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Foreign exchange, which also known as ‘forex’, is the conversation of one country’s currency into another country’s currency. The number of foreign exchange transactions has increased due to the increasingly globalization. This is because foreign exchange assists in both maintaining monetary stability and promoting trade. The rate of foreign currency depends on some factors such as the country’s economy status, the demand and supply of the foreign currencies, and also the country’s trade balance. Some countries are dealing with floating rates system; some are dealing with fixed rates system while some are using pegged rates system.
Law of one price is a simple idea to understand how exchange rates are determined. It means that price of identical goods between two countries should be same throughout the world no matter which country produces it given that the transportation costs and trade barriers are very low. Besides that, theory of purchasing power parity (PPP) is the most prominent theories that explained how exchange rates are determined. It states that changes in the price level of two countries will adjust the exchange rates between the two countries. However, this theory provides some guidance for movements of exchange rates in the long-run but it is not perfect and it was a poor predictor for the short-run.
The foreign exchange rate is controlled by exchange control system. Exchange control is stated as types of controls that governments adopt in order to ban or restrict the amount of currency either foreign or local that is allowed to be traded or purchased throughout the world. In other words, countries which are in the weaker economies condition will employ the exchange controls and these exchange controls will then help those countries with a greater degree of economic stability by limiting the amount of exchange rate volatility due to currency inflows or outflows. There are two types of methods of exchange control which are direct exchange control and indirect exchange control. For the direct methods of exchange control, governments take use of those devices for the purpose of having an effective control over the exchange rate, while indirect methods are designed for the regulation of international movements of goods. In general, measures for direct exchange control are intervention, exchange restrictions, exchange clearing agreements, payment agreements, and gold policy. For indirect exchange controls, there are also consist of several types of measures, such as changes in interest rates, tariffs duties and import quotas, export bounties, and concluding remarks.
Foreign exchange controls are known as various forms of controls imposed by a government on the purchase/sale of foreign currencies by residents or on the purchases/sale of local currency by non-residents. Typically, in order to protect weak currencies on own country, some governments will put more efforts to impose foreign exchange control to influence the buying and selling of currencies. This is because foreign exchange controls will usually affect both residents; local residents and foreign residents which are involved in the transaction of local currency and foreign currency. Common foreign exchange controls include banning the use of foreign currency within the country, banning locals from possessing foreign currency, restricting currency exchange to government-approved exchanges, fixed exchange rates, and restrictions on the amount of currency that may be imported or exported.
2. The Peg to the British Pound ( 1931-1971 )
The role of sterling was reflected by the adoption of the sterling peg as the primary currency to be used in international transactions during December 1931 when Australia commenced pegging its currency to British pound sterling. It was also recognized that Australia has a close relationship with the United Kingdom and participation in the sterling area together with other countries in the British Commonwealth. The exchange rate for all dealings in sterling was fixed by the Reserve Bank, both bank or customer and interbank. The banks acted as agents for the Reserve Bank. Although there was large swings in the value of sterling, but the peg to sterling was changed only once during when Australia did not devalue with sterling against U.S. dollar and other currencies in the postwar period, in November 1967. There are several reasons for not devaluing which includes devaluation which would lead to inflation via higher import prices, has an expectation that Australia’s balance of payments will improve over the following years, decision by other national governments that not to devalue would enhance effectiveness of sterling devaluation and due to decreasing importance of United Kingdom as a destination for Australian exports, so export receipts were not likely to suffer greatly.
Comprehensive system of exchange control underpinned pegged exchange rate arrangements. It was first introduced as an emergency measures under wartime legislation. During that time, all foreign-currency transactions were prohibited or not allowed unless they were authorized by Reserve Bank. However, certain types of transactions were freely approved like those relating to trade private capital inflow and others. But these transactions were constrained on the timing in terms of leads and lags between accessing funds and completing the transaction in order to minimize the possibility of speculation. Furthermore, restrictions were also placed on investment abroad by Australians and on borrowing by foreigners.
Forward cover was available only for trade-related transactions but not for capital transactions prior to the early 1970s. Reserve Bank provided cover to banks for risk arising from forward transactions with regular customers and therefore transfer the risk from private companies to central bank. Banks acted as agents for the central bank which had the authority to approve trade-related transactions. Prolonged period of reform of Australian financial system began in the early 1970s where the first reform granted the banks to have the authority to act as principals in all foreign- currency dealings. However, at the end of each day, banks required to clear imbalances in spot and forward books beyond a small limit by dealing with Reserve Bank at set rates. In addition, Reserve Bank also gave some freedom to banks by fixing only the outer limits to vary the exchange rates, at which banks dealt spot with customers.
