Exchange Rate Regimes
This is the "balance of trade," a locked-in relationship between short-term transactions in the current account and long-term transactions in the capital account.
This, of course, does nothing to explain how the relationship between the currencies of countries trading with one another is set. That's where the driving forces behind "exchange rates" between currencies come into the picture.
Types of Exchange Rate Regimes
Broadly speaking, the exchange rate between two currencies can be establish in one of three ways.
Free float: This regime is in place when a country simply allows the global currency markets to set the exchange rate between its currency and every other country's. This is the "free-market" approach, with currency traders setting the price from day to day based purely upon supply and demand conditions for the currency. Ideally, this regime would, at least over the long haul, reveal fundamental value of a currency based upon the best information available about the economy underlying it.
Most countries would like to avoid this regime, ostensibly because exchange rates could swing pretty wildly, and this would be disruptive to international business. Underneath this quite legitimate concern is the possibility that a real, fundamental shift in the circumstances of an economy might get reflected too bluntly and rapidly in its exchange rates against other currencies.
Managed float: This regime is favored by many nations. Often, in fact, the central banks of countries will work together to ensure that currency management practices serve each country's reasonable interests within the coalition. In managed float, a country sets a range of exchange rates that it deems acceptable. If its currency gets too close to one end or the other of the range, the country, along with other countries who work together in the managed exchange rate system, intervene in the global currency markets to nudge the endangered currency away from the danger zone.
Consider this example. Suppose the target range of exchange rates for the U.S. dollar to the euro is between .95 euro to the dollar (€.95:US$1) and .75 euro to the dollar (€.75:US$1). Now, the Europeans and the Americans have agreed to work together to ensure that the exchange rate between the euro and the dollar doesn't go outside of this range; but let's say the dollar, which had been drifting around .85 euro, starts to weaken precipitously, heading down toward maybe .76 euro. (Notice that the dollar is, indeed, weakening here since it used to take .85 euro to buy a dollar, and now it takes only .76 euro to buy one.) To control this situation, if the Europeans and the Americans are coördinating their actions (which they actually do, as do the Japanese with the Americans, by the way), the central banks of both Europe and the United States will enter the global currency markets, and they'll start aggressively buying dollars and paying for them with euros. The currency markets should react as would be normal for any commodity market: the demand for dollars is going up, so they become more valuable; at the same time, the supply of euros is rising, so they become less valuable. Under normal circumstances, the result will be that the dollar firms up against the euro.
Now, understand that central banks actually keep some of one another's currency exactly for this purpose. In fact, this is why the so-called current account and capital account don't exactly match. A country won't return all of the foreign reserves it earns to investment in the currency's country of origin because it will keep a little bit just for the purpose of participating in exchange rate management regimes.
Also understand this, though: no matter how aggressively a group of nations might intervene in the global currency markets to maintain an exchange rate regime, if the conditions in an economy are such that the regime is no longer appropriate with respect to that country's currency, the central banks will be unable to stop the border of the band from being breached. In the example above, if the regime maintaining that the dollar should not fall below .75 euro is simply not economically appropriate given the relative states of the economy of the United States and that of the European Union, the Americans and the Europeans could go through all their respective reserves kept for exchange rate management, and the dollar would still eventually make its way below .75 euro.
In other words, exchange rate management is a tool that works only to prevent short-term, excessive volatility that could throw an exchange rate outside an otherwise reasonable range.
Fixed (or pegged): At first blush, this seems like just an extreme version of a managed exchange rate regime, but it is not because the mechanism for maintaining the peg is different, and the result has been wholly catastrophic in the long run for a number of countries that have tried it.
A pegged exchange rate "fixes" the ratio of two currencies at a level set by the central bank of the pegging country. For years, China fixed the exchange rate of its currency at 8.28 yuan to the dollar. It simply set this, regardless of what global currency markets might have determined it should have been were they to have been able to set the rate free of compelling interference from the pegging country's central bank. The fact of the matter is that the yuan was for some years far stronger against the dollar than 8.28-to-one fixed rate indicated. Realistically, because the Chinese economy was strengthening, it shouldn't have taken nearly that many yuan to buy a dollar, but the Chinese had absolutely no intention of letting the yuan start to show its power: by setting it at such a weak level, they were making Chinese imports into the United States very cheap and making American imports into China very strong.
China isn't the first or only country to have done this (or to have at least tried). It's an old trick developing countries use to grow stronger through their export industries. To a certain extent, developed countries have tolerated this game because it's sort of a back-door way of providing foreign aid to those countries that were fixing their exchange rates at some ridiculous levels. Essentially, by allowing countries to peg their currencies cheap, their imports to the developed countries remain very attractive to buy, so these developing nations earn large amounts of foreign reserves, which they can then use to earn even more money (or to at least make the payments on their foreign debt obligations). Eventually, however, the chickens come home to roost; or, in the case of currencies, a pegging country's currency comes home to rest, and that's because of how the fixing of exchange rates is accomplished.
