An UNCTAD study on exchange-rate policies for developing countries notes that the recent crises in East Asia, which spread to Eastern Europe and Latin America, has revealed how little is known about workable exchange-rate policies for developing countries. The study further points out that, except for some extreme cases, neither currency boards nor a clean float of currencies seem appropriate for developing countries.

by Chakravarthi Raghavan

Geneva, 7 Aug 2000 -- Except in some extreme cases, neither currency boards (or even dollarisation) nor a clean float of currencies are appropriate for developing countries, according to a study by Mr. Andres Velasco, published by the UN Conference on Trade and Development in its G-24 Discussion Paper series.

The study by Velasco, an academic at New York University and the University of Chile, is under the UNCTAD Project of Technical Support to the G-24, with research work coordinated by Prof. Dani Rodrik and administered by UNCTAD’s Macroeconomic and Development Policies Branch.

in the study “Exchange-rate Policies for Developing Countries,” published in UNCTAD’s G-24 Discussion Paper series, Velasco notes that the 1997-1998 Asian crisis, and its offshoots in Eastern Europe and Latin America, has revealed how little is known about workable exchange rate policies for developing countries.

Arrangements that had performed relatively well for years (as in Indonesia and South Korea) came crashing down with no advance notice.  Others that once seemed invulnerable (like the Hong Kong currency board) almost tumbled down as well. Mid-course corrections proved equally troublesome - in every country that abandoned a peg and floated (Brazil, Ecuador, Russia, Thailand, and again Indonesia and South Korea), the exchange rate overshot massively and a period of currency turmoil ensued. And all these had real costs.

But despite the confusion, financial pundits are not shy of drawing conclusions, and eschewing any middle path, are now advocating hard pegs (currency boards) or free floating as the only options.

In the aftermath of the Asian crisis, hard pegs, especially currency boards have become increasingly popular. The main argument for this rests on the need to make monetary policy credible: if credibility of monetary policy at home could not be built, the argument seems to be to import it by fixing the value of the currency.

But the strength (and the potential weakness) of hard pegs lies in the absence of escape clauses. Another reason that leads many to advocate hard pegs is their alleged ability to induce discipline - whether its fiscal or monetary.

However, what this conventional wisdom fails to understand is that under flexible rates, imprudent behaviour, especially fiscal laxity, has costs as well. Under fixed rates, unsound policies manifest themselves in falling reserves or exploding debts, and only when the situation becomes unsustainable do costs begin to bite. Flexible rates by contrast allow effects of unsustainable fiscal policies to manifest themselves immediately through movements in exchange rates and price level. And if inflation is costly for fiscal authorities and these discounts the future heavily, then flexible exchange rates, by forcing the costs of misbehaviour to be paid up-front, can provide more fiscal discipline. In fact several studies show that in Latin America, fiscal policies have been more prudent under flexible rates than under fixed ones.

Its true that these were under ‘soft’ pegs. But would hard pegs do better? The experience of sub-Saharan Africa, especially Francophone Africa with currencies pegged to the french franc (in the CFA zone), and with a change in currency rates only once since 1948, the countries exhibited less fiscal discipline than their Anglophone counter-parts.

The recent experience of Latin America too is more ambiguous, says Velasco. “The fiscal performance of Argentina (where the peso is tied to the US dollar) and Panama (which uses the dollar as its currency), has not been outstanding, though in the case of Argentina it is a vast improvement from the hyper inflation-producing deficits of the 1980s.”

Hard pegs seem to have some important, but not unambiguous, advantage.  But a currency board or full dollarization is not for everyone. A number of conditions are necessary for their use:

*        Large countries are worse candidates than small (for hard pegs with currency boards or dollarisation), and pegging to a country subject to very asymmetric real shocks is likely to prove very problematic;

*        the bulk of an adopting country’s trade must be taking place with the country or countries to whose currencies it plans to peg. Thus, Mexico and Central America are much better candidates for dollarisation than Argentina, Brazil, or Chile;

*        the adopting country must have preferences about inflation broadly similar to those of the country to which it plans to peg;

*        flexible labour markets are essential: with fixed exchange rate, nominal wages and prices must adjust, however slowly, in response to adverse shocks;

*        strong, well-capitalized and well-regulated banks are also essential, since a hard peg prevents the local central bank from serving as a lender of last resort to domestic banks;

*        hard pegs are most necessary for countries with weak central banks and chaotic financial institutions. But making hard pegs work require high quality institutions and rule of law, and may involve putting the exchange rate into law—arrangements that only make sense in countries where governments adhere to their own rules and laws cannot be changed by fiat.

