Proceedings 2nd CBRC, Lahore, Pakistan November 14, 2009

THEORETICAL ASSESSMENT FOR AN APPROPRIATE EXCHANGE RATE REGIME IN PERSPECTIVES OF PAKISTAN’S EXTERNAL SECTOR PERFORMANCE

Seemab Rana

Bahaudin Zakaria University, Multan, Pakistan [email protected]

ABSTRACT

This paper proposes a theoretical study for assessing whether or not a Pakistan’s external sector characteristics make it an appropriate candidate for a peg exchange rate regime. The template employs qualitative measures of attributes - trade orientation, financial integration, economic diversification, macroeconomic stabilization, credibility, and "fear- of-floating" type effects - that have been identified in the literature as key potential determinants of regime choice.

To illustrate, the template is applied to Pakistan’s major trading partners. The empirical evidences indicate a fairlystrong case against a pegged regime in Pakistan. The implications for Pakistan trade sector are mixed, although changes in that economy in recent years strengthen the case against a peg.

INTRODUCTION

". . . . the choice of appropriate exchange rate regime, which, for economies with access to international capital markets, increasingly means a move away from the middle ground of pegged but adjustable fixed exchange rates towards the two corner regimes of either flexible exchange rates or a fixed exchange rate supported, if necessary, by a commitment to give up altogether an independent monetary policy"(Summers 2000).

The considerations that have led countries to shift toward more flexible exchange rate arrangements vary widely; also, the shift did not happen all at once. When the Bretton Woods fixed rate system broke down in 1973, many countries continued to peg to the same currency they had pegged to before, often on simple historical grounds. It was only later, when major currencies moved sharply in value, that countries started to abandon these single- currency pegs. Many countries that traditionally pegged to the U.S. dollar, for instance, adopted a basket approachℵ during the first half of the 1980s, in large part because the dollar was appreciating rapidly. Another key element was the rapid acceleration of inflation in many developing countries during the 1980s.

Robert Mundell and Marcus Fleming gave the concept of impossible trinity almost 50 years ago, stating that it is difficult for a country to simultaneously attain three goals of having unhindered trade sector progress, an independent monetary policy and a stable exchange rate and any country will have to compromise on any one of these three goals to achieve the other two. Since the collapse of the Bretton Woods system, a vast literature has

ℵ peg to the average of more than 1 currencies rather than pegging to a single currencuy 1

developed on the virtues and pitfalls of fixed versus flexible arrangements. While a variety of theoretical criteria for choosing the right regime have been proposed, there is still no consensus on how precisely should these be quantified and, to the extent they bear conflicting implications, how should they be prioritized. Following the disorderly exits from pegged regimes by a number of emerging market economies over the past decade, regime choice has drawn increased attention and a more systematic approach to assessing the implications of the various criteria appears warranted.

The higher the degree of integration of an economy’s trades with its partners, the greater the benefits of a fixed exchange rate or common currency. An argument that has often been advanced in favor of fixed exchange rates is that exchange rate variability discourages trade and investment. By eliminating this variability and the associated transactions costs via a peg—or in extreme a currency union—a country can, in principle, promote trade. Although time series studies have generally found a small or negligible effect of exchange rate variability on trade and investment, gravity models such as those in Rose (2000) and Frankel and Rose (2002) find larger effects and conclude that countries that trade a lot will tend to benefit from entering into a currency union with their principal trading partner(s).

The simplest measure of a country’s trade orientation, and hence the magnitude of its potential gains from nominal exchange rate stability, is the ratio of its exports plus its imports to GDP. The larger is this ratio, the larger might be the transaction costs saving associated with a stable exchange rate.

However, even if a country’s trade ratio is relatively large, its trading patterns may well be spread across different partners that have different currencies. Since a country can eliminate the volatility of its exchange rate against only a single currency via a peg, the potential transaction cost saving is limited to trade with the largest partner (or partners using a common currency). This may be measured by the weight of the top currency in total exports, where the top currency captures the share of exports destined for countries that either use the top currency or peg their exchange rates against the top currency.

According to IMF’s website, the last report regarding de facto exchange rate regimes of different countries came out in 2007 and, surprisingly, it ranked Pakistan as one of those countries having different claimed and de facto exchange rate policies. According to the report, in actuality, Pakistan falls under the category of ‘other conventional fixed peg arrangement’. Despite the claims of so-called economic progress during the last seven years, one wonders that why there was a difference between our claimed and pursued policies. Were we trying to artificially peg the rupee price with the dollar, throughout the last five years, by somehow managing the market sentiment or through the oxygen of heavy foreign aid inflow? If we were, then what has caused this reversal now - some policy compulsions or the removal of that oxygen mask? Are we also exposed to an economic crisis, in the days to come, as witnessed in East Asia, due to following this pegged float arrangement? Some optimists are predicting that the depreciation in the rupee will bring the much needed boost to exports and will be beneficial specifically for our textile sector. While that may offer a short-term recipe for marginally increasing our exports, any such measure does not and cannot contribute towards enhancing the overall competitiveness of our exports. Furthermore, the inflationary pressures caused by such devaluation will greatly undermine, if not nullify, any such benefit.

Following this introductory part, the second section draws upon the Chronology of exchange rate regimes. The third section reviews an extensive literature with some theoretical and empirical aspects on the subject to identify the general economic characteristics suitable for competitiveness of Pakistan’s external sector. Fourth section discusses current exchange rate regimes prevailing in different economies of the world in perspectives of its key economic objectives. The paper ends with concluding observations that summarize the theoretical considerations and their implications for the choice of the exchange rate regime in Pakistan and some policy recommendation in accordance to the economy like Pakistan.

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CHRONOLOGY OF EXCHANGE RATE REGIMES

The bulk of the de facto regime transitions in the past century have occurred in the wake of exceptional events, such as the breakdown of Bretton Woods, the creation of the European Economic and Monetary Union, the shift from fix to flex, dollar diplomacy and then emergence of euro-dollar market. It is convenient of focus sequentially on the different international monetary regimes that have evolved over time, starting with a section on the international gold standard regime that prevailed for a third of a century leading up to World War I. Particular fraction of this analysis covers the evolution of exchange rate regimes starting from 17th century till present situation following inter-wars, pre-wars and post-wars experiences with four short-lived regimes i.e., a system of relatively free floating, a gold exchange standard of fixed exchange rates, an uncoordinated hybrid system, and a system of managed floating-along with the experience under the Bretton Woods system of adjustable pegs during the four centuries. Assigned perspective of dissertation is from the other side of the pond because it highlights the century wise scenario of world's exchange rate arrangements (table 1).

TABLE 1. CHRONOLOGY OF WORLD EXCHANGE RATE REGIMES 1880-2000

17TH CENTURY STYLE

Rather than the outcome of design, at the end of the seventeenth century, silver coins were disappearing from circulation. An attempt was made to remedy the problem through the great recoinnage of 1696, during which old silver coins were turned in and reminded into heavier ones. That proved unsuccessful in arresting the outflow of silver from Britain. In the event, however, gold kept flowing into Britain, silver supplies to the mint remained meager. Although the shortage of silver can be regarded to have stabilized an effective gold standard from 1717, Britain did not officially demonetize silver until 1774. The coinage act of 1792 defined the dollar as the basic monetary unit, established a bimetallic standard>. Soon thereafter, the market exchange rate in the US rose toward the rates prevailing on world markets. This curtailed deliveries of gold to the US mint, since gold could be sold elsewhere at terms that are more attractive.

18TH CENTURY STYLE

> Under which both gold and silver were legal tender, and fixed the mint prices of the two metals to imply an official exchange rate of 15 ounces of silver per ounce of gold. 3

From about 1880, until the eve of World War 1, most major countries adhere to a gold standard'. England had establishes a gold standard during the eighteenth century, which was abandoned in 1797 but revived in 1819. Germany moved to a gold standard in the early 1870s and was joined before the end of the decade by the Latin monetary union (France, Belgium, Switzerland, and Italy), Holland, the Scandinavian countries, and the US. Australia, Hungry adopted a gold standard in 1982, followed by Russia and Japan in 1897.

These historical perspectives point to some of the possible advantages and disadvantages of a gold standard system (Figure 1). The main attraction of an international gold standard regime when private citizens are free to buy and sell gold and when supplies of domestic money are linked by rules to the stocks of national gold holdings in its potential to promote an environment of stable exchange rates (Figure 2) and stable domestic price levels (Figure 3).

During the eighteenth century, economists had argued that outflows of gold would be curtailed automatically by a so-called ‘price-specie flow mechanism’. Political opposition to the gold standard was particularly weak in to core European countries – Britain, France, and Germany. In addition, producers that competed with imports – in particular, French and German farmers – were protected from strong competition by the presence of tariff barriers. In practice, the process of adjusting to economic disturbances during the gold standard ea was much less automatic than economic theory suggested.

