Exchange Rate Regimes (Hard Peg, Soft Peg and Floating)

Each country depending on their economic expectation and their political view has applied different types of exchange rate regimes. Although there are too many classifications on this issue, we will use the following classification which is summarized under three titles:

·    Hard peg system

·    Soft peg system

·    Free floating system

Hard Peg Regimes

Hard peg regimes are the exchange rate systems in which the national currency is either fixed to a respectable foreign currency or the government completely gives up its national currency and start to use a strong one.

In recent years, hard or soft pegged exchange rates have been a factor in every major emerging market financial crisis; Mexico at the end of 1994; Thailand, Indonesia, and Korea in 1997; Russia and Brazil in 1998; Argentina and Turkey in 2000; and Turkey again in 2001. Emerging market countries without pegged rates including South Africa, Israel, Mexico, and Turkey in 1998 have been able to avoid such crises.[1] That scenario was the same after 1970s in industrialized economies and they have given up applying this regime since the central banks started to take control on their local economy.[2]

Therefore, when a country wants to apply a form of hard peg they need to think twice. However, these regimes are used by several countries in order to sustain the price stability; hence they are still preferable by different countries. The best known hard peg regimes are listed in the following:[3]

·    Currency Board: Strict exchange rate regime supported by a monetary system based on legislative commitment to exchange domestic currency for a specified foreign currency at a fixed rate. In this regime, the domestic currency is backed 100% by a foreign currency.

·    Currency Union Dollarization: In this regime, one other country’s currency is used as the only legal tender or the country belongs to a currency union in which the same legal tender is shared by all members of the union. Under “dollarization” the country in question completely gives up monetary independence and monetary policy is run by the advanced nation’s central bank.

Like all foreign exchange regimes these two regimes both have advantages and disadvantages which are very similar to each other. The main advantages of hard peg regimes are administrative expenses are reduced, financial sector is sounder, inflation is reduced, interest rates are reduced, and exchange rate risk is mitigated. Although there are several advantages in applying this regime, there are also many disadvantages such as losing a national symbol by adapting dollarization, the autonomy in the monetary transactions is lost, the domestic banks may be more exposed to potential liquidity risks in the depression or recession times.[4]

Soft Peg Regimes

The Soft Peg regimes which are still working under peg mechanisms are more flexible than hard pegs which were explained in the above section. These regimes can be summarized in four different subtypes. These are; crawling narrow band, crawling peg, pegged within bands, crawling broad bands and fixed peg.

The soft peg regimes are mentioned as follows:

·    Crawling narrow band: The exchange rate is maintained within a narrow band around a central rate that is adjusted periodically at a fixed pre-announced rate to keep the effective exchange rate competitive. A common adjustment rule is forward looking crawl (based on differentials between target inflation and expected inflation in major trading partners). The bandwidth is ± 1% around the central exchange rate.[5]

·    Crawling Peg: This is a method of achieving a desired adjustment in a currency exchange rate (up or down) by small percentages over a given period, rather than by major revaluation or devaluation. In this regime, the exchange rate is adjusted periodically according to a set of indicators with a range of fluctuation of less than 2%.[6] The rate of crawl can be set at a pre-announced fixed rate at or below the projected inflation differentials (forward looking). Maintaining a credible crawling peg imposes constraints on monetary policy.

·    Pegged Within Bands: The exchange rate is allowed to fluctuate within a narrow band around a formal or de facto central fixed peg. The central rate is fixed in terms of a single currency or of a basket of currencies. This regime may be the result of cooperative arrangements or unilateral. There is some limited degree of monetary policy discretion depending on the bandwidth.

·    Crawling Broad Peg: The exchange rate is maintained within a broad band around a central rate that is adjusted periodically at a fixed pre-announced rate to keep the effective exchange rate competitive. A common adjustment rule is forward looking crawl (based on differentials between target inflation and expected inflation in major trading partners). It imposes constraints on monetary policy, with the degree of policy independence being a function of the band width.

·    Fixed Peg: The exchange rate is pegged at a fixed rate to a major currency or a basket of currencies in which the trade partners’ currencies are mainly put.[7] The monetary authority is not committed to the peg indefinitely. The peg is adjusted when misalignment becomes unsustainable. The monetary authority stands ready to defend the peg through direct intervention and monetary policy. Traditional central banking functions are possible but the degree of monetary policy discretion is limited.

Like the hard peg regimes, soft peg regimes have also both advantages and disadvantages. The advantages can be summarized as maintaining stability and competitiveness, reduces the interest rates, provides a clear and easily monitorable nominal anchor and reduces inflation. Despite these advantages, these regimes have also some disadvantages like; the country is open for currency crises when the country is open to international markets (this has happened in Turkey), since the national money is revalued, the foreign debts become more cheaper and this increases the short positions in all sectors but mainly in banking sector.

