MANAGED CURRENCY SYSTEMS

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Another explicit objective of some central banks is to maintain a stable currency. Central banks have to decide between two distinct options, to allow the currency to ﬂoat freely against other currencies or to attempt to manage the exchange rate. Most economists would agree that central banks can make a reasonable stab at maintaining a stable exchange rate or a stable inﬂationary environment but that it is not possible to achieve both at the same time.
Over the past 20 years central banks in most developed economies have chosen to target stable inﬂation and allow their currency to ﬂoat freely. Floating systems may lead to more volatile exchange rates but those rates adjust gradually over time and reﬂect market perceptions of underlying economic fundamentals. Central banks in many developing countries have persisted with tr ying to achieve both objectives with a bias towards targeted stable exchange rates. There are a number of ways for a central bank to tr y to manage its country’s exchange rate. These include currency boards, ﬁxed currency pegs, currency bands, managed devaluation and the use of trade-weighted baskets of currencies:
Currency boards. A currency board is a system where the local currency is based on that of another currency, usually the US dollar. It is for this reason that the adoption of managed currency systems is frequently referred to as “dollarization”. The system requires the central bank to maintain a reser ve of US$. A conversion rate between the US$ and the local currency is then ﬁxed. The amount of local currency that the central bank can issue is then constrained by the amount of US$ reserves. In other words the local currency is fully backed by the foreign currency.
If those foreign reserves fall, by people or institutions selling the local currency and buying US$, the amount of local currency in circulation is automatically reduced by a corresponding amount. This has the effect of pushing up local interest rates. Currency boards can result in a stable exchange rate even at times of crisis but only at the cost of local pain. A potential currency crisis can usually be avoided through disciplined adherence to the currency board. This can only be achieved by imposing ver y high interest rates and at the expense of a recession. The Hong Kong dollar peg is one of the best-known currency boards.
Fixed currency pegs. Fixed currency pegs are another method of linking a local currency to the US$. The central bank attempts to ﬁx the exchange rate at a particular level even though the local currency is not fully backed by US$ reserves. There are then two ways to try to maintain this level, open market operations by the central bank and capital controls. In open market operations the central bank intervenes directly in the foreign currency market. If holders of the local currency sell it and buy US$ the central bank steps in to supply the US$ at the speciﬁed rate. If on the other hand institutions sell US$ and buy the local currency the central bank issues the local currency. It then normally acts to sterilize these inﬂows by issuing bonds to mop up the additional local currency. The Thai baht and Argentine peso were both ﬁxed currency peg systems maintained by open market operations, before their demise.
Currency bands. Some countries have operated using currency bands. Before the adoption of European Monetar y Union European currencies traded within speciﬁed bands against one another in a system called the European Rate Mechanism (ERM). When a currency came close to the top of its band European central banks would sell the currency and when it came close to the bottom they would buy it. The risks involved in such systems were highlighted when the British pound was forced out of the ERM by speculators who believed that sterling had entered the system at too high an exchange rate.
Managed devaluation. Some countries have tried to adopt a policy of a managed devaluation. Indonesia in the mid-1990s gives us an example of a currency where the central bank made it clear that it was aiming for a managed devaluation of approximately 10% per year. When the currency collapsed in 1997, however, it fell from 2500 to the US dollar to reach a low of 17 000.
Trade-weighted basket. This is a system that avoids some of the above problems. The objective is to manage the currency against a trade-weighted basket of currencies. No ofﬁcial target is given, which makes the currency less of a target. This system is intended to help maintain a country’s competitiveness with trading partners and shield the economy from imported price inﬂation.
The basic problems that most of these systems share are that the central bank risks pitting itself against the market and that in the event of a crisis there is no mechanism for a ﬂexible adjustment. The result has often been a shar p correction resulting in a signiﬁcant dislocation to both the ﬁnancial system and the real economy. Argentina provided a good example in 2001 of the effects of the collapse of a managed currency system and its devastating impact on Argentineans’ life.
Capital controls are another way in which central banks may seek to manage their exchange rate and level of foreign reserves. These prevent a currency from being fully convertible. The degree of capital controls imposed may vary widely. The least onerous capital controls simply make foreign exchange more difﬁcult by requiring central bank approval for all transactions above a speciﬁed level, with approval usually being granted after a certain period. Capital controls encourage companies to look for ways to circumvent such constraints and also usually result in some form of black market where rates offered differ signiﬁcantly from ofﬁcial rates.
Organizations such as the IMF are usually opposed to the use of capital controls under any circumstances but, as we will argue in future posts “Banking crises”, the combination of open capital accounts and an overreliance on short-term foreign funding is an impor tant source of potential instability in developing countries.

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MANAGED CURRENCY SYSTEMS