Managed Floating Exchange Rate

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21 Aug, 2024

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A Managed Floating Exchange Rate, often referred to as a dirty float, entails central bank intervention in the foreign exchange market to influence the currency's value, typically when it becomes excessively weak or strong. The aim is to lessen economic shocks and their impact on the economy rather than directly controlling daily exchange rates.

It provides both the benefits of a free-floating system and the intervention of the government, allowing market forces to play a role in determining exchange rates while providing stability through occasional central bank interventions. Central banks come into action, particularly when exchange rate fluctuations significantly impact international trade, aiming to maintain competitiveness in global markets.

What Is Managed Floating Exchange Rate?

The managed floating exchange rate definition involves the intervention of central banks in situations of volatile currency exchange rates to stabilize the currency and balance the trade deficit.
This approach acts as a safeguard from deflationary inflation risk and harmful effects on the export of goods with the intervention of the central banks of nations.
Many countries use it to manage the balance of trade and currency exchange rates. However, implementing it can be challenging for poorer countries needing more substantial forex reserves.
Many countries have adopted the technique of managing the floating exchange rate to their advantage and increasing their forex reserves.

Managed Floating Exchange Rate System Explained

A managed floating exchange rate is an approach adopted by central banks to keep the exchange rate of currency under check to safeguard the economic interest of consumers and exporters from getting hurt by the rapid movements of the exchange rate.

To safeguard their local industries and exporters, many developing countries resort to employing dirty float. They do so via an established currency board or band. They use the managed floating exchange rate system to keep the currency less volatile and promote economic stability and growth. There have been many instances where central banks have intervened in the currency exchange rates to control foreign trade. Hence, let us know the reasons why central banks have to intervene in the first place, as discussed below:

1. Market ambiguity: At times when the market becomes uncertain, the central banks intervene to stabilize the currency market rate.

2. Currency depreciation: Interventions to induce currency depreciation serve several purposes as follows:

It helps in improving the balance of trade.
It reduces the deflationary inflation risk.
Redirecting focus from domestic consumption towards exports.
To reduce government debt by selling foreign currencies.

3. Currency appreciation: Central banks may intervene to promote currency appreciation for various reasons, including:

To control inflationary pressures of demand-pull.
To decrease the cost of imported technology and capital.

4. Massive selling of local currency: In such cases where a hedge fund or other seller tries to sell in appreciation of the nation's currency depreciation, the central banks intervene by purchasing their currency to prohibit currency devaluation.

History

The Bretton Woods Agreement, established in 1944, created an international monetary system that governed currency exchange rates and financial relations among nations. These nations collaborated to regulate and enhance international trade across borders. Currency pegging regimes, like all such arrangements, are anticipated to stabilize currencies, facilitating the trade of goods and services as well as financing. This system lasted until the early 1970s, when it collapsed, marking the end of the Bretton Woods era.

Examples

Let us go through a pair of examples to get some in-depth knowledge about the topic.

Example #1

In view of speculation of Xi Jinping's re-election as Chinese premier, foreign investors started selling yuan in large numbers. In China's controlled market, the yuan fell sharply to its lowest level since late 2007, dropping by 0.6% to around 7.3 yuan per dollar. The Chinese yuan maintained a fixed exchange rate, pegged at 8.28 to the US dollar, for years until 2005, when China shifted to a managed floating exchange rate system.

This transition marked a significant policy change, enabling the yuan to appreciate steadily over time. By 2014, it had climbed to a peak value of nearly 6.01 against the US dollar. This shift coincided with a historic global sell-off of Chinese assets. In short, the decline in the yuan's value during Xi Jinping's re-election underscores the complexities of China's exchange rate policies and their impact on global financial markets.

Example #2

In a hypothetical scenario, let us consider the country of Econonia, which operates under a managed floating exchange rate system. Here, the value of Econonia's currency, the Econo, fluctuates with market dynamics, but the central bank intervenes to prevent extreme swings. For instance, if there's a sudden surge in export demand causing the Econo to appreciate, the central bank might sell Econos and buy foreign currencies to weaken its value.

Conversely, during economic downturns, the central bank might purchase Econos and sell foreign currencies to stabilize the economy. This system allows Econonia to maintain currency stability and support export competitiveness.

Advantages & Disadvantages

The managed floating exchange rate has its own set of pros and cons. Let us explore a few of them below:

Advantages	Disadvantages
It is a resilient & strong monetary policy.	It has resulted in the competitive devaluation of currencies in the globalized world.
Banks could use the loans as a tool to suck out or pour in the required liquidity from the markets.	Economically disadvantaged countries often use it.
The domestic economy is not affected by it.	It leads to weak domestic fiscal policies.
It acts as a double-layered protection for the economy.	The governments still need to carry out a counter-cyclical budget.
It helps improve the balance of trade.	Its implementation requires a lot of foreign exchange reserves that need to be improved in poorer nations.
It also improves a nation's current account by increasing the competitive price of exports.	Central banks fail to influence the currency exchange market as they lack market power.
It also reduces deflationary inflation risk.	Any interest rate change might severely affect a nation's economic growth.

Frequently Asked Questions (FAQs)

Which countries use managed floating exchange rates?

Following countries mentioned in the list follow the said currency management system:
● Turkey.
● New Zealand.
● Chile.
● South Africa.
● Brazil.
● South Korea.

Is a Managed Float Better than a Fixed Float?

The suitability of a dirty float versus a fixed exchange rate depends on various factors unique to each country's economic circumstances and the strength of its currency. There is no universal law dictating which approach is superior. Instead, the decision relies on careful evaluation of economic conditions and policy objectives to determine the most appropriate exchange rate regime.

Is the managed floating exchange rate system an amalgamation?

Yes, the managed floating exchange rate system can be considered an amalgamation of different exchange rate systems. It combines elements of both fixed and floating exchange rate systems, allowing the currency's value to fluctuate based on market forces while also permitting central bank intervention to stabilize the currency when necessary. This hybrid approach provides flexibility and stability, making it a popular choice for many countries navigating complex economic conditions.