INTERNATIONAL FINANCE

MBA(FT)
TOPIC 02-A
Exchange Rate Systems
Exchange Rate Systems (1973 Onwards)
Exchange Rate Systems (1973 Onwards)
• Dollarization
• Currency Board
• Pegging to a Currency
• Pegging to a Basket
• Crawling Peg
• Managed Float
• Clean Float
Dollarization
• Circulation of currency of another country as a legal tender
• The currency of another country may be dollar or any other currency.
 Unofficial Dollarization
Circulation of currency of another country or countries
• Dollarization, the holding by residents of a significant share of their assets in the form of foreign-
currency-denominated assets is a common feature of developing countries and some transitional
economies. However, as Zimbabwe's experience has shown, dollarization can, and does occur, when
the 'flight from domestic currency' gets under way. Chronic inflation does not necessarily degenerate
into hyperinflation, which is triggered by an uncontrolled expansion in the money supply that is fuelled
by endemic fiscal imbalances. Though in official terms Zimbabwe's dollarization (or Randization) is of
unknown quantity, the country already has a high, but unknown, degree of unofficial dollarization. The
phenomenon started with the practice of prices of cars and houses, fees for services, and salaries of
scarce personnel, either paid or calculated in US dollars. This was followed by licensed foreign currency
shops, where virtually most goods, including local manufactured ones, are priced in US dollars. With
the virtual collapse of the domestic currency as a means of transacting business, most business is now
transacted in foreign currency. Nearly all goods and services in Zimbabwe are paid for with hard
currency, and the Zimbabwe "dollar has fallen out of use except for paying certain official fees and
fines.Zimbabwe has skirted the adoption of official or full dollarization where a foreign currency—
possibly rand or US dollar—has the exclusive, predominant status as full legal tender so that the
domestic currency is phased out and replaced by the US dollar or South African rand. There were two
policy moves in 2009 that were very promising: (a) Zimbabwe was abandoning the production of its
own currency and (b) it was allowing foreign currencies to be used as a legal tender.Zimbabwe's
dollarization is near complete. Joint circulation of an anchor currency, in this case the US dollar and the
Zimbabwe dollar, for a period would help restoring the Zimbabwe dollar as the sole legal
tender.Countries that adopt this model can no longer have an independent monetary policy and set
their own interest rates but must 'import' the monetary policy of the country whose currency is
chosen.Alternatively, Zimbabwe can continue with its current unofficial dollarization but regularize its
exchange rate through some pre-determined fixed rate, and at the same time look for an appropriate
monetary anchor.
Currency Board
• Currency Board for any country is a monetary authority that issues
notes and coins freely convertible into a foreign currency at a fixed
rate and on demand
• The foreign currency Is referred to as anchor or reserve currency.
• Currency board must have sufficient reserves to convert all issued
money into anchor currency, without any restriction on the nature of
transaction.
Currency Board
Currency Board-The case of Argentina (1991-2002)
• Average inflation in Argentina between 1975 to 1991 was 325% p.a..
• During the period, there was poor or negative GDP growth and severe
lack of confidence in the government.
• Inflation peaked at 5000% in 1989 and GDP was 10% less than that in
1980.
• Per capita income had fallen over 20%
• Fixed investments had fallen by 50%
• Real wages collapsed to about half of their 1974 peak.
• The reason was hyperinflation which was due to growth of money
supply for financing large fiscal deficits. (external borrowings were
not available)
Currency Board-The case of Argentina (1991-2002)
• Implemented currency board in 1991;
• Changed currency from austral to peso
• Choose USD as anchor currency
• Under the system, new peso could be issued only when USD were
available as backup.
• The main achievement was decrease in inflation from more than
3000% in 1989 to 3.4% in 1994.
Pegged Exchange Rate System
• Fixed exchange rate with respect to one currency or a basket of
currencies (composite).
• The exchange rate ma fluctuate within a band of +/- 1%.
• The monetary authorities of the concerned country has to maintain
the fixed parity through direct/indirect interventions.
• The value of currency remains fixed with one currency but varies with
other currencies as does the anchor currency.
Pegged Exchange Rate System
Crawling Pegs
• The exchange rate is adjusted periodically in small amounts at a fixed
rate.
• Examples
• Honduras
• Nicaragua
• Botswana
• Liberia (Crawl like arrangements)
• Singapore (Crawl like arrangements)
Managed Float
• Attempt to influence exchange rate without having a specific target or
path.
• Managed float has two benefits;
• Prevents speculative attacks
• Smoothen the exchange rate changes
Exchange Rate Volatility in Some Emerging
economies
Currency 1993-1995 1996-2000 2004 2005 2006

Indian Rupee 7.5 4.3 4.7 3.5 4

South Korean Won 2.6 22.2 6.5 6.8 6.9
Indonesian Rupiah 2.1 43.4 7.7 9.1 8.9
Thai Baht 1.7 18.3 4.3 4.7 6.2
New Taiwan Dollar 3.7 5.3 4.9 4.9 4.9
Singapore Dollar 3.7 7,4 4.6 4.4 3.9
Philippine Peso 6.8 12.9 3.1 4.1 4.6
Asian Currency Crises
• It started with sudden and unexpected devaluation of Thai Baht in
July 1997.
• It had maximum impact on Indonesian rupiah, south Korean won,
Malaysian ringgit and Philippines peso.
• Most currencies in the entire region declined in the range of 40% to
80%.