Exchange Rate Systems,

Currency Convertibility, Types

 Fixed Exchange Rate System
 In a fixed exchange rate system, exchange rates are either held constant or allowed
to fluctuate only within very narrow boundaries.
• Devaluation refers to a downward adjustment of the exchange rate by the central
bank.
• Revaluation refers to an upward adjustment of the exchange rate by the central
bank.
 The Bretton Woods era (1944-1971) fixed each currency’s value in terms of gold.
 Governments must act to counter and appreciation/depreciation of their currency
 It is necessary for the central bank to hold large reserves of foreign currency,
which they either buy or release onto foreign exchange markets in order to maintain
the fixed rate.
 Example:
If the rupee is appreciating, the Indian govt. will buy $U.S(sell Rupee) – release rupee
into the market – increase the Indian money supply
If the rupee is depreciating, sell dollar(buy rupees) – decrease the Indian money supply.
 Example

 The Chinese Yuan was fixed against the US$

until 2005, principally to keep the Chinese
currency low in order to boost exports.
 China fixed the exchange rate at P*, below its
natural free market equilibrium at P, which
should rise as demand for Chinese exports
increases.
 In order to maintain this rate, China increases
the supply of Yuan on foreign currency
exchanges by gap Q*1- Q*2 and buys US$’s.
 The Chinese were able to do this by utilizing
the large reserves of currency they had built
up through exports.
 Fixed Exchange Rate System
In a fixed exchange rate system, exchange rates are either held constant or allowed to
fluctuate only within very narrow boundaries.

Advantages
In a fixed exchange rate environment, MNCs may be able to engage in international trade,
direct foreign investment, and international finance without worrying about the future
exchange rate since it is simple and clear.
Disadvantages
– There is still risk that the government will alter the value of a specific currency
– Each country may become more vulnerable to the economic conditions in other
countries like inflationary problem.
– Speculation: If investors know for example that a government might intervene to buy
back currency to maintain its level, they might sell extra currency in order to make a
short-term profit.
 Pegged Exchange Rate System
 The currency’s value is pegged to a foreign currency or to some unit
of account, and thus moves in line with that currency or unit against
other currencies.
 Some governments peg their currency’s value to that of a stable
currency, such as the dollar, because that forces the value of their
currency to be stable.
•For example: In 1994, Mexico’s central bank pegged the peso to the
U.S. dollar, but allowed a band within which the peso’s value could
fluctuate against the dollar.
•By the end of the year, there was substantial downward pressure on the
peso, and the central bank allowed the peso to float freely.
 Pegs
• Pegged exchange rate—implies that the government probably will exercise its
right, at some point(s), to “move” the peg.
• Adjustable peg—implies that the gov’t will adjust the level of the peg as required in
the face of substantial fundamental changes in the country’s international position.
• Crawling peg
– The exchange rate is changed often, but only by official revaluation.
– Best of both worlds? Allows some degree of stability and control, as well as
some degree of flexibility.
– The peg move according to some set of indicators, or according to the
gov’t monetary authority.
• Central bankers set the rate much as the Fed changes the discount
rate.
 Pegs - Example
• The currency of China was pegged with US dollars which is foreign currency.

