Exchange Rate Policy in Developing Countries 3

Richard Bart, and Chorng-Huey Wong
Published Date:
June 1994
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This paper distinguishes between two approaches to exchange rate policy in developing countries: the “real targets” and the “nominal anchor” approaches. It also looks at whether the exchange rate follows other policies and private sector price and wage setting or leads them. The real targets approach, which is now the orthodox policy, assumes that nominal exchange rate changes have prolonged real effects and that the exchange rate should adapt to other policies. The nominal anchor approach uses the exchange rate as an instrument of anti-inflation policy, as a way of constraining domestic policies and influencing private sector reactions. In examining the implications of the nominal anchor approach, the paper considers to what extent such an approach might explain the low-inflation experiences of the many countries in which exchange rates have been (more or less) fixed for long periods. The implications of increasing capital mobility for exchange rate policy are also examined, and some conclusions for policy are presented. The analysis draws on examples of exchange rate policies and the experiences of a group of 17 developing countries that have been studied as part of a World Bank project on macroeconomic policies and growth over a longer period.1

I. Two Approaches to Exchange Rate Policy

The real targets approach uses the nominal exchange rate, together with other policy instruments, to attain real objectives such as an appropriate (noninflationary) level of demand for home-produced goods and services (internal balance) and a desired current account target. In its assumption that a nominal policy instrument can achieve a real objective, this approach is essentially Keynesian. Furthermore, it assumes that the government can be trusted to make sensible use of the exchange rate and other instruments—that is, it does not need to be constrained. In addition, this approach assumes that the nominal exchange rate is a policy instrument distinct from domestic monetary and fiscal policies, although it must be applied together with these policies.

The assumption that the exchange rate is a policy instrument separate from domestic monetary policy is particularly important to the discussion. It means that a nominal exchange rate objective can be attained by sterilized intervention. It is thus assumed that effective exchange controls or other measures are used to ensure that international capital mobility is not high for the country.

The approach implies that a nominal devaluation has real effects that are sufficiently long lasting to be worth pursuing, at least provided expenditure policy avoids excess demand at the same time. Domestic prices and wages are assumed to be imperfectly flexible downward (in the simplest models, they are actually held constant). There is now strong evidence that, except in the chronic-inflation countries of Latin America, devaluations do have real effects that last for several years, provided appropriate credit policies are also followed. Thus the evidence seems to justify one of the key assumptions, at least for a period of, say, two to four years. Even in the case of high-inflation countries, continuous nominal depreciations may have real effects in the sense of preventing the real appreciations that would otherwise take place.2

The alternative, nominal anchor approach is a version of monetarism and used to be known as “international monetarism.” The exchange rate is used to anchor the domestic inflation rate (broadly) to the inflation rate of trading partner countries. Possibly the exchange rate is adjusted on the basis of some predetermined scale to affect the inflation differential with trading partner countries. It constrains domestic monetary policy (and hence possibly fiscal policy), making it endogenous. The exchange rate leads rather than follows other nominal variables, such as domestic price and wage inflation, in order to attain real objectives, such as maintenance of competitiveness. Apart from restraining governments, this approach is meant to send out clear and credible signals to private agents about prospects for inflation. The implication is that if the signals are clear and credible, the real economy will adjust appropriately to various shocks, including anti-inflationary exchange rate policy.

The approach—which focuses both on the need to restrain government inflationary tendencies through some kind of commitment and on the influence of the credibility of government monetary policies on private agents’ expectations—is very much in tune with recent macroeconomic theorizing. For that reason, it is surprising that the current policy orthodoxy with regard to developing countries takes little account of it. Hence I discuss it at some length here.

II. Exchange Rate Policy Targeted on Real Variables

This section presents a systematic analysis of certain issues related to the real targets approach. How should the nominal exchange rate move in response to various “real” shocks or objectives, such as fiscal expansion or trade liberalization? What is the meaning of exchange rate “overvaluation” or “misalignment”?

The basic model: switching and expenditure adjustment

Chart 1 is the familiar “Swan diagram” (Swan (1963)), but it calls for careful interpretation here. It is assumed that the country is small in world markets, so that any changes in the terms of trade are exogenous.

The vertical axis shows the relative price of traded to nontraded goods in domestic currency terms, allowing also for the effects of tariffs, quantitative restrictions, and so on, that affect this relative price ratio. This is the S ratio, the S standing for either “Salter” or “switching.”3 It is sometimes called the “real exchange rate,” a movement upward being a real depreciation.4 The horizontal axis shows real expenditure or absorption (E), which can increase as a result of monetary or fiscal expansion or various other factors, such as higher incomes yielded by a terms of trade improvement. The curve Y0 shows varying combinations of S and E that yield constant real income Y0 resulting from constant demand for home-produced goods. Curve Y1 represents a higher level of demand and income. Similarly, curve C0 represents a constant current account balance, and curve C1 a current account that is more in deficit.

Let us now look at the three crucial prices, namely, the prices of nontraded goods, imports, and exports.

First, there is a large category of nontraded goods N, with price pn. This category contains two subclasses: (1) pure nontradables, which would be priced on the basis of domestic demand and supply even if there were free trade, and (2) goods that might have been imported under free trade but, because of prohibitive quantitative import restrictions, are priced on the basis of domestic demand and supply rather than in terms of the prices of competitive imports. The latter goods are the quantitative restriction-propelled nontraded goods—importables that have been converted into nontraded goods.

Second, there are imports M, whose domestic price is e(1+t)pm, where pm is the border price of imports in foreign currency terms, e is the nominal exchange rate defined as units of domestic currency per unit of foreign currency (an increase being a depreciation), and t is the tariff rate, whether explicit or implicit (quantitative restrictions), whichever effectively determines price. If import restrictions are tightened or their range is expanded within the broad category of M, t will rise.

