A Primer On Currency Regimes

A history of currency regimes (or exchange-rate regimes) is, by necessity, one of international trade and investment and the efforts to make them successful. Sovereign debt levels and gross domestic product (GDP) figure importantly as well in the degree of a currency's volatility. An exchange rate is simply the price of one currency up against another. When groups of nations in a common area conduct commerce with multiple currencies, their fluctuation could either impede or promote trade, depending on either party's perspective.

Money values are a function of a nation's economy, monetary and fiscal policy, politics and the view of traders who buy and sell it based on their opinion of events that could affect its value. At the risk of oversimplification, the intent of a currency mechanism is to promote the flow of trade and investment with minimal friction or, depending upon the country, the achievement of greater fiscal and monetary discipline (increased monetary stability, full employment and lessened exchange rate volatility) than would otherwise occur. This has been the objective of an integrated European Union (EU).

When two or more countries use the same currency under control of a common monetary authority or tether their currencies' exchange rates by various means, they have entered into a currency regime. The spectrum of arrangements runs more or less from a fixed to a flexible regime. The present-day currency anchors may be the U.S. dollar, the euro or a basket of currencies. There also may be no anchor at all.

Fixed Currency Regimes
Dollarization
One country uses another nation's currency as a medium of exchange, inheriting the credibility of that country's currency, but not its creditworthiness. Some examples are Panama, El Salvador and Timor Leste. This approach can impose fiscal discipline.

Monetary Union (or Currency Union)
Several countries share a common currency. As with dollarization, such a regime fails to impose creditworthiness as some nations' finances are more profligate than other nations. Examples are the eurozone (current) and Latin and Scandinavian monetary unions (defunct)

Currency Board
An institutional arrangement to issue a local currency backed by a foreign one. Hong Kong is a prime example. The Hong Kong Monetary Authority (HKMA) holds dollar reserves to cover Hong Kong dollar bank reserves and currency in circulation. This imposes fiscal discipline, but the HKMA may not act as a lender of last resort, unlike a central bank.

Fixed Parity
The exchange rate is pegged to either a single currency or a currency basket with a +/- one percent band of permitted fluctuation. There is no legislative commitment to parity and there is a discretionary foreign exchange reserve target. Examples are Argentina, Venezuela and Russia.

Target Zone
Akin to the fixed parity arrangement, but with somewhat wider bands (+/- two percent), affording the monetary authority some greater discretion. Examples here include the Slovak Republic and Syria.

Active and Passive Crawling Peg
Latin America in the 1980s was a prime example. Exchange rates would be adjusted to keep pace with inflation rates and prevent a run on U.S. dollar reserves (passive crawl). An active crawl entailed announcing the exchange rate in advance and implementing changes in steps, in an effort to manipulate inflation expectations. Other examples include China and Iran.

Fixed Parity with Crawling Band
A fixed parity arrangement with greater flexibility to allow exit from fixed parity or afford the monetary authority greater latitude in policy execution. Costa Rica.

Managed Float (or Dirty Float)
A nation follows a policy of loose intervention to achieve full employment or price stability with an implicit invitation to other countries with which it conducts business to respond in kind. Examples are Cambodia or Ukraine (anchored to the USD) or Colombia and Singapore (anchored or not to a currency basket.)

Independent Float (or Floating Exchange)
Exchange rates are subject to market forces. The monetary authority may intervene to achieve or maintain price stability. Examples are the U.S., Australia, Switzerland and the United Kingdom.

Flexible Currency Regimes

Currency regimes may be both formal and informal. The former entails a treaty and conditions for membership in them. These may entail a limit on the candidate nation's sovereign debt as a percentage of gross domestic product or its budget deficit. These were conditions of the Maastricht Treaty of 1991 during the long march to the ultimate formation of the euro. The currency peg system is somewhat less formal. Indeed, the aforementioned regimes form a continuum and monetary authorities have made policy decisions that could fall into more than one of these categories (regime change). Think of the mid-1980s Plaza Accord taken to lower the U.S. dollar in an effort to combat high trade deficits. This is conduct atypical of a free-floating currency regime.

Currency regimes have formed to facilitate trade and investment, manage hyperinflation or form political unions. With a common currency, ideally, member nations sacrifice independent monetary policy in favor of a commitment to overall price stability. Political and fiscal union are typically prerequisites to successful monetary union where, for example, olive oil is manufactured in Greece and shipped to Ireland without the need for importers or exporters to employ hedges to lock in favorable exchange rates to control business costs.

While the unending to-and-fro of European Monetary Union plays out on a daily basis, the history of currency regimes has been a checkered one, marked by both success and failure. A brief history of the more noteworthy ones, dissolved and extant, follows.

Latin Monetary Union (LMU)
A mid-nineteenth century attempt at monetary union, the effort involved France, Belgium, Switzerland and Italy being tethered to the French franc, which was convertible into silver and gold tender (a bimetallic standard) that was a common medium of exchange across the participating nations that maintained their respective currencies at parity with one another.

The union ultimately encompassed eighteen countries. The lack of a sole central bank with an attendant monetary policy proved to be the union's undoing. So, too, did the fact that the union's member treasuries minted both gold and silver coins with a coinage restriction per capital and a lack of uniformity in metal content that caused price pressures on the two precious metals and a lack of free circulation of the specie. However, by World War I, the union was effectively finished.

Scandinavian Monetary Union (SMU)
First Sweden and Denmark, then Norway shortly thereafter, entered into a monetary union around 1875 with the ultimate goal of forming a political and economic partnership. All of the countries had adhered to a silver standard, accepting one another's currencies. To avoid the failure of the LMU, all three ended up being exchangeable into a fixed amount of gold.

After about three decades, this union, too, unraveled when Norway declared political independence from Sweden and Denmark adopted more restrictive capital controls. With the advent of the First World War, each of the three members adopted their own monetary and fiscal policies, as there lacked a binding agreement to coordinate monetary and fiscal policies.

The CFA Franc
In effect since 1945, several countries that were former French colonies in central and West Africa are pegged to the French treasury, formerly via the French franc, now by the euro.

Belgium and Luxembourg
Each country maintains its own currency, but both currencies serve as legal tender in either country. The Belgian Central Bank runs monetary policy for both countries. This union has been in effect since 1921.

Implications
Though bound in some form by a fixed rate or common monetary unit, the economies of the individual members of a currency regime are a function of their local politics and economic policy. Some nations bear less sovereign debt than others bear and may be called upon to support the weaker members. Overall, such disparity does not bode well for the currency unit that reflects the mixed complexion of what may appear to be at times a currency disunion. A disconnect between common monetary and localized fiscal policies could put pressure on a regional currency bloc, driving down the value of the monetary unit. This occurrence could bode well for exporters, assuming robust trade environment.

Institutional and individual investors' allocations decisions should continue to be a function of exposure sought in accordance with their objectives and constraints. Given the potential volatility of a common currency resulting from the varying condition of its individual members' economies, or the particulars of a currency regime, investors may consider hedging their exposure. Fundamental research (bottom up/top down) on companies, their markets, both global and domestic, would also play a critical role.

The Bottom Line
Currency regimes are dynamic and complex, reflecting the ever-changing landscape of their respective nations' monetary and fiscal policies. A deeper study of them will help investors understand their impact on risk management and asset allocation decisions in the portfolio management process.

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