The international monetary system evolved significantly during the nineties. While Europe established the Monetary Union and some emerging economies (such as Argentina and Latvia) tried to put in place, with different degrees of success, extremely rigid exchange rate regimes, many others, besieged by catastrophes (the Mexican, Asian, Brazilian crises), needed to abandon the currency linkages they had managed to establish, in general to the US dollar, to return, at least temporarily, to flotation systems.

 

The choice of an exchange rate regime carries great weight. It reveals a country’s choice of economic policy, its margin of maneuver and its macroeconomic adjustment policies. It also affects that country’s trading partner since variations in its exchange rate regime may alter their relative competitiveness. Or, they can be led to lend support to a currency linked to their own by a fixed parity system. Exchange rate regimes can thus determine the conditions on the basis of which economies participate in the international economy.

 

What is an Exchange Rate Regime?

 

An exchange rate regime is the sum-total of rules and regulations that govern intervention in the exchange market by monetary authorities and, consequently, influence the pattern of behavior of an exchange rate. There are a great variety of exchange rate regimes: fixed rates of exchange and flexible rates of exchange.

 

Definitions

 

A fixed rate of exchange regime implies a parity of reference between a country’s currency and a foreign currency or group of currencies. It equally implies that the central bank is committed to support such parity. Should the exchange market become more open, a central bank, in order to support such a commitment, has to intervene when the rate of exchange goes beyond the established parity. It does so by way of national currency purchases if the latter looses value in the exchange market, or should the contrary be the case, by way of sales. When an exchange market is controlled, the currency is non-convertible. Its parity is arbitrarily defined and artificially upheld.

 

In a flexible rate of exchange regime, to the contrary, no commitment is undertaken in relation to an exchange rate. An exchange rate fluctuates freely depending on demand and supply in the market (pure flotation). Although monetary policy thus gains autonomy, the central bank looses control on the nominal parity, which is to be determined by the exchange market. Flotation therefore applies in principle to a liberalized exchange market, even if an ‘impure’ flotation mechanism can be imagined wherein such flotation operates in the context of an exchange control regime.

 

Between these two extremes, intermediate regimes can be found. They can be characterized depending on the degree of fluctuation around the parity of reference authorized by the central bank as well as by such parity’s realignment frequency. Thus, the Currency Board regime, which does not contemplate any such realignment, is the contrary of a sliding-parity system, which does imply a realignment calendar. The old European Monetary System, SME, and the present ‘SME bis’, are somewhat between these two extremes. The possibility of realignments, to be negotiated on the basis of accumulated inflation differentials among affected countries, is there. Realignments on a discretionary basis are, in principle, excluded by all such regimes. They are therefore different from an administered flotation regime (Inset 1).

 

Apart from the Monetary Union and Currency Board cases, a national currency’s linkage can be done in relation to a group of currencies or to only one ^T.N..

 

The Present Situation

 

In 1944, the Bretton Woods Conference organized the international monetary system on the basis of fixed rates of exchange. All currencies were fixed on a par value in relation to the US $ and the dollar, in turn, was linked to gold on the basis of a fixed parity: it was the gold-currency standard. This system was nevertheless unable to cope with the expansion of international trade, in need of evermore liquidity, nor with US current account deficits that placed the dollar-gold parity under stress. By 1973 the world system of fixed rates of exchange was abandoned leaving, in its place, a floating exchange rate system. Nevertheless, some countries tried to mutually stabilize their currencies (the ‘serpent’, and then the EMS). Nevertheless, pure flotation by the major currencies (US dollar, yen, European currencies) would soon show its limits, with high exchange rate volatility and long- term exchange rate distortions. Central bank interventions in the exchange markets, particularly during G 7-led coordination episodes, indicate that the international monetary system under which such currencies operate is today an impure flotation system.

 

What are the exchange regimes under which the other currencies nowadays operate? A census of exchange rate regimes as declared to the IMF by monetary authorities - and as shown in the next table - gives us some preliminary answers.

