Under what circumstances should countries adopt fixed exchange rate? Address the benefits (such as monetary discipline to control inflation) against the costs (such as exposure to a currency crisis).
After the breakdown of the Breton Woods system of fixed exchange rates in the 1970s, most of the countries continued to peg their exchange rates, mostly with the dollar or French franc, or to a basket of currencies. But since the 1990s, the international monetary system has known some great evolutions all around the world: in Europe appeared the monetary union with a common currency (euro – introduced between 1999 and 2002) and in the same time some developing countries had to abandon their hard pegs and adopt a floating exchange rate. We have also seen a bipolarisation of the different exchange rates (ER) between fixed (or pegged) and floating regimes. The fixed ER regimes can be classified into different categories, depending how the ER is pegged. The monetary authorities of a country can officially fix it, the ER also become a pure policy variable and can be changed “at the stroke of a pen”. In the contrary, the ER can be externally fixed: as in a monetary union, as currency boards, or as a hard peg on another currency (or basket). Recall here the importance of the ER regime choice for the economy of a country, in term of monetary policy autonomy, of trade and balance of payment, or in term of macroeconomic indicators adjustment: indeed the exchange rate affects largely the competitiveness and the stability of an economy.
We can also ask under what circumstances a country should adopt a fixed exchange rate? What are the different costs or benefits of choosing a fixed ER? In the context of an open economy where the capital mobility is completely free, the best regime is supposed to be the one which guarantees the stabilization of the macroeconomic performances, minimizing the fluctuation of the output, of the consumption and of the domestic price level of this economy. The choice of an ER regime also depends on its structural characteristics. But each country has its own set of specificities and it seems quite difficult to define a general and mechanic rule. Nevertheless, some criterions can be analysed and compared to help the authorities make the best decisions about their ER policy.
I. Flexibility and Credibility
The first point we can analyse is the compromise between flexibility and credibility. The flexibility of the monetary policy and the credibility of the peg are in a kind of conflict. Indeed, a pegged regime establishes the credibility of an economic policy because of the guarantees it allows: the pegged regime provides “an unambiguous objective «anchor» for economic policy” (1). This is especially important to avoid a strong inflation: with credibility there is no the expected inflation and therefore no real inflation. We can consider as well that a fixed ER limits the incertitude of the different agents and is then good for investment and trade, in theory anyway.
However, a fixed ER regime forces the authorities to subordinate the monetary policy to the requirement of maintaining the peg. Fiscal or others policies and the ER regime must then be coherent. To some extent, we can say that the fixed ER «tie the hands» of the authorities set a limit to its flexibility. It can pose some difficulty, for example to borrow through the bound market: because it affects interest rates, it eventually pressures the real exchange rate which can also be appreciated or devaluated. But what are the consequences of a change, appreciation or devaluation, of the ER? We can consider now two different kinds of effects, according to the different aspects of the economy. On the one hand we’ll see the behaviour of the balance of payment (BOP) changing the ER, on the other hand we’ll examine the macroeconomic policy with the opposition between real and monetary consideration.
II. Balance of payment and Macroeconomic policy
a. Trade and capital account
A change of the ER makes the trade sector and the capital account react differently when it is fixed. First on the trade side, let us take the situation where import exceeds export into account. That also means that the demand exceeds the supply of foreign currency. It is also required to restore the equilibrium devaluation. A local currency devaluation means that the local currency now worth less in foreign currency, or that the foreign currency henceforth worth more in the local one. Devaluation allows competitiveness, making import more expensive for the home economy and export cheaper for foreign economy balancing the BOP.
