Sunday, March 3, 2024

How Da Afghanistan Bank Can Interfere in FX Market?

Immigration News

Khaama Press
Khaama Presshttps://www.khaama.com
Khaama Press is a Kabul-based independent and non-political news organization established in 2010.

By Sabir Sidiqee

B.A, M.A Economics (BHU)

Everyday millions of Afghan companies and individuals around Afghanistan do business with companies and individuals located in different localities. We can also say that they also do business beyond the border with different countries and have to pay for their transactions in different currencies. They need a smooth regime of FX to enhance their daily business conducts.

The value of the currency has huge implications for a nation’s economy and an individual’s lifestyle and purchasing power. If the value of the domestic currency goes up, that is, more units of the foreign currency are needed in order to buy one unit of the domestic currency, then this country will be able to buy foreign products at lower prices. On the other hand, the products of this country are going to be prices much higher in foreign markets and, as a result, the stronger currency may hurt local exporters as foreign demand diminishes. It can be argued that not only the value of a currency, but also its predictability can affect international business conduct. If one company is going to have operations in a country whose currency has an uncertain value in the future then there may be uncertainty about this company’s future revenues, operational costs, and therefore profits. As it is well known, risk adversely affects companies prefer to decrease the risk and uncertainty of future revenues and costs. In addition to its importance for trade and investment across countries the exchange rate is important as the essential component of the foreign exchange market or “FX” market. The FX market, the global market for currencies, is the largest and most liquid financial market in the world. According to a survey conducted by the Bank of International Settlements, the average daily trade in the FX market surpasses $ 1.2 trillion US dollars around the globe and millions of US dollars in Afghanistan.

In the past, particularly in the period from the Second World War to the end of the Breton Woods era, it was common for many countries around the world to have fixed exchange rates. That is, the value of the currency was pegged to the value of some other currency. This arrangement was adopted by different countries with the hope that it would avoid uncertainty about the value of their currency and the economic consequences of such uncertainty. Nowadays most major currencies are flexible and their values are determined by demand and supply in the foreign exchange market so does Afghanistan too.

TYPES OF EXCHAGE RATE REGIMES; A GLOBAL PROSPECTIVE

Let’s start the discussion by defining three main types of exchange rate regimes differentiated by their degree of flexibility.

First, there is the floating exchange rate regime in which currencies are free to float and their values are determined by demand and supply in the foreign exchange rate market. Proponents of the flexible exchange rate system argue that floating exchange rates provide monetary policy independence as the central bank is not required to interfere in the foreign exchange market in order to maintain a given value for the currency and insulation from external shocks. In his 1969 article admiring the benefits of floating exchange rates, economics professor Harry G. Johnson even argued that floating exchange rates are necessary part of the national autonomy and independence of each country.

This national autonomy he argues is vital for the efficient organization and development of the global economy. On the down side, flexible exchange rates have been often associated with destabilizing assumption. However, proponents of flexible exchange rates argue that, to the contrary, speculation by rational agents should reduce exchange rate instability and provide a less disruptive adjustment mechanism in the face of nominal rigidities.

Economist and Nobel laureate Milton Friedman argues that if there is a domestic currency appreciation that is expected to be temporary there is an incentive for holders of domestic currency to sell some of their holdings, acquiring foreign currency, and then buying the domestic currency back at a lower price. By behaving this way speculators meet part of the excess demand for domestic currency and accelerate the process of returning to the long term equilibrium value of the currency. Friedman stated that those that argue that speculation can be destabilizing in the foreign exchange market do not realize that this is equivalent to saying that speculators constantly lose money, since speculation can be destabilizing only if speculators sell when the currency is cheap and buy when it is expensive. He suggests that speculators who behave this way will be driven out of the market relatively quickly.

Second type of regime that must be defined is the fixed exchange rate regime, in which the value of the currency is tied to the value of some other currency. The exchange rate uncertainty that may result from floating exchange rates has a negative impact on some types of investments, possibly affecting trade. It is believed that by fixing the value of the domestic currency relative to that of a major economy, a country can lower exchange rate volatility and promote trade and investment. Fixed exchange rates have been seen by some economists as helpful in obtaining several other economic goals. For example, it has been argued that fixed exchange rates are useful in obtaining price stability.

An exchange rate target is straightforward and easily understood by the general public. If this exchange rate target is credible, that is, if the public has confidence that the monetary authorities will pursue such a target, then it may lower inflation expectations to the level existing in the anchor country. Some fixed exchange rates arrangements imply the surrender of the monetary authorities’ control over domestic monetary policy.

For some countries (especially developing countries), with a lack of discipline and too many incentives to create revenue from money creation, a surrender of the monetary policy may be a desirable outcome. Even Milton Friedman, who as we mentioned above championed floating exchange rates, admitted that fixed exchange rates can be sometimes preferable for developing countries. However, because fixed exchange rate arrangements limit the monetary policy options of the country, these arrangements can expose the country to international shocks. Some examples of fixed exchange rates regimes include dollarization and currency boards. In dollarized economies the currency of another country circulates as the sole legal tender. The term dollarization refers to any country that uses a foreign currency as the domestic currency, not only to those countries that adopt the US dollar. Dollarization differs from a monetary union in which members belong to a currency union in which the same legal tender is shared by members of the union. The adoption of a dollarized regime implies the complete surrender of the monetary authorities’ control over domestic monetary policy. In the case of currency boards there is an explicit legal commitment to exchange domestic currency for a specified foreign currency at a certain value, combined with restrictions on the monetary authorities’ power to ensure the execution of that legal obligation.

