Exchange rate as an instrument for economic management

Exchange rate has a significant role in ensuring domestic price stability and equilibrium in balance of payments in a milieu that facilitates economic growth. Recent economic history also demonstrates that wrong policies with regard to exchange rate management have an adverse effect on growth of output and employment and are responsible for a variety of distortions and imbalances. In the case of important world currencies like the US dollar, Euro and Japanese yen, inappropriate exchange rate polices inflict considerable damage on the world economy at large. Thus if the under – valuation of the Japanese yen vis-à-vis the US dollar had been corrected promptly, some of the serious imbalances in the international payments of the 1970s and 1980s could have been avoided. Three hundred and sixty yen for the dollar was an unsustainably high price for the dollar.

It has also to be appreciated that the exchange rate is only one of the policy instruments of economic management. There are other instruments such as fiscal policy, monetary policy and incomes policy that are both complementary and alternative to the exchange rate instrument, depending on the circumstances of a specific situation. Further, although for a while the emphasis of policy may be on a particular instrument, it is desirable to view the various instruments as an integrated whole. The anatomy and pathology of the economic system are like those of the human system, very much inter-connected.  

Reliance on one instrument will not produce the desired results. All the instruments will have to be used in an integrated manner, but with the relative emphasis of the individual instrument varying from time to time.

The importance of exchange management also depends on the policy objectives of a country at a point of time. Today nearly all governments will proclaim that their economic objectives comprise (1) high economic growth, (2) attainment of full employment, (3) domestic price stability, (4) balance of payments equilibrium, and (5) more equitable distribution of income and wealth. In practice, however, there has to be a trade off among these objectives.

In the years since the end of World War-II, the period 1946-71 was marked by remarkable exchange stability under the aegis of the International Monetary Fund (IMF), which had then attached cardinal importance to the system of fixed exchange rates which were to be changed only with the prior approval of IMF. In fact IMFs concurrence had to be secured when a member’s initial par value, i.e. exchange rate in terms of gold / US dollar was fixed.

It should also be noted that the remarkable exchange stability of the period owed much to the strength of the US dollar which came to be the most important reserve currency in the world. The dollar’s strength stemmed from a satisfactory mix of fiscal-monetary policy contributing to price and exchange stability. The US also provided substantial assistance to the rest of the world which eased to a considerable extent the phenomenon of dollar shortage, which had assumed acute proportions in the early post World War-II years.

Being a dominant member of the IMF, the US intervened actively to ensure the fixation of appropriate exchange rates by member countries. The US influence could be seen in the widespread devaluation of the order of 30 per cent that occurred in September 1949, in particular by the UK and most of the commonwealth countries. This correction of over-valuation that had been built up over the years helped much the subsequent exchange stability for many years to come.     

This exchange stability coincided with impressive rate of economic growth and remarkable price stability. Price and exchange stability were made possible by fiscal and monetary discipline in the leading industrial countries.

From 1973, with a series of oil shocks, the Bretton Woods system of fixed par values broke down and the major currencies have been on a floating system. The interesting thing is that during all these years, the US has been experiencing large and persistent deficits on merchandise account as well as the current account of the balance of payments. These deficits have been financed by massive inflows of capital into US, short term as well as long term.

The experience of US deficits defies much of conventional theory.

A large and persistent deficit country attracted large capital and during long stretches of time the currency appreciated. To a large extent this is explained by the massive productive capacity and potential of the US economy and the enormous confidence of the rest of the world in the political, economic and social stability of the US. In any event, the US dollar remains the most important currency of the world despite its considerable devalution vis-a-vis Euro and yen in recent yeas.

In the past three and a half decades, since the breakdown of the Bretton Woods system, all kinds of exchange managements have been tried by many countries – fixed, fully floating, floating within limits through intervention of monetary authorities, and multiple currency practices etc. However, it would be correct to say, that for several years now the general policy has been towards stability rather than fluctuation. Experience has shown that the system of widely or wildly fluctuating exchange rates has not provided any cure for the ills of the international economy. Exchange rates have not reflected inflation rate differentials. Purchasing power parity has been persistently violated, that is real exchange rates have behaved in an erratic and unpredictable manner. Exchange rate volatility has had undesirable side effects.

It has encouraged a shift of resources towards non-traded goods and away from traded goods. This reallocation has contributed to rise of unemployment. Large and unpredictable exchange rate changes are becoming less efficient information signals in the economy. Besides in a floating exchange rate system, there is free scope for speculative positions to be built up both ways, making the exchange rate out of alignment with its fundamental equilibrium position. Further, under such a regime, capital movements could assume large destabilizing dimensions. In a country without financial discipline, the floating rate system will result in a loss of confidence in domestic currency before long. So not only will inward remittances dry up but also residents will shift funds outside the country, the capital flights will assume prodigious proportions and there could be serious destabilizing social and political consequences.

In Pakistan, we have been on a system of managed float since January 8, 1982. We adopted this system at the behest of the IMF in the hope that it would promote a better adjustment of disequilibrium in our balance of payments and also create an environment in which appropriately designed national economic policies could promote high rates of economic growth and employment in an ambiance of low inflation.

Unfortunately the managed float has not lessened the weaknesses of our external balance of payments. Despite a devaluation of our rupee during the past 26 years vis-a-via the US dollar from Rs9.90 to Rs72.50 at present, the external account countries to be under severe pressure. In FY 2006 -07 the current account balance was – $7.36 billion while in FY 2007-08 it is around – $12.5 billion. Total liquid foreign exchange reserves of the country (estimated at $10.95 billion) on June 7, 2008) cover only 17 weeks of imports. Earnings through exports of the services sector in 2007-08 amounted to $3.6 billion, while import payments on this account amounted to $9.9 billion. Thus there was a substantial deficit on this account of $6.6 billion.

The Trade Policy for 2008-09 envisages a target of $22.1 billion for exports and anticipates import payments to be around $30 billion.

The ineffectiveness of exchange rate adjustment in securing improvements in our external balance stems from the fact that changes in costs arising from exchange rate movements feed through quickly and extensively into the economy and contribute to the acceleration of inflationary pressures in its stemming from large fiscal deficits and excessive monetary expansion. The relentless climb in prices over a long period has stimulated among industrialists, agriculturists, businessmen and wage earners defensive inflationary responses and these have nullified the impact of exchange rate adjustments on the international competitiveness of our exports. External depreciation of a currency can improve the balance of payments only if as a result of it a significant switch is brought about in the economy from domestic absorption of tradable goods and services to exports. If because of the escalation of domestic costs it is not possible, downward exchange adjustments can lead to a trap where an unending cycle of depreciation and inflation could disrupt production and investment activity and result in large scale capital flights.

Recent economic trends in the country have made it abundantly clear that wild fluctuations in the exchange rate can only be avoided by restoring financial discipline through appropriate fiscal and monetary policies and checking inflationary forces. – Repeat

Source: The News, 11/8/2008

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