To begin with one should be aware of the basic definition of the word “exchange rate”. This can be best described as the value of one currency against another. It is also known as “forex”, “FX” or “foreign exchange rate”. There are variations in the types of exchange rate regimes. One such category is the linked exchange rate which will be dealt with at length here.
The linked exchange rate is a kind of exchange regime where exchange rates of one currency are linked to that of another. This is different from the fixed exchange rate system where there is interference from the government which in turn influences the exchange rate.
Linked exchange rates are actually a product of recent times. This dates back to 1983 when what came to be known later as the “Black Saturday” crisis of Hong Kong occurred. The value of the Hong Kong dollar plummeted to an all-time low of $9.6 Hong Kong dollars for one U.S. dollar. Stores began to quote product prices in U.S. dollars. The government responded by introducing the linked exchange rate in October 1983.
The linked exchange rate regime was introduced in Hong Kong on 17 October 1983. Certificates of indebtedness were redeemed and the domestic currency was pegged against the U.S. dollar.
From this crisis emerged the currency boards. Currency boards were not unknown even at that time. The earliest record of a currency board is that of the one founded in Mauritius in the year 1849. Subsequently up to 70 nations were to follow suit. The peak of this kind of regime was during the 1940s. In the post-World War period currency boards suffered a decline due to new territories opting for financial independence with their individual central banks.
However, after Black Saturday in Hong Kong in 1983, the concept of currency boards experienced a revival. Following the heels of Hong Kong were Argentina (1991), Estonia (1992) and Lithuania in 1994. Today, about ten countries use the linked exchange system.
The linked exchange rate is only a type of regime adopted by countries. Given below is the classification of exchange rates:
To highlight the nature of linked exchange rates, it is required to understand the other two types of exchange rates prevalent in the foreign exchange market today – floating exchange rates and fixed exchange rates. Fixed exchange rates are those rates which are set by the respective governments of countries. Floating exchange rates follow the trends of the prevailing market conditions. Furthermore, floating exchange rates have a built-in market “self-correction” device. In the case of less demand of a particular currency, the value of that currency falls which in turn causes a rise in the price of foreign goods. This creates a demand for domestic goods. The resultis that money gets injected into the system resulting from increased employment.
There are two kinds of floating exchange rates – dirty float and clean float.
The main advantage is that the floating exchange rate allows currency value to fluctuate as per the trends in the whole foreign exchange market, thus providing a buffer to small variations in the values of currency.
The fixed exchange rate allows for a more stable and certain situation. There is a fixed policy regarding the rates and it is easier to predict the different economic factors and create accurate projections according to the factors thereof.
Linked exchange rates on the other hand, are responsible for linking exchange rates of a particular currency to the rates of another. As against the case of a pegged exchange rate regime, there is no interference from the government or the central bank in the foreign exchange market or the demand and supply control of a particular currency.
The linked exchange rate system helps to restore currencies to their original rates by providing extra “feedback loops”. It may so happen, for instance, that a central bank has guaranteed conversion at a particular rate. The result is that the demand and supply of currency in the domestic market will push the exchange rate back to the natural value. This is in effect one of the main advantages of the linked exchange rate regime.
So in conclusion we can say that the linked exchange rate regime brings fairness into trading onthe foreign exchange market. It ensures competitive business dealing while at the same time keeping a check on the undesirable trends such as inflation and devaluation of currency. It is here to stay and more and more countries are adopting this regime today.