Exchange-Rate Arrangements
Exchange-Rate Arrangements
The Jamaica Agreement formalized the break from fixed exchange rates. As part of this move, the IMF permitted countries to select and maintain an exchange arrangement of their choice, as long as they properly communicated their arrangement to the IMF. Each year the IMF receives information from the member countries and classifies each country into one of three broad categories:
1. currencies that are pegged to a single currency or to a composite of currencies;
2. currencies whose exchange rates have displayed limited flexibility compared with either a single currency or group of currencies; and
3. currencies whose exchange rates are more flexible.3
Table 8.2 identifies the countries that fit in each category. Note that the countries in each category are subject to change each year. In 1983, for example, there were 38 countries pegged to the U.S. dollar, compared with only 31 in 1985 and 28 by mid-1990; there were 33 countries in the more-flexible category in 1983, compared with 48 in mid-1990.
Pegged Rates Countries
that fit in this category peg, or fix, the value of their currency with zero-fluctuation margins (in this case, of countries that peg to a single currency) or very narrow margins of 1 percent or less in the case of pegs to the SDR or other composite currency. Countries in the "other-composite" subcategory have selected a basket of currencies that is different from the SDR. An example of this is the Swedish krona:
In managing the exchange rate of the krona, the Sveriges Riksbank (the central bank) is guided by a trade-weighted index based on a basket of 15 currencies of Sweden's most important trading partners. In constructing the index, the Swedish authorities established two criteria to be met by each country and currency included in the basket: (1) the country had to account for at least 1 percent of Sweden's total foreign trade (exports minus imports) during the previous five-year period, and (2) each currency had to be quoted daily on the foreign-exchange market in Stockholm. The weights are proportional to Sweden's foreign trade with each of the countries whose currencies are included in the index, with the exception that the weight of the U.S. dollar has been doubled and that of the other currencies adjusted accordingly. To take account of changes in average trade shares, the weights are adjusted each year (on April 1) on the basis of trade statistics for the last five calendar years.4
In 1989 the three most important currencies in the basket were the U.S. dollar (22.8 percent), the deutsche mark (16.0 percent), and the pound sterling (11.7 percent).
Limited Flexibility
Llimited-flexibility category of arrangements is divided into two subcategories. In the first subcategory.
"flexibility limited vis-a-vis a single currency," the exchange rates fluctuate within a 2.25 percent margin. In all four cases the U.S. dollar is the benchmark for the currencies. The 2.25 percent margin is consistent with the Smithsonian Agreement signed in 1971, which increased the flexibility in the par value system from 1 percent to 2.25 percent.
The other subcategory, "cooperative agreements," refers to the European Monetary System (EMS). The EMS was created in 1979 as a means of creating exchange stability within the members of the European Community (EC). The major reason for this movement was to facilitate trade among
the members of the EC by minimizing exchange-rate fluctuations. The EMS is a series of exchange relationships determined by the Council of Economics and Finance Ministers, and the Committee of Central Bank Governors of the
EC that link the currencies of most EC members through a parity grid. A central exchange rate is determined for the currency of each country participating in the EMS by the use of a European Currency Unit (ECU). The ECU is similar to the SDR in concept, except that the basket includes the currencies of all countries in the EC, including those not actually part of the EMS.
However, the ECU is different from the SDR in that it is being discussed as the common currency of the EC. Corporations can use the ECU for accounting purposes, and there are ECU bonds and EC traveler's checks.
Once the central exchange rate is determined for the currency of each country in the EMS, a parity exchange rate is determined for each pair of countries. For example, there would be a parity rate for the French franc and German mark, for the Italian lira and French franc, and so on. With the exception of the Italian lira and British pound, which are permitted a fluctuation of 6 percent, bilateral rates are allowed to deviate from the central parity rates by only 2.25 percent before the respective central banks must intervene to protect the integrity of the central rate.
The tenth country to join the EMS was Britain, in 1990. Prime Minister Margaret Thatcher's main reservations about joining the EMS were that Britain would have to engage in a very restrictive monetary policy sponsored by the Bundesbank (the German Central Bank) and that significant unemployment would follow. British interest rates in 1990 climbed to 15 percent, strengthening the pound against the dollar and most major European currencies. This position of strength allowed Britain to join the EMS by the end of the year.
As Europe approaches even greater economic integration, there is some talk of establishing a European Central Bank and a single currency instead of separate national currencies coordinated by the EMS. This would result in the elimination of the "cooperative-arrangements" category, but as of the end of 1990, there was no guarantee that such a move would take place.
More Flexibility
The final major category of exchange arrangements is called "more flexible." In countries whose currencies float independently, government intervention occurs only to influence but not neutralize the
speed of movement of the exchange-rate change as we saw in the intraduc
tory case on JaPan- The leaders of the major industrial countries meet period- ically to discuss common economic issues, and exchange-rate values are often on the agenda. The Plaza meeting of the G-7 in 1985 was where the governments announced that the dollar had been strong too long, and this declaration caused the dollar to begin its slide. However, there were strong economic fundamentals that contributed to the dollar's fall, not just the intervention of these governments. In 1991 the G-7 countries were to meet to discuss the weakness of the dollar and decide whether or not they would intervene to prop up the dollar.