Finally, there are exports X, where px is the foreign price of X, and epx is the domestic price.

Chart 1.The Real Targets Approach

Since there are two kinds of traded goods, weights must be attached to the two prices to get an average price of traded goods. The weights are a and 1 - a. We thus get an expression for S, the relative price of traded to nontraded goods, taking into account trade restrictions and allowing for the possibility that the terms of trade (px / pm) may change:

When the weights are held constant, S can change because of changes in the exchange rate, in protection, in one or two foreign prices, or in domestic (nontraded) prices, the last possibly because of a change in the nominal wage level. If a there is a nominal depreciation, that is, if e rises, and with pn, t, pm, and px given, S will increase. In that case, we can equate a change in S with a change in e, a movement upward in Chart 1 (positive switching) being a real depreciation or devaluation. An increase in pn would lower S (negative switching). If pn rises more than e (and with pm, px, and t still constant), one might say that there has been real appreciation. When pm, px, and t are constant, and only e and pn vary, it seems appropriate in terms of conventional usage to use the real exchange rate concept, with positive switching resulting from real depreciation (e rising more than pn). But a problem with this concept arises when px, pm, or t changes.

A fiscal expansion: how should the exchange rate move?

Let us now consider a common situation in developing countries. A fiscal expansion is financed by borrowing, domestic or foreign. We take this as given. We also hold protection (t), and world prices (px, pm) constant. Which way does S have to move? Should the exchange rate appreciate or depreciate?

It is not difficult to show that if the deficit is domestically financed and there are initial excess capacity and unemployment, the exchange rate needs to depreciate. In Chart 1, at a constant e and pn, the movement would initially be from A to B, the net result of the fiscal expansion itself and possibly of some crowding out of private spending (as a result of a higher interest rate or of credit rationing brought about by the domestic financing). The current account worsens to C1 and demand for nontraded goods rises, bringing demand for home-produced goods to Y1 Clearly, a depreciation could restore the initial current account situation, provided it were possible to sustain higher domestic output. The system would go to D.

The more interesting case is that in which the deficit is foreign financed and the initial situation is one of full capacity or full employment (internal balance). In this case, the system cannot stay above Y0, although it may move there initially, so S must fall to bring the country to C. This could be brought about by a rise in pn, yielding a real appreciation. If a domestic price rise (temporary inflation) is to be avoided, nominal appreciation is required. The current account, of course, worsens. This negative switching reduces the profitability of export industries (and of any import-competing industries) and so yields the familiar Dutch Disease effect. It is caused by a fiscal expansion that is foreign financed or financed, at least temporarily, out of reserves when the starting point is one of internal balance.

(Given such a starting point, any transfer into the country, whether in the form of loans or aid, would have the same effect.)

It follows that the fiscal expansion may have to be associated with either a depreciation or an appreciation, depending on the extent to which the output of home-produced goods can be increased and the extent to which the deficit can be financed by foreign borrowing or the use of reserves.

Now suppose the country is at the last situation, at point C, with a current account deficit and internal balance. Reserves are running out or foreign borrowing is becoming difficult. Can we say that the exchange rate is “misaligned” or “overvalued”? We still hold px, pm, and t constant. Should the country be advised to devalue?

If fiscal policy remained unchanged, a devaluation might temporarily bring the country back to B (or even to D), creating excess demand at home. But pn would rise until S was back at C. Given the fiscal policy, the appreciated e is the correct one and is not overvalued. The fiscal expansion has to be reversed if the current account is to be improved. If it is impossible to reverse the fiscal expansion, there is no point in depreciating, since this would only cause temporary inflation. This point is often forgotten. It is wrong in this situation to advocate devaluation without the assurance that adequate fiscal contraction will also take place. But it would also be wrong to advocate fiscal contraction alone, leaving the exchange rate unaltered and pn inflexible downward, since a recession would result. Given that the current account has to be improved, it is really the package of fiscal policy and exchange rate that is misaligned. A reversal of the fiscal expansion should be accompanied by a devaluation so as to undo the earlier appreciation of the currency.

Import restrictions and exchange rate misalignment

Protection—realistically, quantitative import restrictions—can now be introduced as a variable. To simplify, we hold pn, pm, and px constant. The two policy instruments are e and t, a rise in t representing a tightening or extension of restrictions. According to equation 1, a given S can be obtained with varying combinations of e and t. Suppose we start at the desired level of S, namely S0 (in Chart 1), obtained by combining a particular level of e, namely e0, with a positive level of t, namely t0. Is the exchange rate then “misaligned”? The answer depends on whether the exchange rate leads or follows.

It is certainly possible that it follows. The level of protection may have been set at t0 because this was desired as a long-term protectionist strategy or because tariffs are used to raise revenue. In that case, protection leads, and e0 is then the equilibrium rate to ratify t0, given the target S0.

The currently more familiar story is that of trade liberalization. Again, the exchange rate is meant to follow. The much-repeated message is that trade liberalization requires devaluation to maintain both internal balance and the initial current account balance (see Corden (1971) and Krueger (1978)). This is an important example of the real targets approach. If the devaluation does not take place, trade liberalization cannot be sustained. In due course, import restrictions, although not necessarily the same ones as before, will be reimposed to deal with a current account problem that may have been caused by the earlier liberalization. In fact, this is the explanation for many failed liberalization attempts. The exchange rate is meant to follow but fails to do so (Krueger (1978)).5

A common experience in developing countries has been creeping overvaluation followed by increasing trade restrictions. A country starts at its desired internal and external position (point A in Chart 1) and with a low level of trade restrictions, say zero. But then because of domestic monetary expansion, domestic prices (pn) rise faster than world prices. Therefore S would fall unless e were increased pari passu. Continuous nominal depreciation is needed to compensate for the excess of domestic inflation over world inflation. But the country fails to depreciate sufficiently for a variety of reasons, perhaps primarily to discourage further inflation. Therefore restrictions have to be continually intensified to maintain S0 and hence equilibrium at A in Chart 1. This is a case in which the exchange rate leads when, from the point of view of the real targets approach, it should have followed. Restriction of imports turns out to be the residual policy, and it is not optimal.

