The importance of exchange rate regimes - Essay Example

 The importance of exchange rate regimes Exchange rates are essential indicators in the conduct of international trade and capital flows. However, the way the exchange rate in a country is managed through the exchange rate regime enforced by the government is an essential determinant of how monetary policies will be designed and implemented, ultimately, on how trade and investment flows will behave. This study examines how countries choose on exchange rate regime to employ and how such decisions lead to trade and investment flow performance. The study also seeks to look at how different exchange rate regimes lead to disparity in inflation behavior and economic growth in countries alongside why some regimes fail. Studies show that countries often use the fixed exchange rate system and even “manipulate” free floats to stabilize trade and investment environment. Moreover, studies also show that there is a strong link between fixed exchange rates and low inflation though a weaker link exists between exchange rate regime and output growth. Consequently, the more able countries can carry out their monetary policies in steadying their economic environment, the more they can maintain their trade and investment health. As the twentieth century nears to a close, economies throughout the globe are becoming more open and interrelated. The concept of globalization – that the world is converging into one massive single global economy – is becoming more real and accepted. Because economies are integrated with each other, consumers and investors alike have a vaster array of goods and services to choose from and more investment opportunities to save their wealth in. One of key instruments that primarily facilitate these international activities is the exchange rate. Mishkin (2003) defines the exchange rate as the price of one currency in terms of another (say euros per dollar) and it is in the foreign exchange market that they are determined. In terms of monetary policy (management of money and interest rates), the exchange rate is managed by a country through its exchange rate regime, an organized set of rules through which a nation’s exchange rate is established, especially the way the monetary or other government authorities are or are not involved in the foreign exchange market. These regimes include floating exchange rates, pegged exchange rates, managed float, crawling peg, currency board and exchange controls. It is the manner in which a country manages its currency in vis-à-vis foreign countries and the foreign exchange market. Dornbusch et al. (1999) differentiates the fixed and floating exchange rate regimes through the following: in a fixed exchange rate system, foreign central banks stand ready to buy and sell their currencies at a fixed price in terms of another currency, for example, dollars. From the end of the second world war up to 1973, major countries had fixed exchange rates against one another. Presently, there are still those that use the system while others prefer to use the floating exchange rate. Recent developments include the revaluation of the Chinese yuan in July 2005 in which Chinese monetary authorities decided to allow the currency to gradually “float” against the dollar. By contrast, the central banks allow the exchange rate to adjust to equate the supply and demand for foreign currency in a floating exchange rate system.1 Dornbusch et al. (2003) divides such exchange rate regime into three more subsystems: in a clean floating system, central banks stand aside completely and allow exchange rates to be determined in the foreign exchange markets. Under managed, or dirty floating, central banks intervene to buy and sell foreign currencies in attempts to influence exchange rates. Aside from the floating and fixed exchange rate systems, authorities use other instruments to manage and monitor the exchange rate. Crawling pegs2 are exchange rates that are linked to other currencies and are fractionally changed daily (Vankin n.d.). In this system, the currency is devalued at a rate set in advance and is made known to the public. A currency board, in support to a fixed exchange rate, is an arrangement by which the central bank holds enough foreign currency to back up each unit of the domestic currency (Mankiw 2003)3. Once a central bank has adopted a currency board, it might consider the natural next step: it can abandon the currency altogether and let its country use the US dollar. Such a plan is called dollarization (Mankiw 2003, p. 335).4 Finally, exchange controls involve measures to directly control or influence the in- and outflow of capital over a country’s borders (Bank of Namibia 2005).5 To understand the importance of an exchange rate regime, it is quite helpful to start on the importance of the exchange rate itself. Mishkin (2003) states that exchange rates are important because they affect the relative price of domestic and foreign