The famous Asian financial crisis of 1997 happened in the form of two levels of deterioration in currency starting from the year 1997. Round one involved a drop in the value of Thai baht, Malaysian ringgit, Philippine peso and the Indonesian rupiah. When the above currencies began to stabilize, round two started with downward pressures hitting the Taiwan dollar, south Korean won, Brazilian real, Singaporean dollar and Hong Kong dollar. On October 20-23 1997, the Hong Kong dollar was speculatively attacked leading to it adopting a defensive mechanism to protect its currency. As a result, the Hong Kong stock market drastically dropped and the same happened to Wall Street and other markets to the extent of reaching worse levels. In a bid to counter the deteriorating pressures on currencies, Hong Kong, and other Asian markets traded dollars from their foreign reserves and bought their own currencies to disturb speculators and draw foreign capital. The higher interest rates resulted in slow economic growth and interest bearing securities more attractive than equities (Goldstein 1998).
The international Monetary Fund (IMF) became important in coordinating support mechanisms to the distressed Asian economies. It instituted emergency measures that enabled these countries to respond to the financial crisis in record time (Reinhart and Rogoff 2009). The Fund intensified its operations in four directions, which included:
- empowering IMF surveillance over the member country policies;
- assisting in strengthening the operations of the financial markets which was viewed as a technical assistance;
- offering policy advice and financial assistance when the crises happened and, making sure that no member country was marginalized (left out while expanding world trade and incapable of attracting significant private sector investment). While in a meeting in Hong Kong in September 1997, the IMF Board of Directors agreed to the amendment of the IMF articles of agreement to enable the liberation of the capital flows as one of the Funds roles.
The essay refers to the Hong Kong financial crisis of 1997 or rather the Asian Financial crisis in examining the merits and the demerits of fixed exchange rate system as stipulated in the IMF Articles of Agreement while making a comparison with the floating exchange rate system. It starts by providing a conceptual explanation of the exchange rate regimes as stated in the IMF Articles of Agreement and then a historical review of the exchange rate regimes. The essay then discusses the advantages of the fixed exchange regime and the problems it entails. In comparing the fixed exchange rate system with the floating exchange rate system, the essay gives the reasons why Hong Kong opted for the fixed exchange rate regime. The reasons why the system was tested in the 1997 financial crisis are also explained. The essay concludes with the advantages and disadvantages of the fixed exchange rate regime.
A conceptual explanation of exchange rate regimes as stipulated by the IMF Articles of Agreement
A debate on the optimal exchange rate has gone on for a very long time demonstrating the world economy and the conduct of monetary policy. The system of gold including other systems tied to other commodities offered monetary anchor including standards to finance international transactions for various countries over many centuries. These periods give an account of several periods of financial crisis and very steep variations in the output and prices.
Bretton woods system was developed, with US dollar as the focus, as a standard of fixed but variable exchange rate. When the system came under scrutiny in the 1960s, older deliberations on the relative advantages of fixed versus flexible exchange rate developed new life and the initial Bretton Woods system was replaced by a system of floating exchange rate in major currencies. The puzzle on the exchange rates regime for the other currencies became open to discussions. During the early 90s, the influential economic discussions promoted fixed exchange rate regimes as an anchor to prevent hyper and high inflation in many emerging markets. The emerging Asian financial crisis later in that period led to the reassessment of these discussions and increased focus on the virtues of flexible exchange rate regimes for the huge emerging markets, progressively more incorporated to the word financial system. It made it clear that the economies that operated in the framework of flexible exchange rate system could better absorb the shocks from open capital markets and economies with pegged rates (Ghosh, Gulde-Wolf and Wolf 2002).
A number of points may command emphasis in any discussion of the exchange rate regime options. In an untainted fixed exchange rate system, economic activity adjusts to the exchange rate while in a floating exchange rate; the exchange rate is a reflection of the economic activity. Either way, the fundamentals of the economy are the main determinants of if economic stability and successes are gained and not the exchange regime. None of these exchange regimes can be said to be universally optimal. The choice f the exchange regime reflects the economies individual properties and features (Rose 2011). They all have strengths and weaknesses.
A historical review of exchange rate regimes
Most influential thought not all economist argue that the global economy works well when the main exchange rate is flexible and markets are left to push them up or down with the diverse economic composed conditions depending on the government restrictions and more specifically when the market overshoot. However, this was not the case in the past. Prior to the First World War, most nations linked their currencies to the gold standard system that was abolished during the war. After the war, attempts were made to bring back the gold system but it made the global economy be vulnerable to the shocks that resulted in the great depression (Rose 2011).
