Fixed Exchange Rates

When goods, services, and capital can flow freely across international borders, floating foreign exchange rates adjust to the demand and supply of each currency in the marketplace. However, before the 21st century, exchange rates were largely fixed either by the agreement of cooperating countries or by the unilateral action of a country's central bank. Sometimes, such as with the Bretton Woods System, which lasted from 1945 to 1971, the exchange rate peg is managed to within a narrow band of values rather than a fixed amount. For instance, Hong Kong has pegged its dollar to the United States dollar since 1983, restricting the exchange rate to within 7.75 to 7.85 Hong Kong dollars (HK$) to each United States dollar.

The main benefit of fixed exchange rates (a.k.a. pegged exchange rates) is that it reduces risks for both businesses and investors. For countries that have had profligate economic policies, a fixed exchange rate can help to establish a credible low-inflation policy, and it can enhance the transparency and accountability of the country's monetary authority, which is usually the central bank.

Previous to 1973, countries of the world were on relatively fixed exchange rates, either because they were on the gold standard, or because they were parties to the Bretton Woods agreement that was signed in 1944 and required the participating countries to peg their currency to the United States dollar while the United States dollar was pegged to gold at the rate of $35 per ounce.

Fixed exchange rates were then possible, because there was far less global trade and exchange of currencies. Businesses benefited from the fixed exchange rates because it eliminated foreign exchange risk. However, because the United States started printing more money to help finance the Vietnam War, the Bretton Woods agreement started to break down, since the other countries were not willing to inflate their money supply to maintain their peg with the United States dollar.

Nowadays, with global trade much greater than it ever has been before, fixed exchange rates would hamper trade and would prevent central banks from managing their own economies through monetary policy.

However, there are 2 scenarios in which a country would want to fix its exchange rate to a particular currency:

  1. When a country prints too much money and the people lose faith in the money, sometimes the solution is to peg the currency to a reliable source, which often has been the United States dollar. Such was the case with Argentina in the 1990s.
  2. Many emerging market countries, such as China, fix their exchange rate, because exports are more important to them and affect a larger part of their economy. Without a fixed exchange rate, the currency of a country that exports more than it imports tends to appreciate.

Sometimes, an extreme solution to rampant inflation is dollarization, where a foreign currency is adopted by the people for local transactions. It is called dollarization because the United States dollar is most often adopted, not only because it is relatively stable, but also because many people in poor countries receive US dollars from relatives living in the United States.

How Exchange Rates Are Fixed

The quantity of currency or money in any given economy is highly regulated by the central banks in response to the health of their economies. Because the growth of the money supply is no longer coordinated with other countries, a floating exchange rate is the only thing that can work. Furthermore, floating exchange rates allows the flow of capital to its most efficient uses.

If the central bank wants to fix the exchange rate, then it must be willing to exchange the domestic currency for the reference currency at a fixed rate. Generally, the central bank will have no problem supplying its own currency, but it would need large reserves of the reference currency, since it would have to stand ready to exchange one for the other. For instance, in 2007, Hong Kong had $136 billion, which was more than 7 times the amount of Hong Kong dollars in circulation, to maintain its peg.

Domestic Policy and Capital Market Arbitrage

When capital is free to cross international borders, the major disadvantage of fixed exchange rates is that the monetary policy of the pegging country will be subjected to the monetary policy of the reference country, because to maintain the peg, the interest rates in the pegging country must be equal, or close, to the interest rates of the reference country. Otherwise, capital will flow from the low interest-rate country to the high interest-rate country, until the interest rates are equal – this is called capital market arbitrage.

To illustrate, suppose the European Central Bank (ECB) wanted to peg the euro to the United States dollar. However, the main monetary policy objective of the ECB is to maintain price stability. If inflation starts to increase, then the ECB will want to restrain inflation by raising interest rates. Such was the case in early 2011, when both the Federal Reserve and the ECB maintained interest rates close to zero. However, inflation in Europe was starting to increase, so the ECB raised their interest rates. However, if the euro was pegged to the United States dollar, then Americans would have an incentive to convert their dollars into euros so that they can buy European bonds or deposit the euros in a European bank to earn a higher interest than what they could earn in the United States. This would increase the demand for euros and decrease the demand for dollars; therefore, the ECB would have to increase the supply of euros to keep the exchange rate pegged. But increasing the supply of euros will increase the supply of money, thereby leading to higher inflation, which is the exact opposite of the ECB's monetary policy objective, which is to maintain price stability.

Hence, when capital is free to cross international borders, a central bank can either set the domestic interest rate or fix the exchange rate – it cannot do both.

Fixed exchange rates can only be maintained if the macro economies of the 2 countries are closely related and in the same phase of their economic cycle; otherwise, the equalization of interest rates will probably have a deleterious effect on the pegging country.

For instance, when Argentina fixed its exchange rate to the United States dollar in the 1990s, their domestic interest rate would be influenced by the Federal Reserve's Open Market Committee (FOMC), whose decisions would only be predicated upon conditions in the United States — no consideration would be given to the state of Argentina's economy. Likewise, the FOMC would not be concerned about how their decisions would affect the economies of China and Hong Kong, 2 countries that still peg their currency to the United States dollar. Indeed, how could the FOMC reach any decision if they had to be concerned with its effects on 4 separate economies?

Fixed exchange rates also prevent the stabilization of the economy. For instance, if the country is in a recession, a central bank that can set its own domestic policy would lower interest rates, which would lower the foreign exchange rate of its currency, thereby stimulating the economy by lowering the price of its exports. But without a floating exchange rate, this economic stabilization will not occur.

If a fixed exchange rate is untenable, then the monetary authority can usually change the peg by either devaluing or revaluing the domestic currency. Devaluation lowers the value of the domestic currency against the reserve currency, while revaluation increases the value. Note that devaluation and reevaluation are deliberate policies executed by the monetary authorities. In contrast, with floating exchange rates, appreciation and depreciation describes the rise and fall of a currency with respect to other currencies, which is determined by the market.

Generally, large developed countries, such as United States or Europe, have largely self-contained economies where exports and imports account for only a small portion of their GDP, so domestic concerns are paramount. However, for small countries, imports and exports are far more important. Therefore, emerging market countries tend to fix the exchange rate while letting their domestic interest rate rise or fall with the flow of currency.

However, if investors lose confidence in an emerging market economy, then they may sell the bonds to get their money out of the country. This flight of capital causes the country's currency to depreciate rapidly and domestic interest rates to rise rapidly, which, over the short term, would have a depressing effect on the economy — the exact opposite of what would be needed. To prevent this scenario, countries that peg their currency often enact capital controls, which restrict the flow of capital into and out of the country, thereby allowing the country to maintain its peg while also giving it the flexibility of conducting monetary policy to the benefit of their economy.

Capital Controls

Capital controls allow countries to fix their exchange rate and still use monetary policy to regulate their economies by preventing the flow of capital from reaching its economic equilibrium. Inflow controls restrict the ability of foreigners to invest in the country, whereas outflow controls restricts taking currency or transferring funds out of the country.

Some examples include the following:

Economists generally frown upon capital controls, since they impede the flow of capital to its most efficient uses. Any country that resorted regularly to capital controls would be avoided by investors, since, naturally, they like to keep control of their money.