Exchange Rate Policies In Developing Countries
The monetary exchange in most developing countries is unstable due to the high level of inflation and weak currencies. The monetary policy of a country usually is affected by its monetary exchange rate. A country can attempt to engage on a reductive or expansionary monetary policy depending on the amount of money that is actually in circulation.
A country with more amount of money in circulation with increasing inflationary rate tends to adopt a reductive monetary policy where bank interest rate is increased and expenditure on capital infrastructural goods is limited.
On the other hand, an expansionary monetary policy encourages the increase in money supply to the economy by reducing interest and bank lending rate, and engaging more in capital expenditures. No matter the monetary policy embarked on by a government, this goes to influence the monetary exchange rate of such country. According to Svensson (2000) the significance of exchange rate on a country’s monetary policy lies in the additional channel that exchange rate provides for the transmission of monetary policy.
Secondly, the exchange rate involve a forward looking variable in which case it provides valuable information in the designing and implementation of monetary policy. Thirdly, monetary policy is enhanced through foreign shocks that are mainly propagated thoroughly in exchange rate. A country can utilize either a fixed monetary exchange rate or a flexible exchange rate, depending on the supply rate of money and the monetary independence it choose to stick with.
In a developing country, with weak institutions, the exchange rates of such countries are determined by relaying in comparative measure with currencies from other strong and stable economies. Thus, it is difficult for these developing countries to operate flexible exchange rates. As a flexible exchange rate requires that solid financial structure is laid, and consolidated, fiscal and monetary policy institutions are in place.
Developing countries engages in fixed rate to operate its exchange rate. In operating, a fixed rate for monetary exchange entails that the country’s central financial institution, i. . the Central Bank buy and sell the domestic currency at a given rate. Furthermore, the viability of such monetary operation is entirely tied to the country’s level of international reserves held by its authorities. ECONOMICS INDEXES ASSOCIATED WITH A DEVELOPING COUNTRIES Most developing countries are consumers’ society with little production. Most revenue and means for generating foreign exchange for this category of country are on primary goods in form of exploration of natural resources and agricultural activities.
Agrarian economies and exploration of primary products are mainly source for generating foreign exchange in developing countries. In other words, the economies of most developing countries are tied down to the apron strings of advanced economies. Electronics, technological products, consumable products and finished goods are the main items of import for developing countries. The costs for importing these finished goods are more costly when compared with the amounts that are paid for exports of primary goods and raw materials from developing countries.
The inequalities in the pricing regime in the international market are unfavorable for developing countries. This variable contributes to the foreign reserves of developing countries. Invariably, it affects the values of currency and its exchange rate. The monetary values of developing countries are weak when compared with those of vibrant economies. Inflation affects the economic growth and development of developing countries. In a situation where there is much money in the economy pursuing little goods in the economy, this situation leads to increase in inflation rate.
Inflation reduces the purchasing power of people in a given economy. This weakens the value and use of money as a medium of exchange (especially in a galloping inflationary situation). To Ogbokor (2004), “Inflation, in a developing country, encourages inventory accumulation in the form of raw material, excessive investment in merchandise building and landed property. As a result, capital is prevented from being utilized for projects required for economic growth”.
The implication of information in developing countries is that there brings about dearth of infrastructural amenities and the reduction of purchasing power of people for embracing a meaningful living. Financial institutions in developing countries, such as in Africa, are highly underdeveloped culminating in lack of depth financial consolidation, extensive inefficiency and over populated urban areas. The stock exchange markets in African countries are still in their embryonic state. They are just beginning to gain ground.
In recent times, the Nigerian Stock exchange market (NSE) is making progressive growth in capitalization and growth in stock indexes. The growth in the Nigerian market especially in 2007 financial operation year in the public reform policy taken in the country’s financial sector has aided the stock exchange market in the country. In 2005, the consolidation of the Nigerian banking sector through the recapitalization has brought great improvement in the banking sector and financial institution (Njoku, 2006).
