Role of Central Bank Independence, Monetary and Exchange Rate Policy

1
REFORM Project, USAID/India
Workshop on Macroeconomic Aspects
Exchange Rate Policy
Khwaja M. Sultan
2
Exchange rate

• Nominal exchange rate the rate at which we can
  trade the currency of one country for the
  currency of another
• Real exchange rate the rate at which we can
  trade the goods and services of one country with
  the goods and services of another
• Measures the price of a basket of goods and
  services available domestically relative to the
  same basket available abroad purchasing power
  parity
• Real exchange rate Nominal exchange rate x
  Domestic price
• Foreign price
• The prices are measured in the respective local
  currency
• Real exchange rate (e x P ) / P
• e nominal exchange rate P domestic price
  index P price index abroad
• Shows that nominal exchange rate reflects
  relative inflation

3
Balance of Payment and Exchange Rate

• Balance of Payment the record of all
  transactions of the residents with the rest of
  the world
• Trade balance Balance of exports and imports of
  goods exports are positive and imports are
  negative
• Current account balance Balance of trade in
  goods, (trade balance), trade in services and
  transfer payments
• Balance in services includes freight, royalty
  payments, interest payments, dividend from
  assets abroad
• Transfer payments include remittances, gifts and
  grants
• Capital account balance purchase and sale of
  assets stocks, bonds, land purchase by
  Indians of assets abroad is negative, purchase of
  assets by foreigners in India (e.g., FDI) are
  positive
• Current account Capital account 0
• Increase in official reserves is called overall
  BOP surplus

4
Terms

• Devaluation the price of foreign currencies
  under a fixed exchange rate regime is increased
  by official action
• Revaluation - the price of foreign currencies
  under a fixed exchange rate regime is decreased
  by official action
• Depreciation under a floating rate system,
  price of foreign currencies decreases because of
  market adjustment
• Appreciation - under a floating rate system,
  price of foreign currencies decreases because of
  market adjustment

5
Fixed Exchange Rate

• In a fixed exchange rate system foreign central
  banks buy and sell their currencies at a fixed
  price in terms of the domestic currency
• Prior to 1973, most countries had fixed exchange
  rates against each other
• A fixed exchange rate acts like a price support
  system
• In order to maintain a fixed exchange rate, the
  central bank has to make up for the excess demand
  or take up the the excess supply of foreign
  currency.
• In order to carry out these interventions, it is
  necessary for the central bank to hold an
  inventory of foreign currencies.
• However, if the country persistently runs
  deficits in the BOP, the central bank eventually
  runs out of foreign currencies, and will not be
  able to carry out the interventions
• In such a situation, the central bank will have
  to ultimately devalue its currency

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Fixed Exchange Rate
E
E
Exchange rate
E
E
E2
E
E1
Quantity of dollars
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Pros and Cons of Fixed Exchange Rate

• Argument in favor of fixed exchange rate
• Certainty
• Less inflationary
• Promotes money and capital markets
• Helps in the smooth working of the international
  monetary system
• Prevents monetary shocks
• Argument against fixed exchange rate
• Heavy burden on exchange reserve
• Country must have sufficient reserve
• Fails to solve the balance of payment
  disequilibrium
• Does not prevent real shock
• It is not a long term solution if the underlying
  economy is weak

8
Flexible Exchange Rate

• In a flexible exchange rate system, the central
  bank allows the exchange rate to adjust to equate
  the supply and demand for foreign currency. In
  effect since 1973
• Clean floating the central bank stands aside
  completely and allows the exchange rate to be
  freely determined in the forex market official
  reserve transactions are zero
• Managed float - the central bank intervenes to
  buy or sell foreign currencies periodically in an
  attempt to influence the exchange rates
• Snake in the lake
• Snake in the tube
• Crawling peg
• Target zones
• Currency board

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Flexible Exchange Rate
Exchange rate
S
2
E2
1
E1


E

D2
D1
D
Quantity of dollars
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History of Flexible Exchange Rate

• Collapse of the Bretton Woods system in 1971 when
  the US Treasury refused to convert short-term
  liabilities into gold and made dollar
  inconvertible
• 48 countries including the US, Japan, many EU
  countries abandoned the fixed exchange rate
• Group of Ten industrialized countries met at the
  Smithsonian Institute in Washington, DC in
  December 1971 agreed to a new system of stable
  exchange rate with wider bands US devalued 8,
  Japan revalued 17, Germany revalued 14 -
  allowed 2.25 fluctuation plus/minus1973
  fluctuation widened to 4.5
• US devalued again in Feb 1973 Smithsonian
  Agreement collapsed
• ECU 1979, euro 2001

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Pros and Cons of Flexible Exchange Rate

• Argument in favor of flexible exchange rate
• Simple operation, smoother, more fluid
  adjustment
• Brings realism in forex transactions
• Disequilibrium in balance of payment
  autostabilized
• No need for forex reserve to manage exchange
  rate
• Prevents real shocks
• Reinforces the effectiveness of monetary policy
• expansionary
• contractionary
• Argument against flexible exchange rate
• Exchange rate risk futures market
• Adverse effect of speculation
• Encourages inflation
• Far from perfect system, but no better system
  exists

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Linkages between Fiscal Policy and Exchange Rate
Yincome Consumption Investment Govt
eXport - iMport Also, Yincome Consumption
Savings Taxes C S T C I G X M S
T I G X M S T - I - G
X M (S - I) (T - G) (X -
M) Balance household Balance govt. Balance
foreign
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Foreign Exchange as a Tool of Monetary Policy

