It is essential to distinguish between an individual currency and an exchange rate. While one can possess a specific currency, an exchange rate indicates the value of one currency in relation to another (for instance, the exchange rate between the Birr and the USD). An individual currency can stand alone, but an exchange rate always involves two currencies: the price of one currency compared to another. The exchange rate represents the number of units of one currency (referred to as the price currency) that can be purchased with a single unit of another currency (known as the base currency). Alternatively, the exchange rate can be described as the cost of one unit of the base currency expressed in terms of the price currency.

From the study of economics, it becomes evident that the impact of a currency regime on a country's ability to implement an independent monetary policy is a recurring theme in open-economy macroeconomics. Countries utilize monetary policy because achieving an ideal currency regime is challenging.

In theory, an ideal currency regime would possess three key characteristics:

Credibly Fixed Exchange Rates: The exchange rate between any two currencies would be reliably fixed, eliminating currency-related uncertainty regarding the prices of goods, services, and both real and financial assets.

Full Convertibility: All currencies would be fully convertible, meaning they could be freely exchanged for any purpose and in any amount, ensuring an unrestricted flow of capital.

Independent Monetary Policy: Each country would retain the ability to pursue an independent monetary policy to achieve domestic objectives, such as growth and inflation targets.

Unfortunately, these three conditions are not mutually compatible. If the first two conditions—credibly fixed exchange rates and full convertibility—were met, there would effectively be only one currency in the world. In this scenario, converting from one national currency to another would be as trivial as choosing between coins or paper currency in your wallet. Consequently, any efforts to influence interest rates, asset prices, or inflation through adjustments in the supply of one currency versus another would be ineffective.

Therefore, maintaining independent monetary policy is not feasible if exchange rates are credibly fixed and currencies are fully convertible. In practice, however, countries employ monetary policy alongside fiscal policy to manage their economies effectively. The major types of exchange rate regimes used by countries can be classified into three categories: Fixed Rate, Managed Floating Exchange Rates, and Free-Floating Exchange Rates. Each exchange rate mechanism has its own advantages and disadvantages as an effective tool for a country’s monetary policy.

Until October 1992, Ethiopia followed a fixed exchange rate regime pegged to the US Dollar. Since then, however, the exchange rate between the Ethiopian Birr and a major basket of currencies has been determined by the National Bank of Ethiopia. Over the last 32 years; before the adoption of the new policy last week, the Ethiopian Birr against USD has depreciated by about 3000 percent, but this decline has occurred gradually.

As of July 29, 2024, the Ethiopian government has adopted a Free-Floating Exchange Rate regime, which involves no day-to-day intervention by the National Bank of Ethiopia.

The pros and cons of adopting a specific exchange regime are contingent upon a government’s macroeconomic policy, which has been analyzed in various media outlets in recent weeks but will not be discussed in this article. Instead, this article focuses on the operation of exchange rates by banks and dealers under the newly adopted exchange rate regime moving forward.

In economics and finance, where exchange rates are determined by supply and demand, it is assumed that these rates follow a random walk, making daily fluctuations unpredictable. With the implementation of the new exchange rate regime, it is expected that local banks will no longer face restrictions on engaging in global foreign exchange dealings. This is significant, as the foreign exchange (FX) market—the marketplace where currencies are traded against one another—represents the largest market in the world, measured by daily turnover.

The FX market is a truly global marketplace that operates 24 hours a day on business days. It involves participants from every time zone, connected through electronic communications networks that link players ranging from multibillion-dollar investment funds to individual traders—all interacting in real time.

International trade relies heavily on currency exchange, facilitating cross-border capital flows that connect financial markets worldwide through the FX market. FX markets enable international trade in goods and services, allowing companies and individuals to conduct transactions in foreign currencies. This includes everything from companies and governments buying and selling products abroad to tourists engaging in cross-border travel.

While this aspect of FX markets is significant, an even larger portion of daily turnover is driven by capital market transactions, where investors convert currencies to move funds into or out of foreign assets. These transactions encompass a wide range of activities, from direct investments—such as companies purchasing fixed assets like factories in other countries—to portfolio investments, which involve buying stocks, bonds, and other financial assets denominated in foreign currencies.

Regardless of the underlying motivation for an FX transaction, it requires the exchange of one currency for another in the FX market. Before this necessary transaction occurs, market participants face the risk that the exchange rate may move against them. So far, local banks have limited their foreign exchange trading to spot exchange rates, where exposure related to foreign exchange forward transactions—such as those associated with Letters of Credit or other supplier credit arrangements—is directly transferred to companies or individuals, thereby eliminating currency exposure risks for the banks.

With the adoption of a free-floating system, forward exchange transactions that will settle within 30 to 90 days may expose customers to significant foreign exchange risks. Therefore, it is crucial for local banks to establish a forward exchange market, enabling customers to hedge against their foreign transaction exposures.

Moreover, all companies face some degree of foreign competition, and the pricing of domestic assets—such as equities, bonds, and real estate—also depends on demand from foreign investors. These various influences on investment performance are closely tied to developments in the foreign exchange market. Hence, understanding the foreign exchange market and related financial instruments has become a vital competency for our local banks following significant changes in foreign exchange policy. If they fail to adapt, local banks risk losing this lucrative market to emerging foreign banks that may be entering the country.

The views expressed in the article are my personal research findings. They do not reflect the views of HST, its partners, and directors.

Solomon Gizaw is the Chairman and Chief Executive Officer of HST. He can be contacted at: solomon.gizaw@hst-et.com.