goods. When a country’s currency appreciates (rises in value relative to other currencies), the country’s goods abroad become more expensive and foreign goods in that country become cheaper (holding domestic prices constant in the two countries). Conversely, when a country’s currency depreciates, its goods abroad become cheaper and foreign goods in that country become more expensive (Miskin 2003, p. 153). Appreciation of a currency can make it harder for domestic manufacturers to sell their goods abroad and can increase competition at home from foreign goods because they cost less. From 1980 to 1985, the appreciating dollar hurt US industries. For instance, the US steel industry was hurt not just because sales of relatively cheap foreign steel in the United States increased. Although the appreciation of the US dollar hurt some domestic businesses, American consumers benefited because foreign goods were less expensive. For instance, Japanese videocassette recorders and cameras and the cost of vacationing in Europe fell in price as a result of the strong dollar (Mishkin 2003, p.155). When foreign central banks want to or have to intervene in the foreign exchange market, they hold reserves.6 The amount of intervention that a central bank has to do in a fixed exchange rate system is measured by the balance of payments.7 Thus, fixed exchange rates operate like any other price support scheme. Given market demand and supply, the price fixer has to make up the excess demand or take up the excess supply. In order to be able to ensure that the price (exchange rate) stays fixed, it is obviously necessary to hold an inventory of foreign currencies, or foreign exchange, that can be provided in exchange for the domestic currency (Dornbusch et al. 1999, p. 269). As long as the central bank has the necessary reserves, it can continue to intervene in the foreign exchange markets to keep the exchange rate constant. However, if the country persistently runs deficits in the balance of payments, the central bank will run out of reserves and intervention will no longer be possible. Before that happens, the central bank is likely to decide that it can no longer peg the exchange rate, it will devalue its currency. For instance, in 1967, the British devalued the pound from $2.80 per pound to $2.40 per pound. That meant it became cheaper for Americans and other foreigners to buy British pounds, and the devaluation thus affected the balance of payments by making British goods relatively cheaper (Dornbusch et al. 1999, p. 269). In January 2002, Argentina announced to devalue its peso. The Argentine peso, which stood at a one-to-one rate with the US dollar was then valued at 1.4 to one US dollar. That meant Argentine soybean farmers to receive 40 percent more for their soybeans than they were a few days ago. In the words of the American Soybean Association (ASA) President Bart Ruth, “..this devaluation-driven increase in prices received by Argentine farmers will provide new incentives for Argentine farmers to plant more soybeans and will cause Argentine soybeans and soybean products to become even more competitive on the global market (American Soybean Association 2002).” 8 Even the choice of countries on how to structure their exchange rate policies, such as choosing between a fixed or a floating exchange rate, involves considering the factors that could affect existing trade agreements. Busse et al. (2004), in their study of how Mercusor9 states have the tendency to choose fixed exchange rates over free floats, states that exchange rate varability could be an impediment to trade because changes in real exchange rates with respect to major trading partners can have significant effects on external trade flows. Studies done by Rose (2000), Rose and van Wincoop (2001) and Taglioni (2002) suggest that there is a positive effect of fixed exchange rates on trade flows. Moreover, stable exchange rates are also important for the sustainability of deep integration as the vulnerability of trade and investment flows to exchange-rate movements grows in line with rising interdependence among partner countries (Busse et al. 2004, p. 5). Another reason to adopt a stable exchange rate is the desire to “import” monetary stability since the lack of credibility in monetary policy leads to higher expected inflation and higher interest rates, which countries might be able to lower by credibly tying their domestic currency to an anchor currency (Busse et al. 2004, p. 6). However, Larrain and Velasco (2001) state that though this view might seem very influential in the 1980s and 1990s such that many Latin American countries were prompted to do so, has recently come under attack. Busse et al. (2004) provides that presently, it is often stressed that fixed rates provide a natural target for speculators whereas flexible rates, at least under nearly full capital mobility, appear less inviting to speculators. Fischer (2001) points out that fixed rates, in the absence of