6 Exchange Rate Policies and Management: A Model for Successful Structural Adjustment

Ungku Abdul Aziz
Published Date:
March 1990
  • ShareShare
Show Summary Details

Over the past two decades rising economic performance in the developing countries of East Asia has propelled the region into growing prominence and has raised important questions regarding the role of economic policies in that performance. Annual growth rates since 1965 have averaged over 7 percent. Exports have surged, more than doubling their share of output. The extent of such generalized vitality is unequaled by other regions. Given the resource, cultural, and other diversities of the various countries, evidence regarding a model for structural adjustment may be derived from differences in economic performance and policies.

It is widely agreed that the role of exports has been crucial to the successes of the East Asia region. Only in one country, Indonesia, did the windfall of increased oil prices play an important role. In most others, the increase in oil prices was a significant negative factor, and nontraditional exports, largely of manufactures, have been the key source of dynamism. This points to the importance of policies affecting directly the external sector of these economies—including the role of the exchange system in regulating and pricing international trade and financial flows.

This paper describes and analyzes the principal features of exchange rate policies to date in the region, including points of divergence from performance in some other major developing countries. It traces briefly the impact of these policies through to such key variables as export openness, domestic investment, and growth rates. Because the focus is on the adjustment of economic structures rather than macroeconomic adjustment, a longer time frame of analysis is provided (the last two or three decades, depending on data availability). The role of exchange rate management is also examined briefly in the specific context of financial sector development, which could be viewed as a continuing vital stage of structural adjustment in the East Asian region.

The first part of the paper summarizes salient features of developments since 1970, comparing performance in East Asia and a small sample of major developing countries in Latin America and Europe (Argentina, Brazil, Mexico, and Turkey). The emphasis is on the role of exchange rate policies in investment and growth. The second focuses on more recent developments in financial sectors, particularly in foreign exchange systems, and draws conclusions for future policies and management aimed at securing structural adjustment.


Exchange Rates

The movement of one industrial country exchange rate against another has had significant effects on the pricing of exports of East Asian countries, as over two thirds of their export markets are in industrial countries. Somewhat different inflation rates in the home and export markets have also affected export pricing. Patterns in the evolution of real effective exchange rates show a depreciation in the East Asian countries from the 1960s, but more stable rates from 1975 to 1985 (Table 1). This trend in competitiveness does not differ greatly from the other major developing countries surveyed here. Some differences are apparent for Argentina and Turkey, where there was initially a real appreciation on balance (through 1980 in Argentina, and 1979 in Turkey), followed by sizable depreciation in the 1980s. Significant differences are also indicated in the stability of competitiveness between the individual countries, but not between the two groups.1

Table 1.Real Effective Exchange Rates1(Indices, period averages. 1980 = 100)
Source: International Monetary Fund. International Financial Statistics.

Based on consumer prices as of the end of each year (final quarter*). Weights reflect trade with industrial country trading partners. An increase of the index indicates an appreciation of the real effective exchange rate.

Source: International Monetary Fund. International Financial Statistics.

Based on consumer prices as of the end of each year (final quarter*). Weights reflect trade with industrial country trading partners. An increase of the index indicates an appreciation of the real effective exchange rate.

Using effective exchange rate calculations to judge whether or not the level of the exchange rate is realistic has a number of problems. The indices show only changes over time and therefore must assume some base period in which the exchange rate was right. Second, the prices on which they are based do not reflect fully the trade competitiveness of the economy. For example, consumer prices, which are the only data available for many countries over a long enough period for structural analysis, do not relate to the export sector specifically. Third, real shocks to the economy must be expected to be reflected in shifts in real effective exchange rates.

It is more instructive to look at how markets assessed the exchange rate over time. Because exchange rates of developing countries have been subject in the past to official determination or management, such assessments may be derived only from black or free secondary markets in foreign exchange for their currencies. These market rates indicate private sector judgment as to the true value of the currency.2 It is therefore important that there has been no sustained and large premium or discount for East Asian currencies in their black markets since 1965, although from time to time some discounts have arisen, indicating temporary overvaluation of the exchange rate—for example, Korea in the early 1970s, and the Philippines in the late 1960s and early 1980s (Table 2). Otherwise, official exchange rates have served to clear broadly foreign exchange markets in the East Asian countries, with allowance made for sustained support from official foreign exchange reserves and the effects of trade and exchange restrictions.

Table 2.Exchange Rate Premiums or Discounts in Black or Free Secondary Markets for Foreign Exchange1(Period averages)
Sources: Pick’s Currency Yearbook and International Currency Analysis. Inc.; World Currency Yearbook, various issues.

Ratio of black or free secondary market rate to official or other major market rate, in percent as of the end of each year (both rates in currency units per U.S. dollar). Ratio in excess of 100 indicates overvaluation of the official exchange rate of the currency. Undervaluation may exist to a limited extent without the ratio dropping below 100, owing to the premium payable on purchases of foreign currency in the black market for evasion of taxes and duties.

Small discount for sales of foreign currency in the black market.

Sources: Pick’s Currency Yearbook and International Currency Analysis. Inc.; World Currency Yearbook, various issues.

Ratio of black or free secondary market rate to official or other major market rate, in percent as of the end of each year (both rates in currency units per U.S. dollar). Ratio in excess of 100 indicates overvaluation of the official exchange rate of the currency. Undervaluation may exist to a limited extent without the ratio dropping below 100, owing to the premium payable on purchases of foreign currency in the black market for evasion of taxes and duties.

Small discount for sales of foreign currency in the black market.

