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Understanding exchange rates

In this week’s episode, we’re going to talk all about the different types of exchange rates, or exchange rate regimes, that exist to manage the value of one currency against another.

Let’s start with the basics. What is an exchange rate? Well, simply put, an exchange rate is the value at which one currency is exchanged for another. If the GBP/USD exchange rate is, say, 1.30, then that means every 1 unit of the domestic currency (which is the one of the left hand side of the quote, in this case sterling), equates to 1.30 units of the foreign currency (i.e the currency on the right hand side, which in this case is the US dollar).

Exchange rates are, of course, determined by supply and demand, but governments and authorities can influence or manage these exchange rates in a number of ways, with the extent and nature of these interventions defining the various types of exchange rates.

Broadly speaking, there are two main categories of exchange rate regimes: Floating (where a currency’s value is determined by forces of supply and demand) and fixed (where the value of one currency is tied to another (typically the US dollar or the euro), and set at a defined rate). In between the two, however, we have a variety of intermediate exchange rate regimes that vary based on the degree of intervention, and the extent to which market forces influence the currency’s value.

So let’s talk through these types of exchange rates, and I can provide you with a few examples for each.

Floating systems

We’ll start with floating systems. As mentioned, here the exchange rate is determined by the free market, i.e supply and demand for both currencies in the pair (from both trade and speculators). From a trade perspective, the supply of a currency is determined by domestic demand for imports from abroad, whereas the demand for a currency is derived by foreign demand for a country’s exports. Speculators, meanwhile, either long currencies (that they believe are undervalued), or short them (if they view them as overvalued) in the hope to profit from changes in the exchange rate.

The IMF sub-categories these currencies into ‘free floating’ and ‘floating’ exchange rates. Free floating exchange rate regimes are used by most first world countries, where liquidity is high and currency volatility tends to be lower. Central banks in these countries will sometimes use their foreign exchange reserves to intervene in the market in order to either protect the currency from a sell-off or prevent excessive appreciation, albeit this is very rare and only takes place when absolutely necessary. Effectively, authorities leave the exchange rate to the mercy of the market, and will neither favour, nor actively pursue, either a stronger or weaker currency. So in these instances, the exchange rate is not a target of monetary policy, nor does the central bank need to necessarily worry about accumulating sufficient levels of FX reserves.

Examples of free-floating regimes would be the US dollar, the euro, sterling, the Japanese yen and the Australian dollar.

Other currencies are run under floating regimes that are more actively managed by their respective central banks. Managed floats (often referred to as ‘dirty floats’) allow these central banks to intervene on a regular basis in order to change the direction or manipulate the value of their country’s currency.

How do they accomplish this? Well some central banks will either raise or lower interest rates in an attempt to either trigger an appreciation or a depreciation in the exchange rate. They can also make use of their foreign exchange reserves. In order to prop up, or strengthen, the domestic currency, these central banks can SELL their foreign currency holdings and BUY the domestic currency. And if they want to see a weaker exchange rate, they can increase their FX reserve holdings by SELLING the domestic currency.

Why would central banks do this? Well, it may well depend on the state of the economy. A weaker currency tends to increase competitiveness and support exports (so may be beneficial for a heavily export oriented economy). On the flip side, when inflation is high, a weak exchange rate may be detrimental, as this could lead to higher imported prices, which may trigger an unwanted further increase in domestic prices.

Some examples of a managed float would be the Brazilian real, the Indian rupee, the South African rand, the Thai baht and the Turkish lira. As you can probably tell, these are generally currencies from some of the larger emerging market economies, where it neither makes sense to peg to another currency, nor allow the exchange rate to be completely determined by market forces.

Fixed exchange rates

Now, as mentioned, at the other end of the spectrum, we have fixed exchange rates. A fixed exchange rate occurs when the government or central bank ties the official exchange rate to another country’s currency (or a group of currencies). Generally (but not in every case) this is the US dollar or the euro. The purpose of a fixed exchange rate system is to maintain a currency’s value within a very narrow band.

Why would a government pursue a fixed exchange rate? Well, firstly this provides a higher degree of certainty for exporters and importers, as the exchange rate is not exposed to market volatility. A fixed exchange rate also helps keep domestic inflation low, because, as mentioned earlier, when a currency depreciates, imported prices increase.

Impact of central banks

These fixed exchange rates, or pegs as they are known, can take on slightly different forms. Again, referring to the International Monetary Fund’s definition, first up, we have a conventional peg. In a conventional peg, authorities intervene in order to ensure that the exchange rate fluctuates by no more than 1% either side of a central rate. Examples here would be some of the currencies in the Middle East that are pegged to the US dollar, such as the Omani riyal, Jordanian dinar or UAE dirham, or the Central and West African francs, which are pegged to the euro.

We then have a stabilised arrangement. Here, authorities do not have a central target rate, and are merely required to keep the exchange rate within a 2% margin for 6 months or more. Examples here would be the Trinidad and Tobago dollar, and the Lebanese pound.

Finally, a currency board arrangement differs in that, unlike a conventional peg or stabilised arrangement, where there is no commitment to maintain the peg, authorities have an explicit legislative commitment to maining the fixed exchange rate. Here, the domestic currency is only issued against foreign exchange and is fully backed by foreign assets. Currencies that adopt a currency board arrangement include the Hong Kong dollar, and those in the Eastern Caribbean Currency Union.

For the most part, these fixed regimes will peg the domestic currency to only one foreign currency, but in rare instances, a central bank will maintain a stable exchange rate against two or more currencies, that are determined by the importance of these currencies to the country’s trade. For instance, the Moroccan dirham is kept stable against a basket that consists of two-thirds euro, and a third US dollar, while the Singapore dollar is maintained within a tight range against a basket of currencies, that includes the dollar, euro, Chinese yuan and Malaysian ringgit, among others.

Finally, some developing countries simply adopt another country’s currency as their own legal tender. Ecuador, Palau and Panama (for instance) use the US dollar, Andorra, Kosovo, Montenegro and San Marino use the euro, while Tuvalu uses the Australian dollar.

As you can probably tell, the variety of different exchange rates makes the FX market a very tough one to successfully navigate.

And with that, ends today’s FX 101 episode. I hope that this episode has given you a better understanding of the various different types of exchange rates.  As mentioned, if you’ve not yet had a chance to listen to our previous FX 101 episodes, please check those out… and be sure to look out for further episodes in the future.

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