an institutional commitment, are now considered by many observers as inherently vulnerable to attacks. A third reason why a peg to a major currency is pursued is that capital inflows to emerging markets are typically denominated in foreign currencies. For example, in Latin American countries, most of the long-term debt has been issued in US dollar or the euro. With international capital flows and debt denominated in foreign currency, economies suffer strongly when their domestic currencies are devalued or depreciate to those against those in which their debt is denominated as the crises in Mexico and Asia have demonstrated. As a logical consequence, governments have a strong incentive to peg to the currency in which they are indebted. In economies with weak currencies, the private sector often begins to hold and use foreign currency in transaction as well (Busse et al. 2004, p. 7). An example that illustrates this point is the operation of financial dollarization in many countries. Ghosh and his colleagues (1997) studied if exchange rate regimes matter for inflation and growth.10 According to the study, there is indeed a strong link between fixed exchange rates and low inflation. This results from a discipline effect (the political costs of abandoning the peg induce tighter policies) and a confidence effect (greater confidence leads to a greater willingness to hold domestic currency rather than goods or foreign currencies). In part, low inflation is associated with fixed exchange rates because countries with low inflation are better able to maintain an exchange rate peg. But there is also evidence of causality in the other direction: countries that choose fixed exchange rates achieve lower inflation (Ghosh et al. 1997). There is also a link, albeit weaker, between the exchange rate regime and the growth of output. To the extent that fixing the exchange rate engenders greater policy confidence, it can foster higher investment. Conversely, a fixed rate, if set at the "wrong" level, can result in a misallocation of resources. Countries that maintained pegged exchange rates did indeed have higher investment. But productivity grew more slowly than in countries with floating exchange rates. Overall, per capita growth was slightly lower in countries with pegged exchange rates (Ghosh et al. 1997) . So the question is, is the fixed system of exchange rates better than the free-floats? Apparently not. Mankiw (2003) cites that a system of floating exchange rates leaves monetary policy makers free to pursue other goals, such as stabilizing employment or prices. The Inter-American Development Bank (1996) states that the desirability of fixed exchange rates must rest upon a reasonable expectation that the regime will be robust enough to withstand the major shocks to which it will be eventually subjected. For example, a forceful fiscal response is needed to protect a fixed exchange rate system after a sudden reduction in capital flows. The sustainability of fixed exchange rates also depends upon the strength of the domestic financial system. As the Argentine example indicates, the adjustment to a reduction of capital flows under fixed exchange rates involves a potentially sharp monetary contraction, which means both high interest rates and a cutback in credit extended to domestic borrowers. Under these circumstances, borrowers may experience difficulties in servicing their debts, and unless the banking system is robust, a highly disruptive banking crisis may emerge (Inter-American Development Bank 1996, p. 31). Bordo and Schwartz (1997), in their survey of historical episodes of currency crises in the past two centuries, suggests seven lessons, three of which are the following11: (1) currency crises occur when internal economic conditions are incompatible with the external conditions set for the currency; (2) the recent currency crises in Chile and Mexico represent clear examples of inconsistency between domestic priorities and the demands of adherence to their parities; (3) the theory of self-fulfilling speculative attacks may have intellectual merit but contributes nothing to our understanding of real world events. In every crisis examined in the survey, the fundamentals are more than adequate to account for the actions of the speculators (Bordo and Schwartz 1997). Edwards (2000), on the other hand, provides an explanation on the relationship between exchange rate regimes, capital flows and currency crises in emerging economies. Edward’s paper draws on lessons learned during the 1990s, and deals with some of the most important policy controversies that emerged after Mexican, Asian, Russian and Brazilian crises. Two of these exchange rate lessons from the 1990s currency crises can be summarized into the following12: Nominal Anchors and Exchange Rates. In the late 1980s and early 1990s, and after a period of relative disfavor, rigid nominal exchange rates made a comeback in policy and academic circles. Based on time-consistency