A floating exchange rate is a regime where the currency price is set by the forex market based on supply and demand compared with other currencies. This is in contrast to a fixed exchange rate, in which the government entirely or predominantly determines the rate.
Floating vs. Fixed Exchange Rates
Currency prices can be determined in two ways: a floating rate or a fixed rate. As mentioned above, the floating rate is usually determined by the private market through supply and demand. Therefore, if the demand for the currency is high, the value will increase. This, in turn, will make imported goods cheaper.
On the other hand, a fixed (or pegged) rate is determined by the government through its central bank. The rate is set against another major world currency (such as the U.S. dollar, euro or yen). To maintain its exchange rate, the government will buy and sell its own currency against the currency to which it is pegged on the forex market. Some countries that choose to peg their currencies to the U.S. dollar include Cuba, Hong Kong, and Saudi Arabia.
But in reality, currencies are rarely wholly fixed or floating because market pressures can influence exchange rates.
Options for managing currencies
Historically, most currencies were backed by gold as the standard for trade. This ended in the 1970s when the gold standard collapsed due to debt default and high oil prices.
Currencies backed by gold were accompanied by economic policies that put the state at the centre of economic policy. Known as Keynesianism, the logic was that increased government spending would lead to higher output and, ultimately, full employment. The collapse of the gold standard therefore also had an impact on how economies were managed. Countries were encouraged to put the market mechanism at the centre and privatise state assets. This was the foundation of what is now called neoliberal economic policies, characterised by a small government, privatisation of key institutions including health and education, and free-floating exchange rates.
Countries responded differently to the 1970s crisis, devising new ways to manage their currencies. Some adopted fixed currencies pegged against the currency of their major trading partner. A fixed exchange rate is sometimes called a crawling peg because of the movement of the currency within a band. Others allowed their currencies to float. Variations in between have also been tried. For example, within the floating model approach where the market is left to decide the value of the currency, countries have chosen to “manage” the rate by intervening in the market. And then there is the hybrid model under which the currency is allowed to float, but within a specified band.
The job of managing exchange rates falls under a country’s central bank, which controls monetary policy. Which regime it chooses has a direct impact on every aspect of an economy.
There are those very much in favour of fixed exchange rates, and just as many vehemently opposed to them. Some view a fixed exchange rate regime as too inflexible. Others point out that it reduces uncertainty in the face of international capital flows.
In the 1970s, after the collapse of the gold standard, South Africa fixed its exchange rate against the US dollar within a band. Similarly, between February 2015 and June 2016 Nigeria pegged the naira against the US dollar. It did this because of concerns about the currency depreciating against the dollar, making imports expensive.
The biggest weakness of a fixed exchange rate is that interest rate hikes in the pegged country currency may also strengthen the domestic currency. This inevitably leads to an excess demand of foreign goods and unsustainable external borrowing by government.
For example if the US increased interest rates and the dollar strengthened, the naira would also strengthen. Nigerians, experiencing a wealth effect, would respond by importing more. This phenomenon would not have been caused by factors in Nigeria, such as higher economic growth or higher oil prices, but because of actions by the US Federal Reserve. It is this artificial wealth effect that is of concern.
Both South Africa and Nigeria have abandoned this approach – South Africa in 2000 and Nigeria in 2016 – and replaced it with floating exchange rates. In the case of South Africa, various frameworks were adopted between 1960 and 1998, including exchange-rate targeting and an eclectic approach within a crawling peg.
Their decisions follow a global pattern where the policy choice in exchange rate management has shifted in favour of floating exchange rates.
Why South Africa changed course
In the 1990s the South African Reserve Bank paid a heavy price when trying to control the value of the country’s currency. In an effort to counter speculative activity in 1996 the bank sold about US$14 billion into the market. In taking such action, it temporarily put a bit of a brake on the depreciation of the currency. But in the end the intervention only contained the depreciation from R3.50 to the dollar to R4.50 to the dollar.
In 1997 the bank intervened again, this time in two ways. First, it sold slightly more rand than it had bought, to the tune of about an extra $1 billion. Second, it raised interest rates to 7% in real terms. Higher interest rates attract capital inflow thereby strengthening a country’s currency. The South African Reserve Bank relied heavily on this knowledge.
Once again these actions resulted in only marginally containing the depreciation of the currency.
Subsequent to this episode, there was a shift in the South African Reserve Bank’s policy. The bank adopted an eclectic approach that meant that not only the exchange rate mattered in monetary policy but also money supply.