External Account Liberalization, Currency Convertibility, and Implications for Exchange Rate Policy 5
- Richard Bart, and Chorng-Huey Wong
- Published Date:
- June 1994
I. Introduction and Broad Policy Framework
In general, countries have tended to reform and liberalize their external sector policies within the context of comprehensive macroeconomic and structural adjustment programs aimed at increasing real economic growth, lowering inflation, and achieving external viability. The primary rationales for countries to liberalize and open up their external sectors are improved access to world markets, better allocation of resources as a result of external competition, and closer linkage between the domestic and world prices of tradables.
In order to reap these benefits, reforming countries have been implementing IMF-supported adjustment programs since the mid-1980s. These programs represent broad-based efforts to adjust initial financial imbalances (particularly weak fiscal positions), correct relative price distortions, reform repressed financial systems, and liberalize restrictive and distorted foreign trade and exchange regimes. By addressing these issues within a comprehensive policy framework, policymakers have been faced with at least three unavoidable constraints. First, success in resolving the problems in any one area depends on progress in the other two areas. Second, because the immediate as well as the future consequences of policy decisions must be considered together, intertemporal trade-offs between short-term costs and long-term gains have to be weighed carefully. This consideration is particularly important for investors and producers, who need a long-term perspective on the policy environment in order to restructure their operations. Third, even when problems of macroeconomic stabilization (including domestic resource mobilization and use) are addressed, relative price distortions corrected, and domestic prices liberalized, policymakers must deal with a wide range of institutional rigidities that have prevented economies from responding to the new “market-oriented” environment. These rigidities include a lack of clearly defined property rights and bankruptcy procedures; limited entry and exit for firms; nontransparent public accountability and regulatory provisions; and a weak prudential and supervisory role for the central bank in the financial sector.
In the eyes of the public, the credibility of a program of reforms depends on how consistently the reforms are applied in different policy areas, how efficiently they are sequenced over time, and whether institutional and systemic reforms aimed at helping the economy respond to the new incentives are implemented in a timely manner. Sustained external liberalization that increases the scope of external transactions backed by currency convertibility also strengthens policy credibility.1
II. The Unsustainable Costs of Foreign Trade and Exchange Restrictions
In many reforming countries, the initially restrictive and distortionary foreign trade and exchange regimes in part reflected a desire to have the government direct resource allocation (e.g., Algeria, Ethiopia, and Tanzania in the late 1970s and early 1980s). More importantly, however, they represented a vicious circle of trade and exchange restrictiveness that led to further restrictiveness as the countries’ domestic financial positions, external positions, and growth performances became increasingly weak. The dynamics of the vicious circle referred to here can be illustrated with examples of countries that relied heavily on trade-based taxes and tried to address external imbalances by restricting imports and external payments (for example, Tanzania in the late 1970s and early 1980s, and Uganda in the 1970s). This approach reduced domestic tax bases and increased fiscal deficits, allowing adverse pressures on weak external positions to continue.
In cases such as those cited above, excessive restrictions on and taxation of external transactions contributed to the emergence of parallel exchange markets, the growth of unrecorded trade, and the steady shrinking of the official exchange market. These developments made the task of macroeconomic stabilization more difficult and contributed to obvious relative price distortions in the marketplace. There is also evidence that countries relying heavily on restrictive foreign trade and exchange controls for long periods experienced serious shortages of imported inputs and capital, unproductive inventory buildup, severe deterioration of essential infrastructure and productive capital, and fundamentally weaker growth. These problems were clearly evident in the countries of the former Soviet Union and Eastern Europe prior to the advent of market-based reforms. Under such circumstances, foreign trade and exchange reforms were certainly desirable, not only because of the potential gains from foreign trade-led expansion and greater domestic efficiency, but also because the old trade and exchange regimes were headed toward collapse.
In devising measures to correct the relative price distortions of restrictive foreign trade and exchange regimes, attention had to be given at the outset to two key issues: (1) the appropriate measures for liberalizing exchange rate policy and unifying the exchange system; and (2) the appropriate reforms for both liberalizing the trade regime and correcting its anti-export bias (resulting, for example, from the stronger incentives that protective trade policies provide for the production of importables and other domestic goods). Both sets of issues had to be addressed, because the wedge or link between world prices (in foreign currency) and domestic prices (in local currency) is determined by both the exchange rate and trade measures, and because no trade reform can be initiated without addressing currency overvaluation and distortions in the foreign exchange system. Moreover, given the time needed to complete the trade reforms, early, decisive actions—plus a preannouncement of the timing of future reforms—would prove helpful, allowing economic agents to adjust their production, investment, and savings decisions.