19TH CENTURY STYLE

By 1900, most nations had switched away from silver and bimetallic standards and adhered to the gold standard. Fiat money and floating was considered a radical departure from fiscal and monetary stability and was only to be tolerated in the event of temporary emergencies such as wars or financial crises. Countries, which followed fiat money and permanently floated such as Austria-Hungary, and Spain, were viewed with disfavor. In the pre 1914 period, there were also a number of monetary unions and currency boards. Two types of monetary unions prevailed: international unions such as the Latin monetary union and the Scandinavian monetary union, which basically involved arrangements for standardizing gold and silver coins and the clearing of payments; and national monetary unions, such as the United States, Germany and Italy, which involved the complete economic and political integration of the member states with a common currency. The British and the French in a number of their colonies ran currency boards, which originated in this period. The pre 1914-core countries◊ ought to have floated. In sharp contrast with the period of the prewar gold standard, the postwar period began with large divergence in the macroeconomic conditions of the key-currency countries and substantial differences in their economic policy priorities. This, and the hostile feelings created by the war, made international policy cooperation difficult. In general, countries sought to return to the gold standard eventually. Only the United States was prepared to do so immediately. Influential British economist argued that the restoration of the gold standard was a necessary condition for financial stability.

According to the trilemma view•, the gold standard with free capital mobility had to be jettisoned in the advanced countries in the face of growing demands by an expanding electorate and organized labor to stabilize the business cycle. The breakdown of the international gold standard did not come abruptly, but by late July 1914. The disparity b/w market exchange rates and the official rate were reduced; however, the international gold standard did not completely dissolve. Gradually over the next few years, countries imposed official or de facto restrictions on both the convertibility of paper money into gold and the free international movement of gold. . In the interwar period, the return to the gold standard was short-lived, ending with the Great Depression (1930).

' A country establishes a gold standard when it fixes an official price or mint parity for gold in terms of its currency unit and stands ready to convert freely b/w domestic money and gold at the official par value. ◊ such as Germany, US, UK, France, these countries had developed strong money and financial markets and institutions before World War I

• see Obstfeld and Taylor (2002) 4

A series of international monetary and financial conferences took place in the early 1920s, motivated in part by common interest in rebuilding the international economy. Beyond that common interest, however the three leading countries had very different economic policy objectives. At the time of the Genoa Conference of 1922, the Americans and the British agreed that recovery required a revitalization of foreign trade, whereas the French were strongly conflicting. The period of free floating brought large movements in exchange rates b/w the key currencies. Meanwhile, the US returned to a full gold standard in June 1919, the dollar was the only currency for which gold convertibility was restored. By late 1920, the pond had fallen to a level below its wartime peg against the dollar – a trough from which it had recovered considerably by mid-1922, and fully when the British gold standard was restored in April 1925. Between 1921 and 1925, exchange rates among the major currencies were left to float freely, with virtually no central bank intervention the gold standard was reinstated as a gold exchange standard in 1925. By the end of 1925, nearly three dozens currencies, in addition to the US dollar, were, formally pegged once again or had been stabilized de facto for a full year. These years were characterized as relatively free-floating exchange rate regime.

From 1925 to 1931, exchange rates were predominantly fixed through the restoration of gold standards in a number of countries and the introduction of gold-exchange standard elsewhere. Nevertheless, gold exchange standard collapsed in 1931. In view of great instability in exchange rate during the 1930s, a major objective of the Bretton woods agreement was to promote exchange stability. Moreover, the permitted flexibility in exchange rates was to be closely supervised. Two new international organizations, IMFn and World Bank/IBRDo were created at the Bretton Woods conference. The articles of agreement of the IMF defined a system under which; each member country was to fix, at a level approved by the IMF, a par value for its currency in terms of either gold or a currency fixed to gold; each country was to keep its exchange rate within 1% of its par value; each country, as to eliminate restrictions on currency convertibility for purposes of making payments for imports and other current account transactions on undesired international capital flows. The resulting system of exchange rates in effect established an international gold-dollar standard. Because, the US was the only country to peg its currency to gold; most other currencies were pegged to the US dollar. The US par value was left at 35 dollar per ounce of gold.

With the passage of time, the Bretton Woods era has come to be regarded as a period when both the world economy and the exchange are system performed relatively well. Britain’s departure from the gold standard in September 1931 was ‘unexpected’ also; US left the gold standard unequivocally in April 1933. After 1931, when countries began to abandon gold, the system evolved into an uncoordinated hybrid regime⊕; and after 1936, with the tripartite monetary agreement♦ b/w Britain, France, and the US, it evolved into a regime in which the management of exchange rates became coordinated.

The outbreak of world war in 1939 ushered in period of tight exchange controls. During and b/w the two world wars, the international monetary system evolved through a sequence of short-lived arrangements as stability proved elusive. Plans for a new international monetary system began to take shape during the war. After 1940s, the U.S. dollar was the most popular anchor currency chosen by advanced countries, followed by the British pound and the

n The IMF was designed to promote international monetary corporation and an orderly exchange rate system, and to provide short-term financial assistance to meet temporary balance of payments needs. o The WB was established to finance reconstruction and development. ⊕ for further details see in theoretical framework ♦The Tripartite Agreement established a process of coordination b/w the three major countries and a system of managed floating. The Bretton Woods system moved well beyond the Tripartite Agreement in establishing an international monetary regime that limited the scope for altering exchange rates through “arbitrary unilateral action” It ought to be an elementary principle of international monetary relations that exchange rates should not be altered by arbitrary unilateral action. The Tripartite Agreement was a belated and half-hearted admission of this principle.

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deutschmark. Like the pound sterling of the nineteenth century, the dollar was again not only as good as gold, but also better. Because of the economic predominance of the united states after world war II in terms of production, wealth, and a huge gold reserve, the us dollar became the logical candidate for reserve currency status. With liquid liabilities, the dollar was readily convertible into gold.

In hopes of avoiding the international economic disorder that had followed World War I, the British and American authorities during the early 1940s assembled groups of government and academic experts to begin articulating and negotiating rules and institutions for postwar monetary and financial relations. The agreements that emerged were adopted by 44 nations at a conference in Bretton Woods, New Hampshire, during July 1944. These international monetary arrangements went fully into effect in 1958 and endured until its collapse in 1971. In the early 1950s, a fortuitous set of circumstances gave rise to what became known as the Eurodollar market, or more broadly, the Eurocurrency market. London banks continued to finance no sterling trade, but used Eurodollars to do so. Thus, because of special circumstances that were present in the 1950s, there came into being a banking system distinct from but supplementary to the banking systemp of Europe.

A new literature emerged during the 1960s; analyzing the types of structural characteristics that made it optimal for a country to choose one type of arrangement or the other. The experience of the 1950s and 1960s, however, brought growing disenchantment with the rigidity of exchange rates under the Bretton Woods system and a down ward trend in gold reserves possessiveness (see Table 1 in annexure).

In 1960s, Eurodollar deposits grew rapidly, reaching a level of $22 billion at the end of 1966. The formal creation of this –the special drawing right SDR- took place with the approval in May 1968. The initial allocation of SDR took place in three stages during 1970-72 by the end of the 1960s. By 1969, Eurocurrency deposits had doubled, to $44 billion; by the end of the 1972, they had more than doubled again, to $91 billion, of which $70 billion, or 77 per cent, were U.S. dollars. By the end of the 1960s, Alternative ways of introducing greater exchange rate flexibility into the Bretton woods system were being actively discussed in policy circles. The shift from fixed to more flexible exchange rates has been gradual, dating from the breakdown of the Bretton Woods system of fixed exchange rates in the early 1970s, when the world’s major currencies began to float. Among emerging market economies and other developing countries, the proportion of intermediate regimes rose markedly in the 1970s, but has remained relatively flat since then. For most of the individual countries, the Bretton Woods era was characterized by more rapid growth and less rapid inflation than the subsequently period of floating exchange rates, by faster and less variable growth than either the gold standard era or the interwar period, and by les variable inflation than the interwar period. Within intermediate regimes, however, managed floats have become more prevalent in emerging markets over the past decade, while other developing countries have tended to move in the opposite direction toward more limited flexibility. In fact, devaluation or revaluation was undertaken by the developed industrial nations only sparingly in the years from 1961 to august 1971(see Table 2 in annexure).

In June 1972, the United Kingdom decided to float its currency. By mid-summer 1972, Great Britain ceased pegging the pound, in 1973, Germany permitted the mark to float, and it began to appreciate sharply. Most other industrial countries followed Germany and ceased pegging their currencies. Once these countries stopped pegging their currencies, the semi-revived Bretton woods agreement was dead, replaced by a floating exchange rate arrangement. In effect, the resolving disputes about trade imbalances and exchange rates could be sent to some monetary counterpart of the Smithsonian institute ion to take its place alongside earlier monetary agreements as another historic artifact. From May 1973 on, following a period when it became apparent that the new parities set in December 1971 were unsuitable, most major currencies of the world were allowed to float. In 1975, countries with pegged rates accounted for 70 percent of the developing world’s total trade; by 1996, this figure had dropped to p Like any banking system, its elements consisted of reserves, deposits, and loans; all denominated in dollars and recorded in dollar accounts in curtain European banks, called Euro banks. The reserves were the New York deposits to which these Euro banks acquired title when their previous holders switched them into Eurodollar deposits.