This exchange rate policy, leading to broadly clearing unified exchange markets contrasts sharply with policies in the other major developing countries. Apart from a two-to-three-year period around 1980, Argentina's exchange rate has been substantially overvalued against the black market. Brazil has had an active black market for foreign exchange during most of its postwar history, with the exchange rate in that market indicating overvaluation of the currency at various times, by as much as one half in some years. Similarly, a severe overvaluation of the Turkish lira emerged in the second half of the 1970s. Although the existence of an open market for foreign exchange kept the Mexican peso broadly competitive through 1981, the exchange rate became overvalued for the following five years (1981–86), as rates in the black market persisted at levels as much as half as high again as for official market transactions. More recently, free markets have also dominated the setting of official rates in Argentina, Mexico, and Turkey.

Thus, an important difference in exchange rate policies between the East Asian group and the sample of other major developing countries is revealed by observation of black or free market determined exchange rates. Although exchange rates have been set or administered officially in virtually all of the former group, this has been done in such a way as to clear foreign exchange markets in their broadest sense (i.e., including illegal transactions)—an outcome analogous to floating. In the other group of countries, sustained and marked differences between official exchange rate policies and the views of exchange market participants have been evident.

Restrictive Systems

Analysis of the adequacy of exchange rate policies requires that the policies for exchange and trade restrictions also be examined, because an exchange rate that otherwise would be overvalued may be held in temporary equilibrium by exchange and trade restrictions. It should be noted that over time the restrictions will increasingly tend to become either ineffective or costly to administer. The exchange rate itself will therefore have to be depreciated ultimately, probably by even more than without the restrictions, because the distortions created by the restrictions will undermine investment efficiency and performance in the production of tradable goods.

Major features of exchange systems since 1970 in this group of countries are shown in Table 3; it is apparent that there has been considerable diversity both within the group of East Asian countries and with respect to the other major developing countries. However, the group of East Asian economies has over time been moving to more flexible exchange rate regimes and taking less recourse to exchange restrictions, while the evolution of exchange systems in the other group (at least until 1988–89) has been less clear. Exchange rate regimes have grown broadly more flexible in the latter group but, as discussed above, without giving rise to competitive exchange rates over most of the period. This has led to attempts to support the exchange rate with bouts of increasing restrictiveness from time to time.

Table 3.Main Features of Exchange Systems
Exchange rate regimeMF$$£S$$$$$
Multiple exchange ratesxxx
Current restrictions1xxxx
Capital controlsxxxxxxxx
Import surchargesxxxxx
Advance import depositsxxx
Surrender requirementsxxxxxxxx
Exchange rate regime$CBMFCB$MFMF$MF
Multiple exchange ratesxx
Current restrictions1xxxxx
Capital controlsxxxxxxx
Import surchargesxxxxxx
Advance import depositsxxxxx
Surrender requirementsxxxxxxxx
Exchange rate regimeMFCBMFCB$MFMFMFMF
Multiple exchange ratesxx
Current restrictions1xxxx
Capital controlsxxxxxx
Import surchargesxxxxx
Advance import depositsxxx
Surrender requirementsxxxxxxx
Exchange rale regimeMFCBIFMFCBMFMFMFMF
Multiple exchange ratesxxx
Current restrictions1xxxx
Capital controlsxxxxxxx
Import surchargesxxxx
Advance import depositsxx
Surrender requirementsxxxxxxx
Source: International Monetary Fund, Annual Report on Exchange Arrangements and Exchange Restrictions, various issuesNote: x indicates that the specified practice is a feature of the exchange system; — indicates that it is not; CB = pegged to currency basket; I IF = independently floating: MF = managed floating; $= pegged to U.S. dollar and £S = pegged to pound sterling.

Exchange restrictions imposed on international transactions in the current account of the balance of payments.

Source: International Monetary Fund, Annual Report on Exchange Arrangements and Exchange Restrictions, various issuesNote: x indicates that the specified practice is a feature of the exchange system; — indicates that it is not; CB = pegged to currency basket; I IF = independently floating: MF = managed floating; $= pegged to U.S. dollar and £S = pegged to pound sterling.

Exchange restrictions imposed on international transactions in the current account of the balance of payments.

Korea's exchange system has been marked by the absence of multiple exchange rates in the period examined, but until recently restrictions on payments and transfers imposed on both current and capital account have been combined with surrender requirements for foreign exchange earnings and certain import measures, such as import surcharges and advance import deposits. The Philippines is the only country in the region to have maintained a multiple exchange rate system, which was abandoned in the early 1970s, although both current and capital restrictions have been used throughout the period. In Malaysia, Singapore, and Thailand, the systems on balance have been freer from restrictions since 1970, and multiple rates have not been used.

In the group of other developing countries, Brazil and Turkey have had the most consistently restrictive systems of exchange controls. Mexico's system before 1980 was characterized by a free exchange market with no restrictions on either current or capital transactions and freedom from multiple rates. In the 1980s, under pressure from debt, Mexico first introduced multiple exchange rates combined with a severely restrictive exchange and trade system, but has in recent years returned to its original freedom. Argentina has been marked by occasional recourse to complex multiple exchange rates, including a free exchange rate in the market for capital transactions. Turkey's system has been based on multiple rates and restrictions throughout most of the period since 1965, although recently the exchange rate has been floated and the exchange system increasingly liberalized.