Due to one of the major disadvantages which is the possibility of financial crises of soft peg regimes, most of the countries have given up applying this exchange rate regime after 1970s. Furthermore, it is also seen that behind major crises including Turkish 2001 and Argentina 2001 crises, these regimes are found.

We have tried to show the peg regimes in the above sections. In the following section, we will try to deal with the floating regimes.

Floating Regimes

Finally, we have reached to floating regimes under which the exchange rate of the foreign currency is determined according to supply and demand. These regimes can be summarized under two floating regimes which are shown as follows:

·    Independent float: The exchange rate is determined in the market freely by demand and supply. The monetary authority does not intervene in the foreign exchange market. Monetary policy is independent of the exchange rate regime and can be used freely to steer the domestic economy.

·    Light managed float: The exchange rate is determined essentially in the market freely by demand and supply. Occasional interventions (direct or indirect through monetary policy) aim to moderate excessive fluctuations. Monetary policy is largely free to be used to steer the domestic economy.

·    Managed Float: This is also named as dirty float by many economists. The monetary authority which can be Central Bank usually intervenes actively in the foreign exchange market without specifying or committing to a pre-announced path for the exchange rate. Intervention may be direct (buying or selling foreign currency) or indirect through changes in interest rates, etc. Monetary policy is relatively free to be used to steer the domestic economy.

When we come up the advantages of this regime, the main advantage is it allows a country to adjust to external shocks through the exchange rate whereas the countries with a fixed currency are under stress because of the pressurized domestic wages and prices.[8] Furthermore, it gives liberty to the national economy to determine the foreign exchange rates without depending on a foreign authority.[9] However, the major bad consequence will be continuous increase in the general price levels which will cause inflation. The central bank should be awake to avoid such consequences.

After reviewing all exchange regime types we can conclude that there is no best exchange rate regime for all countries. But, there may be customized exchange rate regimes which fall under one of the above regimes. This is applied according to the last decision of the country after consulting IMF in many circumstances. The country should understand that each regime may have pros and cons, such as volatility in different macroeconomic elements as depicted in the following table and decide on one exchange rate regime depending on its needs.

Volatility Profile of Exchange Rates

Regime	Exchange Rate Volatility	Volatility of Foreign Currency Reserves
Float	High	Low
Soft Peg	Medium	Medium
Hard Peg	Low	High

Source: (YEYATI, Eduardo Levy- and STURZENEGGER, Federico, 2002, A de facto Classification of Exchange Rate Regimes: A Methodological Note [Online], http://200.32.4.58/~fsturzen/AppendixAER.pdf)

Until now, we have discussed the exchange rate regimes and tried to show their influence on a country’s economy policies. The decision of selecting one regime depends on the social and economic infrastructure of the country. The situation of the country should be carefully assessed by the central bank and the government of the country. They need to act together in order to pursue one regime.

---

[1] FISHER, Stanley., 2001, Exchange Rate Regimes: Is the Bipolar View Correct?, Finance and Development, 38, 2, pp.2-21.

[2] MISHKIN, Frederic S. and Miguel A.SAVASTANO, 2002, Monetary Policy Strategies for Emerging Market Countries: Lessons From Latin America, Comparative Economic Studies, 44, 2/3, p. 45-82.

[3] YAGCI, Fahrettin., 2001, Choice Of Exchange Rate Regimes For Developing Countries, Africa Region Working Paper, 16, pp.1-25.

[4] COHEN, Benjamin J., 2000, Dollarization: Pros And Cons, [Online], Http://Www.Cap.Uni-Muenchen.De/Transatlantic/Download/Cohen.Pdf

[5] ÇIMENOĞLU, Ahmet, 2002, Çeşitli Kur Sistemlerinin Değerlendirilmesi, www.bulentsenver.com/Kultur/PPT/KurSistemleri.ppt

[6] CARUANA, Jaime., 2007, Review of Exchange Arrangements, Restrictions, and Controls, [online], http://www.imf.org/external/np/pp/2007/eng/112707.pdf

[7] KUMAKURA, Masanaga., 2005 Exchange Rate Regimes in Asia:Dispelling the Myth of Soft Dollar Pegs, Joumal of the Asia Pacific Economy, 10, 1, pp.70-95.

[8] Economist, 1999, Fix or Float, Economist, 350, 8104, p.21-25.

[9] TAGUCHI, Hiroyuki., (n.d.), The Post-crisis Exchange Rate Management in Selected East Asian Countries [online],  www.dspace.wul.waseda.ac.jp/dspace/bitstream/2065/792/1/20040116_taguchi_eng.pdf