What Is a Dirty Float?
A dirty float is a floatingexchange rate where acountry's central bank occasionally intervenes to change the direction or the pace of change of a country's currency value. In most instances, the central bank in a dirty float system acts as a buffer against an external economic shock before its effects become disruptive to the domestic economy. A dirty float isalso known as a "managed float."
This can be contrasted with a clean float, where the central bank does not intervene.
Key Takeaways
- A dirty float occurs when government's monetary rules or laws affect the pricing of its currency.
- With a dirty float, the exchange rate is allowed to fluctuate on the open market, but the central bank can intervene to keep it within a certain range, or prevent it from trending in an unfavorable direction.
- Dirty, or managed floats are used when a country establishes a currency band or currency board.
- The goal of a dirty float is to keep currency volatility low and promote economic stability.
Understanding Dirty Floats
From 1946 until 1971, many of the world's major industrialized nations participated in a fixed exchange rate system known as the Bretton Woods Agreement. This ended when President Richard Nixon took the United States off the gold standard on August15, 1971. Since then, most major industrialized economies haveadoptedfloating exchange rates.
Many developing nations seek to protect their domestic industries and trade by using a managed float wherethe central bank intervenes to guide the currency. The frequency of such intervention varies. For example, the Reserve Bank of India closely manages the rupee within a very narrow currency bandwhile the Monetary Authority of Singapore allows the local dollar to fluctuate more freely in an undisclosed band.
There are several reasons why a central bank intervenes in a currency market that is usually allowed to float.
Market Uncertainty
Central banks with a dirty float sometimes intervene to steady the market at times of widespread economic uncertainty. The central banks of both Turkey and Indonesia intervened openly numerous times in2014 and 2015 to combat currency weakness caused by instability in emerging markets worldwide. Some central banks prefer not to publicly acknowledge when they intervene in the currency markets; for example, Bank Negara Malaysia was widely rumored to have intervened to support the MalaysianRinggit during the same period, but the central bank has not acknowledged the intervention.
Speculative Attack
Central banks sometimes intervene to support a currency that is under attack by a hedge fund or other speculator. For example, a central bank may find that a hedge fund is speculating that its currency might depreciate substantially;thus, the hedge fund is building up speculative short positions. The central bank can purchase a large amount of its own currencyto limit the amount of devaluation caused by the hedge fund.
A dirty float system isn't considered to be a true floating exchange rate because, theoretically, true floating rate systems do not allow for intervention. However, the most famous show-down between a speculator and a central bank took place in September 1992, when George Soros forced the Bank of England to take the pound out of the European Exchange Rate Mechanism (ERM). The pound theoretically floats freely, but the Bank of England spent billions on an unsuccessful attempt to defend the currency.
