The Evaluation of the Foreign Currency Regimes Utilised by the Major Countries in the Asian Region - Term Paper Example

Dear , Please find attached the report you requested on exchange rate mechanisms. The report contains explanations of the various exchange rate mechanisms utilised throughout the world, as well as the specific mechanisms used by selected countries in the Asian region. Finally you will find an analysis of the various systems used. Contained in the report you will find specific details on the strengths and weaknesses of the different exchange rate regimes as well as an analysis of the policies a country is likely implement given their economic situation. You will find that the currency policy can have an effect on the stability of a country's economy. For any further queries regarding exchange rate mechanisms in general or for a specific country mentioned in the report feel free to contact me at .. Sincerely, Table of Contents Executive Summary Attached you will find the evaluation of the foreign currency regimes utilised by some of the major countries in the Asian region. Australia and Indonesia operate on a free floating regime, whereas Hong Kong is pegged at a fixed rate to the US dollar and China and Malaysia operate a managed float system. Their central banks have operations details in line with their government's monetary policy. A detailed analysis explains that each regime has strengths and weaknesses; however the pegged exchange rate system has the most drawbacks and the most potential for economic crisis. A free floating system allows a currency to be valued purely by the market however it relinquishes control of the central bank to the world market. A managed float allows for more control over the market and greater currency stability however it has some of the drawbacks of a pegged rate system. The appendices outline currency volatility given the type of exchange rate as well as the strengths and weaknesses of each type of currency regime. Name Date Exchange Rate Mechanisms 1. Introduction There are a variety of exchange rate mechanisms that a country can choose to use in order to value their currency. Each mechanism has its own strengths and weaknesses and each country creates an exchange rate policy that they feel will help to keep their currency stable. Since the currency crisis of 1997 in the Asia Pacific region, many countries in this region have revised their monetary policies away from a strictly pegged exchange rate system. Pegged exchange rate systems seek to tie the value of one countries currency (usually a less stable economy) to that of the currency of a country with a very stable economy. However it can be difficult for a country to maintain this peg in times of economic crisis. More countries are now moving towards floating or managed exchange rate systems. Floating exchange rate systems allow a currency's value to be determined by the market, in other words to float freely in relation to other traded currencies. A country that does not have a stable economy may be hesitant to use this method as their currency may be severely devalued in an open market. Managed float systems are a hybrid of a pegged and floating system. In a managed float a country lets its currency float in the market, but only allows it to float within an accepted range compared to other currencies. Outlined below are the exchange rate mechanisms and operations employed by several countries in the Asian region, as well as an analysis of the strengths and weaknesses of the different mechanisms utilised. 2. Country Specific Exchange Rate Regimes 2.1 Australia The Reserve Bank of Australia maintains a floating exchange rate policy. The goal of their policy is, "the stability of the currency of Australia, the maintenance of full employment in Australia, and the economic policy and welfare of the people of Australia (Reserve Bank of Australia 2006, para. 2). Overall the Australian government is concerned with keeping inflation rates low. The Reserve bank of Australia is the institution charged with maintaining the exchange rate policy. While they do not directly intervene in order to ensure the exchange rate stays at a certain level, there are things they can do that have an effect on the exchange rates in the market. The most common mechanism used is the interest rate level; a reserve bank's decision to move interest rates is seen as an indicator of the strength of an economy and can affect the amount of currency that will be in the market having an effect on demand and supply for currency in the open market (Moffet, Stonehill, Eiteman, 2006). In March the Economist Intelligence unit reported that, "The Australian currency was bolstered briefly by expectations of higher RBA rates." (Australia Finance Outlook: Economist Intelligence unit, para. 4) indicating that even a hint that interest rates may rise can cause rises in currency. Overall Australia has a stable currency in the market, not experiencing wide volatility and according to the Economist Intelligence Unit, "The Sydney stock market has remained one of the most dependable around the world (Australia Finance Outlook: Economist Intelligence unit, para. 4)." 