Since the collapse of the Bretton Woods system of fixed exchange rates in 1971, exchange rate regimes have varied between two extremes: a fixed rate at one end and a floating rate at the other - and, in between, a crawling peg or managed float.

Which regime is best is a challenging question. But at least we know that whatever policy regime is adopted, we will be caught in a 'policy trilemma'.

This principle states that there is an intrinsic incompatibility among three macroeconomic policy aims: namely, free capital flow, fixed exchange rates and monetary autonomy. The most any country may choose from this package is two of the three policy objectives.

For example, when a country manages its exchange rate - as Singapore does - its central bank has to cope with capital flows by intervening in the market to buy or sell foreign currencies. The result is that the domestic money supply will fluctuate with each intervention, rendering the money supply uncontrollable.

China, which has a pegged exchange rate and independent monetary policy, must give up free capital flow. And Australia, which has free capital flow and an independent monetary policy, cannot have a fixed exchange rate.

So how do countries decide on particular exchange rate regimes?

Australia chose to float its currency in 1983 after experimenting with a sterling peg until 1971, then a United States dollar peg until 1974, and then a weighted basket of currencies peg until 1983. Its decision to float stemmed from the difficulty of defending the peg when there was massive capital outflow, and was meant to mitigate the inflationary effects of massive capital inflow. But a float also means it has to live with exchange rate volatility.

Singapore's economy is smaller and far more open than Australia's, with trade volume a few times its gross domestic product. Exchange rate volatility would have a far greater impact on Singapore's economy.

Given that mitigating inflation and facilitating export growth are of the highest priority for the country, Singapore has chosen to reduce exchange rate volatility by embracing a managed float. And it has to maintain free capital flow as well, since growing its financial sector is another important priority.

But a policy menu comprising a managed float and free capital flow also means the domestic money supply will fluctuate as capital flows in and out.

Fortunately, Singapore has the capacity to mitigate the effects of capital flows. Its huge foreign currency reserves are helpful in defending its exchange rate against speculative capital outflow and it has financial vehicles such as its sovereign wealth fund to redirect outward any capital inflow that threatens domestic inflation. More importantly, Singapore's prudent fiscal management also helps to reduce speculative capital flows.

One disadvantage of its policy package is that its interest rate is determined by the world rate. Thus mitigating asset bubbles in a low world interest rate environment is a challenging task that requires the use of other policy instruments.

China has chosen a pegged exchange rate. This strategy has delivered fast growth but it has also meant a continual balance of payments surplus.

The result would have been an explosion of China's money supply and runaway inflation had it not been for a combination of various 'sterilisation' policies, such as selling domestic government bonds, raising banks' reserve requirements, and the outward redirection of capital flows.

Some of the sterilisation instruments, such as selling bonds to soak up money supply, would have been ineffective if not for China's capital controls.

Thus China has chosen a pegged exchange rate and independent monetary policy, but at the cost of giving up free capital flow. This is a small cost given that China has more savings than it needs to finance its investment.

But keeping huge foreign reserves to defend its peg has a high opportunity cost. And sterilisation is not without costs. For instance, soaking up domestic money supply by selling government bonds at a yield higher than the world interest rate implies a fiscal subsidy, and raising banks' reserve requirement effectively taxes them and eats into their profits.

In summary, the choice of an exchange rate policy regime is not driven by ideology, but more by what best suits country at particular stages of its development.

Each policy menu has its own advantages and disadvantages. As a country evolves, its policy menu may also evolve.

The writer is a professor at the NUS Business School

Source - The Straites Times (http://www.straitstimes.com/Review/Others/STIStory_606987.html)