ODWAR VINCENT-LIRA UNIVERSITY

EXCHANGE RATE CONTROL

Definition: Is where the State/Monetary authority regulates the

rate at which the local currency exchanges for foreign currencies.

Objectives of Foreign Exchange rate control:

 To ensure price stability /control inflation

 To influence the levels and nature of investment and also
encourage investors.
 To correct and influence Balance of Payment position of the
country
 To ensure stability of exchange rate so as to avoid
speculation
 To influence the level of economic growth
 To minimize capital outflows
 To ensure stability in income of exporters
 To raise revenue for Government

Definition of concepts:
1. Currency revaluation: Is the deliberate Government act of
raising the value of its currency in terms of other currencies. Or it
is the legal/official increase of external value of a country‟s
currency.
2. Currency undervaluation: Refers to fixing of exchange rate of
the currency below its free market level.
3. Devaluation: In macroeconomics and modern monetary policy,
is an official lowering of the value of a country's currency within a
fixed exchange-rate system, in which a monetary authority
formally sets a lower exchange rate of the national currency in
relation to a foreign reference currency.

Effects of currency undervaluation:

 Increases exportation of goods
 Reduces imports
 Improves Balance of Payment position of a country
 Encourages local production
 Checks on dumping
 Reduces imported inflation
 Worsens external debt burden
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EXCHANGE RATE SYSTEM/REGIME

Key Terms

 Exchange rate regime: The way in which an authority

manages its currency in relation to other currencies and the
foreign exchange market.
 Floating exchange rate: A system where the value of
currency in relation to others is allowed to freely fluctuate
subject to market forces.
 Fixed exchange rate: A system where a currency‟s value is
tied to the value of another single currency, to a basket of
other currencies, or to another measure of value, such as
gold.
 Pegged float exchange rate: A currency system that fixes
an exchange rate around a certain value, but still allows
fluctuations, usually within certain values, to occur.
 Merged currency: This approach to exchange rate policy in
which a nation choses a common currency shared with one
or more nations.

1. The Floating Exchange Rate

A floating exchange rate, or fluctuating exchange rate, is a type of

exchange rate regime wherein a currency‟s value is allowed to
fluctuate according to the foreign exchange market. A currency
that uses a floating exchange rate is known as a floating currency.
The dollar is an example of a floating currency.

Many economists believe floating exchange rates are the best

possible exchange rate regime because these regimes automatically
adjust to economic circumstances. These regimes enable a country
to dampen the impact of shocks and foreign business cycles, and to
preempt the possibility of having a balance of payments crisis.
However, they also engender unpredictability as the result of their
dynamism.

2. The Fixed Exchange Rate

A fixed exchange rate system, or pegged exchange rate system, is a

currency system in which governments try to maintain a currency
value that is constant against a specific currency or gold. In a fixed
exchange-rate system, a country‟s government decides the worth
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of its currency in terms of either a fixed weight of an asset, another

currency, or a basket of other currencies. The central bank of a
country remains committed at all times to buy and sell its currency
at a fixed price.

To ensure that a currency will maintain its “pegged” value, the

country‟s central banks maintain reserves of foreign currencies and
gold. They can sell these reserves in order to intervene in the
foreign exchange market to make up excess demand or take up
excess supply of the country‟s currency.

The most famous fixed rate system is the gold standard, where a
unit of currency is pegged to a specific measure of gold. Regimes
also peg to other currencies. These countries can either choose a
single currency to peg to, or a “basket” consisting of the currencies
of the country‟s major trading partners.

[Link] Pegged Float Exchange Rate

Pegged floating currencies are pegged to some band or value,

which is either fixed or periodically adjusted. These are a hybrid of
fixed and floating regimes. There are three types of pegged float
regimes:

 Crawling bands: The market value of a national currency

is permitted to fluctuate within a range specified by a band
of fluctuation. This band is determined by international
agreements or by unilateral decision by a central bank. The
bands are adjusted periodically by the country‟s central
bank. Generally the bands are adjusted in response to
economic circumstances and indicators.
 Crawling pegs: A crawling peg is an exchange rate regime,
usually seen as a part of fixed exchange rate regimes that
allows gradual depreciation or appreciation in an exchange
rate. The system is a method to fully utilize the peg under
the fixed exchange regimes, as well as the flexibility under
the floating exchange rate regime. The system is designed to
peg at a certain value but, at the same time, to “glide” in
response to external market uncertainties. In dealing with
external pressure to appreciate or depreciate the exchange
rate (such as interest rate differentials or changes in foreign
exchange reserves), the system can meet frequent but
moderate exchange rate changes to ensure that the economic
dislocation is minimized.
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 Pegged with horizontal bands: This system is similar to

crawling bands, but the currency is allowed to fluctuate
within a larger band of greater than one percent of the
currency‟s value.

