Definition of Fixed Vs. Flexible Exchange Rate

Fixed Vs. Flexible Exchange Rate

Exchange rate stability has always been the objective of monetary policy of almost all countries. Except during the period of the Great Depression and World War II, the exchange rates have been almost stable. During post-war II period, the IMF had brought a new phase of exchange rate stability. Most governments have maintained adjustable fixed exchange rate till 1973. But the IMF system failed to provide an adequate solution to three major problems causing exchange instability, viz.,

Providing sufficient reserves to mitigate the short-term fluctuations in the balance of payments while maintaining the fixed exchange rates system;

Problems of long-term adjustments in the balance of payments; and

Crisis generated by speculative transactions.

As a result, the currencies of many countries, especially the reserve currencies were subject to frequent devaluation in the early 1970s. This raised doubts about the continuation of the Brettan Wood System, and also the viability of the fixed exchange rate system. The breakdown of Brittan Wood System generated a debate on whether fixed or flexible exchange rate. Let us briefly describe the main arguments in favour of fixed and flexible exchange rates.

Arguments for Fixed Exchange Rate

The first argument in favour of fixed exchange rate is that it provides stability in the foreign exchange markets and certainty about the future course of exchange rate and it eliminates risk caused by uncertainty. The stability of exchange rate encourages international trade. On the contrary, flexible exchange rate system causes uncertainty and might also often lead to violent fluctuations in the international trade. As a result the foreign trade oriented economies become subject to severe economic fluctuations, if import-elasticity is less than export elasticity.

Secondly, fixed exchange rate system creates conditions for smooth flow of international capital simply because it ensures continuity in a certain return on the foreign investment, while in case of flexible exchange rate; capital flows are constrained because of uncertainty about expected rate of return.

Thirdly, fixed rate eliminates the possibility of speculations, where by it removes the dangers of speculative activities in the foreign exchange market. On the contrary, flexible exchange rates encourage speculation. As mentioned earlier in this chapter, there is controversy about the destabilizing effect of speculation. But, if speculators buy a currency when it is strong and sell it when it is weak, speculation will be destabilizing.

Fourthly, the fixed exchange rate system reduces the possibility of competitive depreciation of currencies, as it happened during the 1930s. The possibility has been further strengthened by the IMF rule for the member nations. Also, deviation from the fixed rates is easily adjustable.

Finally, a case is also made in favour of fixed exchange rate of the basis of existence of currency area. The flexible exchange rate is said to be unsuitable between the nations which constitute currency area, since it leads to chaotic situation and hence hampers trade between them.

Advantages of Basked Currencies

With the existing system of exchange controls in India, a free floating rupee was out of question in the eighties. The rupee is not strong enough to with stand the speculative onslaughts. Our trade would have suffered. Alternatives left to the monitory authorities in India were therefore to link it with $ or L a combination of some major currencies like the SDR. Since both $ and L were having their own problems, the choice has fallen on a basket of currencies but unlike the 16 major currencies in the case of SDR, at that time only 5 major currencies having good trade connections with India in 1975 were chosen in its basket.

The SDR valuation would have been unrealistic for India as some of the currencies represented in SDR have no relations with India’s trade. The basis of SDR valuation was itself changed to a bag of 5 currencies in 1981. It was felt that it would be advantageous for India to link the rupee to a mix of currencies properly weighted as this would give greater stability and more certainty so that India’s trade and investment abroad would not suffer. The import bill and debt servicing burder are heavy for India and it would be necessary to have relative stability in the exchange rate. The fact that moderate depreciation took place in effect as against $ DM etc. would have probably helped our export trade in particular.

Present Exchange Rate System

With the initiation of economic and financial reforms in July 1991, for reaching changes were introduced in the Foreign exchange policy and exchange rate management. FERA was diluted and banks have been allowed greater freedom of lending and their deposits and lending rate have also been freed to a large extent. Foreign exchange release is mostly left to the banks, for many purposes, subject to an upper limit for each purpose. Rupee was made partially convertible first in 1992 followed by full convertibility on trade account in 1993 and thereafter full convertibility on current account inclusive of invisible account in 1994. The era of decontrol on Foreign exchange has started with these reforms. We have now a system of exchange rate management adopted by the RBI since 1994 and the FERA was replaced by FEMA in the year 2000.

Exchange Rates in India

The table below gives TT rates of various currencies in terms of rupees. TT means telegraphic transfer which is next best means and quickest method of transferring fund from one currency to another currency. It is next to physical delivery of currency on spot. The rates for TT buying and selling for major currencies in the world are given in terms of rupees for each of the foreign currency units. The margin between buying and selling rate is the profit to the whole seller.

Foreign Exchange Market

The foreign exchange market is an informal arrangement of the larger commercial banks and a number of FOREX brokers. The banks and brokers are linked together by telephone, Telex and satellite communication network called the SWIFT (Society for World Wide International Financial Telecommunications). This counter based communication system, based in the Brussels, Belgium links banks and brokers in just about every financial centers. The banks and brokers are in almost constant contact with activity in some financial center or the 24 Hrs. a day. Because of the speed of the communications, significant event have vertically instantaneous impacts every where in the world despite the huge distances separating market participants. This is what makes the foreign exchange market just as efficient as a conventional stock or commodity market housed under a single roof.

The efficiency of the Spot foreign exchange market is revealed in the extremely narrow spreads between buying and selling prices. These spreads can be smaller than a 10th of the percent of the value of currency exchanged and are therefore about 50th or less of the spread faced on bank notes by international travelers.

Clearing House

A clearing house is an institution at which banks keep funds which can be moved from one bank’s account to another’s to settle interbank transactions. When foreign exchange is trading against the US Dollar, the clearing house that is used is called CHIPS an acronym for the Clearing House Inter bank Payments Systems (CHIPS). CHIPS is located in new York and as we shall explain below, transfer funds between member bank currencies and also trade directly with each other without involving the dollar – For example Deutsche mark, for British pounds or Italian Lire for Swiss Francs. In these situations a European clearing house will be used. However because a substantial volume of transactions is settled in dollars, we describe here how CHIPS works, although we can note that settlement between banks is similar in other financial centers.