In a simplified framework, when China set its exchange rate at 8.28 yuan to the American dollar, it was doing so by printing as many yuan as necessary, then entering global currency markets and buying dollars with them. There was never a hint of deviation from the 8.28-to-one rate in global currency markets since the Chinese would simply deliver as many yuan as it took to hold the exchange rate right smack on the mark. If currency traders needed more to keep the yuan from strengthening, they'd get them. Even as the Chinese economy began to grow robustlywhich would have, in a free float regime, caused fewer yuan to be needed to buy a dollarthe Chinese just kept printing the yuan as fast as needed to keep the peg at 8.28 yuan to the dollar, thereby ensuring that Chinese imports to the United States stayed super cheap.
Unfortunately, this canand it has hada catastrophic end for countries pegging their exchange rate against the currencies of stronger countries. When the money supply of a country grows at a rate faster than that of the real economy represented by the currency, the result will be inflation. In fact, that's the only thing that can cause inflation, as was explained in earlier installments of Pulp Economics here at The Dark Wraith Forums. (See, in particular, "A Brief Story of Money, Part 2" for a detailed explanation of how inflation is related to the money supply.)
Sooner or laterand it's usually not only later, but too much later to salvage the currencyall those piles and piles of currency a country has been printing start washing back up on the shores of its own economy. Unless the economy is growing so fast that it can absorb all the extra currency pouring in, domestic prices of everything start to go up since the value of each unit of the currency is falling because it's getting watered down by the excess amounts of it in circulation. This so-called "overhang" can be staggering for a country that's been printing money for years to maintain a fixed exchange rate against another currency.
So suddenly the country that was trying to keep its currency cheap against other currencies is in the position where its own domestic inflation is rapidly starting to make its currency virtually worthless against other currencies. The country's currency can get so worthless, in fact, that it can't be used to buy anything overseas.
That's when the death spiral starts: to stop the free-fall of its currency in global currency markets, the central bank of the afflicted country has to enter those markets and actually start buying its own currency. (Remember, for all those years that it was maintaining a fixed exchange regime, it was buying other currencies by selling its own!) But what does a country use to buy its own currency? Well, the first and obvious thing is to use all the foreign reserves it's accumulated over the years by selling cheap imports in other countries; but recall from above that using foreign reserves to defend a currency is only a temporary mechanism to control short-term volatility. No country, especially a developing one, can use foreign reserves to do more than temporarily slow down a fundamental exchange rate shift the global markets are bound and determined to accomplish.
So the country quickly wipes out its foreign reserves, but the inflation is still raging upward at home, and the domestic economy is starting to stagger. Foreign interests start swooping in with their powerful, stable currencies to buy up everything in site because people, companies, and even the government of the country will trade anything for "hard" currencies and commodities.
This, by the way, is the reason for those old stories during the Cold War of being able to buy just about anything in Eastern Bloc countries with American dollars or even with packs of American cigarettes: the local currencies were so shot that people would trade anything just to get their hands on assets denominated in what they perceived to be a stronger currency.
Anyway, back to the main story, the country that had been pegging its exchange rate is suffering raging inflation, its currency is so worthless that it can't buy anything from overseas markets, and it has ripped through every bit of its foreign reserves trying to defend its currency. So what's the end-game?
The country's store of gold and other precious commodities, of course. The central bank starts to enter global markets and buy its own currency with gold (and maybe national treasures of diamonds and other universally accepted commodity moneys). Not only does it buy its own currency with its gold, it probably also buys critically needed other materials with it, too. It also might use metal to make the payments on its foreign debt obligations.
Sooner or later, the gold will run out. The country is, for all intents and purposes, bankrupt. Busted.
That's when one of two things will happen: either the rebels will make it to town, or the International Monetary Fund will. If the rebels show up first, they'll bring rifles. If the IMF gets there first, its representatives will bring an austerity plan. Either way, things are likely to get rough. Unless the rebels have the backing of a Western power, they'll have to start the economy from scratch with respect to currency legitimacy, foreign relations, and a whole host of internal civil and legal structures. If the IMF moves in to do a re-organization, the first thing that will happen is an old-fashioned, money supply clamp-down. Interest rates, already high and rising because of the expected inflation premium impounded in them, will go through the roof since interest rates are the price of money, so when the money supply gets knocked flat, its pricedomestic interest rateswill tear into outer space. Quite a few businesses will go bankrupt, and a whole lot of poor and middle class people will get poor beyond their wildest dreams. The wealthy will do alright under the IMF fist: if they had any sense at all, they would have long before the crisis moved their wealth into foreign currencies in foreign banks in foreign lands. (Or, in the case of China, they would have completed the semi-friendly take-over of Hong Kong so they owned their own off-shore banking system to stash their money in.)
One way or the other, by the brutal regime change heralded by rebels with automatic weapons or by the equally brutal regime change heralded by financial professionals with economic policy overhaul documents, the country will slowly find its way out of the abysmal situation. Usually, anyway. And all it will take is a lot of suffering.
Economics: calling it the 'dismal science' is such an understatement.
The Dark Wraith has once again brought a story of hope and joy to an otherwise sad and hopeless time.