2.2 China In July 2005 China changed its exchange rate policy from a pegged exchange rate to a managed float. They un-pegged their currency from the US dollar and have replaced it with a managed float against a basket of currencies. The currency will be allowed to float up to 0.3% from a point set against the US Dollar that will be reset daily. The system will be the same with other currencies but the Yuan will be allowed to float up to 1.5% from the other currencies (Economist Intelligence Unit 2005). Since then revaluation the Yuan has appreciated against the US Dollar. The goal of this change was to make the Yuan more stable in world markets. The Chinese central bank actively intervenes in order to keep the rate of the Yuan stable against other currencies. Whereas countries with a floating rate and hands off in the market, a managed float requires the central bank to constantly monitor their currency in order to ensure it maintains the desired value. Recently however the central bank has been allowing the currency to move within a wider band. According to the Economist, "China has made clear that it will allow more flexibility in its exchange rate. Since last summer, the Chinese authorities have carried out several reforms in the foreign-exchange market, introducing forward contracts and swaps, creating an independent market-making system among banks and giving firms more freedom to invest foreign exchange offshore. Indeed, bigger daily movements in the Yuan over the past few weeks suggest that the central bank is purposely creating volatility, to encourage firms to hedge their positions and so create a more liquid foreign-exchange market (Economist, para. 14)." While the central bank is currently very involved in the Yuan's valuation there will come a time when this policy will change. Bloomberg recently reported that, "China's government wants to move to a more freely traded currency system and everyone has to adjust,'' the central bank's Wu yesterday told reporters during a financial forum in Beijing (Soon, para. 19)." Eventually there may come a day when China allows it's currency to freely float in the market. 2.3 Hong Kong Hong Kong operates a pegged currency exchange rate system. Currently they have the value of the Hong Kong Dollar fixed at a rate of 7.75HKD to 1 USD (Hong Kong Monetary Authority, 2005). The Hong Kong Monetary Authority, HKMA, is responsible for maintaining these rates. They undertake specific operations to keep this rate pegged to the US Dollar. 1) They have agreements to purchase USD from licensed banks at 7.75HKD 2) They have agreements to sell USD to licensed banks at a rate varying between 7.80-7.85HKD, with a goal of this linked rate being 7.80HKD. 3) They may conduct market operations which promote the smooth functioning of their linked exchange system, that seek to correct any problems in the market. Hong Kong Monetary Authority, http://www.info.gov.hk/hkma/eng/press/2005/20050518e4_index.htm The Hong Kong government's monetary policy is committed to this exchange rate system as they feel it helps to keep their economy stable. The HKMA Website states that, "The Government has no plan or intention to change Hong Kong's Linked Exchange Rate System (HKMA, 2005)." Hong Kong is the only country discussed in this analysis that operates on a pegged exchange rate system. While there are some benefits to this system there are also some pitfalls as well which will be outlined later. 2.4 Malaysia The Malaysian Ringgit has recently become a managed float after removing its peg to the US Dollar in July 2005. It will now be trade-weighted to a basked of currencies (Economist Intelligence Unit 2005). Malaysia made this move the same day that China un-pegged their currency, since then the ringgit has appreciated (Arnold 2005). Malaysia uses a currency basket that is made up of its' major trading partners, most of which are in the Asian region. The central bank feels that this will help to keep their currency stable in the world market. This requires constant monitoring by the bank to ensure that the currency maintains its' value. The system employed is similar to that of China where a currency board at the central bank monitors the rate. 2.5 Indonesia Indonesia has had 3 different exchange rate policies over the course of the last 30 years. From 1970-1978 they operated on a fixed exchange rate policy, then switched over to a managed float in 1978 and finally since 1999 have been operating on a free floating exchange rate system (Bank Indonesia, 2006). Since they have implemented a free floating system the value of the Rupiah is determined by the market. In other words Bank Indonesia, Indonesia's central bank does not directly interfere with the exchange rate on a normal basis. However according to Indonesia's monetary policy they may intervene in the case of an irregular fluctuation of their exchange rate. 3. Exchange Rate Regime Analysis 3.1 Free Floating Exchange rate regimes Floating exchange rate regimes rely purely on demand and supply to determine the value of a currency. Therefore it is beneficial for countries with stable economies, i.e. countries that would experience high demand for their currency to use a free floating exchange system in order to have their currency get its maximum value in the world market. However there are strengths and weaknesses associated with using this kind of exchange rate system. The main strengths associated with this system are that a country is not necessarily affected by the problems of other countries; examples include unemployment and inflation (Madura 2006, 176-177). Additionally a central bank is not required to constantly monitor exchange rates given normal economic conditions. If a central bank has to maintain rates, according to Madura (2006, 177), "they could be forced to implement intervention policy that may have an unfavourable effect on the economy just to maintain exchange rates." A major drawback of the free floating system is a lack of control over the value of a country's currency. Instead of a value being known by a central bank they will have to rely on the market and the available information in the market to determine the "right" value for their currency. Additionally in times of economic crisis there is nothing to stop a currency from drastically being devalued in the market. Generally the free floating system is used by stable economies that can be relatively sure of how their currency will consistently perform in the market. 