Exchange-rate Policies For Emerging Market Economies

Richard J Sweeney

• Publisher: Routledge
• Year: 2019
• ISBN:
  9780429721069
• Edition: 1
• Topic: Politics & International Relations
• Subtopic: Politics
• Index: Politics & International Relations

With the loss of Soviet control in Central and Eastern Europe, as well as the move toward economic liberalization in many developing countries, a huge increase in the number of convertible currencies in the world has occurred. A key aspect of the management of these currencies involves their relationships with the world economy, which is determined

Part One
Fixed vs Flexible Exchange Rates: The Debate Continues

1
The Case for Hard Currency Strategies for Emerging Market Economies

Eduard Hochreiter

Introduction

There is almost universal agreement that the statutory prime objective of central bank policy is the maintenance of price stability. As has been pointed out elsewhere,¹ the basic policy problem facing the central banks of economies in transition is how to best achieve this objective, i.e., with the least economic cost in terms of frictional unemployment.²

Recall that government policymakers in the transitioning economies initially faced, inter alia, massively distorted relative price structures characterized by heavy subsidies and state monopolies. There were neither central banks nor monetary policy in the Western sense, and financial markets were nonexistent. The opening of these economies to market forces required very substantial changes in relative prices, which, in conjunction with downward stickiness of prices, initially implied a once-and-for-all jump in the general price level. This, in turn, led to an (economically warranted) dramatic decline in measured real wages, which subsequently made it difficult in many of these countries to contain renewed pressures to raise nominal wages.

There continues to be an urgent need for economic policymakers to devise policies that stabilize expectations and speed up economic adjustment, i.e., to make the supply side more flexible and responsive to market signals, and so increase the adaptability of the economy. Such considerations are also relevant for central bank policy.

The challenge for governments and central banks is, therefore, to select a monetary regime that is conducive to the achievement and maintenance of price stability, to define the intermediate target(s), and to devise effective operating procedures. In addition, and closely linked to these goals, the central bank should support the development of financial markets. The policies that support these goals critically depend on how the systemic reform process evolves. At the same time, it is my conviction that no new monetary policy theory has to be developed for economies in transition, but rather that the same economic principles of, say, exchange rate policy, apply both to market economies and transitioning economies.³

This chapter develops arguments for the adoption of a fixed peg by six selected transitional economies: Bulgaria, the Czech Republic, Hungary, Poland, Slovakia and Slovenia.⁴ It interprets the likely occurrence of real appreciation and, in the context of fostering credibility for the peg, examines the role of currency convertibility in these countries. The final section presents my conclusions.

A Fixed Peg as Anchor for Monetary Policy

There is an abundant literature dealing with the choice of the exchange rate regime.⁵ However, so far no consensus has emerged. In principle—taking the G-3 countries (the United States, Japan, and Germany) as a yardstick—one could argue that the larger, the less open, and the more diversified a country's trade links with the rest of the world (and thus in the absence of an obvious dominant economy with common policy aims which is politically acceptable as the center country), and the more developed the financial system, the more likely that policymakers will opt for a flexible exchange rate regime; that is, to employ a monetary aggregate as the intermediate target or anchor for monetary policy and let the market determine the exchange rate.

The recent experience of the European Monetary System has led to arguments that the lifting of exchange controls has advanced the case for greater exchange rate flexibility because of the ensuing rise in capital mobility. Increased capital mobility makes pegged exchange rates much more vulnerable to speculative attacks.⁶ In a world with substantial economic interdependence, one cannot in general sustain a combination of pegged exchange rates, freedom of domestic monetary policy and freedom from capital controls. Eventually, at least one of these policies will have to go. My argument is that giving up the pegged exchange rate is generally not the least-cost solution for a small, open (reforming) economy.

It is my view that the substitution of other nominal anchors for the exchange rate peg—save in extreme circumstances—is not the best way to anchor monetary policy, at least for the smaller transitioning economies.⁷ The use of monetary aggregates as the nominal anchor critically depends on the stability of the demand for money and the central bank's ability to control the money supply process. At this point, the transitioning economies lack the track record to empirically test if these conditions hold.⁸ Moreover, the smooth operation of floating exchange rate regimes requires well-developed money and capital markets to offset short-term fluctuations in the demand for money. Finally, floating exchange rates tend to substantially over- and undershoot, even in countries such as the United States where money and capital markets are very well developed. The volatility and the tendency of floating exchange rates to overshoot is related to the fact that monetary aggregates do not provide such a clear, simple and transparent anchor for expectations as pegged exchange rates. As we learned a long time ago, the time lags in monetary policy are long and variable. Deviations from purchasing power parity are large and sustained, and the construction of monetary aggregates is complex and subject to change over time. For these and other reasons, floating exchange rates have not converged on purchasing power parity for extended periods, even in developed market economies (Hochreiter 1989:214). For countries undergoing the transition from planned to market economies the problems are all the greater. Consequently, floating exchange rates and the use of monetary aggregates as intermediate targets are—as a rule—not the preferred option, at least for the smaller transitioning economies.

