Margaret G. de Vries
THERE HAS BEEN a great deal of misconception about the Fund’s approaches to fluctuating exchange rates, or as they are often called, “floating rates.” Critics of the Fund frequently suggest that it has been too uncompromising in its support of the present world-wide system of fixed exchange rates. The implication is that the Fund’s attitude stems primarily from the requirements of its Articles of Agreement, or that its economic reasoning is too rigid. It is worthwhile, therefore, to take a deeper look at what the Fund policies have been, and their underlying rationale.
The Fund has, of course, consistently and strongly supported the system of institutionally agreed par values. However, this stand has only in part reflected the requirements of its Articles; it owes far more to the Fund’s own widening experiences with deviations from that system. Furthermore—and this is much less generally realized—while the pursuit of fixed exchange rates has remained the underpinning of its philosophy, the Fund has also, temporarily and in carefully delineated circumstances, supported what it regards as less than ideal types of exchange rate adjustments; the latter have included fluctuating rates.
Moderations of Policy Over Time
From 1946 to 1968, it is possible to discern almost step-by-step movements in the Fund’s policies on fluctuating rates. In its very early days the Fund put primary stress on the fact that fluctuating rates were inconsistent with its Articles. Concern with the formal position of a country with a fluctuating rate was exemplified by the Fund’s first encounter with such a rate: In July 1948 Mexico suspended transactions at its par value and let the market set the exchange rate. The Mexican authorities did not wish to resort to exchange controls on capital movements—the source of the deficit—and believed more time was required to determine an appropriate new par value.
For the newly formed International Monetary Fund this posed a serious problem. Accordingly, the Mexican Government and the Fund were in continuous consultation with a view to establishing a new par value for the peso; this was done in July 1949, one year after the suspension of the initial parity.1
The “Exceptional” Situation
Very soon pragmatic considerations began to overshadow the more technical ones. Hoping that a few exceptions would not cause a return to the rate instability of the pre-Fund era, the Fund recognized the possibility that certain unusual circumstances might arise.
This change in attitude was evidenced in November 1949 when Peru suspended transactions at its par value. Peru had had an exchange system consisting of three separate markets, the rates in one of which were fixed on the basis of the par value. Now the market with fixed rates was to be abolished and all transactions were to be conducted in two markets, both of which would have fluctuating rates. The rates in the two markets were expected to follow each other closely.
This time the Fund recognized the exigencies of the situation that had made Peru unable both to maintain its old par value and immediately to select a new one. There was possibly even something to praise in the Peruvian exchange system. It was essentially unified and the new rates seemed realistic; this represented substantial progress compared with the complex multiple rates of many other countries. Therefore, with the understanding that the purpose of Peru’s action was the establishment of a unitary exchange system on a more appropriate level, the Fund did not object to the use of the fluctuating rate as a temporary measure.
As of March 1, 1969, Peru still had not set a new par value. Meanwhile, in the intervening years, the Fund had permitted Peru to draw on the Fund’s resources and to assume the obligations of Article VIII—that is, to be regarded as a country which is relatively free of restrictions and which has a convertible currency.
The Instance of Canada
A second example of the Fund’s acceptance or toleration of a fluctuating rate in exceptional circumstances is, of course, that of Canada, which had a fluctuating rate from September 1950 to May 1962. This rate was introduced in order to dampen a heavy inflow of capital, mainly from the United States. This inflow, which had become especially great in 1950, added to the money supply and tended to depress interest rates, thus augmenting inflationary pressures. The object of this exchange rate change was thus in contrast to most other exchange rate adjustments that are intended to rectify an unfavorable balance of trade and to check an outflow of capital. Because of the speculative nature of much of the capital inflow, the Canadian Government felt unable to foresee the end of the capital movement so long as a fixed exchange rate was maintained. As, in the view of the Canadian Government, it was impossible to determine in advance with any reasonable assurance what new level would be appropriate, it announced that the rate of exchange should be left to be determined by market forces.
After discussion of possible alternative courses of action that Canada might follow, the Fund again decided to recognize the exigencies of the situation as well as to take note of the intention of the Canadian Government to remain in consultation with the Fund and to reestablish an effective par value as soon as circumstances warranted.
