Wednesday, November 21, 2007

Foreign Exchange Rates & Systems

Fixed Exchange Rate System

A fixed exchange rate is one where the foreign exchange rate is artificially pegged to a reference standard, ie the gold price or a trade weighted basket of currencies. The benefit of a fixed exchange rate system is that people know exactly what the exchange rate will be. The disadvantage is that holding exchange rates at fixed levels can require a lot of intervention through foreign exchange and/or money markets. This can create distortions in the economy and may reach a point where an adjustment (usually a de-valuation) is unavoidable. When these occur they are typically large devaluations which have a major impact.

Floating Exchange Rate System

A floating exchange rate system is one where the foreign exchange rate varies with supply and demand for the currency. The benefit of floating exchange rates is that the market is allowed to determine its own level. The disadvantage is that the market may set exchange rates at levels not considered desirable.

Evolution of the Foreign Exchange Rate System in Australia

The British pound was used as legal tender in Australia until 1931 when the Australian pound came into existence. The Australian pound was fixed to the pound sterling at a rate of 1.25 pound equaling GBP 1. In 1966, Australia introduced decimal currency with the Australian dollar replacing the Australian pound as Australia's currency with AUD 2 = 1 Australian pound.

Under the gold standard, exchange rates were fixed to the price of gold. A British pound was originally one pound weight of gold. Under the Bretton Woods system, which operated from 1947 until it broke down in 1971, the value of the US dollar was fixed as equal to 1 oz of gold. Other currencies were given 'parity' against the USD. 1 Australian pound was set at USD 3.224. Central banks held reserves to keep their exchange rate fixed at the parity level. Very occasionally the paritities were changed. For example, in 1949 the Australian pound (in line with sterling) was devalued by 30% against gold, and the USD to 1 Australian pound = USD 2.224. In 1967, the pound sterling was devalued by 14.3% - but the AUD did not follow.

The Bretton Woods system ended in late 1971 and the major currencies returned to a floating rate mechanism. It was decided that the AUD would be linked to the USD, rather than the pound. Adjustments to the AUD/USD rate were made in December 1972, February 1973 and September 1973. In September 1974 the link with the USD was broken and replaced with a link to a trade weighted basket of currencies. In November 1976 the AUD was devalued by 17.5% against the trade-weighted basket and it was decided to make frequent small adjustment rather than occasional large changes.

Each morning the Reserve Bank (RBA) posted a mid-rate for the day based on the closing New York exchange rates, and the then secret trade-weighted index. Until December 1984, when a large number of foreign owned banks were given authority to trade in foreign exchange in Australia - only the major trading banks were permitted to deal in deliverable foreign exchange. Exchange controls existed that restricted dealing in foreign currencies to importers and exporters with documentary evidence of international trade. An unofficial market known as the 'hedge market' developed in which non-deliverable forward contracts were traded. The forward prices in the hedge market were based on the day's mid-rate and reflected supply and demand.

The Australian dollar was floated and exchange controls were lifted on 11 December 1983. The RBA mid-rate was replaced with a daily published rate known as the 'hedge settlement rate', (HSR). The HSR was (and still is) determined by calculating the average spot rate at 9.45am Sydney time of ten banks, after excluding outriders. The hedge market no longer operates, but the HSR is still used as the basis of settlement of a number of derivative contracts.

From 1979, most European currencies joined the European Rate Mechanism (ERM), which was known as 'the snake'. Under this arrangement, exchange rates between participating currencies were kept within a band of 2.5% of each other, but the ERM was free to move against other currencies, particularly the USD. As with the Bretton Woods system, realignments were made from time-to-time.

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