6 Fluctuating; Rates in the Par Value Era
- Margaret De Vries
- Published Date:
- June 1986
While the regime of par values was in force, a great deal of misconception existed about the Fund’s attitudes toward fluctuating exchange rates, or as they are usually called, “floating rates.” Critics frequently suggested that the Fund was too uncompromising in its support of the then prevailing world-wide system of fixed exchange rates. The implication was that the Fund’s attitude stemmed primarily from the formal requirements of its original Articles of Agreement, or that the economic reasoning of Fund officials was too rigid. This article takes a deeper look at what the Fund’s policies were, and their underlying rationale.
After its establishment and for the next quarter century, the Fund consistently and strongly supported the system of institutionally agreed par values. However, this stand only in part reflected the requirements of its original Articles; it owed far more to the Fund’s own widening experiences with deviations from that system. Furthermore—and this was much less generally realized—while the pursuit of fixed exchange rates remained the underpinning of its philosophy, the Fund also, temporarily and in carefully delineated circumstances, supported what it regarded as less than ideal types of exchange rate arrangements; these included fluctuating rates.
GRADUAL EROSION OF EARLY FORMAL APPROACHES
From 1946 to 1968, there were almost step-by-step movements in the Fund’s policies on fluctuating rates. In its very early days the Fund put primary stress on the fact that fluctuating rates were inconsistent with its Articles. Concern in these initial years with the formal, or legal, position of a member with a fluctuating rate is exemplified by the Fund’s first encounter with such a rate. In July 1948 Mexico suspended transactions at its par value and let the market set the exchange rate. The Mexican authorities did not wish to resort to exchange controls on outward capital movements—the source of the balance of payments deficit—and believed more time was required to determine an appropriate new par value.
For the newly formed International Monetary Fund, Mexico’s suspension of its par value posed a serious problem. The Fund regarded Mexico’s action as an important deviation from the requirements of the Articles of Agreement that had potentially farreaching consequences for the system of par values. Accordingly, the Mexican Government and the Fund were in continuous consultation with a view to establishing a new par value for the peso; this was done in July 1949, one year after the suspension of the initial par value.1
Very soon thereafter pragmatic considerations began to overshadow the more technical ones. Hoping that a few exceptions would not cause a return to the exchange rate instability of the pre-Fund era, the Fund recognized that in unusual circumstances a floating rate might be acceptable, at least temporarily.
The change in attitude was evidenced in November 1949 when Peru suspended transactions at its par value. Peru had had an exchange system consisting of three separate markets, the rates in one of which were fixed on the basis of the par value. The market with fixed rates was to be abolished and all transactions were to be conducted in two markets, both of which would have fluctuating rates. The rates in the two markets were expected to follow each other closely.
This time the Fund recognized the exigencies of the situation that had made Peru unable either to maintain its agreed par value or to select a new one immediately. There was possibly even something to praise in the proposed Peruvian exchange system. The proposed system was essentially unified and the new rates seemed realistic; this was substantially better than the complex multiple rates of several other Latin American members. Therefore, on the understanding that the purpose of Peru’s action was the eventual establishment of a unitary exchange rate at a more appropriate level than the par value that had been agreed with the Fund earlier, the Fund did not object to the use of the fluctuating rate as a temporary measure.
As of March 1, 1969, Peru still had not set a new par value. Meanwhile, the Fund had permitted Peru to draw on the Fund’s resources and to assume the obligations of Article VIII, that is, to be regarded as a member relatively free of restrictions and with a convertible currency.
The Instance of Canada A second example of the Fund’s acceptance, or at least tolerance, of a fluctuating rate in exceptional circumstances while the par value system was in operation was that of Canada, which had a fluctuating rate from September 1950 to May 1962. The fluctuating rate for the Canadian dollar was introduced to dampen a heavy inflow of capital, mainly from the United States. This inflow, which had become especially great in 1950, added to the money supply and tended to depress interest rates, thus augmenting inflationary pressures. The object of this exchange rate change was thus in contrast to most other exchange rate adjustments at the time, which were usually intended to rectify an unfavorable balance of trade and to check an outflow of capital. Because of the speculative nature of much of the capital inflow, the Canadian Government felt unable to foresee the end of the capital movements so long as a fixed exchange rate was maintained. Since the Canadian Government believed that it was impossible to determine in advance with any reasonable assurance what new par value would be appropriate, it announced that the rate of exchange should be left to be determined by market forces.
After discussion of possible alternative courses of action that Canada might follow, the Fund again, as in the instance of Peru, decided to recognize the exigencies of the situation as well as to take note of the intention of the Canadian Government to remain in consultation with the Fund and to re-establish an effective par value as soon as circumstances warranted.
