Monetary Law and Monetary Policy 8. Currency and exchange rates Dr Marek Porzycki Chair for Economic Policy

Overview basic concepts exchange rate regimes evolution of the international currency system Special Drawing Rights (SDR) currency unions

Basic concepts Currency Foreign exchange synonym of money system of monetary units in use in a country or an area Foreign exchange foreign currency (in: foreign exchange reserves) market for trading currencies (in: FX market, i.e. global decentralized market for the trading of currencies) Exchange rate – value (price) of one currency expressed in another currency spot and forward exchange rate buying and selling rate, mid-market rate

Basic concepts 2 Convertibility full convertibility currency of a country can be freely converted into foreign exchange at market determined rate of exchange as determined by demand for and supply of a currency no restrictions on currency trade on the foreign exchange market. E.g. USD, EUR, PLN convertibility on current account- exports and imports of merchandise (goods) and invisibles capital account convertibility - in respect of capital flows (flows of portfolio capital, direct investment flows, of borrowed funds, capital gains like dividends and interests) advantages: greater trade and capital flows, better living standard, improved access to international financial markets and reduction in cost of capital. greater confidence of global investors disadvatages: volatility of exchange rates, vulnerability to reversals in capital flows (outflows of foreign capital – e.g., Asian crises in 90’s)

Basic concepts 2 Convertibility partial convertibility – control on cross-border capital flows, some restriction on currency conversion (permissicion of central bank). E.g. CNY, INR India : „Liberalised Exchange Rate Management” scheme in which 60% of all receipts on current account (i.e., merchandise exports and invisible receipts) could be converted freely into rupees at market determined exchange rate quoted by authorised dealers, while 40% of them was to be surrendered to Reserve Bank of India at the officially fixed exchange rate, for meeting Government needs for foreign exchange and for financing imports of essential commodities. no convertibility – currency conversion is generally banned, currency is not traded on the FX market. E.g. Eastern Bloc currencies before 1989, Cuban „national” peso, North Korean won.

Exchange rate movements appreciation / depreciation - an increase/loss (decrease) of value (exchange rate) of a currency with respect to one or more foreign reference currencies due to market forces, Appreciation: if the Polish PLN appreciates relative to the euro, the exchange rate falls: it takes fewer PLN to purchase 1 euro (1 EUR= 4.20 PLN → 1 EUR=4.10 PLN). When the PLN appreciates relative to the Euro, the PLN becomes less competitive. This may lead to larger imports of European goods and services, and lower exports of Polish goods and service. Depreciation: if the Polish Zloty (PLN) depreciates relative to the euro, the exchange rate (the PLN price of euros) rises: it takes more PLN to purchase 1 euro (1 EUR=4.15 PLN → 1 EUR=4.25 PLN)

Appreciation Reasons for appreciation: increased demand for that currency on world markets High exports (the buyers of these exports need its currency to pay for those exports) increase of interest rates by country's central bank (people will want that currency to deposit in the banks to earn that higher interest rate) Increase of employment and per capital income in a country increase, the demand for its goods and services increases, along with demand for that country's currency in the local market Loosening fiscal policy by the government (borrowing money) Effects of appreciation: imports cheaper lower inflation Balance of trade deficit (because our currency is strong, our own goods we look to export appear expensive to other countries)

Depreciation Reasons for depreciation: inflationary pressure (inflation reduces the value of money) collapse of confidence in an economy or financial sector (outflow of capital) lower growth and lower interest rates current account deficit (a country imports more goods and services than it exports) price of commodities (If an economy depends on exports of raw materials, a fall in the price of this raw material can cause a fall in export revenue and a depreciation in the exchange rate. E.g. Russia is suffering from a fall in price of oil). speculation Effects of depreciation: Exports cheaper, imports more expensive, demand for imports will be reduced inflation is likely to occur (in particular cost push inflation) Improvement in the current account

Devaluation devaluation vs. revaluation an official lowering (reduction)/increasing of the value of a country's currency within a fixed exchange rate system, by which the monetary authority formally sets a new fixed rate with respect to a foreign reference currency. Devaluation – in order to reduce a country's trade deficit by improving competitiveness of country’s commodities and help to increase its export volume. Sometimes devaluation is caused by impossibility of maintaining a previous fixed exchange rate due to downwards pressure on the currency. Example: Argentinian peso in 2002

Exchange rate regimes Fixed exchange rate (currency peg) - rates are centrally determined (usually by the Central Bank or by the Currency Board) In order to maintain the local exchange rate, the central bank buys and sells its own currency (interventions) on the foreign exchange market in return for the currency to which it is pegged (more vulnerable) In order to maintain the rate, the central bank must keep a high level of foreign reserves. This is a reserved amount of foreign currency held by the central bank that it can use to release (or absorb) extra funds into (or out of) the market. currency board – currency reserves in the anchor currency need to cover all local currency cash and reserves held with central bank (all M0 monetary aggregate). New money in local currency can be issued only in return for anchor currency. a further step: currency substitution- citizens of a country officially or unofficially use a foreign country's currency as legal tender for conducting transactions. dollarization (El Salvador, Ecuador, Panama), euroization (Kosovo, Montenegro)

