INTRODUCTION
The Bretton Woods monetary
system of fixed exchange rates, which evolved immediately after
the Second World War, worked fairly well for nearly thirty years
until 1973 when it broke down.
U.S. huge current account
deficits occasioned by its involvement in the Vietnam war, posed
significant challenges to the system.
Upon the demise of the
Bretton Woods system, a generalized system of floating exchange
rates emerged, particularly for the developed countries. The
developing countries have had varied experiences with exchange
rate regimes.
- Since the mid-1970s, the
developing countries have moved to either pegging to a basket of
major currencies, away from a single currency peg, or adopting a
more flexible exchange rate regime.
- In order to reduce the
uncertainties arising from the medium or long-term swings of major
currencies which have produced various problems for them,
developing countries have had the inclination to adopt
intermediate exchange rate regimes rather than the polar regimes
of firmly fixed exchange rate and floating exchange rates.
Since the early 1990s two
notable developments have conditioned the type of exchange rate
regimes adopted by the developing countries; these are the
intensification ofglobalization and emergence of financial crises.
-No doubt, the deep
integration of a number of developing countries into the global
economy has promoted trade in goods and services between the
developed countries and the developing/emerging market economies
-Capital flows to the
developing countries especially foreign direct investment (FDI),
have also provided significant benefits.
-However, large inflows of
short-term capital and abrupt reversal of capital flows to the
developing countries have tended to lead to currency and financial
crises with resultant losses of output, investment and employment.
-Thus, the choice of
exchange rate regime by developing countries is of crucial
importance to their self-protection from speculative attacks and
currency crisis as well as achievement of long-term growth.
-And the choice of exchange
rate regime in the developing countries means which regime would
be most appropriate not only for preventing massive capital
inflows and currency crises but also for better facilitation of
trade, FDl and economic growth.
-Thus, for the developing
country, more access to the global capital market poses a policy
dilemma for the choice of exchange rate regime.
It seems, therefore, that
the choice of an appropriate exchange rate by a developing country
is not a straightforward task.
-Suggestions have been made
that an appropriate exchange rate varies depending on the specific
circumstances of the country in question and on the circumstances
of the time period in question (Frankel, 1999).
-Yet, in recent years,
following the currency and financial crises of the 1990s, many
developing countries have been advised to shift to the polar
exchange rate regimes: flexible or fixed exchange rates with
monetary union (or currency board). The feeling is that
intermediate regimes between two polar regimes are no longer
tenable, considering the trilemma entailed in the principle of the
impossible trinity.
-This trilemma entails the
difficulty in attempting to pursue exchange rate stability,
capital mobility, and independent monetary policy. It is not
possible to achieve all three objectives simultaneously; it is
possible at most to achieve two of the objectives, making it
necessary to sacrifice at least one.
-And as the argument further
goes, as more countries try to have access to global financial
markets, the choice of exchange rate regime is narrowed down to
the degree of flexibility in terms of a perfect free floating or
hard fixed exchange rates such as monetary union, currency board
or even dollarisation.
-This tends to be in line
with the thinking of some analysts that some countries are better
suited for a fixed exchange rate regime with monetary union or
currency board while others are better off adopting a flexible
regime.
-It would seem that
following the financial crises of the 1990s, more developing
countries have moved to flexible exchange rate regimes: 46.5% in
2004 compared to 34.8% in 1991. Over the same period, exchange
rate pegs including currency boards declined form 54.0% in 1991 to
42.1% in 2004.
Nevertheless, as at date,
not much knowledge can be claimed about workable exchange rate
regimes. As Velasco (2000) has observed, during the 1997 - 98
Asian crisis, arrangements that had performed relatively well for
years came crashing down with almost no advance notice; other
arrangements that once seemed invulnerable almost tumbled down as
well. Mid-course corrections and policy changes proved equally
troublesome; in every country that abandoned a peg and floated,
the exchange rate overshot massively and a period of currency
turmoil followed with attendant tremendous real costs.
In choosing exchange rate
regimes, therefore, developing countries need to be fully aware of
the circumstances and conditions for their successful adoption.
The important factors and criteria in such choices also need to be
properly understood. These are reviewed in this presentation
Structure of Presentation:
-Types of Exchange Rate
Regimes
-Consideratons in the Choice
of Exchange Rate Regime:
-Conventional Factors
-Further Issues on Criteria
for Choosing
Hxchange Rate Regime
-What are the Lessons and
Policy Conclusions
2. TYPES OF EXCHANGE RATE
REGIMES
Various forms of exchange
rate regimes are open to individual countries. They range from
clean floating or flexible exchange rate regime at one extreme to
firmly fixed arrangements at the other extreme, with the remaining
regimes falling in a continuum in between. These include managed
float, pegs, target zones, etc.
