EXCHANGE RATE REGIMES
The signal grid and the risk appetite indicator should be the two main tools of the currency strategist. There are however other aspects of the currency markets that still have to be considered. For instance, the type of exchange rate regime is an important consideration as it can have a significantly different impact on the economy depending on what type of regime is being used. The latest fashion within the official community in Washington DC is to advocate the so-called “bi-polar” world of exchange rates, supporting the idea that in a world of free capital markets only the hardest currency peg or a completely free-floating currency are appropriate, and that anything else is unsustainable. It seems likely that this will ultimately give way to a new trend, whereby there are significantly less currencies, all of which are freely floating. As far as currency market practitioners are concerned, key questions that a corporate executive or an investor must ask if they are exposed to a currency peg regime are:
Does the currency peg itself contribute to macroeconomic stability?
What is the degree of participation in global capital flows of the country concerned?
Is the currency peg at the right value?
Most soft or semi-pegged exchange rate regimes have gone, voluntarily or otherwise. If you have currency exposure to a pegged exchange rate regime and you are concerned about currency risk, the rule to remember is that you should hedge when the market has no interest in hedging and thus when risk premiums are low. By the time the market is keen to hedge currency risk, liquidity and price conditions will have deteriorated and it will be too late to obtain anything but the most expensive of currency protection.
The beauty of freely floating exchange rates is that they act as a self-adjusting mechanism, transmitting changes in fundamental dynamics across the economy. In that sense, a freely floating exchange rate regime cannot be defeated, unlike a pegged exchange rate regime. That said, they can still be highly volatile at times.