Daily The Business

Transition to Floating Exchange Rate Regime

890In 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 (current account and capital transactions) . 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.
(i) Floating exchange rate system gives central banks autonomy to control money
supply and preferred rates of trend inflation. High inflation countries have weaken
currencies than that of their low inflation countries. It is argumented in favour of
flexible exchange rate that it insulates countries from effects of monetary as well as
fiscal changes of the world. Flexibility in exchange rate helps to cushion the

 

2
disturbances in output and price level. Market determined currency value system
doesn’t stress much on acquiring of international reserves for precautionary
measures against currency crises.

(ii) Flexible exchange rate causes more volatility in currency values because exchange
rate is an asset price. It sometimes leads to vicious circle of depreciation and
inflation. It affects international trade and occasionally investment is also affected
due to increase uncertainty in foreign exchange market. Although exchange rate
risks can be avoided by use of forward market to hedge the exchange rate
fluctuation risk but it has cost of avoiding such risks. Changes in exchange rates have
macro-economic effects that Central Bank are compelled to intervene in currency
markets to moderate movements even without a formal commitment to fix
exchange rate system. The countries which has opted for flexibility in determination
of currency values have continuously maintained international reserves to import
values ratios since their old fixed exchange rate system despite the theoretical
consideration that acquisition of international reserve is not emphasized.

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

3
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.
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 amidst 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. 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.

Leave A Reply

Your email address will not be published.