III. Liberalization and Reform of the Exchange System
The exchange system reforms that have been undertaken vary widely, depending in large part on the nature of the initial distortions.
In many cases, the de facto segmentation of exchange markets into a shrinking official market and a widespread parallel market characterized the prereform situation (e.g., The Gambia, Nigeria, Tanzania, and Uganda in the first half of the 1980s). In these cases, the prevailing exchange restrictions in the official market for current external transactions were progressively liberalized. In particular, exchange restrictions were removed for all trade and other current transactions, licensed and unlicensed. (In the prereform period, it was the presence of such restrictions that led to the emergence of parallel markets and excessive premiums in the free market price of foreign exchange.) In terms of nontrade transactions, care was taken to allow foreign investors to repatriate profits and dividends in order to maintain incentives for inflows of direct investment.2
Second, in a number of cases, the parallel market was initially believed to be dominant, foreign reserves were relatively low, and recovery of foreign exchange receipts through the official exchange market was uncertain and expected to increase only gradually. Moreover, the authorities typically found it difficult to determine the equilibrium (fixed) exchange rate. In these situations, the official exchange rate policy was to ensure that the rate was market determined and thus realistic. A variety of systems were used, including (1) an official and unified auction administered by the central bank (as in Zambia in 1985-87); (2) a unified floating interbank arrangement, with the float either bounded within a band or free (e.g., the free float introduced in The Gambia in 1986 and the float within a band in Sri Lanka in 1990); (3) a managed or administered (unified) rate constrained within a declining percentage differential from the parallel market rate (as in Zambia in 1989-92 and Uganda in 1983–84); and (4) an official dual exchange market, with a temporary segmentation between transactions using the official market-determined rate and those using a more appreciated rate administered by the central bank (as in Uganda in 1982 and Guyana in 1990). In countries where the initial foreign reserves were adequate or the projected exchange receipts during the reform period were considered sufficient to build some reserves and defend an exchange rate after the initial correction, consideration was given to a fixed or adjustable fixed peg policy.
The main risk in both the floating and the adjustable fixed rate approaches has generally been the exchange rate variability that results from inadequate supporting fiscal and monetary policies. Both approaches required repeated tightening of fiscal and monetary policies at the same time that the exchange rate was adjusting in response to permanent external shocks (e.g., trend declines in the terms of trade or external financing inflows). When it seemed that financial policies were creating inflationary pressures, policies were, in general, tightened (as in Kenya, Malawi, and Nigeria in the early 1990s). (Nominal depreciation would have been an inefficient substitute in these cases.) The recommended approach in such cases—which would help avert the serious risk of inflation—was to weaken wage indexation, alleviate labor market rigidities, strengthen fiscal adjustment, and achieve productivity gains. In some chronic-inflation countries (e.g., Argentina and Brazil in the second half of the 1980s), policymakers found it difficult to successfully implement such fixed exchange rate-based programs, on account of weak incomes policies and inadequate adjustment of the fiscal deficit. Mexico (1988) and Israel (1985-86) are well known for their successful experiences in combating inflation inertia through tight incomes policies during stabilization efforts.
IV. The Role of the Central Bank and Government in the Exchange System
In operating the reformed exchange systems, the central banks have had a key role to play in three important areas. First, a clear separation had to be made between the banks’ intermediary functions for the government and any market interventions. The intermediary role has included conducting transactions on behalf of the government (for example, paying for government purchases of goods and services abroad and externalizing public debt service payments) and building up official foreign reserves to targeted levels. But it was clearly understood that while central banks may usefully smooth out temporary shocks in the exchange market, they should not embark on unsustainable intervention against market trends.
Another aspect of central bank policy has had to do with building or strengthening the institutional framework of the exchange system by increasing the number of participants in the official exchange market. Thus, countries have taken steps to broaden the participation of banks, foreign exchange bureaus, hotels, and other institutions by licensing them to operate within the official exchange market, subject to appropriate prudential regulations and supervision regarding capital adequacy, as well as to limits on foreign exchange working balances and exposure to uncovered foreign exchange positions. Following appropriate institutional reforms, some countries have moved from auctions administered by the central bank to floating interbank-cum-dealer arrangements that signal a reduction in administrative interference in the official exchange system. To give a similar signal, some countries have transferred the daily administration of the reformed exchange control regime to commercial banks. The basic objective is to ensure that exchange control regulations are transparent and administered in a nonarbitrary and predictable manner.