But a key implementation problem is that in a world of floating rates, pegging to one currency means floating against the others. It is not a problem for countries whose trade is geographically very concentrated.  Otherwise, cross-rate fluctuations can do serious damage - as shown by East Asian economies whose currencies were pegged to the dollar, and whose sharp appreciation vis-a-vis the yen, caused substantial real exchange-rate appreciation.

In principle, for such countries, pegging to a basket of currencies could help insulate them from cross-rate instability. Under a currency board, the weights used to calculate the basket must be public information. But banks have traditionally preferred to manage such baskets (privately), and there is also the problem of changing the weights of the basket in response to structural change.

If simplicity, transparency and observability are the main virtues of a currency board, moving to a complex, ever-changing basket, may undermine the very foundations of that policy.

A currency board may be good for preventing inflation, but can be bad for bank stability. A currency board makes a balance-of-payments crises less likely only at the price of making bank crises more likely. “The price of low inflation, may be endemic financial instability.”

An alternative is to use fiscal policy to help troubled banks. But this requires building up and maintaining a war chest in liquid form. For such a system of ‘self-insurance’, the cost could be high. For a country whose M2 (currency in circulation plus demand and savings deposits in banks) is two-thirds of its GDP, to keep half of it in time-deposit in Zurich (where such deposits pay 50 basis points below LIBOR), while its own domestic interest rates are 2.5 percent above LIBOR, means the net cost of holding the war chest is one percent of GDP!

Can the country do better by purchasing such insurance abroad - as has been done by Argentina through contracting a line of credit for which premiums are paid annually, to be used in case of bank troubles? If there be a regional or global contagion, the risk of bank runs need not be easily diversifiable for lenders. And the potential for moral hazard makes such contracts hard to write and enforce. And Argentina’s line of credit (from media reports) is said to be $6 billion, which is 10% of its M2. It is unclear whether larger amounts can be provided by the market at a reasonable premium.

As for the currently fashionable alternative of encouraging foreign ownership of domestic banks, this is a completely untested one. Will Citibank US ride to the rescue every time a Latin or Asian bank in which it has a 10% equity stake runs into trouble? Perhaps it may. But hanging a whole financial system’s health on that conjecture seems risky.

As for greater flexibility in exchange rates, if properly managed they can be stabilizing, although the key to it lies in credibility.

Standard theoretical debates centre on the trade-off between credibility and flexibility. But while this trade-off might be relevant for developed economies, it is not necessarily so for emerging market economies, where credibility appears to be a pre-requisite for flexibility to be useful. In its absence, flexibility could be destabilizing.

The crucial question is whether a regime of exchange-rate flexibility is compatible with sustained monetary credibility or whether, in countries with a weak track record, some kind of exchange-rate anchor is needed. But neither theory nor empirical evidence seem conclusive on this. Much would depend on the independence with which the central bank can carry out policy. In turn, this depends to a large extent on the degree of social consensus regarding the benefits of low inflation.

A number of small open economies have had successful experience with exchange-rate flexibility coupled with inflation targeting—Australia, Chile, Colombia, Israel, New Zealand and Sweden. More recently, Chile and Mexico have engaged in a ‘dirty float’. In both cases, in response to the Asian and Russian crises, their currencies came under pressure, and inflation temporarily rose, but there was a soft landing, with lower but positive growth and reduced current account deficits.

However, says Velasco, the evidence is limited.

At one level, the current enthusiasm for hard pegs spring from a lack of enthusiasm for the ability of developing countries to build institutions and govern themselves soundly. But if the assessment of developing countries’ limited capacity for sound policy-making is empirically correct, this undermines the whole case for hard pegs, Velasco points out. For, not even the most enthusiastic advocate of currency boards would deny that they require soundly supervised banks and prudent fiscal policies. And the literature is littered with calls for strengthening bank supervision and eliminating budget deficits before adopting hard pegs. But both these are technically taxing and politically troublesome.