2.1 Fixed Exchange Rate
Regimes
A fixed exchange rate system
is one in which exchange rates are maintained at fixed levels.
Each country has its currency fixed against another currency. It
may seldom be changed (hard peg) or changed occasionally
(adjustable peg).
In the post World War II
period, the world economics maintained fixed exchange rates under
the Bretton Woods monetary system until that system collapsed in
the early 1970s.
A number of reasons why
fixed exchange rates are appealing:
-to reduce transactions
costs;
- certainty in international
transactions arising from reduction of exchange rate risk which
can discourage trade and investment;
-to promote orderliness in
foreign exchange markets; and
- to provide a credible
nominal anchor for monetary policy.
Fixed exchange rates may
take the form of(i) firmly fixed exchange rate regimes such as
currency boards, monetary union and
dollarization (the three are also known as hard pegs) and (ii)
other conventional fixed peg arrangements such as single currency
peg and
pegging to a basket of currencies
Hard pegs tended to become
increasingly popular in the aftermath of the East Asian financial
crises.
Main argument in favour of a
hard peg is the need to make monetary policy credible. Related to
this is the alleged ability of hard pegs to
induce discipline, whether fiscal or monetary.
(i) Dollarisation
In dollarisation, a country
adopts as its own currency the currency of a "hegemon", or
dominant economy.
As at 2004, 9 countries used
other countries’ currencies as their legal tender. Ecuador, for
example, adopted the U.S dollar.
Adopting such a regime
implies the complete surrender of the monetary authorities’
independent control over domestic monetary policy.
(ii) Monetary Union
In a monetary union, a group
of well-integrated economies adopt a single currency and
coordinate monetary policy. This means that the
same legal tender is shared by the members of the Union.
The CFA Zone in Africa, for
example, is made up of two currency unions, the West African
Economic and Monetary Union (WAEMU) and the Central African
Economic and Monetary Community (CAEMC), each with its own central
bank that issues its own currency with a fixed parity to the euro.
Both currencies are called
the CFA Franc. But they are distinguishable and not freely
interchangeable.
As in dollarisation, a
monetary union implies the complete surrender of the monetary
authorities’ independent control over domestic monetary policy.
(iii) Currency boards
A currency board is central
monetary institution that issues domestic currency only in
exchange for assets of the currency to which the
currency board country has chosen to peg.
A currency board combines
three elements: a fixed exchange rate between a country’s currency
and an "anchor currency", automatic
convertibility, and along-tenn commitment to the system, often
made explicit in the central bank’s law. Under a currency board
arrangement, the central bank commits to exchanging a unit of
domestic currency for a larger, more stable foreign currency at a
fixed exchange rate as Argentina did with the U.S dollar from the
late 1990s.
In a strict currency board
system, each dollar acquired by the board will result in creation
of base money equivalent to the dollar, and
each dollar sold by the board to finance a balance of payments
deficit will result in extinguishing a dollar’s worth of domestic
base money. This creates a self-correcting balance of payments
adjustment mechanism.
Modern currency boards have
often been instituted to gain credibility following a period of
high or hyper-inflation.
A currency board is credible
only if a country’s central bank holds sufficient
official foreign exchange reserves to cover at least its entire
monetary liabilities, thereby assuring financial markets and the
public at large that every
domestic currency note is backed by an equivalent amount of
foreign currency
in the official coffers.
And to be able to do this as
well as have a successful peg requires, as Mishkin (2000: 354) has
argued, an independent central bank, sound financial system, and a
strong fiscal position.
The notable advantages of a
currency board are economic and monetary credibility, low
inflation, low interest rates than world otherwise prevail,
following from zero expectations of devaluation.
Also of note as strength of
the currency board system is the virtual removal of the nominal
exchange rate as a means of adjustment. But, according to Fischer
(2001), this is also its major weakness, for adjustment to an
external or internal shock via differential inflation is slower
than via the nominal exchange rate.
In general, currency boards
can prove limiting, especially for countries that have weak
banking systems or are prone to economic shocks.
With a currency board in
place, the central bank can no longer serve as a lender of last
resort for banks in trouble.
This, however, can be
compensated by the creation, typically with fiscal resources, of a
banking sector stabilization fund.