Exchange rate regimes Fixed exchange rate (currency peg) - Advantages: avoids currency fluctuations – decrease of costs of international trade stability encourages investment keeps inflation low Disadvantages: less flexibility – it is difficult to respond to temporary shocks (e.g. on the oil market) „join at the wrong rate” – it is difficult to set the right rate for fixing the exchange rate. If the rate is too high, it will make exports uncompetitive. If it is too low, it could cause inflation. current account imbalances

Exchange rate regimes Flexible (floating) exchange rate – exchange rate results from supply and demand on the foreign exchange market Advantages: No need for international management of exchange rates No need for frequent central bank intervention, lower foreign exchange reserves needed Automatic balance of payments adjustment - Any balance of payments disequilibrium will tend to be rectified by a change in the exchange rate Greater insulation from other countries’ economic problems Disadvantages Higher volatility in exchange rates Speculation which can be destabilising for the economy Uncertainty into trade that can be reduced by hedging the foreign exchange risk on the forward market risk of inflation

Exchange rate regimes hybrid regimes, e.g.: managed float - exchange rates fluctuate from day to day, but central banks attempt to influence their countries' exchange rates by buying and selling currencies pegged float - a central bank keeps the rate from deviating too far from a target band or value (e.g. ERM II), crawling peg - a part of fixed exchange rate regimes that allows depreciation or appreciation in an exchange rate gradually, frequent but moderate exchange rate changes exchange rate floor or ceiling

‘Impossible trinity’ Constraints on monetary policy resulting from a fixed exchange rate. Impossibility of maintaining three features simultaneously: fixed exchange rate, free flow of capital independent monetary policy Examples: China (tightly managed float similar to a currency peg, capital controls, some degree of independence in monetary policy) Bulgaria (currency peg, free flow of capital under EU law, no independent monetary policy) Poland (floating exchange rate, free flow of capital under EU law, independent monetary policy)

Evolution of the international currency system ‘gold standard’ until WWI – effectively a system of fixed exchange rates with gold as a measure of reference Advantage: it prevented inflation, stabilized world trade; disadvantage: danger of deflation crisis; it restricted monetary policy Bretton Woods system (after WWII) system of fixed exchange rates: currencies were pegged to USD USD became international reserve currency that was linked to the price of gold ($35 = 1 oz.), convertibility of the USD to gold IMF (goal: to bridge temporary imbalances of payments) and World Bank (International Bank for Reconstruction and Development) Crisis of the Bretton Woods system: growing dollar overhang—the difference between the dollars in international circulation and the value of the gold backing held in Fort Knox - as a result of increased US investment abroad and military spending (1960s). 1971: United States unilaterally terminated convertibility of the US dollar to gold Since 1970s – a system of flexible exchange rates, with several mutual or regional arrangements

Special Drawing Rights (SDR, XDR) an accounting unit created by the IMF in 1969 to facilitate management of foreign exchange reserves and international settlements represents a claim on currency held as reserves by IMF member states value based on a weighted basket of 4 currencies (EUR, USD, JPY, GBP) allocated by the IMF Board of Governors to IMF Member States (current total allocation at ca. 204 bn SDRs, average rate 1 SDR = 1,50 USD) used as supplementary foreign exchange reserve asset (relatively minor importance) and unit of account XDRs are allocated to countries by the IMF Private parties do not hold or use them a 2009 proposal by Zhou Xiaochuan, chairman of the People’s Bank of China, to increase the role of SDR as global reserve currency

Currency unions use of the same currency in more than one country usually result from a formal arrangement (treaty) but may also result from de-facto usage of a currency of another country (see also  dollarization/euroization) need for a common monetary policy (see  optimum currency area), loss of monetary sovereignty

Currency unions - examples historical: Latin Monetary Union (1865-1914/1927), Scandinavian Monetary Union (1873-1914) existing: West African and Central African CFA Franc zones (CFA Franc, pegged to EUR) East Carribean Currency Union (East Caribbean dollar, pegged to USD) Singapore-Brunei currency interchangeability agreement Common Monetary Area, South Africa (South African rand) Economic and Monetary Union (euro area) [see  further courses] planned: - initiative of the Gulf Cooperation Council (currency: Khaleeji)

Reading Additional (facultative): F. Mishkin, The Economics of Money, Banking, and Financial Markets, Pearson, 10th ed. 2013, p. 506-513 Ch. Proctor, Mann on the Legal Aspect of Money, 7th ed. 2012: Chapter 33, Other Forms of Monetary Organization, pp. 861-891 Zhou Xiaochuan, Reform the International Monetary System, March 2009, http://www.pbc.gov.cn/publish/english/956/2009/2009122 9104425550619706/20091229104425550619706_.html