Choosing Between Fixed or Floating Exchanged Rate for Small, Open Economy - Example

Choosing between fixed or floating exchanged rate for small, open economy (Malaysia, Hon Kong) Every country has its own foreign exchange regime by which it manages its currency in respect to foreign currencies in the foreign exchange markets. Foreign exchange rate decides as to how much a currency of a country is worth in terms of another country’s currency. The exchange rate is a conversion factor. The exchange rate is the rate at which the currency of one nation can be exchanged with another one. By exchange rate the value of a currency is compared with another country. In a fixed exchange rate, a currency’s value is matched with another currency or another measure like gold. In a floating exchange rate the value of a currency fluctuates as per the foreign exchange market. Both the types have merits and demerits. The value of currency in a fixed exchange rate varies according to the rise and fall of reference value. The type of exchange rate followed by a country has a direct impact on its domestic monetary stability. Practically a fixed exchange rate followed by a Government tries to stabilize its internal monetary policy. A floating exchange rate is determined by the supply and demand theory in the market. A currency which has more demand in the market has more exchange value. On the other hand exchange value of a currency decreases when it has no demand in the market. An open economy allows the people and business to trade in the international market. The people gets chance to consume goods and services of other countries. One pertinent point here is the choosing of one type of exchange rate for a small economy like Malaysia or Hong Kong. The very purpose of choosing a fixed exchange rate is to keep a country’s currency value with in a narrow band. Fixed exchange actually pegs the domestic currency with some foreign currencies. (2) Getting the correct and exchange rate for a currency is inevitable for the development of an economy whether it is under developed, developing or developed. The developing countries in Asia which had opted for a fixed exchange rate is now thinking of or already thought of changing to a floating exchange rate. It is mainly consequent to the Asian financial Crisis that tied Asia during the period from July 1997. It was alleged that the economic crisis that came to surface was mainly because of the fixed foreign exchange rate. Its main causes were not clear. The economic crisis caught the countries like Thailand, Indonesia, South Korea, Malaysia etc. Before the crisis Malaysia was an investment destination and economists predicted that the country will soon rise to the status of a developed nation. But instead of becoming a developed nation the country soon fell into a financial crisis. It all happened within no time. It was an overnight development. Consequent to the Thai baht devaluation Malaysian ringgit was attacked and the country’s economy declined. Agriculture, manufacturing and construction sectors shrank to the lowest. To overcome the crisis Malaysian Government announced a fixed rate of foreign exchange in place of a floating exchange rate. Because of the other measures also taken in the wake of the crisis, the country gradually returned to its pre- crisis stage though asset values did not return to the pre crisis stage. Malaysian Government in 2005 removed the last crisis measure by lifting the fixed exchange rate and bringing a more or less floating exchange rate. But the floating exchange rate in vogue in the country is exactly not the one it had in the pre crisis period. Malaysia’s major exports include electronic equipment, petroleum product, forestry products, palm oil, rubber and textiles. Agriculture produce include cocoa, pepper, pineapple etc. Tin and petroleum are also contributing substantial portion to Malaysia’s economy. Malaysia is rich enough to produce oil for the next 18 years and gas for 35 years according to the present production rate. Malaysia’s economic growth has been one of Asia’s best registering an average 6.5% growth in GDP/year from 1967 to 2005. (3) High performance was seen in the 80s and mid 90s. Malaysia was heavily depending in primary sector for maintaining its economy. It has been once a good place for foreign investments and its economy diversified and modernized. Now Malaysia is a middle income country concentrated in multi sector economy based on services and manufacturing. It has become one of the largest exporters of semi conductor devices, electrical goods and information and communication technology products. Malaysia’s national economy policy aims higher technology production. Now the world is driven by two main forces i.e. globalization and liberalization of markets. Since the coming into being of the world trade organization if 1995, a rapid economic growth is visible almost in all countries in the world. Many developing countries in the world during the past two decades have shifted the fixed foreign exchange rate to floating foreign exchange rate. The shift from fixed rate to floating rate was gradual. In the beginning most of the developing countries preferred to peg their currency value and their percentage rose to nearly 87% in 1975. But in 1996 the percentage of developing countries which preferred to continue with the fixed rate was only 20%. It took some time for the developing countries to decide on the matter in favor of adopting a floating foreign exchange rate as they had to take into account the pros and cons. The countries with flexible growth rate registered a rapid growth in their economy. These countries with floating foreign exchange rate particularly from Asia began to switch over to flexible rate category. When coming to the point of choosing between fixed and floating and exchange rate by small economy, there were opinions in the recent past that small countries which depend on exports and imports, a fixed foreign exchange rate will do better. Now economists have changed their approach to this issue. Now the issue is seen on the basis of the disturbances it makes in the domestic economy like fluctuations in output, consumption etc. A decision on this issue is to be taken on the basis of the impact it brings on the economy. If the economy is affected severely with demand of more money which affects the prices of the commodities, then a fixed foreign exchange rate will suffice where as a flexible exchange rate will be useful with economy is affected consequent to the changes in technology or tastes. A country