Abstract

Whenever a country undertakes a program of balance of payments adjustment, it needs to consider whether a change in the exchange rate is required to achieve a viable external position and a reasonable rate of economic growth over the medium term. The ways in which exchange rate policy works to correct balance of payments problems and to improve the allocation of resources are well known and need no repetition here. To provide a setting for the discussion in the remainder of the paper, however, this section briefly considers four conceptual issues: (1) the use of indicators to assess the appropriateness of the exchange rate in adjustment programs; (2) the role of exchange rate policy in relation to other program policies; (3) the extent to which exchange rate stability should in itself be a proximate policy objective in adjustment programs; and (4) the attention given to exchange rate policy when use of Fund resources is involved.

Whenever a country undertakes a program of balance of payments adjustment, it needs to consider whether a change in the exchange rate is required to achieve a viable external position and a reasonable rate of economic growth over the medium term. The ways in which exchange rate policy works to correct balance of payments problems and to improve the allocation of resources are well known and need no repetition here. To provide a setting for the discussion in the remainder of the paper, however, this section briefly considers four conceptual issues: (1) the use of indicators to assess the appropriateness of the exchange rate in adjustment programs; (2) the role of exchange rate policy in relation to other program policies; (3) the extent to which exchange rate stability should in itself be a proximate policy objective in adjustment programs; and (4) the attention given to exchange rate policy when use of Fund resources is involved.

Most situations in which exchange rate policy is an issue are characterized by both excess demand and incorrect relative prices. In addition, almost all of the countries undertaking Fund-supported adjustment programs in recent years have been developing countries, where the level of institutional and statistical development limits the range of policy choice and the feasible types of economic analysis. A third salient characteristic of program countries is that, by and large, they maintain severe restrictions on external transactions, a factor which complicates exchange rate analysis. Because restrictions generally affect the demand side of the foreign exchange market more than the supply side, the currency depreciation consistent with efficient allocation of the country’s resources would need to go beyond that indicated by the need to deal with the immediate problem in the external accounts.

Assessment of the Appropriateness of the Exchange Rate3

An essential element in the design of adjustment programs is assessment of the appropriateness of the exchange rate.4 This paper focuses mainly on the indicators that have been used in such assessments in Fund-supported adjustment programs. These indicators may help to evaluate the medium-term implications of a given exchange rate, or may be used to determine the amount of exchange rate action required at the outset of a program, as well as the timing and amount of subsequent exchange rate adjustment.

Where the exchange rate is freely determined by market forces, indicators may not be needed to decide the amount of exchange rate action. Nevertheless, indicators play an important role in assessing both the likely future path of the rate and its consistency with the program’s other objectives. Such an assessment might not raise questions about exchange rate policy as such, but could suggest a need to adjust other policies to produce a rate that is more appropriate from a medium-term perspective.

Full market determination of the exchange rate is relatively rare in Fund-supported adjustment programs. Fund resources are provided to ease the process of adjustment, and in that sense are effectively available for intervention in the exchange market.5 Such support may, of course, be provided in a form broadly consistent with the principle of market determination. For example, limits may be imposed on the amount of intervention during a given period. Most countries— particularly developing countries—go further and follow exchange rate arrangements where the rate is determined administratively.6 In these cases, a basis needs to be found to determine any initial devaluation and to guide further exchange rate action during the program period. The indicators discussed later in this paper serve this purpose.

Because indicators are necessarily imperfect, there is always a danger that they may give misleading signals regarding the appropriate rate. In a restriction-free system, however, deviations from the market-clearing rate will show up in a need for intervention, which provides an automatic check on the signals provided by indicators. Restrictions on external transactions interfere with the operation of this corrective mechanism. The fact that few Fund-supported adjustment programs provide for early elimination of restrictions means that exchange rate policy relies on indicators to a greater extent than would otherwise be the case. Great care therefore must be exercised in their use.

The Relation Between the Exchange Rate and Other Policies

The policy mix chosen to restore a sustainable external position depends on the size and nature of the external imbalance, as well as the economic efficiency and sociopolitical implications of the various policy instruments. A relative price adjustment may not be needed in some instances where a sustainable external position can be restored by reducing aggregate expenditure without incurring unacceptable short-term losses in output and employment.7 Similarly, where a moderate improvement in competitiveness is indicated, it may be feasible to correct relative prices through demand restraint, particularly if such action is supported by incomes policy and other means. Where a major improvement in competitiveness is required, however, exclusive reliance on demand restraint and related policies is unduly costly in terms of forgone output and unemployment, particularly where costs and prices are relatively unresponsive to such policies.

By contrast, an exchange rate adjustment immediately corrects the price misalignment and permits adjustment to take place at higher levels of economic activity. Generally, the desired change in relative prices cannot be accomplished without some immediate increase in the price level, but appropriate supporting policies will limit the increase.8 Although the superiority of exchange rate policy as a means of correcting major price misalignments is likely to be empirically valid for all countries, the optimum policy mix and the extent of reliance on exchange rate policy will be considerably influenced by a country’s individual characteristics, such as the extent to which incomes policy can be used to adjust relative prices. If price inflation tends to be passed through to wages, for example, a targetted improvement in competitiveness will require a larger devaluation than when wages are less intimately linked to prices.

