Currency Wars: “Beggar Thy Neighbor” Policy
February 12, 2025
We studied the different methods to calculate the free cash flow to the firm (FCFF) in the previous articles. In this article, we will learn about how to derive free cash flow to equity (FCFE). Here too there are multiple methods involved. However, since we already have a background in calculating cash flows, we need […]
The retail industry has been constantly innovating in order to become financially more viable. There are several innovations which have been introduced in the retail industry. However, very few innovations have been as effective as the Buy Now Pay Later (BNPL). The use of Buy Now Pay Later (BNPL) payments has been increasing over the […]
Sears has been one of the largest retailers in the world for many years now. The company has been in operation for about a century. Sears is one of the most widely known corporations in the world. Finally, in October 2018, Sears is now filing bankruptcy. Many investors were already expecting this move given the […]
Commercial banking is fundamentally different from retail banking in several ways. One of the main differences between the two types of banking is the relationship management approach. The commercial banking system relies heavily on relationship management. Each and every corporate customer of a commercial bank has a dedicated relationship manager. This is possible because of […]
Stock investments are supposed to be made based on rational choices. In this module, we have so far learned that investors are not exactly rational and tend to become emotional a lot of times. However, it is important to note that there are some cases in which investors are pretending to be rational but are […]
The freely floating currency system is the predominant system of foreign exchange that is prevalent in the world today. As globalization has progressed, more countries have abandoned their currency pegs and have allowed their currencies to freely float. Some have been forced to do so by market participants whereas others have made their choice in the light of the advantages that this system has to offer.
In this article, we will have a look at the advantages and disadvantages that are faced by any country when it adopts a floating exchange rate regime.
Fixed exchange rates require the Central Banks to set up trading desks and currency boards to manage the currency actively on a daily basis. In case of a floating exchange rate, the central bank does not have to take so many efforts. Instead, it can just passively manage the currency by setting important rates and interfering in the market only when it becomes necessary.
For instance, when the dollar raises its interest rates, all currencies pegged to it also have to make necessary changes. Hence, the countries that have their currencies pegged to the dollar have limited independence whereas countries that let their currencies float have a far greater degree of independence.
The point is that speculative attacks happen only when the currency remains stagnant at a given point whereas its underlying fundamentals have changed. It is then that the speculators see an opportunity to bring the currency to its equilibrium point quickly and make a quick buck by doing so.
However, if the currency is traded on the Forex market as a freely floating currency, adjustments happen on a minute to minute basis. Therefore, the gap between the underlying fundamentals and the market value never really widens up enough for the speculators to mount a sudden attack.
Central Bank operations are a very rare event for countries that have a floating rate system. This is a major advantage of this system since holding foreign exchange for trading purposes is an expensive strategy.
Firstly, it requires the country to maintain a huge currency reserve. Then, it also requires the central bank to have an active trading desk 24 by7! The floating rate system is simply a lot more convenient since it does not have any such requirements.
The freely floating currency system also has its critics. They suggest that the system has a few serious flaws. Some of the important ones have been listed below:
In the short run, traders find it difficult to engage in foreign trade since they are not aware of the exact prices that their goods will fetch them. Movements in the currency market can cause a significant dent in the profits of companies which indulge in foreign trade. However, these risks can be managed with tools like hedging.
For instance, a rising exchange rate makes imports a better option whereas a falling rate makes exports easier. Hence, if exchange rate keeps of fluctuating, the country cannot really create a long term strategy and stick to it. The allocation of resources is optimized in the short run. However, in the long run, this allocation seems to be ad-hoc since it does not follow any given plan.
It is for this reason that a lot of third world countries prefer to peg their monetary policy to major currencies like the dollar or the euro.
Therefore, the advantages of fixed rate system are the disadvantages of the floating rate system and vice versa. The choice between these two systems is therefore an ideological choice. There are no right or wrong answers. Rather the appropriate choice depends on how the country views the Forex markets and what its long term objectives are.
Your email address will not be published. Required fields are marked *