Because of the increasing import restrictions imposed as a result of the continuous overvaluation of the real exchange rate, export industries are continuously squeezed.6 Eventually, however, the limit of import restrictions will be attained: the country will be down to its bedrock level of imports. Then either S must fall below S0, producing a current account deficit or an internal balance problem (depending on whether real expenditure, E, is raised or reduced), or the exchange rate must start depreciating.

Numerous examples of this pattern could be given. Indeed, there is hardly a country in our group of 17 that has not at some time gone through an episode like this, where rigidity of the nominal exchange rate leads to increasing import restrictions.7 That this is an undesirable outcome is, of course, a constant theme in the literature. The exchange rate should be adjusted appropriately. That is the essence of the real targets approach.

Nigeria presents a rather dramatic example of this kind of story. Inflation (consumer price index) was about 23 percent in 1983 and 40 percent in 1984, and yet the exchange rate stayed fixed. From the end of 1982 to the end of 1984, the real exchange rate (calculated by the IMF) increased by 64 percent (appreciated). Import restrictions were increasingly tightened. In 1985, the exchange rate was allowed to depreciate substantially, so that by mid-1986 the earlier real appreciation was more than fully reversed. But it was still far too high in real terms, mainly because of the precipitous fall in the price of oil in 1986. By that time, imports were certainly down to bedrock. A structural adjustment program was adopted in 1986 and implemented through 1987. Import licensing was abolished, and the exchange rate was floated. There was a massive nominal and real devaluation: the IMF index (in which a real depreciation is a decline) went from 114 in mid-1986 to 25 at the beginning of 1989 (which may also give some indication of the tariff equivalent of the import restrictions just before they were abolished).

Wage indexation: what difference does it make?

The implications of wage indexation for the real targets approach need to be considered. Wage indexation, explicit or implicit, has been a factor at certain times in all the Latin American countries, above all in Brazil, but much less so in the other countries of our group. At the same time, however, one cannot help noting the big drops in real wages that have taken place since 1981 in Argentina and Mexico (both countries with influential and centralized trade union movements), as well as in Chile (which had wage indexation from 1976 to 1981). Turkey has also seen a big decline in real wages since 1980, but in many of the other countries, wage indexation has not been a factor at all. Of course we cannot conclude that just because real wages have fallen substantially over some period, they can fall indefinitely. For example, in Mexico since 1988 there has been some degree of indexation as part of a social pact.

If there is formal or informal wage indexation, pn will tend to rise, usually with a lag, when e rises. In the extreme case, a devaluation cannot bring about a change in S. How does this possibility affect the orthodox real targets model?

With the economy starting at internal balance (Y0 in Chart 1), a devaluation in the absence of indexation would lead to an endogenous rise in pn until internal balance was restored. This rise in pn could be avoided by a simultaneous reduction in E. So, if a current account improvement is desired, E must fall; if internal balance is also to be maintained, then e must rise. There is a role for devaluation, but only as part of a policy package. By contrast, when there is indexation, pn rises when e rises and would do so even if E were reduced. There is no role for devaluation at all, not even as part of a policy package. A reduction in E would be needed to improve the current account, but supplementing it with a devaluation would not affect S and thus could not maintain internal balance.

Suppose we observe that devaluations have been followed by increases in pn, possibly causing the whole effect on S to be eroded after a while. There can be two explanations, and, from a policy point of view, it is important to know which is correct. One possible explanation is that E was not reduced sufficiently, so pn rose because of excess demand. The conclusion then follows that a policy package that included contractionary aggregate demand policy should have been implemented or implemented more strongly. The second explanation could be that there was some tendency to indexation, formal or informal. In that case, a reduction in E would not have allowed S to rise—that is, would not have brought about positive switching, even though it was still required for a current account improvement. The policy implication in that case may be to try to end indexation.

There is some useful evidence about which explanation is likely to be more important. Edwards (1989, 264–69) analyzed the erosion of the real effects of nominal devaluations for a large group of developing countries (29 “stepwise” devaluations) and found that the rate of growth of domestic credit played a crucial role. In terms of our model, that would mean that a failure to reduce E would tend to lead to the failure of devaluation to have a sustained real effect. This suggests that indexation is relatively less important than adoption of the full policy package.

III. The Exchange Rate as Nominal Anchor

We now consider the alternative approach to exchange rate policy, in which the exchange rate is used as a nominal anchor, restraining government inflationary policies and sending out clear, credible signals to private agents about prospects for inflation. In this approach, the exchange rate leads. In terms of the model presented so far, pn is no longer given: it becomes endogenous and depends on what happens—and what is expected to happen—to e. In this view, a readiness to devalue to achieve short-term real objectives means that this anchor is abandoned, and in the long run more inflation results. And when expectations are also allowed for, the long run may not be very long. Furthermore, the argument is that in the long run, real output will not be affected by the exchange rate or the level of nominal expenditure.

Domestic policies and private agents’ reactions

There are three steps to the nominal anchor approach. (We continue to assume low capital mobility owing to effective exchange controls or other reasons.) First, the government makes a nominal exchange rate commitment. Second, the government is presumed to adjust its domestic monetary policies to this commitment as well. Since, to a great extent, monetary policy in developing countries is determined by fiscal policy (deficits tend to be monetized to varying extents), fiscal policy must adjust to exchange rate policy. To reduce the rate of money supply growth, a fiscal deficit will have to be reduced. Phrased in somewhat oversimplified form, in the nominal anchor approach the exchange rate leads and fiscal policy (insofar as deficits are monetized) must follow.8 (This is in contrast to the real targets approach, in which fiscal policy leads and the exchange rate follows.)

