The Role of Valuation of a Nations Currency to Another - Term Paper Example

In a time when globalization is already a common practice it is but inevitable to discuss the role of valuation of a nation's currency to another. Tomaintain a harmonious and transparent relationship between trading countries, there should be a mathematical basis for currency exchange. The basis for valuing one's currency against another is the primary role of every country's central bank. Central banks of different countries all over the world choose and implement its own exchange rate regime, the way by which "a country manages its currency with respect to foreign currencies and the foreign exchange rate (Exchange rate regime)." The International Monetary Fund (IMF) has enumerated several de facto (observed behavior of the exchange rate) classification of exchange rate regimes used in different countries: 1. Exchange arrangements with no separate legal tender - These are countries that belong to a currency union where there is a common legal tender that are used by all the members. An example of this is the Eurodollar of the European Union. 2. Currency board arrangements - a kind of exchange rate regime implemented by the government based on an explicit legislative commitment in exchanging its local currency for a specific foreign currency with corresponding restrictions that ensures the compliance of its legal obligation. 3. Conventional fixed peg arrangements - a country's exchange rate regime that pegs its currency within margins of less that 1 percent as compared with another currency; a cooperative arrangement; or a basket of currencies, "where the basket is formed from the currencies of major trading or financial partners and weights reflect the geographical distribution of trade, services, or capital flows." 4. Pegged exchange rates within horizontal bands - The currency's value "is maintained within certain margins of fluctuation of more than 1 percent around a fixed central rate or the margin between the maximum and minimum value of the exchange rate exceeds 2 percent." 5. Crawling pegs - the currency is subjected to periodic adjustments in small amounts at a fixed rate or in response to changes in selected and specific quantitative indicators, like previous inflation differentials in comparison with major trading partners or differentials between the inflation target and anticipated inflation in major trading partners. 6. Exchange rates within crawling bands - The currency is maintained within certain fluctuation margins of at least 1 percent around a central rate-or the margin between the maximum and minimum value of the exchange rate exceeds 2 percent-and the central rate or margins are adjusted periodically at a fixed rate or in response to changes in selective quantitative indicators. 7. Managed floating with no predetermined path for the exchange rate - influence of the monetary authority to the exchange rate is done herein without having a specific exchange rate path or target. 8. Independently floating - Under this the market is the one that determines the exchange rate. The central bank intervenes in the foreign exchange market with the aim to moderate the rate of change and to prevent "undue fluctuations in the exchange rate," rather than imposing a level for it (De Facto Classification of Exchange Rate Regimes and Monetary Policy Framework). It is the responsibility of a nation's central bank to choose the appropriate exchange rate regime for its own country. Economic managers, particularly central bank heads, in a country use this as a tool to maintain economic stability. The importance of having the appropriate and fitting exchange rate regime for a specific country is to protect the country from its susceptibility to create economic problems because of its monetary authority's power. Each type of exchange-rate regimes manifests diverse characteristics and produces different results. Reclassifying the existing de facto exchange rate regimes enumerated above will result into the fusion of the eight regimes into three: floating, fixed and pegged exchange rate. For Hanke (1998, p.1-2), floating and fixed rates "are members of the same family" since both are free-market mechanisms for international payments. In an economy implementing floating rate regime, monetary policy is being set by monetary authorities, but without having an exchange-rate policy. Under this system, the exchange rate is allowed to fluctuate, as backed-up by existing monetary policy. On the other hand, under a fixed rate regime, it is the exchange rate that is being set up and not the monetary policy. It is the balance of payments that determines the monetary base under this regime. In this structure, the nation's official net foreign reserves increases and decreases proportionally to its monetary base. The possibility of conflicts between exchange rate and monetary policies is reduced with these free-market exchange rate regimes. Also, as consequence, crises in balance of payment