Facts and myths about currency exchange rates :
Today choosing an optimal exchange rate regime is one of the major issues of global policy waiting to be settled.
As international financial markets are closely integrated, just two antithetical regimes are likely to remain: free floating and tight fixation. Will the regimes in between of these two extremes persist? This is an open question.
In 1982 the IMF approved of the classification of exchange rate regimes based on self-determination of national monetary authorities. The central bank and Finance Ministry of a country had 30 days to inform the IMF about relevant changes they introduced, such as altering the national currency exchange rate. An official statement made it possible to attribute the exchange policy of a country to a certain regime. There were three main categories distinguished proceeding from flexibility:
- Fixed exchange rate;
- Managed floating exchange rate;
- Floating exchange rate.
This classification rested on simplicity, statistical selection of countries, quarterly updating and long-term currency rates monitoring. All these factors represented a sufficient ground for an empirical analysis.
Yet the classification had two drawbacks. First, a range of classes was rather narrow, so it was difficult to classify a certain type of “mild adjustment”. Moreover, this classification ignored the fact that monetary policies tend to vary in countries maintaining the same exchange regime.
Second, the discrepancies between nominal and actual national exchange policies appeared to be neglected. Some countries, officially sticking to a fixed rate, carried out numerous devaluations with the currency rate acting as a regulator of the national export competitiveness. Meanwhile, the rest of the countries, adhering to floating, in fact fixed the currency rate.
This was the strategy national governments followed in order to prevent political expenses and loss of trust, which always come along with devaluation. At the same time they seeked to make the most of the currency rate as an anti-inflation anchor of monetary policy.
The final total was a difference between the declared exchange regime and the actual one, which proved to be rather huge.
In the 1990-s there were several alternative classifications put forward. Eventually, a new comprehensive classification, including 25 categories of exchange currency rate regimes, was established. All the categories were split into 9 major clusters. Yet the new classification failed to mirror distinctions between tough and mild ways of fixing an exchange currency rate. This caused many countries to have been attributed to an ”unidentified floating” group.
The classification has been going through changes for many years. Amid the pressure of critics and new classifications emerging the IMF had to update its own one. Unlike the preceding variations, a modernized classification was based on monitoring actual behavior of exchange rates. Applying this classification in practice required the investigation of nominal currency rates dynamics.
In case a country has a unified exchange-rate system, it is an official rate set by the monetary authorities that counts. If, however, economic agents deal with a variety of currency exchange rates, significance is attached to the parallel market exchange rate.
The new classification contained supplementary categories of fixed rates, reflecting the extent of monetary autonomy and obligations of corresponding authorities regarding the currency rate. Despite changes registered in practice, the classification was not broadly employed.
In the 1990-s supporters of fixation started to switch from mild adjustment to tough one. Meanwhile, the gradually increasing number of countries which prefer tough adjustment and free floating is suggestive of the world smoothly moving to two poles of the exchange rate regime.
Polarization of currency exchange rates is seemingly an incarnation of the so-called “incompatible trinity” concept. So, a country is able to ensure only two conditions out of three: the currency rate stability, international capital mobility and monetary policy independence.
Intensifying integration of international financial markets urges monetary authorities to decide between a stable currency exchange rate and monetary autonomy.
An intermediate exchange rate regime has been favoured only in the countries that have not opened their capital markets to foreign investors yet.