Central Banks and Currency Controls

Introduction
Any International Finance textbook contains a good chapter on currency regimes (or systems). Bekaert and Hodrick (2009) dedicate Chpater 5 to this issue. Eun and Resnick (2009) have a shorter discussion (p. 54) as do Kim and Kim (2006, p. 86).

A 1913 law establishing the Federal Reserves Bank (the Fed or FRB) charged it with four functions:
1. Assure stable price levels
2. Assure stable sustainable economic growth
3. Minimize (non-frictional) unemployment
4. Assure stable exchange rate for the U.S. dollar (USD)

This last task, also called, central bank intervention in currency markets. To fully understand the intervention process by the Fed, I request you read an excellent brief FRB publication titled "U.S. Foreign Exchange Intervention".


Exchange Rates Systems (a rough description)
To what purpose and how do central banks intervene? There are several basic exchange rates regimes or systems that are maintained by central banks' actions:
i. Floating exchange rates that allow a country's exchange rate (mostly against the USD) to float freely as determined by supply and demand. All major central banks allow their currencies to float (e.g., USD, GBP, EUR, JPY CFH). As you can learn from the above recommended FRB publication, the FRB is committed to intervening to "counter disorderly market conditions" that remain undefined.
ii. Fixed (or pegged) exchange rates. Under this regime, the central bank intervenes daily to keep the value of its currency constant against another currency. Bahrain, for example, fixed the value of its dinar to the USD at a rate of 2.65957 USD/BHD.
This means that the central bank of Bahrain will sell and buy US at this rate.
iii. Managed floating rates. Under this system a country's central bank intervenes occasionally not in order to counteract disorderly market condition but to manipulate the value of its currency with some economic objective in mind.


How does a country choose a system?
It is difficult to give a general answer to this question but here are a few thoughts:

A central bank should allow its currency to float freely if it wishes to control interest rates in its country. In sum: it gives up objective number four in the above list in order to manage objectives 1 and 2. To understand this, assume the U.S. had pegged its currency against the EUR at a rate of 1.5 USD/EUR. If U.S. consumers' demand for European goods increases, importers convert USD into EUR to finance the purchase of goods in Europe. This may push the exchange rate to above 1.5:1 (higher supply of USD causes it to weaken). To bring the exchange rate back to 1.5:1 the FRB must generate additional demand for the U.S. currency by raising interest rates. Higher interest rates cause European investors to shift their money into U.S. investments. To do so they must convert their euro into U.S. dollars. This resulting higher demand for the USD should move the exchange rate back toward towards 1.5:1. Higher U.S. interest rates may however cause a decline in the U.S. economic activity as well as elevate unemployment.

Why peg a currency? There are several possible situations where a country might prefer this regime:
a) The case of China: The Chinese government adopted a growth agenda that is based on exporting goods to the rest of the world (but mainly to the U.S.). To achieve its goal it had to make sure that its export products are reasonably cheap for U.S. consumers. It (non-officially) committed itself to an exchange rate that undervalued the yuan. This meant that Chinese exporters who sold their products for USD had to yield these dollars to the People Bank of China for approximately 8.2 CHY/USD. To do so, the People Bank must print yuans and inflation may (and did) raise its head. Luckily enough, Chinese citizens are very thrifty and they use this excess yuans to purchase Chinese government securities (this is called yuan sterilization)
b) A country that pegs its currency to the USD (for example) must offer the same interest rates as in the U.S. (otherwise: a money machine can be build to take advantage of the arbitrage opportunities inherent in any discrepancy). This mechanism disciplines the country's central bank. It cannot print as much money as it wishes because this will lower its interest rate below that of the U.S.

Why choose a managed float?
a) The Chinese example: After may years of maintaining its currency on (approx.) 8.2 to the dollar, the Chinese government decided to slowly enhance its value. You can see the graph in a WSJ article dated January 23 ("U.S. Stance on the Yuan Gets Tougher"). This was accomplished by gradually changing the official exchange rate. Note however that the process stopped in mid-2008. Following the start of the financial crisis in the U.S., a decline in U.S. demand for Chinese goods motivated the Chinese government to stop appreciating the yuan.
b)The Russian Example. Russian consumers and foreign investors in Russia dislike large fluctuations in the value of the ruble. Consumer don't like it when the price of a Mercedes in Moscow goes up by 20% in a week. Likewise, a German investor who invests in a St. Petersburg shopping mall may want to know that when time comes to sell the investment, she will be able to convert her rubles into euros at a reasonable rate. For all these reasons, the Russian central bank acts to reduces exchnage rates volatility by intervening in currency markets ("Russia Signals a Halt in Ruble Devaluation" The WSJ, January 23)