In the modern era, many countries claim to be running a floating exchange rate. However, many of these countries actively limit fluctuation in the external value of their national monies. This behaviour has been dubbed “fear of floating”, several reasons exist for it.
Firstly, there is the ‘original sin’ problem. Many emerging economies are unable to borrow overseas in their domestic currency. This leads to an accumulation of foreign debt liabilities that are unhedged. If there is a sharp depreciation in these nations’ exchange rate, the domestic currency value of their external debt will be altered and thus their economies net worth will also change.
Secondly, policymakers in emerging markets suffer from a chronic lack of credibility. The economies may therefore experience large and frequent shocks to exchange rate expectations or to interest rate risk premiums. To gain confidence and credibility, the authorities who set the interest rate will therefore accord a much higher weight to the stabilization of the exchange rate.
A third reason for a ‘hidden peg’ is that monetary policy is often pro-cyclical. As central banks raise interest rates to restore confidence and stem capital outflows, benefits will result for the monetary authorities. That is, the central bank will not be indifferent to ‘surprise inflation’ which generates additional revenue from money creation and erodes the real value of nominal government debt.
Loss of trade may result for nations with flexible exchange rates. There is a current conception that access to global financial markets for developing countries is conditioned on currency stability. Correspondingly, a steep drop in the nominal exchange rate will often cause a reversal of capital flows into the country, resulting in a current account surplus, an output contraction and a collapse in credit ratings.
There are also political reasons behind “fear of floating”. Policymakers are very interested in the movements of both nominal and real exchange rates. Understandably, politicians will endeavor to keep the exchange rate stable overall given the impact that can arise with a wildly fluctuating exchange rate.
A “fear of fixing” refers to monetary authorities avoiding an announced fixed exchange rate target. An announced target may produce unwanted implications for countries that maintain a pegged exchange rate. For example, speculators may test the actual commitment that a central bank has to the target rate, in order to profit. In modern economic times, the scale of international integration is such that at some point, the announced target rate will be unsustainable.
Another reason is that central banks realize that the economy is open to experience serious shocks. If a Government is committed to a fixed exchange target, there will be political repercussions if it won’t adjust interest rates when the exchange rate becomes overvalued and real income of the domestic economy begins to fall. Where domestic banks are subject to moral hazard, the choice of exchange-rate regime may have important implications for the macro economic stability of the economy. Central banks which hold Government guarantees with a targeted exchange rate have an incentive to increase foreign borrowing and incur foreign-exchange risks. In the absence of capital controls, this increases the likelihood of over borrowing and leaves the economy both more vulnerable to speculative attack and more exposed to the real economic consequences of such an attack. Therefore, the monetary authorities would be even more wary of publishing a fixed rate.