Abstract

Since the Fund granted the first stand-by arrangements in the 1950s, its policies regarding the programs supported by such arrangements consistently have emphasized the need for an appropriate structure of relative prices to promote the attainment of a viable balance of payments. In the relatively stable economic environment of the 1950s and 1960s there tended to be more emphasis on adjustments through demand management, and most programs could exclude exchange rate action without seriously compromising their objectives. At the same time, there was a general international commitment to fixed exchange rates. In the 1970s the economic environment changed. Partly in response, commitment to fixed exchange rates was regarded as less important than before, and exchange rate action began to figure in the majority of Fund-supported adjustment programs. In the 1980s, the difficult economic environment, together with the need to correct serious distortions resulting from policy failures, has contributed to a continued increase in the incidence of exchange rate action in Fund-supported programs.

Since the Fund granted the first stand-by arrangements in the 1950s, its policies regarding the programs supported by such arrangements consistently have emphasized the need for an appropriate structure of relative prices to promote the attainment of a viable balance of payments. In the relatively stable economic environment of the 1950s and 1960s there tended to be more emphasis on adjustments through demand management, and most programs could exclude exchange rate action without seriously compromising their objectives. At the same time, there was a general international commitment to fixed exchange rates. In the 1970s the economic environment changed. Partly in response, commitment to fixed exchange rates was regarded as less important than before, and exchange rate action began to figure in the majority of Fund-supported adjustment programs. In the 1980s, the difficult economic environment, together with the need to correct serious distortions resulting from policy failures, has contributed to a continued increase in the incidence of exchange rate action in Fund-supported programs.

The Par Value Era—Emphasis on Demand Management

In the 1950s and 1960s, most stand-by arrangements were granted in support of programs designed to correct balance of payments problems that were moderate and uncomplicated by structural distortions in the economy. In view of the then-prevailing emphasis on maintaining par values, the adjustment process tended to rely mainly on demand management. Even so, there were many instances of stand-by arrangements that were granted to overcome payments difficulties of a more deep-seated character, often where balance of payments pressures had persisted for several years. These cases met the requirement under the par value system that exchange rate changes were to occur only in the event of a “fundamental disequilibrium.” Exchange rate action was thus a central element in such programs.

Of 85 upper credit tranche stand-by arrangements approved from 1963 to 1972, 26 (31 percent) involved action on the exchange rate or the exchange system (Table 1).12 Of the programs that did not include such action, about half were designed to correct overexpansionary demand management policies, and the remainder were intended to facilitate external debt rescheduling or to deal with problems, such as the impact of recession and temporary shortfalls in export receipts, for which exchange rate action was not considered a necessary solution.

Table 1.

Exchange Rate Action in Programs Supported by the Use of Fund Resources in the Upper Credit Tranches, 1963–83

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Source: Fund staff estimates.

Excludes arrangements where significant net purchases (not less than one half of one credit tranche) did not occur.

Includes countries for which a foreign currency is legal tender.

No programs with members of currency unions involved exchange rate action.

Increasing Emphasis on Medium-Term Structural Adjustment (1973–80)

With the growing strains in the par value system at the end of the 1960s, the Fund increasingly emphasized flexibility in exchange rate policy. In 1970, for example, the Fund’s first comprehensive review of the mechanism of exchange rate adjustment noted:

“In the past, adjustment of parities has often been considered appropriate only when evidence of fundamental disequilibrium has become overwhelming. If it were desired to increase the likelihood that necessary exchange adjustment would be prompt and to reduce the risks of delay, such adjustment might be implemented as soon as evidence of fundamental disequilibrium had become substantial, rather than overwhelming.”13

The sharp shifts in terms of trade, economic activity, and inflation rates associated with the major changes in oil prices in the 1970s meant that for many countries exchange rate action was a necessity if they were to return to a viable balance of payments position. At the same time, however, readily available international finance permitted many of them to postpone adjustment longer than before.

Moreover, the continuing preference of many countries for avoiding exchange rate action was evident. For example, a Fund staff review of the 1973–75 adjustment programs concluded that the objectives of five of the programs (out of a total of ten not involving a depreciation) could have been better served if they had included a currency depreciation. The review noted: “Because of the impact of exchange rate depreciation on prices and real incomes, the change of the external value of the currency has been a sensitive issue of stabilization programs. If any doubt existed, exchange rate action was postponed and instead the program relied on demand management policies to cope with the balance of payments problem.”14 Nonetheless, from 1973 to 1980, exchange rate action figured in 51 percent of programs supported by upper credit tranche stand-by arrangements—a considerably higher proportion than in the previous decade.