Central banks and governments have had to cooperate closely to ensure not only that fiscal and monetary policies are adequately restrictive (as noted in Section III) but also that government transactions remain predictable and do not crowd the nongovernment sectors out of the foreign exchange market. To this end, governments (including those in the reforming countries noted in Section III) have gradually shifted their transactions to the more liberalized segment of the official exchange market and restrained their own net demands for foreign exchange. In general, these shifts have provided the market with more information on official transactions and allowed other market participants to discount appropriately for government demands.
The governments of reforming countries have often mobilized foreign financing, in the form of import support, to move to external current account convertibility. In many cases, inflows of foreign financing in various forms (such as grants, loans, and debt relief) have significantly facilitated government efforts to eliminate the overhang of outstanding external payments arrears, create a reformed and well-functioning exchange system, and help relieve the initial import scarcity and foreign reserve shortages. These flows have been particularly helpful in the case of the import support programs that multilateral and bilateral donors have financed in recent years in several countries, including Mozambique, Tanzania, and Uganda. At the same time, tying foreign aid to lists of imports that vary across donors and to specific donor-based policy conditionalities has not improved the delivery of aid and at times has made operating exchange systems unnecessarily complicated.
V. Reforming Foreign Trade
The foreign trade reforms many developing countries embarked upon in the 1980s have involved two primary sets of actions.3 First, countries have taken steps to liberalize quantitative restrictions (QRs) and other nontariff barriers by raising quotas stepwise, eliminating them altogether, and introducing positive import lists (these are expanded and eventually replaced by negative lists that generally prohibit imports considered hazardous to security and health). At this stage, there has often also been a shift from QRs to tariffs, which roughly reflect the prereform black market premiums in the prices of quota-based imports. These premiums at times reflected not only import quotas but also the monopolistic or oligopolistic market position of domestic traders; the new tariffs, however, have been introduced simultaneously with the freeing of the domestic trading environment and other measures aimed at improving the performance of public sector monopolies. In some cases, data from import license auctions have been used to set tariff levels that reflect the premium in the auction price. It has also been necessary to bear in mind the tariff levels in neighboring countries. In fact, a common second phase of trade reform measures has included steps to rationalize the tariff structure and progressively reduce its dispersion and average level, with a view to gradually narrowing the band of tariffs. Such far-reaching reforms of the import trade regime were particularly evident in the 1980s in Chile, Korea, Mexico, and Turkey.
In sequencing the trade reform measures, two key issues have had to be addressed. First, from the viewpoint of efficient resource allocation, policymakers needed to progress from a nontransparent, non-neutral incentive regime to a transparent and neutral incentive structure. Unlike QRs, tariffs were levied on both outputs and inputs. In narrowing the tariff band structure, then, reductions at both the high and low ends were important (as in Kenya in 1983-85, Tanzania in 1981-83, and Thailand in 1980-83). Also, the tariff rates for various products were adjusted according to the degree of processing required, ensuring some neutrality across industries on a value-added basis. Assessing the prereform, anti-export bias of incentives, required that a broad assessment of incentives be undertaken for both import substitutes and exports, because trade taxes and subsidies existed alongside other types of incentives (including domestic tax exemptions, subsidized domestic credit, and subsidized input sales).
Second, a three-pronged approach has been used to address the need to promote exports. Initially, any obvious impediments to exports were removed or alleviated through a variety of steps, including an exchange rate depreciation sufficient to restore the export sector’s profitability;4 efficiency-enhancing and cost-reducing measures for public sector exporters (often combined with increased private sector participation); removal of disparate rates of export subsidies; liberalization of imports to allow the export sector to benefit from both improved access to imported inputs and a reduction of the bias toward import substitution; and investment in supportive public infrastructure.5 A key point here is that export promotion has often been accompanied by import liberalization, particularly in Jamaica, Mexico, Senegal, and Turkey. This dual approach has helped in two ways: by alleviating input supply bottlenecks for the export and complementary sectors, and by reducing the risk of inflation and exchange rate appreciation from the monetization of export surpluses not offset by imports.
