Floating exchange rates are a fact of life in the modern global economy. Yet some countries still opt to peg their currencies or manage them within a tight band relative to another currency or basket of currencies. This reticence to let exchange rates float freely is known as “fear of floating.” In this comprehensive guide, we’ll examine the pros and cons of floating versus fixed exchange rates, the implications for monetary policy, and why some countries are afraid to let their currencies float.

Introduction

Since the collapse of the Bretton Woods system of fixed exchange rates in the early 1970s, floating exchange rates have become the norm for most major economies. Under a floating rate regime, the relative price of currencies is determined by supply and demand in the foreign exchange market. This allows the exchange rate to naturally adjust in response to macroeconomic conditions, interest rate changes, inflation, and capital flows between countries.

However, some countries are still afraid to let their currencies float freely and so opt for some form of fixed or managed exchange rate instead. This fear of floating arises because the volatility and swings inherent to floating rates are seen as undesirable. Sharp currency movements can negatively impact trade, cause inflation, and reduce living standards. On the other hand, relinquishing monetary policy freedom to maintain a peg also has costs. Understanding the nuances of this debate is key for forex traders navigating markets impacted by fear of floating.

The Theoretical Benefits of Floating Exchange Rates

According to mainstream economic theory, floating exchange rates have significant advantages over hard pegs. First and foremost, floating rates provide monetary policy autonomy. With a floating currency, central banks can set interest rates based on domestic conditions rather than external constraints. This flexibility is a major benefit.

Floating rates also allow adjustments in the terms of trade via currency fluctuations. For example, if a country’s currency weakens, its exports become more competitive internationally while imports become more expensive at home. This helps rebalance trade relationships. These adjustments happen automatically as exchange rates float up and down.

In addition, a floating regime acts as a shock absorber. For instance, if an economy suffers a downturn, its currency will depreciate, which over time should boost growth by supporting exports, jobs, and inflation. Without this automatic stabilizing factor, the downturn would linger longer.

Thus, in theory at least, floating rates promote independent monetary policymaking, facilitate trade rebalancing, and provide insulation from economic shocks.

The Case for Fixed Rates and Managed Floats

Given the ostensible benefits above, why do some countries still fear floating? There are several arguments in favor of fixed exchange rates or heavily-managed floats:

  • Reduced volatility – Pegged rates reduce volatility versus floats, making trade and investing between countries steadier and more predictable. This can stimulate economic activity.
  • Inflation anchor – For countries prone to high inflation, pegging to a low-inflation currency forces monetary discipline and provides an external inflation anchor. This discipline can help stabilize the economy.
  • Trade integration – Fixing to a major trading partner’s currency can reduce exchange rate risks and transaction costs, facilitating greater trade integration.
  • Financial integration – Pegged rates may promote cross-border banking system integration and foreign investment by reducing currency mismatches and risks.
  • Macroeconomic credibility – Maintaining a peg signals a country’s stability to investors and builds policy credibility over time. This allows greater access to foreign capital.
  • Geopolitical factors – Pegs may arise from geopolitical influence or interests. For example, several countries peg to the USD or euro to align themselves geopolitically.

The Costs and Risks of Fixed Rates

However, fixed exchange rates also come with considerable drawbacks:

  • Relinquishing monetary autonomy means interest rates can’t be optimized for domestic conditions. This loss of policy flexibility can exacerbate economic swings.
  • Defending pegs often necessitates procyclical policy. For example, higher rates may be needed to defend a currency when the economy is already weak.
  • Without floating adjustments, trade imbalances can persist and accumulate over time.
  • Speculative attacks, shifts in capital flows, and shocks can quickly force a devaluation of rigid pegs, causing financial crises as occurred across Southeast Asia in 1997-98.
  • Frequent foreign exchange intervention to maintain pegs can drain reserves and affect monetary policy.
  • Black market exchange rates may develop due to market pressures to revalue pegged currencies. This leads to informality in transactions.
  • Arbitrage around pegs with convertibility restrictions can encourage inefficient capital flows and possibilities for rent-seeking.

In essence, fixed rates are prone to periodic crises and ultimately unsustainable without stringent capital controls. This limits their viability in globalized economies.

