Exchange Rate Policy

Introduction

 Till the 1990s, the reserve money creation process predominantly originated from the RBI’s financing of government and the instruments of monetary control were essentially reserve requirements, interest rate controls and direct credit controls. Against the backdrop of tight capital controls, exchange rate policy was governed by the preoccupation of conserving foreign exchange and maintaining India’s competitiveness in international markets. In other words, there was only limited interaction between monetary policy and exchange rate policy. With the gradual relaxation of controls in the domestic financial sector beginning in the early 1990s, there has been move away from reserve requirements, interest rate controls and other direct controls and increasing reliance on market related instruments.

With the gradual opening up of the external sector, and the relaxation of capital account controls, there has been an upsurge of capital inflows. The reliance of government on the RBI credit is now reduced and virtually the entire reserve money is externally generated. The preoccupation of monetary policy is to a large extent on managing capital flows while ensuring monetary and financial stability and meeting the real sector’s requirements for credit. The progressive integration of India into the global economy exposes the real sectors to the vicissitudes of the international economy.

Definition

Policy of government towards the level of the exchange rate of its currency. It may want to influence the exchange rate by using its gold and foreign currency reserves held by its central bank to buy and sell its currency. It can also use interest rates (monetary policy) to alter the value of the currency.
A fall in the exchange rate will mean that the price of imports will rise while exporters can choose either to lower prices for their buyers or leave them the same and increase their profit margins. As a result, domestic producers should become more internationally competitive. Import volumes should fall whilst export volumes should rise. Output at home should rise, leading to higher economic growth and a fall in unemployment. There should be an improvement in the current account of the balance of payments too as the gap between export values and import values improves. However, higher import prices will feed through to a rise in inflation in the economy.

The Exchange Rate System: Some Issues

it is now more than a decade since the world abandoned the system of fixed but adjustable exchange rates which was the center-piece of the old Bretton Woods system. That system collapsed in 1973 with no official agreement on what was to replace it, and the major currencies were set afloat in world currency markets. These arrangements, which at first had no official international sanction, were later legitimized by the Second Amendment to the Articles of Agreement of the IMF in 1978 which allowed members to adopt exchange rate arrangements of their choice.

The new system, which some have called a "non-system", is characterized by a mix of exchange rate arrangements. Major currencies float relatively freely in world currency markets. The countries forming the European Monetary System float as a group against other major currencies and maintain a form of managed floating within adjustable margins against each other, with well defined rules of intervention backed by currency swap arrangements. The developing countries have not resorted to independent floating but have ether pegged their currencies to one of the major currencies or, increasingly to a basket of currencies. Whatever the exchange rate arrangements adopted, all countries face a world in which exchange rates vary considerably and often unpredictably. In the ten years and more that the new system has been in operation, considerable experience has been gained and a degree of consensus has emerged on the functioning of the system and its short-comings. The object of this paper is to review the main elements of this consensus and to identify the outstanding issues in this area which remain on the agenda of international monetary reform.

 

The Experience with Floating Rates

In evaluating the experience with floating rates we must avoid the temptation to lay entirely the blame for the dismal state of the world economy in recent years on the exchange rate system. It is clear that world production and world trade grew much more rapidly under the old Bretton Woods system than they have during the period of floating rates. It is also true that developing countries on the whole have experienced much greater difficulty in almost all dimensions under the new regime. This does not however establish that the exchange rate arrangements were the prime cause of the difference in performance. There is a multitude of factors which affect world trade and production growth, and within that, the prospects and performance of the developing countries. The exchange rate system is an important part of the totality of influences on the functioning of the world economy, but it is not the only influence, and we certainly cannot assume that the world would have been a better place, ceteris paribus. if only the old fixed rate system had remained in place. On the contrary, one of the elements on which there is a wide consensus is the view that structural developments in the international economy in the two decades after Bretton Woods had made the fixed rate system unworkable. It is important to understand the reason why the fixed rate system became infeasible since any recommendation regarding exchange rate arrangements in the future must deal with these structural developments as given.

Infeasibility of Fixed Rates

The proximate cause of the breakdown of the Bretton Woods system was the inability to maintain the fixed dollar price for gold. The United States did not take effective corrective action when the dollar came under increasing pressure in the late sixties, by when the 'dollar shortage" of the fifties had been converted into a "dollar glut". This in turn has been attributed to the fundamental asymmetry in the Bretton Woods institutional arrangements in which there were no effective disciplinary instruments that could be used for surplus countries and the key reserve currency country.

