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
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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-
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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,
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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. the labor market. This is because the Free capital flows between coun- central bank cannot fight inflation tries with differing rates of inflation without attracting capital inflows in usually break the link between inter- the short term, and provoking vola- est rate differentials and the risk of tility of capital flows and exchange currency depreciation, because ex- rates in the medium term. Neither change rates do not follow PPP in the can it lower interest rates without short term. Introducing PPP as a running the risk of failing to reach “theoretical norm” (J. A. Schumpeter) the inflation target. or a political target is the only way Independently of whether a high- out. With exchange rate expectations inflation country with a fully liberal- being “rational” in terms of PPP, ex- ized capital account chooses to fight change rate expectations should al- inflation by maintaining high interest ways equal the interest rate differen- rates, or to keep the real interest rate tial and the price level differential. at a level at least as high as in the low- But this solution does not apply in inflation country, its currency will reality. Expectations are not formed attract international investors in rationally along the lines of PPP, as short-term assets. The high-inflation un-hedged borrowing offers a short- country can achieve domestic price term profit in most exchange rate re- stabilization only if it maintains nom- gimes only if major imbalances have inal interest rates at a level higher not occurred. than those of the low-inflation coun- try. But if, in the short run, the infla- 2 Patterns of Adjustment tion differential between the two The UNCTAD secretariat conducted countries is not matched by a corre- some calculations in order to exam- sponding expectation of depreciation ine the evolution of returns on short- of the high-inflation country’s cur- term international portfolio invest- rency, the occurrence of a fundamen- ment in a number of developing coun- tal disequilibrium will be unavoid- tries over the period 1995–2003. As able. However, choosing the alterna- a first step, assuming exchange rates tive approach and trying to fix the to remain stable, the real interest rate nominal exchange rate is, in this that is relevant for the decision of an framework, also very costly. Inter- investor from the United States to vention by the central bank of a make, for example, a three-month in- developing country implies buying vestment in a developing country, is foreign currency against bonds de- the three-month nominal interest nominated in domestic currency that rate in the developing country minus
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the inflation rate in the United States. has, in many instances, been much International investors base their de- higher than in the United States over cisions on the inflation rate in their a long period. Thus transactions of a home country, and not on the rate in huge size must have taken place, as- the country in which they invest, be- suming that the money and currency cause they intend to re-import the in- markets operated efficiently. The cri- vested money at the end of the invest- ses in Mexico (in the mid-1990s), ment period rather than to buy goods Brazil (1999), and Argentina (2001– in the country in which they invest.1 2002) demonstrate that, as a rule, fi- The results of these calculations nancial crises and the collapse of the are shown in chart 1 (of the Trade and exchange rate are preceded by phases Development Report 2004) for six of enormous effective returns and ex- countries. The exchange rate regimes tremely high interest rates for foreign that govern the relationship between investors. Only in 2002 did Mexico the dollar and the currencies of these manage to bring inflation and its six countries strongly differ. China short-term interest rate down, and to has maintained a stable currency peg avoid attracting foreign investors with against the dollar for a long time. The offers of high financial yields. Brazil, chart indicates that from the financial on the other hand, still offers inves- side, this peg is sustainable, as China tors very attractive conditions. does not offer real interest rates for In addition to the interest rates international investors that could di- calculated at a fixed exchange rate, a rectly endanger the peg. The incen- second step in the calculations takes tive to invest in China on a short-term account of the actual change in the basis, as reflected by the line showing bilateral exchange rate in order to the real interest rate for United States calculate the effective rate of return investors, has consistently been either for United States investors in the de- only marginally positive or even neg- veloping country. This rate (shown by ative. By contrast, Mexico and Brazil the yellow area in chart 1) reflects maintained a very high real interest the ex-post observed change in the rate for international investors exchange rate, but provides no infor- throughout the second half of the mation on the rate that the investors 1990s. Even Argentina maintained expected. Indeed, the calculations positive real interest rate differentials are based on ex-post known interest during this period – reflected by the and exchange rates, which may differ difference between the two solid lines from the rates the investors expected. in the chart – despite its hard cur- As such, the results of the calcula- rency peg with the dollar. Indeed, the tions do not allow any assessment of real interest rate that underlies deci- the actual size of capital flows that sions of United States investors to in- may have been induced by the config- vest in the Latin American countries uration of these rates at any point in
1 The same reasoning applies for a developing country enterprise seeking a low-interest, short-term credit. In other words, the enterprise will have an incentive to obtain the credit in the United States if the nominal interest rate in the United States is lower than in its home country.