The currencies in the "independently floating" subcategory are of prime importance in the world economy. In 1988, for example, the four major currencies that comprised the official holdings of foreign exchange of the member countries of the IMF were the U.S. dollar (63.3 percent), the deutsche mark (16.2 percent), the Japanese yen (7.2 percent), and the pound sterling (3.1 percent).5
In the "other-managed-floating" subcategory, governments usually set rates for short intervals, such as a week at a time, and buy and sell the currency at that rate for that period. Mexico is an example of a country that is in this category. As discussed in the previous chapter, the Mexican government determined in 1990 that it would let the value of the Mexico peso slide by 0.4 pesos per dollar per day. The basic determination of the amount of the change was the inflation differential between Mexico and the United States and the desire on the part of the Mexican government to not allow imports to have an inflationary impact on the Mexican economy.
The final subcategory, currencies that are "adjusted according to a set of indicators," includes the Malagasy franc of Madagascar. The Malagasy franc's exchange rate "is managed flexibly with reference to a basket of several currencies. The weight assigned to each currency in the basket is based on the distribution of Madagascar's trade during 1973-1980. There is no single intervention currency, although the majority of transactions take place in French francs and U.S. dollars. In accordance with the movement in the basket, the Central Bank of Madagascar adjusts the Malagasy franc exchange rates on a daily basis against ten currencies which it quotes."6
Parallel Markets
As shown in Table 8.2, only 23 of the 151 countries of the IMF that reported their exchange-rate arrangement have currencies that are floating independently.
Many of the other countries control their currencies fairly rigidly. Some of them license their exchange, as noted in Chapter 7, so that residents and nonresidents alike do not enjoy full convertibility. In many of these cases a The black, or parallel, black market parallels the official market. The less flexibility there is, the like-market closely appro^i- lier there is to be a black market. However, even Mexico, a country in the
mates real supply and demand for a currency. other-managed-floating category, has a black market for its currency. In
these countries, the black market is aligned more closely with the forces of supply and demand than is the official market. The black market exists because the government buys dollars for less than the market thinks they are worth. In economic theory, if the government's official rate for the currency is overvalued, the black market tends to undervalue the same currency. The true economic value is probably somewhere in between.
The Jamaica Agreement formalized the break from fixed exchange rates. As part of this move, the IMF permitted countries to select and maintain an exchange arrangement of their choice, as long as they properly communicated their arrangement to the IMF. Each year the IMF receives information from the member countries and classifies each country into one of three broad categories:
1. currencies that are pegged to a single currency or to a composite of currencies;
2. currencies whose exchange rates have displayed limited flexibility compared with either a single currency or group of currencies; and
3. currencies whose exchange rates are more flexible.3
Table 8.2 identifies the countries that fit in each category. Note that the countries in each category are subject to change each year. In 1983, for example, there were 38 countries pegged to the U.S. dollar, compared with only 31 in 1985 and 28 by mid-1990; there were 33 countries in the more-flexible category in 1983, compared with 48 in mid-1990.
Pegged Rates Countries
that fit in this category peg, or fix, the value of their currency with zero-fluctuation margins (in this case, of countries that peg to a single currency) or very narrow margins of 1 percent or less in the case of pegs to the SDR or other composite currency. Countries in the "other-composite" subcategory have selected a basket of currencies that is different from the SDR. An example of this is the Swedish krona:
In managing the exchange rate of the krona, the Sveriges Riksbank (the central bank) is guided by a trade-weighted index based on a basket of 15 currencies of Sweden's most important trading partners. In constructing the index, the Swedish authorities established two criteria to be met by each country and currency included in the basket: (1) the country had to account for at least 1 percent of Sweden's total foreign trade (exports minus imports) during the previous five-year period, and (2) each currency had to be quoted daily on the foreign-exchange market in Stockholm. The weights are proportional to Sweden's foreign trade with each of the countries whose currencies are included in the index, with the exception that the weight of the U.S. dollar has been doubled and that of the other currencies adjusted accordingly. To take account of changes in average trade shares, the weights are adjusted each year (on April 1) on the basis of trade statistics for the last five calendar years.4
In 1989 the three most important currencies in the basket were the U.S. dollar (22.8 percent), the deutsche mark (16.0 percent), and the pound sterling (11.7 percent).
Limited Flexibility
Llimited-flexibility category of arrangements is divided into two subcategories. In the first subcategory.
"flexibility limited vis-a-vis a single currency," the exchange rates fluctuate within a 2.25 percent margin. In all four cases the U.S. dollar is the benchmark for the currencies. The 2.25 percent margin is consistent with the Smithsonian Agreement signed in 1971, which increased the flexibility in the par value system from 1 percent to 2.25 percent.
