Between a Rock and a Hard Place: The Dilemma of Fixed Versus Floating Exchange Rates
I. International Exchange Rate Regimes
When crafting its monetary policy, any country is faced with a dilemma labeled by economists as the “unholy trinity” (Willet 2004). It gained that moniker because despite countries’ best efforts, only two of the three goals are attainable at any given time. The three points of the trinity are a sovereign monetary policy, free flow of capital, and fixed exchange rates (Rose 2011, 653). The appeal of a sovereign monetary policy is perhaps self explanatory as it allows a country to adapt to conditions within the country rather than relying on outside actors. Fixed exchange rates offer the appeal of predictability which generally encourages economic investment and growth within the country by other parties (Kenen 2000, 109). In the modern age of technology, the free flow of capital is generally accepted as a given due to the impracticality of placing serious restrictions on its movement. This leaves a country the choice between either the predictability of a fixed exchange rate or the flexibility of a sovereign monetary policy.
The current environment of international exchange rate regimes is the product of the collapse of the Bretton-Woods system in the 1970s (LeBarron & McCulloch 2000, 32). Crafted by the U.S. and its allies in the aftermath of World War II, the Bretton-Woods system established the direct convertibility of U.S. dollars to gold as well as the convertibility of other currencies into U.S. dollars (Garber 1993, 463). This required the U.S. to maintain sufficient gold reserves to cover the entire amount of dollars in circulation at any given time (Garber 1993, 470). This system lasted until the United States refused to should the burden of being subjected to speculative currency attacks on the price of gold. With the end of the convertibility of dollars to gold, the rest of the world was left to re-build their exchange rate policy framework. Some countries chose to continue a mostly fixed exchange rate program, while others favored a more flexible approach. It is important to note, however, that even so called “floating” exchange rates may allow for some government intervention to protect a country’s perceived interests (Banbula, Kozinski, & Rubaszek 2011, 286).
One of the more prominent types of fixed exchange rate programs is known as Dollarization, or more recently – Euroization. Under this system, a country adopts the United States Dollar or some other foreign currency as its own official currency (LeBarron & McCulloch 2000, 32). This approach has some benefits as it allows a country to essentially outsource decisions about its monetary policy to a more developed nation known as the anchor (LeBarron & McCulloch 2000, 34). However, it is not without its drawbacks. It naturally sacrifices a country’s ability to craft a sovereign monetary policy, as the Dollarized country is entirely dependent on the anchor country to maintain the value of its currency (LeBarron & McCulloch 2000). Additionally, the total money supply of the country is limited to the amount of money the country can acquire through payment for exports, borrowing, and remittances sent home from citizens living abroad. This approach also prevents the country’s central bank from acting as a lender of last resort because it has no control over the currency on which the money supply is based (LeBarron & McCulloch 2000, 35). Countries which have adopted the Dollarization approach include Panama – which has used the U.S. dollar as its official currency since 1904 – and Ecuador – which Dollarized in 2000 (LeBarron & McCulloch 2000, 35; Lyderson 2002). Dollarization can occur either unilaterally or bi-laterally if the decision is made in concert with the anchor country (LeCarron & McCulloch 2000, 34).
Another type of fixed exchange regime is a currency board. A currency board involves setting a fixed exchange rate between the national currency and an anchor currency (Atanasov & Valchanov 2011, 7). The entire system rests on the principle of automatic convertibility which means that the national currency can be converted at any time to the anchor currency (Atanasov & Valchanov 2011, 2). Maintaining a currency board requires a long term commitment to the system in order to assure investors and citizens of its stability (Atanasov & Valchanov 2011, 7). The country running the currency board must also hold enough foreign reserves to cover the entire money supply of the country ( Atanasov & Valchanov 2011, 6). This is necessitated by the convertible relationship between the national and anchor currencies. This system restricts a country’s ability to craft a sovereign monetary policy as it is largely dependent on the anchor country’s monetary policy – although not to the extreme of a Dollarized country (Kenen 2000, 112). In order to maintain credibility, a currency board cannot adjust the exchange rate with any frequency or conduct open market operations which removes an important tool from the government’s arsenal (Kenen 2000, 112). Several countries have utilized currency boards including Argentina, Hong Kong, South Africa, and Bulgaria (Atanasov & Valchanov 2011, 4). In the case of Argentina, the system helped rein in inflation for several years in the 1990s but ultimately collapsed in response to domestic economic pressures for a more responsive arrangement (Rebelo & Vegh 2006, 1).
A related system is known as a fixed peg in which the country’s exchange rate is fixed to a single currency or basket of currencies (Masalila & Motshidisi 2003, 1). The prime example of this system recently is China. From 1994 to 2005, China maintained an exchange rate of 8.28 yuan to the dollar (McKinnon 2007, 1). Since then, China has allowed some minor changes, but has generally maintained strict control over its exchange rate (McKinnon 2007, 7). This has given rise to accusations of persistent misalignment as foreign politicians have suggested that the Chinese government has consistently undervalued the yuan to encourage foreign exports (Murray 2013). Maintaining a fixed peg can also put countries at risk of being targeted by speculative attacks if the currency is considered overvalued.
