Question

Do you think a common currency as Euro would solve many issues related to Exchange Rate Risk? What are the issues related to having a common currency?

Answer 1

A fixed exchange rate is when a country ties the value of its currency to some other widely-used commodity or currency. The dollar is used for most transactions in international trade. Today, most fixed exchange rates are pegged to the U.S. dollar. Countries also fix their currencies to that of their most frequent trading partners.

A fixed exchange rate provides currency stability. Investors always know what the currency is worth. That makes the country's businesses attractive to foreign direct investors. They don't have to protect themselves from wild swings in the currency's value. They are hedging their currency risk.

A country can avoid inflation if it fixes its currency to a popular one like the U.S. dollar or euro. It benefits from the strength of that country's economy. As the United States or European Union grows, its currency does as well. Without that fixed exchange rate, the smaller country's currency will slide. As a result, the imports from the large economy become more expensive. That imports inflation.

For example, the dollar's value is 3.75 in Saudi riyals. Let's say a barrel of oil is worth $100 or 375 riyals. If the dollar strengthens 20 percent against the euro, the value of the riyal, which is fixed to the dollar, has also risen 20 percent against the euro. To purchase French pastries, the Saudis pay less than they did before the dollar strengthened. For this reason, the Saudis didn't need to limit supply as oil prices fell to $50 a barrel in 2014. The value of money is what it purchases for you.

If most of your country's imports are to a single country, then a fixed exchange rate in that currency will stabilize prices.

A fixed exchange rate can be expensive to maintain. A country must have enough foreign exchange reserves to manage its currency's value.

A fixed exchange rate can make a country's currency a target for speculators. They can "short" the currency, artificially driving its value down. The central bank must convert its foreign exchange to prop up its currency's value. If it doesn't have enough, it will have to raise interest rates. That will cause a recession.