Exchange rate policies suitable for developing countries

Exchange rate is one of the central factors that influence the monetary policies in developing countries. A country can choose to make use of a fixed exchange rate (Single or Multi-currency peg), intermediate regime like (Adjustable or Crawling peg) or adopt a flexible exchange rate depending upon the supply rate of money and her monetary self-sufficiency. In any developing country where institutions are weak, the exchange rates are generally determined by relaying in comparative measures with currencies from other sound economies. In this essay attempt is, to look at the options available to developing countries in deciding what exchange policy might be most suitable for them .The effects of adopting dollarization or currency unions in developing countries will also be examined. “According to the IMF approximately 85% of developing countries had fixed exchange-rate arrangements” [1] before the collapse of Bretton Woods fixed system. A sharp shift of exchange rate systems was observed when fixed exchange rate system collapsed in 1970.

The purposes of an exchange regimes is to have a sustainable current account deficit, trade competitiveness, keeping inflation in check, to have high employment and achieve microeconomic efficiency in resources to maximize income levels. But empirical observations reveal that there are many trade-offs between these objectives.

Floating exchange rate is where the government do not have an exchange rate target. It allows the economy to pursue an independent monetary policy strategy such as inflation targeting and the market determines the exchange rate level. The regime helps to facilitate real adjustment. Exchange rate movement provides a buffer against real shocks that may arise from adverse terms of trade development for developing countries. There are two types of floating rates – an independent float and lightly managed float available for consideration.

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The difference between the two exchange rates is that independent float its operated freely with no intervention from the monetary authority and the exchange rate will determine the supply and demand but in lightly managed exchange rate system their will be occasional intervention direct and indirect from the monetary policy to moderate excessive fluctuation. In recent year’s many developing countries have adopted market determine floating system. They include Uganda in mid 1982, Uruguay in late 1982 that was followed by Dominican Republic in 1985. As “Friedman argued in the early 1950s,if prices move slowly, it is both faster and less costly to move the nominal exchange rate in response to a shock that requires an adjustment in the real exchange rate” [2] 

There is also an argument against floating exchange rate policy for developing countries “know as fear of floating as labeled by Calvo and Reinhart (2002)” [3] . It is argued that floating exchange causes rapid movement often undesirable, in real exchange rates. Inflation targeting under floating system is problematic given the fiscal dominance and weak financial system in developing countries. For example “Brazil faced problems in inflation targeting under floating exchange policy due to the volatility nature in exchange rate brought as effected by external shock and expectation’s. Its currency in 1999 depreciated from R$ 1.20 to R$ 2.06” [4] Other examples are of “Indonesia and Thailand that displayed considerable instability in the 1970s and 1980s. The huge fluctuation caused by volatility of the nominal exchange rates, which in turn may be caused by the increased volatility of capital flows.” [5] As the diagram shows below [6] : –

www.fondad.org/uploaded/…%20Imbalances/Fondad-imbalances-Part3.pdf

Fixed exchange rate policy is another policy where central banks will protect exchange rate. In this case, policy maker will allow value of currency to move within certain band limit with reference to other country or basket of currency, that is usually their leading trading partner. It is seen as an anchor against inflation that is important for a developing country that have tendency to hyper inflate. Furthermore if nominal shocks prevail in an economy, fixed exchange rate regime can accommodate money demand or supply shocks while minimising output volatility in a country. That helps to bring a more stable environment for international trade and also benefits from investment due to absence of a currency risk premium. For example China operates

under a fixed exchange rate regime and has benefited from the competitiveness that its goods have, due to its currency being undervalued and not being allowed to appreciate. It resulted in an increase of foreign exchange reserves to $514.54 billion for China.

The drawback from a fixed exchange rate is that central bank will lose last resort lending power. Central bank lending activities will only be effective if the backing of a credible institutional setting is available. Therefore, even if adopting a regime that allows the central bank to print money, a non-credible banking rescue operation is likely to trigger inflationary expectations and increase the probability of observing a devaluing currency. This is due to exhaustion of reserves and collapse of the fixed exchange rate system implying a big political cost for the policy makers as evident by Bretton Wood fixed exchange rate system collapse in 1970.

