Similar to the Balance of Payments Approach to exchange rates is that which focuses on the relationship between a long-term equilibrium value for the real exchange rate and the external balance. Under this, the long-term equilibrium exchange rate is that which generates both internal and external balance, where internal balance is defined as full employment and external balance as the current account. Since the creation of this model, the emphasis has shifted away from focusing on full employment to concentrating on achieving a sustainable current account balance — not necessarily zero — which will achieve a perceived economic and exchange rate equilibrium.
As with the Balance of Payments Approach, the current account is seen as the transmission mechanism for the exchange rate, albeit this time under both fixed and floating exchange rate regimes. If the current account balance is showing an unsustainably high deficit relative to historic deficit levels, this will require a real exchange rate depreciation to restore equilibrium. Conversely, if it is showing a very high current account surplus, this will require a real exchange rate appreciation to restore equilibrium.
The example that is often used with regard to this is Japan, which has had a structurally high current account surplus. Using the external balance approach, if that current account surplus is seen as unsustainably high relative to historical norms, it requires a rise in the yen’s real exchange rate to restore equilibrium. Barring periodic reversals, this is what we saw from 1971 to 1995. Since then, the yen has reversed course, not least because the strengthening of the nominal yen exchange rate to a record dollar–yen low of 79.85 caused such a real shock to the current account balance that it in turn required a significant real exchange rate depreciation to restore equilibrium once more.
Within the emerging markets, another good example is that of Russia. Before the Russian rouble crisis of August 1998, Russia continued to record significant current account deficits. The external balance approach suggested that at some point a real exchange depreciation would be required to restore equilibrium. However, the Russian rouble was pegged to the US dollar and in order to maintain that peg real interest rates were kept high. Eventually, the costs of defending the Russian rouble peg — yet another case of trying to have all three of monetary independence, reasonably high capital mobility and a fixed exchange rate regime — proved too much and the rouble was de-pegged and devalued, and for good value Russia defaulted on its domestic debt.
Posts Tagged Market
A Fixed Exchange Rate Regime
Jun 26
Under a fixed exchange rate regime where capital mobility is extremely limited, the focus is on the current account rather than the capital account. Assume for the purpose of this exercise that national income is rising. As national income rises, so stronger demand sucks in an increasing amount of imports, which in turn causes current account balance deterioration. The exchange rate cannot be the transmission mechanism for restoring balance of payments equilibrium since the exchange rate is fixed. Hence, the monetary authority has the choice of either selling its foreign exchange reserves in the market to alleviate pressure on the exchange rate or more practically tightening monetary policy in order to dampen domestic demand, thus reducing import demand and restoring the balance of payments equilibrium.
Equally, within that same fixed exchange rate regime, say national income was falling. This would imply that weaker domestic demand would cause a decline in import demand, which would paradoxically cause an improvement in the current account balance. Because the capital account would not be a consideration given our premise that capital mobility is highly restricted and the exchange rate is fixed, equilibrium in the balance of payments can only be restored through a reversal of that current account balance improvement. Such an improvement would pressure the fixed exchange rate to appreciate. The monetary authority could either absorb this pressure by increasing its foreign exchange reserves and selling the domestic currency in the market to do so, or by loosening monetary policy. Either way, this would cause market interest rates to fall, spurring domestic demand and thus import demand, which in turn would cause the current account balance to move back to a position such that the balance of payments equilibrium would be restored.
The dynamic whereby a change in national income is transmitted within a fixed exchange rate regime through the current account balance is expressed in the following diagram:
Change in national income -> Change in current account balance -> Monetary reaction -> Reversal of current account balance change -> Balance of payments equilibrium restored
In theory, a fixed exchange rate regime should automatically be in balance as left to its own devices it should be self-correcting through changes in capital flows and interest rates. An imbalance of one kind or the other should automatically be corrected, albeit after a lag. Yet, in reality, fixed or pegged exchange rate regimes have faced an increasingly turbulent time during the 1990s to the extent that many of them have collapsed in the face of seemingly irresistible speculative pressure. Why has this been the case? Many of the reasons for this are case-specific. However, the underlying theme is that frequently countries simply have not been prepared to maintain the degree of economic discipline that is required to maintain the fixed exchange rate regime. In addition, many appeared to forget the core rule established by the Mundell–Fleming example that you can have only two but not all three outcomes with a fixed exchange rate regime, high capital mobility and an independent monetary policy. Under the misguided influence of the official community in Washington, many emerging market countries, which had fixed or pegged exchange rate regimes, opened up their economies to high capital mobility at the same time they sought to maintain some degree of monetary independence. Looked at from this perspective, the result was inevitable.
Maintaining a fixed or pegged exchange rate regime within a world of high capital mobility requires a considerable degree of economic discipline given that the transmission mechanism for restoring imbalances to the equilibrium of the balance of payments cannot be the exchange rate but instead must be the real economy. Furthermore, global financial markets must be convinced that the monetary authority of this fixed exchange rate regime will hold the line come what may. In the case of Asia, countries like Thailand, Indonesia and Korea were ultimately either unwilling or unable to maintain that discipline. Interestingly, China, Hong Kong and Taiwan were all able to weather the storm, not least because they upheld the principles of the Mundell–Fleming rule. In the case of China and Taiwan, both had monetary independence and a fixed or pegged exchange rate regime (Taiwan’s cannot be called a freely floating exchange rate regime by any stretch of the imagination), but maintained significant restrictions on capital mobility. In the case of Hong Kong, on the other hand, it had very high capital mobility and a fixed exchange rate regime in the form of a self-balancing currency board, but its monetary authority, at least in theory, abandoned monetary independence in favour of following the monetary policy of its peg currency, namely that of the Federal Reserve. Granted, Hong Kong, China and Taiwan perhaps had both greater resolve and ability to resist speculative pressures, but the structure of their exchange rate regimes was crucially more secure. As the example of Argentina shows in 2002, following this two-but-not-three model is not a guarantee of success. However, one could well say that not following it is more or less a guarantee of failure.
Two Legs but not Three
Jun 25
The final word on the Monetary Approach and the exchange rate impact from policy combinations concerns the idea from the Mundell–Fleming model that a central bank can in a world of high capital mobility target the exchange rate or the interest rate but not both. Another way of expressing this is that you can have two of the following but not all three:
A fixed exchange rate regime
Monetary policy independence
High capital mobility
The first assumes the targeting of the exchange rate, while the second assumes the targeting of inflation and interest rates. The discovery of this rule was the stuff of brilliance, the monetary equivalent of the discovery of penicillin, yet history is littered with examples of policymakers who ignored it to their cost. While the example of Asia and the subsequent Asian currency crisis may spring to mind, there are also examples within the developed world, notably that of the ERM crises of 1992–1993. Here, there was indeed a commitment to a type of fixed exchange rate regime under conditions of high capital mobility. At the same time however, ERM members were allowed monetary independence. In practice, some, notably the Benelux countries, appeared to all but abandon monetary independence in favour of adopting the harsh benchmark of Bundesbank monetary policy. Others, such as the UK, Italy and Spain, sought a greater degree of monetary independence. Is it any coincidence that these were either forced out of the ERM altogether or forced to devalue within it? While the argument is frequently made that the UK pound sterling went into the ERM at an overvalued level to the Deutschmark, a contrary argument could be made that sterling would have been forced out of the ERM no matter what its entry level because the UK authorities refused to relinquish monetary independence to the Bundesbank.