Executive summary : exchange rate policies in developing and post-socialist countries

They were joined, in 1989, by the countries of Eastern Europe, which threw off the legacy of communism and moved toward democracy and the free market. The experiences of the developing countries may offer lessons for the liberalization efforts of the formerly socialist countries. An important element in the liberalization and stabilization efforts of both groups of countries is exchange rate policy, and both are facing similar issues and choices. This paper examines a number of issues related to exchange rates, set in the larger context of macroeconomic policies. Conclusions include the following. Important differences and similarities exist between developing and socialist countries. For example, the socialist countries rely (or relied) on a centrally planned economy, while the developing countries rely, for the most part, on a market economy with a huge public sector and many disruptive state interventions. Most developing countries participate in multilateral international trade, while the socialist countries do not. Both socialist and developing countries, however, have experienced unbalanced growth, because both stressed industrialization at the expense of agriculture. Both types of countries suffer from disguised unemployment and from capital-intensive production due to the artificially low price of capital. Both have rudimentary financial systems. The currencies in the formerly socialist countries are not convertible into goods either internally or externally. With price controls in effect, a currency cannot function as a means of payment and a store of value, and goods take on the functions of money. Internally, goods are simultaneously abundant in hoarded supplies and in shortage in the marketplace. Externally, trade among Eastern European countries is basically bilateral (in other words, barter); shortages of goods obstruct multilateral trade. One result of the shortage of goods in a planned economy, and the main cause of inconvertibility, is monetary overhang; this overhang generates inflation during the transition period. Inflationary situations could be corrected by properly administered currency reform, with an appropriate mix of monetary, fiscal, and exchange rate stabilization. To succeed, any fundamental liberalization reform must be credible. For example, currency reforms are probably only credible when they are accompanied by a fixed exchange rate. The recent tendency in developing countries toward more flexible exchange rate arrangements may contribute to the external adjustment needed to absorb external shocks, but it could also be the result of internal mismanagement. In the latter case, more flexible exchange rates could mean the loss of a credible nominal anchor as a yardstick for monetary discipline. An important issue for both groups of countries is the sequencing of liberalization reforms. Gradual reform may lack credibility and lead to a complete failure of reforms. In general, it appears that trade liberalization should come before financial convertibility. The phenomenon of overvaluation has plagued many developing countries. Overvaluation can be blamed for the growth collapse of several countries during the 1980"s. A deliberate overvaluation policy can be used, in countries with an overvalued official rate and a black market rate, to generate considerable tax revenues. Recognition of an overvalued currency presumes knowledge of the fundamental real equilibrium exchange rate, which is important for all types of economies. The exchange rate policy of the newly industrialized countries (NIC"s) of East Asia is a special case among developing countries. These countries are close competitors, their development strategy is based on manufacturing and export-led growth, and their growth performance has been around 10% a year for the past two decades. These countries should not establish an Asian Monetary System, with Japan at the center, because there is relatively little intraregional trade among Asian economies compared with trade with the United States and Europe for exports and with Japan for imports. A potentially viable proposal is a managed joint float of the NIC"s with respect to a trade-weighted basket of key currencies. However, the political leadership for such a scheme seems to be lacking. The traditional choice between fixed and flexible exchange rates has changed to one between fixed and managed floating exchange rates. Candidates for a pegged exchange rate are small, open economies such as those of Eastern Europe. A managed floating exchange rate can be combined with the formation of a currency area. The worst of all exchange rate regimes, and one which has been observed in many developing countries in the past, is a fixed and overvalued exchange rate. (Author abstract)