| Countries devalue their currencies only when they | | | | South America). The exchange rate is allowed to |
| have no other way to correct past economic | | | | move within a band, above and below a central |
| mistakes - whether their own or mistakes | | | | peg which, in itself depreciates daily at a preset |
| committed by their predecessors.The ills of a | | | | rate.This pre-determined rate reflects a planned |
| devaluation are still at least equal to its | | | | real devaluation over and above the inflation |
| advantages.True, it does encourage exports and | | | | rate.It denotes the country's intention to |
| discourage imports to some extents and for a | | | | encourage its exports without rocking the whole |
| limited period of time. As the devaluation is | | | | monetary boat. It also signals to the markets that |
| manifested in a higher inflation, even this | | | | the government is bent on taming inflation.So, |
| temporary relief is eroded. In a previous article in | | | | there is no agreement among economists. It is |
| this paper I described WHY governments resort | | | | clear that fixed rate systems have cut down |
| to such a drastic measure. This article will deal | | | | inflation almost miraculously. The example of |
| with HOW they do it.A government can be | | | | Argentina is prominent: from 27% a month (1991) |
| forced into a devaluation by an ominous trade | | | | to 1% a year (1997)!!!The problem is that this |
| deficit. Thailand, Mexico, the Czech Republic - all | | | | system creates a growing disparity between the |
| devalued strongly, willingly or unwillingly, after their | | | | stable exchange rate - and the level of inflation |
| trade deficits exceeded 8% of the GDP. It can | | | | which goes down slowly. This, in effect, is the |
| decide to devalue as part of an economic | | | | opposite of devaluation - the local currency |
| package of measures which is likely to include a | | | | appreciates, becomes stronger. Real exchange |
| freeze on wages, on government expenses and | | | | rates strengthen by 42% (the Czech Republic), |
| on fees charged by the government for the | | | | 26% (Brazil), even 50% (Israel until lately, despite |
| provision of public services. This, partly, has been | | | | the fact that the exchange rate system there is |
| the case in Macedonia. In extreme cases and | | | | hardly fixed). This has a disastrous effect on the |
| when the government refuses to respond to | | | | trade deficit: it balloons and consumes 4-10% of |
| market signals of economic distress - it may be | | | | the GDP.This phenomenon does not happen in |
| forced into devaluation. International and local | | | | non-fixed systems. Especially benign are the |
| speculators will buy foreign exchange from the | | | | crawling peg and the crawling band systems which |
| government until its reserves are depleted and it | | | | keep apace with inflation and do not let the |
| has no money even to import basic staples and | | | | currency appreciate against the currencies of |
| other necessities.Thus coerced, the government | | | | major trading partners. Even then, the important |
| has no choice but to devalue and buy back dearly | | | | question is the composition of the pegging basket. |
| the foreign exchange that it has sold to the | | | | If the exchange rate is linked to one major |
| speculators cheaply.In general, there are two | | | | currency - the local currency will appreciate and |
| known exchange rate systems: the floating and | | | | depreciate together with that major currency. In |
| the fixed.In the floating system, the local currency | | | | a way the inflation of the major currency is thus |
| is allowed to fluctuate freely against other | | | | imported through the foreign exchange |
| currencies and its exchange rate is determined by | | | | mechanism. This is what happened in Thailand |
| market forces within a loosely regulated foreign | | | | when the dollar got stronger in the world |
| exchange domestic (or international) market. Such | | | | markets.In other words, the design of the pegging |
| currencies need not necessarily be fully convertible | | | | and exchange rate system is the crucial |
| but some measure of free convertibility is a sine | | | | element.In a crawling band system - the wider the |
| qua non.In the fixed system, the rates are | | | | band, the less the volatility of the exchange rate. |
| centrally determined (usually by the Central Bank | | | | This European Monetary System (EMS - ERM), |
| or by the Currency Board where it supplants this | | | | known as "The Snake", had to realign itself a few |
| function of the Central Bank). The rates are | | | | times during the 1990s and each time the solution |
| determined periodically (normally, daily) and | | | | was to widen the bands within which the |
| revolve around a "peg" with very tiny | | | | exchange rates were allowed to fluctuate. Israel |
| variations.Life being more complicated than any | | | | had to do it twice. On June 18th, the band was |
| economic system, there are no "pure cases".Even | | | | doubled and the Shekel can go up and down by |
| in floating rate systems, Central banks intervene | | | | 10% in each direction.But fixed exchange rates |
| to protect their currencies or to move them to | | | | offer other problems. The strengthening real |
| an exchange rate deemed favourable (to the | | | | exchange rate attracts foreign capital. This is not |
| country's economy) or "fair". The market's invisible | | | | the kind of foreign capital that countries are |
| hand is often handcuffed by "We-Know-Better" | | | | looking for. It is not Foreign Direct Investment |
| Central Bankers. This usually leads to disastrous | | | | (FDI). It is speculative, hot money in pursuit of |
| (and breathtakingly costly) consequences. Suffice | | | | ever higher returns. It aims to benefit from the |
| it to mention the Pound Sterling debacle in 1992 | | | | stability of the exchange rate - and from the high |
| and the billion dollars made overnight by the | | | | interest rates paid on deposits in local currency.Let |
| arbitrageur-speculator Soros - both a direct result | | | | us study an example: if a foreign investor were |
| of such misguided policy and hubris.Floating rates | | | | to convert 100,000 DEM to Israeli Shekels last |
| are considered a protection against deteriorating | | | | year and invest them in a liquid deposit with an |
| terms of trade.If export prices fall or import | | | | Israeli bank - he will have ended up earning an |