Quantitative restrictions imposed directly on imports and exports perform functions similar to those administered through the exchange system, although differing in the stage of the external transaction on which they have a direct impact. In analyzing the trade systems, it is difficult to find sharp differences between the two groups of countries.3 Some of the systems have been extremely complex and have been subject to many changes in the direction of policy, for example, Argentina. In contrast, the Mexican system has been kept quite simple and has experienced fewer changes. In the 1960s, all Korean imports required licenses and the import regime was divided on the basis of local funds (KFX) and U.S. aid. Within the KFX it was subdivided into automatic, semi-restricted, restricted, unspecified, and prohibited items; automatic approval was reserved for “essential” consumer and intermediate goods. This basic system of import licensing has been retained although much liberalized since the mid-1970s. Some countries began with liberal treatment of imports in the 1960s (the Philippines and Thailand) and then more stringent licensing. Despite Mexico's liberal exchange system from the mid-1960s, most of its imports were licensed and, with the emergence of payments difficulties in the mid-1970s, licensing was tightened. In the 1980s, the Mexican trade system was relaxed again as part of liberalization measures to cope with the debt situation. Argentina and Brazil also renewed liberalization efforts.

Nevertheless, in policies affecting the pricing of trade flows through the imposition of import and export duties, as well as the exchange rate policies described above, there are clear differences between the two groups of countries. Most Latin American economies had an ambitious program of import substitution dating back into prewar years (Ground (1988)). Generally speaking, traditional exports have also been heavily taxed under Latin American systems and remain so today. Argentina had in place in the 1960s industrial promotion import surcharges ranging from 5 percent to 235 percent, on top of which there was a 50 percent advance import deposit for some imports. At the same time, Argentina also exercised restrained use of export incentive devices (although there was an export rebate scheme for nontraditional imports). In Brazil, exports of beef, cocoa, and cocoa products were subject to “contribution quotas” (in effect, export taxes ranging from 5 percent to 30 percent). Coffee was taxed through a margin for the “Coffee Defense” fund, corresponding to different effective exchange rates (roughly, Cr. 2,000 = $1 in the official market as against Cr. 800 = $1 for coffee receipts). In addition, Brazil has had a tax on industrialized products (IPI), although this has been subject to credit for exporters of manufactured products, and has maintained other incentives, such as lines of credit at preferential rates of interest and export credit insurance guarantees. Export taxes have generally been less extensive and maintained at lower rates in the East Asian region. Thailand has subjected rice and sugar to export taxes on an occasional basis (so-called export premiums), and Malaysia has taxed rubber exports. The Philippines introduced a stabilization tax on exports in 1970, but at the same time introduced an export incentives law based on income tax exemptions. In 1980 it introduced further incentives for export-oriented firms.

Differences in exchange rate policies between the two groups thus appear to have been reinforced by differences in the tax treatment of exports and imports, with overvalued exchange rates thereby becoming even more overvalued in effect.

Interest Rates

Although interest rate policies would be assigned loosely to the category of “domestic” rather than “external” instruments, it is not possible to give a balanced account of exchange rate policy developments without reference to them. As a determinant of savings behavior, interest rates have important implications for flows of capital over borders and for decisions to consume or invest, which lie at the heart of trade imbalances.

As with exchange rates, it is necessary to take account of differences in inflation rates when comparing interest rate policies between countries (see Table 4 for “real” interest rates). Here again, clear differences exist between the groups of countries. Although domestic interest rates in the Asian group were somewhat negative in real terms in the 1970s, they were considerably closer to interest parity (with the United States) than in the other sample group.4 Moreover, real rates have been positive in the latter group with only one exception in the 1980s. Singapore and Thailand have maintained positive yields on domestic saving after inflation throughout most of the period for which data are generally available (1971–87), while in Malaysia they have been positive on average in the 1980s. In contrast, the Philippines and the other sample of developing countries have had largely negative real rates over the period analyzed.

Table 4.Real Interest Rates(Period averages, percent a year)

Sources: International Monetary Fund. International Financial Statistics; and national data.Note: Annual averages deflated by change of GDP deflator in same year.

Money market interest rate.

Deposit rate.

Bank rate.

Discount rate prior to 1976.

Discount rate prior to 1979.

Treasury bill rate.

The figure is for 1986.

Deflated by change in consumer price index after 1985.

Sources: International Monetary Fund. International Financial Statistics; and national data.Note: Annual averages deflated by change of GDP deflator in same year.

Money market interest rate.

Deposit rate.

Bank rate.

Discount rate prior to 1976.

Discount rate prior to 1979.

Treasury bill rate.

The figure is for 1986.

Deflated by change in consumer price index after 1985.

Effects of Policies

The effects of realistic exchange rate policies as against overvalued exchange rates and large export taxes are clearly demonstrated by the evolution of ratios of exports of goods and factor services to gross domestic product (GDP). Here the startling growth of exports in the East Asian group is evident. The “openness” ratio for Korea rises from 3 percent in 1960 to almost one half of total output in 1987 (Table 5). In both the Philippines and Thailand it has roughly doubled over the same period. The importance of exports in the Malaysian economy has been evident from as early as 1955 when one half of annual output was exported; this has changed little to date. In contrast, in Latin America under the long-standing import substitution policies outward orientation of the economies actually diminished in the 1950s and 1960s. In Mexico, the ratio of exports to GDP was only half as high in 1970 as it had been in the 1950s, and in Argentina it was falling until 1980. In Brazil, export orientation was low at 7 percent through the 1960s, and in Turkey it was also small to begin with (around 5 percent). As a consequence, the sample group of non-Asian economies entered the 1970s with small export markets.5

Table 5.Export Openness: Exports of Goods and Factor Services

(Percent of GDP)1

Source: International Monetary Fund. International Financial Statistics.

Exports from national income accounts. Data for Singapore include re-exports.

The figure is for 1986.

Source: International Monetary Fund. International Financial Statistics.

Exports from national income accounts. Data for Singapore include re-exports.

The figure is for 1986.

