Question

In one paragraph, identify the exchange rate regimes in the world today and briefly explain why countries may have different exchange rate regimes.

Look at the exchange rate regime in South Korea against the backdrop of this week's course content, especially Hill and Hult (2018, pp. 303-311). Why might that policy be the best choice for that particular country? Be specific.

Identify a multinational enterprise (MNE) doing business in South Korea, and note two other Asian countries that company does business in -- indicating both the exchange rate regime in each of those countries and how strong the monetary system is in each.

Answer 1

The exchange rate regime is the way a country manages its currency in relation to other currencies and the foreign exchange market. An exhange rate is simply the price of one currency in terms of other currency.

Different Types of Regimes are:

1. Dollarization: Here, inhabitants of a country use a foreign currency in parallel to or instead of the domestic currency. Like in Zimbawe, Panama
2. Currency Boards: A moentary authority maintains a fixed exchange rate with a foreign currency. For e.g in Hongkong, Bulgaria
3. Monetary Union: A group of countries using a common currency issued by a common regional central bank such as in Euro Union of 27 nations
4. Float with Discreationary Intervention: Exchanges rates are determined in the foreign exchange market, however authorities can and do intervene. Egs India, Bangladesh, Sri Lanka
5. Pure Float/Independent Floating: The exchange rate is determined in the market without public sector intervention such as in Japan, New Zealand and United States
6. Traditional Peg/Fixed Exchange Rate System: The countries tries to keep the value of its currency constant against another country but it has no legal obligation to do so. There can be a very small percentage allowable deviation on both sides of the rate.

The countries may have different exchange rate regimes because of the following:

1. Different Levels of Development
2. Different Position in the World
3. Different Levels of International Demand
4. Different Regional & Economic Structure
5. Disparity in International Trade & Speculation
6. Different Internal Factors affecting Exchange Rate [inflation rate, interest rate, public debts, current account deficits, terms of trade, political stabililty, economic performance]

There is no right answer for which exchange rate is better, advanced economies generally follow floating rate, emerging economies may gain from floating rates and underdevelpoed economy gains from fixed exchange rate system.

South Korea has a free- floating exchange rate (a rate determined by supply and demand). This type of fluctuating exchange rate limits the he Ministry of Finance and Economy [MOFE's] ability to prevent or to minimize the negative impacts of sudden changes of exchange rates.

Floating exchange rates have following main advantages:

• No need for international management of exchange rates: Unlike fixed exchange rates based on a metallic standard, floating exchange rates don’t require an international manager such as the International Monetary Fund to look over current account imbalances. Under the floating system, if a country has large current account deficits, its currency depreciates.
• No need for frequent central bank intervention: Central banks frequently must intervene in foreign exchange markets under the fixed exchange rate regime to protect the gold parity, but such is not the case under the floating regime. Here there’s no parity to uphold.
• No need for elaborate capital flow restrictions: It is difficult to keep the parity intact in a fixed exchange rate regime while portfolio flows are moving in and out of the country. In a floating exchange rate regime, the macroeconomic fundamentals of countries affect the exchange rate in international markets, which, in turn, affect portfolio flows between countries. Therefore, floating exchange rate regimes enhance market efficiency.
• Greater insulation from other countries’ economic problems: Under a fixed exchange rate regime, countries export their macroeconomic problems to other countries. Suppose that the inflation rate in the U.S. is rising relative to that of the Euro-zone.

Under a fixed exchange rate regime, this scenario leads to an increased U.S. demand for European goods, which then increases the Euro-zone’s price level. Under a floating exchange rate system, however, countries are more insulated from other countries’ macroeconomic problems. A rising U.S. inflation instead depreciates the dollar, curbing the U.S. demand for European goods.