and political economy arguments, a number of authors argued that fixed, or predetermined, nominal exchange rates provided an effective device for guiding a disinflation program, and for maintaining macroeconomic stability. However, a recurrent problem with exchange rate-based stabilization programs – and one that was not fully anticipated by its supporters —was that inflation tended to have a considerable degree of inertia. That is, in most episodes domestic prices and wages continued to increase even after the nominal exchange rate had been fixed (Edwards 2000, p.3). Inflationary persistence in the presence of a fixed – or predetermined – nominal exchange rate will result in a real exchange rate appreciation, and consequently in a decline in exports’ competitiveness (Edwards 2000, p.4). Real Exchange Rate Overvaluation. The currency crises of the 1990s underscored the need of avoiding overvalued exchange rates—that is, real exchange rates that are incompatible with maintaining sustainable external accounts (Edwards 2000, p.5). The option of exchange rate regimes entails numerous factors to consider, all of which are crucial to the health of investment and trade flows in different economies. The decisions regarding the regimes to be implemented should be backed by strong fiscal capacity to implement them if the regime is expected to be successful in carrying out its purpose. Ultimately, these decisions will then translate into the macroeconomic level such as inflation and economic growth. Finally, lessons from different currency crises help us to identify the reasons why such regimes fail to fulfill their intended goals for the economy. Rojas-Suárez and Weisbrod (1996) state that in countries where public support for the exchange rate system is less strong, the fiscal response to capital account shocks may not be forthcoming, and the system is unlikely to survive a major shock. References ‘ASA Emphasizes Importance of Maintaining $5.26 Soybean Loan Rate to Help Offset Effects of Currency Devaluations in Argentina & Brazil’ 2002, American Soybean Association, 7 January 2002. Retrieved 26 November 2005 from: http://www.soygrowers.com/ newsroom /releases/2002%20releases/r010702.htm Bank of Namibia, 2005. Exchange Controls. Retrieved 27 November 2005 from: http://www.bon.com.na/content/excon/ Bordo, M and Schwartz, A 1997, ‘Why Clashes between Internal and External Stability Goals End in Currency Crises, 1797-1994,’ The Collapse of Exchange Rate Regimes Causes, Consequences, and Policy Responses, vol. 7, supplement 1, pp. 464-465. Retrieved 28 November 2005 from:http://books.google.com.ph/books?ie=UTF-8&hl=en&id=JKnD3wrpcgYC&dq=reasons+for+crises+in+exchange+rate+regimes&prev=http://www.google.com.ph/search%3Fhl%3Den%26q%3Dreasons%2Bfor%2Bcrises%2Bin%2Bexchange%2Brate%2Bregimes%26meta%3D&lpg=PA34&pg=PA35&sig=4GW3XUtOxvZ54utVMYxeoRAwOg0 Busse, M, Hefeker, C, Koopman, G 2004, Between Two Poles: Matching Trade and Exchange Rate Regimes in Mercosur, HWWA Discussion Paper 301, pp. 3-8. Retrieved 28 November 2005 from http://www.hwwa.de /Forschung/Publikationen /Discussion_Paper /2004/301 .pdf. Dornbusch, R, Fischer, S, Startz, R 2001, Macroeconomics, 8th edn, McGraw-Hill Higher Education, New York Edwards, S 2000, Exchange Rate Regimes, Capital Flows, and Crisis Prevention, Retrieved 28 November 2005 from: http://www.anderson.ucla.edu/faculty/sebastian.edwards/ woodstock_edwards.pdf. Europa, 2005. The EU’s Relation with Mercosur. Retrieved 28 November 2005 Available from:http://europa.eu.int/comm/external_relations/mercosur/intro/ Federal Reserve Bank of St. Louis, 2005, China/US Foreign Exchange Rate. Retrieved 26 November 2005 from:http://research.stlouisfed.org/fred2/series/DEXCHUS/15 Ghosh, A, Ostry, J, Gulde A M, Wolf, H 1997, Does the Exchange Rate Regime Matter for Inflation and Growth? Retrieved 28 November 2005, from http://www.imf.org /external /pubs/ft/issues 2/#Regime Mankiw, G 2003, Macroeconomics, Worth Publishers, United States of America. Mishkin, F 2003, The Economics of Money, Banking and Financial Markets, 6th edn update, Addison-Wesley, United States of America. Rojas-Suárez, L and Weisbrod S, 1996, ‘Achieving Stability in Latin American Financial Markets in the Presence of Volatile Capital Flows’, Volatile Capital Flows Taming Their Impact on Latin America, Inter-American Development Bank, Washington, D.C., Retrieved 28 November 2005 from Inter-American Development BankE-books:http://books.google.com.ph/books?ie=UTF-8&hl=en&id= zuWOvMSg1hMC&dq=importance+of+exchange+rate+regime+to+investment&prev=http://www.google.com.ph/search%3Fhl%3Den%26q%3Dimportance%2Bof%2Bexchange%2Brate%2Bregime%2Bto%2Binvestment%26meta%3D&pg=PR2&printsec=3&lpg=PR2&sig=N1LSpwKjgE-4jcgCp2Povja976A Trading-Glossary, 2005. Crawling Peg. Retrieved 27 November 2005 from: http://www.trading-glossary.com/c0532.asp Vankin, S PhD, n.d., How do Countries Devalue their Currencies? 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