3. The Peg to the U.S. Dollar (1971-1974)
Subsequent to World War 2, U.S. dollar became the primary international reserve currency. Besides that, the settlement of international trade and monetary payments also increasingly took place in U.S. dollar. In the period prior to the U.S dollar peg, U.S. government had suspended convertibility due to the Bretton woods system in August 1971. In this period, the Australian dollar remained pegged to British pound.
In late 1971, officials from G-10 restore the previous exchange rate system which is Smithsonian agreement. This agreement is to end the fixed exchange rate system established under the Bretton Woods Agreement.
By late 1972, Australia was running a substantial balance of payment surplus, with record capital inflow at that time. The Australian government has strengthened capital controls to reduce the capital inflow. The revaluations in December 1972 and February 1973, together with the imposition of a variable deposit ratio, which substantially increased the cost of borrowing abroad, were explicitly aimed at stemming capital inflows which had been building up over the course of 1972.
At early 1970, the official market offered forward exchange facilities limited by 2 exchange controls which are forward cover and “seven-day rule” to provide exchange risk protection. However, due to the official forward exchange facilities are inadequate so the market participants established the foreign-currency hedge market, which was a non-deliverable market that based on matching opposing risks over an identical time period. The foreign-currency hedge market is successfully achieved the forward cover without violation of the exchange controls discussed previously. The development of foreign-currency hedge market is similar process to non-deliverable forward market that given the exchange controls operating in the respective domestic markets but most of the NDF market are offshore.
4. The peg to effective exchange rate
The pegged was changed again after the devaluation on 25September1974. The Australian dollar was pegged to a basket of trade related currencies in order to reduce the fluctuations that Australian was exposed to. In November 1974, the government reduce the restriction of borrowing by altering the duration of loan from two years to six months. In 1976, the government devalue the Australia dollar by 17.5% because the deficit was still persisted regardless the sizable positive interest rate differential.
5. The Crawling Peg (1976-83)
Crawling peg is known as a system of exchange rate adjustment. The currency with a fixed exchange rate is permitted to fluctuate within a band of rates. Due to the market factors, for example inflation, the par value of the stated currency is also adjusted frequently.
In November 1976, due to the discrete devaluation, the crawling peg replaced fixed effective exchange rate to the effective rate. The rate of crawl was intended that there would be frequent small shifts in the peg even though it was not predetermined. The changes of regime will allow the exchange rate to be adjusted each day. This is very important to prevent the need for such large exchange rate adjustments in the future. At first, under the crawling peg, the adjustments were small and less. However, in later years, they became gradually larger and more frequent because obviously there were not enough and insufficient for the Reserve Bank to control over monetary conditions in the face of sometimes unstable capital flows.
In the first half of 1983, the crawling peg regime came under immense pressure and pressures increased in the run-up to the election. There were heavy outflows in the week preceding the election and yet since 1976, the fact that the crawling pegs arrangements with small daily adjustments has been in place. There was a mass of speculation of currency devaluation in the media exacerbated the situation. With the action of the new government by devaluing the Australian dollar by 10 percent within the days of taking office, causes the existing of a perception in the market that speculators could precipitate a large exchange rate adjustment, regardless of a regime designed to discourage exactly this outcome.
There was a change in the situation during the second half of 1983. The capital inflow gradually mounted and began to destabilize monetary policy due to Australia’s high interest rate. The exports grew strongly and the current account also recovered. The Reserve Bank set up significant changes to exchange rate arrangements in response to a rising volume of short-term capital inflows. The crawling peg system was facing some technical changes, but these had little effect. The Reserve Bank was no longer responsible for the obligation of clearing the foreign exchange market as a predetermined rate.
In December 1983, the Australian dollar was finally floated and foreign exchange controls were removed too. The Reserve Bank was no longer responsible for the obligation of clearing the foreign exchange market as a predetermined rate. The Reserve Bank withdrew as an underwriter of official forward exchange facilities, gave banks the ability to take spot against forward positions in foreign exchange as well as removed outer limits on banks’ dealings with customers. This allows the forward exchange rate to float effectively.
6. The floating exchange rate
Floating exchange rate, which means the exchange rate is solely, depends on the supply and demand of different currencies within the foreign market. In 1983, the federal treasurer was decided to practice a new regime, which is to cancel the exchange control and to float the Australian dollar. This is because market participants stated that the new exchange rate regime did not fulfil the needs of the Australian’s economy and therefore it did not success when the Reserve Bank was trying to interrupt the speculators by devaluing the Australian dollar and reduce the interest rate. The foreign exchange market has become more efficient after floating the exchange rate. Moreover, banks also do not have to clear their spot foreign exchange position every day. Anyhow, the Australian still takes some time to accept the new regime.