• In 2015, China broke the peg and separated itself with US dollars.
• It later established its peg with the currency baskets of 13 countries.
• The basket of currencies allowed China to have competitive trade relations.
• The export of china became strong with countries with relatively weaker currency
than that of the Chinese currency Yuan.
• However, certain types of business in the United States gained or thrived due to a
weaker Chinese currency Yuan.
• However, in 2016, it re-established the peg with US dollars
 Floating (Flexible) Exchange Rate
• Floating (Flexible) Exchange Rate
– Pure (clean) float
– Managed (dirty) float
 Freely Floating Exchange Rate System
 In a freely floating exchange rate system, exchange rate values are determined by market
forces without intervention by governments.
 Freely floating exchange rate system allows complete flexibility for exchange rate movements.
 A freely floating exchange rate system adjusts on a continual basis in response to demand and
supply conditions for that currency. Also known as a pure/clean float.
Example: One U.S. dollar might buy one British Pound today, but it might only buy 0.95 British
Pounds
tomorrow. The value "floats."
Demand forces Supply forces
Exports of goods and services Imports of goods and services
Inflows of FDI Outflows of FDI
Speculation Speculation
Inflows of ‘hot money’ Outflows of ‘hot money’
 Conti
If a currency is widely available in the market - or there
isn’t much demand for it - its value will decrease. On the
other hand, when a currency is in short supply or in high
demand, the exchange rate will go up.
Example
• Imagine an exchange rate is in equilibrium at
demand(D) of £1(U.K) supply(S) of £1 with £1 able to
buy $1.50.
• If there was an increase in UK interest rates, this would
increase the D£1 and there would be a shift to D£2.
This would cause an appreciation in the exchange rate
with £1 now able to buy $1.60.
• If there was an increase demand for US exports, there
would have to be an increase in S£ to pay for them, so
there would be a shift to S£2. This would cause a
depreciation in the exchange rate with £1 now able to
buy $1.40.
 Managed/dirty Float Exchange Rate System
 Exchange rates are allowed to move freely on a daily basis and no official
boundaries exist. However, governments may intervene to prevent the
rates from moving too much in a certain direction.
 If this is done deliberately to gain an advantage over trading partners,
this is known as a dirty float.
 This typically involves the government and central bank deciding upon an
upper and lower limit that they ideally would like the exchange rate to
operate between.
 The government and central bank will only intervene in the event that
there is a danger of the upper or lower limits being breached.
 Example
• The U.K government might hypothetically set
a
price ceiling of £1/$2 and a floor of £1/$1.
• If there is danger that the £ has strengthened
significantly towards the upper band, this may
damage exports, so the government/central
bank might intervene by for example, lowering
interest rates, or increasing the S£ to buy $.

• Equally, if the £ has weakened considerably so

that imports are more expensive and creating
inflationary pressure, intervention to buy £’s or
raise interest rates may keep the currency
within its permitted bands. The wider the band
in the managed float, the less intervention will
be required, and vice versa.
 Forward Rate
• A forward rate is one that is determined as per the terms of a forward
contract. It stipulates the purchase or sale of a foreign currency at a
predetermined rate at some date in the future. A forward contract is
generally entered into by exporters and importers who are exposed to
Forex fluctuations. The forward rate is quoted at a premium or
discount to the spot price.
Forward Rate….Cont…
• Advantage
• A forward contract freezes the rate of exchange for both parties and thus
eliminates the element of uncertainty. Therefore, it provides a complete
hedge against all unruly movements in the market.

• Disadvantage
• Any exchange does not back a forward contract. Therefore the possibility of
default is quite high. Also, freezing the rates may prove to be a loss-making
decision in some situations. For example, a long forward in a bearish market
or a short forward in a bullish market are instances of the forward backfiring.
 Spot Rate
• The spot rate is the current exchange rate for any currency. It is the rate at
which your currency shall be converted if you decide to execute a foreign
transaction “right now.” They represent the day-to-day exchange rate and
vary by a few basis points every day.

• Advantage
• Trading at a spot rate does not require deep mathematical or statistical
analysis. It is what it is. It is a straightforward rate without any ambiguity.

• Disadvantage
• Spot rates can be a misleading indicator in times of economic crisis,
unreasonable demand or supply patterns, or temporary transitional phases
in an economy.
 Dual Exchange Rate
• In this type of system, the currency rate is maintained separately by
two values-one rates applicable for the foreign transactions and
another for the domestic transactions. Such systems are normally
adopted by countries that are transitioning from one system to
another. This ensures a smooth changeover without causing much
disruption to the economy.
Dual Exchange Rate….Cont.
Advantage
• Countries enforcing a dual exchange rate can enforce separate rates for capital and
current account transactions. Therefore a significant amount of control is with the
government whereby it can influence revenues from capital or current sources
depending upon the need of the hour. It also becomes easier to regulate international
trade and, at the same time, protect the domestic markets.

Disadvantage
• A dual exchange rate system may cause a mis-fixing of the exchange rate and
consequent misallocation of resources in various industries. Because of these, several
economic anomalies such as black markets, arbitrage opportunities, and inflation may
emerge.
Currency Exchange Quotes
• Direct & Indirect Quotes
• A direct currency quote uses the domestic or home currency as the
base. For example, for an American national, the direct currency
quote to obtain Euros will look like USD/EUR 1.17.

• An indirect currency quote denotes the domestic currency as the

quoted currency. Or, in simpler terms, the value of our home currency
is expressed in terms of the foreign currency sought to be acquired or
sold. For example, EUR/USD 0.87. This means that a European
Currency holder will have to give up 0.87 Euros to acquire 1 USD.
Currency Exchange Quotes…..