The increased incidence of exchange rate action demonstrated a growing emphasis on medium-term adjustment through structural reform. Fund-supported adjustment programs had always been oriented toward restoration of viability to the balance of payments over the medium term, but in most cases it was anticipated that the measures adopted in an initial one-year program would be adequate to do so, provided that financial policies remained appropriate. Establishment of the extended Fund facility in 1974 gave explicit recognition to the need for more time to implement programs where structural reforms were necessary. Of the 17 extended arrangements approved from the inception of the facility through 1980, 11 involved exchange rate action. The overall proportion of standby and extended arrangements during 1973–80 that involved adjustment of the exchange rate amounted to 53 percent.

Considerable emphasis also was given to the need for continuing adjustments of the exchange rate. More than half the stand-by arrangements involving exchange rate changes, for example, called for such adjustments during the program period in addition to any initial devaluation. In many of the programs without a change in exchange rate policy, moreover, it could be argued that such action would have been desirable. In four of the 1980 programs, for example, requests for the arrangements presented to the Fund’s Executive Board made it clear that a change in the exchange rate was under study by the authorities. In each program, understandings were to be reached on exchange rate policy at a later date.

The Prevalence of Exchange Rate Action (1981–83)

The adverse circumstances of the non-oil developing countries in the early 1980s have resulted in a sharp increase in recent years in the number of adjustment programs supported by use of Fund resources in the upper credit tranches. The overall incidence of exchange rate action in such programs has also risen sharply. During 1981–83, the incidence was 64 percent. In contrast to earlier years, countries which were members of currency unions or in which a foreign currency was legal tender accounted for a large number of the 1981–83 programs. Excluding such countries where exchange rate adjustment would require major changes in institutional arrangements, only 18 percent of Fund-supported adjustment programs during 1981–83 did not involve a change in exchange rate policy. Even some of these had previous or subsequent programs that included exchange rate action.

The incidence of exchange rate action was particularly marked in 1983. During that year only two programs with countries which were neither members of currency unions nor using a foreign currency as legal tender did not include an adjustment of the exchange rate. In both countries longstanding parities vis-à-vis the U.S. dollar resulted in an emphasis on stability of the exchange rate as a proximate policy objective. In this sense, they could be considered similar to members of currency unions.

The increasing resort to exchange rate action was a consequence of the continuing deterioration of the economic position of the non-oil developing countries at a time when the availability of external finance was declining sharply. This deterioration can be seen both in balance of payments developments15 and in various indicators of movements in relative prices, some of which are set out in Table 2. Domestically, inflation rates remained high, and in each of the years 1979–83 the median inflation rate involved a rise in consumer prices of at least 2.6 percent relative to the industrial country average. Despite the large number of countries undertaking exchange rate action during these years, most countries lost competitiveness. The median real effective exchange rate index increased each year to reach a level, by 1982, almost 10 percent above that of 1978. For one quarter of developing countries the increase in the real effective exchange rate index approached or exceeded 20 percent. Inflation rates declined in both developing and industrial countries in 1982 and 1983. The decline in 1983 was relatively much sharper in the industrial countries, and the median increase for the developing countries involved a rise in consumer prices of 5 percent relative to the industrial country average. More vigorous exchange rate action in 1983, however, succeeded in reducing somewhat the median real effective exchange rate index, though it remained substantially above its 1978 level and the upper quartile continued to increase. In each of the years 1980–82 the terms of trade for non-oil developing countries deteriorated, and with only a slight recovery in 1983 the cumulative deterioration since 1978 was nearly 10 percent.

Table 2.

Non-Oil Developing Countries: Selected Indicators of Relative Prices, 1979–83

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Sources: Country authorities; and Fund staff estimates.

Use of the median instead of the mean avoids giving a disproportionate weight to a few very high inflation countries.

Because countries needing adjustment could no longer postpone it through new external borrowing, an active exchange rate policy was usually essential both to reverse the inflation-induced erosion of profitability in the traditional tradable goods sectors and to provide incentives for the production of new tradables to counter the unfavorable external developments. The growing international experience with exchange rate adjustment also may have allayed some of the earlier misgivings about the use of this instrument. In addition, there may have been a lessening of concern that changing the exchange rate would be construed as an admission of failure of economic policies.