Reasons for Fixed Exchange Rate Regimes

 A fixed exchange rate is usually used to stabilize the value

of a currency against the currency it is pegged to. This
makes trade and investments between the two countries
easier and more predictable and is especially useful for
small economies in which external trade forms a large part
of their GDP.
 This belief that fixed rates lead to stability is only partly
true, since speculative attacks tend to target currencies with
fixed exchange rate regimes, and in fact, the stability of the
economic system is maintained mainly through capital
control. Capital controls are residency-based measures such
as transaction taxes, other limits, or outright prohibitions
that a nation‟s government can use to regulate flows from
capital markets into and out of the country‟s capital account.
A fixed exchange rate regime should be viewed as a tool in
capital control.

How a Fixed Exchange Regime Works

Typically a government maintains a fixed exchange rate by either

buying or selling its own currency on the open market. This is one
reason governments maintain reserves of foreign currencies. If the
exchange rate drifts too far below the desired rate, the government
buys its own currency in the market using its reserves. This places
greater demand on the market and pushes up the price of the
currency. If the exchange rate drifts too far above the desired rate,
the government sells its own currency, thus increasing its foreign
reserves.

Another method of maintaining a fixed exchange rate is by simply

making it illegal to trade currency at any other rate. This method is
rarely used because it is difficult to enforce and often leads to a
black market in foreign currency. Some countries, such as China in
the 1990s, are highly successful at using this method due to
government monopolies over all money conversion. China used
this method against the U.S. dollar.

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4. Managed Float

Managed float regimes are where exchange rates fluctuate, but

central banks attempt to influence the exchange rates by buying
and selling currencies.

How a Managed Float Exchange Rate Works

Generally, the central bank will set a range which its currency‟s
value may freely float between. If the currency drops below the
range‟s floor or grows beyond the range‟s ceiling, the central bank
takes action to bring the currency‟s value back within range.

Management by the central bank generally takes the form of

buying or selling large lots of its currency in order to provide price
support or resistance. For example, if a currency is valued above
its range, the central bank will sell some of its currency it has in
reserve. By putting more of its currency in circulation, the central
bank will decrease the currency‟s value.

Why Do Countries Choose a Managed Float?

Some economists believe that in most circumstances floating

exchange rates are preferable to fixed exchange rates. Floating
exchange rates automatically adjust to economic circumstances
and allow a country to dampen the impact of shocks and foreign
business cycles. This ultimately preempts the possibility of having
a balance of payments crisis. A floating exchange rate also allows
the country‟s monetary policy to be freed up to pursue other goals,
such as stabilizing the country‟s employment or prices.

However, pure floating exchange rates pose some threats. A

floating exchange rate is not as stable as a fixed exchange rate. If a
currency floats, there could be rapid appreciation or depreciation of
value. This could harm the country‟s imports and exports. If the
currency‟s value increases too drastically, the country‟s exports
could become too costly which would harm the country‟s
employment rates. If the currency‟s value decreases too drastically,
the country may not be able to afford crucial imports.

This is why a managed float is so appealing. A country can obtain

the benefits of a free floating system but still has the option to
intervene and minimize the risks associated with a free floating
currency. If a currency‟s value increases or decreases too rapidly,

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the central bank can intervene and minimize any harmful effects
that might result from the radical fluctuation.

5.A Merged Currency

A final approach to exchange rate policy is for a nation to choose a

common currency shared with one or more nations is also called
a merged currency. A merged currency approach eliminates
foreign exchange risk altogether. Just as no one worries about
exchange rate movements when buying and selling between New
York and California, Europeans know that the value of the euro
will be the same in Germany and France and other European
nations that have adopted the euro.

However, a merged currency also poses problems. Like a hard peg,

a merged currency means that a nation has given up altogether on
domestic monetary policy, and instead has put its interest rate
policies in other hands. When Ecuador uses the U.S. dollar as its
currency, it has no voice in whether the Federal Reserve raises or
lowers interest rates. The European Central Bank that determines
monetary policy for the euro has representatives from all the euro
nations. However, from the standpoint of, say, Portugal, there will
be times when the decisions of the European Central Bank about
monetary policy do not match the decisions that would have been
made by a Portuguese central bank.