Governments have two temporary ways of evading the constraint on monetary policies that a nominal exchange rate commitment is meant to provide. One way is to impose increasingly tight import restrictions to deal with the consequences of the incompatibility of monetary and exchange rate policies. The other way is to run down reserves and finance the growing current account deficit with foreign borrowing. The constraint imposed by the exchange rate can be—and often has been—evaded in these ways, with severely adverse effects. An example from Nigeria was given earlier, and many other examples could be given as well.

If the constraint is effective, however, then the third step is that in due course private agents adjust their price and wage setting to the fiscal, monetary, and exchange rate policies. If government commitment to the exchange rate itself and to any needed adjustment in domestic monetary policy has sufficient credibility and is clearly perceived by private agents, their price and wage setting may adjust quickly and without much loss of output when policy is designed to reduce the rate of inflation.

This nominal anchor approach thus hinges on both government and private behavior. It can fail, or work badly, either because domestic monetary policy (implying, usually, fiscal policy) is slow to adjust or evades the constraint completely, or because private price-and wage-setting agents are slow to adjust and devaluation has real effects for some time.

We might take the view that government does not need to be constrained, that it might have a genuine commitment to reducing inflation or maintaining price stability. It could achieve these goals either through an exchange rate policy to which domestic monetary policy is adjusted—as in the approach just discussed—or through a noninflationary or anti-inflationary domestic monetary policy to which the exchange rate is adjusted. Thus, again, the exchange rate could lead or follow, but this time the choice is between two ways of achieving the same nominal objective—that is, between two forms of monetarism—exchange rate and money supply (or nominal income) targeting.

The case in favor of using the exchange rate as the nominal anchor is that it is a very visible, very well-defined anchor, which increases the likelihood that private agents will adjust quickly. It is much more visible, and so more credible, than a money supply or normal expenditure target or a more general anti-inflation commitment. Its visibility is strengthened when the exchange rate is fixed to a particular currency, such as the dollar, rather than to a basket of currencies. The case against using the exchange rate as a nominal anchor is that exchange rate targeting is more likely to produce a balance of payments problem.

The last point is illustrated in Chart 2. We assume that the country starts at point A with a steady rate of inflation, nominal expenditure growth, and depreciation yielding a constant S and constant E at point A. To reduce the rate of inflation, one approach is to reduce the rate of depreciation. If the nominal expenditure reduction comes with a lag, the movement is thus first from A to B, with S falling and E constant (or even rising). The current account deteriorates from C0to C1. In addition, output falls. Then real expenditure is reduced (the rate of growth of nominal expenditure is reduced) to restore the current account, and the system moves to D. Output falls further. Eventually the domestic rate of inflation declines and the system returns gradually to A, with output recovering. The movement from B to D represents the government’s monetary policy reaction, and the movement from D to A the private agents’ reaction. Of course, in the final equilibrium the inflation tax will have to be replaced by some other tax, or government expenditure will have to fall.

Chart 2.The Nominal Anchor Approach

Now we contrast this with the case in which domestic expenditure reduction leads rather than follows. First, the rate of growth of expenditure falls, while the exchange rate is not yet adjusted. The system moves to F, with the current account improving. Then, with the improvement in the current account, the real exchange rate appreciates (the rate of depreciation declines), bringing the country to D and restoring the original current account situation. The third stage—the move from D to A—is the same as in the case in which the exchange rate leads. The main point we notice here is that when the exchange rate leads (as it does in the nominal anchor approach), domestic policy adjustment might lag behind, resulting in a temporary balance of payments problem.9 This possibility is avoided when domestic expenditure policy leads in the disinflationary process.

Experiences in five Asian countries and Turkey: have exchange rate policies actually constrained domestic policies?

The exchange rate experiences of the five Asian countries in our group may shed light on the relevance of the nominal anchor approach. At some stage between 1975 and 1984, these countries switched from a fixed exchange rate (tied to sterling or the dollar) to pegging to a basket, with some exchange rates more flexible than others. In general, these countries have had low inflation (with exceptions in some periods). To what extent have their exchange rate policies constrained domestic policies and provided nominal anchors? (Of course, a fully documented answer can hardly be given here, nor can their exchange rate policies be described in detail.)

Let us begin with the extreme case. Thailand’s rate was fixed to the dollar from 1955 until 1984, with just one small devaluation (9 percent in 1981) during that period and a 15 percent devaluation at the end. Thailand did not even adjust its nominal exchange rate to its two severe adverse terms of trade shocks (the two oil shocks). The baht has tended to move with the dollar, even after formal pegging to the dollar ended.

India’s rupee was fixed to sterling until 1975, with just one major devaluation (36 percent in 1966) during the postwar period before 1975. In 1975, India switched to a flexible peg tied to a trade-weighted basket. Since then, overt devaluations have been avoided, and there have been various movements in nominal and real rates. At times there seems to have been some tendency toward rigidity (but not actual fixing) in terms of the dollar; the real rate depreciated between late 1985 and 1988, reflecting dollar depreciation.

Pakistan’s rate was unified in 1972, then devalued sharply (130 percent) because of the secession of Bangladesh. The rate was then pegged to the dollar until 1982. Since 1982 it has depreciated in terms of the dollar and in real terms.

In Indonesia, the nominal exchange rate was fixed to the dollar from 1970 to 1978, but there was substantial real appreciation owing to higher domestic inflation. This was made possible by the oil boom, which generated the Dutch Disease effect. In 1978 there was a 33 percent devaluation. Since then, the rupiah-dollar rate has been kept fairly constant, apart from devaluations in 1983 (33 percent) and 1986 (31 percent).