The export opening in the sample of non-Asian developing countries remained modest despite significant growth of domestic investment activity as the ratio of investment to GDP rose to well over 20 percent in 1976–80 in all four economies (Table 6). However, investment rates were even higher in the East Asian group, where they peaked at around 30 percent in the same period in Korea, Malaysia, the Philippines, and Thailand. The rate of investment in Singapore was yet higher, reaching almost one half of GDP by the early 1980s.

Table 6.GNP/GDP Growth Rates (1) and Incremental Capital/Output Ratios (2)

(Period averages)1

Source: International Monetary Fund, International Financial Statistics.

Growth rates are averages of percent changes in GDP from preceding year. Gross domestic investment is expressed as percent of GDP.

The figure is for 1986.

Source: International Monetary Fund, International Financial Statistics.

Growth rates are averages of percent changes in GDP from preceding year. Gross domestic investment is expressed as percent of GDP.

The figure is for 1986.

In part, because of their limited external sectors, the non-Asian economies borrowed more heavily in the 1970s to finance increased domestic investment and public sector expenditures, and their associated imports. Capital inflows had cumulated to large amounts by the end of that decade (Table 7). In contrast, the growth of capital inflows in the East Asian group was steadier, and with the expansion of export sectors from their already strong base in the early 1970s, export earnings were generally sufficient for the servicing of the external debt that had been incurred. In the Latin American economies, although export sectors grew in prominence in the 1970s, they remained insufficiently large to service the enormous debt that had been accumulated, and investment then dropped off sharply in the 1980s and with it the export orientation of the economies and overall growth rates.

Table 7.Net Capital Inflows(In billions of U.S. dollars; negative sign denotes outflows)
Source: International Monetary Fund. International Financial Statistics.Note: Including net errors and omissions, but excluding reserves, exceptional financing, and liabilities constituting foreign authorities' reserves.
Source: International Monetary Fund. International Financial Statistics.Note: Including net errors and omissions, but excluding reserves, exceptional financing, and liabilities constituting foreign authorities' reserves.

The import substitution policies adopted in earlier years therefore had a crucial effect years later on structural adjustment in the Latin American economies: they rendered them susceptible to the instabilities of successive oil shocks. On the other hand, the position of the Asian economies was more secure, despite the shocks to their import bills and export markets administered by the two major oil price increases. They had a larger initial export base and exchange rates that were not overvalued. Consequently, their export sectors were able to grow sufficiently to service the capital needs of the economies, and rapid growth ensued.

This is not to say that periods of difficulty were not evident. In Korea, for example, questions of overindebtedness did arise in 1975 and 1983, underlining the finely gauged extent of the investment effort. While the development of the export sectors was reasonably rapid in the 1970s in the sample of non-Asian economies, it was nevertheless impeded by a system of heavy export taxation for traditional goods, coupled with overvalued exchange rates. By limiting the external orientation of these economies, the exchange rate and restrictive system policies therefore sowed the seeds for the problems of the region—vulnerability to the effects of the recycling of oil receipts. The effects of these policies were compounded by negative real interest rates, which limited domestic saving and contributed to overdependence on foreign gross savings, accommodated by easy availability of credits at the time. Poor yields on domestic assets, reflecting both the negative real interest rates and expectations of exchange rate depreciation, also caused resident capital to flee abroad. Net saving available for domestic investment was thus sharply reduced. Such dissavings through the external capital account occurred despite extensive capital controls, emphasizing the ineffectiveness of these controls.

This brief discussion of the experience in East Asian and some other developing countries suggests strongly that any model of structural adjustment will have as essential components a realistic, market-related exchange rate and positive real interest rate structure, and an adequate after-tax return to exporting industry.6 These are necessary but not sufficient conditions for successful adjustment. Flexible exchange and interest rates may for a time, perhaps even for several years, buffer the economy from the worst effects of inappropriate fiscal and monetary expansion, but ultimately a point will be reached where the financial markets will no longer be able to handle such uncertainties, and growth will suffer.


Exchange Rate Regimes

Exchange rate “policies” and “management” are distinguished in that management refers to the technique by which a policy is implemented. There are two main areas of decisionmaking in the management of exchange rates. The first is the extent of official intervention (usually by purchases or sales of foreign exchange), and the second is the frequency of adjustment of the exchange rate. In principle, any technique may be used to replicate the effects of another, but in practice, the form of exchange rate management, ranging from a single currency peg to a market-determined float, has led to major differences in the evolution of competitiveness of exchange rates in Fund member countries.

The exchange rate policies described above have been the product of a number of management techniques that have varied between countries and over time. Malaysia and Thailand have used a currency composite peg to set their exchange rates on a month-to-month and day-to-day basis against the U.S. dollar. Korea, on the other hand, has moved from a freely floating exchange rate in the 1960s to a peg to the U.S. dollar, and subsequently in the 1980s to a managed float by which the rate is varied frequently against the dollar. In the late 1980s, after following a number of different arrangements, the Philippines, Mexico, Singapore, and Turkey either floated or came close to accepting market determination of their exchange rates. Argentina in 1989 adopted a virtually unified float of the currency after experimenting with different forms of pegging and managed flexibility.

In practice, the choice of technique for exchange rate management has mattered substantively, in the sense of giving rise to exchange rate variations lasting beyond one year.7 Authorities in many countries, including the sample of other major developing countries discussed here, have been unable in the face of inflation to undertake adjustments of their pegged or heavily managed exchange rates that were sufficient and timely enough to avoid serious overvaluation. The exchange rate has often been imbued with a political significance that has made it difficult for governments to act—the “weak” currency problem in the case of deficit countries, and to be seen as “caving in” to pressures from abroad in the case of surplus countries. Further, problems are arising from short-term tradeoffs between exchange rate adjustment and transitional cost-push inflation effects and J-curve effects on the balance of payments.

