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Working Paper 2010-05: Monetary and exchange rate policy issues in Pacific Island countries

Date

Against the backdrop of the global economic crisis, this paper reviews the recent application of monetary and exchange rate policies for a group of Pacific island countries that have their own currencies. These countries are Papua New Guinea, Fiji, Solomon Islands, Samoa, Tonga and Vanuatu.

The global economic crisis impacted Pacific island countries principally through inflation, commodity prices and trade channels, and in some cases through remittances and tourism as well. Banking crises in the countries surveyed were avoided. High volatility in cross-border capital flows - evident in the East Asian region and elsewhere - was largely absent, and not a disruptive influence for most Pacific island countries.

During the global economic crisis, monetary policies in the surveyed Pacific island countries addressed multiple problems including high inflation, substantial changes in the terms–of-trade, exchange rate overvaluation, falling foreign currency reserves, balance of payments difficulties, rapidly changing liquidity and falling output. One of the objectives in this paper is to explore how monetary policy instruments were assigned to deal with these interrelated problems and the roles played by different exchange rate regimes in the context of short-term economic stabilisation.

A number of Pacific island countries with fixed exchange rates suffered a loss of exchange rate competitiveness and a fall in exports during the global economic crisis. One question that arises, therefore, is whether greater flexibility in exchange rates could have acted as a shock absorber in the short-term, and have enabled these countries to cope better with the crisis. It is concluded that greater downward exchange rate flexibility could have avoided a loss of competitiveness and currency overvaluation which would have worked to protect exports. However, greater exchange rate flexibility in response to the shock represented by the global economic recession may not have strongly countered the recession-induced decline in exports in the short-term, but could be expected to have favourable impacts over the medium to longer term.

For two countries - Fiji and Solomon Islands - exchange rates became substantially overvalued as the global recession exposed deeper underlying structural balance of payments difficulties. These countries face the challenge of restoring adequate and sustained internal and external balance in the period ahead. Policy options and assignment issues are reviewed.