The weights assigned to various policy objectives will also influence the policy mix. A larger devaluation will, other things being equal, permit adjustment to occur at higher levels of production and employment, but perhaps at the cost of a more immediate and visible effect on income distribution. Over the medium term, there are clear advantages to the stronger action; but the immediate political consequences may be more severe.9 Concern over the short-term impact on inflation of a realignment of relative prices and over the distributional effects of a devaluation, in some cases, may lead a country’s authorities to choose adjustment policies that rely heavily on demand restraint. Such a lesser exchange rate action may well be consistent with adequate adjustment, although the process will be slower and more painful. There is thus an element of flexibility in choosing the policy mix. Beyond that range of flexibility, any shortfall significantly lowers the likelihood of successful adjustment.

Any assessment of exchange rate policy therefore needs to be carried out in the context of an overall policy assessment. Because the extent of the needed exchange rate action depends on the stance of other policies, indicators of the rate’s appropriateness cannot be applied automatically, even when they are free of the various conceptual and statistical weaknesses noted in Chapter IV.

A policy objective that has particularly intimate ties to exchange rate policy is the avoidance of restrictions on external transactions. Insofar as restrictions are used to maintain the exchange rate at a level other than that consistent with market clearing (after allowance for any stabilizing intervention), the rate cannot be considered to be fully appropriate. Consistent with the Fund’s objective of promoting reduced reliance on restrictions on external transactions (particularly on current exchange transactions), Fund-supported adjustment programs generally aim at reducing such restrictions. In case of a severe imbalance, however, the extent of the needed policy adjustment is often so great that action on restrictions is postponed. So long as restrictions remain, adjustment cannot be considered complete, and any assessment of the appropriateness of the exchange rate needs to take this into account.

Exchange Rate Stability as a Proximate Policy Objective

Aside from wishing to avoid whatever costs may be associated with short-term exchange rate volatility, for many countries intervention to stabilize the exchange rate is a means of reducing the impact on the economy of short-term real (as opposed to monetary) shocks. In most developing countries, moreover, exchange markets are thin and financial markets undeveloped, increasing both the volatility of market-determined rates and the cost of hedging against future fluctuations.10 In any case, virtually all developing countries exercise some degree of exchange rate management.

Pegging a currency involves a particularly strong commitment to exchange rate stability. Formal commitment to a realistic peg can help stabilize capital flows, provided that exchange market transactors have confidence that other policies will be consistent with maintaining the rate. Commitment to a realistic peg may also produce more general stabilizing effects. Because the currencies chosen as pegs typically belong to stable, low-inflation countries, maintenance of the peg implies that the pegging country has to follow stable financial policies.11 If the pegging country does not follow such policies, adherence to the peg will in itself lead to difficulties.

An important issue for exchange rate policy in adjustment programs is the extent to which it is appropriate to continue with a pre-existing peg, even when the need for adjusting relative prices suggests that exchange rate flexibility, at least to the extent of a change in the peg, would be desirable. The dilemma is clear: when there is a great need to enhance competitiveness, programs that rely exclusively on demand management will exact heavy costs in terms of forgone output and unemployment over a prolonged period. At the same time, provided that developments and policies have not irreparably shaken confidence in the rate’s viability, maintaining the peg may encourage public acceptance of the adjustment measures and enhance their effectiveness. Where such confidence can no longer be sustained, as in cases of severe inflation, or where the rate is supported by restrictions on external transactions, devaluation is clearly necessary.

The question of what importance should be attached to exchange rate stability is particularly relevant in two very different situations: countries that have a particularly strong institutional commitment to fixed rates, as in the case of members of currency unions, and, at the other extreme, countries whose exchange rates have changed frequently, as in the case of many countries with a history of high inflation. Some aspects of this question are examined in Chapter V.

Exchange Rate Policies in the Context of Fund-Supported Adjustment Programs

In determining whether Fund resources will be used to support a country’s adjustment program, the Fund has to be satisfied that the policy changes adopted under the program will be sufficient to allow the balance of payments problem to be overcome and to permit timely repurchases to be made without undue strain. This judgment in turn depends on assessments of the magnitude and character of the balance of payments problem and the effects of the corrective policies adopted before the request for support was made. Sets of alternative policies to achieve the needed adjustment also are evaluated. Accordingly, discussions between the Fund staff and member country officials regarding requests for use of Fund resources focus on all of these questions, as well as on establishing monitoring mechanisms that provide adequate assurance that the policies adopted will accomplish the required amount of adjustment.

It is in this context that the role of exchange rate policy in the adjustment program figures in the discussions between the Fund staff and member country officials. The first step in the process is a convergence of technical views with regard to the dimensions of the balance of payments problem and its causes. Because there is generally a history of discussions on these issues between the Fund staff and country authorities, this first step normally presents few difficulties, although assessments of the implications of a given set of information may differ.

More complex discussions often take place regarding the precise form of the adjustment package and the role to be played in it by the exchange rate. Although the process is essentially technical, it involves political considerations to the extent that the country authorities must choose among alternative sets of policies involving an equivalent amount of overall adjustment, but with varying adjustment paths which may have different political implications. It is generally preferable to take the entire amount of an indicated exchange rate action at the outset, but the immediate and visible effects of such a policy on recorded inflation and on the sectoral distribution of income may make such a step politically difficult. Nevertheless, failure to implement fully the indicated exchange rate action requires stronger compensating action in other areas, which may also involve choices with political implications. Considerable discussion is sometimes required between the Fund staff and member country officials to work out a set of measures that takes the political constraints adequately into account, while maintaining an appropriate speed of adjustment and avoiding excessive reliance on adjustment instruments that have unduly high costs in other respects.