The usual asymmetry between debtors and creditors means there is no early limit to surplus countries' attempts to maintain a depreciated currency through reserves accumulation. Ultimately, however, trading partners' debt-servicing capacities corresponding to the surplus will be broached, or there will be serious problems for domestic monetary management in the surplus country resulting from attempts to sterilize reserves accumulation. As an example of the latter, Taiwan Province of China has had to turn somersaults in order to sterilize an enormous reserves accumulation. (It recently gave up these operations and liberalized the exchange market.) The problem arose because the central bank had been paying above-market rates of interest, thus withdrawing credits available for domestic investment. In addition, there were losses on the foreign exchange transactions by the central bank, and the sterilization of capital inflows may also have redistributed credit within the private sector, creating financing difficulties in some sectors. For the debtor countries, the lack of timely exchange rate adjustment has had even more disturbing real effects, as documented above, including acting as an incentive for massive capital flight leading to external payments arrears.

The net effect on international reserves of policies aimed at sustaining exchange rates is shown in Table 8. Reserves accumulation has been modest for most of the East Asian countries because debt servicing and repayments have accelerated in recent years. (Malaysia and Singapore had the equivalent of 6 and 7 months' of imports, respectively, in reserves at the end of 1987.) The converse has been a sizable decline in the reserves of two of the countries in the comparator sample (Argentina and Brazil) to support an overvalued exchange rate. The declines would have been even more marked if the reserves changes were adjusted for incurrence of external arrears.8

Table 8.International Reserves Accumulation(In billions of SDRs)
reserves as months
of imports1.
Source: International Monetary Fund. International Financial Statistics.Note: Total change in gross official international reserves over the period shown.
Source: International Monetary Fund. International Financial Statistics.Note: Total change in gross official international reserves over the period shown.

Similar arguments apply to the effects of inflation on official interest rate determination (but are not discussed further in this paper) as the negative real rates reinforce the adverse balance of payments effects of a disequilibrium exchange rate. In the particular case of surplus countries, in accordance with the covered interest parity condition, expectations of exchange rate appreciation would have a counterpart in lower domestic interest rates, thus exerting a reflationary effect and increasing demand for foreign goods.9 However, from a comparison of differences in real interest rates vis-à-vis the U.S. money market (see Table 4), it can be seen that, generally speaking, real interest rates in the East Asian region in the 1980s have been higher than in the United States and have contributed to strong incentives for capital inflows—given that both exchange rate expectations and real interest differentials have been in favor of the domestic currencies.

Liberalization of Capital Controls

The issue of the optimal sequencing of trade and capital liberalization has mostly been taken up in the context of deficit developing countries. However, Belassa and Williamson (1987) argue that there was not a case for liberalizing capital inflows into Taiwan Province of China, a surplus economy, because “it [the liberalization] would [have] preclude[d] any chance of securing the adjustment because of expected appreciation attracting a flood of hot money.” This argument may not recognize sufficiently the interdependence of the capital inflows and the overvaluation. It is primarily the prospect of a realized appreciation of the exchange rate that attracts speculative capital inflows and the pressure for hot money inflows will continue, delaying the abolition of capital controls, for as long as an exchange rate is kept at an undervalued level. The key point is that it is easy to obtain an exaggerated impression of the likely extent of appreciation following floating, if the mutual interdependence of the exchange rate and the controls is not recognized.

In the presence of market-clearing interest and exchange rates, Lal (1987) argues that the question of sequencing does not arise when a moderate fiscal policy is adhered to. Some (e.g., Edwards (1985)) have argued that the experience in the southern cone countries of Latin America strongly suggests liberalization of trade before the capital account, but as Lal notes, this precedent is limited in applicability because none of the countries in question had in place market-clearing exchange rates at the time that they liberalized capital.

The argument most often given for continued capital controls in deficit developing countries is that their liberalization would lead to capital flight. This assumes that capital controls are an effective constraint on capital flight, which manifestly they have not been. In fact, adoption of liberalized interest rates and a floating exchange rate coupled with a freeing of capital controls has been seen to stem and then to reverse capital flight in deficit countries. The opposite would be expected from adoption of such policies by a surplus country—namely, a sharp reduction in pressures for capital inflows.

The experience with international capital controls in industrial countries shows clearly that the disruptions that were expected to follow liberalization of the controls did not occur. 10 The German and Swiss experiences with controls on capital inflows in the 1960s and 1970s are instructive. In the end, both nations abandoned their attempt to control capital inflows because they were ineffective. Australia and New Zealand floated their currencies and eliminated exchange controls in the mid-1980s, and in both, substantial capital inflows followed. Nonetheless, it should be noted that in the years prior to these actions the Australian and New Zealand dollars had been overvalued, thus the unwinding would be the opposite of that to be expected in a surplus country.

Another reason for capital liberalization includes the pursuit of structural efficiencies. Achievement of efficiency in the use of capital requires a sound and sophisticated institutional basis for risk assessment in the bank and nonbank sectors. This is vital because of the increasingly fine distinctions to be made in the choice of investments in a more developed economy, as rising standards of living rapidly shift competitiveness between industries and sectors. It is generally accepted that the “picking-of-winners-by-government” strategy for industrial development is even less appropriate for more advanced developing and industrial countries.