After the World War II, those who were victorious from the war developed a fixed exchange rate system although it was not fully fixed but sometimes flexible. The system was known as Bretton Woods for the New Hampshire hotel where the pact was negotiated. Under the supervision of IMF, economies were expected to sustain a fixed exchange rate that their currencies were exchanged for but allowed to change them during extraordinary situations like recession where a significantly undervalued currency increased the export prices. They had hoped that by doing so it would merge the merits of fixed and floating exchange rates (Grenville 2000).
After the turbulent period in the 60s when the US sought to devalue its currency, the Bretton Woods system disintegrated in 1973. It was replaced by a system where major currencies float versus other major currencies depending on the verbal guidance from governments and the intermittent intervention (subject to the existing conventional abilities in wisdom and economic attitudes) in the markets by the governments. Despite the fact that fixing the values for small economies can be advantageous in controlling inflation, the IMF warned that countries land themselves in problems when they wait longer before changing their currency to unstable economic conditions and end up in damaging crisis as the Hong Kong economic crisis in 1997 (Ghosh, Gulde-Wolf and Wolf 2002).
In 1999, several big continental Europe nations relinquished the merits and the demerits of the fixed currency to adopt a shared currency the euro and multiple country central banks to set interest rates. On the other hand, developing economies have switched to flexible exchange rate regimes in the past quarter of a century. After 1975 for instance, 87% of the developing countries had some sought of pegged exchange rates but by 1996, the figure had dropped to 50%. Most of the countries that pegged the US dollar took the basket approach in the half of 1980s due to the rapid appreciation of the dollar (Reinhart and Rogoff 2009).
The international monetary fund was developed with the main purpose of promoting the exchange stability and preventing competitive exchange depreciation. It was originally charged with the role of the custodian of the fixed but adjustable exchange rate. However, in the year 1978, the Articles of Agreement were amended to enable each member the liberty to choose its preferred exchange rate regime. The IMF took the responsibility of exercising surveillance of the suitable operation of the international monetary standard and the obligations of the members under Article IV plus hose that relate to the exchange rate policies. Although the participants may opt for exchange rate plans, it is their responsibility to work together with the Fund to keep stability in the system (Rose 2011).
What are the advantages of fixed-rate exchange regime and the problems it entails?
A fixed exchange rate regime is where one country links its currency to the currency of another country or puts together currencies of certain nations with the intention of maintaining the policy (Ghosh, Gulde-Wolf and Wolf 2002).
Advantages of a fixed exchange rate
A fixed exchange rate prevents the risks of unstable currency for international trade and investment and this favors Canada that conducts most businesses with the US. In the case where the rate fixed and investors are certain that the rates will not change, it becomes unnecessary to insure against uncertainty. It also makes its simple for investors, businesses and policy makers to predict and make plans. Representatively, when an economy sets its rate at a low inflation currency, it shows its pledge to achieving and keeping up low inflation (Frankel 2006).
To make fixed exchange workable, an economy has to stick to the fixed-rate even in situations of economic threats from the outside. The country has to have enough reserves to guard the currency against speculative attacks. Such credibility supported by enough reserves and commitment to powerful monetary and economic policies is meant to woo investors that there is no need of attacking the currency where in the case of speculative attack; the central bank will take charge (Rose 2011).
However, a pegged regime is prone to currency crisis since it gives the leeway to speculators to anticipate against the system. It is only in cases where there are enough currency reserves that the system is credible. With enough foreign reserves, the country may counter those who bet against the currency by spending the reserves to uphold it. Similarly, the fixed exchange regime is less flexible. It is hard to respond to temporary shocks, for instance, an oil importer may be faced with a deficit in the balance of payment if the oil prices increase but in fixed exchange rate situation, it is hard to devalue (Ghosh, Gulde-Wolf and Wolf 2002).
A comparison with the floating exchange rate system
The main opposite of the fixity of exchange rate is the flexibility of it. Under the floating exchange, the exchange rate is not fixed but determined by the forces of demand and supply for the countrys currency. Those who support the floating system argue that it more advantageous than the fixed system because it enables the economy to take in both foreign and domestic shocks with ease (Ghosh, Gulde-Wolf and Wolf 2002). The number of countries using the floating system has gone up significantly from the 70s. whereas in fixed exchange rate system external shocks influence prices of commodities and wages, floating currency increases and decreases according to the changing economic conditions like capital flows and economic downturns. Also unlike the fixed system, floating currency allows for monetary fr...
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