, the amount of foreign reserves held by the government in this nation reduces. The government costs of currency defuse rises and in such events, most governments abandon the fixed exchange rate regimes that run in these nations. In such twin affects one crisis type becomes the cause of the other. This brings in a vicious cycle of the two types of crisis which contribute towards destabilising the economy. This report proves that twin crisis are more likely to occur in developing nations which work under the fixed exchange rate regime and are yet to be liberalised than in industrial nations. The triple crisis situation comes when in addition to the twin crisis; the government also defaults on its debt obligations. The issue of triple crisis was faced in Argentina in 2001. Such a situation again occurs where the currency is managed by the government. The government of Argentina was forced to give up the currency board regime which led to a huge devaluation of the local currency peso. Hence developing nations who run under the fixed exchange rate regime are the one worst hit by twin or triple crisis (Contessi and El-Ghazaly, 2011). Reference List Contessi, S. and El-Ghazaly, H. S., 2011. Banking Crises around the World: Different Governments, Different Responses. [online] Available at: [Accessed 11 August 2014]. Duttagupta, R., Fernandez, G. and Karacadag, C., 2005. Moving to a Flexible Exchange Rate How, When, and How Fast? International Monetary Fund. December. Feenstra, R. C. and Taylor, A. M., 2014. International Economics. New York: Worth Publishers. Rajapatirana, S. and Seerattan, D., 2000.Exchange Rate Regimes and Economic Performance in the Carribean. Paper presented at the Annual Review Seminar, Central bank of Barbados, July. Royal Economic Society, 2012. Explaining Twin Financial Crisis. [online] Available at: [Accessed 11 August 2014]. Read More