Since the mid-1970s, many developing countries have altered their exchange rate regimes. They have moved away from pegging to a single currency toward either pegging to a basket of currencies or adopting a more flexible arrangement under which the domestic currency is frequently adjusted.
Table 1 presents the patterns of exchange arrangements of developing countries during 1976–89. The proportion of developing countries pegging to a single currency has declined steadily from 63 percent in 1976 to 38 percent in 1989.1 The proportion of countries pegging to the U.S. dollar declined from 43 percent to 24 percent during this period. The share of countries pegging to the pound sterling fell even more dramatically; in fact, by 1989, no country pegged to this currency. By contrast, the French franc held its ground, as the countries in the Communauté Financière Africaine (CFA) franc zone maintained their currency union arrangement.
Developing Countries: Exchange Rate Arrangements, 1976-891
(In percent of total number of countries)
Based on mid-year classifications, except for 1989, which is based on end-year classification, excludes Democratic Kampuchea, for which no information is available.
Includes the following categories: “flexibility limited vis-à-vis single currency,” “managed floating,” and “independently floating.”
Developing Countries: Exchange Rate Arrangements, 1976-891
(In percent of total number of countries)
| Classification | 1976 | 1979 | 1983 | 1999 | |
|---|---|---|---|---|---|
| Pegged to a single currency | 62.6 | 52.1 | 43.5 | 38.2 | |
| U.S. dollar | 43.0 | 35.0 | 29.0 | 23.7 | |
| French franc | 12.1 | 12.0 | 10.5 | 10.7 | |
| Other currency | 4.7 | 2.5 | 3.2 | 3.8 | |
| (Pound sterling) | (2.8) | (2.6) | (0.8) | (—) | |
| Pegged to composite | 23.4 | 23.1 | 28.2 | 28.2 | |
| SDR | 10.3 | 11.1 | 11.3 | 5.3 | |
| Other (currency basket) | 13.1 | 12.0 | 16.9 | 22.9 | |
| Flexible arrangements | 14.0 | 24.8 | 28.3 | 33.6 | |
| Adjusting to Indicators | 5.6 | 3.4 | 4.0 | 3.8 | |
| Other2 | 8.4 | 21.4 | 24.3 | 29.8 | |
| Total | 100.0 | 100.0 | 100.0 | 100.0 | |
Based on mid-year classifications, except for 1989, which is based on end-year classification, excludes Democratic Kampuchea, for which no information is available.
Includes the following categories: “flexibility limited vis-à-vis single currency,” “managed floating,” and “independently floating.”
Developing Countries: Exchange Rate Arrangements, 1976-891
(In percent of total number of countries)
| Classification | 1976 | 1979 | 1983 | 1999 | |
|---|---|---|---|---|---|
| Pegged to a single currency | 62.6 | 52.1 | 43.5 | 38.2 | |
| U.S. dollar | 43.0 | 35.0 | 29.0 | 23.7 | |
| French franc | 12.1 | 12.0 | 10.5 | 10.7 | |
| Other currency | 4.7 | 2.5 | 3.2 | 3.8 | |
| (Pound sterling) | (2.8) | (2.6) | (0.8) | (—) | |
| Pegged to composite | 23.4 | 23.1 | 28.2 | 28.2 | |
| SDR | 10.3 | 11.1 | 11.3 | 5.3 | |
| Other (currency basket) | 13.1 | 12.0 | 16.9 | 22.9 | |
| Flexible arrangements | 14.0 | 24.8 | 28.3 | 33.6 | |
| Adjusting to Indicators | 5.6 | 3.4 | 4.0 | 3.8 | |
| Other2 | 8.4 | 21.4 | 24.3 | 29.8 | |
| Total | 100.0 | 100.0 | 100.0 | 100.0 | |
Based on mid-year classifications, except for 1989, which is based on end-year classification, excludes Democratic Kampuchea, for which no information is available.
Includes the following categories: “flexibility limited vis-à-vis single currency,” “managed floating,” and “independently floating.”
A number of countries have chosen to peg their currencies to the SDR as a convenient method of approximating the relative importance of the major currencies in international transactions. The proportion of these countries, however, has declined from about 10 percent during 1976-83 to 5 percent by the end of the 1980s. By contrast, the share of countries opting to peg to a trade-weighted basket of currencies has risen sharply—from 13 percent in 1976 to 23 percent in 1989.