which follows a fixed foreign exchange rate is very keen to keep inflation under control and will keep away from borrowing as it will necessitate paying interest and that may affect the pegged rate. A fixed rate is well and good if credibility is maintained which reduces the chances for inflation. In reality the choice between fixed and floating exchange rate is between nominal exchange rate appreciation and instant inflation. A perusal of the economy of countries with floating foreign exchange rate will reveal that in countries with fixed rate, inflation has come down. However inflation among the developing countries with flexible foreign exchange rate also has come down. But the need of the hour is to follow a flexible foreign exchange rate as economy of each country has become close to world economy due to the liberalization and globalization. In the light of the above discussion it can be concluded that it is better for a small open economy like Malaysia to choose the floating foreign exchange rate. In this context it is pertinent to have a look on the economy of Hong Kong; the world’s largest trading entity. Hong Kong has been under the governance of British and Chinese since 1970. Now the sovereignty of Hong Kong vests with China. It followed a policy of positive non intervention which means no Government interventions. Noted economists Milton Friedman termed it as laissez faire policy. Hong Kong’s economic policy was regards as world’s freest economy. When most of the countries in Asia made a transition of their economy from collectivism to market capitalism, Hong Kong remains on their economic freedom. Gifted with natural facilities Hong Kong has a well built infrastructure and highly skilled labor force. Hong Kong imports food and raw materials from other countries. A large portion of Hong Kong’s export consists of re exports. The Sino- British joint declaration entitles Hong Kong to continue with the autonomy till 2047. Its capitalist economy based on service industries stands on a policy of pre market, low taxation, nonintervention from Government. Hong Kong is considered to be an important centre for finance and trade. Its stock exchange is the 6th largest in the world. The Government of Hong Kong continues a policy of passive role in the financial industry allowing the economy to be directed by the market forces. Since the 2nd World War Hong Kong was rapidly industrialized and became a manufacturing centre and mainly depended on exports. Subsequently a transition was made to service based industries. For more than 90% of its GDP accounts for service sector. During the 2nd half of 1990 Hong Kong’s economy was severely affected due to the Asian financial crisis. But they regained their earlier position and deflation ended. Hong Kong comes under high income nations. Its economy is highly depended on international trade and commerce. Hong Kong has registered a strong economic growth in the recent years. It has the 2nd highest per capita holding of foreign exchange reserves. (4) Hong Kong’s GDP expanded nearly to 7%. The per capita GDP of Hong Kong is comparable to the developed European countries. On the external sector, exports of goods rose to 8%. Export in the service sector marked 10% in the 1st quarter of 2008. Growth in the external sector of Hong Kong is very encouraging. Trading and logistics, tourism, financial services, professional and other produces are the main sectors of Hong Kong’s economy. Foreign direct investment is high in Hong Kong. As per the UNCTAD world investment report 2007, Hong Kong was 2nd in Asia and 7th in the world in 2006 in terms of foreign direct investment. The trade in 2007 shows that it’s external trade has registered 9.2% growth in 2007. Chinese main land, the European Union, United States and Japan are Hong Kong’s major export markets. An over view of Hong Kong’s economy reveals that it follows a free market. It mainly depends on service sector which contribute to 90% of its GDP. Foreign direct investment is high in Hong Kong. It has become a place for import to and export from the China mainland. Hong Kong’s economy depends mainly on exports. Hong Kong has registered a low inflation rate in the recent past. After reviewing the economic scenario of Hong Kong, the question here is what type of exchange rate will be suited to Hong Kong. It is to be examined in the present world scenario. The world market has become so close to every country. Hong Kong is actually a centre of trade of the world. It cannot be an isolated member in the world market. The two forces that direct the world market are globalization and liberalization and naturally Hong Kong has to take care of these directing forces. Trade between the countries in the world has increased with the advent of world trade organization. In fact a country chooses a particular type of exchange rate in order to stabilize its economy. Fixed exchange rate and floating exchange rate have proved that both have the qualities to make an economy stable. Some economists opined that fixed rates provide certainty for exporters and importers,helps to maintain low inflation, keep interest rate and increase trade and investments. (6) The problem in going for a fixed foreign exchange rate is that it acts as a barrier to receive foreign loan as the interest to be paid on it may destabilize the internal economy. In the case of Hong Kong, where a free market system is followed, an economy which depends mainly on exports and an economy concentrated in service sector, it is better to go in for a floating exchange rate. It is opined that the floating exchange rate will bring back the balance of payments of the country to equilibrium automatically. More over the floating rate will reduce inflationary pressures. Hong Kong which follows a free market system will find it beneficial in choosing a floating exchange rate. In the light of the economy of Malaysia and Hong Kong, it can be said that a floating foreign exchange rate is better than a fixed foreign exchange rate for a small open economy. References: 1) Floating and fixed exchange rates by Reem Heakal – retrieved on 15-8-2008. www.econlib.org 2) Fixed or flexible – getting the exchange rate right in the 19190s Francesco Caramazza, Jahangir Aziz PDF file 215 K retrieved on 15-80-2008 3) Back ground notes Malaysia – Bureau of East Asian and Pacific Affairs June 2008 – retrieved on 15-8-2008 4) HKTDC.com retrieved on 15-8-2008 (Hong Kong Trade Development Council) 5) Investopedia retrieved on 15-8-2008 6) http:/bized.co.uk/virtual/de/index..htm retrieved on 15-8-2008 Read More