cannot take effect. Under these two regimes, financial flows automatically rebalance because of the market forces involved and with this, balance of payments crises are averted. Pegged rates, on the other hand, require a robust monetary authority that will manage both the exchange rate and monetary policy. Domestic and foreign components comprise the economic monetary base. This feature of pegged exchange rates ensues conflicts between exchange rate and monetary policies. Before the Currency Crisis of 1990's, most economies in the Asian region implement the pegged exchange rate. It showed its weakness when currencies, particularly in Asian countries were overvalued and undervalued, causing exchange rates all over the world to affect the economic stability of nations worldwide. In terms of application it is advisable to impose fixed exchange rate in developing countries because of their weak monetary authorities and monetary instability background. One likely reason is that fixed exchange rate has the reputation of having a clear and well-defined policy (Dehejia, V.H., p.2). The Polish exchange rate regime history can be divided into 3 phases. The first phase of the transformation is characterized by the typical hyperinflation episode. The monetary authorities aimed to stabilize the economy by imposing a stabilization program. One of the program's components is the implementation of fixed exchange rate. It serves as the nominal anchor. The second phase started in 1991. This time the crawling peg exchange rate was taken effect. Inflation coupled with a fixed rate exchange rate provided great pressure on local producers. With still a minimal level of international reserves the country, Poland decided to shift its fixed rate to a crawling peg. The execution of liberalization of capital flows and a major transition in economic performance has initiated the smooth transition form crawling peg to full floating. Current account surplus and privatization of inflow of capital pushed the Polish government to alter its exchange rate regime to full floating (Kokoszczyski, p.1-2). In the case of Russia before the primary feature of the currency policy in the first half of 1998 was the imposition of pegged exchange rate regime. The notable surplus in Russia's balance of trade and huge foreign portfolio investments became the deciding factors. At some point, the capital inflow put considerable upward pressure on the rate of the rouble and enabled the Bank of Russia to increase its foreign exchange reserves significantly. The suppression of inflation was the important feat that the financial stabilization policy that the Russian economic managers did. Nevertheless when budget expenditures continued to exceed revenues, the government's use of non-inflationary sources to offset the budget deficit ushered the notable growth in government debt. Coinciding with this, the crisis that had spread in East Asian financial markets forced numerous foreign investors to review their investment strategy regarding transitional economies and emerging markets. This, joined with the diminishment of Russian key exports, results into reduction of Russia's balance of trade surplus. This paved the way to financial instability in Russian financial markets. This led made the rouble's value to fall. The Bank of Russia intervened by performing maintaining the value of the rouble within the level of 6.10-6.30 roubles to a dollar. The Bank of Russia had to abandon the announcement of daily buy and sell rates in the interbank foreign exchange market and reconsideration of midterm targets of the changes in exchange rate. This exchange rate policy failed as, despite the Bank of Russia's efforts to limit the rouble to a certain bandwith, the dollar still rose quickly. This led Bank of Russia to convert their currency rate policy to a floating exchange rate regime (The Central Bank of the Russian Federation). One apparent resemblance of the Polish and Russian treatment towards their exchange rate policies is the transition of their exchange rate regimes from crawling peg to floating exchange rate after the Asian Currency Crisis. They both realized the importance of respecting the market forces that made the rise and fall of their currency. Also they concluded that any direct intervention in their currency rate will worsen the situation of their currency. The difference between the two is the methods that the central governments of the two nations used in curbing the increase of the inflation rate in their attempt to stabilize their economies. The Polish government imposed the fixed exchange rate regime in minimizing the hyperinflation that they experienced. Bank of Russia, on the other hand, turned to pegged. In the case of the United States, according to Hanke (International Economic and Exchange Rate Policy Hearings, May 1, 2002), the US government embraces the floating regime because of its adherence to free capital mobility. Before the 1973 transition, the International Monetary Fund, under