The decision by an increasing number of developing countries to switch their pegging arrangement from a single currency to a composite basket of currencies has been prompted partly by the desire to minimize the adverse effects on their economies of fluctuations in the exchange rates of major currencies that have taken place since the advent of generalized floating in 1973, and particularly in the 1980s. These fluctuations have engendered various problems for the developing countries, ranging from uncertainty about the profitability of investment in traded goods sectors, to the management of public finances, external debt, and foreign exchange reserves.
Developing countries have also increased their reliance on more flexible arrangements under which the exchange rate is adjusted frequently. These arrangements are often officially described as “adjusting to indicators,” “managed floating” or “independently floating,” but these terms do not accurately reflect the arrangements in place, as in an overwhelming majority of cases the exchange rate is effectively set by the authorities, albeit adjusted frequently. For the purpose of the present discussion, these arrangements are described as “flexible.”2 As is evident from Table 1, during 1976-89 the proportion of countries relying on flexible arrangements more than doubled, to one third of the total.
The increased use of more flexible exchange rate arrangements in developing countries can be attributed to a number of factors. First, domestic rates of inflation in many developing countries have sharply accelerated during the 1980s. This acceleration was particularly pronounced in the countries of the Western Hemisphere—their average rate of inflation rose from 25 percent in the late 1970s to nearly 300 percent in the late 1980s—but was also evident in some of the developing countries in Africa and Europe. These countries were forced to depreciate their currencies rapidly to avoid a deterioration in external competitiveness. In fact, in many of these countries, the nominal exchange rate and domestic inflation were systematically linked.
Second, the adoption of more flexible arrangements has been encouraged by the uncertainty associated with the fluctuations in the exchange rates of the major currencies. As indicated earlier, many countries have adopted a basket peg to neutralize the effects of such fluctuations on their economies. However, some countries have been reluctant to adopt such an arrangement, as it would entail frequent adjustments of the exchange rate vis-à-vis the intervention currency according to a preannounced formula. These countries have been particularly unwilling to follow those movements of major currencies which they considered to be transitory. Furthermore, given the political stigma attached to devaluation under a pegged regime, an increasing number of countries have found it expedient to adopt a more flexible arrangement for adjusting the exchange rate on the basis of an undisclosed basket of currencies. Such an arrangement enables the authorities to take advantage of the fluctuations in major currencies to camouflage an effective depreciation of their exchange rate, thus avoiding the political repercussions of an announced devaluation.
It is useful to review the exchange rate arrangements adopted by the developing countries in different regions and the movements of the exchange rate indices under different arrangements. For the purposes of this review, the countries that kept their exchange rate arrangement broadly unchanged throughout 1982-89 were put into two groups—pegged and flexible.3 With very few exceptions, countries in Africa and in the Middle East adopted a pegged regime. Asian countries generally fell in the flexible category, although a few pegged their currency to a basket. The developing countries in Europe and in the Western Hemisphere adopted both types of arrangements, with low-inflation countries generally adopting a pegged regime, and high-inflation countries a flexible regime.
Table 2 provides the movements of exchange rate indices for the two groups. For the pegged group, the nominal exchange rate initially appreciated, but sharply depreciated after 1985, reflecting both a weakened U.S. dollar (to which the currencies of many of the countries in this group were pegged) and more frequent devaluations. This pattern was mirrored in the movements of the real exchange rate, despite a rise in the average rate of inflation for this group. For the whole period, the real exchange rate for the pegged group depreciated by about 11 percent, but this depreciation masked large differences among the subgroups using different pegging arrangements (single currency, trade-weighted baskets, or the SDR).