Financial supervision is always hard, and globalization and innovation have made it much more so. The financial crashes in recent years in Japan, and the Scandinavian countries could be traced back to poor regulation.  And the near collapse of the hedge fund, Long-Term Capital Management in the summer of 1998 revealed a gaping hole in regulatory arrangements covering Wall Street. “There can be no doubt that supervising banks is as technically demanding, if not more so, than implementing monetary policy. And the political constraints are just as large, as we learn from the uproar that inevitably follows attempts to close insolvent banks or make good on earlier promises of no government bailouts.”

The dilemma facing those who attempt to design policy institutions for developing countries is stark.

“If politics prevents a country from managing its monetary policy soundly, then politics will be likely to prevent its banks and public finances from being properly managed as well. In that case,adopting a hard peg solves part of the political problem, but leaves the country potentially exposed to financial or fiscal crises. And these in time may also erode the viability of the peg."

“Alternatively, if a country’s politics and institutions allow bank regulators some autonomy and legislators some fiscal forethought, then that country can also probably sustain an independent and credible central bank. And if it can make itself credible in the eyes of investors and markets, should not the country be entitled to enjoy the benefits of exchange rate flexibility?”

The argument that a clean float is the only alternative to a hard peg, Velasco argues, is largely academic. In the real world, clean floats do not exist. Major industrialized countries (the UK, and smaller OECD countries) and middle-income countries such as Peru and Mexico, all practice floating with varying degrees of ‘dirt’. Even the US intervenes occasionally on the foreign exchange market.

Clean floating involves high volatility of the nominal exchange rates.  Hence, any scheme to control the rate of inflation on the short horizon must control, to some extent, the behaviour of the nominal exchange rate - thus helping to explain the prevalence of managed or dirty floats in the real world.

But should authorities attempt to mitigate not just short-term volatility but longer swings in nominal and real exchange rates?

The experiences of the 1980s, when under President Reagan, the dollar had a massive appreciation, and of Latin America in the 1990s when large capital inflows kept coming because of expectations of currency appreciation, there were capital outflows when the expectations were reversed, have led to policies to limit exchange rate movements via floatation bonds.

But any exchange rate regime, especially a flexible one, requires complementary policies to increase chances of success.

Some, Velasco notes, have suggested use of controls on capital flows.  He does not discuss its merits or demerits, but merely going on to discuss prudential regulations of the financial systems and counter-cyclical fiscal policy as “less controversial”.

He cites, that of some 26 banking crises studied, 18 were preceded by financial sector liberalization within a five-year interval. And financial liberalization accurately signalled 71% of all balance-of-payments crises and 67% of all banking crises. This general tendency, he adds, is confirmed by experiences of Chile, Mexico and now East Asia.

“Freeing interest rates, lowering reserve requirements, and enhancing competition in the banking sector are sound policies in many grounds.  Countries that apply them often experience an expansion in financial intermediation. But they can also sharply reduce the liquidity of the financial sector, and hence set the stage for potential crises....  Financial liberalization should be undertaken cautiously. Reserve requirements can be a useful tool in stabilizing a banking system..”

There is also a case for discouraging short-term debt. High required reserves on liquid bank liabilities - whether in domestic or foreign currency, and whether owed to locals or foreigners - is an obvious choice, and may be a sound policy even if it has some efficiency costs.  However, if banks are constrained, firms will do their own short-term borrowing as happened massively in Indonesia. Taxes on capital inflows, where the tax rate is in inverse proportion to maturity of the inflow (and long-term FDI goes untaxed at the border) were used by Chile and Colombia in the 1990s.

As for fiscal policies that could be counter-cyclical (accumulating surplus during economic growth and deficits during slowdowns), a first step to make them credible would be to reduce levels of public indebtedness. With less initial debt, there is more room to expand in bad times. A second step is to reform fiscal institutions to make spending less cyclical and repayment more likely - such as through a National Fiscal Council.-SUNS4724

The above article first appeared in the South-North Development Monitor (SUNS) of which Chakravarthi Raghavan is the Chief Editor.

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