VI. The Role of Supporting Policies in External Liberalization
In general, the process of external liberalization must be accompanied by adequately restrictive fiscal and monetary policies in order to avoid serious pressures on the balance of payments and prevent inflationary pressures from undermining the relative price incentives and competitiveness of the tradables sector. Moreover, the fiscal impact of the envisaged trade reforms—potential revenue losses from lower trade taxes—has to be considered.
To ensure a supportive fiscal policy, the various reforming countries introduced tax initiatives that (to different degrees) cover a wide range of measures. These measures have included shifting from foreign trade-based taxes to domestic tax bases (as in Jamaica, Malawi, Mauritius, Mexico, Morocco, the Philippines, and Turkey) and strengthening tax administration and collection (as in Ghana and Thailand). Efforts have also been made to rationalize consumption taxes to cover both domestic and imported goods and to eliminate tax exemptions on imports as well as on other tax bases. Measures to reduce expenditures have been aimed at avoiding public outlays on projects that are unlikely to strengthen growth performance and debt-servicing capacity, reducing quasi-fiscal deficits to ease the burden of budget subsidies, and rehabilitating infrastructure and sectors (parastatals and financial institutions) considered essential to recovery and export growth. A special effort has been made to improve the financial performance of public enterprises and subject their operations to hard budget constraints. With these measures, the overall pace of fiscal adjustment is geared to reducing excess demand, especially in inflationary circumstances, and adjusted in response to major exogenous shocks (such as those affecting the terms of trade). In addition to minimizing the risks of payments imbalances and inflationary pressures, fiscal adjustment also helps to reduce the burden of adjustment on monetary policy and to facilitate financial sector reform.
Monetary policy has played a key role in supporting external liberalization and ensuring a stable, noninflationary environment in reforming countries. Since the real exchange rate is a relative price, monetary policy has had to be tight enough to prevent competitiveness from being eroded by domestic inflation. In this way, the external position has been protected during the process of trade reform without too much reliance on frequent and recurrent exchange rate depreciations. Unstable inflation and exchange rates could weaken the signaling effects of the relative price changes introduced by structural reforms.
The key financial sector reforms in reforming countries have included a movement away from administered interest rates, selective credit controls, stringent reserve requirements, and other portfolio constraints on banks’ assets. The result has been a less repressed financial sector and a shift by the authorities to indirect methods of monetary management. Moreover, the authorities have strengthened prudential standards and the supervision of the banking sector.
These essential steps have helped make the domestic financial sectors of the reforming countries more competitive prior to external capital account liberalization.
In most countries, foreign trade reform and the liberalization of external current account transactions have preceded the opening up of the external capital account, for two reasons. First, structural reforms of fiscal and monetary policies, domestic pricing and marketing systems, foreign trade and current account exchange controls, and institutional and regulatory rigidities—especially in the financial sector—must be well advanced before the external capital account is opened up. The inflow of foreign resources can be used efficiently only after domestic distortions have been largely corrected. Secondly, the premature opening up of the external capital account during the process of current account liberalization and macroeconomic stabilization could, in some situations, cause the exchange rate to appreciate, hindering the progress of the trade liberalization process and weakening the competitiveness of the tradables sector. These problems have generally arisen in countries where interest rates rose above world levels (as in Argentina, Chile, and Uruguay in the late 1970s) because of relatively high domestic inflation rates and weak fiscal positions. Indeed, such problems have been a matter of concern recently in some middle-income countries (including in Latin America) that are well along in the process of structural reform.
Claudio M. Loser
Convertibility is what we understand it to be. I see convertibility as a liberalization of external transactions compatible with the open system provided for under the IMF’s Articles of Agreement. During the process of economic reform in Latin America, we have assumed that moving toward a system that seeks to liberalize transactions is the correct path, because a system offering greater freedom of movement for goods, services, and capital will help enhance the prospects for economic growth.
For reform to succeed, however, more is required than just convertibility (which has been generally accepted in Latin America in the sense just given). No matter what exchange regime a country uses, the macroeconomic fundamentals must be right, including the fiscal situation and monetary management. In addition, over the longer term the process of reform must permit the economy to compete effectively with the rest of the world. Otherwise, the fiscal and monetary reforms the authorities pursue may not last. In terms of external liberalization—which is part of structural reform—experience shows that trade, or current account, reform must be accompanied by capital account liberalization. If the capital account is liberalized too soon without underlying trade reform, then it is very likely—as was shown in the southern cone of Latin America in the late 1970s—that the reforms may fail. And, as said before, the exchange system may or may not function, depending on whether these conditions are met.
