The Relevance Of The Exchange Rate Regime

In this article, the topic of discussion is the relevance of exchange rate regime in real world. However, first let us have a brief idea what does exchange rate relevance mean? Well, it can be explained as the mechanism which is out into action by the government in order to administrate the currency of its country in the context of the other major currencies of the world.

Coming back to our topic of discussion, the real world relevance of exchange rate regime, we’ll see how in actual the exchange rate regime affects forex currency traders in practice. Since, the exchange rate regimes of both developed and developing countries are still evolving, therefore its bit difficult to find definitive answers. However, we can draw some conclusions based on some of the facts and figures which are available regarding different exchange rate regimes around the globe. To start, the fixed currency pegs need not necessarily be fixed forever; however, if you are struck long a currency which has just devalued it can kill your balance sheet. Let us take an example here; on Feb 9, 1982, the Mexican peso lost around 29% of its value. After a period of 15 years, on July 2, 1997, the Thai baht lost 10% of its value in a single day. The question arises here is that how can this type of portfolio or balance sheet losses be avoided?

The traders in the currency market within fixed or pegged exchange rate regimes need to consider the following points:

Do the type of exchange rate regime relevance and currency peg contribute to economic stability or instability of a currency? The monetary credibility can be provided by currency pegs by making use of exchange rate to force lower inflation, and they can also attract substantial and potentially destabilizing capital flows.

An another important point to know while discussing relevance of exchange rate regime is to what extent is a country open to global capital flows? This is important because if a country permits high capital mobility, a currency peg may not be suitable unless it abandons monetary independence and adopts the hardest of pegs, such as a currency board. Capital flows are less easily anticipated than trade flows, but much more quickly reversed.

In discussing real world relevance of exchange rate regime, the next thing is to know if the currency is pegged at the correct level or not. This question holds equal significance for both developing and developed economies. The currency exchange market traders need to think carefully whether the currency peg level is appropriate. There are corporations with subsidiaries in the countries concerned to carry out this given local pricing and demand knowledge.

Currency risk is not the only point important point to consider in relevance of exchange rate regime. Especially in the developing markets, there may be other important factors to consider such as convertibility risk. It is important to know if a currency is convertible on the capital account. The developing market currencies are by nature much less liquid as compared to those f developed economies. There is political risk also, which are more important consideration in emerging markets.

The relevance of exchange rate regime in real world is also affected by the free floating exchange rates. The free floating exchange rates mean high capital mobility. The theoretical meaning of this combination implies that the capital flow reversals are transmitted through the exchange rate more efficiently and with less volatility. However, the free floating exchange rates can however still see major bouts of volatility. Freely floating exchange rates also exact costs and involve risks on the part of the currency market practitioner in seeking to manage currency risk.