12 April 2011

The Exchange Rate Story (1)

Dollar rate is changed. Maldives currency lost the value. Our economy is going to collapse. We are getting poorer. These are some of the talks that has dominated our life in the past 3 days.

All these came after the government announced a controlled floating of the Maldivian Ruffiyaa by 20% higher or lower to the pegged value of MRF12.85. In other words, the government permitted buying and selling of US Dollars between MRF10.28 to MRF 15.42 instead of the fixed rate.

Many wonder what will be the outcome. Just like everything else is Maldives, several people decided the right or wrong of the decision taken depending on the political group or party they follow or believe in. Yet, this may not be the very right decision when it comes to our own economy. So, as someone who has interest in the topic, I thought of posting an article on this very matter. However, we need to know what this is, before we try to think of the impact it could bring on us.

What is exchange rate actually?

Exchange rate is the rate at which a currency can be changed to another currency. Lets make it simple. An "Addu Bondi" is sold at MRF12. A US Dollar is sold at MRF12. Ok, now it is MRF15 or so.

What is this change?

There are two ways in which the exchange rate is made.

1) Fixed exchange rate: In this system, the central bank of the country (our MMA) will fix a particular rate and peg it with one of the hard currencies. Hard currencies are the currencies like US Dollars or UK Pound which are from industiralised and stable economies and the currencies which are often accepted in international market.

In order to maintain the fixed rate, the central bank often will control by buying up the local currency if too much Dollar is in circulation or selling off them if there is shortage of Dollars to ensure that only enough money is in circulation. However, in Maldives this was done by making it illegal to sell at any other price, which was also a pracitced system. Fixed exchange rates were believed to be more stable and said to suit well for small economies and specially for economies like Maldives where import is very high compared to the exports. However, there are arguments against this too, most important of them that it hinders free trade and self regulation of market. Also if the fixed exchange rate is maintained by law like in Maldives, there will be chance of a black market.

2) Floating exchange rate: In floating exchange rate, the rate of exchange will be decided by the forces of demand and supply. The rate of exchange will be the market price of Dollars in Maldivians currency. More like our fish market, where the fish will be expensive if the catch of the day is less and vice-versa. The shortages or surplus of foreign currency in the market will be settled by the reactions in the exchange rates. It is often said as the invisible hands, that corrects the market instability.

Floating exchange rate, which is most common and often believed to be better for the economy than a fixed exchange rate, stabilizes itself in reaction to market instability. However many criticizes this as too volatile and may cause an unstable markets for the emerging economies.

What Happened in Maldives???

If the fixed exchange rate is changed, it will be either a devaluation or revaluation of currency. Devaluation means the rate of exchange gets lower. Eg: From $1=MRF12 to $1=MRF15 will be a devaluation and opposite will be a revaluation.
IF the floating rate changes it is known as an appreciation or depreciation of currency. Eg: From $1=MRF12 to $1=MRF15 will be a depreciation and opposite will be an appreciation.

Did we see any of these in Maldives? Well, talking in simple terms, we did not see any. Yet we saw something more. Since 2004, there was a shortage of US Dollars in Maldives. This shortage became quiet large in the last 2 years or so. As a result a well established black market for Dollars started in here, though it was more or less like a "public secret". What we saw was a switch from a fixed exchange rate to a floating exchange rate. To be more specific, its a switch to a controlled or managed floating where a band range is given for floating and the exchange rate will be permitted to float in that range.
Now that the question is what will be the outcome. There will be short run and long run effects which I'd continue in my second post, God willing.