• Foreign currency market operationsgtgtgtExchange
  rate
• In addition to government bonds, RBI buys and
  sells foreign currency
• If RBI buys dollars/yen/euros/pounds etc., it
  increases MS
• If RBI sells forex, it decreases MS
• Buying or selling forex affects the exchange rate
• Sterilization
• Sometimes RBI wants to sell foreign currency to
  support the rupee, but does not wish the MS to
  fall
• To do this, RBI uses the rupee it acquires to buy
  government bonds, thus putting the rupee back
  into circulation
• This process of offsetting foreign exchange
  market operation with an open-market operation is
  called sterilization

14
Exchange Rate Adjustments

• Automatic adjustments of to correct BOP
  disequilibrium can take place through price and
  income changes, both under fixed and flexible
  exchange regime
• Adjustment to external balance needs
  expenditure-reducing and expenditure-switching
  policies
• Under fixed exchange rate, automatic adjustment
  mechanism works through price and money
  unemploymentgtgtfall in pricesgtgtincrease in
  exportsgtgtgain in employment
• Price adjustmentsgt increasing the price of
  imports through raising tariff now becomes
  difficult under WTO unless temporary
• Income adjustments gt contractionary fiscal, wage
  and monetary policies

15
Exchange Rate Adjustments

• A BOP deficit is usually a reflection of monetary
  disequilibrium but the correction mechanism
  involves unemployment more painful than
  devaluation
• Monetary expansion, in the long run, increases
  price level and exchange rate, keeping terms of
  trade and real balance constant
• In the short run, monetary expansion increases
  output and reduces interest rates, depreciating
  the currency
• Government can intervene in exchange rate markets
  to limit the impact of exchange rate fluctuation
  on output and prices

16
Exchange Rate Policy Synchronization

• If policies are not synchronized between
  countries, they may pose a major threat to free
  trade
• When import prices fall due to currency
  appreciation, large shifts in demand will occur
  domestic workers become unemployed leads to
  pressure for protection tariff and quotas
• Flexible exchange regime calls for more
  interdependence than fixed exchange rate.
• Through international coordination of interests
  and policies, the system works better
• Regular consultation between major currencies

17
Indias Exchange Rate Experience

• In 1972, when the pound was floated, the rupee
  kept parity with the British pound
• Between 1975 and 1991 India followed the basket
  of currency system, with the British pound as the
  currency of intervention
• This was a managed float with a margin of /- 5
  percent with a discretionary crawling peg
• The basket peg reduced exchange risks compared to
  the earlier pound peg, but did not eliminate the
  risk
• In 1991, during the BOP crisis, the RBI brought
  about a sizeable downward adjustment of the rupee
  value
• LERMS Liberalized Exchange Rate Management
  System 50 of the currency was freely
  convertible at market exchange rate, and 50
  under a managed float
• 1993 Unified Exchange Rate System
• Convertibility of the rupee under current account
• No full convertibility and capital account
  convertibility

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Asian Crisis of 1997

• In the spring of 1997, there was the start of the
  economic crisis
• High growth, high export, high investment, large
  ST borrowings
• Crisis triggered by sharp fall in export growth
  in 1996 of semiconductors (a major item of export
  from the region)
• Adversely affected the confidence of ST lenders
  who pulled out
• Rapid outflow of private capital resulting in
  rapid devaluation and fall in stock market
• One after another, countries were forced to
  devalue their currencies
• The crisis spread to Eastern Europe and Russia
• Banks were shut down , stock markets dropped
  steeply
• Both troubled and sound Asian economies were
  swept up in the contagion. Fears of a worldwide
  depression loomed
• By 1990, most of the economies were back on track

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Lessons Learned

• Asian economies reaped immense benefits from
  globalization
• Achieved huge growth
• However the financial sector did not have
  necessary safeguards
• Rapid expansion of credit during 1994-97,
  including high-risk lending by banks
• The bulk of capital inflow initially went into
  manufacturing and infrastructure, but later large
  speculative investments were made in real estate,
  stock purchase and consumer creidt
• Banks did not have adequate financial supervisory
  and regulatory system keeping pace with the
  change in global capital flows
• Falling assets price exposed the weakness of the
  financial system
• India remained largely unaffected
• Prudential norms and improved asset
  classification and accounting practices were
  introduced
• Very little exposure to real estate by Indian
  banks
• Public sector ownership and trade unions reduce
  efficiency

20
Latin American Crises

• In mid 1980s hyperinflation hit Israel and many
  Latin American countries (Argentina and Brazil)
• Using a heterodox approach, monetary, exchange
  rate and fiscal policies were used with income
  policies wages and prices were frozen. That
  stopped inflation
• The stabilization succeeded in Israel because it
  corrected its fiscal deficit, whereas it did not
  succeed in Latin America where the fiscal
  correction was not sustained.
• Wage and price control alone cannot hold
  inflation under check if the underlying
  fundamentals of fiscal and monetary policy are
  not consistent with low inflation.
• Mexico had borrowed too much in the 1980s from
  the world markets. Under great pressure because
  of high interest rates of the 1980s.
• Crisis emerged when foreign lenders lost
  confidence in Mexico. Huge financing gap emerged.
• Ended in major devaluation and deep depression

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Latin American Crises

• In 1994 and 1995, Mexico underwent a major
  devaluation from 30 cents to a peso to 15 cents
  to a peso
• The need for a policy change was predicted well
  in advance
• Argentina had perpetual currency mismanagement
• 55 governors of central bank in 55 years
• Ten different monies in succession
• In 1990 Argentina chose the currency board system
  , which provides the local currency with 100
  percent backing in foreign reserves
• As a result no discretion for central bank to
  print money to finance budget deficit
• But public finance and property rights continued
  to malfunction
• As a result the currency board system crashed and
  Argentina had to devalue again