How Does Unification of Exchange Rate Work?

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What is the Unification of Exchange Rates?

Unification of exchange rate refers to the process through which a country that has multiple exchange rates for its currency consolidates them into a single rate.

Unifying the exchange rate seeks to simplify and streamline foreign exchange systems, and it has economic, financial, and sometimes political implications. Nigeria, for instance, unified all segments of the forex exchange market on June 14, 2023

An exchange rate represents the value of one country’s currency in terms of another. For instance:

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  • USD to EUR
  • USD to NGN
  • GBP to JPY
  • AUD to CAD

Example of countries that use unification or floating regime

  • Nigeria
  • Kenya
  • Madagascar
  • Moldova
  • Mauritius
  • Mauritania
  • Liberia
  • Papua New Guinea
  • Mozambique
  • Laos
  • Pakistan
  • Paraguay
  • Myanmar
  • Kyrgyzstan
  • Morocco
  • Malaysia

Classification of Exchange Rate Systems

Fixed Rates:

The value of a currency is pegged to another (like the US dollar or gold). for instance, Nigeria’s government is known for pegging its currency to the US Dollar until the administration of President Bola Tinubu changed the country’s FX policy direction by unifying the FX market.

Floating Rates:

The value of a currency is allowed to fluctuate according to the foreign exchange market. When a country floats the rates, it allows the market forces to determine the rate at the FX market. In this case, willing buyers and willing sellers agree on the exchange rate.

Hybrid Systems:

A mix of fixed and floating, often leading to multiple exchange rates in a single country. It’s within these hybrid systems where the intricacies of dual or multiple exchange rates emerge. It looks like this is the position that has found itself.

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The existence of multiple exchange rates often reflects a nation’s attempt to balance internal policy goals with external trade demands. However, they can also give rise to complications, leading experts to advocate for the unification of exchange rates.

Historical Background of Exchange Rate Systems

The Gold Standard Era

In the late 19th Century to early 20th Century, most major economies anchored their currencies to a specific quantity of gold which was called, “The Gold Standard Era”. During this period, the exchange rates remained relatively stable since they were pegged to gold.

Also, it fosters trust because gold-backed currencies instil confidence in international trade. However, the rigidity of the gold standard made it difficult for governments to respond to economic downturns, ultimately leading to its decline, especially after the Great Depression.

Then came the Bretton Woods System, where leading economies sought to create a new international monetary system, that established fixed but adjustable exchange rates.

That was the USD was pegged to gold at $35 an ounce, while other currencies were pegged to the dollar. This necessitated the formation of institutions like the International Monetary Fund (IMF) to oversee this system.

But by the early 1970s, the system faced strains due to mounting US balance of payments deficits and led to its eventual collapse.

Modern Day Systems

From 1971 onwards which marked the end of Bretton Woods, the world transitioned to a system dominated by three different rates:

Floating Exchange Rates: Major currencies like the USD, EUR, and JPY began floating freely.

Managed Floats: Some countries chose to intervene occasionally to stabilize their currencies.

Multiple Exchange Rates: Certain economies, aiming to achieve various economic objectives, adopted multiple rates. Multiple exchange rate systems often emerged from the need to control different types of transactions. For instance:

  • Official Rate: Used for government transactions and essential imports.
  • Secondary Rate: For other commercial transactions.

However, such divisions could create economic distortions, spurring debates on the merits and demerits of a unified system.

Also Read:  Why A Strong Dollar Is Bad for Emerging Economies

Benefits of Unifying Exchange Rates

The unification of exchange rates may be challenging, but it offers some benefits, including boosting economic growth and international collaboration. Here are the advantages of unifying a country’s exchange rates

Enhanced Financial Transparency

Clear Economic Indicators: A unified rate offers a clear picture of the economy’s health, enabling both domestic and international stakeholders to make informed decisions.

Elimination of Black Markets: With no disparities between official and unofficial rates, the allure of black market rates will diminish if a country is sincere about the unification of FX market, leading to a more transparent financial environment.

Streamlined Monetary Policy

Simplified Policy Implementation: Central banks can more effectively design and implement monetary policies without the complexities of juggling multiple rates.

Improved Economic Stability: The transparency and predictability associated with a single rate can help stabilize economies, especially in volatile situations.

Boost to Foreign Investment

Reduced Uncertainty: For international investors, a single rate removes the ambiguity associated with multiple rates, making investment decisions more straightforward.

Enhanced Investor Confidence: A unified exchange rate often signals economic stability and transparency, essential ingredients to attract foreign direct investment.

Simplification for International Trade

Predictable Trade Dynamics: Businesses involved in international trade can more reliably predict costs and revenues without the fluctuations of multiple rates.

Strengthened Trade Partnerships: By eliminating rate disputes and providing clear economic signals, countries can foster stronger and more reliable trade relationships.

Reduction of Economic Distortions

Accurate Pricing: Goods and services can be priced based on real economic fundamentals rather than distorted by multiple exchange rates.

Fair Competition: Domestic industries compete on a level playing field without artificial advantages or disadvantages due to differential rates.

Challenges in Unifying Exchange Rates

The benefits of unifying exchange rates are interesting, it comes with its own challenges for a country, particularly for struggling economies that heavily rely on importations. Here are the disadvantages of a unified exchange rate:

Immediate Economic Shocks

Sudden Price Adjustments: The shift can lead to immediate price fluctuations, affecting both consumers and businesses.

Also Read:  43 Products Banned By Buhari From Accessing Forex

Potential for Inflation or Deflation: A sudden revaluation or devaluation of the currency could lead to inflationary or deflationary pressures e.g Nigeria

Public Perception and Sentiments

Resistance to Change: Invariably, any economic change is met with scepticism and resistance from certain quarters, especially if it leads to short-term hardships.

Fear of the Unknown: The general public might harbor anxieties regarding the implications of the new system, especially if not adequately informed.

Adaptation by Financial Institutions

System Overhauls: Banks and financial institutions might need to modify their systems, processes, and training to accommodate the unified rate.

Initial Confusion: The transition phase could lead to misunderstandings, errors, or misinterpretations in financial transactions.

Impact on Domestic Industry

Competitive Challenges: Industries previously shielded by favorable rates might face heightened competition, possibly leading to business closures or layoffs.

Need for Restructuring: Certain sectors might need to revamp their strategies, production methods, or even product lines in response to the new economic landscape.

International Diplomacy and Trade

Renegotiation of Trade Deals: The unification might necessitate revisiting previously established trade agreements to reflect the new economic dynamics.

Short-term Trade Disruptions: As global partners adjust to the unified rate, there could be interruptions or delays in trade.

Regulatory and Policy Challenges

Overhaul of Regulatory Framework: Existing laws, regulations, and guidelines anchored around the old system might need extensive revisions.

Continuous Monitoring: Authorities would need to maintain a vigilant eye on the economy, ready to intervene if unforeseen repercussions emerge from the transition.

Conclusion

The benefits of a unified exchange rate are numerous as it promises transparency, predictability, and an opportunity to propel national economies onto the world stage with renewed vigor. But the journey towards this unified rate comes with a lot of challenges.

Author

  • Opeyemi Quadri

    Ope is a finance writer and researcher with 10+ years of experience in content creation. His interests cut across decentralized finance, investment, foreign exchange, government policies and politics.

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