In this environment, the existence of inflexible interest and exchange rates seriously impedes investment efficiency. For foreign financing, the assessment of risk becomes largely a matter of politico-economic judgment as to the timing of government actions to change interest and exchange rates, and subsidy policies. In the case of nonmarket domestic interest rates, the allocation between investments is likely to be distorted if there are limitations on lending that bias the selection of investments. The elimination of ceilings on the rates and more active involvement of the private sector in appraising yields and risks and directing credits will become increasingly crucial for investment efficiency over time.

On the question of the timing of capital liberalization, a major problem with a gradualist approach is that it hinders progress by making credibility more difficult to achieve. In contrast, a quick transition to free mobility of capital means that the design and assessment of future investment projects can be based on realistic pricing and availability of domestic and foreign exchange financing, thus avoiding needless industrial restructuring and bankruptcies when controls are dropped and prices are adjusted ultimately. Transitional problems aside, it is instructive that Indonesia has kept an open exchange system, free of capital controls, since the early 1970s and has not had destabilizing flows of foreign capital.

There is the broad question of the impact of exchange liberalization on macrostructures, through its effects on the elements of the aggregate production function. In many developing countries one effect of a restrictive trade system backing up an overvalued exchange rate has been to encourage the overimporting of capital goods, thus raising capital intensity beyond its optimal level. However, in the case of surplus countries with an undervalued currency the tendency may be in the opposite direction: making imported capital goods relatively expensive shifts the production function toward labor intensity. Policies to raise real wages directly were adopted by Singapore in the early 1980s with the aim of reducing labor intensity. Instead the policies depressed activity and had to be eliminated.

Restraints on the ability of the domestic banking and nonbanking sectors to participate in the international market for their services can also have a direct bearing on overall growth rates and efficiency. For example, Singapore has been able to sustain outward growth in the early 1980s to a large degree on the strength of expansion of markets and financial and business services. This would not be possible in an economy without a liberalized environment.

The sophistication of the financial markets varies widely from country to country. The full menu of forward exchange market transactions is available in both Singapore and Thailand, while the market in the Philippines is more limited in depth, and Indonesia, Korea, and Malaysia have maintained an official presence in the market through the provision of swap facilities (Table 9). Indonesia, Malaysia, and Singapore maintain no controls on financial capital, including no restrictions of residents' holdings of foreign currency deposits with domestic banks. Korea does not maintain the latter restrictions, while the Philippines and Thailand maintain both forms of capital controls. Furthermore, most continue to maintain controls on foreign participation in equity investments. In regulating domestic money and credit markets, there is similarly a diversity of recourse to credit and interest rate controls. Clearly, scope remains for further strengthening of financial structures in a number of the East Asian economies.

Table 9.Selected Characteristics of Financial Systems
1.DirectInterest rateInterest rateInterest ratesInterest rates haveInterest ratesInterest rateInterest ratesSelective creditInterest rates
monetaryand creditceilings remain,liberalized, selectivebeen liberalized.have beenceilings remain,regulated. Quotascontrols.and credit
controls1controls liftedcredit controlscontrols remain controlson nonregulatedcontrols
as part ofin effect.effect.on credit lastrate deposits,lifted as part
financialused in 1984.acceptances, andof financial
2.Restrictions onNoYesNoYesNoYesNoYesNo
3.Residents’No restrictions.All residentsNo restrictions.Subject toNo restrictions.Not permitted.No restrictions.Limited toNot
holdings ofpermitted toauthorization givenexcept forexporters,permitted,
foreignhold foreigngenerally for export-exports.importers,except in
currencycurrencyOrientedcompanies withborder
deposits, orforeign participationareas.
domesticinward private(accounts held at
banks2remittances.Central Bank).
4.Operations inCommercialMaturity andCommercial bankLimitedForwards,Forwards,Limited officialMaturity restrictions;Limited
forwardbank market“real”market supported bytransactions; nofutures, andfutures, andtransactions;transactions limited.transactions;
exchangesupported bytransactionsofficial swap facility.restrictions oroptions inoptions ininformal parallelsupported
markets 2official swaplimitations;official Bank of
facility.commercialbank market.Mexico.
bank market
supported by
official swap

From Jotinston and Per Brekk (1989): and national authorities.

From Quirk and others (1988): and national authorities

From Jotinston and Per Brekk (1989): and national authorities.

From Quirk and others (1988): and national authorities


Successful structural adjustment in East Asian economies has been widely associated with the competitiveness of their export industries. Exchange rate policies in this region have had one major element in common over the past two or three decades: regardless of whether the official exchange rates have been pegged or flexibly managed, they have deviated little from rates in domestic free or black markets for foreign exchange. This has differentiated exchange policies in these countries sharply from a small sample of major developing countries with lower growth rates, in which politico-social considerations arising from short-run tradeoffs in adjusting exchange rates (inflation passthrough and J-curve effects) have led to delayed changes in pegged and managed rates. Such important differences in the market realism of exchange rates between East Asia and the sample of other major developing countries appear to have been reinforced by other policies: the absence of punitive taxes on exports, including those arising from systems of multiple exchange rates, and the absence also of significantly negative real interest rates. In the other countries, such policies have created inefficiency in the use of imported capital recycled from oil surpluses, including capital flight that reduced net saving available for domestic investment, and “white elephant” industries that were not competitive when exchange rates, interest rates, and other controlled prices were finally adjusted to realistic levels.

That capital flight has occurred in the face of extensive systems of capital controls in developing countries with debt difficulties has underlined the irrelevance of the current and capital account liberalization “sequencing” debate. For countries not experiencing such difficulty (the bulk of the East Asian group), rapid liberalization of capital controls coupled with increasingly more market-determined exchange rates is unlikely to trigger sharp exchange rate adjustments or large shifts in capital flows. The experience freeing international capital controls in both surplus and deficit countries with floating exchange rates has been that the disruptions it was feared would follow liberalization of such controls did not occur.