• Bid & Ask Price

• In practical life, currency quotes are always quoted as USD/EUR 1.1681-1.1685

• The former part of the quote, USD/EUR 1.1681, is known as the bid rate. Bid Rate is the
rate at which the bank will pay you should you go to it to buy Euros against USD. It is
nothing but the buying rate for the bank.

• The latter part of the quote, USD/EUR 1.1685, is known as the ask rate. Ask Rate is the
rate which the bank “asks” from you to obtain a unit of Euro against the value in the
dollar. It is nothing but the selling rate for the bank.

• It is important to know that the ask rate will always exceed the bid rate. The bank will
always buy at a lower rate and sell at a higher rate. The simple reason is that the
difference is the margin that the bank earns for facilitating such currency exchange.
Currency Exchange Quotes…..

• Cross Currency Rate

• Reserve currency or an anchor currency is essentially the one in terms of which
most other currencies are expressed. Such currency is held in large amounts by
governments as Forex reserves. The US Dollar is currently the most widely held
reserve currency, followed by the Euro.

• Consequently, a currency quote not expressed in terms of USD is known as a

cross rate. All dominant and frequently traded currencies are translated in terms
of USD. However, certain transactions may be such that they do not contain the
dollar component at all. In such cases, the currency quotes are required to be
expressed at a rate relative to one another to facilitate that exchange.
• Example - Cross Currency Rate
• A manufacturer in Germany wants to obtain certain automobile parts from a supplier in
Australia. The supplier only accepts payment in Australian Dollars (AUD). Therefore, the
German manufacturer will be compulsorily required to convert EUR to AUD to close the
contract. The amount payable to the Australian Supplier is AUD 350,000.
• The following quotes are quoted by the exchange.
• EUR/USD 1.1670-1.1674
• USD/AUD 1.3561-1.3570
• The quote relevant to the German manufacturer is EUR/AUD
• Therefore, the same is obtained by carrying out the simple work mentioned below
• The simple multiplication of (bid*bid)-(ask*ask) gives the required cross rate.
• = (1.1670*1.3561) -(1.1674-1.3570)
• =1.5826-1.5841
• Therefore, the amount payable to the bank to obtain AUD 350,000 is (350,000/1.5841)
EUR 220,945.
Currency
Convertibility
 Currency Convertibility
 Convertibility essentially means the ability of residents and nonresidents to exchange
domestic currency for foreign currency, without limit, whatever be the purpose of the
transactions.
Currency convertibility refers to the freedom to convert the domestic currency into other
internationally accepted currencies and vice versa at market determined rates of exchange.
 Currency convertibility is vitally important in the foreign exchange market;
higher
convertibility means that a currency is more liquid and, therefore, less difficult to trade.
For example: Rupee can be converted in USA dollars more easily and USA dollars can be
converted in Indian currency for buying and selling of goods and services.
 CON
TI..
 Non-convertible Currency
– Also known as a "blocked currency". (A blocked currency is a currency that can’t freely
be
• converted to other currencies on the foreign exchange (FX) market as a result of exchange
controls.)
– Any currency that is used primarily for domestic transactions and is not openly traded on a foreign
exchange market. This usually is a result of government restrictions, which prevent it from being
exchanged for foreign currencies.
– These are several reasons for making money blocked, including foreign exchange regulations,
government restrictions, physical barriers, political sanctions or extremely high volatility.
• For example:
 Angola-Angolan Kwanza (AOA)
 Armenia-Armenian dram (AMD)
 Bahamas-Bahamian dollar (BSD)
 Barbados-Barbadian dollar (BBD)
 Cuba- Cuban peso (CUP)
 Why do countries limit currency
convertibility?
The main reason is to preserve foreign exchange reserves and prevent capital flight: when residents and
nonresidents rush to convert their holdings of domestic currency into a foreign currency. Capital flight is
most likely to occur when the value of the domestic currency is depreciating rapidly because of
hyperinflation, or when a country's economic prospects are shaky in other respects.
By restricting the exchange of one money to an outside currency, a country would try to control and
keep its currency more stable.
In the case of a nonconvertible currency, firms may turn to countertrade (barter like agreements by
which goods and services can be traded for other goods and services) to facilitate international trade.
 Types of Currency Convertibility

 Freely convertible when the country's government allows both

residents and nonresidents to purchase unlimited amounts of a
foreign currency with the domestic currency.
 Externally convertible when only nonresidents may convert
domestic currency into a foreign currency without any
limitations.
 Non-convertible when neither residents nor nonresidents are
allowed to convert it into a foreign currency.
 Conti…

