Managed currencies, those where governments set or maintain a currency level, present opportunities and challenges for exporters. Exporters need to understand the type of exchange rate regime that a country has and the risks that a country may not be able to maintain that regime.
Many developing countries have fixed exchange rates. The government (usually the central bank) manages all foreign trade transactions and dictates the exchange rate against a currency (if it is the dollar, you may hear it referred to as “pegged” against the dollar).
The fixed exchange rate regime works in theory if it reflects a level that the clears the market (supply = demand). In reality, that is usually hard to manage and maintain on a long term basis. If there is a current account deficit, the central bank has to draw down on international currency reserves. If there is a surplus (as has happened in China), the extra money enters the domestic money supply, creating inflationary pressures. If there is a parallel currency black market (which there almost always is), there will be a divergence between the official and black market rate. Inevitably, market pressures will force a change in currency peg.
Recognizing these market forces, many central banks adopt tools to gradually manage the exchange rate. There is a tool called a crawling peg in which the central bank changes the exchange rate along a pre-announced path. Another tool is a managed float. The Central Bank announces a desired exchange rate with a band around the rate (for example +/- 2%). If the market results in an exchange rate that is above or below the band, the Central Bank intervenes.
So what does a managed currency mean to an exporter? Remember as I noted in last month’s column, you don’t have to be selling goods or services in the currency for an exchange rate change to affect your competitiveness in the market.
- A fixed rate may give some short term certainty to the exporter. As you look into the future, there is increasing risk that a change (devaluation or revaluation) will occur.
- A float or crawling peg may result in short-term fluctuations in the currency. My experience is that generally the countries can adapt more readily to changing market conditions with a managed float.
- In the event of a major political or economic event, the exchange rate can shift suddenly and radically, with major impacts for the exporter.
One real life example: I was loaned out to Caterpillar Financial Services for one year and I helped them set up operations in Mexico just following the entry into force of the NAFTA. Mexico had a fixed exchange rate regime at the time and the Mexican government swore that it would not devalue, despite a growing current account deficit. Those of you who are familiar with Mexican history know that there is six year boom-bust cycle associated with the presidential elections. In this case, Salinas was leaving office as Zedillo took over. I asked Caterpillar’s advisers on Wall Street who believed that there would be no devaluation. I went to Mexico and asked wealthy businessmen what they were doing with their money. All said they were sending their money to the US until after the devaluation. I told Caterpillar to wait until after the devaluation. The devaluation came after the inauguration but was much larger than expected. As a result, Caterpillar was able to set up a subsidiary for less than half of the amount that was originally planned.