Should economically less developed countries fix their exchange rates or let their currencies float freely?

 

An exchange rate represents the value of one currency in terms of another. Central banks can attempt to ‘fix’ these rates by declaring a value at which the currency will be exchanged. They can then defend this rate against market speculation, should there be any, by manipulating interest rates, using currency controls, or buying and selling currency on the international markets. No one country can ‘hold out’ against the markets however, even if it is the biggest in the world, for very long, as exchange markets can mobilise more money than exists in any one country at any time. Therefore, countries which fix their rates either do so at a realistic level, and allow their currency to be traded, or use another currency internationally to that which is used domestically. In addition, some countries use a foreign currency for trade, and simply make any trade in their currency outside their own borders illegal.

The reasons for which a country might choose to fix its exchange rate are simple, and apply to a variety of types of economy, but especially to less developed ones. Firstly, if the country owes a great deal of money either as a government or through private borrowing to another country or another country’s banks, it makes sense to fix the currency rate. This means that falls or changes in the exchange rate will not affect repayments and will encourage further lending. The government will also be saved from the temptation of simply inflating the debt away, possibly by simply printing more money.

When a country has an inelastic demand for imports, a fixed currency could mean that the value of the imports was stable, and that the country would not face shortages or excessive changes in price. In terms of exports, however, a currency which was set at a rate higher than the market price would find that it could sell less to others than if its currency were lower. The terms of trade of such a country would therefore not be much improved by fixing the currency, though they might be less volatile than if the currency floated (terms of trade are defined as the value of exports divided by the cost of imports over time.)

Nevertheless, a fixed exchange rate may aid a developing country to create stability in its current and capital accounts, and therefore in its balance of payments. The People’s Republic of China, for instance, during its developmental phase, set the value of the Yuan at a low rate which encouraged its exports to the US whilst encouraging Americans to recycle profits into joint ventures inside China as the dollar had great purchasing power. This rate, whilst low, allowed China to accumulate large amounts of dollars inside the USA, which it then used to cover a trade deficit with East Asia and Russia (as China is resource poor.) The existence of the deficit, without a fixed rate, would have pushed the Yuan down against the East Asian currencies. The fixed rate chosen was higher than it would have been, allowing China to make more purchases in those limited areas where it used Yuan in East Asia.

Eventually, China was forced to adapt its currency to the demands and advantages of a managed float, rather than a free float. As the Chinese economy grew, it became more and more difficult to justify having a currency set at a low rate against the dollar given the PRC’s trade surplus. This caused difficulties in the trade relationship with the USA. The government in Beijing therefore allowed the central bank to relax controls on the currency, and let it float upwards and downwards within a managed set of boundaries. At the same time, China began spending its dollar surplus on foreign resources and businesses and encouraged the direct use of the Yuan in key food and oil trades. The effect of this, in time, should be to allow the PRC to ‘float’ its currency and to gain the advantages of reserve status.

Reserve status occurs where third parties use the currency between themselves and accept it rather than their own currency in trade with the issuing country. This is a great advantage to a country which has a reserve currency but is based on the credibility and stability of the currency and its institutions. Countries which operate a reserve currency also must issue enough currency for themselves and the rest of the world, which means that they must have large equity markets and economies. This is the reason why the Swiss Franc is not a global reserve on a par with the US Dollar and Euro.

A free-floating currency has advantages in circumstances where a country’s trade is subject to a J-curve. The J-curve arises where the Marshall-Lerner condition applies. If the sum of the elasticity of imports and exports is greater than one, a free-floating currency will stabilise trade by eliminating trade surpluses and deficits. If the fiscal and monetary policies of a country are stable and credible, and if it is not experiencing an overall flow of money out, or speculative capital in, then its exchange rate will be stable, once a series of ‘Js’ have placed it in a stable and predictable zone.

If the currency is stable and free-floating, a government and central bank can use the interest rate inside the country to deal with inflation and to manage demand, rather than to deal with the exchange rate. Market discipline will replace government control, and governments will be encouraged to adopt stable fiscal rules and, if not balanced budgets, then low debt: GDP ratios. Occasional falls and rises in the currency might still happen, but balance of payments crises should not.

A third option exists for a country on the path to development, if it desires stability but also wants the benefits of a regional reserve, the lower costs that come with the use of a more widespread currency, and the incentives of a stable shared currency for investment, lower interest rates, and trade. This option will arise if most a country’s trade is made with countries very near it, which have similar interest rates, debt levels, and business cycles, but different specialised economic sectors. The option is to join a regional single currency.

This option forces discipline on the government, by prioritising central bank control of inflation and stable fiscal policies, whilst giving access without exchange costs to a bigger market. It is very successful in Africa, where the CFA/AFC in the West, and the East African Community in the east, either operate or are preparing to operate regional currencies.  The CFA Franc was and is backed by the Government of France and is tied to a nominal Franc (which no longer exists in euroland) and is the most successful single currency in the world, though it operates in two separate zones. The East African Shilling, which is projected for 2023/4, would solve the problems of a growing powerhouse which covers the Democratic Republic of the Congo, South Sudan, Tanzania, Rwanda, Kenya, Burundi, and Uganda.

Simply letting a currency float and hoping in market ideas has not worked for the majority of ‘normal’ developing countries (the post-Soviet Eastern European and former Soviet states did do so in a ‘big bang’ in 1989-92, but this was because of the Soviet collapse and probably not something which will ever be repeated.) In such circumstance, as in the 1997 east Asian crisis, countries could become subject (blamelessly) to regional contagions which undermined their stability. Similarly, the experiment of San Salvador, which tied the bonds issued in its own currency to bitcoin, and therefore which adopted a ‘bitcoin standard’ has not suggested that there is any ‘cryptocoin’ fixture that could be relied upon for developing countries.

By analogy, fixing a currency to gold, which would in theory exert the ultimate fiscal discipline on a government and demonstrate a commitment to absolute monetary stability, might simply guarantee a deflated, low-growth economy and force reliance on gold stockpiles which would be difficult to accumulate and rely upon in the modern world. The history of COMECON, the Soviet/Socialist economic community, suggested that fixing currencies to commodities was also a bad idea.

The best option for a developing country, if it can effect such a policy, is to join a single regional currency which floats. This gives countries the advantages of both fixed and floating currencies, though of course, in joining such a bloc, a country technically fixes its own currency forever. The second-best option, if it has no or low debt but could be subject to speculative flows of investment which could destabilise it, or if it operates in distinct markets, is to allow a ‘managed float.’ If a country has great debt with another currency which issues or uses a global reserve, then fixing currency values to that reserve is a good idea, but this complicates trades with others who do not use the reserve and orients the developing country towards the dominant one.