January 12, 2017

'FIXED EXCHANGE RATE' HOW CURRENCY VALUES DETERMINED?




'FIXED EXCHANGE RATE'
HOW CURRENCY VALUES DETERMINED?
DR MUZAHET MASRURI

‘Fixed exchange rate’ or sometimes called ‘pegged exchange rate’ is a system in which the government or the central bank of a country fix the exchange rate with the currencies of other countries (eg United States, United Kingdom, Germany or France).

What is the purpose?

The aim of the fixed exchange rate is to stabilize the exchange rate from uncertain fluctuations that makes it difficult for trade transactions and investments. This is because the stable currency is important for a country where foreign trade accounts for a significant share of the national income and gross domestic product (GDP).

When the fixed exchange rate was introduced?

After World War 2, most countries in the world using the currency exchange rate pegged to the USD, which in turn pegged to the value of gold. This method is called Bretton Woods Fixed Exchange System. But in the early 1970s, when the system collapsed, many countries began using the 'floating system' in determining the value of their currencies.

However, today, there are some countries that still use 'fixed exchange rate'.

How is the mechanism work?

When the value of a currency is pegged with the currency of other country, the central bank must keep maintaining its currency peg rates in the foreign exchange market (FOREX). For example, since 1997, the dirham (United Arab Emirates currency) is pegged to the USD = 3.6725 dirhams. But in reality, both currencies are always fluctuating in the currency market.

Therefore, in maintaining the equilibrium value of dirham, United Arab Emirates central bank must have enough foreign exchange reserves to intervene in FOREX. The way it's done is by buying dirham currency when its value fall and sell when its value increased against the USD in the market.

How many countries in the world use this system?

Currently there are 34 countries in the world that still use the fixed exchange rate system. These countries are as follows:


Of these, 17 countries pegged their currencies with Euro, 13 countries with USD, three countries with South African Rand (ZAR) and a country with the Indian rupee.

Had Malaysia been using fixed exchange rate?

Malaysia used the fixed exchange rate at which the ringgit pegged to USD = RM3.80 from 1 September 1998 (during the Asian Financial Crisis, 1997/98). On 21 July 2005, the fixed exchange rate system had been abolished and until now Malaysia is using the floating system in determining the value of the ringgit

Why a currency pegged to currency of a particular country?

Countries have several reasons to peg their currencies to the currencies of certain countries. The main reason is due to trade and investment among these countries.

For example, countries in the Middle East (Jordan, Oman, Qatar, Saudi Arabia, and United Arab Emirates) pegged their currencies to the USD as these countries need the United States as a trading partner for oil trading.

Countries in Caribbean Island (Aruba, Bahamas, Barbados and Bermuda) pegged to the USD as their main source of income is from tourism paid in USD.

In Africa, most countries pegged their currencies to euro because euro is stable and can protect them from sudden depreciation of their currencies.

What are the advantages of fixed exchange rate?

i.   To stabilize the currency from fluctuating its value in the market.
ii.   To facilitate international trade and foreign investment inflows into the country
iii.   To reduce uncertainty and volatility of the price of goods in exports and imports.
iv.   To reduce instability in the country's economic activity
v.   To reduce currency speculation in the financial markets because the currency speculators are not interested to trade the stable currencies.

What are the weaknesses?

i.   The central bank must hold high level of reserves, both in foreign and local currencies all the time in maintaining the exchange rate and absorb the excess currency supply and demand in the market.
ii.   Countries will lose control over domestic monetary policy as they need to comply with the policies in the countries whose currencies are fixed.
iii.   This method is not suitable for countries with significant differences in terms of the level and economic policies of the countries involved.