Monday 16 Jul 2018 | 05:37 | SYDNEY
Monday 16 Jul 2018 | 05:37 | SYDNEY

Exchange rates: To float or to fix?


Stephen Grenville

22 January 2010 08:32

I'm glad Mark has put exchange rates on the Lowy blog agenda. With the severe damage that the Global Financial Crisis has done to the credibility of the efficient markets hypothesis, it's time to look at exchange rates again.

Even the International Monetary Fund (typically ten years behind in its understanding of how the real world works) has finally realised that something is wrong with its prescription that countries should adopt the so-called 'corner solutions' — either have a pure free float or an immutably-rigid fixed rate. It pushed this prescription in the aftermath of the Asian Crisis of 1997-8. But the Fund has noticed that almost no emerging market country has taken its advice, and it is now advocating the very thing it said was either wrong or impossible, or both, ten years ago.

The truth is that a rigid fix is almost never the way to go, unless, like Hong Kong, you have a Big Brother to give you endless support. As for a pure free float, exchange rates are not well anchored in emerging countries and are pushed around by volatile capital flows. Is it possible to conduct a middle-path policy, relying on the market most of the time but retaining the capacity and readiness to intervene when the market goes awry? Well, just about all the emerging countries of our region have done just that, and it has worked fine so far.

Of course, this is not the only issue on which the IMF might issue a mea culpa. It's hard to imagine, even in the different circumstances of the time, that the Fund would now offer the advice it gave Indonesia in 1997:

  • Free-float the exchange rate.
  • Raise interest rates until the exchange rate stabilises.
  • Sharply tighten fiscal policy.
  • Tightly restrict base money growth.
  • Shut down troubled banks immediately.
  • Don't offer universal deposit insurance to other banks.
  • Embark on  politically-difficult major structural reforms in the middle of the crisis.

Photo by Flickr user Tony Bracjun, used under a Creative Commons license.