 

It would seem that fixed exchange rate systems have been progressively replaced by floating systems. Nevertheless, information based on official sources is in itself insufficient in as far as it does not provide any indications about the monetary policy applied. Thus, a managed flotation might in fact operate as a linkage to a currency or to a group of currencies without such purpose being made public. Upon review of effectively applied monetary policies in a group of 66 countries, measured on the basis of their relative volatility in relation to three potential currency links (US dollar, DM and yen), authors Agnes Bénassy-Queré and Pierre Deusy-Fournier show that the majority of the countries under consideration do in fact have a tendency to stabilize their currencies in relation to a currency of reference. Some 30 % do it in relation to the DM (basically the EU countries) and another 30 % in relation to the US dollar (the yen does not come up as a currency of reference). Such proportions would no doubt be more important if linkages in relation to groups of currencies, instead of to individual currencies only, could be studied.

 

Choice of an Exchange Rate Regime

 

The exchange rate regime a country chooses to apply is the result of both its economic goals and the demands it must cope with.

 

The Choice of an Exchange Rate Regime and Economic

 

Policy Goals

 

The ultimate goal of economic policy, and therefore of an exchange rate regime, is to insure the fastest and more stable growth possible. The exchange rate regime has indeed a bearing on the stability and competitiveness of the economy.

 

If predictable, rates of exchange limit the uncertainty that economic agents face in their international relationships. Thus, in principle, they benefit both investment at the national level and trade. A fixed rate of exchange allows meeting such stability goals best. Nevertheless, it has two downsides:

 

First, stability is achieved only in as far as the economy does not suffer an asymmetric shock. Exchange rate rigidity, by definition, will hamper the economy’s ability to cope with any such shock on the basis of an adjustment in the nominal exchange rate.

 

Under such conditions, a fixed exchange rate would not be desirable unless the concerned countries are party to an Optimal Monetary Zone (OMZ). That is to say, if price- flexibility and factor-mobility conditions allow for the absorption of the economic shocks without  the need for an adjustment in the nominal exchange rate.

 

Nevertheless, a fixed parity exchange rate may be adopted precisely on the basis of the anti-inflationary discipline it entails. A fixed rate of exchange becomes an external condition a country undertakes in order to stop inflation. The competitive deflationary policy adopted by EMS countries is based, partly, on such a mechanism and it also justifies exchange rate policy in some emerging economies. In the case of Argentina, for example, the adoption of a Currency Board came up as the last available recourse to preserve the currency, deeply shaken by the hyper-inflationary situations experienced during the eighties.

 

Such a linkage strategy is all the more justified since exchange rate regimes geared exclusively towards competitiveness can accelerate inflation. When an exchange rate constantly devaluates to cope with inflation differentials, a process of imported inflation can be set in motion thereby forcing a new devaluation, and so on and on. A vicious circle of inflation-devaluation takes hold which, in some cases, can lead to hyper-inflation, and which, more often than not, can only be broken by the establishment of a fixed exchange rate system.

 

External Restrictions on the Choice of an Exchange

 

Rate Regime

 

A number of limitations restrict a country’s choice of an exchange rate regime. In a context of absolute capital mobility, for example, it is impossible to have at the same time a totally fixed exchange rate system and a perfectly autonomous monetary policy. Conversely, if a country wishes to preserve its autonomy on its monetary policy it is forced to choose between a flexible exchange rate regime and capital mobility  (Inset 3).

 

Thus, within a fixed exchange rate system, an economic recovery generates either a surplus in the money supply or lower interest rates, thereby inducing currency depreciation. Such a tendency can only be countered by way of currency acquisitions, which in turn eliminate monetary stimuli. While it is temporarily possible to escape from such a restriction by way of freezing reserves in foreign currencies (the central bank can, for example, buy obligations in the domestic financial market thereby injecting liquidity into the economy), such a policy cannot be sustained for long.

 

With a fixed exchange rate in place, monetary authorities must prove to the markets that they can meet the conditions imposed by a fixed exchange rate system also in the future. Otherwise the currency will face speculative runs, all the more strong the more liberalized the capital and monetary markets are. An exchange control then becomes the only way to preserve the exchange regime since it limits buy-and-sell operations on the currency. It is a convertibility restriction that presents itself as an alternative to a money supply restriction (Kurt Schuler, 1999).

 

How Exchange Rate Regimes Operate

 

Exchange Rate Regimes Efficiency: Inflation and Growth

 

A number of studies have tried to measure the relative efficiency of exchange rate regimes. A compilation undertaken by the IMF (Gosh, et al., 1995) arrived at the following conclusions: On one side, fixed exchange rate regimes were in the past associated to lower inflation and higher levels of investment but, equally, to slower productivity rises and, consequently, lower economic growth. Even if it is difficult to establish a cause-effect relation, it would seem that it is on the basis of the exchange rate regime that lower inflation can be explained, and not that a less inflation-prone situation justifies a fixed exchange rate.