Besides, with a currency
board arrangement, it is not possible to use financial policies
i.e, adjustments of domestic interest or exchange rates- to
stimulate the economy.
Instead, economic adjustment
can be achieved only through wage and price adjustment, which can
be both slower and painful.
In other words, a currency
board arrangement, entails the loss of power by the authorities to
conduct independent monetary policy, control monetary aggregates
and serve as a lender of last resort. This involves real economic
cost, in terms of unemployment, stagnant output and low demand
that may result as was the case in Argenina.
In sum the limits on the
ability of the authorities to extend domestic credit by currency
boards may be good for preventing inflation, but it can be bad for
bank stability.
(iv) Single Currency Peg
In this case, the local
currency may be pegged to that of a dominant trading partner. But
most pegging countries tend to peg to the U.S dollar.
Pegging to a single currency may yield a number of advantages:
Reduction in exchange rate
fluctuation between the focus country and the
country to which it is pegged. This facilitates trade and capital
flows between the two countries.
- Confidence in the
developing country’s currency may be enhanced if the
country whose currency is being used for the peg is regarded as
following
economic policies conducive to stable prices and the pegging
country also
follows polices which will maintain stable prices.
Drawbacks of a single
currency peg.
Where the local currency is
pegged to a floating currency, e.g the US dollar,
the local currency will float along with the dollar vis-a-vis
other currencies. Movements in the exchange rate in relation to
the currencies of the other
countries may interfere with domestic policy (Macroeconomic)
objectives.
(v) Pegging to a Basket of Currencies
In an attempt to stabilize
its effective exchange rate, the developing
country may peg its currency to a basket of currencies of major
trading or financial partners.
There is no commitment to
keep the exchange rate irrevocably fixed. The exchange rate may
fluctuate within narrow margins of less than
-1 per cent around a central rate.
Advantages
- The country that pegs to a
basket may be able to avoid large fluctuations in its
exchange rate with respect to several trading partners’
currencies. As a result, it
is able to stabilize its nominal effective exchange rate.
- The system results in the
reduction of price instability which arises from
exchange rate changes.
Some Disadvantages
Technical difficulties of
implementing a peg which would in general change on
a daily basis vis-a-vis all of the industrial countries (Barth,
1992: 38).
The determination of the exchange rate without reference to the
domestic
policies of the pegging authorities is a notable limitation.
(vi) Crawling Peg/Crawling
Band or Target Zone
Crawling peg is a middle
course exchange rate arrangement between fixed and flexible
exchange rates. It is appropriate for countries that have
significant inflation compared with their trading partners, as had
often been
the case in Latin America.
The monetary authorities fix
the exchange rate on any day but periodically adjusts it in small
amounts at a fixed rate or in response to changes in selective
quantitative indicators such as past inflation differentials
vis-a-vis
major trading partners.
Advantage of this type of
peg is that it combines the flexibility needed to
accommodate different trends in inflation rates between countries
while
maintaining relative certainty about future exchange rates
relevant to
exporters and importers.
One disadvantage is that the
crawling peg leaves the currency open to
speculative attack because the government is committed on any one
day or
over a period to a particular value of the exchange rate.
Another is that maintaining
a crawling peg imposes constraints on
monetary policy in a manner similar to a fixed exchange peg
system.
Exchange rates can, however,
operate within crawling bands. In this case,
the currency is maintained within certain fluctuation margins of
at least ± 1
per cent around a central rate.
The degree of exchange rate
flexibility is a function of the band width.
Bands are either symmetric around a crawling central parity or
widen gradually with an asymmetric choice of the crawl of upper
and lower bands (there may be no pre-announced central rate in the
latter case).
In the context of the band framework, the crawling peg becomes the
crawling band or target zone. This has three features:
A wide band (1 5% or even
more) geared towards fulfilling three purposes
(Williamson, 1999); recognize the impossibility of precisely
estimating the
"fundamental equilibrium exchange rate"; allow some room for
contra-cyclical policy, and give scope to market forces.
- The band (and its centre,
the parity) is defined as to keep the effective exchange rate
roughly constant even in the face of fluctuations in third
currency exchange rates.
- The parity (and,
therefore, the band) should crawl in a way that will avoid the
emergence of any substantial misalignment, requiring the
offsetting of any inflation differential, allowance for any
productivity bias, and adjustment to
any real shocks.
The target zone allows for
flexibility among a country’s policy
objectives. It is also said to prevent extreme movements in the
exchange rate.
