Exchange rate regimes
A country can control its exchange rate, its interest rates, or the free movement of capital. It cannot control all three, and pretending otherwise ends the same way every time.
Every country makes a choice about its currency, even if it makes it by default. The options sit on a spectrum from complete flexibility to abandoning the currency entirely, and each carries a specific trade-off.
The spectrum
- Free float — the rate is set by markets. Monetary policy is fully independent; the exchange rate is volatile.
- Managed float — mostly market-determined with intervention to smooth movements. The most common arrangement in practice.
- Crawling peg — a rate adjusted gradually against a reference, usually to accommodate an inflation differential.
- Hard peg or currency board — a fixed rate, with domestic money issued only against foreign reserves. Credible and rigid.
- Monetary union or dollarisation — the currency is given up. No independent monetary policy at all.
The constraint that governs all of it
A country can have a fixed exchange rate, independent monetary policy, and free capital movement — any two, never all three. If capital moves freely and the rate is fixed, domestic interest rates must match those of the anchor currency, or capital flows in or out until the peg breaks. If you want independent rates and a fixed rate, you must restrict capital flows. If you want independent rates and free capital, the rate must float.
This is not a policy preference. It follows from the fact that investors move money toward higher returns, and a fixed rate removes the currency risk that would otherwise offset the return difference.
Why a peg breaks
Maintaining a fixed rate requires selling foreign reserves whenever the currency is under pressure. Reserves are finite. Once markets conclude the defence cannot be sustained, selling accelerates — because the reward for being right is immediate and large — and the reserves go faster.
The standard defence is to raise rates sharply, making the currency attractive to hold. That also raises mortgage costs, business borrowing costs and unemployment. Every currency crisis is ultimately a question about how much domestic pain a government will accept to hold a number, and markets are testing exactly that.
The case for each
Floating gives an economy an automatic shock absorber: a fall in export demand weakens the currency, which restores competitiveness without anyone deciding. The cost is volatility, which complicates trade and investment planning.
Fixed imports the anchor country's credibility, which can break an inflation problem quickly, and removes exchange risk for trade. The cost is the loss of that absorber, so adjustment must happen through wages and employment instead, which is slower and more painful.
Monetary union
Sharing a currency across economies with different cycles means one interest rate for all of them — too tight for the weak, too loose for the strong. Existing unions address this through labour mobility, fiscal transfers, or neither. The design question is well understood and the politics of fiscal transfers is why it remains unresolved in some cases.
What it means for an investor
A pegged currency looks stable right up until it does not, and returns denominated in it carry a hidden, non-continuous risk. Country funds and emerging market bonds are exposed to regime change as well as to the economy. And a government defending a peg has a strong incentive to say it will never devalue on the morning it devalues — which is not dishonesty so much as the nature of the game being played.