Fixed exchange rates

While many countries afflicted by financial crisis in the past decade have subse-quently adopted floating rates, the increased volatility associated with such regimes has become a source of concern. As a result, there now appears to be a greater interest among developing countries and transition economies in hard pegs and, in a closely integrated global financial system, the existence of many independent currencies is increasingly being called into question (UNCTAD, 2001: 109). In this context, what are the arguments that can be made in favour of fixed exchange rates?

Advantages

If the exchange rates are fixed in a careful way, uncertainty is reduced and

• international trade flourishes. As we have seen in the introduction, this was indeed the experience under the Bretton Woods agreement for the first decade and a half of its operation. Under such a system, monetary discipline is inevitable. If, for example, a government attempts an excessively ambi-tious fiscal expansion, imports are likely to rise, threatening both foreign reserves and, eventually, the exchange rate itself. Fixed exchange rates can thus act as a powerful incentive for fiscal discipline.

Disadvantages

The principal difficulty is that the wrong choice of parities may actually

• create more uncertainty instead of less. In a dynamic world economy, rela-tive prices are constantly shifting. Any regime of fixed exchange rates would thus need to take into account such underlying shifts. Otherwise, a country may eventually find itself in a situation where its exchange rate is either overvalued or undervalued, with negative repercussions on growth.

A key disadvantage is that under fixed exchange rates governments loose a

• key monetary and exchange rate instrument and fiscal policy becomes cor-respondingly more powerful, but at the expense of monetary policy.

Faced with the

accom-• modate external changes, there is the possibility of greater vulnerability to asymmetric shocks.

The first point here is worth elaborating. It is well established that an economy that is fully committed to the free movement of capital (or finds itself unable to control capital movements effectively) cannot both fix its exchange rate (at a given value or within a narrow band) and simultaneously pursue an independent monetary policy.

Eventually, such a country would be forced to abandon one of these objectives.

This was precisely the dilemma in which the Asian countries affected by the cur-rency crises of 1997-98 found themselves. Faced with the destabilizing impact of large-scale capital flows, and not wishing to relinquish control over their domestic economies, the Asian countries and others concerned opted for re-imposing capital controls.⁴

In the previous section, we noted that one of the dangers of adopting flexible exchange rates was the risk of engendering a “deflationary bias” in macroeconomic policy. But it should be stressed that deflationary bias is not peculiar to flexible exchange rate regimes. In a fixed exchange rate regime too, if market pressures gen-erate an exchange rate equilibrium above or below the fixed nominal rate, this must eventually be addressed by the central bank. And if the expectations of currency holders shift toward a de facto depreciated level for the exchange rate, the central bank would have to sell dollars to take local currency out of circulation and restore the market-determined rate to the fixed nominal rate.

This reduction in the money supply causes interest rates to rise and leads to declines in output or income from what they would have been under a floating rate regime.

Macroeconomic policy under a fixed rate regime thus tends to dampen the rate of economic growth and restrict the capability of monetary policy to stimulate growth.

This is the price that must be paid in real-economy terms for the financial stability achieved both in the exchange rate and in the price level. Monetary policy autonomy is lost and the priorities of real-economy objectives are made secondary to finan-cial objectives because of the deflationary pressure on monetary policy of a fixed exchange rate regime (Bradford, 2005:4).

4 Despite its vociferous opposition to capital controls in the past, in post-mortems of the Asian crisis, the IMF in fact conceded that under the circumstances the re-imposition of certain kinds of capital controls was perhaps the lesser of evils. As Director of the IMF Research Department, Kenneth S. Rogoff (2002) acknowledged that:

“There seems to be a good case for keeping an open mind on the issue of capital controls and debt, especially when debating ways to better immunize the global financial system against crises in the twenty-first century.”

As a consequence,

Assignment of Policy Tools to Policy Goals under Floating Exchange Rate (*) and Fixed Exchange Rate (#) Regimes

Price stability Current account

In short, the dilemmas for policymakers can be appreciated by looking at table 3.3.

The point of departure here is an appreciation of Tinbergen’s famous dictum that for economic policy to work, there needs to be at least as many policy instruments as there are policy goals (Tinbergen, 1956). In floating rate regimes, the capital account is assumed to be fully open, i.e. monetary policy has to be assigned to the capital account. Thus, the three macropolicy tools (fiscal, exchange rate and monetary) are assigned to three targets. Growth is, in effect, crowded out of the economic policy choices.

In fixed exchange rate regimes, on the other hand, the independence of monetary policy autonomy is foregone. In addition, the capital account is assumed to be fully open and thus capital controls are removed as an instrument of macropolicy. As a consequence, in the trade-off between assignment to the current account and eco-nomic growth, fiscal policy tends to be assigned to external balance rather than internal growth. The exchange rate becomes an anchor for achieving internal price stability with spillover effects on the external balance.

Under both scenarios then, growth and employment take a back seat to financial and exchange rate stability. How real a concern should such a deflationary bias be for African policymakers? More will be said on this in later chapters of this report.

However, it is worth stressing that a number of studies exist that do indeed point in the direction of a deflationary bias in existing national policies. In their study of the Ghanaian economy, for instance, Epstein and Heintz (2006) critique the current

“financial programming approach” that has been adopted by the government under the tutelage of the IMF. This model has been incorporated into the Poverty Reduc-tion Strategy Papers (PRSP) as well as the HIPC processes. It stresses macro-stability and particularly price stability and a stable exchange rate over the medium term. Yet as Epstein and Heintz (2006:11) note:

The problem with

“A key and troubling implication of this programming approach is that there is no clear set of conditions under which expansionary monetary policies are called for, even in a situation of slow growth and high unem-ployment. Even if both targets are met, programming does not call for expansionary monetary policy. This is largely because there is no explicit operational target for economic growth, employment creation, or poverty reduction. The bias of financial programming is therefore highly contrac-tionary.”

