Forex Exchange Rates
Did you
know that the foreign exchange market (also known as FX or
forex) is the largest market in the world? In fact, over
$1.9 trillion is traded in the currency markets on a daily
basis. Here we will discuss forex exchange rates and
why some fluctuate while others do not.
What Is
a Forex Exchange Rate?
A forex
exchange rate is the rate at which one currency can be
exchanged for another. In other words, it is the value of
another country's currency compared to that of your own. If
you are travelling to another country, you need to "buy" the
local currency. Just like the price of any asset, the forex
exchange rate is the price at which you can buy that
currency. If you are travelling to Egypt, for example, and
the forex exchange rate for USD 1.00 is EGP 5.50, this means
that for every U.S. dollar, you can buy five and a half
Egyptian pounds. Theoretically, identical assets should sell
at the same price in different countries, because the forex
exchange rate must maintain the inherent value of one
currency against the other.
Fixed Forex Exchange Rates
There are
two ways the price of a currency can be determined against
another. A fixed, or pegged, rate is a rate the government
(central bank) sets and maintains as the official forex
exchange rate. A set price will be determined against a
major world currency (usually the U.S. dollar, but also
other major currencies such as the euro, the yen, or a
basket of currencies). In order to maintain the local forex
exchange rate, the central bank buys and sells its own
currency on the forex market in return for the currency to
which it is pegged.
If, for example, it is determined that the value of a single
unit of a local currency is equal to USD 3.00, the central
bank will have to ensure that it can supply the market with
those dollars. In order to maintain the rate, the central
bank must keep a high level of foreign reserves. This is a
reserved amount of foreign currency held by the central bank
which it can use to release (or absorb) extra funds into (or
out of) the market. This ensures an appropriate money
supply, appropriate fluctuations in the market
(inflation/deflation), and ultimately, the forex exchange
rate. The central bank can also adjust the official forex
exchange rate when necessary.
Floating Forex Exchange Rates
Unlike the
fixed rate, a floating forex exchange rate is determined by
the private market through supply and demand. A floating
rate is often termed "self-correcting", as any differences
in supply and demand will automatically be corrected in the
market. Take a look at this simplified model: if demand for
a currency is low, its value will decrease, thus making
imported goods more expensive and thus stimulating demand
for local goods and services. This in turn will generate
more jobs, and hence an auto-correction would occur in the
market. A floating forex exchange rate is constantly
changing.
In reality, no currency is wholly fixed or floating. In a
fixed regime, market pressures can also influence changes in
the forex exchange rate. Sometimes, when a local currency
does reflect its true value against its pegged currency, a
"black market" which is more reflective of actual supply and
demand may develop. A central bank will often then be forced
to revalue or devalue the official rate so that the rate is
in line with the unofficial one, thereby halting the
activity of the black market.
In a floating regime, the central bank may also intervene
when it is necessary to ensure stability and to avoid
inflation; however, it is less often that the central bank
of a floating regime will interfere.
The World Once Pegged
Between
1870 and 1914, there was a global fixed forex exchange rate.
Currencies were linked to gold, meaning that the value of a
local currency was fixed at a set forex exchange rate to
gold ounces. This was known as the gold standard. This
allowed for unrestricted capital mobility as well as global
stability in currencies and trade; however, with the start
of World War I, the gold standard was abandoned.
At the end of World War II, the conference at Bretton Woods,
in an effort to generate global economic stability and
increased volumes of global trade, established the basic
rules and regulations governing international forex exchange
rates. As such, an international monetary system, embodied
in the International Monetary Fund (IMF), was established to
promote foreign trade and to maintain the monetary stability
of countries and therefore that of the global economy.
It was
agreed that currencies would once again be fixed, or pegged,
but this time to the U.S. dollar, which in turn was pegged
to gold at USD 35/ounce. What this meant was that the value
of a currency was directly linked with the value of the U.S.
dollar. So if you needed to buy Japanese yen, the value of
the yen would be expressed in U.S. dollars, whose value in
turn was determined in the value of gold. If a country
needed to readjust the value of its currency, it could
approach the IMF to adjust the pegged value of its currency.
The peg was maintained until 1971, when the U.S. dollar
could no longer hold the value of the pegged rate of USD
35/ounce of gold.
From then on, major governments adopted a floating system,
and all attempts to move back to a global peg were
eventually abandoned in 1985. Since then, no major economies
have gone back to a peg, and the use of gold as a peg has
been completely abandoned.
Why Peg?
The reasons
to peg a currency are linked to stability. Especially in
today's developing nations, a country may decide to peg its
currency to create a stable atmosphere for foreign
investment. With a peg the investor will always know what
his/her investment value is, and therefore will not have to
worry about daily fluctuations. A pegged currency can also
help to lower inflation rates and generate demand, which
results from greater confidence in the stability of the
currency.
Fixed regimes, however, can often lead to severe financial
crises since a peg is difficult to maintain in the long run.
This was seen in the Mexican (1995), Asian and Russian
(1997) financial crises: an attempt to maintain a high value
of the local currency to the peg resulted in the currencies
eventually becoming overvalued. This meant that the
governments could no longer meet the demands to convert the
local currency into the foreign currency at the pegged rate.
With speculation and panic, investors scrambled to get out
their money and convert it into foreign currency before the
local currency was devalued against the peg; foreign reserve
supplies eventually became depleted. In Mexico's case, the
government was forced to devalue the peso by 30%. In
Thailand, the government eventually had to allow the
currency to float, and by the end of 1997, the baht had lost
its value by 50% as the market's demand and supply
readjusted the value of the local currency.
Countries with pegs are often associated with having
unsophisticated capital markets and weak regulating
institutions. The peg is therefore there to help create
stability in such an environment. It takes a stronger system
as well as a mature market to maintain a float. When a
country is forced to devalue its currency, it is also
required to proceed with some form of economic reform, like
implementing greater transparency, in an effort to
strengthen its financial institutions.
Some governments may choose to have a "floating," or
"crawling" peg, whereby the government reassesses the value
of the peg periodically and then changes the peg rate
accordingly. Usually the change is devaluation, but one that
is controlled so that market panic is avoided. This method
is often used in the transition from a peg to a floating
regime, and it allows the government to "save face" by not
being forced to devalue in an uncontrollable crisis.
Although the peg has worked in creating global trade and
monetary stability, it was used only at a time when all the
major economies were a part of it. And while a floating
regime is not without its flaws, it has proven to be a more
efficient means of determining the long term value of a
currency and creating equilibrium in the international
market.
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