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about 20 percent. In 1976, pegged rate regimes were the norm in Africa, Asia, the Middle East, non-industrial Europe, and the Western Hemisphere. At the beginning, eight of the nine members of the European community participated in the fixed Exchange Rate Mechanism (ERM) of the EMS. Following the collapse of Bretton Woods, in 1970s and 1980s, the British pound disappeared entirely from the menu of anchor choices. Pegs to the U.S. dollar declined in popularity among advanced countries as an increased number of free and managed floaters emerged, and the majority of advanced countries that retained pegs ended up tying their currencies in some form to the deutschmark, and later to the euro♀.

Since the early 1980s, however, developing countries have shifted away from currency pegs–toward explicitly more flexible exchange rate arrangements. In the 1980s, each country had agreed to peg its currency to those of other members to facilitate the trade and investment with neighboring countries. Many countries that traditionally pegged to the U.S. dollar, for instance, adopted a basket approach during the first half of the 1980s, in large part because the dollar was appreciating rapidly. Pakistan has maintained a de facto peg for much of the time since the early 1990s. Where there did exist various types of exchange rate systems . In December 1991, the prime ministers of the member countries of European community met at Maastricht - the capital of a relatively small province in the south of the Netherlands - and agreed to adopt a common European currency by the end of the 1990s. By the end of 1992, more than half of the currencies of the members of the European community had been devalued, or allowed to float. Maastricht seemed barely alive - still it survived and consequently German, France, and their neighbors returned to the timetable for the move to a common currency. Both the Smithsonian and the Maastricht agreements were efforts to reduce uncertainty about exchange rates. The premise of both agreements was that international trade and investment would be enhanced if traders and investors had greater confidence about currency values in the future. Among 180 countries classified by the international monetary fundq at the end of 1993, 77 countries were listed as having fixed exchange rate arrangements, 91 maintained flexible arrangements (including gliding pegs), and 12 were regarded as having arrangements with “limited flexibility”. Notably, the proportion of IMF members with flexible exchange arrangements has increased markedly over the past quarter century.

The trend in 1990s toward greater exchange rate flexibility has been associated with more open, outward-looking policies on trade and investment generally and increased emphasis on market-determined exchange rates and interest rates. In addition, some countries have reverted, against the trend, from flexible to fixed rate regimes. These include Argentina, which adopted a type of currency-board arrangement in 1991, and Hong Kong SAR, which has had a similar arrangement since 1983. By 1996, flexible exchange rate regimes predominated in all these regions. Nevertheless, the general shift from fixed to flexible has been broadly based worldwide. The 1992-93 ERM crises was similar to the crises that followed in that macroeconomic and microeconomic policies proved to be insufficiently supportive of the exchange rate rigidity that built up within the ERM and associated European exchange rate arrangements since 1987. Consequently, the ERM had evolved into a very rigid regime, and that rigidity was reinforced by the Maastricht treaty's emphasis on exchange rate stability as a condition for participation in stage three of EMU.

When the euro is created on January 1, 1999, its conversion rates against other currencies—internal and external∇— will need to be established. European Commission and the EMI have announced the procedures that have been followed to establish euro rates. As an initial step, it was announced in early May that the eleven currencies participating in monetary union would be converted on December 31 among each other at the current central bilateral rates of the ERM. The central banks of the participating countries agreed to use appropriate market techniques to the extent necessary. That was depending on market exchange rates of the participating currencies, plus the exchange values of the three currencies in the ECU basket that will not be part of the euro area at the outset.

♀ see in annexure (Table 3)

see in annexure (Table 4) q In the official classification by the IMF, exchange rate arrangements are divided into three broad categories: pegged or fixed arrangements, flexible arrangements, and an in-b/w category of arrangements with limited flexibility. ∇ Internal conversion rates are the rates at which participating currencies will be converted into euros, while external exchange rates are the exchange rates against currencies outside of the euro area. A key distinction is that the internal rates will be irrevocably fixed while the external value of the euro will be market determined. 7

This last constraint reflects the requirement, based on the Maastricht Treaty, that one euro must equal one ECU at the time that the euro comes into being. However, because the Danish Krone, the Greek drachma, and the British pound will not be replaced by the euro but are in the ECU basket, special procedures are needed. These will become the irrevocable euro conversion rates on January 1, 1999, and by construction, will satisfy the requirement that one- euro equal one ECU when trading begins.

The overall distribution of anchor currencies did not change much in the 1990s, apart from the introduction of the euro in 1999. Following the breakup of the Soviet Union in the early 1990s, most transition economies initially fell in the “freely falling” category for several years, and then increasingly started trying their currencies to the deutschmark and the U.S. dollar6. Looking ahead from the end of 1999, Greece has joined EMU, and Hungary and Poland are likely to. Israel is likely to move to an independently floating rate regime; Turkey is scheduled to move in that direction too, with possible membership in EMU a more distant prospect. Thus within this group of emerging market countries, there has been and will be a shift away from intermediate, soft peg, regimes, towards both greater fixity and greater flexibility7.

20TH CENTURY STYLE

In addition to the inter-convertibility b/w domestic money and gold at a fixed official price, in most major countries the gold standard regimes that prevailed during the late nineteenth and early twentieth centuries had two basic features: private citizens were free to import and export gold: and the stocks of national banknotes and coinage in circulation were backed with gold reserves.

The Brazilian crisis of 2002 reminds a lesson: no exchange rate regime is best for all countries, at all times, or in all circumstances, it follows that any exchange rate regime must be supported by macroeconomic and microeconomic (institutional or structural) policies that are consistent with and compatible with that regime as well as with the economic circumstances of the country at the time. Of the 43 countries listed as hard pegs by the Natural classification in 2001, only five had pre-announced pegs, of which only one (Malaysia) was in the emerging markets group. MENA countries has also shown interest towards exchange rate arrangements and adopted successfully5. Similar scenarios could be developed for other countries that are candidates for EU accession. Based on the official classification published in the IMF's International Financial Statistics 2002, Jordan, Lebanon, Egypt, Hungry, and Morocco have some type of pegged exchange rate regime.

In the first quarter of 2006, the EUR/USD shook off its 2005 trending mode and resorted to trading in an albeit wide range. Over in Europe growth is increasing at a stable rate, but if the EUR/USD begins to rise significantly in value once again, they will become more and more nimble with rate hikes and will frequently resurface to remind the world that it is tough to be a currency except euro that is representative of twelve independent countries3.

LITERATURE REVIEW

This paper seeks to apply to the case of Pakistan a broad set of theoretical considerations that have been identified in the literature as important factors affecting the performance of external sector—and hence the choice—of exchange rate regimes. The selection of the key factors—trade orientation; financial integration; economic diversification; macroeconomic stabilization; credibility; and “fear-of-floating” type effects—has been guided by quantifiability and cross-country comparability.

6 see in annexure (Table 5) 7 see in annexure (Table 6) 5 see in annexure (Table 7) 3 see in annexure (Figure 4) 8

This is a substantial theoretical and empirical literature on the alternative pegs and external sector performance of Pakistan’s economy. In Pakistan, considerations in choosing a currency peg include credibility of exchange rate regimes and monetary policy stance, the effects of exchange rate volatility on financial markets and financial wealth, the transactions costs arising from exchange rate volatility. If no substantial gain is to be achieved by switching from flexible exchange rate to basket-peg, such considerations might well dominate to ensure the competitiveness of external sector and favor the decision to continue with flexible exchange rate regime. Following this introduction, the theoretical framework is explained in section II of this part. Empirical aspects related to study are discussed in section III.

THEORETICAL FRAMEWORK

Economic theory provides a relatively little guidance on the relationship between exchange rate and trade policies. Trade and exchange rate policies have a common denominator in that they provide a certain degree of protection or support to domestic industries. There will always be a change in the level of the exchange rate that will, increase the return to certain exporting or import-competing activities. At first glance, one is tempted to argue that stable exchange rates are a precondition for stable trade policies. However, this need not be the case. We can view the impact of exchange rate regimes on the stability of trade policy in four ways. The first link concerns the taxonomy of exchange rate regimes following with sub sections like, currency basket peg, OCA, and target zone framework. The second link, performance of exchange rate regimes, has its origin in the direct impact of exchange rate policy on the external sector, BOP, national price level, capital flows, interest rate, and monetary policies more generally. The third link comes from the relationship of real effective exchange rates and external sector. The study shall turn to each of these aspects in turn. The fourth link examines the different sides of exchange rate regimes i.e., determination of exchange rate regimes and new orthodoxy. From the view point of theoretical aspects of exchange rate regime, First of all theoretical framework takes up a set of other issues briefly in subsequent sub-sections: the fear of floating argument, Keynesian analysis of flex, and on the argument the no" size fits for all" exchange rate regime.