A final example of a fixed exchange rate system is a monetary union. In a monetary union, a single monetary policy is adopted across multiple countries (Ghosh, Gulde, & Wolf 2002, 3). This may involve the adoption of a single currency or – less frequently – the free convertibility of multiple currencies within the union. The monetary union is built around the primacy of a regional central bank which sets monetary policy rather than national level central banks (Hoogduin 2011, 2). The primary example of a monetary union today is the European Union which has unified most of Europe within the Eurozone. The advantage of such an arrangement is that inconsistency is reduced within the zone which can lead to improved efficiencies in trade within EU countries (Hoogduin 2011, 1). On the other hand, there is a clear sacrifice of sovereignty which can harm a country within the union if it faces asymmetrical effects from crisis and is unable to adjust its monetary policy accordingly (Hoogduin 2011, 1).
Flexible exchange rates on the other hand tend to sacrifice the predictability of fixed rates for the advantages of a sovereign monetary policy. A crawling peg is similar to a fixed peg, however it can be adjusted based on clearly defined rules (Ghosh, Gulde, & Wolf 2002, 3). In many cases, these rules are tied to inflationary measures which allow for a government response should the situation demand it (Ghosh, Gulde, & Wolf 2002, 3). A crawling peg is often used by countries experiencing high levels of inflation to avoid appreciation (Ghosh, Gulde, & Wolf 2002, 3). Several countries including Vietnam and China (since 2005) have utilized a crawling peg approach (Martin 2008, 3) This system attempts to balance the benefits of flexibility with the continued desire by investors for stability. In general, the fewer restrictions a country places on adjustments of the currency peg, the fewer benefits it will reap in terms of credibility (Ghosh, Gulde, & Wolf 2002, 3 ). Like a fixed peg, a crawling peg may provide an attractive target for speculative currency attacks (Ghosh, Gulde, & Wolf 2002, 3).
The next step towards non-intervention in currency markets is the exchange rate band approach. In this system, a government allows the exchange rate to freely fluctuate within certain defined bands (Ghosh, Gulde, & Wolf 2002, 3). That is, the government establishes a target rate, defines the acceptable margin of variability, and agrees to take no action to influence the exchange rate within those parameters. However, if the exchange rate leaves the band, its defense through market intervention is important for maintaining the currency’s credibility (Cukierman, Spiegel, & Liederman 2004, 381). There is no standardized width for a currency band, but experts generally recommend a 7-10% range on either side (Cukierman, Spiegel, & Liederman 2004, 380). A variety of countries have utilized currency bands including Chile, Colombia, Ecuador, Finland, Hungary, Israel, Mexico, Norway, Poland, Russia, Sweden, The Czech Republic, and The Slovak Republic (Cukierman, Spiegel, & Liederman 2004, 379). Some, like Chile, allow for periodic readjustment of the target rate (Morande & Tapia 2002, 1). The credibility – and the resulting benefits – of a currency band are dependent on the strength of the surrounding institutions as well as perceptions of policymakers willingness to maintain and defend the integrity of the bands (Cukierman, Spiegel, & Liederman 2004, 381).
The last two types of flexible exchange rate programs are a managed float and the related free float systems. Under a managed float, authorities can intervene to defend a target exchange rate but are not bound to do so as they are with currency bands (Ghosh, Gulde, & Wolf 2002, 3). A free float system takes that idea to its extreme and allows the exchange rate to be determined solely by supply and demand forces in the market (Ghosh, Gulde, & Wolf 2002, 3). While many countries have been labeled ‘free floating’, in practice their governments may still intervene in limited circumstances to influence the exchange rate (Martin 2009, 1). With regards to managed floats, the uncertainty of intervention reduces the credibility benefits of exchange bands and crawling pegs (Siklos 2005 4-7). The lack of established rules for intervention has also led to charges of inadequate transparency surrounding decision making which can reduce confidence in a currency (Ghosh, Gulde, & Wolf 2002, 3). An example of a free floating currency is the Polish Zloty. As of 2011, Poland’s last currency intervention took place in 1998 before it was officially floated in 2000 (Banbula, Kozinski, & Rubaszek 2011,).
II. Exchange Brokers and Retail Trading
Foreign exchange companies, also known as foreign exchange brokers or just Forex brokers, are companies that provide international currency monetary transfers to companies and individuals (HiFX 2013). The global foreign exchange market is quite sizable as brokers may be involved in trades with a total value of $3 trillion in a single day (Pierron 2007, 3). In the United States, brick and mortar foreign exchange locations have generally been replaced by online companies such as Travelex and Wells Fargo (Welsh 2013). Foreign exchange brokers are differentiated from Forex traders in that exchange brokers actually conduct transactions dependent on the physical delivery of money (PSG Online 2013). Such transactions include spot FX transactions which arranges physical delivery in two business days or less and forward FX transactions in which the delivery date is more than two days from the time of the transaction (AFMR 2009). Forex traders, which are discussed below are involved in speculative trading rather than an actual exchange of currency.