By 1956 the Fund regarded Canada’s relative success with a fluctuating rate as a reflection of Canada’s unique circumstances. Canada had not only a trade deficit but also a substantial capital inflow. There was confidence in the Canadian dollar because of the fiscal and credit policies being followed. Canada was relatively free of restrictions and had a convertible currency. Moreover, the close economic relation between Canada and the United States led many persons to regard as natural a parity for the Canadian dollar somewhere near that of the U.S. dollar. Furthermore, close interdependence between short-term capital movements and movements of the exchange rate had caused capital flows on the whole to be equilibrating rather than disturbing. Finally, the exchange rate had fluctuated only about 3–5 percent, despite the absence of intervention by the authorities except to maintain an orderly exchange market. For these reasons, Canadian trade and normal capital transactions had not lost the important benefits commonly associated with exchange rate stability. The Canadian example was therefore not a precedent for the circumstances of other members.
By mid-1961 disenchantment with the way the Canadian rate had been operating since the late 1950s began to be discernible both among Canadian authorities and Fund officials. A very large deficit on current account had emerged, the rate of economic growth had decreased, and unemployment had risen. The Canadian authorities attributed these economic reverses in large part to the then unduly high exchange rate; the inflow of capital had caused the rate to reach a point at which it acted as a stimulus to imports and as some deterrent to exports. And the Fund itself, observing the adverse developments, had entered into active consultation with Canada concerning the circumstances in which the establishment of a new par value would be appropriate. On May 2, 1962, in the midst of exchange difficulties, Canada finally gave up its fluctuating rate and declared a new par value to the Fund.
Need for Special Rules for the Fund’s Transactions Other Fund members, who had never declared par values, also had fluctuating exchange rates, for example, Lebanon, the Syrian Arab Republic, and Thailand. In 1954, to facilitate its transactions in currencies for which fluctuating rates prevailed—such as drawings in these currencies or payment of additional local currency to preserve the value of its assets—the Fund set up special rules for computing exchange rates of those members with fluctuating rates. Computations were to be based on the midpoint between the highest and lowest rates for the U.S. dollar quoted for cable transfers for spot delivery in the main financial center of the member with the fluctuating currency on specified days.
As of 1968 computations under this decision had been made only for those members for which transactions no longer took place at their par values. As of August 15, for example, computed effective rates applied only to Argentina, Bolivia, Brazil, Chile, Colombia, Indonesia, Korea, Paraguay, Peru, and Venezuela.
FLUCTUATING RATES AND EXCHANGE REFORM
In a second set of circumstances, the Fund went somewhat further: in conjunction with exchange reform and stabilization, the Fund supported programs which included a fluctuating rate. To some extent Peru’s fluctuating rate, described above, had been introduced as part of an exchange reform. But even before reform, Peru’s exchange system had been fairly simple, inflation had not been severe, and the devaluation involved was modest. In the late 1950s the technique of using a fluctuating exchange rate to effect reform of very complex exchange systems, with a multiplicity of rates, became more widely used. Bolivia and Thailand were among the first, in 1955–56, to take this type of action. They were followed in the next few years by Chile, Paraguay, and Argentina. Similarly, in 1962, the Philippines resorted to a fluctuating rate as a means of devaluation and decontrol of restrictions; this rate lasted until November 1965.
At the time of stabilization after a prolonged period of inflation, these members devalued their currencies but not necessarily to new fixed rates. Fluctuating rates were used for a time as a means of finding the level at which the exchange rate could ultimately be maintained. In the circumstances that prevailed in those members, it was impossible to determine the appropriate level for the exchange rate in advance. Where a combination of quantitative restrictions and multiple rates existed, the level even of the current effective rate could not readily be determined. In any event, it was uncertain how effective any newly adopted anti-inflationary measures might be. The movements in prices and wages likely to follow the adoption of measures designed to eliminate distortions in the economy were also difficult to predict. In still other instances, a new par value could not be determined until after a new customs tariff schedule had been introduced. For all these reasons, as exchange reforms were undertaken in the late 1950s and early 1960s, several members had recourse to a single fluctuating rate.
Although problems arose, experiences with these temporary fluctuating rates often proved to be quite successful. Several members eventually stabilized these rates which became the basis for new par values.2 By 1962–63, the Fund, therefore turned to positive encouragement of exchange reform involving the temporary use of a fluctuating exchange rate.