Trend Movements of Relative Prices, Nominal Effective Exchange Rate, and Real Effective Exchange Rate for Groups According to their Exchange Rate Arrangement, 1982-89
(Cumulative percentage change)
Using a log-linear formulation, the real effective exchange rate (re) is defined as the nominal effective rate (ne) adjusted for the difference between a weighted average of foreign prices (fp) and domestic prices (dp):
Trend Movements of Relative Prices, Nominal Effective Exchange Rate, and Real Effective Exchange Rate for Groups According to their Exchange Rate Arrangement, 1982-89
(Cumulative percentage change)
| 1982-85 | 1986-89 | 1982-69 | |||
|---|---|---|---|---|---|
| Pegged arrangement | |||||
| Relative prices (rp) | 4.2 | −19,8 | −15.6 | ||
| Nominal effective rate (ne) | 9.0 | −35.6 | −26.6 | ||
| Real effective race (re) | 4.7 | −15.8 | −11.1 | ||
| To U.S. dollar | |||||
| Relative prices (rp) | 3.7 | −64.7 | −60.9 | ||
| Nominal effective rate (ne) | 19.5 | −76.1 | −56.6 | ||
| Real effective rate (re) | 15.8 | −11.4 | 4.3 | ||
| To French franc | |||||
| Relative prices (rp) | 5.2 | 18.4 | 23.6 | ||
| Nominal effective rate (ne) | −1.5 | 15.8 | 14.3 | ||
| Real effective rate (re) | −6.7 | −2.6 | −9.3 | ||
| To SDR | |||||
| Relative prices (rp) | 4.7 | −2.2 | 2.5 | ||
| Nominal effective rate (ne) | 19.8 | −20.1 | −0.3 | ||
| Real effective rate (re) | 15.1 | −17.9 | −2.9 | ||
| To composite | |||||
| Relative prices (rp) | 4.1 | 0.9 | 4.9 | ||
| Nominal effective rate (ne) | 1.1 | −28.0 | −26.9 | ||
| Real effective rate (re) | −3.0 | −28.9 | −31.9 | ||
| Flexible arrangement | |||||
| Relative prices (rp) | −72.9 | −101.8 | −174.7 | ||
| Nominal effective rate (ne) | −88.3 | −123.4 | −211.6 | ||
| Real effective rate (re) | −15.3 | −21.6 | −36.9 | ||
Using a log-linear formulation, the real effective exchange rate (re) is defined as the nominal effective rate (ne) adjusted for the difference between a weighted average of foreign prices (fp) and domestic prices (dp):
Trend Movements of Relative Prices, Nominal Effective Exchange Rate, and Real Effective Exchange Rate for Groups According to their Exchange Rate Arrangement, 1982-89
(Cumulative percentage change)
| 1982-85 | 1986-89 | 1982-69 | |||
|---|---|---|---|---|---|
| Pegged arrangement | |||||
| Relative prices (rp) | 4.2 | −19,8 | −15.6 | ||
| Nominal effective rate (ne) | 9.0 | −35.6 | −26.6 | ||
| Real effective race (re) | 4.7 | −15.8 | −11.1 | ||
| To U.S. dollar | |||||
| Relative prices (rp) | 3.7 | −64.7 | −60.9 | ||
| Nominal effective rate (ne) | 19.5 | −76.1 | −56.6 | ||
| Real effective rate (re) | 15.8 | −11.4 | 4.3 | ||
| To French franc | |||||
| Relative prices (rp) | 5.2 | 18.4 | 23.6 | ||
| Nominal effective rate (ne) | −1.5 | 15.8 | 14.3 | ||
| Real effective rate (re) | −6.7 | −2.6 | −9.3 | ||
| To SDR | |||||
| Relative prices (rp) | 4.7 | −2.2 | 2.5 | ||
| Nominal effective rate (ne) | 19.8 | −20.1 | −0.3 | ||
| Real effective rate (re) | 15.1 | −17.9 | −2.9 | ||
| To composite | |||||
| Relative prices (rp) | 4.1 | 0.9 | 4.9 | ||
| Nominal effective rate (ne) | 1.1 | −28.0 | −26.9 | ||
| Real effective rate (re) | −3.0 | −28.9 | −31.9 | ||
| Flexible arrangement | |||||
| Relative prices (rp) | −72.9 | −101.8 | −174.7 | ||
| Nominal effective rate (ne) | −88.3 | −123.4 | −211.6 | ||
| Real effective rate (re) | −15.3 | −21.6 | −36.9 | ||
Using a log-linear formulation, the real effective exchange rate (re) is defined as the nominal effective rate (ne) adjusted for the difference between a weighted average of foreign prices (fp) and domestic prices (dp):
For the flexible group, an active exchange rate policy led to a significant depreciation of the real exchange rate (37 percent). Although the average inflation rate was much higher for the flexible group than the pegged group, the average depreciation of the real effective exchange rate was much greater for the flexible group. Thus, at this level of generality (and without any presumption about the direction of causality), exchange rate flexibility, improvement in external competitiveness, and domestic inflation seem to be positively correlated. The depreciation of the real exchange rate, however, was particularly pronounced for the Asian countries, which, although adopting a flexible arrangement, maintained low inflation rates.
Some countries classified under the pegged regime have undertaken frequent devaluations.
This grouping includes countries with a floating arrangement under which the exchange rare is determined by the market. Such floating arrangements, however, are relatively rare in the developing countries owing to institutional and structural reasons, although a number of countries have experimented with auction markets (see Quirk and others (1987)).
This period was chosen because the pattern of exchange rate arrangements across countries was much more stable after 1982 than in the earlier period.