Chile, Columbia, Israel,
Russia and Indonesia have, at one time or the other used the
regime.
Pre-Requisites For Adopting Firmly Fixed Exchange Rate Regimes
Satisfaction of optimum
currency criteria. This means that small countries are better
candidates than large countries. Also, pegging to a country
subject to very asymmetric real shocks is likely to create
problems.
The bulk of the trade of the
country adopting the peg takes place with the country or countries
to whose currencies it plans to peg.
Preferences about inflation
of the pegging country must be broadly similar to those of the
country to which it plans to peg.
Flexible labour markets are
crucial. This is because with the exchange rate fixed, nominal
wages and prices must adjust in response to an adverse shock.
As a hard peg prevents the
central bank from serving as a lender of last resort to domestic
banks, strong, well-capitalized and well- regulated banks are
indispensable.
For countries with weak
central banks and chaotic fiscal institutions, hard pegs are very
necessary. But in opting for a hard peg, the government must
adhere to its own set of rules governing monetary policy. Laws
cannot be changed by Hat.
In practice, problems arise
when the pegging countries are unable to abide by the rules. This
suggests that if a country chooses to peg it must do it properly.
This means one of two things:
Implementing an unambiguous
rule that is ruthlessly followed, such as a currency board (in
Hong-Kong) but this may entail huge costs arising from internal
price deflation in the absence of the devaluation instrument; or
Adopting a sufficiently
sophisticated management regime to allow adaptation to the
pressures of capital mobility.
2.2 Floating Exchange Rate
Regimes
A freely floating exchange
rate system or flexible exchange rate system is one in which the
exchange rate, at any time, is determined by the interaction of
the market forces of supply of and demand for foreign exchange.
The authorities thrust the market to manage the
exchange rate.
The basic case for flexible
exchange rates is that if prices move slowly, it is faster and
less costly to move the nominal exchange rate in response to a
shock that requires an adjustment in the real exchange rate.
The alternative is to wait
until excess demand in the goods and labour markets pushes nominal
goods prices down. That process is likely to be painful and
protracted.
The degree of flexibility of
the exchange rate depends on the nature of government intervention
in which event a clean float or managed float can result.
A clean float or independent
float results where the government does not intervene in exchange
rate determination to establish its level.
A managed float results
where the government intervenes in the foreign exchange market in
order to manipulate the exchange rate to a desired rate because
(he authorities have views about where the exchange rate ought to
be or not.
However, the monetary
authority may also attempt to influence the exchange rate without
having a specific exchange rate path or target.
The government worries if
the exchange rate depreciates a lot or appreciates so
much as to threaten trade competitiveness and so intervenes
directly or indirectly.
Indicators for managing the
rate arc broadly judgmental (i.c balance of payment position,
international reserves, parallel market development), and
adjustments may not be automatic.
The managed float
approximates what obtains in reality and has become quite common
in recent years. The clean float is academic as it does not exist
in the real world. Even the industrialized
countries practice floating with different degrees of government
intervention.
As at June, 2004, 48
countries operated managed floating with no pre-determined path
for the exchange rate while 36 operated
independently floating systems. The latter could actually fall
under "managed float" criteria.
As today managed floating is
probably the appropriate description of
the exchange rate regimes of many developing and emerging market
economies in Asia, Latin America and Africa.
The series of currency
crises in Latin America and Asia in the 1990s provided strong
support for the movement toward a flexible
exchange rate regime. Specifically:
There is the argument that
fixed or defacto fixed exchange rates in those crisis
countries produced moral hazard in exchange rates and induced
excessive
capital inflows to those countries. Where the fixed exchange rate
regime had
credibility, it tended to generate implicit guarantee by
increasing unhedged currency borrowing and promoted more
short-term capital flows. A flexible
exchange rate system tends to check this.
A flexible exchange rate
regime allowed large adverse shocks to be more easily absorbed
than a pegged exchange rate system and hence less likely to
provoke currency crisis. The fixed exchange rate policies followed
by some of
the East Asian countries were partly held responsible for their
crises in 1977 -
78. Accordingly, emerging market economies have been encouraged to
adopt a
floating exchange rate regime instead of the pegged exchange rate
systems
which are inherently prone to crisis.
A country has the freedom to
pursue independent monetary policy unlike under
the fixed exchange rate system.
A flexible exchange rate
regime allows exchange rates to move in response to
market forces.
However, some concerns have
been expressed about the adoption of floating exchange rate by
developing and emerging market
countries.
