Significance of exchange rates for the economy 2

Significance of exchange rates for an economy. Professor D. Daniels et al in their book International Business list about eight types of exchange systems which we must look at to know to which category own system belongs to now and what it will belong to in future.

1. Exchange arrangements with no separate legal tender. In this arrangement, the currency of one country freely circulates in an economy of another country. This other country has no legal tender currency of its own. This was the case in the colonial days in the British Central Africa, Nyasaland and Northern Rhodesia. Instead, these countries were using the Southern Rhodesia currency. This system continued during the 10 years period of the Federation of Rhodesia and Nyasaland. The other example is the eurozone. Only the euro is legal tender in most member countries.

2. Currency board arrangement. This monetary regime is based on an implicit legislative commitment to exchange a domestic currency for specified restrictions to ensure the fulfilment of legal obligations. Two examples in this category are Bosnia and Hong Kong.

3. Other conventional peg arrangements. A country pegs its currency (formally or de facto) at a fixed rate to a major currency or a basket of currencies in which the exchange rate fluctuates within a narrow margin. China pegs its currency to the US dollar.

4. Pegged exchange rates within horizontal bands. The value of the currency is maintained within margins of fluctuation around a formal or de facto fixed peg. Countries once considered having a managed floating exchange rate system basically peg their currencies to something else. A country may not be part of the euro exchange rate mechanism and yet may peg its currency to the euro as much as possible, but at a wider degree of flexibility.

5. Crawling peg. The currency is adjusted periodically in small amount at a fixed pre-announced rate or in response to selected quantitative indicators.

6. Exchange rate within crawling band. The currency is maintained within certain fluctuation margins around a central rate that is adjusted periodically at a fixed pre-announced rate or in response to selected quantitative indicators. Romania, Israel and Uruguay are said to fall in this category.

7. Managing with no pronounced path for the floating exchange rate. The monetary authority influences the movement of the exchange rate by actively intervening in the foreign exchange market. This is done within a pronounced path for the exchange rate. India is said to fall in this group.

8. Independent floating. The exchange rate is market determined with some foreign exchange intervention aimed at moderating the rate of change and preventing undue fluctuations in the exchange rates. It is not intended to settle a level for the currency.

We see from the above details that exchange regimes are not polarised between the fixed and the floating. There are subtle differences as you move from one country to another.

Black markets

Of the more than 180 International Monetary Fund (IMF) member countries, nearly half of them have currencies which are reasonably flexible, 40 have currencies which float independently. The rest control their currencies somehow rigidly.

In many of these countries, a black market operates side by side with the official market. The black market is aligned more closely with the forces of supply and demand than the official market.

A black market exists when people are willing to pay more for the dollar or other scarce reserve currency than the official rate. The less flexible the exchange rate, the more likely there will develop a parallel market.

On July 4 2012, we learned that the parallel forex trade in Malawi collapsed because the official exchange rate responds to market forces; hence, it is more competitive than it was during the period of the fixed exchange rate.

Does this mean that floating exchange rate systems are always better than others? Not necessarily, otherwise, every country would adopt the flexible exchange rate system. The right system is that which is conducive to the macroeconomic aggregates that the country tries to attain. Hence, though the floating exchange rate system is registering positive results, let us assume that it has come to stay. Every economy is subject to social dynamics.

Forecasting exchange rate movements

One disadvantage of floating exchange rate is the instability they introduce into contracts. You may contract to pay someone in future when the rate is K250 to one US dollar at the agreed date, the dollar may be selling for K300. You then have to find more kwacha than you contracted for.

Under the floating exchange rate system business managers must develop skills in forecasting exchange rate movements. It is here that those trained in business economics become particularly valuable.

Forecasters may make use of current trends in economic variable or may be guided by past movements. Prediction is not a precise science. All the same attempts are made to forecast future trends and base planning on what seems probable.

If a country’s exchange rate is fixed and its reserves remain perpetually low and inadequate, you can rest assured devaluation will follow sooner than later. This is what has happened here.

[This piece is a continuation from Monday]