Currency risk – Exchange rate regimes
There are three basic types of exchange rate regimes: pegged exchange, floating exchange and pegged-float exchange. For many countries, there is often a distinction between the official exchange rate policy, and the actual (de facto) policy implemented. While some countries, particularly developing economies,
may claim to have a floating exchange, they often intervene in the foreign exchange market to stabilise their currency.
A pegged exchange rate is a regime applied when a government or central bank ties the official currency exchange rate to another country’s currency or the price of gold. The purpose of a pegged exchange rate system is to keep a currency’s value within a narrow band. Pegged exchange rate regimes lower exchange rate volatility, provide greater certainty for importers and exporters and help the government maintain more moderate levels of inflation.
However, pegged regimes limit the extent to which central banks can adjust interest rates for economic growth and prevent adjustments for currencies that become under or overvalued.
A floating exchange rate regime is where the currency price is set by the market based on the supply and demand relative to other currencies. The main advantage of floating rates is monetary independence that allows automatic adjustments to trade shocks. This flexibility, however, brings additional currency volatility and in economies where the financial system is not sufficiently developed enough to allow for adequate currency hedging instruments, this volatility could be a significant concern for investors. A pegged currency removes the ability of a country to have an effective monetary policy; rather, the focus is on maintaining the target exchange rate.
One of the significant disadvantages of a fixed exchange rate regime is that interest rate hikes in the anchor country currency may also strengthen the pegged currency. This artificially increases the wealth of the pegged currency country due to reasons other than improved growth, which is problematic in the long-run.
Most African countries have a pegged exchange rate regime, with conventional pegs being the most popular.
An artificial currency peg also creates parallel rates as few parties are willing to transact at the official rate. This leads to significantly decreased levels of liquidity. Euro and dollar shortages will follow as those with hard currency are also not willing to buy local currency at the official rate. Before the oil price collapse in 2015, Nigeria had USD 43bn in reserves. By June 2016 following efforts by the Central Bank of Nigeria to support the naira, total reserves decreased to below USD 27bn. Enforced official rates are significantly different from a currency’s fair value and lead to foreign currency shortages that prevent the repatriation of foreign capital.
A similar situation occurred in Angola over this period. Although Angola had significantly higher foreign reserves going into the crisis, which enabled it to manage the collapse in the oil price, the country was not able to avoid a currency depreciation.
The situation in Egypt was very similar to that in Nigeria in 2015, facing high levels of debt, a foreign currency crisis and in need of an IMF bailout. However, unlike Nigeria, Egypt took the decision to float its currency in 2016. Today, inflation has decreased to single digits, down from highs above 30% and portfolio inflows increased substantially. According to the UN, Egypt also received the most foreign direct investment (FDI) in 2018 than any other African country.
As African financial markets deepen, more countries are likely to float their currencies as a natural consequence of increased international capital flows and less reliance on government intervention.