Epstein and Heintz use a vector auto regression (VAR) model of the Ghanaian economy to simulate the scope for a more expansive monetary policy, and conclude that a more expansionary policy would be both feasible and have positive impacts on economic growth without significant negative impacts on inflation. Moreover, their results indicate that interest rate increases can have stagflationary costs, and that increases in GDP growth appear to have minimal effect on inflation. Hence,

“having a narrow focus on controlling inflation by raising interest rates and moderating economic growth in order to contain inflation is not a sensible strategy, especially in light of the significant costs in terms of forgone income and employment in a poor country such as Ghana.”

3.2.3 “Intermediate” regimes

As mentioned earlier, since the crises of the mid-1990s, and especially since the Argentinean crisis of 2001, the policy options open to developing countries are now often portrayed in terms of polar extremes: floating or permanent pegging (mon-etary union). With the breakdown of the Bretton Woods system, large countries like the United States and Japan, for whom the importance of international transactions was still limited, opted to float. For those countries, the uncertainties of a fluctuating exchange rate, while not pleasant, were tolerable. But, as Eichengreen (1996:137) has pointed out: “for smaller, more open economies, especially developing countries with thin financial markets, floating exchange rates were even more volatile and disruptive”

Two basic routes are open to developing countries. One option is to move further in the direction of hardening the exchange rate peg. A few countries in the 1980s and 1990s, namely, Hong Kong, Bermuda, the Cayman Islands, and more recently, Argentina and Estonia, did so by establishing currency boards. The problem with currency boards is that monetary authorities are constrained even more tightly than under the nineteenth-century gold standard from engaging in lender-of-last-resort intervention. As Grabel (2000:9) notes:

“Currency boards epitomize the credibility advantages of rule-based finan-cial policy: in all cases where currency boards have existed, they have

oper-The subsequent

ated in accordance with a strict set of simple, transparent rules. Hence, they possess even less scope for discretion than do independent central bank”.

Currency boards are thus attractive only for countries with special circumstances:

typically they are very small; their banks are closely tied to institutions overseas and hence can expect foreign support; they possess exceptionally underdeveloped financial markets, or they have particularly lurid histories of inflation (Eichengreen, 1996: 139).

The subsequent scale of the macroeconomic disaster for Argentina shows just how dangerous a policy of currency pegging can be. As confidence in the ability of the Argentinean authorities to maintain the peg collapsed in 2001, Argentina’s GDP fell by more than 12 per cent, industrial activity by 18 per cent, and construction by 36 per cent (Garnier, 2003). Some analysts have compared the scale of the economic decline to that of the Great Depression (Palma, 2004). The Argentinean experience provides a salutary lesson in the dangers of a mistaken exchange rate policy.⁵

Events like that experienced by Argentina have led some analysts to challenge the sustainability of all intermediate solutions. Eichengreen (1996: 139), for example, argued that:

“What is clear is that informally pegged or pegged-but-adjustable exchange rates are no longer a feasible option. In most cases, the only alternative to monetary union has become more freely floating rates”

Not all analysts agree with this advice, however. UNCTAD (2001: Chapter V), for instance, argues that an important negative implication of mainstream advice to avoid “intermediate solutions” is that developing countries with similar foreign trade structures and market orientation might end up at opposite ends of the spectrum in terms of exchange rates – some with floating rates and others with fixed exchange rates against the dollar. Given the misalignments and fluctuations that characterize the currency markets, this could be very prejudicial to the long-term prospects for regional integration between such countries.⁶

5 Whether the Argentinean authorities alone were to blame for this is a moot point. Grabel (2000), for exam-ple, notes the extent to which the policy of pegging the Argentinean peso to the dollar was supported by the international financial institutions and, in particular, the IMF. The IMF itself has conceded that the policy was mistaken in this case. As one Fund document notes,

“While the decision to establish and maintain the currency board arrangement was the authori-ties’ and commanded broad popular support, the Fund could have questioned more forcefully the appropriateness of the arrangement and of the associated policy mix…At the very least, the Fund should have insisted on greater prudence regarding the public debt dynamics during the boom years, since the currency board regime ruled out both discretionary monetary policy for stabilization purposes and money financing of the deficit when the government ran into funding difficulties.”

(IMF, 2003:66).

6 UNCTAD (2001:110) cites the case of the bilateral tensions that arose between Brazil and Argentina while the peso was pegged to the dollar.

In the face of increased need to service international debt, the shift towards open trade regimes in Africa was ostensibly made in order to achieve an improved balance of payments and export performance One final dimension that needs considering when evaluating the pros and cons of

flexible exchange rates is the political economy. Macroeconomic policy measures are not politically neutral. Indeed, some policies that may appear to be based on particular grounds, in reality, have a different underlying motivation. For example, in the face of increased need to service international debt, the shift towards open trade regimes in Africa was ostensibly made in order to achieve an improved bal-ance of payments and export performbal-ance. But proponents of these policies, how-ever justifiable on their own merits, must have been aware that these same policies make domestic demand management increasingly difficult. In effect, it took away an important macroeconomic tool (fiscal policy) from national policymakers. As we shall see in the following sections, regional integration is one potential way of regain-ing some of that autonomy.

3.3 From exchange rate regime to monetary