Prof. Jayanth R. Varma’s Financial Markets Blog

A blog on financial markets and their regulation

The many different kinds of fixed exchange rate regimes

In recent decades, economists have been increasingly focused on the de facto exchange rate regime using the ideas developed by Reinhart and Rogoff (2004) and by Frankel and Wei (1994). This approach of looking at the actual data is of course a huge advance over the naive approach of relying on official pronouncements. Intermediate approaches are also possible as exemplified in the IMF’s De Facto Classification of Exchange Rate Regimes and Monetary Policy Framework.

Obsessive contemplation of currency breakups (see my blog post last month) has made me more sensitive to the legal nuances of a fixed exchange rate regime, and I am beginning to think that looking only at the statistical properties of the exchange rate time series is not sufficient.

I have been thinking of three small but rich and highly successful jurisdictions which have today adopted a fixed exchange rate regime – Switzerland, Hong Kong and Luxembourg. The statistical properties of recent exchange rate behaviour in these three countries might be very similar, but the legal and institutional underpinnings are very different. A de-pegging event would play out very differently in these three cases.

  1. Switzerland has temporarily pegged its currency (the Swiss franc) to the euro through an executive decision of its central bank. There is no statutory basis for this peg. Technically, the Swiss have put a floor (and not a peg) on the EUR/CHF exchange rate (Swiss francs per euro); but given the massive upward pressure on the franc, the floor is a de facto peg.

    Exiting this peg would be very easy through another executive decision of the central bank. The only real costs would be (i) the exchange losses on the euros bought by the Swiss central bank, and (ii) probably a modest loss of credibility of the central bank. I would imagine that a significant uptick in the inflation rate in Switzerland would be sufficient to cause the central bank to drop the peg and accept these costs.

  2. Hong Kong’s peg to the US dollar is much stronger and longer. It has lasted a whole generation and is enshrined in a formal currency board system. Having survived the Asian crisis, the peg is regarded as highly credible. Yet, it would be very easy to change the peg or even to remove the peg completely. In fact, my reading of the statutes is that this could happen through an executive decision of the government without any changes in the law.

    Indeed, there is a significant probability that over the course of the next decade, the HK dollar would be unpegged from the US dollar and repegged to the Chinese renminbi. This change could happen quite painlessly and without any legal complications.

  3. Luxembourg has adopted the euro as its currency. This means that leaving the euro and recreating its own currency would be a legal nightmare. The doctrine of lex monitae asserts that each country exercises sovereign power over its own currency, and that it is the law of that country which determines what happens when a currency is changed. This might appear to give enough leeway to the Luxembourg government to do whatever it wants.

    However, in a cross border contract, the other party would argue that the term “euro” in the contract did not refer to the currency of Luxembourg at all, but to the currency of the euro area as governed by various EU treaties. This argument may not help if the contract is governed by Luxembourg law because the local courts are likely to interpret lex monitae very broadly. But if the contract were governed by English law (as is quite common in international contracts), it is quite likely that the English courts would take the EU interpretation. Assuming that the UK remains a member of the EU, its courts might not have any other choice.

I am beginning to think that we tend to focus too much on the role of money as a medium of exchange or as a store of value. If we do this, it appears that all the three countries have surrendered their monetary sovereignty to an equal extent. But the role of money as a unit of account is extremely important. Of the three countries described above, only Luxembourg has (arguably) surrendered its sovereignty on the unit of account. This loss of sovereignty is the most damaging of all.

An alternate way of constructing the euro way back in 1999 might have been for Luxembourg to adopt its own new currency (say the Luxembourg euro) of which no notes would be printed, peg this currency to the euro issued by the ECB (the ECB euro) at 1:1, and declare the ECB euro to be the only legal tender in the country. From a medium of exchange or store of value point of view, this arrangement would be identical to what exists today because only ECB notes would circulate. But in Luxembourg law, under this alternate approach the ECB notes would just happen to be the legal tender for the Luxembourg euro which would just happen to be equal to the ECB euro. The Luxembourg euro would then be capable of being unpegged from the ECB euro at any time under the doctrine of lex monitae.

The problem as I see it is that technocrats always have a temptation to try and build something that cannot fail. The technocrats who created the euro therefore set out to create something irreversible and permanent. I think it is better to approach the matter with greater humility, and endeavour to build something that would fail gracefully rather than not fail at all.

Finally, there is a fourth small, rich and highly successful country – Singapore – which is also an important financial centre like the other three and has gotten by quite well without pegged exchange rates.


2 responses to “The many different kinds of fixed exchange rate regimes

  1. J.V. Dubois April 4, 2012 at 3:47 pm

    Interesting, article but I still have one detail to add. If it is impossible for Luxembourg (or any other Eurozone country) to get rid of Euro as a unit of account, how come these countries were able to actually convert into EURo?

    The process of conversion to Euro works like this:

    1. The government officially states arbitrary exchange rate, like for example 1.95583 Deutsche Mark for Euro

    2. All contracts and prices have to be converted into from DM to EUR at this exchange rate. I do not know of any case, where some partner refused such conversion. What if some Russian company refused to accept Euro as payment from their German partner and they would require DM instead – even if the currency is discontinues or if they want to use different exchange rate? I suppose that there is some international legal system to solve these situations.

    I do not know of anything that is fundamentally different from converting back to DM from Euro from the medium of account point of view. Sure, there may be more people, companies and institutions that could protest against the new exchange rate or the currency, but the process is very similar to the one of adopting Euro in the first place. And I did not hear about any nightmares regarding that one.

  2. Jayanth Varma April 5, 2012 at 1:07 pm

    The difference is that the DM was Germany’s currency and a country has full sovereignty about its own currency. But the euro is not the currency of any single currency; it is the currency of the euro area.

    Now if there is a contract between two Greek companies under Greek law, it could be argued that euro means the currency of Greece and if Greece goes back to the drachma, then the contract will automatically be interpreted as referring to the new Greek currency and not the euros.

    But if there is a contract between a Greek company and a Japanese company governed by UK law, then a UK court will have to interpret whether euro in that contract referred to the Greek currency or to the eurozone currency. Just as references in that contract to the dollar remain unchanged by Greece changing its currency, it would be argued that references to the euro remain unchanged.

    One can not be sure what the courts will do, but one can be sure that lawyers will make a lot of money.

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