Dr Marek Porzycki

Chair for Economic Policy

basic concepts

exchange rate regimes

evolution of the international currency system

Special Drawing Rights (SDR)

currency unions

Currency- 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

Convertibility- full convertibility

- currency of a country can be freely converted into foreign exchange at a 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 (e.g. services, intellectual property)

- 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

- disadvantages: volatility of exchange rates, vulnerability to reversals in capital flows (outflows of foreign capital – e.g., Asian crises in 1990s)

Convertibility

- partial convertibility – control on cross-border capitalflows, some restriction on currency conversion(permission of central bank). E.g. CNY, INR

- no convertibility – currency conversion is generallybanned, currency is not traded on the FX market. E.g. Eastern Bloc currencies before 1989, Cuban „national” peso (CUP), North Korean won.

- 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 Polish economy becomes less competitive. This may lead to larger imports of EUR-priced goods and services from the euro area, and lower exports of PLN-priced Polish goods and services.

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=4.25 PLN → 1 EUR=4.40 PLN)

Reasons for appreciation:

- increased demand for the currency on the market

- high exports (buyers of exports need home currency of the producer to pay; or the exporters are exchanging their foreign currency receipts into home currency)

- increase of interest rates by the country's central bank (people will want its currency as deposits in it attract a higher interest rate)

- increase of employment and per capita income in a country → the demand for its goods and services increases, along with demand for that country's currency in the local market

- loosening of the fiscal policy by the government (borrowing money)

Effects of appreciation:

- cheaper imports

- lower inflation

- balance of trade deficit (because our currency is strong, our own exported goods become more expensive for foreign customers)

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 ofcommodities, a fall in the price of this commodity can cause a fall in export revenue and a depreciation of the exchange rate. E.g. Russia is suffering from a fall in price of oil).

- speculation

Effects of depreciation:

- exports get cheaper, imports more expensive, demand for importswill be reduced

- inflation is likely to occur (in particular the „cost-push” inflation)

- improvement in the current account

devaluation vs. revaluation

- an official lowering (reduction) or increase 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 deficitby 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

Fixed exchange rate (currency peg) - rates are centrally determined (usually by the central bank) and kept stable in relation to an anchor currency (e.g. USD or EUR).

- In order to maintain the 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 exchange 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 alllocal currency cash and reserves held with central bank (all monetary base -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, Timor-Leste), euroization(Kosovo, Montenegro)

Fixed exchange rate (currency peg) -

Advantages:

- avoids currency fluctuations – decrease of costs of international trade

- exchange rate stability encourages investment

- keeps inflation low

Disadvantages:

- less flexibility – it is difficult to respond to temporary shocks(e.g. on the oil market)

- „joining at the wrong rate” – it is difficult to set the right levelfor 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 – no adjustments resulting from exchange rate fluctuations are possible

Flexible (floating) exchange rate – exchange rate results from supply and demand on the foreign exchange market

Advantages:

- no need for management of exchange rates

- no need for frequent central bank intervention, lower foreignexchange reserves needed

- automatic adjustment of the balance of payments - 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, potentially destabilising the economy

- uncertainty for trade (exports and imports) → can be reduced by hedging the foreign exchange risk on the forward market

- risk of inflation

hybrid regimes, e.g.:

- managed float - exchange rate fluctuates from day to day, but the central bank attempts to influence it by buying or selling its currency

- pegged float - the 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

Constraints on monetary policy resulting from a fixedexchange rate. It is impossible to maintain simultaneously:

- fixed exchange rate,

- free flow of capital

- independent monetary policy

Examples:

- China until mid-2015 (a tight combination of a managed floatand a crawling peg similar to a currency peg, capital controls, some degree of independence in monetary policy); Cubacurrently (currency peg, tight capital and foreing exchange restrictions, independent 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)

‘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 was linked to gold ($35 = 1 oz.), convertibility of USD to gold

- USD became international reserve currency

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 amount of dollars in international circulation and the value of the gold backing held by the U.S.- as a result of increased U.S. investment abroad and military spending (1960s).

1971: United States unilaterally terminated the convertibility of the US dollar to gold

Since 1970s – a system of flexible exchange rates, with several mutual or regional arrangements

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 5 currencies (EUR, USD, JPY, GBP, CNY). CNY was added to the basket from 1.10.2016.

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

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 (seealso → dollarization/euroization)

need for a common monetary policy (see →optimum currency area), loss of monetarysovereignty

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 → furthercourses]

planned/considered:

- initiative of the Gulf Cooperation Council (currency: Khaleeji)

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, https://www.bis.org/review/r090402c.pdf