Trend and Management of Exchange rate policy in Uganda

Uganda‟s trade and payments regime has evolved considerably

since independence in 1962.

In the immediate post-independence era, Uganda pursued an

inward looking import-substitution trade and industrial strategy,
with a fixed exchange rate regime. Indeed, for most of the 1970s,
the official exchange rate with the US dollar was held close to the
original rate at which the East African shilling had been fixed,
which the Uganda shilling inherited in 1966 after the dissolution of
the East African Currency Board.

Economic mismanagement at the time, and artificial shortages

created by the fixed exchange rate regime led to the emergence of
a parallel foreign exchange market. The premium on the parallel
foreign exchange market increased dramatically and by 1981, the

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price of foreign currency in the parallel market was over 10 times

higher than the official exchange rate.

In 1981, an adjustment program partly aimed at correcting the

exchange rate distortion was initiated. Its centerpiece was a
massive devaluation of the shilling, followed by a further
devaluation in July 1982. In August 1982, a two-window system
was introduced; with key transactions including exports of coffee,
tea, tobacco and cotton; imports of petroleum; aid-financed
projects; official loan and grant inflows; and the servicing of debts
and arrears being carried out through Window I at the official
exchange rate; and other transactions falling under Window II
through an auction system.

The two windows were subsequently merged in 1984 just before

the collapse of the adjustment program.

In 1986, there was a brief return to the two-window system before

a fixed rate system was again established at the end of 1986. This
further aggravated the external disequilibria in the economy.
Consequently, a currency reform was undertaken in May 1987 in
which one hundred shillings were exchanged for one new shilling,
and the shilling devaluated by 77.0 percent in an attempt to address
external imbalances. This reduced the parallel market premium
substantially. In addition, various schemes, such as the Open
General Licence System, the Special Import Programs and the
Dual Licensing schemes for exporters wishing to import crucial
inputs, were put in place to assist import-dependent industries.

In October 1989, the policy of maintaining the real effective

exchange rate constant (a „crawling peg‟ system) was introduced.
As a result, the nominal exchange rate was adjusted on a monthly
basis.

In July 1990 the parallel market was legalized, leading to the

establishment of foreign exchange bureau. The bureaus were
permitted to conduct spot transactions at freely determined
exchange rates. Limits, albeit liberal, were placed on invisible
payments in a bid to address concerns about capital flight.

In a further move towards a market based exchange rate regime, a

foreign exchange auction system for import support funds was
introduced in January 1992. Initially, commercial banks, and later
foreign exchange bureaus, were permitted to bid in the auction,
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provided they were in a good financial footing with the Bank of

Uganda. The auction was held weekly under the Dutch auction
system, whereby each successful bidder paid its bid price.
Eligibility of imports was based on a short “negative” list of goods
jointly set by the Government and the donor community. The
move to the auction system effectively ended the period of
administered exchange rates. The private sector bought foreign
exchange at market-determined rates in the bureau market or
through the auction. Transactions through the official channel,
including Government, were initially conducted at the auction rate
and later at an average of the bureau rates. However, while
exchange rates were market determined, the foreign exchange
market remained segmented. By end October 1993, there was still
a premium of about 5.0 per cent between the auction and the
bureau rate. Thus, in spite of the introduction of the auction
system, exchange rate convergence remained elusive.

The adjustment program almost achieved the unification of the

exchange rates before it collapsed.

In order to eliminate the segmented nature of the foreign exchange

market and to bring about convergence of the exchange rates, an
inter-bank foreign exchange market system was introduced in
November 1993. This was expected to provide a more efficient and
reliable mechanism for determining the official exchange rate and
allocating scarce foreign exchange resources. Authorized dealers,
including bureau were free to set their exchange rates while trading
among themselves.

Subsequently, on fifth April, 1994, the government accepted the

obligations of Article VIII, Sections 2, 3 and 4 of the IMF‟s
Articles of Agreement, expressing its commitment to a free and
open exchange rate system. The floating exchange rate system has,
nonetheless, presented certain difficulties for the country. First, it
has heightened the risk of exchange rate volatility, which is
synonymous with the flexible exchange rate system. Second, the
adoption of a flexible exchange rate system meant the loss of the
exchange rate as a nominal anchor for domestic prices. Finally, the
operation of an efficient foreign exchange market may not be
technically feasible in a situation where financial markets are
underdeveloped. This is where Uganda finds itself today.

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