TAXONOMY OF EXCHANGE RATE ARRANGEMENTS

Every country that has its own currency must decide what type of exchange rate arrangement to maintain. In reality, however, there are different varieties of exchange rate regimes, providing a range of alternatives. An exchange rate is simply a price: the price in domestic currency of a unit of foreign currency. Unlike most prices, the exchange rate has normally been fixed in some manner. To put the point graphically, if exchange rate arrangements lie along a line connecting free floating on the left with currency boards, dollarization, or currency union on the right, the intent was not to remove everything but the corners, but rather to pronounce as unsustainable a segment of that line representing a variety of soft pegging exchange rate arrangements. For the same reason, countries rarely allow their exchange rates to float freely. In most countries with floating currencies, the national authorities follow exchange market developments closely throughout every trading day, sometimes intervening to purchase or sell currencies, on their own account for limiting the extent to which the excess demands of supplies of market participants cause exchange rate to fluctuate. Hybrid exchange rate system combines some of the attributes and characteristics of both pegged and flexible exchange rate system.

PEGGING: A SINGLE CURRENCY OR BASKET?

If a country traded heavily with countries that were already on gold, then it could have an incentive to adopt the same monetary regime as its main trading partners. For those that do adopt an exchange rate anchor, a further choice is whether to peg to a single currency or to a basket of currencies. The choice hinges on both the degree of concentration of a country’s trade with particular trading partners and the currencies in which its external debt is

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denominated. When the peg is to a single currency, fluctuations in the anchor currency against other currencies imply fluctuations in the exchange rate of the economy in question against those currencies. By pegging to a currency basket instead, a country can reduce the vulnerability of its economy to fluctuations in the values of the individual currencies in the basket.

OPTIMUM CURRENCY AREAS

The theory of optimal currency areas suggests that countries benefit from adopting the same anchor as trade partners, since this reduces their bilateral exchange rate variability. They find that, after controlling for other factors∂, the probability of choosing a particular anchor currency increases with the amount of trade with other countries that use this same anchor. The question at issue is; what is an optimum currency area? During recent years, the theory of optimum currency areas has been resuscitated, greatly benefiting from, and contributing to, the consideration of various practical issues. The Mundell Fleming model led to two important developments in the theory of Exchange rate regime choice: the impossible trinity or the trilemmaT: and the Optimal Currency Area.

FEAR OF FLOATING

The fear-of-floating literature [e.g. Calvo and Reinhart (2002)] points to a number of additional factors that may explain why some countries are reluctant to allow much exchange rate flexibility. To the extent that a lack of exchange rate flexibility over time contributes to a buildup of dollarization and fear-of-floating-type effects, countries that do not have such effects at present may be well advised not to maintain a peg and thereby avoid having the effects develop.

In contrast to the other analytical considerations, apparent evidence of potential balance-sheet-type effects seems to suggest a case for a peg of the rupee. However, Pakistan’s degree of dollarization ranks in the middle of the sample and, in contrast to occasional assertions in the Pakistani press, there is little evidence of significantly higher pass- through of exchange rate changes into domestic inflation in Pakistan than in other countries. Hence, on balance there appears to be a modest case for a peg on the basis of fear-of-floating-type effects.

KEYNESIAN ANALYSIS OF FLEX

Work on flexible rate in macroeconomic perspective goes back to Polka and Leursen and Metzler, as well as James Meade. Keynes model identifies the terms of trade with the exchange rate; it essentially assumes that prices and costs are fixed in terms of supplies currency and that fore exchange rate raises import prices relative to export prices.

The analysis drew flexible rates into a macro economic framework by identify the exchange rate with the terms of trade. Which in turn effect the composition of domestic appending and are a determinant of exports? In the absence of capital flows, the exchange rate will adjust to maintain the trade balance in equilibrium. An expansionary domestic policy, e.g., would raise income and import spending. The resulting trade would cause depreciation and switch demand toward domestic goods until the deficit was eliminated (Drnbusch and Krugnan, 1976).

No "One-Size-Fits-All" Exchange Rate Regime

∂ such as country size, openness, and colonial history T According to the trilemma, countries can only choose two of three possible Outcomes: open capital markets, monetary independence and pegged exchange rates. 10

An important decision for the Central and Eastern European countries seeking membership in the European Union is choosing the most appropriate exchange rate regime. Experience has shown that many considerations are involved in this decision and that there is no "one-size-fits-all" solution. Because accession countries maintain a wide diversity of exchange rate regimes, from a currency board arrangement (Estonia) to floating regimes (Poland since April 2000 and the Czech Republic). A common goal of the countries is to move toward meeting the Maastricht criteria as they complete their transitions, but there seems to be no direct link between the exchange rate regime they have in place and their progress in meeting that goal.

THE TARGET ZONE FRAMEWORK

The attention that target zone systems began to receive around the mid-1980s was stimulated by the behavior of US dollar exchange rates. The development of conceptual models of exchange rate dynamics within a target zone system began with an important contribution by Krugman (1991). Notably, Krugman’s analysis was based on the strong assumption that the target zone was perfectly credible, in the sense that market participants expected the exchange rate to remain within the zone forever. It also assumed that the policy authorities did not act to resist exchange rate movements unless the exchange rate reached one of the boundaries of the zone.

EXCHANGE RATE REGIMES AND EXTERNAL SECTOR

By its very failure in this respect, a fixed exchange rate system promotes the introduction of controls over international trade and investment, whereas, FLEX promotes freedom of trade and investment. In particular, empirical studies have failed to uncover statistical evidence that exchange rate variability has had much of a depressing effect on international trade volumes. Dellas & Zilberfarb (1993) also argue that higher volatility of exchange rate witnessed since the adoption of the floating regime in 1973 has led to a decline in international trade transactions. Looking at the volume of trade is not the place where one would expect to find the costs of fluctuating exchange rates.

EXCHANGE RATES VS. BALANCE OF PAYMENTS

By the early seventeenth century, moreover, the influence of exchange rates and the balance of payments on domestic economic conditions was recognized in British and Italian policy circles (Salera, 1946).

Since the middle of the twentieth century, major developments in both macroeconomic analysis and the evolution of the world economy – most notably, the Keynesian revolution and the rapid expansion of international capital transactions relative to the growth of international trade have altered perceptions of the behavioral linkages b/w exchange rates and the balance of payments. In its pure form, a system of fixed exchange rates must be rejected on the ground that the “balance of payments discipline.” Under flexible rates, however, if market forces are allowed to work unimpeded, so that no actual or export payments deficit are surplus can appear. In sum, the highly competitive foreign exchange market is the most efficient means for bringing international payments and receipts into balance (Caves, 1963).

EXCHANGE RATES VS. NATIONAL PRICES LEVEL 11

The perception of exchange rates are related to national price levels has been traced back to the sixteenth century. The general inflation that has taken place during the war has lowered this purchasing power in all countries, though in a very different degree, and the rates of exchanges should accordingly be expected to deviate from their old parity in proposition to the inflation of each country. Countries with inflation rates higher than their main trading partners often depreciated their currencies to prevent a severe loss of competitiveness. A system of flexible exchange rates, on the other hand, achieves adjustment entirely through relative price changes (David, 1976).

In Chile and Poland, the transition took place through a gradual shift from targeting exchange rate bands and inflation toward focusing on inflation. Moreover, as many as 19 developing countries floated their exchange rates in 2002 and announced their inflation targets without a formal inflation-targeting framework. Lebanon also has a small open economy with a fixed peg to the dollar; its economy is highly dollarized.

EXCHANGE RATE REGIMES VS. CAPITAL FLOWS

The right statement is that for countries open to international capital flows: (i) pegs are not sustainable unless they are very hard indeed; but (ii) that a wide variety of flexible rate arrangements is possible; and (iii) that it is expected that policy in most countries will not be different with exchange rate movements (Mundell, 1963). According to Fleming (1962) view, the gold standard flourished with open capital markets and fixed exchange rates because monetary independence was not of great importance. As it has been noted, fixed exchange rates stimulate capital inflows while more flexible exchange rates regimes tend to discourage them (Griton and Henderson, 1976).

EXCHANGE RATE REGIMES VS. INTERNATIONAL MONETARY REGIMES

A short theory of the international monetary regimes that have transpired over the past century, elucidate that monetary policy in countries with floating exchange rate systems is likely to respond to movements of the exchange rate. In Canada, the use of a monetary conditions index to guide monetary policy, based on movements in both the exchange rate and the interest rate, formalized the impact of exchange rate movements on monetary policy (Flemine, 1962). In countries that pursue an inflation targeting approach to monetary policy, movements in the exchange rate will be taken into account in setting monetary policy, because the exchange rate affects price behavior. A system of FIX is inconsistent with the degree of monetary and fiscal independence required in today’s world. FLEX allows old maximum independence with regard to monetary and fiscal policy (Emminger, 1976).

