Exchange Rate Regime Tendency and Regulations - Essay Example

management al Affiliation) Key words: exchange rate, markets, spot, futures DECLARATION This research study is my original work and has not been presented to any other institution or examination body. No part of this research should be produced without my consent or that of my institution. .................................................... .......................................... Signature Date INTRODUCTION Capital markets involve the transfer of funds from companies or governments with a surplus in their reserves to companies or governments with a shortage of these funds. These markets can either be local or international; primary or secondary; and spot or futures (Liaw, 2004). Local capital markets explore the financial, cultural, regional, and foreign-investment variables. These variables affect conditions in local capital market within emerging markets. It is the obligation of these markets to identify the links between emerging markets and the global markets. They, therefore, deepen local markets in emerging market countries. An international capital market includes all transactions with an international dimension (Woepking, 2007). It represents a number of closely integrated markets. The foreign exchange market is forms the major component of the international capital market. The world’s major financial centers are; Singapore, London, Hong Kong, New York, and Paris. New securities are issued in primary markets while a majority of capital transactions take place in secondary capital markets (Árvai, & Heenan, 2008). The spot market involves the sale of goods for cash and their delivery done immediately (Cuthbertson, & Nitzsche, 2001). A futures market involves transactions of goods and their delivery completed on a specified future date (Kline, 2000). Theory offers numerous insights to the possibility of linkages between the exchange rate regime and macroeconomic performance. A country’s exchange rate regime is classified as either “fixed” or “floating.” A country that operates a fixed (pegged) exchange rate regime has its exchange rate tied to another country’s currency. This regime is set by the government or central bank of such a country so as to maintain its currency’s value within a narrow band. A floating exchange rate regime is concerned with the demand and supply for a country’s currency relative to other currencies. In such a case, a country’s exchange rate regime is set by the foreign-exchange market (Adams, 2006). Exchange rate regimes have unique characteristics. These characteristics are accompanied by various principle issues. The different characteristics of exchange rate regimes are; Dollarization: A foreign currency acts as a legal tender. This means that monetary policy is delegated to the ‘parent’ country. Monetary Union: economies use a common currency issued by a common regional central bank. Traditional peg: A fixed rate is used against a single currency. Currency Boards: A pegged regime is accompanied by a minimum backing requirement for local currency in foreign currency. This is usually enshrined in law. Crawling peg: this is an exchange rate regime whereby the par value is altered as a function of inflation differentials or at a predetermined rate. Bands: the exchange rate is flexible within a preset band. Pure float: this is a regime where the exchange rate is not influenced by the public sector, but determined in the market. Float with discretionary intervention: exchange rates are as per the foreign exchange market. Authorities intervene, but are not bound by any intervention rule. The exchange rate is accompanied by an inflation target, or other separate nominal anchors. In a floating exchange rate, instability in the local currency forces a country’s central bank to intervene by buying and selling its own currency reserves in the foreign exchange market. However, central banks are not willing to intervene, unless it is absolutely necessary. In a pegged regime, there is greater certainty for importers and exporters. The government is able to maintain low inflation which has positive effects in the long run (Gagnon, & Hinterschweiger, 2011). The debate of fixed versus floating exchange rate regime has been a prominent issue in international capital markets for many years. A verdict has finally been arrived at that the floating exchange rate regime is preferable to Fixed Exchange Rate regime. Exchange rate flexibility does not necessarily mean free floating. For example, it may entail the implementation of broader bands with an active intervention (Tornell, Aaron, &Velasco, 2000). DISCUSSION Numerous discussions about the optimal exchange rate regime have persisted in international capital markets. These discussions provided and continue to provide a platform for the conduct of the monetary policy and the evolution of the world economy. The gold standard provided a monetary anchor for international transactions. This standard led to financial turmoil and sharp variations in output and prices (Giovanni, & Shambaugh, 2007). The Bretton Woods system was established to serve as the centerpiece for a system of exchange rates. Debates concerning the merits of fixed versus Flexible Exchange Rates arose when the system came under stress in the 1960s. The era of Flexible Exchange Rates among major currencies replaced the original Bretton Woods system. The points of departure between pegged and floating exchange rates remained open to debate. In the early 1990s, it became clear that operating in the framework of a Flexible Exchange Rate system was efficient in absorbing shocks from open capital markets as compared to economies operating a pegged rate. Many developing countries have gradually moved away