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Re-visiting Exchange Rate Regimes

Raj Nallari's picture

The choice of exchange rate regimes by governments has evolved since the 1990s. In the early 1990s, as transition economies joined the world economy, they pegged to the Deutsche Mark, while the East Asian countries were pegged to the US dollar. The Mexican crisis of 1995, The East Asian crisis of 1997-98, the Russian Ruble crisis and the collapse of Long Term Capital Management both in 1998 revealed that the capital account crises in these countries was the result of a sudden stop or reversal in capital inflows. This brought about the vulnerability of countries with fixed exchange rate regimes.

By 1999, the re-thinking was hard pegs such as the currency board in Argentina (where peso was pegged to US dollar in a one to one basis) or a monetary union were better suited netter for exhibit commitment and discipline among some countries where credibility was historically low. At the other extreme, Asian countries where the macroeconomic fundamentals were strong both before and after the 1997 Crisis, were advised to move to a freely floating exchange rate regimes as the world became more and more integrated into a global economy. So in practice a bipolar exchange rate arrangement was in place in the developing world.

Calvo and Reinhart showed that emerging economies are in fear of floating and de facto maintain a 'managed float.' The fear arises from the fact the when the value of local currency declines significantly the government is worried about imported inflation and balance sheet effects of foreign currency borrowing (both by private and public sectors) as the costs of debt service go up. On the other hand, when the value of local currency rises there is a loss of competitiveness and hence lowers growth.

Countries were therefore preferring an intermediate exchange rate regimes (where the exchange rate was relatively rigid but not pegged to a single currency). Central banks are now cognizant that a fixed exchange rate regime brings in benefits in terms of low inflation, lower nominal and real exchange rate volatility and more prone to over-valuation (as currency depreciation is politically sensitive and takes months for government to announce a new depreciated rate), and this over-valuation erodes competitiveness and likely lowers growth. On the other hand, full floating regimes while avoiding over-valuation do not yield lower inflation or reduce exchange rate volatility. Growth performance is shown to be best under intermediate exchange rate regimes as it avoids too much over-valuation.

Eastern European countries with an intermediate arrangement with Euro enjoyed strong growth in the years leading up to the present crisis, but they did build up large external imbalances and were vulnerable to the crisis and they did not have fiscal room to take counter-cyclical macroeconomic policies.

What is happening since the global crisis of 2008?

At the time of the crisis of 2008, most large developing countries were on a more flexible exchange rate regime. Local currencies depreciated sharply during August-October 2008, but on average the depreciation was in the range of 8-10%. But Brazil, Chile, Colombia, Hungary, Mexico, Poland, Turkey and South Africa had much larger depreciations in the initial months of the crisis. Some central banks intervened heavily to slow down this depreciation and lost large reserves in doing so. The immediate response by countries during those 3 months was that developing countries appeared to be targeting policy more to address domestic conditions rather than to defend exchange rate levels. Interest rates were increased during the early months of the crisis but when compared with other emerging market crises of previous decades…

Since the early months of the crisis, expansionary fiscal policy and monetary easing in 40+ countries have been put in place to avert a serious economic downturn. This will put additional pressure on specific currencies to depreciate against the US dollar and other major currencies.

For almost a decade, international economic observers have advised governments that the world needs a major adjustment. Sustained global growth requires that the U.S. cut back on its domestic demand and let the dollar depreciate to increase net exports, which will enable the U.S. to improve its current account balances. Conversely, China and other Asian countries should stimulate domestic demand and let their exchange rates appreciate. This would rebalance aggregate demand from the U.S. and towards China, which would help sustain a global recovery. If this rebalancing does not happen quickly, global growth may be flat.

With the U.S. at the epicenter of the financial crisis, countries such as BRICs and oil producers with large foreign exchange reserves primarily in U.S. dollars began to worry about the efficacy of the dollar as the main reserve currency. Barry Eichengreen (2009) points out that the US dollar is still widely used around the world and that in the recent crisis, the power brokers around the world fled to safety in the US dollar and US safe haven when they had an opportunity to move to the Euro, Yen or Yuan. While the Euro is a major challenger to the US dollar as the world’s currency, it is still widely used only in Eurozone countries. The Yen is still more limited in its use around the world. The Yuan is hampered by China’s closed capital account. Therefore, the Euro and Yen may find it hard to dislodge the dollar as the reserve currency. The rising US public debt reaching unsustainable levels however is putting a lot of pressure on the US dollar as the world’s currency. The worst case scenario will come to fruition if surplus countries such as China, Japan and South Korea move away from dollar-denominated Treasuries in favor of accumulation of gold or alternative currencies. For example, some of the BRICs met in Russia in early 2009 to think about pushing the International Monetary Fund to make the Special Drawing Right (SDR) a reserve currency.

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