SUNS4513 Wednesday 22 September 1999

Geneva, 20 Sep (Chakravarthi Raghavan) -- Developing countries need to improve their management of exchange rates to benefit from greater integration into the international trading system, and must not only sustain competitive rates over the longer-term but must also retain policy autonomy to make orderly adjustments when faced with exogenous shocks.

This, says UNCTAD in its Trade and Development Report 1999, is best achieved by managing nominal exchange rates flexibly to minimise fluctuations in real exchange rates, and combining this with controls on destabilising capital inflows.

Discussing the three options of fixed exchange rates, floating exchange rates, and a currency pegged to an external one and a currency board regime, UNCTAD says none of the three can provide financial stability.

"The question is not so much one of designing an appropriate exchange rate regime as of managing and regulating capital flows; no exchange rate regime can ensure the stability and autonomy needed for successful trade performance unless destabilising capital flows are brought under control."

TDR-99 notes that debates on exchange rate regimes in developing countries have focused on the connection between such regimes and financial crisis, instead of on implications of alternative regimes for trade and competitiveness.

Pegged exchange rate regimes have fallen out of favour, and developing countries are being advised to choose one of the two extremes -- currencies floating freely or lock in the rates to a major currency like the US dollar, either through a currency board or simply adopting the dollar as the national currency.

Recent World Bank research has shown that developing countries with floating currencies have been more vulnerable to financial crises. Nor is a currency board or adopting an external currency as national a more viable solution. The experience of Hong Kong and Argentina show that speculative attacks against a currency
can occur even with a currency board, and pegs can be maintained only by allowing interest rates to rise sharply and output decline sharply too. And contrary to the principles of a currency board, the central bank has still to intervene and provide liquidity to banks to avoid their collapse.

"Under free capital mobility, no exchange rate regime will guarantee stable and competitive rates, nor will it combine steady growth with financial stability."

Differences among exchange-rate regimes lie not on the extent to which they prevent volatility of capital flows or contain their damage to the real economy, but rather to how the damage is inflicted.
Damage can be prevented or limited only through effective regulation and control over destabilizing capital flows. And while not without costs, the cost is likely to be smaller compared to that of currency instability, misalignhment and financial crises.

Managing a nominal exchange rate in a flexible manner to minimise real exchange rates, in combination with controls on destabilizing capital flows, thus remains the most plausible option for most developing countries.

Referring to the experiences of Chile and Colombia, TDR-99 adds: "It is important to recognize that the main objective of controls in a world of integrated capital markets is to prevent the cumulative build-up of foreign liabilities that can be easily reversed. Consequently, controls on capital inflows should be a permanent feature of policy, to be used flexibly and in the light of circumstances."

Exchange rates can also be used to deter arbitrage flows - a crawling exchange rate band, clearly targeted to avoid persistent real appreciation, a band width that creates a modicum of uncertainty and selective intervention by the central bank to smooth fluctuations, but with the width of the band and announced adjustment margins never being less than the forward discount on the currency. The goal should be to substitute changes in controls for use of reserves and to free interest rates for domestic policy objectives.

Discouraging dollarisation of the economy should also be part of the overall regime for capital controls.

And the need for controlling outflows would be reduced to the extent speculative inflows can be prevented and dollarisation avoided.

But no developing country is immune to a currency crisis, particularly if it limits its control over capital movements to market-based measures and prudential regulations, the TDR-99 says.

"If all else fails, debt standstill accompanied by temporary exchange controls over all capital transactions, by residents and non-residents alike, including transfers involving deposits and investments in securities and stocks, provide an effective and equitable response to speculative attacks and self-fulfilling debt runs."