INTEREST RATE VS. EXCHANGE RATE ARRANGEMENTS

A country that lowers its interest rates relative to those of other countries will tend to experience a decline in the demand for its currency, ceteris paribus, leading to depreciation of its exchange rate (Whiteman, 1975).

RELATION SHIP BETWEEN REER & TRADE PERFORMANCE

Most recently, some studies' have focused on the impact of REER on the stability of trade policy for transition economies. Trade performance as measured by the changes in the trade balance is as expected, with a dramatic deterioration in the trade balance, particularly in the countries with the sharpest appreciation in the REER. The link between changes in REER and trade performance is very tight in some countries including the Czech Republic and Slovakia; in others, the relationship is more tenuous. The relatively stable REER in Hungary has been associated with a constant level of trade balance and, most recently, with some improvement in the trade balance. The case of

' Wickham (1985), Sachs (1996), Frenkel (1996) and others 12

Poland is somewhat puzzling; the deterioration in the trade balance has been associated with a constant level of the REER measured by producer prices.

DETERMINANTS OF CHOICE OF EXCHANGE RATE REGIME

Exchange rate regime choice has evolved considerably in the past 100 years. At the beginning of the twentieth century, the choice is also becoming more obvious - - go to floating exchange rates, all the advanced countries have done it. There has been keen interest in empirical and theoretical studies on the choice of exchange rate regimes in developing countries in the aftermath of the currency crises in Mexico (1994), Southeast Asia (1997), Russia (1998), and Brazil (1999).

The theoretical literature provides broad guidance on exchange rate regime choice. The main criterion for regime choice is to reduce the output cost of an adjustment to exogenous shocks. Thus, the nature and the magnitude of shocks the economy is likely to face, as well as the structural characteristics of its goods, labor, and financial markets, are important con side rations in choosing an exchange rate regime (Bordo and Flandreau 2003). The early literature on the choice of exchange rate regime took the view that the smaller and more "open" an economy (that is, the more dependent on exports and imports), the better it is served by a fixed exchange rate. In this framework, the best regime is the one that stabilizes macroeconomic performance, that is, minimizes fluctuations in output, consumption, the domestic price level, or some other macroeconomic variable. The ranking of fixed and flexible exchange rate regimes depends on the nature and source of the shocks to the economy, policymakers’ preferences, and the structural characteristics of the economy.

THE NEW ACCEPTED CREDENCE

The claim of the new credence is that the choice of exchange rate regime has been hollowed out to one of two "corner solutions.” One is a firmly fixed exchange rate, with an institutional guarantee that it will stay fixed, in the form of at least a currency board, or else "dollarization or monetary union. The other is a floating exchange rate that is almost "lightly managed.”

EMPIRICAL EVIDENCES

INTRODUCTION

Importance of exchange rate as a nominal anchor is quite high, especially for external stability. Abed, Arbas and Gruerami (2003) has compared the dollar peg to a dollar-euro basket peg as alternative exchange rate regimes for the incipient GCC currency union for serving as a more beneficial to external sector stability». Quantitative evidence suggest basket peg does not dominate dollar peg for improving the external sector stability and a more flexible exchange policy is necessary for compositeness and stability of GCC oil exports. There is, therefore, a need to separate exchange rate weights due to exports and imports when constructing a basket peg for a small and open economy. Dellas and Zilberfarb (1993) ponder at the issue of real exchange rate volatility and international trade for a small country like Cushman. Nevertheless, his empirical study was unable to establish a systematically significant

» For this purpose, series of IMF Occasional Papers has focused on exchange rate regimes, including Aghevli, Khan, and Montiel (1991), Eichengreen, Masson, and others (1998), Mussa, Masson, Swoboda, Jadresic, Mauro, and Berg (2000), and Rogoff, Husain, Mody, Brooks, and Oomes (2004). 13

link between exchange rate variability and the volume of trade on bilateral basisz

EVIDENCES FROM PAKISTAN

The impact of exchange rate volatility on the volume of international trade has been studied intensively since the late 1970s when the exchange rate moved from fixed to flexible exchange rate, means facing a volatile real exchange rate. The theory says that higher exchange rate volatility will reduce trade by creating uncertainty about future profit from exports trade. Pakistan follows the flexible exchange rate system since 1982. At the initial stage the fluctuation of exchange rate is very nominal. However, exports evolved broadly in line with total world imports. Pakistan’s share in world imports was stable during the last 24 years, ranging b/w a minimum of 0.12% in 1980 and a maximum of 0.18% in 1992. In 2002-2003, the share was 0.17%. This suggests that Pakistan’s performance was based on the flexibility of exchange rate. In this context a lot studies are there. Like, the focus of Mustafa and Nishat (2005) is to see the impact of exchange rate volatility on exports of all trading partners of Pakistan. In addition, concluded that flexible exchange rate has a significant relation with export growth.

Aftab and Aurangzeb (2002) investigate the Marshall Lerner condition for Pakistan. Moreover, proves that ML condition holds for Pakistan in the end by using quarterly data for the period 1980-2000. Kamal(2005) examines the nature of association of exchange rate with exports and imports. In addition, concluded that exchange rate flexibility affects export positively and imports negatively which implies that it helps in improving trade balance.

EVIDENCES FROM DEVELOPING & DEVELOPED COUNTRIES

Mohsin (1986) analyzed the five year trend of movement away from fixed pegs against at single currency toward flexible arrangements and pegging to currency composites within five years and made a right statement for countries open to international trade flows: (i) pegs are not sustainable unless they are very hard indeed ; but (ii) that a wide variety of flexible rate arrangements are possible; and (iii) that it is to be expected that policy in most countries will not be indifferent to exchange rate movements. Corder (1993) discusses the 1980s regime in every developing country by using real target approach. In addition, purposes floating exchange rate regime for liberalism of trade regimes. A similar argument may hold in the case of the European transition economies, which hold a large part of their debt in Euros and trade largely with the EU (euroization). Wolf (1985) examined the distinctive features of the exchange rate systems for centrally planned economies– (CPE) and found that the exchange rate in the classical CPE has little or no effect on prices or real trade flows. Black (1976) and Branson and Katseli-Papaefstratiou (1981) have argued that, where the potential benefits of a floating (flex) exchange rate are not necessarily limited to industrialized countries, certain characteristics found in many developing countries rule out floating as a feasible or realistic option. The analysis of Kandil and Mirzaie (2003) also favor the floating exchange rate for some developing countries to ensure the desirable current account balance. Over the last five years or so, the trend in developing countries has been away from fixed pegs against a single currency towards flexible arrangements and pegging to currency compositions.

EVIDENCES FROM EMERGING ECONOMIES z also see Broll and Eckwert (1999) and Gregorio, Jose, Wolf and Holger (1994) – the USSR, the German democratic republic, Poland and hungry 14

Kandil and Aghdas (2003), Whickham (1985) provide a good summary about the exchange rate regime in emerging economies. The largest group of countries (13) of out of 33 emerging economies consists of those described as independently floating. Six of those countries (Indonesia, Korea, Thailand, Russia, Brazil and Mexico) became floaters after the major crises of the last decade, while Colombia joined the group in 1999. Three economies are described as having managed floats.

With regard to exchange rate arrangements for the non-emerging market developing economies, Mussa et al (2000) had focused so far on exchange rate regimes for 55 developed and emerging market economies and states: "Reflecting wide differences in levels of economic and financial development and in other aspects of their trade situations, no single exchange rate regime is most appropriate for all such countries.

Calvo and Reinhart (2000b) offer a longer list of reasons as to why emerging markets may be unwise to float, even if one believes that floating is a good choice for industrial countries. Exchange rate volatility is more damaging to export performance. Many emerging markets (especially in Latin America) have large dollar-denominated liabilities, whose domestic currency value is inflated by devaluation, Given the random behavior that governs the behavior of a floating exchange rate (Meese and Rogoff 1983), there would seem to be a strong case for seeking an alternative regime.

FOR AND AGAINST EVIDENCES ABOUT FIXED EXCHANGE RATE REGIME

Trade-offs exists between fixed and more flexible regimes. If economic policy is based on the "anchor" of a currency peg, monetary policy must be subordinated to the needs of maintaining the peg. Under a more flexible arrangement, monetary policy may be more independent but inflation can be somewhat higher and more variable. The annual report of IMF (2006-07) reveals that different varieties of fixed and flexible exchange arrangements are attractive to different countries. Thus in 1994 report, which covered 180 countries out of which, 77 cases are listed for fixed exchange rates, 12 cases of exchange arrangements allowing limited flexibility, and 91 cases of more flexible arrangements.