Finally, our third type of regime is the intermediate regime. This regime is essentially some type of pegged float in which the exchange rate is free to fluctuate but it is kept by the country’s monetary authorities from deviating from a certain range. There are numerous intermediate arrangements and the possibilities are only limited by the imagination. Some of the intermediate exchange rate regimes recognized by the International Monetary Fund include pegged exchange rates within horizontal bands, crawling pegs, exchange rates within crawling bands, and managed floating with no predetermined path for the exchange rate. Next we discuss the International Monetary Fund definition of each of these regimes. The pegged exchange rate within horizontal bands is a regime in which the value of the currency is maintained within a range of 1 percent around a fixed value or the difference between the minimum and maximum value of the exchange rate exceeds 2 percent. In a crawling peg regime the exchange rate is adjusted periodically at a fixed rate or in response to changes in several indicators (e.g. relative inflation measures). These two regimes leave the country with a limited degree of monetary policy discretion. The exchange rate within crawling bands is a regime that combines certain aspects of the previous two regimes. Finally, in a regime of managed floating with no predetermined path, the monetary authority influences the exchange rate without having a specific exchange rate path or target. Across time, countries have moved from one currency regime to another in order to facilitate business and improve national economies. Next we provide a short historical recount of the main trends in exchange rate regimes.

WHAT DA AFGHANISTAN BANK CAN OPT TO STABILIZE VALUE OF AFGHANI?

Exchange rate regimes have their respective followers and critics at the same time, differing in their respective schools of thoughts. As Afghanistan is concerned, it follows the floating exchange rate regime where the rate of Afghani (؋) is determined by demand of Afghani by the general public and business entities and supply of the same by the central bank of the country known as Da Afghanistan Bank (DAB). NONE in the short-run can alter the strategy of the central bank to change the exchange rate regime of the country [but] can tune its line of business in accordance with international best practices utilizing maximum of benefits of free market economy.

In short DA AFGHANISTAN BANK can opt PEGGED-floating exchange rate regimes in its MONETARY policy to have a say in the FX market of Afghanistan and can have policy making affects on determining value of Afghani.

The other possible regimes that Da Afghanistan Bank can choose should be based on its limits of transactions and principle of identifying general, targeted and potential buyers.

Here I conduct a cost-benefit analysis of floating exchange regime for any FX business dealer for further decision making.

PEGGED-FLOATING EXCHANGE RATE REGIME (The Best Possible Option)

Pegged-floating exchange rate means that the market will determine the rate at which one currency can be exchanged for another. The market will set these rates on a real time basis as and when new information flows in. This reduces the need for an elaborate mechanism to ensure that the exchange rates remain within a particular range.

Pros of Pegged-floating Exchange Regime

  • Independence:Pegged-floating exchange rates allow any Da Afghanistan Bank to have a great degree of independence. In case of fixed exchange rates, any business has to act in cycle. This is because the monetary policy that it sets can influence or be influenced by the economic conditions of market participants. For example, when the dollar raises its interest rates, Afghani which will be pegged to it in fixed exchange rate regime will also have to make necessary changes.
  • Less Probability of Speculative Attacks:A Pegged-floating currency faces adjustment on a minute to minute basis. There are some days that the currency faces rapid appreciation whereas others when it faces rapid decline. However, for most of the days, the currency remains stable. The point is that speculative attacks happen only when the currency remains inactive at a given point whereas its underlying fundamentals have changed. It is then that the speculators see an opportunity to bring the currency to its equilibrium point quickly and make a quick dollar by doing so. However, if the currency is traded on the FX market as a floating currency, adjustments happen on a minute to minute basis. Therefore, the gap between the underlying fundamentals and the market value never really widens up enough for the speculators to mount a sudden attack.
  • Low Requirement of Reserves:A pegged-floating exchange system does not require Da Afghanistan Bank to hold massive reserves. This is a major advantage of this system since holding foreign exchange for trading purposes is an expensive strategy. Firstly, it requires the Da Afghanistan Bank to maintain a huge currency reserve. Then, it also requires Da Afghanistan Bank to have an active business conduct desk 24 by7! The Pegged-floating rate system is simply a lot more convenient since it does not have any such requirements.

Cons of Pegged-floating Exchange Regime

  • Uncertainty: Firstly, a pegged-floating currency rate regime implies a lot of instability. The value of currencies change on a real time basis. Also, since all exchange houses are DAB regulated entities, currency values could skyrocket or hit rock bottom in a matter of minutes. In the short run, customers find it difficult to engage in foreign exchange trade since they are not aware of the exact prices that it’s in hand currency will fetch them. Movements in the currency market can cause a significant dent in the profits of foreign exchange houses which spoil in foreign currency trade. However, these risks can be managed with tools like hedging.
  • Allocation of Resources:At a macro level, foreign exchange dealers may face problems while allocating resources. This is because as exchange rates change so does the benefit that can be derived from resources. For instance, a rising exchange rate makes imports of other currency option on, whereas a falling rate makes exports easier. Hence, if exchange rate keeps fluctuating, the FX dealers cannot really create a long term strategy and stick to it. The allocation of resources is optimized in the short run. However, in the long run, this allocation seems to be ad-hoc since it does not follow any given plan.
  • Lack of Discipline:Lastly, pegged-floating exchange rates only make sense if the Da Afghanistan bank have sufficient internal control mechanisms in place. Hence, if there is likelihood that the operation policy may be misused for personal gains by a group of influential people, then it is better to peg the currency Afghani to another more developed currency such as USD. In this way, fiscal/operation discipline is imposed on Da Afghanistan Bank. Pegged-floating currencies provide independence. However, the independence can only be utilized if the central bank is disciplined enough.
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