A V Rajwade: 'Flexible exchange rates'

WORLD MONEY

Diplomats of the financial world, particularly those belonging to the multilateral institutions like the International Monetary Fund (IMF), World Bank, World Trade Organisation (WTO) and so on have become adept in the use of euphemisms and code words. For instance, one favourite is "poor governance", often blamed for the lack of development or economic growth.

This phrase is a euphemism for corruption. The use of such words is unavoidable given the prickly sensitivities of developing countries "" we ourselves are hardly immune from this.

The problem is that such code words are rarely defined with any degree of precision "" indeed, precise definitions would defeat the very purpose of using them "" and, therefore, they sometimes tend to get used to express exactly opposite concepts. One such word is "flexible exchange rates".

Recently, a call for flexible exchange rates has been given by both the Group of Seven (G7) that met in Washington as part of the IMF-World Bank meetings a couple of weeks ago, and Raghuram Rajan and Arvind Subramanian in an article titled "Exchange rate flexibility is in Asia's interest" (Financial Times, September 27)

[Rajan is IMF's economic advisor and director of its research department. Subramanian also works for the IMF].

The G7 had called for flexible exchange rates earlier as well. For instance, its meeting in Dubai almost exactly a year ago concluded that, "more flexibility in exchange rates is desirable".

At that time, the currency markets had interpreted the statement as a tacit call to depreciate the dollar "" the G7 participants themselves gave varying interpretations.

US Treasury Secretary John Snow compounded the confusion by claiming that there was no change in the "strong dollar policy". In reality, of course, the US would like nothing better than a sharp appreciation of the Asian currencies in order to limit its yawning current account deficit, projected at 5.5 per cent of GDP in the current year.

As part of the recent G7 meeting in Washington, for the first time, China was invited to take part in the discussion on exchange rates. Obviously, the reason was to pressurise China to up-value its currency and reduce its trade surplus, particularly with the US. While the Chinese resisted the call to float its currency, the G7 communique at the end of the meeting repeated its call for "more flexibility in exchange rates".

Shorn of euphemisms, the G7-advocated flexibility is in the direction of an upward movement in Asian currencies, particularly the yuan, vis-à-vis the dollar.

On the other hand, the cited article by the IMF officials seems to argue for flexible exchange rates from a different perspective: They apprehend that "with a fixed exchange rate, real appreciation will take place".

This would lead to "an unviable domestic sector", "a drag on long run growth" and "the fiscal burden of accumulating non-performing loans in public sector banks". They argue, "it is better to move towards exchange rate flexibility".

So the G7 advocates exchange rate flexibility to achieve real appreciation of Asian currencies, even as Rajan and Subramanian advocate exchange rate flexibility to avoid the risk of real appreciation! So take your choice of what exchange rate flexibility means!

One does not know, of course, how these policy makers and advisors would describe India's exchange rate policy "" flexible in nominal terms, leading to a stable exchange rate in real terms. Incidentally, the IMF has recently praised India's management of the exchange rate.

Still on the subject of flexible/floating exchange rates, Milton Friedman, the free market guru, was a persistent critic of the fixed exchange rate system, which collapsed in 1971.

His arguments were based not only on the free market philosophy, but also because he felt that rigid, fixed exchange rates lead to misalignment of currencies, inviting speculation. He believed that floating exchange rates will lead to less speculation and more stability in exchange rates.

He has turned out to be wrong on both counts. The latest Bank of International Settlements (BIS) survey of the global foreign exchange market evidences a daily turnover of $ 1.9 trillion.

Given that world trade in goods and services is barely $ 30 billion a day, it is obvious that more than 90 per cent of the activity in foreign exchange markets consists purely of speculative trades. What about stability?

In the last decade, the yen has moved between ¥ 80 and ¥ 147, and is currently ¥ 110. The euro in its short life of less than six years has moved between $ 0.83 and almost $ 1.30. No wonder more analysts seem to be questioning the virtues of freely floating exchange rates.

Martin Wolf of the Financial Times is a recent convert. In an article ("We need a global currency", August 4) in that paper, he lists the following as the major sources of instability in the current international monetary system:

"The world's richest country is its biggest capital importer and net debtor."

Two periods of sizeable net lending to emerging economies that "ended in financial crises and sharp reversals in lending".

The accumulation of "enormous quantities of foreign currency reserves" by emerging economies, particularly Asian.

He feels that "a single factor helps explain these phenomena: global currency instability". Wolf goes on to argue that, "a global market economy needs a global currency" and that "in its absence, the world of free capital flows will never work as well as it might".

He concedes that "this is a world I am unlikely to ever see". On the topic of exchange rate flexibility, it is good to see analysts moving away from Milton Friedman and towards James Tobin and Robert Mundell.

Email: avrco@vsnl.com