Sri Lanka’s exchange rate was fixed to sterling from 1952 to 1976 (with some devaluations after 1972). In 1977 the rate was unified, many exchange controls were removed, and there was a large (81 percent) depreciation. The rupee depreciated against the dollar until 1985 but stayed almost constant in trade-weighted nominal terms. During the period 1977-85, Sri Lanka’s experience was somewhat similar to Indonesia’s in 1970-78, with real appreciation resulting from some degree of rigidity of the (trade-weighted) nominal exchange rate.

So what can be said about the experience of these countries, in which the exchange rate was fixed in nominal terms for fairly long periods of time (either formally or effectively), sometimes to the dollar or sterling and at other times to a currency basket? Since 1973, the floating of the major currencies has clearly presented a problem—especially since 1981, when the dollar started appreciating and later depreciating. With the currency relationships among major trading partners changing so much, the concept of a clear nominal anchor became difficult to maintain and abandonment of the various pegs became inevitable—late though this was, in many cases, relative to the 1973 watershed year when the Bretton Woods system finally collapsed. We can sense that some of the Asian governments have wanted to maintain the credibility of a peg by moving with the dollar rather than firmly pegging to a basket, even after the formal peg to the dollar was ended. But this created problems by leading to unintended real appreciations or depreciations as the dollar moved up and down.10

Thailand, India, Pakistan, and Sri Lanka have been low-inflation countries, and even Indonesia (from 1969) could be categorized that way (certainly compared with the Latin American experience).11 Did their exchange rate policies compel these countries to follow low-inflation fiscal and monetary policies in order to avoid balance of payments and competitiveness problems? Can their low-inflation records be explained in terms of the exchange rate’s function as a nominal anchor? The real commitment, I suspect, was not to the exchange rate as such, but to low inflation and hence to conservative domestic monetary and fiscal policies.12

What kept these countries off the South American road? What was the nature of their exchange rate commitment, especially up to 1981? Clearly, the commitment has not been absolute. There were devaluations before 1981 (and there have been significant real and nominal depreciations since 1982). In focusing on the pre-1982 period, it seems to me that the explanation for a considerable degree of the rigidity of nominal exchange rates lies in certain well-established beliefs.

One was a concern with prestige: devaluation was thought to represent an admission of failure. More generally, views about the desirability of fixed exchange rates remained widely held in these Asian countries even after the 1973 collapse of the Bretton Woods system. A second important factor was the thoroughly justified belief that devaluation was inflationary. In Sri Lanka’s first macroeconomic crisis of 1968-70, devaluation was ruled out as an appropriate policy instrument because of concern with the adverse effect of a devaluation on newly established industries that depended heavily on imported inputs. Other countries have also had this concern.

When exchange rate pegging to a single currency came to an end, all five of these countries continued to follow low-inflation policies. Hindsight tells us that the spell of the fixed exchange rate may have backed up the anti-inflation commitment, so that there was some element of a nominal exchange rate anchor. But with substantial devaluations by some countries since 1973, and with large changes in bilateral nominal rates compelled by the fluctuations in the dollar, the spell has no doubt been broken by now.

Similar issues arise for various other countries in our group that maintained more or less fixed rates (sometimes with occasional devaluations) for long periods, namely Costa Rica until 1980 (with a devaluation in 1974), Kenya, Mexico until 1976, Morocco, Nigeria (to 1984), and Turkey. In all these cases, there have been long periods with fixed or near-fixed rates lasting well after the 1973 breakdown of the Bretton Woods system. Some of these countries—Costa Rica (briefly), Mexico, Nigeria, and Turkey—have gone through high-inflation episodes, while Kenya and Morocco have not. All have used quantitative restrictions for balance of payments purposes at various times. Only the two countries in our group that are part of the franc zone—Côte d’Ivoire and Cameroon—have had a true fixed exchange rate commitment, leading inevitably to low inflation and to real depreciations and appreciations that reflect movements in the franc-dollar rate.

The case of Turkey is particularly interesting. Since about 1977 the economy has moved from relatively low inflation to high inflation, a transformation associated with a switch in exchange rate regime from a fixed rate to a crawling peg.13 From the point of view of the real targets approach, a very simple story can be told. For reasons that need not be discussed here, Turkey had its debt crisis from 1977 to 1979. The need to drastically improve the current account and to reverse the appreciation of the real exchange rate that occurred between 1974 and 1979 called for substantial real depreciation. As part of a major stabilization program, the nominal exchange rate was depreciated by about 70 percent in 1980. From 1981 on, the rate was adjusted daily. The net result was a substantial real depreciation of about 30 percent by 1984, followed quickly by a remarkable export boom. This episode was regarded by Balassa (1983) and others as a striking and praiseworthy example of the success of exchange rate policy and, above all, as evidence that export supply and demand elasticities were high.

How does this episode look from the point of view of the nominal anchor approach? The exchange rate was fixed to the U.S. dollar up to 1973, and during the period 1960-70 inflation averaged less than 5 percent. From 1971 to 1977, it averaged 18 percent. In 1980, an exceptional year, inflation was over 100 percent, reflecting the effects of the stabilization program, principally the big devaluation and large price adjustments by state enterprises. Inflation averaged 37.5 percent from 1981 to 1986 and has increased since then, reaching 75 percent in 1988 and 1989.

It is possible to argue that such a high rate of inflation sustained now for nine years after a drastic stabilization program can be explained only by the removal of the nominal anchor in 1980. If that is the case, we would have to say that Turkey faced a trade-off between the benefits of maintaining a more appropriate real exchange rate for some time and the longer-term costs of higher inflation. This could be described as an “exchange rate-adjusted Phillips curve” trade-off. It is the trade-off that is implied in conceding the validity of both the real targets and the nominal anchor approaches. But against the view that the change in the exchange rate regime explains (or helps to explain) the relatively high inflation rate since 1981, it can be pointed out that the inflation rate was already beginning to increase in 1971 and had reached 44 percent by 1978.