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Chart 1 Incentives for Short-Term International Portfolio Investment in Selected Developing Countries, 1995–2003 % China Argentina 10 20 10 20
8 15 8 15 6 6 10 10 4 4 5 5 2 2
0 0 0 0
–2 –5 –2 –5 –4 –4 –10 –10 –6 –6 –15 –15 –8 –8
–10 –20 –10 –20 1995 1997 1999 2001 2003 1995 1997 1999 2001 2003
Brazil Mexico 10 20 10 20
8 15 8 15 6 6 10 10 4 4 5 5 2 2
0 0 0 0
–2 –5 –2 –5 –4 –4 –10 –10 –6 –6 –15 –15 –8 –8
–10 –20 –10 –20 1995 1997 1999 2001 2003 1995 1997 1999 2001 2003
Hungary South Africa 10 20 10 20
8 15 8 15 6 6 10 10 4 4 5 5 2 2
0 0 0 0
–2 –5 –2 –5 –4 –4 –10 –10 –6 –6 –15 –15 –8 –8
–10 –20 –10 –20 1995 1997 1999 2001 2003 1995 1997 1999 2001 2003 Real interest rate in the United States for the respective country’s investors (left-hand scale) Real interest rate in the United States for United States investors (left-hand scale) Real interest rate in the respective country for that country’s investors (left-hand scale) Real interest rate in the respective country for United States investors (left-hand scale) Effective rate of return in the respective country for United States investors (right-hand scale)
Source: UNCTAD secretariat calculations, based on data from IMF, International Financial Statistics, Thomson Financial. Note: The scenario that underlies the figure is based on a three-month investment horizon. Real interest rates lower than minus 10% or higher than plus 10%, and effective returns lower than minus 20% or higher than plus 20% are not shown for expositional clarity.
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time. At some points there may have but had to be complemented by higher been huge flows, while at others there domestic interest rates to avoid a re- may have been no flows at all. While turn of inflation. Under conditions of these limitations need to be kept in free capital flows, the Brazilian soft mind when interpreting the results, peg offered very high real rates of re- the calculations reveal the dilemma turn until the beginning of the crisis of developing countries that liberalize in 1999. However, even after the cri- their capital account without being sis, the Brazilian central bank did not able to keep their inflation rate at the fundamentally change its policy of level of the developed economies. maintaining a high level of interest Hungary and South Africa are ex- rates relative to that in the United amples of countries with rather flexi- States. The resulting recent rise in ble exchange rate regimes and high de capital inflows has put sharp pressure facto exchange rate volatility. Since on the Brazilian real to appreciate. 2002, both countries have tried to re- Looking at the experience of a duce domestic inflation by maintain- larger group of economies, chart 2 ing relatively high interest rates. This reveals sharp differences in patterns has resulted in a decline in competi- of adjustment. In this chart, the real tiveness due to real currency appre- interest rate for a United States inves- ciation. Chart 1 shows that the real tor is correlated with the effective interest rate incentive for foreign in- rate of return for that investor. The vestors is significant and induces economies are grouped according to short-term capital inflows, causing the attractiveness of their currencies an adverse impact on the real ex- for international portfolio investors. change rate. During 2003, for exam- If the nominal exchange rate is per- ple, a three-month investment in fectly stable, there is no scattering of South Africa could yield as much as the points and the correlation is very 10% to 20%, which may add up to an high, as is the case for China. The po- annual rate far beyond 50%. sition of the curve (right of the zero Argentina and Brazil followed point or on the zero point) indicates similar approaches in the second half whether, in terms of the interest rate of the 1990s but with varying rigor. differential, the country has been at- Argentina fixed its exchange rate very tractive (Argentina, Brazil) or not strictly to the dollar, offering a posi- (China) for international investors. In tive and, over many years, fairly sta- group 1 (column 1 of the chart), the ble real rate of return to foreign in- countries aim at a rather low nominal vestors; this rate increased sharply in interest rate, with or without fixing the run-up to the crisis of its currency the exchange rates. In Malaysia, Sin- board system and led to the collapse gapore and Chile, the exchange rate of that system. Brazil adopted a crawl- is not as stable as in China, but these ing peg, visible in the stable differ- three countries’ central banks avoid ence between the real interest rate giving incentives to foreign investors for United States investors and the to speculate on an overvaluation. effective rate of return. This system In group 2, the interest rate in- per se was less restrictive than the centives are fairly small and the effec- Argentinean one on the external side, tive returns (including exchange rate
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Chart 2 Alternative Exchange Rate Regimes and Incentives for Short-Term Portfolio Investment in Selected Economies, 1995–2003 % Group 1 Group 2 Group 3 Group 4 China Kenya Czech Republic Argentina 15 15 15 15