The basic problem arises because the maintenance of external equilibrium with a set of fixed normal exchange rates requires that the major trading countries accept the fixed nominal exchange rates as parametric, and adjust their domestic economic policies to ensure external account viability at these rates This requires a substantial sacrifice of domestic policy objectives to uk requirements of external equilibrium. Assuming that the initial exchange rate structure corresponds to a set of equilibrium real exchange rates, for it is real exchange rate structure through stable nominal rates requires that the tales of inflation in different countries should not diverge. Since difference in economic performance and in the importance attached to different domestic economic objectives, typically reflect themselves in different rates of inflation, the requirement that inflation rates should not diverge imposes an important restriction on domestic economic management. It is a restriction that may prove extremely cumbersome under certain circumstances.

It is in these circumstances that the alternative of delinking domestic economic management from the maintenance of exchange rate stability gained intellectual acceptability. Floating rates enable countries to pursue independent domestic economic policies, making their own choices about the relative importance to be given to conflicting domestic objectives such as employment and price stability, while the requirements of external equilibrium are met by allowing nominal exchange rates to adjust to achieve the required real exchange rate configurations. In its extreme from the delinking argument could be stretched to assert that coordination of policies was simply not necessary. Paul Samuelson, participating in a seminar in late 1978 put it as follows "I have heard people say that we have to have coordinated policies under floating exchange rates. That is what we don't have to have. Germany can fight inflation if it wants to, that is its own business under a properly running floating exchange rate. If the Germans and the Swiss wish to regard us as banana republics; if our political system insists upon making compromises, which it does not insist upon making, it is precisely floating exchange rates — not the automatic gold standard, not the Bretton Woods standard — that makes this possible".

Floating Rates in Practice: Volatility

The actual experience under floating rates has belied expectations that the new system would provide an easy way of insulating domestic policy from external balance considerations. Countries have in fact followed uncoordinated macro-economic policies, but floating has not ensured a reconciliation of these policies with a satisfactory external equilibrium. There is a widespread feeling that currency swings have been excessive, that exchange rates have tended to overshoot and that there have been persistent currency misalignments. In short, there is widespread agreement that the external balance achieved under floating rates docs not constitute”equilibrium" or at any rate not a "satisfactory equilibrium".

At the outset, it is important to recognize that exchange rate stability under floating rates can at best be understood in terms of stability in the real (price adjusted) exchange rates. Once an equilibrium real exchange rate structure, consistent with the basic stance of macro-economic policy, is achieved we can expect that nominal exchange rates will change in response to inflation differentials to maintain the equilibrium real exchange rate. There can be no presumption of stability in nominal exchange rates as long as inflation rates are not the same and they are surely not likely to be the same if the switch to floating rates has been necessitated precisely because macro-economic policy could not be effectively coordinated.

Another extremely important factor that militates against the achievement of "equilibrium" real effective exchange rates in the traditional sense discussed above is the increased importance if not dominance of capital account transactions in the determination of exchange rates. The removal of capital movement restrictions combined with the enormous expansion in the volume of offshore funds held in world financial markets, has meant that capital account transactions among currencies arising from portfolio switches, can dwarf the size of current account transactions and exert a dominant influence on exchange rate movements. The factors which determine these asset choice decisions include the overall macro-economic policies and prospects of different countries, and expectations of changes in these policies. Expectations are necessarily subject to considerable uncertainty. The possibility of random destabilizing movements is further increased because information available on a day to day basis is often of a tenuous kind, yet it can have a substantial effect in terms of the volume of funds moved in the market.

Having established that the operation of a floating rate system is likely to lead to exchange rate instability ,it is necessary to consider whether these phenomena are quantitatively important, and if so, what costs they entail. It is useful in this context to distinguish between volatility and misalignment.

Distinguish between Volatility & Misalignment

Volatility refers simply to fluctuations either from period to period or around some trend level and these fluctuations may be measured either in terms of nominal or real exchange rates. Misalignment refers to divergence of the exchange rate from some notional equilibrium level. Volatility does not necessarily imply misalignment since the exchange rate may be volatile because the equilibrium rate is volatile in which case there is no misalignment as such (although this is unlikely to occur in practice). Misalignment also does not necessarily imply volatility since exchange rates may be relatively stable but persistently misaligned in terms of their equilibrium levels.

Volatility is measured by the average absolute value of day-to-day percentage changes. Figures in brackets are adjusted for the trend factor during the period and thus indicate the degree of "excessive" movements.

