Exchange Rates
Exchange rates are simply the values at
which one currency trades against another.
But there are many different types of
exchange rate policy, which can determine
how that value is created.
Fixed exchange rates
A fixed (or pegged) exchange-rate occurs where a government
tries to keep the value of its currency constant against another.
This value can be decided in terms of the cost of a fixed weight of
gold, a fixed amount of another currency or a basket of other
currencies. The central bank must then commit to buying and
selling its currency at a fixed price. A good example of this is the
‘gold standard’, which was a global fixed exchange rate policy
adopted between 1870 and 1914. The values of all currencies
were determined in terms of gold, and each central bank had to
store gold as the official reserve asset.
The Bretton Woods system emerged as the fixed exchange rate
system following World War II, but this used the US dollar, rather
than gold, as the official reserve asset. Given that it was the
owner of the world’s strongest currency at the time, the US
agreed to link the dollar to gold at the rate of $35 per ounce of
gold, and dollars could be converted into gold at that given price.
The 44 member countries each had to maintain their exchange
rates within 1% of parity through buying or selling foreign
currency as required. However, the Bretton Woods systemroke
down in the very early 1970s, largely due to concerns over the
US balance of payments, which caused capital to flee and
speculation against the dollar to increase. Since that time, most
economies have allowed their exchange rates to float.
Floating exchange rates
A floating exchange rate regime allows a currency's value to
fluctuate according to the foreign-exchange market. One of the
key arguments for this type of exchange rate mechanism is that
monetary policy no longer needs to be focused on maintaining a
country’s exchange rate at a given fixed level, and can be
focused on other goals, such as encouraging an increased level
of economic activity or containing inflation. And the automatic
adjustment of exchange rates can help to dampen the impact of
the business cycle, or of external shocks to an economy, in
particular helping to reduce the risk of a balance of payments
crisis. But floating exchange rates can also bring unpredictability,
and occasional instability, if the movement in the currency – the
appreciation or depreciation - is too great.
Reflecting supply and demand
Exchange rates should reflect supply and demand for the two
currencies in question. Often this is driven by demand for exports,
as the buyers of goods need the relevant currency to make
payment. But demand for a currency can be influenced by other
factors too – such as general economic activity and employment,
politics, government fiscal policy and both inflation and interest
rate differentials. And exchange rate movements can also have
an impact on activity – e.g. if sterling appreciates against the euro
the UK’s goods become more expensive and less competitive,
and this can result in a lower level of exports to Europe, but a
higher level of imports into the UK. But if sterling depreciates
against the euro then export sales can increase, import sales
could fall and the UK’s trade deficit and balance of payments
could improve.
Exchange rate volatility
A free floating exchange rate brings an increased level of foreign
exchange volatility, and this can sometimes cause serious
problems, especially in emerging economies which are heavily
reliant on trade. Another problem facing emerging economies is
that they often have loans denominated in a foreign currency and
so currency depreciation can cause rapid and severe
deterioration in the balance sheets of banks, households and the
corporate sector.
For any economy, bouts of extreme appreciation or depreciation
can be destabilising, forcing the central bank to intervene to
stabilise the currency, either buying or selling a large amount of
currency to support it, or to prevent it from weakening further. If
this intervention happens often, the exchange rate regime may
actually be a ‘managed float’. In these cases the central bank
allows the value of its currency to float freely between an upper
‘ceiling’ and a lower ‘floor’, but intervenes whenever the exchange
rate approaches either boundary. Countries need to maintain an
appropriate level of international reserves to use in any foreign
exchange interventions.
Developing a hybrid – fixed and floating
Given that there are strengths and weaknesses in both fully fixed
and free floating exchange rate regimes, some economies adopt
a hybrid system which combines some of the characteristics of
both. These hybrid systems allow exchange rates some degree of
fluctuation, but do not have the full flexibility of a free floating
regime. The most popular examples of these are;
(a) A ‘pegged’ system’ in which the central bank specifies
a central exchange rate with reference to a single
currency, or a composite of currencies, and establishes
the acceptable width of symmetrical bands around this
rate. Depending on the size of these bands, the central
bank may still have some discretion in carrying out
monetary policy. Denmark currently pegs its exchange
rate to the euro.
