Heiner Flassbeck: Exchange Rate Management in Developing

Heiner Flassbeck Acting Director UNCTAD Heiner Flassbeck Exchange Rate Management in Developing Countries: The Need for a Multilateral Solution in a Globalized Economy The discussion about adequate ex- to reconcile with the expectation of change rate systems for developing neoclassical general equilibrium mod- countries takes a new turn. Whereas, els where poor economies with a low in the 1990s the official doctrine of endowment of capital receive the the Washington-based finance insti- scarce resource from rich countries tutions has been the corner solution with an abundant endowment of capi- idea, developing countries either ab- tal. The fact that the most successful solutely fix their exchange rate against countries in the South have violated an international anchor currency of that “law” puzzles many orthodox ob- float freely, after the Asian crises the servers and leads them to argue that international economics community holding United States treasuries is a favored the return to floating. But waste of resources as this money only a few countries accepted this ad- could have been used much more ef- vice. Most of the countries affected ficiently by investing it in fixed capi- by the storm of the financial crises in tal or by using it for more imports of Asia and in Latin America decided to investment goods. use the opportunity of a low valua- For policymakers in developing tion of their currencies and the swing countries, the fact that exchange rate from current account deficit to sur- movements directly influence the plus to unilaterally fix their exchange overall competitiveness of a country rate or – at least – to frequently inter- and have the potential to directly im- vene in the currency market to avoid prove the overall trade performance the rapid return of their currencies to of the majority of their firms and the pre-crisis levels. The most striking balance of payments is a promising example is China where the authori- prospect. On the other hand, the use ties, after the traumatic experience of of the exchange rate as a powerful an overvaluation and a big devaluation tool of economic policy is often in 1994, absolutely fixed the value of strictly limited by the influence that the renminbi-yuan against the US- the global capital market and the pol- dollar. icy of other countries exert on that Beyond this untypical corner so- rate. The exchange rate of any coun- lution the unilateral attempts to fix try is, by definition, a multilateral the value of their currencies at rather phenomenon, and any rate change has low levels has created another puzzle multilateral repercussions. for the mainstream of economic In the last three decades, develop- thinking. Due to their current ac- ing and emerging market economies count surpluses and their interven- in all the major regions have had to tion in the currency markets many struggle with financial crises or their developing countries have piled up contagion effects once they have tried huge amounts of international re- to manage the exchange rate unilater- serves and thus have become net ally or even opted for free floating. exporters of capital. This is difficult Nevertheless, in the Bretton Woods ◊ 101 Heiner Flassbeck era, as well as in the period of float- tial amounts of foreign exchange re- ing or managed floating thereafter, serves. some patterns of successful adjust- It is clear that for these countries, ment to the vagaries of the interna- avoiding currency overvaluation is tional capital market emerged, which not only a means to preserve or im- have been increasingly adopted by prove macroeconomic competitive- developing countries’ economic and ness, but also an insurance against the financial policies. Since the Second risk of future financial crises. The World War, some experiences of suc- accumulation of current account defi- cessful catching up – such as by West- cits, and frequent financial crises, ern Europe, Japan and the newly in- with overshooting currency deprecia- dustrialized economies (NIEs) – sug- tions, proved very costly in the past. gest that, among other factors, long- Surges in inflation, huge losses of real lasting currency undervaluation can income, and rising debt burdens have be extremely helpful to fully reap the been a common feature of all recent benefits of open markets. Today, as financial crises. multilateral arrangements do not ex- However, a strategy of avoiding ist on a global scale, a strategy to currency overvaluation cannot easily avoid overvaluation by any means has be implemented if the capital account become the preferred tool of many is open. If inflation rates in develop- governments and central banks. ing countries exceed those in the de- This is in stark contrast to the ex- veloped world, or if there are expec- perience of the 1990s in Latin Amer- tations of an imminent currency ap- ica. During that decade many Latin preciation, monetary policy will of- American countries maintained hard ten face a dilemma in trying to keep or soft currency pegs with some over- the exchange rate stable and