A concise and authoritative summary of traditional views on the criteria relevant in choosing an exchange-rate regime has been offered by Jeffrey Frankel (1999): The two big advantages of fixing the exchange rate…are: (1) to reduce transactions costs and exchange rate risk which can discourage trade and investment, and (2) to provide a credible nominal anchor for monetary policy. Similarly, the big advantage of a floating exchange rate, on the other hand, is the ability to pursue an independent monetary policy. If one believes that the exchange rate needs to serve as a nominal anchor, then the logical choice is a fixed exchange rate. Floating exchange rates have repeatedly led to the emergence of large misalignments. Caves (1963) rise with a strong argument for employing a flexible exchange rate for direct concerns with the balance of payments. He considers the case for flexible exchange rate as a method of dealing with problems of internal liquidity and payments equilibrium. Caves (1963), a theoretical analysis, discussed the merits of fixed vs. flexible rates for a customs union. Broad (2001) concluded that in the developing world, flexible exchange rate regime can insulate the concerns the theoretical and practical implications of the increased mobility of capital under fixed and flexible exchange rate and oppose the fix exchange rate b/c flexible exchange in a little help in increasing employment b/c of ensuring inflows of capital which kept exchange high and balance of trade deficit.

EVIDENCES IN FAVOR OF INTERMEDIATE REGIMES

Helpman and Razin (1979) has regarded as the primary benefit of an intermediate regime is that it allows policy to be directed to limiting misalignments. The proportion of intermediate arrangements in 1999 was significantly lower than it was in 1991, and there was a corresponding gain over the decade among the hard pegs on one side and more flexible arrangements on the other. According to some literature, the degree of crises proneness seems to be broadly similar across different types of intermediate regimes. Bubula and Otker-Robe (2003) highlight that the incidence of 15

crises during 1990-2001. Moreover, finds that intermediate regimes (mainly soft pegs and tightly managed floating regimes) have been more crises prone than the both hard pegs and other floating regimes-a view consist with the bipolar view of exchange rate regimes.

EVIDENCES IN FAVOR OF OTHER EXCHANGE RATE REGIMES

In sum, Genberg and Swoboda (2005) would expect a band system and managed floating to be less susceptible to misalignments than fixed rates and free floating. In terms of the first key criterion identified, avoiding misalignments, the presumption is that the crawling band would be the most effective system, followed by a managed float, and then fixed rates with a currency board, and, worst of all, free floating. In terms of the second key criterion, avoiding crises, the ranking is more or less reversed: free floating has the greatest invulnerability to crises, followed by a managed float, followed by fixed rates provided these are backed up by a currency board arrangement. Currency bands are probably the most vulnerable of the four regimes to crisis. Macdonald (1954) evaluates multiple exchange rates as an instrument for improving foreign trade balance for Latin American countries. Lewis (1997) argues that weak exchange rate targeting is likely to be superior to either indifference towards the exchange rate or the policy of joining a quasi-fixed exchange rate regime and purpose weak exchange regime as an optimal exchange rate regime.

FINANCIAL INTEGRATION

Other factors being equal, the disadvantages of exchange rate inflexibility rise as economies’ integration into global markets increases. In emerging market economies, where exposure to international financial flows is greater, less flexible regimes have had a higher propensity to experience banking and/or currency crises. In advanced economies, free floats have, on average, registered faster growth than other regimes, without incurring higher inflation.

International financial integration considerations also suggest a case against a peg in Pakistan. Pakistan is included in most emerging market indices, suggesting that it is relatively well integrated into global markets and, therefore, relatively more exposed to the volatility of private international capital flows. In addition, Pakistan’s stock market turnover ranks it among the countries in the sample with relatively developed capital markets.

DIVERSIFICATION/TERMS OF TRADE

Diversification considerations also point to a moderate case against a peg in Pakistan, although the implications of the alternative quantitative measures are somewhat mixed. On the one hand, Pakistan’s terms of trade volatility and the share of primary commodities in its exports are relatively low, suggesting that Pakistan’s need to adjust to commodity price shocks is not especially high. However, as the bulk of Pakistan’s exports are cotton-related products rather than raw cotton, these measures (especially the latter) probably do not capture Pakistan’s true dependence on cotton and, consequently, its need to adjust to cotton-related shocks. Indeed, the more direct measure—the correlation of world cotton prices with Pakistan’s economic cycle—indicates a relatively low degree of diversification for Pakistan and therefore a moderate case against a peg since one could complicate the necessary adjustment to cotton-related shocks.

STABILIZATION

16

Whether or not fixed rates provide better insulation against shocks depends on the degree of capital mobility and on the relative importance of real and nominal shocks. If capital is relatively immobile, a positive aggregate demand shock in a country with a fixed exchange rate leads to higher imports and a loss of reserves. Under a floating regime, the shock results in depreciation, this exacerbates the effects of the initial shock. Hence, a fixed regime provides better insulation of output against shocks to aggregate demand when capital mobility is low. Under high capital mobility, however, a fixed regime is disadvantageous. Under a floating regime, by contrast, the shock leads to an appreciation of the exchange rate, partly offsetting the initial shock.

Fixed rates better insulate against monetary shocks, regardless of the degree of capital mobility. Under a fixed regime, reserves increase, either because of lower imports (under low capital mobility) or larger capital inflows in response to the incipient increase in interest rates (under high capital mobility). Either way, the money supply expands to match the higher money demand, and output is unaffected. Under a floating regime, however, the increase in domestic interest rates causes the exchange rate to appreciate, thereby curbing exports and amplifying the initial shock. On balance, considerations emanating from the Mundell-Fleming framework point to a case against a peg in Pakistan. The capital mobility measure does not indicate a strong case either for or against a peg. However, monetary shocks have been relatively small in Pakistan, as has the ratio of monetary to real shocks, thereby suggesting that a peg would not be advantageous.

CONCLUSION

Comparisons with other countries are used to assess whether a particular country is a “natural” candidate for a fixed regime on the basis of a particular criterion. For example, countries that have a high degree of trade orientation will benefit from a regime that pegs the currency to that of its major trading partner. The application of the template to Pakistan indicates a fairly strong case against a pegged regime for Pakistan. Cross-country comparisons of quantitative and qualitative indicators for most of the analytical factors show Pakistan to be among the least likely to benefit, and most likely to be hurt, by a pegged regime. In particular, Pakistan’s relatively low trade orientation, high international financial integration, exposure to volatile commodity prices, and susceptibility to real rather than nominal shocks all point to the value of not pegging its exchange rate. This stands in sharp contrast to the de facto peg that has actually been in place for much of the past 15 years and suggests that increased exchange rate flexibility would be advantageous.

It is noteworthy that the present Pakistan’s situation is in contrast of basket peg or single currency peg. A basket peg with different weights may not establish a strong correlation between the Pakistan’s currency and two basket currencies. While taken into account the flexible regime system, the following features stand out: Pakistan’s relatively high degree of integration in global financial markets subjects it to the volatility of private capital flows and raises risks associated with operating a peg. Its relatively high dependence on cotton, which implies that Pakistan has a greater need for adjustment to commodity price shocks than more diversified economies. Moreover, real shocks have been far more important in Pakistan than nominal shocks, implying that a pegged regime would not be advantageous from a macroeconomic stabilization perspective.

The quantitative measures of trade orientation and optimal currency area effects suggest that Pakistan should not peg its exchange rate. Pakistan’s trade orientation is the lowest, and the share of its exports to its main trade partner currency area is relatively low. Moreover, the synchronicity of its economic cycle with that of its main trading partner is towards the lower end.

RECOMMENDATIONS

17

A few qualifications to the analysis should be noted. First, the literature generally considers the relative advantages of fixed versus flexible regimes without explicitly dealing with “nearly-fixed” regimes. Some of the conclusions about fixed regimes may or may not be valid for nearly-fixed regimes and should therefore be interpreted with caution. Second, the analysis for the most part takes as given that macroeconomic policies needed to support the chosen regime are in place, and methods to assess the sustainability of a particular regime are not covered. Regime choice would clearly be of limited importance in improving economic performance if policies are not sustainable. Third, the assessment of the efficacy of a fixed regime under a particular criterion may well depend on the sample period over which the relevant indicator is measured. To the extent possible, alternative sample periods were used to check the robustness of the results. Fourth, different analytical considerations could well point in different directions in terms of whether or not a given country should peg. Weighing the importance of each consideration will depend on country-specific circumstances, which invariably introduces some subjectivity to the analysis.