(b) A ‘crawling peg’ system in which a country fixes its
exchange rate to another currency or basket of
currencies, but this ‘fixed rate’ changes periodically. This
system is designed to help eliminate some of the
exchange rate volatility associated with a floating
exchange rate, but without imposing the limitations of a
fixed exchange rate. During the 1990s Mexico put into
place a crawling peg system against the dollar, allowing
the peso to devalue slowly.
(c) A ‘currency basket’ which includes the currencies of
major trading partners. An example of this is the special
drawing rights (SDR) created by the IMF which consists
of a fixed quantity of US dollars, euros, Japanese yen
and sterling.
(d) A ‘currency board’ which fixes one country’s currency
to another. This currency board then effectively replaces
the central bank as both inflation and interest rates will
be highly influenced by those of the economy to which
the domestic currency is fixed. For this scheme to
operate successfully, the currency board needs to
maintain adequate reserves of the target currency. Hong
Kong operates a currency board and has fixed its
currency to the US dollar.
Any form of exchange rate ‘fixing’ helps to limit currency instability
and its impact on trade, economic activity and relative prices.
Fixing can also entail some degree of discipline, in terms of both
monetary and fiscal policy and this can help to reduce
speculation. But many economists would argue that there is less
need for any type of fixed exchange rate regime, due to the more
prevalent use nowadays of sophisticated derivative products and
other financial tools which allow companies to hedge their
exchange rate exposures. There is also a danger that the
exchange rate announced in one of these regimes is not actually
the market equilibrium rate, which can lead to instability. Arguably
the euro area provides a good example of this type of problem.
On an even broader scale incorrect pricing, via fixed exchange
rates, can lead to inefficient allocation of resources, between
countries or even on a global basis.
It is difficult to establish the true exchange rate between two
countries. Economic theory frequently uses the theory of
‘purchasing power parity’, which proposes that the exchange rate
between two countries is in equilibrium when it results in the cost
of a particular bundle of goods being the same in both
economies.
Trade weighted and effective exchange rates
In addition to single exchange rates between two countries,
commonly called a ‘cross rate’ you will often see reference to a
‘trade weighted effective’ exchange rate. This is a more multiple
measure, using several different exchange rates, weighted on the
basis of how important each country is as a trade partner. Trade
weighted effective exchange rates allow us to compare the
general exchange rate of one economy against another and, in
the globalised world that we live in today, the trade weighted
effective exchange rate index can highlight changes in the overall
competitiveness of an economy.
Exchange rates and investments
Exchange rates can be quite complex but cannot be ignored as
they have a huge impact on the global economy and, therefore,
on investment. Corporate returns from a foreign market can be
impacted on translation into the relevant domestic currency, and
this can affect the company’s apparent performance. A company
selling 100 items at $1 in the US when the exchange rate is
£1=$2 will receive £50 but, if the exchange rate moves to £1=$1,
due to sterling depreciation or dollar appreciation, the return to
the company will increase to £100.
Exchange rates can also impact portfolio returns if investors
invest directly in foreign markets. As an example of this, suppose
an investor based in the UK puts £1000 into the Japanese stock
market at an exchange rate of £1=¥140, buying ¥140,000 of
stock. Japan’s stock market then rises 50% and the investor
decides to sell and bring his investment, now worth ¥210,000,
back to the UK. But, during that time the yen has depreciated by
almost 25% against sterling, falling to a level of £1=¥175. This
means that the returns generated are only worth £1200 and the
investor’s apparent gain of 50% has been reduced to just 20% in
sterling terms. If the stock market had risen by just 20%, the
investor would have returned only £960 to the UK, making a loss
of £40.
It is therefore important to remember that the exchange rate of
the currency in which the bulk of a portfolio is held will determine
the real return to an investor. Exchange rate movements will also
influence, and be influenced by, many other important economic
factors, such as interest rates, inflation and trade. Exchange rate
determination, and forecasting, is extremely complex, but
investors should be aware of the importance of currencies and
exchange rates in determining the rate of return on their
investments.