That repeated depreciations
only cause inflation without real effects. However
exchange rate flexibility, if properly managed, can be
stabilizing.
Increased variability in exchange rates may have adverse
consequences for
capital inflows, particularly if foreign investors also are
concerned that
exchange rate flexibility may reduce a country’s willingness to
follow restrained domestic monetary policies.
Where massive capital
inflows occur in a country due to enabling domestic
factors, an irrational swing in the foreign investors’ perception
may exacerbate
misalignment of exchange rates from economic fundamentals.
Short-term volatility and mid-or long-term misalignment in the
exchange rates can hamper
the viability of flexible exchange rates in developing countries.
’the adoption of a flexible exchange rate regime reduces exchange
rate hazard
by removing implicit guarantees. But floating may reduce unhedged
borrowing
by simply reducing foreign capital inflows, leading to less
investment and
economic growth.
The issue of nominal anchor
in a floating regime is important. If the country
choses a flexible exchange rate regime, an appropriate nominal
anchor for the
economy is to be chosen except the exchange rate. But where the
country does
not have a long history of consistent macroeconomic polices, the
credibility of
such policies remain questionable in the market. Where there is no
credible
policy objective, market dynamics exacerbate misalignments and/or
short-term
volatility of exchange rates (Chung and Yang, 2000: 25). Finally,
under a floating regime the presence of foreign debt may
contribute to
financial fragility.
For success, though, a
flexible exchange rate system requires complementary policies
which can take different forms: counter-
cyclical fiscal policy, prudential regulation, capital controls,
etc.
Weak banks can be a main
constraint for monetary and exchange rate policy.
Policy can be used freely only when banks are reasonably healthy.
Then, the
fear that interest rate or exchange rate fluctuations will bring
the banking system down will be limited. So, there is need for
prudential regulation of the
financial system against the background of cautious financial
liberalization.
The experiences of Mexico
and East Asian countries during their financial crises in the
1990s illustrate the risk of open capital accounts in the face of
less
flexible exchange rates. Short-term debt proved to be dangerous in
the case of
Mexico and proved to be risky in the case of East Asia. Thus, a
policy which
discourages short-term debt may be required. This may take the
form of
prudential capital controls as used by Chile and Colombia in the
1990s. In this
regard, taxes on capital inflows where the tax rate is in inverse
proportion to
the maturity of the inflow was used. The restrictions affected the
maturity
composition of the flows.
Pro-cyclical fiscal policies
are the inevitable consequence of weak and deficit-
prone fiscal institutions. But where the country’s budgetary
institutions are
weak, fiscal policy becomes an unhelpful counter cyclical policy
tool. And
where monetary policy is also not available, two options are
suggestive:
reduction of the levels of
public indebtedness and reforming the fiscal
institutions to make spending less cyclical and repayment more
likely.
Considering that a free
floating exchange rate may be highly volatile
with many consequences, managed floats, in combination with
prudential capital controls, can do much to prevent large swings
in capital flows, thus making an important contribution to
macroeconomic stability.
- Given that managed floats
may be vulnerable to large accumulations of short-term external
investment (UNCTAD, 1998), it is necessary to introduce
occasional flexibility by widening the exchange rate band. This
could eliminate
one-way bets and discourage arbitrage outflows.
Finally, in a managed float,
the authorities should be able to
intervene if the exchange rate "strays too far" from the perceived
medium-term equilibrium.
3.0 CONSIDERATIONS IN THE
CHOICE OF EXCHANGE RATE
REGIME
Insights from the
theoretical literature indicate that the choice of exchange
rate regime depends on various characteristics of the economy, in
terms of
its stage of development, structure and its institutional
features. Historical
factors also play a role.
The factors range from size
and openness of the economy to type of shocks,
capital mobility and credibility of policy makers.
A few of the factors are
elaborated upon as follows:
i. Openness
It has been argued that the
more open an economy, the stronger the case
is for fixing the exchange rate, since the potential costs to an
economy
increase where frequent changes to the exchange rate are required.
In the context of the theory
of optimum currency areas, fixed exchange
rates have been recommended for small open economies wide open to
international trade.
The country can peg to the
exchanger rate of a much larger trading partner.
If it does so, its economic structures would need to be aligned
with those of
the anchor area and its labour market should be flexible.
However, the more open an
economy is, the more vulnerable it is to
external shocks. In this case, frequent adjustments to the
exchanger rate
are necessary to mitigate foreign shocks.
’thus, the degree of
openness does not provide unambiguous answers for
the choice of exchange rate regime.