 

Truly flexible exchange rate regimes have undoubtedly been the ones that have worked less well, with higher inflation and more mediocre results in terms of growth. Intermediate regimes (for example, sliding-parity systems) have shown better growth performance even though by their nature they have allowed for more inflation.

 

Thus, since truly flexible exchange rate regimes have only given unsatisfactory results, the choice would seem to be mainly between a fixed parity system and a managed exchange rate in relation to a currency of reference system. Such a conclusion is consistent, on the other hand, with the exchange strategies of a great number of countries, particularly developing countries, as observed since the late eighties.

 

Unfortunately, in the present day context, capital flow liberalization and developing countries’ higher currency convertibility, place these countries in a not very comfortable situation, at the limits of Mundell’s ‘Incompatibility Triangle’. Taking into account developing countries’ de-facto linkage strategies and higher capital mobility, relatively stricter monetary policies become mandatory in order to avoid inflationion. This requires higher nominal interest rates which, as happened in Asia, in turn have induced an inflow of speculative capital movements and opened the way to exchange rate crises. The negative Asian experience with a currency linkage to the dollar has made some authors suggest the need of abandoning intermediate exchange rate regimes to the benefit of either strict fixed exchange rates, as the Argentinean Currency Board, or flexible exchange rate regimes (Barry Eichengreen, 1999). Nevertheless, the same authors recognize that a quasi-monetary union is difficult to achieve, particularly in the case of an emerging economy, and that a free flotation system implies a volatility that puts growth under risk.

 

Such a problem raises the issue of economic policy credibility, particularly as regards exchange rate policy. It underlines, once again, the crucial nature of the choice of an exchange rate system, as well as the important demands such a choice places on economic policy.

 

The Evolution of Exchange Rate Strategies

 

Two trends will no doubt mark the international monetary system during the coming years. On one side, strategies based on either an official or on an effective linkage of developing country currencies to major currencies must persist. On the other, the euro might place itself alongside the dollar as an international currency thereby becoming an important reference for exchange rate strategies.

 

It is likely that the trend towards linkages to the major currencies will continue, no doubt reinforcing the euro’s regional if not international role. This is what authors Agnes Bénassy-Quéré and Amina Lahreche-Révil show in relation to the South-Mediterranean countries (SMC) and Central and Eastern European countries (CEEC). If countries close to the European Union from a regional perspective reason in terms of an OMZ in choosing the currency of reference for their monetary policies, they will undoubtedly have an interest in choosing the euro (above the dollar or the yen), on the basis of their important trade links to the Union. More so if we acknowledge that these countries would equally pursue stability in their external accounts (that is to say, that they would seek to preserve their competitiveness levels and to insure stability in their external debt overhang). The choice of the euro as the major currency of reference thus seems obvious, and this important considering that  the euro would represent in the majority of cases more than 70 % of the group of currencies to which a link would be of interest.

 

The probability of such a double, in real and in nominal terms, currency-stabilization strategy based on the euro by SMC and CEEC countries, in principle advocates in favor of the adoption of sliding-parity exchange rate regimes. As the majority of Latin-American countries, and numerous Asian countries, have already chosen to conduct their exchange policies in relation to the dollar, two major regional monetary zones might well appear.

 

Undoubtedly such an evolution will reinforce the euro’s role as an international currency. At the same time, an international monetary system with two major poles of reference, and the linkages of an increasing number of currencies to one or the other of the major currencies of reference, should make fluctuations between them more efficient as regards overcoming trade imbalances between the euro and dollar zones. Greater efficiency of exchange rate fluctuations between the euro and the dollar should indeed limit the extent of such imbalances.

 

Finally, for developing countries this evolution renders ever more necessary, and more complex, the management of exchange rates. The development of major monetary areas will render independent strategies more difficult to sustain. It is to be expected that, just as the greater part of emerging economies try to establish currency linkages to one of the three major world trade areas, developing countries will do the same. If for no other reason, such currency linkages would most likely  be established by developing countries because the choice of a currency of reference is linked to the geographical area in which trade relations take place.

 

Inset 1

 

Main Exchange Rate Regimes Classified According to Decreasing Exchange Rate Rigidity.