By 1956, the Fund regarded Canada’s relative success with a fluctuating rate as reflecting the uniqueness of Canada’s circumstances. Canada had not only a trade deficit but a substantial capital inflow. There was confidence in the Canadian dollar because of the fiscal and credit policies being followed. Canada was relatively free of restrictions and had a convertible currency. Moreover, the institutional background led many persons to regard as natural a parity for the Canadian dollar somewhere near that of the U.S. dollar, and close interdependence between short-term capital movements and movements of the exchange rate had caused capital flows on the whole to be equilibrating rather than disturbing. Finally, the exchange rate had fluctuated only about 3-5 per cent, despite the absence of intervention by the authorities except for the purpose of maintaining an orderly exchange market. For all these reasons, Canadian trade and normal capital transactions had not lost the important benefits commonly associated with exchange rate stability. The Canadian example was not a precedent for the circumstances of other countries.
By mid-1961 disenchantment with the way the Canadian rate had been operating since the late 1950’s began to be discernible both among Canadian authorities and in the Fund. A very large deficit on current account had emerged, the rate of economic growth had decreased, and unemployment had risen. The Canadian authorities attributed these economic reverses in large part to the then unduly high exchange rate; the inflow of capital had caused the rate to reach a point at which it acted as a stimulus to imports and as some deterrent to exports. And the Fund itself, observing the adverse developments, had entered into active consultation with Canada concerning the circumstances in which the establishment of a new par value would be appropriate. On May 2, 1962, in the midst of exchange difficulties, Canada finally gave up its fluctuating rate and declared a new par value to the Fund.
In addition to Peru and Canada, other Fund members which have had fluctuating exchange rates for relatively long periods include Lebanon, the Syrian Arab Republic, and Thailand. In 1954, in order to facilitate Fund transactions in currencies where fluctuating rates prevail—such as Fund drawings in these currencies or payment of additional local currency in order to preserve the value of Fund assets—the Fund set up special rules for computing exchange rates of those countries with fluctuating rates. Computations were to be based on the midpoint between the highest and lowest rates for the U.S. dollar quoted for cable transfers for spot delivery in the main financial center of the country of the fluctuating currency on specified days. Computations under this decision have been made only for those countries for which transactions no longer take place at their par values. As of August 15, 1968, for example, computed effective rates applied only to Argentina, Bolivia, Brazil, Chile, Colombia, Indonesia, Korea, Paraguay, Peru, and Venezuela.
Fluctuating Rates and Exchange Reform
In a second set of circumstances, the Fund has gone somewhat further: in conjunction with exchange reform and stabilization, the Fund has supported programs which have included a fluctuating rate. To some extent Peru’s fluctuating rate, described above, had been introduced as part of an exchange reform. But even before reform Peru’s exchange system had been fairly simple, inflation had not been massive, and the devaluation involved was modest. In the late 1950’s the technique of using a fluctuating exchange rate to effect reform of very complex exchange systems, with a multiplicity of rates, became more widely used. Bolivia and Thailand were among the first, in 1955-56, to take this type of action. They were followed in the next few years by Chile, Paraguay, and Argentina. Similarly, in 1962, the Philippines resorted to a fluctuating rate as a means of devaluation and decontrol of restrictions; this rate lasted until November 1965.
At the time of stabilization after a prolonged period of inflation, these countries have devalued, but not necessarily to new fixed rates. Fluctuating rates were used for a time as a means of finding the point at which the rate could ultimately be maintained. In the circumstances that prevailed in those countries it was impossible to determine the appropriate level for the exchange rate in advance. Where a combination of restrictions and multiple rates existed, this was true because even the level of the rate currently in effect would not readily be determined. As well, it was uncertain how effective the new anti-inflationary measures would be. Movements in prices and wages following the adoption of measures designed to eliminate distortions in the economy are difficult to estimate. In still other instances, a new par value could not be determined until after a new tariff system had been established. For these reasons, as exchange reforms have been undertaken, several countries have instituted a single fluctuating rate.
Although problems have arisen, experiences with these temporary fluctuating rates have often proved to be quite successful. Several of them have eventually been stabilized and have furnished the basis for new par values (see Margaret G. de Vries, “The Decline of Multiple Rates, 1947-67,” Finance and Development, Vol. IV, No. 4, December 1967). The Fund, by 1962-63, therefore, turned to positive support of this means of exchange reform.
Even more significant is that a fluctuating rate adopted in these circumstances has carried with it an understanding between the country and the Fund that the fluctuating rate will be allowed to move in accordance with market forces; the authorities are to intervene only to maintain orderly market conditions. Even when the need for rate flexibility is recognized, the authorities often find it difficult to maintain a flexible rate; in the absence of clear criteria for exchange rate action, the tendency is to peg the rate at a level which soon becomes out of line with developments in the economy. Accordingly, in some countries where a flexible rate policy is considered essential because of continuing inflation, a test has been set up as a means of assuring that a rate will be maintained which conforms to the basic market trends. Such a test usually consists of a prescribed minimum level at which the foreign exchange reserves of the country are to be maintained during a stated period, with exchange rate action taken whenever that level is threatened. Even so, inasmuch as most countries have been reluctant to see their rates depreciate excessively, the Fund has frequently had to call upon countries with flexible rates not to stabilize prematurely.
