Today’s international monetary system remains in large part a managed float system, whereby most nations’ currencies float against one another and governments engage in limited intervention to realign exchange rates. Within the larger monetary system, however, certain countries try to maintain more stable exchange rates by tying their currencies to other currencies. Let’s take a brief look at two ways nations attempt to do this.
Pegged Exchange-Rate Arrangement
Think of one country as a small lifeboat tethered to a giant cruise ship as it navigates choppy monetary waters. Many economists argue that rather than let their currencies face the tides of global currency markets alone, developing economies should tie them to other, more stable currencies. Pegged exchange-rate arrangements “peg” a country’s currency to a more stable and widely used currency in international trade. Countries then allow the exchange rate to fluctuate within a specified margin (usually 1 percent) around a central rate.
Many small countries peg their currencies to the U.S. dollar, European Union euro, the special drawing right (SDR) of the IMF, or other individual currency. Belonging to this first category are the Bahamas, El Salvador, Iran, Malaysia, Netherlands Antilles, and Saudi Arabia. Other nations peg their currencies to groups, or “baskets,” of currencies. For example, Bangladesh and Burundi tie their currencies (the taka and Burundi franc, respectively) to those of their major trading partners. Other members of this second group are Botswana, Fiji, Kuwait, Latvia, Malta, and Morocco.
A currency board is a monetary regime that is based on an explicit commitment to exchange domestic currency for a specified foreign currency at a fixed exchange rate. The government with a currency board is legally bound to hold an amount of foreign currency that is at least equal to the amount of domestic currency. Because a currency board restricts a government from issuing additional domestic currency unless it has the foreign reserves to back it, it helps cap inflation.
Monetary regime that is based on an explicit commitment to exchange domestic currency for a specified foreign currency at a fixed exchange rate.
Thanks to a currency board, the country of Bosnia-Herzegovina has built itself a strong and stable currency. A currency board’s survival depends, however, on wise budget policies.6 Argentina had a currency board from 1991 until it was abandoned in early 2002, when the peso was allowed to float freely on currency markets. Other nations with currency boards include Brunei Darussalam, Bulgaria, Djibouti, Estonia, and Lithuania.
European Monetary System
Following the collapse of the Bretton Woods system, leaders of many European Union (EU) nations did not give up hope for a system that could stabilize currencies and reduce exchange-rate risk. Their efforts became increasingly important as trade between EU nations continued to expand. In 1979, these nations created the European monetary system (EMS). The EMS was established to stabilize exchange rates, promote trade among nations, and keep inflation low through monetary discipline. The system was phased out when the EU adopted a single currency.
How the System Worked
The mechanism that limited the fluctuations of European Union members’ currencies within a specified trading range (or target zone) was called the exchange rate mechanism (ERM). Members were required to keep their currencies within 2.25 percent of the highest- and lowest-valued currencies. To illustrate, suppose that a weakening French franc were about to reach the 2.25 percent variation in its exchange rate with the German mark. The central banks of both France and Germany were to drive the value of the French franc higher—forcing the exchange rate away from the 2.25 percent fluctuation limit. How did they do so? By buying up French francs on currency markets, thereby increasing demand for the franc and forcing its value higher.
The EMS was quite successful in its early years. Currency realignments were infrequent and inflation was fairly well controlled. But in late 1992, both the British pound and the Italian lira had been on the lower fringe of the allowable 2.25 percent fluctuation range with the German mark for some time. Currency speculators began unloading their pounds and lira. The central banks of neither Britain nor Italy had enough money to buy their currencies on the open market. As their currencies’ values plummeted, they were forced to leave the ERM. The EMS was revised in late 1993 to allow currencies to fluctuate 15 percent up or down from the midpoint of the target zone. Although the Italian lira returned to the ERM in November 1996, the British pound remained outside the ERM. Many European nations moved to the euro as their currency (see Chapter 8), which eliminated the need for the ERM.
Of the three nations (Britain, Denmark, and Sweden) opting out of the euro, Denmark is the only one participating in what is called the exchange rate mechanism II (ERM II). The ERM II (in which membership is voluntary) was introduced January 1, 1999, and continues to function today. The aim of ERM II is to support nations that seek future membership in the European monetary union (see Chapter 8) by linking their currencies to the euro. The euro acts as an anchor of a hub and spokes model, to which a currency is linked on a bilateral basis. The currencies of participating countries have a central rate against the euro with acceptable fluctuation margins of 15 percent, although narrower margins can be arranged. Future accession countries to the EU will be obliged to join the single currency once they satisfy the criteria of the Maastricht Treaty.
Recent Financial Crises
Despite the best efforts of nations to head off financial crises within the international monetary system, the world has experienced several wrenching crises in recent years. Let’s examine the most prominent of these.