Even more significant was that a fluctuating rate adopted in these circumstances carried with it an understanding between the member and the Fund that the fluctuating rate would be allowed to move in accordance with market forces; the authorities were to intervene only to maintain orderly market conditions. Even when the need for rate flexibility was recognized, the authorities often found it difficult to maintain a flexible rate. In the absence of clear criteria for exchange rate action, the tendency was to peg the rate at a level which soon became out of line with developments in the economy. Accordingly, in some members where a flexible rate policy was considered essential because of continuing inflation, a test was set up as a means of assuring that an exchange rate would be maintained that conformed to basic market trends. Such a test usually consisted of a prescribed minimum level at which the foreign exchange reserves of the member were to be maintained during a stated period, with exchange rate action taken whenever that level was threatened. Even so, inasmuch as most members were reluctant to see their exchange rates depreciate excessively, the Fund frequently had to ask members with flexible rates not to stabilize prematurely.
STABILITY, THE ULTIMATE OBJECTIVE
The Fund’s ultimate objective, nonetheless, even in cases of exchange reform, was to create the conditions for the restoration of a stable and unified exchange rate. The fluctuating rate was regarded as a temporary means to an end. Moreover, the Fund also continued to regard a general system of fixed rates and institutionally agreed par values as decidedly superior to a system of fluctuating rates. These positions were taken primarily because Fund officials believed that experience had revealed several weaknesses in fluctuating rates.
First, to those who advocated allowing rates to find their “natural” level, the Fund responded that there was no such thing as a natural level for the rate of exchange of a currency. The proper rate, in each case, depended upon the economic, financial, and monetary policies followed by the member concerned, and by other members with whom it had important economic relationships. In addition, whether a given exchange rate was at the “correct” level could be determined only after there had been time to observe the course of the balance of payments in response to that rate.
Second, movements in fluctuating rates were significantly affected by large speculative transfers of capital. Consequently, members preferred fixed rates which enabled them to make exchange rate adjustments in a manner that minimized distortions caused by speculation. In addition, fluctuating rates were often inappropriate where excessive outflows of capital, underinvoicing of exports, and smuggling had been troublesome. Also capital inflows that were based on speculation on movements in exchange rates might be induced.
Third, in circumstances of continuous inflation, fluctuating rates gave rise to a vicious circle of devaluation and inflation. On the one hand, flexible rates were necessary to prevent overvaluation, so long as internal prices were not stabilized. Yet under conditions of internal price instability, the rate depreciated regularly, which in turn contributed to even greater inflation. Furthermore, if a member did not clearly and quickly adopt a monetary policy aimed at general stability, its fluctuating rate was likely to oscillate not around a stable value but around a declining trend.
In this regard, the Fund concluded that it was an illusion to expect a fluctuating rate to ease the problems facing the monetary authorities. On the contrary, by eliminating the rallying point of the defense of a fixed par value, a fluctuating rate made it necessary for the authorities to exercise greater caution in determining monetary policy. Fluctuations of significant amplitude might themselves contribute to the forces leading to depreciation. Depreciation might create inflationary pressures. Indeed, depreciation of the exchange rate often outran the accompanying or ensuing price inflation.
Consequently, the Fund’s experience with fluctuating rates as of the 1960s suggested that members using this device had not found these rates useful for protecting their economies from pressures arising abroad. Moreover, should they pursue expansionary domestic policies, members might still lose reserves, unless the authorities were prepared to let the rate depreciate continuously.3 Furthermore, orderly exchange arrangements and exchange rate stability had been recognized by most members to be important and generally accepted objectives of economic policy. Even in member countries where the authorities were not prepared formally to stabilize the exchange rate on the basis of a realistic parity, de facto stable rates were often maintained for long periods. For these reasons, the Fund retained exchange rate stability as the ultimate goal even for those members that had temporarily resorted to fluctuating rates.
Finally, Fund officials had still another reason for preferring a general system of institutionally agreed par values. The Fund was a body for international consultation on exchange rate changes, and Fund officials feared that, under a system of flexible rates, exchange rate policy would tend to become much more a matter of unilateral action and thus make the process for international collaboration in financial matters far more difficult.
Thus, as debates over the relative merits of fixed and fluctuating exchange rates increased among economists in the 1960s, three major developments in the Fund’s policy were worth noting. First, Fund policy had evolved in a direction of accepting, indeed supporting, flexible rate regimes as temporary expedients where carefully defined exceptional circumstances seemed to warrant such flexibility; the Fund had not categorically opposed all such schemes. Fund policy had gone far beyond a mere reiteration of the requirements of its original Articles. Second, Fund policy in favor of fixed and stable rates had increasingly been based on its own widening unsatisfactory experiences with deviations from the par value system. Third, Fund officials were convinced that a general flexible rate system would make international monetary cooperation extremely difficult.