from a pegged regime to Flexible Exchange Rates regime (James, 2012). Globalization and liberalization of trade and capital markets has promoted rapid economic growth. This move has proved to favorably serve a number of economies. Moreover, countries are faced with numerous challenges that are dynamic, thus, the requirement to adopt an exchange rate policy to suitable for various circumstances. The shift has been ongoing, since the collapse of the Bretton Woods system of Pegged Exchange Rates when the world’s main currencies began to be flexible. Developing countries moved towards basket pegs, such as the IMF’s special Drawing Rights (SDR). For example, in 1977, pegged regimes were dominant in Africa, the Western Hemisphere, Asia, non-industrial Europe, and the Middle East. By 1996, floating exchange rates regimes began manifesting themselves among the international capital markets of these continents (Klein, & Shambaugh, 2010). Autonomous monetary policy is the main idea behind a floating exchange rate. In a case where a country’s economy slips into recession, the autonomous monetary policy enables the central bank, of such a country, to boost demand. This reduces the impact of economic shocks on domestic output and employment. Autonomous monetary policy is lost in a pegged regime since a country’s central bank must constantly influence the foreign exchange market to preserve the exchange rate at the set level. In this regime, transactions costs are reduced due to uncertainties in the exchange rate. This might end up discouraging international trade and investment, which provides a credible anchor for low-inflationary monetary policy (Goldberg, 2013). Developing countries have experienced a series of exterior economic shocks. These shocks include; sharp increment in international interest rates, and the debt crisis. Adjustments to these shocks required the implementation of more Flexible Exchange Rate arrangements besides discrete currency depreciations. Capital mobility (capital inflows and outflows) has increased the vulnerability of economies to shocks. This has given rise to the increased pressures for flexibility. Trade and investment policies have become more open and outward-looking. This has promoted the trend towards greater exchange rate flexibility, hence, the increased stress about market-determined interest rates and exchange rates. Active management in the market, by authorities, has enabled the practicality of floating exchange rates. Most developing countries have relatively ‘thin’ financial markets, and cannot allow their exchange rates to float freely. Official involvement by authorities has greatly promoted the shift to floating exchange rate regimes as extensive volatility and harsh misalignments have been eliminated (Lardic, 2004). A larger scale of flexibility is preferred if economic shocks are predominantly real (changes in technology and/or tastes that affect relative prices of local goods). Countries operating under a Flexible Exchange Rate regime indicate a higher average growth rate as compared to countries operating under a pegged regime. That result indicates the inclusion of the fast growing Asian countries operating a Flexible Exchange Rate regime. Another concept that supports the preference for floating rates is the “credibility versus flexibility” concept. Credibility is the general belief inherent in the international capital market that the rate will be maintained. When the Pegged Exchange Rate is credible, forecasts of inflation will be restrained. The accompanying risk will be that, the peg will become unsustainable if the authorities lose confidence on the ability and willingness to maintain it. This is the main determinant of chronic inflation in a country. In pegged regimes, the monetary policy must be incorporated to the necessities of maintaining the rate. This means that other policies, such as fiscal policy, must be consistent to the rate eventually limiting the intervention by authorities. An economy operating a pegged regime may not be able to maximize its borrowing through the bond market as it would affect interest rates exerting pressure on the exchange rate. A floating exchange rate creates room for maneuver by authorities. They allow inflation to rise at their own discretion, which indirectly increases tax revenue. In a flexible regime, widely observed fluctuations in prices and exchange rates may reveal the costs accompanying an unstable policy. A flexible regime would, therefore, enhance a stronger discipline on policy. In cases where the economy fails to function successfully, a policymaker’s commitment to a fixed rate may not exhibit credibility for long. For example, high interest rates may undermine the credibility of a peg if it has adverse effects on real activity. Political considerations also contribute to the preference of a floating regime to a fixed regime. For example, in political terms, it is more costly to adjust a Pegged Exchange Rate than to allow a floating rate to move by an equivalent sum. The cost of adjusting a peg is incurred by the authorities. A floating regime creates room for fluctuations in the exchange rate in response to shift in the demand and supply of the local currency in response to the market forces. Economies operating a floating exchange rate experience lower rates of inflation as compared to those operating a pegged regime. For example, between 1981 and 1997, Hong Kong experienced quite higher inflation than Singapore. Hong Kong operated under a currency board arrangement since 1982 whereas Singapore managed a floating regime (Edwards, 2006). Exchange rate flexibility can help mitigate the severity of unstable capital inflows. Under the concept of “adjusting to capital inflows,” emerging markets