What is flotation?
Before we talk about the meaning of floating, we must first know the foreign exchange management systems.
The truth is that there are many systems, but I will focus on two types, and any other type we will find that is between these two types
Exchange Rate Systems
The first type is called fixed exchange rate, meaning that the central bank fixes the currency rate with another currency, often the dollar.
Let’s assume, for example, that Saudi Arabia fixes the dollar to about SAR 3.75.
We won’t discuss how they fix the FX rate, let’s just say that the country fixes it (which in our example is Saudi Arabia) and provides cash reserves in foreign currency (the dollar) through which you can fix the exchange rate, and of course, the price is not fixed with nails, meaning it can fluctuate within 1% plus or minus.
In general, we can say that the exchange rate is almost really “fixed”, and this remains due to international or commercial agreements between two countries.
The second exchange rate system is the free-floating system, meaning the independent floating of the currency in front of any other currency.
In this case, the country allows the currency to float depending on supply and demand. Let’s take the Canadian dollar against the US dollar, for example.
Today, the US dollar is equal to 1.25 Canadian dollars. Tomorrow it is equal to 1.34, and then it is equal to 1.14. It fluctuates depending on supply and demand.
Other exchange rate management systems
The truth is that there are many, but they all fall between the fixed exchange rate and the free float system.
For example, there is a system called managed float, meaning that the central bank or the country leaves its currency to the forces of supply and demand, but to a certain extent.
We can leave the EGP, for example, to supply and demand until the USD reaches EGP 30. In this case, policymakers intervene by pumping USD into the market, making the USD not equal to EGP 30 (this is just an example, it does not mean that this is really the policy of the Egyptian government)
Impact of floatation on the currency
The truth is that no one can say that floating or devaluing the currency is beneficial or harmful in an abstract way. It is both beneficial and harmful.
Depending on the economy of each country, flotation has positive and negative impacts on the country.
The flotation lowers the value of the local currency against foreign currencies, and this of course reduces the value of individuals’ savings and even the value of their wages and may expose the country to the risk of increased inflation.
Inflation is twice the purchasing power of the local currency. If 1 EGP buys five commodities before the flotation, it can buy 3 or 4 of the same commodities after the devaluation.
On the other hand, flotation makes the prices of imported products more expensive and makes the export revenue greater. We can theoretically say that flotation increases exports and reduces imports.
But if we zoom in on some developing countries, we will find that these countries’ exports depend on components for production, originally imported in hard currency, and therefore flotation can make production more difficult, or push business owners to lay off employees to reduce the cost of production for components.
But suppose, for example, that a country like Germany (assuming it has its own currency and assuming that it is not part of the European Union) decides to float its currency.In this case, most of the components of production are local and the machines are local, so the float will make German products sold at a competitive price in the global markets and the economy will benefit significantly.
Previously, we mentioned that flotation increases inflation, which means that a company’s stock prices will theoretically increase, meaning that its price as a number will increase, but not its value.
Well, this is good or bad. It is definitely good that your money, if it is in the stock exchange and in assets (fairly priced), after the flotation, your savings or investments will maintain their value.
On the other hand, if the companies in which you own a share falter, because of the flotation and the difficulty of providing production components (if they are imported), this means that the company’s profits will decrease, and with time the company’s share will decrease in value and price.
To summarize, a strong economy reaps more benefits from the decision to float than a weak economy.
This was not written by Thndr and this is not investment advice, you should do your own research before making investment decisions.