the Bretton Woods agreement, was established with the aim of supporting fixed exchange rate via a "gold-exchange" standard, and lay the foundation of GATT. Under the Bretton Woods System, the world's major currencies were pegged to the US dollar. Also the system also, more or less, fixed the US dollar to 1 ounce of gold per 35 US dollars. The currency crisis in 1973 collapsed the Bretton Woods system. This turned the world's major currencies: US dollar, the Deutsch mark and Japanese yen to "float freely against one another. This move, together with the huge increase in world price of oil as imposed by OPEC countries, had altered the US exchange rate regime into a floating rate regime (Dean, J.W. p.3-4). Until July 21, 2005, The People's Republic of China, for more than ten years has managed to fix its exchange rate of 8.28 renmenbi to a US dollar. The People's Bank of China had to find ways in intervening in the foreign exchange market. What it usually did under this system is to sell yuan (renmenbi) in exchange for a dollar denominated assets when demand for the yuan increases. Conversely, it buys yuan with dollar denominated assets when demand for it decreases. In recent years the Chinese central bank did the intervention greatly to a point that the Chinese government's foreign reserves had risen from $153 billion to $360 billion. This fixed exchange rate policy of the Chinese government has been recently altered to a new regime on July 21, 2005. The People's Bank of China (PBOC) declared the revaluation of the currency from 8.21 to 8.11 renmenbi to a dollar. According to PBOC, this reform will include a "reference basket" of currencies that will be used as basis in picking up the target for the renmenbi. This is aimed to improve the socialist market economic system that will enable "the market to fully play its role" in allocating resources and to introduce and "further strengthen" the managed floating exchange regime with the supply and demand of the market as its basis. Under this system, PBOC will declare its target for the following working day based from the current renmenbi closing price in terms of a "central parity," This means that the PBOC has the option to allow the renmenbi to fluctuate within a certain band or not depending on the performance of its "reference basket"(Spiegel, 2005). Because of the active free capital flow trading in the international economy brought about by the oil price crisis of 1973 and the ensuing floating of the US dollar and other major currencies, the economies around the world has been pressured to let their exchange rate regimes like that of the United States. Even the formerly socialist and conservative economy like China was not spared from this global movement. From using the fixed rate regime, China realized the importance of riding with the flow with the rest of the world to improve its competitiveness. This also shows the subservience of the economies around the world to the existing market forces. Even the most powerful and the richest country, the United States, is not spared from this economic reality. The Bretton Woods tried to control the US dollar's fluctuations and fine-tune the economies of the world by having the gold standard as its basis. However, market forces persisted and, as a result, the dollar gave way to the market's power. Works Cited A look at China's New Exchange Rate Regime. FRBSF Economic Letter, 2005-23, 09 Sept. 2005. Federal Reserve Bank of San Francisco. 29 Oct. 2006. Corbo, V. Exchange Rate Regimes in the Americas: Is Dollarization the Solution Monetary and Economic Studies (Special Edition). Dec. 2002 Dean, J. W. Exchange Rate Regimes for the 21st Century: Asia, Europe and the Americas., presented in the W. Irwin Gillespie Seminar Room. Department of Economics, Carleton University, in a seminar cosponsored by the Department of Economics and the Carleton Applied Economics Research Unit (CAERU). Ottawa, October 2, 2003 "Exchange Rate Regime" Wikipedia, 28 Oct. 2006. Hanke, S. H. Financial Meltdown and Exchange-Rate Regimes. Prepared for the Cato Institute's 16th Annual Monetary Conference cosponsored with The Economist: Washington, D.C., 22 Oct.1998. Hanke, S. H. On International Economic and Exchange Rate Policy Hearings. 01 May 2002. Statement before the Banking, Housing and Urban Affairs Committee, United States Senate. 29 Oct. 2006 Kokoszczyski, Ryszard. From Fixed to Floating: Other Country Experiences: The Case of Poland Paper to be presented at the IMF seminar "Exchange Rate Regimes: Hard Peg or Free Floating", Washington, DC, March 19-20, 2001. Taylor, J.B. China's Exchange Rate Regime and Its Effects on the U.S. Economy. Testimony before the Subcommittee on Domestic and International Monetary Policy, Trade, and Technology House Committee on Financial Services, 1 Oct. 2003. U.S. Treasury Department. 29 Oct. 2006. The Central Bank of the Russian Federation. The Objectives, Tasks and Instruments of the Exchange Rate Policy. 25 Feb. 1999. 29. Oct. 2006. Read More