Managing exchange rates is vital for developing economies whose competitiveness is highly dependent on this
What economic function did the exchange rate changes among these islands of stability fulfil? Except for stuffing gift socks of hedge funds, the answer is, none
— Nobel laureate
Robert Mundell, in an article in The Wall Street Journal.
In my column last week, I referred to the question of managing exchange rates. Dr Raghuram Rajan, in his lecture at the Reserve Bank a few weeks ago, had advocated a focus on inflation, and an intervention in the exchange market only at the time of extreme volatility. One wonders whether this view was partly based on the presumption that if inflation is kept stable, the exchange rate would take care of itself. In a paper published in 1976 (‘an instant classic’, as Kenneth Rogoff described it 25 years later), Rudiger Dornbusch attributed the volatility in exchange rates to differing monetary policies. To quote Rogoff again, “In Dornbusch’s view, excessive exchange rate volatility was the inevitable result of the chaotic monetary policies that had led to the break-up of fixed rates in the first place. If domestic monetary policies are unpredictable, then so, too, will be domestic inflation differentials. Ergo, the exchange rate must be volatile because, in the very long run, there has to be a tight link betwee national inflation differential and exchange rates…” “In the very long run”, yes; but we all know what is really certain over that time horizon.
Rogoff went on to point out, however, that “Whereas the over-shooting model is a landmark theoretical achievement, it is an empirical bust”. In other words, it does not work in practice; that exchange rates often deviate significantly from the diktats of inflation differentials. To be sure, both Dornbusch and Rogoff were focusing more on the exchange rates between the industrial economies. What about the developing countries?
The issue of exchange rate policy is perhaps even more important for developing economies, which are often dependent on labour-intensive exports of undifferentiated manufactured goods whose competitiveness is highly dependent on the exchange rate. And, exports is only one aspect. Another is: In a globalised world, domestic industry has been rendered uncompetitive with imports because of an overvalued exchange rate. The issue is has a lot more to it than “the grumblings of a few exporters” which Dr Rajan advised the Reserve Bank to ignore: A competitive exchange rate is crucial to investment, growth and employment, not just to balance of payments.
It is worth spending a couple of minutes pondering over who benefits from freely floating exchange rates and their tendency to overshoot and deviate significantly from fundamentals:
More From This Section
* Volatility surely benefits the currency trader, and increases the risks of cross-border trade;
* An overvalued exchange rate is deflationary and, therefore, adverse for corporate profitability, and hence for FDI, and the equity investor;
* On the other hand, a rapidly depreciating currency is inflationary, reduces consumption, creates debt-servicing problems for companies who have forex loans, potentially destabilising the banking system.
If China has become the fastest- growing economy ever in world history (10 per cent annum for three decades), an important element of macro-economic policy has been the exchange rate which helped create hundreds of millions of jobs in export manufacturing. Surely, the example of China is far more relevant for the developing world than say the US’s ‘benign neglect’ of the dollar’s external value?
There are those who believe that it is not possible to ascertain what the ‘correct’ exchange rate should be, and hence argue that it is futile to try to manage it. Alan Greenspan had the same view about equity prices and hence his unwillingness to take pre-emptive action in the face of ‘irrational exuberance’. But his ‘markets know best’ ideology now stands discredited, not least in his own eyes: In a Congressional testimony in October 2008, he confessed his disillusionment with his earlier beliefs, claiming ‘a flaw in the model’. But apart from this, it is possible to ascertain what a reasonable level for the exchange rate should be.
In a 2007 paper titled Global imbalances and destabilising speculation, Heiner Flassbeck and Massimiliano La Marca, UNCTAD economists, argue that the most important price for exports and imports is the real exchange rate. If it moves in the ‘wrong’ direction — this means if it appreciates when the current account is in deficit — there is no easy way out of a protracted imbalance. “... such ‘false’ price movements should be avoided at all costs”. They further argue that exchange-rate flexibility does not discourage portfolio and currency speculation unless interest rate differentials could be offset by the risk of depreciation, in periods of extreme volatility. They add that, in particular, if the herd behaviour of speculators is sufficient to influence appreciate the target currency, the appeal of large returns is sufficient to generate them.
Clearly, the paper argues that the real effective exchange rate index is a good measure of the competitiveness of an exchange rate. So, to my mind, is the deficit on current account, the mirror image of the real exchange rate. But more on the issues next week.