A Brief Overview of Currency Regimes

By Keith Heng, 2 Sep 2024

Currency regimes are complex. This article touches on the key traits of each main type of exchange rate arrangement, providing a baseline for further examining the currency and monetary frameworks of individual countries.

Introduction

Investigation of any country's currency regime inadvertently involves thorough delving into its exchange rate history, monetary policies and trade economy. This can be daunting, especially since exchange rate policies are constantly changing to tackle evolving sovereign challenges.

As a start, we can look at the key types of currency regimes that exist today. Here, we use the International Monetary Fund's (IMF) classification to expand our discussion (see appendix). It is noteworthy that these stereotypical regime 'types' should not be interpreted too rigidly. In practice, most countries do not fit 'perfectly' into one type or another and have traits unique to themselves.

Keeping that in mind, we abstract away the jargon and technicalities, focusing only on the few, key defining traits of the currency regimes that surround us today.

Dollarisation

Some countries do not have their own separate legal tender. An example of this is dollarisation — where a country uses another nation's currency as its own medium of exchange and unit of account. Example countries include Ecuador, El Salvador and Panama.

In this case, these countries inherit the credibility of their 'chosen currency' but not its creditworthiness. For instance, amidst a troubling economic crisis in Jan 2000, Ecuador adopted dollarisation which attracted foreign investment and reduced inflationary pressures, owing to the global trust and stability of the U.S. dollar.

Creditworthiness however, differs depending on each country's own ability to repay its debt. Ecuador banks might borrow and lend in U.S. dollars but they are ultimately not members of the US Federal Reserve System or backed by the Federal Deposit Insurance Corporation. Interest rates on U.S. dollars in a dollarised are thus generally not the same as dollar deposits in the United States.

Dollarisation might also promote fiscal discipline since governments can no longer just print money to manage fiscal deficits. Not being able to rely on inflation to reduce the real value of its debt, dollarised economies tend to undergo structural reforms to better manage long-term fiscal health.

The flip side of this of course, is that countries are no longer able to exercise domestic monetary policy since they are not the issuer of the currency. Monetary tools such as the Open Market Operations (OMO) used by the U.S. Fed are not options for countries like Ecuador.

Monetary Union

The other case of countries not having separate legal tender is when they participate in a monetary union and share the same legal tender. The European Economic and Monetary Union (EMU) is the most notable example of this arrangement.

Somewhat similar to dollarisation, each EMU member country does not have their own monetary policy, but jointly determines policies surrounding the Euro through representation at the European Central Bank (ECB). For countries with a troubled history of managing its exchange rates, monetary unions might confer added currency credibility.

However, the potential conflicts between overarching monetary union policies with the needs of individual countries and spillover effects of problems faced by individual nations as shown by thee European Sovereign Debt Crisis, are all issues that plague such regimes.

Currency Board

Countries adopting a currency board make an explicit legislative commitment to exchange its domestic currency for a specified foreign currency at a fixed exchange rate. This is done by placing restrictions on issuing authorities to ensure the obligation will be met.

Taking the case of Hong Kong, the HKD is issued only against the USD and is fully backed by the USD. What this means is that for the entire HKD monetary base (see appendix), there are corresponding foreign assets (usually foreign currency reserves) to ensure that the exchange rate obligation can be met. This rule also prevents careless over-issuance of money. In essence, this could confer stability, inflation-protection and trust to a country's currency regime.

Note: Foreign exchange reserves in Hong Kong increased to $423.4 billion in Aug 2024. It represented over five times the currency in circulation or about 39% of Hong Kong dollar M3.

Source: Trading Economics

However, this obligation also prevents issuing authorities from acting as a lender-of-last-resort as they cannot simply 'print' money beyond its foreign assets to inject liquidity and prevent bank failures. Also, the currency board imports much of the foreign's country's monetary policy since their currency are strictly pegged to the foreign currency. For instance, rate hikes in the US to curb inflation might ripple to the HK economy, regardless of local HK conditions.

Fixed Parity

In a fixed parity/simple fixed-rate system, the domestic currency is also pegged to a foreign currency or currency basket with a ±1% permitted fluctuation band. However, there is no legislative commitment to parity and correspondingly, a discretionary foreign exchange reserve target. Examples include Jordan and The Bahamas.