Given the problems of both fixed and floating exchange rate systems countries have tried to adopt various intermediate regimes in an effort to combine the advantages of the two systems. It is where country can either use adjustable peg system or crawling peg regime that both defend the peg. But the only difference is that under adjustable peg monetary policy can alter the exchange rate and crawling peg reserves the right to change the peg in steps, which are small but discretionary in size and timing. The pegs allow country to maintain stability and competitiveness. On the basis to reduce inflation by moderating inflation, a problem faced by many developing countries. As ” Williamson (2000) has argued that such “intermediate” regimes could, in principle,

allow countries to reap the benefits of fixed and flexible regimes without incurring some of their costs.” [7] 

This intermediate regime also faces problems such as currency crisis if the country is open to international capital markets and is seen to encourage foreign debt. For example “Argentina and Chile who implemented crawling peg regime in mid 1960s to deal with high inflation, managed to relax the balance of payment constraint and experienced acceleration in economic growth” [8] . There are also adverse effects related to crawling pegs regime in the form of inflation as evident in “Argentina that saw inflation around 30% per year and Colombia who’s inflation around 5-10% before crawling pegs to 25% after crawling pegs was implemented by the late 1970s and early 1980s” [9] . This would impact country growth as “Khan and Senhadji estimated that inflation’s negative impact on growth in for developing economies that seems to happen for inflation rates exceeding 11-12%” [10] 

Countries with macro economic instability can adopt alternative currency such as dollar known as Dollarization. The adopting of dollarization will help bring credibility to the country’s financial system, remove currency risk, eliminate currency mismatching and stop exchange rate attacks due to mismatching currency that causes adverse balance sheet affects of large devaluation. Countries have options where they can adopt a Full Dollarization system that would mean country would surrender its ability to issue currency like Panama and Ecuador in 2000. They can also adopt a

Partial Dollarization if a country is suffering from high inflation and there is a history of economic instability like “Bolivia, Peru and Uruguay in 1980” [11] . In circumstances where there are monetary weaknesses, instability and loss of confidence, Investors would be reluctant to invest in that economy, as they would like to hold safer assets. Dollar is more dominant and creditable as U.S Federal Reserve backs it. Therefore removing speculations or hedging against currency is not possible. Dollarization attracts Foreign Currency Deposits that stops any reverse capital flights. “Thus by adopting the currency of a credible economy, a country is effectively tackling the inflation bias problem studied by Barro and Gordon (1983)” [12] . For example “Ecuador contracted -7.3% in 1999, saw its economy grow by 2.3% in 2000, the year dollarization occurred and 5.6% in 2001” [13] . The costs of dollarization are, the loss of independent monetary policy, lack of a lender of last resort (and thus the need for additional dollar assets), and the loss of seignior age.

Currency union is similar to dollarization with minor difference, as some countries keep their own currency. Members of currency union surrender their monetary independence for significant trade increase and stable exchange rates. Countries benefit at a micro level due to sharing of currency. That brings a deeper integration of financial sector, as they are sharing single money like those operating under the Franc Zone in Central African Economic and Monetary Community (CEMAC) and West African Economic and Monetary Union (UEMOA).

Research indicates that there is no clear choice on what exchange rate regime works best for developing countries. As one exchange rate might be beneficial for one country but could be problematic for another. It is because all countries have different policy objectives and different economic environment. “As important consensus on the choice of exchange rate regimes is that no single exchange rate regime is best for all countries or at all times (Frankel 1999, Mussa 2000)” [14] . Exchange rate policy has its benefits like it absorb adverse shocks, brings credibility, ease currency attacks by adopting alternative currency and currency unions that increase trade. But there are tradeoffs when country joins an exchange rate policy, such as losing monetary independence. Furthermore the country would need to look at whether it has adequate financial system in place to deal with shocks. The choice of policy would be determined by what macroeconomic factors are given more weight.

Words: – 1592

Refrences: –

Books

Micheal G. Hall, (2005), New Developments of The Exchange Rate Regimes In Developing Countries, The Political Role of The Banking Sector, P87

Subrata Ghatak, José Roberto Sánchez-Fung, (2007), Monetary Economics In Developing, 3rd Edition, Palgrave Macmillan, P139, P176, P192,

Internet

www.worldbank.org/afr/wps/wp16.pdf

www.carnegie-rochester.rochester.edu/April04-pdfs/regimes_cr.pdf

www.fondad.org/uploaded/…%20Imbalances/Fondad-imbalances-Part3.pdf

ideas.repec.org/a/aea/aecrev/v90y2000i2p71-75.html

ideas.repec.org/p/unc/g24pap/5.html

http://www.mindspring.com/~tbgray/dollar.htm

Journals

Anoop Singh, Agnès Belaisch, Charles Collyns, Paula De Masi, Reva Krieger, Guy Meredith, and Robert Rennhack, (2005), Stabilization and Reform in Latin America A Macroeconomic Perspective on the Experience Since the Early 1990s, P80