Money Matters – Part I | Trade Samaritan

Money Matters – Part I

Currency regimes around the world differ in many ways and do not necessarily follow a fixed pattern however broadly speaking there are two basic categories of currency regimes, fixed currency regime and floating currency regime.

In today’s world economy time seems to be more important than money as economies are printing currencies in abundance and money has become a free flowing commodity. World trade and currency exchange go hand in hand as both current and capital account transactions are conducted in foreign currencies by all countries. Hence currency trading is perhaps even bigger than goods and services trading as currency trading is more prone to hedging and speculation. Paper money first emerged in China under the Tang dynasty (618 – 907 AD) and soon governments of all other countries took over the system of printing currency. Currency regimes around the world differ in many ways and do not necessarily follow a fixed pattern.

Fixed regimes have more stability and credibility which can attract investors but are rigid in nature. These are most suitable to smaller economies, economies relying on aid and economies that have very few but prominent as well as dominant trading partners. Floating currency regimes require a strong monetary, budgetary and fiscal structure along with a close to matured financial market; these regimes offer freedom but are prone to fluctuations.

Let us take a look at commonly adopted currency regimes with country level examples.

Currency regimes

1. Exchange agreements with no separate legal tenders: The currency of another country circulates as the sole legal tender. Under such regime the country usually belongs to a single monetary or currency in which the same legal tender is shared by all the members of the union. Economies which have adopted this regime experience low interest rates and inflation as the currency is extremely credible, less elastic to market fluctuations.

1.	Exchange agreements with no separate legal tenders: Eurozone Countries: Eurozone comprises of 17 countries which are Austria, Belgium, Cyprus, Estonia, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg, Malta, Netherlands, Portugal, Slovakia, Slovenia and Spain. The monetary policy of all countries in the Eurozone is managed by the European Central Bank (ECB) and the Euro System which comprises of the ECB and the central banks of the EU states that have joined the euro zone. All the 17 countries have replaced their national currencies with euro with a hope of gaining credibility and exchange rate stability in the markets. Some other European countries such as Turkey and Poland are keen to join Eurozone in spite of its current crisis situation.

East Timor: Democratic Republic of Timor-Leste is a country in South East Asia. This country adopted US dollar as its legal tender in 2000 post gaining independence from Indonesia in 1999. Post-independence East Timor was battling with issues such as poverty, lack of commercial expertise, population resettlement; its per capita income was merely $300. Country was highly dependent on IMF aid and hence adopted US dollar as its legal tender. Adopting US dollar as a sole legal tender is also known as Dollarization. It is nearly impossible to exit dollarization for the country as it takes time and immense progress to set up an alternate currency as credible as US dollar. Dollarization requires minimal local administration and support.

Republic of Kiribati: Kiribati is an island located in central tropical Pacific Ocean. This island with a mere population of 100,000 has adopted Australian dollar as its sole legal tender.

Nauru and Tuvalu are two other countries to adopt Australian dollar as their legal tender.

Similarly Cameroon and Senegal have adopted African franc as their sole legal tender.

2.  Currency board arrangements: Under a currency board the country would have its own currency and would fix its value to that of another currency. Under a currency board, a country has to back 100% of its currency with reserves of the target currency. Naturally the country needs to tie its interest rates to be at least equal to those of the target country. It is very difficult to change the fixed exchange rate under currency board and hence this is a very rigid form of arrangement. It is a monetary regime based on a legal commitment to fix the exchange rate of the domestic currency for a specified foreign currency at a specified rate. Interest rates are compatible with the target country and the inflation is low as the currency is rated as credible in the markets.

Currency regimes

HongKong dollar: HongKong dollar is pegged against US dollar at $7.80.  In 1983 Great Britain the then proprietor of HongKong pegged its currency to US dollar as a response to flooding out investments. It saved the country from falling price of HK dollar. It’s been 30 years since then but the currency board arrangement with US dollar continues. There are debates on whether HongKong will break its dollar peg and allow its currency to float or peg it with Chinese Yuan especially as it is a part of Mainland now. As reported in June 2013 by HongKong Monetary Authority (HKMA) the present foreign exchange reserves are to tune of US$303.5 billion which is over seven times the currency in circulation. These numbers seem to depict that Hong Kong is still very far from changing its currency board arrangement.

Brunei: Brunei is a sovereign state located in South East Asia and gained its independence from United Kingdom in 1984. Brunei dollar is pegged 1:1 to Singapore dollar and is even managed by Monetary Authority of Singapore (MAS) which happens to be the largest trading partner of Brunei.

 3. Fixed peg arrangements: Fixed peg arrangement is also known as the standard peg where the country has its own currency and would fix its exchange rate value to another currency or basket of currencies. The interesting attribute of this regime is that the country retains its right to change the rate basis economic circumstances. It also allows the exchange rate to fluctuate within different margins around a central rate. Country must have a stock of foreign exchange reserves to be able to implement, support and sustain this regime. On the flip side this currency is subject to fluctuation and is less credible compared to fixed regimes, interest rates in the country are higher compared to those with fixed regime.

United Arab Emirates: UAE is an Arab country on the south east of the Arabian Peninsula. United Arab Dirham (AED) which is the currency of UAE is pegged to US dollar.  The dirham was officially pegged to the U.S. dollar at one dollar to 3.6725 dirhams in 1978.

Fiji: The Fiji dollar is pegged to a weighted basket of currencies of Fiji’s main trading partners Australia, New Zealand, the United States, Japan and the Euro-zone. Each day, the Reserve Bank of Fiji (RBF) calculates the official exchange rate for the Fiji dollar and releases this rate to commercial banks and foreign exchange dealers. The movements of the Fiji dollar are entirely a result of the movements in the major currencies in our basket in the international currency market. It should be noted that pegging the exchange rate to a basket of trade currencies results into a fluctuating exchange rate in the short term but a stable exchange rate in the long term.

Fixed Peg

4. Crawling pegs: Under crawling pegs the currency is adjusted periodically in small amounts at a fixed pre announced rate or in response to changes in selective quantitative indicators.

Crawling pegs

Bolivia: Bolivia is a land locked country located in South America and is still dependent on foreign aid. Bolivia’s currency regime is semi-fixed or crawling as though its exchange rate is fixed it undergoes high frequency re-adjustments which are not necessarily disclosed in advance to public. During the Latin American regional crisis of 1999-2003, for example, the Bank accelerated the rate of crawl (depreciating the currency) which may explain why Bolivia came through that tumultuous period for Latin America relatively unscathed. Crawling peg regime it appears to have contributed to relatively moderate inflation, financial stability, and a very high level of international reserves.

Tunisia: Tunisia is the smallest country is North Africa and gained independence from France in 1956. Since 1992, the value of the Tunisian Dinar has been managed by a controlled float, pegged to a basket of currencies comprised of the country’s primary trading partners. The value of Tunisian dinar has reached its lowest point today which reflects its bad health in terms of foreign trade and shaky socio-political situation.

This brings us to the end of fixed currency regimes, in Part II we shall be discussing Floating exchange rate regimes or systems.