A discussion of fixed exchange rate system may sound outdated
in an age when Financial news headlines are regularly dominated by sharp
fluctuations in the exchange rate in major developed countries. But fixed
exchange rate system is important for it is the first exchange rate system the
World has seen, however it is not the importance of fixed exchange rate system
that I intend to discuss today, instead it is the nature in which a fixed
exchange system is managed that caught my attention.
Why is Hong Kong and more recently China doing great under a
fixed exchange rate system, but Argentina, Turkey, Brazil and Mexico were
forced to abandon the system after an unsuccessful trial? To keep an exchange
rate fixed a central bank must always be willing to trade currencies at the
fixed exchange rate. In it’s simplest term a fixed exchange rate means the
Central bank must be willing to buy all the amount of its currency the market wants
to sell and at the same time be willing to sell all the amount of it’s currency
the markets wants to buy. Sounds complicated right? Well that’s what leads me
to the topic of this blog, are central banks with more intelligent Economists
more likely to be successful with managing a fixed exchange?
Given what it takes to keep an exchange rate constant
infinitely, it is tempting to say that it requires a mastery of an Economic
understanding where the Central banks policy makers have to be ahead of the
market to keep the rate fixed. This was the view I had, but then I still had
some questions about this ideology, how about if the market doesn't believe
that the Central bank will keep the currency fixed? More specifically how about
if Investors believing that the country will depreciate its currency starts
dumping the currency for foreign currency in an effort to make profit out of
nothing, A phenomenon known as “Arbitrage”, to Understand this suppose you are
holding 100 Argentinean Peso currently fixed at $1=100 peso, but you believe
that due to Argentina’s Balance of payment problems it will depreciate it’s
currency to $1=200 peso. Now if you sell you current 100 peso for dollars you
get $1, if the Central bank of Argentina go ahead and depreciate the currency,
you can exchange your $1 back to pesos at $1=200 peso’s, a profit of 100 peso
out of nothing.
What is interesting about the above scenario? In the above
example for simplicity I used 100 pesos but in reality this could be in
Billions of pesos. I just jump to how people can profit from the central bank
devaluing the currency, but didn't exactly explain why would the central bank
devalue the currency, remember from our definition of the fixed exchange rate
system, the Central bank of Argentina have to be willing to buy all the Pesos
the investors are supplying with Dollars, now if everyone believes that The
central bank indeed will devalue the peso and start dumping it for dollars, as
this process continues the question is how much dollars can the Bank of Argentina
use to buy the pesos? The answer to this questions depend on how much dollars
the bank of Argentina have in reserves, at any rate such a process can only
continue for so long, because the Bank of Argentina doesn't print Dollar notes
and as such can only have so much of it. By the time the central bank runs out
of dollar reserves, it either has to devalue the currency or allow the exchange
rate to float freely, a devaluation occurs when a central bank still keeps the
exchange rate fixed but depreciate the fixed exchange rate (example from 100 peso
= $1 to 200 peso = $1).
The above scenario demonstrates what is known as a
“Speculative attack” or “Capital flight”, a situation where investors speculate
against the devaluation of a currency and start fleeing that currency for
foreign currency.
What causes speculative attacks or more generally currency
crises? Krugman, Obstfeld and Melitz (2012) noted that often because a
Government is following policies that are not consistent with maintaining a
fixed exchange rate system over the long term, they gave an example of a
central bank buying domestic Government bonds to allow the government to run
large fiscal deficits.
After taking a class in International finance and dedicating
so much time to understanding fixed exchange rate systems through research, I
have come to the conclusion that, a fixed exchange rate system requires well
informed Economist to work, however this is not the ultimate. The authority,
perhaps the Central bank overseeing the management of the fixed exchange rate
system has to be credible, and the public have to have belief in it,
expectations have to be positive, but then positive expectations are based on
credibility. If a central bank has a history of deviating away from its
announced policies (targets), what will make the public believe that it won’t
deviate this time?
It is of my belief that successful and unsuccessful Central
banks under fixed exchange rate regimes don’t have great differences in the
type of Economist tasked with managing the system; instead they do have great
differences in their “credibility” and the “expectations” of the public on their
future macro-economic policies.
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