This brings us to the question: Does volatility matter? The existence of volatility in the sense of random fluctuations adds to uncertainty in foreign trade transactions. The uncertainty can be reduced by hedging in forward markets but this does not solve the problem. In the first place hedging involves costs and these costs may be measured by the bid-offer spreads in the forward markets. It is interesting to note that these spreads have risen sharply since 1979 itself a reflection of the increase in uncertainty in world exchange markets. Secondly, and this is very important, hedging is possible only over a relatively short period, typically six months and at most a year. While this is adequate for trade payments lags, it is not adequate for longer period contractual payments obligations as for example on debt servicing. At present no effective mechanisms exist to hedge against exchange rate movements over longer periods as many countries may wish to do especially in so far as debt obligations are concerned. Finally developing countries typically do not find it easy to engage in forward market activity so that the effective scope for hedging available to economic agents in developing countries are relative limited.Thus volatility has a cost and the cost has increased as the extent of volatility has increased. The cost is larger for developing countries than for developed countries. For the developed countries the consensus of opinion thus far seems to be that the costs of volatility are on the whole not large enough to have disrupted the level and pattern of trade. For developing countries there is some evidence that volatility in real exchange rates has had adverse effects (Goes 1981 on Brazil and Diaz-Alejandro 1976 on Colombia) but it appears that in these cases the real exchange rate uncertainty arises from erratic pegging practices and not the erratic market movements of a floating rate. This has relevance for the question of how developing countries should manage their exchange rates in a world of floating rates—a point we return to later in this paper.

These are very large magnitudes and it is interesting to note that the misalignments have continued over a fairly prolonged period. There can be no doubt that the would have a quantitatively significant impact on both the level and pattern of world trade. The costs of misalignment are many and varied. They give the wrong price signals leading to misallocation of resources. Because of adjustment costs they involve loss of potential production and employment for the economy since resources cannot in fact move as much as required by misaligned exchange rate. Most dangerous of all they give intellectual respectability to protectionist pressures especially since the industries affected are not only those that should naturally be phased out but also those suffering purely from exchange rate misalignment. William- son makes the important point that while protectionist pressures increase in countries where the currency is overvalued this is not likely to be offset by comparable pressures to liberalise where the currency is undervalued. On the contrary there may be over investment in export or import competing industries on the strength of the undervaluation of the exchange rate which, when the misalignment is removed, will have to be abandoned. In short, sequences of overvaluation and undervaluation may ratchet up the degree of protectionism with clear economic costs

Some other Policy Issues

The above review of the functioning of the floating rate system indicates that the system has not functioned as smoothly as its proponents had expected. Floating rates have certainly not made the world immune from the adverse consequences of uncoordinated micro-economic policies. On the contrary, inappropriate micro-economic policies are often at the root of the serious misalignments that have emerged under the system. These difficulties focus attention on a number of policy issues that are relevant in designing a better exchange rate system. In this section we comment briefly on each of these.

Target Zones

Since fixed exchange rates are infeasible and floating rates have not solved the problems, there has been our understandable search for intermediate solutions and one of these is the concept of "target zones". The term is extensively used but is not always precisely defined. The basic idea seems to be that national authority, instead of taking the view that the exchange rate can settle where it will, should instead declare some sort of commitment of managing the exchange rate so that it stays at or near an equilibrium real effective rate. Instead of the narrow band of permissible variation allowed under the old Bretton Woods system the intention seems to be to allow wider variation and also to have soft margins.6 Since the target zone is in terms of real effective rates, the nominal exchange rate band is expected to be continually adjusted to take account of inflation differentials. The target zone should be published and it should be understood that monetary policy and sterilised intervention would be used to keep the exchange rate within the target zone as far as possible.

It is difficult to be confident about how a system of target zones would work in practice. On the one hand the proposed width of the zone and the existence of the soft margins suggests that a significant degree of instability and misalignment would still arise. However the implicit commitment to manage the exchange rate by using monetary policy and sterilised intervention can be expected to dampen these tendencies. In effect the "target zone" approach could provide mechanical signals from the exchange markets to domestic policy management to counter any excessive departure of exchange rates from fundamental equilibrium. The knowledge that such contracting policy would be triggered would also help to stabilise expectations in currency markets.

An important qualification on the effectiveness of the target zoning is that it is likely to be most effective only when target zones for the major currencies are determined in a mutually consistent manner. The target real effective exchange rates to be pursued by the major countries must be consistent with the patterns of current surpluses and deficits envisaged and there must be confidence that intervention will be symmetrically followed by countries at either end of the band. All this implies a high order of macro-economic coordination to which we revert later in this paper.