10 10 10 10
5 5 5 5
0 0 0 0
–5 –5 –5 –5
–10 –10 –10 –10 R2 = 0.78 R2 = 0.02 R2 = 0.00 R2 = 0.02 –15 –15 –15 –15 –5 0 5 10 15 –5 0 5 10 15 –5 0 5 10 15 –5 0 5 10 15
Malaysia Taiwan Prov. of China Hungary Brazil 15 15 15 15
10 10 10 10
5 5 5 5
0 0 0 0
–5 –5 –5 –5
–10 –10 –10 –10 R2 = 0.09 R2 = 0.01 R2 = 0.01 R2 = 0.08 –15 –15 –15 –15 –5 0 5 10 15 –5 0 5 10 15 –5 0 5 10 15 –5 0 5 10 15
Chile Republic of Korea Poland Russian Federation 15 15 15 15
10 10 10 10
5 5 5 5
0 0 0 0
–5 –5 –5 –5
–10 –10 –10 –10 R2 = 0.01 R2 = 0.00 R2 = 0.05 R2 = 0.08 –15 –15 –15 –15 –5 0 5 10 15 –5 0 5 10 15 –5 0 5 10 15 –5 0 5 10 15
Singapore Thailand South Africa Mexico 15 15 15 15
10 10 10 10
5 5 5 5
0 0 0 0
–5 –5 –5 –5
–10 –10 –10 –10 R2 = 0.00 R2 = 0.01 R2 = 0.01 R2 = 0.39 –15 –15 –15 –15 –5 0 5 10 15 –5 0 5 10 15 –5 0 5 10 15 –5 0 5 10 15
Effective rate of return in the respective country for United States investors Trend line
Source: See Chart 1. Note: For the calculation of the real interest rate and the effective rate of return, see text. Vertical scale: effective rate of return in the respective economy for United States investors. Horizontal scale: real interest rate in the respective economy for United States investors.
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changes) scatter quite remarkably pectation tends to turn around for a along the vertical axis. This means time, as the international investors that these economies – as demon- expect revaluation and not a new de- strated by the Republic of Korea, Tai- valuation. This has been the recent wan Province of China and Thailand experience of Brazil and South Af- – avoid one-sided flows by maintain- rica. To avoid a quick and strong real ing high exchange rate volatility and currency revaluation, which would low interest rates. destroy the gains in competitiveness Countries in group 3, consisting the country has just achieved, the mainly of transition economies, have monetary authorities intervene by adopted a floating exchange rate re- buying foreign currency and piling up gime but with some interest rate in- international reserves. This is costly centives for international investors, as for the country involved, as its inter- the inflation rate in these countries est rates are higher than the rates it was relatively high during the 1990s. can earn by recycling the money to The fourth group of countries fol- the country of origin or to another lows a different approach. By keeping safe haven. In these circumstances, it the exchange rate fairly stable and of- is difficult, if not impossible, to strike fering incentives for financial inves- a balance between the domestic needs tors, their central banks try to use to fight inflation and the negative re- the exchange rate to stabilize infla- percussions of incentives for foreign tion. This implies prolonged periods investors in portfolio capital on do- of rather risk-free arbitrage for inter- mestic growth and employment. national investors. These hard or soft pegs are sustainable only if the high 3 Multilateral Solutions interest rate does not depress the rate Are the Answer of domestic investment, or if an ap- The message of the preceding analysis preciation of the real exchange rate is a simple one. If the nominal short- can be avoided. In most cases, how- term interest rate in a financially open ever, these conditions do not apply. emerging market economy exceeds Sooner or later, the currency peg, that in a developed country by more soft or hard, has to be discontinued than the growth differential, the and replaced by a new system. nominal exchange rate of the former The examples of intermediate sys- should depreciate at a (annual) rate tems of managed floating (as in Po- that equals the difference in (annual) land, Hungary, the Czech Republic, interest rates. If this is not the case, South Africa, or in Brazil and Argen- the situation is not sustainable, as tina after their currency crises) show either the high interest rate or the that the variability of the exchange overvalued exchange rate hampers rate may increase the risk for the in- sustainable economic development in ternational investor at certain points, the emerging market economy. but it may increase the reward as Hence the political choice to com- well. If, for example, the country bine floating of the currency with re- with the floating currency has been strictive domestic monetary policy to going through a crisis phase with real bring down inflation will destabilize depreciation, the exchange rate ex- the external account. Speculation on