are advised to adopt floating exchange rate regimes. By providing room for Flexible Exchange Rates according to capital inflows, policymakers can affect market expectations (Veyrune, 2007). Heightened awareness may arise as policymakers make market participants aware of the “two-way” system (appreciations and depreciations). Increased awareness by economies of the inherent exchange rate risks, speculative short-term capital inflows would be discouraged, thus reducing the need for abrupt solutions. These economies become integrated into the international financial system eventually leading to developed financial sectors. If Flexible Exchange Rates are put to operation, economies become resilient and robust. This concept was exhibited in 2002 in Brazil when the markets exerted substantial downward pressure on the real currency ahead of the Presidential elections. This downward pressure on currency yields greater flexibility limits that result in fast exhaustion of reserves allowing the external sector to bear a fraction of the required adjustment, instead of imposing undue pressure on domestic demand. In the Capital Account Convertibility concept, emerging economies have relaxed capital controls and are gradually proceeding towards maximum capital account convertibility (Tarapore, 2003). This movement is only possible in the presence of a floating exchange rate policy, stable economic fundamentals, and a well established banking sector. Most developing countries are adopting Flexible Exchange Rate regimes that reflect recognition that improved flexibility is critical in making the transition to full convertibility (Memdani, 2008). The International Monetary Fund’s articles of agreement allow countries to adopt an exchange rate regime of their choice. It also recognizes the danger of not allowing balance of payments adjustments to take place. The international financial system would gain from a multilateral approach to greater flexibility in the exchange rate. It is in the greater interest of all economies for the IMF to assume this responsibility CONCLUSION Both the Fixed Exchange Rate regime and the floating exchange rate regime have their own pros and cons. Analysts need to be put into consideration numerous factors concerning the right regime due to the inherent conditions in different countries. These two extreme variants create room for the existence of a variety of exchange rate regimes lying between them. These “other” exchange rate regimes provide a compromise between flexibility and stability. For example, until early 1996, the Czech Republic was pegged to a collection of currencies. After a substantial widening of the fluctuation band, the peg was eliminated, and now Czech operates a managed floating regime. This means that the exchange rate can be floating, but the central bank may opt for interventions should there be extreme fluctuations. Apparently, the requirement for improved flexibility has resulted from globalization of financial markets. Developing economies have been integrated into the international financial system, therefore, imposing harsh regulation on their macroeconomic policies. From this study, it is evident that maintaining a fixed regime is more expensive as compared to a floating regime (Senay, & Sutherland, 2004). Although trade-offs exist between the two regimes, the effects of each regime on monetary policy must be considered. Under a pegged regime, the burden of adjustments to economic distress falls largely on fiscal policy. A peg must be credible for it to last. This means that the fiscal policy has to be flexible enough to respond to such distress. It is better to operate a floating exchange rate regime where the monetary policy would be more independent. Deliberation on the choice of a regime may change on a timely basis. It is very important for analysts to know the right time to switch from one regime to the other and the appropriate trade-off between the two. From the research above, it is evident that inflation levels can lead to a dilemma between the two regimes. High inflation levels may call for a Pegged Exchange Rate that would act as a short-run stabilization program. In periods of surging capital inflows flexibility of the exchange rate is preferred. This regime would relieve the pressures and signal the requirement for modification to contain an exterior imbalance. In a general point of view, a floating exchange rate regime is better to enable economies to move towards full capital account convertibility, mostly in a world of dynamic capital flows. Exchange rates are determined in the asset markets. Expectations and their respective changes in money supplies dominate the course of the exchange rate in the short run. A Flexible Exchange Rate regime does not exhibit homogeneity. Prevailing stickiness in exchange rate expectations transmits monetary changes and foreign price disturbances internationally destroying the argument that a floating regime provides isolation from and for monetary disorder. REFERENCES Tornell, Aaron, and Andrés Velasco, 2000, “Fixed Versus Flexible Exchange Rates: Which Provides More Fiscal Discipline?” Journal of Monetary Economics, Vol. 45, April, pp. 399–436. Adams, T. D. 2006. Fixed versus Floating exchange rates. Working with the IMF to strengthen exchange rate surveillance, 1, 1-4. Woepking, J. 2007. Capital markets. International capital markets and their importance, 1, 1-11. Árvai, Z., & Heenan, G. 2008. A framework for developing secondary markets for government securities. Washington, D.C.: International Monetary Fund, Monetary and Capital Markets Dept.. Cuthbertson, K., & Nitzsche, D. 2001. Investments: spot and derivatives markets. Chichester [England: J. 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