A reasonable conclusion is that by 1980, substantial devaluation was essential and indeed inevitable. But a government more committed to low inflation might have tried to fix the exchange rate firmly at a new, more depreciated level. Yet this would have worked only if there had been a genuine long-term commitment to a non-inflationary monetary policy (and hence fiscal policy) in support of the nominal anchor at its new level. This commitment would have required strong public support, including a willingness to accept the transitional costs.

Inflation and exchange rates in Latin American chronic-inflation countries

Any discussion of the exchange rate as a nominal anchor must refer to the much-discussed experiences of the four South American chronic-inflation countries in our group, as well as Mexico. Brazil and Colombia have practiced crawling peg policies over long periods, but it is clear in these cases that the exchange rate followed rather than led.14 The aim of continuous nominal exchange rate adjustment was to avoid real appreciations—a clear example of the real targets approach in an inflationary context—not to slow up inflation by constraining government or sending signals to private agents. This “passive crawling peg” policy, as Williamson (1981) has called it, has also been practiced in Argentina, Chile, and Mexico since 1982.15 Finally, Argentina and Chile had each experienced an earlier brief, but much discussed, nominal anchor episode.16

The Argentine episode of 1976–80 (under Finance Minister Martinez de Hoz) is now viewed as a classic case. A crawling peg exchange rate, with advance announcement of the devaluation rate (a tablita) operated for two years from 1979. In Williamson’s (1981) classification, this was an “active crawling peg.” A real appreciation resulted, and there was massive capital outflow. Domestic inflation failed to decline much because of continued high fiscal deficits. The failure of domestic inflation to decline sufficiently brought about the real appreciation. The failure was thus in the accompanying domestic policy, which led directly to a balance of payments problem and indirectly, because of the policy’s lack of credibility, to a slow reaction by private agents.

In the case of Chile, the exchange rate was fixed to the dollar for a brief period from the end of 1979 until 1981 in order to bring inflation down from 33 percent. The policy succeeded, since inflation was 7 percent by the end of 1981. But there was still high unemployment and a large real appreciation (the U.S. dollar was appreciating during that period relative to other currencies, and Chilean inflation was still higher than U.S. inflation). Domestic monetary and fiscal policies were not out of line. To some extent, domestic prices and wages were slow to adjust to reduced inflation because of lagged wage indexation. But such slow adjustments in prices and wages in response to disinflationary policies could have been expected even if there had been no formal wage indexation. In addition, some degree of real appreciation was also to be expected because of massive capital in-flow. In my view, this much-analyzed episode cannot really be con-sidered a failure. Chile’s subsequent problems arose because of excessive private borrowing during that brief period, a decline in the terms of trade, and a rise in real interest rates.

The two-year Chilean exchange rate commitment was a nominal anchor only insofar as the government chose to adhere to it. The fundamental commitment in Chile was to the objective of reducing inflation, just as in the five Asian countries the commitment has been to the objective of keeping inflation low.17 The true anchor is the policymakers’ conviction—usually rooted in and backed by widespread community conviction—that inflation is undesirable. Perhaps a fixed exchange rate has a role in signaling the government’s anti-inflationary commitment to private agents. But they will always be alert—as they were in Argentina—to the possibility that the signal is a false one. If they are rational, they will look for the underlying commitment.

IV. Capital Mobility: What Difference Does It Make?

Finally, in considering exchange rate policy, we cannot ignore the increase in capital mobility. Without going into the issue in detail, the judgment may be made that in many of the countries in our group—including Indonesia, Pakistan, Thailand, Morocco, Turkey, and all the Latin American countries—international capital mobility increased steadily during the 1970s and 1980s and is now high.18 What is the implication of this finding for exchange rate policy?

In general, the appropriate model is still one in which sterilized intervention is possible—that is, in which domestic interest rate policy is distinct from foreign exchange rate intervention policy. Hence the model is one of imperfect capital mobility, whether owing to partially effective exchange controls or imperfect substitutability of domestic currency-denominated and foreign (usually dollar) assets.

The implication is that it is no longer possible to maintain for any length of time a nominal exchange rate that the market considers seriously overvalued. Such expectations would lead to capital outflow and thus to a balance of payments problem, unless domestic interest rates rose sufficiently. And the tightening of domestic monetary policy to sustain an exchange rate may have to be so severe that there are limits to this instrument. While the exchange rate does not have to float, the rate must be quickly adjusted when market expectations turn significantly against it.

Some countries’ policies of maintaining exchange rates have been so consistent and hence so credible that market pressures against it hardly take place. Perhaps Thailand is the best example. But for most developing countries, the days of the Bretton Woods “fixed but occasionally adjustable” system are over. This consideration explains why many countries in our group have moved in the direction of more flexibility since 1982—usually, so far, to flexible pegs rather than floating rates (with the exception of Nigeria, which has had a floating rate since 1986).

The Bretton Woods system broke down in 1973 largely because of increasing capital mobility and the failure of the United States, and perhaps others, to pursue credible domestic policies to sustain particular rates. Thus the developed world moved into the floating rate stage. By contrast, the developing countries (other than the four chronic-inflation countries of South America) generally tried until around 1982 to maintain either fixed rates or a fairly inflexible peg, with intermittent adjustments. But capital mobility increased for them as well, although with a lag, and many of these economies became destabilized as a result of the recession and debt crisis of 1980-82. With a few exceptions, their exchange rate regimes have now become much more flexible, and it seems unlikely that they could go back to the fixed but adjustable regimes of the earlier period.