The great feet attained in the reform, policy has led the government to introduce this recapitalization policy in the insurance sector. In the past the Breton institution, such as the International Monetary Fund (IMF) and the World Bank have recommended several medicines for the ailing economies of third world and developing economies. Such measures to embark on a structural adjustment programmed that will involve the devaluation of their currencies, among other measures such as privatization of public enterprises, removal of subsidies on public goods and less government intervention in their countries economies inter-alia.
Even though these developing countries have put the structural programmed into use there situation economically still remain the same, sometimes made worst. “This SAP-induced inflation has resulted in adverse income redistribution, leading to increased personal insecurity and lessened personal satisfaction, while heightening interpersonal and institutional tensions and deterring investment and inhibiting consumer spending” (Anyanwu 1992). MONETARY EXCHANGE POLICIES IN DEVELOPING COUNTRIES The move to find an appropriate policy for monetary rate for developing countries has being on for decades now.
But the volatile capital situation in these category of countries have made it more challenging for finding a lasting solution for the monetary exchange these countries. In these view, Velasco (2000) argued, “a significant conclusion that is shared from the volatile monetary exchange rate from developing countries is that adjustable or crawling pegs are extremely fragile in a world of volatile capital movements. The pressure resulting from massive capital flow reversals and weakened domestic financial systems was too strong even for countries that followed sound macroeconomic policies and had large stocks of reserves”.
Since the 1970s, the volatile nature of the exchange rate of poor and developing countries is seen to be pervasive; as there are no stable, developed and consolidated financial institutions to peg exchange rate for countries and partners that these developing countries transact international business. The concern here according to Collins (1995) was that “the market for the developing countries currency were so thin, creating a volatile exchange rate that would be disruptive for economic activity”.
The missing link for developing countries for a lasting solution for its exchange rate has being on the lack of a consolidated financial institution and stable economy. This situation for developing countries is made worst during the 1970s and 80s. “Prior to the 1980s, it was widely believed that operating a competitive floating exchange rate regime required a level of institutional development that developing countries did not possess” (Quirk, 1994: 135). The volatile nature of the exchange rate as recognized in the economy of developing countries is not entirely an inherent cause sometimes the activities of foreign and developed economies.
For instance, the emergence of the European currency bloc has aided in rendering the exchange rate more volatile in developing countries. This according to Collingnon (1999) cited in Kawai & Takagi (2003) “has made exchange rates between the three major world currencies more volatile and thereby contributed to the reduction of cross-border investment worldwide”. The economic structures in developing countries in term of its embryonic and underdeveloped financial institutions are contributory factors that are making them have an unstable and unpredictable monetary exchange policy.
The explanation for the long run inflationary trend in developing nations, according to the Structuralists, is in terms of certain structural rigidities. These include market imperfections and social tensions in those nations, including the relative inelasticity of the food supply, foreign-exchange constraints, protective measures, a rise in the demand for food, a fall in export earnings, hoarding, import substitution, industrialization, and political instability, inter-alia” (Ghatak 1995).
The devaluation of currency of developing country is done with the aim to create a real basis for measuring feasible and accurate exchange rate between imports and exports of transactions in the international market. However, “the usefulness of real devaluation in stimulating growth may seem self-evident; this view is not uniformly supported either by prior theoretical research or by the experience of countries implementing exchange rate devaluations” (Kamin & Rogers 1997). Devaluation of currency of developing countries have it untold hardship and high cost for goods and services.
Looking at the devaluation of the Nigerian currency, Anyanwu (1992) argues, “…the continued naira depreciation has encouraged the smuggling out of goods (especially food stuffs) leading to local scarcity and higher prices. It has also encouraged a brain drain, partly in an attempt to reap the benefits of naira depreciation, the remittances from which are mainly used for consumption activities, again aggravating local prices”. THE SIGNIFICANCE OF A FIXED EXCHANGE RATE FOR DEVELOPING COUNTRIES
In recent times, some scholars have conducted research to analysis the use of a fixed exchange rate as basis for structuring the exchange rate regime in developing countries. “Probity analysis is used to study the determinants of exchange rate regime, build their empirical models around a framework in which the political cost associated with devaluation under fixed exchange rates plays a major role” (Frieden et al 2000). In a fixed exchange rate regime, the government of the developing country directly set the nominal exchange rate.
