Sunday, May 8, 2011

Forex Fixing

An exchange rate is the rate at which one currency may be traded (bought or sold) for another currency. Normally it is more expensive to buy another currency than it is to sell that currency. This differential is referred to as the "spread" and the difference between the buy rate and the sell rate is referred to as the "mid rate".


Unlike gold fixing exchange rate fixing or forex fixing does not have a universal method to globally stabilize the exchange rates. Without any central point of reference, it is up to every country to control their own exchange rates with other currencies in what is now a highly volatile and potentially lucrative but dangerously volatile market.

There are various ways that any country can peg its currency to all the other currencies that it may have forex dealings with. Broadly these fall into three regimes:

* Hard Pegs — No separate legal tender; currency bound by arrangement
* Intermediate — From soft pegging through to tightly managed "floats"
* Floating — Freely managed or freely floating against other currencies, driven by supply and demand economics

Exchange rate fixing or the pegging of an individual country's exchange rate is generally done in an attempt to control that country's inflation. But this may have the undesired effect of slowing growth and even curbing the country's productivity. Assistance from the International Monetary Fund (IMF) is often called upon.History

From 1870 to 1914 all exchangeable currencies were linked to a gold standard and the rates between them were therefore fixed. This was abandoned at the start of World War I.

After World War II a meeting was conferred at Bretton Woods to discuss trade and economic stability at the global level. The International Monetary Fund (IMF) was set up with the mandate of promoting trade and stability between all countries. This time all currencies were pegged to the U. S. dollar which, at the time, could buy an ounce of gold for thirty-five dollars, fixed!

The IMF could permit countries to adjust their currency's price under fairly stringent guidelines. In 1971 it became obvious that the US$ could no longer remain pegged to gold so the major trading countries started to adopt a free market valuation of their currencies. Any global pegging was completely abandoned in 1985 and individual countries have to decide on the best way to control their liquidity and their trade by adopting the forex fixing regime that they consider works best for them.

It is interesting to note over the last ten years a hardening and a softening of exchange rate pegging. In 1990, developed countries did not use hard pegging at all. In 2001 over fifty percent of them were hard pegging their currencies. Similarly, in 1990, under thirty percent of developed countries could be categorized in the floating forex fixing regime. This grew to over forty percent by 2001.[ibid]

Forex fixing: good or bad?

Some reasons for governments to peg their currencies are:

* The quest for stability
* Encourage foreign investors
* Consistent foreign curreny value
* Controls inflationary tendencies
* Creates demand because of the stability

Unfortunately forex fixing by individual countries is not sustainable in the long term. There are quite a few recent examples of countries suffering serious financial crisis because they have fixed their currencies high for too long. (e.g. Mexico, Russia and parts of Asia). Devaluing or revaluing a currency downwards proves that a government is no longer able to support the high value that is has pegged its currency. Fixing a currency higher than its fair market value requires a government to institute a number of measures to show the rest of the market that it is serious about its desired position. Certainly their dealings must be completely transparent and their financial institutions must be stronger, even bolder than the rest.

The preferable solution is the "floating" or "crawling" peg. Market forces are allowed to control the currency's natural fluctuations but in stepped quantities at arranged times. Government's employing this regime avoid panic devaluations (for the most part) and are well poised to move to a pure floating regime if and when appropriate.
Conclusion

Pegging a currency can work to produce conducive trading environments and fiscal stability respective to world markets but it does have a sinister side if over done.

There are a few difficulties that can be be attributed to floating a currency but ultimately these are far outweighed by the strength and stature a currency attains from the equilibrium attained by floating in the international market.

Source : http://en.wikipedia.org/wiki/Forex_fixing 

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