On the other hand the capital account is a completely different situation. Here, Large inflows increases the supply of foreign currency and then tends to appreciate the local currency. Currency appreciations make the economy more attractive to the foreign investors, because their profits now worth more than before in the foreign currency. It reduces the cost of the debt servicing which is denominated in local currency. To balance the capital account, the authorities need to use reserves of foreign currencies to keep the ER fixed. Then come a simple and quite obvious advice which have to be followed: a country should fix its ER on the currency with which it trades the most.
b. Real and monetary considerations
From the monetary point of view, it is important to accommodate the demand for foreign currency with the money supply. Fixed ER also reduces monetary policy discretion (restricts inflation and growth in money supply) and need more stable macroeconomic policy to keep the inflation level of the country to the level where the ER is pegged: it also limits the seignoriage (profit made by a government by issuing currency).
In term of a real consideration a country should aim to keep relative domestic prices aligned to world prices. To explain, let us introduce the Real exchange rate (RER), which takes the price of the tradable (PT or PT* for the world price) and non-tradable (PN) goods. We have also this inverse mathematical link between the nominal (e) and the real ER defined by: RER = PN/ PT = PN/ e.PT* . Indeed, if the inflation of the country is higher than the world inflation and the nominal ER is fixed, we can say that a real appreciation happens. Finally, in a context of hard peg regime, money supply can increase faster than the money demand growths. This also forces the authorities to defend the parity of the peg using the reserves by buying off the excess supply of domestic currency. Thus, a good management of these reserves is required.
a. Internal and external chocks
The fixed ER regimes are suffering of disadvantage faced with external chocks, especially for the monetary union and the currency board, and all economy where the bank sector is weakened. Indeed, the monetary supply depends quite only of its reserves in foreign currency. In that case it is difficult to help a weak bank sector.
b. Crisis model
Let us consider now the Case of the Mexican (1994) crisis. At this time the Mexican peso was pegged on the US dollar. At the beginning of the 90s (1990-1993), the capital mobility was liberalised and allowed a massive capital inflow in the country: more than 90 billions of US dollars were introduced, which produced a kind of “dollarization” of the Mexican economy and grown up the private credit sector (+25% /year). Then, the country knew a very high inflation rate compared to the US one, an inflation rate that the authorities controlled hardly. Nevertheless, this peg gave the economic agents the illusion that there were some good guarantees to keep the peg stable. The assassination of a candidate of the Mexican presidency chocked the economy: the growth slowed down and some rumours of pesos devaluation feared the investors. “After a second political assassination in November and the inauguration of a new president on December 1, devaluation rumours intensified, sparking a further interest rate jump and the nearly complete exhaustion of the country’s foreign reserves. On December 20 Mexico’s government finally devalued the peso” (2).
To conclude, I would insist on the different criterions which can be helpful to adopt a fixed exchange rate regime. As we just said before, this choice depends first of the macroeconomic characteristics of the country. Thus, a developed country and a developing country don’t have to follow the same way in their situations are different: the monetary independence, the integration (neighbour, trade currency) and the size of the economy, the inflation rate (of the country and of the trade partners), the capital mobility, are so many parameters which can influence this choice. The monetarist analysis has shown with the “Triangle of impossibility” (Mundell-Fleming model) that there was a trilema between the capital mobility, the monetary policy autonomy and the fixity of the exchange rate. According to this model, a free capital flow and a fixed exchange rate don’t allow a sovereign monetary policy.
We could eventually add the real risk of crisis that authorizes the adoption of a fixed exchange rate when this one is not appropriated. The context of general liberalisation of the world economy and trade which advocate the free capital circulation can play a large part in the responsibility of the crisis, henceforth we could also question the policy of the IMF and World Bank.
(1) F. Camarazza & J. Aziz, Fixed or Flexible?, The Economic Issues, International Monetary Fund, Washington, 1998
(2) Krugman P., and M.Obstfeld (2006), International Economics, 7th Edition, Addison-Wesley.
– Amina Lahrèche-Revil, Les regimes de change, from “L’économie mondiale 2000”, La découverte, collection repères, Paris, 1999
– Laetitia Ripoll, “Choix du regime de change: Quelles nouvelles ?”, 2001
Thierry Montalieu, “Quelle stratégie de change dans les pays en développement?”, from “Régime de change et développement”, Monde en développement n°130, 2005