7. The floating Exchange Rate (1983-Present)
The Australia has gradually become more comfortable with the variable exchange rate along with a number of dimensions. Basically, the flexible exchange rate regime has assisted to mitigate the impact of external shock and has contributed to the reduction in the volatility of output that has happened over the past two decades.
Since the earlier 1990s after the exchange rate was floated, monetary policy has been carry out under an inflation targeting framework, inflation target has took over the exchange rate as nominal anchor in the economy which the Reserve Bank no longer used intervention to defend any level of the exchange, instead the exchange rate become part of the transmission mechanism but not the policy target.
In considering the role of the exchange rate in the transmission, the Reserve Bank found the MCI weights the policy interest rate and the exchange rate together are not helpful in assessing the overall stance of monetary condition in economy.
The volatility in the exchange rate has been higher in the post float period. However, the maximum daily movements were higher in the fixed-exchange-rate regime as compared with the volatility in the exchange rate in the post float period, reflecting the occasional large realignment of the peg.
Volatility in the exchange rate was handled easily by the market, it reflects the experience gained in the pre-float period, market participant were able to adapt quickly to new environment.
The exchange rate does contribute to the decline in volatility in the macro economy, together with other economy reforms.
There is close relationship between Australia dollar and the term of trade. They move close from one to another one in the medium term.
Under the floating-exchange-rate regime, it has played a part to counter the effects of terms-of-trade movement and support in the maintenance of internal balance. In contrast, under the fixed-exchange-rate regime, increase in inflation reflects the real appreciation, unless there is adjustment in the exchange rate peg.
The relationship between the floating exchange rate and term of trade has not been exact. In late 1990s and early 2000s, Australia’s term of trade were rising, but the nominal and real exchange rate declined substantially, as there was a portfolio shift toward investment in technology stocks.
Attempts to find a role for variables other than the term of trade in explaining movement in Australia’s real exchange rate have proven less successful. Hence, a modelling strategy broadly allows for a time-varying role for potential determinants of the exchange rate, may be highly effective.
Furthermore, to counterbalancing the effect of external shocks, the exchange rate has a big influence on inflation. Under the floating-exchange-rate regime, movement in the exchange rate itself had become a direct influence in inflation.
There are two episodes highlighting the role that the exchange rate has played in macroeconomic adjustment in the post float period in Australia. The first occurred in 1985-1987 which exchange rate depreciated by 40% over the period was linked to the term-of-trade decline. Inflation increased but not to the scope that had happened when the exchange rate had depreciated under the fixed-rate regime. The real depreciation did assist to counter the impact of term-of-trade decline and lead to a substitution toward domestic production.
The second episode occurred in 1997, it caused a sharp drop in exports. The Australia dollar depreciated by 35%. This diverts its exports to United States and Europe, from Asian markets. Again the nominal depreciation translated into real depreciation of same magnitude. In this example, the lack of inflation from the depreciation gained from noticeably less pass-through of the exchange rate change to domestic inflation.
The Reserve Bank has permitted large swings in the exchange rate during the post float time. It has search to intervene in the market only after the exchange rate has shifted from level judged to be constant with economic fundamentals and/or when speculative forces seem to be controlling the market. In recent years, result shows that there are lesser intervention as the authorities have become more confident in the resilience of the market.
In general, around the major peaks and troughs in the exchange rate, Reserve Bank has tended to become less care about the smooth level of short-term volatility in the exchange rate and has intervened less frequently. Strategy of buying low and selling high has been a profitable one for the Reserve Bank, which can be regarded as an indication that the intervention has been broadly successful.
8. Capital Flows
In December 1983, prior to the float, much of the capital inflows were in the form of equity instead of debt-based. Automatically this also allows them to obtain funding on relatively attractive terms and then making lending to domestic borrowers.
Some borrowers funded themselves in Swiss franc in the mid-1980s to avoid paying much higher domestic interest rates. This action had leaded to the Australian dollar had subsequently depreciated against Swiss franc. Most of them were unprepared for the rise in Australian dollar payments required to service their foreign- debt liabilities. It did not have an impact on economy or soundness of banking system but it provided the Australian borrowers by highlighting the risk of borrowing in the foreign currency when exchange rate is floating. It encouraged extensive hedging of foreign-currency loans that is present today. Thus, Australian-dollar value in debt liabilities and thereby the ability of borrower to service those liabilities was not affected by the movements in exchange rate. Australia dollar was also not affected as Australia’s equity liabilities are all denominated in Australian dollars.
Exchange rate depreciation reduces the value of Australia’s net foreign liabilities which is similar to the situation in United States where its assets are denominated in foreign currency and its external liabilities are denominated in U.S. dollars.
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