| prices surge - the exchange rate will adjust itself | | | | interest rate of 12% annually. The exchange rate |
| to reflect the new flows of currencies. The | | | | did not change appreciably - so he would have |
| resulting devaluation will restore the | | | | needed the same amount of Shekels to buy his |
| equilibrium.Floating rates are also good as a | | | | DEM back. On his Shekel deposit he would have |
| protection against "hot" (speculative) foreign | | | | earned between 12-16%, all net, tax free profit.No |
| capital looking to make a quick killing and vanish. | | | | wonder that Israel's foreign exchange reserves |
| As they buy the currency, speculators will have | | | | doubled themselves in the preceding 18 months. |
| to pay more expensively, due to an upward | | | | This phenomenon happened all over the globe, |
| adjustment in the exchange rates. Conversely, | | | | from Mexico to Thailand.This kind of foreign capital |
| when they will try to cash their profits, they will | | | | expands the money supply (it is converted to |
| be penalized by a new exchange rate.So, floating | | | | local currency) and - when it suddenly evaporates |
| rates are ideal for countries with volatile export | | | | - prices and wages collapse. Thus it tends to |
| prices and speculative capital flows. This | | | | exacerbate the natural inflationary-deflationary |
| characterizes most of the emerging economies | | | | cycles in emerging economies. Measures like |
| (also known as the Third World).It looks surprising | | | | control on capital inflows, taxing them are useless |
| that only a very small minority of these states | | | | in a global economy with global capital |
| has them until one recalls their high rates of | | | | markets.They also deter foreign investors and |
| inflation. Nothing like a fixed rate (coupled with | | | | distort the allocation of economic resources.The |
| consistent and prudent economic policies) to quell | | | | other option is "sterilization": selling government |
| inflationary expectations. Pegged rates also help | | | | bonds and thus absorbing the monetary overflow |
| maintain a constant level of foreign exchange | | | | or maintaining high interest rates to prevent a |
| reserves, at least as long as the government | | | | capital drain. Both measures have adverse |
| does not stray from sound macro-economic | | | | economic effects, tend to corrupt and destroy |
| management. It is impossible to over-estimate the | | | | the banking and financial infrastructure and are |
| importance of the stability and predictability which | | | | expensive while bringing only temporary |
| are a result of fixed rates: investors, businessmen | | | | relief.Where floating rate systems are applied, |
| and traders can plan ahead, protect themselves | | | | wages and prices can move freely. The market |
| by hedging and concentrate on long term | | | | mechanisms are trusted to adjust the exchange |
| growth.It is not that a fixed exchange rate is | | | | rates. In fixed rate systems, taxes move freely. |
| forever. Currencies - in all types of rate | | | | The state, having voluntarily given up one of the |
| determination systems - move against one | | | | tools used in fine tuning the economy (the |
| another to reflect new economic realities or | | | | exchange rate) - must resort to fiscal rigor, |
| expectations regarding such realities. Only the | | | | tightening fiscal policy (=collect more taxes) to |
| pace of changing the exchange rates is | | | | absorb liquidity and rein in demand when foreign |
| different.Countries have invented numerous | | | | capital comes flowing in.In the absence of fiscal |
| mechanisms to deal with exchange rates | | | | discipline, a fixed exchange rate will explode in the |
| fluctuations.Many countries (Argentina, Bulgaria) | | | | face of the decision makers either in the form of |
| have currency boards. This mechanism ensures | | | | forced devaluation or in the form of massive |
| that all the local currency in circulation is covered | | | | capital outflows.After all, what is wrong with |
| by foreign exchange reserves in the coffers of | | | | volatile exchange rates? Why must they be fixed, |
| the Central bank. All, government, and Central | | | | save for psychological reasons? The West has |
| Bank alike - cannot print money and must | | | | never prospered as it does nowadays, in the era |
| operate within the straitjacket.Other countries peg | | | | of floating rates. Trade, investment - all the areas |
| their currency to a basket of currencies. The | | | | of economic activity which were supposed to be |
| composition of this basket is supposed to reflect | | | | influenced by exchange rate volatility - are |
| the composition of the country's international | | | | experiencing a continuous big bang. That daily |
| trade. Unfortunately, it rarely does and when it | | | | small fluctuations (even in a devaluation trend) are |
| does, it is rarely updated (as is the case in Israel). | | | | better than a big one time devaluation in restoring |
| Most countries peg their currencies to arbitrary | | | | investor and business confidence is an axiom. |
| baskets of currencies in which the dominant | | | | That there is no such thing as a pure floating rate |
| currency is a "hard, reputable" currency such as | | | | system (Central Banks always intervene to limit |
| the US dollar. This is the case with the Thai | | | | what they regard as excessive fluctuations) - is |
| baht.In Slovakia the basket is made up of two | | | | also agreed on all economists.That exchange rate |
| currencies only (40% dollar and 60% DEM) and | | | | management is no substitute for sound macro- |
| the Slovak crown is free to move 7% up and | | | | and micro-economic practices and policies - is the |
| down, around the basket-peg.Some countries | | | | most important lesson. After all, a currency is the |
| have a "crawling peg". This is an exchange rate, | | | | reflection of the country in which it is legal tender. |
| linked to other currencies, which is fractionally | | | | It stores all the data about that country and their |
| changed daily. The currency is devalued at a rate | | | | appraisal. A currency is a unique package of past |
| set in advance and made known to the public | | | | and future with serious implications on the |
| (transparent). A close variant is the "crawling | | | | present. |
| band" (used in Israel and in some countries in | | | | |