Balancing Act: The Challenges and Consequences of Fixed Exchange Rate Systems

In July 1944, delegates from 44 nations, including the renowned economist John Maynard Keynes, gathered for the Bretton Woods Conference. The result was the establishment of the International Monetary Fund (IMF) and a system of fixed exchange rates. In this system, currencies were pegged to the U.S. dollar, which was in turn convertible to gold at a fixed rate ($35/ounce). Although this system collapsed in the 1970s, many countries still use fixed exchange rate regimes or variations of it. Understanding how and why countries choose to fix their exchange rates sheds light on the broader economic impacts, from trade to inflation.

Fixing Currency

Under a fixed exchange rate system, a country’s central bank commits to a set exchange rate for its currency against another — typically the currency of a major trading partner or a large economy like the U.S. This decision is driven by a desire for stability in trade and investment, as fixed rates reduce the uncertainty and fluctuations that can hinder economic transactions. For example, if Thailand fixes its currency to the U.S. dollar, it provides predictability for businesses involved in Thai-U.S. trade.

To maintain this fixed rate, the central bank must hold reserves of foreign currency and domestic currency. For instance, if Thailand pegs its baht to the U.S. dollar at 20 baht per dollar, the Thai central bank must have enough U.S. dollars in reserve to exchange at this rate. These reserves act as a buffer to absorb fluctuations in supply and demand in the foreign exchange market.

However, market forces don’t always align with the central bank’s fixed rate. The actual market clearing rate — the rate at which demand for and supply of foreign currency balance — can differ from the fixed rate, leading to two possible scenarios: undervaluation or overvaluation.

Undervaluation

Undervaluation occurs when a country fixes its currency at a weaker level than the market-clearing rate. For example, if the Thai central bank fixes the baht at 20 baht per dollar when the market-clearing rate is 15 baht per dollar, the baht is artificially weaker than its real value. This scenario creates incentives for foreign investors and traders to buy Thai currency at a cheaper rate. As a result, Thailand’s goods and services become cheaper for foreign buyers, boosting exports and attracting foreign investment.

At the same time, undervaluation has its downsides. Thai importers and consumers must pay more for foreign goods, as the weaker baht buys fewer dollars. While exporters benefit from an undervalued currency, consumers and businesses that rely on imports suffer higher costs. To maintain this undervalued exchange rate, the central bank must absorb the excess supply of U.S. dollars by selling baht and accumulating U.S. dollars as reserves. This increases foreign exchange reserves but can lead to domestic inflation over time, as the money supply grows with more baht in circulation.

Historical examples of sustained undervaluation include Japan in the 1980s and China in the 2000s. Both countries kept their currencies artificially weak to promote export-driven growth. Japan’s undervaluation after the Bretton Woods collapse led to a surge in exports but also contributed to a massive asset bubble, particularly in real estate and stock prices. Similarly, China faced international pressure, particularly from the U.S., for keeping its currency undervalued, which allowed China to build up large foreign reserves and become a manufacturing powerhouse.

Overvaluation

Overvaluation is the opposite scenario, where a country’s currency is pegged at a stronger rate than the market-clearing rate. If Thailand fixes its currency at 20 baht per dollar when the market-clearing rate is 25 baht per dollar, the baht is overvalued. This makes Thai exports more expensive abroad, hurting exporters, but benefits importers and consumers by making foreign goods cheaper.

Maintaining an overvalued exchange rate is more difficult for the central bank because it must sell foreign currency reserves (e.g., U.S. dollars) to keep the baht artificially high. As the central bank depletes its reserves to meet the excess demand for foreign currency, it risks running out of reserves entirely, making it impossible to sustain the fixed rate. For example, if Thailand’s central bank has $100 billion in reserves and faces an excess demand for $10 billion per month, its reserves would be exhausted in just 10 months.

Countries in such situations have three main options:

1. Acquire more foreign reserves: Borrow from international institutions or foreign governments to boost reserves.
2. Devalue the currency: Officially lower the value of the domestic currency. For example, the Thai central bank could shift from 20 baht per dollar to 25 baht per dollar to make the baht less valuable and bring it closer to the market rate.
3. Abandon the fixed exchange rate: Let the currency float and allow market forces to determine its value. This was Thailand’s approach during the 1997 Asian financial crisis when it allowed the baht to float, leading to a sharp devaluation.

Consequences of Overvaluation

Sustained overvaluation depletes a country’s foreign reserves and can trigger a crisis. When market participants realize that the central bank is running low on reserves, they may anticipate a devaluation and rush to convert their domestic currency holdings into foreign currency before the devaluation happens. This creates a self-fulfilling cycle: as more people convert baht into dollars, the central bank runs out of reserves even faster, accelerating the inevitable devaluation. This scenario played out during the 1997 Asian financial crisis when the Thai baht’s collapse led to devaluations across the region, severely affecting countries like Malaysia, South Korea, and Indonesia.

Consequences of Undervaluation

Undervaluation, while easier to sustain than overvaluation, also has its long-term consequences. By continuously buying foreign currency and expanding the domestic money supply, the central bank fuels inflation. As domestic prices rise, the benefits of an undervalued currency — such as increased exports — can be undermined. Inflation can also lead to economic imbalances, including asset bubbles, as seen in Japan’s property market in the late 1980s. Moreover, an undervalued currency can strain international relations, particularly if trading partners accuse the country of unfair currency manipulation.

Adjusting Exchange Rates

Governments facing persistent overvaluation or undervaluation must eventually decide how to adjust their exchange rate policy. They have three primary choices:

1. Do nothing: Continue the current policy, absorbing or depleting reserves.
2. Revalue or devalue the currency: Adjust the fixed rate closer to the market rate. For example, China revalued its currency by 2% in 2005 to ease international pressure.
3. Abandon the fixed exchange rate: Let the currency float, as Switzerland did in 2015 when it allowed the Swiss franc to appreciate after years of fixing it to the euro.

Conclusion

The decision to fix a currency can bring economic stability but also presents significant challenges, particularly when market conditions change. Overvaluation drains foreign reserves, risking currency crises, while undervaluation can cause inflation and distort trade relations. Governments must carefully manage their foreign exchange reserves and weigh the benefits of a stable currency against the risks of inflation or reserve depletion. The history of exchange rate management, from Japan and China to Thailand and Switzerland, shows that no policy is perfect, and countries must remain flexible in the face of changing economic realities.

Reference: Akila Weerapana (2023), Macroeconomics Made Clear, Course Guidebook, The Great Courses edition.