The Need for Reserves

An important issue arising out of the adoption of floating rates is what it does to the need for reserves The two dominant characteristics associated with the floating rate system are its equilibrating and insulating properties. As a result of the operation of both these properties, it was argued that the demand for international reserves would go down and that countries could manage with a lower order of reserves than under fixed exchange rate system. At a theoretical level the arguments in support of insularity as mentioned previously were at fault because they did not take into explicit account capital account transactions. The actual experience of floating rates has also belied the anticipation that demand for reserve would go down. Frenkel has estimated the demand function for reserves using cross section data for all the years from 1963 onwards and tested whether there was a shift, after floating, in the values of the co-efficients of the independent variables such as variability of international receipts and payments, the level of GNP and the average propensity to import. The equations showed that the demand for reserves has not been affected by the shift to floating rates. The fact that the demand equations remained unaffected implies that countries still feel the need for holding owned reserves inspite of the increased access to the capital markets and bank borrowings. Indeed the demand for reserves may have been underestimated to the extent that the actual holding of reserves by developing countries in the second period may have been less than the desired holding.

Except for the U.S., the other central banks in recent years have chosen to intervene whenever they feel there has been a misalignment in the exchange rate. Thus, the equilibrating property has not necessarily been ensured by the floating rate system. Consequently, the need for reserves has not diminished.

Under floating rate system, it is true countries acquire an extra degree of freedom in policy formulation and implementation because they do not have an exchange rate to defend.

However as stressed earlier this does not free completely domestic economic policy from external factors. This is particularly so when the frame- work has to take into account the inter-dependence, which comes from both the capital market side and the international currency side. The recent experience with the U.S. dollar provides a telling example of the situation. A high interest rate arising from unusually large budget deficits has led to large scale attraction of the capital inflows into U.S. which in turn have tended to maintain a strong dollar. The other countries, which have experienced capital outflows are not in a position to pursue independent monetary policies and let their interest rates to be determined solely by domestic considerations. Even under a fixed exchange rate system a high interest rate will attract capital inflows. But once the exchange rate has reached the top of the band, further capital inflow will be held back even if rates of interest are raised because there is always some risk of a fall in the exchange rate. However, with the floating rate, capital inflow can be accelerated by the prospect of a further appreciation of the currency. In short, a country may not have much more freedom in its monetary policy with floating exchange rate system than under fixed exchange rate system. In any case the adoption of target zones would require monetary policy to be supplemented by intervention as discussed earlier. Consequently the need for reserves to prevent the domestic economy from having to adjust too frequently to external shocks remains large.

A continued need for reserves under the floating exchange rate system needs to be emphasised because there has been a persistent opposition to the creation of new international liquidity in the form of SDRs on the ground that additional reserves are not needed. From the way floating rate system has been functioning, neither from the point of view of the developed countries nor from that of the developing countries can it be argued that additional reserves are not needed.

Implications for Developing Countries

Much of the discussion about exchange rate systems focusses on exchange rate options in the industrialised world. The issue of exchange rate options for the developing world have in general received much less attention. Developing countries clearly have a deep interest in the efficient functions of the international exchange rate system even among industrialised countries and any modifications in this area which improves the functioning of the world economy and world trade would contain significant advantages to the developing countries. Apart from this aspect, however, there are exchange rate options that individual developing countries must necessarily face.

Most developing countries have chosen to peg rather than float for a variety of reasons. The merits of this decision are not examined here—to do so would take us well beyond the scone of this paper. But it is relevant to ask, how should developing countries peg their exchange rates? Increasingly, developing countries have pegged to a blanket of currencies. In some cases the basket is tailor made, taking account of trade directions for example, and in other cases the basket is simply ready-made in the form of the SDR.

There is extensive theoretical work on what is the optional basket and how basket weights should be determined all of which is designed to ensure a change of basket which stabilises the nominal effective exchange rate at some desired level. However stabilisation of the nominal effective exchange rate is important only in circumstances in which domestic inflation rates closely follow inflation rates in trading partners. This is not likely to be the situation in most developing countries so that stabilisation of the nominal effective exchange rate will in general not stabilise the real effective exchange rate at a desired level, which is what matters.

This suggests that it is less important to worry about the design of the currency basket, which determines the extent of nominal exchange rate stabilisation, than to ensure that exchange rate policy is sufficiently activist to ensure that real effective exchange rates move in a desired fashion. It may not be possible to design a basket that ensures that this objective is automatically achieved which in turn means that whatever the basket is adopted realignments of the basket may be necessary so that real effective rates remain on target.

