Exchange Rate Management

An exchange rate mechanism (ERM) is a set of procedures used to manage a country’s currency exchange rate relative to other currencies. It is part of an economy’s monetary policy and is put to use by central banks.

The International Experience and Evolution: 

From around 1870 to the outbreak of the First World War in 1914,

the prevailing system to determine the exchange rate of various currencies at the gold standard. Under it, all currencies were defined in terms of gold. Each country in the framework of this system, committed to guarantee the free convertibility of its currency into gold at a fixed price.

It also made it possible for every currency to be convertible into any and all others at a fixed price. 

Determination of exchange rates-

Exchange rates were determined by the currency’s worth in terms of gold.

To preserve the official equivalence, every country needed an adequate stock of gold reserves. 

All the countries on the gold standard had steady exchange rates.

However, certain problems arose under this system: 

• World prices were at the mercy of gold discovery. Subsequently, with mines being unable to produce sufficient gold,the world prices started to fall. 
• This gave rise to social unrest in many countries. 

Some alternate ways emerged such as: 

For a short period of time, silver supplemented gold, and this system came to be known as ‘bimetallism’. 

Under fractional reserve banking the paper currency of countries was not entirely backed by gold; typically, countries held one-fourth gold against its paper currency. 

Under the gold exchange standard, countries although fixed their currency prices based on gold, but held little or no gold reserves instead, held the currency of some large country which was on the gold standard. 

The Post-World War 2 Bretton Woods Conference was held in 1944. It made the following changes in the International Exchange Rate Systems: 

• The International Monetary Fund (IMF) and the World Bank were set up.

• A system of fixed exchange rates was re-established. 
• This system varied from the international gold standard in the choice of the asset in which national currencies could be convertible.

• A two-tier system of convertibility was recognized, at the center of which was the US dollar. 
• The US financial specialists ensured the convertibility of the dollar into gold at a decent pace of $35 per ounce of gold.

• The second tier of the system was the commitment of the monetary authority of each IMF member participating in the system to convert their currency into dollars at a fixed price (called the official exchange rate).

• A change in exchange rates was to be allowed only in case of a ‘fundamental disequilibrium’ in a nation’s BoP – which meant there was to be a chronic deficit in the BoP of substantial proportions.

Reasons for introducing this system:

• Distribution of gold reserves across countries was uneven with the US has almost 70 per cent of the official world gold reserves. 

• A credible gold convertibility would have required massive redistribution of gold reserves.

• It was held that the existing gold stock would be inadequate to sustain the growing demand for international liquidity in the long run. 

• Post–World War II scenario, countries devastated by the war needed enormous resources for reconstruction, raising their imports which put pressure on their forex reserves to finance the BoP deficit. These reserves mainly consisted of US Dollars at that time. 

Problems with this system:

• The holdings of US Dollars by other countries, was in effect a liability for the US to convert dollars into gold whenever needed. 

• Such an extent of the liability in relation to its gold reserves could put convertibility in doubt. 

• The central banks would thus have an irresistible motivation to convert the existing dollar holdings into gold, and that would, in turn, force the US to give up its commitment. 

• This was called the Triffin Dilemma after Robert Triffin, the main critic of the Bretton Woods system.