This leaves us with the alternative of using the exchange rate as nominal anchor for macroeconomic policy.⁹ Such a view has been echoed by Michael Bruno. He argues that Estonia, which is not covered in this study, is a textbook case of successful monetary stabilization using an immediate and credible fixing of the currency (CEPR 1993:4). Another interesting point in favor of a pegged exchange rate system has been made by Guitián (1994:24). He notes that "with a fixed exchange rate, an economy expresses its willingness to withstand the consequences of external shocks and disturbances."

The optimal choice of the peg remains an unresolved issue although, after the experiences with the European Exchange Rate Mechanism in the early 1990s, the majority opinion of policymakers and academia appears to lean to some form of limited flexibility; say, in the form of some sort of adjustable peg. But before setting a peg, several critical issues must be addressed: which currency or currencies to peg to; the speed of price liberalization and the initial degree of price distortions to be corrected; the degree of convertibility to be introduced and when, and the population's reaction to it (currency substitution); the existing and/or expected disequilibrium in the current account of the balance of payments, the (prospective) foreign reserve position and the level of foreign debt; the supply-side reaction of the economy to systemic change, etc.¹⁰ All of these factors entail massive uncertainty with regard to the initial equilibrium level of the exchange rate and its likely evolution. As a consequence, a more flexible peg has generally been recommended for transitional economies.¹¹ A flexible peg is defined as a peg which is devalued or revalued at irregular intervals. Alternatively, the exchange rate may be adjusted according to some indicator (crawling peg) or not at all (fixed peg). Crawling pegs come in two varieties: the endogenous and the exogenous crawling peg. In the former case the nominal exchange rate is periodically adjusted to the actual inflation rate, while in the latter case the exchange rate is adjusted in steps related, among other things, to the projected rate of inflation.

In spite of the problems enumerated, my preference—drawing heavily on the Austrian experience—remains for a fixed peg to one or more of the stable Western currencies with no—or next to no—escape clauses after having taken into account the initial effects of price liberalization and of the (near) abolition of subsidies.¹² An initial devaluation of the currency to a somewhat undervalued level is desirable before pegging the rate, because an undervalued exchange rate will help support exports at a very difficult juncture of the economy. This will help sustain the fixed peg through the period when the development of the services sector and further liberalization measures drive the (overall) inflation rate above that of the center country(ies).

One decisive factor for a successful monetary policy and, indeed, for the sustainability of a pegged exchange rate, is the credible commitment of the central bank to price stability. In this respect a single-currency peg constitutes the simplest, and preferred, rule: it is transparent and easily understood by policymakers and the public alike. Since monetary policy in the Western sense is new to the transitioning economies, their central banks have no track record against which to evaluate their commitment to stated policy aims. Therefore, one of the central banks' first goals ought to be to build a reputation for policy steadfastness and to earn credibility as quickly as possible. Institutional design can aid or hinder the achievement of this goal; legal independence is important.¹³ The creation of favorable expectations concerning price stability at home and a stable exchange rate with regard to the center country (or countries in the case of a basket peg) should positively influence investment and savings behavior and should, in particular, limit currency substitution.¹⁴ In my view, an endogenous crawling peg risks the continuation (or even the acceleration) of inflation, while an exogenous crawling peg tends to work too slowly to reduce inflation expectations because of continuing devaluations, even when they are less than the current inflation rate.

The initial setting of the exchange rate is, however, an extremely difficult task. It appears that in Poland and the former Czechoslovakia policymakers did err as far as devaluation was concerned: the initial undervaluation of the exchange rate was more than was warranted by the (expected) jump in the price level due to the liberalization of prices and the sharp curtailment of subsidies. It is my judgment that in no case was the initial error so large that the peg had to be abandoned on this account later on.¹⁵ Provided that the initial mistake in setting the exchange rate is not "too large," one can expect that—over time—the domestic economy will adjust to the exchange rate level chosen without undue economic cost. Within bounds, the commitment of the authorities is more important than the exchange rate level selected.

Indeed, the flexibility and adaptability of the micro side of the domestic economy in conjunction with consistent fiscal and incomes policies are crucial. Successful macroeconomic stabilization requires both stringent monetary and fiscal policy. Apart from making sure any initial error in setting the exchange rate level is not "too" large, the sustainability of the peg critically depends on the wage formation process. Therefore, it seems advisable to supplement the exchange rate anchor by a wage anchor.

There are several options available for such a (supplementary) anchor: administrative wage controls either in the form of a temporary wage freeze (Bruno 1991), longer term wage controls (e.g., taxing the marginal wage increase), or a productivity-orie...

Table of contents

• Cover
• Half Title
• Series Page
• Title
• Copyright
• Contents
• Acknowledgments
• Introduction
• PART ONE Fixed vs Flexible Exchange Rates: The Debate Continues
• PART TWO Exchange Rate Pegging as an Anti-Inflation Strategy
• PART THREE Issues for Exchange Rate Management
• PART FOUR Currency Areas and Currency Boards
• PART FIVE Experiences from the Emerging Market Economies