Taken together, the qualitative analysis capturing the various regime choice considerations indicate a fairly strong case against pegging the rupee. The following features stand out:

(i) Pakistan’s relatively high degree of integration in global financial markets subjects it to the volatility of private capital flows and raises risks associated with operating a peg (such as a disruptive exit, possibly accompanied by a banking/currency crisis); (ii) Its relatively high dependence on cotton, which implies greater need for adjustment to commodity price shocks than more diversified economies; (iii) Real shocks have been far more important in Pakistan than nominal shocks, implying that a pegged regime would not be advantageous from a macroeconomic stabilization perspective; (iv) Since Pakistan’s external trade orientation remains relatively low by international standards, the trade gains that could be achieved via a peg are also low. Hence, economic integration factors also weigh against a peg; (v) some evidence of contractionary effects of rupee depreciation may be a good reason to “fear floating” and adopt a peg. However, factors specific to Pakistan weaken, if not reverse, this argument. Since dollar borrowing by the corporate sector in Pakistan remains very limited, balance-sheet effects normally associated with “contractionary devaluations” are not likely to be present. Rather, causality more likely has been in the reverse direction—the de facto peg of the rupee was likely adjusted in response to the emergence of balance of payments pressures (reserves depletion), which often were the result of adverse supply shocks (e.g. weaker exports); (vi) The implications of the various considerations for regime choice are much more uniform for Pakistan than for many other countries. For example, in Morocco and Russia, some factors point to a peg while others suggest flexibility. In these cases, subjective judgment about prioritizing the factors is needed to conclude whether or not a peg is useful. In Pakistan’s case, however, the case against a peg appears relatively clear cut.

REFERENCES

Aftab Z. and Aurangzeb (2002), “The Long-run and Short-run Impact of Exchange Rate Devaluation on Pakistan’s Trade Competitiveness”, The Pakistan Development Review, Vol. 41, No. 3

Afzal M. (2005), “Estimating Long Run Trade Elasticities in Pakistan-Cointegration Approach”, The Pakistan Development Review, D. I. Khan: Gomal University

Ahmed M. (1992), “Pakistan’s Exchange Rate Policy: An Econometric Investigation”, The Pakistan Development Review, Vol. 31, No. 1

18

Ahmed, Eatzaz, and S. A. Ahmed (1999), “Exchange Rate and Inflation Dynamics”, The Pakistan Development Review, 38:3 235-251

Akhtar S. M. (1978), Modern Economics, Publishers United Limited, vol. 2, PP. 257-291

Alam, Shaista, M. S. Butt, and A. Iqbal (2001), “The Long-Run Relationship Between real exchange Rate and Real Interest in Asian Countries: An Application of Panal Co-integration”, The Pakistan Development Review, 31:1

Arize A. C. (1997), “Conditional exchange rate Volatility and the Volume of International Trade: Evidence from seven Industrial Countries”, Southern Economic Journal, Vol. 64, No. 1

Asteriou D. (1973), Applied econometrics: a Modern approach Using Eviews and microfit, library of Congress Cataloging-in-Publication Data, British

Bhattacharya R. (2003), “Exchange Rate Regime Considerations for Jordan and Lebanon”, IMF Working Paper, No. 03/137 (Washington: International Monetary Fund)

Bordo M. D. et. al (2004), “Exchange Rate Regimes, Past, Present, and Future”, IMF Working Paper, (Washington: International Monetary Fund)

Boughton, “Exchange Rate Movements and Adjustment in Financial Markets: Quarterly Estimates for Major Currencies”, staff papers, International Monetary Fund (Washington), Vol.31 (September 1984)

Broda C. (2001), “Coping with Terms of trade Shocks; Pegs VS Floats”, The American Economic Review, Vol. 191, No. 2, PP. 376-380

Broll U. and B. Eckwert (1999), “Exchange Rate Volatility and International Trade”, Southern Economic Journal, Vol. 66, No. 1, PP. 178-185

Bubula A. and Otker-Robe (2003), “Are Pegged and Intermediate Exchange Rate Regimes More Crisis Prone?” IMF Working Paper, No. 03/ 223 (Washington: International Monetary Fund)

19

Calvo et. al, (2000), “Fear of Floating”, University of Maryiend

Catao L. and S. Solomou (2002), “Exchange rates in the Periphery and International Adjustment under The Gold Standard”, IMF Working Paper, No. 03/ 41 (Washington: International Monetary Fund)

Caves R. E (1963), “Flexible Exchange Rates”, The American Economic Review, Vol. 53, No.2, PP. 120-129

Corder W. M. (1993), “Excahnge Rate Policies for Developing Countries”, The Economic Journal, Vol. 103, No. 416, PP. 198-207

Dellas H. and B. Zillberfarb (1993), “real exchange Rate Volatility and International Trade: A Reexamination of the Theory”, Southern Economic Journal, Vol. 59, No. 4, PP. 641-647

Drabek Z. and J. C Brada., “Exchange Rate Regime and the Stability of Trade Policy in Transition Economies”, Arizona State University, AZ 85287-3806

Edwards M. and M. A. Savasteno (1999), “Exchange Rates in Emerging Economies: What Do we Know? What Do we Need To Know?” NBER Working Paper, No. 7228, Jel No. F31, F33, F41

Edwin M. Trumen (2002), “Economic Policy and Exchange Rates Regimes: What have we learned in the Ten Years Since black Wednesday?” Institute for International Economics, (England: London)

Flanders M. J. and E. Helpman (1978), “Exchange Rate Policies for a Small Country”:, The Economic Journal

Flood, Bhandari, and Jocelyn P. Home, “Evolution of Exchange Rate Regimes”, staff papers, International Monetary Fund (Washington), Vol.36 (September 1984)

Genberg H. and A. K Swoboda. (2005), “Exchange Rate Regimes: Does What Countries Say Matter?” staff papers, International Monetary Fund (Washington), Vol.52

20

Ghosh A. and A. M. gulde (2002), Exchange Rate Regimes: Classifications and Consequences, BMW Centre for German and European Studies

Gujrati D. N. (2003), Basic Econometrics, McGraw-Hill Companies, New York, U.S.A

Helpman E. and A. Razin (1779), “Towards a Consistent Comparison of Alternative Exchange Rate Systems”, The Canadian Journal of Economics, Vol. 12, No. 3, PP. 394-409

Hussain A. M (2005), “Choosing Right Exchange Rate Regime”, The Pakistan Development Review

Hussain A. M (2006), “To Peg or Not To Peg: A Template for Assessing the Nobler”, IMF Working Papers, (IMF: Middle East and Central Asia Department)

International Monetary Fund, Direction of Trade Statistics, International Monetary Fund, Washington D. C

International Monetary Fund, International Financial Statistics, International Monetary Fund, Washington D. C

International Monetary Fund, World Bank Outlook Database, International Monetary Fund, Washington D. C, April 2004

Sun Y. (2002), “ A Political-Economic model of the Choice of Exchange Rate Regime”, IMF Working Papers, No. 02/212, (Washington: International Monetary Fund)

Tuesta P. R. V (2005), “Euro-Dollar Real Exchange Rate Dynamics in an Estimated Two-Currency Model: What is Important and What is not?” IMF Banco Central De Reserva Del Peru

Wang K. L. and C. B. Barrett (2002), A New Look at the Trade Volume Effects of Real Exchange Rate, unpublished paper, Department of Applied Economics and Management, Cornell University, New York, U.S.A

Wickham (1985), “The Choice of Exchange rate Regime in Developing Countries”, staff papers, International Monetary Fund (Washington), Vol. 32

21

Wickham (2002), “Do Flexible exchange Rates of Developing Countries Behave Like the floating exchange Rates of Industrialized Countries?” IMF Working Papers, No. 02/82(Washington: International Monetary Fund)

Williamson J. (2000), “Designing a Middle Way between Fixed & Flexible exchange Rates”, Institute for International Economies, No. 19-20

ANEXURES

Figure 1: Real per Capita Income Growth 1880-1910

Source: NBER

Figure 2: Exchange Rates Volatility 1880-1910

22

Source: NBER

Figure 3: Inflation 1880-1910

Source: NBER

Figure 4: EUR/USD Rates 1999-2005

23

Table 1: US Gold Reserves and Liquid Foreign Liabilities ($bln)

1950 1957 1960 1965

Gold reserves 24.3 24.8 19.4 15.5

Liquid foreign liabilities 7.1 13.6 17.3 24.0

Source: IFS, 1965/1966 Supplement.

