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BLOG OF PROF. J. R. VERMA

Thu, 19 Jan 2012

The many different kinds of fixed exchange rate regimes

In recent decades, economists have been increasingly focused on the de

factoexchange rate regime using the ideas developed byReinhart and Rogoff

(2004)and byFrankel and Wei (1994).This approach of looking at the actual data is

of course a huge advance over the naive approach of relying on official

pronouncements. Intermediate approaches are also possible as exemplified in the

IMFsDe Facto Classification of Exchange Rate Regimes and Monetary Policy

Framework.

Obsessive contemplation of currency breakups (see myblog postlast month) has

made me more sensitive to the legal nuances of a fixed exchange rate regime, and Iam beginning to think that looking only at the statistical properties of the exchange

rate time series is not sufficient.

I have been thinking of three small but rich and highly successful jurisdictions which

have today adopted a fixed exchange rate regimeSwitzerland, Hong Kong and

Luxembourg. The statistical properties of recent exchange rate behaviour in these

three countries might be very similar, but the legal and institutional underpinnings are

very different. A de-pegging event would play out very differently in these three

cases.

1.

Switzerland has temporarily pegged its currency (the Swiss franc) to the euro

through an executive decision of its central bank. There is no statutory basis for

this peg. Technically, the Swiss have put a floor (and not a peg) on the

EUR/CHF exchange rate (Swiss francs per euro); but given the massive upward

pressure on the franc, the floor is a de facto peg.

Exiting this peg would be very easy through another executive decision of the

central bank. The only real costs would be (i) the exchange losses on the euros

bought by the Swiss central bank, and (ii) probably a modest loss of credibility

of the central bank. I would imagine that a significant uptick in the inflationrate in Switzerland would be sufficient to cause the central bank to drop the peg

and accept these costs.

2. Hong Kongs peg to the US dollar is much stronger and longer. It has lasted a

whole generation and is enshrined in a formal currency board system. Having

survived the Asian crisis, the peg is regarded as highly credible. Yet, it would

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be very easy to change the peg or even to remove the peg completely. In fact,

my reading of the statutes is that this could happen through an executive

decision of the government without any changes in the law.

Indeed, there is a significant probability that over the course of the next decade,

the HK dollar would be unpegged from the US dollar and repegged to theChinese renminbi. This change could happen quite painlessly and without any

legal complications.

3.

Luxembourg has adopted the euro as its currency. This means that leaving the

euro and recreating its own currency would be a legal nightmare. The doctrine

of lex monitaeasserts that each country exercises sovereign power over its own

currency, and that it is the law of that country which determines what happens

when a currency is changed. This might appear to give enough leeway to the

Luxembourg government to do whatever it wants.

However, in a cross border contract, the other party would argue that the term

euro in the contract did not refer to the currency of Luxembourg at all, but to

the currency of the euro area as governed by various EU treaties. This argument

may not help if the contract is governed by Luxembourg law because the local

courts are likely to interpret lex monitaevery broadly. But if the contract were

governed by English law (as is quite common in international contracts), it is

quite likely that the English courts would take the EU interpretation. Assuming

that the UK remains a member of the EU, its courts might not have any other

choice.

I am beginning to think that we tend to focus too much on the role of money as a

medium of exchange or as a store of value. If we do this, it appears that all the three

countries have surrendered their monetary sovereignty to an equal extent. But the role

of money as a unit of account is extremely important. Of the three countries described

above, only Luxembourg has (arguably) surrendered its sovereignty on the unit of

account. This loss of sovereignty is the most damaging of all.

An alternate way of constructing the euro way back in 1999 might have been for

Luxembourg to adopt its own new currency (say the Luxembourg euro) of which no

notes would be printed, peg this currency to the euro issued by the ECB (the ECBeuro) at 1:1, and declare the ECB euro to be the only legal tender in the country. From

a medium of exchange or store of value point of view, this arrangement would be

identical to what exists today because only ECB notes would circulate. But in

Luxembourg law, under this alternate approach the ECB notes would just happen to

be the legal tender for the Luxembourg euro which would just happen to be equal to

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the ECB euro. The Luxembourg euro would then be capable of being unpegged from

the ECB euro at any time under the doctrine of lex monitae.

The problem as I see it is that technocrats always have a temptation to try and build

something that cannot fail. The technocrats who created the euro therefore set out to

create something irreversible and permanent. I think it is better to approach the matterwith greater humility, and endeavour to build something that would fail gracefully

rather than not fail at all.

Finally, there is a fourth small, rich and highly successful countrySingapore

which is also an important financial centre like the other three and has gotten by quite

well without pegged exchange rates.