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Transition to Floating Exchange Rate Regime

 

Muhammad Hassan Farid

In practice many developing countries prefer fixed exchange rate system over floating exchange rate because they want to avoid the volatility in exchange rates. However, relatively fixed exchange rate system needs adequate holdings of international reserves assets but to build up or even maintain their reserve stocks is difficult because of need for capital goods imports as well as capital flights from developing countries towards industrialized countries where the real rate of return on capital may be higher and more stable. Present international monetary system has made perilous for developing country like Pakistan to fix its exchange rate unless it has means and commitments to do so come what may. Pakistan is continuously quagmired in external financing constraints: most of the time since early 1970s Pakistan remained under IMF programs due to balance of payment stress. In return IMF has prescribed many of the measures like reforms in fiscal policies, removing price controls, removing subsidies on energy, adoption of market oriented policies and floating of currency etc. Currently, Pakistan is seeking another bailout package from IMF and negotiations are underway to finalize the terms and conditions of the said program. One of condition is adoption of floating exchange rate of Pak rupee and some of developing countries like India, Afghanistan, Turkey, Indonesia, Egypt and Thailand etc. are already practicing floating exchange rate system. Presently Pakistan maintains a de facto exchange rate anchor to US$ (Stabilized arrangement) and expected conditionality of IMF to abandon stabilized arrangement system due to non-performance of de-facto fixed currency value regime in avoiding the financial crises repeatedly and frequently even in the presence of widespread exchange controls . In the present macro-economic conditions, it is analyzed whether to retreat to market determined currency rate immediately or to delay it till the macro-economic stability is achieved.
The past experience of different developing countries switching their exchange rate system towards flexibility is not pleasant in initial years. In 1994, Mexico retreated to float its currency rate during amidst of the financial crises under the recommendations of IMF. Resultantly, GDP growth rate shrank by 6% and the inflation was sky-rocketing and these factors contributed to worst unemployment rate. In 2001-02, Argentina abandoned the fixed exchange rate system in amidst of the recession. The Peso (currency) depreciated and resulted in price hike which was difficult for its citizens to bear the burden and resultantly due to depreciation more than 20%, Argentina defaulted on its external debt. Similarly, Brazil during the financial crises devalued its currency, the real, by 8% and then allowed to float. Immediately, the real lost 40% of its value against the dollar which resulted into deep economic recession.
During East Asian Crises of 1997, Thailand floated the currency (baht) and it quickly depreciated by more than 50% in value against US$ and more than 11% GDP fell. In the same year during amidst of the crises, Indonesia adopted floating exchange rate and its rupiah lost 85% of value which turned most of the companies insolvent and massive unemployment with inability to afford even basic food items which resulted into breaking out of ethnic violence and worst inflation in the history of Indonesia. Real GDP in Indonesia fell by 13.5% in 1998. On December 1997, South Korea during the peak of the Asian economic crises on the recommendations of IMF floated its Korean won and its real GDP fell by 6% and unemployment rate grew to more than double in 1998. When devaluation occurred, much of the financial sector and many corporations became insolvent due to disproportionately foreign currency denominated debts. Similarly Egypt floated its exchange rate in 2016 under IMF program and she experienced almost 50% loss in her currency value against $US. The Egyptian Central Bank had to increase interest rates to 14.75% and inflation rate jumped to 24%.
In March 1993, India adopted managed floating exchange rate system during broad economic reform package and country was not passing through any economic or financial crises. This flexibility did not deteriorate any of the economic indicators. Similarly, Bangladesh adopted a floating regime on May 2003 by abandoning the adjustable fixed rate system and the transition to the floating exchange rate was smooth and without any market disturbance because the economic conditions were relatively stable at the time of switching the exchange rate system but later again reduced volatility of exchange rate fluctuations by heavy intervention in foreign exchange market and now classified again as having stabilized arrangement.
The clear lesson is that countries should successfully control inflation, recover from balance of payment crises and then move to greater flexibility in determination of currency values. There was a right time in 2016 at the end of IMF program to bring flexibility in exchange rate as Pakistan had achieved macro-economic stability but government defended the currency value against US$ and at that time Pak rupee appreciated in real term against trading partners currency values. This overvalued exchange rate deteriorated export competitiveness which resulted into current account deficit and present macro-economic situation is outcome of that defending currency value policy.
During the midst of crises it is unwise to adopt flexibility in currency rates because speculators will pounce on the exchange rate value immediately and push the rupee rate further down (may be rupee value dropped from 170 to 190 against $ US) and inflict heavy pain on the masses in term of further pushing price level up (CPI may rise to 15 to 25%), declining GDP (turn negative), and inflating fiscal deficit further due to high borrowing cost (Interest rates may jump to 14%). So government should reduce inflation and interest rates and stabilize other macro-economic conditions then it can be advisable to abandon fix exchange rate regime. State Bank may need to adopt its monetary policy framework as ‘inflation targeting’ after switching to floating exchange rate regime which will be required to give considerable monetary policy credibility.

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