There is no single entity that decides the Forex rates for all currency pairs as each currency belongs to a respective country or region and its value is determined using different methods. Some of the mechanisms used to set Forex rates include currency board, fixed peg with a band, crawling peg, and floating rate among others.
There are two broad categories in which we can classify the different methods used to determine foreign currency exchange rates. These two categories are floating currency rates and pegged currency rates.
Difference between floating and pegged Forex rates
Floating currency rates refer to Forex rates that keep changing based on several factors, with the biggest factor being supply and demand. On the other hand, pegged Forex rates usually refer to fixed rates that are set by the government or central bank, but pegged rates can also float based on the value of the currency to which they are pegged.
The main difference between pegged and floating Forex rates is that a pegged rate is usually set by the country’s government through its central bank, which is also responsible for the country’s monetary policy. However, a floating currency rate is typically set by the market forces of demand and supply with a currency’s value rising based on increased demand or lower supply and its value dropping due to lower demand or increased supply.
Pegged currency rates
Currency board
A currency board regime is a type of hard currency peg where a country’s central bank is replaced with a currency board authority, which sets a fixed exchange rate of its domestic currency to some foreign currency. The currency board promises to maintain the set rate by ensuring that the country has adequate reserves of the peg target currency to cover all the money supply of the domestic currency. Currency board makes using domestic monetary policy or inflation targeting impractical - countries that employ such currencies tie their economies to the economies of countries whose currencies they target. Countries such as Bulgaria and Hong Kong have this type of foreign exchange regime. Hong Kong adopted this system in October 1983, while Bulgaria switched to this Forex system in 1997. Hong Kong’s currency is pegged to the US dollar, while Bulgaria has pegged its currency to the euro.
Conventional peg
A normal peg is less rigid than the currency board regime as it involves neither a hard promise to maintain it at all costs nor a complete surrender of the country's monetary policy. The country's central bank implements a number of restrictions and utilizes necessary market operations to keep the domestic currency at a fixed rate with its counterpart. It is widely used as a simple form of currency stabilization method by economies that deal with a lot of exports and imports. For example, such oil producing countries as Saudi Arabia, United Arab Emirates, Bahrain, Qatar, and Iraq peg their currencies to the US dollar.
Peg with a horizontal band
A peg with a horizontal band is used by countries where the central bank sets the foreign exchange rate of the country’s currency within a particular range instead of a fixed rate. Some central banks may specify the range (such as ±6%) within which a currency shall fluctuate from a fixed point, while others may have an unspecified range.
Danish krone is hard-pegged with a horizontal band to the euro since 1999. The krone's officially sanctioned range of change is ±2.25% from a central point of 7.46038 DKK to EUR.
Crawling peg
A crawling peg is another currency pegging method used by central banks to have the ability to adjust the par value of the country’s currency depending on changes in the market environment and economic conditions. This type of peg works by benchmarking the country’s currency against a major currency such as the US dollar, euro, or a basket of currencies.
The main difference between a crawling peg and a conventional peg is that the central bank regularly changes the reference rate, setting it at any point they deem fit, regardless of the percentage change in the new rate. A central bank typically moves the crawling peg at times when it deems that market conditions have shifted significantly to warrant a different par value for the country’s currency. This makes the crawling peg very responsive to changing market conditions, while letting the country enjoy a certain degree of currency exchange rate stability. Currently, it is in use only be three countries: Honduras and Nicaragua tie their currencies to USD, and Botswana uses a basket of currencies to attach its crawling peg to.
Crawling peg with a horizontal band
The crawling band is a variation of the crawling peg where the currency’s Forex rate is managed the same way as the crawling peg but within a specified range (band) determined by the central bank.
The most notable example of a country using such foreign exchange regime is China. The People’s Bank of China currently sets a mid-point rate for the yuan daily and then allows the currency to trade within a +2% range.
China is also one of the few countries that have two quotes for its national currency, one for the on-shore yuan (USD/CNY traded in mainland China) and a different one for the offshore yuan (USD/CNH traded in Hong Kong).
Floating currency rates
There are two main types of floating exchange rate regimes - the managed float and the free float.
Managed float
A managed float is a form of floating exchange rate where a central bank allows the exchange rate of a country’s currency to be largely defined by the forces of demand and supply but with periodic interventions to stabilize the domestic currency.
This is a system implemented by many developing countries in Eastern Europe and Latin America where a central bank may intervene in the currency markets to mop up excess liquidity and boost the currency or to increase supply and weaken the said currency.
Turkey has a floating currency rate system where the Turkish lira is traded rather freely in the Forex market but the central bank often acts to manipulate the EUR/TRY and USD/TRY rates either up or down as it sees fit.
Free float
A free float foreign exchange rate is a system where the foreign exchange rate is driven purely by supply and demand with extremely rare interventions from the government or its appointed agents. Countries that have this type of Forex arrangement usually let the market participants (investors, traders, companies, and banks) determine the exchange rate of their currency with the central bank only intervening when necessary. According to the IMF, 31 countries had this type of foreign exchange rate system as of 2018.
Advantages of a fixed Forex rate
The main advantage of a fixed (pegged) Forex rate is that it creates certainty for import and export businesses regarding their current and future earnings. This system also helps governments to ensure low inflation levels due to the stability of the country’s currency against foreign currencies.
This system is also likelier to spur steady stream of investment into the country as investors can rely on a stable exchange rate. This, in turn, boosts the country’s economy resulting in higher GDP growth levels.
Disadvantages of a fixed Forex rate
A major disadvantage associated with a pegged Forex rate is that the country’s central bank has to acquire and maintain a large supply of foreign currency reserves to boost the currency when its falters against foreign currencies.
A fixed exchange rate also makes it quite difficult for a central bank to stabilize a currency’s value in case economic situation changes abruptly. Countries in fiscal and monetary distress may choose to fix their currency’s exchange rate to stabilize its value. However, this usually leads to the creation of illegal foreign exchange systems that reflect the currency’s true value, as witnessed in Zimbabwe and other countries with significant black market currency exchange. The result is that illegitimate flows of money mushroom, diverting the economy away from the central bank's influence.
Fixed exchange rate also limits the power of a central bank to implement an independent monetary policy unless strict capital control is enabled. This is know as the financial trilemma.
The bottom line
Most countries claim to follow a particular foreign exchange system also known as a de jure system, yet in reality, their foreign exchange system varies as the market conditions often require changing the actual mode from one to another without any announcement. This is known as following a de facto Forex regime.
However, in the end it still means that the Forex rates are decided either by the market's demand and supply forces or by a central bank. Sometimes, as is the case with managed float and crawling pegs, it is a combination of both.
