Exchange rates: Regimes in a fix

By Martin Wolf, Financial Times, Wednesday 19 August 1998

Adjustable exchange rates and free capital flows do not mix. If crises are to be avoided, countries must choose between them

Some countries devalue; others default. Few do both on the same day. Never inclined to do things by halves, the Russians are the exception.

By combining a devaluation with a forced restructuring of domestic debt, imposition of capital controls and a 90-day moratorium on foreign commercial debts, the Russian authorities have sacrificed their stabilisation policy and initiated a general default. In just one day, the fruit of the long effort to give Russia a stable currency and win a reputation for financial reliability has, it appears, been thrown away (see opposite).

Whatever the direct repercussions turn out to be for Russia and the world at large, this failure underlines and amplifies lessons that must be drawn from all the crises of the past 14 months.

First, the International Monetary Fund cannot eliminate the confidence crises to which adjustable peg exchange-rate regimes are so prone.

Second, attempts to operate such regimes in the absence of tight controls on capital inflows and strong regulation of domestic financial system have potentially devastating effects on economic stability.

Third, for particular countries, the choices of regime break down into a freely floating exchange rate or a currency board (without capital controls) or pegged exchange rates (with them).

Finally, if there is to be a world with pegged exchange rates, but no capital controls, there must also be a true international lender of last resort.

Consider each of these points in turn.

On the first, only last month the IMF agreed to a $23bn support package for Russia. The main purpose was to increase confidence in the government’s ability and willingness to service debt and maintain the exchange rate.

Although that lack of confidence had, at its root, the political, financial and economic frailties of the country, it was also self-fulfilling: the extraordinarily high interest rates (of well over 100 per cent in real terms) that the government was forced to offer undermined credibility rather than reinforced it.

This package has failed. When a borrower has to cope with a run, it needs a lender of last resort able to supply the desired funds without limit. But the IMF can never provide funds in this way. Worse, what it does provide is available only in tranches, with the delivery of each depending on the borrower’s ability to satisfy demanding conditions. Thus the new funds are not merely limited in aggregate, but the chances of delivery are also uncertain.

Any exceptionally large IMF programme is therefore more likely to convince creditors of the extent of the crisis than persuade them to wait while it is resolved. As the IMF’s money comes in the front door, creditors leave by the back, carrying as many sacks as they can.

IMF funds will always be both limited and subject to tough conditions. It is difficult enough to get the money from legislators, particularly the US Congress. It would be impossible to do so without the promise of tough conditionality. Yet this means that the IMF is unable to remedy a crisis of confidence in an adjustable-peg regime that is not buttressed by effective controls on capital inflows and outflows.

Turn, then, to the second point. The failure of an adjustable-peg regime can, as the chart indicates, be devastating. Currencies are prone to collapse. The principal reason for this, powerfully demonstrated in east Asia and likely to prove true in Russia as well, is that the devaluation validates one side of what were previously highly divergent expectations.

When governments implement pegged exchange rates over a reasonably lengthy period, some investors will start trusting them, while others will not. Believers are likely to look at interest rates abroad and compare them with often much higher interest rates at home and decide to borrow in foreign currency and lend at home. Behind such divergences often lie efforts by the monetary authorities to target the exchange rate and curb domestic credit expansion at one and the same time.

This form of speculation is precisely what financial institutions and private companies did in Thailand, Indonesia and South Korea. They borrowed abroad, under what they thought would be a stable exchange rate, to replace expensive borrowing at home. For these borrowers, devaluation is devastating. Institutions that have borrowed foreign exchange find themselves cut off from further credit. They have to sell domestic assets to obtain foreign currency. The currency falls, exacerbating speculation against it, and spreading insolvency throughout the private sector. This is what lay behind the devastating collapse of east-Asian currencies.

The danger explains the third point. Where capital flows are uncontrolled - and implicit and explicit speculation correspondingly easy—governments have to avoid potentially expensive divergences in expectations about their future policies. They need to establish a clear and over-riding exchange rate regime, buttressed by robust flanking policies for the budget and financial regulation. Of the alternatives only free floating and currency boards pass muster.

Under free floating, a country must establish stable inflation. The best way to achieve this is via an independent central bank with an inflation target. For small countries, or countries unable to establish autonomous domestic institutions, the alternative is a currency board. In this, the country’s cash is fully backed by foreign currency, and exchange between the two is at an irrevocably fixed rate. Autonomous monetary policy is then eliminated.

If it is impossible for a country to make any commitment to monetary stability, neither alternative will work. But an intermediate policy will also fail, as Russian experience demonstrates. After this latest debacle, the case made by Steve Hanke of the Johns Hopkins University for a currency board needs consideration, even in the case of Russia.* It may be impossible to make such a disciplined system work there. But it is difficult to see what else will.

The point can be turned round. If a country wants the flexibility of an adjustable-peg regime, it cannot also allow free speculation on the durability of the rate. It must have some control over capital flows. The old Bretton Woods system was logical. With exchange controls, that regime was manageable. Without them, it was not.

Finally, all this also says something important about the aim of putting capital account convertibility into the IMF’s articles. There is a case for this. But one must also insist that countries have exchange-rate regimes, fiscal policies and a system of financial regulation fully consistent with such freedom. Alternatively, there must be an international lender of last resort capable of supplying enough money to deal with the inevitable crises of confidence.

Indeed, it is very likely that there will need to be both, particularly if emerging market economies, with all their economic, political and financial weaknesses, are to take the recommended plunge. The alternative is one ruinous financial crisis after another. Russia’s is just the latest in a long line. It is not going to be the last.

Steve H. Hanke, Lars Jonung and Kurt Schuler, Russian Currency and Finance: a Currency Board Approach to Reform, London, Routledge, 1993.