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LETTER FROM THE EDITOR

Sound as the pound

Monetary policy in the modern world often comes down to a choice between fixing and flexing. Many economists in recent years have argued that – while each extreme has its particular strengths and weaknesses – either one is preferable to a mixture of the two, which may leave monetary mechanisms working against each other. Advocates of intermediate monetary regimes say stipulated "bands" on exchange rates can ensure monetary stability while still providing a fair degree of flexibility. These bands are supposed to be like a novice gymnast’s balance beam – straight and solid, but wide enough to allow a bit of room for maneuver.

The band – a range of percentage points within which a local currency is allowed to fluctuate against a major foreign currency such as the US dollar – is supposedly more resilient than a rigidly fixed peg. But among the proponents of band-based policies, too, there are different theories about how and why they actually work.

One view is that bands provide a sense of security (like pegs do) but also leave enough room for natural market development. According to economist John Williamson, who presented a paper on monetary policies in Cairo last November, a band may act to "crystallize market expectations" about a currency’s natural point of equilibrium.

Put another way, a band can defend a currency against "irrational behavior" in the market, as the Egyptian government hopes will happen with its newly announced monetary regime. The new rules cannot just be dismissed as the paranoia of a state that demonizes forex bureaus while pursuing what could be perceived as illogical – or at least macroeconomically irresponsible – fiscal policies. The experiences of many emerging markets in the 1990s leave good reason to fear major international currency speculators – even if it’s unfair to pick on street-corner exchange shops.

Studies of different countries’ monetary systems suggest that bands do actually work to limit exchange-rate fluctuations. Bands aren’t quite as rigid – and hence liable to snap – as firm pegs, but the delaying action they produce usually succeeds in reducing "noisiness" in the local currency market. "Noise traders," therefore – those who like to play on wild fluctuations – simply lose interest and go elsewhere.

Critics, however, contend that a band’s edges provide "targets of attack," especially when governments try to defend a rate that is seriously out of line with real values. So in the end, bands may provide stability if, and only if, the "official" rate on which they are based is credible. And credibility is derived not only from setting a rate at a realistic level, but also from developing and maintaining transparent mechanisms and creating public awareness of monetary policy.

Transparency, therefore, should be paramount in Egypt – where the trustworthiness of the institutions that oversee the economy is arguably tarnished. But is Egypt’s newly announced monetary regime – described in some reports as a "banded peg" – truly a band system at all? A band only two-percent wide – that is, allowing a range of only one percent up or down against the official dollar rate at any given time – seems less like a balance beam and more like a tightrope.

A leading economist questioned the applicability of the term "banded peg," suggesting that Egypt’s current arrangement should be called a "managed float." In managed-float systems, governments manipulate interest rates and foreign reserves on a regular basis, in order that the currency’s real value stays at – or very, very close to – a nominated rate. And such measures could be necessary, if the authorities want to prevent the band from breaking.

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