Exchange Rates and the Policy trade-offs

Think Piece By Prof. Dr. Obiyathulla Ismath Bacha

Most Muslim countries, being commodity producers have witnessed serious pressure on their currencies arising from a widespread fall in commodity prices. While none of the GCC currencies, all of which are pegged to the US$, appear at risk of devaluation, currencies of countries like Malaysia and Indonesia have come under intense pressure. One would have thought that the worst hit would be those dependant on one or a narrow group of commodities. Those with a manufacturing based ought to be impacted less. Yet, this is clearly not the case. The GCC countries that depend almost entirely on a single commodity export; oil appear to have had much less pressure on their currencies than more diversified economies like Malaysia, which brings us to the interesting question of what exactly are exchange rates, exchange rate policy and the trade-offs involved. Exchange rates are nothing but a price. The price of a foreign currency in terms of home currency and vice-versa. Since countries have a single unique currency for all their domestic transactions, the ‘price’ of this currency is very important. A currency mispriced or misaligned over a period of time can have serious long term consequences on a country. This ‘pricing’ is often premised on the exchange rate policy.  Exchange rate policy can vary over a spectrum with fixed exchange rate or pegs at one end and free floats at the other, with different levels of managed floats in between. While several Islamic countries, the GCC in particular have opted for fixed peg of their currencies to the US$, no Islamic country has a free float. Most Muslim countries as is the case with the majority of nations, have some form of managed float. As with everything in economics, these policies involve choices and trade-offs. The key trade-off being between exchange rate volatility and monetary policy flexibility. A currency on a fixed peg would have no volatility against the currency it is pegged to, however in exchange for currency stability, the country would have little domestic monetary policy independence. Taking the case of the GCC countries, their domestic money supply growth, and interest rates have to be in sync with that of the US. Deviations over any sustained period would put pressure on the peg. While a pegged rate that is undervalued can hold for sometime an overvalued rate can attract speculative attacks. This was exactly the case with Argentina. A currency pegged to the US$ can become overvalued if domestic money supply growth is faster than the US or if inflation rates are higher, causing real interest rates to be lower in relative terms. Thus, a decision to peg is not a one-off decision followed policy inertness. It requires careful maintenance. In particular, the ability to defend the peg with foreign reserves or raising domestic interest rates substantially if the need arises. As a rule, the more independent monetary policy is, the greater the chances of misalignment. The more subservient it is, the better the chances for synchronicity and continued alignment. Given these trade-offs, most countries opt to settle for a little of both, that is some exchange rate stability and some level of policy independence. Thus, the popularity of managed floats, which essentially means allowing the home currency to fluctuate within a band against one or more major currencies. Here the trade-off is the size of the band. The broader the band, the more policy independence but also more currency volatility.

A policy of deliberately over or undervaluing one’s currency, may be sensible over short periods. Overvalued exchange rates can help check domestic inflation and improve the welfare of citizens by making imports more affordable but overtime can hamper export competitiveness. Kuwait and Bahrain, for example, have pegged their currency to the US$ at a rate that is obviously expensive / overvalued vis-à-vis other currencies. This may make sense as their only export, oil is denominated in US$ and being price takers, export competitiveness is not an issue. On the other hand, their expensive currencies makes luxury German automobiles, French biscuits and Swiss chocolates very affordable for their citizens, thereby improving welfare. However, there is a cost, it will be very difficult for globally competitive industry or manufacturing to root at such exchange rates. So, if these countries are serious about diversifying their economies, they ought to take a serious relook at their exchange rates.

Deliberately undervaluing a currency may be more sustainable over a longer period relative to overvaluation. Japan, S.Korea and China more recently, are examples of countries that have used undervalued home currencies to pull themselves up the development chain. Undervaluing one’s currency is effectively announcing to the rest of the world, the willingness to do the same work or sell the same products at a lower foreign currency price. Thus, it is no surprise that one’s export competitiveness is enhanced. However, such a policy only works when the domestic value-added is high. That is the import content of exports is very low. Japan in the post-war period, grew by importing low-cost commodities in raw form and using these to produce for export, automobiles, electrical appliances and electronics that were highly valued. Since the import content is very low, the higher import price due to undervaluation is easily absorbed. Malaysia, Indonesia and the like, that manufacture for export a small part of the value chain, cannot use undervalued exchange rates to leapfrog. The import content of exports is far too high to make such a policy successful. Whatever advantages one can derive from exchange rates is temporary at best. One cannot devalue ones way to prosperity, nor peg one’s currency to avoid depreciation.


Opinions expressed are solely the writer’s and do not express the views or opinions of INCEIF.

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