Given the constraints and undeveloped financial institutions in developing countries, the practice of a fixed monetary exchange rate for developing countries is made difficult. The advantage of engaging a fixed exchange rate is to help stabilize a country’s economy. This is aimed at bringing structural change that would integrate the country’s economy into the world economy order in the quickest time possible. This has made currency board of most developing countries to take the move of attaining a fixed exchange rate as a priority that should be attain (Mart, 2004).
Before the fall of the Bretton Woods system in 1973, many countries including many Latin American developing countries had adopted a fixed exchange rate regime. The reason for adopting this exchange rate regime measure is to control inflation, reduce exchange rate volatility or to improve competitiveness (Frieden et al 2000). In addition a fixed exchange rate regime tend to enable government of developing countries be disciplined in that they cannot fix any fiscal rate that would be excessive to cause the end or currency collapse.
Fixed exchange rate sometimes is used as a short term corrective to harness a developing country’s monetary policy and help it gain credibility. For some developing countries like Poland, Mexico and Vietnam in the 1990s, the fixed exchange rate was utilized as a temporary measure to re-establish these countries policies to gain credibility (Ohno, 1998). Thus, a fixed exchange rate is acceptable in certain circumstances for developing countries, especially where there are unexpected real and financial shocks.
However, this should not be permanently used as a measure for operating a developing countries monetary exchange. The flexibility exchange rate is more adequate for revamping the ailing and volatile exchange rate of developing countries. “In an unstable world economy, they must retain the ability to combine stability and flexibility as circumstances change. For the same reason, currency boards and permanently fixed exchange rates (with no escape clause) are not to be recommended” (ibid).
In a galloping inflationary situation in a developing country, the exchange rate policy to adopt is a flexible one that allows currency to float and depreciate. After the tightening of the macroeconomic policies in such a country, it becomes useful to adopt a fixed exchange rate as a measure. As Ohno (1998) puts it, “As inflation subsides to a more manageable level (say, 10 to 20 percent per year), the fixed exchange rate becomes a symbol of monetary and fiscal prudence and its abandonment becomes politically too costly”.
Invariably, it means that the utilization of a fixed exchange rate should come in when the inflationary rate of a developing country is becoming low and at a manageable level. Furthermore, the utilizing of a fixed exchange regime in developing country is significant in the sense that it provides stability of price to local economic agents. This is especially in the case where a country operates an open economy, in which exchange rate volatility may have substantial costs within itself (Frieden et al 2000). As earlier stated a country has the option either to choose a fixed monetary exchange rate or one that is flexible.
For developing and emerging economies that want to choose a policy of a permanently fixed exchange rate this can be done through its currency board with it could adopt a common currency (‘Dollarisation’). On the other hand, developing countries can adopt a flexible policy, which according to Taylor (2000) is “…the only sound monetary policy is one based on the trinity of a flexible exchange rate, an inflation target, and a monetary policy rule”. However, the benefits and the cost implication of fixed exchange rates depend on the country and those variables and characteristics it is associated.
For instance, a country with exceedingly high level of inflation with the urgently need to stabilize its economy will be beneficial to utilize a fixed exchange rate. “The higher the rate of inflation; i. e. one below some hyperinflationary threshold, the more a fixed rate will impose competitive pressures on tradable producers and more generally pressure on the balance of payments” (Frieden et al 2000). According to Collins (1995), a government of developing country should opt for a fixed exchange rate regime when it sense and anticipate a small misalignment cost from maintaining the existing peg.
In addition, the need for government to adopt a fixed exchange rate is when she believes that discrete nominal exchange rate adjustments have only small political costs, when the government perceived her ability to manage a flexible exchange rate as low, or when the government attempt to stabilize a very high inflation. Third world countries usually are faced with political instability. During period of political instability, the adopting of fixed exchange rate by a developing country is more pronounced (Frieden et al 2000).
