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
facto exchange rate regime using the ideas developed by Reinhart and Rogoff
(2004) and by Frankel 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
IMFs De Facto Classification of Exchange Rate Regimes and Monetary Policy
Framework.
Obsessive contemplation of currency breakups (see my blog post last month) has
made me more sensitive to the legal nuances of a fixed exchange rate regime, and I
am 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 regime Switzerland, 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 inflation
rate 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
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 the
Chinese 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 monitae asserts 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 monitae very 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 ECB
euro) 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
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 matter
with 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 country Singapore
which is also an important financial centre like the other three and has gotten by quite
well without pegged exchange rates.