The “Bipolar” or Middle Ground View

Given the pros and cons above, some experts argue the optimal currency regime is somewhere in between the two poles. These intermediate solutions try to balance macroeconomic flexibility with exchange rate stability. Options include:

  • Crawling pegs – The exchange rate is fixed, but adjusted gradually over time.
  • Adjustable pegs – The currency is pegged, but market pressures can prompt discrete revaluations or devaluations.
  • Basket pegs – The currency is linked to a basket of currencies rather than a single currency.
  • Target zones – The exchange rate can fluctuate within a specified band or target zone.
  • Managed floats – The central bank periodically intervenes to smooth volatility and guide the rate.

In practice, many emerging market currencies lie on the spectrum between pure floats and hard pegs. The optimal middle ground regime depends on factors like trade openness, capital mobility, macroeconomic stability, financial development, and more. Policymakers face a tradeoff between retaining monetary autonomy and limiting currency fluctuations.

Fear of Floating in Emerging Markets

Why do many developing countries remain afraid to let their currencies float freely? Several factors drive this fear of floating:

Liability Dollarization

Many emerging economy firms and banks hold debts denominated in dollars or other foreign currencies. Currency depreciation due to floating exchange rates makes servicing this foreign currency debt more difficult. Officials often prefer reduced volatility to limit balance sheet damage.

Financial Underdevelopment

Underdeveloped capital markets and limited hedging options mean firms in emerging markets struggle to hedge exchange rate risk. Officials then manage rates to reduce volatility.

Pass-Through Effects

Currency swings under floating rates get passed through to domestic inflation via imported input costs. Central banks in developing countries with high pass-through prefer to stabilize exchange rates to control inflation expectations.

Export Competitiveness

Emerging market countries rely heavily on exports for growth. Some limit currency appreciation to sustain export competitiveness, especially versus China and other low-wage exporters.

Dollarization Discipline

For highly dollarized countries, pegging to the USD imposes fiscal and monetary discipline required to reduce dollarization over time. Floating could lead to destabilizing inflation and currency substitution.

Geopolitical Factors

Some developing countries peg to the currency of a major political or economic partner. For example, multiple African and Central Asian countries peg to the euro or dollar in this manner.

Fear of Floating in Developed Countries

While less pronounced than in emerging markets, fear of floating exists in the developed world too. For example:

  • Policymakers may view exchange rates as misaligned from economic fundamentals and intervene to guide rates back to desired levels.
  • Japan and Switzerland have actively intervened to limit currency appreciation and protect export competitiveness at various times.
  • Many smaller open economies manage floats to smooth volatility and counter destabilizing capital flows.
  • Currency pegs are still used in some cases like Denmark pegging to the euro.

So while advanced country currencies do float, occasional bouts of fear of floating surface where policymakers judge exchange rates as threatening economic objectives.

The Role of Inflation Targeting

For countries that adopt floating exchange rates, inflation targeting has emerged as a monetary policy framework to manage macroeconomic stability. Under inflation targeting, the central bank forecasts and targets a specific low inflation rate over the medium-term horizon. This provides a transparent policy anchor to guide interest rate decisions and influence inflation expectations.

Inflation targeting represents a compromise. It provides monetary discipline and macroeconomic stability while retaining the flexibility of a floating currency. This combination addresses some of the concerns that typically prompt fear of floating.

Many emerging markets have adopted inflation targeting, with transparent regimes established in Brazil, Chile, Mexico, South Africa and others. This approach allows these countries to float their currencies more freely within a structured policy framework. The result is that fear of floating has receded considerably in recent decades.

Conclusion: Weighing the Tradeoffs

The choice of exchange rate regime has significant implications for macroeconomic policymaking and performance. Hard pegs provide stability but surrender monetary autonomy. Freely floating rates allow policy flexibility, but at the cost of higher volatility. Determining the right compromise depends on the structure of a country’s economy and policy priorities.

Fear of floating remains a reality for some developing countries. But others have managed to float successfully using inflation targeting and macroprudential regulations to limit volatility. This suggests exchange rate flexibility has become more viable with appropriate institutions and policy frameworks. As global markets continue to evolve, more emerging markets may embrace floating regimes.

For traders, understanding where a country lies on the spectrum between fixed and floating rates provides insight into policymaker reactions and potential currency moves. The implication of exchange rate choices will continue influencing markets and capital flows between countries going forward.