In more advanced developing countries, inflexibility of exchange and interest rate policies becomes an increasingly serious impediment to investment efficiency, because of the increasingly fine distinctions to be made in the choice of investments as rising standards of living shift competitiveness rapidly between industries and sectors. Restrictions on financial services and their pricing can also limit competitiveness in international markets for such services.



Mr. Quirk's paper provides an insightful analysis of the experiences of the East Asian countries in their exchange rate policies and management for the past two or three decades. Among many roles of exchange rate policy, the paper focuses on its role in the promotion of structural adjustment and financial sector development. Major findings of the paper are as follows.

First, compared with other developing countries, the East Asian countries have had greater stability in their international competitiveness. This has been made possible by the proper exchange rate policies, which resulted in steady depreciation and relative stability of real effective exchange rates around the market-clearing levels. Second, the successful structural adjustment of the East Asian countries has been facilitated not only by their exchange rate policies, but by the liberalization of various restrictions on trade, capital flows, and interest rates, which in effect reduced distortions in exchange rates. Third, in order to enhance structural efficiencies, including efficiency in capital allocation, further liberalization of capital controls should be pursued. Furthermore, more rapid and simultaneous liberalization of capital flows and exchange rates is preferable to a gradual approach. This way it would be possible to maintain policy credibility, to reduce adjustment costs, and to prevent disruptive capital flows after liberalization. Finally, it is recommended to further strengthen and internationalize the structures of exchange and financial markets of the East Asian countries, which currently show great diversity in terms of the degree of controls and institutional arrangements.

I find myself mostly agreeing with these conclusions. I raise the following four questions, however, which are related to the main theme of the paper but are either overlooked or only lightly touched upon.

First, the diversity of exchange rate policies among the East Asian countries seems to be largely ignored; the paper is more concerned with the differences in the exchange policies of these nations as a whole compared with other developing countries. Bijan B. Aghevli, for example, focuses on such diversity and even hypothesizes an interesting relationship among the levels of inflation, real exchange rate movements, and exchange rate regimes of several Asian countries in the 1960s and 1970s.1 Quirk's paper points out the diversity of exchange rate regimes among these nations and also mentions, “[i]n practice, the choice of technique for exchange rate management has mattered substantively, in the sense of giving rise to exchange rate variations lasting beyond one year” (p.116). To what extent it has actually mattered is not discussed however.

Second, although the paper focuses on the longer-term effects of exchange rate policies on structural adjustment, these effects often conflict with the short-term macroeconomic effects on inflation, balance of payments, debt service burden, etc. In fact, I believe that this tradeoff between the short- and long-term effects of exchange rate changes is one of the major causes of concern about adopting the structural adjustment package of the International Monetary Fund, especially in the developing countries that are cited in the paper as having failed in structural adjustment. It would have been more persuasive had the paper elaborated on such concern by examining the experiences of more successful East Asian countries.

Third, even after so much discussion about exchange rate policies in the literature, including its economic effects, proper management, and optimal regime, several fundamental questions still seem to remain unsettled. One of them, which is related to the topic of the paper and may be most controversial, is the question of the appropriate (or equilibrium) level of exchange rates. In this regard, my question is whether the absolute stability of real effective exchange rates can be a proper indicator for the appropriateness of exchange rate policies. Not to mention the many problems involved in the calculation of these rates, there are also cases in which they should be allowed to change, especially in view of certain real shocks to the economy, such as crop failure and shifts in export demand.

Finally, regarding the liberalization of capital controls, the potential risk of destabilizing capital flows seems to be much greater in reality than in theory. It may be right, in principle, that if all of the controls on exchange and capital flows are liberalized in one quick step, the workings of the economy could get started from a new equilibrium position. Then no incentives for disruptive capital flows exist, only stabilizing capital flows. In practice, it would be much safer to make errors on the conservative side by taking a gradualist approach. This is especially true when we consider for the policymakers the existence of much distortion in the real sectors, as well as the financial sectors, of most of the developing economies the paper is concerned with. In addition, as long as liberalization continues to proceed, the credibility of policy would not diminish and the adjustment costs would not be much higher than the once-and-for-all liberalization.


Empirical Tests

In order to establish the statistical significance of the relationship observed in the text between growth, free market exchange rate premiums and discounts, and real interest rates, various lags were tested. The data for the tests are those in Tables 2, 4, and 6 in the text, that is, for five-year averages spanning the period 1970–88, and nine countries (Korea, Malaysia, the Philippines, Singapore, Thailand, Argentina, Brazil, Mexico, and Turkey).

The most satisfactory equation was the following (t-probabilities are shown in parentheses below the coefficients):

Coefficients therefore have the expected signs and the exchange rate and interest rate variables “explain” about one fourth of the variation in growth rates within the overall sample. Of particular interest is the pattern of actual and predicted growth rates:

East Asian GroupComparator Group

Although the equation does not predict all instances of significantly below-average growth performance (P3 and P4 in the East Asian group of countries and M’3 and M’4 in the comparator group), in all but one instance in the second group (T’1) where a below-average performance is predicted, it occurred (A2, A3, A4, B3, M’4, T’2). This supports the hypothesis that realistic interest and exchange rates are necessary but not sufficient conditions for satisfactory growth. The equation also explains fully differences in means between the two groups, suggesting the importance of such policies sustained over the longer run as exogenous shocks to growth even out between countries.


    AghevliBijanB.“Experiences of Asian Countries with Various Exchange Rate Policies,”in Exchange Rate Rules: The Theory Performance and Prospects of the Crawling Peg.ed. byJohnWilliamson (New York: St. Martin's Press1981) pp. 298318.