In addition, the characteristics of the exchange system will again be a function of the government’s ability to control the monetary and fiscal situation, and therefore countries will choose a fixed, flexible, or managed exchange rate on the basis of these macroeconomic considerations. And I certainly agree with Mr. Basu that a government should not be rigidly linked to any particular system, because the country’s underlying strengths will determine its future course. The fact is that no exchange rate system offers the perfect solution to every country’s problems. Policymakers know this.
A good point of reference for discussing recent developments in structural reform, exchange rates, and exchange rate management in Latin America is 1982, the year of the debt crisis. At that time we were confronted with the sudden interruption of the flows of foreign financing on which the region depended. Before 1982, Latin American economies were characterized by weak macroeconomic policies, high public sector deficits, significant state control of the means of production, and controls on foreign trade. During the 1970s, however, this method of governance did not create clearly adverse effects because of the availability of ample foreign financing linked to existing oil surpluses. Countries were able to maintain some distortions in their domestic policies and still spend well in excess of their revenues.
Certain countries—for example, oil producers like Venezuela and Mexico—and the rest of the world believed that oil prices would continue to increase. Based on those expectations and low real interest rates, Latin American governments borrowed heavily. But an inflationary environment in the late 1970s resulted in a tightening of financial policy in the United States and Europe, higher real interest rates, and a decline in the prices of commodities, including oil. The results were a sharp decline in exports and reduced access to financial resources. In these circumstances, in a world that had moved slowly toward greater integration, where export orientation was the key, the countries of the Western Hemisphere had to confront this crisis by revising their policies. Latin America thus faced a very difficult political, economic, and institutional process. In response, some countries developed a three-pronged strategy for reform, though not all at the same time. Chile, for instance, had already begun the process in the 1970s. Other countries, such as Mexico, started in the early 1980s. Still others, including Argentina, started but failed in the early 1980s and have returned to reform only in recent years.
The three-pronged strategy consisted of macroeconomic adjustment, structural reform, and the settlement of external debt. The key elements were the improvement of macroeconomic and in particular fiscal performance, combined with monetary discipline. A related issue was management of the exchange rate; in the early 1980s, there was a tremendous shift from overvalued rates to rates that would make an economy more competitive. Structural reform touched on many areas. Financial sector reforms were very important in Chile and Mexico, where the systems were modernized. Domestic trade and direct investment were liberalized and public enterprises privatized.
These reforms were a question not of dogma but of economic efficiency. The private sector, it was believed, with appropriate conditions of competitiveness, could provide better services and make better use of resources. In certain cases, the public sector itself modernized, resulting in significantly improved efficiency. At the same time, the trade and exchange systems were modified to eliminate dual or multiple rates (a source of inefficiency and corruption). The result was simple, transparent exchange rate systems with either fixed exchange rates (Argentina), floating exchange rates (Bolivia), some type of crawling peg, or auctions. In Mexico, there has been a preannounced rate of depreciation, and in Chile and Brazil, a rule of depreciation linked to inflation.
Foreign financing, the third element in the equation, fell into two categories, private and public sector. During the last ten years, there has been a tremendous effort on the part of the debtor and creditor countries, multilateral agencies, and commercial banks to bring the public sector external debt to more manageable levels through either debt reduction or restructuring. Normalizing the relations between public sector and external creditors has been crucial to improving Latin America’s attractiveness to foreign investors and has helped create the conditions that allow the private sector to make use of foreign financing, either through credits, direct investment, or the reversal of the capital flight of previous years. The reversal of these capital flows was in fact an aftereffect of the new domestic policies.
The overall result of the policies was that the fiscal performance in Latin America in the 1980s strengthened tremendously. Central government deficits improved an average of four percentage points of GDP from the period 1981-1983 to 1990-1992, providing a major contribution to adjustment by helping reduce aggregate demand and inflationary pressures. As a consequence, national savings have increased by two to three percentage points of GDP for countries in the region. Investment has increased, although by a smaller amount—some 1 percent of GDP—and therefore the current account deficits have tended to shrink.