The other subcategory, "cooperative agreements," refers to the European Monetary System (EMS). The EMS was created in 1979 as a means of creating exchange stability within the members of the European Community (EC). The major reason for this movement was to facilitate trade among
the members of the EC by minimizing exchange-rate fluctuations. The EMS is a series of exchange relationships determined by the Council of Economics and Finance Ministers, and the Committee of Central Bank Governors of the
EC that link the currencies of most EC members through a parity grid. A central exchange rate is determined for the currency of each country participating in the EMS by the use of a European Currency Unit (ECU). The ECU is similar to the SDR in concept, except that the basket includes the currencies of all countries in the EC, including those not actually part of the EMS.
However, the ECU is different from the SDR in that it is being discussed as the common currency of the EC. Corporations can use the ECU for accounting purposes, and there are ECU bonds and EC traveler's checks.
Once the central exchange rate is determined for the currency of each country in the EMS, a parity exchange rate is determined for each pair of countries. For example, there would be a parity rate for the French franc and German mark, for the Italian lira and French franc, and so on. With the exception of the Italian lira and British pound, which are permitted a fluctuation of 6 percent, bilateral rates are allowed to deviate from the central parity rates by only 2.25 percent before the respective central banks must intervene to protect the integrity of the central rate.
The tenth country to join the EMS was Britain, in 1990. Prime Minister Margaret Thatcher's main reservations about joining the EMS were that Britain would have to engage in a very restrictive monetary policy sponsored by the Bundesbank (the German Central Bank) and that significant unemployment would follow. British interest rates in 1990 climbed to 15 percent, strengthening the pound against the dollar and most major European currencies. This position of strength allowed Britain to join the EMS by the end of the year.
As Europe approaches even greater economic integration, there is some talk of establishing a European Central Bank and a single currency instead of separate national currencies coordinated by the EMS. This would result in the elimination of the "cooperative-arrangements" category, but as of the end of 1990, there was no guarantee that such a move would take place.
More Flexibility
The final major category of exchange arrangements is called "more flexible." In countries whose currencies float independently, government intervention occurs only to influence but not neutralize the
speed of movement of the exchange-rate change as we saw in the intraduc
tory case on JaPan- The leaders of the major industrial countries meet period- ically to discuss common economic issues, and exchange-rate values are often on the agenda. The Plaza meeting of the G-7 in 1985 was where the governments announced that the dollar had been strong too long, and this declaration caused the dollar to begin its slide. However, there were strong economic fundamentals that contributed to the dollar's fall, not just the intervention of these governments. In 1991 the G-7 countries were to meet to discuss the weakness of the dollar and decide whether or not they would intervene to prop up the dollar.
The currencies in the "independently floating" subcategory are of prime importance in the world economy. In 1988, for example, the four major currencies that comprised the official holdings of foreign exchange of the member countries of the IMF were the U.S. dollar (63.3 percent), the deutsche mark (16.2 percent), the Japanese yen (7.2 percent), and the pound sterling (3.1 percent).5
In the "other-managed-floating" subcategory, governments usually set rates for short intervals, such as a week at a time, and buy and sell the currency at that rate for that period. Mexico is an example of a country that is in this category. As discussed in the previous chapter, the Mexican government determined in 1990 that it would let the value of the Mexico peso slide by 0.4 pesos per dollar per day. The basic determination of the amount of the change was the inflation differential between Mexico and the United States and the desire on the part of the Mexican government to not allow imports to have an inflationary impact on the Mexican economy.
The final subcategory, currencies that are "adjusted according to a set of indicators," includes the Malagasy franc of Madagascar. The Malagasy franc's exchange rate "is managed flexibly with reference to a basket of several currencies. The weight assigned to each currency in the basket is based on the distribution of Madagascar's trade during 1973-1980. There is no single intervention currency, although the majority of transactions take place in French francs and U.S. dollars. In accordance with the movement in the basket, the Central Bank of Madagascar adjusts the Malagasy franc exchange rates on a daily basis against ten currencies which it quotes."6
Parallel Markets
As shown in Table 8.2, only 23 of the 151 countries of the IMF that reported their exchange-rate arrangement have currencies that are floating independently.
Many of the other countries control their currencies fairly rigidly. Some of them license their exchange, as noted in Chapter 7, so that residents and nonresidents alike do not enjoy full convertibility. In many of these cases a The black, or parallel, black market parallels the official market. The less flexibility there is, the like-market closely appro^i- lier there is to be a black market. However, even Mexico, a country in the
mates real supply and demand for a currency. other-managed-floating category, has a black market for its currency. In
these countries, the black market is aligned more closely with the forces of supply and demand than is the official market. The black market exists because the government buys dollars for less than the market thinks they are worth. In economic theory, if the government's official rate for the currency is overvalued, the black market tends to undervalue the same currency. The true economic value is probably somewhere in between.
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