Non-Convertible-
 Example: capital Cuba(peso) and North Korea(won)
 Non participation in FOREX market Major challenge for domestic currencies
there.
Partial Convertible Capital-
 Example: Indian Rupee
 RBI’s restriction on the inflow and outflow of capital
Full Convertible Capital-
 Example: US dollars
 No restrictions or limitation on the amount to be traded
 Thus, this is one of the major currency traded in FOREX market
 A example of Partial Convertibility of Rupee
According to its Directors’ Report, a public document filed with India’s Registrar of Companies, “Google
India Private Ltd” reported revenues of Rs. 779.34 crore (around $172.03 million at current rates), over
the 15 month period from Jan 2009 to March 2010. There was a foreign exchange of Rs. 304.24 crore.
• From economic point of view, if any country has largest amount of other countries currency, that
country will become economically sound. Suppose, if India does not have US dollars for exchanging
Rs. 304.24 crore to Google India Pvt. Ltd, at that time, India has to take loan of same US
Dollars from USA and will pay interest on it. So, it will increase adverse balance of payment.
• It is true, with partial convertibility of Rupees, investment in foreign country has become easy but
it
is also harmful for India
So, for India's interest, we have some strict rules for stopping outflow of fund on the name of
convertibility of rupee or liberalization.
 Conti…
There are two popular categories of
currency convertibility, namely :
• Convertibility for current
international
transactions (Current Account
Convertibility) and
• Convertibility for
capital movements
international
(Capital Account Convertibility)
.
 Example
What is Kenya’s experience?
• Kenya’s current account balance has generally been in deficit since 2004 when the deficit stood at 0.82
percent of GDP. The deficit widened to stand at about 10 percent of GDP in 2012 largely reflecting a faster
growth in imports of goods into the country relative to exports.
• The imports have been largely in machinery and transport equipment, manufactured goods and oil
products for industrial purposes. These are essential goods whose demand is not responsive to price
changes. Growth in exports has been sluggish with little diversification away from the traditional exports
of coffee, tea and horticulture.
• International trade in services which form part of the current account balance has been in a surplus over
the years, mainly due to improved earnings in export of transportation services, tourism services,
communication services among others. Net current transfers also increased, supported largely by rising
emigrant remittances.
• However, the growth in the services account and net current transfers was not sufficient to offset the
deficit in the merchandise or goods account.
• The huge import bill in the current account increases demand for foreign currency, while slowdown in
exports of goods reduces the inflow of foreign currency.
• The combined effect exerts pressure on the exchange rate to depreciate (weaken).
 Government
Debt
•Countries with high amounts of debt are
less attractive to foreign investors due to
the chance of default as well as possible
high inflation rates. This can decrease the
currency’s value. Example of Greece.
 Speculation or Expectations
 Most trades in the forex markets are speculative trades, which means that sentiment and
momentum can play big roles in market activity. Even if the fundamentals don’t align, the
market for a currency can continue soaring or depreciating if traders and governments
perceive it should.
 If a country's currency value is expected to rise, investors will demand more of that
currency in order to make a profit in the near future. As a result, the value of the currency
will rise due to the increase in demand. With this increase in currency value comes a rise in
the exchange rate as well and vice versa.
 Because of speculative transactions, foreign exchange rates can be very volatile.
 Conti
SIGNAL IMPACT
…
ON $
Poor U.S. Weakened
economic indicators

Fed chairman suggests Strengthened

Fed is unlikely to cut
U.S. interest rates

A possible decline Strengthened

in Indian interest rates

Central banks expected Weakened

to intervene to boost
the Rupee
 CONTI..

Example
• Suppose the exchange rate today is ₹. 70 /US $ .
• The speculator anticipates this rate to become ₹. 71/US within the coming three months .
• Under these circumstances , he will buy US $1,000 for ₹ 70000 and hold this amount for three
months , although he is not committed to this particular time horizon .
• When the target exchange rate is reached , he will sell US $1000 at the new exchange rate , that is
at
₹ 71 per dollar and
• Earn a profit of ₹. 71000- 70000 =₹. 1000
Government intervention and government
influence on exchange rates
 Exchange Rate
Systems
Also known as currency system , establishes the way in which the exchange rate is
determined, i.e., the value of the domestic currency with respect to other currencies.
Exchange rate systems can be classified according to the degree to which the rates are
controlled by the government:
 Fixed
 Pegged
 Floating
 Pure float
 Managed/dirty float
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