The experience, however, varies tremendously from country to country. In Brazil, for instance, the current account has been in surplus or has shown only a very small deficit. Other countries, like Mexico, have experienced a sharp increase in the current account deficit in recent years. Notwithstanding the fact that many countries’ balance of payments have shown current account deficits, foreign reserves have increased significantly. International reserves were very low—maybe $6 billion gross—at the beginning of the 1980s; in 1992, they were estimated to be on the order of $60 billion for the region as a whole. While only a few countries hold most of these reserves, the increase has been a general trend for all countries in the region. The external debt ratios increased initially, but the structure of the debt improved significantly. Exports over the last ten years have grown rapidly, notwithstanding the fact that growth in industrial countries has been slow and that oil prices, in real terms, are probably as low as they were in 1986.
Output growth in the region has been in the order of 3-4 percent in recent years, although some countries have been growing at a much faster rate. Chile is currently growing at the rate of about 7 or 8 percent annually, Argentina at about 6 percent, and other countries at some 3-4 percent. In general, there has been an upward trend, and it seems that growth has been sustained. Of equal interest is the fact that the rate of inflation in the region has tended to decline. Of course, some countries, Brazil among them, still have high rates of inflation. But in broader terms, 10 years ago 12 countries had inflation rates that were under 10 percent per year; today, that number has risen to 20. In the early 1980s, six countries had inflation rates of more than 50 percent, but today only Brazil and Peru have rates that high. Furthermore, Peru’s inflation rate fell from over 50 percent for the 12 months ending in November 1992, to about 35 percent.
While there has been a tremendous improvement in the region, new policy dilemmas have emerged. The economic systems have become more open and the exchange systems more liberal, resulting in a significant increase in capital inflows as the private sector responds to the changed policies. Some of these inflows have come in as direct investment or other types of long-term capital, but others have been purely speculative. In principle, as capital flows come in, the exchange market comes under pressure, and the exchange rate tends to appreciate in order to accommodate the inflows. In these circumstances, policymakers need to decide whether the inflows are a short- or long-term phenomenon and to develop an appropriate response. Some Latin American countries have simply let the capital flow in, allowing the economy to adjust without intervention. Some have had occasional current account deficits that reflect the increased investment. Others, concerned about controlling monetary aggregates, have tried to sterilize these movements by placing bonds in the market, resulting in relatively high interest rates. Capital has continued to flow into these countries, putting upward pressure on either the nominal exchange rate or the domestic inflation rate and weakening external performance.
As noted earlier, these events reflect the private sector’s changed view of economic conditions in the region. As economic performance improves, increased capital flows have resulted in growing aggregate demand, putting pressure on overall resources and inflation. In response, the authorities have sought to tighten fiscal policy, a tactic that has helped reduce the level of aggregate demand, curtail inflationary pressures, lower interest rates, and ease upward pressure on the local currency. While this type of solution seems the most effective one, individual countries must assess their own situations. Short-term flows might better be offset with some type of monetary policy. Experience shows, however, that capital inflows have continued despite such policies.
Some Latin American academicians and policymakers fear that because many countries once more have high current account deficits and are again tremendously dependent on foreign financing, the region will face the same crisis it experienced ten years ago.
However, I believe that today’s situation is very different from that of the early 1980s, owing to significant structural reform, a public, sector that has improved its finances (and so does not depend entirely on foreign financing), and a generally better understanding of the need for governments to establish clear rules. Because of these changes, the potential dangers to the region are much lower today, and the Latin American economies are better able to compete effectively in an increasingly integrated world.
John R. Dodsworth
My focus will be on the policy issues of currency convertibility and stabilization, but from an Asian perspective.
The accepted wisdom on currency convertibility is that it should come late in the reform process, because it can be destabilizing. Following conventional tenets, several Asian countries that opted for currency convertibility—including Japan and the Republic of Korea—-introduced it after they had liberalized their current accounts and the accounts had strengthened. In fact, these countries moved to currency convertibility because they had very large current account surpluses that were themselves posing a threat to price stability. In Japan, the delay between current account liberalization and currency convertibility was some 20 years or more. It was not until the late 1980s that the Republic of Korea accepted the obligations even of Article VIII—a fairly narrow definition of convertibility—of the IMF’s Articles of Agreement. In Korea, capital account convertibility is still under way.
The motivation for establishing convertibility in Singapore and Thailand was somewhat different. Despite current account deficits, they undertook currency convertibility as part of an overall development strategy. But even Singapore and Thailand waited until their overall payments balances had grown very strong before undertaking the move to Article VIII status.