3.2 Managed Float Regimes In a managed float a country wants to ensure that their currency maintains its value in relation to certain other currencies. While not a purely pegged rate to another currency, it is a type of peg, wherein a pre-determined value is maintained within a range set by the central bank. We saw examples of two countries with a managed float Malaysia and China. Both of these countries have decided to maintain a certain level in relation to a basket of other currencies. This method is a bit of a hybrid of a peg and a free floating system. While it seeks to take the best of both systems there are also disadvantages associated with using this kind of system. Having a managed float allows a country to easier manipulate their currency values for their gain, whereas in a free floating market this would not be possible. A managed float allows for a level of control with not as much risk as a purely pegged system. In the case of China they have recently been letting the Yuan lose its value against the currency basket in order to benefit Chinese exporters (Soon, 2006). If a country in a managed float allows their currency to appreciate then it can risk local companies losing ground to imports which will be closer in price to local goods. The two main advantages of this system are maximisation of control and relative currency stability with limited downside risk. However some problems associated with a managed float is still that it is expensive to maintain and requires a very hands on approach by a central bank to maintain properly. It remains to be seen what the long tern effects of a managed float will have on the economies of China and Malaysia. So far the managed float has worked well for both but this is also given booming economic conditions in both countries. 3.3 Pegged Exchange Rate Regimes In a pegged system a country sets a certain value on their currency and actively maintains that level by intervening in the market. This has been a popular system used by developing countries. An advantage of the peg is that it allows a country to maintain currency stability which may not occur in a free floating system. By using a peg a country can be sure that its currency will not devalue in the terms of other currencies. Depreciation of a currency can lead to imported products being extremely expensive, and could also lead to liquidity problems for local banks and businesses. According to the IMF, a country may maintain a peg if it is not open to international cash flows, i.e. international investments. In reality though there are very few countries not subject to international cash flows. It is expensive to maintain a currency peg and in times of economic crisis this may become nearly impossible for a central bank leading to total econonomic collapse. There have been several currency crises that have arisen when countries were not able to maintain their currency's value. Probably the most spectacular being the Asian Currency Crisis in 1997 which devastated the region and had far reaching effects. According to the International Monetary fund, "Each of the major international capital market-related crises since 1994-Mexico, in 1994, Thailand, Indonesia and Korea in 1997, Russia and Brazil in 1998, and Argentina and Turkey in 2000-has in some way involved a fixed or pegged exchange rate regime (2001)." In a world where we are becoming increasingly globalised and investment across borders is increasingly common a country would be hard pressed to maintain a pegged rate in the case of an economic crisis. This would lead to large amounts of money being pulled out of the country and an inability to maintain a pegged rate. In other words in the world we live in to day a country could be setting itself up for disaster by using a pegged exchange rate regime. 4. Conclusion Analysing the 3 types of currency systems used by the selected countries it is hard to say which is best. Clearly each country feels that their monetary policy is a good one for them. In reviewing the strengths and weaknesses of each system it becomes apparent that there are many problems with a pegged exchange rate system. Many currency crises have been brought on by the use of such a system. A managed float system gets the best of both worlds where a central bank maintains control over how the rates move, yet allows them a margin for volatility. However this allows a false sense of the "real" value of a currency since it is not allowing the true value to be determined by the world market. A free floating exchange system allows all available information to be used to determine the value of one country's currency in relation to another. While this gets us closest to the true value of a country's currency it may not be right for all countries as it could pose lots of problems for a developing economy. Ultimately a country's government has to weigh all their options and decide which system will help them to maintain currency stability and foster economic growth. 5. Appendices 5.1 Australia Currency Volatility, May 2005-April 2006-Free Float 5.2 Chinese Yuan Currency Volatility, May 2005-April 2006-Managed Float 5.3 Hong Kong Dollar Currency Volatility, May 2005-April 2006- Pegged 5.4 Malaysian Ringgit Currency Volatility, May 2005-April 2006 5.5 Indonesian Rupiah Currency Volatility, May 2005-April 2006 5.6 Summary of Strengths and Weaknesses: Floating Exchange Regimes Strengths Valued by supply and demand True value of the currency determined by the market Makes a country less susceptible to currency crisis Weaknesses Central bank has little to no control on currency value Can cause currency to be unstable depending on economic strength 5.7 Summary of Strengths and Weaknesses: Managed Float Regimes Strengths Allows for currency stability Allows central bank a high degree of control Weaknesses Expensive to maintain Can be fairly risky, as a set rate must be maintained 5.8 Summary of Strength and Weaknesses: Pegged Exchange Rate Regimes Strengths Allows for currency stability Allows central bank a high degree of control Weaknesses Expensive to maintain Could be impossible to maintain in economic crisis Can lead to economic disaster if currency value is not able to be maintained in the market. 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