• Market Determined Rates: Freely floating exchange rate means that the market will determine the rate at which one currency can be exchanged for another. The market will set these rates on a real time basis as and when new information flows in. This reduces the need for an elaborate mechanism to ensure that the exchange rates remain within a particular range. Fixed exchange rates require the Central Banks to set up trading desks and currency boards to manage the currency actively on a daily basis. In case of a floating exchange rate, the central bank does not have to take so many efforts. Instead, it can just passively manage the currency by setting important rates and interfering in the market only when it becomes necessary.
• Independence: Freely floating exchange rates allow the governments and central banks of a nation to have a great degree of independence. In case of fixed exchange rates, the Central banks of different nations have to act in tandem. This is because the monetary policy that they set could influence or be influenced by the economic conditions of member nations. For instance, when the dollar raises its interest rates, all currencies pegged to it also have to make necessary changes. Hence, the countries that have their currencies pegged to the dollar have limited independence whereas countries that let their currencies float have a far greater degree of independence.
• Less Probability of Speculative Attacks: A freely floating currency faces adjustment on a minute to minute basis. There are some days that the currency faces rapid appreciation whereas others when it faces rapid decline. However, for most of the days, the currency remains stable.The point is that speculative attacks happen only when the currency remains stagnant at a given point whereas its underlying fundamentals have changed. It is then that the speculators see an opportunity to bring the currency to its equilibrium point quickly and make a quick buck by doing so. However, if the currency is traded on the Forex market as a freely floating currency, adjustments happen on a minute to minute basis. Therefore, the gap between the underlying fundamentals and the market value never really widens up enough for the speculators to mount a sudden attack.
• Low Requirement of Reserves: A freely floating exchange system does not require the central bank to hold massive reserves. This is because the Central Bank does not have to conduct active trading operations in order to maintain the value of the currency. Central Bank operations are a very rare event for countries that have a floating rate system. This is a major advantage of this system since holding foreign exchange for trading purposes is an expensive strategy. Firstly, it requires the country to maintain a huge currency reserve. Then, it also requires the central bank to have an active trading desk 24 by7! The floating rate system is simply a lot more convenient since it does not have any such requirements.

Samsung & LG Electronics, Both Multinational Enterprises are doing business in South Korea and in other two Asian Nations i.e. India & China. The exchange rate regime in each of the countries are s a hybrid of fixed and floating exchange rate. The Float with Discreationary Intervention/Intermediate Exchange Rate Regime exists in these two countries where Exchanges rates are determined in the foreign exchange market, however authorities can and do intervene.

The present exchange rates of India & China are 0.015 $ & 0.016 $ respectively. The monetary system prevailing in India at present is managed and controlled by the Reserve Bank of India. The present monetary system is based on inconvertible paper currency, supplemented by coins.

On the external front Indian currency 'rupee' is again convertible to various other currencies of the world. At present, the Issue Department is still following the minimum reserve system of note issue which has provided greater elasticity to the Indian currency system. The present currency system has provided ample scope to the government for adopting deficit financing, especially for financing its plans since the Second Plan onwards.

Since independence, a serious effort has been made to develop an organized banking and a financial system in the country. In the mean time the country has developed a different type of banking institutions like commercial banks, co-operative banks, regional rural hanks etc. and term lending institutions which are working in various spheres of the country. All these institutions are supervised by the Reserve Bank of India which is the Central Bank of the Country.

While China currently maintains its currency rate within a controlled band that fluctuates according to market demand, some market participants have noted the central bank has at times signaled its preferences for near-term currency levels through its interbank foreign exchange system. In 2014, however, the bank began easing local interest rates to counteract a slowing economy. The rate easing had the effect of discouraging foreign currency inflows into the economy and subsequently brought pressure for the weakening of the yuan. In addition to altering interest rates, the government can alter reserve requirements within the domestic banking system, freeing up the supply of local money available to the market.

The country has sought to integrate itself further into the global economy by aiming to promote the yuan as an international reserve currency, similar to the dollar, the British pound, euro, and the Japanese yen. The currency’s internationalisation has involved seeking the yuan’s inclusion in a basket of currencies making up the International Monetary Fund’s “Special Drawing Rights, SDR.” The yuan will have the third-highest weight after the dollar and the euro after the International Monetary Fund (IMF) decided to include the Chinese yuan in the composition of SDR basket. This recognition of the yuan is well deserved, given that China is the world's second-largest economy at nominal exchange rates (largest in terms of purchasing power parity), as also the world's largest exporter and cross-border trader.