Unlike many Asian countries, most of the countries of Eastern Europe and the former Soviet Union have set aside balance of payments considerations and are pressing for the convertibility of their currencies. Currency convertibility has become part of a comprehensive policy package to get relative prices right and as such amplifies the need to move on a number of fronts at once. Asia’s experience, however, suggests that unless there are strong policies and adequate external support, steps toward currency convertibility in the former centrally planned economies may be premature.
With respect to a country like Sri Lanka, which has now decided to move at a fairly early stage toward current account convertibility while simultaneously undertaking structural adjustment, the issue of currency convertibility is extremely important. There are risks involved in this decision, because convertibility requires additional policy discipline. It is important in this case that (1) the necessary instruments to stabilize the economy are developed, or (2) the political will to take necessary measures is present. In the absence of either of these conditions, the country takes certain risks in moving to an entirely open exchange system.
A second question concerns capital inflows, which arise from successful economic reform but can cause complications for policies. About three years ago, Sri Lanka had practically no international reserves and was experiencing a severe balance of payments crisis. After stronger adjustment policies and structural reforms were adopted, the economy turned around, reigniting capital inflows. At that time, Sri Lanka did not have the policy instruments to deal with the inflows. The IMF advised Sri Lanka to develop a treasury bill market to help mop up this liquidity. Although treasury bill auctions helped to reduce monetary growth, the capital inflows continued and the authorities were forced to allow the exchange rate to appreciate at a time when the competitiveness of the country’s exports was in question. The situation called for fiscal adjustment, but fiscal adjustment on the necessary scale may not be realizable in the very short run.
In such a situation, a policy dilemma develops: while seeking fiscal adjustment, what does a country do with respect to exchange rate and monetary policy? It may be argued that the exchange rate should not be revalued, on the grounds that capital inflows will eventually change the structure of the economy and restore competitiveness. But to support this view, we would need to know the nature of the capital inflows. Are they really going to change the structure of the economy and increase efficiency, or are they short term, subject to reversal and flight? On a practical basis, it is very difficult to differentiate between these types of flows.
Summary of Discussion
The discussion focused on the implications of capital account convertibility. The point was made that the degree of international capital market integration is such that country authorities could do little to move effectively against the general tendencies of capital flows. Central banks might have to intervene, however, in order to slow capital flows that are clearly short-term fluctuations rather than part of a trend.
A related issue was whether or not governments should stand ready to bail out the private sector when the private sector was not able to service its debt. Most participants felt that the public sector needed to give clear signals that it would not bail out private sector enterprises experiencing foreign debt servicing problems. In this way, it would be possible to avert the Latin American experience of the early 1980s, when the exchange risk of private sector debt was transferred to governments. However, simply announcing this intention might not be seen as a credible response by either the international financial system or the domestic private sector. In the event of excessive inflows of nondirect investment capital, governments might be better off imposing exchange controls. Fortunately, circumstances in the 1990s differed from those in the early 1980s. Most countries’ fiscal positions were substantially improved, and foreign borrowing was now directed mainly at investment rather than at supporting consumption.
Most participants felt that the capital account should not be liberalized before real sector reforms were implemented. Real sector reforms, however, were judged to be relatively difficult to implement, perhaps more so than macroeconomic reforms. The former—which include modification of the trade system, privatization of public enterprises, and reform of the domestic distribution system, among others—required a strong and persistent commitment from the authorities, in part because of potential conflict of interest. It was important for governments to try to eliminate other distortions in the economy, in particular those resulting from a restrictive trade system, before moving to currency convertibility.
Finally, the consensus was that there was no single solution or unique sequencing of steps that could be used as a model in the timing of reforms; rather, advice regarding currency convertibility would need to be tailored to individual country circumstances.
For the purposes of this paper, currency convertibility is broadly defined as the absence of official restrictions on the exchange of domestic for foreign reserve currencies, for both external current and capital account transactions.
The issue of sequencing the liberalization of external current and capital accounts is discussed in Section VI.
In the 1980s, trade liberalization was undertaken with varying degrees of intensity in Bangladesh, Chile, Colombia, Ghana, Jamaica, Korea, Madagascar, Malawi, Mauritius, Mexico, Morocco, the Philippines, Senegal, Thailand, and Turkey.
Notably, Chile, Colombia, Ghana, Mauritius, and Morocco relied on exchange rate depreciation.
Bangladesh and Mauritius introduced export promotion schemes, such as duty drawbacks, exchange retention privileges, and other measures. Public investment in infrastructure was given high priority in Chile, Colombia, Korea, Malawi, Mexico, and Turkey.