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

2. IMF Classification of Exchange Rate Regimes
Independent floating
Managed floating
Exchange rate systems with crawling bands
Crawling peg systems
Pegged exchange rate systems within horizontal bands
Conventional pegs
Currency board
Exchange rate systems with no separate legal tender

3. Independent Floating
Exchange rate determined by market forces, with intervention aimed at minimizing volatility:
Example: United States

4. Managed Floating
There is no pre-announced path for the exchange rate, although intervention is common. Policy makers will try to influence the “level” of the exchange rate: example: India

5. Crawling Band
The currency is maintained within bands around a central target for the domestic currency against another currency (or group of currencies). The bands themselves are periodically adjusted, sometimes in response to changes in economic indicators.
Example: Costa Rica, Mexico in 1994.

6. Example: Belarus through Feb 2008

7. Crawling pegs
The domestic currency is pegged to another currency or basket of currencies at an established target rate. The target rate is periodically adjusted, perhaps in response to changing economic indicators.
Example: Bolivia, China
China allows for a daily revaluation of the RMB against a basket of currencies.

8. Birr/$ between Apr 10 and Apr 11

9. 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: Any ERM II country, including Denmark

10. 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

11. 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.

12. Hong Kong
Jim Rogers a famed currency trader has noted: “If I were the Hong Kong government, I would abolish the Hong Kong dollar. There's no reason for the Hong Kong dollar. It's a historical anomaly and I don't know why it exists anymore…. You have a gigantic neighbor who is becoming the most incredible economy in the world.”

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

14. 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.

15. 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.

16. 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.

17. Integration in Europe
Integration in Europe begins with the ECSC in With the Treaty of Rome, the ECSC, EUROTOM, and the EEC are formed, which eventually are absorbed into the EU in 1994.
ESCS leads to EEC, which leads to EC, which leads to the EU.
Monetary integration is formalized with the establishment of the EMS where exchange rates are fixed. The mechanism by which exchange rates are fixes is known as the exchange rate mechanism. The EMS leads to European Monetary Union. The 17 countries that use the euro are part of a currency union known as the EMU. Monetary policy for the entire EMU is overseen by the European Central Bank in Frankfurt.

18. The EU and the EMU. EU Countries
Today, there are 27 EU countries. The European Union is a political and economic union based on free trade. NOT ALL countries use the euro.
There are several distinct groups
EU Countries
EU countries who are not in the ERMII and have no intention of adopting the euro
EU Countries that will adopt
ERM II countr(y)ies that have no stated intentions of adopting the euro
ERM II countries that will adopt
EMU Countries

19. Euro Area EU Austria Denmark Belgium Latvia Cyprus Lithuania Estonia
Finland
France
Germany
Greece Bulgaria
Ireland Czech Republic
Italy Hungary
Luxembourg Poland
Malta Romania
Netherlands
Portugal Sweden
Slovenia UK
Spain
Slovakia
Cyprus, Denmark, the Czech Republic, Estonia, Hungary, Latvia, Lithuania, Malta, Poland, Slovakia and Slovenia, Sweden and the United Kingdom are members of the EU but are not currently participating in the single currency. Denmark is a member of the Exchange Rate Mechanism II (ERM II). This means that the Danish krone is linked to the euro, but the exchange rate is not fixed.
This map is used with permission

20. EU countries that are not part of the ERMII
EU countries that will eventually adopt (or plan to):
Bulgaria
Czech Republic
Hungary
Poland
Romania
EU countries (not part of ERMII) with no stated intention of adopting the euro
Sweden UK

21. ERM II Countries That will adopt:
Latvia
Lithuania
The have no stated intentions of adopting
Denmark

22. EMU Countries Austria (in 1999) - Netherlands (in 1999)
- Portugal (in 1999)
Belgium (in 1999) - Slovenia (in 2007)
Cyprus (in 2008) - Slovakia (in 2009)
Estonia (in 2011) - Spain (in 1999)
Finland (in 1999)
France (in 1999)
Germany (in 1999)
Greece (in 2000)
Ireland (in 1999)
Italy (in 1999)
Luxembourg (in 1999)
Malta (in 2008)