This has implications for both the real targets and the nominal anchor approaches. Both call, at any point in time, for a policy-determined nominal rate. It might be an active crawling peg, but this still means that it is fixed at a point in time. Yet such a rate cannot be sustained unless the market is convinced it will be sustained. It is true that expectations of depreciation can be offset by sufficiently high domestic interest rates. But the need to target domestic monetary policy on sustaining the exchange rate when the market expects substantial depreciation is itself a constraint on the attempt to fix the exchange rate.19

It follows that the whole package of policies that goes with an exchange rate commitment—whether to achieve a real target or a nominal anchor—must be thoroughly credible if an exchange rate is to be maintained. This is conceivable when a country has been following consistent policies in the past (like Thailand or like Mexico up to 1973) and is perhaps keeping the rate constant or crawling on some steady basis. In the absence of such credibility, the actual rate would have to follow the direction in which the market expects it to move.

The policy implication is that, when there is high capital mobility, it is no longer possible to have extensive discussions about the appropriate real exchange rate and what this implies for the nominal rate, and then to make a major adjustment, perhaps as part of a stabilization program. Changes have to be made quickly, and normally they must be small and more frequent. This is the direction in which countries have been moving. When large changes are expected—and it is rare for a large change to be unexpected20—the market will force an early adjustment. If particular changes are desired in order to achieve real targets, the domestic policies that go with them must be in place or credibility about policy intentions must first be established. If there is a change in the fundamentals, such as a change in the terms of trade or a major trade liberalization, a nominal exchange rate change will be expected and cannot be delayed. If quick policy action does not bring it about, the market will force it.

While all the issues connected with the two approaches remain relevant when there is capital mobility, and the basic trade-offs remain the same, credibility now becomes crucial. If either approach calls for a particular nominal exchange rate and the market does not believe it will be sustained, two steps will need to be taken quickly. First, domestic monetary policy will need to be tightened sufficiently to maintain the rate immediately. Second, signals will need to be sent out—for example, through fiscal policy decisions—that will convince the market the rate will be sustained. Argentina’s short episode in 1979-80 under Martinez de Hoz clearly shows what happens when this is not done.

V. Conclusion

Is it possible to conclude with some simple policy recommendations? I would suggest four propositions that have important repercussions. First, in general, the real targets approach to exchange rate policy is the right one. The exchange rate should follow rather than lead, taking into account the various shocks or changes in other variables—notably fiscal policy, trade policy, and terms of trade changes.

Second, exchange rate policy should be associated with an appropriate noninflationary monetary policy. Normally, there has to be a direct commitment to the anti-inflation objective if inflation is to be avoided. In the absence of such a commitment—with monetary policies being inflationary—exchange rate policy must still be aimed at the real target (the real exchange rate) unless there is reason to believe that this would significantly affect the commitment itself.

Third, because of capital mobility, delayed exchange rate adjustments must be avoided; if the rate needs to be changed, it should be done quickly.

Fourth, there is some role for the nominal anchor approach for the two groups of countries at opposite extremes of the inflation scale. One group includes countries that have long-established fixed exchange rate systems (with occasional devaluations) and relatively noninflationary records. These countries may be well advised to stay with such a system, since their commitment will be credible. I think here especially of Thailand (and possibly Indonesia) and, of course, of the African countries in the franc zone. But only a few countries in our group could fall into this category now, although many more would have in 1973.21

At the other extreme are countries with a history of high inflation that are ready to stabilize by radically shifting their policies and making the necessary commitment. These countries may find a fixed exchange rate (or an active crawling peg) a valuable anchor in helping to constrain government monetary policies and in achieving credibility with the markets (including the labor market). Possibly Argentina, Brazil, and Mexico are in this category. But whenever a fixed rate regime or an active crawl is chosen, there is likely to be some cost because of the real exchange rate misalignment (the exchange rate-adjusted Phillips curve trade-off), at least for a limited period.


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Note: The analysis in this paper draws on some of the findings of a World Bank research project (Little and others (1993)). The views expressed here are those of the author and should not be attributed to the World Bank. The author is indebted to Premachandra Athukorala for valuable comments on an earlier version of this paper.

All references to developing countries are to this group or to individual members of the group. The countries include 2 that are members of the franc zone—Cameroon and Côte d’Ivoire—and so their exchange rates have been completely fixed; 4—Argentina, Brazil, Chile, and Colombia—that were “chronic inflation” countries before 1973, when they had quite high inflation rates and crawling peg or variable exchange rates even when most other countries had fixed rates and low inflation; and finally, 11 others—Costa Rica, Mexico, Morocco, Turkey, Kenya, Nigeria, India, Indonesia, Pakistan, Sri Lanka, and Thailand.

On the basis of the real exchange rate indexes calculated by the IMF, it seems clear that, for many of the countries in our group, real and nominal (trade-weighted) exchange rates have moved together closely since 1981. For earlier years, there is strong evidence in Edwards (1989). But the effects do tend to get eroded, as evidenced both in Edwards (1989) and, for example, for Indonesia, in Warr (1984).

The reference is to Salter (1959), who presented the first systematic, diagrammatic model with traded and nontraded goods.

The assumption is made here that imports and domestically produced importables are perfect substitutes—an assumption that is dearly unrealistic in a world of product differentiation. Hence it should be regarded as no more than a simplifying assumption. It should be noted that the real exchange rate, as well as being defined as the relative price of domestically produced tradables to nontradables, as here, could be defined as an index of “competitiveness”—that is, as the price of traded goods in foreign countries, adjusted for the nominal exchange rate, relative to their prices in the domestic economy. This definition, which is favored in Balassa (1987), hinges on the realistic assumption that foreign and domestic tradables are imperfect substitutes, so their prices, adjusted for the exchange rate, can indeed differ. The main arguments in this paper—especially in the comparison between the real targets and the nominal anchor approaches—apply fully when imports and domestically produced import-competing goods are imperfect substitutes; the latter, in terms of the (Salter) model of this paper, are, in effect, nontradables.

