International Finance Theory and Policy
by Steven M. Suranovic

Finance 80-5

Other Fixed Exchange Rate Variations

Basket-of-Currencies

Countries that have several important trading partners, or who fear that one currency may be too volatile over an extended period of time, have chosen to fix their currency to a basket of several other currencies. This means fixing to a weighted average of several currencies. This method is best understood by considering the creation of a composite currency. Consider the following hypothetical example, a new unit of money consisting of 1 Euro, 100 Japanese Yen and one US dollar. Call this new unit a Eur-yen-dol. A country could now fix its currency to one Eur-yen-dol. The country would then need to maintain reserves in one or more of the three currencies to satisfy excess demand or supply of its currency on the FOREX.

A better example of a composite currency is found in the SDR. SDR stands for special drawing rights. It is a composite currency created by the International Monetary Fund (IMF). One SDR currently consists of a fixed quantity of US dollars, Euros, Japanese yen, and British pounds. For more info on the SDR see the IMF factsheet. Currently Saudia Arabia officially fixes its currency to the SDR. Botswana fixes to a basket consisting of the SDR and the South African Rand.

Crawling Pegs

A crawling peg refers to a system in which a country fixes its exchange rate, but also changes the fixed rate at periodic or regular intervals. Central bank interventions in the FOREX may occur to maintain the temporary fixed rate. However, central banks can avoid interventions and save reserves by adjusting the fixed rate instead. Since crawling pegs are adjusted gradually, they can help eliminate some exchange rate volatility without fully constraining the central bank with a fixed rate. In 2004 Bolivia, Costa Rica, Honduras and Tunisia were among several countries maintaining a crawling peg.

Pegged Within a Band

In this system a country specifies a central exchange rate together with a percentage allowable deviation, expressed as plus or minus some percentage. For example, Denmark, an EU member country, does not yet use the Euro but participates in the Exchange Rate Mechanism (ERM2). Under this system, Denmark sets its central exchange rate to 7.46038 krona per euro and allows fluctuations of the exchange rate within a 2.25% band. This means the krona can fluctuate from a low of 7.63 kr/euro to a high of 7.29 kr/euro. (Recall: the krona is at a high with the smaller exchange rate value since the kr/euro rate represents the euro value.) If the market determined floating exchange rate rises above, or falls below the bands, the Danish central bank must intervene in the FOREX. Otherwise, the exchange rate is allowed to fluctuate freely.

As of 2004, Denmark, Slovenia, Cyprus and Hungary were fixing their currencies within a band.

Currency Boards

A currency board is a legislated method to provide greater assurances that an exchange rate fixed to a reserve currency will indeed remain fixed. In this system the government requires that domestic currency is always exchangeable for the specific reserve at the fixed exchange rate. The central bank authorities are stripped of all discretion in the FOREX interventions in this system. As a result they must maintain sufficient foreign reserves to keep the system intact.

In 2004 Bulgaria, Hong Kong, Estonia and Lithuania were among the countries using a currency board arrangement. Argentina used a currency board system from 1991 until 2002. The currency board was very effective in reducing inflation in Argentina during the 1990s. However, the collapse of the exchange rate system and the economy in 2002 demonstrated that currency boards are not a panacea.

Dollarization/Euroization

The most extreme and convincing method for a country to fix its exchange rate is to give up one’s national currency and adopt the currency of another country. In creating the Euro-zone among 12 of the European Union countries, these European nations have given up their own national currencies and have adopted the currency issued by the European Central Bank. This is a case of Euroization. Since all 12 countries now share the Euro as a common currency, their exchange rates are effectively fixed to each other at a 1-1 ratio. As other countries in the EU join the common currency, they too will be forever fixing their exchange rate to the Euro. (Note however, that although all countries who use the Euro are fixed to each other, the EUro itself floats with respect to external currencies such as the US dollar.

Other examples of adopting another currency as one’s own are the countries of Panama, Ecuador and El Salvador. These countries have all chosen to adopt the US dollar as their national currency of circulation. These they have chosen the most extreme method of assuring a fixed exchange rate. These are examples of dollarization.

International Finance Theory and Policy - Chapter 80-5: Last Updated on 12/2/05

PREVIOUSNEXT