    Asian Development BankCapital Market Development in Selected Developing Member Countries of the Asian Development Bank (Manila1985).

    BalassaBela andJohnWilliamsonAdjusting to Success: Balance of Payments Policy in the East Asian NICs (Washington: Institute for International EconomicsJune1987).

    ChengHang-ShengFinancial Policy and Reform in Pacific Basin Countries (Lexington, Massachusetts1986.)

    EdwardsS.“The Order of Liberalization of Current and Capital Accounts,”in Economic Liberalization in Developing Countriesed. byA. M.Choksi andD.Papageorgiu (Blackwell1987).

    GroundRichardLynn“The Genesis of Import Substitution in Latin America,”CEPAL Review No. 36 Economic Commission for Latin America and the Caribbean (Santiago: United NationsDecember1988) pp. 179203.

    HughesHelened.Achieving Industrialization in East Asia (Sydney; Cambridge: Cambridge University Press1988).

    JohnstonR.Barry andOdd PerBrekk“Monetary Control Procedures and Financial Reform: Approaches, Issues, and Recent Experiences in Developing Countries,”IMF Working Paper No. 89/48 (Washington: International Monetary FundJune1989).

    KruegerAnneO.Liberalization Attempts and Consequences (Cambridge, Massachusetts: Ballinger1978).

    LalDeepak“The Political Economy of Economic Liberalization,”World Bank Economic Review (International) Vol. 1 (January 1987) pp. 27399.

    MathiesonDonaldJ.“Exchange Rate Arrangements and Monetary Policy,”prepared for the San Francisco Federal Reserve Conference on Pacific Basin Monetary Policy September 21–22 1987 IMF Working Paper No. 88/14 (Washington: International Monetary FundFebruary1988).

    McKinnonRonaldI.“The Order of Economic Liberalization: Lessons from Chile and Argentina,”in Carnegie-Rochester Conference Series on Public Policy 17 (North-Holland1982) pp. 15986.

    QuirkPeterJ.GrahamHaccheViktorSchoofs andLotharWenigerPolicies for Developing Forward Foreign Exchange Markets Occasional Paper No. 60 (Washington: International Monetary Fund1988).

    QuirkPeterJ.MartinGilmanKyung MoHuhPisitLeeahtam andJoslinLandell-MillsDevelopments in International Exchange and Trade Systems World Economic and Financial Surveys (Washington: International Monetary FundSeptember1989).

    ReisenHelmut andAxel vanTrotsenburg“Should the Asian NIC's Peg to the Yen,”Intereconomics (Federal Republic of Germany) Vol. 23 (July/August 1988) pp. 17277.

    RaffertyKevin“Taiwan's Embarrassment of Riches,”Institutional Investor (September1987) pp. 27578

    WickhamPeter“The Choice of Exchange Rate Regime in Developing Countries,”Staff PapersInternational Monetary Fund (Washington) Vol. 32 (June 1985) pp. 24888.

The author wishes to thank the discussant Bongsung Oum of the Korean Development Institute and colleagues in the Fund, including Jeffrey Davis and Jose Fajgenbaum, for helpful comments, also Virgilio Sandoval for capable research assistance. Remaining errors are, of course, the author's responsibility.

Absolute annual percentage changes in real effective exchange rates averaged over the period 1971–88 were higher in the following countries: Argentina, 31 percent; Mexico, 12 percent; and the Philippines, 10 percent. In the six other countries (Korea, Malaysia, Singapore, Thailand, Brazil, and Turkey), the corresponding averages were in the relatively narrow range of 6 to 8 percent.

The relevance of black or free secondary market rates has become clearer from the experience with the introduction of independently floating exchange rates by a number of developing countries in recent years. In the absence of official intervention in most instances, after the official rate was floated, the new certified rate moved initially to a level close to that of the black market rate prevailing before the float.

Quantification of the overall intensity of systems of quantitative restrictions is inherently difficult and has to involve qualitative judgments. To date, econometric testing of such data along with other determinants of the balance of payments has been confined largely to “on-off” dummy variables for specific measures rather than overall restrictiveness—although such tests are the only means of establishing the validity of indicators of overall restrictive intensity.

The absence of clearing forward exchange markets in several countries precludes calculation of covered interest differentials. In lieu of these, the use of real interest rate differentials assumes that purchasing power parity determination of the exchange rate is approximated in the short run.

This is not to say that development is a simple matter of the ratio of exports to GDP. Clearly, the size of the internal market is a factor. As an example, Japan achieved takeoff with a structure that was less export oriented (reaching a maximum ratio of 15 percent of GDP only by 1984).

See the Appendix for econometric testing of the role of the first two variables in growth.

In the 1980s, developing countries' exchange rate regimes have yielded markedly different magnitudes of real effective exchange rate adjustment. In descending order of adjustment the regimes have been ordered as follows: independently floating, managed floating, single currency pegs, and composite pegs (see Quirk and others (1989, p. 11)).

Countries with severe payments difficulties have also tended to carry a large portion of reserves that is earmarked against liabilities: these are not truly “in reserve.”

In the absence of capital controls or taxes, and interest rate controls.

The United States in 1974, Switzerland in 1979, and the Federal Republic of Germany and the United Kingdom in 1978.

Bijan B. Aghevli, “Exchange Rate Policies of Selected Asian Countries,” in Exchange Rate Rules: The Theory, Performance, and Prospect of the Crawling Peg, ed. by John Williamson (New York: St. Martin's Press, 1981), pp. 298–318.

    Other Resources Citing This Publication