 

Fixed rate of exchange

 

Monetary Union: It is the strictest regime. Exchange rates among participants in the union are irrevocably established since national currencies can be replaced by a common currency.

 

Currency Boards (Emission Boards or Monetary Councils): money supply depends on the level of reserves in the currency of reference. These regimes allow for a double currency system (e.g. US dollar and the peso in Argentina).

 

Traditional fixed exchange rate systems: A fixed parity is set. It can be modified under exceptional circumstances in order to re-establish a current account balance. Flotation bands may be defined, whether narrow (the Bretton-Woods system, the EMS prior to 1993) or less narrow (EMS after 1993 or the EMS bis).

 

Intermediate regimes

 

–Sliding-parity (or crawling peg): The exchange rate is, in principle, a fixed one. Nevertheless, the parity of reference changes from time to time according to pre-established criteria (crawling peg in a strict sense), or in a more discretionary way (adjustable peg) in order to partially compensate for, at least, inflation differentials with the base currency country.

 

–Managed flotation: Rates of exchange float but markets are put on notice about the desired parity by individual or coordinated central bank interventions. It is an ‘impure’ flotation.

 

Pure flotation

 

Only the market establishes the exchange rate.

 

Exchange Rate Regimes Declared to the IMF in 1980 and 1988 and Number of Declaring Countries

 

 

Regime	1980	1998
Fixed rate of exchange	94	55
– On a single currency	57	40
– On a group of currencies	37	15
Limited flexibility (EMS included)	12	17
Flexible rate of exchange	34	73
– Managed flotation	-	38
– Free flotation	-	35
Number of declaring countries	140	145

 

 

Source: IMF, Exchange Rate Arrangements, 1980, 1998.

 

Inset 2: The Real Exchange Rate

 

Real exchange rates compare prices for two sets of goods valued in a single currency: r = e P* / P.

 

(e) is the nominal rate of exchange (number of national currency units per unit of foreign currency); p* and P stand for foreign and national price levels.

 

When the national price level rises faster than foreign price levels (p* / P) becomes smaller; if the nominal rate of exchange (e) is fixed, the real rate of exchange (r) becomes higher, the currency appreciates and competitiveness deteriorates.

 

Inset 3: Mundell’s Triangle of Incompatibility

 

Mundell’s Triangle of Incompatibility represents the three organizational principles on the basis of which the viability of the international monetary system is judged: degree of exchange rate policy rigor, degree of capital mobility and degree of monetary policy autonomy.

 

Combinations of monetary policy, exchange rate policy and capital mobility, which fall inside the triangle, are deemed sustainable. Thus, capital mobility associated with exchange rate stability corresponds to the ‘monetary union’ angle. This angle is placed in total opposition to ‘monetary policy autonomy’.

 

A                                              B

 

Fixed exchange rate                                   Policy autonomy

 

               

 

C

   

Absolute capital mobility

 

A: Financial autarky. A satisfaction of both fixed commitments and domestic economic policy goals is feasible if exchange reserves so allow.

 

B: Monetary Union. Absolute capital mobility and a fixed exchange rate do not allow for any monetary policy autonomy.

 

C: Floating exchange rates. Absolute capital mobility and exchange rate flexibility allow for economic policy independence.

 

Bibliography

 

·         Bénassy-Quéré A. and Deusy-Fournier p., “La concurrence pour le statut de monnaie internationale depuis 1973”, in Economie Internationale, No. 59, 3^rd. Quarter, pp.107 – 144, 1994.

 

·         Bénassy-Quéré A. and Lahreche-Révil A., “Pegging the CEEC’s Currencies to the Euro”, CEPII Working Paper, No. 1988-04, 1998.

 

·         Bénassy-Quéré A. and Lahreche-Révil A., “The Euro and Southern Mediterranean Currencies”, in H. HANDOUSSA (ed.), The Euro-Mediterranean Partnership and After, in press, 1999.

 

·         Eichengreen B., Toward a New Financial Architecture, Institute for International Economics, Washington D.C., 1999.

 

·         IMF, Exchange Rate Arrangements, 1980, 1998.

 

·         Gosh A., Gulde A.M., Ostry J. and Wolfh., ”Does the Exchange Rate Regime Matter”, IMF Working Paper, No. 95/121, November 1995.

 

·         Schuler, K., "The Problem with Pegged Exchanged Rates", Kiklos, 52 (1), 1999.