Types of Exchange Rate Regimes

Before posing the question whether banking crises are more likely under hard-pegged exchange rate regimes let us make an overview of the different exchange rate regimes.

Sometimes there is a considerable difference between what the monetary authorities declare as de jure exchange rate regime and what they actually practice, de facto exchange rate regime. From this difference arises the difficulty in classifying the exchange rate arrangements. Furthermore, in some countries parallel exchange rate markets may exist, complicating even more the de facto classification.

From the IMF evaluations of the de facto regimes it can be concluded that 38 percent of the countries had either a hard peg or a floating exchange rate in 1991, while 62 percent had various types of soft peg arrangements. By 1999 the situation had essentially reversed so that 66 percent of the countries had a hard peg or a floating exchange rate whereas only 34 percent had a soft peg arrangement. Table 1 presents the situation by number and percentage in the trend of exchange rate regimes from 1991 to 2002.

Table 1: Trends in Global Exchange Rate Regimes (IMF member countries)

International Monetary Fund identified and classified the de facto exchange rate arrangements according to their degree of flexibility and to the existence of commitments to a path for the exchange rate. The classification scheme starting from the hardest to the most flexible regime is given below.

Hard pegged exchange rate regimes

Exchange Arrangements with No Separate Legal Tender allow the currency of another country to circulate as a legal tender (“dollarization”) or the country is part of a monetary or currency union where all members share the same legal tender. These kinds of arrangements do not allow monetary authority to have independence in controlling the domestic currency.

Currency Board Arrangements (CBA) is a monetary regime which involves an explicit legislative commitment of the monetary authority to exchange the domestic currency for a specified foreign currency, called the reserve currency, at a fixed exchange rate. A second requirement is that the domestic currency has to be issued only against foreign currency, called hard currency or other foreign assets and gold, called gold standard system. This is called the backing rule. This rule limits the monetary authority’s scope for lender-of-last resort (LOLR) support to the amount of foreign exchange in excess of that required for backing. The flexibility of discretionary monetary policy depends on the strictness of the backing rule of CBA.

Soft pegged exchange rate regimes

Countries with Other Conventional Fixed Peg Arrangements peg their currency to another currency or a basket of currencies formed from the currency of major trading partners. The maximum and minimum value of the exchange rate may remain within a narrow margin of 2 percent-for at least three months. The monetary authority maintains the fixed parity through direct or indirect intervention. In this arrangement, central banking functions are still possible, and the monetary authority can adjust the level of the exchange rate, although relatively infrequently.

Pegged Exchange Rates within Horizontal Bands maintain the value of the currency within certain margins of fluctuation of at least ±1 percent around a fixed central rate. It also includes arrangements of countries in the exchange rate mechanism (ERM) of the European Monetary System (EMS) that was replaced with the ERM II on January 1, 1999. There is a limited degree of monetary policy discretion, depending on the band width.

In Crawling Pegs regimes, the currency is adjusted periodically in small amounts or in response to changes in certain macroeconomic indicators (e.g. past inflation or difference between targeted inflation and expected inflation). In this case, the monetary policy has constraints similar to those in a fixed peg regime.

Exchange Rates within Crawling Bands. This regime has a central rate periodically adjusted like in Crawling Pegs regime case. The currency fluctuation is maintained inside a margin of at least ±1 percent around the central rate.

Flexible exchange rate regimes

The arrangement with Managed Floating and No Predetermined Path for the Exchange Rate gives the monetary authority the possibility to directly or indirectly intervene to influence the exchange rate without having a specific target for it. Among the macroeconomic indicators for managing the exchange rate, one can count the balance of payment, international reserves and market developments.

Independently Floating regime allows exchange rate to be determined by the market, with any official intervention aimed to limit or to moderate its fluctuations.

As it has been claimed by many authors, when choosing an exchange rate regime, a primary concern should be the sustainability of the regime. In this direction, Inter-American Development Bank documents the destabilizing consequences of frequently changing the exchange rate regime. Fragile financial systems cause problems in attempting to maintain a fixed exchange rate regime. Balance of payments deficit resulting from shock will lead to a decline in money supply and an increase in interest rate. The increase in interest rate will make it more difficult for borrowers to pay their debts. The decrease in money supply has as a consequence a contraction in bank credit. Thus, a further pressure is put on borrowers and, therefore, banks. More than this, adverse external shocks can create a decline in the quality of bank assets.

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