Table 2: Changes in Par Value, 1961 to 1971 year country Devaluation Revaluation %change

24

%change

1961 West Germany 4.6

Netherlands 5

1967 Denmark 8

UK 14.3

1969 France 11

West Germany 9.3

1971 Austria 5

Source: World Bank

Table 3: Short-term Variability of Exchange Rates among European Currencies

(April 1973-August 1992)

Bilateral exchange rates Apr.1973- Mar. Apr. 1979 – Oct. 1983 – Mar. Apr. 1988 – Aug. against the deutschemark 1979 Sept. 1983 1988 1992

Nominal

Belgian franc 0.6 0.7 0.3 0.2

Nether land Krone 0.8 0.5 0.3 0.3

Danish Krone 0.9 0.7 0.5 0.4

Austrian schilling 0.4 0.2 0.2 0.2

French franc 1.6 0.8 0.6 0.4

Italian lira 2.3 0.9 0.6 0.5

Irish pound 2.2 0.7 0.6 0.3

Swiss franc 1.7 1.4 0.9 1.1

Pound sterling 2.3 2.6 1.8 1.5

Swedish Krone 1.2 1.7 1.1 0.9

Norwegian Krone 1.1 1.5 1.2 0.8

Finnish Markka 1.6 1.4 0.9 1

25

Spanish peseta 2.4 1.8 1 1

Portuguese escudo 1.9 1.9 1.1 0.9

Real, based on consumer prices

Bulgarian franc 0.8 0.8 0.3 0.4

Netherlands guilder 1.0 0.6 0.4 0.4

Danish Krone 1.1 0.8 0.7 0.6

Austrian schilling 0.5 0.4 0.4 0.5

French franc 1.6 0.9 0.6 0.5

Italian lira 2.3 1.1 0.7 0.6

Irish pound 2.3 1 0.7 0.4

Swiss franc 1.8 1.4 0.9 1.1

Pound sterling 2.2 2.7 1.9 1.5

Swedish Krona 1.2 1.9 1.2 1.2

Norwegian Krone 1.2 1.7 1.2 1

Finnish Markka 1.5 1.5 1 1.2

Spanish peseta 2.7 1.9 1.1 1.1

Portuguese escudo 2.2 2.1 1.1 1.1

Table 4: All Other Countries Grouped by Exchange Rate Arrangements

(as of December 31, 1991)

Exchange Rate Regime (Number of countries) Countries NS/CBA (22) Antigua and Barbuda, Benin, Burkina Faso, Cameroon, Central African Rep., Chad, Congo (Rep. of), Côte d'Ivoire, Djibouti, Dominica, Equatorial Guinea, Gabon, Grenada, Kiribati, Mali, Namibia, Niger, Senegal, St. Kitts and Nevis, St. Lucia, St. Vincent and the Grenadines, Togo

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FP (51) Albania, Algeria, Angola, Bahamas, Bahrain, Bangladesh, Barbados, Belize, Bhutan, Botswana, Burundi, Cape Verde, Comoros, Cyprus, El Salvador, Ethiopia, Fiji, Iran, Iraq, Kenya, Kuwait, Lesotho, Liberia, Madagascar, Malawi, Malta, Mauritius, Mongolia, Myanmar, Nepal, Nicaragua, Oman, Papua New Guinea, Rwanda, Saudi Arabia, Seychelles, Solomon Islands, Sudan, Suriname, Swaziland, Syrian Arab Republic, Tanzania, Tonga, Trinidad and Tobago, Uganda, United Arab Emirates, Vanuatu, W. Samoa, Yemen, Yugoslavia, Zimbabwe

HB (3) Iceland, Libyan Arab R., Luxemburg

CP (8) Bolivia, Costa Rica, Guinea Bissau, Honduras, São Tome and Príncipe, Somalia, Tunisia, Uruguay

MF (9) Guatemala, Guinea, Lao PDR, Maldives, Mauritania, Mozambique, Romania, Vietnam, Zambia

IF (11) Afghanistan, Dominican Republic, The Gambia, Ghana, Guyana, Haiti, Jamaica, Lebanon, Paraguay, Sierra Leone, Zaire

Source: IMF.

Key: NS = Arrangements with no separate legal tender CBA = Currency board FP = Other conventional fixed pegs HB = Pegged rate in horizontal band CP = Crawling peg CB = Rates within crawling bands MF = Managed float with no pre-announced exchange rate path IF = Independently floating

Table 5: Exchange Rate Arrangements 1990s

pegged floating Single currency Currency composite Other managed Independently floating floating

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U.S. dollar French Algeria Afghanistan Other Algeria Afghanistan franc Belarus Albania Belarus Albania Angola Brazil Australia Bangladesh Brazil Australia Antigua Benin Cambodia Azerbaijan Botswana Cambodia Azerbaijan and Burkina Chile Bolivia Burundi Chile Bolivia Barbuda Faso China, Bulgaria Cape Verde China, Bulgaria Argentina Cameroon Colombia Canada Cyprus Colombia Canada Bahamas Central Costa Rica Ethiopia Czech Republic Costa Rica Ethiopia Barbados African Croatia Gambia Fiji Croatia Gambia Belize Rep. Dominican Ghana Iceland Dominican Ghana Djibouti Chad Ecuador Guyana Jordan Ecuador Guyana Dominica Comoros Egypt India Kuwait Egypt India Grenada Congo, El Salvador Jamaica Malta El Salvador Jamaica Iraq Rep. of Georgia Japan Morocco Georgia Japan Lithuania Côte Greece Kenya Nepal Greece Kenya Marshall d’Ivoire Hungary Korea Seychelles Hungary Korea Islands Equatorial Indonesia Lebanon Slovak Republic Indonesia Lebanon Micronesia, Guinea Iran Liberia Solomon Islands Iran Liberia Federated Gabon Israel Mauritania Thailand Israel Mauritania States of Guinea- Kazakhstan Mexico Tonga Kazakhstan Mexico Nigeria Bissau Kyrgyz Moldova Vanuatu Kyrgyz Moldova Oman Mali Macedonia, Mongolia Western Samoa Macedonia, Mongolia Panama Niger Yugoslav Mozambique Yugoslav Mozambique St. Kitts Senegal Malaysia New Malaysia New Zealand and Nevis Togo Maldives Zealand Maldives Paraguay St. Lucia Mauritius Paraguay Mauritius Peru St. Vincent Norway Peru Norway Philippines and the Pakistan Philippines Pakistan Romania Grenadines Poland Romania Poland Rwanda Syrian Russia Rwanda Russia Somalia Arab Singapore Somalia Singapore South Africa Republic Sri Lanka South Africa Sri Lanka Sweden Sudan Sweden Sudan Switzerland Tunisia Switzerland Tunisia Tajikistan Turkey Tajikistan Turkey Tanzania Turkmenistan Tanzania Turkmenistan Uganda Ukraine Uganda Ukraine UK Uruguay UK Uruguay US Uzbekistan US Uzbekistan Yemen Venezuela Yemen Venezuela Vietnam Vietnam

Source: Calvo and Reinhart (2000a).

Table 6: Emerging Market Countries Grouped by Exchange Rate Arrangement (December 31, 1999)

Exchange Rate Regime (Number of Countries) Countries

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NS/CBA (3) (*3) *Argentina, *Bulgaria, *Panama

FP (7) (*2) *China, Egypt, Jordan, *Malaysia, Morocco, Pakistan, Qatar

HB (1) (*1) *Greece

CP (1) Turkey

CB (5) (*2) Hungary, *Israel, Poland, Sri Lanka, *Venezuela

MF (3) (*1) Czech Republic, Nigeria, *Taiwan POC

IF (13) (*7) *Brazil, *Chile, Colombia, Ecuador, *India, Indonesia, *Korea, *Mexico, Peru, *Philippines, Russia, *South Africa, Thailand

Source: IMF, Annual Report 2000 Note: * indicates country whose weight in either the EMBI+ or MSCI index is 2% or greater. Numbers in parenthesis indicate number of countries in each group; asterisked numbers are self- explanatory.

Key: NS = Arrangements with no separate legal tender

CBA = Currency board

FP = Other conventional fixed pegs

HB = Pegged rate in horizontal band

CP = Crawling peg

CB = Rates within crawling bands

MF = Managed float with no pre-announced exchange rate path

IF = Independently floating

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Table 7: Selected MENA Countries’ Exchange Rate Arrangements 2001

Nominal Exchange Nominal GDP Fluctuations International Total Regime GDP (Per in Terms Fluctuations Labor Reserves Trade Classification (Millions capita, in Money Market (Months of (Percent by IFS (As of Country of dollars) dollars) of Trade1 Demand2 Rigidity3 imports)4 of GDP) April 2003)

Eygpt 96,256 1,418 9.7 4.3 0.39 7.1 17.5 Managed floating with no preannounced path for the exchange rate

Iran 83,640 1,287 13.3 14.2 ... 9.7 36.6 Managed floating with no preannounced path for the exchange rate

Jordan 8,828 1,698 5.4 8.3 0.11 6.1 80.9 Fixed peg arrangement against a single currency

Lebanon 16,660 4,680 ... 4.1 ... 8.1 49.0 Fixed peg arrangement against a single currency

Morocco 33,876 1,161 9.1 7.7 0.24 8.3 53.7 Fixed peg arrangement against a composite

Tunisa 20,003 2,069 2.0 5.7 0.39 2.3 80.6 Crawling peg

Sources: National authorities: IMF, International Financial Statistics: World Bank; and IMF staff estimates. 1Defined as standard deviation of the terms of trade index for 1996—2002, in percent. 2Defined as standard deviation of the differences between the estimated trend velocity and actual income velocity of money for 1991—2001, in percent.

3The labor rigidity indicator is an average for 1970–99. The higher the indicator is, the higher labor rigidity is. The indicator for Hong Kong SAR is 0.07.

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