This means that the issuing authority can execute traditional functions such as acting as the lender-of-last-resort, since they no longer have to strictly back each unit of domestic currency with foreign assets. Flexibility of monetary policy is limited, but still greater than currency boards or dollarisation since traditional central banking tools are available and the level of exchange rate can potentially still be adjusted.

On the other hand, market participants are aware that the country might adjust or abandon the parity since there is no legislative commitment or full backing. The ability and willingness of issuing authorities to offset imbalances — through direct intervention (e.g. sale/purchase of foreign exchange) or indirect intervention (e.g. imposition of foreign exchange regulations) — plays a big role in the credibility of such regimes.

Target Zone

A target zone is similar to the fixed parity regime, but with wider fixed horizontal intervention bands (±2%) around the fixed central rate. This provides the monetary authority with greater allowance for discretionary policy. Examples include Denmark and Slovenia.

Crawling Peg

Crawling peg is where the exchange rate is adjusted gradually in response to economic conditions, such as inflation. Essentially, both the par value of the pegged currency (e.g. 24.82 HNL/USD) and the band widths (±7%) can be adjusted in response to changing economic conditions.

For instance, crawling pegs against the U.S dollar were common in 1980s inflation rampant Latin America, and adjusted frequently to keep pace with the inflation rate. This system is also known as the passive crawl. The active crawl variation is where the exchange rate is pre-announced for the coming weeks with changes taking place in small steps.

Such regimes aim to manage inflation expectations, allow controlled devaluation to prevent economic issues and minimise forex fluctuations.

On the other hand, it can result in artificial exchange levels and speculative activity which can destabilise the currency in extreme situations, leading to a broken peg. A notable example of this is in 1997, where Thailand depleted its reserves and was unable to defend its currency against speculative attacks to devaluate the Baht.

Fixed Parity with Crawling Band

Countries can also have a fixed central parity with crawling bands. For instance, a country can anchor its currency to the USD at a fixed rate to stabilise inflation and gradually introduce more flexibility by widening. the bands around the central parity. This is similar to a fixed parity but provides greater flexibility over time to exit from a fixed parity or provide issuing authorities with greater scope for policy discretion.

Managed Float

Under a managed/dirty float regime, the currency is allowed to fluctuate in response to market forces, but the central bank/monetary authority could intervene when deemed necessary, to achieve goals such as trade balance, price stability, or employment.

This allows countries to exercise a higher degree of independent monetary policy. Since the central bank is not committed to maintaining a fixed exchange rate, it doesn't have to maintain large foreign currency reserves or constantly intervene to defend the peg. This allows it to focus more freely on internal economic issues. Also, tools such as interest rates come into greater play to curb inflation or fuel growth. In a fixed parity however, raising interest rates could attract foreign capital and compromise the fixed rate.

Independent Float

In an independent/free float, the exchange rate is left to market determination with minimal or no intervention from monetary authorities. Any official intervention is aimed at moderating the rate of change and preventing excessive fluctuations, rather than at establishing a level for it.

This provides the greatest degree of independent monetary policy. An example of this is the US, where interest rates and even, quantitative easing, are employed to target domestic conditions with little constraint from exchange rate considerations. Additionally, an independent float likely improves economic shock absorption, reduces speculative attacks and reduces the need the hold large foreign currency reserves.

However, this is accompanied with greater exchange rate volatility (currency risk), inflation pass-through (e.g. when substantial depreciation of currency leads to import inflation and purchasing power erosion) and the loss of exchange rate as a policy tool.

Conclusion

There are no hard and fast rules to exchange rate regimes. Owing to individual circumstance, no country's currency regime fits perfectly into any 'regime type' and tends to possess traits unique to their situation and objectives. Moreover, regime switches are not out of the question.

One example would be the Plaza Accord. In the mid-1980s, with record-high US trade deficit and strong US dollar appreciation, the Plaza Accord was engineered, in which Japan and Germany would appreciate their currencies against the US dollar to weaken the US dollar. The combination of fiscal, monetary and direct FX intervention obviously went against the free-float arrangement that the USD follows.

Understanding the different regime classifications however, provides a foundation from which we can delve further into each country's exchange rate history, specific policy implementations and currency performance.

Appendix

For reference to IMF's 'Classification of Exchange Rate Arrangements and Monetary Policy Frameworks', read this page. An explanation of each regime classification is provided followed by a table summarising IMF's perspective on each country's place in its classification scheme. Do note that the data used by IMF is not current and the exchange rate implementation of certain countries might have evolved since.