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uncovered interest rate parities will credibility in markets. Once investors yield high returns to arbitraging in- are convinced that the anchoring ternational portfolio investors, as country will not be able to manage nominal and real interest rates in the slowing down the growth of its ex- developing economies are higher than ternal debt smoothly, confidence will in the leading industrialized econo- deteriorate. This will lead to renewed mies. The currencies of the high-in- crisis, a reduction of reserves and flation countries will tend to appreci- eventually a depreciation of the coun- ate, thereby, temporarily, even in- try’s exchange rate. creasing the incentive for foreign in- In any case, exchange rate changes vestors to buy domestic assets and the are necessary to compensate for the incentive of domestic borrowers to opening scissor blades of the price borrow abroad. and cost developments between a Overall, the dilemma for devel- high-inflation and a low-inflation oping country policymakers of a situ- country. As long as developing coun- tries are not able to perfectly con- verge in nominal terms with the de- veloped countries, devaluations are unavoidable in order to preserve the competitiveness of the high-inflation countries. However, exchange rate changes, and in particular, real ex- change rate changes, that determine the competitiveness of the whole economy, cannot be left to the mar- ation in which international investors ket. Given the arbitrage opportuni- earn high rates of return in their ties between high- and low-inflation countries, despite falling real income, countries, a rule of competitive neu- domestic profits and employment, trality of the exchange rate, like cannot be resolved under conditions the PPP rule, has to be enforced by of free capital flows. Developing governments and/or central banks. country policymakers are usually un- Ideally, such a rule should be the able to reduce interest rates to stop result of multilateral agreements, as the speculative capital inflow, be- exchange rate changes always have cause doing so would endanger the multilateral repercussions. But if the credibility of their monetary policy international community is not able domestically. The political will to to agree on rules to avoid competitive achieve economic stability is reflected devaluations and huge destabilizing in the decision to keep nominal inter- shocks, countries will continue to est rates high. How long an external manage the floating of their curren- economic imbalance following an ex- cies unilaterally. change rate peg or an appreciation Managed floating, however, faces can be sustained is an open question. an adding-up problem on the global With growing visible external imbal- scale. Not all countries can simulta- ances the developing country’s ex- neously manage the movements of change rate policy will begin to lose their exchange rate and achieve their
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targeted rates. The exchange rate, by by multilateral regulations. Such a definition, is a multilateral phenome- multilateral regime would, among non, and attempts by many countries other things, require countries to to keep their currencies at an under- specify their reasons for real devalua- valued rate may end up in a race to tions and the dimension of necessary the bottom – or in competitive deval- changes. If such rules were strictly uations – that would be as harmful applied, the real exchange rate of all for the world economy as in the the parties involved would remain 1930s. Moreover, given the size of in- more or less constant, as strong argu- ternational short-term capital flows ments for creating competitive advan- and the inherent volatility of these tages at the national level would rarely flows, only those developing coun- be acceptable. tries that are big and competitive In a world without a multilateral enough to withstand strong and sus- solution to the currency problem, the tained attempts of the international only way out for high-inflation or financial markets to move the ex- change rate in a certain direction, will be able to manage the floating successfully. A small and open devel- oping economy will hardly be able to continue fighting a strong tendency to appreciate over many years or even decades. Multilateral or even global ar- rangements are clearly the best solu- tions to this problem. The idea of a high-growth countries that are not cooperative global monetary system members of a regional monetary would be to assure, on a multilateral union is to resort to controls of short- basis, the same rules of the game for term capital flows or to follow a strat- all parties involved, more or less in egy of undervaluation and unilateral the same way as multilateral trade fixing. If developing countries are rules apply to every party equally. able to avoid destabilizing inflows and That is why the main idea behind the outflows, either by taxing those flows founding of the International Mone- or by limiting their impact through tary Fund in the 1940s was to avoid direct intervention in the market, the competitive devaluations. In a well- hardest choices and misallocations designed global monetary system, the due to erratic exchange rate changes need and the advantages of the cur- can be avoided; but the resort to con- rency depreciation of one country trols or permanent intervention have to be balanced against the disad- should not replace the search for an vantages to the others. As changes in appropriate exchange rate system at the exchange rate, deviating from the regional or global level. õ purchasing power parity, affect inter- national trade in exactly the same way as changes in tariffs and export duties do, such changes should be governed
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