The drawback associated with a fixed exchange regime for developing country is that an inflation differential between the pegging country and the anchor generates an appreciation of the real exchange rate, which in the absence of compensating productivity gains, hurts the tradable sector and might generate a balance of payments crisis (ibid) THE NEED TO ADOPT A FLEXIBLE EXCHANGE RATE FOR DEVELOPING COUNTRIES For a country adopting a flexible exchange rate, the government of such country has imperfect control over the nominal exchange rate in its monetary policy.
In this case, “the actual exchange rate is influenced by some shocks both at home and abroad The greater the variance of these shocks the less control policy makers will have over the actual nominal exchange rate” (Collins, 1995). The right situation for a government of a developing state to adopt a flexible includes when it perceives and anticipate a large misalignment costs from maintaining a pegged rate, when the political costs to discrete nominal adjustments are high flexibility exchange rate is conducive in such situation.
Furthermore, when the government believes her ability to manage a flexible rate was high, and when the government of the state is not planning to stabilize very high inflation (ibid). In the same vain Velasco (2000), argues, “If shocks to the goods markets are more prevalent than shocks to the money market, then a flexible exchange rate is preferable to a fixed rate for developing countries”.
On the other hand, when every movement in the nominal exchange rate is quickly reflected in an upward adjustment in domestic prices, then the insulation provided by flexible exchange rates is nil and thus not expected to provide a satisfactory exchange rate regime (ibid). Under a flexible exchange rate, the change in relative price quickly takes place, unlike the situation in fixed exchange rate where it changes slowly. Thus, there is advantage for developing borrowing under a flexible exchange rate.
A flexible exchange rate gives borrowers an incentive to hedge that may be absent under more rigid regimes” (Velasco 2000). With the advantage that accomplish flexible exchange rate, it is still expected that each developing countries should choose and adapt to its own exchange rate system with respect to common basket. “Whatever the formal arrangement that is adapted; be it a flexible exchange rate regime or a managed float, the important point is that each country in the region should stabilize the real effective exchange rate at normal times by targeting a common currency basket” (Kawai &Takagi 2003).
The need for developing countries to adopt a flexible exchange rate is more on the volatile nature of the countries with weak financial institutions. The negative effect of exchange rate volatility for developing countries on trade is more obvious when compared to those of developed economies. Taking on comparison between the difference in exchange rate volatility between developing countries and developing countries, it is seen that work on Pakistan’s exports to Germany, Japan, and the United States for 1974-85 suggests that exports were significantly adversely affected by variability in nominal bilateral exchange rates.
On the other hand, the effect of real exchange rate variability on the exports of Chile, Colombia, Peru, the Philippines, Thailand and Turkey have attained the clear evidence of generally considerably negative and substantial impact (ibid). Scholars have advocated more of flexible exchange rate for developing countries than a fixed one, however there are demerits associated with the use of flexible exchange rate. According to Collins (1995), “flexible exchange rates make it very difficult to alter domestic price and wage setting behavior so as to reduce inflation”.
More flexible exchange rate regimes may result in higher equilibrium levels of inflation because they do not effectively discipline central bankers (ibid). CONCLUSION The monetary exchange rate of developing is characterized by a highly volatile and unstable exchange rate regime. Thus, it becomes difficult to adopt a fixed exchange rate regime, given the weak financial institutions in this category of countries. Furthermore, the embryonic state of capital market and other financial institutions in developing country further weakens the currency of these countries.
Inflationary rate in developing countries are on the increase thus to stable the economy within shorter period, anticipating a short misalignment costs will be adequate for a government of a developing country to adopt a fixed exchange rate. On the hand to correct, a flexible exchange rate regime is suitable for a developing country in managing its economy currency stability over a longer period. The development of financial institutions and the consolidation of capital and money markets of developing country will aid them to embrace a feasible regime that would contribute to strengthen its currency value and ensure a vibrant economy.