A second issue which is extremely relevant in a world of floating rates in which large exchange rate variations are likely over the medium-term is the currency composition of external debt. Since it is not possible to hedge over long periods, developing countries must ensure that the composition of their foreign assets and liabilities is such as to minimise risk. In general this calls for much greater diversification in the currency composition of debt with due allowance to interest rate differentials. 

Coordination of Macro-Economic Policy

Whether the exchange rate system is floating, fixed or a combination of the two, there is no way that a country can insulate itself from external factors. It is an illusion to think that the floating rate system provides an escape route. This lack of insulation enforces interdependence. The more dominant an economy the more wide spread is the impact of its domestic economic policy on other countries. Therefore a satisfactory exchange rate system can emerge only if macro-economic policies of the major industrial countries are stable, mutually consistent and conducive to satisfactory performance of the world economy. In fact, the 1978 amendment to the IMF Articles recognizes this and enjoins the member countries to Endeavour to direct its economic and financial policies towards the objective of fostering orderly economic growth with reasonable price stability'. On paper, the amended articles imply a more active role for the Fund in its surveillance over exchange rate policies. The practice of course has been woefully inadequate.

In the light of the experience of the last few years, there is an increasing near universal emphasis on the need for coordination of domestic economic policies. This raises a critical institutional question. How is such coordination to be achieved and who is to participate in it? Coordination would indeed be partial if the synchronization of policies is confined to industrial countries aimed at minimising the imbalances among them. The international monetary system must remain 'international'. The goal that is sought to be achieved must be one of the optimal global welfare.

The equilibrium that results from any given set of macro-policies in industrialised countries affects the whole world often in powerful ways. The persistence of a system which compels the flow of savings from developing countries to developed countries as is currently happening is surely inherently inequitable and in the long run also inefficient in the strict sense. On the contrary, the system should facilitate the flow of resources from the developed to the developing. The surveillance of the exchange rate policy of member countries has no meaning unless it seeks as Article 1 of the IMF Agreement asserted 'to contribute to the promotion and maintenance of high levels of employment and real income and to the development of the productive resources of all members as primary objective of the economic policy.

Conclusion

Part of the reason why countries are concerned about exchange rates is psychological, and part real. Psychological – because of headline effect of a depreciating currency – "all time low", "weak", "tumbling" creates a negative impact about the soundness of a country’s currency. For an ordinary man or woman on the street and the political leaders who represent t hem, it becomes a matter of concern as nobody wants his country’s economy or currency to be weak or tumbling. However, irrational it may be, it is a fact which has to be reckoned with by all Central Banks. It would be nice if there was a new terminology to describe movements in exchange rates which is less emotive and less sensational.

Part of the reason for concern with exchange rates is also real, as seen in East Asia, Russia and elsewhere. The contagion effect is quick and a sharp change in the currency value can affect the real economy. Exporters may suffer if there is unanticipated sharp appreciation and debtors or other corporate may be affected badly if there is a sharp depreciation, which can also lead to bank failures and bankruptcies

A fundamental change that has taken place in recent years is the importance of capital flows in determining exchange rate movements as against trade deficits and economic grow th, which were important in the old days. The latter do matter, but only over a period of time. Capital flows, on the one hand, are primary determinants of exchange rate movements on a day to day basis. For example, the US with the largest trade deficit in the world today has the strongest currency. Europe, with a massive trade surplus, on the other hand (until lately) has one of the weakest currencies. This result is explained by movements in capital flows, which is a relatively a new phenomenon. The same is happening the world over – East Asia, New Zealand, South Africa and Australia

We have tried to give you a bird’s eye view of the dilemmas the Central Banks face as well as the issues that are currently being debated internationally at the level of Finance Ministers, Central Bank Governors and Heads of International Institutions. It may be useful to remember that floating exchange rate system, and volatility associated with capital flows, are relatively new phenomena. Until the 90s, we lived in a world of fixed exchange rates with par values or, fixed but adjustable exchange rates, in response to changes in fundamentals. Floating rates, Capital volatility, massive changes in technology and integration of world wide markets across different time zones are relatively new phenomena. So, we are still on the learning curve. There are also some major structural changes taking place in the organisation of markets, for example, as a result of emergence of common European currency, whose full impact is not yet evident.

Recent changes have brought tremendous benefits to the developing world, including India. Capital constraints and technological constraints to developments are fast disappearing. As the new horizons open, we are also faced with some new challenges. With your help, support and guidance, India and other countries represented here will be able to take maximum advantage from new technological and other advances while minimizing risks.