Stability the Ultimate Objective—Fixed Rates for the General System
The Fund’s ultimate objective, nonetheless, even in cases of exchange reform, has been to create the conditions for the restoration of a stable and unified exchange rate. The fluctuating rate has been regarded as a temporary means to an end. Moreover, the Fund has also continued to regard a general system of fixed rates and institutionally agreed par values as decidedly superior to a system of fluctuating rates. These positions have been held primarily because, in the Fund’s view, experience has revealed several weaknesses of fluctuating rates.
First, to those who advocate allowing rates to find their “natural” level, the Fund has stated that there is no such thing as a natural level for the rate of exchange of a currency. The proper rate, in each case, depends upon the economic, financial, and monetary policies followed by the country concerned, and by other countries with whom it has important economic relationships. In addition, whether a given exchange rate is at the “correct” level can be determined only after there has been time to observe the course of the balance of payments in response to that rate.
Second, movements in fluctuating rates have been significantly affected by large speculative transfers of capital. Consequently, countries have preferred to make adjustments in their exchange rates in a manner that would minimize distortions through speculation. And fluctuating rates are often inappropriate where excessive outflows of capital, or underinvoicing and smuggling, have been troublesome. Additional capital inflows that are speculative on exchange rate movements may be induced.
Third, in circumstances of continuous inflation, fluctuating rates give rise to a vicious circle of devaluation and inflation. On the one hand, so long as internal prices are not stabilized, flexible rates are necessary to prevent overvaluation. Yet under conditions of internal price instability, the rate depreciates regularly, which in turn contributes to even greater inflation. Furthermore, if a country does not clearly and quickly adopt a monetary policy aimed at general stability, the movements of its fluctuating rate are likely to be oscillations not around a stable value but around a declining trend.
In this regard, the Fund has concluded that it is an illusion to expect a fluctuating rate to ease the problems facing the monetary authorities. On the contrary, by eliminating the rallying point of the defense of a fixed par value, a fluctuating rate makes it necessary for the authorities to exercise greater caution in determining monetary policy. When fluctuations in the rate become of significant amplitude, these fluctuations may themselves contribute to the forces leading to depreciation. Depreciation may create inflationary pressures. Indeed, depreciation of the exchange rate often proceeds more rapidly than the accompanying or ensuing price inflation.
Consequently, experience with fluctuating rates has suggested that the countries using this device had not, on the whole, been able to protect thereby their economies from pressures arising abroad. Moreover, should they pursue expansionary domestic policies, countries might still lose reserves, unless the authorities are prepared to let the rate depreciate continuously.2 And, the Fund observed, orderly exchange arrangements and exchange stability had been recognized by most countries to be important and generally accepted objectives of economic policy. Even in countries where the authorities were not prepared formally to stabilize the exchange rate on the basis of a realistic parity, de facto stable rates were often maintained for long periods of time. For all these reasons, the Fund has retained exchange rate stability as the ultimate goal even for those countries which have temporarily resorted to a fluctuating rate.
Finally, the Fund has had still another reason for preferring a general system of institutionally agreed parities. As a body for international consultation on exchange rate changes, the Fund has feared that, under a system of flexible rates, exchange rate policy would tend to become much more a matter of unilateral action and thus make the process of international collaboration in financial matters far more difficult.
The debates over the relative merits of fixed and fluctuating exchange rates, such as have been going on among economists in the last several years, may never end. Certainly similar discussions of this issue have also occurred in the past. In the early 1950’s, for example, interest in a possible fluctuating rate system, even in some official quarters, was sufficiently intense that the Fund felt obliged to explain its position.3 However, as time has gone on, two major developments in Fund policy stand out. First, Fund policy has evolved in a direction of accepting, indeed supporting, flexible rate regimes as temporary expedients where carefully defined exceptional circumstances seem to warrant such flexibility; by no means has the Fund categorically opposed all such schemes. Second, Fund policy in favor of fixed and stable rates has increasingly been based on its own widening unsatisfactory experiences with deviations from the par value system and because, in its view, a general flexible rate system would make international monetary cooperation extremely trouble some; Fund policy has gone beyond a mere reiteration of the requirements of its Articles.
Annual Report, 1951, p. 25.
Evidence along these lines was presented, for example, in the Fund’s Annual Report, 1962, pp. 58-67.
Fund Annual Report, 1951, pp. 36-41.