Forex brokers may compete somewhat with banks and money transfer companies for business, but generally focus on different market segments. In order to utilize a Forex broker, it is generally necessary to establish an account using a bank account or a credit card (FX Compared 2013). Money transfer organizations like Western Union or MoneyGram usually do not require such an account to initiate a transfer (FX Compared 2013). Forex brokers also usually require a minimum transfer amount – at least $5,000 US dollars – while money transfer organizations generally transfer any amount although a fee may be required (Money Advice Service 2013). Banks are a more direct competitor to Forex brokers as they offer many of the same benefits of reliability as brokers (Money Advice Service 2013). In most countries, Forex brokers fall under some type of regulatory oversight. In the US, for example, official brokers should be members of the National Futures Association (NFA) and registered as a Futures Commission Merchant (FMC) with the Commodity Futures Trading Commission (FX:1 Academy 2013). Dealing through unregistered brokers may place customers at risk of losing money to fraudulent enterprises.
In contrast, currency trading – also known as retail foreign exchange – is focused on speculation rather than actual delivery of currency (Aite Group 2011). A popular target of currency speculation is the South African Rand whose value may fluctuate more than $0.20 in a single day (PSG Online 2013). By either buying long on a currency – if the value is anticipated to grow – or selling short if the value is expected to fall, a savvy trader can accumulate significant gains (ADS Securities 2013). Currency trading companies operate on a marginal system which means that individual traders only have to pay a fraction of the transactions total value (ADS Securities 2013). For example, in order to hold a position of $100,000 on 4% initial margin, a trader would only be required to hold an initial margin of $4,000 (MF Global 2013, 8). This creates the potential for both larger gains and larger losses compared to traditional investment trading (ADS Securities 2013). Currency trading, especially high frequency trading, relies on instantaneous trades rather than the time consuming transactions typical of actual foreign exchange brokers (Markets Committee 2011).
For many years, currency trading was limited to larger financial institutions and investors. Starting an account required between $10 million and $50 million dollars (MF Global 2013, 3). At that time, most currency trades occurred between banks rather than between banks and customers. However, several factors contributed to change that reality; none more significantly than the spread of personal computers and the internet in the 1990s and early 2000s (Aite Group 2011). The internet combined with marginal trading opened up the currency market to average investors leading to the predictable explosion of the market (Rime 2003, 471). From 2001 to 2007, the overall foreign exchange market grew by 10% annually with speculative trading leading the way (Pierron 2007, 8). By 2010, the Aite Group estimated that there were 8.3 million people participating in retail foreign exchange trading in a marketplace with a daily turnover of $315 billion (2011). That value means that currency trading makes up 7.9% of the total daily foreign exchange market (Aite Group 2011). Contributing to the large turnover is high frequency trading – a popular currency trading strategy which relies on high volume, small order sizes, low margins, and typical holding periods of less than 5 seconds (Markets Committee 2011, 1).
As with any high-growth industry, the risk of fraud has also increased according to the Commodity Futures Trading Commission – the relevant regulatory body (CFTC 2013). In 2012, a U.S. citizen living in Panama was sentenced to more than 14 years in prison by a federal judge (USDOJ 2012). According to court documents, Jeffery Lowrance used a Ponzi-type scheme to scam 343 investors out of roughly $17.6 million (USDOJ 2012). On a smaller scale, Gregory Baldwin pleaded guilty to a similar scheme in 2004 when he accepted $228,500 from 33 investors which he used for personal expenses (Delaware Attorney General 2013). Authorities have warned investors repeatedly about offers that assure investors of quick profits of tens of thousands of dollars based on an initial investment of just $5,000 (Delaware Attorney General 2013). These offers which seem too good to be true usually are. The internet has connected large numbers of new investors, but has also introduced new risks. Investors should be wary of trading through companies based in countries without a strong regulatory regimes as many of these offers are fraudulent schemes, and the lack of regulation means the investors may never see their money again (IFIE 2013).
The collapse of the Bretton Woods system has left governments searching for viable exchange rate solutions. Some gravitated towards the credibility of fixed exchange rates but in the process sacrificed their sovereign monetary policy and left themselves vulnerable to speculative attacks . Other chose the flexibility of floating rates but have found that the lack of transparency has negatively impacted the volume of their trade. Both outcomes illustrate the inevitable dilemma inherent in the unholy trinity. Regardless of the exact exchange rate policy, the advent of the internet and personal computers has allowed investors to speculate on the future value of currencies and potentially reap significant profits – or losses – though not without some risk of falling victim to fraudulent schemes. In the case of currency trading as well as exchange rate policy, the old adage holds true: if it sounds too good to be true, it probably is.
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