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. 2 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.