yet at a valuation during the 1990s, and used level that preserves the international the exchange rate as a nominal anchor cost competitiveness of the country’s to achieve rapid disinflation. This led exporters. to an impressive improvement in their monetary stability but also to cur- 1 The Dilemma Posed by rency appreciations that impaired the Capital Account Openness competitiveness of exporters in these Even a slightly diverging inflation countries. Today, with inflation rates trend between two open economies being relatively low and stable due to is sufficient for highly volatile short- favorable domestic conditions, adopt- term international capital flows to ing a strategy designed to avoid cur- force the central bank of the country rency overvaluation has become fea- with high inflation to give up its un- sible for a much larger number of dervaluation strategy or to face the developing countries. Indeed, many severe fiscal costs that can be associ- developing countries (such as China, ated with this strategy. Differences in Brazil and South Africa) have recently inflation rates are usually reflected in sought to avoid a revaluation of their differences in nominal interest rates, currencies through direct central with the high-inflation country hav- bank intervention, with the result ing higher interest rates than the low- that they have accumulated substan- inflation country, even if both coun- 102 ◊ Heiner Flassbeck tries have similar growth trends and a in the post-Bretton Woods era have similar monetary policy stance (e.g. if been characterized by unsustainable they try to apply a Taylor rule). The nominal interest rate differentials. reason for this is that nominal interest The differential in nominal interest rates have to be higher in the high-in- rates attracts portfolio investment in flation country if the central bank is the currency of the high-inflation to bring the domestic real interest country. This, in turn, improves the rate in line with the given real growth short-term attractiveness of the high- rate and degree of capacity utiliza- inflation country’s currency, because tion. an appreciation would increase the However, short-term capital flows expected return from such an invest- are not driven exclusively by interest ment. On the other hand, if govern- rate differentials. Speculators may ments try, from the outset, to limit attack the currencies of countries that the extent of an appreciation of the follow an undervaluation policy, be- domestic currency by buying foreign cause they expect a revaluation to oc- cur sooner or later. This means that, contrary to textbook scenarios, in the real world, international investors do not form short-term exchange rate expectations on the basis of the pur- chasing power parity (PPP) rule. Since the PPP rule is relevant only over the long term, policymakers in financially open developing countries need to be aware that international currencies, this will usually add to investors in short-term deposits base the confidence of international inves- their decisions on the expected nomi- tors as the high-inflation country’s nal return rather than the expected international reserves increase. real return on investments. This is Thus, independently of whether because portfolio investors do not in- high nominal interest rates or the ex- tend to buy goods in the country in pectation of a revaluation attract which they invest, but simply invest short-term capital inflows, the cur- money for a day, a week or three rency of the high-inflation country months. If, during that period of will tend to appreciate in the short- time, the inflation divergence be- term. This undermines the funda- tween the high-inflation and the low- mental exchange rate in the short inflation country does not trigger the term, does not preclude the exchange generally expected depreciation of rate from eventually returning to the high-inflation country’s currency, PPP. In the medium term, the clearly portfolio investment will be more visible deterioration of the interna- attracted to the high-inflation than tional competitive position of the to the low-inflation country. As high-inflation country will reverse discussed in UNCTAD’s Trade and expectations of international inves- Development Reports 1998, 2001 tors: they will lose “confidence” in and 2004 most of the financial crises the high-inflation country’s currency, ◊ 103 Heiner Flassbeck thus making a correction of the over- bear relatively high interest rates, and valuation unavoidable. investing the foreign currency pur- Even in the absence of short-term chased at a lower interest rate in the capital flows, internal and external developed country. Thus a strategy of equilibrium cannot be achieved at the intervening in currency markets and same time by adjusting interest rates, accumulating foreign currency reserves if inflation rates in the two countries amounts to a permanent subsidization diverge, for example, because of dif- of foreign investors with domestic ferent institutional arrangements on taxpayers’ money.

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