The point is also made in many papers by Bela Balassa.

The term “real exchange rate” is used here in a particular way, namely to refer to the movement of epm/pn or epx/pn—that is, excluding the effect of the change in t. Alternatively, we could follow Edwards and van Wijnbergen (1987) and define the real exchange rate as S (equation 1 in this paper), in which case there would not necessarily be any real appreciation when a fall in epm/pn led to a sufficient rise in t.

It might be argued that the chronic-inflation countries of Latin America in our group have never been reluctant to depreciate. In particular, Brazil has been most ready to depreciate, and the nominal exchange rate has tracked domestic inflation with the aim of roughly maintaining the real rate over considerable periods. Nevertheless, Brazil has made much use of quantitative import restrictions. Wage indexation has often limited the ability of nominal exchange rate depreciation to bring about sufficient real depreciation. In the case of the other chronic-inflation countries in our group—Argentina, Colombia, and (at an earlier stage) Chile—there has also often been a reluctance to depreciate enough or quickly enough Colombia has usually had a crawling peg, although from the point of view of optimal switching and avoidance of restrictions, it has not always crawled fast enough

This simplification does not apply when a fiscal deficit is financed by issuing domestic bonds or by foreign borrowing. The reference then is specifically to monetary, not fiscal, policy. As the experience of Côte d’Ivoire shows, a fixed exchange rate is compatible with a big budget deficit, provided foreign financing is available.

When expectations and capital mobility are introduced, a foreign exchange crisis can occur at this point.

This problem has been central to the literature on exchange rate policies for developing countries. How should developing countries fix their rates in a world where the major currencies are themselves floating? See Black (1976), Williamson (1982), and Joshi (1990).

The average annual inflation rates (consumer price index) for the period 1965-88 have been 8.7 percent for Pakistan, 8.4 percent for Sri Lanka, 8.2 percent for India, and 6 percent for Thailand. For Indonesia, the inflation rates in each year during the period 1962-68 were well over 100 percent, but the average for 1969-88 was 14 percent. Figures for 1982-38 were 10.3 percent (Sri Lanka), 8.6 percent (India), 8.5 percent (Indonesia), 5.9 percent (Pakistan), and 3 percent (Thailand)—rather remarkable when seen from the Latin American perspective or, in the case of Thailand, from any perspective.

It must also be noted that all these countries used quantitative import restrictions and exchange controls for short-term balance of payments purposes (strongly so in the case of India, Pakistan, and Sri Lanka). So all had available a switching instrument that could substitute for devaluation—although not, of course, for continuous devaluation.

This discussion draws on the study on Turkey conducted for the World Bank project (Onis and Riedel (1993)).

See Urrutia on Colombia and Fendt on Brazil, both in Williamson (1981).

With respect to Mexico, it should be added that, after six years of depreciation necessitated by high inflation, the Mexican peso was fixed to the dollar in 1988 and adjusted on the basis of an active crawling peg policy in 1989. Both episodes were part of the Mexican stabilization plan which, among other things, required limiting wage increases. But it is really not certain in this case that the exchange rate was the nominal anchor: the anchor was (and is, at the time of writing) the commitment to the whole stabilization plan.

On Argentina see Calvo (1986); on Chile, Balassa (1985), Corbo (1985), and Edwards and Edwards (1987); and on both countries, Corbo, de Melo, and Tybout (1986) and Corbo and de Melo (1987).

A critique of the nominal anchor approach as applied to Chile can be found in Balassa (1985, 203-8).

Measuring capital mobility is difficult (see Cumby and Obstfeld (1983), Cuddington (1986), various papers in Lessard and Williamson (1987), and Haque and Montiel (1990)). It is not sufficient to look at actual capital movements. There have been dramatic episodes of capital flight from Argentina and Mexico, so clearly mobility is high in those cases. But capital mobility may also be high in the case of a country such as Brazil where, until recently, incentives for capita! outflow were not as strong—because the flexibility of the nominal exchange rate was designed to maintain the real rate. In other countries, interest rates are raised quickly when there is a tendency toward capital outflow; in still other countries, notably Pakistan and Turkey, the flow of remittances from citizens working abroad is likely to vary to some extent in response to exchange rate expectations.

The problem arises only when expected depreciation substantially exceeds expected domestic inflation, so that a high real interest rate is required to sustain the current nominal exchange rate. But a high real exchange rate has adverse effects both for private investment and for the budget. This problem is intensified when inflationary expectations are excessive (when actual inflation falls below expected inflation). In addition, in many developing countries the domestic free market rate exceeds the international (U.S.) rate by a substantial risk factor. The net effect of all these factors is exemplified by Mexico’s experience. In 1989, when Mexico practiced an active crawling peg policy, its real rate of interest as usually calculated was around 30 percent, while the U.S. rate was closer to 4 percent. The usual calculation assumes that the expected rate of inflation is equal to the current rate, but there is little doubt that in this case the expected rate of inflation in Mexico exceeded the remarkably low current rate, so that the true real rate of interest must have been less than 30 percent.

The one example from our group of countries of a large unexpected devaluation is the 33 percent Indonesian devaluation of 1978, the motive for which was “exchange rate protection” of the tradables sectors, not a balance of payments problem (see Warr (1984)). It appears from the low forward premium that the 15 percent Thai devaluation of 1984 was also unanticipated.

We might even wonder about the franc zone countries. As a result of a public spending boom in Côte d’Ivoire in 1976-80, inflation increased, causing a real appreciation, which led to increased tariff and nontaríff import restrictions. Latin American-style inflation has certainly been avoided in spite of a prolonged fiscal crisis, but import restrictions and a severely reduced growth rate have not.

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