Exchange rates: avoiding a race to the bottom

President Thabo Mbeki’s statement in his State of the Nation address on the exchange rate and volatility of the rand brings to mind the dilemmas faced by policymakers in most developing countries under conditions of economic globalisation.

The ANC has previously proposed that the government should implement policies that allow for a competitive currency to bolster economic growth and stem the tide of job losses in crucial sectors such as manufacturing and mining. 

Traditionally, the exchange rate has been accepted in international policymaking circles as a vital tool of industrial policy that can be used, under certain circumstances, to strengthen the global competitiveness of domestic economic sectors, boost exports, diversify the economic structure and generate sustained growth rates. But, as the United Nations Conference on Trade and Development emphasised in its trade and development report in 2004, it is more difficult in the contemporary global economy for national states to pursue these policy objectives effectively through exchange rate devaluation than it was several decades ago. 

Managed currency depreciations can by and large improve the trade performance of developing countries.
But the same cannot be said for the sudden and sharp exchange rate depreciations that have taken place in numerous financially open developing countries in the past 30 years. The reason for this is that the latter devaluations were frequently accompanied by sharp decreases in imports and diminished access to trade finance and working capital. This, in turn, reduced the ability of domestic exporters to benefit from their increased competitiveness as the result of a weaker currency.

At the heart of the problem is the paucity in the current multi­lateral system of coherence between national development strategies and global economic policies, as well as between the international trade, monetary and financial systems.

The collapse of the Bretton Woods system in 1973 made way for the adoption by many countries of floating exchange rates and the resurgence of rapid global capital flows reminiscent of those that had induced systemic instability in the 1930s. Driven by advances in telecommunications and information processing technologies, and championed by governments that had benefited from financial openness, the progressive deregulation and liberalisation of financial markets impeded efforts to restrict financial flows.

Short-term financial capital, moving with great speed across national borders, became a defining element of the international financial system, with the capital markets responding swiftly to differences in macroeconomic policies between countries. And deeper financial integration raised the costs of pursuing monetary policies that diverged from regional or global policy trends.

These developments have posed a significant challenge for economic policy. Although capital inflows have provided essential development finance for developing countries, financial market volatility has made it difficult for governments to manage interest and exchange rates in ways favourable to domestic capital formation and companies’ international competitiveness. It has also been a contributor to financial crises in emerging market economies, even in countries with sound macro­economic policies.

In particular, there has been a concern about the adverse impact of exchange rate instability on trade. Huge currency devaluations in crisis-ridden countries have had a destabilising effect on the external trade positions of other countries. This, in turn, has sparked resistance from import-sensitive sectors in the countries affected by the devaluation, with governments in those countries also being forced to depreciate their currencies to ensure that the competitiveness of their exporters is not undermined.

In the absence of multilateral rules to avert competitive currency depreciations, a growing number of countries have attempted to raise their international competitiveness by managing the floating of their currencies unilaterally. Yet only a few developing countries are able to manage their exchange rate movements successfully.

This has underscored the need for a better model of global economic governance that would tackle trade imbalances and distortions that emanate from the financial and monetary domains. Multilateral cooperation should be strengthened to make sure that the international financial system is responsive to the needs of developing nations, and appropriate mechanisms should be instituted to reduce the vulnerability of these countries to rapid financial liberalisation.

Moreover, effective coordination should be established between national policies and global economic processes. Developing countries should be allowed to administer their exchange rates in a manner that permits them to maintain competitive rates, while giving them adequate policy space to carry out orderly adjustments when confronted with external shocks. This is necessary if the benefits of globalisation are to be shared equitably among all countries, rich and poor.

Mills Soko is a senior lecturer at the University of Cape Town’s Graduate School of Business

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