BUS614: International Finance

In general, currency exchange rates are affected by the political situation of the host state and by its economic and fiscal policies. The sounder these policies are and the more stable the political situation is, the stronger the currency will be. A strong currency encourages investors to invest in a given state. The weaker the currency is, the more discouraged investors will be to invest in the host state using its currency. As such, investors are normally encouraged by the host state's limited intervention in determining currency's exchange rates.

Any given state may opt for one of three policies in determining how its currency preforms. This initially will either give investors the assurance they need to make their investment in the host state's currency or will make them reluctant in doing so.

When looking at how the host state's currency is performing, it is advisable to understand the nature of the policy followed by host state. As such, the host state may opt to control its currency through pegging it to another one or it could manage it through monitoring it periodically or it could give markets the freedom to determine its value.

a. Demand-Based Exchange Rate

States that opted for a free-floating currency initially allowed exchange rate of their currency to be determined by the demand on it meaning that, demand is the driver in determining the value of the host state's currency. In states like the United Kingdom and the United States and even in trade blocs that have unified currencies like the European Union, determining the value of their currencies was left to the markets.

In these states, what is notable is that government intervention is virtuall non-existent. In essence, this means the currency is behaving freely in the markets and the host state will not intervene in determining its value unless there was an underlying threat to the markets in which case it will intervene to evade such threat.

b. Managed Exchange Rates

There are states that opted for what is known as the dirty float or managed float policy in which the government intervenes in determining the market exchange rate. In these states, the government determines the limit of "floating" that the currency may be traded in. States like China and Malaysia decided to determine the exchange rate path.

In these states, investors may be at risk once the hots state intervenes in determining the exchange rate in a manner that would affect the investor negatively.

c. Controlled or Fixed Exchange Rates

Some states opted for directly controlling their currency exchange rates in order to guard and protect their markets. These states decided to tie their currencies to a foreign one where the value of their local currency appreciates or depreciates depending on how the foreign currency is performing. In essence, this means that the currency's exchange rate is fixed to the one it is pegged to. Such concept has historical grounds drawn within the Bretton Woods Agreement where other currencies were pegged to the US Dollar which in turn was pegged to gold. States like Saudi Arabia and the UAE opted to peg their currencies to the dollar through determining a specific exchange rate that is constant against the dolar. For example, the Saudi Riyal is pegged to the US Dollar where each US Dollar is equal to 3.75 Saudi Riyals whereas in the UAE, each US Dollar is equal to 3.6725 Dirhams. On the other hand, Lebanon opted to for a stabilized arrangement whereby each US Dollar is equal to 1,507.5 Lebanese Pounds. Such pegging could be considered another form of control over the currency and may present foreign investors with a layer of security while investing in the host state using the host state's currency but it, nevertheless, exposes them to other underlying risks such as currency manipulation.

Moreover, there are states, like Honduras and Nicaragua, that opted for what is known as a crawling peg whereby they revise and reassess periodically the value of the peg and change it as they deem suitable.

For that, it is of importance to differentiate between controlling a currency and manipulating it. Controlling refers to guarding the currency and ensuring its performance is stable in order to protect the currency and markets. Whereas manipulating refers to appreciating or depreciating the currency exchange rate in a deliberate manner by the host state in order to cause harm to foreign investors or to limit them from benefiting from their property rights in part or in full.

Investors who opted for investing in states that have pegged currencies using the host state's currencies my find their investments at risk if the host state decided to suddenly unpeg its currency causing harm to foreign investors as happened in Argentina in the early 2000s when the government decided unpegged the Peso from the US Dollar.