23. Is the EMU an OCA?
OCA optimum currency area: The best geographic region where one currency is used within the region, and where outside the region, different currency(ies) are used.
It is generally accepted that within an OCA:
Countries should be relatively buffered from asymmetric shocks
Factors of production should be mobile

24. Debt crisis
On April 27 ,2010, Greece sovereign debt is downgraded to “junk” status by Standard & Poors. Facing a strong probability of default, the EMU and IMF approve a €110 billion rescue package for Greece on May 2, 2010.
In May 2010, the European Financial Stability Facilty is formed. In conjunction with the IMF, up to €750 billion is available for countries potentially facing a crisis.
In Ireland, the Anglo-Irish Bank is effectively nationalized in December On November 21, 2010, Ireland reaches an agreement for a bailout. On March 30, 2011, Ireland announces that it will need an additional €24 billion from the IMF and EFSF to aid ailing banks. The total bailout for Ireland has reached €70 billion.
The Portuguese government released figures on March 30, 2011, indicating that the deficit had reached 8.6% of GDP.
On April 6, 2011, the Portuguese government asks the EMU for a bailout.

25. Debt crisis continued (2011)
July 2: A compromise is reached so that an installment of the €110 billion can be made. European leaders call on private bondholders to contribute to the bailout.
July 21: A new bailout is approved for Greece. Originally valued at €109 billion, the totally has recently increased to €130 billion.
August 7: The ECB begins to actively intervene to aid bond markets in PIIGS countries.
October 26: In a summit of EU leaders, a grand plan is put together, where bondholders indeed agree to take up to 50% losses on holdings of Greek debt.
As a result of severe political pressure, prime ministers George Papandreou (Greece) and Silvio Berlusconi (Italy) resign in November.

26. Debt crisis continued
December 9: In a summit in Brussels, an intergovernmental treaty is agreed to, which among other things, cements more rigid rules for broaching thresholds on deficit and debt to GDP levels.
December 21: The ECB announces that it will provide€489 billion in three-year loans to more than 500 banks in the EMU.
As of January 4, 2012, with Italian sovereign debt hovering around 7%, the dollar price of the euro is $

27. Major currency crises EMS crises of 1992-93.
Following German re-unification contractionary monetary policy caused the currencies of German trading partners to become overvalued.
Mexican peso crisis
An overvalued exchange rate, policy mistakes, and political turmoil led to collapse of the peso, a severe recession and inflation before an IMF and US led bailout.
Asian currency crisis ( )
Contagion
Argentina ( )
Failure to use fiscal restraint and inflexibility in labor markets led to the collapse in this board system.

28. Overvalued/Undervalued?
How would we know if a currency was overvalued or undervalued?
Most economists use “real exchange rates”.
According to the law of the one price:

29. Real Exchange Rate The real exchange rate is defined as:
Take Mexico as an example: Suppose St is relatively stable but, PtMex increases much more rapidly than PtUS. The result, Rt increases. The Mexican peso appreciates in real terms.

30. Real Exchange rate
If a country’s real exchange rate rises, some combination of the following three are occurring:
The nominal exchange rate is appreciating
Domestic prices are rising rapidly
Foreign prices are falling.
ALL THREE LIKELY LEAD TO A DECLINE IN THE DEMAND FOR EXPORTS

31. The Asian currency crisis
On July 2, 1997, Thai Baht is devalued.
July 11 Philippines devalues the peso
July 14: Malaysia floats the ringgit
July 17: Singapore devalues
August 14: Thailand moves to a float
October 14: Taiwan devalues
November 14: Korea floats
August 17, 1998: Russia abandons its peg
Hong Kong: At one point, Hong Kong monetary authority raises rates to 500%.

32. Asian currency preview: The causes
Liberalization of capital markets in a weak domestic financial environment.
Crony capitalism
Surge in risky real estate investment
Maturity mismatch
Secondary cause: Over-valued real exchange rates.