By Ben Calzini
Only 64 countries worldwide allow market forces to determine the official value of their national currency (or in other words, allow their currencies to “float”). Among this minority of states, most are considered developed economies. Yet, with all the empirical benefits that come from a market economy in these developed countries, why are the majority of states around the world reluctant to embrace the market when it comes to their national currency?
For those unfamiliar with the labels of “floating” versus “fixed” currencies, the distinction is this: the official value of “floating” currencies is determined by the international supply and demand for a given currency. Countries that “fix” their currencies decide and regulate an official exchange rate at which they will accept another currency for their own.
Returning to the main question, why are most nations reluctant to adopt a floating exchange rate? In economic theory, there are several reasons for and against a floating versus fixed exchange rate regime. But from this pros and cons list, holding foreign currency reserves is one drawback that is particularly worthy of discussion, as it poses an extraordinary flaw with the fixed exchange rate framework. To best exemplify how this drawback manifests, we can turn to Thailand’s experience during the Asian Financial Crisis.
Along with several other “Asian economic miracles” prior to 1997, Thailand experienced impressive economic growth by raising interest rates to attract foreign investment, as well as pegging (fixing) its currency (the Baht) to the dollar in order to boost trade. However, pegged rates are susceptible to changes against the anchor currency, and as part of the Fed’s efforts to combat U.S. inflation in the 1990s, the Fed raised interest rates. This had the effect of appreciating the dollar, thus appreciating the Baht as well. An appreciated currency slowed exports in Thailand, which spooked investors into capital flight. The Thai government responded to the impending crisis by using its foreign reserves to buy up the surplus Baht on the foreign exchange market, but the reserves were not enough. In turn, the Baht was forced to float, plummeting in value between 15% to 20%.
The case of Thailand exposes two critical flaws. First, it shows that a fixed exchange rate regime is not, in fact, exempt from market forces. Thus, the line between floating versus fixing a currency runs dangerously thin. In effect, the only difference between a float and a fixed exchange rate regime is that the latter requires the government to hold and liquidate enough foreign reserves to generate the demand (by buying back its own currency) to inflate the equilibrium price to the official rate. A government’s failure to do so presents problem two. The second problem with a fixed exchange rate is that if the government fails to uphold the peg - that is, the country does not have enough foreign reserves to buy back its currency on the foreign exchange - correction invariably necessitates floating the currency. The currency must float because if the government cannot create the demand to uphold the official exchange rate, then the only remaining authority is the market itself (to be precise, other stakeholders in the market). Thus, without enough foreign reserves held by the government, demand falls leading to depreciation of the currency at market equilibrium (the same result as would have been if the currency floated in the first place).
In light of the case made against fixed exchange rate regimes, it remains curious that if foreign reserves are the linchpin to a successful peg, why does much of the developing world - countries without excess capital - continue to fix their currencies? One compelling reason is that a benefit of pegs is that they offer a semblance of stability to foreign investors and trading partners. However, as the case of Thailand exemplifies, a peg only promotes stability insofar as the government can maintain it. It is not unfair to suggest that the commitment to a fixed exchange rate is an emotional matter. Researchers Calvo and Reinhart in particular have advanced the theory of “fear of floating.” This theory refers to emerging economies that have suffered a financial crisis and thus exhibit pegged regime behaviors in their monetary policy despite officially claiming to float. Such is the case of Thailand, even after adopting an inflation targeting framework since May 2000, research shows that the Bank of Thailand continues to be most responsive to exchange rate indicators.
Although the burden of upholding a peg most obviously falls on developing countries, advanced economies are not exempt from the duties of intervention. In mid-September 2022, Japan spent a record 2.8 trillion yen ($19.7 billion) intervening in the foreign exchange market to prop up the yen, draining nearly 15% of currency reserves just to prevent a .1% depreciation against the dollar. In contrast to Thailand’s experience, Japan’s intervention is very unlikely to result in the same financial catastrophe; however, it does herald other grave concerns. The first is that the scale of intervention signals poor performance of the Yen – $19.7 billion just to address a .1% depreciation rate is an alarmingly disproportionate return.
Second, even successful attempts to reverse depreciation against the tides of market forces would only end up overvaluing the Yen such that further interventions may be necessary. In many respects, this is undesirable for Japan as the Ministry of Finance will have to expend time and money in order to maintain an artificial exchange rate. On the other hand, it is important to remember that government intervention in the exchange rate is nothing new, even in floating regimes (governments are stakeholders after all). However, the scale and degree of intervention, such as that seen in Japan, should raise concern about the state of the currency and financial stability.
Ultimately, the bottom line is this: without sufficient foreign reserves, foreign exchange risk compels states to float their currency. Topical in the debate about whether to float or to fix, leaders in the francophone CFA currency union in Africa ought to consider heeding the lessons of the past in their recent deliberations to adopt their own currencies. In the long run, it would be reasonable for countries - particularly developing nations - to forgo pegging their currencies not only to reap the trade benefits of an undervalued currency (assuming an overvalued peg), but also to relieve governments of the unrealistic expectation that they can uphold a fixed rate indefinitely.
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