International Finance FINA 5331 Lecture 3: Exchange rate regimes Read: Chapters 2

1. International Finance FINA 5331 Lecture 3: Exchange rate regimes Read: Chapters 2 Aaron Smallwood Ph.D.

2. Classifications • There are various classifications as it can be difficult to determine what countries are actually doing (de-facto) as compared to what the claim they do (de-jure). • The IMF provides an annual classification of different exchange rate systems. The most recent classification can be found at: https://www.imf.org/external/pubs/nft/2013/areaers/ar2013.pdf

3. IMF Classification of Exchange Rate Regimes Categories were recently changed: • No separate legal tender • Currency board • Conventional pegs • Stabilized arrangement • Crawling peg • Crawl-like arrangements • Horizontal band • Other managed arrangements • Floating • Free floating

4. Free Floating • Intervention occurs only “exceptionally” with the aim being to calm markets. According to the IMF, intervention must be limited to 3 times in the previous 6 months, with each intervention lasting fewer than 3 days. • Example: United States

5. Floating • Exchange rates are largely market determined without obvious policy interference. Intervention can be direct or indirect, but only serves to “moderate the rate of change and prevent undue fluctuations in the exchange rate.” • Examples: Brazil, India, Thailand

6. Managed arrangements • A residual category, which captures countries that cannot be placed into others. Countries in this category are typically characterized by frequent changes in policy. • Examples: Iran, Myanmar, Syria, Switzerland

7. Exchange rates within horizontal bands • The domestic currency is pegged to another currency or group of currencies. The exchange rate is maintained within bands that are wider than +/-1% of the established target: • Example: While ERMII countries could fall into this category, they choose not to. The only country that falls into this category is Tonga.

8. Crawl-like arrangements • The exchange rate must remain in a narrow band of 2% relative to a “statistically identified trend” for at least 6 months. The annualized rate of change in the exchange must be at least 1%. • Most prominent example: China.

9. Yuan-Dollar

10. Currency issues • In June 2010, the RMB price of the dollar was 6.8322. On March 12, 2013, the price had dropped to 6.1258. • Represents a 11.53% appreciation of the yuan. • In a recent interview, Huo Jianguo, President of the Chinese Academy of International Trade and Economic Cooperation stated: • “Hot money is flowing into China, and that will push up the yuan exchange rate.”

11. Effects??? • Exporters that accept payment in currencies like the dollar are seeing profits eroded. • – In competitive industries, like apparel, it can be very difficult to pass costs on to customers. • – Says, Donald Lee of Esquel Group: • “The appreciation in the value of the yuan will have a big impact on our business. Most of our customers are invoiced in dollars, yet a very large percentage of our cost structure is in renminbi. In our industry, we are facing a situation of excess global capacity and, as a result, a very high level of competition. Therefore, we cannot simply pass on the increase in our costs caused by the revaluation to our customers. Instead, we will need to address this cost increase in other ways.”

12. Recent developments • In April, 2012, the PBOC announced that it would widen the trading bands within which the RMB was allowed to fluctuate each day from +/-0.50% to +/-1.00%. • On March 15, 2014, the PBOC doubled the trading bands from +/- 1.00 to +/- 2.00%. • Recently the RMB has been depreciating against the dollar.

13. How do we avoid risk? • According to an article in China Daily, “In order to minimize currency exchange losses, suppliers are also trying out financial instruments, such as Chinese yuan- NDF contracts. By fixing the desired exchange rate, a NDF contract allows you to hedge against risk of exchange rate fluctuations.” The article goes on to say: “‘Using financial instruments requires significant capital’, said Chen Cunman, a power equipment salesman in Suzhou…`The most effective method to minimize currency loses is yuan settlement.’”

14. Crawling pegs • The domestic currency is pegged to another currency or basket of currencies at an established target rate, that is either publicly announced or made available to the IMF. The target rate is periodically adjusted, perhaps in response to changing economic indicators. The exchange rate remains within +/- 1% relative to the targeted value.

15. Example: Nicaragua

16. Stabilized arrangement • An arrangement where the spot rate remains within a margin of 2% for 6 months or more. • There can be a small number of specified outliers. • There is no actual policy commitment. • Example: Vietnam

17. Conventional pegs • The country pegs its currency at a fixed rate to another currency (or group of currencies). The currency cannot fluctuate by more than 1% relative to the established target: • Example: Saudi Arabia, formerly China

18. Saudi’s currency

19. Currency boards • Currency board countries are sometimes called “hard peggers”. Example: Hong Kong…. • The currency board is a separate government institution whose only responsibility is to buy and sell foreign currency at an established price. The country will typically maintain foreign currency reserves equivalent to 100% of the total amount of outstanding domestic money and credit.

20. No separate legal tender • The country uses another country’s (or group of countries’) currency as its own: • Example: Ecuador (US dollar)

21. Benefits of pegging your currency • Exchange rates are stable • Could possibly benefit trade • If pegged to a country with stable inflation, we may be able to import stable inflation. • Likely provides an anchor for future inflation.

22. Drawbacks • Loss of monetary policy independence • Loss of the exchange rate as an automatic adjustment mechanism following economic shocks. • Potential for major currency crises, especially if the trillema is violated.

23. Trillema • The trillema, also known as the “impossible trinity” states that a country can ONLY have TWO of the following three: • Fixed exchange rate system • Free flow of capital • Independent monetary policy.